An uphill battle: Auditing and corporate governance reforms in China

Corporate governance, some say, is an expansive web of mechanisms put into place within and outside corporations to ensure the interests and behaviour of managers match shareholders' expectations. In the academic world, scholars attempt to unravel the complexity of the problem from different angles and approaches. For Associate Professors Dr Charles Chen and Dr Su Jiaxi, long-time research collaborators in CityU's Department of Accountancy, auditing is their unique entry point to understanding the fast-changing landscape of corporate governance in China.

Auditing-a yardstick of corporate truth

Auditing, like many other business practices, has a relatively short history in China. Twenty years ago, as the country began to search for ways to reform its moribund economy, there was no independent auditing of the quality of business corporations' financial statements. Now, the field is crowded with a huge contingent of domestic certified public accountants and local branches and subsidiaries of international accounting firms. "It now provides us with an interesting scenario to find out how fast the new market has learned to adopt and make use of this important corporate governance mechanism," said Dr Su, a core member of CityU's Accounting and Corporate Governance Centre (ACGC).

Managers of a listed company, Dr Su explained, must disclose enough financial information to shareholders for the latter to monitor the performance of the company. But because managers may be motivated by self-interest the information they provide is likely to be biased. Thus, a system of principles, policies and practices is needed not only to guarantee that the financial information released meets some minimum statutory requirements, but also that its quality must be checked independently before it can be used by shareholders. And this is where the auditors come in.

"Our interest in this area is to try to find out how auditing in China can effectively detect management wrongdoings," said Dr Chen, another ACGC core member. "We also want to see how such information is used by shareholders."

But before they could start, they had to determine how accounting practices in China differed from the rest of the world. In a pioneer study of the listed companies in the Shanghai Stock Exchange in 1997, they discovered that those companies using Chinese GAAP (Generally Accepted Accounting Practices) had reported, on average, a 30% inflation in their net profits and book value of assets over what would have been acceptable under international accounting standards (IAS).

Although the situation might have improved over the years, Dr Chen said, other researchers who carried out follow-up studies found differences still exist. "Accounting standards leave a lot of room for managers to play around with their financial information." said Dr Su. Both, however, stressed that China is moving rapidly towards adopting international accounting standards. "While the accounting standards of two countries cannot be totally identical," said Dr Chen, "China's are now substantially similar to IAS."

Within the domain of auditing, the CityU group carried out several research projects. First, they wanted to find how the market reacted to non-standard (as compared to clean) audit reports of listed companies and if the market were aware of the kind of mechanisms meant to protect shareholders' interests. Listed companies in 1997 to 2000, they discovered, were generally more aggressive in their accounting practices. The percentage of the listed companies receiving non-standard audit opinions ranged from 12.6% to 19.6% (12.6%,

16.6%, 19.6% and 16.3%, respectively, in years 1997 to 2000), which could be interpreted as their annual reports were problematioc and not agreed b the auditors.

In China, more listed companies received modified audit opinions (MAOs) than in countries in the West. "An MAO in China often means that there is something suspicious in the financial statement," explained Dr Su. The institutional environment in China gave managers strong incentives to meet important profit targets, by hook or by crook. Managers cared little about shareholders and whether shareholders would find such information useful or not. Rather, they were focused on meeting profit targets, lest they couldn't continue raising capital and went under.

"Our research showed that managers were not motivated or rewarded in the right way," said Dr Su, "in fact, they were motivated in such a way that they had to manipulate earnings, often paying at a low price for what they did." It was the first time such findings-as reflected in the MAOs-had been documented but the Chinese government had not reached the stage of tackling the problem seriously. Meanwhile, the market reacted strongly to the MAOs as shareholders, who did not have many alternatives for receiving accurate information, dumped the shares in question. Auditors' opinions became their yardstick of truth. "If a company reported a RMB $2 yuan profit per share, the market normally would initially regard it as a reasonable performance," Dr Su explained, "but by way of a modified audit opinion, which was usually taken to suggest some wrongdoings existed, the market would quickly turn around and treat the $2 yuan profit as zero." The two researchers tried to compare those companies that reported a profit and subsequently received an MAO with those that reported a profit without an MAO. They found very marked differences in the market response to these disclosures. Before 1998, Chinese investors reacted only mildly to accounting numbers and MAOs but after 1998, they reacted more strongly to the numbers. That is, if a company received an MAO and reported a higher profit than previously disclosed, the investors would still offload their shares to bring down the price, because they saw the accounting numbers were less truthful.

