Kicking A China Business’s Tires – The Checklist

February 9, 2011 Posted by Chris Devonshire-Ellis Reading Time: 18 minutes

Part Four in our four part series on China due diligence

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

Feb. 9 – As we have discussed in our previous articles this week (see links to these articles at the end of this post), due diligence is perhaps one of the most important concepts that any investor in China needs to consider. Whether setting up for the first time, taking a look at internal practices after years of doing business on the mainland, or evaluating a company for acquisition or listings purposes, it is important to stay compliant with China and the global business community’s evolving regulations. This means making sure all Chinese documentation is current, accurate and authentic, all financials are properly reported and employee issues and other assets have been properly accounted for.

The concepts presented here should not only be followed when considering investing in China (as they help to identify the real value of any potential China investment), but also should be used as a foundation for conducting reviews in companies already operating in China, where they can help to reduce risk and avoid the sorts of problems that can evolve when not enough attention is paid to internal issues.

In this article, we summarize three forms of due diligence in checklist format: operational, financial and HR.

Operational Due Diligence

Foreign enterprises based in China often lack reliable operational information and the method of booking transactions by Chinese employees may not live up to the expectations of the parent company. One reason is the occasionally unique aspect of the business environment in China: administrative processes that are not transparent. This does not necessarily mean outright fraud is being committed, however lack of transparency in administrative processes can lead to a breakdown in transparency of business transactions, which can reduce management accounting strength and in turn lead to tax exposures or theft. The likelihood of being disappointed by the performance of local accounting and administrative staff can be reduced by conducting operational due diligence.

This type of investigation can be a highly effective tool in helping understand exactly how a China entity works and can also prove effective in evaluating how well the current operations support future strategic objectives. The examination should include a detailed assessment of the following:

• The functional operations of the business and the processes and systems supporting it
• The inter-connectedness of these operations
• The likely impact of operations on the future continued viability of the company

Operational due diligence completes the view of a company in areas not fully addressed by financial due diligence and can often be a very important tool in identifying the real administration and value of a China-based business. Financial due diligence typically verifies the company’s financial statement and the potential future sales and profitability, but chiefly uses historic patterns and trends as its base point. Operational due diligence goes much deeper in assessing a company’s functional operations and the interactions between them.

One of the most fundamental issues that needs to be verified in operational due diligence is whether a company has been properly established and is a legal entity. Documents which need to be checked include:

• Current and former business licenses plus all ancillary licenses and permits to operate
• Constitutional documents of the company – and if any changes made have been properly reflected in the articles of association
• Verification documents issued by the company’s bankers as regards to capitalization and bank account holdings
• Other registration documents as issued by the appropriate government authorities and pursuant to the applicable laws and regulations, including tax registration as well as foreign exchange registration
• Documents relating to the contribution of capital – for FIE’s this includes the valuation certificate which relates to in-kind contributions, the capital contribution verification report, and copies of the investment certificates that are issued to each investor by the FIE
• Asset valuation reports – these must be ratified
• Any documents that give evidence to any transfer of equity interest or shares
• Documents evidencing any increase or decrease of registered capital or the total amount of investment
• Documents that supply evidence to equity interest or shares being used as securities
• Any other documents pertaining to approvals, licenses or permits required for the establishment and operation of the company or nay branches or subsidiaries

The examination of any of these documents should be done so while taking into consideration the context of other documents. This should allow for a full understanding of a business’ overall legal status. Such checks should be conducted each year and each aspect of compliance should be methodically checked.

