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Auditing of State-Owned Enterprises in China: HistoricDevelopment, Current Practice and Emerging Issues

Qingliang Tang,* Chee W. Chow,y and Amy Lauz*University of Western Sydney, Nepean, N.S.W., Australia; ySan Diego State University, San Diego, CA,

USA; and zOklahoma State University, Stillwater, OK, USA

Key Words: Auditing; State-owned enterprises; Reform; China

Abstract: State-owned enterprises (SOEs) play a pivotal role in the Chinese economy. Together,

they manage over 50% of China's national capital. With China steadily moving towards a market

economy, SOEs increasingly are given the latitude to seek external funding, develop joint ventures

and more generally, to operate without direct government involvement. This separation of

ownership and management, in turn, has increased the need to monitor and control China's SOEs,

and audits can play a key role in this oversight function. Despite the potentially important role that

SOE audits can play in safeguarding the interests of the state and external investors, there is a

relative dearth of research on the current state of, and challenges facing such audits. This paper

provides an overview of the historical development of the SOE audit by the Ministry/Department

of Finance, and current SOE audit practices performed by the State Audit Administration/Office.

The main conclusion of the study is that, with ownership of the SOE being further diversified and

the operation of the SOE being completely commercialized (i.e., without any political

consideration), the nature of the state audit office as a government agent is incompatible with

the role of independent auditor for SOEs. SOEs need a non-government third party to verify its

financial statements and audit its business activities to meet the information needs of diversified

interest groups in the SOE including the state, individual or institutional investors, creditors and

employees etc.

Audit of state-owned enterprises (hereafter SOEs) is an important issue. First of all,

China currently has about half a million SOEs (Wang, 1995), which employ more than

50% of China's national capital. Due to their size, SOEs play a significant role in the

Chinese economy. Secondly, from the early 1980s, with the enterprise reform program,

most SOEs have been given increasing autonomy to make business decisions without

substantial interference from the government (Chow et al., 1995; Chen et al., 1997). The

controlling role of the government has diminished and new forms of financial incentives

at the enterprise level have been adopted. One would expect that this change in the

The International Journal of Accounting, Vol. 34, No. 2, pp. 173±187 ISSN: 0020-7063.

All rights of reproduction in any form reserved. Copyright # 1999 University of Illinois

Direct all correspondence to: Qingliang Tang, Lecturer in Accounting, School of Accounting, Universityof Western

Sydney, Nepean, N.S.W., Australia; E-mail: [email protected]

The InternationalJournal ofAccounting



organization structure of SOE (from a governmental agency to an independent business

entity) would have tremendous impact on the nature, objectives and procedures of theauditing of SOEs. Thirdly, it is importantbecause there existsa largeamountof embezzlement

involvingSOEs1andatleastone-thirdoftheSOEsarelosingmoney.Itisexpectedthatauditmay

resolveandpreventtheseproblems,oratleastcontroldysfunctionalbehaviorinSOEs.

Despitethewidelyrecognizedrolethatauditsplayinassuringtheintegrityofaccountingand

financial reporting, only a few studies have addressed auditing issues in the Chinese context

(Huang, 1987; Lau and Yang, 1990; Skousen et al., 1990). While these studies have increased

awareness and understanding of the topic, limited discussion has been provided on the recent

SOEs' developments and reforms in China. Moreover, prior studies only covered general

issues of auditing, such as the auditing system (Huang, 1987; Lau and Yang, 1990), auditing

legislation and enforcement of law (Skousen et al., 1990), but did not attempt to discussspecifically auditing practices of SOEs.

The primary purpose of this paper is to provide an overview of SOEs' auditing

practices, pre and post the restructuring of SOEs. In addition, it will examine the effects of

the change in the organization structure of SOEs on the nature of SOE's audit and the

issues encountering the audit profession in general.

The remainder of this paper is organized as follows. The next section provides

some background on the practice of auditing of SOEs prior to the SOEs' restructuring.

This is followed by a description of current practices of SOEs' audit, including some real

world examples. The next section discusses some recent developments and related

emerging issues in the audit profession. The final section provides a summary andconclusion.

