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What is the end game?

Last week I wrote that the President’s Working Group proposal to make the U.S. Big Four  (the Big Four audit all Chinese companies of any substance) the principal auditors of Chinese listed companies was naïve and unworkable, and that that might have been the plan. The proposal requires the U.S. member firms of the Big Four to assume liability for the audits of their Chinese member firms, and for China to allow the U.S. Big Four to remove audit working papers potentially containing state secrets from China. I don’t believe either will happen. 

The Washington Post has a story that explains this is a well-used tactic of the Trump administration. Propose an unworkable solution and either get your way or force your opponents to spend considerable effort to defeat it.

I understand that the PCAOB is no longer involved in the negotiations. They have been taken over by the White House and the SEC, which is working closely with the Big Four. Some corporate governance types fear the objective is to weaken or eliminate PCAOB inspections, and not just for Chinese companies.  The parties all know that China will not allow the U.S. Big Four to conduct audits in China and to remove working papers. The end game is said to allow the Big Four to self-inspect its China member firm’s audits as a substitute for PCAOB inspections.  

President’s Working Group

The President’s Working Group (PWG) issued its report on July 24, 2020. The report makes five recommendations for the SEC to implement. While the PWG says it has considered the Holding Foreign Companies Accountable Act (HFCAA), it proposes to solve the problem using rules instead of laws—with regulation, not legislation. In my view, the PWG’s proposed solution is both naïve and unworkable. 

The PWG proposes to ban companies from listing on U.S. exchanges after 2022 if the auditor of the company cannot be inspected. New IPOs’ auditors must be inspectable immediately. 

An exception is provided. If a foreign auditor cannot be inspected, it may appoint a U.S. member firm to serve as principal auditor. While existing PCAOB rules allow the U.S. member firm to use the work of foreign affiliates, the proposal requires that the U.S. member firm serve as principal auditor. Under this recommendation, because the U.S. Firm would be the principal auditor and would be required to maintain the work papers in the U.S., the PCAOB would have the ability to inspect the audit work and practices of the U.S. Firm. This is most easily understood with respect to the Big Four audit firms, which audit most U.S. listed Chinese companies by market capitalization. For local Chinese firms not affiliated with U.S. member firms, the solution would be more complicated, but there are few, if any, of these auditing U.S. listed companies. 

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