Organizational Structure
The organizational structure is a key point for the operational success of any business in China. Details that need to be checked:

• All investors or shareholders in the business are mandated
• The company’s external organization structure; this includes the details of all domestic and overseas subsidiaries, representative offices, branches, distribution centers, research operations and other associated enterprises, together with the appropriate documents evidencing their proper establishment and operations
• The company’s internal organizational structure with an organizational chart disclosing the full names, age, remuneration and contract details of the members of any supervisory board, board of directors, senior management and other key personnel
• Any company manuals or internal company rules or policies
• Details of all meetings of the company organs such as the board of directors, general shareholders meetings or any supervisory board, as well as any committees including adopted resolutions in the last three years
• Documentary evidence pertaining to all of the above, including copies of business licenses, constitutional documents (such as shareholder agreements), joint venture contracts and articles of association, government approvals and registration documents
• Other documentary evidence including minutes of all meetings of the company organs and adopted resolutions from the last three years, as well as letters of appointment and employment agreements

Risk Assessment
Risk assessment is vital. The four main categories of operational risk by international standards are: process-related; people related; systems-related; and external events. These are qualitative problems that can have a significant quantitative impact, and they tend to be the instigators of the conditions for the most serious mismanagement and endemic corporate corruption. Operational due diligence aims to assess the possibilities of these risks and their potential effects on the business.

Key Operational Functions
A company’s operational capabilities can be the basis of specific auditing and tests should be devised in order to measure the value chain. The steps involved in this will vary depending upon the company, but should involve an on-site analysis of the company’s daily business processes and of the systems supporting the business’ operations. This analysis should involve an evaluation of production capacity, raw material flows, inventory levels (especially when measured against purchasing and sales) and all other factors that are necessary for the business to conduct normal operations.

Operational due diligence may also assist in assessing the possibilities and, from an operational point of view, administrative advantages of merging or centralizing already existing independent operations. How this is done is unique to each situation and if you have a combination of JVs, WFOEs and ROs, then it may make a lot of sense to try to bring all these into one holding operation in China for ease of management.

External Relationships
These should extend to the businesses relationships with both buyers and suppliers, and checks completed against the highs and lows on both accounts. The insertion of beneficial relationships into this is very common. Are there buyers who receive preferential treatment in price or credit terms (or even debt)? Are there purchasers whose prices are not in line with market norms who may be selling to you at above market rates? Due diligence checks for these questions and comparisons to market norms can verify the transparency of your supply chain management and ensure the system is not being abused.

Competitors
We have come across cases in the past whereby orders into the foreign-invested enterprise are siphoned off to a “mirror” company. Often these are established by employees directly or their relatives. Usually such companies operate Chinese language-only web sites, and incoming orders are redirected to them.

Checks need to be made against incoming orders and related documentation, with a random check of inquiries that did not result in a sale being followed through as part of an internal investigation with the potential buyer about where the order was ultimately placed. Checks should also be carried out on any documentation that may lead to a mirror company being parasitic on your incoming orders. In one case we found, an invoice had been presented for a Chinese domain name. It turned out to belong to Chinese employees of the foreign invested enterprise, who redirected orders to their own business. Annual loss of orders to this mirror company were in the region of US$4 million. Blame for poor sales by the FIE had been placed upon “competitive market conditions.” An experienced auditor completing administration checks will help identify any such fraud – and hopefully keep staff aware that checks against such practices are in place.

Environmental Considerations
As the Chinese government becomes more concerned about environmental issues in China and the damage that polluting companies cause, it is taking decisive steps to regulate and to ensure compliance with environmental standards. As a result, manufacturing businesses now need to take conscientious due diligence with regard to environmental liabilities. For example, a factory built on land that has been previously polluted may be required to clean up. The concept of “polluter pays” is not always followed in China. Assessing land quality – especially if new plots are to be purchased – is a prerequisite and assessing what potential liabilities may lurk beneath the soil is wise.

Attention should be paid to the following:

• What is the current environmental situation of the company? Has it had any environmental problems in the past or might it get any environmental problems in the future after the take-over? If yes, then what types of counter-measures have been taken and what are the results of these?
• Has the company stored or used any hazardous substances, raw materials, objects or has it been involved in any hazardous procedures?
• Has the company paid any pollutant discharge fees over the last years?
• What is the company’s policy regarding environmental issues?
• Can the company provide any documentary evidence regarding information such as environmental impact assessments, licenses, approvals, permits, permissions, certificates, applications, registrations and notifications?
• Can the company provide any reports on its environmental situation produced by (private and governmental) third parties over the last five years?

