Bad auditors protected by bad law | China Accounting Blog | Paul Gillis

Bad auditors protected by bad law

The SEC yesterday banned Sherb & Co. from auditing public companies. The firm was also fined an insignificant $75,000 to settle charges related to audit failures on China Sky One Medical, China Education Alliance Inc., and Wowjoint Holdings Ltd., all Chinese reverse mergers.  

Sherb failed to properly plan and execute audits, failed to obtain sufficient audit evidence on sales, revenue, and bank balances, and ignored clear red flags.  

This is the second action by the SEC against Chinese reverse merger auditors in recent months. On September 30, the SEC banned Patricio and Zhao LLC (P&Z) from auditing public companies. P&Z was found to have done a failed audit on Keyuan Petrochemicals, Inc. I expect to see more actions like this against CPA firms that audited reverse mergers in the coming months as the SEC completes its efforts to bring to account the gatekeepers on failed Chinese reverse mergers. 

Both of these firms were based in the United States and had been inspected by the PCAOB. The PCAOB cannot inspect accounting firms in China but since these firms were based in the U.S. they were inspected, even though the act of removing the audit work papers from China likely violated Chinese law. 

In 2010, the PCAOB inspection of P&Z looked at four engagements, and found in three of them that the firm had done insufficient work to justify issuing an audit opinion. In 2012, the PCAOB inspected P&Z again, looking at three audits and finding one with such serious defects that the audit opinion was unsupported. In the 2009 inspection of Sherb, the PCAOB looked at seven engagements and found in two that Sherb had done insufficient work to justify their audit opinion. The PCAOB reports were made public a year or two after the inspections were done and even then the names of the clients were not identified, so investors had no way to know that they were relying on faulty audits.

So, in both cases, the PCAOB knew that the firms were doing shoddy audits, but the firms were allowed to continue to practice until the SEC finally shut them down. Short sellers figured this out, and targeted clients of Sherb and some other small CPA firms that audited Chinese reverse mergers.  

Something is seriously wrong here. Why were these firms allowed to continue to do audits when there was strong evidence that those audits were defective? Why didn’t the PCAOB shut these firms down before the SEC acted?

The PCAOB may have long ago instituted disciplinary proceedings against Sherb and P&Z, but under the Sarbanes-Oxley Act disciplinary proceedings are confidential and nonpublic until there is a final decision imposing sanctions. Recalcitrant firms can continue to do shoddy audits while these proceedings continue, possibly for years if the firm appeals PCAOB findings, and investors are left at risk. That is probably why the SEC had to ultimately step in. These confidentiality rules unfairly protect the reputations of CPA firms over the interests of investors. Congress must act to revise the Sarbanes-Oxley Act to allow the PCAOB to announce the commencement of disciplinary proceedings against CPA firms and the disciplinary process must be made transparent. 

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