Big 4: They’re Not what you think
The Big 4 are not what you think and why Chinese SOEs are replacing them.
Recently, Bloomberg made headlines1 when it reported that the Chinese Ministry of Finance (MOF) has urged state-owned enterprises (SOEs) not to renew mandates to so called “Big 4” accounting firms to conduct statutory audits on the financial statements of SOEs.
Immediately after the Bloomberg article was out, wild speculations flooded the media about why the MOF has made such a move and what the consequences could be. The comments revealed two major misconceptions of the public about: 1) the level of assurance that can be obtained from audits by the “Big 4”, and 2) the level of international oversight over reported financial figures of SOEs from “Big 4” audits.
Having worked for a Big 4 for over 20 years, I provide a few facts about what “Big 4” actually means, as they are in substance merely a complex structured international franchise.
First thing to understand: the “Big 4” are not global firms.
When people use the term “Big 4”, they are referring to four brands: PwC, EY, KPMG and Deloitte. Most people think that the “Big 4” are globally acting accounting firms. However, in reality, these four brands are used by international networks, comparable to a franchise. Through numerous agreements, they commit to certain practices to ensure the appearance in public and quality standards are the same. Each of the “Big 4” brand is owned by a separate legal entity in England (PwC, KPMG, Deloitte), and respectively in the UK (EY) .
Similar to the descriptions of other Big 4, PwC’s website describes the situation concisely:
“In many parts of the world, accounting firms are required
by law to be locally owned and independent. Although regulatory attitudes on this issue are changing, PwC member firms do not and cannot currently operate as a corporate multinational.
The PwC network is not a global partnership, a single firm, or a multinational corporation.”
What is a Big Four in China?
In China, the audit firms (i.e. entities) that conduct statutory audits on financial statements are all Chinese companies in the form of an LLP (limited liability partnership). Without getting into the details of the special legal requirements for audit LLPs in China, the most important takeaway is that the partners are (mostly) Chinese nationals and must have the Chinese CPA qualification (CPA = certified public accountant) from the Mainland, which is the CICPA certificate. In substance, they are all ethnical Chinese and there is zero foreign involvement or oversight in these local LLPs. As a matter of fact, many partners in these Chinese LLPs are members of the CPC (Communist Party of China).
That means, Chinese SOEs are audited by Chinese audit firms, which are merely members of global audit networks. They charge them handsomely for using the Big 4 brand, around 3-4% of the annual revenues that these Chinese “Big 4” member firms earn.
Statutory audit in China: how much assurance are you really getting?
There is still common perception that financial statements audited by a “Big 4” in China are a guarantee for the accuracy of the financial figures reported by the audited company. This is not the case. The audit opinion merely states that the figures presented by the management for a past period/cut-off day are in accordance with certain accounting standards based on information provided. Statutory audits do not express an opinion on the overall quality of a company’s business or its management.
Any Chinese CPA with the relevant qualification can issue a so called “unqualified opinion” (i.e. no material issues found) on a Chinese company’s financial statement and it has the exact same legal effect like one that is “Big 4” branded. The only reason why “Big 4” member firms in China enjoy
a higher reputation for audit services is that the brands are globally known and that they have a scale from international client referrals that their non-internationally-branded local competitors do not have.
A Big 4 audit is not flawless in regard to accounting fraud.
Each of the Chinese “Big 4” audit member firms had its share of troubles with Chinese audit clients after accounting fraud or other irregularities became apparent. Most prominent and recent cases are KPMG’s former audit client China Forestry , EY as former auditor of Luckin Coffee4 and PWC5 which has resigned as auditor of stumbled real estate developer Evergrande. Deloitte resigned as auditor of Tianhe Chemicals in 20156 and was also recently fined by the US SEC for letting clients conduct certain audit tasks on their own . The numerous cases of resignations from audits and fines by regulators have impacted the reputation of the “Big 4” audit member firms in China.
With regard to audit outcomes, the track records of SOEs in the public domain is flawless.
This has to do with two important factors: 1) SOEs are controlled by the CPC, and 2) courts in China are not independent.
