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ISSUES RELATING TO ACCOUNTING PRACTICES IN CHINA: IMPLICATIONS TO INTERNATIONAL ENTREPRENEURS Richard Chamblin Millikin University, 1184 West Main Street, Decatur, Illinois 62522 217-425-4691
[email protected] J. Mark Munoz Millikin University Roy J. Hinkamper KPMG LLP
ACADEMIC ABSTRACT As a result of heightened trade interest due to globalization, international entrepreneurs are actively exploring business opportunities in foreign locations such as China. Despite continuing advances, a common challenge faced by entrepreneurs is that financial systems and accounting standards are often different across borders. This article explores key accounting issues confronting entrepreneurs as they do business in China. In addition, strategies for success are offered. EXECUTIVE SUMMARY This paper is practitioner-oriented. The authors believe that the highlighted issues herein have direct implications in the conduct of business in China. There are several ways in which accounting divergence exists between China’s GAAP and the GAAP used in Western countries, specifically the US. This article highlights key areas where issues exist, and discusses its implications to entrepreneurs intending to do business in the People’s Republic of China (PRC). The recent adoption of most international accounting standards appears to solve the problems of comparability and disclosure that has reduced the usefulness of Chinese financial reports issued to out-of-country stakeholders in the past. However, Chinese financial reporting still represents a troubling lack of consistency, reliability, timeliness, and full disclosure. These issues are coupled with important differences between PRC GAAP and US GAAP. This paper provides entrepreneurs with some familiarity with the current business landscape in China by increasing the awareness of the key differences in accounting practices between the Peoples Republic of China (PRC) and the United States of America (USA). The paper provides the entrepreneur with the main reasons for the accounting and reporting differences, the key differences, and the effect on financial reporting. The paper also provides the entrepreneur with recommended actions to cope with these differences. Enhanced awareness of specific accounting and reporting differences can contribute to the reliability and transparency of information and improve the decision-making.
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This paper specifically addresses the impact of the differences between PRC accounting practices compared to USA accounting practices in four areas: revenue recognition, transfer pricing, income taxation, and cash flows. Revenue recognition differences promote confusing ratio analysis results and diminishes the ability of the entrepreneur to make informed decisions. Transfer pricing issues reveal the opportunity for in-country partners to acquire a share of wealth that is in excess of the terms of the partnership. Income taxation addresses the need to go beyond acquiring tax law knowledge and to conduct careful industry analysis concerning the tax status of competitors. Cash flow issues speak to the need for quick, reliable accounting information that can be used as a quasi-internal audit of the cash sources and uses, and data for meaningful ratio analysis related to the venture. The Accounting Implementation Time model develops a structure for the entrepreneur to evaluate accounting information for decision-making purposes. By understanding the complexities of the accounting system in Chine, some of the risks encountered by entrepreneurs who embark on ventures in China may be reduced. INTRODUCTION Globalization has accelerated business interactions and facilitated capital flows across countries (Greenberg and Baron, 1997:37). The contemporary business environment is characterized by (1) lower transportation and communication costs arising from sprouting technologies, (2) trade liberalization across several fronts, and (3) more aggressive business endeavors in both developed and developing countries that has led to expanding exports and cross-border foreign direct investments. This trend has consequently spearheaded economic growth and competitive activities worldwide (Greenberg and Baron, 1997:37). In the case of the USA and the PRC, trade across countries has expanded dramatically in recent years. The USA is China’s largest export destination accounting for 21.4% of the country’s total exports. In 2006, China exported a total of $974 billion dollars worth of products and services (CIA World Factbook, 2007). China imported a total of $777.9 billion worth of products and services in 2006, with the USA as one of its largest import sources. Global investments are pouring heavily into China. In the past three-years, private equity investment in China has increased by almost six-fold, reaching $3.1 B in June 2007 (Cho & Heath, 2007). Globalization has shaped business practices both in the USA and in China. Chinese scholar Cai Tuo (1998) defined globalization as an “objective historic process and tendency of contemporary human development beyond nation-state boundaries, which is unfolding as global communication, global networks, and global interactions.” Based on an AC Nielsen 2003 online survey on 7,230 Asia-Pacific consumers, Dumlao (2003) reported that: (1) 86% of Asians believed that globalization was giving access to the same quality of products available to anyone else in the world, (2) 77% of Asians felt that globalization was creating more jobs and career opportunities, (3) 90% of Asians acknowledged that globalization was giving more access to news, entertainment, and information, (4) 64% of Asians are under the impression that
