Due to the emerging credit crisis among Chinese companies in the U.S., the SEC has tightened its scrutiny of them. This situation has urged This ice-breaking agreement is a milestone on solving the controversy between China and the U.S. regarding the auditing process of Chinese firm.
After a long negotiation, (Public Company Accounting Oversight Board) announced a draft proposal outlining a plan for joint inspections. The proposal allows U.S. officials to observe the auditing work of the companies in China. It also allows the PCAOB to send observers to China to see how Chinese authorities inspect the quality control work of the U.S.-registered, China-based auditors. This cross- border regulation is a milestone on solving the audits controversy of U.S.-listed Chinese companies. This ice-breaking cross-border inspection agreement signifies an important step in solving the stalemate between China and the U.S. regarding inspecting audit work of Chinese companies.
The negotiations originated in 2011, when the number of litigations on China concept stocks skyrocketed and several U.S.-traded Chinese companies were discovered to be engaged in financial frauds. This triggered the credit crisis of China stocks within the US capital market. The stock prices of Chinese companies plummeted to new lows and many international short-selling research firms issued negative reports to short Chinese stocks. The American stock exchanges increased their inspection of Chinese stocks, and the demands for an official cross- border tentative auditing inspection agreement between the two countries continued growing.
The ice-breaking trip enhanced the investors’ confidence
Research is an American short-selling research firm. Since 2006, Citron has issued reports to attack more than 21 oversea listed Chinese companies. Many of them lost a large portion of their market value within a day, and some were eventually delisted. In 2011 short selling research firm Muddy Waters accused Orient Paper of financial fraud. After which, Chinese companies encountered a large scale of hunting by the U.S. short-sellers, leading to vastly diminished stock prices. Citron and Muddy Waters, two research firms known for issuing short reports on Chinese companies, recently launched attacks on Evergrande Real Estate Group, New Oriental Education, and Qihu 360, resulting in substantial market cap reduction of Evergrande and New Oriental Education.
As a partner and founder of Marcum Bernstein & Pinchuk LLP, Drew Bernstein is working with more than 25 Chinese companies as their independent auditor. He also serves as independent director and chairman of the audit committee of two Chinese companies that are listed in U.S. He has witnessed many of the challenges that Chinese entrepreneurs have gone through, hence gaining an in-depth understanding of the vast differences between Chinese and American business culture. He also understands the differing ways of handling crisis between Chinese entrepreneurs and their U.S. counterparts.
According to his observation, short selling research firms have mostly employed two primary weapons to attack Chinese companies. Citron and Muddy Waters are two of the most famous research firms issuing short selling reports to Chinese companies. A powerful weapon the two firms have used repeatedly is examining a company’s financial statements and finding anomalies caused by differences between the U.S. and Chinese auditing work process, including inflated sales revenues, and false, delayed and uncompleted financial reports.
The key task of financial analysis, through the analysis and interpretation of various financial information, is evaluating a company’s financial situation and operational results, as well as analyzing a public company’s profitability and development trends. This analysis is done to help investors pick quality stocks for investment. Short-selling research firms, through analyzing the information that public companies disclose, seek to uncover differences for further investigation. One reason these research firms succeeded is that the Chinese companies did, to some degree, inflate their profitability and report better financials to the SEC than what they submitted to the local business bureau. This way, their investors could not discover true information in the company’s financial filings.
The second powerful weapon that short-selling research firms have often employed is exploiting the lack of international capital markets experience of most presidents, CEOs and/or CFOs of Chinese companies. These Chinese entrepreneurs have experience in local capital markets but lack international capital markets experience. Even with their insufficient understanding, they must make many important decisions. What is worse, many Chinese companies that went public in the U.S. in the past a few years were privately owned. These types of companies are often overly dependent on a few top executives to manage the business, who may also make hasty decisions when crises emerge. “I often compare a crisis to a heart attack.” Bernstein said. “The quick, unexpected attack requires executives to make important decisions before the market reacts. If they can understand clearly what is happening and work with senior consultants and professional firms to make wise decisions to minimize the damages, it would work like sending a patient to the hospital fast enough to save his/her life.”
