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Can U.S. and China Avert Accounting Armageddon?

June 17, 2012

China and the U.S. appear to be an a collision course over accounting.  That’s a lot more serious than it sounds.  By the end of this year, unless a compromise can be reached, there is a very real chance that U.S. securities regulators may end up employing the “nuclear option”:  forcibly delisting every Chinese company currently listed on a U.S. stock exchange — such as Sinopec, Sina.com, China Life, and China Unicom.   It’s a potential catastrophe-in-the-making that few investors or politicians have given any serious thought to.

Last year, the US-listed stocks of more than a few Chinese companies took a beating following accusations by short sellers and research shops like Muddy Waters that SinoForest and other companies — many of which had avoided IPO scrutiny by arranging reverse mergers with already-listed entities — were grossly exaggerating their real assets and business performance in their official financial statements.  These accusations prompted the Securities and Exchange Commission (SEC) to launch several fraud investigations into the Chinese companies in question.

Rather than assisting the SEC in its cross-border probes — as other countries regularly do — the China Securities Regulatory Commission (CSRC) has actively blocked the SEC’s information requests, insisting that audit materials on Chinese firms fall under China’s ambiguous yet draconian State Secrets Law.  This April, when the SEC issued a subpoena to the Chinese arm of Deloitte, demanding the audit records of Longtop Financial (which collapsed last May after Deloitte resigned as its auditor), Deloitte refused, noting that the CSRC directly ordered them not to turn over such papers.  The firm argued it could be dissolved and its partners jailed for life if they were to comply.  In May, the SEC responded by initiating administrative proceedings to punish Deloitte China for violating its duties under the 2002 Sarbanes-Oxley Act.  Penalties could include suspending the firm’s authority to perform audits for US-listed companies, which are required under U.S. securities laws.  Apparently similar subpoenas have been issued to each of the other “Big Four” global audit firms (E&Y, KMPG, and PWC), and have met with similar replies.

There is a further complication.  The Sarbanes-Oxley Act established the Public Company Accounting Oversight Board (PCAOB), a five-person body appointed by the SEC.  Public accounting firms that wish to perform audits on US-listed companies must register with PCAOB, and PCAOB is required, by law, to conduct inspections of those firms.  So far, Chinese authorities have refused PCAOB permission to inspect auditors based in China, including the local arms of “Big Four” global audit firms.  Last month, it looked like PCAOB might have worked out a compromise that would let it observe Chinese regulators perform their own inspection, but the SEC action against Deloitte China appears to have derailed that plan.   The stage is set for a deadlock with serious, potentially disastrous implications, as my fellow CPA and Peking University counterpart Paul Gillis describes in his blog:

The PCAOB faces a December deadline to complete inspections of Chinese accounting firms that are registered with the PCAOB. It seems highly unlikely that they will meet this deadline, since Chinese regulators will not let them come to China. While the PCAOB could extend the deadline, they have already been under political pressure to act … Without resolution, the only meaningful option for the SEC, and the PCAOB, is for the PCAOB to deregister the firms and for the SEC to ban them from practice before the SEC.

The consequence of those actions would be that U.S. listed Chinese companies would be without auditors and unable to find them. Having an auditor is a listing requirement of the exchanges, so under exchange rules the companies face delisting. The U.S. listed Chinese companies would be unable to file financial statements as required. That should lead the SEC to eventually deregister the companies with the SEC.

Paul notes that shareholders in the delisted Chinese companies would still own their shares, but would be unable to trade them on U.S. exchanges.  The companies would probably try to list their stock on other non-U.S. exchanges such as Hong Kong, which could prove an expensive and cumbersome option.  The effect on US-China relations, and on investor confidence in cross-border investments in either direction, would be devastating.  Yet the alternative would be to allow Chinese companies to trade their shares on U.S. exchanges while openly flouting U.S. securities laws — not just Sarbanes-Oxley, which is somewhat controversial, but anti-fraud provisions dating back to the 1930s.

