China gamble
By Peter Diekmeyer

As far back as the 1970s, when David Nicholson was studying for his CA designation and working at Ernst & Whinney (now Ernst & Young), he knew one day China would be a major economic force. And sure enough, by the time Nicholson made partner at E&W's Toronto office, China had launched the bold reforms that would begin to open up its economy. The result was a more than two-decade-long growth spurt, which experts say will turn China into the world's largest economy by 2050. But Nicholson couldn't have imagined the number of ways his career would intertwine with China's emergence onto the world stage.

Today Nicholson is president of Bennett & Wright International, an architectural and project management firm that has seen most of its recent growth take place in China. The firm has contributed to the country's most innovative building designs. And through his ownership stake in Bennett & Wright, he has a substantial personal investment in the country. As a result, Nicholson has had an impressive bird's-eye view on the massive changes China has gone through.

"It's an amazing country," says Nicholson, one of many Canadian public accountants whose careers have been swept up by China's growth. "There are so many projects and their scope is so large that an architect can get more experience here in just a few years than he could in an entire lifetime in Canada."

Canadian companies are increasingly seeking opportunities to profit from China's growth, and CAs are there doing what they do best to ensure things go smoothly. Canadian exports to China more than doubled during the past five years to $6.6 billion in 2004. Imports have shot up too, jumping almost 30% last year to $24.1 billion. China is now Canada's second largest trading partner in imports.

But that's not all. Canadian companies have invested an average of nearly $700 million a year in China during the past five years. And that doesn't include the millions of dollars they invest indirectly by buying shares in companies that trade with China and benefit from its growth.

That interest cuts both ways. Chinese businesses, cognizant of their country's thirst for resources, are setting their sights on raw materials producers worldwide, including Canada. Several Chinese-controlled companies, such as Kingsway International Holdings Ltd., now trade on Canadian exchanges.

The upshot is that Canadian CAs are taking a heightened interest in what goes on in China. That includes not only those whose companies invest in, import or export to China, but also those whose companies might be active in one of those areas in coming years.

For example, last year Chinese state enterprise China Minmetals Corp. tried to acquire Noranda Inc., one of Canada's oldest mining companies. As a result, its executive vice-president and CFO Steven Douglas, a CA, was forced to contemplate the implications Noranda would face as the subsidiary of a Chinese firm. (The deal eventually fell through, and Noranda later merged with Falconbridge.)

Among the notches in Bennett & Wright's belt are work on the Shanghai Deepwater Harbour Commercial Square, Shanghai International Ocean Shipping Building and the massive Changning Road apartments.

Most recently, the firm oversaw the design of the Shanghai branch of the Chinese National Accounting Institute. The institute, along with those in Beijing and Xiamen, sprang from the goal former Chinese president Jiang Zemin set a decade ago of training 300,000 CPAs to help the country move forward in its development goals.

In a way it's fitting that the firm was chosen to design the campus of one of China's most important institutions should be headed by a former public accountant. CAs are likely to be aware of both how far China has come since the days of the Mao suits and the centrally planned economy and how far the country still has to go.

Indeed Nicholson's background and his involvement with the Shanghai National Accounting Institute give him a unique perspective on what those changes mean for the accounting profession. "The economy is racing ahead, which means there are a lot of opportunities," he says. "But the administrative and regulatory structures haven't quite caught up."

Although China is integrating itself into the international financial community, its accounting, auditing, governance and taxation systems lag. The country has a severe shortage of accountants, and much of the existing pool is underqualified by Western standards. The Shanghai National Accounting Institute serves as a resource to provide continuing education, conference facilities and testing services for China's public accountants and tax professionals. As a result CAs from the Big Four firms, many of them Canadians of Chinese heritage, have moved to the Middle Kingdom to help bridge the gap. "Canadian CAs can do very well here, especially if they have language skills or are willing to learn," says one.