The environment is still a developing issue in China. Expect over the next few years that regulations will become tighter and more strictly enforced, thus requiring further attention to due diligence.

Corporate Secretarial
It is vital to remain in compliance in both accounting and the corporate secretarial (documentation) aspects of your business. A lack of attention to detail in paperwork alone can seriously jeopardize operations. Have trademarks and patents been registered in China? If not, get them done. If they have, was it an agent who registered it or the parent company directly? Check where ownership lies. Are all business licenses up to date? This should include annual renewals as well as other pertinent licenses and permits – export licenses, customs and SAFE (foreign currency) registrations.

Financial Due Diligence
Copies of accurate financial accounts can sometimes be difficult to extract from your business. This is largely due to the fact that many businesses in China operate two sets of books – one internal, which shows their true position, and one official, which shows their “official” position. This is of course illegal, but is a common practice, as tax avoidance in China is rampant due to the relatively high level of income tax (25 percent) companies in China have to pay. Well-meaning staff, trying to save money for the company, can inadvertently cause serious compliance and potential liability problems, either through naivety or deliberate actions.

The State Administration of Taxation (SAT) is also somewhat inefficient at making collections. Some of the SAT’s practices – such as making VAT liable on invoicing, not on collection – have also led to inappropriate financial reporting being the norm in many companies based in China. In such cases, sales income may for example be directed to the general manager’s personal bank account rather than the company account “to save on VAT” until the full income has been received. Well-meaning maybe, but illegal, and certainly a vehicle for potential fraud.

If accounts are run in such a manner, this means that the official set of books as presented to the Chinese authorities and audited will not represent the true strength of the business. The SAT, if it finds out about such activities, has the right to levy late payment penalties of up to five times the amount due on any taxes paid later than should be properly administered. The SAT can also give staff leverage over an employer if the business is deliberately kept out of compliance. Such activities should be rooted out and accounts should reflect the true position, even if the tax burden increases. Operating a business without full disclosure in China is ultimately a false economy and should not be tolerated.

Assessing Financial Statements and Audits
It is advisable to contract a professional accounting practice that has experience with SOEs to assess the quality of the audited accounts as presented. A two-to-three day site visit by an experienced, impartial auditor should be enough to provide an opinion on whether accounts and financial statements presented are indeed a true statement of fact or whether there are areas within them that warrant further investigation or explanation.

This needs to be handled with care and understanding. If it’s purely a business assessment that needs to be made as to the administrative transparency of the business, then to some extent a pragmatic approach to the staff reporting methodology may be taken as a first tier check. If this raises questions, depending on the nature of the matter, a more complete examination may be pertinent based on areas of concern. This can sometimes escalate into more serious cases and become a much more complex issue with far more serious implications.

The SAT places all foreign-invested enterprises in China, including joint ventures, under Category 1 – the highest – in tax bureau monitoring and assessments. Administrative staff not aware of this fact and familiar with the corner-cutting common in many purely domestic businesses may not fully appreciate the difference between domestic and foreign-invested firms in this respect. It is wise to insist that staff work to the company’s administrative standards and not to ones they wish to impose.

Taxes and Tax Filings
Most filings need to be conducted on a monthly basis, with audit annually. If these are not being conducted, then the business is not in compliance and will have an unpaid tax liability. Reporting should be to a professional standard and maintained. An inability to provide accounts, audited accounts or on-going documentation is a sign that all is not well.

