Accounting

Why Care About China’s Reporting System?


by FEI Daily Staff

China’s accounting system — though regarded as on par with Western practices — is criticized by some as deeply flawed. Understanding the Chinese system can provide valuable insight and help evaluate business opportunities.

China has become a global economic force. It’s on the radar of many businesses for a variety of reasons, including its population of 1.35 billion people — nearly 20 percent of the world’s population — as well as a huge manufacturing base and an average annual gross domestic product growth rate of 10 percent for the past 30 years.

The United States is China’s largest trading partner, accounting for almost $92 billion in exports in 2010, a nearly five-fold increase from a decade earlier. Imports during 2010 were just under $365 billion, or about four times exports to China.

Trade between the two nations and China’s overall economy are only expected to grow. Some prognosticators forecast that China may overtake the U.S. in the next 20 to 30 years due to the substantial growth of China’s GDP.

Based on these trends and expectations, China is now part of the strategic planning process of many companies. Financial executives throughout the world are exploring how China can be part of their growth platform. Others are investigating how China can offer opportunities for sourcing goods and services, and whether the country represents a looming competitive threat. Standard accounting practices may help guide these decisions.

Function of Standardized Accounting Systems

Generally accepted accounting principles and International Financial Reporting Standards are the primary financial accounting systems used throughout the world. These standardized information systems govern market-driven capitalism and generally serve three important functions: contracting, valuation and administration and control.

The contracting function facilitates trade because the accounting system generates reliable information. This information is used by parties in decision-making and when monitoring the out­comes that result from the choices made. There are many ways financial accounting is used in contracting. These include debt contracts, customer/supplier relationships, compensation contracts and for strategic alliances.

The valuation function involves the use of earnings, cash flows and other financial accounting information to forecast future values and to anticipate business vulnerabilities. This information is used as inputs to valuation and risk models.

The administration and control function relates to the government’s use of financial reports as a means for administration and control of the economy. Financial metrics are used to allocate resources to accomplish policy goals.

State Capitalism vs. Market-Driven Capitalism

China’s economic system is referred to as state capitalism. The market-driven capitalism in the West values assets based on market forces, but under state capitalism the government owns and controls key firms and industries that are used strategically to advance political goals.

Companies conducting business in China need to understand the interconnected nature of business, culture and governmental control.

Even as China gradually adopts some market-driven elements, its state capitalism economic system works to ensure that key assets are developed and deployed by political officials rather than market forces. State-owned enterprises, or SOEs, are still dominant in the country’s economy even though they are not particularly profitable. The average return on equity of SOEs is barely 4 percent. By comparison, the return on equity of private firms is no less than 10 percentage points higher.

Control of three primary economic mechanisms make China’s politically commanded capitalism feasible: capital, personnel and organizations, including SOEs. In addition, the nation’s top tiers in politics and economics are synchronized. Personnel move freely from the political hierarchy to the state-controlled and state-affiliated economic hierarchy and back, at the command of the party/state.

Financial metrics such as profitability and safety and growth of assets are openly used in determining executives’ performance. But its application lacks consistency and transparency. Political control also extends from personnel to the organization itself.

Each state-owned, controlled or affiliated organization carries a rank in the hierarchy of all public organizations. Positions in corporations are likewise assigned ranks. Synchronization of organizations and positions makes it easy to transfer personnel across corporations. For example, CEOs of banks and oil companies are regularly “rotated” between organizations in the same or differing sectors.

With control of personnel and organizations, there is little wonder that the financial institutions cooperate fully with the directives of the party-state. When China responded to the world financial crisis in 2007-08, it asked the banks to substantially increase their loans; the banks responded in unison and received credit for the swift economic recovery.

Accounting Functions in China

Reliable accounting is critical to the smooth function of any sophisticated economy. While the Western world uses GAAP or IFRS information primarily for contracting and valuation purposes, China’s “macro-control-dominant” accounting model favors the administration and control function.

China’s system has two relatively rare features not usually identified with capitalism: the state itself acts as a capitalist and economic activities are heavily embedded in social relationships or networks (known as guanxi) that wield tre­mendous influence and power.

These networks lower the need for accounting information used in the contracting process because business is conducted based on political or social relationships rather than objective, arm’s-length relationships. As business in China moves away from guanxi and toward arm’s-length contracts, the value of financial metrics will increase.

In 2010 and 2011, China was the world’s biggest initial public offering market, with 347 companies, raising nearly ¥490 billion (US $73.92 billion). Its SOEs are among the largest firms in the world. Advancing their plans for continued growth, China’s SOEs have recently made strategic investments in coal, copper and iron ore reserves along with other critical manufacturing inputs. China also holds more than $1 trillion of U.S. sovereign debt, about 20 percent of the total U.S. treasury securities held by foreign interests.

Since their inception in the early 1990s the Chinese stock markets in Shanghai and Shenzhen have been dogged by fraudulent activities. As recently as 2001, the former Premier Zhu Rongji made a public call to accountants in China: “Don’t cook the books.” The call from top leadership indicates the seriousness of creative accounting but, given the state capitalism in place, the problem was not simply a managerial behavior but a joint effort of government and firm managers.

