On December 20, 2012, the PCAOB announced that the SEC has approved a new auditing standard on communications with audit committees. James Doty, PCAOB Chairman said: "The standard moves the auditor's communication with the audit committee away from compliance checklists, and decisively in the direction of meaningful, effective interchange.”
Among other things, the new rules require that the auditor explain to the audit committee: “The basis for the auditor's determination that the auditor can serve as principal auditor, if significant parts of the audit are to be performed by other auditors.” The principal auditor is the one that signs the audit report. Because of all of the problems with mainland auditors, it matters who signs the audit report.
This change will have a significant effect on auditing practices in China. Driven in large part by Hong Kong Stock Exchange rules, many overseas listed Chinese companies have audit reports issued by the Hong Kong member of the accounting firm. In many of these cases, most, if not all, of the audit is actually conducted by the mainland member firm, yet when investors look to the audit opinion, it references only the Hong Kong firm. The Hong Kong rules were changed a couple of years ago for H-shares and the mainland firm now signs off on many H-shares. Red chips, however, continue to be signed off by the Hong Kong firm.
For H-shares that also have U.S. listings, the Hong Kong firm also typically signs the audit report included with Form 20F. Under the new rules, the auditor is going to need to justify this to the audit committee. I predict they cannot justify this behavior – the Hong Kong firms should have never signed off on work done mostly by their mainland affiliates.
I cannot fathom how the auditors plan to explain to the audit committee that they are the principal auditors if most of the audit is actually done by the mainland affiliate. It is the mainland affiliate that is the principal auditor and shareholders deserve to know that fact.
The rules do not go into effect until years beginning after December 15, 2012, so the firms have another year to come up with a story. Audit committees should not let them off the hook. Audit committees should demand that the firms explain who is the principal auditor now and not wait until next year.
This situation affects many of the big state owned enterprises listed in the U.S. – PetroChina, Sinopec, China Mobile, etc. For private companies listed in the U.S., a quick sample suggests that only KPMG signs off using its Hong Kong firm; the others have the mainland affiliate sign the reports of private companies listed in the U.S. Audit committees of KPMG clients in China should be particularly attentive to the issue.
The problem also extends to Hong Kong. While PCAOB rules do not apply to companies listed only in Hong Kong, international auditing standards contain a similar concept of principal auditor. The problem is that Hong Kong listing regulations still require use of a Hong Kong auditor for red-chips (the requirement has been removed for H-shares). The rules need to change in Hong Kong to reflect the reality – that these audits are actually being done by the mainland affiliate. Hong Kong regulators have learned that this matters. They were recently blocked from accessing audit working papers for Standard Water when Ernst & Young in Hong Kong explained that, although they were the auditors of record, the audit was actually done by their mainland affiliate who could not produce the working papers because of Chinese restrictions.