SOE AUDITING BEFORE RESTRUCTURING

Before the economic reforms in the 1980s, businesses in China were operated

and strictly controlled by governmental agencies (state or ministry levels). Operations

of SOEs were conducted according to state plans. The government and its agencies

retained all investment and operating decisions. The managers of these entities had

little incentive and managerial authority to enhance the efficiency of SOEs. SOE was

not regarded as a mere commercial organization in the sense that its objective was tomaximize profit. It was also considered as a quasi-government agent that was required to

pursue the broad social, political and economic objectives of the government. Some

examples of activities conducted by a typical SOE, which may not make business sense,

include:

1. Employment. Consistent with the policy of full employment of the government

before the 1980s, SOEs could not fire redundant or under-performing employees;

2. Production of unprofitable products. An SOE must manufacture products according

to the state plans even though there are no profits for such a product or service;

3. To run unprofitable operations, such as hospital, child care, employee accommoda-tion, etc.

174 THE INTERNATIONAL JOURNAL OF ACCOUNTING Vol. 34, No. 2, 1999



In such a planned economy and financial reporting environment, the main objective

of financial reporting was to provide financial information for the government toformulate and enforce state economic plans and to control economic activities. In

addition to direct supervision exercised by the governmental unit directly superior to

the particular enterprise, the Ministry/Department of Finance performed annual ``financial

examination'' of SOEs. Regular audit was not considered necessary under the planned

economy. In the case of central government-controlled SOEs, the Ministry of Finance

was responsible for such an examination (usually performed annually). For local SOEs,

the Department of Finance of a local governmental office is responsible (Lau and Yang,

1990).

The purposes of the financial examination were:

1. to ensure the compliance of business activities with government policies, economic

law and regulation, tax rules or profit submission schemes;

2. to ensure the implementation of detailed state plans, such as production plans,

financial plans, quotas and so on;

3. to ensure integration of state assets and funds and the proper use of these funds.

The financial examination by the Ministry/ Department of Finance served as a

means of direct control and management of the SOE. This was appropriate, as the

cash flows of SOEs were part of the overall cash flows of public finance of the state. 2

There was an overwhelming focus on compliance with certain economic and financialrules and profit/tax submission rather than a verification of financial statements. As the

SOEs were under direct control of the government, there was no need for an independent

audit of financial statements by a third party who provides an independent view as to

whether the financial statements are true and fair. Prior to 1980, independent audit did not

exist.

THE MAIN FEATURES OF SOES AFTER RESTRUCTURING

It has been generally agreed that the government's direct control and management of

SOEs, together with other factors such as an over-centralized national economy, result in poor performance of SOEs (see, e.g., Tang et al., 1996). In the early 1980s, the

government began reforming the SOEs. The objective of the SOE's reform was to

rejuvenate the SOEs by giving more and more autonomy in making economic decisions

and providing financial incentives to managers and employees of SOEs. Two major

reforms have been adopted for SOEs. They are the contract responsibility system (CRS)

and corporatization.

Under CRS, while the government retains the ownership, the SOE is subcontracted to

selected individuals (managers) to independently run the firm. The managers are rewarded

if the operating targets set in the contract are achieved. The financial incentives for

managers include sharing of the profits in excess of the targeted amount. Unfortunately,the CRS has not been successful in improving the economic efficiency of SOEs. Liu and

Zhang (1996) discuss several factors contributing to the inefficient and unprofitable

operations. Consequently, the government intends to replace CRS by corporatization.

Auditing of State-Owned Enterprises in China 175



Corporatization refers to converting SOEs into companies with limited liabilities. After

restructuring, the SOEs would have the following features.

1. There is increasing degree of separation of management and ownership. Although

the government still retains ownership of an SOE or may have majority shares,

there is no longer direct control over the SOE by the government. Most SOEs are

becoming profit centers and investment centers. The decision power now is in the

hands of the SOE's managers or the board of directors.

2. Except for large and key SOEs, operations of most SOEs are no longer subject to

state plans. Rather, profit is the primary goal and is becoming a key criterion to

measure performance.

3. SOEs are now operating in freer markets and are subject to market forces. Thegovernment no longer guarantees a market for an SOE's products and has stopped

subsidizing losses incurred in SOEs. In other words, SOEs have to bear the full

consequences of their operation and investment decisions.

4. The reward of the manager is often directly linked to the performance of the SOE.3

Accounting information is widely used to measure performance.4

5. There is no market for stocks issued by most SOEs. Only a small number of

SOEs are listed companies whose shares are traded on a stock exchange. For

other SOEs, the value of the firm cannot be determined in a free market.

Merger and acquisition of SOEs is not a common practice as there are political

restrictions (e.g., unemployment, transfer of public ownership) as well as tech-nical problems (e.g., no independent assessors for properties, intangible assets,

etc.).

Although the abovementioned reforms have improved efficiency of SOEs (Chang,

1997), new problems have emerged. One of the problem is the self-serving management.

