The Big 4 Audit Firms are stuck between the US and China
When liquidation expert Cosimo Borelli set out to dismantle the remains of China Medical Technologies, which collapsed after a suspected $400m fraud, he ran into a snag.
KPMG, which has been auditing the company from Beijing since it listed in New York in 2005, refused to hand over its financial records. It has even refused to carry out a court order to do so, citing Chinese security laws that prevent sensitive documents from being taken out of the country.
Determined to track down the missing money — the wife of a top executive was suspected of gambling more than $100 million of it in Las Vegas casinos — Borelli came up with a plan.
Over the next two years, his team of eight settled near KPMG’s Beijing office, taking detailed notes of more than 5,000 audit files. KPMG reluctantly gave them access to prevent its liquidation experts from suing its 91 auditors for ignoring a court order to turn over documents.
Liquidators are now using those notes to sue KPMG in Hong Kong over allegations of negligence.
The issue has become the subject of a major rivalry in a long-running impasse between China and overseas regulators and agents over access to corporate financial records. The row has left the big four global auditing firms — Deloitte, PricewaterhouseCoopers, KPMG and EY — which have spent three decades building large operations in the Asian country, besieged. Between antagonizing Beijing and being subject to sanctions elsewhere.
This is the latest challenge to the Big Four audit firms, which have faced growing criticism over audit quality controls in the wake of frauds at Wirecard, Luckin Caffe and others. It has also been threatened by regulators who want to curb its monopolistic practices, and its global business models are once again under scrutiny.
The dispute is also another flashpoint in escalating tensions between Washington and Beijing over issues ranging from trade to security, which have already led to the delisting of three Chinese groups from the stock exchange and the banning of American investors who own shares in companies suspected of links to the Chinese military.
It came to a head in March, when the Securities and Exchange Commission began implementing a Trump administration law requiring foreign companies listed in the United States to allow U.S. regulators to review their financial audits or face delisting from U.S. stock exchanges.
In response, China’s Foreign Ministry accused the United States of “politicizing security regulations,” while a wave of Chinese companies made secondary listings in Hong Kong to mitigate the fallout.
“Auditing firms are caught between two warring jurisdictions,” said Daniel Julzer, a founding member of the Public Company Accounting Supervision Board, the US accounting regulator. Increasingly it seems unlikely that China will eventually accept a settlement (with the United States), while at the same time China becomes more important economically for companies.
US-listed companies have been required to submit their audits to Public Company Accounting Supervisory Board inspections since the introduction of the Sarbanes-Oxley Act in 2002 in the wake of the Enron scandal.
The number of Chinese companies listed on US stock exchanges has ballooned since then, and investment in Chinese IPOs in US markets has reached record levels this year.
The Big Four audit firms, which dominate China’s audit market, audit about 140 Chinese companies listed in the United States, according to the Securities and Exchange Commission.
While they were collecting fees from burgeoning internet start-ups looking to access international capital markets, the Big Four audits in China have grown to nearly the size of their bases in Britain, where they employ about 6% of the total. global staff.
However, many of China’s major tech companies, such as Alibaba, JD.com and Baidu, are among the audit clients who do not make Chinese audit documents available to US regulators.
“The (SEC) provisions are designed to promote transparency,” said Catherine Eddy, vice president of professional practice at the American Center for Audit Quality. While regulatory activity continues, the audit profession in the United States remains highly committed to maintaining audit quality.”
If no solution is found, the Chinese branches of the Big Four audit firms could be de-registered by the Public Company Accounting Supervisory Board, preventing them from auditing US firms. The Big Four audit firms are also concerned about losing access to the Chinese market.
This could have devastating repercussions for the audits of multinational companies like Apple or General Motors, which are headquartered in the United States and have large operations in China.
“This is not good for the entire audit profession,” said Paul Leader, a former director of the Securities and Exchange Commission’s Bureau of International Affairs, who was directly involved in the agency’s engagement with Chinese authorities on the issue. As a result of the conflict between government authorities in the United States and China, audit firms face the threat of enforcement action in both the United States and China and the associated costs.”
“The current impasse does not serve the interests of international accounting firms, issuers, investors, or markets,” added Leader, who now works at Miller & Chevalier, a Washington, DC-based law firm.
Since the introduction of Sarbanes-Oxley, US regulators have tried a number of ways to enforce compliance, including negotiating with Chinese regulators and suing audit firms. In 2012, the regulator targeted corporate practices in China over the accounting scandals at nine companies that left shareholders in the billions of dollars in losses.
Those lawsuits changed the nature of the profession. Some second-tier companies have pulled out of scrutiny of Chinese companies listed in the United States, after their insurers stopped guaranteeing such work.
A recent increase in the number of accounting scandals has prompted regulators to take tougher measures to protect investors, including tighter rules for audit firms.
“We are in a golden age of fraud,” famous short seller Jim Chanos said last year, referring to LuckinCaffe, the largest scam by a Chinese company on Wall Street. Mike Pompeo, the US Secretary of State at the time, warned US investors about a “pattern of fraudulent accounting practices in China-based companies.”
The Big Four audit firms market themselves as global entities with a common culture and consistent standards, but operate as legally separate franchises. This is a particular problem in China, where companies have to link up with a local accounting firm but still maintain central quality control over thousands of audits.
“The network architecture is basically there to protect audit firms from taking responsibility for risks that occur outside their home country,” said the head of international auditing at a large accounting firm.
A possible solution put forward by US regulators last year would have required US accountants to “participate in the audit” of the work of their Chinese counterparts. It would have made the companies’ US partners liable for the work their Chinese partners had done in the event of a meltdown and sue the investor or the regulator – something the companies are trying hard to avoid. To the relief of the Big Four auditing firms, that proposal is “basically dead,” according to people close to the conversations.
Other solutions are being offered – many of them undesirable. “We could end up doing duplicate audits around the world just to meet (Securities and Exchange Commission) requirements that don’t necessarily address quality,” said the head of policy at one of the Big Four. I think this is a risk.”
But the current model turned out to be vulnerable to challenge. In the case against KPMG over its audits of China Medical Technologies, a Hong Kong judge ruled that all of the company’s partners have a “personal obligation to take steps to facilitate compliance”, whether or not they are based in China. A British court issued a similar ruling against EY Global over its Dubai audit of the Al Kaloti gold refining company last year.
Meanwhile, the Big Four have pledged to try to improve global audit quality standards across their networks, after former Securities and Exchange Commission Chairman Jay Clayton urged them last year to improve the quality of audits conducted in China for US-listed companies.
“Based on the current trajectory of US-China relations, it seems likely that the impasse will continue and that Chinese companies will move their listings elsewhere,” Leader said. The Chinese arms of international audit firms will become less connected to the public entity, while another link between the United States and China will be severed.”
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