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The Trump administration is considering whether to
step into the controversy over whether foreign companies listing their stock on
U.S. exchanges should be subject to the same accounting and audit regulations
as U.S. companies. The problem is some foreign companies are reluctant to
provide access to the Public Company Accounting Oversight Board to enable it to
conduct audit inspections of registered public accounting firms. Absent equal
access, there is a disconnect between regulatory oversight of U.S. companies
and foreign firms.
According to the SEC, 224 U.S.-listed companies
representing more than $1.8 trillion in combined market capitalization are
located in countries where there are obstacles to PCAOB inspections of the
kind. About 95 percent of firms whose financial statements cannot be reviewed
use Chinese auditors.
The Public Interest
The public interest demands that foreign governments
provide such access to level the playing field and protect investors. U.S.
investors need to know that foreign companies are following the same rules that
U.S. companies follow. Effective audits and regulatory oversight provide the
foundation of trust in foreign companies listed on U.S. exchanges.
The world’s capital markets are global, as are the
world’s largest companies. It is important that capital investment continue to
flow internationally and U.S. stock markets are a major player in that process.
In return for free access to foreign companies listed on U.S. exchanges,
foreign companies must abide by market rules. One such requirement is for the PCAOB
to have access to audits conducted by registered firms in order to inspect
audits and make sure the financial information is of high quality and reliable.
U.S. Regulations
In order for the securities to be traded in U.S.
capital markets, public companies, whether located in the U.S. or abroad, must
comply with certain U.S. legal requirements, including the requirement to
periodically file financial statements with the U.S. Securities and Exchange
Commission. Sarbanes-Oxley requires that the auditor of these
statements—whether a U.S. auditor or a non-U.S. auditor— must be registered
with and be subject to the jurisdiction of the PCAOB. This includes undergoing
regular PCAOB inspections to assess the auditor’s compliance with U.S. law and
professional standards in connection with its audits of public companies.
According to the SEC, the PCAOB has conducted
inspections of registered audit firms in 50 different non-U.S. jurisdictions (https://www.bloomberg.com/news/articles/2020-05-20/senate-passes-bill-to-delist-chinese-companies-from-exchanges).
For the most part, regulators from foreign jurisdictions have cooperated with
the PCAOB and allowed U.S. auditors to have access to the audit information of
foreign companies. Still, this level of interconnectedness creates challenges,
including regulatory oversight with respect to U.S.-listed companies with
international operations.
Chinese Companies
Chinese companies that list their shares in the U.S.
have long fought with the PCAOB over audit inspections. In some cases, the government
either prohibits it or is not interested in cooperating with U.S. regulators. The
Chinese typically explain it by saying the financial information may contain
state secrets. More likely, it is a cultural issue in that by examining the
audits already conducted by Chinese audit firms, a message is sent that those
firms and, indeed, the Chinese system cannot be trusted
President Trump and U.S. lawmakers have decided to get
involved. Back in May, the President said that regulators are looking to see
whether Chinese companies should be forced to comply with American accounting
rules. Senators Chris Van Hollen (D-Md.) and John Kennedy (R-La.) have
sponsored bipartisan legislation (Holding Foreign Companies Accountable Act) that would kick Chinese companies off
U.S. stock exchanges if they continue to deny the PCAOB to access their audits (https://www.congress.gov/bill/116th-congress/senate-bill/945).
The U.S. Senate overwhelmingly approved the Act
(S.945) on May 20, 2020, that would bar Chinese companies such as Alibaba Group
Holding Ltd. and Baidu Inc. if they do not certify that they are not owned or
controlled by a foreign government. Moreover, if the board is unable to inspect
the issuer’s public accounting firm for three years, the issuer’s securities
are banned from trade on a U.S. exchange or through other methods.
Costs and Benefits of Delisting
The costs of delisting Chinese companies should not be
ignored. Indeed, the Trump administration may back off if it means delisting
Chinese companies that do not comply with U.S. regulations when that motivates Chinese
firms to flee to a competing foreign stock exchange. There may not be the
appetite to deprive Americans of the chance to invest in Chinese companies. The
stock exchanges may be reluctant to lose the presence of an important emerging
market.
The benefits of removal from the exchanges are many.
It starts with being able to verify that the audits were conducted in
accordance with U.S. standards, which may be part of the reason Chinese
authorities are reluctant to open up the books of Chinese companies. In China,
most of the enterprises are state-owned and the standards for auditing are set
by the government. Most important, holding both U.S.-based and foreign-based
audit firms to the same PCAOB oversight rules enhances trust, a key element of
transparency.
Chinese companies benefit by having access to American
markets but they do not play by the same rules. A lack of transparency into the
ownership and finances of Chinese companies has been criticized by American
businesses. In particular, China has classified some auditor reports on company
finances as state secrets, thereby prohibiting cross-border
transfers of audit documentation.
Conclusions
U.S. audit firms suffer when Chinese authorities place
barriers to access audit reports including those of Chinese affiliates of the
Big Four accounting firms. Recently, each paid $500,000 to the SEC to settle a
dispute about their refusal to provide documentation on Chinese companies,
which an American judge ruled was a violation of U.S. law.
Recent examples of delisting illustrate why it is so
important for the PCAOB to be able to audit Chinese affiliates of U.S. Big 4
audit firms. Failing to open up the books so that the PCAOB can conduct an
audit inspection can mask a financial fraud that would otherwise be detected. A
good example is Chinese company Luckin Coffee Inc., which recently disclosed it
had an accounting fraud. Luckin’s shares
were sold on the exchange for just one year. It was touted as a Chinese rival
to Starbucks. But trading was halted in April 2020 after an internal
investigation found about $310 million in fabricated transactions.
Chinese companies should be held to the same standards
as other foreign companies that list their stock on U.S. exchanges. There is no
sound basis to give preferential treatment to Chinese companies simply because
they are reluctant to open their books and audits for inspection by U.S.
regulators.
Steven Mintz, professor emeritus Cal Poly
San Luis Obispo