The market for auditing U.S. listed Chinese companies is dominated by the Big Four. In 2009 the Big Four collected 96% of the audit fees for Chinese companies listed on the NYSE and 72% of the fees for Chinese companies listed on NASDAQ. During the boom in U.S. IPOs in the middle of the last decade the Big Four were completely tapped out and did not have the capacity to serve many smaller IPOs, even if they had wanted to. While they took on some of these companies as the market slowed with the great recession, they have come to regret most of those decisions. Smaller listed companies, and the many companies that came to market as reverse mergers, have used smaller accounting firms. Few Chinese CPA firms have shown any interest in the market serving U.S. listed Chinese companies, so most of this work has gone to small U.S. accounting firms that specialize in smaller public companies.
Some of these smaller U.S. based CPA firms were found to have outsourced most of the work to local Chinese CPA firms. In 2010 the PCAOB issued a Staff Audit Practice Alert that indicated that some firms were outsourcing substantially all of the audit work. The PCAOB also found that some audit partners were not capable of reading or speaking Chinese and accordingly could not communicate with their clients or read source documents. In the wake of that Alert several firms decided to open offices in China
I have found six U.S. CPA firms that have opened offices in China. The six exclude the Big Four and second tier global firms that have member firms in China. These six firms are:
Marcum Bernstein & Pinchuk LLP (New York)
Friedman LLP (New York)
GHP Horwath P.C. (Denver)
Kabani & Company, Inc. (Los Angeles)
MaloneBailey LLP (Houston)
Sherb & Co. LLP (New York)
These are not large firms; only Friedman is included among the Top 100 CPA firms in the U.S. by Inside Public Accounting (Friedman is 47th). Marcum, a joint venture partner in Marcum Bernstein and Pinchuk, is 15th. At first impression, opening an office in China would appear to significantly improve audit quality. It allows the firm to hire local accountants with a deeper understanding of local language, culture and business practices. Upon closer examination, I am concerned that these firms fall into a regulatory hole that actually increases the risks to investors in companies that these firms audit.
I have learned that some of these firms have set up a wholly foreign owned Chinese subsidiary (known locally as a WFOE) to operate their China offices. None of the firms responded to an email requesting information on how they operate in China. It is not clear whether the WFOE is the structure that they are all using, but the options available to a foreign accounting firm that wishes to operate in China are limited. A foreign accounting firm cannot set up an auditing office in China. They can obtain a temporary audit practice certificate, which allows them to come to China to audit clients, but that certificate does not allow them to hire staff or rent office space. Under Chinese law, only licensed Chinese CPAs can own an interest in a Chinese CPA firm (a special exception for the Big Four expires beginning next year). As a consequence, it appears that the entities have been organized as consulting companies, which can be owned by foreigners. Their authorized business scope would not include auditing, yet the websites and recruiting advertisements of some of these firms indicate that is what the China WFOE does. The Ministry of Finance (MOF) is responsible for regulating accounting firms in China. Should MOF determine that the company was illegally doing audits through a WFOE, they could fine the companies five times their illegal revenues and shut them down. They have done it before. Arthur Andersen was caught during the 1990s auditing through their consulting WFOE and paid a significant fine to keep their right to do business in China.
The other problem these CPA firms potentially face is with the PCAOB. Every firm that performs a significant role in the audit of a U.S. listed company must register with the PCAOB. The registration requirement applies to each legal entity in the firm, which explains why the Big Four have separate registrations for each of their operations. However, of the six firms that have opened offices in China, and presumably established a WFOE, only Kabani has registered the China WFOE with the PCAOB. Even if the other firms were able to register, the PCAOB is unable to visit China to inspect their work.
The risk to investors is that either the MOF or the PCAOB shuts these firms down. If it were to happen in the midst of an audit the company may be unable to timely produce audited financial statements, jeopardizing their listing. Shareholders and audit committee members ought to be holding the auditor's feet to the fire on this issue.