In today's Finshots, we see why China is auditing auditing giants like PwC.

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The Story

The Big Four auditing giants—Deloitte, PwC (PricewaterhouseCoopers), EY (Ernst & Young), and KPMG are in hot waters in China.

According to a Reuters report published last week, the Chinese Finance Ministry is tightening the noose around them. It is concerned about the quality of the work these firms are doing for the local Chinese companies that have appointed them as auditors.

Why is the Chinese government concerned, you ask?

Look, the primary responsibility of a financial auditor is to offer an unbiased assessment of a company's financial statements. The goal is to catch problems like inflated revenues, risky loans, excessive borrowing, and the like early on to prevent probable financial misinformation.

However, the government is now sceptical about whether the Big Four auditing firms are genuinely committed to uncovering dubious activities in the companies they audit. As a result, the government has been bombarding these firms with a barrage of questions and asking them to produce a mountain of documents.

Now, you might be wondering why is the Chinese government acting so paranoid?

Well, because these efforts are intended to prevent another Evergrande-like crisis!

So let’s take it from the top.

In the mid-90s, Hui Ka Yan, the founder of China’s property behemoth, Evergrande, embarked on a journey that would make him one of China's wealthiest individuals.

By taking on substantial debt available at dirt-cheap rates, Hui expanded the company’s reach with thousands of real estate projects across China.

Eventually, the company went public in 2009, and by June 2023, it had owned land reserves totalling 190 square kilometres.

It is safe to say that Hui’s ambitious vision and aggressive expansion strategies quickly made Evergrande China's second-largest property developer.

Other than the easily accessible credit, what helped Hui and Evergrande was the cash at hand that came from pre-selling homes. For context, in 2021, nearly 90% of homes in China were sold before they were built.

So yes, this strategy kept the cash flowing for years, allowing Evergrande to purchase new land and start new projects continuously.

Everything was running like clockwork.

But the tide actually turned against Hui and Evergrande in 2020 when the government, concerned about the sky-high debt levels in the property sector, clamped down on what it saw as reckless lending.

In response, it introduced the "three red lines" policy, which limits debt-to-asset, debt-to-equity, and cash-to-short-term debt ratios. You don’t need to know what these ratios are. But think of them as numbers that measure a company's financial health and stability, ensuring they don't take on too much debt compared to their assets, equity, and available cash.

And guess what?

Evergrande breached all three red lines. Thereafter, the government and the banks closed all the debt taps for the property giant, leaving Evergrande and other developers scrambling.

By 2021, Evergrande, which thrived on debt and revenues from pre-sales, could not repay interest on its staggering $300 billion debt.

It formally defaulted in December 2021, marking the start of a liquidity crisis. In other words, they had no money at hand.

And here is a thing about China's property market: It contributes between 20% and 30% to China's GDP.

And therefore, Evergrande’s downfall had a domino effect, threatening to destabilise the broader real estate sector and, by extension, the entire Chinese economy.

And it’s not over yet. The repercussions of Evergrande's fall are still unfolding. For instance, prices for new homes in Chinese cities dropped by 1.3% year-on-year in August 2023, reflecting the turbulence in a sector that once drove China's growth and prosperity.

Now here’s the kicker. PwC was Evergrande's official auditor for almost 14 years until it resigned in early 2023. Precisely during the period when the company was accumulating those massive debts.

Apart from the mountain of debt, Evergrande, through its subsidiary Hengda, engaged in various accounting malpractices to inflate its revenues by approximately $78 billion between 2016 and 2020.

And this created a misleading picture of Evergrande's financial stability and growth.

Investors believed the company was more profitable and stable than it actually was.

With inflated revenues and assets, Evergrande secured more loans and funding. Not only this, but the misstatements also initially boosted market confidence in Evergrande, driving up its stock price.

Now, as an auditor, PwC was responsible for reviewing Evergrande's financial statements and ensuring they accurately represented the company's financial health.

But it never once raised a single concern, and this let Evergrande continue its fraudulent activities.

And as a consequence, the Chinese Finance Ministry has held PwC responsible for failing to disclose Evergrande's real financial health.

Not only this, but PwC must also pay a hefty fine.

Here is an interesting fact: PwC made 400 million yuan from Evergrande and its subsidiaries in 14 years and now likely must pay a 1 billion yuan fine! That’s over ₹1,100 crores.

And do note that this thing with PwC is not an isolated case.

Here is another instance.

Deloitte was also fined $30.8 million last year for failing to properly assess China Huarong Asset Management's asset quality. And there are other similar instances where the Big Four firms didn’t disclose the actual financial health of the companies they were auditing in China, causing substantial financial fraud and thus harming the Chinese economy.

So it’s no wonder then that the Chinese government is fighting back.

Chinese companies, especially state-owned enterprises, are now relieving PwC of their duties and switching to other auditors.

Also, China's stock market regulator has fined Evergrande Group 4.2 billion yuan (about $580 million) for allegedly falsifying its revenue and deceiving its investors and lenders about the company's financial health.

And as you may already know Evergrande is being liquidated in a bid to recoup what’s left. But the question remains: Will the Big Four firms be able to regain the trust they once wielded in China?

Well, we will have to wait and see.

Until then…

Correction: An earlier version of this story misstated the Yuan-to-Dollar conversion for the 4.2 billion Yuan fine imposed on the Evergrande Group. We regret the error.

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