Auditing U.S. Companies in China: Symptomatic of Bigger Accounting Fraud Problems?

The Security and Exchange Commission’s (SEC) Dec. 3, 2012 lawsuit against the Big Four accounting firms and BDO (a “second-tier” firm) got a few brief headlines, but not the kind of attention that should have been attracted by a move that could result in serious penalties for the defendant firms.

Though not explicitly stated in the SEC complaint, the key issue in question appears to be potential accounting irregularities among Chinese companies that are clients of the Big Four China affiliates.

The immediate problem is that Chinese law forbids the release of audit workpapers to U.S. regulatory agencies, referring to what The Wall Street Journal calls “state secrets.”

But there are bigger problems in the mix. U.S. multinational companies doing business in China have, for the most part, hired large U.S. accounting firms as their auditors. If Chinese law prohibits disclosure of audit papers, it could make it difficult for auditors to sign off on their audits of China-based clients, which in turn could have a negative impact on share prices and efforts by China-based foreign multinationals to raise capital.

Moreover, the very fact of having been sued by the SEC raises questions among investors. The SEC’s latest lawsuit against the Big Four and BDO reveals that:

“The [SEC] Division of Enforcement has ongoing fraud investigations concerning Clients A, B, C, D, E, F, G, H, and I, each of which is a U.S. issuer whose securities were registered with the Commission and whose principal operations were based in the People’s Republic of China.

“...This action stems from Respondents’ willful refusal, in response to Commission requests, to provide the Commission with audit workpapers and other materials prepared in connection with audit work or interim reviews performed for Clients A, B, C, D, E, F, G, H, and I, in contravention of their legal obligations as foreign public accounting firms.”

Obviously it is hard to know which companies are designated as “A” through “I,” however it is probably safe to assume that, since the SEC is investigating them, they are clients with financial records of questionable accuracy. The assumption is based in part on a substantial history of Chinese companies listing in the U.S. — often through what is known as reverse mergers — and then proving to have falsified or otherwise substandard financial records which in turn causes their share prices to tank.

An administrative law judge must review the claim and rule on its merits. According to The Wall Street Journal, “If the judge decides against the firms, they could be suspended from seeking new U.S.-traded clients, or even blocked entirely from auditing U.S.-traded companies.”

PCAOB’S Angle 

The Public Company Accounting Oversight Board (PCAOB) has also been trying to monitor the activities of U.S. audit firms in China. The agency targeted Chinese firms with a 2011 Alert reiterating its concerns by stating that “some U.S.-registered audit firms may not be conducting audits of clients with operations in China in accordance with the PCAOB standards.”  

Moreover, according to research published by Masako Darrough, Ph.D., chairperson of the Stan Ross Department of Accountancy at Baruch College in New York City: “To further address the ‘heightened fraud risk’ in audits of companies based in emerging markets, specifically in China, the PCAOB published Staff Audit Practice Alert No. 8 [which] states that auditors should be particularly alert to the effect of differences in local business practices and cultural norms in emerging markets (i.e., China), to the risks of material misstatement, and focus on the audit procedures required to respond to these risks.” 

From the wording of its Dec. 3 complaint, the SEC is clearly concerned that U.S. audit firms are neglecting this directive in a systematic way. 

If this is the case, the reasons are unclear. One answer might be that the firms are concerned about going against Chinese regulatory authorities who, as mentioned above, have a wholly unique view of the sanctity of audit work documentation. 

Still, experts assert that one form of accounting fraud or another is at the heart of the SEC’s latest attempt to obtain the workpapers of the China-based affiliates of the Big Four and BDO. But it is hard to know specifics. According to Professor Frederic Stiner, Visiting Professor Department of Accounting at the Merrick School of Business of University of Baltimore, “Once a fraud starts, perhaps some [Big Four] CPAs [in China] thought they couldn't back away without it all being exposed.  An analogy might be WorldCom, where the management began making fraudulent entries to make an earnings target. They were only going to do it once, because there will be increased earnings soon. Then the expected new earnings don't materialize and they make fraudulent entries again.” 

Possible Fallout 

The fallout from this stalemate is what Ken Brown, Asia Financial Editor of the Wall Street Journal, interprets as: many China-based firms that are audited by American firms can’t release audited financial statements, which would be a major blow to western companies doing business (or seeking to do business) in China.

The solution may hinge on diplomatic efforts. Until then, U.S. businesses must be extremely cautious about their activities in China, and especially, the ability of their auditors to perform the work needed to certify that there are no material misstatements or other fraudulent elements, in compliance with U.S. accounting and regulatory standards. 

REVERSE MERGERS: THE OTHER CHINESE FRAUD AUDIT ISSUE 

A group of researchers headed by Masako Darrough Ph.D., chairperson of the Stan Ross Department of Accountancy at Baruch College in New York City, co-published a paper describing reverse mortgages with these succinct words:

“A reverse merger is a non-traditional mechanism of going public. In a typical reverse merger, a private operating company works with a ‘shell promoter’ to choose a public shell company that has no or minimal assets or earnings. A reverse merger is typically structured as a reverse triangular merger. Specifically, the public shell forms a new, wholly-owned empty subsidiary, and then merges the subsidiary into the private operating company. In the merger, shares of the operating company are converted into shares of the shell company (a majority stake of 85% to 90% or more). After the merger is completed, the operating company becomes a wholly-owned subsidiary of the shell company, while the owners and management of the operating company gain effective voting and operating control of the surviving company. In effect, the operating company succeeds to the shell company’s public status.”

There is nothing inherently illegal about this. And indeed, many Chinese reverse mergers (CRM) have not been found to be in violation of any U.S. laws. However, a sizeable number have. The problem arises when the owner of the Chinese operating company orchestrates a reverse merger for the primary purpose of raising capital in the U.S. capital markets without having to go through the regular IPO process.

The SEC and PCAOB have filed suit against numerous CRM companies based on fraudulent accounting and auditing issues related to the fraud cases including, according to the Baruch researchers:

Cash balances 

Revenue recognition 

Related party transactions 

Subsidiary ownership 

Disclosure of subsequent events 

Accounting irregularities 

Important:  According to the researchers, “While these issues could be independent of each other, they often occur as a combination. For example, KPMG resigned from the engagement with Shengda Tech in April 2011, due to ‘serious discrepancies and unexplained issues’ relating to the company’s bank balances, transactions with major suppliers, sales, accounts receivables, and value-added tax (VAT) invoices and payments.’

And, a report co-authored by Professor Frederic Stiner, Visiting Professor Department of Accounting at the Merrick School of Business of University of Baltimore, notes that “the PCAOB has encountered many difficulties with auditors of CRM companies, described in Staff Audit Practice Alert No. 6 (PCAOB 2010). In general, the auditors of CRM companies do not appear to be following PCAOB standards. The Alert was written considering ‘…audit reports on financial statements filed by issuers that have substantially all of their operations outside of the U.S.’ The real target of this was the emerging recognition of abuse by Chinese firms, as stated in a footnote (PCAOB 2010, p. 2): For example, in a 27-month period ending March 31, 2010, at least 40 U.S. registered public accounting firms with fewer than five partners and fewer than ten professional staff issued audit reports on financial statements filed with the SEC by companies whose operations were substantially all in the China region.”