The continued standoff between U.S. and China audit officials is starting to become a sore spot for public companies with operations in China and their auditors.

If they can't get a compliant audit out of China, they will soon have to consider some potentially painful alternatives.

A year-end deadline for a diplomatic solution to the standoff between authorities in the two countries is fast approaching, says Jim Feltman, managing director at Mesirow Financial Consulting, who believes pressure is mounting on the Public Company Accounting Oversight Board to gain access to audit files that for years have been withheld from the board.

The PCAOB imposed a year-end 2012 deadline on itself when it adopted a rule in 2009 to modify its inspection schedule to allow more time to work through inspection obstacles in various countries, most notably in China. PCAOB Chairman James Doty said in May that Chinese authorities had agreed to allow U.S. inspectors to observe Chinese inspections before the end of 2012, but there's no further word on whether or when those observations will begin.

For several years, China has blocked the PCAOB from inspecting firms in China, even registered firms that audit financial statements relied on in U.S. capital markets, citing sovereignty and conflict with its own laws. China also forbids auditors from releasing audit work papers as a way to protect state secrets, it says. The Securities and Exchange Commission is deep in the battle as well, slapping an enforcement order on Deloitte & Touche Shanghai in May because if refused—citing conflict with Chinese law—to produce audit work papers for Longtop Financial as the SEC tried to investigate accounting irregularities.

The PCAOB has already demonstrated patience by extending years-overdue inspections into 2012, says Feltman. “If the Chinese authorities continue to take the position that they exert sovereignty over firms that are listed in the United States, then there's going to be a collision,” he says.

Amid a series of accounting problems with Chinese companies listed on U.S. exchanges, many of those companies already are delisting and returning to China for funding, he says. But there are still plenty of U.S. companies with operations in China relying on China-based audit work to submit their financial statements to the SEC. “No one can know if those audits are compliant with U.S. accounting or auditing standards unless the regulators can inspect the work papers, and they can't do that,” he says.

Paul Gillis, professor at Peking University in Beijing and a close observer of the regulatory standoff, says time is running out for U.S. authorities. “If the PCAOB is unable to reach accommodation with China, the only real option is to deregister accounting firms,” he says. “For U.S.-listed companies with operations in China, they're facing a risk that they may be without an auditor in China.”

It's a worst-case scenario, or the “nuclear option” for regulators, says Scott Univer, general counsel for U.S.-based audit firm WeiserMazars. Barring an entire country's audit firms from auditing financial statements that are relied on in U.S. capital markets would create a compliance nightmare for U.S. companies. It would force companies to consider alternatives like withdrawing securities or finding a new auditor that is registered with the PCAOB. “The latter option may not be practical for companies with operations in China,” he says. “It is uncertain that the Chinese would allow such foreign auditors in to do their work.”

If U.S.-listed companies would find themselves in such a position, they might consider applying to the SEC's Division of Corporation Finance for a waiver of the requirement to produce an audit for their China-based operations, says John Huber, senior managing director for FTI Consulting. “A company could argue to the staff of the SEC that it's impossible for them to get an audit of the financial statements for the Chinese operations and they could ask for a waiver of that portion of the audit,” he says. “A waiver would be accompanied by disclosure in the company's SEC filing about the inability to obtain an audit.”

“If the Chinese authorities continue to take the position that they exert sovereignty over companies that are listed in the United States, then there's going to be a collision.”

—Jim Feltman,

Managing Director,

Mesirow Financial Consulting

Audit firms might also disclaim an audit opinion for the portion of the audit that arises from a country where the audit is impossible, says Kelly Bossard, managing director at FTI. Such an audit opinion would not be compliant with SEC requirements, however, so companies would still need to appeal to the SEC for a waiver, he says.

Greg Esslinger, also a senior managing director with FTI, agrees it would be difficult for a company or an audit firm to send in auditors from a nearby country to perform audit work in China that the country's own auditors are barred from performing, particularly if protection of state secrets is the concern. “One of the big difficulties is the proliferation of state-owned enterprises,” he says. “There aren't a lot of entities where there isn't some nexus to the Chinese government.”

Bossard points out that U.S. companies might take comfort in knowing that PCAOB rules require an auditor of a subsidiary to be registered with the PCAOB only if they play a "substantial role" in the audit, and the threshold for a substantial role is generally set at 20 percent. That means if a U.S. company's business in China represents less than 20 percent of its total business, then having an unregistered auditor in China might not present a compliance problem, he says.

BIG 4 FIRMS REORGANIZING CHINA OPERATIONS

In another wrinkle to the regulatory standoff between the United States and China, it appears audit firms are beginning to reorganize to comply with an order by Chinese authorities that China's audit firms must employ more locally trained and certified professionals. By 2017, no firm in China may have more than 20 percent of its partners as non-Chinese-certified accountants or auditors, according to the order.

KPMG is the first Big 4 firm to reorganize its audit practice in China. The firm published a press release in Beijing to say it had converted its China business from a joint venture structure with KPMG internationally to a “special general partnership,” similar to ownership structures used for smaller and mid-sized firms in China, under the name KPMG Huazhen (Special General Partnership).

