There is an auditing scandal that has been drowned out in China’s much talked-about property market shake-up - one that continues to cost investors dear. Troubled developer Evergrande has been accused by the Chinese regulator of inflating revenues by USD $78 billion in 2021. The company is under investigation by an auditing watchdog with expanded disciplinary powers in Hong Kong, where Evergrande is listed. The fall from grace was rapid for a stock that notched over HKD $300 billion ($38.4 billion) in market capitalisation at its peak. Now, the company that traded under the auspicious ticker of ‘3333’ - a symbol of infinite life - is worth next to nothing.

Evergrande is an extreme case, and the probe in the world’s fifth largest stock market has not yet concluded. It nevertheless speaks to the structural challenge in sifting out bad apples in a competitive market. Just take a look at Hong Kong auditors’ own accounts. Between 2010 and 2021, the average revenues of listed companies climbed 67 per cent, the average total assets of listed companies increased 91 per cent, while average audit fees rose just 9 per cent.[1] This implies auditors, on average, are taking on more complex projects but the heavier workload is not being reflected in their pay. As companies grow and become more complex - expanding overseas, for instance - auditing gets more challenging. Fierce competition is driving some auditors to sign up to jobs involving jurisdictions where they may have limited experience, compounding audit quality issues.

Our engagement with Hong Kong-listed companies confirms that cost is a key consideration for management teams when considering auditor appointment or reappointment. Between 2017 and 2021, the number of companies that appointed new auditors rose 90 per cent, from 148 to 285.[2] Almost two thirds of companies admitted they were motivated to switch auditors because of the offer of lower fees from competitors.[3] What’s especially alarming is that many of these changes took place shortly before audits were due, leaving the new auditor with precious little time to examine the accounts.

Investors’ voice

The situation in Hong Kong reminds investors everywhere that signs of ‘maturity’ (market capitalisation, high liquidity, etc) do not ringfence capital markets from corporate governance risks. In a recent corporate governance ranking by the Asian Corporate Governance Association (ACGA), the city’s auditing quality lagged smaller Asian markets such as Malaysia and Taiwan, as well as regional rivals Japan and Singapore.[4]^{, [5]} Listed companies will always want the most cost-efficient audits, and rightly so. But quality must not be compromised in the process, especially in a global financial centre such as Hong Kong.

Shareholders have an incentive to act - it’s their capital that’s at risk from poor audits. But they are handicapped by the lack of transparency in the Hong Kong market. Companies’ disclosures are superficial, limited to standard audit fees and boilerplate endorsements of the appointed auditor by the audit committee, with scant details on the evaluation process or the thinking behind the recommendation. Other than the name of the appointed auditor and fees paid for audit and non-audit services, the exercise produces little useful information.

Luckily, investors who want change have had the heavy lifting done for them. Three and a half years ago, Hong Kong created an independent regulator for auditors, the Accounting and Financial Reporting Council (AFRC), resolving a longstanding conflict of interest of the industry organisation supervising itself. Crucially, the AFRC provides a register of auditors with information on disciplinary orders, inspection reports, and a set of guidelines. The guidelines include concrete recommendations for companies’ audit committees on auditor appointment and reappointment, running the tender process, managing auditor resignation and removal, and what companies should disclose in their Corporate Governance Report on these issues. While the guidelines provide plenty to work with, we believe shareholders would be wise to focus on three specific demands when engaging with companies on audit-related issues.

Three-pronged reform

The most urgent task is to bring about transparency in the process. We expect management teams to explain the reasoning behind the audit committee’s decision, both when they are appointing a new auditor and reappointing the existing one. Investors should also be informed of any changes to fees - and the rationale for doing so - tenure of the incumbent auditor, engagement partners (the person at the audit firm who is accountable for the audit view), and their relevant track record. They should also be told how the audit committee evaluated and challenged the incumbent auditor. We deem the company responsible for keeping their shareholders up to speed and ensuring that outgoing and incoming auditors share as much information with one another as possible.

In auditing, objectivity matters. To avoid conflicts of interests, we want restrictions on auditors engaging in non-audit business. Both utilities provider CLP and the bourse operator Hong Kong Exchanges and Clearing (HKEX) already have such policies in place. CLP’s audit committee have gone the extra mile, disclosing that they have met with auditors without management present - another good practice we encourage other companies to take up. In the event that an auditor resigns, we want the company to ensure any new auditor has more than three months to carry out a comprehensive audit - and stop landing auditors with last-minute scrambles.[6]

Small changes could make a big difference in audit quality. We urge companies to redact fee details when selecting auditors, so the job goes to the best contender. Companies retaining an auditor for too long can also be problematic, giving rise to conflicts of interest. While the Code of Ethics for accountants in Hong Kong suggests appointing a new engagement partner once every seven years, we suggest companies proactively review auditor tenure and demonstrate how independence is ensured. A good example is HKEX, which rotates the engagement partner every five years.

Make no mistake, companies will have to pay more. But the cost of inaction - loss of investor confidence - is far greater for all market participants. We invite investors to make use of the AFRC guidelines and push for companies in Hong Kong to implement as many of these proposals as possible. Working together, regulators, auditors, companies, and investors can elevate the Hong Kong market to new heights.

[1] Mean averages. See pages 10-11 in a report by Accounting and Financial Reporting Council (AFRC). When adjusted for inflation, mean and median fees declined by 20 per cent and 10 per cent, respectively.

[2] AFRC report, p.25

[3] AFRC report, p.26

[4] Asian Corporate Governance Association (ACGA)’s ‘CG Watch’ 2023 report, published with the brokerage CLSA, which is based on desktop research and conversations with regulators, investors, listed companies, auditors, and other stakeholders in Asia Pacific.

[5] ACGA indicates the scores are based on responses to two groups of questions a) those related to accounting and auditing standards, the independence of auditors, disclosure of audit and non-audit fees, and the adoption of the key-audit matter (KAMs) standard, and b) the performance and transparency of independent audit regulatory bodies in each market.

[6] AFRC recommends in a letter in September 2023 that audit planning shall begin no later than three months before the end of the financial reporting period. Our recommendation on the length of the notice period takes into consideration additional time for appointing a new auditor.