Professor Paul Gillis, who writes the essential (and highly readable) China Accounting Blog, just came out with a bombshell of a post. Or rather, his post explains the bombshell that landed Wednesday in the form of a 112-page opinion from Cameron Eliot, Administrative Law Judge at the US Securities and Exchange Commission (SEC). Judge Eliot’s opinion prohibits the Big Four accounting firms’ China entities (i.e., Ernst & Young Hua Ming, KPMG Huazhen, Deloitte Touche Tohmatsu, and PricewaterhouseCoopers Zhong Tian) from practicing or appearing before the SEC for six months.

I highly recommend reading Gillis’ post in its entirety, but the short version is that the Big Four’s Chinese entities were found to have violated the Sarbanes-Oxley Act by refusing to turn over documents of US-listed Chinese companies under investigation for accounting fraud. Good ol’ Sarbanes-Oxley. As someone who did a judicial clerkship in Houston not long after the collapse of Enron, it’s oddly comforting to hear echoes of that scandal still reverberating.

The Big Four’s basic defense was quite succinct: Chinese law prevented them from turning over the requested documents. Judge Eliot’s response was equally succinct: then don’t represent US listed companies. In one of many tartly worded sentences, Judge Eliot observed that “to the extent Respondents [i.e., the Big Four’s Chinese entities] found themselves between a rock and a hard place, it is because they wanted to be there.” As Paul Gillis sums up: “Ultimately, the only way this gets settled is if China agrees that companies that list in the US are subject to all US securities laws.”

Judge Eliot’s decision can be appealed, and it appears it will be, but there’s no positive spin on this for the Big Four’s Chinese entities. They defied the SEC, and they got hammered. Although they are allowed to continue practicing before the SEC during the pendency of the appeal, it’s unclear how many of their clients will wait for the other shoe to drop. Would you risk your firm being delisted out of loyalty to an accounting firm that is banned from appearing before the SEC?

It’s this consequence of Judge Eliot’s decision which may have the greatest ripple effect. Once again, Paul Gillis: “Companies could switch to non-Big Four firms and avoid any consequences. There are almost 50 Chinese CPA firms registered with the PCAOB, but few, if any, have the scale and skills to audit the Big Four’s clients. I do expect that some of the second-tier firms like Grant Thornton, BDO, and Crowe Horwath/RSM are going to pick up a number of IPOs given the uncertainty surrounding the Big Four.”

The Big Four, it should be noted, have a near-monopoly on the auditing of public companies in China.

Many of our clients use either the Big Four or second-tier firms to do their accounting work in China. These clients are primarily non-Chinese companies that have WFOEs or joint ventures in China. But if their second-tier accounting firm suddenly acquires a dozen big new clients with upcoming audits or IPOs, what happens to all the regular accounting work for the old clients? The status quo cannot hold, but what will come is anyone’s guess.

No fewer than three people have sent me an article, entitled, “The Simplicity of Chinese Accounting Scandals.”  All three people raved about the article, one going so far as to use the term “revelatory” in describing it.  Wrong, wrong, wrong.  There is absolutely nothing revelatory about it and that is the heart of the problem.

The article consists mostly of a list of four methods commonly used by Chinese companies to perpetrate a fraud on their investors.  Paul Gillis, who knows China accounting better than just about anyone, is the progenitor (I’ve been waiting years to use/mis-use that word) of the list.  And it is a good list in that all of the methods are fairly common.

But here is the problem.  These sort of accounting cheats are not by any means peculiar to China.  They are cheats that have been employed again and again all around the world.  Yes, Virginia, even in the United States.  There is nothing new here because when it comes to fraud, there is rarely anything new under the sun.  I doubt there is an auditor with even two months of experience at any big accounting firm who has not already been trained to look out for every single one of them.  These methods are not even interesting because they are so routine.


No, the big deal here is not so much the methods of cheating, but the need to always be vigilant for cheating.  In other words, the big deal here is the need for anyone who is buying a Chinese company (or any company for that matter) to look at every number/every line item with a very healthy skeptism.  We talked about this in our post last year, entitled, Buying A Chinese Company? Why China Deals DON’T Get Done.

Yes, Chinese company fraud is no doubt far more common than in the United States and, in many instances, more blatent and bolder.  But in the end, thorough due diligence is necessary everywhere and it works most of the time.  Most of the frauds I have seen (and I have seen far too many) could easily have been spotted had the victim merely done the basics to try to uncover them.  We have ended many of our posts on topics like this by saying “trust yet verify.”  When it comes to investing in China, one word suffices:  verify.

What do you think?