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Auditors Under ‘Reverse’ Inquiry

The Securities and Exchange Commission is investigating some accounting firms over their audits of Chinese companies whose shares trade in the U.S., and the inquiry is expected to lead to enforcement cases, people familiar with the situation said.

The SEC has publicly indicated it was examining accounting and disclosure issues regarding Chinese companies that engaged in “reverse mergers,” which allow companies to list on U.S. exchanges without as much regulatory scrutiny as an initial public offering. People familiar with the matter say the investigation also includes auditors, which hadn’t previously been known. As part of its inquiry, the SEC has suspended trading on some Chinese companies, questioning their truthfulness about their finances and operations.

The Public Company Accounting Oversight Board, or PCAOB, the governments accounting regulator, said it is investigating some audit firms over whether their audits of Chinese clients are are stringent enough.

The regulators’ investigations involve both large and small accounting firms.  It isn’t known which accounting firms are part of regulators’ probes.

If regulators find violations, they could file administrative proceedings against audit firms over allegations such as improper professional conduct, and the SEC could file civil lawsuits as well.  It is unclear when regulators might act.

The accounting oversight board says the audits are sometimes weak in part because of obstacles that make it hard to sniff out problems: Some U.S. auditing firms outsource accounting work to inadequately trained Chinese accounting firms, and China has blocked the board from inspecting audits onsite, though PCAOB Chairman James Doty said he was optimistic the inspection issue could be resolved by year’s end.

“Right now, the auditing and regulation of U.S.-listed Chinese companies isn’t working very well,” said Paul Gillis, a visiting professor of accounting at Peking University’s Guangha School of Management.

In reverse mergers, a foreign company is “bought” by a publicly traded U.S. shell company.  But the foreign company assumes control and gets the shell’s U.S. listing without the level of scrutiny that an IPO entails.  Though companies from other countries also engage in reverse mergers, such deals are especially common among the Chinese.  The PCAOB says nearly three-quarters of the 215 Chinese companies listing in the U.S. from 2007 to early 2010 did so via reverse merger.

Since Feb., about 40 Chinese companies have either acknowledged accounting problems or seen the SEC or U.S. exchanges halt trading in their stocks because of accounting questions.

The U.S. firms that audit Chinese companies are mostly small shops.  From 2008 to early 2010, at least 40 U.S. firms with fewer than five partners and 10 professional staff issued audit reports on China-based companies, according to the PCAOB.

Regulators’ scrutiny puts these accounting firms in a difficult position: Some firms whose Chinese clients have seen their accounting questioned say they are doing everything they can to perform strong audits, including maintaining their own offices in China and employing bilingual staffers, and they are intensifying their efforts to detect improper accounting.

But that may raise questions about whether their past efforts were strong enough, especially among some investors who have criticized Chines companies.

The PCAOB says some U.S. auditors who farm out work to local Chinese auditors are not verifying that the work complies with U.S. auditing standards.  In 09, the board barred an Arizona firm from auditing public companies, in part over that issue.  In April, the PCAPB barred Utah’s Chisholm Bierwolf Nilson& Morril LLC, in part because of a similar issue; the board said Chisholm Bierwolf relied on inexperienced Chinese-speaking assistants to help audit Chinese clients without adequately supervising them.

The Chisholm Bierwolf ban is permanent.

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