One of the most challenging tasks for foreign investors and finance executives in China is to fully understand the financial statements prepared for their entities.
Contrary to other countries, where invoices are usually used to simply record a transaction, in China they are also the way in which the government monitors the tax paid on any transaction
Multinational corporate groups would normally carry out reconciliations between Chinese GAAP and International Financial Reporting Standards (IFRS) or US GAAP for the purpose of consolidation of financial statements on a group level.
While it is important to make sure that the accounting practice in China follows China’s GAAP, investors also need to note that discrepancies may surface as a result of the tensions between Chinese GAAP standards and the practical realities of dealing with China’s tax system, especially when it comes to accounting practice.
In this article, we walk investors and executives through the accounting practice in China, as well as explain the differences between China’s tax system and Chinese GAAP.
When performing accounting bookkeeping and reporting functions, a commonly observed accounting practice adopted by many China’s accounting professionals is to prioritize the management of China’s value-added tax (VAT) and fapiao system.
In China, fapiao (invoices) are more than just ordinary receipts. Contrary to other countries, where invoices are usually used to simply record a transaction, in China they are also the way in which the government monitors the tax paid on any transaction.
Fapiao are printed, distributed, and administered by tax authorities, and taxpayers are required to purchase the invoices they need from the tax authorities according to their business scope.
Fapiao can mainly be sorted into two categories: general invoices and special value-added tax (VAT) invoices. These two types are often used interchangeably, but there are notable differences between them.
First, a special VAT fapiao can be used for tax deduction purposes while a general invoice cannot. Second, the VAT fapiao will contain more details about the trader’s information, including tax number, address, telephone number and bank account information.
Finally, the purchase amount on a VAT invoice is usually explicitly broken down into its non-tax and tax components. The purchase amount shown on a general invoice fapiao is usually a tax-inclusive figure.
A special VAT fapiao can be used as a credit against outstanding VAT liabilities. In effect, this physical receipt effectively serves as a form of cash.
This is where the ‘tension’ between practical reality and accounting standards kick in. Routine accounting practices in China are heavily inclined towards prioritizing the issuing and receiving of special VAT fapiao and, in general, towards administering the VAT and fapiao system, instead of the theoretical accounting standards.
But given that all the companies in China are required to prepare financial reports at the end of each year based on Chinese GAAP, accounting professionals may need to make accounting adjusting entries during the annual audit for annual compliance purpose.
What leads to the discrepancy that may require adjusting?
Chinese GAAP prescribes that the appropriate time to recognize sales revenue and cost of sales is when all the risks and rewards associated with the product (inventory) have been sufficiently transferred to the buyer.
From a practical perspective, however, it is much easier for an accountant to confirm whether a special VAT fapiao has been issued or received, because the transfer from one party to another of the near cash value of a special VAT fapiao is usually a much stronger indicator to Chinese business persons that a transaction has truly been finalized.
Deferring the issuance of fapiao will allow companies to pay VAT and other relevant tax in the next month, which is attractive when considering the impact on cash flow
In this case, there’s no need for accountants to make professional judgment in deciding whether the risks and rewards of goods have been transferred to the buyer.
This often leads to accountants in China to focus on the issuing or receiving of special VAT fapiao in deciding whether a transaction should be recorded in the books, with little or minimum reference to the more theoretically revenue recognition criteria prescribed in Chinese GAAP.
To illustrate these, we have designed the following case study.
B is a trading company registered in China. It has sold a batch of products at the end of June and has delivered the products to the buyers.
The goods were delivered to the designated locations without the necessary document to prove that the buyers have received the goods (e.g. fapiao, delivery notice and receiving notes), a common practice in China.
Thus, B’s accountant looks to the actual issuance of the special VAT fapiao as the most obvious moment for the recognition of sales revenue and cost of sales to July (the following month), which effectively defers the profit and tax payable to the following month.
The above practice has its advantages and disadvantages. On the one hand, such practice could easily be regarded as inconsistent with Chinese GAAP standards and could lead to distortion of the reported profit and tax payable in a given month by failing to reflect the underlying economic transaction in a timely manner.
On the other hand, from a practical perspective, the qualitative characteristics of financial statements such as “reliability” and “verifiability” of the occurrence of a transaction could be confirmed relatively easily by checking whether the corresponding special VAT fapiao has been issued or received.
Lastly from a tax obligation and cash flow perspective, deferring the issuance of fapiao will allow companies to pay VAT and other relevant tax in the next month, which is attractive when considering the impact on cash flow.
In order for foreign investors and finance executives to better understand how accounting bookkeeping and reporting is practiced in China, they should take a more holistic view of the accounting environment. This includes considering Chinese GAAP standards as well as how the VAT and fapiao systems affect accounting practices.
About the Author
Dezan Shira & Associates, a specialist foreign direct investment practice that provides advisory services to multinationals investing in emerging Asia. This article was first published in China Briefing and was reedited for clarity and conciseness. For further details or to contact the firm, please visit www.dezshira.com.