China’s regulatory bodies are making concerted efforts to create an environment of quality in the application of accounting and internal controls over financial reporting, aligned with global standards. But what exactly do these regulations entail and how are companies in China preparing for their implementation?
Don’t call me… C-SOX
China’s internal control regulations are commonly referred to as China SOX (C-SOX), but in fact C-SOX is a term that is technically incorrect, accordingly to William Gee, Partner at PWC China. “Although there are similarities, the nature of China’s internal control regulations is very different from the US SOX. The US Sarbanes-Oxley Act (SOX) is a piece of legislation while the Chinese “Basic Standard for Enterprise Internal Control” (the Basic Standard) and related regulations and requirements are more appropriately classified as departmental regulations,” he says, adding, “while the Basic Standard focuses on listed companies” obligation for reporting on the effectiveness of their internal controls over financial reporting, the US SOX covers more than just companies – its scope extends over the entire financial reporting supply chain.”
Under the Sarbanes-Oxley Act, management need to perform its evaluation of the effectiveness of the company’s internal control over financial reporting against a ‘suitable, recognised control framework’, and specifically noted that the Internal Control – Integrated Framework (COSO Framework) issued by COSO in 2002 is considered appropriate for this purpose. The Basic Standard (published in 2008 by the Minister for Finance and four other government bureaux) presents five layers of internal control which is very similar to the COSO Framework. However, on further inspection, Gee believes that the Basic Standard is more a combination of the two major COSO Frameworks – the 1992 Internal Control Integrated Framework and the 2004 Enterprise Risk Management Framework – and also borrows from concepts that define the Sarbanes-Oxley Act itself.
“Under the COSO Framework, three objectives are referred to: legal/regulatory compliance, operational efficiency and effectiveness, and financial reporting. In the Basic Standard, however, two additional objectives are added: the first is safeguarding of assets (a concept under the Sarbanes-Oxley Act) and the other is realising the objectives of the company (a concept borrowed from the enterprise risk framework as it incorporates the whole risk management)” he says. The Basic Standard is therefore actually closer to COSO than to the Sarbanes-Oxley Act.
When the Basic Standard was issued in 2008, the original implementation date was set at 1st July 2009 but this was subsequently amended. In April 2010, the revised implementation timeframe was published: companies that were listed both domestically and overseas would need to implement the Basic Standard on 1st January 2011, and all the other Main Board listed companies would have to implement from 1st January 2012 onwards. The implementation timeframe was restructured in this way as those companies that were listed both in China and overseas, the majority of those were listed in the US, had been complying with SOX since 2006, says Gee. “The reason for making this split was to make sure that the companies with internal control experience would be the first ones to adapt and move forward as they should be better prepared,” he says.
Despite that split, some 215 companies were selected as pilots for early adoption by the regulators last year to give the Standard a trial run and allow any issues or obvious required changes to surface. The results that were achieved allowed the regulators to realise that both companies and auditors may require more time to properly prepare for the adoption of the Basic Standard and related requirements. Thus, on 15th August 2012, a further modification to the implementation schedule was made. Gee explains the latest amendment: “The implementation is to be effected in three phases. Phase 1, commencing 1st January 2012 includes the listed subsidiaries of state-owned enterprises. Phase 2, commencing 1st January 2013, will include all other large Main Board listed companies with a net asset value over RMB five billion and average profit from 2009-2011 exceeding RMB 30m. All other Main Board listed companies will become effective from 1st January 2014.”
The revised schedule also clarified that newly listed companies should commence implementation of internal control upon listing, and only required to perform management self-assessment and be subject to external audit on the effectiveness of internal control over financial reporting in the year following listing. This provides some relief for the newly listed company.
Doing it properly
As the Basic Standard is an internal control framework that embraces not just financial reporting objectives, it created some confusion when it was issued in 2008 in relation to the scope of the control assessment – whether it was just concerned with financial reporting or covering all aspects of internal control. But it wasn’t just the corporates who were flummoxed – the regulators have travelled quite a steep learning curve since the initial proposal was released also.
“It wasn’t until 2011 (the first year of implementation) that regulators really began to comprehend the level of effort and change required, and agreed that the industry should focus its efforts on financial reporting controls. But by that time, a lot of companies had already started implementation and had already gone the whole nine yards,” explained Gee.
Because of the challenge of scope and focus, and with independent audit being a mandatory requirement, the hard work of many companies was directed towards ensuring that they ‘pass’ the audit; the main objective of maintaining a system of effective internal control became a second priority in some cases. Companies need to stop looking at the standard as an exam to pass, but rather as a lifestyle change to embed in their daily processes, according to Gee.
Understanding the essence of control and integrating that internal control into daily operations is an ongoing process that companies are adapting to. From this perspective, it is a good idea – and a welcome announcement – that the regulators are realising that, in order for companies to take the right approach, some need more time to come around than others.
In the latest document, there is a paragraph that states that companies should avoid implementing this standard just for show, according to Gee. “From an auditor’s point of view and from the advisor angle, that is certainly the right thing to do. Establish a function to do this properly,” he says.