One of the conditions of China's entry into the World Trade Organization was its general acceptance among the international community as a market economy. At first glance it looks like one. The country has two stock exchanges on the mainland (in Shanghai and Shenzhen) and a more mature, Western-style exchange in Hong Kong. A 24-hour news channel is broadcast in major metropolitan areas and there are a few flourishing, though government-controlled, business journals and newspapers.

But scratch a little deeper and a slew of reporting, taxation and governance issues become apparent. Despite the massive sky- scrapers and fleets of cars, computers and cellphones, it's clear businesses can't operate in China the way they would in other OECD countries. As a result, China is beginning to hit speed bumps in key development areas that public accountants will play a big role in solving.
These areas include the privatization of many of the 170,000 state-owned enterprises, especially banks, and the migration of Chinese GAAP to international standards, steps that will ease the continuing hesitation on the part of foreign firms to partner with Chinese companies.

"Many investors continue to bet on China's growth by investing either in companies that sell to China, or by buying only shares on the Hong Kong exchange, which has tougher listing requirements than the mainland exchanges," says Bich Pham, managing director of TAL Global Asset Management's Hong Kong branch. Of the $800 million in assets that Pham manages in TAL's China funds, only $50 million is invested in mainland companies listed on the Hong Kong Exchange.

China's rapid growth and the opening up of its accounting services market, which began in the 1980s, has attracted the attention of public accounting firms the world over. The Big Four firms have substantial operations in China, lured by the potential service demands stemming from 1,200 listed companies, 450,000 foreign-owned firms and more than 2.2 million private enterprises.

In addition to the Big Four's extensive Chinese operations, their Canadian affiliates have specialists in Canada to help clients do business in China. These challenges range from simple business consulting to highly technical advice in specialized areas. For example one Big Four partner got a call from a manufacturing client who had sent machinery parts to China. Several weeks later, he was assessed a bill for hundreds of thousands of dollars of duty at rates approaching 40% of the parts' value. Later the client learned that duty reduction under WTO arrangements was to be phased in over several years. Fortunately the Big Four accounting firm was able to negotiate a discount from Chinese authorities.
China's regulatory systems often leave Canadian firms vulnerable. One complaint is that Chinese companies have been known to use their connections with local banks to freeze letters of credit and use the leverage to negotiate better terms with suppliers.

However many Canadian CAs have decided to boost their careers by seeking opportunities in China. "There are many potential synergies between Canadian and Chinese goals," says Ronald Chao, a Canadian citizen and one of three Canadian partners at Deloitte's Shanghai office. "We have natural resources, energy and environmental technology, all the things China really needs. We can't afford to miss the boat."
Deloitte, which has been active in China since 1917, has been substantially beefing up its operations in recent years. The company has 4,500 employees, dispersed among 10 offices throughout China. But in April last year it announced a five-year US$150-million acquisition and investment plan, designed to boost its head count of partners and local staff five-fold.

Chao came to Canada in 1990 from Hong Kong amidst fears about the impending transfer of sovereignty from the former British territory to China. In the early 1980s, he travelled frequently to the mainland, which was then in the early stages of its economic reforms.

Two decades later, sitting in a restaurant in the Bund Center adjoining Deloitte's plush Shanghai offices, which he joined in 1997 to help Western companies do multimillion dollar M&A deals, Chao marvels at the changes. "It's like night and day. Who would have thought they could come so far, so fast?"

Chao's M&A work has given him a frontline seat to watch the evolution of Chinese accounting standards. "There are many foreign companies looking to partner with Chinese firms," says Chao. "But since the standards are not exactly the same, financial statements often have to be adjusted, so you can compare apples with apples."
For the past decade, the Chinese finance ministry has been working tirelessly to align the country's GAAP with international accounting standards. But it is a long, slow road. In 1997, the finance ministry issued more than a dozen proclamations, regulating the reporting of assets, revenue and specialty items such as leases and the disclosure of related-party transactions. These standards were to be phased in over several years ending January 1, 2002.