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globalization leads to changing values and makes life too fast and impersonal, and (5) 72% of Asians feared that globalization could threaten local traditions and culture. For many companies, international expansion is a way to build on competitive advantages and explore unique opportunities (Capar & Kotabe, 2003). Many entrepreneurs have been attracted to the Chinese business landscape (The Economist, 2004). In countries around the world, entrepreneurs expanding their business on foreign shores need to be sensitive to the dynamics of the operational business environment. According to Li (1998) government transformations in China have been dramatic and hard to comprehend. In addition, entrepreneurs have to be cognizant of disparity of business practices. Many business practices in China have been shaped by its long history and remain anchored on its culture (Su & Littlefield, 2001). Many business practices also tend to be politicized (Steidlmeier, 1997). ACCOUNTING PRACTICES IN CHINA Culture and tradition have a role to play in the divergence of accounting practices. For instance, in China, while many businesses maintain proper accounting records, some of the systems used require thick manuals and incorporate provisions that are confusing (Economist, 2007). In addition, the business landscape has been characterized by documented cases of corruption, poor planning, little regard for shareholder rights, and even market manipulation (Tam 2002, Chandler, 2004). Information accuracy is an issue in China. One accounting challenge that exists in the country relates to the availability of adequate and accurate information to make informed decisions (Chang, 2001). Another challenge exists in the auditing systems where substandard viewpoints from auditors were noted. (Tang et al, 2000). In the Chinese culture, the emphasis on relationship building or guanxi (Li, J. & Wright, 2000) can lead to business approaches that are divergent from Western practices. Guanxi is often utilized to further one’s position or business (Xin & Pearce, 1996 ; Leung & Wong, 2001). It might lead to the release of private information, expedited work, and even faster debt collection (Barnathan, et al, 1996). A study has indicated that guanxi in China can add anywhere from 35% to business costs (Oriental Daily News, 1993). Szeto, Wright, & Cheng (2006) depicted the Chinese environment as one where business ethics and guanxi clash, as accountants are driven to operate closer to Western standards by the need for better quality professional appraisal of control systems and reports and more complex technology. In fact, Tsui and Windsor (2004) observed that ethical reasoning scores of Chinese auditors were lower than that of their Australian counterparts. Aside from culture, the Chinese accounting environment is unique due to differences in accounting treatment and the economic environment (Choi & Levich, 1992). In addition, differences in currencies can be a factor in accounting. While the yuan has been relatively stable in recent years, confusion in conversions can easily arise specially among inexperienced practitioners.
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Government policies and procedures can also play a hand in accounting practices. In 2005, the Chinese government decided to implement measures to converge their systems with the International Financial Reporting Standards (IFRS). On February 2006, China’s Ministry of Finance released new accounting guidelines for companies. These new standards take effect in 2007 (KPMG Primer, 2006). Many Chinese managers are making efforts to implement international accounting standards (Miller, 2001). While the standardized guidelines and framework of Generally Accepted Accounting Principles (GAAP) exists in China, implementation challenges abound. Accounting system enhancements are needed to aid in implementation (Chen et al, 2001). A confluence of other operational business issues affects the accounting practices in China. For instance, 1) there exists a shortage of trained practitioners resulting from the adoption of international standards, 2) partnerships and networks drive the conduct of business, 3) trustbuilding is critical, 4) goal mutuality among business associates is deemed important, and 5) the business landscape is constantly evolving. The accounting system in China is in a state of flux. The recent adoption of most international accounting standards appears to solve the problems of comparability and disclosure that has reduced the usefulness of Chinese financial reports issued to out-of-country stakeholders in the past. However, Chinese financial reporting still represents a troubling lack of consistency, reliability, timeliness, and full disclosure. These issues are coupled with important differences between PRC GAAP and US GAAP. The authors have identified twelve (12) significant accounting issues that are important for entrepreneurs to consider. These issues are presented in Table 1.
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TABLE 1 12 Key Accounting Issues in China Issue Revenue Recognition: Warranty Costs Multi-Element Sales Contracts
Disclosure of Related Party Transactions—Transfer Pricing
Cash Flow StatementsDisclosure
Explanation Lack of detailed guidance on specific types of transaction (e.g. software, long-term contract, services sales involving rights of returns, warranties, and installation clauses) by PRC. Current GAAP allows for revenue recognition when significant portions of elements have not been completed. Disclosure is required under most standards. However, PRC GAAP does not consider state owned enterprises as related parties. Therefore, no disclosure is required for related party transactions if the other party is a state owned enterprise. Statement of Cash Flows is required under most standards. PRC GAAP allows for the inclusion of bank overdrafts in cash for cash flow statement presentation purposes. In addition, interest received/paid is classified as operating or financing by PRC GAAP. Cash Flow Statement present in Direct Method is required by PRC GAAP. Under the US GAAP, the company has a choice between Direct and Indirect Method.
Business Implication Revenue may be overstated when compared to an identical economic transaction reported in the US.
Related party transactions and transfer pricing schemes can inflate performance and lead to tax avoidance schemes.
Cash flows are affected by translation rates, timing of receipts and payments, and classification of specific items (e.g interest received or paid) and related party activities. More detailed cash flow information is required to be disclosed under Direct Method as compared with Indirect Method.
