The PCAOB released their first public research note earlier this week, "cautioning U.S. registered accounting firms that their audits of companies with operations outside of the U.S., particularly in China, may not be in accordance with PCAOB standards if the company accessed the U.S. capital markets through a reverse merger transaction." The actual research note can be found here.

Their article goes on to state that inspections have uncovered significant audit deficiencies in some cases and that approximately 26% of all reverse mergers during the period studied involved Chinese companies. This is an interesting statistic, given the increasing number of Chinese companies looking to access U.S. capital markets - and the growing desire to become listed through the less-traditional reverse merger route.

From our own experience we know that proper internal controls audit work involves going to the source, and that reliance on local outside parties should be scrutinized more heavily. It seems that some of the cases involved U.S.-based firms placing too much reliance on local outside parties whose work was used primarily as the basis to deliver their official opinion. 

The report also stated that 2/3 of these companies had a market cap of less than $75 million after the merger. This means that their internal controls over financial reporting may not have been included in the audit initially, and raising even greater doubts as to their financial transparency in our minds.

We tend to agree with the PCAOB in their premise that it is "buyer beware" when it comes to investing in newly public companies resulting from a reverse merger transaction with a non-U.S. entity. So do you your homework, especially for smaller market-cap companies where the reporting requirements are less stringent with regard to the internal controls that protect their financial reporting integrity!

The full article can be found here.