China faces a conundrum - either back down to US demands to inspect Chinese audit firms or risk further damaging the credibility of its companies and auditors abroad.
The long-standing feud between US and Chinese audit authorities, which has been simmering for the past few years, is coming to a head.
Last summer, nearly 30 audit firms were forced to resign from auditing Chinese companies listed in the US due to dodgy accounting and the exodus has continued since.
A lack of confidence in Chinese companies is diminishing the value of their stocks and leaving investors wary of pouring capital into unreliable accounts.
The US hopes to reach an agreement with China that would allow it to inspect Chinese audit papers of US listed companies.
So far, China has resisted US overtures, preventing Chinese firms from handing over audit papers. The world’s second largest economy does not like foreign powers meddling in its affairs and attempts by US authorities to place legal pressure on firms has hardened the resistance.
US law requires all firms that audit listed companies to undergo regular audit inspections by the US audit watchdog, Public Company Accounting and Oversight Board (PCAOB). Although the US has agreements with most jurisdictions that allow joint inspection, China is not the only exception. France, Denmark and Belgium also deny access but their companies are not embroiled in Securities and Exchange Commission (SEC) investigations.
To date, most of the attention had focused on one high profile case. Despite taking out legal action, the SEC has failed to retrieve audit papers from Deloitte’s Shanghai office in an investigation of software company Longtop Financial Technologies. Former Deloitte client Longtop falsified financial records and has come under the scope of US investigators.
It is understood US authorities have approached other Chinese firms for audit paperwork, including PwC.
The regulation tug-of-war places global accounting firms with Chinese offices in a tight spot.
Chinese law prevents them from directly dealing with other jurisdiction and all requests for audit papers must go through China’s Ministry of Finance, which so far isn’t playing ball.
At present, Mainland Chinese affiliates of global firms have 130 clients listed on US stock exchanges with Deloitte (48 clients), PwC and KPMG (28 clients each) top of the pile.
This number is already under threat.
Global firms are sensitive to the spread of reputational damage and would quickly drop a client (Chinese or otherwise) if they suspected it lacked credibility.
Firms may also start leaving Chinese clients if US government pressure begins affecting their US businesses.
What is clear is US authorities are losing patience with the impasse, although negotiations are ongoing.
If a solution isn’t found soon, Chinese firms could be banned from auditing US-listed companies. This could lead to a string of companies leaving US capital markets and heading back to Shanghai, or elsewhere.
A better outcome would be that US and Chinese authorities end the posturing and thrash out a mutually beneficial solution.
But don’t hold your breath.