Podcast: China Refuses US Audit Inspections. Why It Matters.
Effective auditing of companies’ financial statements is important for investor confidence, but Chinese companies traded in the U.S. don’t get U.S. oversight of their audits as other companies do. And that could be a risk for investors.
The Public Company Accounting Oversight Board, the U.S. audit regulator created to restore confidence in financial reporting after accounting scandals of the early 2000s, isn’t allowed to inspect the work of China-based accountants.
That lack of access is a concern to the PCAOB, the Securities and Exchange Commission, and some members of Congress. They have introduced legislation to crack down on China if it doesn’t let audit inspectors in.
Bloomberg Tax’s Amanda Iacone spoke with Paul Gillis, who teaches at Peking University’s school of management in Beijing, about the significance of the problem and what may lie ahead.
Amanda Iacone:
From Washington. This is Talking Tax. I’m Amanda Iacone. More than 200 Chinese companies are registered to trade in the US but unlike domestic companies, these companies are able to skirt a key investor protection in U.S. law, the Sarbanes-Oxley Act. It was born out of the Enron and WorldCom accounting scandals regulated the audits of publicly traded companies in the US and created the Public Company Accounting Oversight Board to serve as the industry’s watchdog, but the board isn’t able to inspect the work of auditors based in China and that lack of oversight increases the chance of fraud and could put investors money at risk. The Securities and Exchange Commission raised concerns about the PCAOB’s lack of access in China and the possible risks last year. Some members of Congress are worried to and introduced legislation in June that would crack down on China if Beijing doesn’t let U.S. audit inspectors in. So what’s being done? I spoke with Paul Gillis who teaches at Peking University School of Management in Beijing about why this issue has resurfaced suddenly and what’s likely to happen next. Paul, thank you for joining me today to talk about China and auditing.
Paul Gillis:
Thank you for having me on.
Amanda Iacone:
So the U.S. audit regulator has not been able to access the work papers of Chinese auditors. This has been a long standing barrier to the regulators watchdog role, which is to keep tabs on the auditors of public companies trading here in the US. Both the Public Company Accounting Oversight Board and the SEC have been chipping away at this trying to reach an agreement with China for years now without much success. Why is this an important issue?
Paul Gillis:
What Sarbanes-Oxley required is that all accounting firms be inspected by the PCAOB at least every three years. And that includes foreign accounting firms that audit U.S. listed companies or play a significant role in the audit of U.S. listed companies. Many countries after Sarbanes-Oxley came into effect, initially resisted allowing the PCAOB to come to their countries to inspect citing national sovereignty concerns or privacy concerns. China was the biggest holdout and the biggest because Chinese private companies have for almost 20 years used the U.S. capital markets as their primary capital market. They tended to list in China rather than list in Hong Kong, or they listed in the United States instead of listing in Hong Kong or in China because the U.S. market was better specialized in the kind of technology companies that we have here.
And the US had more relaxed standards for listing then did Hong Kong or mainland China. The PCAOB tried to do inspections with China for a number of years and has had some breakthroughs to allow for certain types of cooperation. But in general, China has taken the position that the disclosure of audit working papers to a U.S. regulator would cause two harms to China. One, it would allow a foreign regulator to enforce foreign law on Chinese soil against Chinese people. It’s considered to be an infringement of China’s national sovereignty. And then secondly, there was a concern that the audit work papers might contain state secret. China has a very expansive definition of state secrets such that basically any transaction with a state owned enterprise in China is considered to be a state secret. So for example, my mobile phone bill is technically a state secret.
Amanda Iacone:
So why now with this, has attention of the SEC again, the PCAOB is talking about this again, Congress involved at this point.
Paul Gillis:
Well, this has been an issue, has been a real thorn in the side of the PCAOB and the SEC now for a couple of decades. And there were quite a large number of accounting fraud that basically hurt many U.S. investors in Chinese companies. Many of these frauds were identified by short sellers. And there’s an argument that a more effective audit regime might’ve found more of these frauds before they were able to rip off American shareholders. And so that put a lot of pressure on trying to get something done. And I think also the rising tensions between the United States and China have encouraged some of the legislators to pile on to the anti-China sentiment in the United States. And so I think that the trade war has also encouraged some of these legislators to induce this kind of legislation to control the Chinese companies that are taking advantage of U.S. capital markets.
Amanda Iacone:
I want to talk more about what Congress has proposed in a minute, but first let’s talk about that trade war. Let’s talk about the trade tensions. How does this issue of access to audit work papers tying into the, you know, as we record this, the ongoing US-Chinese trade negotiations, is this even on the table and should it be?
Paul Gillis:
Well, I don’t think the issue, that issue has really been on the table. It’s a somewhat narrow issue. And one that I don’t think either side has been all that excited about in the past. So a lot of the sort of a background issue to the trade wars is this concern of a rising technological China. And, there are a couple of aspects to that. One is the many of the people who work in that industry are American educated. U.S. PhD programs turnout hundreds of Chinese PhDs every year in the science fields that are often returning to China to help develop China’s new found leadership in this area. And then Chinese companies have traditionally tapped the U.S. capital markets for the money necessary to develop these industries. And as a result China now has some very large and very successful e-commerce companies that the position to change the world map in terms of technology and e-commerce over the coming decades.
Amanda Iacone:
I wondered what else we should know about China, how the government works, how its economy is structured. You know, you just mentioned that it’s positioning itself to be a world leader, world technology leader. You know, that they would help us better understand the barriers facing a U.S. regulator. And the potential risks to U.S. investors. You mentioned that you heard there had already been some cases of us investors being defrauded from defrauded by Chinese companies. You know, what else do we need to know about what’s happening there?
