U.S. and China Sign Historic Agreement on Audit Firm Supervision
August 29, 2022
The U.S. Public Company Accounting Oversight Board (PCAOB) on Aug. 26, 2022, finally signed an agreement with Chinese authorities that will allow the board to inspect and investigate audit firms based in China and Hong Kong whose clients trade on American exchanges. And the PCAOB inspection team is planning to be on the ground by mid-September to begin audit inspections.
This comes as Congress stepped in to help the PCAOB to get a deal with Chinese authorities. Among other legislative provisions, if the U.S. board cannot inspect auditors for three years in a row, then their clients—such as technology giants Alibaba Group Holding Ltd. and Baidu Inc.—will face a trading ban.
The PCAOB and China have been in on-again, off-again negotiations to carry out audit inspections, to no avail. China has so far not granted full access to audit papers fearing infringement to its sovereignty. Moreover, the communist regime was worried that audit work papers may contain state secrets. However, U.S. officials did not buy some of the arguments made by the Chinese.
In the meantime, there have been many accounting frauds at Chinese companies that cost a lot of money for U.S. investors, including at Luckin Coffee Inc., a coffee chain that competes against Starbucks Corp. in China. About $1.7 trillion in securities of China-based issuers are listed on U.S. exchanges.
“The U.S. Congress sent a strong message with the passage of the Holding Foreign Companies Accountable Act that access to the U.S. capital markets is a privilege, not a right,” PCAOB Chair Erica Williams said. “The PCAOB has been working to execute our mandate under the law.”
The Sarbanes-Oxley Act of 2002 established the PCAOB following a string of large accounting scandals that cost investors an estimated $85 billion at the time. Under the law, not only does the board have the power to inspect and investigate accounting firms that audit public companies, it can also write auditing standards that firms must follow.
The PCAOB is overseen by the U.S. Securities Exchange Commission (SEC) which is the American capital market regulator. And SEC Chair Gary Gensler cautiously welcomed the agreement.
“This agreement marks the first time we have received such detailed and specific commitments from China that they would allow PCAOB inspections and investigations meeting U.S. standards,” he said.
Whether the long-running problem with the Chinese will be solved with the statement of protocol (SOP) remains to be seen, however.
Both Gensler and Williams emphasized that the deal with the China Securities Regulatory Commission (CSRC) and China’s Ministry of Finance is only the first step. The agreement grants the PCAOB complete access to audit workpapers, audit personnel, and other information that board needs to carry out its mission of protecting investors.
“Make no mistake, though: The proof will be in the pudding. While important, this framework is merely a step in the process,” Gensler said, noting that the agreement will be meaningful only if the PCAOB can do its job without interference. If not, about 200 China-based issuers will face trading prohibitions.
The agreement also comes as the PCAOB has had agreements with other jurisdictions for a while, and China has been the sole holdout until now. And some observers welcomed the agreement that would set a level playing field amongst all companies that raise capital publicly in the U.S.
“This is a major step forward, and one many people thought would never occur. But it is just the end of the beginning,” former PCAOB acting chairman Daniel Goelzer said. “There have been some false starts before with inspections of Chinese audits. We need to see what today’s agreement means in practice.”
For example, in 2013, the PCAOB and Chinese authorities signed a memorandum of agreement (MOU) that at the time paved the way to exchange documents when investigating audit firms. The two parties also tried a pilot inspection program in 2016-2017.
Notwithstanding all the efforts, Chinese cooperation has not been sufficient for the PCAOB to get timely access to relevant documents and testimony for its inspectors to do their job properly. And in 2020, the PCAOB finally removed the MOU from its website. China had insisted that there have been many successful cases of cooperation.
Shaswat Das, a lawyer at King & Spalding LLP and PCAOB’s chief negotiator with the Chinese regulators from 2011-2015, agreed with Goelzer.
“This is very significant, but Chair Williams rightly expresses caution until the inspections have been completed,” Das said. “Nevertheless, the PCAOB and SEC should be commended in what appears to be a robust agreement.”
Agreement in Detail
While the American and Chinese authorities decided not to make the statement of protocol public as had been done with some other jurisdictions, the SEC provided some information about the new protocol.
Just as the PCAOB is able to inspect any other domestic or foreign public company audit firms under Sarbanes-Oxley, the board will have independent discretion to select any Chinese company audits for inspection or investigations. The board does not inspect all audits but selects based on an assessment of risk. Random selection is also thrown in for an element of surprise for large audit firms.
Further, the PCAOB can directly interview or take testimony from all audit personnel of audit firms whose engagements are being inspected or investigated.
The PCAOB has the ability to transfer information to the SEC.
In addition, PCAOB inspections can see work papers without any redactions even if the information is deemed sensitive.
The agreement does allow for in camera or “view only” review. The PCAOB has done so in other jurisdictions for “restricted data,” including personally identifiable information. The PCAOB can retain any audit information it reviews, including restricted data as needed to support its inspection or investigation findings.
The Chinese securities regulator in the meantime also emphasized the significance of the agreement.
“The agreement, in line with common practices in global capital markets, has laid the foundation for reciprocal and efficient cooperation between the two sides in compliance with domestic laws and regulatory requirements,” according to answers provided to reporters on CSRC website. “The cooperation will help improve audit quality, protect investors, and build a benign regulatory environment for companies to list on overseas markets in accordance with laws and regulations.”
However, it is unclear whether this agreement will translate into smooth cooperation in practice.
Regarding a question about whether sensitive information can be properly protected under the agreement, Chinese officials pointed to the Data Security Law, Personal Information Protection Law, and other relevant laws and regulations in recent years.
This “clearly identifies the obligations of relevant entities on information security and provides a more operational guidance for them to follow,” CSRC stated. “All companies, listed or not, are obligated to comply with laws and regulations of their home country.”
Still, the U.S.-China framework provides for cooperation between the two parties, CSRC said.
“Both sides will have thorough communications in advance. Audit work papers and other information that the U.S. regulator need access to will be obtained by and transferred through Chinese regulators,” CSRC stated. “Meanwhile, the agreement has also made clear arrangements on the treatment and use of possible sensitive information during audit oversight cooperation, including procedures for processing personal information and other certain data categories. It provides a feasible path for both sides to discharge their regulatory mandates while protecting relevant information.”