Accounting horizons june 1998

© 1998 American Accounting Association Accounting Horizons Vol. 12 No. 2 June 1998 pp. 105-119

Institutional Factors Influencing China's Accounting Reforms

and Standards Bing Xiang

Bing Xiang is an Assistant Professor at Hong Kong University of Sci- ence and Technology.

SYNOPSIS: By analyzing the changes in the accounting environment of China dur- ing the recent economic reforms, this paper places the development of accounting reforms in China into perspective and assesses the desirability of China's adopting accounting principles in close conformity with International Accounting Stanclards (IAS). The recent economic reforms, particularly the enterprise reform, in China have changed the corporate landscape and have profoundly altered the accounting environment. The Chinese accounting profession and government have responded with the enactment of a number of accounting regulations. These regulations have essentially transformed China's accounting from the traditionally rigid and uniform systeni into a predominantly Anglo-Saxon approach to financial reporting. Account- ing reform in China will be followed by the enactment of 30 detailed accounting standards which will bring China's accounting practice into further conformity with IAS. However, the paper argues that accounting rules in China should not be formu- lated to cater to the need of a small number of firms which are already listed (or will be listed) on overseas stock exchanges. Rather, China GAAP should be designed to serve China's large industrial and commercial enterprises that are characterized by extensive managerial autonomy and an effective separation of ownership and control. These enterprises in China operate in an accounting environment which differs considerably from that which is typically presumed by IAS. China's account- ing environment, both now and in the foreseeable future, is characterized by a lack of independent/professional auditing. Without an independent audit profession, in- formation provided under IAS will be unreliable; therefore, adopting IAS may not be warranted in the specific context of China. The analysis sheds light on the role of IAS in developing and transitional economies with rudimentary auditing and judi- ciary infrastructure, suggesting the limit of accounting harmonization.

Data AvaHability: Data used in this study are available from public sources.

The author thanks Steve Albrecht, Lynne Chow, Michael Firth, Jerry Han, Eric Noreen, Jim Ohlson, Katherine Schipper, Earl Stice and workshop participants at the Chinese University of Hong Kong, the City University of Hong Kong and Hong Kong Polytechnic University, three anonymous reviewers and Eugene Imhoff, the editor, for helpful comments on earlier drafts.

Submitted June 1997 Accepted November 1997

Corresponding author: Bing Xiang Email: achxiang@usthk.ust.hk

106 Accounting Horizons/June 1998

INTRODUCTION The development and practice of accountmg are influenced considerably by its envi-

ronmental factors (see Zeff (1972) and Cooke and Wallace (1990)). This paper analyzes the changes in China's accounting environment and explores the implications of these changes for financial reporting. The analysis of changes in China's accounting environment, impor- tant in its own right, is useful for the understanding of the development of China's ac- counting practice. Further, a clear understanding ofthe impHcations of China's current accotmting enviroimient is essential for an adequate assessment ofthe desirability of China's adoption of accounting principles which conform closely to International Accounting Stan- dards (IAS) (as reflected in China's proposed, detailed accounting standards). It is argued that, without an independent audit profession that can ensure comphance with the stan- dards, the information provided under IAS will be unreliable, and therefore adopting IAS may be undesirable in the specific context of China.

In 1978, China adopted an "open-door" policy and initiated an unprecedented tran- sition from a command economy to a market one. China's recent economic reforms, particularly the enterprise reform, have profoiindly altered the country's accounting environment. The ownership structures ofthe industrial and commercial enterprises in China are now highly diverse. State enterprises, generating 34 percent of the 1995 industrial output compared with 78 percent in 1978, have lost their dominance; much of the industrial output is currently produced by the non-state sectors. Collectively- owned enterprises are the largest sector of the Chinese economy, while enterprises with foreign investment (including joint-ventures and foreign wholly owned enterprises) and individually owned enterprises play an increasingly important role.

State enterprises, once the production units in the centrally planned economy, are now organized as profit and investment centers with a substantial degree of manage- rial autonomy and a separation of management fi-om ownership. Furthermore, China has evolved from a closed economy with negligible imports and exports to one of the world's major trading nations.