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Issue Intangible Assets
Borrowing CostsClassification of Costs and Timing of Expenses
Leases-Capitalization, Land Rights
Inventories-Valuation and Effect on Cost of Goods Sold
Explanation PRC GAAP recognizes internally developed Intangible Assets (e.g. brand name) pursuant to their legal recognition. The Intangible Assets are measured at cost, including such items as registration fees and legal fees incurred in the legal application. In contrast, in the US internally developed intangibles have been written off immediately against earnings. PRC GAAP requires the capitalization approach when the capitalization criteria are satisfied. Under IFRS, company has a choice to classify expense as incurred or capitalized provided the capitalization criteria met. Land rights in China have changed and company or individual can effectively possess rights of land permanently. Rights themselves are capitalized, underlying assets (land) remains with PRC. PRC GAAP prohibits the use of LIFO formula to assign the cost of inventories. In addition, PRC GAAP does not have guidance for Inventory Valuation Reserves.
Business Implication Intangible assets and income may be overstated under PRC GAAP.
Capitalization of borrowing cost could affect company’s net assets, income and lead to tax avoidance schemes.
PRC still effectively owns the land itself, so the possibility of the revocation of land rights exists.
The future declines in price of inventory is not recorded and disclosed.
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Issue Fixed Assets-Valuation and Expensing
Research & Development Costs
Accounts Receivable (A/R)-Valuation and Timing of Bad Debt Expense
Effects of Currency Conversion Methods on Income
Explanation Fixed Assets are recorded using cost method under PRC GAAP. The depreciation methods are straight-line, DecliningBalance, United-ofProduction and Sum-ofYears’-Digits. Generally expensed when incurred, due to uncertainty of actual development. PRC does allow for capitalization and amortization of development costs once project deemed to be viable, based upon meeting specific criteria, but research remains expensed as incurred. With the history of business conducted between traditionally government owned entities, A/R is generally never considered ‘bad.’ A/R typically aged in PRC based upon years rather than 30-day increments. In addition, doubtful accounts are reversed and limited to very low amount (.3% to .5% of receivables). Exchange rate is held artificially constant by PRC government, but forces international participants to anticipate PRC actions, rather than relying on market forces.
Business Implication Fixed Assets are generally accounted for in the same manner as elsewhere in the world. Generally, questions around fixed assets arise concerning existence of the asset. Typically R&D activities focus on the use of existing technologies and applying to China marketplace. However, the differences in accounting treatment can result in expense reporting that could vary significantly from practices outside PRC.
As companies move towards privatization, A/R becomes more important in terms of valid sales, valid assets and cash flow. Allowance for doubtful accounts under PRC GAAP often do not adequately provide for old receivables. It would affect the valuation of the quality of earnings and working capital. Unpredictability in revenue and expenses as the exchange rate could be changed at any time by PRC.
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Issue Income Taxation
Explanation PRC GAAP adopts the balance sheet liability method to determine deferred tax of temporary difference in 1/1/2007. The income taxation now has very similar accounting treatment between PRC GAAP and US GAAP.
Business Implication China has a very complicated tax system, involving national, provincial, city and district. Each has it own regulations on income taxes. Depending on companies industry, location and corporate structure, the income taxes may have different implication on your investment. For example, China has a number of tax zones, and each may offer a different corporate income tax rate ranging from 15% to 33%.
There are several other issues that can potentially affect the practice of accounting in China. After evaluating several potential challenges, the authors believe the 12 issues listed above are the most critical and can have considerable business implications. In the interest of brevity, and for discussion purposes, the authors focus on four accounting issues identified by the authors to be applicable in most industries to illustrate their implications on entrepreneurial decision-making. These issues are: revenue recognition issues, disclosure of related party transactions (i.e. transfer pricing issues), income taxation policies, and cash flows. The eight remaining issues described in Table 1 are industry-specific in regard to implementation and will be discussed in future papers. Revenue Recognition In the case of the manufacturing industry, revenue recognition is similar in the PRC GAAP and the US GAAP (KPMG Primer, 2007). The PRC GAAP provides no guidance concerning the timing of revenue recognition when rights of return, warranties, installation charges, and post-support services are elements of the transaction. US GAAP has very specific guidance (KPMG Primer, 2007). Converting from “PRC GAAP” to US GAAP can result in the deferral of revenue recognition until substantially all elements are accounted for. The conversion would result in the recognition of less net income. For example: Company US and Company PRC each have gross revenues of $1,000,000 and have experienced identical warranty costs to sales ratios in the past. Company US uses past experience to determine the ratio of warranty cost to sales (in compliance with US GAAP) that they have determined to be 5% of sales. Company PRC decides to use only $10,000 as the expected warranty costs on its revenue in order to show a larger net income. The results are:
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Company US C-S Revenue 1,000,000 100% Warranty Exp 50,000 5% Net income 950,000 95% C-S = Common-size percentages.
