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What US Audit Inspections Mean for Big Four China: Explained

May 11, 2023

PCAOB finalizing first set of China audit inspections
2022 deal with Beijing opened audit firms to US scrutiny

The US accounting oversight board on Wednesday released the first batch of inspection results for audit firms based in China, a historic step that’s ended a years-long struggle to open up the work of auditors responsible for vetting the revenue and cash for $1 trillion worth of Chinese stocks listed in New York.

“The reports are a big first step. By shining a light on deficiencies, our inspection reports provide investors, audit committees and potential clients with important info so they can make informed decisions and hold firms accountable,” said Erica Williams, chair of the Public Company Accounting Oversight Board.

Inspectors faulted KPMG’s China affiliate and PwC’s member firm in Hong Kong for a wide range of shortcomings in seven out of the eight audits reviewed. While that high rate was “unacceptable,” Williams said, it was consistent with results for other firms that have undergone the board’s routine inspections for the first time.

“We were tough here, but we are everywhere,” she said.

PCAOB staffers spent nine weeks in Hong Kong last fall reviewing the work of KPMG Huazhen LLP, which is based in mainland China, and PricewaterhouseCoopers, which is based in Hong Kong. The regulator scrutinized the firms’ work testing out a historic deal between the board and Chinese regulators that subjected the firms to US scrutiny for the first time.

Beijing had long barred the board from inspecting and investigating Chinese auditors, citing national security concerns. The inspection results are the first the regulator has released for China-based audit firms in the board’s 20-year history.

What is the PCAOB?
Congress created the Public Company Accounting Oversight Board in 2002 to help restore investor trust in corporate financial statements after a series of accounting scandals that culminated in the collapse of Enron Corp. and Worldcom Inc.

The board oversees the work of accounting firms who audit US-listed stocks and certain broker-dealers. Inspections form the backbone of that oversight providing routine reviews of how well firms are meeting PCAOB audit standards. The board inspects the work of auditors in more than 50 jurisdictions around the world.

What does the PCAOB review?
PCAOB inspections are intended to assess if firms are meeting the board’s audit standards and rules. Inspectors typically check areas that carry the highest risks for misstatements or fraud such as revenue, business combinations, cash, derivatives and inventory. They frequently focus on firms’ largest, most complex clients.

Sometimes inspection teams focus on specific risks like how auditors vet warrants and equity, tricky areas of accounting common among special purpose acquisition companies, or how banks addressed interest rate risks. The board also recently said it would give more details in inspection reports about how firms vetted fraud risks their clients.

Among Chinese companies, complex accounting for variable interest entities, a common structure used by stocks listed on US exchanges, and how they accounted for acquisitions could spur extra inspector scrutiny.

The board typically conducts its inspections in arrears. So 2022 inspections would have tested auditors work in vetting their client’s 2021 fiscal-year financial statements.

Inspectors review only the work that the auditors did to ensure they provided a thorough, independent audit and complied with the board’s rules. Inspectors aren’t testing the company’s accounting, though they do sometimes uncover flaws in the audit that may result in a client restating its results or reporting that their internal controls weren’t working effectively.

What did the board inspect in China?
The board looked at eight audits across two firms, KPMG Huazhen LLP in mainland China and PricewaterhouseCoopers in Hong Kong. The firms’ audit clients represent 40 percent of the market cap of US-listed companies whose auditors are based in China or Hong Kong.

Williams has said that the board intends to inspect additional firms during its 2023 inspection cycle to capture the majority of those remaining stocks’ market share. More than 250 Chinese stocks were listed on US exchanges as of January with a market share worth $1.03 trillion.

The board has said that it selected audits to review among state-owned enterprises and so-called “sensitive” industries that the Chinese government in the past objected to the PCAOB inspecting.

Are inspection violations common?
Yes. PCAOB staff routinely note audits that fall short of the board’s requirements including among international firms that typically undergo inspections every three years. Violations would be expected for firms that have never gone through a routine PCAOB inspection.

For example, when the board first began inspecting firms in Chile, the regulator found the Deloitte affiliate there had four violations across two audits, according to the firm’s 2008 inspection report. A decade later, the Chile firm’s results had improved and staff noted no violations across its three audits in 2018.

One-third of all audits inspected last year fell short of PCAOB standards, an increase from the prior year when only 29% missed the mark. Inspectors found a growing number of problems among the largest four US firms—16% of Big Four audits missed the mark compared to 12% the year before.

Will reports name the audited companies?
No. The board releases the industry for each company that is audited, but not its name. The regulator recently said it would begin providing more context about clients—for example if it was a new client for the auditor.

In general, inspectors pick the most complex, or high-risk clients such as those with a large market cap. For its inaugural China inspections, the board said it had selected issuers the Chinese government had denied the board from reviewing in the past, including state-owned enterprises and certain industries.

What happens next?
The board has said that it would resume inspections in China and Hong Kong this year. Any interference with its inspection or investigation process could stall those reviews and jeopardize the US-listing status of scores of companies.

“Should PRC authorities obstruct or otherwise fail to facilitate the PCAOB’s access in anyway, at any time, the board will act immediately to consider the need to issue a new determination,” Williams said Wednesday.

The board in December determined that it had secured the access it needed to both inspect and investigate the work of auditors in China and Hong Kong. That finding effectively eliminated the threat of delisting for about 200 Chinese companies on New York exchanges under a 2020 US law.

Last year, Congress raised the stakes by tightening the compliance window for companies to hire an auditor that complies with US requirements.

Despite the high rate of violations that inspectors documented, those findings alone won’t renew any delisting threat for Chinese companies. That risk of trading bars will remain distant as long as the board continues to get the access to audit staff and their records the PCAOB has long demanded.

[Bloomberg Law]

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