PCAOB: Audits of Chinese Reverse Mergers Create Compliance Concern

A PCAOB research note released on Tuesday attributes instances of noncompliance with AU section 543 to the increasing prevalence of transactions the regulator classified as Chinese reverse mergers (CRMs). The PCAOB’s research assessed data from a July 2010 audit alert that had raised a concern that some U.S.-registered accounting firms may not be properly conducting audits of companies with operations outside the U.S.


Research Note 2011-P1, “Activity Summary and Audit Implications for Reverse Mergers Involving Companies from the China Region (January 1, 2007 through March 31, 2010),” was prepared by the PCAOB Office of Research and Analysis (ORA) to provide further context to the issues discussed in Staff Audit Practice Alert no. 6 issued on July 12, 2010.


The research said that 159 companies from the China region accessed U.S. capital markets through a reverse merger transaction or CRM between Jan. 1, 2007, and March 31, 2010. The companies had combined market capitalization of $12.8 billion as of March 31, 2010. A reverse merger was classified as a CRM if the private operating company that merged into the public shell company was incorporated in the China region, had its headquarters in the China region, or its revenue or production cycle was substantially based in the China region. The China region includes the People’s Republic of China, Hong Kong and Taiwan.


The PCAOB found indications that U.S. firms, when auditing CRMs, were not properly applying AU section 543, Part of Audit Performed by Other Independent Auditor, which applies when an auditor uses “the work and reports of other independent auditors who have audited the financial statements of one or more subsidiaries, divisions, branches, components, or investments included in the financial statements.” The standard does not contemplate an auditor taking responsibility for the work of another auditor that has audited an issuer’s financial statements substantially in their entirety.


In one example, a U.S.-registered accounting firm retained an accounting firm in the China region, and the audit procedures performed by the other firm constituted substantially all of the audit procedures on the issuer’s financial statements. The U.S. firm’s personnel did not travel to the China region during the audit, and substantially all of the audit documentation was maintained by the firm in the China region. The board’s inspection staff cited other situations in which U.S.-registered firms engaged assistants from outside the firm for audit work on companies with substantially all of their operations in another country, where the U.S.-registered firm’s involvement in the audit work performed by the consultants was insufficient for the firm to assert that the audit provided a reasonable basis for the firm’s opinion on the financial statements.


The report said that, while reverse merger transactions, including CRMs, are not inherently problematic, CRMs often result in a company with substantially all of its operations in the China region having its securities trade in the U.S., often with its financial statements audited by a U.S. auditor. The PCAOB in Audit Practice Alert no. 6 first raised a concern that some U.S.-registered accounting firms may not be following PCAOB standard when conducting audits of companies with operations outside of the U.S. The alert said the following factors may have a negative impact on the audits of such companies:


  • The need to understand the local language;
  • Use of local audit firms or assistants from an outside firm to complete a portion of the audit work;
  • Additional travel time and expense necessary to complete an audit; and
  • The need to understand the local business environment in which the client operates. 


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