Chinese Firms Need to Open Up Books

Chinese Firms Need to Open Up Books

Poor access to information is a major culprit in the selloff of China's overseas-listed companies. If China hopes to limit the damage, it needs to open up.

The Securities and Exchange Commission is investigating accounting and disclosure issues at a number of U.S.-listed Chinese companies that acquired backdoor listings through so-called reverse mergers, and even top-name Chinese companies are inviting new scrutiny. Renren Inc., a social-networking site that launched its shares to much fanfare in early May, now trades at about half its IPO price. Renren itself stirred controversy when it lowered the growth rate of its user base without explanation in its IPO prospectus and the head of its audit committee resigned just before the listing.

Shares of Toronto-listed Sino-Forest Corp. have plunged 80% since late May after a short seller alleged problems in the forestry company's accounting, which the company denies. Hong Kong-listed Chinese companies, too, are drawing new scrutiny over their accounting.

Not all Chinese companies are shady. But investors are right to ask: How do you know which aren't?

One answer is access to information. Auditors need it to be sure a company's business is as good as management says it is. So do regulators who oversee the auditors.

In the case of Chinese companies, however, there are no arrangements that allow the Public Company Accounting Oversight Board, the U.S. government's accounting regulator, to inspect the work of accountants in China. So the PCAOB can't really know whether that work is reliable. Using U.S. accountants doesn't help because they outsource the real work to accountants in China anyway.

In testimony to U.S. lawmakers this past April, James Doty, the PCAOB's chairman, called the group's inability to inspect the work of registered firms in China "a gaping hole in investor protection."

The limited ability of Hong Kong regulators to access information on Chinese companies has long been a risk factor for the city's stock market, the primary venue through which foreign investors buy a piece of China. That ability suffered a new blow late last year when the local exchange agreed to let mainland Chinese companies listed in the territory use mainland auditors. As part of the new arrangement, Hong Kong's Securities and Futures Commission secured a promise that it would be able to examine records of auditors for companies it wants to investigate.

"Clearly the test will be when we have a live case to go through," Martin Wheatley, the outgoing head of the SFC, recently said in an interview. That hasn't yet happened.

Concerns about the transparency of Chinese companies put one Hong Kong-listed stock through the wringer last week. On Tuesday, Standard & Poor's withdrew its ratings for long-term corporate debt of a major Chinese packaging manufacturer, Nine Dragons Paper (Holdings) Ltd., after its analyst complained of being unable to get senior management to answer questions about the company's business. The stock plunged more than 17% after S&P's move, though it regained much of the loss the next day, when Nine Dragons said it was willing to cooperate with S&P and respond to requests for information.

China isn't the only market where information is hard to come by. It comes with the emerging-markets territory. That won't diminish the impact of these accounting questions at a time when trust in China's corporate success stories can no longer be taken for granted.

Chinese regulators could start repairing the country's reputation with investors by signing a deal with the PCAOB giving it access to work done by the country's auditors. No doubt, investors may not like everything they get to see. But right now, what they don't see is even scarier.

—Isabella Steger contributed to this article.