Everyone at LehmanBrown wishes
you a very Merry Christmas and Happy
New Year!
Internal
controls in China
Managing risk
is essential for positioning a company for growth in the current business
environment. Yet
as companies around the
world clamber to implement integrated risk controls and measures in
light of corporate meltdowns and terrorist concerns, many firms fail
to pull the onions out of their own backyard in China before trying
to harvest the profitable crops ... assuming they are still there!
A large majority of foreign enterprises
with operations in China continue to rely on annual statutory audit
reports and monthly financial statements to monitor potential financial
and business risks. Yet even in highly developed and mature financial
environments, reliance on such limited information
has been proven to be ill-conceived. The Enron debacle
is a perfect case in point - the company was given a clean bill of
health by the auditors and seemed financially stable based on statutory
financial statements, yet the material business risks of the company's
concentration of revenue flows and extraordinary profits which caused
the collapse were not even properly examined.
As management
accountants will poignantly argue, only by "evaluating factors
such as quality of revenues, relevance of costs and accruals, quality
and relevance of assets and liabilities, capital adequacy and structure
and major projects" can a comprehensive enterprise risk management
assessment be made. Such factors are not necessarily published in
statutory reports and, thus, such statements can potentially be misleading
as to the true health of a business.
Further clouding the validity of financial
statements and accounting reports in China is the current business
and professional environment. With the new
Accounting System for Business Enterprises expected to adversely effect
company profits (including Foreign Invested Enterprises),
taxation bureaus cracking down on avoidance and noncompliance, and
with regulations on foreign exchange and treasury management relaxing,
companies now, more so than ever, must fully understand the new risks
in the China marketplace affecting their business.
Business
environment driving professional direction!
The current
environment in China epitomizes the precise reasons why measures such
as internal audits (IA), management system evaluations, business reviews,
due diligence, special audits, and extra internal controls are becoming
a fundamental aspect of surviving and being profitable in China.
Due to
a whole variety of reasons a company often becomes very 'blinkered'
and often does not have the resources or expertise required to review
existing internal processes and procedures. As a result there are
often many areas in a company which can possibly benefit from greater
integration and system/process improvement. The most influential factors
in China creating this lack of efficiency and integration at present
include:
-
- Cost pressures
and expense cutbacks
- Many
companies have frozen headcounts, slashed budgets and wound
back corporate spending globally. This has seen a push for localization
of staff in China, reliance on junior (inexperienced) staff
and a cutback in non core-business services (e.g. finance and
legal).
As such
many companies are not able to seggregate duties as required
and the focus has shifted to reducing cost base rather than
improving processes.
- Boom in Merger
and Acquisition (M&A) activity
-
A surge in M&A activity attributed to an easing of industry
restrictions, sales of SOEs and a more sophisticated stock market
is causing many companies to operate fragmented businesses and
not capitalize on synergy savings and cost efficiencies.
- Increased
dependence on technology
- Companies
in China have spent large amounts of money on Enterprise Resource
Planning (ERP) systems as part of their growth strategies, yet
surrounding processes have not been re-engineered to drive such
efficiencies.
Similarly,
many firms are not realising the benefits of such enterprise
systems as they are not integrated with, or being used by the
business.
- Opaque
corporate governance
- A lack of a comprehensive legal and accounting framework,
as well as unclear government directions, mean that corporate
governance standards and professional ethics are only just beginning
to be developed and put into practice.
- Underdevelopment
of professional bodies and services
- Professional bodies such as the Chinese Institute of Certified
Public Accountants (CICPA) and the China Law Committee have
only been in existence for a short number of years. As such
they have limited control over professional ethics and regulatory
standards which are enforced by government legislation.
- Rapid
changes in regulations
- Development of
the new accounting system, changes to the taxation system and
filing procedures, developments of industry regulations and
WTO commitments have meant that firms are continually grappling
to understand the rules and regulations effective in China.
Given the above issues, there is burgeoning
gap appearing in the relevance of traditional external and internal
audit functions. This has seen greater risks
for companies to ensure compliance (financial, legal and
tax) and also a growing need for company risk assessments to cover
both financial issues and a comprehensive business analysis. Where
as a financial auditor will usually simply cross check and reference
invoices, receipts, cheques and other such 'supporting documents',
an IA will review the business as a whole and identify key areas of
risk and possible weaknesses in control systems accross all business
functions.
In recognising such problems, the Chartered
Institute of Management Accountants (CIMA) (www.cimaglobal.com)
, in late October 2002, submitted a proposal to the Hong Kong government
calling on the government "to impose on listed companies, the
need to conduct Independent Business Risk Reviews and publish Management
Accountant's Reports annually." Such reviews and reports would
be conducted in a similar manner to internal audits "with
the aim of enriching existing statutory statements with an additional
opinion on whether the reported state of company affairs carries exceptional
material business risks."