In the evening of Oct. 9th, 2012, China and the U.S. reached an initial agreement on cross-border inspections of auditing work of Chinese companies. This tentative agreement, called “observational visits,” in principle, grants PCAOB officers limited opportunities to observe how Chinese regulatory authorities inspect and evaluate the work of auditing firms in China. While the development was driven by the American regulatory authority’s goal to protect American investors’ interests, Mr. Bernstein believes it also benefits China. Joint auditing inspections are designed to improve the quality of overall capital markets. The current challenge of Chinese companies is insufficient credibility. Based on the promise that joint auditing inspection won’t touch China’s national security issues, such action will benefit all public companies by enhancing their credibility and public image so as to improve investors’ confidence. Meanwhile, it could help to improve the transparency of stock markets in Shanghai, Shenzhen and Hong Kong.
Internal audits complement external audits
China is in a period of active capital transactions, which has brought Chinese CEOs tremendous opportunities, as well as challenges. Growth companies are challenged in the quest to find experienced CFOs who can participate in the decision making and execution process. There is challenge to find CFOs that can plan and implement financial strategies that take into account overall budget management, performance management and cross-border financial management.
Before a company goes public, to maximize its value, the company’s CFO is often consumed by a lot of financial work. If the company can include the CFO during the process of making financial management and risk control strategies, it will be able to largely improve its credibility in the public eye. In recent years, Chinese companies, especially the public ones, have an increasing demand for qualified CFOs and candidates who have IPO experience are hard to find. Many small and mid-size companies are based in second or third-tier cities, a disadvantageous geographic location that makes it difficult for them to recruit CFOs who are familiar with U.S. GAAP and internal control procedures.
“In China, it seems to me that large companies and small and mid-size companies are in two different worlds.” Mr. Bernstein said. “They adopt different management styles. In small and mid-size companies, the power is highly concentrated. When we are selecting Chinese clients, we want to make sure that we understand who the decision makers are so we can better evaluate the companies’ current situations and the growth prospects.” When describing the status of auditing work in Chinese companies, Mr. Bernstein said, “Without a sound internal audit and external audit system, it would be practically impossible to obtain reliable data in China. The key challenge in Chinese companies is limited internal control and external auditing resources. This has also contributed to the high cost for companies.”
Edward E. Nusbaum, CEO and Executive Partner of Grant Thornton LLP, said that the tentative cross-border inspection agreement is only the first step. To make material progress, the regulatory authorities in both countries need to work more closely and share information more openly. However, this may cause concerns about confidentiality in China, and as the information sharing between China and other countries is subject to approval by Chinese regulators.
Edward E. Nusbaum said that in addition to the U.S., Chinese companies have many financing opportunities in Germany, Frankfurt, U.K. and other major capital markets around the world. If a Chinese company is discovered to have committed financial frauds, press coverage will alarm its investors, and the incident will also negatively impact other Chinese companies. Of course, investments always have risks and investors can’t expect the companies they invest in will always be successful. It is acceptable that a company’s business may not go well after investors make an investment, but the company has to make sure that it has excellent internal controls and corporate governance in place. The company must also validate that their financial information is accurate, in order to help their investors make important business decisions. How regulatory authorities of different countries work together to ensure an efficient global capital market is an important breakthrough for all countries, not just to China.
Play with rules
A couple of years ago, China was a large market of high-growth companies. Investors almost forgot to conduct thorough due diligence before rushing in to make investments. At the same time, many investors faced serious challenges when communicating with Chinese companies. Due to the unbalanced information exchange between key players in the market, both retail investors and institutional investors with huge capital support found it difficult to make sound investment decisions based on the unbalanced information exchange with public companies. It’s challenging, especially when investors want to check if there are any inconsistencies in a public company’s ownership of all of their properties, if the company has clear ownership of financial benefits, and if the company has good business models and growth prospects. Investors want to make sure they understand the China market, a public company’s management’s short and long-term goals, and the company’s ownership structure, so that they can make a fair evaluation of potential return and risk of investments.
