Investors have an opportunity to reshape corporate governance in Hong Kong-listed firms by demanding higher quality auditors and more transparency in the appointment process.
This is according to Tina Chang, associate director, sustainable investing at Fidelity International, the global asset manager with $816bn in assets under management.
She pointed to Hong Kong-listed property developer Evergrande as an extreme example of the challenges shareholders face in assessing the true financial condition of their investments.
After wiping out $38bn of shareholder capital, Evergrande is currently under investigation by an auditing watchdog after being accused of inflating revenues by $78bn in 2021 before its downfall.
Although the probe into the troubled property developer has yet to be concluded, there will be questions around why the auditors failed to raise alarm bells.
A race to the bottom in the Hong Kong auditing business may be partially to blame, according to Fidelity, who found that cost was a key consideration for management when considering an auditor appointment or reappointment.
“Listed companies will always want the most cost-efficient audits, and rightly so,” Chang said. “But quality must not be compromised in the process, especially in a global financial centre such as Hong Kong.”
According to a 2023 report by the Hong Kong accounting regulator, the number of companies that appointed new auditors rose 90% between 2017 and 2021, with almost two thirds citing lower fees as motivation.
Chang said: “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.”
Market maturity doesn’t automatically create better corporate governance
The report showed that between 2010 and 2021, the average revenues of listed companies climbed 67%, the average total assets of listed companies increased 91%, while average audit fees rose just 9%.
Fidelity said this implies auditors, on average, are taking on more complex projects but the heavier workload is not being reflected in their pay.
“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,” Chang explained.
“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.”
Although shareholder capital is at risk from poor audits, Chang argued that investors 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,” she said.
“Other than the name of the appointed auditor and fees paid for audit and non-audit services, the exercise produces little useful information.”
More transparency is needed
To address this, Fidelity urged investors to demand management teams to explain the reasoning behind a new auditor appointment and reappointment of the existing one.
The asset manager also said investors should be informed of any fee changes, as well as the rationale for doing so – including the tenure of incumbent auditor, engagement partners, their relevant track record, and how the audit committee evaluated and challenged the incumbent auditor.
It added that management should also be responsible for keeping shareholders informed and ensuring outgoing and incoming auditors share as much information with each other as possible.
Fidelity also suggested restrictions on auditors engaging in non-audit business to avoid conflicts of business, and ensuring management gives any new auditor more than three months to carry out a comprehensive audit to stop landing auditors with last-minute scrambles.
“Small changes could make a big difference in audit quality,” Chang said, recommending that redacting fee details when selecting auditors could make sure the job goes to the “best contender”.
She continued: “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.”
“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.”
