What's Fueling the U.S.'s Audit Standoff With China?

With the collapse of talks between the Public Company Accounting Oversight Board and its Chinese counterparts, a trans-Pacific auditor inspection conflict is escalating and threatening to spin out of control.

The PCAOB will soon be forced to follow its own rules and de-register Chinese accountants, a move that would likely lead to a series of tit-for-tat responses and ultimately could further harm the already delicate financial and business relations between the United States and China.

“That's the nuclear option,” says Paul Gillis, a visiting professor of accounting at Peking University and a member of the PCAOB's Standing Advisory Group. “The PCAOB gets so much pressure from Congress that it simply decides to act and de-register the firms and sets in motion a whole series of events that are unthinkable.”

All audit firms that inspect the books of U.S. public companies are supposed to register with the PCAOB and submit to inspections by it. While China-based auditors have complied with the first requirement, none of them are permitted to allow the second; the Chinese government believes that the inspection of working papers by a foreign regulator constitutes a violation of its sovereignty. For a number of years, the PCAOB has been trying to get China to agree on access, issuing announcements and publishing papers identifying the problem, and finally meeting with the China Securities Regulatory Commission (CSRC) and the Ministry of Finance in July. Representatives of the Securities and Exchange Commission also attended.

After the first meeting, held in Beijing, the U.S. authorities felt as though progress had been made. They believed that the Chinese were beginning to understand the importance of inspections, especially since around that time stock prices of Chinese companies listed in the United States were declining, as investors lost confidence is their financial statements.

At that point, a compromise seemed possible. Many countries had expressed similar concerns regarding sovereignty before, and the solution was that the local regulator would lead inspections in cooperation with the PCAOB. The hope was that China would follow this path too.

As often happens with the Chinese, the visiting foreign party believed that good communications had been established and were confident after the July meeting that some agreement could be reached. At the conclusion of the conference, plans were announced for a second round of talks in Washington in the fall.

That meeting never happened. The Chinese side mysteriously backed out. Some observers suggest that the U.S. negotiators may have misinterpreted what really transpired in July. While it is generally acknowledged that the PCAOB-SEC team was professional and experienced, it is possible that they were unprepared for the gamesmanship that often characterizes negotiations in China, and mistakenly saw agreement or goodwill in what might have just been a tactical feint.

“The PCAOB may have reached agreements with a number of countries, but they haven't reached agreements with too many communist countries. And that's a different animal.”

—Drew Bernstein,

Partner,

Marcum Bernstein & Pinchuk

“The American side may have misconstrued what was happening,” says Bill Uchimoto, a partner at Stevens & Lee, chair of the firm's China practice and a former SEC attorney. “The Chinese can be accommodative in these negotiating sessions, but whether that signals true agreement and consent, that's always questionable. There may have been no consensus.”

Negotiations with communist countries, even over mundane commercial issues, are often complicated affairs. Highly involved and arguably devious strategies not usually employed in open societies are common. The U.S. regulators may have been somewhat out of their element.

“The PCAOB may have reached agreements with a number of countries, but they haven't reached agreements with too many communist countries. And that's a different animal,” says Drew Bernstein, a partner at Marcum Bernstein & Pinchuk, a PCAOB-inspected accounting firm with branch offices in China. “It's not like dealing with the Swiss, or the British, or the Germans, or the Brazilians.”

Much has happened since the first meeting, and that may also in part explain the chilling of relations from the Chinese side. In early September, the SEC demanded from Deloitte Touche Tohmatsu's Shanghai office the workpapers from its audits of Longtop Financial Technologies, a Chinese company that stands accused of fraud. Deloitte responded that it couldn't hand over the documents because Chinese law would not allow it to comply with the request.

SCHUMER LETTER

Below is the letter sent by Sen. Charles Schumer to PCAOB Chairman James Doty.

Dear Chairman Doty,

I write today to express my concern about the Public Company Accounting Oversight Board's continued failure to inspect Chinese audit firms. Close to 100 Chinese auditors, or China-based affiliates of U.S. auditors, have registered with the Board to perform audit work for over 300 U.S. public companies with operations in China. The Board's failure to inspect means that American investors have no independent assurance that Chinese accounting firms' audits on U.S. public companies' operations in China comply with U.S. law. This is a serious problem that threatens to undermine public confidence in the companies' financial statements.

It goes without saying that the integrity of public companies' financial statements is critical to confidence in U.S. markets—whether those financial statements are prepared in the United States or in other countries. Yet, despite six years of Chinese audit firms' refusals to cooperate in inspections, the Board has taken no disciplinary actions with respect to any of those firms. I recognize that the Chinese government is acting to obstruct the Board's inspection of registered Chinese audit firms, but this standoff has gone on long enough. I respectfully urge the Board to take immediate disciplinary actions against Chinese audit firms that continue to refuse to cooperate.

