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Legal-Ease
Business> Legal-Ease
UPDATED: March 11, 2008 NO.11 MAR.13, 2008
LEGAL-EASE: Analyzing Chinese Financial Statements
By EDWARD MA
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In this article, we will focus on understanding and analyzing the typical accounts of Chinese financial statements, including the balance sheet and income statement. Accounts are generally incorrectly prepared. This can be due to several factors, incompetence, as well as more serious cases of deliberate attempts to deceive. Regardless, accounts can be understood and errors or specific acts of misrepresentation uncovered. We will conduct some simple analysis to demonstrate how these can be spotted.

In the balance sheet, we focus on: accounts receivable, other accounts receivable, fixed assets, construction in process, accounts payable, other payable and payroll payable.

In the income statement, we analyze: sales income, cost of goods sold, expenses and income tax.

All the usual mistakes are identified according to our practical experience and have come from live cases.

The cases we analyzed came from projects we conducted in the past. Most of them are Chinese private companies; some of them are medium-sized foreign-invested enterprises.

The balance sheet:

1) Accounts receivable

The account mainly deals with the transactions of the company.

Typical weaknesses:

a) Many businesses in China cannot prepare an accounts receivable aging analysis, as the communication between the sales department and financial department is poor.

b) It is a common practice for businesses to attempt to hide sales to reduce taxable income, and as such, the accounts receivable is usually under-reported.

2) Other accounts receivable

Typical weaknesses:

Many irrelevant transactions are often recorded in the other accounts receivable. For example, there may be an internal loan between two related companies, with this being recorded into the account of other accounts receivable and not listed as a transaction in the investment account.

3) Fixed assets

Typical weaknesses:

a) Often self-established fixed assets are not included into the fixed assets account, and the relevant depreciation is not taken accordingly.

b) The cost for establishing the fixed assets is recorded in the expenses account or cost account but not capitalized.

c) Only a small number of companies conduct periodic counting and post fixed assets label correctly.

4) Construction in process

Typical weaknesses:

a) Some self-established fixed assets are not recorded in this account nor later transferred to the fixed assets account.

b) Original supporting documents related to construction in process are not properly filed and documented.

5) Accounts payable

Typical weaknesses:

Sometimes the enterprises will book irrelevant transactions in payable.

6) Other payable

Typical weaknesses:

Please refer to the introduction of accounts receivable.

7) Payroll payable

Typical weaknesses:

Often there will be an ending balance of the payroll account, however we note many Chinese companies delay part or all of the employees' salaries.

8) Sales income

Typical weaknesses:

a) It is common that the company management does not record all sales revenue in the financial statements prepared for the tax bureau. For example, for some cash sales, the target company will not include them into the financial statements and will maintain them in an internal sales book.

b) Sometimes the sales will be delayed as recognized in order to reduce the sales volume in the current accounting period.

9) Cost of goods sold

Typical weaknesses:

a) In many cases, the businesses did not adopt a sound cost carrying forward method to record and allocate costs.

b) Often businesses will record irrelevant items in the cost account, such as self-established fixed assets cost.

10) Expenses

Typical weaknesses:

a) Many businesses book non-deductible expenses in the expense account, such as fixed assets cost, penalties and so on. The auditor will adjust the inappropriately recorded expenses out at the end of each year.

b) Some expenses have exceeded the limitation of deduction as listed in China's tax law.

11) Income tax

Typical weaknesses:

In almost all cases, income tax will be under-reported by most companies. Their profit and loss usually shows a loss at the end of the financial year.

Summary

The points mentioned above are only a general level introduction of typical problems when assessing Chinese private enterprises or small and medium-sized foreign-invested enterprises. Investors in China should be aware of relevant risks when making investment decisions and obtain professional advice when assessing Chinese financial statements.



 
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