Taxes that need to be considered include:

• Corporate income tax
• Value-added tax
• Consumption tax – additional turnover tax placed on luxury goods
• Business tax – applicable to services not subject to VAT
• Land value-added tax
• Resource tax
• Urban real-estate tax
• Stamp duty
• Motor vehicle and vessel acquisition tax – including taxes on usage and license plates
• Deed tax – imposed on acquisition of land use rights and real property

Representative Office Taxes
One should remember that representative offices are subject to business tax of approximately 9 percent of their expenses, which has to be calculated, filed and paid on a monthly basis. An annual audit is also required. On rare occasions, an RO can file for and obtain tax exempt status, but this must be approved by the local tax bureau beforehand. If taxes have not been paid, the tax bureau can fine you up to five times the total amount due plus the original amount, and in extreme cases, withdraw the business license.

This can add up to a significant amount of money. In one case, a well-known international luxury goods brand in Shanghai had not paid taxes for over three years. With monthly overheads of some US$8,000, the amount due was US$28,800 with late payment penalties potentially increasing that to US$172,800. The implications are serious. Non-payment of taxes by ROs is a serious matter and business should make sure that they are in compliance from day one. If not, a day of reckoning will arrive, and if the company wishes to remain in China, the tax bill will need to be met.

Financial Reporting
Differences in China GAAP protocol 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.

A Chinese balance sheet should detail, among other things, accounts receivable, other accounts receivable, fixed assets, construction in progress, accounts payable, other payable and payroll payable. Several typical weaknesses can creep into these accounts.

Accounts receivable mainly deals with the transactions of the company. Two common weaknesses often occur: many businesses in China cannot prepare aging analysis due to poor communication between sales and finance; and it is common practice for businesses in China to attempt to hide sales to reduce taxable income, which means that many accounts receivables are often under-reported.

A typical weakness in other receivables account is that many irrelevant transactions are often recorded. For example, there may be an internal loan between two related companies recorded into the other receivables and not listed as a transaction in the investment account.

Often, self-established fixed assets are not included into the fixed assets account, and the relevant depreciation is not taken accordingly. In addition, the cost for establishing fixed assets is recorded in the expenses account or cost account but not capitalized. Some self-established fixed assets are often not recorded in a construction in process account nor later transferred to the fixed assets account. Original supporting documents related to construction in process are also sometimes not properly filed and documented.

Sometimes enterprises will book irrelevant transactions in accounts payable. Finally, with payroll payable, there is often an ending balance in the payroll account, however many Chinese companies delay part or all of their employees’ salaries. Note that China GAAP can differ significantly from International Financial Reporting Standards (IFRS) and U.S. GAAP in several other areas as well.

Depreciation of Assets
In accordance with China GAAP, fixed assets related to production and operations of an enterprise with an estimated useful life of more than one year are capitalized. Other fixed assets (e.g. office furniture and equipment) above RMB2,000 with useful lives of more than two years should be capitalized. Under IFRS, enterprises have the discretion to determine a threshold above which expenditures are capitalized. Fixed assets are those tangible assets that are expected to be placed in service for more than one reporting period. Under U.S. GAAP, enterprises determine their own materiality threshold above which expenditure is capitalized, but must have a useful life of more than one year.

Under China GAAP, cost is treated similar to IFRS except that it includes purchase taxes rather than non-refundable purchase taxes. Under international accounting standards, the cost of an item of property, plant and equipment comprises its purchase price, including import duties and non-refundable purchase taxes, and any directly attributable costs of bringing the asset to working condition for its intended use. When carrying value under China GAAP, tangible fixed assets are stated at cost less accumulated depreciation. Subsequent revaluations are generally not allowed. While with IFRS, tangible fixed assets are stated at cost less accumulated depreciation. They may be carried at a revalued amount, being its fair value at the date of the revaluation less any subsequent accumulated depreciation and subsequent accumulated impairment losses.

