Balance sheets are a fundamental financial report on which a business can be evaluated. Though they tend to receive less attention than the financial statements that show the business profitability and performance, they are the preferred document by tax authorities interested in discovering any type of tax discrepancies and foul play.
Taxes represent one of the most important sources of revenue for the Chinese government, and tax authorities have recently stepped up their efforts on enforcement and collection of corporate taxes. Even well-intentioned and honest businesses can get penalized for unqualified fapiao, missing supporting documents, and simple mistakes made by employees.
In the past few years, the Chinese government has improved the country’s business environment to allure foreign investment and offset a slower economic growth. At the same time, they have tried to increase the overall awareness of the society and to pre-empt taxpayers from engaging in any non-compliance tax practice.
Some poor-quality accounting practices had been tolerated in the past, but in the last few years the strengthening of the tax compliance regulations has become one of the center pieces in the economic reform taking place in China.
Many companies have balance sheets that are not as clean as they should be, not because of any intentional oversight or effort, but because owners and leadership teams often do not know how to maintain a clean balance sheet.
Unless Generally Accepted Accounting Principles (GAAP) are followed properly, balance sheets can get distorted to the point where they no longer reflect an accurate image of the business’s current financial position. Small to medium sized business owners can often judge whether their balance sheet accurately reflects their businesses by examining figures and balances carefully.
Keeping a clean balance sheet for your China business is crucial.
A clean balance sheet presents a clear picture of the company's assets and liabilities, with no surprises or required adjustments. The more accurate and clear the balance sheet, the more credible your company's financials. Adjusting balance sheet items that contain tax risks will often involve additional tax liability.
To avoid a possible tax audit, business professionals should learn how to identify tax risks by evaluating the contents of a company’s balance sheet.
There are a few things you can consider, that may present some tax risks. By identifying and correcting these potential discrepancies before the tax authorities find them, you clean your balance sheet and avoid a possible tax audit.
You can start by checking your inventory balances. If the amount of inventory goes up, but the sales revenue does not, this probably means that some products have been sold without recognizing revenue or issuing VAT Fapiao. This discrepancy -high inventory to low sales ratio- will probably push the tax authorities to want to visit your warehouse, in case of a tax audit.
At the same time, if the tax authorities estimate a theoretical revenue that turns out to be much higher than the revenue reported by a company, this may indicate to them that the business is not reporting the real profits.
With the Golden Tax 3 system, tax authorities can estimate the revenue your business should report based on multiple data sources. Tax officers are automatically alerted if a business submits profits significantly lower than the “estimated revenue” within a certain period. Estimated revenue numbers are calculated using the following formula;
Estimated Revenue = (Inventory Opening balance + Purchases in the period – Inventory Closing balance)
Another situation that can be a sign that you might have used the input VAT of the inventory (unsold products) to offset output VAT of the sold products, is when the inventory closing balance cannot be reconciled with your unused input VAT. In this case, you have underreported your VAT and postponed your CIT liability, both of which are non-compliant with tax law in China.
One of the first categories the Chinese tax authorities investigate when they suspect fraud is the “Accounts Payable” on a balance sheet. Some businesses in China purchase input fapiao to overstate their expenses, thus, reducing tax profit and CIT payable. Since these expenses are never paid to any vendors, the payables for these fake payments remain pending and accumulated in the “Accounts payable” category.
The accounting law in China requires accountants to accrue expenses without knowing the exact value in a balance sheet item specifically for accrued expenses. Once the true value is known (fapiao received), the accrued expense needs to be reversed and correct values – as per fapiao – recorded in the balance sheet category related to the nature of the transaction.
It is common that this causes double or wrongful booking, especially when the accountant is not familiar with the business. In the long term, this can get complicated and during an annual CIT clearance, accrued expenses that have not been reversed are treated as non-deductible expenses and incur an additional 25% of CIT payable.
Some accountants book the payments received by a company without a corresponding output VAT fapiao in the “Received in advance” category. Since not all transactions require a fapiao – such as goods for export – accountants that recognize revenue on the basis of fapiao (Fapiao Accountants) often do not identify the payments and they stay under the “Received in advance” category indefinitely.
The “Received in advance” balance can increase significantly over time if this situation persists, calling the attention of the tax authorities. The business is – whether intentional or unintentional – concealing its revenue and under reporting its VAT and CIT.
When a business is experiencing cash shortages, some accountants manipulate revenues to relieve cash flow. When the sales revenue is received, part of the amount is booked as “Received in advance” and the recognition of revenue postponed. This allows for postponing the recognition of revenue to a later period when the business has enough cash to pay the tax. However, it is illegal to manipulate and postpone the company’s tax liability.
To disguise revenue as a payable to delay or reduce VAT and CIT payment is another type of fraudulent behavior that will alert the tax authorities. Payment received for which a fapiao was never issued is often booked in the “other payables” category of the balance sheet, which is similar to “Received in advance”.
Inter-company transactions – especially those which are cross border – such as expense recharges, expenses allocations (such as “overseas headquarter management fee”), short term funding between the overseas headquarter and the Chinese subsidiaries or among associated companies may seem suspicious to the tax authorities.
These transactions are often scrutinized due to strict foreign exchange restriction in China. In order to settle the invoices charged from an overseas inter-company entity, the Chinese entity is required to file and register with the State Administration of Foreign Exchange (SAFE), a time consuming process, or is restricted from transferring funds to the overseas entity as per tax regulations (such as headquarter management fees). As such, those overseas bills remain pending and accumulate in the “Other payables” category on the balance sheet. A significant “Other payables” category increases the likelihood that the company will be subject to a tax audit.
Another payment that will be handled as a cash advanced and registered on the balance sheet as “other receivables” is when an accountant reimburses an employee for an expense claim without the proper documents.
The employee should always submit the correct receipts, mainly fapiao, and the accountant must ensure these documents are registered. Nevertheless, many expense claims go without the necessary supporting forms and remain in the “Other receivables” category on the balance sheet. A substantial “Other receivables” category raises the risk for a tax audit and the potential financial penalty resulting from that process.
Similarly, when company funds are given to shareholders not as taxable dividends or salary but as a personal loan, the amount is recorded on the balance sheet under “other receivables”. However, many business owners often borrow money from the company without any written contract and for an indefinite amount of time. If discovered, the loan will be treated as a dividend paid to the shareholder and subject to 20% Individual Income Tax and, depending on the circumstances, incur financial penalties for non-compliance.
Your balance sheet is the first document tax authorities will investigate should your business be audited. Business owners should be able to look at their own balance sheet and evaluate
whether the figures may or may not contain potential tax risks. A smart way to avoid financial penalties is to reverse the tax risks contained in this document.
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