Xiang (1998) states that

[a]s a result of these profound changes, China's large SOEs, either corporatized or still

under the CRS, now significantly resemble modern corporations in the West in that the

SOEs are characterized by a high degree of managerial authority and a separation of ownership from control. As a consequence, potential agency problems have emerged.

The agency problem is more serious among the SOEs' managers as the incentive

system is short-term oriented. Their primary financial reward system is linked to the profit

performance. As these managers are not allowed to own shares in the SOEs they managed,

there is no long-term incentive.

After restructuring, without direct control and without involvement in day-to-day

management, the government has to rely on the SOEs' financial statements to make

decisions. However, there are growing incentives for the manager to manipulate the

financial information. The manager may inflate the profits to their benefit or provide false

financial statements to conceal embezzlement and other irregular behavior. The financial

statements provided do not represent the true and fair state of SOEs. As a result, relying on

these misleading or false financial information may lead to serious consequences, such as




the loss of state funds, the wrong assessment of managers, and the formulation of incorrect

economic decisions and policies.

CURRENT AUDITING PRACTICES OF SOES

Establishing State Auditing Offices

Due to the narrow focus of the financial examination by the Ministry/Department,

these management problems could not be discovered or resolved. By and large, audits

by the Ministry/Department of Finance tended to be concerned with uncovering taxes,

profits and charges that should be submitted to the government but still retained in theenterprise (State Council of China, 1986). In addition, there was a lack of independence.

The Ministry/ Department of Finance might have financed the SOE and have been

involved directly or indirectly in making business decisions. They have to consider their

interest when performing the financial examination. Consequently, the examination might

be biased as the examiner has a strong and direct interest in the revenue outcome of the

audit. There are anecdotal stories that some departments of finance would not correct

accounts as long as they achieve the budgeted revenue collections for the current year,

leaving the (uncorrected) detected errors as a hedge for attaining future years' collection

targets.

In responding to these changes resulting from SOE restructuring and particularly inrecognizing the need for a more independent auditing organization, the Chinese Constitu-

tion was amended to create state auditing offices (Audit Administration or Audit office),

and to charge it with this responsibility. Article 91 of the Constitution (1982) states that:

``The State Council establishes an auditing body to supervise through auditing the revenue

and expenditure of all departments under the State Council and of the local governments at

different levels, and those of state financial and monetary organizations and of state

enterprises and undertakings.'' Article 91 also states that: `Ùnder the direction of the

Premier of the State Council, the auditing body independently exercises its power to

supervise through auditing in accordance with the law, subject to no interference by any

other administrative organ or any public organization or individual'' (emphasis added ). In1983, the Audit Administration under the State Council was officially set up according to

Article 91 of the Constitution. This signaled the beginning of modern state auditing in

China. After that local state audit offices were also established. On 30 November 1988, the

State Council issued the `Àuditing Provisions of the People's Republic of China,'' which

was effective on and from 1 January 1989. As described in Lau and Yang (1990), the 1988

Audit Provisions strengthened the line supervision of the auditing organization structure

and eliminated the dual leadership problem encountered by the state auditing offices. In

addition, the state auditing offices were permitted to establish an internal audit department

or standing agency to perform audits on their behalf.

On 31 August 1994, replacing the `Àuditing Provision,'' the Standing Committee of the People's Congress adopted the Auditing Law of the People's Republic of China, which

was effective on 1 January 1995. The Auditing Law reinforces the roles and responsi-

bilities of the state audit office. It prescribes the scope and procedure of auditing of SOEs.

More specifically, Auditing Law (Articles 2 and 20) states that the state audit office should




audit financial revenue and expenditure, assets, liabilities, profits and losses of SOEs. In

addition, due to the vast number of SOEs, the Law (Article 21) focuses on the audit of those SOEs that are considered essential to the national economy (e.g., energy, transporta-

tion, communication, airlines, steel, electricity, defense, hi-tech, and food) and those

enterprises that received large financial subsidies from the government.

Basically, auditing by the state audit office involves the evaluation of the fiscal plans

implemented, reviews of the revenue and expenditures, and assurance of compliance with

the state's financial and economic guidelines, regulations, rules and disciplines (Huang,

1987). Under the Auditing Law of the People's Republic of China, the main objectives of

an SOE audit can be summarized as:

1. Assessing whether the financial revenue and expenditure are true and correct;2. Assessing whether the transactions and business activities that give rise to the

revenue and expenditure are conducted in accordance with financial and economic

laws and regulations; and

3. Assessing whether public funds are used effectively and efficiently.

In practice, while the last objective is explicitly stated in the Auditing Law (Article 2),

its implementation is hampered by the lack of specific criteria for measuring effectiveness

and efficiency. It is also difficult for the state audit office as a government agent to make

judgment about SOE business decisions and activities in terms of effectiveness and

efficiency.The approach for the auditing of SOEs involves the following (Lau and Yang, 1990):

