The Public Company Accounting Oversight Board has reached a tentative agreement to begin observing Chinese regulatory authorities during inspections of auditing firms in China as a kind of “trust-building exercise.”

The PCAOB has been seeking the ability to inspect Chinese auditing firms after accusations arose in recent years of accounting irregularities at a number of Chinese companies that trade on U.S. markets. Chinese regulators have resisted direct inspections by U.S. regulators, but the PCAOB has been in negotiations on resolving the stalemate.

“As a first step toward further cooperation, we are working toward and have tentatively agreed on observational visits where PCAOB inspectors would observe the Chinese authorities conducting their own audit oversight activities and the Chinese could observe the PCAOB at work,” said PCAOB board member Lewis Ferguson during a speech Friday at California State University’s SEC Financial Reporting Conference in Irvine, Calif. “This would not be a substitute for a PCAOB inspection but would be a trust-building exercise between regulators. Initially, such observations would focus on quality control examinations of the audit firm being examined rather than a substantive review of a specific audit. We hope such exercises will build trust and lead to further cooperation.”

Ferguson noted that in the past year or so, allegations of financial fraud and related accounting problems have been disclosed about a number of China-based companies whose securities are registered outside of China, particularly in the U.S., Singapore and, to a lesser extent, Europe.

“Beginning in the latter part of 2010, alleged financial frauds and serious accounting issues were revealed at a number of the smaller Chinese reverse merger companies,” he said. “To date, 67 of these China-based issuers have had their auditor resign, and 126 issuers have either been delisted from U.S. securities exchanges or ‘gone dark’—meaning that they are no longer filing current reports with the SEC. Billions of dollars of market capitalization of such companies have  been lost in U.S. securities markets and it is fair to say that all of these smaller China-based companies listed on U.S. securities exchanges  have suffered serious losses of both market value and investor confidence as a result of the problems of other companies.”

Ferguson noted that many of the smaller Chinese companies most commonly sought access to U.S. markets by merging with existing, registered U.S. shell companies in reverse mergers, while the larger companies filed initial public offerings. A PCAOB research note showed that, in the U.S. alone, between Jan. 1, 2007 and March 31, 2010, 159 Chinese companies entered the U.S. securities markets using reverse mergers and generated market capitalization of $12.8 billion.

These transactions represented the largest share of the reverse merger market during that period. In the same period, 56 Chinese companies, including a number of very large state-owned enterprises, completed U.S. IPOs and had an aggregate market capitalization of $27.2 billion. Seventy-four percent of the reverse merger companies were audited by U.S.-based audit firms and China-based audit firms audited the balance, but all of the firms were registered with the PCAOB.

However, because of the increasing investor skepticism about Chinese companies’ accounting, the number of China-based companies that have successfully filed an IPO in the U.S. in the past year has slowed to a trickle. “We understand that smaller Chinese companies have also suffered similar adverse consequences in other non-U.S. and non-Chinese markets,” said Ferguson.

The PCAOB currently does not have cooperative agreements with either the China Securities Regulatory Commission or China’s Ministry of Finance, which share jurisdiction over Chinese accountants, Ferguson noted. The CSRC has jurisdiction over the 53 accounting firms, including the affiliates of the global network firms, which are authorized to file audit reports with respect to companies listing securities on the Chinese domestic securities markets in Shanghai and Shenzhen. The MOF licenses all accountants in China and has jurisdiction over more than 7,000 accounting firms in China, including some of the firms registered with the PCAOB.

“Under Chinese law, it is illegal to remove audit work papers from China,” said Ferguson. “At the present time, Chinese authorities will also not permit any non-Chinese regulator to conduct inspections on Chinese soil. As a result, it is impossible for the PCAOB or other regulators to inspect China-based audit firms or to assess the quality of such firms registered with it. This limitation also applies to the affiliates of the global network firms that perform audit work on the audits of the Chinese operations of the large global companies operating in China.”

In an attempt to address these problems, the PCAOB has intensified its dialogue with both the China Securities Regulatory Commission and the MOF over the past year. “Both we and the Chinese regulators recognize the importance of improving audit quality and investor protection,” said Ferguson. “For the PCAOB, an agreement with China is important not only because of the risks investors face, but because of the size and rapid growth of the Chinese economy. Almost 5 percent of PCAOB-registered firms are based either in China or Hong Kong, the largest group of non-U.S. firms.”

Ferguson noted that Chinese authorities say that the PCAOB should rely on their oversight of auditors. “They have two principal concerns,” he added. “The first is that any action by a foreign regulator on Chinese soil, even a mere inspection, could violate Chinese sovereignty. This concern has deep historical roots, specifically relating to the humiliations that China suffered at the hands of Western powers in the nineteenth and early twentieth centuries. The second concern grows out of China’s very expansive state secrecy laws. There has been a concern expressed that inspection of audit work papers, particularly work papers from the audits of state-owned enterprises, could lead to disclosures of state secrets. The question for both countries is how to conduct inspections in ways that respect national sovereignty and the legitimate regulatory goals of both countries.”

Ferguson noted that there is another complicating issue with China and Hong Kong. Both the PCAOB and the SEC are in discussion with Chinese authorities about cooperation in connection with investigative activities. Both agencies are seeking the cooperation of the Chinese authorities in obtaining documents in appropriate investigations.

“Although we remain hopeful that breakthroughs will be achieved, to date difficulties remain,” he acknowledged. “Despite our hopes, the question arises as to what happens if we are not able to achieve an agreement on regulatory cooperation with the Chinese. Any firm that registers with the PCAOB is legally obligated to cooperate with us and provide documents and potentially testimony if requested in connection with an inspection or investigation.”

A refusal to cooperate, either in an inspection or an investigation, could subject the firm to PCAOB sanctions even if the firm is motivated by compliance with local laws that restrict such cooperation, Ferguson noted. One possible sanction could be the revocation of a firm’s PCAOB registration. Any company audited by such a firm would either have to get a new audit opinion signed by a firm registered with the PCAOB or risk being in violation of SEC and stock exchange rules, he added.

“The stakes in this matter are very high,” said Ferguson. “But U.S. financial authorities have a primary responsibility to protect the integrity of our capital markets and the interests of U.S. investors. We believe the Chinese authorities are aware of the seriousness of this matter and we are hopeful that we will be able to work out satisfactory arrangements. We continue to engage in dialogue with the Chinese authorities, but at this time it remains uncertain where this dialogue will ultimately lead.”

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