In
China, there is a gap in GAAP. Given the differences that exist between
Chinese GAAP and International Accounting Standards (IAS), at the
end of every month accounting departments in China typically get busy
preparing three sets of books: one in accordance with Chinese accounting
standards, one for the taxman, and if a foreign company, one in accordance
with the standards of its head-office's home country.
In
an effort to increase the international comparability and the quality
of accounting standards throughout the world, the generally accepted
accounting principles (GAAP) are a widely accepted set of rules, standards,
and procedures for reporting financial information. The ideal outcome
of cooperative international accounting standard-setting efforts would
be the worldwide use of a single set of high-quality accounting standards
for both in-country and cross-border financial reporting.
China
has however made considerable progress in the convergence of the two
standards and the authorities fully understand that a transparent
and sound financial reporting environment, and no rotten onions, are
essential if the country is to continue to attract the record amounts
of foreign investment witnessed over the past few years. This article
will help foreign invested enterprises (FIEs) in China to understand
the importance of bridging the gap between Chinese GAAP and IAS for
management reporting purposes.
Compliance at Audit Time
All FIEs in
China are required by law to be audited on an annual basis and all
2003 audited accounts, including balance sheets and income sheets,
must be filed with the relevant authorities by the end of April
this year. The Chinese authorities stipulate that all audited accounts
must be prepared in accordance with Chinese GAAP. It's therefore
important that FIEs pay particular attention to the differences
that exist between Chinese GAAP and IAS in order to ensure compliance
with the authorities in China and the requirements of foreign investors.
Chinese GAAP has been developed by a number of different
government authorities including the Ministry of Finance (MoF),
and, for listed companies disclosures, the China Securities Regulatory
Commission. Most notably, the principles are based upon the Accounting
Law, which sets out general principles of accounting for all enterprises,
including a definition of the nature and role of accounting regulations.
In accordance with its commitments under the Accounting Law, since
the 1980s the MoF has issued various accounting regulations that
apply to different categories of enterprises in China.
Although the accounting standards that the MoF unveiled
in the early 1990s were broadly based on international practice,
the regulations failed to make provisions for doubtful debts and
obsolete inventories. The standards also provided for limited disclosure
of financial information for the users to understand the results
and financial position of the reporting enterprise. Therefore, since
1993, the MoF has been working to develop a body of Chinese Accounting
Standards (CAS) that are broadly in line with IAS. Until now sixteen
standards have been adopted and others are under active development
and hope to be adopted within the next two years.
Gaining the Trust of International
Investors
In
January 2001 the MoF implemented a comprehensive Accounting System
for Business Enterprises (ASBE), based on the existing individual
CAS already issued. From that date all joint stock listed enterprises
were required to follow the ASBE, but more importantly, as of January
2002 the MoF extended the applicability of the ASBE to all FIEs in
China. It is expected that eventually all medium-size and large enterprises,
including state-owned enterprises (SOEs), will be required to adopt
the ASBE. Early in 2002, the MoF also issued a new separate Accounting
System for Financial Institutions, applicable to all listed and foreign
investment banks, insurance companies and finance companies.
In
order to gain the trust of more and more foreign investors, the MoF
has set itself the goal of bringing Chinese GAAP fully in line with
those standards used internationally. A senior official at the MoF
declared little over a year ago that:
"Since
financial reports are the most fundamental way in which a company
communicates its operating results and financial conditions to
outsiders, companies must provide reports that its business partners
and investors can understand. If the financial report is prepared
or provided only in conformity with its national accounting standards,
it may be difficult for investors to understand. Communicating
solely on the basis of national GAAP can, therefore, affect the
capital raising activities of an enterprise."
Hence
the need for a set of accounting standards accepted by most countries
around the world. The International Accounting Standards Board (IASB)
is responsible for the convergence of accounting standards on a worldwide
scale. Founded in the 1970s as a result of an agreement between the
accountancy bodies of nine different countries, including the USA,
the UK, Germany and Japan, it has been decided that the IASB should
have full and complete autonomy in the setting of international accounting
standards, recently designated as International Financial Reporting
Standards (IFRS), and in the issue of discussion documents on international
accounting issues.