Regarding point 1, the internal controls in an SOE are extensive, and much better than in private companies. SOEs do not rely on the statutory auditor to find irregularities. They have extensive internal controls that are far more thorough than private companies. Furthermore, the consequences for a fraudster who steals from the SOE are beyond description. The CPC has its own disciplinary commissions who go after executives and staff who embezzle funds of an SOE. That is very different for the private ventures where CEOs have unchallenged powers, whatever governance charts and ESG reporting may say otherwise.
Point 2 is particularly relevant for SOEs. A a good friend and Chinese attorney explained to me that courts in China are not independent. While they are tasked to follow strict procedures and judge any case without prejudice, they are still required to follow the guidance of the CPC and maintain “justice and harmony” - whatever that means from a legalistic perspective. In practice, it is unlikely - if
not impossible - that any shareholder who invested in an SOE via, for example, the HK stock market, can simply hire a lawyer to sue the management of the company or request an instigation by court order.
This also applies to courts in HK, which is a special administrative region of China. While attorneys in HK might challenge the assumption that the courts there are in any way subject to instructions from Beijing, cases involving matters of national importance have to be handled by the local courts in the same way as it is done in the mainland, as explained by several subject matters experts I spoke to and observed in the overall change of the regulatory climate in HK.
The situation for SOEs when subject to US jurisdiction.
A listing in the US is a delicate situation for an SOE. The PCAOB, a US non-profit organization - often called the “auditors’ auditor”- finally made a breakthrough in 2022 when it went to HK to inspect the working papers of China-based “Big 4” audit firms. That means, US experts can now get access to audit work papers of Chinese companies listed in the US and with that, they might be able to obtain confidential information of US-listed SOEs. However, on 9 January 2023, there were only two Chinese SOEs listed at US exchanges. Thus, a review of sensitive details stated in audit work papers is hardly the reason for the MOF to call SOEs to end the audit mandate with Chinese member firms of the “Big 4” networks.
The true reasons why the Chinese government wants the “Big 4” out.
There are three main reasons why the Chinese government wishes to replace the Big 4 member firms in China with large local firms:
1 A system-inherent control paranoia
2 Sinification
3 Cost
1 Control paranoia
Although the China-based “Big 4” entities are under full supervision and control of Chinese regulators and law enforcement, they still operate under foreign brands. They also have affiliated entities who provide all kinds of consulting and advisory services, sometimes with the involvement of foreign nationals flying in. Partners of the Chinese Big 4 member firms travel to international partner meetings and they talk to their member firm counterparts in other countries. The China- based “Big 4” audit firms still have various Hong Kong citizens on board who also have a second citizenship from countries that are having an increasingly strained relationship with China.
Concerns over sensitive data leakage
In a one-party system where total control of all aspects of social and economic life is a dogma of political rule, even the slightest possibility that
an individual might obtain sensitive data from the audit work and somehow get it to someone outside of China, still gives those in charge sleepless nights. Having local firms with partners with PRC citizenship only and no foreigners in important roles would enable total control over compliant behavior of which the most important is to keep the mouth shut.
2 Sinification
Sinification is a political program in the PRC with a wider goal. Strategies such as “Made in China 2025” not only aim at producing certain, strategic products in China, but also those that are made by Han-Chinese-owned companies. Regarding the topic of ethno-centricity of Chinese politics, I recommend the publications of Peter Zeihan, a US geo-strategist who explains very well in his China analyses this phenomenon of ethno-centric policies (although I do not share all his conclusions about China).
SOE executives are usually very well educated and carefully selected. Even those who have received an overseas education, they are socialized over decades in their families and higher education institutions to adhere to the political and traditional norms of the ruling nomenclature. The existence of anything foreign, be it the use of English or foreign brands, is seen as disruptive and inconsistent with the culture within which SOEs operate.
Audit partners and staff of the “Big 4” member firms in China behave in the most-submissive and compliant manner to please their SOE audit clients when pitching for audit mandates or while conducting audits.
Until around 2015, there were numerous audit partners and staff from HK and other South-EastAsian countries in audit functions. Their attitude towards SOEs changed substantially in the early 2010s. This was partly due to a legal change in 2012, which required audit partners to have the mainland CICPA qualification, which most of them did not have.
