China Accounting Standards

A New Beginning

This year marked a large step forward for the continuing integration of world trade and capital markets, with China adopting a significant number of the accounting standards laid out by the International Accounting Standards Board (IASB). Chinese Accounting Standards (CAS) were largely replaced by the International Financial Reporting Standards (IFRS), to bring China more in line with the rest of the world.

The new procedures which became law at the beginning of 2007, on January 1, have been the fruit of considerable discussion and protracted debate, involving the Ministry of Finance, members of the International Accounting Standards Board and representatives of some Chinese firms. Deloitte Touche Tohmatsu, the professional services firm, had been providing consultancy services to the Chinese Ministry of Finance since 1993, giving advice on how best to implement a new accounting methodology, and how it would best suit the Chinese accounting system.

These consultations bore fruit on 15 February 2006, when the Ministry of Finance announced that they were to usher in a new era in Chinese accounting with the introduction of Accounting Standards for Business Enterprises, or ASBEs.

The ASBEs cover almost all of the major topics found in the International Financial Reporting Standards literature, albeit with some notable exceptions, and have been applicable to all listed Chinese companies since the beginning of the year. In the future, other firms are likely to be mandated to conform to the reformed standards in the MoF’s plans. Companies that are not listed are being strongly advised to adopt the new measures, or at least prepare in some part to make their finances more transparent and to international investment.

The Need for and Benefits of New Accounting Standards

Quite simply, changes needed to be made. For China to maintain its development as a big player in the foreign investment market it needs to continually update its business practices, which have often been considered out of sync with the rest of the world. Accounting practices were an area which had been criticised, with standards falling somewhat short of those set out by the IASB, giving foreign investors an investment headache when looking to perform due diligence work and other important procedures on domestic Chinese firms.

Furthermore, now that China has made considerable inroads towards being a fully-fledged market economy, some accounting methodologies that were applicable to the previous system of a centrally planned economy, were often obsolete. An accounting method designed to measure how well production targets are met in a planned economy is largely at odds with what is required in a free market.

Modern accounting needs to be able to analyse the financial health of a company in order to correctly allocate funds and other resources to its various departments. The Chinese system on the other hand, was, initially, simply a compilation of the assets owned by a particular company, with no measure of profit and loss. Moreover, there was no recording of the debts of a company, giving managers an extremely difficult task of running a profitable firm, as they were unable to determine from where the firm is losing money.

Financiers and investors around the world have long called for harmonisation of accounting standards around the world so that companies can be compared on a level playing field. Whilst this is unlikely to be entirely achieved in the short-term, the accountancy reforms mark a noteworthy step towards unification, and will assist investors in becoming more confident about their decisions. In turn this is likely to “enable a broader base of investors to consider investment in more Chinese companies,” says Yvonne Kam of PricewaterhouseCoopers, further cementing China’s reputation as an attractive place to do business.

The New Standards and Potential Pitfalls

Instead of being phased in gradually over time as was the case with many other countries’ adoptions of standardised procedures, China is choosing to adopt the main standards essentially in one go. Quite how this will pan out is difficult to tell and may be a question which only time has the answer to. However, this initial shift in standards is unlikely to be the end of the Chinese accounting reforms and so changes are expected to be ongoing. Sir David Tweedie, Chairman of the IASB, writing in a Deloitte Report of 2006, remarks that “convergence is a process” and that the goal of fully uniform accounting standards between Chinese firms and those applying IFRS is attainable “in light of the progress that has been made,” though no mention is made of any additional convergence procedures.

Taken as a whole the majority of the changes are in line with IFRS but the differences that do exist represent China’s unique position in the global economy. This includes a prohibition of reversing an asset impairment decision; financial statements incorporating certain government grants; and related party disclosures between certain state-owned enterprises. Prior to the reforms Chinese Accounting Procedures had one basic standard and sixteen specific standards, most of which were implemented fairly recently, between 1996 and 2001. This will have to be increased considerably to conform to IFRS standards. Indeed, 22 additional specific standards have been added to CAS, more than double the original number, with the initial sixteen also experiencing some modifications.

Some potential impacts of the new scheme:
•    Firms undergoing transition to the new system may find it difficult to present a true picture of the impact of the change, at least in the short term. This has the potential to provide misleading information to shareholders in the form of incorrect financial reporting, damaging share values. It is imperative for persistent market confidence that firms are able to communicate their true performance to shareholders.
•    A new accounting system will also mean a new taxation system, which will need to be established and regulated by the appropriate authorities. This could mean assessing a firm’s tax liability may be subject to whatever tax amendments, if any, are brought in.
•    More consistent and regulated financial reporting could lead to higher volatility in results for firms, a situation which would need to be explained to any parties with a stake in the firm. This could also be coupled with difficulties in acquiring finance with loan agreements becoming tighter.

Some remaining differences with IFRS:
•    Certain specific standards allow only a cost model to compute the value of fixed and intangible assets with the IFRS allowing a revaluation model.
•    IFRS provides an option to class as expenses all borrowing costs while ASBE maintains, under certain circumstances, that borrowing costs should be capitalised.
•    Biological assets must be measured using a cost model under ASBE, rather than with a fair value model in the IFRS, unless evidence exists to warrant the use of fair value.
•    The new ASBE prohibits reversing impairment losses but IFRS allows it under some circumstances, preventing only goodwill impairment.
•    When presenting a financial report, ASBE still restricts some aspects of the statement that would be allowed under IFRS. Expenses, for instance, are analysed in different ways depending on the particular aspect of the statement. They are analysed by function for income statement, and the direct method for cash flow statements.

But it must also be noted that various caveats still exist. A substantial problem remains in form of the sheer volume of financial information required by firms in order to comply with the new regulations. Embedding what will be an almost totally new accounting system into an economy may prove to be an arduous process. Addison Everett of PwC claims that, from his experience, integration of new standards into old ones can be difficult: “clients who adopted IFRS for the first time…did not fully contemplate the amount of financial information, most of which had not been collected in the past that is needed.” This increase in information requirements will need to be met with increases in training and knowledge of the new systems by those drawing up financial statements. Developing such expertise is neither an easy nor a particularly rapid procedure. It will require huge upheavals not just from accountants but everyone in the financial market from bankers to investors, and also a firms’ non-financial workers such as human resources and management.

For detailed information regarding the new accounting procedures and their potential impacts on a firm, it is advisable to contact a specialist firm.