There’s No Accounting for China’s Accounting; A deal between Beijing and Washington to share audit information still leaves U.S. investors exposed

May 29, 2013, 11:31 a.m. ET

There’s No Accounting for China’s Accounting

A deal between Beijing and Washington to share audit information still leaves U.S. investors exposed.

By PAUL GILLIS

For a brief moment last week it looked like there had been a break in a serious regulatory dispute between the U.S. and China. On Friday, Washington and Beijing announced a deal for some information sharing between them concerning audits of U.S.-listed Chinese companies embroiled in accounting scandals. But there’s a whole lot less to this compromise than meets the eye, and those listings may still be in jeopardy.

Under Friday’s agreement, Chinese regulators will allow the U.S. Public Company Accounting Oversight Board (PCAOB) to access audit documents from Chinese accounting firms for PCAOB’s investigations. Washington has bristled for a long time that whenever a U.S.-listed Chinese company implode in an accounting scandal, American authorities have little or no access to the auditing documents that would allow for a thorough investigation and perhaps sanctions.Both PCAOB and the U.S. Securities and Exchange Commission have a stake in this issue, and both regulators have tried negotiating with Beijing for access to records. The SEC’s talks broke down last year, and in frustration the SEC sued accounting firms directly demanding access to audit working papers the commission needed for its investigations. The auditors say that Chinese law prohibits them from complying with SEC requests. Failure to resolve this issue could result in both the SEC and PCAOB banning Chinese accounting firms from auditing U.S.-listed companies, which could in turn lead to those companies being delisted.

The PCAOB kept negotiating, and Friday’s deal is the reward. But it’s a small reward that doesn’t come close to fully resolving the problem.

The information-sharing arrangement covers only one of several duties the PCAOB performs. The accounting body has three functions: It makes the rules for auditing public companies; it inspects accounting firms to make sure they are following those rules; and it administers sanctions to those who do not. The new deal with Beijing covers information sharing for investigations related to possible sanctions, but that’s it.

Up to now, sanctions administration has not been a major focus of the PCAOB. The board has done a commendable job setting auditing standards for U.S.-listed Chinese companies, strengthening the auditor’s role in fraud detection, and advising on the audit implications of Chinese reverse mergers (in which a Chinese company buys a listed U.S. shell company so that the Chinese firm can gain a listing without an initial public offering). In contrast to all that activity, in 2012, only 11 sanctions were handed out, three of which related to China audits.

The really important work PCAOB does concerns inspections. Inspections determine whether audits have followed U.S. standards, and firms that issue reports on public companies are to be inspected at least every three years under U.S. law. While it might be helpful to have Chinese cooperation in after-the-fact investigations of alleged auditing failures, regular inspections try to head off those failures in the first place. The deal with Beijing doesn’t cover regular inspections at all.

That means this is not a particularly pro-investor agreement. Investors need auditors to nip accounting scandals in the bud. PCAOB inspections ensure the auditors are actually auditing. Sanctions have a purpose, but they come into play only long after the investors have already been wiped out.

Nor is the deal beneficial for China. Without inspections, investors can’t trust Chinese audits. Investors in Chinese companies are currently on a buyer’s strike because of the widespread accounting scandals. Audit inspections would help to restore some credibility to Chinese financial reports, and perhaps open up access to the capital markets again. China’s IPO markets have been nearly shut down, and its entrepreneurial companies are being starved for capital. If IPO markets do not reopen soon, China risks damaging indigenous innovation.

And the deal leaves two major problems outstanding. First, it does not include the SEC. Although the deal allows the PCAOB to share documents with the SEC after notifying the Chinese, the PCAOB has said—presumably to assuage Chinese sensibilities—that it will not provide a backdoor way for the SEC to get documents. That leaves the SEC action against the auditors in play, with the danger of a ban on the firms auditing U.S. companies. So a mass delisting of U.S.-listed Chinese companies is still a risk.

The PCAOB deal also contains a loophole that allows China to withhold documents on grounds of public interest or essential national interest. But that has been the problem all along. China has an expansive definition of state secrets, and audit working papers, particularly relating to state-controlled enterprises, may be considered state secrets. This is the nub of the SEC’s dispute with Beijing, and also the auditors’ defense against the SEC action.

China and the U.S. will soon meet in their annual Strategic and Economic Dialogue. Regulatory cooperation ought to be high on the agenda. The U.S. needs a deal that protects investors and requires Chinese companies listing in the U.S. to follow U.S. securities laws. Chinese companies need a deal that helps them to convince investors that their numbers are real. And investors need to believe it is safe to invest in China again.

Mr. Gillis is a professor of accounting at the Guanghua School of Management at Peking University.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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