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Big Four auditors squeezed between US and China

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When he started to pull apart the carcass of China Medical Technologies, which collapsed after a suspected $400m fraud, liquidator Cosimo Borrelli hit an obstacle.

KPMG, which had audited the company from Beijing since it listed in New York in 2005, refused to hand over its financial records. It even defied a court order to do so, citing Chinese security laws that prevent the removal of sensitive documents from the country.

Intent on tracking down the missing money — a senior executive’s wife, it was suspected, had gambled more than $100m of it in Las Vegas casinos — Borrelli hatched a plan.

Over the next two years, his team of eight camped out near KPMG’s Beijing office and took detailed notes of more than 5,000 audit files. KPMG reluctantly granted them access to prevent the liquidators suing 91 of its auditors for ignoring a court order to hand over the documents.

The notes are now being used by the liquidators to sue KPMG in Hong Kong for alleged negligence.

Borrelli and KPMG declined to comment.

The case has become a key contest in the long-running stalemate between China and overseas regulators and agents over access to companies’ financial records. The clash has left the Big Four global accounting firms — Deloitte, PwC, KPMG and EY — which have spent three decades building large operations in the Asian country, trapped between antagonising Beijing or incurring penalties elsewhere.

It is the latest challenge for the Big Four firms, which have faced mounting criticism over their audit quality controls in the wake of frauds at Wirecard, Luckin Coffee and others. They have been threatened by regulators who want to rein in their oligopolistic practices and their global business models face renewed scrutiny.

The spat is also one more flashpoint in the escalating tensions between Washington and Beijing over issues from trade to security, that has already led to the delisting of three Chinese groups and a ban on US investors holding shares in companies with suspected ties to China’s military.

The issue came to a head in March: the Securities and Exchange Commission started to implement a law passed under the Trump administration that compels foreign companies listed in the US to allow America’s regulators to review their financial audits, or face being kicked off its stock exchanges.

Daniel Goelzer, a founding member of the US accounting regulator
Daniel Goelzer, a founding member of the US accounting regulator, said: ‘The audit firms are caught in the middle of two warring jurisdictions’ © Anne Lord

In response, China’s Foreign Ministry accused the US of “politicising security regulation”, while a wave of Chinese companies has set up secondary listings in Hong Kong to mitigate the fallout.

“The audit firms are caught in the middle of two warring jurisdictions,” said Daniel Goelzer, a founding member of the Public Company Accounting Oversight Board, the US accounting regulator. “It seems less and less likely China will eventually compromise [with the US], while at the same time China is becoming more important economically for the firms.”

Worst of all worlds?

Companies listed in the US have been required to submit to PCAOB inspections of their audits since the Sarbanes-Oxley Act was introduced in 2002 in the wake of the Enron scandal.

The number of Chinese companies listed on US exchanges has ballooned since then, and investment in Chinese IPOs on US markets reached record levels this year.

Column chart of funds raised year to date as of April 21 ($bn) showing Chinese issuers tap US stock markets at record pace in 2021

The Big Four, which dominate China’s auditing market, audit about 140 Chinese companies that are US-listed, according to the SEC.

As they have raked in fees from booming internet start-ups looking to access international capital markets, the Big Four’s China operations have grown to nearly the size of their UK bases, employing about 6 per cent of total global staff.

Yet many of China’s largest technology companies such as Alibaba, JD.com and Baidu are among their audit clients that do not make Chinese audit papers available to US regulators.

“The [SEC] provisions are designed to enhance transparency,” said Catherine Ide, vice-president of professional practice at the US Center for Audit Quality. “While the regulatory activity continues, the US audit profession remains strongly committed to maintaining audit quality.”

Paul Leder, former SEC director
Paul Leder, former SEC director, said: ‘The current impasse doesn’t serve the interests of the international accounting firms, issuers, investors or the markets’ © Handout

If no resolution is reached, the Chinese operations of the Big Four could be deregistered by the PCAOB, blocking them from auditing US companies. The Big Four are also concerned about losing access to the Chinese market.

It could have damaging ramifications for the audits of multinational corporations such as Apple or General Motors that are headquartered in the US and have large operations in China.

“This is not good for the entire auditing profession,” said Paul Leder, former director of the SEC’s Office of International Affairs, who was directly involved in the agency’s engagement with Chinese authorities on this issue. “As a result of the conflict between government authorities in the US and China, auditors face the threat of enforcement actions in both the US and China and the associated costs.

“The current impasse doesn’t serve the interests of the international accounting firms, issuers, investors or the markets,” said Leder, now at Miller & Chevalier, a law firm in Washington, DC.

The Big Four’s Asian expansion

A ‘golden age of fraud’

Since Sarbanes-Oxley, US regulators have tried a number of ways to force compliance, including negotiating with Chinese regulators and suing audit firms. In 2012, the watchdog took aim at the firms’ China practices over accounting scandals at nine companies that led to billions of dollars of shareholder losses.

