Friday, June 10, 2011

Accounting Watchdog has Bite

A Hong Kong-based accounting firm, Zhonglei CPA, has been denied registration by the lead accounting industry watchdog for the U.S., the PCAOB (Public Company Accounting Oversight Board).  The group was set up through the Sarbanes-Oxley legislation passed by Congress after it became apparent that huge frauds by Enron and Worldcom were enable by at least lax auditor performance if not outright complicity. 

Under the Sarbanes-Oxley Act of 2002, auditors of financial statements that issuers file with the Securities and Exchange Commission must be registered with the PCAOB and must undergo regular PCAOB inspections to assess their compliance with U.S. law and professional standards in connection with those audits.  The PCAOB reviews completed audits and determines if the work met minimum standards.  Deficient auditors are put on notice to clean up their practices.

The decision makers at the PCAOB denied the application on the grounds that it would not have full access to Zhonglei’s audits work and therefore would not be able to fully determine if the audit firm was fully following minimum audit standards.  Zhonglei you see works on audits in mainland China and the good old boys in the PRC will not let those audit papers see the light past doors of the company itself.

Zhonglei is now saying they really do not want to be a PCAOB-registered firm.  There is plenty of business at home for them, says the head accountant.  I am in sympathy with him.  Inspection by the PCAOB is hardly a ringing endorsement anyway.  It typically takes the inspectors years to get around to a firm in the first place.  Then it takes another couple of years before the PCAOB report is published.  With the rate of staff overturn at audit firms, by the time the PCAOB report gets to the public any bad egg accountants in the wagon are likely long gone and replaced by other bad egg accountants with their own poor work habits.  The public never gets to know anyway because the PCAOB redacts its findings before it makes its inspection reports available to the public.

That the PCAOB actually found its voice or rather “bark” seeing how it is a “watchDOG” is really quite remarkable.  Apparently, they have been emboldened or maybe just put to shame by the SEC, which has recently warned investors about taking stakes in China-based companies that have executed a so-called reverse merger to become a public company in the U.S.  There have been wide spread allegations of fraud and so far a couple of companies appear to have cooked their books or at least kept them very close to the stove.

China is not the only country to deny access to work papers of audit firms in their jurisdiction.  The European Union and Switzerland are closed off to the PCAOB inspectors.  The PCAOB had to reform an understanding with its counterpart in the United Kingdom and only recently has been allowed back in to inspect U.K. firms that audit European companies that trade in the U.S.  More than 890 audit firms currently registered with the PCAOB are located outside of the U.S.  This encompasses 87 countries.  In the U.K. there are 59 registered firms registered with the PCAOB.

The PCAOB has had similar discussions with authorities in the PRC.  It is hoped that a cooperative agreement of some kind can be reached that will allow the PCAOB to conduct proper inspections of audit firms serving China-based companies with U.S. listed stock.  There is much to be gained by all constituents:  the issuer, the shareholders, the audit firms.  It is not certain that Chinese officials will see it that way.  After all, in the greater scheme of things, it is really not a big problem if a few U.S. investors, lose a bit of money.  By any measure the capitalization of China-based companies listed in the U.S. is a small sum compared to the broad market in either China or the U.S.

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