The U.S.-China audit showdown, and the decision the Big Four don’t want to make

Are they global, unified giants, or bunches of separate firms at arm’s length from each other?

This is an entry from guest author Michael Rapoport. Michael is a business and financial journalist who specializes in stories about accounting, banking, and financial regulation and a former reporter for The Wall Street Journal. His work has appeared recently in Quartz, Institutional Investor, and Business Insider. Michael is on Twitter as @rapoportmike.

By Michael Rapoport

The U.S.’s long-festering clash with China over corporate audits is finally coming to a head - and a dramatic upheaval in the U.S. stock market could result, with more than 200 Chinese companies potentially getting booted out of trading in the U.S.

Can such a showdown be avoided? Maybe. But it might take a far-fetched idea that, among its other challenges, would require the Big Four audit firms to get off a fence they’ve insisted on straddling for a long, long time.

The clash is over China’s longstanding refusal to allow U.S. regulators to inspect the Chinese audit firms which check the books of U.S.-traded companies from China. That lack of oversight means investors have no way to ensure that these companies’ financial information has been properly vetted and that the companies are financially healthy and free of fraud. (Spoiler: A lot of them aren’t.)

But the U.S. Congress is now throwing down the gauntlet. Congress may not be able to agree on much, but last week the House of Representatives unanimously approved a bill, already passed by a unanimous Senate, that would require Chinese companies to use auditors who will submit to U.S. inspection. If President Trump signs it into law, China, as well as any other foreign jurisdiction such as Belgium that still restricts U.S. regulators’ access to its companies’ audits, would have three years to comply.

If China doesn’t do so, Chinese companies with more than $2 trillion in market value, including giants like Alibaba, would have to leave U.S. markets.

So, if neither side blinks, what’s the way out? It may lie in a proposal the Securities and Exchange Commission reportedly plans to issue by year’s end aimed at accomplishing the same goal: making sure the auditors who audit Chinese companies get proper oversight.

As reported by the Wall Street Journal, the SEC proposal would allow the audit oversight requirement to be satisfied if there were a “co-audit” of a Chinese company from a second audit firm that can be inspected by regulators - possibly the U.S. counterpart of the same Big Four firm in China that did the original audit. That’s a provision that isn’t included in the measure now headed to Trump’s desk.

It’s unclear exactly what such a co-audit would entail. But a working group advising Trump on the China issue, which made a similar proposal last summer, suggested that a U.S. firm could co-audit by “supervising” the Chinese audit firm’s work, which would be “performed under the U.S. firm’s guidance and control.” In a way, the U.S. firm would vouch for the Chinese firm.

That shouldn’t be a problem, right? If, say, PricewaterhouseCoopers’ Chinese affiliate isn’t cooperating with a U.S. regulator’s inspection, it would be able to have PwC’s U.S. firm stand in and assume that responsibility.

However, that’s something the Big Four firms have shown they really, really don’t want to do.

For many years, the Big Four have tried to have it both ways. On one hand, each of the Big Four - PwC, Deloitte Touche Tohmatsu, KPMG, and Ernst & Young - portrays itself as one big happy global family, with auditors around the world who all belong to the same firm and collaborate. Deloitte, for instance, calls itself “a leading global provider” of audit and other services, and says “our organization has grown in scale and diversity … yet our shared culture remains the same.”

But in fact, they aren’t the same firm. Each Big Four firm is actually a network of separately owned, legally independent firms in each country where they do business - so PwC U.S. and PwC China, for instance, are different firms. They all belong to the same global network, but they aren’t responsible to each other, and the network doesn’t have much authority or control over them.

That means that when one of their affiliates in a place like China gets into hot water — a scandal, a major audit failure — the U.S. firms quickly wash their hands of the problem, saying, “That’s not us.” Deloitte — the “leading global provider” with a “shared culture” — notes in the fine print on its website that its member firms are all “legally separate and independent entities.” They’re straddling the fence — they’re one firm when it suits their marketing purposes, and different firms when it suits their aim of avoiding legal liability and reputation risk.

That’s what would make the prospect of co-audits very dicey for them. If the U.S. arms of the Big Four were called upon to vouch for the work of their Chinese counterparts — to commit themselves legally to being one big happy firm — that might be the equivalent of bringing those relatives you usually avoid a little too close for comfort.

Imagine, for instance, if E&Y U.S. had been called upon a year ago to vouch for the work of E&Y China in its audits of Luckin Coffee, to satisfy a co-audit requirement. What would have happened when Luckin admitted its $310 million fraud scheme? Would E&Y U.S. be on the hook for any failings at E&Y China in its audits of Luckin? (E&Y China has said it isn’t responsible for Luckin’s fraud, and the audit firm hasn’t been charged with any wrongdoing.)

Carson Block, the short-seller who’s been the bane of shady Chinese companies, thinks U.S. audit firms should be held liable for the failures of their Chinese counterparts. If global audit networks “are happy to rent their names” to firms in other countries that don’t cooperate with U.S. regulators, they “should bear responsibility similar to how parents are often financially responsible for the misdeeds of their minor children,” Block wrote in a July letter to the SEC.

Beyond the U.S. Big Four’s possible reluctance, there are plenty of other reasons co-audits might not work. A co-auditor of a Chinese company would need to see corporate documents and audit work papers to sign off on the audit, and China might not be willing to let a U.S. auditor see them if they might end up in the hands of U.S. regulators. Earlier this year, China enacted a law barring Chinese companies from cooperating with foreign securities regulators.

Co-audits are a long-shot idea at best, and they might require U.S. audit firms to make a choice they’ve always avoided. But if the U.S. doesn’t want to see a significant chunk of China company market cap leave the U.S. for Shanghai and Hong Kong, a long-shot might be the only shot.

© Francine McKenna, The Digging Company LLC, 2020

For another take on this issue, see “Marcum in the Middle: Watchdog Research - Marcum LLP and its sister firm Marcum BP seem to have found an interesting niche between China, the U.S., and the PCAOB”

See also Carson Block’s views on the Chinese companies listed on U.S. exchanges.

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