These changes have profoundly altered China's accounting environment and have resulted in a fundamental change in the role of financial reporting in China. The Chinese accounting profession and govemment have responded with the enact- ment of a number of accotmting regulations. The most significant change was catalyzed by the Accounting Standards for Business Enterprises, China's accounting conceptual framework, which was promulgated in 1992 and came into effect on July 1,1993. This conceptual fi-amework, which governs all enterprises in China, has essentially trans- formed China's accounting from the traditionally rigid and uniform system into a pre- dominately Anglo-Saxon approach to financial reporting. This paper provides an analy- sis ofthe changes in China's accounting environment, in order to put these accounting reforms in perspective.

Accounting reform in China has scheduled the enactment of 30 detailed account- ing standards, 25 of which may be promulgated in the near future. The detailed ac- counting standards were formulated with conformity to IAS as their overriding objec- tive. However, it remains debatable whether IAS actually fit China's special circum- stance ("Guo Qing" in Chinese). This issue, currently being fiercely debated in China, is considered the most important and controversial in setting China's detailed accounting standards. The lack of consensus on this issue contributed to the delay ofthe enact- ment of the detailed accounting standards, which were supposed to be effective on January 1, 1997. This paper sheds some light on this poUcy debate by providing a

Institutional Factors Influencing China's Accounting Reforms and Standards 107

profile of China's current accounting environment, which is essential for a proper as- sessment ofthe proposed detailed accounting standards.

The remainder of the paper is organized as follows. The next section reviews the development of the enterprise reform and identifies state enterprises as the primary targets of China's proposed detailed accounting standards. Section three examines the accounting reforms in China since the 1980s and provides a description ofthe proposed detailed accounting standards. Section four provides an assessment of China's detailed accounting standards in light ofthe salient attributes ofthe accounting environment in China. Section five concludes the paper.

CHINA'S ACCOUNTING ENVIRONMENT China's accounting reforms have been largely responsive to the country's enter-

prise reform. One cannot put China's accounting reform and the proposed accounting standards in perspective without a succinct understanding of the evolution of enter- prise reform. This section reviews the recent enterprise reform in China since 1978 and determines the types of enterprises that are likely to be the primary targets ofthe new accounting standards.

What are the Targets of the New Accounting Standards? The industrial reform since 1978 has fundamentally altered the corporate land-

scape of China. Specifically, the output value from state-owned enterprises (SOEs) ac- counts for an ever-shrinking portion of industrial output between 1978 and 1995, as noted in table 1. SOE output produced 78 percent of industrial output in 1978 and this percentage was reduced to 34 percent in 1995. In 1992, for the first time, SOEs ac- counted for less than half the industrial production in China. In 1995, SOEs, collec- tively owned enterprises (COEs), individually owned enterprises (IOEs), and enter- prises with foreign investments (FOEs) accounted for 34 percent, 36.6 percent, 12.86 percent and 16.54 percent, respectively, of industrial production.

The implications of these changes for the demand for financied reporting may not be obvious. It is well recognized that the demand for both financial reporting and auditing is significantly infiuenced by, among other factors, the extent ofthe separation between owners and corporate management. IOEs, whose owners are not separated from man- agement, Eire unlikely to have much demand for external financial reporting. Further, because IOEs in China typically obtain loans from external parties who are close friends and relatives, their financial statements usually do not play a significant role in bor- rowing transactions.

COEs, currently contributing the most to China's industrial output, have been the most important driving force in China's economic growth. COEs are comprised mainly of township-village enterprises (TVEs). The majority of COEs remain small in size and operation (Naughton 1994). TVEs obtain their equity mainly from a group of closely related individuals such as farmers from the same village or commune (Tang et al. 1996, 29). TVEs' primary source of new capital comes from their retained earnings and further borrowing from their existing shareholders because state policy has prohibited them from borrowing from China's large state banks. Further, due to ideological con- straints, TVEs are unlikely to be permitted to raise capital through public hstings on a large scale, as the limited number of slots for Ustings have always been awarded to SOEs. Thus, TVEs will continue to be severely constrained by their lack of sources of new capital.

