China frequents the news these days with debates over contentious trade deals and other political maneuvers. The financial reporting realm is no stranger to the ongoing challenges that China’s secretive, autocratic system presents to investors and international regulators. Financial fraud in Chinese companies had been a constant worry, since the auditors’ procedures and controls were not open to review by foreign countries.
Back in 2012, the Audit & Accounting Alert (A&A) reported on a slight crack in the door, offering limited access to firms that audit Chinese companies. Specific audit workpapers were still off limits, but “observational visits” would be allowed whereby the regulator, in this case the American Public Company Accounting Oversight Board (PCAOB), could send inspectors to observe an audit firm’s overall audit quality control procedures. The audit workpaper prohibition stemmed from Chinese regulators’ concerns that any access to audit documents would violate the country’s sovereignty. Also, there was a perceived risk that state secrets would be disclosed, especially for audits of state-owned entities. Obviously, such restrictions did not meet PCAOB requirements, but were seen as a first step in what was anticipated to be a protracted negotiation.
Then in May, 2013, a Memorandum of Understanding provided for workpapers from audits to be sent to the PCAOB and SEC for review. Nevertheless, onsite review of workpapers was still off limits, and there was no telling what manner of redaction would be performed before the workpapers were sent for review.
The issue became even more visible as described in the June 2014 A&A article,
Alibaba Spotlights SEC Dispute with Auditors in China. In what was called the largest Initial Public offering (IPO) in history, Chinese mega-conglomerate, Alibaba Group Holdings, Ltd., was launched despite regulatory warnings against it and its auditors for non-compliance. Though the PCAOB and SEC had the power to stop the listing and sanction the auditors, apparently the financial benefits presented and geopolitical imperatives allowed Alibaba and a number of other China-based companies to thrive on American exchanges.
With regard to accounting standards, the news was more positive. By November 2015, the International Accounting Standards Board (IASB) reported in conjunction with the Chinese Ministry of Finance that Chinese accounting standards were substantially converged with International Financial Reporting Standards (IFRS). However, full compliance with PCAOB audit inspection requirements proved elusive for several more years, despite continued litigation and threats of suspending audit firms and delisting noncompliant companies.
A dramatic example of the potential for disaster such flagrant abuse portends is the recent case of Luckin Coffee Inc. Similar to collapses the A&A has reported on in other parts of the world, like Enron in America, Carillion in the United Kingdom, and most recently Wirecard in Germany, Luckin is China’s latest entry. With a plan to beat out Starbucks for coffee dominance in China, Luckin’s May 2019 U.S. public offering and explosive growth, only led to reports in January 2020 of massive exaggerated and fraudulent sales, resulting in a May 2020 implosion and delisting.
Consequently, on June 4, 2020, the Administration of United States President Donald Trump directed the President’s Working Group on Financial Markets (PWG) “with examining certain risks to investors in U.S. financial markets posed by the Chinese government’s failure to allow audit firms that are registered with the PCAOB to comply with U.S. securities laws and investor protection requirements.” The PWG responded with recommendations in a report dated July 24, 2020. The PWG is composed of the U.S. Secretary of the Treasury, Federal Reserve Chairman, Securities and Exchange Commission (SEC) Chairman, and Commodity Futures Trading Commission Chairman.
The five PWG recommendations to the SEC are:
- For initial and continued listing on U.S. stock exchanges, require access to work papers of the company’s principal audit firm, or if governmental restrictions preclude such access, then have the company provide a co-audit firm that the PCAOB determines to have sufficient access to work papers and practices to conduct an appropriate inspection. For currently listed companies, a transition period until January 1, 2022 is suggested.
- Require enhanced and prominent disclosures of the risks of investing in Non-Cooperating Jurisdictions (NCJs) such as China.
- Enhance registered fund disclosures for funds exposed to companies from NJCs.
- Encourage or require performance of greater due diligence of indexes and index providers by registered funds that track indexes.
- Issue guidance to investment advisers concerning fiduciary obligations when considering investments in NJCs.
On August 27, 2020, Bloomberg reported that the China Securities Regulatory Commission (CSRC) had responded, proposing to allow U.S. regulators to audit its state-owned enterprises (SOEs), but would insist on editing some information for national security reasons. Under the proposal, U.S. authorities would pick one of China’s SOEs for a trial joint inspection. The CSRC is also calling for direct talks with the U.S. on the audit issue, and stating that only through dialogue could there be mutually agreeable resolution.
The negotiations are a developing story. Similar attempts in the past have been unsatisfactory. Since both the U.S. Administration and Congress are currently applying pressure, and in light of the fraught political climate, results could be different now. Time will tell.
Further details can be found at
Report and Recommendations on Protecting Investors from Significant Risks from Chinese Companies and
China makes proposal to U.S. in concession to solve accounting dispute.
https://home.treasury.gov/news/press-releases/sm1086) and (
https://www.reuters.com/article/us-china-audit-dispute/china-makes-proposal-to-u-s-in-concession-to-solve-accounting-dispute-bloomberg-idUSKBN25N0BR).
