Chinese accounting scandals spur auditor upgrades

Thu Mar 10, 2011 11:03am EST

* Companies pay up for Big Four stamp of approval

* Investors more skeptical of small, low-fee auditors

* Auditor upgrades boost battered shares

By Dena Aubin

NEW YORK, March 10 (Reuters) - Beaten up by accounting scandals, some Chinese companies that list shares on U.S. stock exchanges are dumping smaller auditors and hiring Big Four firms to convince investors their bookkeeping can be trusted.

Chinese companies have been on the defensive amid scrutiny of their accounting and a spike in shareholder lawsuits that allege securities fraud. Their auditors have been accused of missing fabricated contracts and inflated profits that triggered stock drops when they were revealed.

Investor fascination with China, whose economy is growing at the fastest pace in the industrialized world, has been part of the problem, experts say. Many investors overlooked the fact that companies used unknown auditors, normally a big red flag.

"Companies are under pressure from investors to get the best auditor they can," said Paul Gillis, an accounting professor at Peking University in Beijing.

More than 200 Chinese companies are listed on U.S. exchanges, and hundreds more trade on over-the-counter bulletin boards. In the last five months, at least 15 have upgraded to a Big Four auditor -- Deloitte, Ernst & Young, PricewaterhouseCoopers or KPMG -- from a smaller firm, according to an analysis from Audit Analytics.

China is not the only country whose companies have had accounting issues, and auditors of U.S. companies also face lawsuits contending they helped mask financial problems.

But Chinese companies face skepticism because many went public through mergers with shell U.S. companies, a procedure known as a reverse merger, bypassing the due diligence of an initial public offering. They still must get audited, but many have used small, unknown firms to save money.

INVESTORS DEMAND AUDITOR UPGRADES

An auditor's stamp of approval is key for investor confidence. But many investors have been more willing to speculate on Chinese stocks given the big potential for gains, said Kurt Schacht, head of standards and financial market integrity at the Certified Financial Analysts Institute.

Problems also stem from inexperience with U.S. accounting, experts say. Few Chinese companies listed on U.S exchanges were audited in a meaningful way before going public, Gillis said.

The Big Four are being cautious in taking on more China business, Gillis said. Their biggest advantage is their size, he said, with each having up to 10,000 employees in China, a market they have courted for years.

Investors have cheered auditor upgrades. China Valves Technology CVVT.O shares jumped 18 percent on Jan. 18 when it said it planned to hire a Big Four auditor. The stock had been battered after a research firm questioned the accounting of a firm China Valves had acquired. [ID:nSGE70H0BN].

Upgrading auditors is costly. A Big Four audit for a small Chinese company with less than $30 million in annual sales typically costs three or four times more than what a Hong Kong auditor would charge, said Nancy Mangold, an accounting professor at California State University in East Bay and a consultant to companies operating in China.

But the price of accounting failures can be high. Shares of Rino International Corp (RINO.PK), a pollution control equipment maker, have tumbled almost 90 percent since research firm Muddy Waters questioned its accounting on Nov. 10.

Rino has since disclosed it did not enter into two of its previously reported contracts, and said its 2008 and 2009 financial statements were unreliable. Delisted by Nasdaq, Rino is a target of lawsuits and a U.S. regulatory probe.

The company, like many other smaller Chinese businesses, had used auditor Frazer Frost, a combination of Moore Stephens Wurth Frazer & Torbet LLP (MSWFT) and Frost Pllc. The auditor split back into two firms after the Rino controversy.

MSWFT was fined by the U.S. Securities and Exchange Commission in December over its work for China Energy Savings Technology, a reverse merger company that previously was fined for securities law violations. MSWFT did not exercise skepticism or catch mistakes that led to inflated revenue, the SEC contended.

Citing confidential relationships with clients, MSWFT managing partner Jeff Jones declined to comment on Rino. He said that in the China Energy case, the firm did not admit or deny the SEC's findings. "We are glad to have put that matter behind us" and continue to audit companies in China, he said.

Investors' heightened attention to auditors may be the best solution, Mangold said. "That trend is going to really strengthen the financial reporting for these Chinese companies," she said. (Reporting by Dena Aubin, editing by Dave Zimmerman)

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