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Viewpoint Part 2: Can the SEC demand information from the China arms of accounting firms?

by Paul Gillis

April 23, 2013

Paul Gillis, Visiting Professor of Accounting at Peking University
Paul Gillis, Visiting Professor of Accounting at Peking University

There are two problems at play here: national sovereignty and state secrets

CKGSB Professor Qi Daqing and Peking University Professor Paul Gillis share their views on the regulatory battle between the US Securities and Exchange Commission and the China branches of five international accounting firms over access to work documents. In Part 2 of this Viewpoint series, Paul Gillis, Visiting Professor of Accounting at Peking University, says that while complying with US regulation is ultimately China’s decision to make, the conflict is a small facet of two superpowers redefining their relationship in the 21st century.

Both the American and Chinese positions on this issue make sense, and that is the problem. The Public Company Accounting and Oversight Board (PCAOB) in the US has been negotiating with the Ministry of Finance and the China Security Regulatory Commission for many years so that PCAOB can come to China to inspect accounting firms that audit US-listed companies. China thinks that allowing foreign regulators to enforce foreign laws against Chinese people and firms on Chinese soil impinges on China’s national sovereignty.If the issues between the US and Chinese regulators are not worked out soon, the SEC and PCAOB may have no choice but to ban the Chinese accounting firms from auditing US-listed companies. While that would be bad for accounting firms, it may be worse for their clients, who may get kicked off the US stock exchanges.

There are two problems at play here: national sovereignty and state secrets. China has forbidden the PCAOB from performing inspections on its soil because it would violate China’s national sovereignty, to which China is particularly sensitive.

Chinese regulators have declined the PCAOB’s offer to conduct inspections alongside local regulators as it does with that of several other countries. Without access, the PCAOB has forgone its own requirements to complete the initial round of foreign inspections required under its rules by the deadline for the end of 2012. China’s State Secrets Law prohibits the transfer of information related to the country’s national security and interests outside of China’s borders without approval. But China has an expansive view of what might constitute a state secret. While most countries have such laws, China’s definition of a state secret often includes information related to transactions with SOEs. China’s Archive Law also restricts the transfer of information outside the country’s borders.

China wants US regulators to rely on China’s own robust regulation of accounting firms. But China does not regulate most of the audits conducted for US-listed Chinese companies because most of these companies have incorporated outside of China, typically in the Cayman Islands, to avoid Chinese regulation. Consequentially, these companies fall into a regulatory hole lacking regulation from either nation. In my opinion, this hole encourages fraud.

Not only is it law, but the PCAOB and the SEC help to protect investors by requiring complete and accurate disclosure of financial activities. Removing this investor protection on Chinese stocks listed in the US won’t do. If Chinese companies and their auditors can’t follow US laws, then they should not be listed in the US.

Conversely, China has the right to decide what goes on within its borders. China is perfectly within its rights to keep working papers from leaving China and to ban foreign regulators from coming to China to enforce foreign laws. But, it is also within China’s rights to cooperate with foreign regulators if it chooses to.

The decision is up to China. China may decide that cooperation with the SEC and PCAOB is too much of an impingement on China’s national sovereignty and risks national secrets. The consequence of taking that position is Chinese companies getting kicked off of the US stock exchanges. So the real risk of not finding a deal is for China. China’s own markets are not ready to handle the $100 billion in private equity money currently tied up in Chinese firms looking for an IPO exit. If US markets are closed to China’s entrepreneurs, there is a risk that indigenous innovation will suffer.

In the political short-term, China wins by standing up to “American hegemony”. The US wins by showing that it “will not allow China to cheat”. But ultimately, this is a case of two superpowers working out their relationship for the 21st century. The US is used to making the rules and expecting others to follow them. That is going to change.

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