The Public Company Accounting Oversight Board has struck a tentative agreement with regulators in China to begin observing each other's oversight activities in the hope it will eventually lead to greater cooperation.

PCAOB member Lewis Ferguson said in a speech at California State University that the board and Chinese authorities will soon begin “observational visits,” where PCAOB inspectors will observe Chinese authorities conducting their audit oversight activities and Chinese authorities will observe the PCAOB. At first, observations would focus on quality control examinations at audit firms, but not detailed reviews of individual audits. Ferguson said the board is working with both the China Securities Regulatory Commission and China's Ministry of Finance, which share authority over accountants in China.

“This would not be a substitute for a PCAOB inspection but would be a trust-building exercise between regulators,” said Ferguson. “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.”

Presently, Chinese law prohibits the removal of audit work papers from China, and Chinese authorities will not permit non-Chinese regulators to conduct inspections inside China. That makes it impossible for the PCAOB or other regulators to assess the quality of audit work originating in China, Ferguson said. “As major U.S. companies like General Motors, IBM, Microsoft, Apple Computer, Proctor & Gamble, General Electric and Walmart began to build extensive operations in China, the China and Hong Kong based affiliates of the global network audit firms began to play an increasing role in the consolidated audits of those companies,” Ferguson said. Yet the regulatory limitation applies to the affiliates of global network firms that perform audit work on such giants in U.S. capital markets, he said, making it impossible for the PCAOB to fully regulate such entities.

Complicating a possible path to regulatory cooperation, said Ferguson, is another dialogue taking place between U.S. and Chinese authorities over investigative activities. The Securities and Exchange Commission has pursued charges against Deloitte Touche in Shanghai to pursue audit work papers in connection with accounting irregularities at Longtop Financial, and regulators in Hong Kong are pursuing a similar matter with Ernst & Young in China. In both cases, audit firms are stuck between those investigative orders and Chinese law that forbids releasing work papers.

Ferguson said the board is hopeful for a breakthrough, but also acknowledges questions about what happens if the U.S. can't achieve regulatory cooperation with China. Firms that are registered with the PCAOB to do business in U.S. capital markets are required to comply with inspection or investigation matters. Refusal to cooperate could lead to sanctions, including revocation of registration, barring a firm from doing U.S. audit work. That would leave public companies to scramble for a new auditor or risk violation with SEC and stock exchange rules. “The stakes in this matter are very high,” he said. “We continue to engage in dialogue with the Chinese authorities, but at this time it remains uncertain where this dialogue will ultimately lead.”