End of Year Audits and Internal Controls in China
Klaus Koehler, Managing Director, Klako Group

Setting up a business in China involves extensive documentation, knowledge of regulations and their constant changes and regular contact with the local government, as anyone who has already been through this experience will know. However, this is only the beginning. Maintaining the legal entity that has been established starts from the moment you receive your business license. There is no dormant status for companies in China, once alive they are required to prepare accounts, complete annual audits and file for taxes, even if zero filing when loss making. Additionally, because companies are required to have a registered office address and receipts to support, they have transactions from day one even if only expenses. Complying to the rules and regulations with a new entity in China can be a daunting task therefore to any new business.

End of Year Audits

One of the requirements is the financial year of companies, which in China is set by the State and must be from January 1st to December 31st, regardless of the financial year of the China company's overseas parent. All foreign investment enterprises (FIEs) require an audit and must submit their auditor's reports for year then ended (together with other specified documents) to the relevant industrial and commercial administrative bureau for the annual review by 30th April each year. Any companies failing to do so may be penalized (i.e. in the extreme case, may revoke their business license), it is possible though to gain extensions with valid reason. The audit should be carried out by a Certified Public Accounting (CPA) firm, which is registered with relevant Chinese authorities, who will then usually assist in filing various copies with the tax bureau and Administration of Industry and Commerce for annual inspection purposes.

Audited financial statements are similar to those in other countries, requiring an auditor's report, balance sheet, profit and loss account, cash flow statement and notes on the accounts, along with comparatives for previous years. The audited accounts must be in Chinese.

Foreign Currency Reporting

Companies are required to engage a CPA to complete a foreign currency report annually, which summarizes the foreign currency transactions during the year. This is then filed with the State Administration of Foreign Exchange (SAFE) by the end of April for the past year. FIEs will also be dealing with SAFE when bringing funds into the country and sending funds out of the country, though the later depends on the nature and size as to whether SAFE approval is required.

Statistics Bureau Reporting

Despite having provided much of the same information already, the Ministry of Statistics (MoS) has a package of forms for completion, involving much of the same information as provided for everyone else. The forms must be completed annually, however certain areas entail monthly filing. Many firms do not bother completing and the MoS is not the most diligent in chasing or fining, however they are becoming more diligent in ensuring filing.

Other Bureaus Reporting Systems

Not only does the MoS and SAFE require annual reports, the following bureaus also require them:
- Bureau of Foreign Trade and Economic Co-operation
- Administration of Industry and Commerce
- China Customs Bureau

These bureaus necessitate for annual checking and renewal of documents. In the majority of situations similar documentation has to be filed as the above listed bureaus.

The responsibility for filing in China is with the tax payer. The tax bureau does not send out tax returns as in many countries, the tax payer has to collect the forms and file them according to the regulations. The method of filing varies depending on locations, with some cities using electronic filing while others insist on hand delivery. It is possible to obtain extensions for some filing, for example, the year-end audit, though application for extension is not usually advisable as it can provide a "red flag" to the authorities.

The tax authority requires that accounting records and ledgers be setup and kept properly and that details of the accounting system to be filed with them. The chart of accounts is governed by the Chinese accounting regulations and is the same for all companies. Accounts must be prepared according to the Accounting Standards for Business Enterprises (ASBE) and the regulations of the head office. The head office has to prepare its reports separately. The accounting regulations provide that the records must be in Chinese, however, practically the accounting software can be an English based software as long as the supporting documentation such as journal vouchers are Chinese and these can easily be cross referred back to the system. Actual reporting to Government must be in Chinese and therefore the system would need to be able to extract the information into the Chinese reports, or have Chinese reports written to pull information for review.

Although China's regulations can be burdensome, the key is to be organized, on time and ensure proper supporting records should the tax authorities ever wish to review. The regulations are continually changing or being updated and generally for the better, and overall life should become easier for foreign firms going forward.

