Vol. 44 No. 12 June 22, 2011

∗ ELIZABETH P. GRAY is a partner and JESSICA L. MATELIS is an associate in Willkie Farr & Gallagher LLP’s Washington, D.C., office. Their e-mail addresses are EGray@willkie.com and JMatelis@willkie.com.

IN THIS ISSUE

● PCAOB FOREIGN INSPECTIONS: A CHINESE CONUNDRUM

June 22, 2011 Page 145

PCAOB FOREIGN INSPECTIONS – A CHINESE CONUNDRUM Aided by a provision in the Dodd-Frank Act, the PCAOB has made progress in its inspection program for foreign audit firms in some countries, but remains blocked in China. The authors describe the program and its progress and suggest that the gap in the inspection program could be addressed by additional disclosures, supplemental risk management procedures, and possibly through enforcement actions.

By Elizabeth P. Gray and Jessica L. Matelis *

One of the most important missions of the Public Company Accounting Oversight Board (“PCAOB” or “Board”) is its mandate to inspect the work of audit firms that are registered with the Board.1 Any audit firm, whether domestic or foreign, must register and be subject to periodic inspections by the PCAOB if it (a) prepares or issues any audit report with respect to any issuer2; or (b) plays a substantial role in the preparation or furnishing of an audit report with respect to any issuer.3 Most foreign audit firms currently registered with the PCAOB are subject to inspection at least every

three years pursuant to the Sarbanes-Oxley Act of 2002 (“SOX”) and Board rules.

———————————————————— ———————————————————— 1 The PCAOB is a private non-profit corporation created by the Sarbanes-Oxley Act of 2002.

2 Under Section 2(a)(7) of SOX, an issuer is defined to include any issuer with debt or equity securities registered under Section 12 of the Exchange Act or required to file reports under Section 15(d) of the Exchange Act, as well as any issuer that files or has filed a registration statement that has not yet become effective under the Securities Act and that it has not withdrawn.

3 Financial statements for SEC registered broker-dealers must also be audited by a PCAOB registered firm.

4

While the PCAOB has been able to conduct some foreign audit firm inspections, it has faced obstacles to conducting inspections in several jurisdictions including the United Kingdom5, members of the European Union, Switzerland, and, most notably, China. During his time as Acting Chairman, Daniel Goelzer noted that resolution of this issue was one of the Board’s highest

4 Registered firms that audit more than 100 issuers are subject to inspection every year. Registered firms that audit fewer than 100 issuers are subject to inspection every three years. Some foreign firms have registered on a voluntary basis and are not subject to regular inspection, but the PCAOB reserves the right to inspect these firms at its discretion.

5 The PCAOB had conducted some inspections in the United Kingdom but those were suspended until recently when the Board and the Professional Oversight Board in the UK reached a new agreement in January 2011.

priorities,6 and it remains a Board priority under the new Chairman, James Doty.7 In recent months, the Board has made considerable progress in attaining its goal of implementing a successful foreign firm inspection program in Europe. In January 2011, the PCAOB and UK accounting authorities reached an agreement that allows the PCAOB to continue its inspections in the UK.8 A similar agreement was reached with Switzerland on April 6, 2011.9 Additionally, the European Union took recent action that recognized the PCAOB as an equivalent oversight regime, which opens the door for member states to negotiate terms under which the PCAOB could conduct inspections.10

As Chairman Doty recently recognized, despite this progress, “the PCAOB’s inability to inspect the work of registered firms from China is a gaping hole in investor protection.”11 This is particularly true given that China represents the world’s second largest economy and a significant and growing participant in the U.S. public markets. Although Chairman Doty has stated that he was “optimistic” that China would ultimately allow the

Board to conduct inspections, he also recognized that contact with the Chinese over this issue has been “intermittent” and that it will take “creativity and persistence” to resolve the issue,

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6 E.g., Statement of Daniel L. Goelzer Before the United States House of Representatives Financial Services Committee, Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, May 21, 2010 (noting inspection of non-U.S. audit firms as one of the PCAOB’s main challenges); see also Speech by Daniel Goelzer at the AICPA National Conference on SEC and PCAOB Developments, December 7, 2010 (citing foreign audit firm inspections as the Board’s second agenda items for 2011).

