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DIALOGUE: ‘Conflicting Accounts’ -Can China and the US Come to Terms?
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The conflict between US accounting authorities (the SEC and PCAOB) on one side and the China Securities Regulatory Commision (CRSC) on the other officially began on May 27th 2011. On this day the the US Securities and Exchange Commission (SEC) served a subpoena to Deloitte over their refusal to provide the Chinese firm Longtop Financial Technology’s working papers. In reality this conflict had been brewing since 2009 when the SEC first started sending information requests to the CSRC. The future of the big four accounting companies, and several other MNCs, hangs in the balance as a workable solution is sought. Today we speak to Paul Gillis, Co-director of the IMBA program at Peking University's Guanghua School of Management, to help us disentangle this problem. 
 
altPlease tell us about your work with the Public Company Accounting Oversight Board (PCAOB) and the time you have spent in China. 
I serve on an advisory board for the PCAOB - the Standing Advisory Group. It advises on the development of auditing standards. I am the only foreign based member. My opinions here are my own and do not represent the views of the PCAOB or its staff.
 
What are the current accounting standards in China, particularly in relation to Big Four accounting firms’ Chinese branches?
China has essentially adopted international auditing and accounting standards. There have been questions raised, however, about how well those standards get applied in practice. Most overseas listed Chinese companies use International Financial Reporting Standards (IFRS) or U.S. Generally Accepted Accounting Principles (US GAAP).
 
The Big Four in China are member firms that operate much like franchises. The China based firms are mostly controlled by Hong Kong people, but local PRC partners are rapidly taking them over.  Starting this year, the audit practices are being conducted in special general partnerships that can have no more than 40% unlicensed expatriate partners. In each case, however, the firms still have a Hong Kong senior partner; although that will change in the next three years. 
 
When did you first notice this dispute between U.S. and Chinese financial regulators? Who are the major players in this issue and what consequences could there be?
I have been working on this issue for the last seven years. I retired from PWC in 2004 and went back to school to get a PhD. My research focused on the development of the accounting profession in China, and the problems created by gaps in international regulation were an early finding. 
 
What we have is a situation whereby China’s private sector could not find sufficient capital in China, so it looked abroad. China made it difficult for private companies to seek foreign investors or go public in China. The companies found a way around Chinese regulations by incorporating in offshore locations like the Cayman Islands. That got them out from under Chinese regulation, but it created a regulatory hole. 
 
China cannot regulate these companies because they are not Chinese companies, they are Cayman Island companies. But when U.S. regulators asked to come to China to regulate the companies, China said no. China will not allow U.S. regulators to enforce U.S. laws against Chinese people on Chinese soil. While China’s position is reasonable, it leads to regulatory holes. China can’t regulate the companies because they are not Chinese, and it won’t let the U.S. access people and records that are in China. The result means that the companies are unregulated, and it is not surprising that there has been a fraud as a consequence. 
 alt
Can you tell us the different ways in which the US Securities and Exchange Commission (SEC) and the PCAOB are looking at Chinese auditors and foreign auditors?
The SEC is responsible for enforcing American securities laws. It is a task force focused on the many frauds that have taken place among U.S. listed Chinese companies. It has had great difficulty bringing these frauds to justice, mainly because the fraudsters and their records are in China and China won’t help.
 
The PCAOB is charged with setting auditing standards and inspecting auditors of U.S listed companies to make sure they follow those standards. The PCAOB has been blocked by China from coming to China or Hong Kong to inspect auditors because policymakers  believe that would impinge on China’s sovereignty. 
 
Will the results of the SEC and PCAOB decision process have different consequences for SOEs and Variable Interest Entities (VIEs)? 
With regards to SOEs, China is concerned that giving records to the SEC or PCAOB might disclose state secrets. China listed many large SOEs in the U.S. as a means of importing U.S. corporate governance practices and improving transparency. U.S. listings helped these companies to reform and become more competitive, but there may now be more transparency than is desired. China needs to think about whether it really wants to list the big SOEs in the U.S. 
 
Private companies have not had access to capital in China until recently. When China’s stock markets reopened in 1990, they were used mostly to reform SOEs until Jiang Zemin legitimised private business by welcoming entrepreneurs into the Communist Party in his ‘Theory of the Three Represents’. We have seen a rapid expansion of Chinese venture capital, private equity and the SME and ChiNext boards in the last decade. For most of the early 2000s, however, private Chinese companies looked to the West for capital. Many of these companies used the variable interest entity structure (VIE) to get around Chinese laws restricting foreign investment in sensitive sectors. The VIE uses control of Chinese companies through contracts instead of ownership. The contracts arguably violate Chinese laws, and it is questionable whether they are enforceable, and many investors have been burned when insiders just take the Chinese operations. 
 
Would companies being listed in Hong Kong solve this crisis?
The SEC has charged the Big Four accounting firms and BDO with securities laws violations for refusing to turn over audit working papers as is required by U.S. law. The accounting firms say that Chinese laws forbid them from doing so, and that they have been told that their partners could face life in prison if they went ahead and gave the working papers to the SEC.
 
The SEC case might lead to the firms being banned from auditing U.S. listed companies. At the same time, the PCAOB is in the late stages of trying to negotiate access to inspect the accounting firms. The PCAOB wants to do joint inspections with Chinese regulators, and the Chinese regulators want the PCAOB to instead rely solely on Chinese inspections. If they don’t reach a deal, the PCAOB may be forced to deregister all Chinese accounting firms, meaning that no Chinese firm can audit U.S. listed companies. 
 
What likely happens if companies face delisting is that they look to moving their listings to Hong Kong. That is not an easy process, but most companies should be able to do it. Hong Kong does require a track record of profitability, while the U.S. does not. Some early stage companies that are listed in the United States might find it impossible to list in Hong Kong because they have yet to turn profitable. 
 
What would the worst case scenario mean for investors?
In the worst case, all the auditors get deregistered. When a U.S. listed company does not have an auditor, the stock exchanges delist them. Companies have to provide financial statements audited by a PCAOB registered firm in order to be listed in America. 
 alt
What solutions could you see coming from the US or the Chinese that would resolve this issue without any delisting of companies?
The SEC and PCAOB are bound by U.S. laws, so there is only so far they can compromise. I think both have already put their best offer on the table. The SEC needs to see the working papers, and the PCAOB needs to at least do joint inspections. The Chinese might have a little more room to work with, but there are important issues of state secrecy and national sovereignty at play.
 
Is there much room for optimism that there will be a satisfactory solution for both parties? 
I think this really comes down to a decision by China as to whether it wants to continue to use U.S. capital markets. China’s own markets are not ready to meet the needs of its private sector. Announcements this week by CSRC of plans to make it easier for Chinese companies to list abroad, indicates that the government understands this point. If access to U.S. markets is denied to Chinese companies, China risks harming indigenous innovation, with long-term negative consequences to China’s economy. 
 
Has there been any recent developments which indicate that Chinese private companies will find it easier to raise capital?
Yes, the CSRC announced on 13 December 2012 plans to make it easier for private companies to raise capital. China should allow its private companies to find capital where they can. The big change needed is to allow private companies to directly list abroad- getting rid of the need for Cayman Island holding companies and variable interest entities. That will help solve a lot of the problems. 

By Matthew Baum
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