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.

  • iwishitweretrue

    The problem with the “rogue” decision is that its 100% a political decision. It does not take a big IQ to realize that these big four operate in China and in the US. The judge is therefore barking up the wrong tree – and China has already hinted at “consequences” if the SEC does not pull itself together and behave reasonably. It is obvious – that the only way that fraud is going to get solved – is by co-operating with China and finding a solution – not by trying to pretend that the SEC has jurisdiction over China – which it patently does not.

    • bystander

      My goodness. It takes my breath away to read this: “… pretend that the SEC has jurisdiction over China”. You realize, do you not, that these companies are listed (or are asking to be listed) on U.S. stock exchanges. The audits in question are exclusively for the purpose of satisfying the legal requirements that every company that lists on those exchanges must also satisfy. Is it the position of the Chinese that they should be able to decide what the legal requirements for listing on the NYSE or NASDAQ should be? Are the Chinese willing in return to allow the U.S. to determine unilaterally what the requirements are for listing on a Chinese exchange or doing other business in China? Amazing.

  • bystander

    I don’t understand why the situation will be different for second-tier accounting firms if they take over this work and these clients. Why would it be easier for them to obtain and release the documents that the Chinese gov’t doesn’t want released and the Chinese companies most probably refuse even to produce? Confused about this part of the story.

  • It is likely that the Big Four will see some defections. And they will also likely not be penalized as much as it appears in the SEC’s judicial decision (via appeals). It is clear that large clients cannot always be “completely” served by the mid-sized firms. However, as an advocate of those same mid-sized firms, I hope that clients understand that.. unless they are GE, CAT, or Cameron, they can find capable talent in the second tier CPA firms for their work in China. Knowing many of those firms, I don’t see the better of them slipping on current client work to meet the challenge of adding new, larger, clients. I see opportunistic growth, that if managed properly, will simply mean greater diversity in the accounting marketplace in China.

  • escoffery_s

    Will this opinion affect any other accounting firms or is the effect limited to the big 4 (and BDO a little)?

    Wouldn’t any other Chinese accounting firm that handles clients regulated by the SEC face a similar problem in terms of handing over workpapers or would this only come up with cases of alleged fraud?