7 Michael Rappaport, New Regulator Looks East, Wall Street Journal, B2 (Feb. 12-13, 2011).

8 PCAOB Release, PCAOB Enters Into Cooperative Agreement with United Kingdom Audit Regulator, January 10, 2011.

9 PCAOB Release, PCAOB Enters into First Cooperative Agreement with Swiss Regulators, April 6, 2011.

10 James Hamilton, European Commission Declares U.S. and Nine Other non-EU Countries Equivalent for Inspections of Auditors, CCH Financial Reform News Center, January 24, 2011.

11 Andrew Ackerman, SEC Probes Backdoor Mergers by Chinese Firms, Wall Street Journal, April 4, 2011.

12 acknowledging that progress with China is “slower.”13 Other Board members have expressed pessimism about the prospects of inspecting in China and the potential for a domino effect in other foreign jurisdictions if Chinese inspections do not become a reality.14

This gap in the PCAOB’s inspection program exposes not only U.S. investors to uncertainty regarding the quality of the audits being performed in China, but also U.S. companies with growing subsidiary and joint venture activity in China. Additionally, given the recent spike in reverse mergers by Chinese companies with U.S.-registered shell companies,15 the number of Chinese companies listed on U.S. exchanges is on the rise and there is little known about the quality of the audits performed on these companies.16 Although the China Securities Regulatory Commission (CSRC) has oversight authority for some audit firms in China, its jurisdiction is not all-inclusive and its inspection process, results of inspections, and enforcement activity are not readily shared.

Resolving the inspection issue for registered firms in China presents a significant challenge for the Board.

12 Michael Rappaport, supra note 7. 13 Speech by James R. Doty, Update on PCAOB Developments,

March 24, 2011. 14 Speech by Bill Gradison, What Lies Ahead for the PCAOB,

January 15, 2011. 15 PCAOB Research Note #2011-P1, Activity Summary and Audit

Implications for Reverse Mergers Involving Companies from the China Region: January 1, 2007 through March 31, 2010, March 15, 2011; see also Tammy Whitehouse, PCAOB Questions U.S. Audits for China-Based Companies, Compliance Week, July 13, 2010 (discussing PCAOB staff alert regarding U.S. audits of China-based companies that had merged with a U.S. shell).

16 Andrew Ackerman, SEC Probes Backdoor Mergers by Chinese Firms, Wall Street Journal, April 4, 2011.

June 22, 2011 Page 146

Until the PCAOB satisfactorily resolves the Chinese inspection issue, U.S. investors and companies face uncertainty regarding the quality of the audits being conducted on the financial statements of Chinese issuers listed on U.S. exchanges as well as those of joint venture partners and subsidiaries. Although it is difficult to quantify the value of PCAOB inspections, the increasing presence of U.S. businesses in China as well as the rise of Chinese reverse mergers, suggests that investors and companies are losing some value as a result of this gap in the Board’s inspection program.

THE PCAOB’S INSPECTION PROGRAM

Section 104(a) of SOX gives the PCAOB the authority to conduct inspections to ensure compliance with relevant laws, regulations, and Board rules. Pursuant to Board Rule 4003, a registered firm that audits more than 100 issuers is subject to annual inspection, while registered firms that have issued at least one but not more than 100 audit reports are subject to inspection every three years.

Of the four primary responsibilities of the PCAOB, the inspection process consumes the greatest portion of the Board’s resources – representing approximately 50 percent of the staff and over 45 percent of the annual budget.17 The inspection process itself entails two components – reviewing the workpapers of specific audit engagements and reviewing the firms overall “professionalism” and quality controls.18

Following an inspection, a firm is given an opportunity to review and respond to the draft inspection report after which the Board will issue its final report, taking into account the firm’s responses. If the final report contains criticisms of or defects in the firm’s quality control systems, the firm has 12 months to remediate these issues to the Board’s satisfaction. If the defects are not sufficiently addressed, the Board “shall make” those portions of the report public.19

PCAOB Inspections of Foreign Registered Firms

Under section 106(a) of SOX, any non-U.S. accounting firm that audits a U.S. issuer is subject to the PCAOB’s rules to the same degree as a U.S. audit

firm.