Earnings manipulation

However, how were corporate earnings in these listed companies actually manipulated? Dr Chen and Dr Su went on to undertake another related study: assets write-down. Companies, expenditures are either recorded as assets (building new factories or buying new equipment, for example) or expenses (which result in direct deductions from the company's revenue). One common way for Chinese companies to conceal their expenses, Dr Su explained, was for the managers to hide them in the guise of assets. As a result, the quality of the assets of many companies was very poor-a significant part of these assets were actually hidden losses.

The Chinese government was well aware of the problem and in 1998 offered these companies a one-off opportunity to write down such poor quality assets in their financial statements. The companies concerned were at first not enthusiastic because such a move would wipe out most of their reported profits, jeopardizing their chance of raising capital in the market. The problem was not solved until the government decided to give the companies a once-only opportunity to record asset write-downs against retained earnings (i.e. accumulated profit) without reducing current earnings in the income statement. Many companies were then happy to comply. "This shows how bad asset quality was and how wary the market was of financial reports," said Dr Su.

Audit quality and corporate health

Audit quality, no doubt, has improved in China in the past two years as the country's accounting standards and practices have moved closer to international norms. One contributing factor has been the opening of the China market to the Big Five (now Big Four, after the fall of Arthur Andersen) international accounting firms, particularly after China joined the World Trade Organization in 2001. However, Dr Chen and Dr Su have not yet had any data to compare the quality of audits between local and international accounting firms.

"The problem is audit quality is not really observable from outside," said Dr Su, "When everything is done in the right way, you can't see quality. You can spot it only when a scandal erupts or if there's a lawsuit." One way to unravel the mystery is to study the accounting numbers before and after the audits and observe how the market reacted to the discrepancies. The two researchers did observe, however, that listed companies in China tend to be more aggressive in manipulating their accounts and profit numbers. They are now working on three consulting projects for the Chinese Institute of Certified Public Accountants (CICPA) on the issue.

In 1999, China's National Audit Office surveyed 33 listed companies. It found nearly three-quarters of them had cooked their books. In 2001, the China Securities Regulatory Commission (CSRC) penalized 27 listed firms for disclosure violations. One notorious case, perhaps similar to Enron, was that of the ST Yingguangxia group, a conglomerate headquartered in Ningxia Autonomous Region. It reported for many years huge profits that never existed but the auditors issued standard opinions on its accounts, without alerting the shareholders. On the book, various laws and regulations existed and stipulated auditors' liability. Punishment is severe for such offenders in China, perhaps even more so than in the United States, and as many as two dozen auditors have already been put behind bars. Dr Chen said in China, however, the pressure for auditors to collude with clients on cooking the books was high, because the payoffs might be high, too.

Auditor's fee and role

One logical follow-on research topic for the two accounting professors is auditor's fees. Until the year 2001, the auditor's fee was not a required disclosure item in a listed company's financial report. "As more data became available," said Dr Chen, "this has become an intriguing topic for us." The amount of payment to the auditors in exchange of their professional services can be interpreted, however indirectly, as an indication of whether auditors have dutifully and diligently discharged their assignments.

"The auditor's fee is a good indicator of the relationship between the auditor and his corporate client," concurred Dr Su. Theoretically, the fee level is determined by the size of the company and the complexity and potential risk of its business. Other factors may include the working relationship between the auditor and his client, and whether the company in question has undergone major organizational restructuring or mergers during the year. In China, the average payment for an audit of a listed company falls between RMB400,000 yuan and RMB700,000 yuan, but this can range from as low as RMB100,000 yuan to as high as RMB2 million yuan.

