Paul Gillis is Professor of Practice at Peking University's Guanghua School of Management and Editor of China Accounting Blog
"If the trade war continues to escalate as Trump has threatened, there's going to be a big impact on the capital markets... I expect that we're going to see a winter in IPOs next year."
Paul, you've gotten to this point where you've become this guru for all issues related to accounting in China. How did that journey come about?
I came to China 21 years ago. I was transferred here by the international accounting firm PriceWaterhouseCoopers. It was Price Waterhouse at the time. I was in China with them for seven years. Then I took early retirement from PwC and I tried playing golf for a while, but got bored with that. So I went back to school. I first studied theology. I enjoyed the academic side of it, so I decided to get a PhD in accounting. I chose, as my topic for my dissertation, the development of the accounting profession in China.
One of the things that I discovered in my research was that there were gaps in the regulation of Chinese companies that were starting to rush to U.S. stock exchanges in the early 2000s. Those gaps in regulation were likely to lead to an environment where there might be a lot of fraud. I predicted it would happen in my doctoral dissertation. About the time I finished it, it all came true. There were over 100 cases of fraud brought against overseas-listed Chinese companies. My work came to the attention of the Public Company Accounting Oversight Board (PCAOB), which asked me to serve on their standing advisory group. And also a lot of hedge funds and other market participants got interested in what I had to say.
My blog, The China Accounting Blog, got quite a bit of attention. After a while, basically, everybody who was following the China stock market was reading what I was writing. That has led to me being, probably, the leading Western expert in Chinese accounting and auditing problems for overseas -listed Chinese companies.
Why Audit Procedures Fail in China
How would you say that the accounting profession has evolved in response to those problems that were uncovered with the accuracy of financial reporting, starting about eight years ago?
I believe a lot of the problems were caused because when auditing came to China — which was really brought here by the foreigners — they brought international auditing practices and standards to China. They didn't modify them for Chinese business practices. The key factor is there's an assumption in international auditing standards that collusion is quite difficult, because it's hard to get people to cooperate in committing a fraud.
What we learned in China it's actually easier to get people to cooperate than in other markets. Because of concepts, like guanxi, where people have relationships that are viewed as more important than in other jurisdictions. Auditing standards were really not designed to catch those. For a fraudster, who wanted to commit a fraud, it wasn't hard to circumvent the standard processes so they wouldn't get caught by the auditors.
Did you ever think about taking the research from your doctoral thesis, and turning it into a book that would talk about the evolution of the accounting industry in China?
I did actually publish a book, The Big Four and the Development of the Accounting Industry in China. It was really an academic book. It was published in 2014. It didn't sell very many copies, but it gets cited quite a bit in academic research.
You’ve written quite extensively about the challenges that the PCAOB faces in accessing working papers and doing inspections of the affiliates of the Big Four that are based in China. How does that issue stand today? What do you think the outlook is for resolving it, longer term?
Well, I think the issue has largely been dropped. It was a favorite issue of the past chairman of the PCAOB, James Doty. He seemed to be committed to getting this issue resolved. What has happened in the recent administration is that a new chairman was appointed at the SEC by Donald Trump. That new chairman at the SEC, Jay Clayton, was Alibaba's counsel on their IPO. He has basically replaced the entire PCAOB. The new board does not seem particularly interested in taking this issue up.
Now, it's gotten some attention in Congress, in part, because of the documentary that came out earlier this year called, The China Hustle. Marco Rubio has been making some noise that the Chinese should be required to comply with all U.S .laws or they shouldn't be listing their companies in the United States. That's a position I would agree with. However, I don't know that, that's going to go anywhere.
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The issue with the lack of PCAOB inspections. How does that impact multinationals that have significant operations over in China?
The lack of the inspections simply means that there's no independent regulator looking to determine whether the audits are being done in accordance with American auditing standards. That is troubling to investors and to multinational companies that are counting on the auditors to be their eyes at looking at what's going on in China. Should the PCAOB ever get tough on this issue, it could actually ban the auditors from practicing in China, which the SEC attempted at one point in time. If that were to happen, that could cause some significant problems for a lot of the American multinationals that are operating in China.
