PCAOB’s Chinese “Potemkin audit” plan: Blame state secrecy & Western colonialism?

by Kurt Schulzke

$12.8 billion.  That’s the market capitalization created by reverse mergers through which 159 Chinese companies entered U.S. securities markets between January 1, 2007 and March 31, 2010. Speaking at Cal State Irvine last Friday, PCAOB Member Lewis H. Ferguson disclosed that of these companies, 67 have had their auditors resign, while 126 have been “delisted” or “gone dark,” resulting in “billlions” of losses to investors, all since late 2010.

Meanwhile, the Chinese government steadfastly refuses to allow the PCAOB access to workpapers of firms that audit Chinese SEC registrants:

At present, the PCAOB does not have cooperative agreements with either the China Securities Regulatory Commission or China’s Ministry of Finance which share jurisdiction over Chinese accountants. The CSRC has jurisdiction over the 53 accounting firms, including the affiliates of the global network firms, that are authorized to file audit reports with respect to companies listing securities on the Chinese domestic securities markets in Shanghai and Shenzhen. The MOF licenses all accountants in China and has jurisdiction over more than 7,000 accounting firms in China, including some of the firms registered with the PCAOB.

In this context, Ferguson noted:

Under Chinese law, it is illegal to remove audit work papers from China. At the present time, Chinese authorities will also not permit any non-Chinese regulator to conduct inspections on Chinese soil. As a result, it is impossible for the PCAOB or other regulators to inspect China-based audit firms or to assess the quality of such firms registered with it. This limitation also applies to the affiliates of the global network firms that perform audit work on the audits of the Chinese operations of the large global companies operating in China . . .

Chinese authorities say that we should rely on their oversight of auditors. They have two principal concerns. The first is that any action by a foreign regulator on Chinese soil, even a mere inspection, could violate Chinese sovereignty. This concern has deep historical roots, specifically relating to the humiliations that China suffered at the hands of Western powers in the nineteenth and early twentieth centuries.

The second concern grows out of China’s very expansive state secrecy laws. There has been a concern expressed that inspection of audit work papers, particularly work papers from the audits of state-owned enterprises, could lead to disclosures of state secrets . . . (emphasis added)

It might be time for the Chinese government to (a) stop obsessing over 19th-century slights that have no discernible connection to current reality, and (b) remove itself from the private sector to the point where Chinese state secrets are not jeopardized by disclosure of audit workpapers. Meanwhile, as we continue hoping and waiting for such change in China, how will the PCAOB execute its regulatory mandate? Very gradually, it appears:

As a first step toward further cooperation, we are working toward and have tentatively agreed on observational visits where PCAOB inspectors would observe the Chinese authorities conducting their own audit oversight activities* and the Chinese could observe the PCAOB at work. This would not be a substitute for a PCAOB inspection but would be a trust building exercise between regulators. Initially, such observations would focus on quality control examinations of the audit firm being examined rather than a substantive review of a specific audit . . .

The ultimate goal for the PCAOB is to achieve a level of cooperation with the Chinese authorities that will enable us to have enough information and confidence that we could issue inspection reports on those China-based audit firms that prepare or participate substantially in the preparation of audit reports filed in the United States . . .

Despite our hopes, the question arises as to what happens if we are not able to achieve an agreement on regulatory cooperation with the Chinese. Any firm that registers with the PCAOB is legally obligated to cooperate with us and provide documents and potentially testimony if requested in connection with an inspection or investigation. A refusal to cooperate, either in an inspection or an investigation, could subject the firm to PCAOB sanctions even if motivated by compliance with local laws that restrict such cooperation. One possible sanction could be revocation of a firm’s PCAOB registration. Any company audited by such a firm would either have to get a new audit opinion signed by a firm registered with the PCAOB or risk being in violation of SEC and stock exchange rules.

The stakes in this matter are very high. But U.S. financial authorities have a primary responsibility to protect the integrity of our capital markets and the interests of U.S. investors.

No truer words!

We believe the Chinese authorities are aware of the seriousness of this matter and we are hopeful that we will be able to work out satisfactory arrangements.

Not so much?

For U.S. investors, the bottom line is that the PCAOB is currently unable to get inside the “black box” of Chinese-company audits. Investors should, therefore, be considerably more wary of Chinese stocks than U.S. ones.

Ferguson’s entire speech is available at http://pcaobus.org/News/Speech/Pages/09212012_FergusonCalState.aspx.

* Such staged “observational visits” are reminiscent of a Potemkin village, like the one China now maintains in Lhasa, Tibet.


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