Internal control systems
in China.

In Western countries, although amendments and revisions to accounting practices or standards do not have legal binding power, they are formulated according to an existing national legal framework which is provided in most cases by Companies Ordinance or Acts. Companies Ordinance or Acts together with other regulations applicable to individual industries, such as the Banking Ordinance for financial institutions and Listing Rules or Securities Acts for listed or public companies, provide a framework upon which accounting professional bodies formulate accounting and auditing standards. These standards form the basis for establishing accounting principles, and perhaps conventions, that allow enterprises flexibility in formulating their own accounting policies best suited to their individual circumstances. The ultimate objective, in a nutshell, is to produce a set of financial statements that are ‘true and fair’.

Until 1994, China lacked a regulatory framework on which accounting and auditing standards could be set since the country’s first national Companies Laws were not effective until 1 July 1994. The lack of such a framework also rendered the formulation of other regulations, such as the national Securities Laws and Listing Regulations, more difficult and time consuming.

Nevertheless, having realised the need for establishing acceptable accounting principles to enable PRC enterprises to attract foreign investment or have their stocks listed on overseas markets, the MOF promulgated a separate set of accounting regulations for selected joint stock companies in January 1992.

In addition, MOF was made effective on July 1, 1993, and were the first set of accounting standards – Accounting Standards for Enterprises – applicable to all PRC enterprises. Although it might be confusing at times which accounting regulations or standards should be applied, together with the then Accounting Regulations for Foreign Investment Enterprises of the PRC, they have provided relatively uniform accounting practices for enterprises to follow in preparing their financial statements. More importantly because of the lack of a complete regulatory and conceptual framework, these accounting rules or regulations are so comprehensive that they encompass accounting concepts, disclosure requirements, accounting entries, control procedures, record keeping and some aspects of auditing requirements and liquidation.

With the introduction of the Accounting Law in 1999, the Regulations on Financial Reporting of Enterprises in 2000 and the Accounting Systems for Business Enterprises in early 2001, which harmonises the different accounting standards and regulations applicable to different enterprises, the framework of modern Chinese accounting has finally become clear. With the implementation of the Accounting Systems for Business Enterprises in 2006, accounting standards in China have become more convergent with IAS and IFRS.

The general accounting principles or concepts employed in China’s accounting regulations include accuracy, completeness, consistency, comparability, timeliness, materiality, accrual basis, matching, prudence, substance over form and going concern. By and large, the principles mirror those of IAS and IFRS . Other major features of these regulations are as follows:

• The historical cost convention is prescribed. Assets are required to be recorded at purchase cost (less any necessary impairment provision) and revaluations are strictly prohibited except when allowed by other State provisions.
• The concept of fair market value is not commonly used due to the limited existence of open markets.
• These regulations also require companies to use the calendar year, which is January 1 to December 31, as their financial year.
• The double-entry bookkeeping method should be adopted. Records in accounts and books have to be made in Renminbi (Yuan) (the lawful currency of the PRC). Transactions and balances denominated in foreign currencies have to be converted into Renminbi at the official rate, which may differ from the current market rate. All records and balances of transactions made in foreign currencies and the exchange rate used must be maintained for reference.
• A clause in these regulations specifically requires the appropriation of a collective Welfare Fund and a Statutory Reserve Fund from profit after tax.
• Due to the infancy of the new systems, certain footnote disclosures may not be as comprehensive as those acceptable elsewhere in the world. Yet, in certain areas, the Chinese standards are extremely stringent. This includes disclosing the corporate identity of related parties and commenting on the fairness of transactions conducted between related parties, and preparing the cash flow statements using both the direct and indirect methods.

The old standards are neither broad nor flexible enough to allow discussion or maneuverability on particular subjects. For the first time, ASBE gives management the authority to exercise professional experience and judgment. While the setting of the ASBE has in theory narrowed the gap between accounting issues in China and those of the Western world, the rigour of applying the ASBE may vary from province to province and from company to company.

In Western countries limited liability companies are generally subject to an annual audit carried out by independent external auditors whose role is to express an objective opinion on the truthfulness and fairness of the financial statements.

