Postings | China Accounting Blog | Paul Gillis


China accounting market is turbulent

For many years I have been analyzing the accounting market in China based on data released by the Chinese Institute of CPAs. The data tell an interesting story of the development of the accounting profession.

Here are the top ten firms for 2018:

Among the more notable observations is that only one purely local firm (Pan China) has made the top ten. Most people consider all of the non-Big Four firms to be local, however. Unlike the Big Four, which tend to be managed from Hong Kong, local firms (including those with global affiliations) tend to have local Chinese leaders. Last year there were two purely local firms in the list, but Shinewing, once thought likely to lead the profession, dropped out of the top ten.

With the exception of PwC, the Big Four enjoyed strong growth rates in 2018. The Big Four grew 8% in 2018, while local firms (including those affiliated with international networks grew at a slower pace of 6.1%. While the Big Four grew faster until the global financial crisis, local firms then enjoyed faster growth rates until 2016, when the Big Four once again began growing faster.

Rubio proposes to delist Chinese companies

Senator Marco Rubio has introduced the Equitable Act—an acronym for Ensuring Quality Information and Transparency for Abroad-Based Listings on our Exchanges. The act would serve to resolve the longstanding conflict over the inability of the Public Company Oversight Board to examine the work of Chinese auditors that report on the financial statements of US listed Chinese companies.

There are presently over 156 Chinese companies traded on US exchanges with a market capitalization of over $1.2 trillion, including widely held Alibaba Group Holdings (NYSE: BABA).

The PCAOB has long been blocked by China from inspecting Chinese accounting firms (including the Chinese member firms of the Big Four). China argues that allowing the US to enforce US laws on Chinese soil against Chinese persons violates its national sovereignty and risks disclosure of state secrets. US investors suffer because fraud prone Chinese companies are not subject to the same regulatory oversight as other companies that trade on US exchanges.

Update on VIEs in China

Almost seven years ago I wrote what became the seminal article on the use of variable interest entities in China. The article has been cited many times both in academic publications as well as in Congressional hearings.

I have updated the article together with my former student, Fredrik Oqvist, who has spent much of his early career on this topic. The article was published by GMT Research, a Hong Kong based accounting research firm. GMT Research does excellent work on Chinese companies and I commend their newsletter to anyone investing in this sector.

They have given me permission to repost the article here.


New tax law to drive out expats

bChina reformed its individual income tax system last year, and changes that will take effect in 2021 are likely to drive many expatriates out of China.

China started an individual income tax shortly after opening up began. Initially, only foreigners paid the tax largely because most local nationals did not earn enough to pass the thresholds. Income has risen spectacularly in recent decades, yet finance officials believe that only 2% of the population actually pays income taxes (in 2015 28 million people paid while it is thought 187 million should be paying). I expect to see much stricter enforcement in coming years.

Those who pay tend to be employees whose employers withhold the tax. That means the tax burden tends to fall on urban professionals. Rich people and those operating in the shadow economy find it easy to evade taxes.

Tax reform will lower the tax burden on lower- and middle-income people, while leaving the top rates intact. China has a progressive tax system with rates topping out at 45% on income over 960,000 RMB (US$143,000).

PCAOB enlists in the trade war

The SEC and PCAOB jointly released a statement on the challenges they face with respect to access to China to regulate U.S. listed Chinese companies. There is nothing new in this statement, but it is noteworthy because of its existence and timing.

For those have not been following the issue, the PCAOB is mandated by Sarbanes-Oxley to inspect accounting firms that audit U.S. listed companies, including foreign accounting firms. When the PCAOB attempted to come to China to inspect firms (mainly local affiliates of the Big Four) auditing U.S. listed companies China blocked them on the basis of national sovereignty. Attempts to find alternatives also foundered on arguments that the working papers might contain state secrets. The PCAOB was also blocked from inspecting Hong Kong firms to the extent the work related to the mainland.

After the wave of frauds by U.S. listed Chinese companies in the past ten years, the SEC finally got fed up with the intransigence of the Big Four firms about producing their working papers and brought charges against the firms. The firms argued to a SEC administrative trial judge that they were caught between a rock and hard place, having to decide whether to break Chinese or American law, and the judge appropriately observed that if that were the case, it was only because the firms put themselves in that position when they decided to do U.S. audits for Chinese companies. The judge threw the book at the Big Four, and BDO. The firms appealed and settled with the SEC paying a $500,000 penalty each and promising not to sin again.