Big Four vs. China's Domestic Auditors
Despite these regulatory challenges, it seems that the Big Four's businesses in China have actually been thriving in the last couple years. How is the market currently divided between the Big Four and domestic Chinese audit firms? How do you see that relationship evolving?
The local accounting firms have grown quite spectacularly over the past decade. In fact, two of them grew large enough to kick the two of the Big Four out of the top firms and become two and three in China. They have slipped back since. Interestingly, the Big Four have outperformed the local firms in the last couple of years.
I think the reasons for that are, one, there has been a resurgence of large Chinese IPOs in the United States, which are done almost exclusively by the Big Four accounting firms. Second, the Chinese regulators have gotten pretty tough on the local firms. In fact, two of the largest firms in China faced temporary bans on their practice in China, because of audit failures on companies listed on the Chinese stock exchanges. That basically shut them down for a period of time, which meant they lost clients and shrunk in size.
Now, you mentioned Alibaba in the context of the appointment of Jay Clayton. Alibaba, Tencent, and others have been able to raise an enormous amount of money through overseas listings. Up until this summer, investors had, generally done well with those investments. How do you think that this period of escalating trade tensions will impact that trend for overseas listings?
Most of these big Chinese companies that have listed in the United States — like Alibaba, Tencent or JD.com — are not particularly hit by the trade war, because they don't actually do a lot of cross-border trade. Alibaba is primarily selling goods that are made in China to people in China.
But we're already seeing a lot of volatility in the stock market as companies start to disclose that they have less than ideal prospects for growth earnings going forward because of economic uncertainty around the trade war and new Chinese government directives. If the trade war continues to escalate as Trump has threatened, there's going to be a big impact on the capital markets.
I would predict that we'll see a huge correction in the stock market if the tariffs go to 25% because so many companies are going to lose access to the China market, and then at the same time they're going to be facing these high import duties on imports into the United States. That will cause huge disruptions to their supply chain.
Then that will kill the market for IPOs, because trying to do an IPO into that kind of market headwind just doesn't make a lot of sense. I expect that we're going to see a winter in IPOs next year.
Now, these larger tech companies like Alibaba and Tencent have also been voracious investors in smaller companies. A number of these investees or subsidiaries have been also going public, either in Hong Kong or in the US. From an accounting perspective, what issues does that pose, if any?
What's happening is that as these companies get big, the rates of growth that they've had are very hard to sustain for a long period of time. So they start looking for new sources of revenue. One thing the Chinese have figured out very well in the internet space is that there are two types of businesses. There are those who have platforms and those that provide services. Those that have platforms need to go acquire companies that provide services in order to have things to sell on their platforms.
So you have the big platform companies like Tencent that have done lots of acquisitions of businesses that are often unrelated to their original business as they try to expand. We've seen the same kind of thing happening with Alibaba.
One of the trends in China, which you don't tend to see as much in other places, is that if a company has a division that is doing well, they will package that as a separate company and then do an IPO of that company. This can often increase value because the new company may sell at a very high valuation, much higher than just being included in the public company.
But when these spinout deals first get put together, Chinese management cuts themselves in for a big stake that does not come through as compensation expense. Basically, management is forming this investment company that then goes and acquires the soon to be public company before taking an IPO. They manage to skirt the accounting rules that would require them to record compensation. Now, it does take a lot of value away from the existing shareholders. Yet management often ends up with a pretty big stake in the spinout for really just doing their job.
I know some investors have complained about it, but there's a lot of money at stake, and the boards have tended to not stand up to it. The investment bankers make a lot of money on these transactions, so they have tended not to complain about it, either.
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Chinese Unicorns and Outlook for IPO Market
Right now, China has a huge number of private tech companies that have multi-billion dollar valuations that are getting cued up to go public. Where do you think that most of these Chinese unicorns are going to end up listing? Will it be domestically or overseas?