Major overhauls should be expensed when incurred under China GAAP. However, if future economic benefit in excess of the originally assessed standard of performance can be demonstrated, then the amount not in excess of the fixed assets’ recoverable amount can be capitalized. It should be depreciated over the period between two major overhauls. Under IFRS, except when the enterprise has identified as a separate component of the asset, major overhauls are usually recognized as an expense when incurred as they are made to restore or maintain the future economic benefits that an enterprise can expect from the originally assessed standard of performance of the asset.

Under U.S. GAAP, major overhauls are defined as repair expenditures that increase the value of the asset and extend its useful life longer than one year. As such, the major overhaul expense is capitalized. All other repair and maintenance costs are expensed as incurred. Many FIEs in China do not cater for depreciation and this only adds unnecessary expenditure against profitability if it is not properly booked into the accounts.

HR Due Diligence

For a company, adequately comprehending the HR environment, hiring appropriate people and managing them effectively is critical to maintaining a successful operation on the mainland. Unfortunately, mainly due to lack of reliable information in English (and the proliferation of unreliable information) as well as the rapidly changing nature of both the labor market, it is very difficult for foreign investors and managers to understand the overall situation in enough detail.

Employment Issues
Make sure all payments and contributions have been made to the employees such as individual income tax and social insurance. Also ensure that all employment contracts are checked for non-compete and confidentially obligations that could give rise to liability on his or the employees part. Staff still have legal claim as employees of the business. Ensure that the head count and payroll match, and request a written statement from the HR department as to the matching of these.

In cases where a labor union is involved, it is also wise to make sure you have identified the charter and payments that have been made to the union. The business has a liability of 2 percent of all staff salaries to be paid to union funds, so ensure you know what this is and that it matches up against payroll.

Some other issues to consider:

• Inheriting staff – one can pick up the entire welfare and pensions burden of a company’s personnel if they are transferred over to your company, backdated to the day they started work
• Contracts – look into all contracts worth more than RMB100,000 or 5 percent of the company’s net assets, this would also include employment contracts, insurance, or any other material contract that is essential for the operation of the business and any of its subsidiaries

Social Security
Social security in China is a complex topic because it is organized on a regional level. The formal social security system only covers urban workers, and partially covers rural workers that have come to the cities to work (the so-called “floating population”).

Monthly contributions to the social security system are determined from a base figure. In most cities it is calculated as follows: Social security base = Previous year’s total income / 1216.

For new hires the starting salary may be used as the social security base during the first year.

Note that the base figure for social security contributions is capped at 300 percent of the social average salary for the location in which the employee pays social security. Therefore any employees earning more than this amount will actually pay a smaller percentage of their salary in social security contributions (employers will also have a smaller percentage burden).

The maximum base figures will generally be updated once per year for all employees. This often happens in May. Sometimes the government will also adjust the percentages to be contributed by employee and company at this time. Note that although the maximum base figures will usually be updated during the middle of the year, the calculation of the each individual employee’s base will be made based on their average salary during the period from January to December of the previous year.

China’s social security system is made up of five different kinds of insurance, plus one mandatory housing fund. The insurances are as follows: Pension, unemployment insurance, medical insurance, occupational injury insurance, maternity insurance and the mandatory housing fund.

Pensions for workers in China are financed by contributions from both the employee and the employer. The portion contributed by the employer is normally higher than the portion contributed by the employee.

Contributions to unemployment insurance are made by both the employee and the employer to this fund. In most cities the proportion is less than 1 percent of monthly salary, although in Shanghai the employer’s contribution is 2 percent. If an individual becomes unemployed this insurance will pay a fixed amount every month on the condition that contributions have been made on behalf of the employee for a continuous one year period prior to the application.

Both employer and employee contribute to the medical insurance fund. Proportions vary considerably between cities, but generally the company will be expected to contribute between 5 percent to 12 percent of the employee’s monthly salary, while the employee will contribute around 2 percent. In the event an individual falls ill, they will go to the hospital and receive treatment. Usually the full amount of treatment fees will have to be paid to the hospital up front. At some date in the future a refund should be received from the insurance scheme for the portion that is covered.

