The decision by the SEC's administrative law judge (ALJ) to ban China's Big Four accounting firms for six months creates serious uncertainty for U.S. multinational corporations (MNCs) with significant operations in China. If the ALJ's decision stands, the ban would mean that the China member firms of the Big Four would be unable to participate in the audits of U.S. listed MNCs, jeopardizing the ability of these MNCs to file the financial statements required to remain listed in the U.S. Audit committees need to have a plan B.
The China Big Four firms have appealed the ALJ decision to the full SEC Commission. I understand that the Commissioners have seven months to make a decision, although they can extend that period. In a worst-case scenario, they could act tomorrow, but I think it is unrealistic to think that they would do so. A realistic worst case is that they act in September as the seven months ends. While I expect the Commissioners to affirm the ban, I am hopeful that they will restrict it to foreign private issuers, exempting work on MNCs. The SEC asked the ALJ to limit the ban this way, but the ALJ did not believe he had the authority under the law to do so. I hope the Commissioners decide they have that authority. If the Commissioners limit the ban to foreign private issuers, there should be no problem for most MNCs. The U.S. Chamber of Commerce ought to be screaming at the SEC to do this. Foreign private issuers (U.S. listed Chinese companies), however, are screwed but their plan B is not the subject of this post.
If the ban goes into effect, don't expect that the problem goes away in six months. The next time the SEC demands working papers and the firms refuse to provide them, the firms will be hauled back into court and the judge will likely give the recidivists a lifetime ban.
The worst realistic case is that the SEC bans the firms without exception late Summer/ early Fall this year. The firms will likely appeal the decision to the Federal Circuit Court of Appeals and ask the justices to grant a stay. Lawyers tell me a stay is likely, but not a slam-dunk. The potential harm of not granting a stay is obvious, but the justices might also evaluate whether the firms have a case. Most lawyers I talk to say they don't.
I must emphasize that I do not think it is at all likely that the Big Four firms will face a ban. I believe negotiations between China and the U.S. will ultimately lead to a solution. However, there remains a chance, not likely but not remote, that things fall apart and the firms get banned.
So what can MNCs using Big Four auditors do to mitigate the risk of their auditor getting banned in China? Here are a few ideas:
1.Permanently switch their China audit to a Chinese CPA firm that has not been banned. There is cost and risk in doing this. Keeping all the audit work in one firm is usually the best approach from both a cost and risk perspective. And any successor firm that does U.S. work is likely to come into the crosshairs of the SEC sooner or later, leading to it being banned as well. If the bans become permanent, MNCs will have no choice but to adopt this alternative, but I think it is premature to take such an extreme action.
2.Ask the auditors to accelerate their 2014 work, auditing the accounts through midyear and updating that work monthly. The idea is to get as much work as possible done before the bans come into effect. This might enable alternative audit procedures that could be done from the U.S. on the rest of the year. Or, another audit firm that has not been banned could be engaged to audit the rest of the year. Audit committees should insist that the China Big Four firm line up local firms capable of stepping in if a ban comes into effect. No audit committee should risk being left out when the scramble for replacement firms begins. The local firms that are selected as backups need to have the capacity to take on the work when it needs to be done. There is a cost to this alternative, since auditing this way is highly inefficient.
3.Ask the U.S. audit firm to get a temporary audit license in China and send people to do the audit. This has too much risk for the U.S. firm. It can get the necessary license, but it will be required to follow Chinese law on working papers - leaving the working papers in the country and not disclosing state secrets, which could put it squarely at odds with the SEC. No Big Four firm is going to want to risk its practice rights in the U.S. by putting itself in this situation.
Finding the right plan B depends on the details of how a particular audit is conducted. I personally believe that diplomacy will intervene before any ban comes into effect, but it would be reckless to not have a plan B today.