http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2402330

Posted by Nureen CHAN Wan Wei, Year 4 undergrad at the School of Accountancy, Singapore Management University

The paper first highlights that China has a different legal landscape to the U.S.. Public enforcement in the form of government sanctions against audit firms is used in place of private enforcement (class action law suits in the West) to ensure high quality audits in China. Shareholder litigations are far and few, and rarely successful even when the government has imposed penalties on these auditors. This makes one question why did the Chinese government choose to deviate from the norm of allowing the free market to regulate audit firms?

The author reached a conclusion that “despite a very different legal landscape, it appears government sanctions in China have a similar effect on audit quality as litigation does in the U.S”. However, I would like to point out that this statement was made after examining the TYPES of firms that are likely to be fraudulent, for example, firms with lower ROA, book-to-market, market capitalization etc. While this highlights the common characteristics of fraudulent firms in China and the West, it does not seem to be useful in proving the effectiveness of government sanctions. The author’s use of “similar effect” should not be taken to mean that the Chinese way is as effective as the Western style.

This brings me to my discussion question: If government sanctions are not more effective in improving audit quality than private lawsuits, then what is the motive of the government?

Here is my view, which is definitely up for debate.

Despite recent attempts at liberalization, China still experiences high state control, monitoring and censorship. In recent years, regulations are used to encourage the merger of small and medium-sized audit firms into larger firms, as mentioned in the paper. This consolidation effort might be a devious scheme to allow for easy monitoring of the audit firms. Just this year, China was also under fire for obstructing SEC’s fraud investigations on Chinese listing by withholding financial records on the premise that they are no longer public records under its secrecy rules.

Following this argument, my conjecture is that government sanctions could be another tool to keep audit firms within its tight reigns. This is pertinent, as the authorities do not want auditors calling foul on critical companies, such as state-owned enterprises or Chinese firms making inroads to foreign capital markets. Out of fear of having their licenses revoked, audit firms are forced to abide to the government’s bidding and help cover up the number fudging. Boosting audit quality was never on the agenda.

Recent articles posted on this page seemingly suggest that the Chinese government is making progress in uncovering fraud, which is commendable. However, I believe that there are many Chinese fraud cases that are still left concealed ON PURPOSE. Not all companies are equal in China; some are more “deserving” of government protection due to economic or political reasons. This is one of the benefits of being in the good books of the Chinese government.