By Yuan Yujing
After more than a decade of stalemate, China’s concessions have finally led to a breakthrough on the audit issue between China and the United States. On December 15, the U.S. Public Company Accounting Oversight Board (PCAOB) announced that they had been allowed to thoroughly inspect the audit working papers of Chinese companies for the first time. This resets the three-year delisting timeline faced by Chinese companies listed on U.S. exchanges, mitigating the delisting risk that about 200 Chinese companies could be facing.
Data show that audit disputes between the two countries can actually be traced back to around 2000. At that time, the first batch of Chinese companies began to list in the United States, but most of them were private enterprises on the verge of loss and were not eligible to list in China. The U.S. Securities and Exchange Commission (SEC) soon discovered that they could not inspect the companies’ auditors in China, which has long prohibited foreign companies from conducting such thorough inspections due to national security concerns. To resolve this matter, the SEC and the China Securities Regulatory Commission (CSRC) reached relevant information-sharing agreements in 2013 and 2016, respectively. However, the two countries ultimately suspended the agreements after the information disclosed through the agreements failed to meet the demands of agencies such as the SEC.
Unsatisfied with the progress, the U.S. passed the Holding Foreign Companies Accountability Act (HFCAA) in late 2020, giving China three years to provide the SEC with the access it wanted. Failure to do so may result in the forced delisting of more than 200 Chinese companies listed in the U.S.
The two sides finally reached an agreement in August this year, and the PCAOB sent a team of inspectors to Hong Kong to investigate in accordance with the framework of the agreement. When the agreement was signed, the SEC announced that it planned to provide a progress report in December on whether it got what it wanted from the agreement.
In the latest statement, PCAOB Chair Erica Williams said, “for the first time in history, we are able to perform full and thorough inspections and investigations to root out potential problems and hold firms accountable to fix them”. At the same time, the statement also disclosed the audit workflow conducted by the PCAOB and the CSRC in Hong Kong from September to November, which contained some details of the design work that had not been previously revealed. For example, during the entire audit period, a team of more than 30 PCAOB team members focused their work on two audit institutions, KPMG Huazhen LLP in China and PricewaterhouseCoopers in Hong Kong. The working group examined eight operations involving the two institutions, stressing that the investigations were conducted without prior notification to the CSRC and the auditors.
In addition, the PCAOB also stated that China and the United States began cooperation as early as April of this year, much earlier than the relevant agreement publicly signed in August. It is also mentioned that the cooperation began with an investigation the PCAOB launched in March into two Chinese companies and a Hong Kong company. The agency began sending out requests related to the three investigations around that time, and the CSRC provided access as early as April.
In this regard, the CSRC issued a statement on December 16 saying that it welcomes the recognition of the American regulatory agency and looks forward to forming a normalized cooperation mechanism with the U.S. based on mutual respect and mutual trust to jointly create a more stable international regulatory environment.
In the view of the researchers at ANBOUND, although the breakthrough in the audit disputes is good news for China, it is still far for Chinese concept stocks to be considered “safe” in the United States. There are still many uncertainties about how to resolve the deficiencies exposed in the audit of Chinese companies and whether the two countries will be able to continue the current level of cooperation in the future. At the same time, given the failure of the previous two attempts, the U.S. has also maintained a visible skepticism in the current audit process.
These issues are also reflected in the statement issued by the PCAOB. Although the statement spoke highly of the degree of cooperation and achievements between the two countries during this “trial period”, it also warned about the future: PCAOB said it found “numerous potential deficiencies” in its latest inspection, but added that such results are common in first-time exams around the world. The agency also mentioned that the breakthrough should not in any way be misinterpreted as a certificate of compliance for Chinese companies such as Alibaba. Michael Piwowar, a former Republican member of the SEC, also pointed out that although the PCAOB has obtained more inspection authority in China this time than before, he still doubts whether this can continue.
In addition, the market should also realize that the breakthrough made by the United States and China this time only resets the three-year countdown timetable for the delisting of Chinese concept stocks in the U.S., and the audit institutions used by Chinese companies listed in the U.S. will continue to accept U.S. inspection. The PCAOB stated that it is formulating relevant plans and may resume regular inspections in early 2023 and beyond. If the U.S. regulators are not allowed to obtain audit papers by then, the agency will re-evaluate and the Chinese companies will yet again face the threat of being delisted.
These potential risks are also reflected in the capital market. On December 15, although the stocks of related Chinese companies rose at one point during the session, all of them experienced losses at the close, and some even plunged sharply. Shares of Alibaba, JD.com, and Baidu were all down between 3% and 5%, while Tencent Music fell by 3.5%. Meanwhile, the Nasdaq China Golden Dragon Index fell 2.5% in midday trading, matching the S&P 500’s 2.5% loss. China ETF-iShares MSCI also closed down 2.2% on the same day, but compared with the annual low in late October this year, the ETF is still up nearly 30%.
Some analysts pointed out that the U.S. regulatory agencies have obtained full powers to conduct audits. Although this removes the communication barrier between the two systems in the U.S. and China, it also provides the possibility for the regulatory authorities to discover more problems in Chinese companies. Under the current opposition between the U.S. and China, the resolution of some problems may be beyond the capabilities of the companies themselves.
In any case, the breakthrough made by both sides can still be regarded as a good start. According to the researchers at ANBOUND, the long-term cooperative relations U.S. and China in the past could be likened to a bicycle where both countries are like the front and rear wheels, in which when a wheel moves the other would do so as well. Such a relationship is itself a form of globalization, and it is reflected in the production, consumption, trade, investment, and other aspects of the two countries. In the capital market, the funds provided by the U.S. was an important part of China’s venture capital at one point. However, affected by the deterioration of U.S.-China relations in 2018, this long-term model has gradually disintegrated. As the “front wheel” and “rear wheel” parted ways, a large amount of American capital began to avoid investing in China. At the same time, without the endorsement of the U.S., the reputation of China concept stocks will inevitably be affected, and its attractiveness to international investors may also decline as a result. At the same time, these Chinese stocks will face more difficulties in the process of expanding internationally. In the current downward environments, both internationally and domestically, such a situation would affect China even more.
Under such a backdrop, China’s concession on the audit issue this time is probably the general trend. If this cooperation model can finally bear fruit, the two countries may indeed be able to open up a long-term path to resolve their differences. However, as mentioned above, the Chinese concept stocks currently listed in the U.S. have not actually been free from problems. Facing the complicated and high-standard audit requirements of the U.S. and the current unpredictable international geopolitical relations, both the U.S. and China will still encounter a multitude of uncertainties in the process of resolving audit disputes.
Final analysis conclusion:
China’s concession has made an important breakthrough in the U.S.-China audit dispute. For the first time in history, U.S. regulators have also obtained the opportunity to comprehensively inspect the audit papers of Chinese companies. However, this does not mean that Chinese companies listed in the U.S. are free from further problems. There are still numerous uncertainties about how to address the deficiencies exposed in Chinese corporate audits and whether the two countries can continue to cooperate at the current level. Therefore, it may be too early to say that Chinese concept stocks are now safe in the United States.
Yuan Yujing is a researcher at ANBOUND