China Joint Ventures: Financial Due Diligence

October 30, 2009 Posted by China Briefing Reading Time: 5 minutes

Part Three in our “Joint Ventures as a Strategic Investment” series

By Chris Devonshire-Ellis and Richard Hoffmann

Oct. 30 – Financial due diligence in China can be an awkward issue to resolve, not least because there are no publicly available records systems in China that permit viewing of reported accounts. Instead, field investigations must be carried out to determine the position of the business. Delving into the minutiae of Chinese financial reporting is something of an art – the average Chinese businessman will not have filed accurate accounts, as China’s tax bureau is woefully inefficient at collecting incomes. Tax avoidance is rife, standards of reporting are far less sophisticated than in the West, and some statements may be designed to extract money from the unwary investor. However, because of this scenario, financial due diligence in China goes beyond a look at the books. It also provides a platform to enable the foreign investor to examine the integral honesty of the business, the management systems in place that administer it, and what needs to be done to bring these up to scratch.

Domestic Chinese companies are not generally scrutinized much by the local tax bureau, however foreign investors are. A Chinese investor in a JV should be amenable to changing reporting habits if he is to own stock in a foreign invested JV. Comments such as “We’ve always done it this way” or “We’ll take care of it” are simply not good enough and will lead to trouble later. If that mentality cannot be broken down, walk away. In this article we will examine some of the common issues when conducting financial due diligence on joint ventures in China.

Accounts
The majority of Chinese companies keep two sets of books, mostly for tax avoidance purposes. Accordingly, providing the true set of accounts to you represents a risk – the business owner has to trust the potential partner to keep his secret. This can result in a reluctance to provide a full set of accounts. However, they must be obtained, to examine both risk, and management standards. If you forgo this procedure your investment is at serious risk.

Overheads
There are a number of checks and balances experienced Chinese auditors can employ to “kick the tires” and evaluate how accurate the financial statement is. There are also a number of areas that demand scrutiny. Have overheads been correctly stated? Are there any inflated related party transactions? Have staff liabilities been properly assessed?

Related party transactions
If a supplier is identified and costs merely accepted, then you run the risk that a related party has been inserted into the purchase chain. Costs of materials and services provided must be checked against market norms.

Staff liabilities
Many companies in China do not properly pay mandatory welfare, and this liability may be left off the books. It can be a huge risk. HR payments need to be cross-referenced.

Receivables
Are these at norms? Are there any related third party transactions? Does stock control match up with the sales ledger? It is common for stock to have been shifted without supporting invoices in a mechanism designed to limit the cash flow impact of paying VAT.

Company accounts
Again, for tax avoidance issues it can be common for company money to be in private accounts. If there are sales/stock discrepancies, there maybe an off balance sheet private account somewhere that needs to be tracked down and identified.

Sales
Are these verified? Have they been inflated? Are there third party transactions? Are prices sustainable? Is there a risk in the nature of the buyers? Stock control again will provide some answers, however it is always a good idea to run checks on some of the customers to verify purchase.

Debts
These can be hidden. What are the levels of bad debt? What happened to the stock? Was litigation pursued? Is the debtor still buying from the company? Was a bankrupt notice provided to offset any material loss?

IP
Does the company own any IP, or have license agreements in place? Will any of these be chargeable or liable to the JV?

Audit
Does the company properly declare its financial reports to the tax bureau? What is the extent of any double book keeping issue? What is the liability – including fines – if this is uncovered? What will the impact be on the Chinese partners business when the JV has to sign off on properly reported accounts? Could it cause problems if the JV correctly reports and the Chinese partners business does not?

Management
Due diligence will also demonstrate the capabilities of the existing management team and what needs to be done if this needs to be upgraded. Is the business essentially honest? Is administration competent? Are any problems with the financials fixable? Will you be able to engineer a higher standard of financial reporting in the JV? Management is always a key fixture of Chinese JV’s, and attention to detail needs to be placed upon it. Analyzing the contents of your financial due diligence also gives you an opportunity to examine cultural compatibility, and the level of competence you have to work with.

Professional advice
These are just some of many financial due diligence issues that need to be addressed; they vary depending upon each specific case. A good professional firm will be able to discuss all the issues with you, assess what needs to be checked through, and allocate dedicated on the ground staff to look into and report back. We do not recommend using any firm that subcontracts such work, as if they are not in control of, or managing the process directly, the margin for error is significantly increased. We recommend only using firms with a proven track record and with applicable resources and offices in China.

Chris Devonshire-Ellis is the founding partner of Dezan Shira & Associates and lived in China for 21 years. He has over 17 years of experience in establishing JVs in China. He is now based in Mumbai.

Richard Hoffmann is a senior associate of Dezan Shira & Associates and has seven years experience of foreign direct investment in China. Richard also writes for the Legal Ease column on the Beijing Review, China’s only English national news magazine. He is based in Beijing.

To contact Dezan Shira & Associates’ business advisory services division for JV advice and other corporate establishment issues email info@dezshira.com.

Related Reading:

Why the Need for a Chinese Partner?

China Joint Ventures: Legal Due Diligence

China Briefing Magazine:

Are You (Really) in Control of Your China Operations?

Analyzing Chinese Financial Reporting

Conducting Due Diligence in China

China Briefing Books:

Setting Up Joint Ventures in China (available in hard copy and PDF)