Analyzing Chinese Financial Reporting

February 7, 2011 Posted by Chris Devonshire-Ellis Reading Time: 8 minutes

Part Three in a four part series

Op-Ed Commentary: Chris Devonshire-Ellis and Sabrina Zhang

Feb. 7 – In this article, we will focus on understanding and analyzing the typical accounts of Chinese financial statements, including the balance sheet and income statement. In our firm’s 19 years of experience in China, when called upon to examine accounts prepared by Chinese businesses, we have consistently found accounts have been incorrectly prepared. This can be due to several factors, including incompetence or, in more serious cases, deliberate attempts to deceive. Regardless, accounts can be understood and errors or specific acts of misrepresentation uncovered. We will conduct some simple analysis to demonstrate how errors or acts of misrepresentation can be spotted.

Each of the cases we discuss here derives from analysis gleaned from projects previously undertaken by our practice. Most of these cases relate to Chinese private companies; some of them are medium sized FIEs. They have arisen largely as a result of financial due diligence undertaken by us either as part of the evaluation process for an acquisition, or during the audit process analyzing both wholly foreign owned enterprises (WFOEs) and joint ventures (JVs) in China.

In all cases, the initial recording of the accounting books was conducted 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.

It is the responsibility of the legally responsible person in China to overview and approve accounts as prepared by local staff. If accounts are prepared, submitted to the government and found to be wanting, the penalties can be severe and may lead to not only late tax payment penalties, but also to additional reporting problems with customs and the tax bureau. Government bureaus may for example insist upon bonds being made or even restrict the import-export capabilities of the business. In serious cases, attempted tax fraud can lead to prison. Accurately reported financial statements are thus a priority for foreign investors in China. Prior to an acquisition, these same points of due diligence apply in order to correctly evaluate the exact financial position and compliance of a target company.

We will look at the issues as determined by firstly the balance sheet and secondly the income statement.

In the balance sheet, we focus on: Accounts Receivable; Other Accounts Receivable; Fixed Assets; Construction in Process; Accounts Payable; Other Payable; and Payroll Payable.

In the income statement, we analyze: Sales Income; Cost of Goods Sold; Expenses; and Income Tax.

The Balance Sheet:

1) Accounts Receivable (AR)

This account mainly deals with the transactions of the company

Typical weaknesses

a) Many businesses in China cannot prepare an AR aging analysis because of poor communication between the sales department and financial department.

b) It is common practice for businesses to attempt to hide sales to reduce taxable income, and as such, the AR is usually under-reported.

2) Other Accounts Receivable (Other AR)

Typical weaknesses

Many irrelevant transactions are often recorded in the Other AR account. For example, there may be an internal loan between two related companies, with this being recorded into the account of Other AR and not listed as a transaction in the investment account.

3) Fixed Assets (FA)

Typical weaknesses

a) Often self-established fixed assets are not included in the FA, and the relevant depreciation is not taken accordingly.

b) The cost for establishing the fixed assets is recorded in the Expenses account or Cost account but not capitalized.

c) Only a small number of companies conduct periodic counting and post the FA Label correctly.

4) Construction in Process (CIP)

Typical weaknesses

a) Some self-established fixed assets are not recorded in the CIP, nor later transferred to the FA.

b) Original supporting documents related to CIP are not properly filed and documented.

5) Accounts Payable

Typical weaknesses

Sometimes the enterprises will book irrelevant transactions in Accounts Payable.

6) Other Payable

Typical weaknesses

Please refer to the introduction of Accounts Receivable.

7) Payroll Payable

Typical weaknesses

Often there will be an ending balance of the Payroll Payable, however we note many Chinese companies delay part or all of the employees’ salaries.

8) Sales Income

Typical weaknesses

a) Company management often does not record all sales revenue in the financial statements prepared for the tax bureau. For example, for some cash sales, the target company will not include them into the financial statements and will maintain them in an internal sales book.

b) Sometimes the sales will be delayed as recognized in order to reduce the sales volume in the current accounting period.

9) Cost of Goods Sold

Typical weaknesses

a) In many cases, the business did not adopt a sound cost carrying forward method to record and allocate costs.

b) Often businesses will record irrelevant items in Cost of Goods Sold, such as self-established FA cost.

10) Expenses

Typical weaknesses

a) 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.

b) Some expenses have exceeded the limitation of deduction as listed in China’s Tax Law.

11) Income Tax

Typical weaknesses

In almost all cases, income tax will be under-reported. Their P/L usually shows a loss at the end of the financial year.

Here we examine the balance sheet statement prior to due diligence, then the adjusted figures. Explanations are in the notes below:

Balance Sheet Comparison Year ended December 31, 2010 (RMB thousand)
		Original(Prepared for Tax Bureau)	Revised (Post Due Diligence)
Current Assets	Cash and bank	192	192
	Accounts receivable	6,839	18,332	N1
	Other receivables	611	611	N2
	Inventories	22,910	20,365	N3
	Prepaid expenses
	Total current asset	30,552	39,500
Fixed Assets	Cost of Fixed Assets	37,306	49,876	N4
	Accumulated depreciation	7,083	7,083
	Fixed assets-net book value	30,223	42,793
	Construction in process
	Total fixed assets	30,223	42,793
Total Assets		60,775	82,293
Current Liability	Short-term loans	21,000	21,000
	Accounts payable	8,485	4,670	N5
	Other payables	9,058	13,023	N6
	Accrued payroll	715	715	N7
	Welfare payable	48	48	N8
	Tax payable	11	11	N9
	Other submit	-26	-26
	Total current liability	39,291	39,441
Long-Term Liability	Long-term loans
Total Liabilities		39,291	39,441
Owner’s Equity	Paid-in capital	18,055	18,055
	Capital reserve	5,298	1,333	N10
	Surplus reserves-welfare fund
	Undistributed profit	-1,868	-1,868
Total Owner’s Equity		21,485	17,520
Total Liabilities and Owner’s Equity		60,776	56,961

