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After Inspection Impasse, Chinese Auditors May Face Disciplinary Actions

The PCAOB is getting ready to punish some Chinese auditors that have resisted the audit regulator’s efforts to inspect the audit firms and review their work papers. The disciplinary proceedings could be stayed if U.S. and Chinese officials can agree to inspections, and PCAOB inspectors are given access to the documents they have sought.

The PCAOB is preparing disciplinary proceedings against Chinese audit firms that have resisted the board’s efforts to tighten its supervisory work in the world’s second largest economy.

The firms are subject to PCAOB oversight because they have clients listed on U.S. stock markets. The audit regulator is said to be contemplating punishing the firms because its negotiations with Chinese regulators have not produced a deal to inspect the firms’ audit work and review their documents, according to a source who requested anonymity because the audit regulator’s disciplinary proceedings can not be made public unless the target of the action consents. The disciplinary actions could be stayed if U.S. and Chinese officials can agree to inspections, and PCAOB inspectors are given access to the documents they have sought.

The PCAOB requested that the Chinese affiliates of the Big Four firms hand over some data by early December 2015 after the latest round of negotiations with Chinese regulators stalled. (Negotiations to Inspect Chinese Auditors Come to a Stop in the November 3, 2015, edition of Accounting & Compliance Alert .)

“If the firms didn’t provide this data by December 7, [the PCAOB] was going to commence disciplinary proceedings,” the source said. Chinese government officials generally do not permit companies in the People’s Republic to provide certain data to foreign regulators because of national security concerns.

Section 106 of the Sarbanes-Oxley Act of 2002 requires accounting firms to provide their work papers to the PCAOB or the SEC upon request.

Failing to respond to such a request could lead to fines or suspensions.

“As a matter of policy, the PCAOB does not comment on whether it has or has not commenced disciplinary action against any firm or firms,” said a PCAOB spokesperson.

Section 105(c)(2) and Section 105(d)(1)(C) of Sarbanes-Oxley bar public disclosure of the disciplinary hearings. The public is not allowed to find out what actions are being punished, who was charged, the issues involved, or the outcome. The disciplinary actions remain closed until there is a settlement or a decision by the SEC about the board’s sanctions. A Senate bill to make the proceedings public has languished in Congress the past four years because of the Big Four’s heavy lobbying against the measure.

Talking to reporters at the AICPA Conference on Current SEC and PCAOB Developments in Washington on December 9, PCAOB Chairman James Doty stressed that negotiations with the Chinese continue despite the lack of progress.

“There are difficulties involved in the details of a pilot [inspection] program,” Doty said.

The audit regulator has for years wanted to inspect the auditors of Chinese companies that trade their shares on U.S. exchanges, several of which have been the targets of SEC enforcement because of questionable accounting.

The current impasse underscores the degree to which the optimism PCAOB officials expressed earlier in the year about reaching a deal has been dashed. The Treasury Department said U.S. and Chinese officials were planning a pilot program to let the PCAOB inspect one accounting firm in 2015. The effort was announced in June at the conclusion of the U.S.-China Strategic and Economic Dialogue, a yearly bilateral forum attended by top officials that alternates between the U.S. and China. PCAOB officials hoped the pilot would pave the way to a broader inspection program in 2016, but the breakdown in the negotiations means that PCAOB inspectors are no longer sure about when they can carry out a full-scale joint inspection program.

China bars direct production of audit documents to foreign regulators, and the Chinese believe their sovereignty is compromised if foreign regulators are allowed to inspect firms on site in China. Some officials in China also fear that state secrets may be revealed during inspections.

Doty previously said the agencies he has negotiated with, the China Securities Regulatory Commission (CSRC) and the Ministry of Finance, understand U.S. regulatory concerns. But officials at other government ministries that handle trade, judicial, and information technology matters have a say on the matter, and their resistance may have contributed to the current impasse.

The delay of a final deal between the U.S. and China may have to do with concerns among government officials about inspections of audits involving state-owned enterprises and Internet companies, the source said. Some officials think Internet companies are full of state secrets, the source said, adding that the Ministry of Industry and Information Technology told the CSRC that the technology companies are off limits.

The Chinese stance has been a problem for U.S. regulators investigating suspected accounting frauds at Chinese companies that had gone public on U.S. markets. Paul Gillis, a business professor at Peking University, said neither the PCAOB nor Chinese regulators can afford to overplay their hands.

“The PCAOB needs to be sympathetic to the conflicting demands on Chinese regulators, and the Chinese should limit the state’s secrets defense to true state secrets,” Gillis said. “I don’t think audit working papers contain much that most people would consider state secrets.”

Doty told reporters that an “opportunity to reach an inspection regime does not disappear even if there are enforcement actions and deregistration actions.”

“We may be disciplining firms right and left one day,” Doty said. Still, “they would have the opportunity at some point and say, ‘all right. Let’s work out an inspection regime.'”

Doty added that an inspection deal would benefit China and its companies looking to raise funds from investors.

“Without it, China remains a questionable place to put capital,” he said.

The Chinese embassy in Washington did not respond to request for comment as this story was being written, and three of the Big Four firms, Ernst & Young LLP, Deloitte & Touche LLP, and KPMG LLP, also did not respond. PricewaterhouseCoopers LLP declined to comment.

While an agreement on joint inspections has eluded the PCAOB, U.S. and Chinese financial regulators have cooperated on enforcement matters. Under a May 2013 pact, the CSRC has been handing over audit firm work papers of companies suspected of accounting fraud to the SEC and the PCAOB after checking the papers for state secrets.

It is unclear if the PCAOB can gain any leverage with the disciplinary proceedings to revive the stalled negotiations for inspections. The SEC, which faced similar problems getting audit documents, brought enforcement actions against the firms in Big Four Chinese affiliates in December 2012. In February 2015, each of the affiliates was hit with a $500,000 fine for “willfully” refusing to hand over work papers from Chinese companies in investigations of suspected of accounting fraud.

During the proceedings, the firms said they showed good faith but had no control over a Chinese policy that bars them from handing over papers directly to the SEC. The SEC’s Enforcement Division said the firms violated U.S. laws and at the same time chose to comply with Chinese laws, and an administrative judge agreed in a January 2014 ruling against the firms. The judge said the firms should have shown a good faith effort to obey all laws, not just the laws they wish to follow.

Because of the settlement, the SEC is continuing its stay of the order that banned the firms from auditing U.S. companies for six months. But the market regulator can reinstate the bans if the firms run into new regulatory problems.

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