Company US C-S 1,000,000 100% 10,000 1% 990,000 99%
As a result, the PRC company appears to have incurred less warranty costs. This would lead financial statement users to assume that the PRC company is operating more efficiently than the US company. The PRC company cannot escape the eventual actual warranty cost but they are able to defer it to a later period. A similar difference exists concerning multi-element contracts that specify the delivery of the various elements of a system in stages. US GAAP defers revenue recognition until all elements are delivered unless the separate stages have standalone value that can be determined. An example of a possible multi-element contract would be for a vendor to install computer hardware and software in stages and provide training as needed. China GAAP provides no guidance, which may result in the recognition of the entire contract revenue at the time the contract is signed. Under US GAAP a venture may recognize the revenue pertaining to each element as that element is accepted by the customer or defer recognition of all revenue until the time when the entire contract is satisfied depending on the terms of the contract. If the contract is performed in one accounting period, there would be no difference between the two standards. If performance of the terms of the contract covers more than one period, conversion of Chinese accounting for such a transaction to US GAAP may result in the recognition of less net income by the venture during the period that it takes to satisfy US GAAP rules. The US GAAP provides for the recognition of agency commission revenue while China GAAP provides for the recognition of the gross revenue and expense elements of the transaction. While the net income from the transaction will be the same under both accounting systems, the gross revenue and expense will be reduced by the same amount if the transaction is converted to US GAAP. The use of gross versus net revenues will change the ratios obtained when using common-sized statements and reduce comparability with the operating results of similar ventures and with industry averages. . For example, Company US uses the net revenue approach and Company PRC uses the gross revenue approach to reporting commissions earned as agents: Company US C-S Revenue 10,000 100% Expenses 8,000 80% Net income 2,000 20% C-S = Common-size percentages.
Company PRC C-S 50,000 100% 48,000 96% 2,000 4%
If the US entrepreneur is not aware of revenue recognition standards used for PRC GAAP, the assumption might be that the Chinese operation earned 20% on gross revenues when, if it had used US GAAP, it would have reported earnings of 4% of revenue on the same transaction.
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Disclosure of Related Party Transactions—Transfer Pricing Under international accounting standards, economic transactions between companies with overlapping ownership are supposed to be clearly disclosed. (The Economist, 2007). This rule also applies to transactions between owners and the company they own, individual companies with common ownership, and vendors. The related party rule usually applies to materially significant transactions, measured in monetary terms, between parties that can benefit from the transaction(s) and have the influence to manipulate the economic terms of the contract. The economic terms of related party transactions cannot be presumed to be at “arm’s-length”. A transaction is deemed not to be at “arm’s-length” if it deviates from terms offered to customers or the fair market value (FMV) of the product or service involved. Disclosure is accomplished by providing the details of the related party transactions in the footnotes that accompany the financial statements. Related party disclosure is intended to facilitate financial statement readers’ understanding of the nature and extent of the related party transactions. Such disclosure is intended to prevent companies from window-dressing their financial position and operating results in an attempt to disguise the personal involvement of insiders and enhance the reliability of financial information (Lin & Chen, 2000). The following are examples of related party transactions that should be disclosed: A company with the equivalent of US $1,000,000 in total assets sells an unused warehouse (FMV of US $100,000) to an owner for US $100,000. This is a related party transaction that should be disclosed in the footnotes of the financial statements. Stakeholders would be informed that the transaction occurred in a proper manner. If the same owner had paid less than the fair market value for the purchase of the warehouse, the terms of that transaction would also be disclosed and the readers would be warned that that an improper transaction had occurred. Transfer pricing is another type of related party transaction. Transfer pricing involves economic transactions between commonly controlled enterprises at prices that do not reflect arm’s-length negotiation. An example of transfer pricing is: Company A is located in a 33% tax region and Company B is located in a 20% tax region. If both companies are under common control, the situation provides an opportunity for the two companies to agree to economic transaction terms that decrease the selling price of any products sold only to Company B.
