Features
7 Jan 2014 04:24pm

China's audit rotation

The world’s second-largest economy is an early and rigorous adopter of mandatory auditor rotation. Will the rest of us end up learning from its example or its mistake? Sally Percy reports

Mandatory rotation of audit firms is one of the most controversial topics to concern the accountancy profession currently – for good reason. “It is costly,” says Gilad Livne, professor of accounting at Exeter University Business School. “It is costly for the auditor who loses the job, for the new auditor to set things up and for the company because the new auditor lacks the specific knowledge of the previous one.” And while it may enable an auditor to be more independent, enhancing audit quality, the jury is still out as to whether the benefits outweigh the costs and risks. “We don’t have compelling evidence that either firm or partner rotations are beneficial,” notes Livne.

It could be argued there is a good reason why there is no compelling evidence to support the benefits of auditor rotation: not many countries do it. Mandatory auditor rotation rules have been in place in Italy since 1974 (where rotation must occur every nine years), in Brazil since 1999 (every five years), in Korea since 2003 (every six years) and in India since 2013 (after two five-year terms). Austria, Canada, Singapore and Spain have also flirted with mandatory auditor rotation, but suspended the policy for reasons including cost and having achieved increasing competition in the large audit market.

China appears to be the place where the global dominance of the Big Four has been broken

However, we may all learn from China, which adopted mandatory auditor rotation rules in 2010. While the EU crawls towards agreeing rules that would force listed companies to switch auditors every 20 years (or every 15 years if they are banks and systemically important institutions), China has forged ahead with its own policy. Under its rules, financial institutions and state-owned enterprises must undertake an audit tender process every three years and an auditor cannot serve the same client for more than five consecutive years.

So what’s the logic for China – admittedly the world’s second largest economy but an emerging market nevertheless – being so prompt to roll out a strict auditor rotation strategy while more developed markets prevaricate? “Perhaps they are trying to signal they are serious about the quality of reporting,” observes Livne. James Lee, ICAEW’s regional director, Greater China, concurs. “With the Chinese accounting profession being young, audit rotation is seen as a quick and easy way to improve audit governance, allowing time for the profession to mature,” he says.

In addition, the Chinese government hoped the introduction of mandatory audit rotation might loosen the stranglehold of the Big Four accountancy firms on the large audit market in the country – a concern that also preoccupies authorities in the West. So far, it hasn’t made any progress in this respect. Despite local firms being invited to tender for the audits of three of China’s largest banks in 2012, the Big Four ended up swapping them among themselves. They also dominate the audits of other state-owned enterprises. “Local Chinese auditors are narrowing the gap in terms of revenues but they realise they still have a long way to go to compete with the Big Four, especially when state-owned enterprises, including banks, are getting bigger with more complex international business portfolios,” says Lee.

It is still early days though and change is on the horizon. In May 2013, the local affiliates of accountancy networks Crowe Horwath International and RSM International merged to form a firm called Ruihua China. Its revenues of 2.8bn yuan (£285m) are greater than those of EY and KPMG in China and it has offices in 38 Chinese cities. It will be interesting to see how this affects the Chinese audit market. For now, local firms are sticking to smaller audits in order to gain more experience, but inevitably the time will come when they take on the Big Four.

In July 2013, Paul Gillis, professor of practice at Peking University’s Guanghua School of Management, wrote in his blog: “Chinese regulators encouraged local firms to enter the bidding process [for the audits of the Chinese banks], but none won. A partner in one larger local firm told me his firm declined to bid on the big banks, suggesting they be awarded some smaller banks so they could build banking expertise. Then, in five or 10 years, when the banks rotate again, they might be ready. China’s big banks are some of the largest banks in the world and none of China’s local firms presently have the capability to do these audits. Even in five years, they will need to poach expertise from the Big Four to win those jobs.”

Gillis (who writes for us on p68) also noted that while the Big Four in China grew at a faster rate than local firms for the five years up until 2007, the tables have since turned. “Since 2008 the Big Four have been growing slower than the economy, and that is not the formula for success,” he said. He believes the creation of Ruihua is significant, saying: “China appears to be the place where the global dominance of the Big Four has been broken.” Interestingly, mandatory rotation of auditors appears to have resulted in a drop in audit fees to date since the Big Four firms competed fiercely to secure the work.

While the aims of improving audit choice and market competition seem laudable, there is the dark spectre of the Chinese banking system to consider. The shortcomings of Western banks have been well publicised in recent years, but less is known about the financial skeletons lurking in Beijing’s cupboards. In the 1990s, Chinese banks were forced to lend large amounts of money to unprofitable, state-owned entities that were unable to repay the loans and no longer exist. In 1998 the Chinese government injected 270 billion yuan (£27.5bn) to recapitalise the country’s largest four banks. But the problem of so-called non-performing loans (or bad loans) has not gone away.

