Stalemate Looms for U.S.-China Joint Accounting Oversight

October 14, 2011 Posted by China Briefing Reading Time: 3 minutes

By Vivian Ni

Oct. 14 – Despite efforts by the United States and China to seek closer cooperation on audit oversight, not much progress has been seen on the issue. During the U.S. Securities and Exchange Commission’s (SEC’s) ongoing probe of possible fraud at the Chinese financial software maker Longtop Inc., the company’s previous auditor Deloitte Touch Tohmatsu failed to provide “critical” documents required by the SEC due to regulatory restrictions in China. The SEC decided to take one step further by asking the court for the approval of a “show case” which would order Deloitte to appear in the court to explain its failure in complying with the subpoena.

The Shanghai-based unit of Deloitte resigned as the auditor of Longtop in May of this year because it “identified a number of very serious defects” during their audit practice and efforts made towards a second round of bank confirmation was disturbed and stopped by the company. In contrast, Longtop announced that Deloitte’s resignation was due to errors in the company’s financial records.

The SEC later subpoenaed Deloitte for documents that may contain basic information necessary to determine whether there was evidence of fraud in the company, but Deloitte Shanghai refused to comply due to legal constraints in China. Deloitte’s Spokesperson Lauren Mistretta told the U.S. financial weekly newspaper Barron’s in an E-mail that “Chinese law prohibits Deloitte China from providing the requested documents directly to a foreign regulator and violations can result in severe sanctions, including criminal penalties.”

The SEC and the Public Company Accounting Oversight Board (PCAOB) has for years tried to push Chinese companies and auditors to open up so that the PCAOB can conduct inspections in the country. Regulators of the two countries met in July to look for ways of cooperation, but opening up still does not seem to be an option for China at the current stage. Instead, China really just wants the U.S. side to accept the inspection data and evaluations on Chinese inspectors drawn by its own auditors.

In the SEC versus Deloitte case, experts bet China would probably just ignore the SEC’s demand for information provision and the SEC may even escalate the dispute by forbidding Deloitte Shanghai from working with listed companies, including U.S. multinationals. The regulatory showdown between the two countries gives people a reason to worry that Chinese companies could be completely shut out of U.S. capital markets if things get out of control.

If the worst happens, then the couple of hundred Chinese companies listed on the Nasdaq QMX and the New York Stock Exchange could all be affected, finding themselves losing an important avenue to raise international capital.

Over the years, Chinese companies – which see inadequate capital markets at home – have rushed to get listed in the U.S. stock market because it is relatively cheap and easy. A common corporate structure those companies use is a variable interest entity (VIE), which allows companies to establish contractual relationships that are similar to equity ownership, but may carry risks of financial misstatement or accounting fraud. When a VIE reverse merges with a U.S. company in order to get listed, the U.S. holding company extracts the profit from the VIE through a contract, but does not own any part of the VIE. Therefore, the U.S. audit regulators obtain little access to inspect the levels of risk that VIEs represent.

In order to better protect the interests of investors, the SEC has cautioned them that VIEs may be prone to fraud as well as other abuses and increased scrutiny of reverse mergers. A number of Chinese companies were suspended due to accounting questions and, as a result of the aforesaid legal case, Longtop’s American Depositary Shares were delisted in August.

While some financial analysts warn it may be time for investors to think twice about whether or not they should keep holding the stocks of those Chinese companies, the U.S. audit regulators still seem to hold confidence on the prospect of the Sino-U.S. audit cooperation.

James Doty, Chairman of the PCAOB, believes a protocol can be reached between the two countries because the Chinese companies need access to the capital on the U.S. market, and China does not want to be a global financial outlier. Doty even predicts one or two joint inspections of China-based auditors by the PCAOB and China may take place in 2012.

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