The body has also submitted the same
proposal to the China Securities Regulatory Commission so as "to
promote good corporate governance in the Mainland"
and restore investor confidence. Mr. Albert YK Law,. CIMA Vice President
(Hong Kong), notes that these measures will surely "reinforce
investor protection, speed up development of financial market, assist
China in her integration with other financial markets after entry
into WTO, and facilitate mainland enterprises
in tapping funding at more reasonable costs."
The
changing face of internal audits!
Internal Audit was once simply the domain
of financial accountants and auditors concerned only with providing
a "watch dog" function. However, nowadays companies need
to understand the risks inherent in their industry, the market and
within their entire business, as well as identifying areas for process
improvement, enhancing revenue, generating cost savings and exposing
areas of weak internal controls. As
Bill Connell, Chairman of the IFAC's Financial and Management Accounting
Committe and Director of Risk Management at BOC once explained:
"Corporate governance has
made risk management very topical, but you cannot go through the
risk management process for those reasons. You
have to do it because it helps the business. If you go
through the process ... for corporate governance reasons you simply
end up with bureaucracy"
To facilitate this process and extrapolate
the benefits many companies are currently looking to out-source
their IA and business review functions to external consultants.
Professional advisors often provide a "new set of eyes"
to the company's problems, offer a greater level of understanding
of the corporate environment and also bring to the table experience
and best practice across all business functions - from finance, accounting,
legal, IT, supply chain management etc.
In the P.R.C. these reviews are imperative.
Companies must have the appropriate financial systems and internal
regulations to retain control over the company's day-to-day activities
and mitigate any financial and business risks. Given the place of
relationships in business practices, along with the above-identified
factors, such risks are inherent in all aspects of business in China,
and are particularly prevalent in the following areas:
- Procurement
and Supply Chain Management
- Many companies do not adequately control procurement, inventory
utilization and disposal of inventory.
Common problems include purchasing of overpriced raw materials
(usually through a company related to a member of staff), discrepancies
of bills of lading and goods received, improper storage of raw
materials and safeguarding of inventory, sales of goods at/below
cost to related parties, and illegitimate disposal of scrap materials
and containers.
- Sales
and marketing expenses
- Incorrect accounting for such expenses incurred by China Holding
Companies and Headquarters (severe tax consequences), unauthorized
and illegitimate reimbursement expenses, "fake" official
invoices and false transfer pricing agreements.
- Corporate
compliance - unauthorized
and inpropert tax registration, under-reporting of tax liabilities,
unauthorized use of company chops, and payment of Representative
Office expenses by offshore entities without correct accounting
and taxation payments.
- Human
resources/payroll - deliberate over-accrual of company
welfare benefits (not in line with government requirements), unauthorized
use of staff benefit funds, dummy employees, discrepancies between
contract salary and payroll salary payments.
- Provisions
and accruals -
over-provisioning to create "slush" funds, lack of company
policy and/or experience for accruals for bad debts, lack of company
policies.
This is certainly not an exhaustive
list of all risk areas in the P.R.C. Comprehensive internal audits
and business reviews directed at the above issues do, however, provide
an additional level of analysis to complement financial statements
and often raises serious issues that management is unaware of.
Where as statutory audits tend to be
historically focused in nature and only centered on financial figures
presented and for statutory filing purposes only, internal audits
and business reviews are aimed to provide strategic and proactive
management recommendations focused on improving company performance
primarily through process improvement and, in China particularly,
identification of fraudulent and corrupt behaviour.
The
final word
To
safeguard investments in China, many experts recommend that companies
conduct comprehensive reviews of financial
system controls and the general financial control environment on
a regular basis. Similar reviews have resulted in companies identifying
serious breaches of control and well-hidden financial and business
risks. Rectification and management of these issues almost always
provides the company with a competitive advantage of sorts, and almost
always adds to the corporate bottom line.
As
the face of business in China develops and advances, companies are
under greater cost cutting pressures and face a more competitive environment.
Whilst some companies look to cutback on the fertilizer and water
to grow their crops, the smart companies
may consider pulling the onions out before they reap the fields.
Cameron Hume, LehmanBrown,
Beijing
|
Special
Seminar Opportunity - "Accounting System for Business Enterprises"
LehmanBrown
China is pleased to announce a seminar to explain the inner
workings of the new "Accounting System for Business Enterprises".
The seminar will be held in Beijing from December
18-19th.
These
seminars present an opportunity for bookkeepers, accountants,
financial managers and directors, as well as other interested
parties, to get up to date on the changes and application of
the new Accounting System for Business Enterprises in China
which is mandatory for all companies in China from January 1,
2002. With the crackdown on taxation, especially for FIE companies,
currently underway this seminar is integral for anyone preparing,
interpreting or using financial statements in the P.R.C.
The
seminar will also cover certain topical business issues in China
at present including changes to taxation regulations, FOREX
regulations and other issues applicable to FIEs in China.
For
registration
information visit: www.lehmanbrown.com/seminars.htm
or for phone registration call: Rachel Wan, Tel: (86 10)
8532 1720 today.
Space
is available for a maximum of 15 participants at the 2 day seminar,
so be sure to book early.
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