Opinion: How to Pave the Road to Improved Audit Quality

PricewaterhouseCoopers (PwC) China, a leading “Big Four” accounting firm, is facing severe challenges due to its involvement in the auditing work for Evergrande Group, a property giant mired in scandal. This has led major clients, including state-owned enterprises like PetroChina Co. Ltd. and China Railway Group Ltd., to sever ties with PwC China. Similarly, Dahua Accounting Firm faced heavy penalties, including a 34.4 million yuan ($4.7 million) fine and a six-month suspension, following the Jintongling financial fraud. For top-tier firms like PwC China and Dahua, such scandals pose existential threats and significantly damage their reputations [para. 1].

Accounting firms are critical to capital markets, providing essential services like auditing, which enhance information quality and maintain market order. They play a pivotal role in the triangular relationship among regulators, intermediaries, and companies. Investors rely on these firms’ professional opinions to assess listed companies' quality, making high-quality audit services indispensable for a robust capital market [para. 2].

PwC and other "Big Four" firms have historically contributed to standardizing China’s auditing practices and integrating its market into the global economy. However, as PwC China now faces a crisis of trust, there is a need to examine the core issues [para. 3]. At the heart of this crisis is the fundamental requirement for professionalism and independence within the auditing industry. The integrity of audit reports is vital, but collusion between intermediaries and businesses leads to a collapse of this integrity. Local regulators have pointed out issues in the professional capabilities and independence of audit institutions, which have often led to financial fraud going unnoticed [para. 4].

To improve audit quality, regulators are aggressively investigating major cases, with routine inspections becoming more thorough. The China Securities Regulatory Commission (CSRC) has initiated investigations into several intermediary organizations due to negligence. Jointly overseen by the Ministry of Finance and the CSRC, the finance ministry's 2023 inspections covered 2,161 accounting firms, marking a 16.56% increase from the previous year. This resulted in administrative penalties for 197 accounting firms and 509 registered accountants. Nine firms had their licenses revoked and 49 were suspended. Over 200 listed companies have received “non-standard” audit opinions in their 2023 reports, emphasizing the effectiveness of these stringent measures [para. 5].

Preventative regulation is considered more crucial than post-event accountability. This involves strengthening internal governance and quality control systems to boost self-regulation. Past practices like “drawer agreements” for contingent fees have compromised professionalism and independence. Regulators have banned these agreements, but enforcing the prohibition remains challenging. Efficient internal governance is critical for a competitive market mechanism to function effectively [para. 6].

These issues highlight significant supervision gaps and an acute shortage of inspection resources, coupled with the ineffectiveness of external oversight, including media scrutiny. Although financial institutions and rating agencies had identified potential fraud at Evergrande years ago, these warnings weren’t heeded. Fraud remains rampant due to inadequate market error-correction mechanisms and insufficient market transparency [para. 7].

As China’s capital market grows, accounting firms and intermediaries have improved their business scale and education levels. Regulation has also tightened. Firms like Dahua and PwC China eventually face market penalties for their failings. The challenge now lies in transforming a race to the bottom, led by some intermediaries, into a race to the top, demanding coordinated efforts from regulators, industry professionals, and investors [para. 8].