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17 FY 2011 PCAOB Budget, November 23, 2010. 18 Speech by Daniel Goelzer, The PCAOB and the Oversight of

Non-U.S. Auditors, April 19, 2004. 19 PCAOB Rule 4009.

20 Consequently, foreign registered audit firms are also subject to inspection.

PCAOB Rule 4012 implements the Board’s mandate to inspect foreign registered firms and takes into account that, because of sovereignty and local law, the Board cannot conduct these foreign inspections unilaterally. Rule 4012 sets out a sliding scale approach for cooperating with foreign regulators when conducting inspections. The rule allows the PCAOB to rely to differing degrees on its foreign counterparts based on the Board’s evaluation of the foreign regulator under five general criteria:

1. the adequacy and integrity of the oversight system;

2. the independence of the system’s operation from the auditing profession;

3. the independence of the system’s source of funding;

4. the transparency of the system; and

5. the system’s historical performance.21

As Board member Goelzer explained during the comment process for Rule 4012, the intention behind the rule was to fulfill the Board’s Congressional mandate, avoid duplication, and allow for appropriate deference to other regulatory regimes.22 The rule would thus be implemented by:

For example, rather than attempting to unilaterally inspect a firm in a particular country, the Board will develop an inspection work program in consultation with the other country’s regulator. The program will allocate the inspection work between the Board’s staff and the staff of the non-U.S. system, and the allocation will vary, depending on the sliding scale. In some cases, the Board’s staff might participate in, or even conduct, the part of the inspection that related to audits of U.S. companies. In other cases, it might provide expertise on U.S. accounting and auditing

20 Firms that play a substantial role in the preparation or furnishing of an audit report are also required to register with the Board and are similarly subject to its rules.

21 PCAOB Rule 4012. 22 Speech by Daniel Goelzer, The PCAOB and the Oversight of

Non-U.S. Auditors, April 19, 2004.

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standards, but ask that the other regulator perform the “fieldwork.”23

“Full Reliance” Proposal

In December 2007, the Board published a proposed policy statement entitled “Guidance Regarding Implementation of PCAOB Rule 4012.”24 In this proposal, the Board set out the concept of and framework for “full reliance” on a foreign regulator. The proposed policy statement has not been finalized and has been the subject of considerable comment and debate both within the PCAOB and from other interested parties.

Under the proposal, full reliance by the PCAOB “means the Board will rely upon a non-U.S. oversight entity to plan the inspection, carry out the inspection field work, and make findings based on its fieldwork. In addition, the Board will rely on the non-U.S. oversight entity to assess the firm’s efforts after receipt of an inspection report to address any criticisms of or potential defects in its quality control system.”25

The proposal does not suggest, however, that the Board will simply defer to the foreign oversight entity. The Board will still expect to observe portions of the inspection, which could involve a range of activities where the inspectors may “simply consult with the non-U.S. oversight entity about its inspection plans or discuss with the non-U.S. inspectors any complicated or material inspection findings relevant to U.S. public companies.”26 In some cases the PCAOB inspectors may want to attend interviews with key audit firm personnel or request that the non-U.S. oversight entity allow the PCAOB inspectors to review portions of the firm’s audit workpapers.27

Additionally, according to the proposed policy statement, full reliance could only be achieved over time and would require any foreign oversight entity to have had substantial dialogue with the PCAOB staff. Thus, before any agreement by the PCAOB to fully rely on the foreign audit oversight entity is reached, the foreign oversight entity will need to permit some sort of joint

inspections so the PCAOB can confirm the independence and rigor of the non-U.S. system.