Those lawsuits changed the landscape of the profession. Some second-tier firms pulled out of auditing US-listed Chinese companies after their insurance providers stopped underwriting such work.

A recent surge in accounting scandals has pushed regulators to harsher measures to protect investors, including stricter rules for auditors.

“We are in a golden age of fraud,” said renowned short-seller Jim Chanos last year, pointing to Luckin Coffee, the largest fraud by a Chinese company on Wall Street. Mike Pompeo, the US secretary of state at the time, warned American investors of “a pattern of fraudulent accounting practices in China-based companies”.

Luckin Coffee store
Luckin Coffee was the largest fraud by a Chinese company on Wall Street © Qilai Shen/Bloomberg

Local vs global

The Big Four firms market themselves as global entities with a shared culture and consistent standards, but they operate as legally separate franchises. This is particularly an issue in China, where the firms are required to associate with a local accounting firm but still maintain centralised quality control over thousands of audits.

“The structure of the networks is there primarily to protect the group auditor from liability for risks happening outside their home country,” said the head of international audit at a large accounting firm.

A potential solution floated by US lawmakers last year would have required US accountants to “co-audit” the work of their Chinese counterparts. It could have made US partners of the firms potentially liable for the work done by their Chinese partners in the event of a collapse and investor or regulatory lawsuit — something the firms have tried hard to avoid. To the relief of the Big Four, that proposal is “basically dead”, according to people close to the talks.

Other solutions are being floated — many undesirable. The head of policy at a Big Four firm said: “We could just end up having duplicate audits all over the world just to satisfy [the SEC] requirement that doesn’t necessarily address quality. I think that’s a risk.”

However, the existing model has also proved vulnerable to challenge. In the case brought against KPMG over its audits of China Medical Technologies, a Hong Kong judge ruled that all partners of the firm have a “personal obligation to take steps to facilitate compliance”, whether they are based in China or not. A similar ruling was made by a UK court against EY Global over its Dubai audit of gold refinery Kaloti last year.

Meanwhile, the Big Four have pledged to try to improve global audit quality standards across their networks, after former SEC chair Jay Clayton last year urged them to improve the quality of the audits carried out in China of US-listed companies.

“Based on the current trajectory of relations between the US and China, it seems likely that the impasse will continue and Chinese companies will move their listings elsewhere,” said Leder. “The Chinese arms of the international audit firms will become less connected to the overall entity as yet one more link will be broken between the US and China.”



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China lands spacecraft on Mars

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China has landed a spacecraft containing a rover on Mars, according to state media, in a further sign of its bold ambitions in the sphere.

The rover was part of the Tianwen-1 unmanned mission launched in July last year. Tianwen means “questions to heaven” and was named after a poem by Chinese poet Qu Yuan.

The mission, which was described by Chinese media as a “new major milestone” and the “first step in China’s planetary exploration of the solar system”, was intended to match the US by successfully landing on the red planet.

The Global Times reported that the lander and the rover from the Tianwen-1 probe reached a plain on Mars called Utopia Planitia on early Saturday morning local time, citing information from the China National Space Administration.

The Tianwen-1 probe’s lander and rover separated with the orbiter at about 4am, after which it had a three hour flight before entering Mars’ atmosphere, according to the newspaper.

The spacecraft then “spent around nine minutes decelerating, hovering for obstacle avoidance and cushioning, before its soft landing”. The rover is named Zhurong after a Chinese god of fire, and is 1.85m and weighs 240kg. It is expected to transverse the planet for about 92 days.

The probe was launched into space on July 23 by the Long March 5 rocket from the Wenchang launch pad in Hainan province, in the south of the country.

The achievement of the Mars landing is part of a wider expansion of China’s space programme. The country’s engineers launched the first part of its permanent space station into the Earth’s orbit late last month.

In 2018, China for the first time launched more vessels into orbit than any other nation.

The US views China’s efforts in space in strategic terms. “Beijing is working to match or exceed US capabilities in space to gain the military, economic and prestige benefits that Washington has accrued from space leadership,” according to the annual threat assessment published by the office of the US director of national intelligence.



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Iron ore sinks from record high on concerns over China crackdown

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The scorching rally that propelled the price of steel-making commodity iron ore to a record high came to a shuddering halt on Friday on concerns China will crack down on speculative activity.

The main iron ore futures contract in Singapore fell as much as 14 per cent to $190 a tonne before recovering to $209, while there were also big drops in China where the most active contract on the Dalian Commodity Exchange slumped almost 8 per cent.

The sell-off came as the local government in Tangshan, China’s main steel-making city, said it would examine illegal behaviour and suspend production at mills found to be manipulating market prices by spreading rumours and hoarding material, according to reports from Reuters and Bloomberg.

“China’s central government seems to be very concerned about this major input for its steel-intensive economy,” said Tom Price, head of commodities strategy at Liberum. “I think what the pullback reflects is the government trying to rein in prices.”

