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Battle lines drawn over Chinese auditing

Battle lines drawn over Chinese auditing Ian Fraser

Regulators in China and the US are on a collision course over the future of bean-counting.

At stake is how Chinese companies are audited, and how the Chinese operations of the ‘Big Four’ audit firms will in future be managed and regulated. The US doesn't want to see investors getting burnt when they invest in Chinese firms that are listed in the US; China, for its part, wants to see fewer barriers to Chinese firms raising overseas capital and less overseas interference in how Chinese firms are audited.

On May 10, China's Ministry of Finance decreed that the Chinese affiliates of ‘Big Four’ audit firms – PWC, Deloitte, KPMG and Ernst & Young – must hand over the reins to Chinese nationals by 2017, and that the majority of the partners of such firms must be citizens of the People’s Republic by the same date. The Chinese operations of the four firms are now led largely by expats. The finance ministry's order caps at 40% the number of foreign-qualified partners at Chinese 'Big Four' affiliate firms from this August, and at 20% by 2017.

The 'Big Four' today dominate China's accounting sector. In 2010, their audit practices, excluding their consultancy and other services, had combined revenues of more than 9.5bn yuan ($1.5bn), according to the Chinese Institute of CPAs, via Reuters. Between them, the employ 40,000 people in China, Hong Kong and Taiwan.

However there are fears that handing over the reins to locals and locally-trained accountants may lead to a fall in audit quality. Paul Gillis, professor of accounting at Peking University told Reuters:

"If the changes lead to greater turnover among partners, or a wholesale replacement of leadership by the local partners, there is risk that audit quality would be affected."

China's move came one day after US regulators ratcheted up the pressure on the US arm of Deloitte & Touche to hand over evidence related to a US probe into possible book cooking at a Chinese software company Longtop Financial Technologies.

According to The Economist:

"The American regulatory mandate abroad arises because many Chinese firms choose to list on America’s exchanges while still using auditors based in China. One such example is Longtop [which] used Deloitte’s Shanghai arm to do its books. The auditor resigned a year ago after it claimed to have identified “very serious defects” during its audit for the financial year that ended in March 2011. But Deloitte’s Chinese partners refuse to hand over the work papers arising from the Longtop audits to the SEC on the grounds that doing so would violate local law. The Chinese invoke the need to defend both sovereignty and (more dubiously) “state secrets”.

The stakes are high in this battle over bean-counting. The wrangle over auditing will, ultimately, determine whether Chinese accounting firms – including the affiliates of the ‘Big Four’ firms – are overseen by the US or China. At the moment Chinese firms are allowed to audit companies that are listed on US stock exchanges, but that may change.

The SEC, PCAOB and other US regulators are determined that the Chinese affliliates of ‘Big Four’ firms should be obliged to hand over documentation pertinent to investigations into suspected accounting fraud. However China is distinctly uncomfortable with this,which is probably why it mounted the counter-offensive of saying all audit firms operating in its territory should be locally controlled by 2017 (maybe driven by a belief this gives the firms a greater chance of resisting pressure from US regulators and reveal the skeletons lurking in their closets).

The Wall Street Journal does not believe that an all-out confrontation between Washington and Beijing is imminent, suggesting a compromise of sorts may be reached. It said US audit regulators have not yet been blocked from getting inspectors into China.

However if a compromise cannot be reached, US regulators may well go “nuclear” by banning Chinese audit firms from auditing any companies listed or trading US soil. That would be a serious setback for Chinese audit firms, whilst complicating the audits of multinational companies whose Chinese operations are currently audited by Chinese firms.

In conclusion, The Economist wrote:

It is right to point the finger at the Chinese for rejecting international regulatory co-operation. After all, some three dozen countries already co-operate with the PCAOB; more agreements are in the works. But it is wrong to blame China for localizing. Given that most other countries already demand that accounting firms be run by local partners, China is merely coming into line with global norms. The Big Four and their clients can only pray it does the same on cross-border co-operation.

Whatever happens, a compromise on the cross-listing companies and their audits is likely to be what The Economist calls "messy". However of not such agreement can be reached investors will, with good reason, continue to be chary of the financial statements that emanate from China.

Further reading on auditing of Chinese companies and application of IFRS:

Tags: accountancy , Accounting , audit , audit quality , auditing , auditors , big four , China , China's Ministry of Finance , Deloitte , Ernst & Young , IFRS , KPMG , PCAOB , PWC , Reuters , SEC , Wall Street Journal
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