Paul Gillis:
The private sector is now dominant in China. All the new economy companies are privately held companies where the old economy companies like steel and oil tend to still be state controlled companies. But as the private companies have rose they were unable to access capital in China. Part of it was ideological that many people at the banks viewed that alone to a private enterprise was not patriotic. It certainly was riskier for a bank or for an investor to invest in a privately owned company. Because the state owned companies were all effectively government guarantees. So a banker or an investor would never have to worry about security of their investment if they invested in a state owned enterprise. So China has taken steps to open up its capital markets to private companies better. But it’s still the case that the larger Chinese private companies have tended to go overseas for listings and most of the private companies have chosen the U.S. market. Whereas the state owned enterprises have often gone to the Hong Kong market to raise capital. The private companies like Alibaba have generally chosen the United States markets because they are bigger and more sophisticated with respect to technological investments.
Amanda Iacone:
You mentioned Alibaba, what other Chinese-based companies are traded here in the US? This is not just a small handful of companies we’re talking about. I mean there’s potentially hundreds of them. Are there other household names? I mean, can you give us an example of like just how big of a group of companies we’re talking about?
Paul Gillis:
Well, there are, there are a couple, there are presently several hundred companies, Chinese companies listed on major U.S. exchanges, NASDAQ and New York Stock Exchange. And plus hundreds more that had listed on the over the counter bulletin board system. Many of the companies that listed over the counter were reverse mergers where a Chinese company is merged into a public shell company, often a company that’s already gone through bankruptcy. And then that company is immediately registered with the SEC without having to go through audits or our comments by the SEC staff. So it was a shortcut approach to getting on the market. Reverse merger is largely ended a few years back when the NASDAQ and the New York Stock Exchange both put restrictions on the ability of companies that do reverse mergers to upgrade their listings to NASDAQ or New York Stock Exchange listings. And I haven’t seen any of those transactions in several years, but they are a big part of the legacy and a very high percentage of those reverse mergers proved to be fraud and whether they were delivered frauds or whether they just simply were unprepared for the challenges of reporting as a public company. There’s probably some of both of those issues present.
Amanda Iacone:
The ability to list in the US is sort of a core issue that several pieces of legislation that had been introduced in both the House and the Senate tackles the bill specifically threatened to delist Chinese companies from U.S. exchanges if they don’t comply with PCAOB inspection regulations. Does that threat of delisting put any pressure on the Chinese to relax its definition of state secrets, or to come to the table to negotiate access to audit work papers?
Paul Gillis:
I think China would prefer to retain access to U.S. capital markets, but it is unwilling to make a significant compromise that would be viewed as trading away at national security issues or sovereignty in order to achieve that. China, on the other hand, China would like to see its companies returned to China. So if these law bills become law, what will happen is it begins a three year period to either find a settlement for this issue on inspection or these companies are going to have to find a new home. And what I would expect is most of them would try to move their primary listing from New York to Hong Kong. The Hong Kong stock market is probably the best suited to deal with this. You know, companies like Alibaba and Jingdong are quite huge companies. So I think the Hong Kong exchange is large enough to handle those.
And that’s probably where most of them go. And during that period, there would also be a chance for continued negotiations between the United States and China and some pressure on Chinese regulators to find a way to allow inspections of Chinese auditors, including the Big Four, which audit most of the U.S. listing. The Big Four accounting firms, they’re also the largest firms in China to allow them to be inspected would be something that China might be willing to find some way to reach accommodation on, allow these listings to continue. But I think what we’re seeing is that the bills that have been proposed in Congress are really just piling on to the trade war tensions and a view that China is taking advantage of the U.S. and there’s not much doubt that Chinese companies listed in the United States are subject to lower standards than American companies was spending the United dates.
And that just doesn’t seem fair to anybody. And it’s a legacy of when the exchanges wanted to attract more listings of companies such as German companies that might seek a dual listing for their shares to have some shares listed in the United States and some shares listed in Germany. And they didn’t want to create any additional burdens for those companies. So they tried to make it as easy as possible for them to list, but that created this opportunity for Chinese companies that are not listed in China to take advantage of the looser listing requirements in the United States. And that has created a lot of risks for U.S. investors.
Amanda Iacone:
How much interest is there here among members of Congress on this issue? I mean, is this this bill likely to make it to the floor for a vote, let alone become law?
Paul Gillis:
I would expect that the Chinese will want, if there’s a settlement coming to the trade war and I don’t see that as something that’s going to be easy to achieve. Given the ways that the negotiations have taken place so far then, then I think this issue may get wrapped up in a settlement on the trade war and the bills will never advance. If the trade war stalls out into a cold war that’s going to last for a long time, then I think the these bills probably get pushed forward as a way to just continue to put the pressure on China to come to the table and negotiate.
Amanda Iacone:
How much negotiating is actually happening right now in terms of this specific issue, access to audit work papers? Is anybody talking to anyone?
Paul Gillis:
Yeah, I don’t think there’s really been anything going on. You know, the issue had been negotiated, you know, off and on for more than a decade. And you know, China would keep trying to make promises and make concessions that would allow some pilot inspections and it would agree to a certain degrees of cooperation. But when it actually came down to actually doing something, you know, the PCAOB would be told that they could do a pilot inspection. But when they would arrive they wouldn’t be allowed to really look at anything or ask any question and they’re only able to observe what is going on. And they found that to be inadequate going forward. China is I don’t think gonna negotiate on this issue until it got a gun held to its head. And that’s really what these bills are providing.
Amanda Iacone:
Paul, that’s all I have for you. I really want to thank you for taking time to speak with me today about this ongoing issue with access to audit work papers in China. And thank you for, for speaking with us today.
Paul Gillis:
Well, thank you very much for including me.