Chinese Accounting Standards
The sixteen specific accounting standards
already issued by the MoF in China then are largely consistent with
IFRS, though only seven are applicable to FIEs. Importantly, the new
CAS have sought to define the objectives of accounting statements,
establish a basis for presenting financial reports such as cash flow
statements and define accounting fundamentals such as asset, revenue,
expense and profit.
CAS assert that the objective of accounting
statements is to provide information that reflects the financial condition,
operating results and cash flows of an enterprise that are useful
to investors, creditors and other users of accounting information
in making informed decisions. This objective is in stark contract
to the standards typically prevalent in the old accounting system,
when accounting statements were typically designed to service the
needs of SOEs and local government for supervisory and management
purposes.
Under both Chinese GAAP and IFRS,
accounting statements reflect the characteristics of understanding,
relevance, comparability and reliability and the presentation requirements
of both standards include an income statement, a cash flow statement
and notes to the financial statements. The number of adjustments required
to convert a financial report prepared under Chinese GAAP to a report
prepared using IFRS have therefore reduced over recent years.
Shortcomings of Chinese GAAP
Inconsistencies still exist however
in a few major areas and there are several reasons why international
users consider the quality of financial statements prepared under
Chinese GAAP to be insufficient for financial reporting purposes.
CAS overlook the rule that inventories are valued at cost or at market
price, whichever is lower, and the maximum amortisation period for
intangible assets is ten years, whereas using IFRS it can be extended
to a maximum of twenty years. Companies using international standards
can choose whether to capitalise borrowing costs or not. In China
however, borrowing costs on project-specific borrowings must be capitalised
as part of the cost of acquiring or constructing a tangible fixed
asset.
In some areas, such as mergers, amalgamation
of accounting reports and hyperinflation, there are no specific standards.
Furthermore there is no public requirement on the disclosure of some
important issues such as the agreed value of financial means. There
is also a difference in the classifications of assets in the balance
sheet, since under IFRS assets are either not classified or are classified
into current and non-current. Under Chinese GAAP however it is stipulated
that assets must be classified into one of five different categories.
Before
the implementation of the ASBE, the accounting regulations in China
were closely aligned to tax laws and the taxation system. The new
system however places greater emphasis on a conceptual framework and
since unfortunately the tax system has not moved in the same direction,
there currently exists a greater variance between accounting and tax
requirements in China and the result is a larger number of deferred
and current tax adjustments.
FIEs
can now use a number of different accounting methods when making tax
adjustments, none of which are comparable to the methods used in IAS.
Under the 'tax payable' method the tax expense is equal to the provision
for taxes payable in a particular period and deferred income tax is
not recognised. Other methods do recognise deferred tax assets and
liabilities, but when measuring the deferred taxes however, either
the current tax rate or the expected tax rate may be used.
The
tax implications of the new accounting system include a number of
potential income tax adjustments such as the amortisation of intangible
assets and pre-operating expenses (deferred until the entity begins
operations, then charged to expenses), and timing and measurement
differences on revenue recognition. It's essential therefore FIEs
in China seek the appropriate advice in order getting tripped up by
the potential pitfalls caused by the inconsistency between the accounting
and tax requirements.
Need for Due Diligence
As
a result of the differences that currently exist between Chinese GAAP
and IFRS, financial reports in China do not always accurately reflect
an enterprise's actual financial position and operating results. This
can cause particular problems if a foreign investor needs to ascertain
the true worth of a domestic Chinese company that it might be interested
in acquiring. Many of the tax rules that are still applied by the
majority of domestic Chinese companies were originally designed to
suit the needs of SOEs, and are archaic in nature. Despite the rise
in salaries in China in recent years, domestic companies are still
only permitted to offset 960 RMB of a salary against revenue for tax
as a deductible, meaning that employees are encouraged to offset the
rest of the salary payment against expenses such as accommodation,
transportation costs and meal allowances.
