The China PCAOB audit: The Bad, The Good, and What to Actually Worry About

The PCAOB found issues, but those probably aren't the ones you should be worrying about.

So the PCAOB finally released some comments on their early inspections of Chinese auditors, and going by the headlines we’ve seen it looks interesting. They range from the alarmist view of everything being wrong, to the more sanguine “all is fine” takes. Whatever your view it’s a landmark event, and as such deserves a closer look.

My first impression when reading the statement is that it seems pretty political, the first paragraph is basically the chair thanking the fine folks who drafted the HFCAA for doing such a swell job. The HFCAA returns later for another round of praise as well, so I think it’s fair to say the writer wants to make a point.

I do think it’s important that we’re aware of this as it might be adding some colour to the rest of the statement. The writer wants to show that the HFCAA has been effective, and that the PCAOB is doing a good job fulfilling their end. I don’t doubt that they are thankful to finally be able to do their inspections, and it’s definitely good that they’re getting on with the work. However, I do think the setting might have necessitated them sounding a bit tougher than they might have otherwise chosen to do.

To the bad then. Both the inspected firms had deficiencies in their audits, in fact in almost all of the audits that were inspected there were issues found. This is clearly not great news, and this is the headline most publications have gone with. I also think it might be the statement the HFCAA drafters would want to hear as well.

In the very next paragraph the writer adds some better news:

As I have said before, any deficiencies are unacceptable. At the same time, it is not unexpected to find such high rates of deficiencies in jurisdictions that are being inspected for the first time. And the deficiencies identified by PCAOB staff at the firms in mainland China and Hong Kong are consistent with the types and number of findings the PCAOB has encountered in other first-time inspections around the world.

That is to say the PCAOB likely always expected to find these types of issues, and it’s within normal parameters for the audit firms to work these out. I suspect there have already been some conversations with said audit firms, and moves have likely already been made to comply with whatever issues the PCAOB have found.

In other words, the PCAOB found what they expected, and we can expect the audit firms to work hard to get their future work compliant with the PCAOB demands. It’s important to note that this is a good thing, and will likely lead to better audit work in the future. What it is not is some kind of smoking gun showing that all Chinese audit work is useless and they’re all just trying to steal your money.

The real issue to worry about ahead is likely something different. The audit work by the PCAOB was largely done prior to the Chinese government new hardline view on information and national security issues. This is much more likely to cause potential issues for the PCAOB inspections going forward than some seemingly routine issues at the accounting firms.

While the authorities have indicated a willingness to continue to work with the PCAOB on the audit issues there are often several competing priorities within the Chinese government. While the CSRC might be more than willing to accommodate information requests from the US regulator, it’s possible that the overall landscape has shifted enough that other departments might take a different view.

The new espionage rules as well as actions taken against due diligence firms, and expert networks signal a shift in what Beijing considers information of national interest. A shift from what was commonplace even a few months ago when the PCAOB did their work. I suspect this is where the real potential issues lie for future compliance with PCAOB inspections.