When conducting due diligence of Chinese companies, domestic and international investors often face many restrictions and limitations in obtaining correct information that should have been made public from internal and external sources. This leads to many controversies and to rectify the situation, the government needs to enhance the regulatory system, better regulate the business activities of companies, and adopt international standards to disseminate information, so that Chinese companies will be more internationalized. On the other hand, companies and auditing firms should speak the truth and speak with numbers.
International investment firms, including legal consultants and investor relations agencies, have new demands and concerns about the financial performance, internal control standards and collaboration with external auditors in pre-IPO Chinese companies. Today the world has seen the huge potential of China. The small and mid-size companies in China need to partner with professionals to make timely and accurate information disclosure. The government should give guidance and support with efficient policies. All of this helps the companies raise capital from international market and enhance the international market’s confidence of Chinese companies.
First, when Chinese companies enter the international capital market, they should choose auditing firms that have sufficient resources and experience. According to unofficial data, the majority of Chinese public companies are engaged with subsidiaries of big four auditing firms. The economic policies and market conditions in the Western world created brand awareness for the big four auditing firms. Most people in China believe that the big four apply special auditing procedures and that the information that is certified by big four auditing firms is reliable and trusted by investors. However, some of the Chinese companies audited by the big four auditing firms were also attacked by short sellers. The American regulatory authority also issued serious questions to the big four’s China business.
Mr. Bernstein believes that in addition to factual financial frauds committed by some Chinese companies, the advisory firms, and other professional firms, who helped the companies go public overseas also had some responsibility during the massive short-selling attack to Chinese stocks. “Many so-called investment bankers helped Chinese companies go public to make money. They didn’t conduct thorough due diligence or provide sufficient training or resources to management. ” A professional advisory firm plays a key role during the going-public process. Selecting qualified advisory firms, such as investment banks, legal consultants and auditors, is like visiting a doctor for his advice about a virus in your body. Mr. Bernstein said, “Will you only tell the doctor what you want to disclose? Surprisingly, that’s what some Chinese companies have done to their own advisory team and to investors in the public market.” The outcome is often decided at the time you made the very first decision. Poor or mistaken communications lead to possible delisting, investor law suits, board resignations, stock price tank and other serious sequences. Therefore, including legal consultants, auditors and investor relations consultants in your core advisory team is necessary. Managers should inform the team about the overall situation of the company in a timely, accurate fashion so that the advisors can provide optimal and efficient suggestions for the company.
Next, the companies should make accurate and reliable financial data available to investors. Information disclosure is an important channel for investors to understand companies and for regulatory authorities to monitor public companies. A regulated, efficient, stock market relies on accurate, comprehensive, and truthful information disclosure. Among this, auditing information disclosed is a crucial part. In the securities market, the information disclosed about how auditing firms perform their work can be very influential, as most of the information the investors obtain comes from the auditing reports generated by the auditing firms. Independence is the core value of auditing work. However, in reality, we often see auditing firms collaborate with public companies to forge books and inflate profits, resulting in misleading information. This causes damage to investors and hinders the healthy development of the security market.
Lastly, public companies should consider introducing strategic investors when issuing new shares. The strategic investors can be in business similar to the public company, so the partnership can help the company to grow their own business. The strategic investors could be long-term investors with a meaningful amount of shares, so it’s in their best interest to pursue a long-time return. This can motivate the investors to participate in the public company’s management and operation. If a major international corporation participates in the offering to become a long-term investor and strategic partner, it will bring strong capital support, advanced technology and management strategies to help the Chinese public company improve its core competence and expand market share.
As an auditor, Mr. Bernstein said when working with clients that were attacked by short sellers, he and his staff remained cautiously confident. Such confidence is based on the promise that the clients have hired professional auditing firms and law firms who have done thorough due diligence and the clients themselves are willing to respond to questions with a high-level of responsibility and truthfulness. “Transparency is the key. Only if our clients are honest and trustworthy, can we help them to minimize the damages.”
