To help their companies survive in China, finance chiefs must do a lot more than plan strategy, budget and forecast

By Elizabeth Fry. Reproduced with the author's permission, from the 1st August 2005 Edition of CFO Magazine

Although the Chinese government's famous 2001 prediction that it would turn its loss-making SOEs around within three years has failed to materialise, no one would dispute that it has made significant progress. Many SOEs have modernised and listed - not just locally, but on the London and Hong Kong stock exchanges.

Just 35, a holder of an MBA from Imperial College of London University and with 10 years' experience in KPMG's Shanghai office, Pang was hired to improve and strengthen accounting practices, systems and procedures throughout the government-owned group's 45 hotels. He is one of a new breed of CFOs helping to make China's SOEs look more like western companies.

According to Pang, local companies are gobbling up finance professionals like himself who have been educated in, and have worked in, the United States, Britain or Australia. "The lack of financial talent is definitely an issue," he says. The number of qualified accountants in China is estimated at 60,000; more than 350,000 are needed. "The problem here is that local accountants have their own philosophy, and techniques, and will do what they think is correct for their own company," says Pang. Ask a local company for an income statement, for example, and the chances are that it will not be immediately useful in making a financial decision. "You have to convert the figures into western accounting figures."

Pang readily understands why Australian investors feel less than comfortable with the state of accounting standards and practice in China. Rapid economic growth represents real opportunity, but it can create problems in assessing the true financial health of a potential investment. "We do have rules, but getting everyone to comply with them is the issue," he says. Local companies, with a few exceptions, must follow China's generally accepted accounting principles (PRC GAAP).

As with the SOEs, local accounting standards are a work in progress. In the past, there was a gaping disparity between local standards and those of developed economies, but the gap has narrowed since China's move from a purely cash-based system to accrual-based standards. PRC GAAP is now largely based on International Financial Reporting Standards (IFRS), but adapted for the local market. The authorities adopted 16 IFRS standards and propose to issue another 24 over the next two years.

Since Jin Jiang is a publicly listed company with foreign shareholders, it is required to adopt IFRS as well as PRC GAAP and reconcile the two sets of financial accounts. "It is not a particularly big job, because we have had to do two sets of accounts for many years and so we know where the differences are," Pang says. So, is China becoming substantially less risky?

One side effect of the race towards adopting IFRS is that China's new accounting standards are mixed in with the old. Even more confusing, China's old reporting standards for individual sectors, handed down by the state in 1993, still apply. Worse, different accounting models are used even within a single industrial sector. This mixture of options allows local companies to show a company's net profits and assets to best advantage.

Although the gap between IAS and PRC GAAP is narrowing, differences remain in certain important respects. These include treatment of amortisation of intangible assets, capitalisation of interest and revaluation of land-use rights, time periods for depreciation, and writing off obsolete inventory or allowing bad debt reserves.

"Chinese companies won't follow IFRS exactly," Pang says. "When making provisions for bad debts, for example, they will decide what sort of provision they will make on the basis that the more provisions they make, the less profit they will report. It is also common that they will make more provision if they want to reserve some profits for the future."

That is not to say that "good" numbers do not exist: "China's companies traditionally were very good bookkeepers. The numbers were there; it's just [that] they weren't moved into any sort of accounting context, so there was no provision for doubtful debt and impairment of properties," Pang says.

Stephen Taylor, Deloitte Touche Tohmatsu's audit partner in China, acknowledges that the number of different types of entities to which different standards apply is confusing. Since 1993, Taylor has been working on a World Bank-funded project to write a comprehensive system of accounting standards for China.

He maintains that the Chinese authorities apply IFRS very selectively, but they are going in the right direction and addressing the important issues. "For example, they have resisted applying IAS 39 [the recognition and measurement of financial instruments] across the board, because the Ministry of Finance doesn't believe that the expertise exists outside financial institutions."

Another area the authorities have tiptoed around is the fair value rule. "While MOF [the Ministry of Finance] acknowledges its appropriateness, it also realises that companies just don't have the ability to get a reliable measure at the moment. China doesn't have many professional valuers; that part of the industry has not developed yet, so there is no point in having a fair value standard if no one has a clue how to apply it."

