Opinion: Why the audit disclosure feud needs compromise

On January 22 2014, an Administrative Law Judge of the US Securities and Exchange Commission (SEC) ordered the China member firms of the Big Four accounting firms (PwC, Deloitte, EY, and KPMG) banned from practice before the SEC for six months.

The ban is the consequence of the accounting firms' refusal to turn over audit working papers related to US-listed Chinese companies alleged to have committed fraud. The accounting firms said they were caught between a rock (US law compelling they turn the papers over) and a hard place (Chinese regulations that prohibited doing so), but the judge ruled that the firms had put themselves there. From his perspective, the accounting firms should have known that they would have to comply with US laws when they decided to accept US-listed clients.

A long standoff

While there is unlikely to be any near term impact as the case works its way through appeals, a ban would have serious consequences to the markets. The China Big Four firms would be unable to work on any audit related to a report that will be used by a US listed company. Depending on the timing of the ban, it could mean that US listed Chinese companies would not be able to file required annual reports, potentially leading to the suspension from trading of their shares on US markets and their eventual delisting from US exchanges. Companies using the banned firms could not do IPOs or raise debt offerings while the ban was in effect. The banned firms also could not work on audits for US listed multinationals with China operations during the suspension, potentially causing significant problems for investors in these companies.

The SEC and China have been at a standoff for some time. The SEC needs unfettered access to documents and people in China, in order to enforce US securities laws on Chinese companies that have chosen to list in the US. China rejects this as an impingement on China's national sovereignty and a risk to the safety of China's expansively defined state secrets. The problem remains even if the firms serve their six-month ban, since they will likely find themselves back in court the next time the SEC demands working papers. Any other firms that attempt to move in and capture the Big Four market will soon face the same problems.

Regulatory equivalency

After nearly a decade of negotiations, the US Public Company Accounting Oversight Board (PCAOB) reached agreement last May with Chinese regulators for access to documents needed in connection with enforcement activities of the PCAOB. Documents have begun to flow under these agreements; although they must first go through a robust redaction process to make certain that potential state secrets are excised. The PCAOB can only share documents with the SEC with Chinese permission, and heavily redacted documents do not meet the needs of the SEC. Enforcement activities are a small part of the PCAOB's mandate, which focuses on inspections of firms to make certain they are compliant with US auditing standards.

PCAOB Chairman James Doty is optimistic that the PCAOB will reach agreement with Chinese regulators on inspections in 2014. That agreement may require the PCAOB and auditors to inspect redacted working papers outside of China in order to assuage China's sovereignty concerns. But a deal along these lines is unlikely to meet the needs of the SEC, which needs direct access to original documents in order to fulfil its investor protection mission.

China wants US regulators to adopt the concept of regulatory equivalency. China has a deal on regulatory equivalency with the EU, which allows EU regulators to accept the work of Chinese regulators as if it were their own. US regulators have been reluctant to agree on regulatory equivalency, and for good reason. China has failed to prosecute any of the many alleged frauds of US listed companies, arguing that no Chinese laws were broken, even when serious Chinese crimes including the theft of corporate assets and kidnapping of auditors have been alleged. If China wants the US to back off and let Chinese regulators clean their own dirty laundry, Chinese regulators need to show they will do it.


Paul Gillis, Professor of Accounting, Peking University, Beijing


More from CLP:
SEC spat needs diplomatic solution