September 9, 2011 / 10:27 PM / 8 years ago

Analysis: Deloitte lands at center of U.S.-China clash

NEW YORK (Reuters) - A clash between U.S. regulators and a Chinese arm of accounting giant Deloitte is ratcheting up pressure on auditors doing work in China and complicating efforts to stem accounting scandals there.

In an unusual step, the U.S. Securities and Exchange Commission on Thursday asked a federal court to force Shanghai-based Deloitte Touche Tohmatsu CPA Ltd to hand over its audit records on Longtop Financial Technologies Ltd, which is under investigation for possible fraud.

The move puts Deloitte in the middle of a conflict between U.S. and Chinese regulators, who must consent before Deloitte can release documents.

At another level, the case pits the transparency prized by U.S. investors against the more closed world of finance in China.

“If Deloitte were to comply (with the SEC) it runs the risk of China saying it violated Chinese rules and yanking their license,” said Paul Gillis, visiting professor of accounting at Peking University. If Deloitte does not comply with the SEC, it risks sanctions in the United States, he said.

The SEC’s action could ultimately escalate frictions between U.S. and China regulators and prompt auditors to stop working on Chinese companies that list in the United States, Gillis and other legal and accounting experts said.


The problem could even extend beyond Chinese firms. Big multinational companies that do business in China, such as Microsoft, could get caught up in the problem if the SEC ever wanted to see audit work papers for their Chinese operations, Gillis said.

Moreover, it could be just a matter of time before other Big Four auditors are ensnared in similar problems, he said.

Although it is a Chinese firm, Deloitte’s Shanghai office is registered with the U.S. Public Company Accounting Oversight Board (PCAOB), which regulates auditors, so that the firm can audit U.S.-listed Chinese companies such as Longtop.

The firm is one of several affiliates of the Big Four auditors — Deloitte, KPMG, Ernst & Young and PwC — that have encountered accounting problems at China-based clients listing shares in the United States.

Ernst & Young has been named in at least two class action lawsuits over its work on Sino-Forest, a Toronto-listed company accused by short-seller Muddy Waters of accounting fraud.

KPMG in January said it had found possible irregularities in the books of China Forestry, and online business services firm Subaye announced in April that PwC Hong Kong resigned as its auditor amid concerns about its accounting.

KPMG, PwC and Ernst & Young declined comment.

All of the Big Four have been counting on growth in emerging markets such as China to boost revenues as the audit business in mature markets like the United States levels off.

However, escalating scrutiny by U.S. regulators has underscored the risks of emerging markets auditing.

“An action like this could not only chill, but could make cryogenic, literally freeze the willingness of any auditor to conduct an audit of a China-based business or operation if those audit results may appear in a U.S. SEC filing,” said Jacob S. Frenkel, a partner at Shulman Rogers and former senior counsel in the Division of Enforcement at the SEC.


Chinese companies listing in the United States have fallen through a regulatory loophole, partly because U.S. audit inspectors have not been allowed inside China where the audits are done. Auditors have also resisted handing over records for fear of violating China’s state secrets law.

“The issue that’s been brewing for some time has been the absolute invasion by Chinese companies of the U.S. capital markets without complying with U.S. reporting requirements,” said Duke University securities law professor James Cox.

The SEC and the PCAOB have been talking with Chinese officials to get access for inspections, but the SEC’s latest action could complicate those negotiations, Gillis said.

“I think China is going to become more wary of doing a deal,” he said. “They’ll worry about setting a precedent until they sort out the whole issue.”

China-based software company Longtop is one of the largest U.S.-listed companies involved in a rash of accounting scandals. Deloitte resigned as its auditor in May, saying it found falsified financial records.

Deloitte said Chinese law prohibits its Chinese affiliate from turning over its records directly to a foreign regulator, and violations can result in severe sanctions, including criminal penalties.

“Deloitte China is caught in the middle of conflicting demands by two government regulators,” spokeswoman Lauren Mistretta said. She also noted that the issue affects all accounting firms in China.

Asked whether Deloitte’s China arm could lose its U.S. registration, PCAOB spokeswoman Colleen Brennan said the regulator does not have the authority to revoke a firm’s registration for failing to comply with an SEC subpoena, adding that the SEC has its own enforcement mechanisms.

The PCAOB cannot comment about matters that may be under investigation because of confidentiality provisions of the Sarbanes-Oxley Act that govern its operations, she said.

“We have said, and it still is the case, that we are investigating the audits of China-based issuers,” Brennan said.

Additional reporting by Rachel Armstrong and Sarah Lynch, editing by Bernard Orr

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