By Soyoung Ho
The Donald Trump administration issued a set of recommendations intended to address the long-running inability of the U.S. audit regulator—the PCAOB—to inspect accounting firms based in China whose audit clients are listed in U.S. stock markets. One plan would toughen listing standards on U.S. stock exchanges for what the administration calls non-cooperating jurisdictions (NCJs). But this really targets China as other countries have agreements with the PCAOB.
For Chinese companies—such as tech giants Alibaba Group Holding Ltd. and Baidu, Inc.—that want to continue with their listing or want to initiate listing on a U.S. exchange, the PCAOB must have access to audit work papers of the principal audit firm. Companies that cannot grant access because of government restrictions can satisfy this standard by providing a co-audit from an accounting firm “with comparable resources and experience” that the PCAOB determined can conduct proper exams.
The new listing standard gives a transition period until January 1, 2022, for already listed companies. The new standards will be immediately applied to new listings after rulemakings become effective.
Details of the recommendations are in a July 24, 2020, report drafted by the President’s Working Group (PWG) on Financial Markets. PWG is chaired by Treasury Secretary Mnuchin, and he made the report public on August 6. This responds to a June 4 memorandum by President Trump directing the PWG to come up with plans to address the problem.
Accounting firms that audit companies who raise capital in U.S. markets must be registered with the PCAOB and follow tough U.S. audit standards and be inspected for compliance under the Sarbanes-Oxley Act of 2002. But the PCAOB has not been able to get Chinese authorities to agree to a joint inspection program despite over 13 years of off-and-on negotiations. Congress passed Sarbanes-Oxley in response to scandals at Enron, WorldCom, and others that cost investors $85 billion.
The problem has been especially acute as there have been a string of accounting frauds over the years at Chinese companies. For example, Luckin Coffee Inc., which competes against Starbucks Corp. in April admitted that it booked $309 million in fake sales last year, and Americans who have invested in Luckin lost a lot of money after its stock price tanked.
The audit regulatory board has been unable to gain access to Chinese accounting firms because officials there fear that audit work papers may contain state secrets and may infringe on its sovereignty. Auditors in China say they are unable to violate Chinese laws that prohibit them from handing over documents to foreign regulators without first getting permission from Chinese authorities. This means that U.S. investors who have bought stocks of Chinese companies do not know if their financial statements are properly scrutinized by independent auditors because the PCAOB cannot inspect their audit work.
In a statement, Mnuchin said the PWG unanimously recommends that the SEC take steps to change the listing standards, among other recommendations. The SEC, which regulates the securities markets, oversees the PCAOB.
“The recommendations outlined in the report will increase investor protection and level the playing field for all companies listed on U.S. exchanges,” Mnuchin added. “The United States is the premier jurisdiction in the world for raising capital, and we will not compromise on the core principles that underpin investor confidence in our capital markets.”
Recommended Listing Standards
If a Chinese company cannot hand over workpapers to the PCAOB, it would be required to engage an affiliated U.S.-member accounting firm registered with the PCAOB to serve as the principal auditor through a co-audit arrangement with the audit firm in an NCJ.
The PWG report said that under PCAOB Standards, the principal auditor is allowed to use the work and reports of other independent audit firms that have audited the financial statements of subsidiaries or investments included in the consolidated financial statements.
This would require the SEC and the PCAOB to write rules requiring the U.S. firm to supervise the work of the NCJ firm so that the NCJ firm’s work is performed under the U.S. firm’s guidance and control. This means the U.S. firm must include in its work papers documentation of audit evidence to support its opinion.
“Because the U.S. Firm would be the principal auditor and would be required to maintain the work papers in the U.S., the PCAOB would have the ability to inspect the audit work and practices of the U.S. Firm, including the U.S. Firm’s quality controls with respect to its work on listed companies based in an NCJ,” the report explained. “Importantly, this recommendation would require the government of an NCJ to permit the U.S. Firm to perform the work and retain the relevant work papers outside of the NCJ. The PCAOB’s inspection process would follow its typical process.”
The other recommendations are enhanced company and fund disclosures, greater due diligence of indexes and index providers, and guidance for investment advisers.
“The President’s Working Group has put forward a number of common-sense recommendations that would strengthen protections for U.S. investors and our capital markets,” SEC Chairman Jay Clayton said in a statement. “These recommendations are consistent with bipartisan congressional legislation and are centered on the importance of a level playing field.”
Clayton, who is also a member of PWG along with Federal Reserve Chairman, and Commodity Futures Trading Commission Chairman, said he will work with Congress, fellow regulators, and market participants to move forward with the recommendations. PCAOB Chairman William Duhnke in a statement also said that the board looks forward to working with the SEC on the recommendations.
“The PCAOB is committed to audit quality globally and accomplishing our mission to protect investors and further the public interest in the preparation of informative, accurate, and independent audit reports,” Duhnke said.
Will the Recommendations Work?
Jeffrey Mahoney, general counsel of the Council of Institutional Investors (CII) said the group generally supports the recommendations.
“CII has for many years shared our concerns about the investor, market, and economic implications resulting from the inability of the PCAOB to inspect public accounting firms in China and expressed support for efforts to resolve the issue,” Mahoney said, adding that the enhanced listing standard is “a reasonable approach to addressing those concerns.”