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Transfer pricing transaction (Transactions between cooperating companies): Co. A Co. B Combined Sales 100 200 300 Cost of sales 50 100 150 Gross margin 50 100 150 Tax 17 20 37 Net income
33
80
113
Sales Cost of sales
Co. A 200 50
Co. B 200 200
Combined 400 250
Gross margin Tax Net income
150 50 100
0 0 0
150 50 100
Arm’s length transaction:
The effect of the arrangement is to reduce the taxable income of Company A and to increase the taxable income of Company B; thereby, providing a decrease in the combined tax rate of the two enterprises. A transfer pricing arrangement of this kind is deemed an illegal avoidance of tax. It creates an unrecorded and undisclosed liability for the unpaid taxes and related penalties that may be assessed against both companies. A different (but not arm’s-length) transfer pricing arrangement is sometimes entered into to provide window-dressing for the benefit of prospective investors or out-of-country partners. This arrangement involves the sale of products to a controlled enterprise at inflated prices to overstate net income and thereby increase the stockholders’ equity in the firm. This kind of arrangement may also involve the sale of non-existent goods or goods not delivered to the buyer. Another form of transfer pricing involves selling products to a controlled firm at discounted prices to enhance the profits of the transferee firm. Unfortunately, unethical and illegal transfer pricing has been and continues to be a significant problem in China because of its history of overlapping ownership by the government and by businessmen. Historically, the focus has been on ensuring that the transfer pricing arrangements is compliant with the arm’s length principle. PriceWaterhouseCoopers recommends that taxpayers will need to be increasingly vigilant regarding their transfer pricing arrangements further down the supply chain, e.g. distribution and retail processes (PriceWaterhouseCoopers, 2007).
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If the US entrepreneur is not aware that in-country partners are engaged in transfer pricing practices, he or she may be at risk of being a party to illegal activities and/or experiencing a lower return on investment than entitled. Income Taxation Income taxes are dependent on the determination of income. The differences between PRC GAAP and US GAAP, such as those illustrated above, indicate the possibility that a US entrepreneur may incorrectly estimate income tax expense if the estimate of income is materially incorrect. The National People’s Congress (NPC) passed the unified enterprise income tax law on March 16, 2007, effective January 1, 2008. Under the new law, the extent of income tax liability is governed by the residency status of the taxpayer. A resident taxpayer is defined as an enterprise that is incorporated under Chinese laws and regulations or has its place of effective management in China. However, the new law does not define the “place of effective management”. A non-resident enterprise refers to an enterprise which is established under foreign laws and regulations and which has its place of effective management outside of China (KPMG Primer, 2006). The new law aims to unify the application scope, tax rate, tax deductions, and preferential tax policies for both foreign-invested enterprises (FIEs) and domestic enterprises. The primary objective of the law is to create a “level playing field” and a standardized and transparent fiscal environment that favors fair competition for all enterprises in China. Entrepreneurs should be aware that the taxing authorities in developing countries sometimes exercise independence in awarding special tax discounts to favorite ventures. This practice can place less favored ventures at a disadvantage since income taxes can be a significant expense. The PRC is a developing country and entrepreneurs should not depend only on mere interpretations of the tax laws when they are conducting feasibility studies and valuation analyses concerning potential ventures. An act of due diligence would include scrutiny of the income tax expenses reported by competing ventures to understand their expense status. Income subject to taxation in China is identified according to the source of the income. Resident enterprises will be subject to tax on their worldwide income. Non-resident enterprises will be subject to tax on income from sources in China, including income earned outside China that is effectively connected with the establishment or the place of business in China. Tax rates are established according to the enterprise’s industry classification or the enterprise’s size. Income subject to tax on “encouraged” hi-tech enterprises, regardless of size, will be taxed at a rate of 15 percent. Small-scale enterprises earning a “small profit” will be taxed at a rate of 20 percent. All other enterprises will be taxed at a rate of 25 percent. The taxable income of US corporations is taxed on a graduated scale beginning at 15% of the first $50,000 of taxable income and increasing incrementally to 35% of taxable income in excess of $18, 333,333.
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The tax law contains tax incentives that will encourage investment in energy and resource saving, environmental protection, and the development of high technology rather than in geographical locations. These tax incentives include: 1. A reduction of its taxable profit by an amount equal to a percentage of the investment 2. Bonus deductions for qualified R&D expenses. 3. A reduction of tax by an amount proportional to the level of investment in equipment used for environmental protection, energy or water savings, or industrial safety. 4. 4. Income derived from environmental protection projects and technology transfers may be eligible for tax exemption or reduction. 5. Tax exemptions or reductions will be granted to qualifying investments in energy and water saving projects, infrastructure facilities, as well as, agriculture, forestry, animal husbandry, and fishery industries. The US tax law has historically provided similar incentives to US ventures for investment in operating assets in similar industries. The standard withholding tax rate for dividends, interest, royalties, capital gains, or other income derived by a non-resident enterprise is 20 percent. The PRC is currently considering relief provisions for FIEs : 1. Non-taxable or exempt income includes “financial appropriations, certain administrative charges, and government funds”. Also included as exempt from income tax are: a. interest income from treasury bonds and b. inter company dividends derived by: i. a resident enterprise from another resident enterprise ii. non-resident enterprise effectively connected with an establishment or place of business set up by the non-resident in China. 2. Deductions are unified for all enterprises in China. Wages actually paid in excess of prior limits are now deductible. Charitable contributions are limited to 12 percent of net income. Tax loss carry forward is limited to five years. Overseas branch losses cannot be offset against profits earned in China. 3. Anti-avoidance measures include new disclosure requirements concerning relatedparty transactions (to curb transfer pricing abuses) and thin capitalization rules (to curb interest deduction abuses).
