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Auditors Play Defense on China Stocks

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When short sellers noted that the company used Frazer Frost as its auditor, other Frazer Frost clients, such as Harbin Electric (HRBN) and China Valves Technology (CVVT), saw immediate sharp declines in share prices, though there were no allegations of fraud relating to them, no known investigations, and no other obvious negative catalysts.

Representatives for Harbin Electric did not respond to requests for comment. China Valves CEO Jianbao Wang said his company is "committed to the highest standards of corporate governance. We are working to retain a Big Four auditor to provide internal controls assessment and improve the system."

Over-reliance on Chinese auditors has been controversial. In July, a warning came from the Public Company Accounting Oversight Board, or PCAOB. The PCAOB is a regulatory body created under the Sarbanes-Oxley Act of 2002. Essentially, its mission is to audit the auditors. An industry alert issued by the agency on July 12 called upon U.S. auditors to bear down on Chinese companies.

"Sometimes all the operations or most of the operations are in the China area and the firm in the U.S. is not taking an active role in the audit," says Greg Scates, deputy chief auditor with the PCAOB, in explaining the agency's action. "They're just taking the information from the Chinese auditor and doing little or no work, taking it at face value."

Scates acknowledges that auditors have been the security industry's principal gatekeepers since the securities acts of 1933 and 1934. He understands the ire of investors who have gotten badly burned by the collapse of China-based stocks engineered through reverse mergers.

"If a material fraud has been committed, then obviously you want to find out who were the key players, how they orchestrated this fraud, and then ask whether the auditors should have caught the fraud or why the auditors didn't catch the fraud," he says.

According to Scates, the PCAOB has been seeking access to the records of audit firms in China, but has met resistance from the Chinese.

"We're not into China yet. We're not able to inspect firms domiciled in China right now. A number of countries are blocking us right now."

The PCAOB's Fight Is Hampered

Investors hoping that the PCAOB will ride to their rescue in China may have a longer wait. Of late, the agency's role has grown more complex, and perhaps less transparent, thanks to intervention by the SEC.

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