"If the fee is too low, say less than RMB100,000 yuan," explained Dr Chen, "it could suggest the auditor is not vigorous enough. On the other hand, if the fee is abnormally high and cannot be accounted for by the normal variables, it could suggest some form of collusion between the auditor and the audited company." The two scholars are now collecting data on the research and some preliminary results have been analysed. They hope some concrete findings can be reported in full in 2003. A related side topic is comparing local and international accounting firms: in the level of auditing fees as a reflection of the differences in workload, reputation, etc.

In 2001, the CSRC stipulated that all listed companies in China must be first audited by a local certified public accounting (CPA) firm before an international firm could step in. The decision sent a shock wave through the entire accounting industry, because China would be regarded as having lost confidence in its own accountants. Companies, in effect, would go straight to the internationals, without going through the hassles of asking the local help. Practical issues also abounded: whose opinion-the local or the international CPA firm-would be regarded as meeting the statutory requirements if differences were found? Ultimately, the uproar forced the Ministry of Finance to ask the CSCR to withdraw the ruling.

Dr Chen and Dr Su also want to find out more about the role of auditors in China. With the help of a set of "very special" database that they commissioned from the State Statistical Bureau, they are going to study the differences in financial results before and after they are officially announced. A listed company, for example, may report a profit of RMB10 million yuan in the first instance, only for it to be whittled down to RMB5 million yuan after auditing. "We'd like to determine the differences between these two sets of numbers and see how the adjustments are made and what they mean," said Dr Su. The inquiry should also shed some light onto how such adjustments are linked to company types, which companies have the incentive to manipulate profits, and which companies would easily agree to, or reject, such adjustments. All this information will give the researchers important clues to the state of corporate governance in China, in relation to the incentives and motivation of managers.

Following the footsteps of good international practice, the CSRC has recommended-but not stipulated as a statutory requirement-that audit committees be set up under corporate boards, starting in 2003. If they are established, two-thirds of the membership of these committees would comprise independent directors. Dr Chen believes this will provide a number of research opportunities.

"Over the years, the Accountancy Department has built up a wealth of expertise in auditing-related issues in China." said Dr Su, "No other university, local or overseas, can match our breadth and depth. We observe or study corporate governance from a unique vantage point: we try to link everything to auditing."

Ownership structure and corporate performance

While CityU's team has trained its eyes on auditing, it has by no means ignored other strategic areas of corporate governance research in China. One "hot" area-in fact, the bread-and-butter work of many other academic researchers and analysts in organizations such as OECD and the World Bank-is the relationship between different ownership structures and corporate performance. A report* released by the World Bank and the International Finance Corporation in August 2002, for example, suggests that "the present structure of state ownership and control of enterprises accounts for their poor performance." It is almost a foregone conclusion that state-owned enterprises (SOEs) provide weak incentives for managers to maximize value for all investors and are susceptible to the protectionist practices of government agencies that shield the firms from full market discipline. Only through diversification of ownership schemes in its enterprises, these researchers and analysts argue, can better governance and corporate performance become a reality in China.

While the two CityU researchers agree on the general premise of this notion, they go beyond the basics in unravelling the problem. "State ownership, in my opinion, is not all that bad. No matter how hard the Chinese government tries to liberalize its economy," said Dr Chen, "one has to accept the fact that, in the foreseeable future, the state-owned sector will continue to play a significant role in the economy." The government, for political and practical reasons, will not pull out totally from sectors like railways, telecommunications, oil and gas, utilities and commercial aviation.

"A lot of people study the ownership structure," said Dr Su, "but you cannot narrowly define ownership as state-owned versus non-state owned." Ownership can be direct and indirect, he said, and enterprises in China these days can be private-owned, collective-owned, wholly or jointly owned by foreign investors, or a combination of these options. And even state ownership itself is often exerted through different channels: central or local government, ministries and departments, etc. The wide spectrum of ownership structure makes a study based on a simple dichotomy too simplistic.

