Public Company Accounting Oversight Board member Jeanette Franzel said the ability to inspect auditing firms in China remained one of the PCAOB’s greatest challenges, but the PCAOB is making progress on negotiating a memorandum of understanding with the Chinese government.

Franzel spoke Friday during a conference on sustainable business at Baruch College’s Zicklin Center for Corporate Integrity. She also noted that the PCAOB has taken a brief pause in its deliberations around a concept release proposing mandatory audit firm rotation, but would make a decision on the next steps later this year.

The ability to inspect China, along with broker-dealer audits and the auditor’s reporting model were cited as the top challenges for the PCAOB by Franzel, who joined the board last February after serving as a managing director at the Government Accountability Office.

The PCAOB has been signing audit firm inspection agreements with other countries, including France and Finland earlier this month, but China has remained a sticking point, particularly when it comes to inspections of Chinese companies that are trading on U.S. markets by doing a reverse merger with a U.S. shell company.

“Unfortunately we have seen a lot of fraudulent activities in those companies, and beginning in 2010 and since then, about 67 of those companies have had their auditors actually resign, and 126 of those issuers have either been delisted from the U.S. exchanges, or they’ve gone dark and are no longer tapping into capital,” said Franzel. “We don’t know how many more are out there and may need to remove themselves from the U.S. markets. Both we and the SEC are trying to negotiate with the Chinese government right now. We’ve been negotiating for quite some time, so there could be some more out there. It is a serious issue for investors who have invested in these companies if we and the SEC do not have oversight, so we continue to work on that.”

Franzel pointed out that other Chinese companies and their investors have also taken “a hit” because of the accounting problems at the reverse merger companies, and that should provide incentive for an eventual agreement with the Chinese authorities.

“There’s a lack of trust basically at this point in certain classes of Chinese companies that are trading in the U.S. markets,” she said. “They’re trading lower than they already would have, so I think to some extent investors have already been hurt across the board. Certainly in those companies that have exploded and where frauds have been revealed, investors have been harmed as well. We’re currently in the process of negotiating an MoU, a memorandum of understanding, with the Chinese government. We’ve been doing this for quite some time, but we’re hopeful that we’re making progress because the alternatives are not good for the investors who are currently invested in companies over there, and if we think long term about the interaction of our markets with China, we really hope to see a breakthrough soon.”

She noted that auditing firms in China believe they are prohibited from disclosing information to the PCAOB because of national secrecy laws. “We would not think in the United States that audit work papers as potentially revealing national secrets, so we’re really coming at this from a completely different mindset,” said Franzel. “On the other hand, if you look at it from the Chinese mindset, the Chinese government owns a lot of companies and so maybe at those companies there are national secrets, but those aren’t the types of companies we’re talking about here. But it could be that type of mindset bleeding over into other types of companies, or they could be afraid of what is in those auditing work papers. In the audit documentation, there could be things that if revealed could be embarrassing and damaging, and others are speculating that they’re simply worried about how we might use the information, even if there isn’t anything bad or embarrassing in that information. If the U.S. government were to get financial details, how would it be used? So there are several theories out there for why there’s been a disconnect, but we are negotiating to basically achieve the same level of oversight that we have in any other foreign jurisdiction where there are audits of U.S.-listed companies.”

Franzel noted that the PCAOB is currently researching exactly how many Chinese companies are publicly listed whose audits should fall under the oversight of the PCAOB.

She was also asked about the status of the PCAOB’s concept release on mandatory audit firm rotation. “Independence has been problematic in the profession for a long time, and it seems to go in cycles,” she noted. “Before I came onto the board, the board issued a concept release on a proposal for mandatory audit firm rotation. That proposal wasn’t new. In the Sarbanes-Oxley Act, there was a requirement for GAO to study the prospect for mandatory audit firm rotation. The theory behind that is if an audit firm has been auditing a client for a very long time, perhaps they’re getting cozy with management, or the client becomes so important to the firm that the firm would take actions to keep that audit client. But if the firms knew that they would rotate, then that would not happen. That’s the theory behind it. Also, under our system where the audited entity pays the auditor, there’s an inherent conflict already built into the system, so the theory is that maybe the rotation would help solve that problem.”

Franzel pointed out that while she was at the Government Accountability Office, she headed the GAO study mandated by the Sarbanes-Oxley Act on mandatory audit firm rotation. “At the time we concluded that there wasn’t enough evidence to show that the conflict could be cured that way, and we thought that it warranted some time to look at the Sarbanes-Oxley Act reforms to see how those would help auditor independence,” she said. “The PCAOB took up the issue again in 2011 and said, ‘OK, it’s time for us to look at this again.’ Where are we with it right now? We’ve gotten a tremendous amount of very valuable input from all kinds of different stakeholders, and we’re working on a few different themes that came out of that. One was the important role of audit committees on corporate boards in overseeing the independence of the auditor, and hiring and retaining decisions, as well as issues of professional skepticism. We’ve had a number of initiatives in those areas, and for now we’ve taken a brief pause on the issue. We’re working on some of these other important issues such as professional skepticism, fair valuation, and audit committee roles in trying to improve auditor independence. We will probably make a decision on next steps for this project later this year.”

Franzel was also asked about the recent agreement between the International Accounting Standards Board and the International Integrated Reporting Council to develop a framework for integrated corporate reporting that includes financial, governance, management commentary and sustainability reporting, and whether there might be a role for auditors to play in that (see IASB and IIRC Sign Agreement to Develop Integrated Reporting Framework).

“That’s a tricky question in the United States because of the securities laws,” she responded. “I think there’s a role for auditors to give assurance over performance measures and other things in those reports, because if you start putting out numbers that aren’t reliable, it’s not worthwhile. I definitely think there’s a role for auditors. In the United States, I don’t think we’re as far along maybe as they are internationally. Because we’re so embedded in our securities laws and compliance type approaches, I think actually there are some countries where they’re starting from a cleaner slate and may be more creative, so hopefully we’ll see practice develop.”

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