PCAOB Issues First Research Note on Chinese Reverse Mergers

The Public Company Accounting Oversight Board today issued its first public Research Note, which provides new data on the growth of reverse merger transactions involving companies from the China region.*

The Research Note, entitled, "Activity Summary and Audit Implications for Reverse Mergers Involving Companies from the China Region (January 1, 2007 through March 31, 2010)," was prepared by the PCAOB Office of Research and Analysis (ORA) to provide further context to the issues discussed in Staff Audit Practice Alert No. 6 issued on July 12, 2010.

That Alert was based on observations from the PCAOB inspection process that some U.S. registered accounting firms may not be conducting audits of companies with operations outside of the U.S. in accordance with PCAOB standards.

"Through this Research Note, and the earlier Staff Audit Practice Alert, the PCAOB is actively reaching out to investors and other users of financial statements to give them more information about the audit environment for companies from the China region that may access the U.S. markets through reverse merger transactions," said James R. Doty, PCAOB Chairman.

In the period from January 2007 to March 31, 2010, ORA staff found that out of the 603 reported reverse merger transactions, 159 of those involved companies from the China region; the remaining 444 transactions involved primarily U.S. companies. Overall, reported reverse merger transactions involving companies from the China region during that time represented 26 percent of all reverse merger transactions reported during that time period.

The number of reverse merger transactions in the study involving companies from the China region was almost triple the number of initial public offerings (IPOs) conducted in the U.S. by companies from the PRC during that time. There were 56 IPOs from such companies, representing 13 percent of the IPOs completed in the United States.

Additionally, following the reverse merger transaction, two-thirds of the Chinese reverse merger companies in the study had market capitalization below $75 million as of March 31, 2010, while more than three-quarters of the companies from the PRC that conducted IPOs had market capitalization above $75 million as of March 31, 2010.

As of March 31, 2010, the market capitalization of the 159 Chinese reverse merger companies identified by ORA staff was $12.8 billion, less than half the $27.2 billion market capitalization of the 56 companies from the PRC that conducted IPOs during the same period. As of that date, 59 percent of Chinese reverse merger companies reported less than $50 million in revenues or assets as of their most recent fiscal year.

PCAOB-registered accounting firms based in the United States audited 74 percent of the Chinese reverse merger companies, while China-based registered firms audited 24 percent. Due to the position taken by authorities in the PRC, the PCAOB is currently prevented from conducting inspections of the U.S.-related audit work of PCAOB-registered firms in the PRC and, to the extent their audit clients have operations in the PRC, PCAOB-registered firms in Hong Kong SAR.

"We hope to add to this data later in the year, to bring to investors more of the important financial data we are collecting and analyzing at the Board," said Joseph St. Denis, ORA Director.