Held to account

Chinese firms have a somewhat dubious record when it comes to keeping good accounts. Kelong Electronical Holdings hit the headlines in September as its chairman – well-known figure Gu Chujun – and other top managers were arrested for violating securities laws. The charges included artificial inflation of profits and embezzlement of company funds.

Another high-profile case, in 2003, involved Dongfang Electronics, which was one of China's best-performing stocks until hit by accountancy scandals. The Dongfang president was sentenced to two years in jail and ordered to pay a US$6,200 fine, but this was minor in comparison to the size of the fraud. Regulators said that the company overstated sales by US$205 million over the course of five years.

However, the Dongfang conviction was a relative success story: corporate executives in China are very rarely prosecuted for accounting-related crimes. And given that, when they are, the punishment rarely fits the crime, it's no surprise to hear people question companies' corporate governance. What China needs is its own version of the US Sarbanes-Oxley Act, under which individual executives can face 20-year jail sentences and fines of up to $20 million. But rather than highlight personal responsibility, China focuses on corporate responsibility with companies facing fines, sanctions and possible delisting if they offend. Needless to say, these penalties are weak and rarely enforced, leaving companies thinking that they can get away with almost anything.

Common crimes include inflating profits in order to artificially drive up stock prices so that key personnel can sell their holdings at a profit, and underreporting to create a fall in stock prices so top managers can boost their holdings at a knockdown price. As the government continues its stock market reforms, the ownership and management problems will probably, eventually, clear up.

Meanwhile, as a short-term solution, investors and business partners are starting to demand western-level auditing. The world's top four accounting firms – PricewaterhouseCoopers, KPMG, Deloitte Touche Tohmatsu and Ernst & Young – are also the top four in China, pulling in 45% of the collective revenue of the country's top 100 accounting firms.

Chinese companies keen to list overseas or attract foreign investment are increasingly turning to western expertise to give their accounts some credibility, and smaller foreign-owned accountancy firms are benefiting from this. "We find that we are doing more work for Chinese companies related to finding investors or setting up operations in other countries," said Russell Brown, managing partner at LehmanBrown International Accountants.

But the bulk of accounting work in China is still handled by local firms. Much of the time it is a cost decision: where a top-four firm might charge US$10,000, a quote from a midsized local firm is more likely to be in the RMB10,000 bracket. Local operators can also offer greater experience with Chinese financials, and greater flexibility in interpreting – or even ignoring – accounting rules.

Even when an audit is done by a big-name western firm, there's no guarantee that the books are clean. Kelong Electrical Holdings was audited by Deloitte Touche Tohmatsu from 2002 through to 2004, just before the company imploded. Unsurprisingly, Deloitte isn't prepared to comment on the matter.

Such slip-ups are often blamed on inexperience on the part of employees. The top four accounting firms do a good job in joint ventures because that is where the bulk of their China experience lies. But when it comes to untangling the accounting of private Chinese firms, things are not so straightforward.

The bottom line is that reform of corporate ownership needs to go hand in hand with tougher rules on corporate responsibility. Today, such problems are masked by China's booming growth. If, or when, it slows down, the last thing Beijing wants is a crisis of confidence in the country's economy.

Maria Trombly is the Asia bureau chief for Securities Industry News.

Taxes and accounting standards
Chinese regulators have met with their counterparts at the International Accounting Standards Board to develop a new set of accounting laws – known as the Accounting Standards System for Business Enterprises – that will put Chinese standards in line with international ones. At present, the differences are wide-ranging. For example, Chinese accounting law states that R&D expenses must be counted in the month in which they occur, while IAS allows them to be delayed until the new product is sold. There is also the issue of timing. Every Chinese company has the same fiscal year – January 1 to December 31 – which means accountants and regulators are all busy at the same time. And when they do sit down with a company's accounts, they are faced with three sets of books: one kept according to Chinese accounting laws, another for the taxman, and a third kept under international laws for foreign partners and investors.