The Graduate Baruchian

The Auditing Dilemma of Chinese Companies
by: Michael Wander

Seizure of property through physical threats!?  No, it’s not a street mugging!  It’s a $2.4 billion publicly traded company on the NYSE having a spat with their auditor, Deloitte, who happens to have 182,000 employees and revenue of almost $30 billion[1].  Whoever said audit was boring is dead wrong!

Deloitte Touche Tohmatsu Shanghai had already issued a number of audit reports for U.S. listed company, Longtop Financial Technologies Limited (Longtop).  Skeptical investors were questioning why Longtop needed $606 million in assets as listed on its balance sheets[2].  So before issuing another clean audit in March 2011, Tohmatsu attempted to verify Longtop’s bank accounts by contacting the bank’s headquarters as opposed to doing so from the local bank’s branch as is usually done.

This verification attempt set off red lights at Longtop and, according to Deloitte’s resignation letter[3], the following events occurred:

• Longtop called the banks “asserting that Deloitte was not their auditor”.
• Longtop seized “second round bank confirmation documentation on bank premises”.
• Longtop threatened “to stop our staff (from) leaving the Company (Longtop’s) premises unless they allowed the Company to retain our audit files then on the premises”.
• Longtop seized “certain of our working papers”.

This is more exciting than any Hollywood director could have made up.  There seems to be so much interest in investing in Chinese (and BRIC) companies as their economies are growing a lot faster than those of the West.  However, the need for the PCAOB to regulate auditors of public companies based out of China has been limited at best; this is even the case when the auditors are affiliated with one of the Big 4.

The saga does not end, as of September, 2011 the SEC issued a subpoena to Deloitte to provide them with working papers so that the SEC can continue with its own investigation of Longtop[4].  However, Deloitte is unable to comply because, according to spokesperson Lauren Mistretta, “Chinese law prohibits Deloitte China from providing the requested documents directly to a foreign regulator.”

Misretta continues that “Deloitte China advised the PCAOB at the time it filed its registration application (for Longtop) that it could not provide a blanket consent to comply with all PCAOB requests for documents because of legal conflicts with China law, that it provided a legal opinion in support thereof, and that its registration statement was accepted by the PCAOB thereafter.  Misretta pointed out that this it reminded the PCAOB of this limitation in its annual filings, and that this is not a matter unique to Deloitte, “It is a widely recognized profession-wide issue, and all of the Big 4 firms, as well as other firms, have filed similar statements.”

The latest from SEC.gov dated September 8, 2011, is that the SEC has issued a “subpoena enforcement action against Deloitte Touche Tohmatsu CPA Ltd. for failing to produce documents related to the SEC’s investigation into possible fraud by the Shanghai-based public accounting firm’s longtime client Longtop Financial Technologies Limited”[5].

The SEC claims that large audit firms, such as Deloitte, almost certainly have a second partner auditor verify the audit report.  As stated in Forbes[6], this second verifier is probably based in the U.S., and if that’s the case, Deloitte’s “foreign government restrictions claim may be difficult to stand on.

What will happen?  We will have to wait and see.  Will the Chinese government allow greater oversight of the PCAOB into their auditors?  Paul Gillis, visiting professor at Peking University, was quoted saying that “Deloitte may end up with Sophie’s Choice – follow China’s rules and lose the right to audit U.S.-listed companies or give in to the SEC and lose the right to practice in China.”[7]  The article stated that the PCAOB “could revoke Deloitte’s U.S. registration and standing as an accounting agency if it should fail to produce the desired documents.”

Neither of these sounds like a good option for Deloitte, and particularly harsh punishment especially considering that the PCAOB is aware of the limitations of auditors of foreign companies (see PwC Satyam in India).

However, how much water will the “everybody’s doing it” claim of Deloitte hold legally?  We will have to wait and see.  Gillis pointed out that this is a “major escalation today in the battle between U.S. and Chinese regulators over the accounting profession in China.” [8]
— The author is an MBA candidate at Baruch College —