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stocks audit

The Turnaround in Reviewing the Audit of the U.S.-Listed Chinese Stocks

The U.S.-listed Chinese Stocks, which have been plagued by regulatory and audit issues as well as the impact of the overall market environment over the past year, may experience a turnaround in the near future.

The Context

Let’s briefly review the whole background first. The Public Company Accounting Oversight Board (PCAOB), a self-regulatory organization in the accounting industry, was formed under the Sarbanes–Oxley Act (SOX) of 2002 to protect the public interest by overseeing the audit work of public issuers. In December 2020, the Holding Foreign Companies Accountable Act (HFCA Act) was passed in order to require foreign issuers to satisfy the requirements of SOX and related PCAOB standards.

The Turnaround in Reviewing the Audit of the U.S.-Listed Chinese Stocks

Implications of New Regulations

This new regulation targets registered public accounting firms located in the foreign jurisdiction that the PCAOB has determined it is unable to fully investigate due to the position taken by the political authority. In addition, the SEC requires those U.S.-listed foreign companies to clarify that they are not owned or controlled by government entities in that foreign jurisdiction and to disclose in their annual report about their audit arrangements and whether or not the foreign government exerted any influence on them.

For many years, the PCAOB has maintained a “Denied Access List” of accounting firms. At present, there are only accounting firms located in mainland China and Hong Kong on the list. Since the PCAOB is able to conduct audit inspection anywhere except the aforementioned two regions, it is widely believed that the HFCA Act was created specifically for China.

Chinese regulators had not allowed external audit monitoring for years, arguing that it would threaten national security if audit papers and other data could be freely reviewed by outsiders. YJ Fischer, the director of the SEC’s office of international affairs, commented that such a statement cannot hold. In early 2022, the SEC began publishing a list of public Chinese companies whose accounting firms located in foreign jurisdictions that could not be inspected or reviewed based on the PCAOB reports. So far the total number of companies on the list has exceeded 160.

Status of Chinese Stocks Listed in the U.S.

If the PCAOB fails to conduct inspections of these companies’ accounting firms for three consecutive years, their securities will be banned from trading on the U.S. exchange. About 200 Chinese issuers will face such a fate if their accounting standards remain unchanged. The series of moves have forced some U.S.-listed Chinese companies to replace their auditors with firms based in the U.S. or elsewhere.

In August 2022, the controversy surrounding the PCAOB’s audit requirements for public Chinese companies finally settled. After the Chinese side made concessions, auditors from the PCAOB in the United States and relevant personnel from mainland China went to Hong Kong on September 19 to start reviewing the original audit files of some predetermined companies. The first batch of Chinese companies selected by the PCAOB are mainly Internet companies, such as Alibaba (NYSE: BABA), Baidu (NASDAQ: BIDU), JD (NASDAQ: JD), and NetEase (NASDAQ: NTES).

According to the SEC Chairman Gary Gensler, the whole process will take 8 to 10 weeks to complete, or the inspection results will be available around early December this year. The Chinese government also stated that they would abide by the agreement between the two countries throughout the whole process. Goldman Sachs speculates that the reconciliation between the two countries on the audit issue marks that the probability of the U.S.-listed Chinese stocks being forced to delist from the market has dropped from 95% in March to 50% today; also, the overall price–earnings ratio of these shares will increase by 11% if the delisting risk can be completely eliminated.

When everything is moving in a good direction, a couple new problems have also arisen. Paul Munter, the SEC’s principal advisor to the Commission on accounting and auditing matters, is concerned that auditors from external jurisdictions may not understand local business management in China and Hong Kong, have difficulty reaching company management or have language barriers.

These obstacles could prevent overseas auditors from performing their duties within the scope of PCAOB requirements, resulting in the final audit work being outsourced to local auditors. Thus, he requires these auditors to assume responsibility for oversight, recording and review while adhering to PCAOB responsibilities and constraints.

Economic Effects of the Situation

Businesses around the world are still struggling with the impact on narrowing profit margins and slowing sales growth caused by high inflation and the rising dollar, far more severe than the financial crisis of 2007-2008. The weakness in the stock market has also deepened the pessimism in the market, with analysts at many financial institutions speculating that an upcoming recession is inevitable even though the September employment report in the United States remains strong.

Coupled with the recent announcement by OPEC to cut production by 2 million barrels per day, which is also the largest production cut decision since the outbreak of the epidemic in 2020, people’s living costs will remain high for a long time. Janet Yellen, the secretary of the treasury, commented that the oil cartel’s decision will hurt the global economy and especially developing countries.

While investing in small and mid-sized IPOs in emerging markets can serve as a potential safe haven, with some companies outperforming the broader market, it is important to note that stocks are inherently risky assets. In today’s environment of soaring bond yields and the dollar, most investors prefer safe-haven. An overall YTD return of less than -80% for the U.S. IPO market in 2022 also speaks for itself.

Nevertheless, with the implementation of a sound audit and compliance system, the financial reporting and information disclosure procedures of both newly listed and existing public Chinese companies will gradually become more standardized; therefore, their share prices will more realistically reflect the firms’ fundamentals, ultimately benefiting the interests of public investors

 

Erli Wang