“That said, we believe the ‘co-audit’ provision of the recommendation needs further consideration to ensure that it does not result in a loop-hole that undermines the stated goal of the PWG to ‘protect investors by ensuring a level playing field for all companies listed on U.S. exchanges,’” he added.
Shaswat Das, a counsel at King & Spalding LLP who previously worked at the PCAOB as its primary negotiator with the Chinese regulators on cross-border audit oversight from 2011-2015, also saw some potential issues.
“As contemplated, the notion of a ‘co-audit’ is somewhat different than a ‘joint audit,’ which is not an uncommon practice in a number of E.U. countries, as the U.S. firm would serve as the principal auditor in charge of supervising the work of its Chinese affiliate and be responsible for making the relevant audit work papers available to the PCAOB,” Das said. “Among other issues, it remains to be seen whether the Chinese government would permit the transfer of audit work papers to a U.S. affiliate in the U.S. and whether the U.S. firm will expose itself to potential liability for audits of China-based companies listed in the U.S.”
Daniel Goelzer, former acting PCAOB chairman and former SEC general counsel, said it would probably not solve the problem of PCAOB access to audit work papers in the case of Chinese companies with a Chinese accounting firm as the principal auditor.
“The co-auditor idea is creative, but I assume that the Chinese government is unlikely to agree to the steps necessary to make it workable,” Goelzer said.
He pointed to the report that said the local government must allow the American firm to do the audit work and retain work papers outside the country.
“This seems unlikely, so these companies would be delisted,” Goelzer said.
Lynn Turner, who served as the chief accountant of the SEC from 1998 to 2001, was more blunt in his criticism, calling it “a horrendous idea put forward by the Big Four.”
“It is simply permitting firm—Big Four—on firm—Big Four—reviews just as was done before Sarbanes-Oxley,” Turner said. “Such a review was done by Deloitte & Touche of Arthur Andersen in the summer and fall of 2001, as several Arthur Andersen audits were imploding.” Enron and WorldCom were some of its audit clients.
“Deloitte & Touche gave Arthur Andersen a clean inspection and clean bill of health,” Turner explained. “In fact, up to that point in time, no Big Four had ever given another Big Four anything but a clean bill of health. This report is not in compliance with the Sarbanes Oxley Act of 2002.”
Some, like Thomas Gorman, a partner with Dorsey & Whitney LLP, believe this problem could have been solved much earlier because new rules or statutory amendments are unnecessary to make sure foreign companies listed in the U.S. follow the rules set here.
“Indeed, a proposal such as the one being considered which includes a grace period would be counter-productive and leave investors at risk for years more,” he said. Sarbanes-Oxley “provides the SEC and PCAOB with all the tools necessary to ensure that investors purchasing shares in the U.S. markets are protected,” pointing to the law’s requirement for inspections.
“The SEC previously brought administrative proceedings against firms that failed to comply with these requirements,” Gorman said. “The settlement included arrangements under which CSRC [China Securities Regulatory Commission] was going to make the papers available while protecting the claimed China privacy interests.”
But a 2013 cooperative enforcement agreement Gorman was referring to has failed because of delays and redacted workpapers, making the agreement practically useless.
In Gorman’s view, U.S. regulators should just enforce current rules rather than pass new legislation or rules.
“For those auditors that do not make the work papers available for inspection as required, the board should revoke their registration which is conditioned on compliance,” he said. “That invalidates the audit at which point the stock cannot trade. If notice is published that full compliance is now required with SOX either issuers will comply or their shares delisted. Either way, investors win – they are protected as Congress directed.”
However, Goelzer is worried that if the companies are delisted, those who own their stocks would see their value drop, and the companies might go private at a lower price.
“Ultimately, U.S. investors that wanted exposure to Chinese companies would have to invest through off-shore markets,” Goelzer said. “And, the U.S. markets would no longer be a listing choice for companies from one of the world’s largest and fastest-growing economies.”
Nonetheless, Goelzer agreed that it is time to take action.
“It isn’t sustainable for the U.S. to have an audit inspection requirement and to enforce it against all auditors, except those from China,” he said. “Therefore, something like this proposal or the HFCA legislation will have to be implemented.”
HFCA—the Holding Foreign Companies Accountable Act—says that a foreign company traded on a U.S. exchange would be delisted if the PCAOB is unable to inspect its auditor for three straight years. It passed in the Senate in May, but its enactment is uncertain. A House version was successfully included into the Defense Authorization Act (DAA) for fiscal 2021, but HFCA failed to get into the Senate version. It is unclear how the Senate and the House will reconcile the two versions of DAA.
Ultimately, the proposed delay in co-audits might lead to a better resolution.
“While I am not optimistic that there will be a solution, that allows time for negotiation and time for investors to adjust,” Goelzer said.
Tom Quaadman, Executive Vice President, Center of Capital Markets Competitiveness of U.S. Chamber of Commerce, also said: “We hope that the U.S. and China come to an agreement on transparency and disclosure that is the cornerstone of the global financial system.”
This article originally appeared in the August 10, 2020 edition of Accounting & Compliance Alert, available on Checkpoint.
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