HK to require clean audit opinions

Here is a guest post from a reader about an important change in the acceptance of qualified and disclaimer audit opinions. US exchanges do not accept these opinions and I have only seen them in textbooks, never in the wild. I understand thay have been accepted in Hong Kong, and the change is appropriate.

Charles Dery, CFA +1 (438) 558-5498 Twitter:@Lyra_Insight




In this article, we summarize in a few bullet points HKSE’s consultation paper on new 13.50A rule – which will suspend trading on companies with weak internal control/fraudsters leading to auditor disclaimer or adverse of opinion.

Full paper here (25 pages):


“The Exchange will normally require suspension of trading in an issuer’s securities if it publishes a preliminary results announcement for a financial year as required under rules 13.49(1) and (2) and the auditor has issued, or has indicated that it will issue, a disclaimer of opinion or an adverse opinion on the issuer’s financial statements. The suspension will normally remain in force until the issuer has addressed the issues giving rise to the disclaimer or adverse opinion, provided comfort that a disclaimer or adverse opinion in respect of such issues would no longer be required, and disclosed sufficient information to enable investors to make an informed assessment of its financial positions.”

Who services VIEs?

This is another guest posting by my former student Fredrik Oqvist. I find it unsurprising that PwC has a dominant market share among accounting firms since this firm invented the use of the VIE structure in China.

As we move along thetrove of VIE dataanother thing that I think is interesting to look at is who is servicing the VIEs? VIEs are usually not set up by the companies themselves but by advisors in legal and sometimes accounting.

Traditionally a lot of focus has been placed on the accounting firms, which is natural as the VIE entity itself is something of an accounting creation. Spawned in the aftermath of the Enron scandal to prevent accounting shenanigans, it was the reinterpreted to allow for the listing of Chinese companies in restricted sectors.

But since it is primarily the work of advisors, it seems prudent for us to have some idea of who these advisors are, and how they rank among themselves. In order to do this I looked at both who audits VIE’d companies and who the legal advisor is.

Statistics on VIE usage 2018

This is a guest post from Fredrik Oqvist, a former student who has long focused on VIEs. Fredrik has posted this on his blog.

After a number of requests from professionals and people in academia I decided to use the summer to renew my statistics on VIE usage. As the last one waspublished in 2011, it seemed like it was about time.

I used a list I foundonlineand added in newer IPOs and cleaned up some delistings etc., but as I don’t have access to Bloomberg I can’t guarantee I was able to find all the US-listed Chinese companies. If someone has a better list please feel free to send it over and I’ll update the statistics based on that. All the data was lifted from SEC filings, and encompasses the NYSE and NASDAQ listed Chinese companies.

Although the total number of companies in my sample is down significantly, the percentage of companies using VIEs is up by quite a margin. Given that newer listings, even in 2011, display a higher percentage of VIE usage overall, this is not very surprising, but it does highlight that the importance of understanding VIE structures is if anything more important now than before.

The Big Four are back in China

I have been tracking the development of the accounting profession in China for many years. I have published on this blog a ranking of the top 100 CPA firms in China since 2011 based on data published by the Chinese Institute of CPAs (CICPA). The CICPA published this informational annually in the same format, but suddenly stopped after pubilshing 2015 data in 2016. But they have now published data for 2017, albeit in a slightly different form. It is not entirely clear whether the reported numbers are comparable. Here are the rankings for 2017:

The rankings have changed quite a bit. The last two years have been very good for the Big Four, which have grown 20% while local firms experienced a minor decline in revenue of less than 1%. The Big Four share of the Top 100 market has grown from 27% to 34%, a remarkable reversal of the market share declines of earlier years.

I believe that the poor performance of local firms can be explained by regulatory actions. Early in 2017 Chinese regulators shut down two of the largest local firms for several months due to audit failures. Ruihua, which was ranked second in 2015 and which I thought might climb over PwC to first place, experienced a revenue decline of 29%. BDO, ranked third in 2015, slide to fourth with anemic revenue growth of 5%. While I support strict audit regulation, I fear that the Chinese system is unfair to large local firms that audit thousands of listed companies.

Hong Kong audit reform falls short

Five years ago Hong Kong’s capital markets were dealt a humiliating blow by the European Union (EU). Hong Kong was removed from a list of jurisdictions deemed to have regulatory equivalency with the EU. The move happened because Hong Kong did not have an effective independent audit regulator, since the auditing profession in Hong Kong was self-regulated by the Hong Kong Institute of CPAs. I have written many times about how the HKICPAs is a feckless regulator, reluctant to take on the big firms and when it is finally forced to enforce the rules, doling out miniscule penalties.

