THE GREAT EXPERIMENT
China is attempting its biggest accounting change since the abandonment of
Soviet-style bookkeeping.
By Don Durfee

Visit any Chinese city these days, and you’ll see one sign of the country’s investment boom: block after block of massive apartment buildings. These structures – some bland, some extravagantly kitschy – have gone up seemingly overnight. China’s banks have supplied cheap loans to fund them, and individuals, along with many of China’s listed companies, have invested. And many sit empty, waiting for the tenants who may someday come.

What are these buildings worth? That’s a question that China’s publicly traded companies and their auditors must now ask about these and other assets. Just over a year ago, the Chinese government made a dramatic break with the past, announcing a new set of accounting rules modeled closely on international financial reporting standards (IFRS). Those rules, which came into effect in January this year, allow listed companies to use fair value accounting, among other changes. That means recording the market value of certain assets on the balance sheet (instead of the original purchase price) and showing any gain or loss on the income statement.

That’s not as easy as it sounds – many of the appraiser’s standard tools don’t fit the machinery of China’s markets. Consider those suburban office towers. Without tenants there’s no income, so a discounted cash flow model won’t yield a helpful number. Comparables are hard to come by, since so few apartment units have sold. Nor is the standby, replacement cost, simple to do. The owners may have secured the property through government connections – at preferential prices – rather than on the open market. And the construction costs aren’t clear, since workers often don’t get paid until the apartments sell.

In other words, the value is anyone’s guess. “Companies are hiring appraisers to give them fair-value numbers, so we’ll certainly get those numbers into the financial statements,” says Gary Biddle, an accounting professor and associate dean at the Hong Kong University of Science and Technology. “But who knows where those numbers will come from.”

China’s embrace of IFRS has been widely heralded as further progress toward a more open, rational economy. Rightly so. Investors have long complained that murky accounting hides the true state of many Chinese companies; financial statements would go a long way toward strengthening the country’s financial markets.

The change also signals the growing importance of global standards to Chinese companies, since they are increasingly not just recipients of overseas cash, but international investors themselves. “The Chinese are keen to be part of the [accounting standards] convergence process,” says Stephen Taylor, a partner with Deloitte and the leader of a World Bank-funded project to help China revise its rules. “My impression is that they are trying to do the right thing.”

But there’s a bumpy road ahead. According to experts, these new standards are just one piece of a puzzle that’s missing many pieces, including strong enforcement, experienced accountants, and a business culture that’s ready to embrace principles-based reporting.

Pushing ahead anyway may in fact accelerate change in those other areas. But the next few years promise to be difficult, as CFOs work to comply, auditors race to train new accountants, and officials struggle to prevent a fresh crop of scandals.

Going international

When China announced the new rules – officially known as the new Accounting Standards for Business Enterprises – last February, it took many observers by surprise. According to one story circulating in China’s accounting community, even the Ministry of Finance’s standards setters didn’t know this was coming.

The rules represent another step – albeit a big one – in China’s gradual move toward international accounting standards. And indeed, the country has come a long way since it first began reforming its accounting system. As late as 1993, companies were still using the old Soviet bookkeeping method. China then moved to its own version of GAAP, which was heavily prescriptive and focused on historical costs, and since then has been making small changes as needed.

The new standards bring China almost – but not quite – in line with IFRS. Now used by almost 100 countries, IFRS is generally regarded as better than US GAAP in terms of reporting a more relevant set of numbers and painting a clearer picture of the true economic value of a business. Like IFRS, China’s new standards are principles-based, requiring accountants to make judgments. And beyond fair value, the rules require better reporting of related-party transactions and financial instruments.
Revenue recognition rules have also changed: instead of recognizing revenue from a long-term contract all at once, in some cases companies must now accrue it according to service delivery.

But there are differences. For example, China is only going partway down the path to fair value. IFRS requires an estimate of market value for all assets, but under China’s rules it’s optional for many assets – such as for investment property – and prohibited for property, plant, and equipment used in everyday operations. Nor do companies have to record all related-party transactions; they only have to report them in cases where the relationship in question would influence the outcome of the transaction. And while IFRS allows companies to revalue impaired assets that have recovered, China’s version prohibits this.

The differences don’t amount to a watering down of international standards, argues Stephen Taylor of Deloitte. Instead, the International Accounting Standards Board (IASB), which sets the international rules, is considering many of the same changes. Taylor, who sits on the IASB’s reporting committee, expects that the IASB will eventually take the position that companies shouldn’t revalue property, plant, and equipment, since that creates inconsistency across companies and unnecessary differences with US GAAP. Similarly, rule makers are moving closer to China’s position on related-party transactions.

Fairly complex

Implementing these new standards won’t be easy. For China’s CFOs, the biggest headache stems from fair value – an accounting method that’s been hard for even European companies to adopt and that is still spurring debate in the United States. “The major problem for Chinese accountants will be figuring out how to determine market prices for their assets,” says Li Dun, the Beijing-based CFO of Montage Technology, an integrated circuit design company.