The keyword "performance" is also far more problematic than it appears at a first glance. "A lot of people narrowly define performance as profits alone," said Dr Chen, but he and Dr Su argue that the government may not only have money in mind when it comes to owning and running SOEs. Providing jobs for the workers (for greater social stability) and securing steady streams of tax revenues are, in many cases, as important as reaping monetary profits.

Ambitious project

With these notions in mind, the two researchers set out to conduct a colossal study on the relationship between ownership and performance, with both terms broadly defined. Armed with a huge database they commissioned from the National Bureau of Statistics, they have picked out 20,000 enterprises, spread over 10 provinces throughout the country, to find out how ownership really affects corporate performance. Though basically state-owned, but not listed on the country's two stock exchanges, these enterprises actually come in all sizes and under different ownership schemes. Each of these enterprises reported data in some 100 variables over a 10-year period.

"The quality of the data made available to us and the magnitude of our task are certainly way beyond what we could have imagined a few years ago," said Dr Su. "But we believe you have to tackle the enormous sample before you can begin to understand how the complex system of corporate governance works in China. There are over a million companies in the country but only around 1,200 are listed."

These days the two researchers are still locked in a preliminary data analysis stage; the entire project may take a couple of years before any general conclusions can begin to take shape. Both are reluctant to draw any premature conclusions now, except to say that they have observed a huge gap between coastal and inland provinces, which Dr Su described as "almost like living in two different countries." And if one looks at profits alone versus the other indices such as employment opportunities, taxes levied by the government and interests paid on bank loans, the results are "as far apart as heaven and earth" too. "This shows that, as far as the government is concerned, it is not enough to rely on profits alone in measuring corporate performance."

Progress so far

"Overall, China is inching closer towards international standards in this important area," said Dr Su, "even though some problems still lurk around, waiting to be resolved." From their vantage point of more than 20 years of research experience between them, Dr Chen and Dr Su went on to offer their observations on the progress made so far in corporate governance in China over the past decade:

There has been a tightening of the regulatory framework and a fundamental shift in the legal environment. Various laws and regulations have been put into place to tighten up the statutory requirements, thanks mainly to the CRSC and its deputy chair, Mrs Laura Cha, who was recruited from Hong Kong. For example, fuller and more timely disclosures on financial and corporate information by listed companies are now required. A separate section on corporate governance-the number of board of directors meetings, selection criteria of directors, their fiduciary duties, incentive and remuneration levels-are required in a company's annual financial statement. In addition, at least three independent non-executive directors are required to sit on the boards by the end of June 2002, and they must account for at least one-third of the total board membership by end of June 2003. Audit committees are also required. ¢D China's accounting and auditing standards, or the Chinese GAAP system, have continued to evolve towards closer harmonization with international standards in principle, though some practices and details still remain different.

A more mature and fluid market for corporate directors and executives has begun to take shape. Dr Su said China has been steadily moving away from a system of fixed remunerations for senior corporate managers towards a performance-based rewards practice, which may include, on top of basic salaries, annual bonuses and stock options. The last item is of particular interest because in order for it to work, listed companies and enterprises must be allowed to issue stocks at different times, although presently this is not yet feasible. Change, however, is inevitable as China's stock market develops.

Problems ahead and future outlook

Given China's achievements in closing the gap between its corporate governance standards with those of the US, OECD and European countries, one troubling issue remains: the question of related-party transactions. In the US and even in Hong Kong, listed companies are usually the parent, or holding, companies. In China, it is the other way round: the listed companies are usually not the parents but their subsidiaries. The listed companies, Dr Chen said, will not consolidate if they have related-party transactions with their parents. This creates a loophole, where the huge profits made by the listed companies can often be transferred to their parent companies at great expense to shareholders. Similarly, the listed companies can receive capital transfusions from their parents even if they perform poorly, thus rooting out the need for greater efficiency, or even the threat of bankruptcy.

