U.S. Investors Have Another Reason to Fret Over China Firms

An employee mops the floor in a building lobby at the Alibaba Group Holding Ltd. headquarters in Hangzhou, China, on Oct. 13, 2015.

An employee mops the floor in a building lobby at the Alibaba Group Holding Ltd. headquarters in Hangzhou, China, on Oct. 13, 2015.

Photographer: Qilai Shen/Bloomberg
  • Regulator's plan to inspect China audits said to falter
  • U.S. audit watchdog planned to initiate inspections this year

A key accounting safeguard intended to protect U.S. investors who buy shares of Chinese companies is close to unraveling. 

Last month, a final agreement that would have allowed a U.S. regulator to examine the audits of Chinese companies listed on American stock exchanges fell through, according to two people with knowledge of the matter. The failed negotiations are a setback for the Public Company Accounting Oversight Board, a Washington-based watchdog that has sought access to Chinese audits for years as dozens of companies such as JD.com Inc. and Alibaba Group Holding Ltd. raised billions of dollars from U.S. investors.

The impasse is also a blow to PCAOB Chairman James Doty, who said in June that his agency was “very close” to reaching an accord. The regulator’s inspectors had expected to start traveling to China this year to examine the audits of Chinese businesses, said one of the people who asked not to be named because negotiations aren’t public.

“Without having the PCAOB involved in doing those evaluations, the quality and reliability of audits in China will continue to be a black box to U.S. investors,” said Jason Flemmons, a senior managing director at FTI Consulting Inc. and former deputy chief accountant for enforcement at the Securities and Exchange Commission.

The PCAOB continues “to work toward a resolution on the question of joint inspections of China-based firms,” spokeswoman Colleen Brennan said Monday in an e-mailed statement. An e-mail to China’s U.S. embassy in Washington seeking comment wasn’t returned.

Narrowed Exams

Negotiations over the scope of PCAOB inspections fell through in early October, because U.S. officials thought the Chinese had narrowed the terms of examinations so significantly that it wasn’t worth proceeding, the people said. As the regulator has sought more transparency into audits in recent years, the SEC has deregistered the securities of dozens of Chinese companies and filed fraud cases against their executives.

The breakdown in talks comes as shareholders already had reasons for concern that the outlook for Chinese companies was worsening. Citigroup Inc.’s top economist said in August that China was sliding into recession and some investors have long questioned the accuracy of the country’s official growth data.

Chinese companies have raised $36.7 billion from U.S. investors through initial public offerings since January 2010, according to data compiled by Bloomberg.

For years, Chinese accounting firms have resisted U.S. regulators’ demands for information about their audits of corporations, arguing the disclosures would violate laws against transferring data that might contain state secrets to foreign entities. The PCAOB has tried to strike a compromise that would ease Chinese concerns while still giving the U.S. regulator access to audit work papers.

The SEC has also faced hurdles in securing information about Chinese audits. Over the past several years, it fought with the Chinese affiliates of the four largest audit firms over the companies’ refusal to provide documents that the SEC had requested as part of investigations into accounting fraud. The firms -- Deloitte Touche Tohmatsu CPA Ltd., Ernst & Young Hua Ming LLP, KPMG Huazhen and PricewaterhouseCoopers Zhong Tian CPAs Ltd. -- each agreed to provide the data after an SEC administrative law judge ordered they be barred for six months from auditing U.S.-listed companies.

‘No Solution’

The news was first reported earlier Tuesday by Thomson Reuters Tax & Accounting.

Federal law gives the PCAOB authority to inspect any auditor who examines the financial statements of companies that trade in U.S. markets, including overseas audit firms. PCAOB inspectors will travel to 25 countries this year to examine audit work, Doty said in June.

The PCAOB could respond to the setback with China by pulling the registration of Chinese audit firms. However, such a move would probably trigger collateral damage for U.S. companies that do a lot of business in China, because they might struggle to find accountants who could review their books. Ninety-one Chinese audit firms were registered with the PCAOB at the end of 2014, including 45 based in Hong Kong, according to the regulator’s latest annual report.

“There is no obvious solution that doesn’t have serious side effects,” said Joseph Carcello, an accounting professor at the University of Tennessee who serves on the PCAOB’s investor advisory group.

(Adds number of registered accounting firms in 13th paragraph.)
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