The Ministry of Finance issued important provisional regulations on CPA practices carrying out audit services for PRC enterprises listed outside China. The rules were proposed a little over a year ago, freaking out Hong Kong CPAs who saw their livelihood disappearing.
The new rules take effect on July 1, 2015. They will require foreign CPA firms that audit overseas listed Chinese companies to cooperate with a Chinese CPA firm that has at least 25 CPAs. An exception exists for companies with Hong Kong, Macau or Taiwan auditors that have more than 50% of the shares held be persons in those provinces that will be allowed to continue present arrangements. I think few public companies will qualify for the exception.
I believe these rules were directed at the small US CPA firms that audit Chinese firms that mostly came to market through reverse mergers. Most of these firms clients trade thinly, if at all, on the OTCBB or Pink Sheets. Chinese regulators have expressed frustration that Chinese auditors have been tarred with the poor performance by some of these firms in detecting fraud. Many of the companies that use small US CPA firms are likely to have difficulty getting audits done under the new regulations. The auditor will have to align with a Chinese CPA firm yet still do enough work to be considered the principal auditor. The PCAOB has punished firms that outsourced the entire audit to a local firm. In any event, the economics of the business have changed, since the CPA firms are now going to have to share fees with a local firm. This may be the final straw that leads some of these firms to abandon the market.
The proposed rules should pose no problem for the Big Four, which audit nearly all of the Chinese companies listed on NASDAQ or the NYSE. Most of the audit work on overseas listed Chinese companies is already done by the mainland affiliates of the firms, and for those situations (like Alibaba) where the Hong Kong member firm signs the audit, the Hong Kong office can easily cooperate with the mainland firm.
The regulation will likely increase the number of cases where the issue of principal auditor arises. The principal auditor must sign the report, and if the majority of the audit work is outsourced, probably cannot argue it is the principal auditor. MOF responded to criticism that the proposal might create problems with International Standard of Auditing 600 by indicating their rules are not contradictory with ISA 600 – indeed they are not contradictory, yet they may lead to the mainland firm being the principal auditor.
I have previously written about KPMG’s practice of signing all audit reports in Hong Kong. I note that has begun to change. NASDAQ listed China XD Plastics Company Ltd. recently changed its auditor from KPMG Hong Kong to KPMG mainland. The CFO told me this was mutually agreed between the company and KPMG and was motivated by the attention to the principal auditor issue at Alibaba.