Turning the tables
In a development that is likely to transform the accounting professions in Hong Kong and Mainland China, Chinese accounting firms are gaining access to one of the most lucrative markets for accounting services. On December 10, 2010, Hong Kong Exchange and Clearing Limited (HKEx) decided to accept financial statements of Mainland companies listed in Hong Kong that are prepared under Chinese accounting standards and audited by Mainland accounting firms. This work had previously been limited to Hong Kong CPAs and had become a significant portion of their work.
In 1993, nine leading Chinese companies were selected to list “H-shares” on the Hong Kong Stock Exchange as a means to raise capital and improve corporate governance. The success of this experiment led to additional listings, and by 2009 there were a total of 152 H-share listings with a market capitalization of US$587 billion. Chinese companies also listed “Red Chips” in Hong Kong, which were the shares of companies incorporated outside the Mainland yet which are controlled by state owned enterprises and which conduct most of their operations on the Mainland. By 2009 there were 97 Red Chips with a market capitalization of US$486 billion. Today, H-shares and Red Chips account for half of the market capitalization of the Hong Kong Stock Exchange. Chinese companies also listed on other international exchanges, with over 300 listed on US exchanges, 140 in Singapore, 80 in London and 47 on the Toronto Stock Exchange. Five of the top ten initial public offerings (IPOs) in the world in 2007 came from China, and Chinese companies account for four of the ten largest IPOs in world history.
International CPA firms, mainly the Big Four, were selected as auditors for all of the overseas listings. Hong Kong Stock Exchange rules required companies to select auditors who were either practicing Hong Kong CPAs, recognized international firms or the Mainland joint ventures of accounting firms with Hong Kong partners (all of which are the Big Four). This rule was a windfall for the Big Four, since they already dominated the Hong Kong market and had offices on the Mainland from which to serve the Mainland companies. By 2007 the Big Four had captured over 98% of the H-Share and Red Chip markets and collected US$874 million in fees annually from these companies.
China tried to protect its nascent CPA profession from being dominated by the Big Four as is the case in many other markets. Chinese authorities often voiced aspirations for creating China’s own international CPA firms capable of competing with the Big Four both in China and abroad. The rapid movement of Chinese companies to international capital markets and an explosion in foreign direct investment by the multinational clients of the Big Four doomed those plans. Many of the large domestic companies listed on more than one stock exchange (57 of the 152 H-shares also listed A shares on the Mainland), and selected international auditors for their Chinese listing to avoid duplicate auditing costs. By 2007 the Big Four had captured 33% of the total CPA firm market in China measured by revenue. For the Shanghai and Shenzhen Stock Exchanges, the Big Four earned 62% of the audit fees while auditing only 7% of the companies. China’s largest corporations had become some of the largest in the world, and paid world class auditing fees – as high as US$33 million for the Bank of China in 2007.
Opening up the accounting market in Hong Kong
The Chinese Institute of CPAs decided in May 2007 that it had seen enough of Big Four domination of the Chinese accounting market and issued a policy statement directed at developing larger and more competitive Chinese accounting firms. A goal was set to develop 100 accounting firms of significant scale to come into being in 5 to 10 years. In addition, about 10 accounting firms are to become internationalized and be capable of serving Chinese companies globally. These larger firms are expected to follow international standards and develop unified networks, quality control systems, financial, human resource and information technology support. Firms are encouraged to follow their clients overseas, and to seek partnerships with other accounting and consulting firms in both domestic and international markets. The State Council supported this plan in 2009 with Document 56.
Mainland regulators realized that international firm’s domination of the market serving large overseas listed companies was a major obstacle to the development of large Chinese firms and set out to level the playing field. The first step was to bring Chinese accounting standards in line with international practice. New Chinese accounting standards (CAS) were released in 2006 that were substantially based on International Financial Reporting Standards (IFRS) and commitments were made in 2009 to eliminate the few remaining differences between CAS and IFRS by 2011. The Hong Kong Stock Exchange accepted financial statements prepared under either Hong Kong Financial Reporting Standards (HKFRS) or IFRS. Since HKFRS and IFRS were substantially converged in 2005 there are normally no differences between accounts prepared on either standard. Chinese companies listed on both the Hong Kong and Chinese stock exchanges were required to prepare two sets of accounts, one under CAS and the other under HKFRS or IFRS. In December 2007 the China Accounting Standards Committee and the Hong Kong Institute of Certified Public Accountants (HKICPA) signed a joint declaration on the convergence of CAS and HKFRS as well as the convergence of Mainland and Hong Kong auditing standards. In August 2009, recognizing the convergence of CAS with IFRS, Hong Kong Exchanges and Clearing Limited, issued a consultation paper recommending that Chinese companies be permitted to submit financial statements prepared under CAS.