1. Auditing agencies submit their annual plan and work report to their respective

controlling governmental units;

2. SOEs submit their financial revenue and expenditure plan, credit plan from banks,

budget, final accounts and statements etc., to their respective auditing agencies;

3. Audit agencies submit the audit reports including SOEs' comments to their

respective controlling governmental units;

4. When disagreeing with the audit reports, SOEs could appeal and request to be

reaudited;5. When disagreeing with the reauditing conclusions and decisions, SOEs could

appeal to a court.

A real case is provided in Appendix A as an example of a typical SOE audit report by

the state audit office. The names of the office and the SOE have been disguised. This

report illustrates the main purpose, scope and conclusion of an audit conducted by a

provincial state audit office. It also shows the following required components of an audit

report:

1. Details of audit findings;2. Whether the auditee has admitted the problems (if not, then the details of

disagreement should be indicated);

3. The auditor's opinion as to how to treat the case, indicating what are the

responsibilities of the people involved, and suggestions for improvement;




4. The organizations that will receive the audit report. The main receiving organization

is generally the one which had authorized the audit. (In this case, it was the Officeof the People's Government of the Province.) The audit report also may be copied

to other governmental bodies, such as the higher authority in charge of the auditee.

(In this case, it was the Bureau of Industry of the Province, the Bureau of

Supervision of the Province, and the Bureau of Finance of the Province.)

Under the Auditing Law, the state audit office does not have the authority to take direct

actions against the auditee. Rather, its audit decisions are viewed as recommended

treatments for the case (Auditing Law, Articles 34 and 35). Generally, penalties for

wrong-doings are of three major types: (1) Economic penalties, such as resubmission of

profit, confiscation of property, fines, and termination of funds and/or loans to the auditee;(2) Administrative penalties, such as correction of accounts, sealing of books and

accounts, public reprimand, and removal from office for responsible persons; and (3)

Criminal punishment (Auditing Law, Article 47). This is also presented in the case (see

Appendix A for details of the case).

While the audit decisions must be implemented by relevant authorities, a report of the

implementation has to be submitted to the Audit Office. On receiving the report, the Audit

Office may conduct a follow-up audit to see whether the recommended actions have been

enforced (Guang, 1993; Wei, 1994).

Assessment of State Audit Offices

In contrast to the Ministry/Department of Finance, since the state audit office is funded

separately from SOE, it has no direct economic interest in the SOE it audits or the outcome

of the audit. The state audit office appears to be, and is in fact, more independent than the

Ministry/Department of Finance. As state audits are conducted under the Constitution and

a separate Auditing Law, they have a much stronger legal backing than financial

examinations conducted by the Ministry/Department of Finance. Furthermore, state audit

offices also differ from the Ministry/Department of Finance as they are not involved in the

formulation of financial and economic policies.

Since the establishment of state audit offices, many fraud and irregularities in SOEshave been discovered. Wei (1994), in reporting the 10-year performance of the state audit

office, states that the state audit office discovered more than 25.8 billion yuan of funds not

submitted to the state, 28.7 billion yuan inappropriately used funds, 1615 corrupt cases

and 10,561 corrupt officials.

However, due to limited resources and the lack of qualified auditing personnel, the state

audit offices were only able to audit a small number of SOEs. Since the closure of private

and public accounting firms in 1958, all auditors have been government employees. There

were more than 3000 governmental auditing agencies and nearly 40,000 auditing

personnel in the early 1980s. As there were about 500,000 SOEs and approximately 2

million organizations subjecting to state audit offices' audits, only about 4% of theseorganizations were being audited. In other words, some SOEs were not subjected to

appropriate supervision through the use of annual financial audit.




Wei (1994) also indicated that the main concern of the state audit office was fraud and

irregularities rather than verification of financial statements. Furthermore, the priority of state audit offices was the auditing of expenditure and income of the government

departments rather than audit of SOEs as a whole. This priority is consistent with Articles

2 and 20 of the Auditing Law which specify clearly the responsibilities of the state audit

office.

