The Big Four global audit firms, which dominate the Chinese market, are negotiating with Beijing to lessen the impact of forced changes that could mean only accountants with Chinese qualifications can be partners in their audit practices.
The overhaul comes at a delicate time for an audit industry reeling from a rash of accounting scandals at Chinese companies, particularly those listed in high-profile overseas markets such as the United States.
Any reduction in the audit capacity of KPMG, Deloitte Touche Tohmatsu, Ernst & Young and PricewaterhouseCoopers (PWC) would increase foreign regulators' and investors' concerns about Chinese auditing.
"The Big Four play a critical role in the integrity of financial markets, it's essential they have the right to practice in China," said Paul Gillis, visiting professor of accounting at Peking University and author of the China Accounting Blog.
The foreign joint venture arrangements signed in China 20 years ago by KPMG, Deloitte and Ernst & Young expire later this year. PWC's joint venture expires in 2017, but it is also involved in restructuring discussions.
China's Ministry of Finance (MOF) is using the expiry milestone to force the global auditing giants to form special group partnerships, which in theory would mean all partners would need to hold notoriously tough Chinese accountancy qualifications.
But China's young accounting industry means there aren't yet enough experienced Chinese-qualified accountants to run these businesses, say people close to the Big Four, who did not want to be identified as they are not authorized to talk to the media.
"The Chinese authorities have indicated for some time that the four will have to convert into the same mode of practice as local firms when the joint venture terms end," said Winnie Cheung, chief executive at the Hong Kong Institute of Certified Public Accountants (HKICPA).
The Big Four dominate China's accounting industry, having won much of the lucrative work to audit the books of the country's state-owned enterprises when they first listed.
In 2010, their audit practices, excluding their consultancy businesses, had combined revenue of more than 9.5 billion yuan ($1.5 billion), according to the Chinese Institute of CPAs (CICPA). However, their market share has slipped in recent years to around 70 percent of the revenue among the top-10 auditors, down from 85 percent in 2006.
Including consulting, the four firms say they each employ around 10,000 people in Greater China, which includes Hong Kong and Taiwan.
BIG FOUR LOBBYING
A firm dominated by Chinese-qualified partners would raise concerns at the Big Four's global headquarters as they'll have less control over their China practices. The joint ventures agreed in 1992 allowed foreign-qualified partners to dominate the practices.
The four are now pushing for many of their foreign-qualified partners to be allowed to retain their roles during a 'grandfathering' handover period.
"The Big Four will want to get enough foreign partners into a deal so they can still control it for a few more years," said Peking University's Gillis.
"Although they will be delaying the inevitable, it will at least give them a few more years control until they migrate to a completely Chinese-owned and controlled entity," he added.
Over the last five years, the firms have collectively doubled the number of Chinese-qualified CPAs they employ, according to the CICPA, but many of their partners gained their qualifications in Hong Kong, the United States or Europe.
An email circulated by management at one of the Big Four firms on February 22, seen by Reuters, said the finance ministry was demanding a break-down of all the qualifications held by the firm's China partners.
"This is a complex process and the MOF have been requesting a great deal of information to understand our practice," it said, adding the firm planned to send the data last week.
"The question for the authorities is; are the firms mature and ready enough to just have local qualified partners?" said Cheung at the HKICPA. "They should also think about diversity and expertise, the advantages of allowing a certain number of non-locally qualified partners in the transition of the joint venture to a local firm."
KPMG, Ernst & Young, Deloitte and PWC all declined to comment for this article. Partners at the firms told Reuters they could not discuss the matter publicly as the MOF had insisted the negotiations be confidential.
Neither the MOF nor CICPA responded to faxes asking for comment.
Overseas regulators will be watching events keenly.
The U.S. Public Company Accounting Oversight Board is in negotiations with the MOF and the China Securities Regulatory Commission (CSRC) about being allowed to inspect firms that audit Chinese companies listed in the United States.
The U.S. Securities and Exchange Commission (SEC) has struggled in some of its investigations into alleged fraud at U.S-listed Chinese firms, partly due to the fact auditors in China haven't been able to provide them with key information.
Last year, several Chinese companies were de-listed in the United States after being caught up in accounting scandals, some of which were highlighted by short-sellers such as Muddy Waters.
One high-profile blow-up, Longtop Financial Technologies Ltd LGFTY.PK, showed the difficulties that auditors in China can run into.
Deloitte resigned as the software company's auditor last May, alleging Longtop tried to falsify its financial statements and bank confirmations. The auditor noted in its resignation letter that Longtop management had threatened Deloitte staff and tried to stop them leaving company premises when the discrepancies were uncovered.
But the SEC is struggling in its investigation of Longtop management as Deloitte's Shanghai office said it cannot provide U.S. authorities with its audit work papers. The SEC has gone to the courts to try and force Deloitte's hand, but the auditor says it cannot comply as this could breach China's state secrecy rules.
"If the change in the structure of audit firms loosens their ties to the U.S., the challenges for the SEC enforcement program in China will increase," said William McGovern, partner at Kobre & Kim in Hong Kong.
A report last week from the Canadian Public Accountability Board on the audits of Canadian Chinese companies found many auditors in China failed to apply procedures that would be "considered fundamental" in Canada.
While the Big Four were caught up in a number of recent Chinese accounting scandals, most were at mid-cap companies audited by smaller audit firms.
China's accounting exams are among the toughest around. The pass-rate is well below 20 percent and all papers are in mandarin, making it even tougher for non-Chinese auditors at the Big Four to try to convert.
The difficult exams and the economy's rapid growth over the past two decades means there is currently a shortage of qualified accountants in China.
The CICPA wants to have 250,000 members by 2015, up from around 180,000 today, and aims to boost the number of people in the accounting industry nationwide to 12 million.
A wider part of the ministry's plan for the industry is to develop 10 big domestic accounting firms, reducing their reliance on foreign auditors. The MOF wants at least three local audit firms to be among the world's top 20.
"China recognizes the expertise of the Big Four and the need for them as far as the worldwide market is concerned, but they want to expand and help the growth of local firms to the size and expertise and quality that is required to support the country's increased importance," said HKICPA's Cheung.
($1 = 6.2978 yuan)
(Reporting by Rachel Armstrong in SINGAPORE, additional reporting by Dena Aubin in NEW YORK; Editing by Ian Geoghegan)