There’re a lot of unicorns in China right now. Almost as many as in the United States, maybe even more now. Hong Kong has made a push to try to attract some of those unicorns. It used to be that none of them went to Hong Kong, because Hong Kong had a couple of rules that got in the way. First, they needed a track record of profitability, and these companies tend to want to do an IPO before they've actually turned profitable or when they've just turned profitable.
Second, the Chinese executives like structures that allow them to keep control of the company even if they have sold down the majority of the shares to public investors. The only jurisdiction that allows that is the United States. It's a concept you see used by many tech companies in the US. It came about after Steve Jobs got kicked out of Apple by the board. Companies like Google and Facebook have all had provisions where they have a class of stock which is held by the founders that has most of the voting rights. The shares that get sold to the public have no voting rights or reduced voting rights.
The United States has the only major stock exchanges in the world that tolerate that kind of structure, which is criticized by all corporate governance groups worldwide. Hong Kong lost the Alibaba listing to the New York Stock Exchange because it would not modify its rules. After it lost the Alibaba listing, it became apparent that Hong Kong was not going to see another private technology company from China listing in Hong Kong again if it didn't change its rules. So now unicorns that want to list in Hong Kong are permitted use dual-class shares, and they're also waiving the profitability track record requirement.
That allowed Xiaomi to list in Hong Kong. This summer The Xiaomi offering was reasonably well-accepted, but the stock has done horribly since the IPO. As part of the Xiaomi IPO there was a proposal that Chinese citizens would be able, not just to buy shares through the Hong Kong-Shenzhen Connect, but actually buy them directly on a Chinese stock exchange using CDRs. But the deal fell through.
That was actually my next question. Back in the spring there was a lot of excitement about the potential for CDRs as a way for these larger Chinese companies listed overseas to raise money domestically, and let domestic investors participate in their growth. That seems to have completely dissipated. What's the prospect for CDRs?
Right now there's not a lot of attention being paid to it, and the main reason is that the Chinese stock indexes are doing so poorly. At this point, it’s the worst-performing major stock market in the world. There’s no interest in listing on the Chinese stock exchanges.
But the CDRs are not a bad idea. One of the big problems in China is that Chinese people cannot buy shares of some of China's most successful companies. If they're on New York or NASDAQ, particularly, you've got to get U.S. dollars to buy those shares, and China quite strictly restricts the ability of Chinese people to get U.S. dollars.
Long term, I think these companies will probably all be listed in China. Even if the CDR structure compromised a lot of China's corporate governance concepts by allowing loss-making companies and dual-share structures to list in China, it's a good first step. Eventually these companies could end up buying back shares off of the U.S. and Hong Kong exchanges, and effectively move the listing back to China. I think that will happen. But it's going to take a decade or more before it gets done.
You've written extensively about the risks involved with the VIE (variable interest entity) structure that many companies use in order to be able to consolidate their financials and list overseas, while not violating Chinese laws on foreign ownership. Do you think this structure is now becoming more legitimized under Chinese law, or is it still completely at risk?
The Future of VIEs
I think the structure is not legitimized at all. However, I think the Chinese regulators have gotten comfortable enough to look the other way. I think they are very pragmatic about this. Their belief is that there's more benefits to allowing foreign investment in their tech sector than there are detriments to not following the rule of law that would say that foreigners should not be investing in this sector.
I think it gets resolved over time by modifying the foreign investment rules as opposed to legitimizing the VIE structure. In effect this will make the VIE structure unnecessary, because you'll be allowed to invest directly, as opposed to using an entity that's controlled by contracts. Contracts are never going to be as effective as ownership for the shareholder's purpose.
The other problem that's coming up with VIEs is that, operationally, they're proving much more difficult to use as these companies mature. That's because it's virtually impossible to move profits out of a VIE and off to the public entity in a tax-effective manner. China's tax laws and currency laws make it really difficult to do that. So most of these companies are just accumulating the profits in the VIE, and to the extent that they need cash offshore, they just borrow money offshore.
I did notice that the CDR implementation rules, that it seemed to acknowledge the existence of VIEs as being semi-legitimate.
