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Last week, an SEC judge in the US delivered a spanking to the Big Four accounting firms (Deloitte Touche, KPMG, PriceWaterhouseCoopers, Ernst & Young) barring their Chinese affiliates for six months from doing audit work for US-quoted Chinese companies. "To the extent [the Big Four] found themselves between a rock and a hard place," the judge's decision declares, "it is because they wanted to be there. A good faith effort to obey the law means a good faith effort to obey all law, not just the law that one wishes to follow."

Overall, the judge's 112-page ruling on the audit work of the Big Four in China makes for interesting, and at times damning, reading. You can click here to access it.

The judge's decision should probably be required reading for anyone working in private equity and capital markets transactions with Chinese companies, or investing in ones quoted on US stock markets. Investments in US-quoted Chinese companies with an aggregate market cap of over $500 billion rely, at least to some extent, on the accuracy and reliability of Big Four audits. That audit bedrock looks shakier now than it did a week ago.

The Big Four are appealing the decision meaning that for now at least, they can continue to serve their US-listed Chinese clients, continue to audit their accounts, and continue to earn sizable fees for doing so. If they lose the appeal, they will need to suspend for six months their main activity in China.

Whichever way the appeal goes, the judge's decision, as well as the stinging language he uses, are certain to raise questions among investors about the quality and reliability of Big Four audits done for US-quoted Chinese companies. Shares of some, including giants like Baidu (NASDAQ:BIDU), fell in reaction to the news.

The Big Four have a near-monopoly on audit work for the over 160 Chinese companies listed in the US. Will their Chinese clients permanently go elsewhere? What about the 15,000 people working for the Big Four in China? How will the firms pay them during the half-year suspension? How will they spend their working days if not engaged in audit work?

This much is clear: whatever happens with the appeal, the reputation and trustworthiness of the Big Four's work in China has taken a recent beating. The judge's decision last week is particularly ill-timed. Chinese companies have only just regained some of the lost trust of US investors, allowing IPOs to resume. I have friends at all Big Four firms, and have worked with all of them over the last six years in China.

This dispute between the SEC and the Big Four has been bubbling away for over two years. It was triggered by a series of SEC investigations into serious misbehavior by some Chinese companies then-quoted in the US - fraudulent financial accounts, incomplete disclosure, faked revenues. The companies were punished, and their shares delisted from the US stock exchange. But what about the Big Four auditors? Why hadn't they uncovered and reported their clients' misconduct to the SEC? Were the Big Four in China careless? Negligent? Or even complicit in these Chinese companies' attempts to mislead US investors?

This quickly became a focus of the SEC investigation. To determine if the Big Four audits were performed thoroughly and in compliance with US securities laws, the SEC asked the Big Four in China for their audit papers - that is, the complete written documentation showing what they did and with what level of diligence and accuracy. The Big Four refused the SEC requests to hand over the audit papers, saying that to do so would violate Chinese state secrecy laws.

They used the same argument with the judge. He rejected it outright. Instead, he says the Big Four demonstrated "gall" in "flouting" the SEC, were "oblivious" to some core legal issues, and took a "calculated risk" they wouldn't get punished. Strong stuff. While the judge doesn't say directly that greed was a major factor in the Big Four's decision to disobey SEC orders, but it may be fair to make that inference. Their strategy was basically one of having one's cake and eating it too. They wanted to keep earning big fees for China audit work, while not fully complying with US securities laws. In specific cases cited by the judge, accounting fraud at US-listed Chinese companies was first brought to light by short-sellers, rather than by the Big Four audits.

The judge's decision will likely empower the shorts to seek out other targets among Chinese-quoted companies. Their judgment, at least in some cases, proved to be more bankable than Big Four audits.

The judge's ruling notes the fact that over the last decade, the Big Four have built very large businesses in China. KPMG China and Ernst & Young China both tripled in size from 2004-2012. PWC grew fastest, increasing its staff four-fold to over 8,000 people. Such rapid growth is unprecedented as far as I know in the history of large accounting firms.

One large irony here is that the Big Four are accused by the judge of violating Sarbanes-Oxley. That law has overall been very good to the Big Four, since it gave accountants increased responsibility to police US-listed companies' financial accounts. The scope of audits increased, and with it the fees. But, when things go wrong, as they have with quite a number of Chinese quoted companies listed in the US, the auditors can potentially be held legally liable.

The Big Four all argued to the judge they should be treated leniently because if banned, no other accountants in China have the training and professionalism to do audit work that meets SEC standards for investor protection. Any Chinese company that can't find a new auditor would need to delist from the US stock exchanges. The judge dismissed this argument, and helpfully lists a group of five other accounting firms that have done audits in China and, unlike the Big Four, turned over audit papers to the SEC when asked.

Some big US multinationals including P&G (NYSE:PG), Amazon.com (NASDAQ:AMZN), Apple (NASDAQ:AAPL), The Coca-Cola Company (NYSE:KO) and Nike (NYSE:NKE), with large revenues and operations in China, would probably also need to find new Chinese auditors if the ban is upheld. Investing or operating a US-owned business in China, never easy, will become even trickier if the Big Four are forced to down pencils in China and serve the six-month SEC suspension.

Source: The Misfortunes Of The Big 4 In China