108 Accounting Horizons/June 1998

TABLE 1 Industrial Gross Output Value by Ownership Type (percent)

Year SOEs Collectively Owned Individually Owned Others

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995

Source:

77.63 78.47 75.97 74.76 74.44 73.35 69.09 64.86 62.27 59.73 56.80 56.06 54.60 52.94 48.09 46.95 37.30 34.00

China Statistical

22.37 21.53 23.54 24.62 24.82 25.74 29.71 32.08 33.51 34.62 36.15 35.69 35.62 35.70 38.04 34.00 37.70 36.60

Yearbook (1993, 414),

0.00 0.00 0.02 0.04 0.06 0.12 0.19 1.85 2.76 3.64 4.34 4.80 5.39 5.70 6.76 8.00 10.10 12.86

(1994, 373-375), (1995,

0.00 0.00 0.48 0.58 0.68 0.78 1.01 1.21 1.46 2.02 2.72 3.44 4.38 5.66 7.11 11.05 14.90 16.54

377), (1996, 403).

A TVE is typically run by a group of people with similar or homogenous preference functions who are also the shareholders ofthe TVE. From this perspective, TVEs can either be viewed as syndicates (see Wilson (1968) for an economic analysis of a syndi- cate) or depicted as quasi-family businesses (see Weitzman and Xu (1994) who consider Chinese TVEs as vaguely defined cooperatives). These factors together imply that, in the foreseeable future, TVEs' needs for external financial reporting are limited.

FOEs (i.e., joint ventures and foreign wholly owned enterprises) in China are gen- erally viewed as business units from the perspective of their parent companies and are, accordingly, subject to reporting requirements ofthe host countries of their parent com- panies. These FOEs report regularly to their domestic and foreign parent companies for management accounting purposes. Furthermore, China's phenomenal success in attracting foreign direct investment in recent years indicates that FOEs' demands for external reporting may have been properly served by the prevailing accounting "guide- lines" for FOEs that had been enacted prior to the release ofthe conceptual framework.

It is argued below that the demand for external reporting is most likely to come from the SOEs. First, virtually all the large industrial and commercial businesses in China are still wholly owned or majority owned by the state. This is evidenced by the sustained state dominance among China's 1,000 largest industrial enterprises in recent years. Furthermore, with a few exceptions such as Bao-An Industrials, Yan-Zhong Lim- ited and Shenzhen Development Bank, firms listed on the Shanghai and Shenzhen stock exchanges are majority-controlled directly by the state or indirectly by other SOEs and state institutions (such as state-run universities). Significant state ownership is also prevalent among China's companies that are listed in overseas stock markets such

Institutional Factors Influencing China's Accounting Reforms and Standards 109

as the Stock Exchange of Hong Kong and the New York Stock Exchange (that is, H- share and N-share companies). The dominance of state ownership among the large industrial and commercial enterprises is expected to continue in the future. This is because the Chinese government currently has no intention to privatize the large in- dustrial firms and has formulated specific policies to ensure that state ownership will be the "mainstaj^ for the large industrial enterprises in pillar industries such as auto- mobile manufacturing, petrochemicals, and iron and steel.

SOEs are characterized by a complete separation of management from ownership in that managerial shareholding in SOEs is virtually zero. As a result ofthe enterprise reform since 1978, China's large SOEs now possess a high degree of managerial au- tonomy; they significantly resemble modem corporations in the West that are charac- terized by a separation of ownership from control.

In summary, since 1978 China's enterprise reform has fundamentally changed its corporate landscape. The ownership structures of China's Industrial and commercial enterprises are now highly diverse. The SOEs' share ofthe economy has been shrinking continuously and much ofthe industrial output is currently produced by non-state sec- tors, with COEs now being the largest contributor and FOEs and IOEs playing an in- creasingly important role in the Chinese economy. However, it is argued that SOEs, with extensive managerial autonomy and an effective separation of ownership and con- trol, will become the focus of financial reporting reform. The primary purpose of China's GAAP is not to serve a small number of firms which are already listed or will be listed on overseas stock exchanges. Further, if a firm from China wants to raise capital by listing in the New York Stock Exchange or Tokyo Stock Exchange, it must follow U.S. GAAP or Japanese GAAP, not IAS.

Next, China's SOE reform is examined to facilitate a further analysis ofthe countrys need for financial reporting.

