SEC Investigates Audits of Chinese Firms

As you might know, the Securities and Exchange Commission (SEC) is the federal agency that enforces laws related to stocks and bonds.  The SEC’s primary purposes are to regulate the stock market and to prevent corporate fraud by forcing companies to disclose relevant information related to securities trading in the company’s financial statements.

Recently, the SEC has launched an investigation into some accounting firms over their audits of Chinese companies whose shares trade in the United States.  The SEC has indicated it was going to closely examine accounting and disclosure issues related to Chinese companies that engaged in “reverse mergers”, which is the acquisition of a public company by a private company.  The purpose of a reverse merger is to allow the private company to bypass the lengthy and complex process of becoming a publicly traded company.  Often times in reverse mergers, a foreign private company purchases a publicly traded American company.  The foreign company retains control over the operations, but it can be listed on stock exchanges in the United States.  According to the PCOAB, nearly three quarters of the 215 Chinese companies listing on US stock exchanges from 2007-2010 did so via reverse mergers.  As a result of the investigation, the SEC has suspended trading on the some Chinese companies and questioned the accuracy of their finances and operation disclosures.  

The Public Company Accounting Oversight Board (PCAOB) is the U.S. government’s accounting regulator, and it has said it is questioning whether some audit firm’s methods were rigorous enough.  If violations are discovered, these audit firms could face lawsuits and allegations such as improper professional conduct.  

This is an important issue because improper audits can mislead shareholders as was the case with Enron.  A recent trend in the accounting industry is to outsource accounting work to poorly trained Chinese firms.  Historically, the Chinese government has blocked the investigation of audits on the spot.  As a result, American firms cannot verify that the accounting work complies with U.S. auditing standards.  The PCAOB has barred some of these small accounting firms from auditing publicly traded companies.  As some accounting firms know all too well, the so-called Chisholm Bierwolf ban is permanent.