Chapter 19 Outline

Closing Case China's Evolving Accounting System

Attracted by its rapid transformation from a socialist planned economy into a market economy, economic annual growth rates of around 12 percent, and a population in excess of 1.2 billion, Western firms over the past 10 years have favored China as a site for foreign direct investment. Most see China as an emerging economic superpower with an economy that will be as large as that of Japan by 2000 and of the US before 2010 if current growth projections hold true.

The Chinese government sees foreign direct investment as a primary engine of China's economic growth. To encourage such investment, the government has offered generous tax incentives to foreign firms that invest in China, either on their own or in a joint venture with a local enterprise. These tax incentives include a two-year exemption from corporate income tax following an investment, plus a further three years during which taxes are paid at only 50 percent of the standard tax rate. Such incentives when coupled with the promise of China's vast internal market have made the country a prime site for investment by Western firms. However, once established in China, many Western firms find themselves struggling to comply with the complex and often obtuse nature of China's rapidly evolving accounting system.

Accounting in China has traditionally been rooted in information gathering and compliance reporting designed to measure the government's production and tax goals. The Chinese system was based on the old Soviet system, which had little to do with profit or accounting systems created to report financial positions or the results of foreign operations. Although the system is changing rapidly, many problems associated with the old system still remain.

One problem for investors is a severe shortage of accountants, financial managers, and auditors in China, especially those experienced with market economy transactions and international accounting practices. As of 1995, there were only 25,000 accountants in China, far short of the hundreds of thousands that will be needed if China continues on its path toward becoming a market economy. Chinese enterprises, including equity and cooperative joint ventures with foreign firms, must be audited by Chinese accounting firms, which are regulated by the state. Traditionally, many experienced auditors have audited only state-owned enterprises, working through the local province or city authorities and the state audit bureau to report to the government entity overseeing the audited firm. In response to the shortage of accountants schooled in the principles of private sector accounting, several large international auditing firms have established joint ventures with emerging Chinese accounting and auditing firms to bridge the growing need for international accounting, tax, and securities expertise.

A further problem concerns the somewhat halting evolution of China's emerging accounting standards. Current thinking is that China won't simply adopt the international accounting standards specified by the IASC, nor will it use the generally accepted accounting principles of any particular country as its model. Rather, accounting standards in China are expected to evolve in a rather piecemeal fashion, with the Chinese adopting a few standards as they are studied and deemed appropriate for Chinese circumstances.

In the meantime, current Chinese accounting principles, present difficult problems for Western firms. For

example, the former Chinese accounting system didn't need to accrue unrealized losses. In an economy where shortages were the norm, if a state-owned company didn't sell its inventory right away, it could store it and use it for some other purpose later. Similarly, accounting principles assumed the state always paid its debts--eventually. Thus, Chinese enterprises don't generally provide for lower-of-cost or market inventory adjustments or the creation of allowance for bad debts, both of which are standard practices in the West.

http://china-window.com/window.html

Source: L. E. Graham and A. H. Carley, "When East Meets West,"Financial Executive, July/August 1995, pp. 40 - 45, and K. Theonnes and A. Yeung, "Playing Favorites," Financial Executive, July/August 1995, pp. 46 - 51.

Case Discussion Questions

1. What factors have shaped the accounting system currently in use in China?

2. What problems does the accounting system currently in use in China present to foreign investors in joint ventures with Chinese companies?

3. If the evolving Chinese system does not adhere to IASC standards, but instead to standards that the Chinese government deems appropriate to China's "special situation," how might this affect foreign firms with operations in China?