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Call of Duty: Who Has The Last Word On “Network” Audits of US-Listed Companies?

 On December 4 the PCAOB re-proposed a rule to require public companies to disclose the engagement partner’s name for the most recent period’s audit and the names, locations, and extent of participation of other public accounting firms that supported the completion of the audit.

There are numerous examples, recent ones, showing the audit firms are deliberately less than transparent about where partners who have been sanctioned or had problem audits in the past are currently working. Many continue working at the firms and some have been caught continuing to audit public companies.

I wrote about the proposed engagement partner naming re-proposal on November 24:

The global capital markets, not just current shareholders, need full disclosure of the engagement teams on all public issuers over time, and in a way that is accessible in general, not hidden in Edgar filings and PCAOB Forms.

Most associate the proposal for disclosure of other participating audit firms or experts in the audit with the “Chinese problem”. Audit Practice Alert No. 6 at 2 noted that “in a 27-month period ending March 31, 2010, at least 40 U.S. registered public accounting firms with fewer than five partners and fewer than ten professional staff issued audit reports on financial statements filed with the SEC by companies whose operations were substantially all in the China region.”

The PCAOB’s re-proposal cites an example—a small US-registered public accounting firm signed an auditor’s report for an issuer based in China even though “the audit procedures performed by the other firm [based in China] constituted substantially all of the audit procedures on the issuer’s financial statements.” Additional recent enforcement actions against US-based audit firms who signed audit reports for US listed Chinese companies say those firms failed to properly audit Chinese companies.

The “Chinese problem” runs both ways. Sometimes audit firms based in the US agree to sign audit opinions for Chinese companies listed on US exchanges, even though the company’s operations and management are substantially located in China and, so, all the audit work has to be done in China. The PCAOB re-proposal document describes how that works:

The signing firm uses another firm in a foreign country to audit the financial statements of a subsidiary in that foreign country. These arrangements can be an effective and cost efficient way to audit today’s multinational corporations. At the same time the quality of the audit is dependent, to some degree, on the competence and integrity of the participating accounting firms. This is especially true when the signing firm has not reviewed all the work done by the other firm.

(It’s not just smaller audit firms signing US-based audits that have to use Chinese member firms or affiliates of their marketing consortiums like Praxity to assist. Large US-based multinationals and their Big Four auditors do, too. I wrote about the US-based audits of the major casinos with significant percentages of revenue in Macau, a Special Administrative Region of the People’s Republic of China. The other Special Administrative Region of the People’s Republic of China is Hong Kong. The wholly-owned subsidiary of Las Vegas Sands, for example, is listed on the Hong Kong exchange and its audit is performed by a Hong Kong Big Four firm. That firm is untouchable by the PCAOB and the LVS subsidiary and its executives untouchable by the SEC and Department of Justice. Las Vegas Sands recently changed auditors after a long relationship with PwC to Deloitte.)

Another scenario occurs when the final audit report signing firm is a Chinese audit firm, perhaps the network member of a Big Four firm like Deloitte or PwC, located on mainland China or in Hong Kong. The signing firm, in this case a Chinese audit firm, depends on its fellow audit network member firms, including in the US, to audit the portions of revenue and company assets that are outside of China. An example of this scenario is NQ Mobile Inc. (NQ), a Chinese mobile communications firm with an audit opinion signed by the PwC Beijing firm which claims a significant amount of revenue outside China including in the US.

Somebody has to audit that revenue and it is probably not going to be the PwC Beijing office.

Which scenario is a bigger problem for US regulators? There are a few key differences between the scenarios. In the first case, when the audit report is signed by a US firm, all final engagement quality assurance, including the Appendix K review required for compliance with SEC Practice Section rules is, theoretically, performed by US personnel in the US. A US partner of a US firm is the responsible engagement partner and has the last word before the audit report is final. The audit is subject to PCAOB inspection and is likely, these days, to be selected by the PCAOB and inspected in person at the audit firm’s offices.

When a final audit report is signed by a Chinese audit firm for a US exchange-listed company, the Chinese audit firm and its partners must perform all engagement quality review in China. That includes supervising, reviewing and consolidating work done by audit firms outside of China, including possibly the US firm, and making sure the work complies with US GAAS, the PCAOB auditing standards. The Chinese member firms of the largest global firms often have US expats in China that can perform this service and their National Office colleagues in the US are just a phone call or email away for any consultation. In either case the firm must have this expertise available to assist with required engagement quality review and the Appendix K review.

The Chinese audit firm engagement for a US-listed company is also subject to PCAOB inspection, but that’s the part that’s been disputed by the Chinese audit firms who say that the Chinese government won’t allow it. Unfortunately, with all due credit to recent shiny MOUs and subtle diplomacy, the PCAOB is still prohibited from inspecting Chinese audit firms and their engagements for audits of US listed companies on the ground, whether they’re signed by a mainland China firm or a Hong Kong firm. A Chinese partner of a Chinese audit firm is the responsible engagement partner and, we assume, he has the last word before the audit report is final.

Or does he?

Read this article in its entirety at the re: The Auditors, a blog by Francine McKenna.

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