KPMG said its joint venture license was established in 1992 and was due to expire in August when China issued its order in May. “Over the course of 20 years, we have expanded from a little over 30 employees to our current headcount of around 9,000,” said Stephen Yiu, senior partner with the new entity, in a statement. He thanked China's Ministry of Finance and other government authorities for their “strong support and guidance” to facilitate the conversion “within such a short period of time.”

The newly organized KPMG Huazhen filed “Form 4” with the Public Company Accounting Oversight Board to indicate it now existed to assume the registration originally granted to the predecessor firm. The PCAOB requires a Form 4 filing for any registered firm that undergoes a change in ownership structure, such as through a merger or acquisition, that wants to continue doing business as a registered firm under the registration granted to the original firm.

In its Form 4 filing, KPMG Hauzhen indicates it will not—because of conflict with non-U.S. law—promise its cooperation when asked to testify or produce documents to the PCAOB, nor will it require any of its auditors to make such a promise. It also acknowledges that its pledge of cooperation is “a condition to the continuing effectiveness of the registration of the firm with the board.”

PCAOB spokesman Colleen Brennan said the board is not required under its filing rules to review or approve a Form 4 filing. The Form 4 filing contains an accommodation for a non-U.S. firm that may face conflicts with their home country laws. It allows firms to withhold responses on the form if they say they are doing so based on non-U.S. legal restrictions. “The board has been monitoring (China's) localization initiative and its effect on public accounting firms registered with the board,” she said, but it cannot comment on a specific firm filing.

Gillis says he believes KPMG's move suggests auditors are trying to continue with business as usual, despite the regulatory challenges. Even further, he sees KPMG's change as an exercise in form over substance. “KPMG said they have 25 partners, 15 of them locals, but they have several hundred partners. They've established a tiny firm that meets the technical requirement of the Chinese order, but that's obviously not the KPMG that practices in China, and Chinese regulators seem to be OK with that.”

Scott Univer, general counsel for U.S.-based audit firm WeiserMazars, says the Big 4 names in China all were originally organized as joint ventures between Chinese firms and the international audit firms. “Now they are moving to these national partnership structures, and other firms have said publicly that they are amenable to that as well,” he says. He expects all major firms will move away from their joint venture arrangements as those agreements expire over the next few years.

Along the second tier of international firms, like BDO, firms are organized more through partnerships than through ownership structures, says Lee Graul, a partner with BDO USA. “We don't invest in member firms at all,” he says. “They join us through an unpaid membership in our international partnership.” So the Chinese order to localize firms isn't a great concern to BDO, but the firm still feels the pressure associated with regulatory tension.

—Tammy Whitehouse

The Big 4's Response

In the meantime, it appears audit firms are beginning to reorganize operations and take other measures to try to continue operating in a way that satisfies regulators in both countries. In response to recent events, BDO is making some changes to how its audit work originating in China is completed, says Lee Graul, a partner with BDO USA. For Chinese companies that are listed in the United States, BDO employs some Chinese-born auditors in the United States who go to China to review audit work and assure it complies with U.S. standards. “It's the same as doing a work paper review of our own partners in the United States,” he says.

Graul says his firm debates internally whether to even continue providing such audit services because the risk has skyrocketed in the past several months with numerous Chinese companies flagged for accounting problems. To address the risk, the firm requires U.S. partners and senior managers travel to China, participate in audit planning and supervision, and review engagements carefully to assure the audit meets standards.

The approach is a little different for U.S.-based public companies with operations in China or any other foreign country, Graul says. “In that situation, we send them a program that tells them what they're supposed to do and how they're supposed to do it,” he says. “A senior manager has to visit that country and make sure that what we thought was being done was actually done.”

Because China will not allow work papers to leave the country, U.S.-based auditors have begun  documenting what they see in those work papers in a memo so they have something to show to regulators if the audit is ever called up for inspection, Graul says. “We can't provide the work papers so that becomes the basis for our audit opinion,” he says.

It sounds a bit like an approach suggested by Huber, who says audit firms can use liaisons from U.S. national offices to coordinate and review audit work in a way that manages the technical issues and mitigates the risks of non-compliance with both countries' laws. “Our understanding is that firms are trying to use liaisons and national office personnel who understand PCAOB requirements so they can fulfill their obligations in the Unites States and not run afoul of Chinese secrecy and privacy statutes,” he says. “I would think that will vary among the firms. This idea of how to balance U.S. requirements and Chinese statutes in the current environment is not something that has long-standing practice.”

Gillis says companies operating in China today should consider the risk of losing their audit services for those Chinese operations if the United States and China can't soon iron out their differences. “Everyone is aware of the risk, and there's no easy way to mitigate it,” he says.

Univer believes the United States won't allow the conflict to escalate to the point where an entire country's auditors will be kicked out of U.S. markets, and Chinese authorities won't want to reach that point either. “It's really in everyone's best interests to find a compromise that works,” he says.

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