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China Accounting Scandals Put Big Four Auditors on Red Alert

By Rachel Armstrong | June 24, 2011

The string of accounting problems and stock plunges at publicly traded Chinese groups has sparked deep concerns across the world’s biggest audit firms, putting the so-called Big Four on alert from worries that their reputation could be brought down along with a growing list of stricken companies.

Auditing Chinese firms preparing to go public on overseas exchanges is a lucrative business and one that plays into the strengths of the top, international auditing partnerships known as the Big Four: KPMG, Ernst & Young, Deloitte Touche Tohmatsu and PricewaterhouseCoopers.

Yet fears are growing that the struggle to find enough high-quality auditors in China and Hong Kong means it may only be a matter of time until one of the top firms finds itself caught in a blow-up rivaling Enron, which brought down their old rival Arthur Andersen.

“Costs have gone up; fees have gone down, as competition for fees is enormous. You can easily see there is a real risk of an audit firm failing,” said Paul Winkelmann, the partner in charge of risk and compliance for PWC in Greater China.

According to interviews with professionals at the four firms, each firm is getting more and more cautious about the work they take on from mainland companies looking to IPO.

”The whole industry, I will say, is very sensitive and cautious to China IPOs,” said an auditor at one of the Big Four, who handles IPO work, who did not want to be named.

The Big Four are also getting nervous about work with existing Chinese clients, turning to lawyers at an earlier stage if they think something might be amiss.

“If a risk situation arises they’re now consulting lawyers earlier and dealing with it in a much more structured way than was perhaps the case in the past,” said Tom Fyfe, a partner at law firm Barlow, Lyde & Gilbert in Hong Kong who acts for some of the big four in litigation issues.

All four of the audit firms responded to a Reuters request to comment on the matter. The four firms said they have a rigorous approach to risk management.

The big four have basked in China’s emergence as an economic powerhouse. In 2009 their revenue from work on the mainland stood at 9.1 billion yuan ($1.41 billion) according to the Chinese Institute of CPAs (CICPA), around half of China’s accounting industry’s revenue. Last year’s figures were not immediately available.

As the revenues have risen, so have the risks.

Most of the accounting scandals in the U.S. have come from small Chinese companies who went public via a reverse takeover. Those companies were audited by smaller U.S or Hong Kong-based accountancy practices, not the Big Four’s China firms.

But some recent high profile cases have started to drag in the names of the world’s most prestigious auditors.

Last month, Deloitte quit as auditor of Longtop Financial Technologies after working on the company’s books for six years, citing “recently identified falsity” in their finances.

Ernst & Young was named in two class action lawsuits over its work on Sino-Forest, the Toronto-listed company accused by short-seller Muddy Waters of accounting fraud.

In Hong Kong, KPMG said in January that it had found possible irregularities in the books of China Forestry, leading to a suspension of its shares.

Accounting experts say the firms have been acting as they should by raising the alarm once they find irregularities that can’t be explained by the company. They also point out that the Big Four’s China businesses and its broad global resources are much better placed than small U.S. firms to conduct audits on Chinese companies.

“I think firms here have always been aware of the risks associated with audit work in China. There is more endemic fraud in Asia, but people are much more aware of it here and so manage the risks accordingly,” said PWC’s Winkelmann.

Winkelmann, on behalf of the Hong Kong Institute of CPAs (HKICPA), is drafting a paper to present to the Hong Kong government later this year calling for changes to the law on auditor liability. The IPOs are now so large — last year saw two greater than $20 billion in Hong Kong — the worry is that a massive IPO liability, if it were to hit an auditing firm, would be too big for the firm to handle. The change calls for a cap on the liability.

The latest string of scandals has laid bare some of the difficulties auditors have in China, forcing the big firms to reappraise their methods, given that a loss of reputation could bring them to their knees.

“There’s no doubt about it — the firms are very alert to these issues and very sensitive to what it means. They will be looking at their risk assessment procedures,” said Chris Joy, executive director, HKICPA.

Two of the biggest challenges facing the big four are staffing and the type of companies they audit.

Together the firms now employ just fewer than 40,000 people in mainland China, Hong Kong and Taiwan. While that’s a relatively high number compared to other regions, it’s not enough to handle the huge demand created by the rapid economic growth of the world’s most populous country, experts say.

“We are in tremendous need of experienced accounting professionals and graduating college students,” said a spokeswoman for Ernst & Young, which plans to recruit 1500 new staff this year.

Finding them might be tough.

“Between us and the CICPA and other bodies that offer qualifications, we can’t produce enough at the moment, but we’re not going to compromise the quality of our program just to mass produce accountants,” said Joy at the HKICPA.

That skill shortage is likely to be felt even more keenly now that the type of IPO work the big firms are handling is shifting. Whereas 10 years ago the majority of firms going public in China were state-owned enterprises (SOEs), a lot more of the work now is for privately-run businesses.

“Previously the market was for SOEs, and China is not going to allow a major embarrassment with an SOE,” said PWC’s Winkelmann. “But now it’s changing as international firms are starting to do more of the private enterprises in China, which don’t come with that government support.” (Reporting by Rachel Armstrong; Additional reporting by Benjamin Lim in BEIJING, George Chen in HONG KONG; Editing by Michael Flaherty)

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