China is arguably exporting its own high standards of corporate governance to the rest of the world

In the third quarter of 2013, bad loans held by Chinese banks rose by the largest amount in eight years. They climbed by 24.1bn yuan to 563bn yuan at the end of September, according to the China Banking Regulatory Commission (CBRC).

The commission also said the percentage of non-performing loans at Chinese banks had increased to 0.97% from 0.96% over the quarter. But analysts believe this figure underestimates the true extent of bad loans on Chinese banks’ balance sheets, which is likely to range from 1% to 5% of the total.

So you can’t blame the Chinese government for feeling nervous, especially with the country’s growth slowing to an estimated 7.5% in 2013, according to the International Monetary Fund – its weakest performance in 24 years. The country wants to keep attracting investment from overseas markets; it also hopes to encourage more companies to list in Hong Kong. It views mandatory rotation as a way to provide critical reassurance to investors. “The Chinese government sees audit quality as giving the investing public confidence in the Chinese economy – especially the state-owned sector, including the banking sector, which is still dominated by the state banks,” notes Lee. “In an emerging market environment, where the perceived market risks and operating risks are higher, audit rotation can act as a deterrent to possible financial abuse in the short term, and lead to improvement in audit quality in the long term.”

Foreign companies operating in China are exempt from the mandatory auditor rotation rules, but Chinese state-owned entities listed elsewhere will still need to abide by them. So they will apply to China Mobile, which is listed on both the New York and Hong Kong stock exchanges. In this respect, China is arguably exporting its own high standards of corporate governance to the rest of the world.

It is also questioning the self-assuredness of the Western accounting profession, which took a knock at the end of 2013 when the Securities and Exchange Commission barred two US accountancy firms from carrying out future audits after finding they had botched the audits of Chinese companies listed in the US. It may be a misperception that the US has better corporate governance than China, it seems. “We think good Chinese companies list in the US so the Chinese are left with the rotten apples,” says Livne. “It’s the opposite. If you want to list a company in China, you have to show you have at least three years of profit.”

China is also putting its powerful Asian neighbour, Japan, to shame in many respects. Japan has an embarrassing history of accounting scandals that have involved names such as cosmetic company Kanebo, internet service provider Livedoor, brokerage Nikko Cordial and, more recently, Olympus. It is also known as a corporate governance laggard due to the lack of independent directors on many company boards. Japan is trying to get its house in order by introducing a modified version of International Financial Reporting Standards – known as J_IFRS – that companies can use on a voluntary basis, and revising its accounting standards to enhance auditors’ professional scepticism. Japan enforces mandatory audit partner rotation, but does not impose mandatory rotation of audit firms.

Chinese authorities are keeping a close eye on how mandatory auditor rotation for state-owned enterprises and financial institutions progresses. The Chinese Ministry of Finance and the China Securities Regulatory Commission (CSRC) regulate audit in the country and their scrutiny should prevent bad practices that contravene the spirit of the mandatory auditor rotation rules, such as firms poaching entire audit teams from their predecessor to work on an audit they have just won. Meanwhile, a panel including independent experts is charged with the responsibility of appointing auditors when state-owned entities come to rotate. While some political interference in the process is likely, the existence of this panel should help to strengthen corporate governance over audit appointments. The Ministry of Finance meets with the CSRC, the CBRC and the China Insurance Regulatory Commission on a monthly basis to monitor possible systemic risks to the financial system.

“We Westerners tend to take a dim view of China and it’s not always justified,” says Livne. “China is more progressive than many other countries. By taking bold action they’re sending the signal that they’re setting the standard higher. China is now being proactive rather than reactive. It could be that they’re trying to be market leaders.”

 

The auditing profession in China

The Chinese private audit industry in China began in the 1920s, but large foreign firms did not arrive in the country until several decades later.

The firms we now know as the Big Four entered China through Hong Kong in the 1980s and then as joint ventures with Chinese firms in 1992. This followed government reforms that opened up the domestic audit industry to foreign accountancy practices.

By 2015, China is expected to have 10 “super” audit firms, 200 medium-sized firms and 7,000 small and specialised firms, according to a report by the London School of Economics.

Guidelines issued by the Ministry of Finance in 2012 stated that the senior partner of a Chinese audit firm must be a Chinese national and a certified public accountant (CPA).

China’s indigenous audit firms may be growing fast but they still struggle to compete with the Big Four in terms of reputation for quality and perceived independence from government influence.

Sally Percy

 

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