At-A-Glance

China Agrees to Inspection of Audit Workpapers by US Authorities

Unprecedented access, if realized, will avoid delisting of Chinese companies on American stock exchanges

In 2020, after years of fruitless efforts to gain cooperation from China, the United States government enacted a law that would ban Chinese securities from trading on American exchanges if the PCAOB is unable to inspect such companies’ auditors for three consecutive years. With time running out, the Chinese government appears to have finally consented to join the rest of the world and allow the examinations with little restriction.

Nevertheless, any optimism expressed over the new agreement should be exercised with restraint based on past experience. In the first place, the agreement is in the form of a “statement of protocol,” which the PCAOB indicates is just a “first step toward opening access for the PCAOB to inspect and investigate registered public accounting firms headquartered in mainland China and Hong Kong completely, consistent with U.S law.” What is different from past failed accords is a lack of significant restrictions on the nature of the inspections.

In a Fact Sheet, the PCAOB sets out the following three key provisions of the agreement:

1. The PCAOB has sole discretion to select the firms, audit engagements and potential violations it inspects and investigates – without consultation with, nor input from, Chinese authorities.
2.  Procedures are in place for PCAOB inspectors and investigators to view complete audit work papers with all information included and for the PCAOB to retain information as needed.
3. The PCAOB has direct access to interview and take testimony from all personnel associated with the audits the PCAOB inspects or investigates.

These provisions are in line with those that other public firms around the world have been required to comply with since the implementation of the Sarbanes-Oxley Act of 2002, which proceeded from the Enron scandal of 2001. 

China’s obsession with secrecy had pushed the US to put in place the Holding Foreign Countries Accountability Act (HFCAA) in 2020 that would have caused delisting of noncompliant companies starting in 2024. Anticipating that action, several major state controlled Chinese companies have voluntarily begun the process of delisting, while Alibaba Group Holding Ltd., the large China-based e-commerce technology firm, is considering listing on the Hong Kong exchange. An August 12, 2022, Bloomberg article speculates that the state controlled Chinese companies that are delisting may be ones that China has had the secrecy concerns about. Consequently, with those firms out of the way, possibly China is not as concerned about accepting the new compliance protocol.

China’s level of compliance with the new agreement will be known within a few months, since the PCAOB is required to report its satisfaction by the end of 2022. Consequently, the PCAOB is not wasting any time, having already made selections of companies to inspect, and sending inspectors to Hong Kong in September to start the work. Curiously, Alibaba is one of the first companies selected for review.

Relations between China and the US have been increasingly strained in recent months. Therefore, Congress does not appear inclined to take lightly any indication of noncompliance with the new protocol. In fact, legislation has been under consideration this year that would move up the date for delisting companies in violation from 2024 to 2023. Meanwhile, the SEC has indicated support for the new statement of protocol. Also, the Acting Chief Accountant for the SEC, Paul Munter, on September 6, 2022, issued a letter with a warning. Some Chinese companies have been hiring US audit firms as their lead auditor to establish the appearance of compliance with HFCAA. Those companies and their audit firms are put on notice that they must still comply with all record access requirements, even when the US audit firm employs Chinese auditors to perform audit procedures for subsidiaries or other parts of the Chinese company’s audit. The US audit firm must have access to and communicate with the predecessor and currently employed Chinese audit firms’ personnel, as well as review their audit documentation without restriction. Otherwise they risk enforcement action from the PCAOB or SEC.    

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