That being said, the implementation of regulations and frameworks are certain to translate to increased costs and a drain on resources for affected entities – at least on a short-term basis. However, corporates must focus on the end goal: these frameworks will only make the company healthier in the long-term and in many ways will bring China closer to its western counterparts and the global stage as the same ‘language’ (ie communicating from the same controls platform) will be spoken. There will obviously always be local differences but the fundamental work and control that is required is more or less comparable.
With China currently hoping to launch an International Board, encouraging overseas companies to list in China and tap into the Chinese capital market, it is reasonable to expect internal control as a requirement for overseas companies listing in China, according to Gee. “For overseas companies hoping to come into China and do business, they need to understand that they may need to realign their controls standards when they arrive. We do have clients already asking that question and we have been giving multinationals (MNCs) briefings on the Basic Standard and related regulations to prepare them for that next step,” he says.
CAS and IFRS: an ongoing courtship
The rules and principles for Chinese accounting, PRC GAAP, are still developing from the fully state-owned era when financial reporting was focused on reporting inventories rather than profits and performance. Chinese Accounting Standards (CAS) consist of one basic standard and 38 specific standards. It differs significantly from historically generally accepted accounting principles in China but is, in many respects, converged to International Financial Reporting Standards (IFRS) as issued by the International Accounting Standards Board (IASB), according to Russell Brown, Managing Partner at LehmanBrown. “To some extent, the Chinese Accounting Standards have actually been drafted in alignment with the Hong Kong accounting standards – albeit with their own local nuances. But CAS are almost as fully aligned as possible with the accounting standards that define the IFRS,” he says.
However, there are variations between CAS and IFRS that remain, including:
Reporting debtors or creditors on transactions through the balance sheet still sometimes reflects the old centrally-owned approach.
Many items are still not fully deductible in the same way an inbound investor may expect.
The Chinese authorities are paying particular attention to abuses around inter-company cross-border billings.
Treatment of assets on the balance sheet
For tax purposes, the Chinese authorities will still only allow straight line amortisation/depreciation of capitalised assets.
Fair valuations of assets
There is very limited scope under Chinese accounting rules for stating assets at anything other than historical purchase or investment value.
The PRC GAAP is still relatively undeveloped in the case of consolidating group companies within China.
Rules based philosophy
Considerable advances have been made in the move away from a codified accounting system but CAS rules do not yet match the principles-based approach of IFRS.
Application and enforcement of standards
The application of the accountant standards is variable as accountants need time to familiarise themselves with the new framework.
When CAS was first issued in 2006, it was only required to be applied by all listed companies. Until 2008, non-listed companies were not required to adhere to CAS in their local statutory entities. Gradually, selected regulatory authorities began to mandate the adoption of CAS, extending that to most state-owned enterprises, some foreign-owned entities in regulated financial services sectors, and other companies located in particular provinces and municipalities.
To date, the Minister of Finance has not issued a specific timetable for the adoption of CAS throughout China. Different jurisdictions in China have different timing and scope for the adoption of CAS. A subsidiary located in one location might need to apply CAS while another may not. For example, Shanghai issued a notice requiring non-listed companies located there and meeting certain industry and size criteria to adopt CAS as from 1st January 2011, however, with consideration of company specific practical difficulties in implementing the new rules, accepted applications for postponement have been accepted.
Key challenges for domestic companies…
But Brown feels that the main issue is that the tax regulations that were released in 2008 seemed to fulfil objectives that were opposite to the aims the accounting standards were trying to achieve. “When the new tax regulations came out, the tax regime seemed to veer left while the accounting framework went right. Unless we bring the tax systems and the accounting systems a bit closer together, there is not a lot of incentive for companies to follow the accounting system as they will tend to do more tax accounting,” he says.
Brown highlights his point through the following example:
“You bill a client and you book this as revenue, and then pay tax on it as you’ve booked it as revenue – even though you haven’t yet been paid by your client. Then you find out that your client is not going to actually pay you or you have a problem with the transaction/payment so you book the entry as a bad debt provision. The tax system won’t allow that provision to be deductible which means you then have to go through a lot of motions to try to collect it. This may be to the extent of bringing a legal case to try to get recovery before you can actually take a provision against that revenue. “
…and for MNCs
But domestic companies are not the only businesses to face difficulties when it comes to adopting CAS. Despite China being determined to bring its accounting standards in line with international standards, foreign companies setting up and expanding there still face a number of hurdles.
The result of the staggered and seemingly unco-ordinated timetable for CAS adoption, as well as the flexibility provided for implementation, is that different entities within the same consolidated group of companies can potentially have varying adoption dates and accounting treatments if those entities are incorporated in different provinces. Such a varied accounting policy landscape within a single consolidated entity can greatly complicate and reduce efficiency in systems and processes, consolidation and internal control of the multinational corporate. It can also cause increased complexity for M&A activity, sourcing talent and training staff.
And so, while China may be pro-actively striving to build a financial management structure that is on a par with its global counterparts, this is no doubt a very gradual process as the government is all too aware of the country’s unique characteristics that have defined its landscape thus far. China’s rapid economic growth, although currently slowing, has led to the country becoming a leading market player on the global financial stage. It may take a little longer, however, for its regulations to become fully aligned.