Line chart of $ per tonne showing Iron ore prices have fallen after a strong rally

Authorities in China have sought to cool hot commodity markets, with Premier Li Keqiang calling this week for stable prices. Iron was trading at $90 a tonne a year ago and hit a record high of $230 this week. Tangshan, which accounts for 14 per cent of China’s steel output, has introduced production curbs as part of a crackdown on pollution.

However, these measures have been slow to take effect as mills in the rest of the country have rushed to crank up output to take advantage of reduced capacity in Tangshan and cash in on record domestic steel prices. A decision to remove the export tax rebate for some steel products on June 1 has also led to other mills increasing production.

As a result, China’s steel production hit a record level in March, with output up 19 per cent year on year to 94m tonnes, according to financial group ANZ. The firm said production was even higher in April, with exports up 20 per cent year on year. That in turn boosted iron ore, which climbed 35 per cent over the past month.

“What the Chinese government is trying to do is incrementally contain the steel market, mindful of the fact they have spent a fortune resurrecting their economy over the past 12 months and they don’t want to kill the recovery,” said Price. “The measures are quite clever.”

Iron ore has led a broad advance in commodity markets over the past year, fanning talk that another “supercycle” — a long period of high prices — has arrived.

That has been a boon for big iron producers such as Anglo-Australian company BHP and its Brazilian rival Vale, which require a price of just $50 a tonne to break even.

However, most analysts think the iron ore market will remain tight and prices elevated for the rest of the year. That view is based on rising steel demand outside China as big economies accelerate and while important producers in Australia are operating at full capacity.

“While the price has been thumped in the past couple of days, demand remains robust, helped by the fantastic margins the steel industry is enjoying,” said Andrew Glass, Singapore-based founder of Avatar Commodities.

Elsewhere, copper was set for its first weekly loss in more than a month amid worries that a tightening of credit in China could hit demand for the metal, used in everything from household goods to electric vehicles. Copper, which started the week at $10,412 a tonne, was trading at $10,245 on Friday.



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Biden says ‘strong reason’ to believe pipeline hackers are in Russia

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Joe Biden said the US government has “strong reason” to believe the hackers behind a massive cyber attack that shut the Colonial petroleum pipeline were based in Russia, as he urged Americans to not panic over temporary fuel shortages.

“We do not believe the Russian government was involved in this attack. But we do have strong reason to believe that the criminals who did the attack are living in Russia. That is where it came from,” the US president said in a speech on Thursday afternoon at the White House.

“We have been in direct communication with Moscow about the imperative for responsible countries to take decisive action against these ransomware networks,” he added, noting he hoped to discuss the issue with Russia’s president Vladimir Putin.

The 5,500-mile pipeline system has capacity for 2.5m barrels a day of liquid fuels such as petrol diesel and jet fuel, which it carries from Gulf Coast refineries to major hubs in the north-east. The FBI has indicated that the shutdown was caused by a ransomware attack by hacking group DarkSide.

Cyber experts claim Russia tacitly allows ransomware gangs to operate in the country and will not prosecute them. In return, those criminals do not attack Russian companies and can be called upon to share their access to victims’ systems, experts say.

Last month, the US Treasury accused one of Russia’s intelligence services, the FSB, of “cultivating and co-opting” the notorious ransomware group Evil Corp, which has been sanctioned.

The Colonial pipeline — responsible for carrying almost half of the motor fuel used on the US east coast — began the process of fully reopening on Wednesday evening, five days after it was hit by a cyber attack that triggered a spate of panic-buying by motorists across the US south-east.

Biden said the US government expected a “region by region return to normalcy beginning this weekend and continuing into next week”. He urged Americans to avoid panic-buying petrol, and said he had called on state governors and local authorities to keep a lookout for any illegal price gouging by businesses.

“Don’t panic, number one. I know seeing lines at the pumps or gas stations with no gas can be extremely stressful, but this is a temporary situation,” Biden said. “Do not get more gas than you need in the next few days.”

Shortages at filling stations triggered by panic-buying continued on Thursday, with 70 per cent of stations in North Carolina running dry and about half in Virginia, Georgia and South Carolina, according to GasBuddy, a data provider.

The situation in some major urban hubs was beginning to improve, however. The amount of stations without fuel in Atlanta fell from a peak of 73 per cent overnight to 68 per cent by Thursday afternoon.

Colonial on Thursday morning said it had made “substantial progress” in bringing its operations back online and that all of its markets would begin receiving product by the afternoon.

Prices at the pump have continued to rise. National average petrol prices rose to $3.03 on Thursday, according to the AAA, an automobile association. They crossed the $3 a gallon threshold on Wednesday for the first time since 2014.

Gasoline futures retreated on the news of Colonial’s reopening, as traders anticipated supplies returning to normal. Contracts for June delivery slipped 7 cents to $2.08, their lowest level since April in Thursday afternoon trading.



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