"This kind of transaction really undermines the efficiency of the stock market," he explained, "the better performing companies cannot see a difference between themselves and the poorly performing ones." The heart of the problem: financial statements cannot represent a true and fair view of the real situation. The CSRC, to their credit, have come up with regulations and their approach is to require full disclosure. But related-party transactions still cannot be totally banned, first because the listed companies are an integral part of their parents. "If you forbid such transactions," Dr Chen further explained, "you are basically asking the listed companies to set up their own new systems of suppliers and distributors. The efficiency of the corporate system will be jeopardized and this is not realistic in China now." It may take another few years before this problem can be fully resolved to the satisfaction of both the corporations and the market.

Another root problem, both Dr Chen and Dr Su believe, is the question of ownership structures and corporate performance: how much the state is willing to loosen its grip on the SOEs. For non-listed SOEs, Dr Chen recommended that a system of performance-based compensation and bonuses be introduced, so that the managers' interests can be better aligned with those of the shareholders. The key is to make clear what performance actually means, in each and every type of firm and enterprise.

For listed SOEs, Dr Chen said the government should make up its mind that these companies, once they are placed in the market to raise capital, are obliged to accept monitoring by investors. A case in point is the ST Yingguangxia scandal, in which the leading auditors were sent to jail and the auditing firm barred from business for two years. The company in question, however, emerged from the episode largely unscathed, primarily because there is no provision for class action under Chinese law and it is extremely cumbersome for an individual investor to sue a listed company for fraud. Until recently, an individual investor had little legal recourse for losses arising from fraudulent corporate activities. On 12 November, a 60-year old housewife in Shanghai settled the first investor lawsuit against Shanghai Jiabao Industry & Commerce Group and its directors. She accepted a settlement instead of opting for a lengthy and costly lawsuit against falsified earnings. In China, corporate information is asymmetrical in nature, meaning that what is available to the directors and managers is invariably more timely and substantial than what is communicated to the shareholders. The punishment for corporate wrongdoings is asymmetrical as well-often the auditors receive harsher penalties than the listed companies and their managers do. This is because if the companies are punished, the government fears that in punishing the fraudulent companies the shareholders are indirectly penalized, too. This could lead to social unrest when the disillusioned investors take their demands to the street with protests and public demonstrations.

The Chinese government, Dr Chen said, must be willing to subject SOEs to the full strength of market forces. Currently, only up to 50% of the shares in these listed SOEs can be bought and sold, with the government still maintaining a controlling stake. As such, the government or its agents in these enterprises seldom have the motive or incentive to try to maximize returns. The managers are, as a rule, more interested in career advancement or maintaining a friendly relationship with the banks. They are not held accountable to the shareholders. This is a sign of the government's ambivalence-hoping on the one hand to tap into the capital market while fearing, on the other, that a full exposure to market forces will unleash waves of social unrest. "The root problem in corporate governance reform is the government's willingness, or even eagerness, to lose some economic gains in exchange for political stability," said Dr Chen. "This is an issue beyond the control of the market regulators, such as the CSRC, even though they have done a pretty good job over the last few years." For Dr Su, whose research interest in corporate governance grows by the day as China continues to reinvent itself, the next few years will be both intriguing and challenging. "I personally believe that there will be a better balance between a need for more corporate monitoring and better use of proper incentives for motivation towards good governance practices," he said. The gradual emergence of a market for professional executives and managers will, like lubricants of a huge machine, also help the system run more smoothly than before. Until then, any small swing of the pendulum between more regulations and voluntary compliance will generate more interesting research opportunities for him, Dr Chen and some of their other colleagues in the ACGC and the Department of Accountancy.

* Tenev S . and Zhang C , Corporate Governance and Enterprises Reform in China: Building the Institutions of Modern Markets, World Bank and the International Finance Corporation, Washington, D.C., 2002