There are several reasons for this. First, it’s hard to put an accurate value on many assets in China. Some markets aren’t fully developed, making it hard, if not impossible, to get spot prices. In other cases, the local government effectively sets the prices, resulting in asset values that are unreliable as a benchmark for use by companies in other regions. And sometimes the asset in question could be a contract that might not hold up in court or a business license that the local government could decline to renew.

Jason Chang, an Australia-based partner for KPMG, acknowledges the difficulties. “The only technique [to determine fair value] in such cases is to do a lot more thorough work,” he says. And preparing the books for Chinese companies can indeed be a monumental job. It took KPMG two years and the services of 400 people to prepare China Construction Bank’s financial statements ahead of its 2006 listing in Hong Kong (which requires IFRS).

Fair value accounting also calls for skills that most Chinese companies still lack. Accountants must make judgments – about whether fair value is appropriate or whether a calculated market value really makes sense. That’s a big adjustment for professionals who have been trained to follow inflexible rules, says Martin Fahy, director of development, Asia Pacific for CIMA, an association of management accountants. “The principles-based approach isn’t compatible with a lot of the training Chinese accountants have received, which is highly prescriptive and based on rote learning,” he says.

Wang Tao, the CFO of Shanghai New Focus Auto Tech Holdings, agrees. On a scale of one to ten, he says that the internal accounting skills of Chinese companies merit no more than a three. That shouldn’t be surprising, he says. “China’s financial management, accounting, and asset appraisal professions are still young. Only 14 years ago, people were still using Soviet-style accounting.”

Li Dun recalls that when he introduced fair value accounting at his former employer SinoChem in 2003, his staff had trouble with the practice. “They couldn’t understand the meaning of fair value,” says Li. “And when I turned it over to our local auditor, they couldn’t understand it either.”

The difficulties aren’t limited to the fair value provisions of the new rules. Related-party disclosures will be another burden, says Chang of KPMG. “For Chinese companies, the list of related parties could turn out to be as thick as the book of accounts,” he says. “A lot of the work will be around how do you identify related parties? How do you disclose them? This will be one of the sticking points in trying to get these audits done quickly.”

All of this adds up to a great deal of work for companies and their auditors. That’s been the case for Shanghai Zijiang Enterprise, a material packaging company listed on the Shanghai Stock Exchange. According to CFO Qin Zhengyu, the company has had to delay filing its annual results from February to April. “The new accounting rules have been time consuming and costly to implement,” he says. To bring his staff up to speed, Qin has had to offer training, bringing in experts from the National Accounting Institute to conduct courses. He’s also had to update his accounting software.

Audit woes

Inevitably, many companies will end up leaning heavily on their auditors. For companies that can afford one of the Big Four firms, that may be fine. The major audit firms have experience with international standards as a result of their work in other markets; they have also helped Chinese companies get ready for overseas listings.

For everyone else, it will be a problem. As Li discovered, many local audit firms aren’t much better prepared for the new rules than their clients. “The local firms won’t be able to help listed companies interpret the standards and won’t be able to implement them very well,” says TJ Wong, an accounting professor at Hong Kong University.

But many companies will use them anyway, for a simple reason: they are vastly less expensive than the big four. ATA Testing Authority, a computer-based testing service company based in Beijing, uses both a major Western accounting firm (to prepare its US GAAP filings) and a local firm (to prepare its China GAAP books for tax reporting purposes). According to CFO Carl Yeung, ATA spends about US$1m on its Big Four auditor, and only US$19,000 on its PRC auditor. The local firms have lower labor costs and a less extensive audit process. For example, while the major audit firms generally create a shadow copy of the books to make sure records are complete, PRC auditors typically verify the numbers using the company’s own vouch records.

The Big Four have their own troubles in China, however. The main one – no surprise – is a lack of qualified accountants. Trying to cope with a surge in work, the auditors are scrambling to hire great numbers of people. Deloitte plans to increase its China staff from over 6,000 to 10,000 by 2010. KPMG, which has 5,000 employees in China, has recruited 1,600 new staffers and also hopes to reach 10,000. “Even that won’t be enough,” admits Chang.

As it is, they are losing people to their own clients. Chinese companies see the auditors as a source of trained employees, eagerly recruiting away those who have a few years of experience. “We are often a training ground for other companies,” says Chang. “But we understand that this is a market environment.”

Indeed, there are some early signs that the Big Four are straining under the demands – some Chinese CFOs grumble that unless they are in the midst of an IPO, they aren’t able to get enough attention from their auditors, who are forced to move accountants from project to project.

Trouble ahead?