A
clear analysis of a domestic Chinese company's strengths and weaknesses
is therefore not an altogether straightforward process and extensive
due diligence and repackaging services should therefore be mandatory
in any M&A deal. If Chinese authorities can replace the current
tax systems with one system for both domestic and foreign enterprises,
and continue to reduce the difference between financial statements
prepared under Chinese GAAP and those prepared in accordance with
IRFS, then in the future foreign investors will be able assess the
performance of investments more efficiently.
Steady Convergence
with International Standards
Given
the MoF's desire to establish a set of standards and procedures that
reflect the specific economic conditions in China's evolution towards
a market economy, certain important accounting principles applied
in IRFS are not adopted under Chinese GAAP, such as the use of fair
value. The approach of the MoF has been to establish a set of CAS
suited to China's current business environment, while at the same
time maintaining a steady convergence with IFRS.
The
old accounting principles were designed to meet the needs of a planned
economy, and therefore focused on whether the production goals and
cost plans of the country's many SOEs were being met. Accordingly,
the objectives of the accounting system at that time were starkly
different from the financial reporting objectives necessary in a modern
market orientated economy. The principal aim of the new accounting
system has been to replace this accounting model with a set of standards
more suited to an evolving market economy.
A very significant portion of the
Chinese economy is still dominated by SOEs however. Even after such
enterprises have been restructured into joint stock enterprises, regional
governments that remain stakeholders still exert considerable influence
over the enterprises and their trading partners, and related party
transactions are common. China has adopted a prudent approach in the
consideration of using fair value as a basis for measurement due to
the current market situation and it is therefore difficult to determine
fair value for non-monetary assets. Similar problems apply in other
areas, including the accounting treatment of debt re-structuring.
Since the IASB formulated the IRFS
primarily in the context of developed market economies, the MoF has
asserted that until the obstacles faced by an economy in transition,
as is the case in China, are competently eliminated, it is impossible
to bring Chinese GAAP completely in line with IFRS. In the meantime
then, FIEs will have to continue to make numerous adjustments when
they compile financial statements under international standards, as
almost invariably will be required by their foreign investors. Such
FIEs might therefore consider the benefits of having an outside professional
firm review their financial reports, in particular those prepared
for the annual audit in April, for GAAP adjustments.
Goals for the Future
As
a result of it's accession to the World Trade Organisation in 2001,
China will increase its scope and extent of international cooperation.
It is widely expected that the MoF will have issued a further nine
accounting standards by the end of 2004 and has stated that the MoF's
aim is to "hasten the progress of the accounting standards projects
in order to accommodate the development of the market economy."
The MoF has also stipulated that during this process they will continue
to make reference to standards used internationally, declaring that,
"unless they clearly contradict with the existing law and regulations
in China, CAS will keep in line with the IFRS to the extent possible."
The MoF will also embark on industry-specific standards that focus
on sectors of the economy that are of great significance to China
such as agriculture, banking, insurance, oil and gas.
Despite
the above-mentioned efforts by the Chinese government authorities
to bridge the gap in GAAP, it's important to note however that some
users of Chinese GAAP have considered that such financial statements
have proved insufficient for international users not because of the
disparity that exists between the two standards. Rather, the main
problem is a lack of transparency, auditor independence and reliable
financial information, and a shortage of qualified accounting professionals.
The pressure for transparent, publicly
disclosed accounting information is reduced by the continuing extensive
share ownership by the state and institutional investors. The resulting
close link between tax reporting and financial reporting creates demands
such as ensuring a stable source of tax revenue for the state and
avoiding reporting embarrassingly large profits or losses. So long
as the state remains a major stakeholder in the Chinese economy, there
exists enhanced opportunities for income manipulation to hide losses.
Off balance sheet liabilities of uncertain quantities further reduce
the transparency of financial statements.
The
real challenge facing the accounting environment in China then lies
not only in adopting more internationally accepted standards but also
in the reform of the financial and taxation systems, and in the development
of auditor training and independence. Indeed, without an independent
audit environment, even accounting statements prepared using IFRS
might still prove to be unreliable. Bridging the gap in GAAP might
seem like mission impossible, but with a clear understanding of the
issue involved and the right assistance, all companies in China can
ensure that their accounting statements satisfy all the necessary
requirements, with no rotten onions!
Michael Pennington
LehmanBrown, Shanghai