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Cash Flows Statements The authors believe that an entrepreneur can reduce some of the risks mentioned above by carefully monitoring cash flow. Cash Flows Statements are required by Standard 31 of the PRCs New Accounting Standards for Business Enterprises (PRC NASBE) and closely conform to International Reporting Accounting Standards (IFRS), International Accounting Standard 7 as well as US GAAP (KPMG Primer, 2006). Cash is not subjected to as many valuation rules as accrual based financial accounts and is less subject to interpretation. The verification of cash in-flows and cash out-flows is less time consuming than the verification of accrual based transactions and therefore less expensive to audit. The preparation of cash basis reports tends to require less time than accrual basis reports. These factors tend to improve the timeliness and reliability of the information. A Cash Flows Statement discloses the cash received and cash disbursed during the same period reported by the income statement. The Cash Flows Statement explains the change in the enterprise’s cash position (bank account) during the report-period of activity. The Cash Flows Statement accounts for and classifies all of the cash in-flows and out-flows during the reportperiod of activity into three categories: operating activities, investing activities, and financing activities. The operating activities section reports the cash inflows from customers and the cash outflows to suppliers, employees, and other operating expenses. The investing activities section reports the cash outflows used to purchase property and equipment to be owned and used by the enterprise in the conduct of the business and cash received from the sale of assets no longer needed. The financing activities section reports all cash inflows from lenders and investors and all cash outflows used to reduce debt, purchase treasury stock, and pay dividends. The Statement of Cash Flows provides stakeholders with information, such as: • Significant sources and uses of cash • The ability of the company to generate net cash flows • The ability of the company to sustain operations during a decline in sales • The ability of the company to exercise discretionary spending to retire debt or to react to new opportunities Accrual based income statements are required by US GAAP and Chinese GAAP because they report economic transactions in the period in which income is earned and expenses are incurred. Accrual basis statements recognize revenue earned in an accounting period and “match” it to expenses incurred to generate that income. Such reporting provides the entrepreneur with the ability to compare the results of his operation with the results of other companies and the entire industry. Accrual based operating statements and cash based statements allow the entrepreneur to conduct valuable analyses for decision-making.
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Due diligence is always important in business but especially so across borders where the entrepreneur has no experience with the culture. This is especially true of China, where a shortage of trained accountants exists. In this case, the reliability of reported financial information can and should be improved by a properly conducted audit by independent auditors. In the absence of an audit (during interim periods) stakeholders can use the relationships between accounts reported in the balance sheet, income statement, and statement of cash flows compared to industry averages (ratio analysis) to establish a sense of the degree of reliability contained in the statements. Following is an example of ratio analysis using cash flows from operating activities: If the Income Statement reported sales of US $100,000 and the Balance Sheet indicated that accounts receivable increased US $40,000, then the reader would expect to find an inflow of cash on the Statement of Cash Flows of US $60,000. If the Income Statement reported the cost of goods sold to be US $50,000, and the Balance Sheet indicated an increase in inventory during the reporting period of US $20,000US, then the reader would expect to find an outflow of cash of US $70,000 to suppliers on the Statement of Cash Flows. If the Income Statement reported operating expenses of US $30,000 and the Balance Sheet indicated that accounts payable decreased US $10,000 during the reporting period, then the reader would expect to find an outflow of cash of US $40,000 for operating expenses on the Statement of Cash Flows. Also, cash flows from investing activities could follow this scenario: If the Balance Sheet indicated an increase in the cost of Property, Plant, and Equipment during the reporting period of US $10,000, the reader would expect to find an outflow of cash of US $10,000 for the purchase of equipment on the Statement of Cash Flows. Additionally, cash flows from financing activities would have to follow this scenario if no other activities occurred to explain the change in the cash balance during the reporting period: If the Balance Sheet at the beginning of the reporting period indicated a cash balance of US $10,000 and management decided they wanted to have a US $20,000 balance on hand at the end of the period, then the reader would expect to find an increase in debt (or some other financing arrangement) of US $70,000. The US $70,000 increase in debt is the result of:
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Cash inflow from sales Cash outflow for inventory purchases Cash outflow for operating expenses Cash outflow for purchase of equipment Net decrease in cash from activities Cash required to increase cash balance Expected increase in debt
$60,000 -70,000 -40,000 -10,000 ($60,000) -10,000 $70,000
This paper is practitioner-oriented. The authors believe that the issues herein have direct implications in the conduct of business in China. There are several ways in which accounting divergence exists between China’s GAAP and the GAAP used in Western countries, specifically the US. This article highlights key areas where issues exist, and discusses its implications to entrepreneurs intending to do business in the People’s Republic of China (PRC). THE ACCOUNTING IMPLEMENTATION MODEL In evaluating the above issues, the authors have developed a model that may be helpful in identifying accounting-related activities in China that need specific attention. The authors call this model the Accounting Implementation Time (AIT). This model may be useful not only in China but in other emerging markets as well. The AIT Model propositions that in the practice of accounting in China some activities have Short Implementation Time (SIT), while others have a Long Implementation Time (LIT). SIT activities involve a large number of routine transactions that can be processed by existing technology. This translates into faster processing times and quicker delivery of information to the entrepreneur. SIT activities can be implemented with widely used technologies which do not require a large number of people or specialized skills. LIT activities require expertly trained accountants to analyze and convert the information from PRC GAAP to US GAAP. The shortage of trained accountants coupled with the complex and non-routine nature of the transactions slows down the conversion process. Manpower resources must be specialized and require more planning and supervision. The AIT Model proposes that both SIT and LIT shape entrepreneurial information needed for decision-making. However, greater attention and focus should be placed on LIT as they are more complicated to implement. Figure 1 illustrates this model. The authors believe that entrepreneurs doing business in China need to understand the accounting issues confronting their venture. Utilizing the Accounting Implementation Time (AIT) Model can be useful in identifying priorities and determining key strategies. In addition, there are several ways in which accounting issues can affect entrepreneurial activities, the authors discuss some of the major challenges in the following section.
