The Securities and Exchange Commission has begun cracking down on Chinese companies that go public on the U.S. markets by doing a “reverse takeover” of a U.S. shell company.

The SEC has been finding that the books kept by the companies are often in questionable shape. While the companies are required to be audited by firms registered with the Public Company Accounting Oversight Board, many of them turn to small auditing firms that have few Chinese language skills of their own and need to rely on local auditing firms in China that may be recommended by the company itself.

The SEC’s chief accountant estimates that about 340 companies are using small and little known auditing firms in the U.S., according to an illuminating article in The Wall Street Journal.

Problems are already beginning to arise. On Tuesday, the SEC settled a case against the auditing firm Moore Stephens Wurth Frazer & Torbet LLP, and one of its partners, K. Dean Yamagata, for audits back in 2004 and 2005 of China Energy Savings Technology.   

The SEC found that China Energy materially overstated its earnings per share in its fiscal year 2004 annual report and materially overstated its revenues and net income in its FY 2005 annual report and two quarterly reports. The SEC also said the auditor failed to conduct the relevant audits and reviews in accordance with the standards and rules of the PCAOB, did not exercise professional skepticism and due professional care, and violated professional standards.

Respondents issued unqualified audit opinions, which were included in China Energy’s FY 2004 and 2005 annual reports. They also issued interim review reports which contained no reservations, before China Energy filed its quarterly reports in FY 2005. Another Chinese company, RINO International, was recently delisted from the Nasdaq after it revealed accounting problems.

The issue has begun attracting the attention of Congress, and the House Financial Services Committee may conduct hearings next year, according to the Journal.

The PCAOB has long complained that it encounters resistance when it tries to inspect auditing firms in China and many other foreign countries that audit the stocks of foreign companies trading on U.S. exchanges. If the SEC and Congress crack down on the U.S. auditing firms that they partner with in this country, that may give the PCAOB inspectors some extra leverage and a way to get their foot in the door of the firms abroad.