@ Forbes: Chinese Reverse Mergers: The Auditor Angle

My Forbes column today is about Chinese reverse merger companies and recent reports of potential frauds – plural.  I’ve waited to write about this issue, even though many many people have been keeping me up to date with cards, letters, and calls. There are others who have been doing a great job covering it in the meantime, including Eric Jackson of Ironfire Capital who also writes for The Street.com.

The Farce of Small U.S. Auditors in China By Eric Jackson

11/29/2010 2:30 PM EST

Over the last two weeks, a huge drama has been playing out with a small-cap China stock called RINO International (RINO – commentary – Trade Now). The wastewater filtration equipment provider to the Chinese steel industry was accused by Muddy Waters LLC of fraud earlier this month. RINO said nothing in response, dragged its feet and then released the following baffling 8-K last week…

I waited for the inevitable case that implicated a Big 4 audit firm. When it came – two of them at the same time – it coincided with a great new research paper from the PCAOB on the Chinese reverse merger phenomenon and the risks the model presents to auditors and their clients – investors.

Here’s an excerpt from today’s piece at Forbes. There are plenty of links to other reports about the two companies and their auditors that are now in the news for the worst possible reasons – China Agritech/Ernst & Young and China Media Express/Deloitte.

Both China Agritech and China Media Express are listed on NASDAQ because they are Chinese reverse mergers (CRM). A reverse merger is any acquisition of a private operating company by a public shell company that typically results in the owners and management of the private operating company having actual or effective voting and operating control of the combined company. Through a reverse merger transaction, although the public shell company is the surviving entity, the private operating company’s shareholders control the surviving entity or hold shares that are publicly traded. In a reverse merger transaction, the entity whose equity interests are acquired (the legal acquiree) is the acquirer for accounting purposes. Through such a transaction the private company becomes a SEC reporting company with registered securities without filing a registration statement with the US SEC.

A recent research note prepared by the US accounting regulator, the PCAOB, explains how these quickly constituted public companies meet the SEC requirement for audited financial statements.

Companies, including CRM companies, are required to file audited financial statements with the SEC, and the auditors of those financial statements are required to be registered with the PCAOB. ORA staff found that, after a reverse merger transaction, the auditor of the former shell company frequently is dismissed; the post-merger public company usually retains the Chinese operating company’s auditor, which as noted below is often a U.S. accounting firm.

As of March 31, 2010, the PCAOB says the largest number of CRM companies – 94% of the total, 97% of the total market capitalization – are audited by accounting firms that are scheduled to be inspected only every three years. These are small public accounting firms, not the biggest ones. The remaining CRM companies are audited by a firm that is inspected on an annual basis. These are typically the US or Chinese member firm of a Big 4 global network. US-based firms audited 116, or 74% of the CRM companies and Chinese registered accounting firms audited 38, or 24%.

The challenge to the PCAOB when trying to insure quality audits for CRMs is twofold:

1. Smaller US-based audit firms that are only inspected every three years may not have had their Chinese-related engagements reviewed because their relationship with the the Chinese-related client is recent.
2. The PCAOB is forbidden from inspecting Chinese-based firms, even the member firms of the Big 4 global networks. China Agritech and China Media Express were audited by Big 4 firms, but neither of these firms has been inspected yet in China by the PCAOB.

Please go to my Forbes column, Accounting Watchdog, to read the rest.