In China, auditing is not a legal requirement but is required under the regulations. Prior to the introduction of the ASBE, the primary objective of auditing in China was to carry out inspection on the financial records of a business to ascertain their accuracy and legality (i.e. whether the transactions conducted complied with relevant state laws and regulations). Auditors in China are concerned with protecting the legal interests of the company as well as the interests of the state. Only with the implementation of the ASBE were the concepts of true and fair presentation introduced.

Prior to 2000 financial statements of state-owned enterprises were not required to be audited annually by independent auditors, but periodical or social audits conducted for the purpose of ascertaining the enterprise’s tax liabilities or other purposes might be conducted by the State Audit Bureau or Tax Bureau. Since 2002, except for a few types of specialised industries that have been explicitly exempted, all other state-owned enterprises must be audited at least annually. In addition, the regulations governing the accounting of joint stock companies and foreign investment enterprises require these companies to be subject to annual audit carried out by a registered Chinese certified public accounting firms. When reporting on whether the financial statements of foreign investment enterprises are prepared in accordance with the relevant laws and regulations, auditors may make reference to the following main laws and regulations:

• The PRC Sino-foreign Equity Joint Venture Law (EJV Law) promulgated by the National People Congress (NPC), effective July 8, 1979 and revised March 15, 2001
• Implementing Regulations of the EJV Law promulgated by the State Council (SC), effective September 20, 1983 and revised July 22, 2001
• The PRC Sino-foreign Cooperative Joint Venture Law (CJV Law) promulgated by the NPC, effective April 13, 1988 and revised October 31, 2000
• The PRC Wholly Foreign-Owned Enterprise Law (WFOE Law) promulgated by NPC, effective April 12, 1986 and revised October 31, 2000
• Implementing Rules of the WFOE Law promulgated by SC, effective December 12, 1990 and revised April 12, 2001
• The PRC Small and Medium Enterprises Law (SME Law) promulgated by NPC and effective June 29, 2002 and revised October 18, 2011
• Regulation on the implementation of Enterprise Income Tax Law of the PRC promulgated by NPC and effective January 1, 2008

First promulgated in 1985, the Accounting Law was revised in December 1993 and then in 1999. From July 1, 2000, the new accounting law was adopted. It represents the highest level of legal norms governing accounting and forms the basis for the formulation of administrative rules and regulations in regard to accounting, as well as providing the highest guiding principles on accounting work. In tandem with this piece of specialised legislation, a number of corresponding laws were passed in the 1990s, including the Certified Public Accountant Law, Budget Law and Audit Law followed by related legislation such as Company Law, Law on Negotiable Instruments, Enterprise Bankruptcy Law, Economic Contract Law, and various tax laws. Together they constitute a legal framework of related economic legislation, forming the cornerstone of a legal system governing accounting work.

Both the Accounting system and Accounting standards constitute an integral part of China’s unified accounting system. As administrative documents, they set out the rules for accounting such as the recognition, measurement, disclosure and reporting of accounting elements. While both are formulated and promulgated by the MOF, certain differences exist between the two.

Firstly, in terms of the scope of application, specific accounting standards are mostly applicable to joint stock limited companies although some of them also apply to other enterprises. As for the Accounting System, apart from joint stock limited companies, other qualified enterprises may also adopt the system but prior approval is required for state-owned enterprises wishing to implement the system.

Secondly, the Accounting System covers all aspects of an enterprise’s transactions and events. In other words, if an enterprise falls within the scope of the Accounting System, the accounting treatment of all its transactions and events must be handled according to the stipulations of the system. As for specific accounting standards, they only govern certain transactions and events or certain accounting aspects of an enterprise. For instance, all the 13 specific accounting standards issued to date merely deal with specific transactions and events of an enterprise.

Thirdly, stipulations concerning the recognition, measurement, disclosure and reporting of accounting elements contained in the specific accounting standards are more general, with no stipulations on how accounting records should be made. By comparison, stipulations in the Accounting System are more specific, giving detailed rules on the account titles and instructions for use.