On the other hand, as the SOE is not a company that is governed by the Company Law,

it does not have to provide audited financial statements under the provision of the

Company Law. Only a relatively small number of SOEs have been transformed into listed

companies which were subject to the listing rules which require audited financial

statements. Consequently, for most SOEs, no formal audit of financial statements is

required and no independent opinion is provided as to whether these financial statementsare true and fair. Although there might be some tax audit from the Department of Tax, this

is only for tax purposes, and this audit is not intended to verify financial statements. Given

the relaxed requirement for the state audit office's audit and a strong incentive for the

managers to manage earnings,5 the financial statement figures are very likely to be

fraudulently manipulated6 and unreliable. Economic policy and decision based on these

unaudited financial statements may again have the same problems, which were encoun-

tered when the Ministry/Department of Finance was performing the financial examination

as discussed in the previous section. In other words, the establishment of the state audit

offices did not overcome the SOEs' managerial problems.

As the state audit offices do not have sufficient resources to perform audit for all SOEs,audit becomes highly selective. For those that are not selected, the audit office has no

responsibility for any failure of business and other problems such as misleading or

fraudulent financial statements. As a result, a state audit office may prefer to choose low

audit-risk SOEs and avoid high-risk SOEs.

FUTURE DEVELOPMENTS

Permitting CPAs to Audit SOEs

The above problems cannot be resolved simply by increasing the budget of the state

audit offices. In addition to the limited resources of the state audit offices, there is a

fundamental conflict between SOEs after restructuring as a commercial organization and

the state audit office as a government agent. Given the position of the state audit offices,

they are unlikely to provide unbiased views and to perform appropriate verification of

financial statements and business activities.

With further economic and enterprise reforms, the general structure of SOEs would

lead to:

1. further separation of management and control;2. further diversification of ownership;

3. more transferable ownership;

4. increased degree of commercialization of the business operations.




Diversification of the ownership of SOEs would be inevitable. The Chinese govern-

ment encourages other investors to purchase SOEs' stocks. Some SOEs have alreadytransferred share ownership to individual, institutional and foreign investors. As a

result of diversified ownership, there will be other users of financial statements, such

as non-governmental investors, commercial banks that are also becoming independent

from the government direct control, employees and unions. Before restructuring, jobs

were guaranteed in SOEs. Salaries and wages were fixed and not adjusted according

to SOE performance. Consequently, employees were rarely interested in financial

position of SOEs. However, this is no longer the case. Employees and trade union

can invest in SOEs and are becoming interested in the financial statements issued by

SOEs.7

However, to develop the users' trust in the SOE's financial statements, independent audits have to be performed on these financial statements. The independent audit

professions, which can provide unbiased views on the financial reports have to be

established. The state audit office cannot perform an independent audit due to its

relationship with the state or central government. It can only represent the interest of

the government and cannot represent interests of other investors and interest groups in the

SOE. Therefore, audit of SOEs by the state audit office would reduce the credibility of the

audit reports perceived by non-government users.

Further market reform would cause the operation of SOEs to be completely commer-

cialized, i.e., the business activities are not subject or linked to any political consideration

and state social and economic policies. Consequently, any form of governmental inter-ference with business activities, including state auditing, would be viewed as inappropri-

ate. There are some well-publicized cases that audits by the state audit office were highly

politically motivated. The state audit office might be under political pressure when

performing the audit and its independence might be compromised.8

It is argued that SOEs should be audited by a non-government third party. The existing

Chinese certified public accountants (CPAs) can take over the audit for all SOEs. The

Chinese CPA system was revived due to the economic reform (Huang, 1987). The roles

and responsibilities of CPAs and CPA firms are defined in the 1993 Law of Certified

Public Accountants. CPA firms were employed for doing assets valuation and annual audit

for Sino±foreign joint ventures, companies and occasionally some SOEs assigned by stateaudit offices. The laws, however, are silent on requiring all SOEs, especially those not-

corporatized, to be audited by CPA firms. If the CPAs' audits can be required and extended

to all SOEs, the following benefits may be realized.

1. The audit reports issued by CPAs may have more creditability, as the CPAs are

viewed to be more independent and are subject to less political pressure than a state

audit office.

2. A CPA firm is more likely to add audit value to the business of the firm as the audit

would be conducted from a pure business point of view.

3. It is unlikely that the budget of state auditing services would be increasedsignificantly and the limited resources of the state audit office may be used more

efficiently and effectively by focusing solely on governmental departments'

expenditures and income.




4. All SOEs would be subject to audit, either by CPAs or Certified Public Auditors

(some Chinese CPAs are called ``certified public auditors'').5. The substantial SOEs' audits could strengthen the development of the auditing

profession in China.

However, there are a number of problems that should be resolved regarding the audit of

SOEs by CPA firms. First, CPA firms should be de-affiliated from any governmental units.

