Culture Clash: Implications From the US Censure of Chinese Auditors

OK, let's be honest: Chinese accounting is already held in the same regard as Chinese drywall. Which is to say, knowledgeable consumers avoid it at all costs. Or perhaps more accurately, they avoid it whenever they are informed of its presence. Emphasis on informed.

So when a US judge ordered that the Chinese subsidiaries of the global Big Four accounting firms should be suspended for various aspects of their work, it was hardly a surprising swipe at what has long been considered an embarrassing lack of financial reporting quality by global standards. Chinese firms lead, by far, the numbers of companies being de-listed by US and European exchanges. Savvy investors understand that the numbers they are being shown when pondering deals with Chinese companies can often not be trusted.

Though fraud is an issue, these 'misunderstandings' are not purely ethical in nature, they are cultural and national. There are differing beliefs about what numbers mean, what information can or should be provided and who owes what to whom. As the following article explains, the US Securities and Exchange Commission demands that companies and auditors under investigation hand over audit work papers. In China, such information is a legally protected state secret and can not be provided. This is an especially acute problem given the breadth and depth of Chinese government oversight and even management of ostensibly private enterprises. That such entities are frequently owned by arms of the Chinese military makes the definitional dispute even more fraught. Failure to provide that information is a violation of US law while providing it is a violation of Chinese law.

The problem is truly a global one: the US and China both want to encourage cross-border investment. The amount of trade between the two countries is significant - and growing. But differing attitudes towards the treatment of intellectual capital  could thwart the trajectory of further growth. The Chinese embrace control and seek more it. The US business and regulatory community has a substantial libertarian streak: they want to be free to act as they see fit, but they expect to be able to trust the documents are provided and demand the right to take legal action when they believe there has been malfeasance.

The Chinese believe the SEC and US judicial actions are a violation of their sovereignty and an insult to national pride. Foreign investors just want honest accounting, understanding that standards are different and that the buyer must beware. There may be a compromise in there somewhere, but this situation highlights the the impact of fundamental differences in rights, obligations and responsibilities that define global commerce. They may not easily be resolved. JL

Junheng Li reports in Forbes:

Under U.S. securities laws, the SEC is empowered to investigate alleged fraud and require the production of audit work papers from non-U.S. accounting firms; under Chinese laws, such audit work papers are deemed state secrets and cannot be provided.
On January 22, SEC Administrative Law Judge Cameron Elliot ordered that the China units of the global “Big Four” accounting firms should be suspended from auditing U.S.-listed companies for 6 months. The decision came in the aftermath of the disputes between the auditors and the SEC over submitting work papers on U.S.-listed Chinese companies to U.S. regulators for examination. The news has caused huge share price volatility in Chinese-listed companies in the U.S. today, which we believe will continue for the near term.
Chinese stocks listed in the U.S. got hammered on January 22, and the bloodshed continued on January 23, led by the internet and solar stocks. The market is now concerned that this group of companies will miss filing 2013 annual reports to comply with the U.S. listing requirements. On January 24, the Chinese government struck back.

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In theory, the SEC could see fit to delist all of the Chinese companies listed on American exchanges. The impact of a widespread delisting would be nuclear as it could dissolve the entire food chain that services these listed companies, including investment banking, accounting, auditing, and research coverage. Ultimately, it is the American investors and institutional managers who would take most of the financial losses.
Beyond China’s borders, the SEC’s hard-line policy may also have a devastating effect on multinationals such as YUM, Ford, GM, Coca-Cola KO -2.5%, and P&G, all of which have sizable operations in China and will also no longer to be able to produce audit reports. It is clear that if the standoff between the SEC and the Chinese government persists, the whole auditing regulatory framework supporting the global operation of those firms and the capital raising function of U.S. capital market will suffer.
So what could the SEC do, instead of barring auditors from working on what needs to be audited?
As it stands, a primary function of U.S. securities laws is to ensure that all material information about an issuer, including all investment risks, is adequately disclosed to investors free of material misstatements or omissions. So long as investors are adequately informed about any omissions, they are responsible for the risks of their investments.
In other words, one solution would be for the SEC to require disclosure that the audit work papers of domestic Chinese auditors may not be made available to the SEC, so that investors can take this information into account in their investment decisions.