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What are the US audit regulator’s inspectors doing in Hong Kong?

Sep, 27, 2022

Inspectors from the Public Company Accounting Oversight Board (PCAOB) spent last week at the Central offices of PwC and KPMG examining audit materials
A typical audit working paper will clearly show the name of the preparer, the date of preparation and the objective of the test, and the number of samples collected, auditor association chair says

Teams of US audit inspectors have already spent their first week at the Central offices of accounting firms PwC and KPMG reviewing hundreds of audit working papers pertaining to US-listed, mainland-based companies.

The fates of more than 160 Chinese companies that face potential delisting from US exchanges are on the line in this unprecedented inspection. However, the review is focused not on the companies themselves, but rather on the work of their auditors.

The inspectors need to go through copious documents and interview the accountants to ensure the accounting firms have proper quality-control systems in place and to check their work on selected clients’ financial statements or listing prospectuses.

Who are the inspectors?
The inspectors work for the Public Company Accounting Oversight Board (PCAOB), the audit regulator of the US. The PCAOB was set up in 2002 under the Sarbanes-Oxley Act, the sweeping legislation that regulated accounting practices in the wake of scandals including the collapses of Enron and WorldCom.

The PCAOB sets audit standards and sends inspectors to review accounting firms on a regular basis.

The inspection in Hong Kong, which started on September 19, is historic as it is the first time PCAOB inspectors have been allowed to review the audit working papers of mainland companies listed in the US.

This came after an agreement signed by the Ministry of Finance, the Chinese Securities Regulatory Commission (CSRC) and the PCAOB last month. Under the agreement, China allowed audit materials on Chinese companies outside the mainland for the first time to be reviewed by PCAOB inspectors in Hong Kong.

What are the PCAOB inspectors doing in Hong Kong?
“As with all inspections, they will look at various factors including the audits of specifically selected companies and the overall quality control systems of the audit firms themselves,” said PCAOB chair Erica Williams in a speech in the US on Thursday discussing the inspections in Hong Kong. “They will review audit opinions that firms sign directly, and audit work those firms perform on behalf of others.”

The inspectors stayed at the Central offices of PwC and KPMG for the past week to read through many audit working papers and interview the auditors, according to two sources familiar with the situation.

Before they started their work on September 19, the inspection teams informed PwC and KPMG of what audit engagements they wanted to inspect. The two firms prepared all the audit working papers in advance, in both paper and electronic form.

What are audit working papers?
Audit working papers, also known as audit documentation by the PCAOB, are written documents recording how an accounting firm’s audit team planned its work and exactly what it did in auditing a client’s financial statements. The papers show how the auditors arrived at their conclusions about the reliability of the client’s financial statements.

The Sarbanes-Oxley Act requires all accounting firms registered with PCAOB to prepare and maintain audit working papers for at least seven years, ready for inspection by the PCAOB.

Fifteen Hong Kong and mainland Chinese accounting firms are registered with the PCAOB, and they must follow the PCAOB standards and guidelines to prepare their audit working papers for inspections. These 15 firms have audited 168 US-listed Chinese firms between them, with a combined market value of US$1.5 trillion as of June, according the PCAOB.

What does an audit paper look like?
A typical audit working paper will clearly show the name of the preparer, the date of preparation and the objective of the test. It will also detail the number of samples collected and record any representations or communications made by the executives of the company being audited, said Clement Chan, chairman of the Hong Kong Association of Registered Public Interest Entity Auditors, the industry body of auditors for listed companies in Hong Kong.

“An important sector of the paper is the conclusion, where the auditing staff will conclude, based on the test results, whether the objective of the specific test was achieved,” Chan said. “The result will in turn contribute to the forming of the overall auditor’s conclusion on the reliability of the financial statement prepared by the company being audited.”

Working papers must contain sufficient details to show that the auditors have collected information, conducted on-site inspections or conducted interviews with key people before signing off on the financial statements prepared by the listed companies, Chan said.

The auditor may also meet with key staff and obtain independent confirmation from suppliers or customers of the companies to cross-check certain payments, transactions or invoices against in-house records, he said.

“For a big listed company with hundreds of subsidiaries worldwide, a new listing audit or annual audit may produce thousands of pages of working papers or electronic files,” Chan said.

Why does China ban the removal of audit working papers from the country?
China’s 2019 securities law – effective March 2020 – defines audit working papers as state secrets, which cannot be taken outside the country for inspection by the PCAOB. Section 177 of the law explicitly bars overseas agencies from conducting investigations in China or extract data without the consent of the relevant authorities.

This conflicts with the United States’ Holding Foreign Companies Accountable Act (HCFAA), passed in December 2020, which requires US-listed foreign companies to comply with PCAOB audit inspection rules or face delisting after three consecutive years of non-compliance.

Section 177 of China’s securities law also mandates the CSRC to set up mechanisms for cross-border collaboration with overseas regulators, such as the US SEC and the PCAOB.
“The audit working paper may contain some state secret information such as the location of an oilfield or data on food reserves,” Chan said.

In the historic agreement that brought the audit papers and the PCAOB teams to Hong Kong, the CSRC required that the accounting firms redact certain sensitive details such as addresses, names of factories and personal information, according to two sources.

PCAOB, however, has already said it needs full access to the audit information.

“The PCAOB will accept nothing less than complete access when we make our determinations by the end of this year,” Williams said in her speech on Thursday. “When I say no loopholes and no exceptions, I mean none.”

When will the inspection be completed?
Accounting sources expect it will take several weeks for the inspectors to complete their work in Hong Kong.

“One thing is certain,” Williams said. “By the end of this year, the PCAOB will make determinations whether the PRC authorities have allowed us to inspect and investigate completely, or if they have continued to obstruct.”

The clock is ticking for companies facing delisting, because the three consecutive years that they have to comply started in 2021. Last December, PCAOB confirmed it could not conduct the inspections.

After reviewing the working papers, what will the inspectors do?
If the PCAOB inspection team identifies deficiencies, it will discuss them with the auditing firms to seek explanations.

The inspectors will then prepare an inspection report on whether the auditors have carried out their duty properly. The inspection team may also refer matters it found during the inspection to the enforcement division of the PCAOB, the US Securities and Exchange Commission or other law enforcement authorities.

Will the listed companies be identified?
Not publicly. The inspection report will identify the number of listed companies’ the team reviewed, but will identify each company simply by a letter and industry sector, according to the PCAOB website.

In instances where classifying using an industry sector could make the company identifiable, PCAOB will not include the industry sector in the report.

What comes after the Hong Kong inspection is done? What are the next steps?
According to past experience, the PCAOB inspectors will issue a report on each review of KPMG and PwC of the inspection result. But what is more important would be a separate report expected to be issued by PCAOB in December to determine if the current Hong Kong inspections can fulfil the demand of the US inspectors to conduct its inspection and investigation over audit information of US listed mainland companies

In a similar report issued in December last year, the PCAOB said Hong Kong and mainland China cannot comply with audit inspection requirements under the US Holding Foreign Companies Accountable Act (HFCAA). A company that fails to comply with this US law for over three consecutive years is subject to delisting.

The coming December report, and hence the ongoing inspection in Hong Kong, will thus be important to see if the mainland listed companies can escape from delisting in the US.

[South China Morning Post]