In just a two-month span earlier this year, more than 24 companies doing business in China reported auditor resignations and accounting irregularities. Moreover, the Board itself has expressed concern about the danger lack of inspection of Chinese audit firms poses for U.S. investors. Yet the Board has done nothing more than list the Chinese auditors that have never been inspected, along with the names of their client companies, and issue an audit alert to remind registered audit firms of their obligations. The alert appears to have been prompted by the increasing numbers of companies based in China and Hong Kong accessing the U.S. markets via reverse mergers. These recent reverse merger scandals are case-in-point that failure to scrutinize Chinese audits can cost U.S. investors billions. More problematic is that the reverse merger collapses might just be the tip of the iceberg.

It has been ten years since the wave of corporate accounting scandals that began with the sudden and unexpected collapse of Enron Corp. In the wake of those scandals, Congress established an independent watchdog—the Public Company Accounting Oversight Board—specifically to regulate independent auditors of public companies. To ensure corporate financial statements are subject to tough, outside scrutiny, Congress also gave the Board explicit legal authority to take disciplinary action if auditors refuse to cooperate in inspections. Those sanctions include suspending or revoking an audit firm's registration, which would preclude the firm from preparing or issuing any audit reports concerning any issuer. Despite this enforcement authority, and despite six years of Chinese audit firms' refusals to cooperate in inspections, the Board has taken no disciplinary actions on any Chinese auditors. The Board's failure to do what it was created to do—particularly in the face of Chinese corporate accounting scandals that have already cost U.S. investors billions—is deeply troubling.

I understand the Board has been negotiating the auditor inspection issue with China for over six years. However, as we have seen on other issues, years of discussions with the Chinese government generally fail to produce meaningful results. The Board was not created to merely alert the public to problems. Rather, the Board was set up as a watchdog to protect investors—to inspect and assess compliance with applicable securities laws to protect the interests of investors and further the public interest in the preparation of accurate audit reports. In the case of Chinese audit firms, the Board is failing to do its job.

Mr. Chairman, you recently conceded publicly that it is not tenable to continue indefinitely to allow Chinese audit firms to remain registered if the PCAOB cannot inspect their U.S.-related audit work. I agree. Six years with no resolution on this critical issue is unacceptable, and it is time for the Board to exercise its enforcement authority against Chinese audit firms that have not submitted to independent regulatory review. In a separate letter, I am asking the Securities and Exchange Commission to require upfront disclosure by public companies that use China-based audit firms while we wait for the Board to do its job. The longer the Board countenances this impasse, the greater the danger to American investors and U.S. markets.

Thank you for your attention to this important matter. I ask that you please keep me apprised of developments.

Source: Senator Charles Schumer.

Then in late November Sen. Charles Schumer, (D-NY), sent the PCAOB a public letter castigating the regulator for “failing to do its job” by allowing Chinese auditors to remain registered without being inspected. Schumer also pointed out that long negotiations with China usually fail to produce results. Schumer did not respond to an interview request.

“I think it was the SEC subpoena for Deloitte work papers” that triggered the change in sentiment, says Gillis. “What China suddenly realized was that there is a lot more at stake and that the situation is a lot more complicated than they first thought.” Deloitte did not respond to a request for comment.

Academics and professionals watching this process are generally convinced that the two sides will come together simply because they have to. The consequences of not agreeing are just too great. If the PCAOB de-registers China-based auditors, many Chinese companies will have to delist from U.S. exchanges, capital flows between the two countries will be impaired, and U.S. auditors and U.S. companies in China would likely face retaliation.

The Fallout

“It's hard to imagine that the SEC and its foreign counterpart in such an important country as China are refusing to talk to each other,” says William Currier, a partner at White & Case and a former SEC assistant director. “It is likely that communications are occurring but that those discussions are being conducted privately,” he says. If an acceptable mutual agreement cannot be reached, “that would be quite shocking,” Currier adds.

For its part, the PCAOB says it will continue to chip away at the stone. “We continue to be engaged in discussions with the Chinese authorities,” Chairman James Doty said via email. “While dates for a meeting with the Chinese regulators have not been set, we remain hopeful that such a meeting with the Chinese regulators will occur in early 2012.”

Not everyone is so optimistic. Some say that understanding the true intentions of Chinese bureaucracy is impossible, that Beijing considers too many internal issues and concerns for outsiders to make much of an intelligent guess. Questions of the Chinese currency, the trade surplus, national pride, the economy, and other matters may all be coloring the Beijing perspective.

Others just don't think the Chinese have much reason to agree. They say that the country has little to gain from compromising and would be better served simply by declining any solutions that might be proposed by the PCAOB. “I don't think there are any real reasons to expect the U.S. and China to resolve this issue,” says Michael Stein, a professor of accounting at Old Dominion University and until recently an academic fellow at the PCAOB. “What is the benefit to the Chinese government of allowing this to happen? I don't think they need U.S. capital at the moment.”

“Until recently I tended to agree that the intransigence on the part of the Chinese was a negotiating tactic,” he adds. “But it seems to me that the desire to get this resolved is all on one side of the equation. The difference between China and the U.S. and Europe and the U.S. is that the Europeans would want to get this resolved. I am not sure that the Chinese government would view this as a high priority.”