Are Major Auditors Helping Chinese Firms Get Away with Fraud?

Photo Credit: stock.tookapic.comCC0 license
Why you need to know

Market dominance by the Big Four accounting firms may be helping unscrupulous companies get listed on US stock exchanges.

Listen
powerd by Cyberon

Stock prices of China Huishan Dairy Holdings, a firm that operates on the mainland but is listed in Hong Kong, crashed by over 90 percent on March 24 after investment research company Muddy Waters Research said the company is worth next to nothing. Huishan was claimed to have made fraudulent statements in its earnings reports and to have exaggerated its capital spending on dairy farm acquisitions. Its chairman, Yang Kai (楊凱), was accused of embezzling at least 150 million yuan (US$21.7 million) in company funds.

News of Huishan’s stock price collapse came after its official auditor — KPMG, one of the world’s “Big Four” accounting firms — had approved Huishan’s past three annual reports. Investors have given Muddy Waters credit for bringing the fraud to light, but to date, few have asked a key question: Why did a Big Four accountancy firm, with its scope and prestige, fail to detect fraud when given access to Huishan’s books?

Nabbing a company for financial fraud is not easy, especially with the very limited methods available to third-party investigators. A market research firm like Muddy Waters stood no chance of convincing Huishan to cooperate with its probe, or of delving deep into the company’s accounts. It had to work from the outside in, and yet it quickly worked out that Huishan’s stock wasn’t worth a penny.

KPMG, on the other hand, had, even more, resources at its disposal than unrestricted access to Huishan’s books and financial system — as the auditor, it could also ask for external confirmation of the company’s finances from banks, suppliers, and customers. And yet KPMG still collected its exorbitant audit fee — 6.8 million yuan, according to Huishan’s most recent annual report — and approved the accounts three years running. Are KPMG’s auditing staff truly so inept that they failed to note anything wrong? Or were they complicit in Huishan’s number-flubbing?

Huishan’s chief financial officer, So Wing Hoi, worked for KPMG from 1993 to 2012. That year, he took early retirement to join Huishan, where he was paid an annual salary of 7.73 million yuan. In 2013, Huishan was listed on the Hong Kong Stock Exchange. KPMG has been hired as Huishan’s official auditor for at least the last three years and had not responded to Sixth Tone’s requests for comment by the time of publication.

Many companies hire their chief financial officers from within the ranks of accounting firms, but few end up embroiled in scandal. The last well-known case was that of the American energy company Enron, whose CFO, Andrew Fastow, had joined from Arthur Andersen, one of the then-Big Five accounting firms. The scandal, publicized in October 2001, eventually led to Enron filing for bankruptcy and the de facto dissolution of Arthur Andersen. Cited as the biggest audit failure in history, Enron heralded in a global crisis of confidence in established auditing practices.

A way must be found to break the stranglehold of the Big Four and move past the trouble they’ve caused.

- Li Guangshou, journalist

Arthur Andersen went up in smoke at a time when the Asian financial crisis was winding down and the global economy was growing, so its collapse did not have the same domino effect that the collapse of Lehman Brothers had a few years later during the global financial turmoil of 2008. Still, it led the American government to pass the Sarbanes-Oxley Act, which established an organization called the Public Company Accounting Oversight Board (PCAOB). The act required accounting firms to join the PCAOB and submit to its inspections before they were allowed to audit any listed company in the U.S.

According to the terms of China’s 2001 accession to the World Trade Organization, the U.S. would enter into a transitional period before it acknowledged China’s market economy status. If a Chinese company wants to be listed on an American stock exchange, it usually has to submit to an audit by an American firm.

But the Chinese market is simply too big. As the PCAOB forces Chinese companies to use American accounting firms, the Big Four have expanded their operations into China. They audit Chinese companies according to American accounting standards before making their recommendations to American capital markets. In addition, as there are no foreign companies listed in mainland China, there is consequently no need for Chinese auditors to establish themselves abroad.

Also at issue are the audit papers themselves. The U.S. and China remain unable to come to an agreement regarding cross-border law enforcement, and the Chinese government has turned down American requests for audit reports produced by Chinese auditing firms out of fear that important economic information will be compromised. The U.S. has also repeatedly turned down requests for Chinese auditing firms to be admitted into the PCAOB.

These factors lie at the root of the Big Four’s dominance over the Chinese market. The incentive for Chinese companies to use one of these four firms as their auditor has led to the Big Four enjoying scant competition. As the saying goes, “Absolute power corrupts absolutely” — and so it is with the PCAOB.

Roughly seven years ago, a large number of China Concepts Stocks — companies with the majority of their assets and operations on the Chinese mainland — sought to be listed on American and Canadian stock exchanges, receiving a lot of attention from American markets in the process. Two relatively unknown short sellers, Muddy Waters and Citron Research, found success riding this wave of Chinese interest, short-selling the stocks of businesses involved in financial fraud, including software company Longtop Group and forest plantation operator Sino-Forest.

Take a close look at the Chinese entities being listed in the U.S. and you will find, alongside the admittedly numerous “good” companies, no shortage of “bad” ones as well. Alibaba, China Mobile, and Industrial and Commercial Bank of China are all strong organizations, while duds include the subsequently delisted Longtop and Sino-Forest. And yet the audits of all of these companies — regardless of their financial status — have been undertaken by the Big Four. How is this possible?

At the time of Lehman Brothers’ bankruptcy, its chairman, Dick Fuld, implied that the tragedy was the result of certain corrupt organizations, especially those acting as middlemen. In order to continue collecting their consultation fees and cheating investors by getting companies listed under fraudulent information, many of these middlemen organizations lost sight of business ethics, flooding markets with substandard companies and products.

While Muddy Waters is currently basking in the glow of public approval, it is necessary to consider how the Big Four’s dominance over the Chinese market came to pass. A way must be found to break their stranglehold and move past the trouble they have caused. As companies seek out capital markets, more of them must be incentivized to do so in a way that maintains public company standards, meets all legal and regulatory requirements, and does not involve any fundamental errors of the sort that brought down Huishan.

The News Lens has been authorized to repost this article. The piece was first published on Sixth Tone here. Sixth Tone covers trending topics, in-depth features, and illuminating commentary from the perspectives of those most intimately involved in the issues affecting China today. It belongs to the state-funded Shanghai United Media Group.

TNL Editor: Olivia Yang

Looking for More?
More『Voices』Articles More『Business』Articles More『Li Guangshou』Articles
Loader

Are you over 18?

  • I'm over 18.
  • I'm under 18.