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23 Id. 24 PCAOB Release No. 2007-11, December 5, 2007. 25 Id. 26 Id. 27 Id.

28

ROADBLOCKS FOR FOREIGN FIRM INSPECTIONS

As of December 4, 2008, the Board had yet to conduct a first inspection of 134 non-U.S. firms in 42 jurisdictions that had issued audit reports.29 In addition, there were at least 18 inspections that, by virtue of when the audit firm issued audit reports and were registered with the Board, were required to be conducted before the end of 2008 but because of various issues, including information sharing restrictions and sovereignty concerns, could not be completed.30 As a result, the Board had to amend Rule 4003 to allow itself more time to complete these inspections. In the amending release, the Board set forth the following schedule for completing the outstanding inspections:

• By the end of 2009, the Board would have inspected those firms whose combined audit clients’ U.S. market capitalization constituted at least 35 percent of the aggregate U.S. market capitalization of the audit clients of the 50 firms in jurisdictions where the PCAOB had never conducted an inspection.31

• By the end of 2010, the Board would have inspected firms whose audit clients’ U.S. market capitalization accounted for 90 percent of the aggregate market capitalization of these 50 firms.32

• All remaining inspections would be completed by 2012.33

The Board noted in the release that it seeks to cooperate with local auditor oversight entities and to conduct inspections jointly to take advantage of potential efficiencies, to avoid imposing unnecessary burdens on the firms and to respect the foreign country’s jurisdiction.34 Because of this cooperative approach,

28 Id. 29 PCAOB Rel. No. 2008-007, Rule Amendments Concerning the

Timing of Certain Inspections of Non-U.S. Firms, and Other Issues Relating to Inspections of Non-U.S. Firms, December 4, 2008.

30 Id. 31 Id. at 11. 32 Id. at 11-12. 33 Id. at 12. 34 Id. at 7.

June 22, 2011 Page 148

some of the delayed inspections were a result of scheduling issues with the local audit oversight authority. Others, however, were delayed because local authorities had “raised sovereignty concerns or potential legal conflicts.”35

During the 18 months after this amendment, limited progress was made in resolving issues with the EU, Switzerland, UK, and China. As a result, the Board determined in mid-2010 to publish a list of issuers that in 2009 or 2010 “filed with the SEC financial statements audited by a PCAOB-registered firm located in a jurisdiction” where the PCAOB had been unable to conduct inspections.36 This initial list, as of June 30, 2010, included well over 200 issuers audited by 28 different registered audit firms in China and Hong Kong.37 The list was limited to auditors that issued audit reports and did not include auditors that played a substantial role in the audit of multi-national issuers.

In addition to releasing these lists, the Board took further action in October 2010, when it issued a release regarding the potential impact the inability to conduct inspections could have on new registration applications of foreign firms.38 In the release, the PCAOB said that effective as of October 7, 2010 for all pending and new registration applications, “the Board will ask the applicant whether a PCAOB inspection of the firm would currently be allowed by local law or local authorities.”39 If PCAOB inspections were not currently allowed in the applicant’s home jurisdiction, it would have three options: (1) let the application remain pending by not responding to the question regarding inspections, (2) withdraw the application, or (3) state that inspection would not currently be allowed.40 If the applicant chose the third option, the Board would issue a notice of hearing on the application and cite the lack of

inspection ability as a potential reason for disapproval of registration.

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35 Id. at 8. 36 PCAOB Statement regarding Issuer Audit Clients of Non-U.S.

Registered Firms in Jurisdictions where the PCAOB is Denied Access to Conduct Inspections.

37 PCAOB Release of Issuer Audit Clients of Non-U.S. Registered Firms in Jurisdictions where the PCAOB is Denied Access to Conduct Inspections, as of July 21, 2010.

38 PCAOB Rel. No. 2010-007, Consideration of Registration Application from Public Accounting Firms in Non-U.S. Jurisdiction Where There Are Unresolved Obstacles to PCAOB Inspections, October 7, 2010.