I recall numerous amusing meetings where these ethnical-Chinese (but none-native Mandarin speakers) made an effort to speak Mandarin - even if it had to be done with a strong Cantonese accent - because they gradually recognized the increasing power of SOEs. They somewhat struggled as they did not fully master the vocabulary, nor the habits of their now most important clients. However, they bowed to the executives of the SOEs and this is what mattered the most to the client.
Furthermore, in many pitching meetings I attended, SOE clients were given all kinds of privileges and price discounts that were unthinkable to be obtained by our large audit and advisory clients from overseas. Despite all these efforts and commercial favoring, the “Big 4” in China are still perceived as an arm of their US-dominated networks and that is something SOEs and the Chinese government can hardly accept.
It goes against the pride of an old and highly advanced culture that a country with the highest achievements in science and technology is not able to have a large audit firm comparable to the size and capabilities of the Chinese “Big 4” member firms.
The “Big 4” in China no longer earn most of their profits from statutory audit work. Their profits from highly restricted audit services with high market entry barriers enabled them to acquire and expand into a vast offering of services, such as management consulting, ERP implementation, market research, risk management, etc.. The Chinese government wishes to build national champions who develop these multidisciplinary skills in China with Chinese staff and has no interest in all kinds of payments that the “Big 4” in China pay to overseas entities in the UK or elsewhere to Asia-Pacific structures, which the “Big 4” have built up over the years.
3 Cost
While this point might not be a priority for the MOF or the SOEs, audit fees charged by the Chinese “Big 4” member firms are significantly higher compared to local competitors that are not part of international networks.
I never forget the remarks shared by my former Chinese colleagues who helped on pitches for audit proposals to an SOE. They talked about the staggering price differences to local competitors. Because of the reputation advantage, the SOE decided to choose a Chinese “Big 4” member firm, but the originally proposed fee budgets had to be lowered substantially. Audit fees matter, they do in the West and so do they for SOEs. SOEs consider the “Big 4’s” high fee levels as taking advantage of their oligopoly. The Chinese government and the SOEs wish to see more price competition for the large volume of audit mandates they provide.
And what happens now? Should investors run away from Chinese SOEs?
SOE stands for state-owned-enterprise and that says it all. For example, more than 70% of the shares of listed ICBC (Industrial and Commercial Bank
of China Limited) are owned by other SOEs as of 31 December 2021 . It does not matter much to SOEs whether they are audited by a “Big 4” or not because it is the Chinese government who controls these entities and China is not short of capital - at least not as far as SOEs are concerned.
If SOEs plan to raise capital through international bond or share placements, capital markets will not trust the name of an audit firm whose name they can hardly pronounce or that sounds so generic that it could also be a producer of traditional Chinese herbal products.
The real implications behind the Bloomberg headline
The real implications of the Bloomberg headline about the MOF’s plan has far more consequences than the immediate capital needs for SOEs. It is another piece of the declining confidence that the outside world has in China’s intention to be part of the global business community. Instructing the SOEs not to choose certain audit firms because they are seen as connected to foreign organizations is entirely a political move. It would be another evidence that SOEs are not regular competitors, but political entities.
There are many good reasons to criticize the audit quality of the “Big 4”. There have been too many cases, not only in China, where even the most obvious accounting fraud and reckless management estimates were not detected by the “Big 4” auditors. They have created consulting oligopolies with their profits from their regulated and protected audited services and done little to avoid conflicts of interests. However, they got sued in the US and UK and paid hefty fines for their behaviors. As a consequence, they improved their policies and documentation.
It’s an issue of trust and perception.
Conclusion: Does it really matter whether an SOE in China is audited by a “Big 4”?
Not allowing the market to determine who is best for the job and instead nurturing local audit firms through protectionist measures will certainly create meaningless audit reports a skilled investor will not trust.
The business climate in China is often much better than what is reported in the Western media, but the increasingly protectionist and anti-internationalist attitude of Beijing would be even more in the focus and maybe reported about if SOEs are instructed by the government to stop using the Chinese “Big 4” member firms.