This suggests China has yet to see a transition to strong controls over the accounting profession; that, in reality, there is no real auditing; and that compliance varies significantly.

Clearly, China's fast growth makes it difficult for regulatory authorities to keep pace with the massive job of overseeing businesses. With only two regulators - China Securities Regulatory Commission and MOF - the chances of any auditing offence being discovered appear to be low.

Auditing scandals in China recently have done little to counter this perception. Foremost is the investigation into China Life Insurance by the US Securities and Exchange Commission for accounting fraud following the company's US$3.5-billion initial primary offering last year. Also last year, the CFOs of Yinguangxia, a Shenzhen-listed company based in Yinchuan, and subsidiary Tianjin Guangxia, were jailed for fraud and colluding with the companies' auditors.

Late last year, Singapore-listed China Aviation Oil suffered huge losses as a result of speculating on fuel prices, then sold a 15% stake to western investors - without any disclosure.

There are optimists, however. Peter Arkell, a Shanghai-based partner in executive search firm Swann Group, claims that China's reputation for rampant corruption, falsified accounts and under-the-table dealing will soon be a thing of the past: that the mentality is being washed away by the influence of western companies and by the government's determination for its companies to internationalise.

Arkell notes that the Shanghai Stock Exchange has suspended from trading companies in breach of the listing rules, and that increasingly disgruntled investors are taking legal action. He attests to the hoards of young Chinese nationals who, having gained considerable overseas experience, are returning to China, helping to speed up the internationalisation process. Arkell might have added that this is particularly the case if those returning Chinese nationals have worked for one of the Big Four accounting firms, as Hebert Pang and Shenny Ruan did.

Ruan, a 35-year-old CPA from Shanghai, supervises the finances of five of agriculture company Cargill Starch & Sweetener's entities. She is an Australian who has been through the Australian Graduate School of Management (AGSM), is a member of the Securities Institute of Australia and has been a finance professional for 10 years in multinational companies such as PricewaterhouseCoopers, Danone and Alcatel. In fact, she was working in Alcatel's Sydney office when Cargill called her. The company, with annual sales of $US60 billion, offered her a job in Songyuan, a small city in Jilin, an agricultural province in China's north-east.

Ruan spent 22 months restructuring a business that Cargill inherited through a global acquisition. It was floundering, partly because the previous foreign partner had been too focused on its relationship with the local state-owned partner to gain other benefits, and partly because the foreign partner had failed to understand the local culture. Importantly, the previous foreign investor would employ only expatriates, not local staff, for key positions.

Ruan believes firmly that companies should do more to use the power of local accountants.

"I often see expatriates talking to local partners when they would be better off leaving it to their local accountants. I believe a lot of foreign investors don't fully trust the local Chinese who don't have my kind of experience. They worry that local people are less qualified, but the locals can be trained if you communicate with them properly,".

To her mind, the correct application of accounting and corporate governance rules will remain an issue until there is some consistency between what the state says and how those rules are implemented at the regional and city levels. "China's accounting standards and tax rules are reasonably good, but the definition and application of those rules are carried out at the local level, where either those controls don't exist or the local authorities negotiate their own deals," Ruan says. "They have the right to challenge you. So while you are all talking about the same law, if the definition of the one tenet of law is different, they can reach a different conclusion - especially outside the big coastal cities."

Making sense of China calls for much more from a finance chief than the routine responsibilities of strategic planning, budgeting and forecasting. A good relationship with the local government is crucial, says Ruan: "Getting support from the mayor of the city or the governor of the province will provide more favourable conditions for your investment. Local government support is also important when it comes to buying state-owned assets, since their appraisal is restricted to a government valuer who must be approved by local authorities.

"Valuations are still a headache for CFOs, since in China many of the government valuers still often use a cost-base method, which makes it very difficult to agree on a [weighted average cost of capital]."

