With the clock ticking for Chinese authorities to allow the PCAOB to completely inspect and investigate accounting firms in China and Hong Kong whose audit clients’ stocks are traded on U.S. exchanges, Rep. Brad Sherman sent a letter to the Chinese ambassador in Washington to urge him to resolve the matter as soon as possible.
“This moment presents a critical juncture in the effort to allow the PCAOB access to the information it needs for audit oversight,” Sherman wrote to Chinese Ambassador Qin Gang on July 22, 2022. “Resolving this urgent matter requires the attention and support of the highest levels of the People’s Republic of China. As PCAOB Chair Erica Y. Williams stated last month, ‘time is of the essence.’”
Sherman is a Democrat from California who chairs the House Financial Services Subcommittee on Investor Protection, Entrepreneurship and Capital Markets.
For almost two decades after the PCAOB was established by the Sarbanes-Oxley Act of 2002 to prevent big accounting frauds, China has so far not granted full access to audit papers fearing infringement to its sovereignty. Moreover, the communist regime is worried that audit work papers may contain state secrets.
Thus, Congress passed the Holding Foreign Companies Accountable (HFCA) Act to try to solve the issue once and for all. Among other things, if the PCAOB cannot inspect auditors for three years in a row, the companies will face a trading prohibition. Congress may shorten this time frame to two years. As it stands today, the trading ban will go into effect in 2024.
Sarbanes-Oxley granted the U.S. audit regulatory board authority to inspect audits of public companies to make sure they are complying with relevant audit rules and standards. Such inspections have improved audit quality over the years. The PCAOB has been able to negotiate agreements with other jurisdictions and inspect audit firms except for China, despite years of on-again and off-again negotiations.
The letter comes as the PCAOB and China are again negotiating a deal that would allow board inspectors to do inspections of audits. This has been a significant problem for the U.S. because there have been many accounting frauds or irregularities at Chinese companies that cost a lot of money for American investors, including at Luckin Coffee Inc., a coffee chain that competes against Starbucks Corp. in China.
While there have been some productive discussions recently between U.S. and Chinese authorities, the two sides seem to be stuck on some significant issues. Some of the disagreements have been on redactions, selection of audit engagements for review, and access to audit firm personnel, work papers, and other information.
“To be clear, Congress has tied the hands of the PCAOB and SEC with the bipartisan passage of HFCAA. SEC and PCAOB have very limited flexibility under the HFCAA. If full audit inspections do not occur, companies will be delisted from U.S. exchanges at the end of the three-year time, or two years if Congress amends the Act as it is currently considering,” Sherman wrote. “Neither the SEC or PCAOB can stop or slow down the clock. This must be very clear. Delisting of non-compliant companies will happen in 2024, or 2023, if inspections are not completed.”
While Rep. Sherman said “delisting,” which is used in common parlance, the language in the legislation is “trading prohibition,” which has different legal and reporting implications for companies. The SEC, which is the U.S. capital market regulator, oversees the PCAOB, which supervises accounting firms that audit publicly-listed companies.
The SEC is not contemplating delisting although Chinese companies can choose to delist rather than face a trading ban. (See Senior SEC Official Clarifies Timeline on Rules Addressing PCAOB’s Inability to Inspect Chinese Auditors in the December 8, 2021, edition of Accounting & Compliance Alert.)
Rep. Sherman most likely used the term delisting because Financial Times reported that China is contemplating “delisting” certain companies deemed to have sensitive information. Chinese authorities have denied the report.
However, this will not resolve the issue even if the selected companies are either delisted or stop trading on exchanges.
The PCAOB’s inspections and investigations are retrospective. This means that even if China orders some companies to delist, their audited financial statements over the last year are still subject to inspections or investigations, among other reasons.
“PCAOB will follow U.S. law, and the law is clear that PCAOB must have complete access to audit work papers of any firm it chooses to inspect or investigate – no loopholes and no exceptions,” PCAOB spokesperson Kent Bonham said in an emailed statement. “Time is of the essence as we continue working with the PRC authorities to reach an agreement that meets our mandate under U.S. law.”
Thus, Rep. Sherman said that there is only a very narrow path forward.
“As the lead House sponsor of the HFCAA, I can affirm that the intent of this policy is not to punish the PRC, but to ensure a level playing field for all participants in the U.S. capital markets,” he wrote. “Access to the U.S. capital markets is a privilege, not a right.”
Rep. Sherman further explained that reaching an agreement is only the first step. The PCAOB must have time to test performance under any agreement to make sure that it can comply with U.S. laws.
“And as you know, both of these steps must be completed before the PCAOB reassesses ifs HFCAA determinations in December of this year,” he wrote. “Ensuring complete access under any agreement and sufficient time for implementation of any agreement before time runs out will require support at the highest levels of the PRC government and across agencies. I urge you to engage with your colleagues in the PRC at the highest level to facilitate a timely agreement with the PCAOB, and sufficient support across PRC government agencies to ensure that PCAOB access to audit-related information from PCAOB-registered firms is not impaired.”
The Chinese embassy did not immediately respond to a request for comment.
This article originally appeared in the July 26, 2022 edition of Accounting & Compliance Alert, available on Checkpoint.
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