Chinese Companies Need Vigilant Audit

Some of my readers have shown their interest to the assurance services in BRIC in the comments to the last post. And guess what? The recent issue of The Economist contains the article “Accounting in China”, which reflects my concerns about audit of companies from BRIC in general (see link). The beginning of the article is quite appealing:

“CAN you trust Chinese accounts? Many investors fear (and several short-sellers are betting) that the answer is “no”. Sino-Forest, a big forestry firm listed in Toronto, is a case in point. Last year Muddy Waters, a short-seller, accused it of running a Ponzi scheme, which it denies. On January 31st Sino-Forest released the final report of independent investigators into the charge. Insiders crow that the gumshoes found no smoking gun. The gumshoes grumbled that, lacking access to all the evidence, they were “not able to reach definitive conclusions”.

America’s SEC is trying to force the Shanghai office of Deloitte Touche Tohmatsu, a big Western accountancy firm, to hand over papers related to Longtop, a Chinese software firm that was delisted by the New York Stock Exchange last year. Deloitte refuses, saying this would violate Chinese laws on “state secrets”. Deloitte may have a point. If it co-operates, its local staff could be jailed under Chinese law.”

So, this is the question, which had to be raised sooner or later: can be the companies transparent while operating in the conditions of non-transparent political system? There are no big traditions of Chinese government accountability to citizens of China. The market incentives to provide true and fair financial statements are seem to be not enough.

How to deal with this issue?

China need not take all the blame for the failure to provide true financial statements. The problem is common for all emerging markets. It could be said that the reason for that is not necessarily deliberate misrepresentation. Errors might happen due to lack of knowledge, the absence of open communication tradition.

According to the article in The Economist one of the Big4 bosses acknowledged the issue and insisted that “the Big Four have greatly increased their vigilance in China”. To generalize this comment one can state an implicit rule for the audit of financial statements in emerging markets: the financial statement risk for all companies originated from emerging markets should be assessed as "high" at the beginning of audit unless otherwise could be proven. The proof of lower risk assessment could be obtained after one or two years of audit, which would provide evidence about low susceptibility of systems to errors and effective control system.

I agree that this proposal could be viewed as a strict and reactionary one, but I stated it to initiate discussion of what could be done regarding accounts provided by BRIC and other emerging markets. I expect you to share your valuable ideas in the comments, and we might discuss them.

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