Cultural differences and a unique business culture make analyzing financial management reports in China an area in which both experience and specific knowledge are vital. The importance of understanding Chinese financial reporting and financial management revolves around due diligence, verifiable accounting, and risk reduction.
In the last few years, there has been an increased interest by foreign investors to establish a presence in China. While Chinese accounting standards (CAS) and International Reporting Standards (IFRS) have demonstrated key similarities, it is prudent that foreign companies take note of the differences because they can easily get them into conflict with the law.
Differences in Chinese GAAP protocols and the standards of Chinese financial reporting usually require the expertise of qualified accountants and auditors familiar with the territory and the mechanisms that are often used to hide the true picture. Investors in China should be aware of relevant risks and obtain professional advice when assessing Chinese financial statements.
In general, accounting books are prepared by Chinese nationals. While the level of education is improving amongst Chinese accounting staff, in many businesses Chinese laws in regard to the proper maintenance of accounts are either misunderstood, or willfully neglected in order to present a better situation than reality, to cover up fraud (such as missing inventory) or, in a more negative situation, to avoid tax.
The legally liable person in China is responsible for evaluating and authorizing accounts as prepared by local staff. Severe penalties and other serious consequences with the customs and tax bureau can arise when the reports submitted are incorrect or have missing information. In some cases, attempted tax fraud can lead to prison.
It should be a priority for foreign investors in China to present accurate financial statements to avoid legal problems down the road. Prior to an acquisition, due diligence is necessary to evaluate the exact financial position and compliance of a target company.
The same applies for assessing a potential joint venture partner and the injection of assets into a new entity, as well as during annual audit and on-going reporting of businesses performance to investors.
When companies move to China, they face major challenges, especially on the interpretation of the Chinese accounts and financial reports. Also, they may find it an uphill task when trying to consolidate their Chinese companies’ accounts with the firms in their countries of origin.
Several issues can be identified by examining first, the balance sheet and second, the income statement.
Within the balance sheet, the areas to consider are mainly Accounts Receivable; Other Accounts Receivable; Fixed Assets; Construction in Process; Accounts Payable; Other Payable; and Payroll Payable, while in the income statement, it is important to evaluate Sales Income; Cost of Goods Sold; Expenses; and Income Tax.
Accounts Receivable (AR) deals with the transactions of the company. In China, many businesses try to hide sales to reduce taxable income, and as such, the AR is usually under-reported. Preparing an aging analysis is difficult as well, due to the lack of communication between the sales department and financial department.
In the area of Other Accounts Receivable (Other AR), irrelevant operations may be recorded, such as an internal loan which should have been included in the investment account.
In the Fixed Assets (FA) sector, only a small number of companies conduct periodic counting and post the FA Label correctly. In many cases, self-established fixed assets are not included in the FA, and the relevant depreciation is not taken accordingly, while the cost for establishing the fixed assets is recorded in the Expenses account or Cost account but not capitalized.
It is common to see that supporting documents related to Construction in Process (CIP) are not properly filed and documented. Some self-established fixed assets are not recorded in the CIP, nor transferred later to the FA.
Sometimes, companies will book irrelevant transactions in Accounts Payable.
In China, many businesses delay part or all the employees’ salaries, and often there will be an ending balance of the Payroll Payable.
When it comes to Sales Income, in some instances, management does not record all sales revenue in the financial statements prepared for the tax bureau. For some cash sales, the company will not include them into the financial statements and will maintain them in an internal sales book.
Sometimes the sales will be delayed as recognized in order to reduce the sales volume in the current accounting period.
Expenses is another area prone to vulnerability. Many businesses book nondeductible expenses in the expense account, such as fixed assets cost, penalties and so on.
The inappropriately recorded expenses will be adjusted out by the auditor at the end of each year.
Another aspect to consider is when expenses have exceeded the limitation of deduction as listed in China’s Tax Law.
In almost all cases, income tax will be under-reported. Their P/L usually shows a loss at the end of the financial year.
Doing business in a foreign country is never simple, and the same goes for China. Since Chinese accounting standards and financial reports differ to those in Western nations, and accounting must almost completely be done in Chinese, many foreign companies will need assistance.
When you decide to incorporate a company in China, it is important to understand that the Chinese government takes financial and tax-related matters with a lot of strictness. Therefore, you should ensure that your staff respects and follows the Chinese accounting standards correctly.
Hiring a local accountant could be a solution, but you need to be extremely vigilant and make sure that they are not, inadvertently or otherwise, cutting corners which could cause you to fail your annual audit and run into trouble with the Chinese authorities.
The most important thing is that your company is well informed and prepared, and that you do not go into things blind. Even having an overview of the way things are supposed to be in China, will allow you to protect your investment and make better business decisions moving forward.
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