As most CPA firms are historically affiliated with governmental or educational institu-

tions,9 there is a concern of whether the CPAs are really independent when performing the

SOEs' audits (and other audits as well). The affiliated relationship may affect the CPAs'

judgment and decision and create a perception of lack of independence. The de-affiliation

is required and it is expected that all de-affiliation should be completed in the near future.However, as the process has been very slow,10 it is suggested that only de-affiliated CPA

firms should be allowed to do audit for SOEs. Second, CPA firms should develop auditing

standards about regulation compliance audit .11 This is because the traditional role of the

CPA audit is to verify the financial statements rather than discover fraud and irregularities

which is an important part of the audit of SOEs. The current professional auditing

standards appear inadequate to guide the latter audit.12 Third, audit of SOEs is a

potentially huge market and is a real challenge to CPA firms. More qualified and well-

educated professional accountants are needed. This is crucial to strengthen and to improve

credibility of SOEs' audit. The target may be achieved by professional and educational

efforts, government support and other means, including the cooperation of the interna-tional accounting community such as the Big Five accounting firms and the International

Federation of Accountants.

In addition, the following revisions of the 1994 Auditing Law and the 1993 CPA Law

and the professional auditing standards regarding SOE audit are required.

1. Revision of Article 91 of the Constitution and Articles 2 and 20 of the Auditing

Law. Such a revision would indicate, to the effect, that the financial statements of

commercial SOEs (i.e., those that have a separate legal entity status) should be

audited by a non-government third party (i.e., CPA firm).

2. Revision of the provision in the Auditing Law about economic and efficient auditing. Economic and efficient auditing, if it is done correctly, can be very

beneficial to the audited organizations. However, there is a lack of clearly defined

criteria to perform and evaluate this type of audit. The law should be revised

to provide guidance and criteria for performing the economic and efficient

auditing.

3. Revision of the CPA Law. Under the 1993 CPA Law, a CPA firm has no

responsibility to undertake an audit of SOEs. A provision should be incorporated

regarding audit of SOEs by CPA firms. In addition, it should specify the objective

and basic procedures of SOEs' audit. Furthermore, the principal role and

obligations of a CPA firm for such an audit need to be stated.4. Revision of auditing standards. Current auditing standards should also be revised to

guide the practice of SOE auditing. The main changes would be those regulations

relating to compliance test procedures (beyond financial statements).




SUMMARY

This paper has provided an overview of the historical development and current practices in

the audit of China's SOEs, and offered some observations on current developments and

future challenges. The relationship between the SOE after restructuring and the state audit

office is also examined. It is obvious that developing a uniform and high level of audit

assurance for China's vast number of SOEs in particular, and its economic institutions in

general, will be a most challenging undertaking. Among the issues that need attention are the

development of a sufficient number of trained auditors and accountants, uniform audit

standards, and an institutional framework to support the auditors' exercise of independent

judgment.

LIST OF RELEVANT CHINESE ECONOMIC AND FINANCIAL LAWS AND REGULATIONS

Audit Administration. 1986, Notice of the Audit Administration on Audit of Economic

Responsibility of Head of Unit on Termination of Office.

Audit Administration. 1988, Regulations of the Audit Administration on Audit of

Contractual Responsibility for Industrial State-Owned Enterprises.

Chinese Institute of Certified Public Accountants (CICPA). 1997, Independent Auditing

Standards.

Department of Administration of Accounting Affairs (DAAA), Chinese Government.

1992, Accounting Standards for Enterprises. English version. Publishing House of Law.Department of Administration of Accounting Affairs (DAAA), Chinese Government.

1993, Interpretation of Accounting Standards for Enterprises. Chinese Press of Public

Finance and Economy.

National People's Congress, China. 1985, Accounting Law of the People's Republic of

China.

National People's Congress, China. 1994, Auditing Law of the People's Republic of

China. National People's Congress, China. 1993, Company Law of the People's Republic of

China.

National People's Congress, China. 1993, Constitution of the People's Republic of China. National People's Congress, China. 1993, Law of the People's Republic of China on

Certified Public Accountants.

State Council of China, 1986, Document No. 92. Provisions on General Examination of

Tax, Finance and Prices of Commodities.

State Council of China. 1987, Regulations for the Implementation of the Law of the

People's Republic of China on China±Foreign Equity Joint Ventures.

APPENDIX A. CASE ILLUSTRATION

A.1. Audit Report Regarding State-Owned Factory Da Zhou

State Audit Bureau, *** Province

Reference No. ******* Date:*******




This Bureau has conducted an audit for annual accounts of 1995 for state-owned

Factory Da Zhou, in order to implement the resolution of Audit Administration in 1996regarding strengthening auditing, facilitating reform and maintaining economic order and

continuing financial and economic regulation compliance audit. The following is a

summary of the main findings.