Duncan Calder, head of KPMG China Business Practice, agrees that this is an area in which Australian companies do get into trouble, and it is hardly surprising. For a start, there might be all sorts of relationships between the statutory valuer, the vendor and the government, so an arm's-length deal might be out of the question. Second, there are only a limited number of valuers in China. Third, there are major inconsistencies in the valuation methods, and they can be subjective. Last, valuations must be endorsed by the State-Owned Asset Administration Bureau. Once endorsed, the valuation is unlikely to be changed.

Calder agrees with Ruan's assessment. "In some places, the valuer will value assets as a going concern, whereas in others they might use an earnings-based methodology. But the problem there is that the balance-sheet values might not be supported by the earnings - the state might have spent a lot of money on an asset that did not generate a sufficient return - so they will still want a high price. The bottom line is, stay as close to the valuer as possible if you want to skirt any problems. Knowing the valuation style beforehand might give you enough ammunition to negotiate a lower figure."

Although China is under increasing pressure to tighten its governance standards, it is still a bad environment in which to promote ethical standards, says Ruan. In the north-east, for example, under-the-table transactions and kickbacks along the distribution line are still a way of life, and companies must enforce strong control systems to protect themselves.

The problem is not that China lacks the basic regulatory standards for good governance. Since the introduction of the Company Law in July 1994, and the establishment by the China Securities Regulatory Commission of a code of corporate governance for listed companies in 2001, China has had a basic framework for corporate governance - a framework that the regulators continue to enhance and improve.

According to Pang, corporation law rules are in their infancy. There is a requirement for independent directors to sit on boards of listed companies, but it is not compulsory for companies to set up audit committees. "There is no point in having so many laws, policies and standards if the management has no intention to follow or comply with the company law and to put all this corporate governance into real practice," he says.

But he considers that foreign investors' assets are safeguarded because the administrators, who have enormous power, are cracking down on corruption. "People do go to jail, or worse, if they don't comply with the law or are fraudulent."

Calder can sympathise. "It's just a question of China's companies getting used to a different regulatory environment and more scrutiny. It takes time for local government or wealthy individuals to become attuned to the rights of minority shareholders."

Calder says performance-related pay would go a long way to solving China's governance problems: "You have got companies earning a lot of money and very little of it is going to those who are managing them. So there is an issue of risk and fraud."

In a more competitive China, the skills that CFOs did not necessarily have are now going to be acquired. That means CFOs' salaries across the board should rise, as more qualified finance professionals are presented with ultimate accountability for their company's success or failure, says Lou Lin, financial controller of postal giant DHL. Based in Beijing's Chaoyang District, Lin is a seasoned financial figure. Like Ruan, he is an AGSM graduate who has also worked inside and outside China for many years. He understands the pain faced by new entrants when they fail to achieve their often overblown goals.

As an experienced China hand, Lin knows that the chances of being embroiled in a messy legal tangle or an even messier operating failure can be high. But he argues that the reasons for failure will often have nothing to do with, for example, discovering that a company that looks good on paper looks terrible once acquired - or runs foul of regulations or has had land rights revoked. Companies fail in China for the same reasons that they would fail in any developing market, he says: a lack of real leadership, no clear strategy and doing business with the wrong partners.

Total foreign ownership is now possible, thanks to an easing in investment laws. Yet Lin predicts that offshore companies will continue to pursue joint ventures, despite the many horror stories of foreigners having their fingers burned in dealings with Chinese partners. As thousands of finance managers have discovered, neglecting to put together accurate profiles of potential partners can have disastrous consequences. Lin stresses the importance of understanding exactly why a Chinese partner wants to do business with you - and any other underlying intention. "Profitability and shareholder value might be a clear concern for you, but your partner might be more interested in employment and providing costly pension plans. Or they might be looking to saddle a foreign corporate with hidden costs, off-balance-sheet debts or non-work-related staff benefits. Objectives must be aligned and CFOs have got to get an accurate read of the local team before committing to a deal."

He urges corporate heads to resist the urge to rush in without a well-thought-out strategy because of the fear of missing out on China's vast and lucrative market.

Warwick Smith, chairman of the Australia China Business Council, has seen evidence of this mentality in some quarters. But he says most Australian companies realise China has a different institutional structure than they are used to, and they understand that developing relationships and displaying commitment is vital. "The government structure there is very bureaucratic, so you need to target the right people," he says.

