Audit spat pokes hole in China’s financial edifice

January 23, 2014

By John Foley

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

China’s legal grey areas have been a source of enormous wealth for investors. Now a U.S. judge is threatening to poke a hole in the entire edifice. The Chinese units of the world’s biggest four auditors face a six-month suspension from auditing U.S.-listed companies after the judge decided they wilfully refused to hand over documents on Chinese clients to U.S. regulators. It’s hard to fault his logic, but upholding the rules could bring a huge cost.

KPMG, Ernst & Young, PricewaterhouseCoopers and Deloitte each declined to hand over data on U.S.-listed Chinese clients because China’s government forbade it. In other words, they broke U.S. rules in order to abide by Chinese ones. The wellbeing of over 22,000 employees, and huge profit opportunities, were at stake. China’s auditing and accounting fees are growing by 10 percent a year, according to IbisWorld.

Still, the judge’s logic is persuasive. Auditors, whose job relies on precision, have built businesses in China knowing that local rules prevent them from doing their duty to U.S. regulators. Until now, they have presumably relied on neither the U.S. nor China bringing this glaring contradiction to a head. So long as U.S. authorities believed China was broadly changing for the better, that paid off.

In this and other grey areas, investors have gone in with their eyes open. Take for example the semi-legal “variable interest entity” structures Chinese internet companies like Baidu and Sina have used to skirt rules forbidding foreign investment. Or corporate bonds that turn out to give holders no security over the underlying assets when things go wrong, such as those of bust solar panel maker Suntech.

The auditors will appeal the ruling. They may prevail if the SEC decides stability is more important than transparency. Forcing companies to find smaller, more compliant auditors could cause chaos; share prices could fall sharply and companies unable to find alternatives could be forced to delist. Besides, regulators on both sides agreed last May to co-operate more closely, which may yet deliver results.

But the line is fine. Even if eliminating grey areas at a stroke would be too extreme, shrinking them is in the market’s best interest.

 

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