1. Management had intentionally increased the cost of products and reduced current

year profit by 180,000 yuan.

Evidence: Cost of product C2 for the month of December should be calculated using

weighted average method. But the Head of the Factory and the Financial Controller

instructed the staff to use standard unit cost, which increased the cost of goods sold by

180,000 yuan and reduced the profit by 180,000 yuan.

2. Management had intentionally delayed recognition of sales revenue by 450,000yuan; as a result, the current year profit was reduced by 120,000 yuan.

Evidence: During the audit, we found a record indicating that 85 units of finished goods

(Product G2) were shipped out on 27 December 1995, but there was no sales record. The

sales person and the accountant said that the sale was recorded on 6 January 1996 under

the instruction of the Head of the Factory.

The Financial Controller and the Head of Sales and Purchase Department were also

involved in the manipulation of accounts. Sale of Product B2 was recognized on 17

January 1996 when payment was received rather than on 25 December 1995 when the

goods were shipped.

3. Management had deliberately treated the overhaul expenditure (which should becapitalized) as administration expense and then had written it off as a current expense, so

that current profit was reduced by 250,000 yuan. This was also done under the instruction

of the Head of the Factory and the Financial Controller.

4. Management had deliberately concealed its investment of 10.2 million yuan in an

associated factory in accounts receivable (i.e., not recorded in an investment account); and

the profit on the investment of 1.45 million yuan for this year was recorded in accounts

payable.

The Head of the Factory had manipulated its accounts. This was a breach of

Accounting Law of the People's Republic of China, of Enterprise General Financial

Principles, of Accounting Standards for Enterprises and Accounting System for Industrial(manufacturing) Enterprises. The sales person, the accountant, and the Financial Controller

also had breached the relevant provisions in the Accounting Law, as they had failed to

resist the pressure from the Head, and failed to report the manipulations to the higher

authority. However, all of them have confessed and submitted written reports about the

wrong doings. They have promised never to do it again.

Enclosed, please find a copy of the audit decision and of the audit notice.

Cc: The Office of the People's Government of the Province; The Bureau of Supervision

of the Province; The Bureau of Finance of the Province; The Bureau of Industry of the

Province

A.2. Audit Decision Regarding State-Owned Factory Da Zhou

To: The Factory Da Zhou




During the audit, it has been found that the accounts of Factory Da Zhou were seriously

distorted (the details are summarized in the Audit Report). These activities were in breachof financial and economic regulations and rules, and you have admitted all these wrong

doings. According to the Accounting Law of the People's Republic of China, Enterprise

General Financial Principles, and Accounting Standards for Enterprises and Accounting

System for Industrial (manufacturing) Enterprises, and other relevant rules, we have made

the following decisions:

1. The Factory had reduced current profit by 2 million yuan in the accounts. The

Factory must pay an additional income tax of 0.91 million yuan to the tax office

within * days and pay a fine of 107,000 yuan as well.

2. The Factory must transfer 93,000 yuan profit to the statutory surplus reserve (thisamount is determined by the current profit);

3. The Factory must pay an additional dividend of 270,000 yuan

4. The Factory must pay a special fund charge of 180,000 yuan.

5. The Factory must also correct its accounts for this year and next year within 28

days.

6. The Head and the Financial Controller of the Factory had deliberately breached the

financial and economic regulations and rules. We notice that they have made the

confession and promised to correct these problems. We recommend that the higher

authority take appropriate actions against the responsible persons in order to enforce

the financial and economic regulations and rules and to maintain economic order.

Enclosed: a copy of the audit report.

Cc: The Office of the People's Government of the Province; The Bureau of Supervision

of the Province; The Bureau of Finance of the Province; The Bureau of Industry of the

Province

Provincial State Audit Office (seal)

Date: ***

NOTES

1. For example, it has been reported that from 1986 to 1996, state funds of 337 billion yuan were

embezzled to the supposed overseas branches of SOEs, which actually were controlled by

individuals (Dong Hua Newspaper, 18 December 1997), and the amount of embezzled state

funds that had been transferred overseas in recent years was estimated at US$10 billion a year

(The Chinese Herald, 24 June 1997).