Internal Control System

A large majority of foreign enterprises with operations in China continue to rely on annual statutory audit reports and monthly financial statements to monitor potential financial and business risks. Yet even in a highly developed and mature financial environment, reliance on such limited information has been proven to be ill-conceived.

Only by evaluating factors such as quality of revenues, relevance of costs and accruals, quality and relevance of assets and liabilities, capital adequacy and structure, secureness of and management of controls and organizational and supervisory structure can a comprehensive company risk management assessment be made. Such factors are not necessarily published in statutory reports and therefore such statements can potentially be misleading as to the true health of a company.

The current environment in China provides the precise reasons why measures such as internal audits, management system evaluations, business reviews, due diligence, special audits and extra internal controls are becoming a fundamental aspect of surviving and being profitable in China.

There is a growing gap appearing in the relevance of traditional external and internal audit functions. This has seen greater risks for companies to ensure compliance (financial, legal and tax) and also a growing need for company risk assessments to cover both financial issues and a comprehensive business analysis. Where as a financial auditor will usually simply cross check and reference invoices, receipts, cheques and other such "supporting documents", an internal audit will review the business as a whole and identify key areas of risk and possible weaknesses in control systems across all business functions.

Many companies therefore look to outsource their internal audits and business review functions to external consultants. Professional advisors often provide a "new set of eyes" to the company's problems, offer a greater level of understanding of the corporate environment and also bring to the table experience and best practice across all business functions - from finance, accounting, legal, IT and supply chain management. They also have no undue influence and so can ensure that any review is independent.

In China these reviews are important because companies must have the appropriate financial systems and internal regulations to retain control over the company's day-to-day activities and alleviate any financial and business risks. Given the business environment and business relationships, such risks are inherent in all aspects of business in China, and are particularly prevalent in the following areas:

- Procurement and Supply Chain Management: Many companies do not adequately control procurement, inventory utilization and disposal of inventory. Common problems include purchasing of overpriced raw materials (usually through a company related to a member of staff), discrepancies of bills of lading and goods received, improper storage of raw materials and safeguarding inventory, sales of goods at/below cost to related parties and illegitimate disposal of scrap materials and containers

- Sales and marketing expenses: Incorrect accounting for such expenses, unauthorized and illegitimate reimbursement expenses, "fake" official invoices and false transfer pricing agreements

- Corporate compliance: Unauthorized and improper tax registration, under-reporting of tax liabilities, unauthorized use of company chops, and payment of expenses by offshore entities without correct accounting and taxation payments.

- Human resources/payroll: Deliberate over-accrual of company welfare benefits (not in line with the government requirements), unauthorized use of staff benefit funds, dummy employees, discrepancies between contract salary and payroll salary payments

- Provisions and accruals: Over-provisioning to create "slush" funds, lack of company policy and/or experience for accruals for bad debts, lack of company policies.

The above points are certainly not the complete list of all risk areas. Comprehensive internal audits and business reviews directed at the above issues do, however, provide an additional level of analysis to complement financial statements and often raise serious issues that management may not be aware of.

Whereas statutory audits tend to be centered on financial figures presented, internal audits and business reviews are aimed to provide strategic and proactive management recommendations focused on improving company performance primarily through process improvement and in China particular, establish a control culture to reduce the risk of irregularities. At the same time it should be remembered that it is always cheaper to be preventive rather than corrective.

Recommendations for prevention such as establishing an effective control structure in the early stages of investment in China and having a parent company representative, ideally situated within its China office or alternatively outsourcing the role of financial manager to an "outside" company can warrant an objective picture, thereby relieving the China operation of its administrative burdens, enabling it to focus on its core business.

If you require assistance with the above subject, please contact us at info@klako.com with your detailed questions.

All information in this report is verified to the best of our ability and is assumed to be correct at time of release; however, Klako Group does not accept responsibility for any losses arising from reliance on the information provided within.