39 Id. at 3. 40 Id.

41

While this new aspect of PCAOB registration does not address the inspection issue with regard to previously registered firms, it does highlight the Board’s concern and focus on the issue. Additionally, as noted by one accounting professor currently teaching in China, given the licensing and partnership arrangements required for international accounting firms to practice in China, this new registration requirement may be implicated if international firms’ current Chinese arrangements expire.42

Dodd-Frank – Some Progress

One of the key points of concern raised by the UK and several European countries with regard to the PCAOB’s inspection process was the PCAOB’s inability to share information with its foreign counterparts.43 Without the ability to share information during its inspection process, the PCAOB found that foreign oversight entities had little incentive to cooperate with or conduct joint inspections with the Board. The Dodd-Frank Act, however, addressed this issue by “providing authority for the Board to share confidential inspection information with auditor oversight authorities.”44

Shortly after the passage of Dodd-Frank, as mentioned above, the European Commission and the European Parliament approved the PCAOB as an equivalent agency, allowing EU member states to engage in bilateral inspection arrangements with the Board.45 According to a recent speech by former Acting

41 Id. at 4. 42 Paul Gillis, China and the PCAOB, China Accounting Blog,

November 29, 2010 (available at http://www.chinaaccountingblog.com/weblog/china-and-the-pcaob.html). Ownership of private firms in China is subject to specific legal structure involving licensing and joint venture arrangements with local partners. When these arrangements expire, to avoid a new registration under the PCAOB guideline, the firm will need to certify that the new firm is really a continuation of the old firm.

43 Speech by Daniel L. Goelzer, Update on PCAOB Developments at PCAOB SAG Meeting, Oct. 13, 2010.

44 Goelzer, supra note 43 at 3. Section 981 of the Dodd-Frank Act amended Section 105(b)(5) of the Sarbanes-Oxley Act to allow the PCAOB to share inspection information with other oversight authorities.

45 Id.

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Chairman Goelzer, the PCAOB was actively engaged in discussions with these countries.46 This new ability to share information, however, was less significant for China, where Chairman Goelzer acknowledged seeing “less progress on that front.”47

CHINESE OVERSIGHT OF AUDITORS AND VIEW ON PCAOB INSPECTIONS

CSRC Auditor Oversight

The primary oversight authority for auditors in China is the China Securities Regulatory Commission. According to the CSRC’s 2009 Annual Report, the CSRC Department of Accounting is “responsible for organizing teams of inspectors for all-round and specialized inspections, and ongoing monitoring of accounting firms and asset evaluation agencies with qualifications of securities and futures businesses.”48 The regular inspections, which occur approximately every three years, focus on:49

1. legality and effectiveness of internal management;

2. integrity and effectiveness of quality control systems of business;

3. quality of professional practices in specific projects.50

The report also states that in addition to the triennial inspections, the CSRC Department of Accounting oversees the audit firms “on a daily basis” and that the Regional Offices of CSRC launch inspections on auditors within their respective jurisdictions on an annual basis “so that regulation is ongoing and comprehensive with no loopholes left.”51 It is not clear, however, that the CSRC has jurisdiction over all relevant audit firms due to the way audit firms are registered in

China and the way the government entities are structured.

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47 Id. at 4. 48 China Securities Regulatory Commission Annual Report (2009)

at 107. 49 Id. at 107-08. 50 Inspections of specific projects focus on whether auditors and

evaluators have implemented necessary auditing processes, obtained adequate and appropriate evidence of auditing, and formed the right auditing opinions in accordance with the Practice Guidelines on China’s Certified Public Accountants. Id. at 108.

51 Id.

52

China’s View on PCAOB Inspections

After the PCAOB issued its proposed amendments to the inspection rules, the CSRC sent a short comment letter to the SEC.53 In the letter, the CSRC stridently set forth its view that the PCAOB should “fully rely on the work of the CSRC.”54 The letter further noted that the CSRC was not challenging the PCAOB’s proposal on the basis of timing but because the PCAOB “attempts to take actions on a unilateral basis.”55 The CSRC also reiterated its view that any cross-boarder inspections must abide by “the principles of respecting mutual sovereignty and cooperating as equals.”56 The letter also cited to previously signed agreements between the SEC and the CSRC in 1994 and 2006.