2. That SOE cash flows were part of the overall cash flow system of the state was a feature of the

centralized economic structure before reform. Under that system, the business finance of the

SOE was treated as an integrated part of public finance. This also has a fundamental effect on

financial reporting and accounting system in China prior to reform (see Chen and Yu, 1994 for

a discussion about the relation between the centralized finance structure and accounting

system).3. Tang et al. (1996) describe the rewarding system under CRS and there is a clear and direct

association between firm performance and personal financial benefits. A contractor who fails

to meet the targets specified in the contract is liable for financial penalties. If the results surpass




the agreed-upon targets, the excess profit is divided between the state agency and the

contractor.4. Relying on accounting measurement necessitates special auditing practices for SOEs, i.e.,

audit of contractual responsibility. The purpose of the audit is to see whether the operating

targets contracted had been actually achieved. The audit includes an overview of financial and

non-financial information. Such an auditing is often conducted by the state audit office, but

may be performed by an internal audit office or subcontracted to a CPA firm. See `Regulations

of the Audit Administration on Audit of Contractual Responsibility for Industrial State-Owned

Enterprises' and `Notice of the Audit Administration on Audit of Economic Responsibility of

Head of Unit on Termination of Office' for detailed procedures of such auditing. And also, Li

(1995) provides an example of such an auditing.

5. The current accounting system provides sufficient flexibility to allow earnings management.

One example is making no provision for bad debts, as Chinese accounting standards only provide for a maximum limit on such provisions, but do not require such provisions to be

made. Depreciation charges, expenditures for overhaul and maintenance, staff training and

R&D activities also may be minimized to inflate short-term profits (Chen et al., 1997).

6. See the case in Appendix A for examples of negligent or fraudulent manipulation of

accounting and financial information.

7. Use of financial statements by diversified users is certainly taken into account by accounting

reform. For example, Chen and Yu (1994) argued that as fund sources for SOEs are

diversified, financial statements should reflect the equity interest of all investors besides the

state, so that the traditional format of balance sheet, which only reflects fund flow of the state,

should be abandoned and the international format of balance sheet should be adopted (Chen

and Yu, 1994). Unfortunately, the impact of diversification of ownership on auditing has not been seriously considered yet.

8. One example was the audit of the Disabled Foundation. The audit was triggered due to the

widely circulated assertion that the Disabled Foundation might be engaged in improper or

even illegal commercial activities. This was a politically sensitive case because it involved

high-ranking officials in the government. Another example was the recent case of the audit of

a company that illegally raised huge amounts of fund. The investigation proved extremely

difficult as high-ranking officials in the government and the party were involved (one member

of the Political Bureau, Chen Xi Tong who was involved has been eventually convicted and

sent to jail).

9. For example, the first accounting firm in Shanghai was set up by the Finance Department of

Shanghai and was affiliated with the Department until today.10. For example, by the end of 1996, a total of about 6700 accounting firms had been established

in China; only a handful of them were independent, private partnership structures (Dai et al.,

1998).

11. Many differences are found between financial statement auditing and the regulation

compliance audit. For example, evidence from sampling is generally not accepted for fraud

auditing in China.

12. Chinese professional auditing standards, which are based on International Auditing Standards,

focus on audit of financial statements rather than discovering of fraud and irregularities. See

the new set of auditing standard issued by The Chinese Institute of CPA (CICPA), 1997.

REFERENCES

Chang, C. 1997. Enterprise Restructuring: Cases and Analyses (in Chinese). Beijing: Economic

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Chen, Y. and B. Yu. 1994. !Further Liberating Thoughts and Facilitating Accounting Reform."

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Dai, X., A.H. Lau, and J.L. Yang. 1998. Hooking-up: A Unique Feature of China Public Accounting

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Guang, J.K. 1993. Contemporary Auditing Principles. Shanghai: Li Xing Accounting Publishing

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Huang, H.Q. 1987. !Auditing." Accounting and Auditing in the People's Republic of China (joint

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Li, Z.P. 1995. !Three Steps in Auditing at the End of Management Contract." China Auditing, (in

Chinese), 43.

Liu, K.C. and W.G. Zhang. 1996. Contemporary Accounting Issues in China Ð An Analytical

Approach. Singapore: Prentice Hall, Simon & Schuster (Asia), pp. 113±120.

Skousen, C.R., J. Yang, and X. Dai. 1990. !Auditing in China: Recent Developments and Current

Problems." Research in Third World Accounting, 1: 157± 169.

Tang, Y., L. Chow, and B. Cooper. 1996. Accounting and Finance in China: A Review of Current Practice, third edition. Hong Kong: FT Law & Tax Asia Pacific, Pearson Professional.

Wang, J. 1995. !Problems of Chinese CPAs." Journal of Certified Public of Accountant, (in Chi-

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