Safety/Risk Model - History of Auditors

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Auditors

(accounts for 30% of the final score)

History of Auditors (30/100)

Auditor changes are very common in the group of small cap Chinese companies, and it's not necessarily a bad thing if an audit committee finds such a change desirable. As a rule of thumb for the general U.S. markets (statistics from 2007), about two thirds of auditor changes were initiated by the companies (dismissing their previous auditors), while in the remaining cases the auditor resigned.

Companies may dismiss their auditors for reasons that are welcomed by investors, such as enhancing overall audit quality, looking for a new auditor that spends more time with the client, or engaging a new auditor with best-of-class reputation in the market to enhance credibility and strengthen investor confidence. But they might also dismiss their auditors just for getting cheaper audits, or even for avoiding all those unpleasant questions and demands their current accounting firm might force upon the company for signing off on the financials. If auditors disagree with management on key areas of accounting, companies might shop around for an audit firm that agrees with their viewpoints. There are many examples for all those reasons in the China small caps space.

Auditor resignations are similarly ambivalent. We will likely see more small firms, especially U.S.-based firms with no permanent presence in China, to resign from Chinese accounts, in order to avoid the now stricter compliance requirements of the PCAOB. Some small firms might decide to generally withdraw from auditing public companies. There might also be personal reasons, disagreement on the fees, or any other company-specific reason that is not necessarily indicative of any wrong-doings in the audited company. However, auditors that resign are more likely to have reasons that should concern investors. The CPA firm might just decide that this client is no longer worth the risk, there might be restatements looming or the company lacks sufficient internal controls over financing reporting and inadequate professional staff. A worst-case scenario would be that the auditor simply no longer trusts management.

Investors are usually left in the dark when it comes to the real reasons for auditor dismissals and resignations. Confidentiality rules prevent the CPA firms to go public with their findings, and the companies will do everything they can to present auditor changes in a positive light. That makes adding auditor continuity to our safety/risk model a tricky task, and investors are encouraged to dig into the details of frequent auditor changes with Chinese companies. We give the highest weight to a stable, long-term relationship between a company and their auditor, and to companies that have initiated an auditor upgrade when they reached a certain level of maturity as a public company.

• 30/30 - No Changes (Last 2 Years)
• 25/30 - One Change (Upgrade, Last 2 Years)
• 10/30 - One Change (No Upgrade, Last 2 Years)
• 0/30 - Two or More Changes (Last 2 Years)