In the meantime, Chinese regulators have been moving to exert even greater secrecy and control over companies’ financial information.  Local bureaus of the State Administration for Industry and Commerce (SAIC) have started restricting public access to domestic corporate filings, after short sellers and analysts used information gleaned from those filings to call company financial statements into question.  Of more immediate concern, the Ministry of Finance is following through on plans to force the “Big Four” global audit firms to surrender majority control of their Chinese operations over to local CPAs, and dramatically reduce the number of foreign-certified CPAs they employ.  As Paul Gillis notes on his blog:

One of the unintended outcomes of the restructuring of the Big Four in China will be that the firms will likely be required to re-register with the PCAOB.  That could pose a problem, since the PCAOB has said they will accept no new audit firm registrations from China until the issue of inspections is resolved.

I was pondering the irresistible-force-meets-immovable-object dilemma here last night when I happened across a seemingly unrelated passage in Jim Fallows’ new book China Airborne, which offered a glimmer of hope.

In 1997, Jim relates, three Chinese airlines — Air China, China Eastern, and China Southern — had just been awarded or applied for very prestigious and strategically important routes to the United States, and had purchased brand-new state-of-the-art Boeing planes to fly those routes, with many further orders expected.  However, the safety record of Chinese airlines in the 1990s was atrocious.  In order to actually fly those routes, the airlines required approval from the U.S. Department of Transportation (DOT), the parent body of the FAA.  The DOT, at the FAA’s urging, demanded “confirmation that China’s regulatory standards, as applied by the CAAC, conformed to the worldwide guidelines laid out by international agreements.”  Until then, it was no fly.

The Chinese were furious, believing the Americans had double-crossed them by selling the planes and then reneging on the routes.  The whole thing could have concluded in respective chest-beating and a very ugly, damaging stand-off.  Instead, Boeing took the initiative (since its future sales were on the line) through a series of seminars, tours, and training sessions to reconcile the two points of view.  Key to its success was the way it handled Chinese sensitivities:

One [way] was to present all their recommendations in terms of meeting international standards for air safety and airline procedures, rather than seeming to say, This is how we do it in the U.S. of A.  Presenting the challenge this way made it far more palatable to the Chinese side.  Learning to comply with international standards was one more sign of modernization in China; doing things the “American way” could seem like a sign of continued subservience.  The examples were, of course, from American practices at the FAA or the operational details of Boeing and United Airlines, but the leitmotif was that Americans had learned how to make their practices meet international standards, and they could help the Chinese do the same thing.

Bridging the gap in securities regulation will surely be more difficult than fine-tuning some phrases — especially since Chinese companies that truly are fraudulent have a lot to hide.  But Chinese aviation officials had a lot to hide too, back then.  Many of them, once they realized how far they fell short of “international standards,” doubted whether they could ever make the grade, and feared losing face and making others lose face if they tried.  But working with their American partners, they succeeded:  China’s airline industry today has an admirable safety record, which has laid the foundation for ambitious plans for China to claim a leading role in the global aviation industry.  Caixin reports that at least some officials at CSRC are sympathetic to what the SEC is trying to achieve, and they certainly don’t want to seem too far out of step with their international (and much more cooperative) peers.

If China wants Shanghai to become a “global financial center,” or the Renminbi to develop into an “international currency,” it has to do the same thing in securities regulation that did in airline safety regulation.  It has to win the confidence of global investors just as it successfully won the confidence of global travellers.  China closing the windows and battening the hatches to avoid embarrassment is not a solution; but neither is Americans telling the Chinese “it’s our way or the highway.”  The U.S. has to make a forceful, compelling argument that adopting international norms of openness and cooperation on securities fraud investigations will help China achieve its ambitions — but that until then, it’s “no fly” for unsafe stocks on U.S. markets.

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23 Comments leave one →
  1. June 17, 2012 11:23 pm

    Excellent article – interesting from a perspective of the new CGMA – the UK’s CIMA and the US AICPA (where most of the big 4 come from). This is both an accounting issue and an ethics issue and the UK argues for principles in ethics while most of the financial losses have been on the US market. CIMA has quite a membership in Chinese companies – AICPA is attempting to audit them. Could be an interesting battle in CGMA as well! The legitimacy of Chinese companies operating world-wide is at risk – but, in typical Chinese fashion, there is a reluctance to concede the issues. Interesting to see how CGMA plays this one as well.

  2. ptuomov permalink
    June 18, 2012 2:53 am

    I don’t this approach will work, since family members of the CPC bigwigs are likely important beneficiaries of the stock frauds perpetrated in Singapore, Canada, the US, etc. Therefore, the airline safety analogy fails. Read John Hempton on the topic, he’s been following the money.