However significant differences persist between Chinese and international standards. In a recent publication, Deloitte Touche Tohmatsu enumerated numerous areas of divergence. These include the reporting of undepreciated capital cost of property, plant and equipment. According to international standards these are supposed to be recorded at the lower of cost or a revalued amount. In China they are generally recorded at cost only. Other areas of differentiation include hyperinflation (in which China has no accounting standards) and the use of fair-value conventions.

Another problem is although Chinese accounting standards look good on paper, they are not always applied correctly. "Many Chinese accountants still look at things the old way, thinking of standards as guidance rather than rules," says Chao. "There remains a tendency among private companies to understate earnings [so they pay less tax] and among state-owned companies to overstate them [so their executives look good]."
Frederick Spoke, president of The China Way Group, agrees. A former diplomat who spent 18 years in various foreign affairs postings, Spoke provides consulting services to companies seeking to do business in China. "It's wide open here," he says. "You have to be careful."

Recently a Chinese business approached Spoke to help arrange financing for a projected expansion, providing a set of financial statements that didn't look right. Spoke asked for an audit, which was done by a local CPA firm after which the statements looked even worse. "The guy wasn't worried," Spoke says. "He asked me which numbers I wanted changed and told me he'd have the auditor produce modified statements. Needless to say, I had to turn him down."

In fact the challenge is so stark, says one CA, that Canadian companies looking to merge with or to buy a Chinese firm need to understand what's behind the Chinese financial statement and how differently they account for certain things in order to align the accounting standards of the two countries.

Observers say one problem is that there are two sets of rules in China. "Compliance with accounting regulations can vary dramatically," says Chao. "For domestic firms the rules are more relaxed. For foreign companies the degree of tolerance is vastly different."
One of the biggest challenges facing the Big Four's Chinese operations is the lack of qualified staff. Prestigious schools such as the University of Beijing and others in key financial centres are turning out top-quality graduates. But they are quickly snapped up.
As a result, the major firms are hiring large quantities - in some cases up to half - of university graduates from such fields as English, chemistry and mathematics. The Big Four are also doing extensive training in-house. In June, Deloitte Touche Tohmatsu opened the Deloitte Northern China Learning Centre to provide professional and leadership development courses to its staff.

China is also seeing major changes in its taxation system, which is becoming increasingly sophisticated, says Mark Walters, partner at PriceWaterhouseCoopers' Mississauga office.

PwC has a huge presence in China, and it plans to increase it. In May, it announced plans to double its presence in Hong Kong and the mainland to more than 10,000 staff members and partners over the next five years from 6,000. "It's one of our fastest-growing markets," says Walters, who has been dragged into the China story despite working on the other side of the world.

Several of PwC's clients, particularly those in the auto-parts sector, have been looking at various China options to help drive down costs. As a result, Walters has studied China extensively to give advice to clients on the structure of their Chinese investments. In fact, Walters was able to save one Canadian manufacturer hundreds of thousands of dollars a year in withholding taxes simply by not placing the investments in a Canadian company.
Foreign firms have been concentrating their investment in China's special economic zones, which are mostly concentrated in the southern and coastal regions, where corporate tax rates generally range from 15% to 20%, though they sometimes fall as low as 10%. The problem is massive investment has lead to skilled-labour shortages in some of these areas at a time when China's economy is struggling to catch up.
As a result, China is contemplating tweeking its tax system to spread the benefits of economic growth. One likely change would be an elimination of the lower rates for special economic zones, though existing agreements would be honoured through grandfathering clauses. This would be combined with a lowering of the nominal corporate tax rate to the 24% to 28% range, from 33%.

Another area the Chinese government is looking at is transfer pricing. "It wants to make sure the profits that are earned by companies doing business in China are taxed in China," says Walters. "It makes perfect sense."

One businessman, who asked his name not be used, illustrates the complex issues involved. How and in which jurisdiction do you tax an investor and his company, which operates several factories in southern China? The businessman owns a house in Montreal, where he lives several months a year with his wife and son. His company has a Hong Kong head office, but he travels more than 180 days a year and his company ships its products to a number of countries around the world. Cases such as this are increasingly common and illustrate the need for increasingly specialized tax knowledge.
According to one expert, one of China's biggest challenges in the coming years will be cleaning up shoddy governance, much of which stems from its history as a centrally planned economy.

