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PCAOB Focuses on Audits of Chinese Reverse Merger Companies

03.28.11

Timothy I. Kahler

Henry I. Rothman

On March 14 the Public Company Accounting Oversight Board issued a Research Note focusing on the audits of reverse merger companies from the China region.  The Research Note, titled “Activity Summary and Audit Implications for Reverse Mergers Involving Companies from the China Region: January 1, 2007 through March 31, 2010,” is the first such paper to be issued by the PCAOB, and follows its July 2010 Staff Audit Practice Alert No. 6 which raised concerns about compliance with standards for audits of companies with substantially all their operations outside the U.S.  These two pronouncements show that the PCAOB is highly concerned about practices in this area, has narrowed its scope to focus on audits of companies from the China region, and may investigate and impose sanctions against accounting firms to raise awareness of these issues.

As context for the PCAOB’s concern regarding the audits of Chinese reverse merger companies (CRMs), the Research Note includes certain statistics: 159 CRMs accessed the U.S. capital markets during the period from January 2007 to March 2010; during that period private operating companies from the China region accessed U.S. capital markets more frequently by CRM transactions than by IPOs; CRMs tend to have relatively lower levels of revenue, assets and market capitalization; and the auditors of many CRMs are “triennial firms,” that is, firms inspected by the PCAOB once every three years (as opposed to annually) because they audit fewer than 100 public companies. 

In both the Research Note and Practice Alert No. 6, the PCAOB identified factors that may have a negative effect on the audits of CRMs: language differences; use of third parties to perform audit work; added travel time and expense; and understanding of local business conditions.  The second factor – the use of third parties – appears to be of greatest concern to the PCAOB.  In Practice Alert No. 6, the PCAOB cited examples of improper reliance on or coordination with third parties, including one case where a U.S. firm signed an audit report after using a China-based third party firm to perform substantially all the audit procedures on the issuer’s financial statements.

Accounting firms that audit U.S. public companies must comply with PCAOB standards, which include the AICPA’s Statement of Auditing Standards No. 1, Section 543, “Part of Audit Performed by Other Independent Auditors” (“AU 543”).  AU 543 requires accountants to decide whether their participation in an audit is sufficient to justify serving as the principal auditor and author of the report on the financial statements.  This decision becomes more difficult as more audit work is delegated to a third party, and AU 543 requires an accounting firm to consider various factors in this regard.

Reverse merger companies and their independent registered accounting firms should ensure that future audits are planned and performed in compliance with AU 543.  In addition, companies and accounting firms may want to assess whether prior audits have been conducted in compliance with AU 543, and whether documentation of such compliance exists in order to permit prompt cooperation with any PCAOB investigation.  In planning future audits, or assessing prior audits, companies and accounting firms should involve legal counsel with relevant knowledge and experience.

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