PCAOB reports unfettered access to inspect and investigate audit firms in Mainland China and Hong Kong

The Public Company Accounting Oversight Board (PCAOB) is the independent regulatory agency established by Congress to oversee the audits of public companies and broker dealers. The PCAOB, however, has long been frustrated in its attempts to fully inspect and investigate audit firms located in the People’s Republic of China (PRC), including the Hong Kong Special Administrative Region of the PRC.

Thanks to the legislative pressure applied through the adoption of the Holding Foreign Companies Accountable Act of 2020 (HFCAA), that has now changed. On December 15, 2022, the PCAOB announced that – for the first time in its history – it had been granted complete and unfettered access to inspect and investigate audit firms in the PRC.

Background

Historically, the PCAOB’s attempts to conduct unfettered inspections or investigations of PCAOB-registered PRC-based auditing firms was frustrated by positions taken by Chinese authorities, such as assertion of “state secrets” laws and protections over certain materials. Auditors in the PRC were reluctant to share audit work papers with the PCAOB due to their fear of potential prosecution for the violation of such PRC state secret-related laws and regulations. A 2013 Memorandum of Understanding on Enforcement Cooperation among the PCAOB, the China Securities Regulatory Commission (CSRC) and the PRC Ministry of Finance (MOF) did not result in any substantial progress towards resolving this issue.

To address these obstacles and to put the PCAOB on the same footing with respect to inspections and investigations of PCAOB-registered firms in other foreign jurisdictions, in 2020 Congress passed the HFCAA which, among other things, granted the Securities and Exchange Commission (SEC) authority to delist companies from US securities exchanges if their accounting firms could not, as a result of local laws or otherwise, be inspected by the PCAOB for three consecutive years.

On December 16, 2021, pursuant to that law and PCAOB Rule 6100, the PCAOB issued a report determining that was unable to inspect or investigate PCAOB-registered public accounting firms headquartered in the PRC because of positions taken by authorities in those jurisdictions. The SEC then began publishing a list of PRC-based US-listed companies whose securities might be delisted under the HFCAA.

With the HFCAA clock ticking, the PCAOB, the CSRC and the MOF engaged in extensive negotiations toward achieving a comprehensive bilateral access agreement. On August 26, 2022, the PCAOB, CSRC and MOF announced that they had reached such an access agreement, one that included detailed provisions governing the PCAOB’s ability to conduct inspections and investigations of PRC-based firms consistent with its statutory oversight mandate.

Under that agreement:

• The PCAOB has sole discretion to select the firms and audit engagements to be inspected and the potential violations to be investigated – without consultation with, or input from, the CSRC or the MOF
• There are specific procedures PCAOB inspectors and investigators must follow to view complete audit documentation and for the PCAOB to retain information as needed and
• The PCAOB is given direct access to interview and take testimony from all relevant audit personnel.

After the agreement was announced, beginning in September 2022, PCAOB staff began work to conduct inspections and investigations of audit firms pursuant to the newly executed access agreement. These inspections and investigations included (1) the inspection of a total of seven audit engagements and (2) taking testimony in connection with two investigations of PRC-based firms and associated persons.

The PCAOB’s announcement

Based on the successful inspection and investigative work that the PCAOB completed following the agreement, on December 15, 2022, the PCAOB announced that it had “concluded that, consistent with the HFCAA, the [PCAOB] is able to inspect and investigate completely firms headquartered in mainland China and Hong Kong … in a manner consistent with the provisions of the Act and the rules of the Board, as interpreted and applied by the Board.” Consequently, the PCAOB vacated its December 2021 determination to the contrary.

Comments from the SEC

While SEC Chair Gary Gensler and Commissioner Jaime Lizárraga both praised this new development, each expressed caution, with Chair Gensler noting that:

• The positive development relates only to 2022 and the PCAOB must continue to receive access in 2023 and beyond
• The PCAOB’s announcement relates only to access and does not address the quality of the audits
• PRC-based companies that participate in US markets must provide “specific and prominent” disclosure regarding “heightened operational and legal risks they face” and other material disclosures in light of PRC regulatory developments and the variable interest entity structure, as required by the HFCAA and
• PRC government or party involvement in issuers’ governance and operations should also be disclosed.

Commissioner Lizárraga also cautioned that compliance with the HFCAA requirements for one year does not guarantee future success, and a future failure will restart the three-year mandatory delisting clock.

He also expressed support for shortening the mandatory delisting period to two years, as Congress is currently considering in the form of the Accelerating Holding Foreign Companies Accountable Act.

Key takeaways

The PCAOB’s announcement is momentous and – at least for now – stops the HCFAA delisting clock and removes the potential threat of delisting for some companies, many of which had already started making contingency plans or taken actions involving alternative listing venues. It also may make the US market more attractive for new listings by PRC-based companies by tempering this risk of a future involuntary delisting.

The Chair of the PCAOB, however, was only cautiously optimistic, noting that the PCAOB “does not have to wait another year to reassess its determinations” and, if it finds it lacks complete access to inspect or investigate firms in the future, “the Board will act immediately to consider the need to issue a new determination.” The announcement also leaves little doubt that the PCAOB intends to vigorously enforce its statutory mandate to inspect and investigate PCAOB-registered accounting firms regardless of their location. In that regard, the PCAOB has revealed that it has already identified audit firms for inspection in 2023 and 2024, which would enable the PCAOB to inspect all registered firms in the PRC that would be due or overdue for inspection by the end of 2024. Similarly, the PCAOB has already opened additional investigations of PRC-based auditing firms during the course of 2022 and is likely to open more investigations into 2023 and beyond.

Separately, the comments of Chair Gensler and Commissioner Lizárraga emphasize that the SEC will remain vigilant and that the PCAOB’s ability to perform its oversight functions is just one step towards protecting US investors.

Public companies that have retained a PRC-based registered public accounting firm to issue an audit report should closely monitor PCAOB inspection findings and discuss any such findings with that auditor. Further, those companies should continue to evaluate their disclosures in light of the HFCAA.

PCAOB-registered PRC-based auditing firms should assess whether their systems of quality control are adequate to provide reasonable assurance that audits fully conform to PCAOB auditing and professional standards and PCAOB rules. Further, those firms should ensure they are appropriately advised on how they can cooperate with the PCAOB without risking running afoul of PRC law.

If you have any questions regarding the PCAOB’s announcement or the impact on your business or auditor relationship, please contact any of the authors or your DLA Piper relationship attorney.