The next issue was allowing Mainland auditors to issue reports accepted in Hong Kong. HKSE rules required that the reports not only be issued by an accountant qualified in Hong Kong, but also by a qualified accountant resident in Hong Kong. Perhaps recognizing the inevitability of change HKICPA issued a consultation paper in January 2009 proposing changes to qualification requirements. It proposed that Hong Kong CPAs residing on the Mainland could obtain practicing certificates and Mainland experience would satisfy the one year local experience requirement. These changes would allow Mainland based auditors to sign reports used in Hong Kong, provided they first secured the necessary qualifications as Hong Kong CPAs.
This proposal did little to pacify Mainland authorities because it simply made it easier for Hong Kong CPAs to practice on the Mainland. Many Hong Kong CPAs had moved to the Mainland, including large numbers with Big Four firms and the proposal would make it easier for them to maintain Hong Kong qualifications. Instead, Chinese regulators opened discussion about allowing reports signed by Chinese CPAs without Hong Kong qualifications to be used in Hong Kong. These discussions were initiated under the Closer Economic Partnership Arrangement (CEPA), a trade agreement between Hong Kong and the Mainland that was signed in 2004. CEPA had been hailed in Hong Kong as opening China’s markets for Hong Kong firms but was now revealing its double edge. Hong Kong CPAs complained that the proposal would jeopardize shareholders, who they claimed rely on what they saw as Hong Kong’s more robust system of corporate governance and auditor supervision, although they may have been more concerned about new competition in their relatively closed market.
Hong Kong Exchange and Clearing Limited (HKEx), regulator and operator of the Hong Kong Stock Exchange, issued a consultation paper in August 2009 to address the issue of accepting Mainland accounting and auditing standards and permitting Mainland audit firms to audit companies listed in Hong Kong. The proposal allowed Mainland CPA firms to register and seek approval from both MOF and CSRC. Once approved the firms would be accepted by HKEx without further vetting by Hong Kong regulators. Mainland regulators would be responsible for continuing oversight and have complete responsibility for any disciplinary actions and sanctions. The regulators agreed to work closely together to facilitate effective regulation. Neither Hong Kong’s Financial Reporting Council or HKICPA would have any enforcement capability against approved Chinese CPA firms. The proposal also granted rights for Hong Kong CPAs to audit the reports of Hong Kong companies listed on Mainland exchanges, although presently no such listings exist. The agreements were proposed to be effective on January 1, 2010 and apply to annual accounting periods beginning on or after that date.
CSRC and MOF jointly announced that they were commencing a pilot program to allow a small number of Chinese CPA firms to audit H-share companies. In order to apply to participate in the program firms needed to meet certain requirements, including having total revenue of at least RMB 300 million, audit revenue of at least RMB200 million and no less than RMB50 million of which came from the auditing public companies. Firms must have 400 staff and no partner can own more than 25% of the firm. Few Chinese CPA firms qualify under these standards.