Contributions to the occupational injury fund are made by the employer. Usually the premium is between 0.5 percent to 2 percent of the monthly salary of the employee, depending on what kind of work is being carried out by the employee. In the event a worker experiences an injury at work, the employer will collect evidence of the incident and send it to the insurance company. For a company that has employees based in a number of cities around the country this means that the overall cost to the company for an employee earning RMB10,000 in one city may be quite different to someone on the same salary based in another city.

Contributions to the maternity insurance fund are made by both the employer. Usually only the employer makes a contribution of 0.5 percent to 1 percent. Under this system a female employee generally takes around four months of maternity leave during the period prior to and after the birth of their first child. As an associated point, the company may not terminate the contract of the employee from point of pregnancy until the baby reaches one year of age. If another employee has been hired for the position in the interim period then this person must also be retained at least until the end of the period of that employee’s fixed-term contract.

As its name suggests, the housing fund is designed to ensure that workers save some money in order to purchase a house or an apartment. The contributions are mandatory and come from both the employer and the employee (except for some special cases). The employer will usually have to contribute between 7 percent and 13 percent of the employee’s salary.

China Due Diligence Checklist

Operational
Business license
Is the business immediately accessible? What is the expiration date? What is the scope of business? If these are not under control, the license could expire, have the wrong scope, or simply get lost. If entering into a joint venture, a copy of the Chinese partner’s business license should be reviewed. It will list the legally responsible person, the company’s registered address, the amount of registered capital and the period of the license.

Other registration documents
Have all trademarks and patents been properly registered in China? What about export licenses, customs and foreign currency registrations?

Environmental issues
What is the current environmental situation of the company? If setting up, have the medium and long-term environmental costs been figured in? Is an environmental evaluation report needed?

Financial
Financial statements
Who is in financial control of the company? If it is only one person, they should not also hold the company chops, as this gives them total control over the company’s finances.

Tax filing**
Have all taxes been properly filed? In addition to corporate income tax, business tax and individual income tax, export enterprises need to formally register to apply for VAT refund or exemption status and will need to submit documentation to the responsible tax authority.

**Key SME tax point: SMEs in China should register with the tax authorities in order to retain small VAT taxpayer status – reducing VAT liabilities to 3 percent from 17 percent. If this is not carried out, VAT liabilities will rise to 17 percent. SMEs please note that VAT small taxpayer status needs to be confirmed by June 30.

Financial reporting
For small-medium sized enterprises, it makes sense to have a third party accountant check the books at least every quarter, or monthly if turnover is high. This can help the company stay in tax compliance, keep the accounting staff honest and could result in the implementation of policies that will be financially beneficial to the business.

HR
Social welfare
Contributions from the employee and employer can vary considerably depending on the city in which the contributions are being made. For a company that has employees based in a number of cities around the country this means that the overall cost to the company for an employee earning RMB10,000 in one city may be quite different to someone on the same salary based in another city. Make sure all contributions are being met as the cost can be quite high if it is later discovered that these contributions are not in compliance.

Summary
Due diligence is a process that should be carried out by every foreign investor when assessing their investment in China. Differences in the standards of Chinese financial reporting make analyzing and understanding Chinese company accounts vitally important to understanding the true value of a China asset. Most due diligence in China requires not just a basic legal check of documentation, but also an in-depth look at a company’s financials and an investigation of operational issues unique to the mainland. This is where knowledge and experience in China can go a long way. Please refer below to our previous articles in this series and additionally available published material.

Chris Devonshire-Ellis is the Founding Partner of Dezan Shira & Associates, a fully licensed accounting practice in China and offers business advisory, tax accounting, due diligence, payroll and audit services to multinational clients throughout China. For professional advice and assistance with tax and regulatory matters or specific due diligence and internal audit requests, please contact info@dezshira.com or download the firms brochure here