The U.S. Must Challenge China's Accounting Standards

The SEC should be praised for its stance, but more action is needed.

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Richard A. D’Aveni is Bakala Professor of Strategy at Tuck School of Business at Dartmouth College in Hanover, New Hampshire. Strategic Capitalism, his fifth book, was recently published. Professor D’Aveni is listed in the top 25 of the Thinkers 50, a global ranking of the top management thinkers in the world. See www.richarddaveni.com.

There is new hope that the important but problematic role accountants have played in translating the financial records of China's state capitalist system for the global economy may be corrected.  Witness the Securities and Exchange Commission's move to charge five large accounting firms with securities violations for failing to turn over audit documents of U.S.-listed Chinese companies.

The nine Chinese companies under S.E.C. investigation for fraud have so far been shielded by China's assertion that the detailed documents about their books would reveal "state secrets." To do so it has barred the Big Four accounting firms' local affiliates (along with that of the smaller BDO firm) from passing the secret documents onto U.S. regulators. The Chinese behavior is unacceptable and the United States  must deal aggressively with this problem.

Perhaps the most important reason that the Chinese refuse to cooperate is that they have something really important to hide. The "secrets" are almost certainly not sensitive military details. More likely, they may reveal evidence of criminal fraud, embezzlement, and bribery at some of the largest firms in China—including firms with close links to the Communist Party leadership. No one will know for sure unless the Securities and Exchange Commission gets its way.

[Read the U.S. News Debate: Should Congress Interfere with China's Currency Policies?]

Here's why it is important for greater transparency and S.E.C. regulation over international auditing firms operating in China. The current lack of transparency in China plays a peculiar role in maintaining the status quo. Suppliers in China allegedly pay frequent kickbacks in return for contracts from larger state-owned firms. Such bribes can't be publicly disclosed without triggering awkward questions—particularly since Party leaders or their families and associates are often the beneficiaries. Yet papering over these bribes is increasingly difficult as the missing sums have grown ever larger. In a country where Bloomberg News calculates that the 70 wealthiest members of its national legislature are worth a combined $90 billion, there are plenty of "state secrets" to be hidden.

The Communist Party has managed to keep the problem in the background domestically. Yet their ability to do so may be reaching its limits. As its companies have increasingly sought listings on global markets over the past decade, China Inc.'s corruption, and the faulty accounting that disguises it, have become international concerns. Western markets depend on transparency and accurate accounting, but China can't have American or European auditors exposing facts that might embarrass the Communist Party. Otherwise, revelation of connections between the party and wealthy individuals might create unrest among a population already concerned about the country's growing gap between rich and poor.  Moreover, once properly accounted for at the firm level, China's national growth rate, and hence its economic power and the strength of its currency, may turn out to be overstated. So China has a lot to lose.

[See a collection of political cartoons on the economy.]

So do U.S. and other overseas investors, who have poured billions into Chinese shares. To protect them, the United States and its allies can take three important steps.

First, pressure China to end the practice of allowing the country's large corporations such as web giant Baidu to list on U.S exchanges through offshore shell companies in the Cayman Islands and other regulatory and tax havens. As my colleague Paul Gillis of Peking University has long argued, this allows the companies to shield themselves from both U.S. and Chinese regulations.  

Second, raise the auditing standards of American companies operating in China and other emerging markets. To get around directly paying bribes, American companies often pay locally-connected middlemen, or "agents," to arrange contracts or eliminate bureaucratic delays. U.S.  companies currently benefit from these practices and China's poor accounting because it shields them from potential prosecution under the U.S. Foreign Corrupt Practices Act. The accounting profession should push for accounting and auditing standards that actually expose this behavior and it should push to close this loophole in the law.

[See 2012: The Year in Cartoons.]

Third, move rapidly to delist Chinese firms from U.S. exchanges if China doesn't reform to bring itself in line with U.S. accounting and auditing standards. U.S. listings were supposed to help bring transparency to corporate China. They haven't; as a result our own investors are sitting ducks.

President Obama has made managing China's emergence a second-term priority. Challenging China's accounting and audit standards may not make for easy sound bites for the evening news, but delaying action will only allow the Chinese Communist Party to perpetuate a corrupt system that risks destabilizing our own economy. And failure to confront this issue will make reform more difficult in the years to come.

  • Read Ryan Alexander: 4 Common Sense Ways Congress Should Deal With Our Finances
  • Read Hester Peirce: 10 Ways Dodd-Frank Will Hurt the Economy in 2013
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