It has taken five years, but finally Legco (Hong Kong’s legislative body) is preparing to take action. The Financial Reporting Council (Amendment) Bill of 2018 is working its way through the legislative process in Hong Kong. Unfortunately, the proposal falls far short of what is needed. I fear that the legislators have fallen into the trap of finding themselves up to their ass in alligators while forgetting that their original objective was to drain the swamp. The proposal has the fingerprints of the profession all over it, and has been weakened to the point of being mostly useless.

Spinoffs - Chinese style

Spinoffs are situations where a corporation disposes of part of its business by giving shares in the business to shareholders. When they work, the value of the parts is greater than the value of the whole. “Spinoffs” of US listed Chinese companies work differently.

A favorite transaction of US listed Chinese companies is to "spin off" parts of the business in a new entity in an IPO transaction. Shareholders of the parent company are not distributed shares of the company that does an IPO although they may benefit if the value of the underlying shares is recognized in the stock price. There have been a number of these transactions and several in the pipeline.

I have observed, however, that the biggest winners in these transactions appear to be members of management. Management typically ends up with a big chunk of these deals which are structured in a way that does not report as expense the value transferred to them.

Rather than point to a specific transaction, I am going to examine these transactions through a straw man. When I look at specific transactions, I find the public documents obscure what is going on and add bells and whistles that do not alter the essence of the transaction while providing arguments to counter any attacks on the structure. So, the transaction I describe below is fictitious, although I think fairly represents what is going on. I leave it to others to apply this to specific transactions. I apologize, but this simplified example is still complicated as hell.

ZTE - Where were the auditors?

The US Department of Commerce has banned Chinese tech company ZTE (HK 763) from purchasing American components for seven years. Because American components are essential to its products, there is serious doubt as to whether the company can survive. The stock has been suspended from trading on the Hong Kong Stock Exchange.

The ban came about as a result of ZTE violating the terms of a settlement agreement entered into as part of its 2017 guilty plea for conspiracy to sell telecommunications equipment to Iran and North Korea that included American components that are forbid for export to those countries. ZTE agreed to pay a fine of $892 million and be under probation for seven years. An additional penalty of $300 million was suspended provided ZTE complied with the terms of the probation, which it is reported included the requirement for ZTE to fire four top executives and discipline 35 other employees. ZTE did fire the top executives, but instead of punishing the other employees it paid them bonuses. ZTE was also required to undergo independent compliance audits related to its observation of export controls.

What does the trade war mean for accounting?

Donald Trump has declared a trade war against China by threatening higher import tariffs on $153 billion of Chinese exports. China has said it is only polite to reciprocate.

Services are not subject to import duties, but China has shown no qualms about punishing foreign business for the sins of their government. The Big Four are technically not American companies. The operations in China are not subsidiaries, but more like franchises owned and operated mostly by local Chinese. But they are generally viewed as American and may face regulatory crackdowns and may see an acceleration of the process of transferring major accounts to local CPA firms. Some smaller US CPA firms operate in China in ways that are technically illegal under Chinese law and would be easy to crack down on.

It would be easy for the Chinese to crack down on the Big Four. They simply need to strictly enforce their own rules. Few audits can survive a critical examination by regulators, evidenced by the high rate of audit deficiencies identified during inspections by the Public Accounting Oversight Board (PCAOB) of domestic firms. Earlier this year China temporarily banned several local firms for audit deficiencies. The Big Four had best watch their back.

The China Hustle

A documentary on the many stock frauds in China was released this past weekend.

I have a cameo role in the movie, which has a rating of 74% on Rotten Tomatoes. It was released by Magnolia Pictures (owned by Mark Cuban) and is available for streaming and in selected theatres.

I think it is worth watching as a good review of the past decade in China investing.

KPMG in deep trouble in HK

Matt Miller of Reuters has an interesting update on the troubles KPMG is having in Hong Kong with a failed US listed Chinese company. In my view the problems are of its own making.

KPMG Hong Kong was the auditor of China Medical Technologies Inc., which failed after management was charged by the US Securities and Exchange Commission with looting over $400 million from the company. The company was put into liquidation in 2012 in the Cayman Islands, where it was incorporated.

Actually, KPMG Hong Kong was not the auditor, and that is the problem.

Several years ago I wrote about KPMG’s labeling problem where they had a practice of using Hong Kong letterhead to sign audit opinions on audits done by KPMG Huazhen, KPMG’s China affiliate. To me, this was like a Wenzhou shirt maker sewing a made in Italy tag on a shirt made in China.