  3. Paul permalink
    June 18, 2012 10:15 am

    Why is it that American firms that want to conduct business in China have to go through all sorts of hoops and loops, but when Chinese firms want to do business in the US if they are asked to comply with American standards, we act as if it is perfectly reasonable for them to refuse and expect us to change our standards just for them? No question about it. Every other company from every other nation meets shows this information to the US regulators…why should the Chinese firms be treated differently?

  4. andao permalink
    June 18, 2012 1:36 pm

    Is it possible someone just got greedy without thinking clearly? Maybe I’m missing something, but the line of reasoning appears to be:

    1) Chinese businesses need more capital, plus “daddy needs a new pair of shoes.” US markets much more robust than Hong Kong/Singapore markets, so Chinese companies list en masse.

    2) Meanwhile, a sizable faction of the party does not like this one bit because it potentially exposes top leaders who are simultaneously huge shareholders of these companies.

    3) Get Rich Quick faction wins out, thinking they can properly obscure the various relationships involved. Have you read Muddy Waters’ report on SinoForest? The linkages and ownership structures are insane.

    4) GRQ faction underestimates the SEC, assuming a depressed US economy would welcome new market activities, even if it’s shady. Election year politics and whatnot lead to a more aggressive SEC.

    5) The Cautious Faction manipulates the CSRC into throwing up all these roadblocks to cover their hides.

    I do not think the CSRC will blink. Why?

    1) Money loss is nothing compared to top leaders being outed as multi-billionaire shareholders in US listed companies (while ordinary Chinese are not allowed to invest in US markets)

    2) They could relist in HK or Singapore. Less potential for growth, but a hell of a lot safer.

    3) Reputation for Chinese stocks is mostly shot now anyway. Valuations are all screwy since everyone assumes books are being cooked.

    4) Part of the “indigenous innovation” scheme. Chinese state-backed credit and accounting firms would love to milk the Big Four for all the accounting knowledge they have, then boot them out of the country. Chinese firms proceed to make billions doing business in China, Africa, SEA, LatAm, etc. For an example in a different industry, refer to that story of AMSC, a wind turbine manufacturer that had a multi-million dollar shipment rejected suddenly and inexplicably at Chinese Customs. AMSC technicians later discovered a Chinese state-backed supplier had pirated their source code and reengineered their own software, thus destroying AMSC’s China business.

  5. June 20, 2012 2:53 am

    i understand very good ..all the article /thank you

  6. June 20, 2012 8:20 am

    Thanks for bringing this issue to our attention Prof. Chovanec. If there is an impasse and the egos get in the way, do you think it could cause a significant negative impact on future outbound investment opportunities from China?

    • prchovanec permalink*
      June 20, 2012 8:43 am

      Well, I think it’s more than a question of egos. Accounting standards are really about the quality and reliability of information flow. Without reliable information, it becomes harder to evaluate investments. The greater risk can only be justified by higher returns, which limits amount of investment that will actually take place (much like higher interest rates would). So yes, unless steps can be taken to ensure investor confidence in Chinese companies, the negative impact will definitely be felt, not just in an immediate sense (the threat of delisting) but going forward.

  7. Johannes permalink
    June 20, 2012 7:52 pm

    The situation can be viewed as 1) the SEC visibility into and abilty to act on cases of potential frauds of US firms is much higer as compared to Chinese companies because US companis indeed either follow the rules or it it transparant to SEC when they do not. The Chinese companies need to learn to truly become more transperent.
    or 2) SEC is not doing their job anyways, so the Chinse firms must to learn to appear to follow the rules.
    Which one do you think it is?

  8. Paul Adkins permalink
    June 21, 2012 10:28 am

    “The U.S. has to make a forceful, compelling argument that adopting international norms of openness and cooperation on securities fraud investigations will help China achieve its ambitions…”

    With respect Patrick, this is not a fight that the US needs to take on its own. Sure, the US has the biggest to lose, but this is a fight that all nations that want a fair and unimpeachable accounting system must take up. As an Australian citizen, I hope my country’s regulators join with the US and other countries to take a stand on this.

  9. July 31, 2012 7:59 pm

    I always find such amazing posts on this website and today’s post was really amazing. Now I have become a regular user of this website. Thanks for giving us so much knowledge.

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