The proposals ran into significant political headwinds in Hong Kong, all positioned as looking out for shareholder interests and protecting the integrity of Hong Kong’s markets. Although the majority of comments provided to the HKEx stated that they favored the plan, the detailed responses tended to favor significant delays until such time as Mainland standards were fully converged. Most respondents were careful not to offend Chinese regulators with their comments, yet it is apparent that far more concern was being expressed in private. HKICPA came out in favor of the proposal, while expressing reservations about the effectiveness of regulation of Mainland CPAs and hoping that the Mainland would in turn further open its market to Hong Kong CPAs.A survey done by CPA Australia of its members in Hong Kong found an even split, with half favoring and half opposing the change, with 61% believing that the change would result in fewer business opportunities for Hong Kong CPAs in the long term. After considerable delay, the proposal was finalized in October 2010. Another firestorm erupted, and the HKEx was forced to issue a defense of its decision on December 23, 2010. The first company to announce it was implementing the new policy is Tsingtao Brewery, an auspicious selection since it was the first company to list H-shares in Hong Kong when this market opened in 1993. Tsingtao will report under Chinese accounting standards, which it said in its 2009 report resulted in the same total assets and net income as the accounts it prepared under Hong Kong standards. Instead of PricewaterhouseCoopers Hong Kong signing the accounts, they will be signed by PricewaterhouseCoopers Zhongtian. If you ask anyone at PwC, they will tell you that PwC HK and PwC ZT operate as a single firm. The same team that audited Tsingtao before likely continues.
The limited nature of the pilot program (only H-shares and a small number of audit firms) reflects the tendency of Mainland regulators to seek gradual change. However, it is likely the beginning of this experiment portends profound changes in both the Hong Kong and Mainland accounting professions. While the experiment is initially of small scale, its successful execution will likely lead to a rapid and significant expansion.
In the short term few H-share companies can be expected to switch to local firm auditors, mainly because these firms will have limited short term capacity to handle a huge increase in work. Moreover, the types of companies that switch will likely be the smaller H-shares, since the local firms will not have the expertise to handle large, complex companies and the regulators are unlikely to be willing to accept the risk. Over time, however, it is likely the market becomes significantly more competitive as the number of firms qualified to perform H-share audits increases and as they gain experience, expertise and size. The Big Four had 98% of the H-share market by fees in 2007. The increased competition from Chinese firms is likely to put significant pressure on auditing fees, even for those clients ultimately retained by the Big Four. The fees will also decline when the clients no longer need to prepare two sets of accounts. These pricing pressures will likely increase over time. This development creates a great opportunity for the second tier firms like BDO, Crowe Horwath and Grant Thornton (and larger local firms like Shinewing) to increase their market share against the Big Four.
While the H-share market is large by itself, there would appear to be no significant barriers to expanding the rights of Chinese CPAs to audit Red Chips. While these companies are incorporated in Hong Kong, they typically have all of their operations on the Mainland. Furthermore, it is conceivable that the practice rights could some day be extended to all CPA work in Hong Kong, particularly since audit firms based just across Hong Kong’s border in Shenzhen could perform field work on a commuting basis. It is this further expansion that would most threaten Hong Kong’s CPAs. At some point between now and the end of Hong Kong’s status as a Special Administration in 2047 this issue will need to be resolved, and the current developments suggest the resolution will come earlier rather than later.
Much of the criticism of the decision to allow Chinese CPA firms to report on H-shares has been directed at Hong Kong’s agreement to rely on Mainland regulators for regulatory oversight of these firms. Critics imply that Hong Kong’s regulation is more effective than the Mainland, although Hong Kong has not had a history of being a particularly aggressive regulator of accountants, particularly of the Big Four which audit 92% of listed companies by fees in 2007. In 2010, the HKICPA lists only 19 disciplinary orders, all but one against individuals, and none against the Big Four.
In my view, Chinese regulators will be paying close attention to CPA firms that audit companies listed in Hong Kong to avoid a scandal with long term implications for their CPA profession. In that sense, investors are probably better off with this change, since the level of regulatory oversight will most likely be considerably higher than it was before. This may be particularly true for companies that issue both A share and H-shares, since they are under the jurisdiction of the CSRC. This situation is similar to arrangements that the PCAOB has reached with certain European regulators to rely on their regulatory oversight.
companies that issue only H-shares, the situation is less clear. These
companies are similar to the many privately owned Chinese companies that have
listed on U.S. exchanges. The auditors
of these companies escape regulatory oversight, because China will not allow
the PCAOB to enter China to inspect them.
If China does not assert its regulatory jurisdiction over companies
listing only H-shares their auditors will also fall in to these regulatory
holes. I expect that is not going to
happen with H-shares, and I expect the CRSC will claim jurisdiction over them. Investors should watch this space carefully,
however, to make sure the regulatory holes on U.S. listings don’t pop up on Hong Kong listings as well.