KPMG Hong Kong issued the audit report, yet when liquidators asked to see their working papers they said they did not have them since the actual audit was done by KPMG Huazhen, its mainland affiliate which was prohibited under Chinese law from sharing them. Auditing standards require that the principal auditor sign the audit report. Only the principal auditor can sign the report. It appears that KPMG Huazhen was the principal auditor of China Medical and should have signed this audit report. Had they done it right, this case would never have ended up in a Hong Kong court.

HK races to bottom in corp gov

The Hong Kong Stock Exchange (HKSE) has issued its latest proposal to weaken corporate governance standards in order to attract Chinese listings that have gone to the US. The US has won most of the listings of China's privately held companies, including bellwethers Alibaba, Baidu and Sina. There are several reasons for that, including the fact that the US permits weaker governance than Hong Kong or China, and that fees for investment bankers are considerably higher with US listings. The weaker governance rules led to the NYSE winning the Alibaba listing over the HKSE. Hong Kong faced the possibility it would not win another major IPO from China because most Chinese founders want a controlling vote, even when they no longer hold a majority of the shares.

Much to the consternation of corporate governance advocates, Hong Kong proposes allowing control structures (called weighted voting rights - WVR). Shareholder advocates in the US have opposed the proliferation of these structures in technology companies. Hong Kong is also proposing to relax other listing standards related to profitability.

Drown HK audit regulation in a bathtub

Hong Kong has finally releasedproposed legislation(over 250 pages) to reform audit regulation in Hong Kong. This processbegan in 2014after the European Union withdrew regulatory equivalency from Hong Kong citing its ineffective system of audit self-regulation. Although most members of the profession publicly supported the proposed legislation, privately they have been resisting it, which is why the process has taken so long.

If the legislation is enacted, the Financial Reporting Council (FRC) will become the regulator of auditors of public interest entities in Hong Kong, much as the US’s PCAOB and Canada's Public Accountability Board (CPAB) took over regulation of auditors of public companies in the US and Canada.

Section 20F provides that the HKICPA Council may impose any condition on registration of auditors that it considers appropriate. The PCAOB has refused to register any more Chinese or HK CPA firms on the basis that they are unable to agree to turn over working papers for inspection. The PCAOB has not chosen to revoke existing registrations of firms that are unable to turn over working papers, although it has picked on a couple ofsmall firms. I don’t see that firms will be required to consent to turning over working papers as a condition of registration in Hong Kong.

A lump of Christmas coal for KPMG

It is a bad day for KPMG.Reuters reports that the Hong Kong High Courthas issued a contempt summons to 91 current and former KPMG partners for their failure to hand over audit working papers for US listed China Medical.China Medical is in liquidation and the court apparently has been overseeing the liquidation of Hong Kong subsidiaries. The case is a repeat of an earlier spat with EY over working papers for Standard Water, which was resolved when EY “found” the working papers on a server in Hong Kong.

KPMG says it cannot turn over the working papers without permission from mainland regulators.The US PCAOB reached an enforcement agreement with China that allowed it access to working papers in connection with investigations (but not inspections).Hong Kong has no such arrangements, and this is private litigation.

China has argued national sovereignty and state secrets concerns trump foreign laws requiring the production of documents on Chinese companies listed abroad or doing business abroad.Hong Kong, while part of China, is being treated the same as the United States, presumably to avoid undermining arguments used against the U.S.I seriously doubt there are any state secrets in these working papers.

Shinewing faces huge fine

Chinese regulators have fined leading Chinese CPA firm Shinewing a stunning 4.4 million yuan (US$667,000) for a failed audit of a Chinese listed company. I believe this is the largest fine ever assessed on a CPA firm in China, although many firms have received the death penalty in previous regulatory crackdowns. Earlier this year China's two of China's largest local firms (RSM affiliate Ruihua and BDO affiliate Lixin) faced short term practice bans.

Shinewing was the 9th largest Chinese CPA firm in 2015, the latest year for which CICPA data has been released. Shinewing developed from the former joint venture between Coopers & Lybrand and CITIC. It did not join PWC when PW merged with C&L. Shinewing has long held a reputation of being one of the high quality local CPA firms, although it has not gained the market share that its larger competitors obtained by aligning with second-tier networks like RSM and BDO.

It is a good thing that Chinese regulators are getting tough on CPA firms, since these firms play a vital role in the development of China's capital markets.

Copyright 2018 Paul L. Gillis all rights reserved