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FIGURE 1 Accounting Implementation Time (AIT) Identification of Accounting Issues in China
Short Implementation Time (SIT) Intangible assets Inventories Fixed Asset valuation Leases-capitalization Accounts receivable Currency effects Cash flow statement
Long Implementation Time (LIT) Revenue recognition Disclosure R & D Cost Income taxation Borrowing costs
Entrepreneurial Information for Decision Making
IMPLICATIONS TO INTERNATIONAL ENTREPRENEURS As noted from the above analysis and discussion, the differences in accounting approaches in the PRC and the US have several business implications. It has an impact on the way international entrepreneurship is practiced in a country like China. In this section, the definition of international entrepreneurship is qualified and strategic approaches for entrepreneurs are offered. International entrepreneurship may be defined as a set of cross-border, value-creation approaches that integrate innovation, proactive action, and risk-taking propensities (McDougal & Oviatt, 2000).
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Based on literature gathered on the subject, as well as the cited accounting issues in China, the following recommendations are offered to entrepreneurs contemplating on market entry or business expansion in the country: Understand your strengths and core competencies. The differences in accounting practices suggest that focus on key areas of competencies may be needed. Oftentimes, there is a need for globalizing enterprises to build on organizational attributes and strategies in order to be successful (Hitt et al, 1998). Plan to be aggressive and a risk-taker. The firms entrepreneurial posture is often anchored on its propensity to be proactive, innovative, and openness to risk (Covin & Slevin, 1989). Prepare to take proactive action. International entrepreneurs are often characterized by their ability to explore opportunities and tackle new initiatives in foreign locations. (Lumpkin & Dess, 1996). In China, proactive entrepreneurial action positively impacts the performance of private enterprises (Tan & Li, 1996). Expect results to take time. A series of prolonged adjustments may need to be implemented to get the work finally done. In China, entrepreneurial attributes are associated with hard-work, dedication, and diligence (Wang, 2000). International entrepreneurs need to learn to persevere, adapt, and take responsibility for failure (Morris & Jones, 1999). Doing business in China requires applying practical entrepreneurship principles, common sense, luck, and a lot of patience (Kenna & Lacy, 1994). Utilizing the Accounting Implementation Time (AIT) model can help identify priorities. Anticipate organizational disparity. Level of development, organizational culture, and perspective are different across countries. For example, investors in developed nations tend to be more proactive and long-term focused, as compared to those in emerging nations (Luo, 1998). Preparing for organizational disparities ahead of time can facilitate a smoother market entry. Actively engage in a well-planned human resource development program for employees, a study has recently found that little effort are done by Chinese firms to improve worker skills, enhance satisfaction, and provide employee feedback (China Staff, 2003). Understand legal and contractual obligations well. Emerging economies , such as China have their unique laws and systems that need specialized understanding. Devonshire-Ellis & Baker (2006) cited the need to be aware of the implications of the US Foreign Corrupt Practices Act when doing business in China. Taxation policies require careful scrutiny. Legal frameworks for business in the country are categorized by some as underdeveloped (Xin & Pearce, 1996). However, it has been observed that many younger Chinese managers are growingly reliant to the rules of law (Forbes, 1996). Develop strategic relationships and networks. In China, popular business development strategies are often a result of technological innovation and entrepreneurial networking. (Wang & Zhang, 2005). In the country, guanxi, or relationship building is key to successful business transactions. In international new ventures, expansion of social capital can lead to greater resource access as well as minimize the negative effects of foreignness. (Arenius, 2002).
