China’s regulator is clamping down on one of the country’s biggest accountancy firms in a bid to improve standards. The authorities have suspended approvals of IPOs and bond issuance overseen by one of the country’s biggest auditors, signalling a toughening stance.
Accounting scandals are nothing new to China. Stories like machinery giant Caterpillar unearthing financial misconduct at a Chinese mining equipment company it bought back in 2013, still make the headlines. However, the latest accounting scandal is attracting more attention than usual. A robust reaction from the China Securities Regulatory Commission (CSRC) signals that the authorities are getting much tougher on the industry’s gatekeepers.
An ongoing probe by CSRC into accounting firm Ruihua Certified Public Accounts, has led to the authorities suspending approvals of a swathe of summer IPOs and bond offerings under way at companies Ruihua had audited. According to a report in the South China Morning Post, regulators suspended 46 IPOs and bond offerings on the Shanghai and Shenzhen stock exchanges from Ruihua-audited companies at the end of July.
“The government is sending a very clear message to the accounting profession and they’ve got everyone’s attention,” says Professor Paul Gillis, professor of accounting at Beijing’s Guanghua School of Management, Peking University. “It reminds me of Arthur Andersen and Enron,” he says, citing the infamous 2001 US accounting scandal which ultimately destroyed one of America’s biggest accountancy firms.
One explanation for poor corporate governance in China has been the authorities’ desire to facilitate the flow of capital to the private sector, says Gillis. However, as China seeks to develop its capital markets and encourage investment, regulators are starting to realise that turning a blind eye is more damaging than beneficial.
The success of Shanghai’s new technology innovation board STAR Market, modelled on the tech-heavy Nasdaq, is a case in point. Designed to encourage investment in domestic tech innovators and ensure these companies have the funds to develop and an incentive to list at home, the exchange is an important counterweight to China’s slowing growth and trade conflict with the US. Yet four IPOs scheduled for the flagship bourse which only opened a month ago have been delayed because the companies had been audited by Ruihua. “They are really trying to clean things up because of the importance of the new tech board in Shanghai,” says Gillis.
The tougher regulatory stance signals much greater scrutiny for companies wanting to list in the future, predicts Drew Bernstein, Co-Managing Partner at New York-based Marcum Bernstein & Pinchuk. “This doesn’t change the fact that companies still need money. The IPO environment is framed around unicorn companies with business plans based on growth and innovation. What it means is that from now on the regulator is expecting more from the industry’s gatekeepers like accountancy firms, but also investment banks and lawyers.”
The Chinese authorities are also trying to shore up accounting standards as more foreign investors start investing in Chinese companies. MSCI recently increased the weighting for Chinese stocks in its EM index, a move that is predicted to lead to an inflow of more than US$100bn as investors allocate more to China. “Credible financial reporting is a pre-condition for functioning capital markets,” says Bernstein.
The latest clamp down will help assuage investor and rating agency worries. Fitch continues to sound the alarm, recently reporting that Chinese corporate “defaults call into question the actual availability and amounts of reported cash balances.” In May, the ratings agency reported that it expects another record year for Chinese corporate defaults (when creditors typically discover any financial irregularities) “due to rising refinancing pressure, sluggish industrial-sector growth and weaker investor sentiment caused by the ongoing trade dispute with the US.”
The CSRC’s toughening stance has also come with promises by the authorities to boost jail terms and fines for executives, controlling shareholders, auditors and sponsors who break disclosure rules, according to a Reuters report.
Ruihua is China’s second biggest domestic auditor, providing services to 316 listed companies and posting revenue of 2.9bn yuan (HK$3.3bn) in 2018, according to the Chinese Institute of Certified Public Accountants. Gillis predicts the company is likely to fold. “It’s the end game with respect of Ruihua as they try and clean up the mess,” he says, forecasting that the company will likely split up into sections which will then be bought up by smaller firms. “China doesn’t have a real market concentration in the sector. The loss or Ruiha won’t cripple the accounting profession,” he concludes.