Despite the difficulties, Chinese companies don’t seem to oppose the new rules. One reason, certainly, is that many will see their numbers improve as a result. “You see companies getting excited about reporting higher earnings as the result of these new rules,” says Andy Zhao, an analyst with Merrill Lynch in Beijing. “That doesn’t mean they’ll actually make more money, however.”

Those higher earnings will mainly come from speculative investments such as apartment buildings and shares. Compared with their US or European counterparts, Chinese managers are often more willing to invest in assets far outside of their core business. “In China, it’s quite common for manufacturing companies to have investments in real estate or in shares of other listed companies,” comments Ding Yuan, an associate professor of accounting at the China-Europe International Business School in Shanghai.

Over the past couple of years, listed companies have made many such investments as markets have boomed (the Shanghai stock market rose 130% in 2006). Those gains will flow through the income statement, giving an impression of higher profitability.

In fact, there’s rising concern that the flexibility afforded by principles-based accounting will open the door to widespread earnings manipulation. “These rules offer companies some new opportunities to cook their books which were not allowed in previous accounting standards,” asserts Ding. Here’s how that manipulation might work. In many markets – particularly those in China’s inland – certain enterprises wield great control over prices. Often, companies use transfer pricing among their subsidiaries, which gives them the ability to control the apparent market price. “For example, when a company sells a piece of land to its subsidiary at a certain price, can you believe that price?” asks TJ Wong.

The recent rise of stock options only makes matters worse, says Hong Kong academic Biddle. “The granting of stock options is like pouring gasoline on the fire,” he says. “Now you have executives getting options, but with the freedom to mark their buildings to market based on what? There’s a lot of creativity in areas like real estate accounting already, and now we have this.”

Stephen Taylor of Deloitte acknowledges the worries. “As auditors, we’re always concerned about manipulation,” he says. But, he notes, China’s accounting rules contain a provision that IFRS does not: fair value can only be used if “there is clear evidence that the fair value of an investment property can be reliably determined.” Where there’s no such evidence, then companies must switch back to historical cost. “The fact that China reverts more quickly to historical cost helps,” he says. “It may be less relevant information, but it’s certainly more verifiable.”

A matter of judgment

But again, that’s a decision for a company’s managers to make (with the advice of the auditor). Which brings us back to incentives. Will enough companies decide that it’s not worth the risk? Biddle points out that the government has already set a precedent by offering forgiveness for excesses that occurred at the start of privatization. There may be an expectation that the same thing will happen with accounting.

Furthermore, there’s a consensus among CFOs and market observers that enforcement of market regulations isn’t as strong as it should be. “I’m generally optimistic about the new accounting rules, but for them to work, regulators should really improve their supervision,” says Zhao of Merrill Lynch.

A strong audit profession would help, of course. “Fair value accounting requires strong auditors,” says Stephen Cooper, head of valuation and accounting research for UBS in London. “They have to be in a position to say that this particular number is unrealistic, and put pressure on companies to disclose the uncertainty.”

But there are concerns here, too. China’s CFOs generally regard their local auditors as malleable. A 2004 survey of 378 mainland finance executives by CFO China (a sister publication of CFO Asia) found that over half believe that their auditors would be willing to change their opinion on an accounting matter if they were offered higher fees. (And indeed, 9% of the respondents who use local providers as opposed to one of the Big Four said that one of their top two reasons for choosing the firm was its willingness to “submit to the company’s opinion”.)

The Big Four have a better reputation for objectivity, but China will put that reputation to the test, says Fahy of CIMA Global. “For the accounting profession, China will be a real trial. Anyone can be a cheerleader, but can they consistently highlight the bad news?” It won’t be easy. The objectivity of one firm came under question last May when Ernst & Young withdrew a report on the lending books of China’s big banks. The Big Four firm had estimated that the level of non-performing loans in China was much higher than the official estimate. After the central bank complained, Ernst & Young withdrew its report and backed the official numbers. It denied giving in to pressure, asserting instead that its report contained errors.

How will this experiment turn out? The next few years will be pivotal. Progress toward greater transparency could halt, blocked by weak enforcement, a lack of qualified accountants, and a spate of accounting scandals. And the enthusiasm of Chinese companies could turn sour if the real estate or equities markets crash, and those losses start flowing through corporate income statements.

On the other hand, the new accounting standards could be the catalyst that starts a positive reaction, prompting the accounting profession to build new skills, regulators to tighten enforcement, and business executives to see the advantages of a trustworthy financial reporting environment.

That more positive scenario has a precedent in China’s accession to the WTO. During the 1990s, skeptics argued that the right conditions weren’t in place for China to join the free trade organization – state intervention in the economy was simply too pervasive and a culture of unfair trade practices was too entrenched. But the pressure to meet WTO requirements produced a quicker pace of reform, including great efforts to clean up the country’s banking system.

“[China’s move to international standards] is a great thing,” says Biddle. “But the end of this story hasn’t been written yet.”

Additional reporting by Shan Ling in Shanghai.