ACCOUNTING

VAT Vs. GAAP: How China’s Value-Added Tax Skews Financial Reporting

Foreign investors reviewing Chinese financials may find themselves at a loss to ascertain the standard for booking revenue and expenses. Confounded, they may simply conclude that local accountants are engaged in cash-based accounting.

International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (GAAP) dictate revenue and expense recognition standards. While often complex, the core principle requires matching completed work with corresponding revenue in a way consistent with the business arrangement of the parties.

Chinese GAAP is much the same: It’s accrual-based accounting, not cash-based. But here’s the challenge. The onerous demands of China’s value-added tax (VAT) system may mean that practical VAT system considerations dominate the ordering of business transactions, and deprioritize GAAP financial reporting standards.

Because these very important VAT fapiao may not be freely printed or issued according to the ongoing needs of the company, a company accountant may be unable to accurately record revenue and expenses according to GAAP principles

We explore these practical considerations below in Part One of this article. Part Two will explore how technical differences between China’s VAT system and GAAP can lead to skewed revenue recognition – and confused foreign investors.

The VAT system                     

VAT must be paid on nearly every business transaction in China, with filing and payment due monthly. VAT rates range from zero up to 17%. VAT paid by a company on purchases of products and services (input VAT) may qualify as a credit against VAT due at the sale of the company’s products or services (output VAT).

In many ways, China’s VAT system has historically depended upon one simple task: physically printing and handling a thin piece of six by 10 inch paper called a VAT fapiao (notably, China recently introduced electronic fapaio). A company printing, or issuing, this document will have been authorized by means of a network connection to the Chinese tax bureau.

Because the fapiao represents a potentially substantial value as a credit against output VAT, it is regarded virtually as cash. Like cash, it is physically delivered to a counterparty, in order to be used as credit.

VAT system compliance (and tax payment) is handled by means of two electronic, networked systems: one for authenticating and printing the fapiao, and the other for filing and paying the VAT (e-tax filing system). Together, these two systems comprise the so-called “golden tax system.”

Each company’s accountant must work to harmonize the monthly VAT data entered into these two electronic filing systems, and if inconsistencies arise, he or she will be summoned to the tax bureau to explain and mollify in-charge officials.

How VAT distortions arise

Because these very important VAT fapiao may not be freely printed or issued according to the ongoing needs of the company, a company accountant may be unable to accurately record revenue and expenses according to GAAP principles.

Each company is limited by a monthly VAT fapiao quota. Exceeding this quota requires paying a special visit to the tax bureau to apply for permission to temporarily increase the quota, a requirement of which likely includes, for new companies, pre-paying the entire amount of the applicable VAT exceeding the quota amount. Not a small matter in the case of a large transaction.

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