China and U.S. Seek Closer Cooperation on Audit Oversight

August 25, 2011 Posted by China Briefing Reading Time: 4 minutes

By Vivian Ni

Aug. 25 – The recent rash of accounting scandals associated with Chinese companies listed in the United States has caused both countries to look for more cooperation on audit oversight. Following the Sino-U.S. Symposium on Audit Oversight held last month in Beijing, recent reports indicate that officials from the China Securities Regulatory Commission and the Chinese Ministry of Finance may meet their U.S. counterparts in Washington D.C. this October to conduct a second round of negotiations that will work on protocols for joint inspections of Chinese audit companies.

U.S.-listed Chinese companies – most of which entered the market through “reverse mergers” in which they acquire or merge with a U.S. public company – have seen their market value plummet since late April following a wave of accounting questions surrounding them. On June 9, the U.S. Securities and Exchange Commission (SEC) issued an investor bulletin, cautioning investors about investing in reverse mergers and pointing out that these types of companies may be prone to fraud and other abuses. The bulletin also gave a list of reverse merger companies whose U.S. trading had been suspended in the past few months, including a few Chinese names such as Heli Electronics Corp., China Changjiang Mining & New Energy Co, and RINO International Corporation.

The U.S. Public Company Accounting Oversight Board (PCAOB) – a non-profit corporation created by the Sarbanes-Oxley Act in 2002 to oversee the auditors of public companies – also plans to publish a “practice alert” reminding auditors of the special challenges in emerging markets including fraud risks.

The punishment Chinese stocks received in the U.S. capital market has in return pushed the two countries to work more closely on improving the integrity and transparency of Chinese public companies’ accounting information. On one hand, the SEC hopes the PCAOB can participate in joint audit inspections with Chinese audit companies in the future to better protect U.S. investors’ interest; on the other hand, the Chinese government has also come to realize that – despite its security concerns – mutual cooperation may be the best way to repair Chinese companies’ reputation overseas and rebuild international investors’ confidence.

To date, China has 53 audit companies registered with the PCAOB, including affiliates of the Big Four accounting firms. However, Chinese authorities haven’t allowed the PCAOB to conduct inspections into the country and evaluate the work of those audit firms. The lack of joint inspections may increase fraud risks in Chinese companies from the PCAOB’s point of view. James Doty, chairman of the PCAOB pointed out that the big audit firms practicing in China “have to be concerned that they refine and make more robust their fraud procedures.”

Whether or not joint inspections will be accepted still remains the sharpest difference between the two sides. While the United States actually wants their officials to work together with Chinese inspectors to review Chinese audit firms, China wants the U.S. side to accept the inspection data and evaluations Chinese inspectors have drawn by themselves. However, as a PCAOB member Lewis Ferfguson said, “That is not something we (the PCAOB) have ever done.”

Despite the current shortcomings of audits on Chinese companies, the U.S. regulators still believe small progress is being made. At the Sino-U.S. Symposium on Audit Oversight held in Beijing between July 11 and 12, officials of the two countries discussed a series of arrangements aiming to build mutual understanding and cooperation in the near future. This will include sending staff to observe the inspection of accounting firms in the other’s jurisdiction to learn more about the two countries’ different inspection processes and methodologies.

In addition, while security concerns have typically been cited in the past as China’s excuse to refuse audit oversight by international inspectors, Doty believes the time is long gone “when China could say that there’s a good reason for not having any international inspection of audits based on vague principles of national sovereignty.”

As for reaching an actual agreement on joint inspections, experts believe both countries will need some more time since they were still mostly engaged in a process of learning about each other’s inspection system during the last round of talks.

“I think it is early to start talking about a definite agreement when you are each still digesting the details of the respective inspection programs. They are digesting ours, we are digesting theirs,” said Ethiopis Tafara, the SEC’s head of international affairs.

J.W. Mike Starr, a deputy chief accountant at the SEC who joined last month’s negotiations in Beijing, said the two sides are “still at the stage of sharing information and building trust” and they aim to reach an agreement by 2012.

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