General Introduction
This example is a Chinese private company located in Western China. The company records and maintains a set of financial statements, which are prepared for tax purposes. They also maintain incomplete internal financial data, including sales, accounts receivable and accounts payable, prepared in a different format from the financial statements. An additional issue is that the local management does not prepare complete and accurate cost information.

N1:

1) The company is not disclosing all accounts receivable in their financial statements to the tax bureau due to the under-reporting of sales revenue as mentioned in N11.
2) In most cases, reconciliation between the target company and customers is not conducted in a timely manner.

N2: Note that for certain key transaction accounts such as other receivables and other payables, the company has recorded some questionable transactions. Even if there are no variances between the data before and after the adjustments, the account needs attention.

N3:

1) The company have maintained their financial books manually, and cannot accurately update inventory movements in time. The variances between actual stock and book figures were adjusted manually by an internal accountant.
2) Physical inventory counting has not been conducted properly, and no sound investigation work has been performed.

N4: In some cases, the fixed assets ending balance is not accurate because:

(a) The company is a manufacturing entity, and assets should mention that some equipment is made by the company, not purchased from outside vendors.

(b) VAT implications exist as according to Chinese tax law, VAT related to fixed assets purchasing cannot be deducted from the current period’s input VAT. In order to deduct more VAT, the company has not included materials to produce equipment into the original value of fixed assets, but has instead recorded the materials into the current period’s expense account.

c) Corporate income tax implications. Recording these materials into the expense account instead of amortizing them as fixed assets will deduct more expenses in the current period and allow the company to under-pay their corporate income tax. It is difficult for the auditors to trace back the accurate influenced amounts. As such, the revised figure is maintained as the same as the original figure in our revised financial statements, however this issue has been identified.

d) In other cases, the company has purchased fixed assets from vendors and has not requested an invoice. As compensation, the purchasing price will then be lower. The company has not included this part of the fixed assets into the FA account. As such, the fixed assets included in the FA account are under-reported.

N5: As for the accounts receivable, the company management also maintains an internal record for accounts payable. The transaction accounts such as AR, AP, other receivables and payables needs to be noted carefully.

N6: As mentioned above, other receivables and payables needs to be have attention paid to them. In this case, the company management reduced the end balance of other payables by RMB3.96m. The amount is part of the inter-company liability and the reduced RMB9m was recorded in the debit of the capital reserved account.

N7: We usually see the following situations when due diligence is conducted:
1) There is an ending balance in the payroll account since some target companies usually postpone paying salary to their staff.
2) Errors might occur in the calculation of the salary payable.

N8: Some target companies do not accrue complete social-welfare for their staff which might be challenged by the social welfare bureau.

N9: In some cases, the target company does not issue VAT invoices to customers. As such, the VAT will be under-reported.

N10: Please refer to N6.

Income Statement Comparison Year ended December 31, 2010 (RMB thousand)
		Original(Prepared for Tax Bureau)	Revised (Post Due Diligence)
Sales Revenue from Main Operations		16,991	38,676	N11
Less	Cost of sales	19,975	19,783	N12
	Operation expenses	735	735
	Tax of principle operations	56	56
Operating Profit (Loss)		-3,775	18,102
Add	Other operating profit (loss)
Less	Administration expenses	1,358	1,358
	Finance expenses	1,625	1,625
Operating Profit (Loss)		-6,758	15,119
Less	Other expenses	294	294
Gross Profit		-7,052	14,825
Less	Income tax		4,891	N13
Net Profit			9,934

N11: In most cases, there are two possibilities for an incorrect ending sales account balance:
1) Cut-off issue
It is necessary to understand how revenue is recorded in the company as it quite often departs from GAAP standards. For example, sales revenue of FY2009 can be delayed and recorded in FY2010, as in this example, for the purpose of delaying tax payment.

2) Incomplete sales data
Sometimes, the company management does not record all sales revenue in the financial statements prepared for the tax bureau for the purpose of tax evasion. For example, the target company may conceal cash sales by not putting them into the financial statements but maintain the records in an internal sales book only.

N12: Companies often cannot establish an appropriate costing carry forward method to record accurate cost.

N13: Under-reported sales revenue will influence corporate income tax directly.

Summary
The importance of understanding Chinese financial reporting and financial management revolves around due diligence, verifiable accounting and risk reduction. The points mentioned above are only a general level introduction of typical problems when assessing financial statements prepared by Chinese staff.

Differences in Chinese GAAP protocols and the standards of Chinese financial reporting make the discipline of analyzing and understanding Chinese company accounts an area in which both experience and specific China knowledge are vital. Explanations can only be provided by 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.

As interest in the acquisition of Chinese businesses increases, due diligence is increasingly necessary to correctly assess a potential acquisition target. 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.

Dezan Shira & Associates has 19 years of experience in China and can assist with all aspects of financial and legal due diligence. Please email the firm at info@dezshira.com, or download the firm’s brochure here.