Australians are having reasonable success in finding good people, Smith says, but he has seen cases of Australian companies seeking out one government official or minister rather than a number. "People sometimes put all their eggs in one basket and sometimes it's the wrong basket - the wrong people."

Few Australian companies could claim the same kind of success in their Chinese relationships as IAG's Chinese road services operation, China Automobile Association (CAA).

Deputy chief executive Ian Brown knows from eight years operating in China that success there means making institutional connections and providing some social value to the country. Failure to do so can be a serious mistake.

This code is very subjective, and when Australian companies come across an impasse, they often do not understand why. They may be denied advantages offered to their competitors or, worse, be thrown out. Since 1997, CAA has promoted road safety and towed away free of charge buses that break down on Beijing's ring roads.

Further, CCA's actuary has been invited to join several insurance regulatory committees to help with compliance issues. "The best way is to find out what value you can bring to their community and try to achieve an outcome that is good for you at the same time," Brown says. "Also, because of our skill in motor insurance, we can help the regulators identify the correct data with which to price products, so we think we can add a fair amount of value to the industry."

Brown is fairly confident that an application for a general insurance licence will be received favourably by China's regulators. Licensed foreign non-life insurers will be able to write domestic business from January 1, although Brown says a company, once granted a licence, will have to wait two years to show that it understands the legal corporate requirements and the local market.

He believes the condition might be waived for IAG, on the basis that its knowledge and experience in these areas is self-evident.

Brown has no illusions about the competition he faces, particularly as the state-owned giants and aggressive independents modernise and develop a corporate culture. But, on the upside, returns can be high and commensurate with the risk. Despite the obstacles, foreign companies in China can and do make money.

China: The tax angle
China's membership of the World Trade Organisation might spell the end of big preferential tax breaks for foreign companies. But David Earl, manager, PricewaterhouseCoopers, International Tax & Transaction Services, says there are still plenty of great incentives for Australian companies operating in China - some courtesy of the Australian Taxation Office.

1. Develop your commercial strategy first. Ensure your proposed structure satisfies your commercial needs before considering the tax implications. The "tax tail" should not wag the "commercial dog". That said, if you structure your Chinese investment efficiently, you can reduce unnecessary tax imposts, lower your cost of financing and increase your after-tax return on investment.
   
   
2. Choose your structure wisely. Manage your commercial objectives and tax profile by choosing an appropriate entity type, location and funding mix for Chinese activities.
   
   
3. Plan your financing mix as soon as possible by determining an appropriate level of interest-bearing debt and equity investment. Dividends paid to Australian company shareholders (with more than 10% ownership) are exempt from Australian tax and not subject to Chinese dividend withholding tax. On the other hand, interest payments to service debt financing should be deductible in China and taxable with a credit (for any Chinese withholding tax paid) in Australia.
   
   
4. Take care when acquiring businesses. If you acquire a Chinese entity, you may inherit its tax (and other) exposures. Chinese capital gains tax may also be payable by an Australian buyer of a Chinese company (10% withholding on the vendor's net gain).
   
   
5. 5. Manage tax costs on exit by considering upfront a structure that will mitigate future capital gains tax on disposal. For example, there may be no Australian capital gains tax for an Australian company on disposal of a Chinese subsidiary company, provided at least 90% of the Chinese company's assets are "active". If the Chinese company's assets are a mix of active and passive, you should get a partial Australian capital gains tax concession equal to the percentage of active assets.
   
   
6. Get in now to lock-in current Chinese tax holidays and concessions. From January 2007, Chinese authorities are looking to cut company tax rates to 24% and eliminate the distinction between foreign- and domestic-owned enterprises to level the playing field. Tax holidays and preferentially low tax rates for foreign-owned enterprises will be abolished. So if you are planning on entering into China soon, do so before January 1, 2007 to allow access to "grandfathered" tax holidays and concessions.
   

Source: CFO Web, 01 August 2005

About Us | Practices | Our People | News & Events | Employment | Contact Us | Privacy | Site Map
Copyright Swann Group Pty. Ltd.  ABN: 20 088 304 894