Standard bearers

The incorporation of international accounting and auditing practices into Chinese company law presents both a challenge and a great opportunity. If all goes to plan, China’s 1,400 listed companies will be managing their finances according to International Financial Reporting Standards (IFRS) by the start of next year.

For investors and companies alike, this represents a significant breakthrough. Gone will be the days of keeping a different accounting book for each set of standards – investors will have access to a clearer and more easily comparable picture of a company’s finances. However, it is up to the country’s finance professionals to get up to speed on IFRS and match the new standards with professional integrity, the lack of which has undermined market confidence in the past.

"It’s a revolution – everything is going to change," said Yvonne Kam, director of PricewaterhouseCoopers’s assurance practice. "Investors will benefit from improvements in transparency and consistency."

Announced in Beijing by Finance Minister Jin Renqing, flanked by members of the International Accounting Standards Board, the new China Accounting Standards System will see the current model of one basic set of 16 specific standards amended and enlarged to incorporate a further 22 standards outlined in IFRS. There will also be a total of 48 auditing benchmarks.

China will become the 74th country to conform to IFRS, following in the illustrious footsteps of the European Union, which required its 7,000 or so listed companies to align with the international standard from last year. The response from investors has been favorable. A PwC survey carried out toward the end of 2005 asked 187 fund managers from seven EU countries to compare the merits of IFRS and US General Accepted Accounting Principles in terms of assessing company performance. IFRS emerged the victor with 45% support to 20%. Nearly three-quarters of the fund managers agreed that the greater transparency and ease of comparison offered by IFRS had made at least some impact on their perception of company values.

Unlike Europe, though, China will be making the transition in one leap rather than in phases. Past experiences of other countries making the switch has shown that companies often underestimate the amount of extra information required in preparing financial statements to meet IFRS.

"It is all about changing the mindset and they seem to think they can do it in one go," said Kam. "The 1,400 listed companies are doing it by 2007, and this is different to specific standards being implemented at different times. That said, it will first be rolled out to listed companies and then to other types of enterprises."

Further expansion
As to when it will be extended to include non-listed firms, no plans have been made public. It has been suggested that it could happen as early as 2008, following the imposition pattern of the Accounting System for Business Enterprises (ASBE), which itself made significant steps to align Chinese practices with international ones. Introduced at the end of 2000, the ASBE applied to all joint stock enterprises from 2001 and then moved to encompass foreign investment enterprises the following year, and most other enterprises in 2003. However, while small enterprises and financial institutions have their own systems, most of the larger non-listed state-owned enterprises remain outside the bounds of ASBE.

The fear is that China will promote itself as being IFRS-compliant but hype will not be backed up by reality. "The devil is usually in the detail," said Jamie Allen, secretary-general of the Asian Corporate Governance Association. "A company may say it has converged but when you look closely at the accounting and auditing there is often a big gap between international practices and local ones."

Indeed, there will continue to be a number of differences between Chinese accounting standards and IFRS. Two key exceptions relate to companies’ longstanding and often intricate ties to the state. Under the new standards, firms will not have to disclose details of "related party" dealings when there is no direct relationship simply because all SOEs are essentially related parties. This exception effectively removes the need for a lot of unnecessary paperwork. In addition, some companies will be allowed to count government subsidies as income in their accounts.

Corruption buster
A further exception in the Chinese rules amounts to a crackdown on corruption. While international standards allows records to be altered if an asset that was originally not expected to recover full value turns out able to make a return on its cost, this kind of reversal activity is to be prohibited in China. "Some companies see this as a loophole," said Chen Baolang, assurance partner at PwC. "When they accrue a loss they try to over-provide for the asset impairment and so alter the profit picture."

However, the major weaknesses don’t lie in the exceptions but the rules themselves – and the possibility that companies may just not adapt sufficiently, leaving investors even less informed than they were before. The PwC survey of European fund managers’ views on IFRS found that the chief concern was firms failing to show how they have implemented the new system. The risk is that a change in the data to comply with IFRS will be misinterpreted as a change in the company’s overall economic performance. This effect could be even more pronounced in China, given the distance some firms must go to comply.

"It is a positive step forward but we should not underestimate the amount of effort required in order to apply these principles correctly," said Kam.

The changes required range from the mundane to the complex: on the one hand, inventories may have to switch from the first-in-first-out model to last-in-first-out, while on the other, comprehensive disclosures will have to be made regarding the issue of stock, bonds and derivatives. Another testing area will be measurement as, under IFRS, companies have the option of valuing their assets based on market value (the fair value model) rather than cost price. This is likely to alter the perception of a firm’s underlying worth.

Conforming to IFRS impinges on many of a company’s day-to-day management activities, from budgeting and forecasting to subsequent financial reporting, and so success ultimately depends on having staff that are able to deal with it. "We urge companies to start training personnel early and get the new principles embedded into their systems," said Kam.

The government plans to have 3,000 accountants familiar with the standards in five to 10 years but even then considerable efforts are required to improve the regulation of an industry that has been through more than its fair share of scandals. Few executives are successfully prosecuted for accounting-related crimes and, for those that are, the penalties are relatively weak.

"If it’s not some serious criminal activity, you’ll probably just get a wrap over the knuckles," said Allen. "China can make a big deal about IFRS but they still need to work hard to build up its credibility."