Judge’s Ruling On Accounting Firms In China Touches on Hong Kong Units

February 3, 2014, 6:03 p.m. ET

Judge’s Ruling On Accounting Firms In China Touches on Hong Kong Units

By Michael Rapoport and Kathy Chu

A judge’s ruling against the Chinese affiliates of the Big Four accounting firms over their refusal to cooperate with U.S. regulators has drawn attention to a practice of some auditors’ Hong Kong units.

Last month’s ruling suspended the Chinese affiliates of PricewaterhouseCoopers, Deloitte Touche Tohmatsu, KPMG and Ernst Young from auditing U.S.-listed companies for six months, because they wouldn’t give the Securities and Exchange Commission documents about some of their Chinese audit clients to help the commission investigate the companies for possible accounting fraud.

But in a potential broadening of the issue at hand, the ruling by SEC Administrative Law Judge Cameron Elliot also spotlighted another practice of note in the auditing of Chinese companies that trade on U.S. markets. In some instances, a Hong Kong unit of a Big Four auditor acts as the company’s official auditor, but the bulk of the audit work is outsourced to the same firm’s affiliate in mainland China.

That could raise issues under U.S. auditing rules, which suggest that an audit firm should do a “material” amount of the work to be entitled to serve as a company’s principal auditor and sign the audit opinion.

The ruling by Judge Elliot cites at least three Chinese companies whose documents the SEC sought that had such audit arrangements–a biodiesel company, a petrochemical company and a chemical maker. KPMG’s Hong Kong affiliate was the principal auditor in all three cases, but KPMG’s Chinese affiliate did more than 90% of the audit work, said the judge, who didn’t identify the companies.

The judge didn’t opine on whether such arrangements were proper. Yet where an audit is done makes a difference to investors, who may see the quality of the Chinese firms’ audit work as questionable–more than 130 U.S.-traded Chinese companies have come under scrutiny in the last few years over accounting and disclosure issues.

Paul Gillis, an accounting professor at Peking University’s Guanghua School of Management in Beijing, likens the situation to a Chinese garment maker who sews a “Made in Italy” label onto a piece of clothing. It makes the consumer, or the investor, confident about the product’s quality when that may not be justified, he said.

In last month’s ruling, Judge Elliot said the Chinese firms should have handed over the documents to the SEC. The suspension he levied could complicate the audits of dozens of U.S.-traded Chinese companies and some U.S. multinational companies with major Chinese operations. The firms plan to appeal to the commission itself. The firms contend they can’t comply with the SEC’s requests for documents because that could subject them to harsh penalties under strict Chinese laws that treat such documents as “state secrets.”

The Big Four’s Chinese and Hong Kong affiliates are free-standing companies legally distinct from each other, even though they’re part of the same international network.

Investors “are put at risk if firms that perform little work on an audit hold themselves out as the principal auditors,” said James Doty, chairman of the Public Company Accounting Oversight Board, the U.S. auditing regulator, in a statement last week.

In the past, the PCAOB has said some firms may be issuing audit reports based on another firm’s work without complying with the rules regarding primary auditors. The PCAOB has a proposal pending that would require auditors to disclose which other firms assist them in performing an audit, including different affiliates of the same network.

It isn’t “uncommon” for Big Four affiliates in Hong Kong to act as a Chinese company’s official auditor, but leave much of the work to be done in mainland China, said Clement Chan, president of the Hong Kong Institute of Certified Public Accounts, a self-regulatory body for the profession and a managing director of BDO Ltd. in Hong Kong. “It may be done because of logistical or commercial reasons; it may be done because of perception reasons.”

Outsourced auditing work came under scrutiny in at least one other recent case involving the Big Four. In 2012, Hong Kong’s Securities and Futures Commission started legal proceedings against Ernst Young Hong Kong for not producing audit documents on Standard Water, a Chinese company looking to list in Hong Kong. Ernst Young said it couldn’t comply with the request because the records were held by its mainland affiliate, which did the auditing, the SFC said at the time.

Phones at Standard Water went unanswered on Thursday, the eve of China’s Lunar New Year, as well as during the holiday.

KPMG and Ernst Young declined to comment. Deloitte and PricewaterhouseCoopers haven’t had any known issues over Hong Kong affiliates using Chinese units to shoulder the audit work. Spokesmen for the two firms also declined to comment.

The SEC asked KPMG’s Hong Kong firm for documents directly, according to the ruling, but the firm refused, citing Chinese law and saying the documents were kept in China. The Hong Kong firm wasn’t a defendant in the SEC’s case against the Chinese firms and hasn’t been penalized. The SEC declined to comment.