Auditors Not Licensed to do Fieldwork in China?

A stunning Form 8-K, filed last night by currently halted Chinese food company HQ Sustainable Maritime Industries (HQS), suggests that most U.S.-based auditors of Chinese companies are not even allowed to perform the necessary fieldwork, if they are not officially licensed to conduct auditing services in China. The text explicitly mentions "collection of information directly from the sources of such information, such as vendors, customers and financial institutions."

During the course of the audit work relating to the Company's consolidated financial statements for the fiscal year ended December 31, 2010, the Company learned that Schwartz Levitsky Feldman LLP (SLF) was not licensed to provide auditing services for the Company and its PRC subsidiaries in the People's Republic of China (the PRC). This information came to the Company's attention when SLF insisted upon application of certain heightened, more stringent procedures than those utilized by SLF in prior audits of the Company's financial statements. Specifically, those procedures related to confirmation and verification procedures that involved the collection of information directly from the sources of such information, such as vendors, customers and financial institutions in connection with the 2010 audit work. SLF's attempt to implement these new direct collection procedures raised the issue of SLF's lack of PRC licensing since such licensing is a legal pre-requisite for direct collection of information in connection with an audit in the PRC.

The Company also learned that the PRC Ministry of Finance has reconfirmed its policies regarding the performance of fieldwork by foreign auditing firms auditing the financial statements of companies with operations in the PRC. The PRC rules and regulations governing licensing matters require, among other things, that foreign accounting firms obtain administrative permits to conduct auditing services in the PRC, comply with PRC laws regulating the confidentiality and secrecy of information, and keep audit working papers within the PRC. Violators of the foregoing requirements could be subject to legal sanctions in the PRC, ranging from fines and suspension of business licenses to criminal prosecution. Notwithstanding repeated inquiries by the Company, SLF neither confirmed nor denied that it was not properly licensed to provide auditing services in the PRC.

As an alternative to SLF's more stringent confirmation procedures and a safeguard against violating applicable PRC rules and regulations, the Company proposed that SLF and the Company employ certain "chain of custody" procedures in the confirmation and verification procedures to be utilized in the audit, which the Company believed would satisfy Generally Accepted Auditing Standards. Those proposed procedures involved the proposed collection of the requisite information by the Company in the presence of SLF. Notwithstanding SLF's initial agreement to utilize such procedures, SLF subsequently and without explanation elected not to utilize this alternative and reverted to its demand to utilize the more stringent confirmation procedures. Thereafter in early May 2011, SLF requested that the Company (and its subsidiaries') provide certain written representations to be submitted by SLF to the PRC Ministry of Finance in connection with an application SLF intended to make for a Temporary Practice Permit for Offshore Accounting Firm in accordance with the PRC Ministry of Finance's Interim Provisions on Temporary Auditing Business Activities Carried Out in China Mainland by Offshore Accounting Firms. The Company and SLF apparently have conflicting understandings of those regulations. The Company believes that the subject legal scheme precludes SLF from obtaining such a temporary permit by virtue of SLF's prior activities in the PRC, and the Company has continued to press SLF to utilize alternative procedures. SLF disagreed with the Company's view of that regulatory scheme. If the Company's assessment is correct, the written support that SLF requested that the Company (and its subsidiaries) provided could have subjected the Company to administrative sanctions in the event that the PRC authorities determined that SLF engaged in unpermitted auditing business activities in Hainan Province. The Company, therefore, declined to provide the written authorizations sought by SLF. Subsequently on May 26, 2011, SLF tendered its resignation letter filed as an exhibit to this Current Report.

This is the company's account of the situation, and I haven't confirmed this with a third party. However, if this representation is correct, then it further devalues the opinion of any small U.S.-based accounting firm providing services for U.S.-listed Chinese companies. We can safely assume that not even basic fieldwork, like confirming the cash balance directly and independently with a Chinese bank, could have been performed if the firm is not licensed to work as an auditor in the PRC. Furthermore, if Chinese law demands that audit working papers are to be kept within China, then an American accounting firm with no direct presence (offices) in China will have a hard time to comply.

HQS was the only remaining Chinese client of Ontario-based Schwartz Levitsky Feldman, but in the past the firm was registered as the auditor for more Chinese firms, including China Botanic Pharmaceutical (CBP) and China Automotive Systems (CAAS). China Automotive replaced SLF last December with PricewaterhouseCoopers, since the day of PwC's engagement the stock lost 53% of its value. You can use our comprehensive list of auditors for U.S.-listed Chinese companies to find other names that currently use small U.S.-based accounting firms.