"There are bad practices everywhere," says Simon Ho, dean of Hong Kong Baptist University's business school, which recently set up a centre for corporate governance and financial policy, which is among the world's first institutions to specialize in this increasingly important area.

Many bad practices stem from legitimate grievances, says Ho. For example, CEOs at Chinese state-owned companies often earn as little as 20% of what middle managers at their foreign subsidiaries earn. "Chinese state-owned company board members are often government officials or party officers, many of whom make very little money in their regular jobs," Ho says. "That means the temptations they face are great."

According to Ho, China faces governance issues such as unhealthy ownership structures, inexperienced boards, lack of transparency and weak or inefficient regulators. But improvements won't come from a top down approach. "Executives cannot wait for the laws to catch up," says Ho. "They have to also start acting more responsibly their own."
Most businesses are not waiting for China to come up to speed on its accounting, governance and regulatory standards. They are seeking opportunities now. Chinese companies are on track to issue US$17 billion worth of stock this year, making the country the second-largest stock issuer after the US. Many of these shares will be bought by foreign investors.

As CAs are often among the few executives who get involved in early stage feasibility studies or investment decisions, they are also often the first to stumble across the challenges of China's legal system. That's especially true in smaller businesses in which there is no in-house legal counsel.

Some of the Big Four in China provide legal or quasi-legal advice to their clients, particularly in the area of intellectual property rights, trademarks, copyright and patent protection. Companies that set up manufacturing facilities in China or subcontract work there have often found that their products are quickly duplicated by local competitors, sometimes at a far lower price.

As a result, intellectual property protection has become one of the most important issues facing Western firms thinking of dealing with China. Just sending a product sample to a Chinese subcontractor to get a price quote can be the kiss of death to a company's competitive advantage if the product is knocked off by the supplier or a related company. That means such legal steps as signing nondisclosure agreements, trademark and patent registration need to be diligently pursued.

Despite efforts by OECD officials to get China to clean up its act, problems persist. A 2004 decision by China's state intellectual property office against Pfizer said the company was not entitled to protection from Chinese generic manufacturers of its erectile dysfunction drug Viagra.

The problem is so bad that Toon Boom Animation, a Montreal-based computer software designer, has held back offering a consumer version of one of its most popular programs in China, because the country's poor intellectual property protection enforcement renders it impossible for the firm to earn money on the product.
Managing China's widespread corruption minefield is another challenge. Transparency International's corruption perceptions index rates China 71st out of 145 countries, and 20th out of 21 on its bribe payers 2002 index.

Despite the challenges China is facing in bringing its accounting, governance and regulatory systems in line with those of other advanced economies, Canadian CAs who have worked on these issues tend to accentuate the positive.

"Not long ago the Chinese economy used to be dominated by state-owned enterprises, so public accounting is still a relatively young profession in China," says Alfred Lau, a partner and one of the co-chairs in charge of the China desk at KPMG's Vancouver office. Prior to that assignment, Lau led the firm's audit practice in Bejing. Lau is impressed by the changes he has seen during his frequent contacts.

That said, numerous questions remain as to what degree China's integration into the world economic system will continue. Concerns about mounting protectionism in both Europe and the US also linger, though China's decision to revalue the yuan and peg it to a basket or world currencies should alleviate them. The degree to which China's thirst for oil and other resources will put it into competition with major powers also remains an issue.

But Nicholson remains unworried about the dark clouds. "China has a 6,000- year history and it views things on a different time scale than we do," says the expatriate CA who's personal life came full circle several years ago when he married a Chinese woman, with whom he has two young children. The experience has deepened his roots in the Middle Kingdom and has modified his sense of how rapidly things need to change. "The Chinese will continue to move," says Nicholson, "but they'll do it at their own speed."

Peter Diekmeyer is the Montreal Gazette's management columnist