After a year of grumbling, the US Securities and Exchange Commission last week formally accused the Big Four accounting firms' China branches of refusing to co-operate with its investigations into nine Chinese companies listed on US exchanges -- a decision that may have far-reaching implications.
The firms -- Ernst & Young, Pricewaterhouse Coopers, KPMG and Deloitte Touche Tohmatsu, along with BDO -- are charged with non-compliance of SEC requests to share work papers, the supporting documents for the conclusions reached in an audit that detail everything from cash balances in a bank to the number of trees in inventory. If a company lists an asset, an auditor goes out to the company or one of its storage facilities to eyeball the asset, make sure it exists and count it before jotting it down in a work paper.
In the US, the SEC can subpoena work papers to help with an investigation into a corporate entity. This is impossible in China, because the Chinese government considers anything written in the country about a Chinese company to be a state secret. The law is murky, and it doesn't just apply to auditing and accounting.
Essentially, any information
that might threaten national security or the national interest comes under this umbrella, but foreign listings are especially prickly as they come under the watch of foreign oversight bodies. But why the secrecy? To a certain extent, it’s a familiar answer.
"Take a long hard look at this country," a China-based employee of the Big Four told Crikey
. "The richest people are the Chinese cronies, who are worried that if the SEC opens up the books they will discover a web of relationships -- they might find out that a state-owned enterprise is best friends with (a member of the party), and that would mean that the government is fraudulent because they are involved with fraudulent companies. They don't want these dirty dealings out in public."
Chinese companies seeking listings on foreign exchanges have acquired a reputation for dodginess, aided by the dogged efforts of the likes of Muddy Waters Research
. The majority of Chinese companies aren't fraudulent -- the finger-pointing hasn't always been correct
-- but the source says many of them are "more opaque, not operating in a mature market -- they don't keep evidence and require auditing by instinct".
This means the high-jinks of some companies, like Canada-listed timber firm Sino-Forest
, have left investors with singed hands. They take the status of auditors down with them, too: Ernst & Young paid a record $117 million settlement over the Sino-Forest case; an email trail showed two E&Y auditors telling each other
that the company "could show us trees anywhere and we would not know the difference".
Then there's Chinese financial software company Longtop Financial Technologies, which colluded with local banks
to deceive the auditor, Deloitte. Auditors speaking to Crikey
admit their failings in cases such as these, but stress they are not detectives.
"There is an expectation gap from the public and the regulators. Auditors are not trained to detect fraud, we’re responsible for ensuring that balances are in conformity with the accounting standards of a particular country," they say. "If we see it, we should act, but I'm an accountant, not a fraud investigator."
"Take a long hard look at this country. The richest people are the Chinese cronies, who are worried that if the SEC opens up the books they will discover a web of relationships."
The size and visibility of huge accounting firms make them obvious targets. Those working for the Big Four say regulators "hang us out to dry because we have the deepest pockets", and point out it's not as if they are refusing to share work papers with the SEC -- they just can't.
"We don’t have a choice," said the Big Four employee. "We're caught in a power struggle. On one hand we're bound by Chinese law, on the other we might violate US Supreme Court rulings. If I give the SEC my work papers, I'll have my licence revoked and all my people will be fired. We'd be literally breaching the laws of the country in which we operate, we'll go to jail and face charges."
While the work papers of the Big Four's China-based subsidiaries cannot be revealed to regulators from another country, they are still written based on the particular firm's universal audit methodology. This includes internal appraisals from unaffiliated partners, reviews initiated and conducted by offices from different countries, as well as peer reviews in which the accounting firms review each other's work.
Why do Chinese companies seek a listing in the US in the first place? It's the promise of access to sophisticated investors in the largest and most liquid capital market in the world. But this is tailing off -- 180 Chinese companies
have gone public on global exchanges since 2010, but only two (YY Tech and VIPshop
) sought a US listing this year.
The charges could result in a prolonged period of this moribund sentiment, and eyes are on the SEC's next move. The harshest penalty it could impose would be banning the China branches from working on US-listed companies, which would mean China would have no US-recognised auditors, or that smaller China-based firms with less stringent auditing practices would have to be used for audits. Other doomsday scenarios include a mass delisting of Chinese companies from US exchanges.
The SEC has aired its concerns over the past year -- initially due to reverse mergers, a practice that saw Chinese companies taking over shell companies that are already listed in the US and bypassing certain listing requirements -- but negotiations with Chinese regulators have yielded no results. It's led to the perception the SEC actions are political, a handily indirect means of pressuring the Chinese government.
Paul Gillis, a Peking University professor who writes the China Accounting Blog
, told Reuters
China has decided it won't co-operate: "It believes this is an impingement on China’s national sovereignty, and it’s just too far for them to go."
The SEC's brinkmanship may produce results, but China-based auditors also say its approach is tantamount to seeing someone you fancy and immediately propositioning them -- in either case, a little wooing would work wonders. Such was the case with the US Public Company Accounting Oversight Board, which has begun previously unheard-of observation activities
in China that will allow it to access to Chinese authorities conducting audit oversight activities.
"The SEC needs to try to get the Chinese government onside. Playing hardball isn't going to work," said the anonymous Big Four employee. "If you get in the Chinese government's face, they will set up barriers."