You've also been critical of so many efforts to reform accounting regulation in Hong Kong. How did the Hong Kong accounting profession evolve, and do you see it changing?
Well, the Hong Kong accounting profession is self-regulated, which means that the Hong Kong Institute of CPAs functions as both the membership advocate, like the AICPA is, as well as the regulator. Like the PCAOB or the state boards of accountancy. That conflict has led to Hong Kong tending to not enforce the rules very strictly against accounting firms. There have been some really egregious situations of misbehavior among Hong Kong accountants that has basically been left unpunished, or given a minor slap on the wrist.
The European Union took a look at Hong Kong, and decided that Hong Kong no longer qualified for regulatory equivalency. In the past, an EU regulator could treat work done by a Hong Kong regulator as if they did it themselves. They could trust the Hong Kong regulators to do it. But they said, "Hong Kong doesn't meet our standard."
That was very embarrassing to the profession, and Hong Kong proposed legislation to transfer the regulation of the accounting profession, at least with respect to public companies, away from the Hong Kong Institute of CPAs, and into the Financial Reporting Council . That will be a good move. I strongly support that move. But it has taken forever to move through legislation. It's been going on for several years now.
Role of Short Sellers in China
You mentioned earlier that short sellers had played a key role in flushing out companies with serious accounting deficiencies. But in some of these cases, the companies that were declared to be worthless went on to thrive and in some cases re-list domestically in China at much higher evaluations. How would you grade the accuracy of these short sellers in general?
I think the short sellers usually did a pretty good job. It was a target-rich environment. For a while there, it was almost harder to find a Chinese company that wasn't committing fraud than to find one that was.
However, some of the short sellers have a tendency to throw the kitchen sink at a company, and they make all kinds of allegations. And often, their allegations don't actually pan out. But when the investigation would take place, sometimes other problems would surface.
They haven't been very successful in the last five or six years in China. First, I think they caught most of the low-hanging fruit. Second, trying to do short selling into a bull market is operating against head winds, and so I think that that has made it tougher.
We may see some return of the short sellers now that the market has returned to more of an equilibrium or even bear market. I think they got most of the easy ones already. I think the auditors upped their game, and I think they're generally doing a better job. The real opportunity is probably on the Chinese exchange, but you can't sell stocks short in mainland China.
Given the writing that you do on your blog is often pretty skeptical about the accounting profession, I'm just curious how your former colleagues react to your writing and this new direction in your career?
Well, they're not always happy with it. But it's my job to call it the way I see it. I know that the Big Four firms, they all read what I write. I can see that. And they sometimes complain, but it's my job.
"I do see that a change in attitude over the last couple of years, and one that seems to be accelerating. I think China is more and more starting to feel its oats, and to view that the Chinese have what they need."
Now, you're also a professor at Peking University's Guanghua School of Management. I'm curious, has the environment changed significantly in the last couple of years in terms of what you're allowed to teach? And what do you observe about the attitudes of your students, and the next generation of Chinese business leaders?
Well, I've not faced any difficulties with the university with respect to the work that I do. Peking University is China's leading university. We're expected to raise issues that are provocative when they influence policy, particularly where they can influence it in a positive direction. And so that is what I'm expected to do.
I do see that a change in attitude over the last couple of years, and one that seems to be accelerating. I think China is more and more starting to feel its oats, and to view that the Chinese have what they need. They don't need as much foreign expertise as they once did. That hasn't turned into any kind of hostility yet towards me, but I think I'm probably the last of the breed.
And following on that question, if there was a young accounting professional today who wanted to follow in your footsteps and try and build a career in China as this enormous, high-growth economy, what advice would you give to that young man or woman?
I think there's two things you really need to be successful in China. One is, you've got to have competent language and cultural skills, and you're only going to get those by spending a lot of time on the ground in China and working hard at it. Secondly, you've got to be really good at something. And the best way to get good at something is do it in your home country. Become a great accountant somewhere else and then get transferred to China. Don't come to China as an upstart expecting to start a career here. There's no purchase in that.
Thanks so much, Paul. I’ve enjoyed it and look forward to seeing what you write next.