FIEs should establish a financial accounting department in the place where it is located, to be manned by qualified financial and accounting personnel responsible for handling financial and accounting matters in accordance with the law. (MOF has strict management guidelines regarding the qualifications of financial and accounting personnel.)

Since 1 January 2002, FIEs have implemented the Accounting System for Business Enterprises promulgated by the MOF on 29 December 2000, while the Accounting System for Foreign-invested Enterprises issued by the MOF on 24 June 1992 and its related regulations on account titles and financial statements were nullified. Below are certain issues concerning the implementation of the new accounting system.

If an FIE has to change its accounting estimate as a result of implementing the accounting system, all changes should be made using the prospective application. If an FIE has to change its accounting policies, the following circumstances where it is stipulated that the retrospective adjustment method is to be used:

• Provision for short-term investment write-down and provision for impairment of long-term investment, fixed assets, intangible assets, construction in progress and designated loans.
• The difference between provision for bad debts on receivables and provision for inventory write-down under the new accounting system and those under the old system.
• The changes in depreciation life and residual value for the first time, should be treated as change in accounting policy in the current year and adopt retrospective adjustment method. After that, if FIE adjust on depreciation life and residual value again, it should adopt prospective method.
• Investments made before the accounting system was implemented and which continue after the implementation date should be treated according to the stipulations of the Accounting System as from the date of implementation. In other words, investments and investment income confirmed under the old system prior to the implementation of the new accounting system may not be adjusted retrospectively. Any subsequent confirmation of investment income and adjustment of the book value of investments should be treated according to the stipulations of the Accounting System.
• In implementing the accounting system, under the new accounting standards that promulgate in 2006, the set-up cost cannot be amortised anymore. Instead, the set-up costs should be entered directly under G&A expenses during the set-up period. 

FIEs should abide by the following stipulations in implementing the accounting system:

• The balance of “marketable securities” should be entered under “short-term investment”.
• The balance of “advance payment for goods” and the balance of “advance receipt of payment for goods” should be entered under “prepayment” and “receipt in advance” respectively.
• The balance of “provision for loss in inventory realisation” should be entered under “provision for inventory write-down”.
• The creditor’s balance of “exchange loss during set-up period” should be entered into the profit and loss account of the current period.
• The balance of other deferred expenses should be treated according to different circumstances: it should be entered under “long-term prepaid expenses” if it can generate benefits in subsequent accounting periods; it should be entered under the profit and loss account of the current period if it cannot generate benefits in subsequent accounting periods.
• The balance of “deferred investment loss” should be treated according to different circumstances: it should be entered under “long-term prepaid expenses” if it is a debitor’s balance; it should be entered under “deferred income” if it is a creditor’s balance.
• The balance of bonds payable and the premium or discount on bonds payable should be entered under “bonds payable”.
• The balance of “wages payable” (or “wages and welfare expenses payable”) should be entered under “payroll payable to the employees (including wages, bonuses and allowances, employee incentive and welfare funds drawn from the enterprise’s after-tax profits); the welfare expenses comes under pension funds, insurance, welfare funds and different kinds of subsidies payable to mainland workers should be entered under profit and loss account of the corresponding period when it actually occurred.
• The balance of “reserve fund”, “enterprise development fund” and “profit capitalised on return for investment” should be entered under “surplus reserve”.
• A new item, “deferred income”, should be created under “estimated liabilities” on the balance sheet.
• A new item, “of which: investment of Chinese party (balance of non-renminbi capital at end of period)” and investment of foreign party (amount of non-renminbi capital at end of period)”, should be created under “paid-in capital” on the balance sheet.
• Foreign-invested tourism enterprises, in implementing the Accounting System, should for the time being follow the regulations in the Account Titles and Financial Statements for Foreign-invested Tourism Enterprises in compiling their income statements and supporting reports.

When compiling comparative financial statements using the retrospective adjustment method, if changes in accounting policies occur during the periods covered, adjustments should be made to the net profits and losses and other related items in the periods concerned accordingly. For entries in comparative financial statements subject to cumulative effect due to policy change prior to the periods covered, adjustments should be made to the initial retained income as well as other related items.