The Development of the SOE Reforms Prior to 1978, all business enterprises were state owned and these SOEs were es-

sentially production units (factories). The managers of SOEs in the pre-reform era had little or no managerial autonomy. The state provided all the financing to the factories and controlled virtually all the investment and operating decisions. Inputs were pro- vided by the state and outputs were sold to the state at the price determined by the government. The government also specified the salaries and wages ofthe workers and managers ofthe SOEs. All profits were remitted to the state and all losses were covered by the government. The factories simply served the purpose of fulfilling the production quota stipulated by the government. Consequently, the managers of these factories had neither the incentive nor the managerial authority to reduce costs and generate profits. In such a command economy, the main role of accounting was to assist the government in planning and controlling economic activities.

In 1978, China's enterprise reform program was initiated and restructuring of the SOEs was designated by the Chinese governments as the core of the economic reform. Instead of privatizing the SOEs, as would later be the pattern for the ex-Soviet Union and Eastern European countries, the Chinese government chose to restructure the SOEs by increasing autonomy in making managerial decisions and by creating financial incentives at the enterprise level. To rejuvenate the SOEs, the state has experimented with various measures in the past 17 years (1978-1996). These measures can be broadly classified into two categories: the contract responsibility system (CRS) and corporatization.

110 Accounting Horizons/June 1998

The Contract Responsibility System The CRS was introduced to expand enterprise autonomy and to provide financial

incentives to both workers and managers of SOEs by relating their compensation to performance. The SOEs were first converted from factories (production units) into cost centers where managers were supposed to minimize the cost of production while the state handled pricing and distribution ofthe products. Later, with further decentraliza- tion and price liberalization, SOEs were turned into profit centers where the SOE man- agers obtained authority to make decisions on product pricing, material sourcing, prod- uct mix, marketing and distribution. Thereafter, SOEs were forced to compete in the market and profit becsime an important performance measure for the SOE managers. By the end of 1993, more than 90 percent of SOEs were governed by the CRS. Now most large and medium-sized SOEs have been awarded the authority to make some invest- ment decisions (subject to certain guidelines).

The CRS system is typically implemented as follows. The state sets a profit target for an SOE (or specifies a profit-sharing rule between the SOE and the state) and al- lows the enterprise to retain the profit in excess ofthe target. The SOE under CRS has discretion in using retained profit (subject to guidelines). Accounting profit here serves as a contract variable for specifying profit-sharing rules between the SOEs (the manag- ers and employees) and the state (the shareholder), and thus accoimting has played an important role in the implementation ofthe CRS.

Several versions ofthe CRS have been experimented with by the Chinese govern- ment, although the essential idea remains vinchanged: granting managerial autonomy to SOEs and applsdng profit-sharing rules to motivate the managers and employees within the confines of maintaining state ownership.

Corporatization ofthe SOEs Corporatization refers to converting SOEs into companies with limited liabilities

and joint-stock firms (termed the "shareholding system," in general). SOEs before corporatization are not legal entities separate from the state and, thus, the state as the shareholder ofthe SOEs besirs unlimited liabilities.

The first shareholding company, Beijing Tianqiao Department Store, was formed in July 1984. In October 1984, the experiment was expanded to some large and me- dium-sized SOEs. Corporatization had a low profile imtil late 1991. The establishment ofthe two stock exchanges in China (the Shanghai Securities Exchange and Shenzhen Stock Exchange) played an instrumental role in promoting corporatization. Table 2 provides some descriptive statistics on China's two stock exchanges. An SOE must be converted into a shareholding company with limited liabilities before the SOE can issue shares to the public and before these shares can be listed on the stock exchanges.

The objective ofthe recent corporatization drive in China is to revitalize the SOEs on a large scale by protecting SOE management from government interference. The major effect of corporatization is that it transforms state factories for which the state has unlimited liability into legeil entities with limited liability. This limits the state's exposure to potential liability and lays a foundation for implementation of the Bank- ruptcy Law. Corporatization also helps to clarify the property rights ofthe SOEs, which will help facilitate raising of capital, restructuring ownership and other reorganiza- tions. What corporatization can actually accomplish, however, remains to be seen.