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Furthermore, firm performance may be better understood through the interconnection of relationships (Gulati, et al, 2000). Prepare to innovate. The competitive terrain in China is anchored on technological innovation (Wang & Zhang, 2005). International entrepreneurs need to join the bandwagon of flexible innovators. In the practice of accounting, the pursuit of constant system enhancements and efficiencies will be helpful. Know the financial dynamics well. There is a need to understand all financial angles well. As indicated in the Table 1, numerous challenges exist. In the practice of entrepreneurship, Stansfield (2006) emphasized the need to understand financial performance and characterized it as a scorecard for success. In China, there is a need for investors to integrate elements pertaining to adequate financial control in business contracts (KPMG Primer, 2006). The four issues mentioned by the authors, namely revenue recognition, disclosure of related party transactions, taxation and cash flow statements are relevant considerations in a market like China. The application of the Accounting Implementation Time (AIT) Model can be useful. Manage complexity. Pursuing entrepreneurial ventures in emerging locations is not an easy task. In a survey by Jagersma & van Gorp (2003), foreign companies doing business in China faced 8 major obstacles: 1) management orientation differs significantly, 2) differences in culture are difficult to bridge, 3) market is fragmented, 4) bureaucracy is increasing, 5) lack of judicial code in business conduct, 6) inadequate logistic infrastructure, 7) poor quality of labor, and 8) vulnerable financial system. Entrepreneurs contemplating on a business operation in China should anticipate these complexities and plan ahead. In managing a business enterprise in China seeking ways to integrate Western and Eastern practices may lead to inroads. Younger generation Chinese executives were observed to be receptive to Western management concepts that promote pragmatic approaches and openness. (Ko,1998). Studies suggest that the strength of guanxi and its impact on ethical practices has started to subside in recent years (Hui & Graen, 1997) In the field of accounting, Wright, Szeto, & Lee (2003) suggest finding and working with the “best fit” among existing policies, by using systems that work and modifying or rejecting approaches that does not work with the company’s systems. For example, an international company might adhere to Western financial standards on hiring and compensation, but may adapt wage levels to the local norm. Despite obvious obstacles, there have been numerous business successes in China. Jagersma & van Gorp (2003), identified 6 approaches to business success in China: 1) organizational adaptability, 2) possession of long-term perspective, 3) careful partner and alliance selection, 4) focus on local knowledge building, 5) proactive use of local, regional, and national network and resources, and 6) operate based on simplicity. International entrepreneurs will find the business environment in China to be unique and challenging, especially in the area of accounting. However, efforts are underway to harmonize accounting systems worldwide. The International Accounting Standards Committee is looking
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into common grounds for the standardization of global practice (Weil, 2001). For the time being, while numerous challenges exist in China’s accounting landscape, a strong entrepreneurial attitude, flexibility, and sound financial assessment can be helpful approaches in navigating through the challenges and capturing opportunities. REFERENCES Arenius, P.M. (2002). Creation of Firm-Level Social Capital, Its Exploitation and Process of Early Internationalization, Helsinki University of Technology: Helsinki. Barnathan, J., Crock, S., Einhorn, B., Engardio, P., Roberts, D. and Borrus, A. (1996). Rethinking China. Business Week, 4 March, pp.13-20. Capar, N. & Kotabe, M. (2003). The relationship between international diversification and performance in service firms. Journal of International Business Studies 34 (4): 345-355. Chandler, C. (2004). Inside the New China. Fortune 150, pp.84-98. Chang, G.G. (2001). Coming Collapse of China, Random House, New York, NY. Chen, C.J.P., Chen, S. & Su, XD. (2001). Profitability regulation, earnings management, and modified audit opinions : evidence from China. Auditing 20 (2): 9-31. China Staff (2003). Plenty of room for investment in HR in China, 9, p. 35. Cho, D. & Heath, T. (2007, Nov 13). “US Buyout Kings Bet on China.” Washington Post. Choi, F.D.S. & Levich, R.(1992) “International Accounting Diversity and Capital Market Decisions.” in The Handbook of International Accounting. Ed. Frederick D.S. Choi. Wiley & Sons : New York. CIA World Factbook (2007). Country Profile : China (accessed February 2007), [available at : https://www.cia.gov/cia/publications/factbook/geos/ch.html] Covin, J.G. & Slevin, D.P. (1989). Strategic management for small firms in hostile and benign environments. Strategic Management Journal 10 (1): 75-87. Devonshire-Ellis, C & Baker, RR (2006, Feb 16). The Foreign Corrupt Practices ActImplications for US Business in China. Beijing Review 49 (7) : 40. [available at : http://www.bjreview.com.cn/business/txt/2006-12/15/content_50865.htm ] Dumlao, D.C. (2003, December 28). Filipinos favor opening up of RP to global competition. Inquirer News Service (2). Economist (2007, Jan 13). Finance and Economics : Cultural Revolution ; Chinese Accounting. Economist 382 (8511): 63.
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