Alibaba is audited by the Hong Kong member firm of PwC, or at least that is what the audit opinion says. I am a bit skeptical about that claim. While there may be a Hong Kong partner assigned to the account, I will bet dollars to donuts that a large portion of the hours on the audit were done by mainland staff. This raises the question of whether the audit should have been signed by PwC’s mainland member firm instead of the Hong Kong member firm.
Who signs the audit report matters to investors. I have read bloggers who are arguing that investors should trust the Alibaba accounts because the Hong Kong member firm of PwC and not the mainland member firm audited them. The mainland firm is currently appealing a judge’s order to suspend them from practice before the SEC – a ban that does not apply to Hong Kong. I have previously written about the practice of signing China reports in Hong Kong and said it is the same consumer fraud as a Chinese shirt maker sewing ‘Made in Italy’ labels on shirts made in Wenzhou.
Of course, PwC in Hong Kong could be auditing Alibaba using only its own staff. That seems unlikely to me based on Alibaba’s disclosures. Alibaba says that: “Substantially all of our employees are based in China” and 94% of facilities are located at Alibaba’s headquarters in Hangzhou. To audit Alibaba, PwC needed to spend a lot of time on the ground in Hangzhou. Now, they could have flown in staff from Hong Kong to do it, but why would they do that when there is a PwC office in Hangzhou and PwC’s biggest China office down the road in Shanghai? That said, since firms often measure partner performance based on use of staff from their own group, I have seen entire engagements done with fly-in teams despite having a local office next door that could do the work much cheaper.
While PwC says nothing in their report about who actually did the audit, Alibaba tells us that the mainland firm played a support role and if the mainland firm were banned from practice Alibaba might get delisted. Obviously, the mainland firm must be playing a significant role in the audit. According to Alibaba:
If the affiliate of our independent registered public accounting firm were denied, temporarily, the ability to practice before the SEC, we would need to consider with our Hong Kong based auditor the alternate support arrangements they would need in their audit of our operations in mainland China. If our auditor were unable to have alternate support arrangements or otherwise were unable to address issues related to the production of documents pursuant to Section 106 of the Sarbanes–Oxley Act of 2002, and we were unable to timely find another independent registered public accounting firm to audit and issue an opinion on our financial statements, our financial statements could be determined to not be in compliance with the requirements of the Exchange Act. Such a determination could ultimately lead to delisting of our ordinary shares from the New York Stock Exchange or Nasdaq Global Market or deregistration from the SEC, or both. Moreover, any negative news about the proceedings against these audit firms may adversely affect investor confidence in companies with substantial mainland China based operations listed in the U.S. All these would materially and adversely affect the market price of our ADSs and substantially reduce or effectively terminate the trading of our ADSs in the United States.
Under PCAOB auditing standards the audit report needs to be signed by the 'principal auditor'. The question presented is whether PricewaterhouseCoopers Hong Kong or PricewaterhouseCoopers Zhong Tian LLP is Alibaba’s principal auditor. A briefing paper for the April 2010 PCAOB Standing Advisory Group meeting explained the rules:
AU sec. 543 explains that the auditor considering whether he or she may serve as principal auditor may have performed all but a relatively minor portion of the work, or significant parts of the audit may have been performed by other auditors. In the latter case, the auditor must decide whether his or her own participation is sufficient to enable the auditor to serve as the principal auditor and to report as such on the financial statements. In deciding this question, the auditor should consider, among other things, the materiality of the portion of the financial statements he or she has audited in comparison with the portion audited by other auditors, the extent of his or her knowledge of the overall financial statements, and the importance of the components he or she audited in relation to the enterprise as a whole.
This issue has presented itself so many times with Chinese reverse mergers that the PCAOB issued a Staff Audit Practice Alert warning that many CPA firms were outsourcing the audit work to mainland CPA firms and improperly claiming to be the principal auditor:
If an issuer has no significant operations other than those in another country, a registered public accounting firm that plays no significant part in the audit of the foreign operations is highly unlikely to have sufficient participation in the audit to serve as the issuer's principal auditor. A lack of sufficient participation cannot be overcome by using the work of the other auditor, even if the firm assumes responsibility for that work.
Based on Alibaba’s disclosures of the risks associated with PwC Zhong Tian LLP getting banned by the SEC, it is apparent that the mainland offices played a significant part in the audit. But did the Hong Kong firm retain enough work to justify being the principal auditor? There is no way to tell. PwC gets to make the call, although the PCAOB might second-guess it should they ever be allowed to come to Hong Kong to inspect PwC.
The PCAOB has a proposal outstanding to require firms to disclose in the audit report the names, locations, and extent of participation (as a percentage of total audit hours) of other public accounting firms that took part in the audit. The Alibaba situation shows how important that proposal is to the integrity of the capital markets. The proposal will not be effective in time for the Alibaba offering, but Alibaba and PwC should voluntarily disclose this information.