Publications

20 Jul 2010

Improper audits in China – US accounting regulators express concerns

Corporate Governance and Capital Markets Alert

Andrew D. Ledbetter

The Public Company Accounting Oversight Board (the PCAOB) has issued Staff Audit Practice Alert No. 6 (the Alert) regarding smaller PCAOB-registered accounting firms that are located in the United States but issue audit reports for companies with substantially all of their operations outside of the US. The PCAOB focused specifically on problems with the audits of China-based issuers that are publicly traded in the US. 

In light of this development, China-based issuers, their investment banks and other professional advisors should carefully consider the implications for auditor due diligence and transaction planning.

Too Much Reliance on Local Audit Firms?

The Alert indicates that, in recent years, a number of smaller US accounting firms have improperly based their audit opinions on the work of local audit firms or outside assistants working in China.  The Alert states that a number of these audit firms appear to lack the resources to perform audits in compliance with PCAOB standards, whether due to their small size or lack of resources, inability to overcome language barriers or supervisory and business record considerations.  The Alert suggests that problematic audits often involve China-based issuers that have conducted reverse mergers with US public company shells.

Despite the obvious practical considerations associated with auditing a China-based issuer from the US, the number of such issuers filing with the US Securities and Exchange Commission financial statements audited by US auditors has increased in recent years, including by smaller auditors.  The PCAOB has identified at least 40 US registered public accounting firms with fewer than five partners and ten professional staff that issued audit reports on financial statements filed with the SEC by China-based issuers from January 2008 through March 2010.

The Alert, together with a recent string of comment letters from the SEC, indicate that US regulators intend to scrutinize small US audit firms that audit China-based issuers. 

Numerous PCAOB Rules Govern Reliance on Other Auditors and Outside Consultants

Although it is possible for a PCAOB registered firm to issue an audit report based on the work of another audit firm or outside assistants, there are numerous PCAOB rules regarding such practices.  For instance, AU Section 543, Part of Audit Performed by Other Independent Auditors, establishes requirements that apply when an auditor uses the “work and reports of other independent auditors who have audited the financial statements of one or more subsidiaries, divisions, branches, components, or investments” included in the issuer’s financial statements.  However, AU Section 543 does not provide a way for an auditor to take responsibility for the work of another auditor that has essentially audited an issuer's financial statements in their entirety.  A PCAOB registered firm must have “sufficient” participation in the audit, based on consideration of numerous factors.  In addition to playing a significant part in the audit, the PCAOB registered firm must satisfy several obligations with respect to evaluating and understanding the audit procedures and independence of the other auditor. 

If a PCAOB registered firm engages outside assistants in performing the audit, its responsibilities are the same as those for the work of assistants associated with the firm.  These responsibilities include planning, performing and supervising the audit work, assigning and supervising such assistants commensurate with their level of knowledge, skill and ability, and properly considering their independence.

Improper Audits Raise Significant Deal Risks

An audit that raises potential issues, particularly issues that regulators like the PCAOB are emphasizing, can become the problem of everyone involved in the transaction.  Because Rule 2-02(a) of Regulation S-X requires an audit report to indicate the city and State where it is issued, the SEC staff can very quickly identify audit firms issuing audit reports from locations far removed from the China-based issuer.  An SEC comment is likely to follow, asking whether the auditor relied on an opinion of a local auditor or outside assistants.  Often times, this comment will be in a so-called bedbug letter, in which the SEC staff indicates that it does not intend to begin substantive review of the filing until it understands more about how the audit was performed.  This can substantially delay a transaction. 

Even if substantive review is not delayed, SEC staff comments on this topic can be extensive.  Comments may ask for information regarding where accounting records are maintained, the identity of any local auditor and any outside assistants, their role in conducting the audit and the audit procedures they performed, whether a local firm has issued a report and whether the PCAOB registered firm should reference any such report, the inquiries performed regarding the professional reputation and independence of any other involved audit firm, and the audit procedures performed by the PCAOB registered firm to ensure sufficient oversight of the audit.  In addition, the SEC’s Office of the Chief Accountant may request supplemental information from a foreign auditor to ascertain that the foreign auditor has the necessary knowledge and experience.  Even if such comments are initially avoided, the SEC may raise them at any time in which the audited financial statements are contained in an SEC filing. 

In addition, SEC enforcement inquiries may follow, as may inquiries from stock exchanges or other regulatory bodies.  Improper audits may also easily lead to private litigation for securities fraud or other claims.  Claims that investment bankers relied reasonably on the auditor, including on comfort letters, may be unpersuasive unless adequate scrutiny is given to such issues.

Conclusion

The fact that the PCAOB has issued the Alert suggests that it is making auditor reliance on other auditors or outside assistants a priority when inspecting PCAOB registered firms, particularly those providing audit reports for China-based issuers.  The SEC comment process has also focused on this area of concern.  Given the regulatory emphasis, China-based issuers, their investment banks and their other professional advisors should:

• Consider audit issues as a due diligence point.
• Consider the implications of audit red flags on comfort letters and reasonable care defenses.
• Plan in advance for efficient ways to clear foreseeable SEC comments.
• Consider the impact of potential audit issues on the timing and market perception of transactions.

We are happy to assist you considering these and related issues in planning capital markets transactions and SEC public reporting.

For more information, please contact:

Matthew D. Adler

Andrew D. Ledbetter