PCAOB needs to take the next Chinese step

The Public Company Accounting Oversight Board (PCAOB) is the U.S. regulator responsible for inspecting accounting firms that audit public companies whose stocks trade in the United States. The PCAOB has the right to come into most countries, but such an agreement has not occurred with China.

Chinese companies have been listing on American exchanges for years because it’s (i) relatively cheap/easy and (ii) the Chinese capital markets are not well established. Consequently, there are hundreds of Chinese-based companies that are directly listed on American exchanges (the NASDAQ and the NYSE). Additionally, numerous multinational corporations have significant operations in China. All of these companies would be affected of the PCAOB were to de-register the auditors who are working in China.  For additional details, see this article about the Chinese accounting frauds.

Because of numerous accounting scandals involving Chinese companies, the PCAOB has been trying for months to gain access to China to inspect auditors there. Although the PCAOB held talks with Chinese regulators in Beijing in July, no date has been set for the next round of negotiations, and no meaningful action items have been announced. Chinese regulators are refusing to cooperate with the regulation of Chinese firms whose results materially affect companies whose securities trade in U.S. markets. Though China wants its companies to have access to U.S. markets, it is reluctant to relinquish auditing oversight to a foreign regulator, stating that its domestic regulators are doing a fine job already.

The Big Four accounting firms (Deloitte, PwC, Ernst & Young, and KPMG) audit the most of the world’s largest corporations through networks of legally separate audit firms. The Chinese affiliates of the Big Four are currently beyond the reach of PCAOB inspections.

The PCAOB has the authority to de-register audit firms that cannot be inspected. If the Chinese continue to deny access to Chinese auditors, the PCAOB (through the SEC) pull the registrations of the listed Chinese companies. This would prevent these companies from trading their securities in the United States. Because of the inability to do its job with respect to Chinese companies, combined with numerous accounting problems that have already occurred, it is time for the PCAOB to take action, and stop waiting for Chinese cooperation that does not appear to be forthcoming.

Chinese companies typically sell at significant valuation discounts to their American counterparts. This is a function of the risk of investing in a communist country that is paranoid about the free flow of information and related outside oversight required for transparent capitalistic markets.

I suspect that the Chinese will continue to ignore the PCAOB (albeit politely), which leaves it up to the Americans to make the next decisive move. The PCAOB has already demonstrated remarkable restraint. Since a continuation of the accounting frauds and related lawsuits seems intolerable as a permanent situation, the PCAOB should not procrastinate.


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