Aside from the fact that “full reliance” remains only a proposal, full reliance by the PCAOB as suggested in the CSRC’s Comment Letter seems implausible given the requirements set out in the proposed “full reliance” statement. It is difficult to envision the Chinese authority allowing the steps necessary for the Board to conclude that full reliance is appropriate, particularly given the strident language of the CSRC’s comment letter.

Beyond these preliminary requirements for full reliance, it is also difficult to envision the Board gaining comfort that the CSRC meets the five principles developed by the Board to evaluate the independence and rigor of a foreign oversight entity such as:

• The adequacy and integrity of the oversight system. This includes an assessment of funding and staff given the size of the relevant capital market as well as available expertise in applicable U.S. laws, regulations, and professional standards. The entity must also be willing to consult with the PCAOB,

52 See Paul Gillis, China and the PCAOB, China Accounting Blog, November 29, 2010 (available at http://www.chinaaccountingblog.com/weblog/china-and-the-pcaob.html.

53 Comment letter of China Securities Regulatory Commission re: Public Company Accounting Oversight Board: Notice of Filing of Proposed Amendment to Board Rules Relating to Inspection (File No. PCAOB-2008-06), May 15, 2009.

54 Id. at 1. 55 Id. 56 Id.

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give the PCAOB access to the documents relevant to the inspection, including underlying audit workpapers, and provide access to the oversight entity’s inspection findings and report; and

• The transparency of the system. Essential criteria for transparency include the non-U.S. oversight entity providing insight into its decisions and activities through public disclosure, such as periodic public reports. The entity must either issue public inspection reports on individual firms or agree not to object to the PCAOB issuing such reports based on information from the non-U.S. entity’s inspections.57

These types of criteria present a high hurdle for full reliance, one that seems unlikely to be achieved given China’s clear reluctance to share information about its oversight program and the apparent gaps in firms and audits that are subject to the Chinese auditor oversight system.

WAY FORWARD?

PCAOB inspections of Chinese registered firms remain a distant goal. Until there is some resolution, this gap in the inspection program will need to be dealt with through other avenues available to the Board, the SEC, audit firms, and affected companies, including through disclosure regulations, risk management, and potentially, enforcement actions.

The PCAOB staff has noted that it is considering requiring additional disclosure in audit reports where either the principal auditor has not been inspected or a substantial piece of the audit was performed by a firm that had not been inspected. Such disclosure

———————————————————— 57 PCAOB Release No. 2007-011, December 5, 2007.

requirements might call for the audit report to specify the amount of assets, revenues, and/or cash flows that have been audited by a firm not yet inspected by the PCAOB. The SEC could potentially require companies to include similar disclosures in their filings – perhaps requiring in the risk disclosures that either their primary auditor or an auditor of a substantial portion of their financial statements has not been inspected by the PCAOB.

The SEC and PCAOB may also use their respective enforcement powers to address the issue. The SEC could pursue issuers and audit firms for non-compliance with the inspection rules and the PCAOB could pursue registered firms. The Board has previously been reluctant to address the inspection issue through enforcement; however, if the issue persists, this reluctance may diminish.

Companies and/or audit firms themselves may also address this issue through their own risk management procedures. Once a company is aware of an increased risk, like the lack of a PCAOB inspected audit firm, it may be prudent to implement compensating controls to the extent feasible. A company or audit firm that is aware that all or a portion of an audit is being conducted by a firm that has not been inspected should consider implementing additional procedures and/or controls over that portion of the financial statement or audit in order to address this increased risk.

Whether the Board will be able to negotiate a joint inspection program with the Chinese authorities will play out over the next several months. In the meantime, investors and companies should exercise appropriate caution. ■

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