U.S. and Chinese regulators are headed toward a possible clash over how Chinese companies are audited.
Beijing has moved to assert more control over Chinese affiliates of major accounting firms by requiring that Chinese citizens lead those firms and make up most of the partners. That action came after U.S. regulators increased pressure on a Chinese audit firm to force it to cooperate with a U.S. investigation.
At issue is which superpower holds sway over accounting oversight and control of Chinese accounting firms—including affiliates of the so-called Big Four—that audit U.S.-traded companies. U.S. authorities want the firms to help them investigate suspected accounting fraud, while Chinese officials insist on maintaining tight control over any information about the Chinese companies that the audit firms possess.
An all-out confrontation isn't imminent, and a compromise between U.S. and Chinese authorities is still possible. U.S. audit regulators say they are making progress in getting their inspectors into China so they can evaluate the work of the Chinese accounting firms, for instance. Some observers think there is too much at stake for the two sides not to come to an agreement on oversight.
If they can't, however, U.S. regulators may decide it is time to use the biggest weapon in their arsenal—moving to strip Chinese audit firms of the right to audit any companies that trade in the U.S. That could force some companies to change auditors and potentially complicate audits of multinational companies with operations in China that are audited by Chinese firms.
"Accounting firms have always had to steer between the U.S. authorities and the Chinese government, but those straits are now narrowing," said Nathan Bush, an attorney with O'Melveny & Myers in Beijing.
Last Thursday, Beijing rolled out rules requiring the Big Four firms—Ernst & Young, KPMG, Deloitte Touche Tohmatsu and PricewaterhouseCoopers—to hand over control of their Chinese operations to Chinese partners over the next few years. That is broadly in line with how the accounting industry works in other countries. The firms have welcomed the change—KPMG, for example, says it plans to ensure "a smooth and successful transformation of the firm."
But given China's heavy reliance to date on foreign expertise, it could leave China short of experienced accountants and compromise audit quality, say industry observers. That could compound the problems seen over the past year after a wave of Chinese companies listed overseas experienced accounting problems. Investors lost billions of dollars after the stocks tanked.
China's decision to push localization comes "at a horrible time," said Fredrik Oqvist, an independent adviser who closely tracks China accounting issues. "With all the accounting scandals, they don't need another big question mark over the industry."
U.S. regulators are moving to address the problem—the Securities and Exchange Commission has begun filing lawsuits against Chinese companies, alleging fraud and other misdeeds. But they are frustrated by China's refusal to cooperate with U.S. investigations.
The SEC last week said Deloitte's Chinese affiliate was violating U.S. law by refusing to hand over documents the SEC wants concerning a Deloitte client it is investigating. Deloitte says strict Chinese state-secrecy laws means it can't cooperate and that Chinese regulators have indicated the firm would face legal consequences if it did.
The SEC declined to comment. China's Ministry of Finance and the China Securities Regulatory Commission didn't respond to requests for comment.
Mr. Oqvist said China's concept of national security "is quite different from anywhere else in the world." Since the audit industry examines all companies, including state-owned enterprises, "it could be seen as something that affects national security."
In addition, China still doesn't permit inspectors from the Public Company Accounting Oversight Board, the U.S. audit-firm regulator, to evaluate the work of Chinese firms that audit U.S.-listed companies. The oversight board's chairman, James Doty, said last week that U.S. inspectors could be allowed in as observers to inspections of the audit firms conducted by Chinese personnel this fall, as a first step toward joint inspections next year. A spokeswoman for the U.S. board said China's move to localize its audit industry "does not address, resolve or immediately affect" the issue of U.S. inspectors' access to Chinese firms.
The U.S.-China dispute isnt the only one concerning foreign regulators' push for more openness and better standards in audits involving China. Hong Kong regulators have proposed making firms that sponsor a company's initial public offering liable for false statements in the listing prospectus. The move wasn't aimed specifically at auditors or Chinese companies, but the Hong Kong market is heavily dependent on new listings from mainland China. A swathe of Hong Kong-listed Chinese firms have been dumped by their auditors this year over accounting irregularities.
The SEC and accounting oversight board haven't yet acted to bar any Chinese audit firms from auditing U.S. companies, but they also haven't ruled it out. The SEC specifically raises the possibility in the administrative proceeding it filed last week against the Deloitte Chinese affiliate, though that decision would be up to an SEC administrative law judge.
Some are more optimistic it won't come to that. "I think we're making progress, and that process is going to take a little bit of time," said Mitchell Nussbaum, an attorney at Loeb & Loeb who represents many U.S.-listed Chinese companies. Ultimately, he said, "it just makes sense" for the Chinese to work to resolve the dispute.
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