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China Questions Big Four Auditors

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The Chinese government is sick and tired of hearing U.S. regulators question the validity of the auditing done on U.S.-listed Chinese companies. So it has done what it considers the best thing to do to squash those complaints. It has requested the world's largest auditing firms to come in and recheck the work they did for those Chinese firms in 2010, and to do it quickly.

The Ministry of Finance and the China Securities Commission asked the "Big Four" accounting firms, KPMG, PricewaterhouseCoopers, Ernst & Young, and Deloitte, to also review the initial public offering, or IPO, work they did on behalf of Chinese companies wishing to be listed on the U.S. exchanges.

In addition, the firms have to inform the Chinese regulators whether any of the auditing work or client information was passed on to U.S. and other foreign regulators, something the Chinese government really would be upset about. The auditors have until the end of the week to complete this work.

What has brought on this desperate action by the Chinese? The get-rich-quick allure of investing in the new world of Chinese capitalism brought opportunities for many newly formed companies with little innovation and less financing to get listed on the U.S. exchanges. This made it easy, perhaps too easy, for naive investors to get in on the fun. As my Foolish colleague Alyce Lomax wrote, "The 'Go-go' China investment thesis made logical sense at first."

The main problem with investing in U.S.-listed Chinese companies is the higher potential for fraudulent or inaccurate accounting. A case in point is that of Longtop Financial Technologies. At one time it had a market capitalization of more than $2 billion. But after the company was accused of fraudulent financial behavior, its auditor resigned. That auditor happened to be one of the "Big Four," Deloitte.

According to Tim Hanson, another of my Foolish colleagues, Deloitte wrote in its letter of resignation that it found Longtop's state-owned bank "complicit in helping Longtop deceive Deloitte and its investors." This implied, according to Tim, that "fraudulent practices may be systemic in China's financial system."

This is obviously a perception that the Chinese regulators would like to change. It knows how bad publicity can negatively affect investment in China. And there are U.S.-listed Chinese stocks that certainly seem on the up-and-up (with a caveat regarding so-called variable interest entities): There's Baidu (Nasdaq: BIDU  ) , Country Style Cooking (NYSE: CCSC  ) , Yongye International (Nasdaq: YONG  ) , Guangshen Railway (NYSE: GSH  ) , China Mobile (NYSE: CHL  ) ,and Renren (NYSE: RENN  ) , just to name a handful.

The Big Four auditing firms are in a precarious position. Estimates put Chinese revenues for those firms at $1.5 billion for 2010, with growth at 20% over the previous year, so they can't just ignore the Chinese regulators' concerns. But if they can't do an audit of a Chinese company that would meet the standards that the U.S. regulators set, then their audits would have no credibility.

As Michael Pettis, a professor of management at Peking University, said, "I expect it is going to be a little messy."

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Fool contributor Dan Radovsky has no financial interest in any of the above-mentioned companies. The Motley Fool owns shares of, China Mobile, and Yongye International. Motley Fool newsletter services have recommended buying shares of Yongye International, Guangshen Railway, Baidu, Country Style Cooking Restaurant Chain, and China Mobile. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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