The Public Company Accounting Oversight Board has issued a research note cautioning U.S. registered accounting firms that their audits of companies with operations outside of the U.S., particularly in China, may not be in accordance with PCAOB standards if the company accessed the U.S. capital markets through a reverse merger transaction.

The public research note is a first for the PCAOB, and comes from observations during the PCAOB inspection process. The research note, entitled, “Activity Summary and Audit Implications for Reverse Mergers Involving Companies from the China Region (January 1, 2007 through March 31, 2010),” was prepared by the PCAOB Office of Research and Analysis to provide further context to the issues discussed in Staff Audit Practice Alert No. 6 issued on July 12, 2010 (see PCAOB Warns about Using Work of Foreign Auditors). 

“Through this research note, and the earlier staff audit practice alert, the PCAOB is actively reaching out to investors and other users of financial statements to give them more information about the audit environment for companies from the China region that may access the U.S. markets through reverse merger transactions,” said PCAOB Chairman James R. Doty in a statement.

"As the PCAOB research note describes, small Chinese companies are increasingly seeking access to capital and trading in U.S. securities markets," Doty added. "The PCAOB has inspected the audits of many of these companies, when they were performed by U.S.-based audit firms. In some cases PCAOB inspection teams have identified significant audit deficiencies and, as necessary, made appropriate referrals for enforcement to protect investors’ interests in reliable audit reports. Many other such companies are audited by accounting firms in China. To date, the PCAOB has been denied access to determine through inspection whether such firms have complied with PCAOB standards. This state of affairs is bad for investors, companies and auditors alike. If Chinese companies want to attract U.S. capital for the long term, and if Chinese auditors want to garner the respect of U.S. investors, they need the credibility that comes from being part of a joint inspection process that includes the US and other similarly constituted regulatory regimes.”

In the period from January 2007 to March 31, 2010, PCAOB staff found that out of the 603 reported reverse merger transactions, 159 of those involved companies from the China region; the remaining 444 transactions involved primarily U.S. companies. Overall, reported reverse merger transactions involving companies from the China region represented 26 percent of all reverse merger transactions reported during that time period.

Chinese reverse merger companies, like other public companies that trade in the U.S., are required to file audited financial statements with the SEC, and the auditors of those financial statements are required to be registered with the PCAOB. Office of Research and Analysis staff found that, after a reverse merger transaction, the auditor of the former shell company is frequently dismissed, and the post-merger public company usually retains the Chinese operating company’s auditor, which is often a U.S. accounting firm. This change in auditor must be reported in Item 4.01 of Form 8-K. If the new auditor was not registered with the PCAOB prior to the reverse merger transaction, it is required to do so before issuing an opinion on the financial statements of the company.

The number of reverse merger transactions in the study involving companies from the China region was almost triple the number of initial public offerings conducted in the U.S. by companies from the People’s Republic of China during that time.  There were 56 IPOs from such companies, representing 13 percent of the IPOs completed in the United States.

Additionally, following the reverse merger transaction, two thirds of the Chinese reverse merger companies in the study had a market capitalization below $75 million as of March 31, 2010, while more than three quarters of the companies from the PRC that conducted IPOs had market capitalization above $75 million as of March 31, 2010.

As of March 31, 2010, the market capitalization of the 159 Chinese reverse merger companies identified by PCAOB staff was $12.8 billion, less than half the $27.2 billion market capitalization of the 56 companies from the PRC that conducted IPOs during the same period.  As of that date, 59 percent of Chinese reverse merger companies reported less than $50 million in revenues or assets as of their most recent fiscal year.

PCAOB-registered accounting firms based in the U.S. audited 74 percent of the Chinese reverse merger companies, while China-based registered firms audited 24 percent. Due to the position taken by authorities in China, the PCAOB is currently prevented from conducting inspections of the U.S.-related audit work of PCAOB-registered firms in the PRC and, to the extent their audit clients have operations in the PRC, PCAOB-registered firms in Hong Kong.

“We hope to add to this data later in the year, to bring to investors more of the important financial data we are collecting and analyzing at the board,” said PCAOB ORA director Joseph St. Denis.