U.S. Markets closed

Accounting Divide: U.S. Standards Run Into A Chinese Wall

The U.S. government watchdog that oversees the auditors of U.S.-listed companies inked agreements with France and Finland this month to inspect corporate audits in those nations. But China, which has seen 126 of its firms delisted from U.S. exchanges for accounting and related irregularities, is still rebuffing access requests from the Public Company Accounting Oversight Board.

PCAOB member Jeanette Franzel said at a recent New York investment conference that U.S. ability to inspect auditors in China continues to be one of the agency's biggest challenges. "It is a serious issue for investors who have invested in these companies if we and the SEC do not have oversight, so we continue to work on that," she said.

Franzel, without giving details, says the U.S. is making progress with China on negotiating a memorandum of understanding that allows U.S. regulators to inspect the books of Chinese companies in China. But there's still no sign of when China will act to resolve the issue. How the Chinese side responds may affect the ability of reputable Chinese companies such as Baidu (BIDU) and future IPOs to trade in U.S. markets.

Investigating Longtop The flap started in May when the SEC tried to get Deloitte's Hong Kong unit to hand over accounting data on China-based financial software maker Longtop Financial. Longtop was a former client of Deloitte that was delisted from the NYSE in 2011 for fraudulently concealing its true cash position.

Deloitte refused to comply with the SEC order, saying that Chinese regulators threatened to jail anyone who discloses such information for violating China's state secrets act. China claims this is a national sovereignty issue. Behind the scenes, analysts say, Beijing is cracking down on companies and individuals tied to dubious ADR firms who are threatening the credibility of all U.S.-listed Chinese companies.

The larger question is how far national sovereignty issues of this sort will undercut China's ability to meet international accounting standards now that it's become a global financial player of major proportions.

"I'm sure that the behavior (of Chinese companies) can be improved on the accounting issue," said Chinese economist Justin Yifu Lin at a January conference on the Chinese economy held at the New York Stock Exchange. Lin is a former chief economist of the World Bank who's now a professor at China's National School of Development.

Will China Follow Through? But while China concedes that the bookkeeping of its companies could be better, some analysts question how far it's going to fix the problem. While crackdowns have been rumored, it isn't clear whether anyone has been arrested or if any offending firms have been charged.

On the U.S. side, the SEC on Dec. 3 charged five China affiliates, including those of the Big Four accounting firms, with violating U.S. securities laws in refusing to produce documents. Named were BDO China Dahua, Deloitte Touche Tohmatsu Certified Public Accountants, Ernst & Young Hua Ming, KPMG Huazhen and PricewaterhouseCoopers Zhong Tian CPAs.

The audit papers requested involve Longtop Financial and others. The auditors are fighting the SEC in court.

SEC spokesperson Judith Burns declined to comment on the case since it's in litigation.

The accounting access issue has become such a legal mess that some question whether auditors want to be involved at all.

"There is concern in the sector that the Big Four won't want to take on clients in U.S.-listed Chinese companies," said Janet Stites, the publisher of China Business Knowledge, an online newsletter that tracks Chinese firms listed in the U.S. markets.

It's unclear if the Big Four would actually drop their Chinese clients. Nor is it clear if China will really charge persons tied to the local units of global accounting firms in China who give such records to the SEC. But the SEC clearly requires U.S.-listed Chinese companies to use approved accountants if they want to trade here.

Will there be a bilateral meltdown over the accounting issue? "I don't think the nuclear option is likely," said Drew Bernstein, co-managing partner of global accounting firm Marcum Bernstein & Pinchuk. He also says U.S. and Chinese officials are making some behind-the-scenes progress on audits.

Disagreement On Data Use Bernstein says the China Securities Regulatory Commission, the SEC's counterpart, indicated last April that it would deliver audit work papers for Chinese companies on condition the SEC didn't allow them to be used in legal proceedings without the CSRC's prior approval.

"I don't think there's any disagreement on doing the inspections," Bernstein said. "But there is a disagreement on how the data can be used.

Analysts say rivalry between Chinese ministries may be involved insofar as the CSRC would have to grudgingly involve China's Justice Ministry if Chinese firms faced foreign legal action.

It's easy to see why the SEC pressed China. Longtop was one of dozens of Chinese firms that went public through U.S. back-door listings and have since been called out for various accounting and financial issues. Longtop plunged as much as 61% from its high by the time the stock stopped trading on the Big Board in May.

PCAOB's Franzel disclosed at the New York conference in early February that about 67 U.S.-listed Chinese firms have had their auditors resign since 2010 over alleged accounting issues. She also says that 126 have been delisted or have "gone dark" and are no longer tapping U.S. capital. "We don't know how many more are out there and may need to remove themselves from the U.S. markets," Franzel said.

Issues like weak balance sheets with large receivables vs. sales and amazing revenue and earnings growth relative to peers were first reported by short-seller websites like Citron Research and Alfredlittle.com. The shares of various Chinese firms tanked on their reports and U.S. investors lost billions.

Some short sellers doubt China is moving to clean up its accounting issues. "I do not believe the Chinese are serious at all about fixing the accounting problems," said Jon Carnes, the founder of Alfredlittle.com. "Such a fix would first and foremost require a legal system where all the foreign investors who have been cheated by Chinese companies can obtain restitution.

Said Citron Research founder Andrew Left: "I could only imagine that after the past few years it would be in the best interest of the (Chinese) economy to make these changes, so I hope they are serious.

Sovereignty, at the same time, is a touchy issue with China, which hasn't forgotten its past history of unequal treaties with the West and what it perceives as foreign disrespect for Chinese laws.

Incomplete Access In a stop-gap measure, the U.S. reached an auditing deal with China in early October that allows U.S. officials to begin observing corporate audits in China. The agreement announced by the PCAOB fell short of the full access the board requested to inspect the audits of Chinese ADR firms.

If the PCAOB can't resolve the dispute with Chinese regulators, the issue will likely be taken up in the U.S.-China Strategic Economic Dialogue talks that will take place in the U.S. later this year.

It's doubtful the U.S. would risk a major showdown with China over the access issue. And it's possible China might agree to small steps to widen access at a time when it's encouraging Chinese companies to venture and invest overseas.

"We have to hope that (the U.S. and China) will find some figurative way to step back from the cliff while preserving Chinese sovereignty," Bernstein said.