To realize its financial ambitions, the nation has taken steps to more closely follow international practices. The China Securities Regulatory Commission (CSRC) was set up in 1998 as China’s counterpart to the U.S. Securities and Exchange Commission. CSRC differs from the SEC in two aspects. First, its regulatory authority is shared by the Ministry of Finance, which maintains the power in accounting affairs, including setting accounting and auditing standards. This is consistent to a traditional legacy that has accounting policy play a subservient role to tax policy.

Second, its regulatory ruling may be overruled by other administrative agencies because government has given an explicit policy priority to economic growth and social stability, which may overrule market principles like openness, transparency, fairness, professionalism and integrity.

Primarily, this gives CSRC “selective enforcement of regulation” and allows the commission to take into account whether companies violating the rules have a state-owned background and the strength of that background when investigating and punishing non-compliance. In 2006, China also made a radical move in bringing its accounting standards for business enterprise (ASBE) in line with IFRS.

Chinese exchanges are aimed at helping finance SOEs in an open market and grant them more autonomy. Managers of foreign companies need to keep in mind that China’s exchanges are state-owned and managed by government-appointed officials, while the securities firms are state-owned (or majority-controlled) either directly or indirectly.

Publicly traded SOEs might not behave as a Western firm because most listed firms were carved from their parent SOEs and the government still controls the majority of their shares. Boards of directors are still stacked with government appointees. At times, the companies are asked to take over ailing SOEs, grant substantial long-term loans to parent firms, invest in government infrastructure projects with capital raised from the stock market or even pay dividends when local governments fall short of cash.

While China’s accounting system offers its own distinctive challenges, its legal system has its own features. China’s courts are integrated with its administrative system providing emphasis on administrative and criminal sanctions and there is no formal development of civil liability or procedural law.

As a result, civil lawsuits are rare, and administrative responsibility is the most common type of legal consequence among firms committing fraud. Investors confront a high hurdle in filing suit against exchange-listed companies.

 

Ambitions and Challenges

Most agree that China’s state capitalism approach has been amazingly successful during the past three decades. However, China’s standardized reporting systems favor the administration and control over the contracting and valuation functions. Therefore, a variety of social and economic factors should be taken into consideration when assessing the risks and rewards of doing business in China.

The Chinese policymakers also face substantial challenges. Advancing their plans for continued growth, China’s high levels of investments, particularly the SOEs’ investments in coal, copper and iron ore reserves along with manufacturing inputs such as enriched uranium, have resulted in a declining share of private consumption as a percentage of GDP. Combined with an aging population and weak employment growth, this decline has created social unrest.

Currently, China is facing high-profile disputes with farmers over long-standing land rights. These disputes have incited activists and sparked more turmoil. Environmental and health concerns also need to be addressed.

Cases of creative accounting are subject to regulatory investigation and sanctions in various ways. First, the Chinese Institute of Certified Public Accountants (CICPA) conducts annual audit inspection on accounting firms. Second, the CSRC may investigate cases involving listed companies. Third, the National Audit Office may audit public organizations including SOEs (these are known as “audit storms”).

However, these regulatory measures generally result in high costs and minimal effectiveness because they are subject to administrative discretion and guanxi.

China’s creative accounting practices are further complicated by the fact that the public practice of accounting was not revived in China until 1980. Though the number of CPAs and accounting firms has grown markedly to more than 96,000 registered CPAs and about 7,800 accounting firms in 2010, CPAs are far from being the independent professionals found in free markets.

Within China’s ¥37.5 billion revenue (US $5.87 billion) audit industry, CPAs are viewed as “economic policemen,” enforcing a smooth implementation of government’s economic policies.

The CICPA, the sole national professional body, was created in 1988. Unfortunately, its independence and competence have long been questioned because it is an institutional unit under the Ministry of Finance, which covers its daily budget and appoints its staff.

Agencies such as the CSRC that would seemingly ensure fair and true accounting don’t perform to the same standards as the SEC, and its authority can be trumped by other agencies. While China’s manufacturing sector booms, its financial markets remain in their infancy. Ideally the regulators should act only as referees and allow the market to innovate.

For now, there are too many regulatory restrictions, and liberalization is off the table because of what is happening in financial markets in the rest of the world. The subprime crisis has been a cold shower for the Chinese. It is observed by some commentators that a new economic era has recently emerged, which is described as “state advances, private retreats.”

Chinese firms are now required to publish financial statements using local standards that are close to IFRS. They are required to undergo statutory audits but have little incentive to seek those of high quality, since they may lead to unfavorable opinions.

What‘s Next?

The next few years may be an important turning point for China for two reasons: China last year released its five-year plan, which lays out economic and social reform policies for the country. Most notably, the focus will shift to a trajectory of sustainable, balanced and socially-aware growth, implying there will be a shift away from capital-intensive production and a focus on exports, increased employment and increased benefits to citizens.

In the autumn of 2012, the ruling Communist Party will hold its 18th national congress, implementing its once-a-decade leadership succession by electing its all-powerful Central Committee.

A more level playing field could entice outside firms if China modifies its financial accounting system in the near term to address contracting and valuation functions. That would suggest that China is moving toward a more market-driven economy that benefits from these functions.

Ronald R. King, CPA, is professor of Accounting at Olin Business School of Washington University in St. Louis, Mo., and Mingchuan Ren is professor of Accounting at Fudan University in Shanghai, China. King is an FEI member.
This article first appeared in Financial Executive magazine.