Answers to Articles

2 June 1998 pp.

105-119 Institutional Factors Influencing China's Accounting Reforms and Standards Bing Xiang Bing Xiang is an Assistant Professor at Hong Kong University of Sci- ence and Technology.

SYNOPSIS: By analyzing the changes in the accounting environment of China dur- ing the recent economic reforms, this paper places the development of accounting reforms in China into perspective and assesses the desirability of China's adopting accounting principles in close conformity with International Accounting Stanclards (IAS).

The recent economic reforms, particularly the enterprise reform, in China have changed the corporate landscape and have profoundly altered the accounting environment. The Chinese accounting profession and government have responded with the enactment of a number of accounting regulations. These regulations have essentially transformed China's accounting from the traditionally rigid and uniform systeni into a predominantly Anglo-Saxon approach to financial reporting. Account- ing reform in China will be followed by the enactment of 30 detailed accounting standards which will bring China's accounting practice into further conformity with IAS.

However, the paper argues that accounting rules in China should not be formu- lated to cater to the need of a small number of firms which are already listed (or will be listed) on overseas stock exchanges. Rather, China GAAP should be designed to serve China's large industrial and commercial enterprises that are characterized by extensive managerial autonomy and an effective separation of ownership and control.

These enterprises in China operate in an accounting environment which differs considerably from that which is typically presumed by IAS. China's account- ing environment, both now and in the foreseeable future, is characterized by a lack of independent/professional auditing. Without an independent audit profession, in- formation provided under IAS will be unreliable; therefore, adopting IAS may not be warranted in the specific context of China. The analysis sheds light on the role of IAS in developing and transitional economies with rudimentary auditing and judi- ciary infrastructure, suggesting the limit of accounting harmonization.

Data AvaHability: Data used in this study are available from public sources.

The author thanks Steve Albrecht, Lynne Chow, Michael Firth, Jerry Han, Eric Noreen, Jim Ohlson, Katherine Schipper, Earl Stice and workshop participants at the Chinese University of Hong Kong, the City University of Hong Kong and Hong Kong Polytechnic University, three anonymous reviewers and Eugene Imhoff, the editor, for helpful comments on earlier drafts.

Submitted June 1997 Accepted November 1997 Corresponding author: Bing Xiang Email: [email protected] 106 Accounting Horizons/June 1998 INTRODUCTION The development and practice of accountmg are influenced considerably by its envi- ronmental factors (see Zeff (1972) and Cooke and Wallace (1990)).

This paper analyzes the changes in China's accounting environment and explores the implications of these changes for financial reporting.

The analysis of changes in China's accounting environment, impor- tant in its own right, is useful for the understanding of the development of China's ac- counting practice. Further, a clear understanding ofthe impHcations of China's current accotmting enviroimient is essential for an adequate assessment ofthe desirability of China's adoption of accounting principles which conform closely to International Accounting Stan- dards (IAS) (as reflected in China's proposed, detailed accounting standards).

It is argued that, without an independent audit profession that can ensure comphance with the stan- dards, the information provided under IAS will be unreliable, and therefore adopting IAS may be undesirable in the specific context of China.

In 1978, China adopted an "open-door" policy and initiated an unprecedented tran- sition from a command economy to a market one. China's recent economic reforms, particularly the enterprise reform, have profoiindly altered the country's accounting environment. The ownership structures ofthe industrial and commercial enterprises in China are now highly diverse. State enterprises, generating 34 percent of the 1995 industrial output compared with 78 percent in 1978, have lost their dominance; much of the industrial output is currently produced by the non-state sectors. Collectively- owned enterprises are the largest sector of the Chinese economy, while enterprises with foreign investment (including joint-ventures and foreign wholly owned enterprises) and individually owned enterprises play an increasingly important role.

State enterprises, once the production units in the centrally planned economy, are now organized as profit and investment centers with a substantial degree of manage- rial autonomy and a separation of management fi-om ownership. Furthermore, China has evolved from a closed economy with negligible imports and exports to one of the world's major trading nations.

These changes have profoundly altered China's accounting environment and have resulted in a fundamental change in the role of financial reporting in China.

The Chinese accounting profession and govemment have responded with the enact- ment of a number of accotmting regulations. The most significant change was catalyzed by the Accounting Standards for Business Enterprises, China's accounting conceptual framework, which was promulgated in 1992 and came into effect on July 1,1993.

This conceptual fi-amework, which governs all enterprises in China, has essentially trans- formed China's accounting from the traditionally rigid and uniform system into a pre- dominately Anglo-Saxon approach to financial reporting.

This paper provides an analy- sis ofthe changes in China's accounting environment, in order to put these accounting reforms in perspective.

Accounting reform in China has scheduled the enactment of 30 detailed account- ing standards, 25 of which may be promulgated in the near future. The detailed ac- counting standards were formulated with conformity to IAS as their overriding objec- tive.

However, it remains debatable whether IAS actually fit China's special circum- stance ("Guo Qing" in Chinese). This issue, currently being fiercely debated in China, is considered the most important and controversial in setting China's detailed accounting standards. The lack of consensus on this issue contributed to the delay ofthe enact- ment of the detailed accounting standards, which were supposed to be effective on January 1, 1997. This paper sheds some light on this poUcy debate by providing a Institutional Factors Influencing China's Accounting Reforms and Standards 107 profile of China's current accounting environment, which is essential for a proper as- sessment ofthe proposed detailed accounting standards.

The remainder of the paper is organized as follows. The next section reviews the development of the enterprise reform and identifies state enterprises as the primary targets of China's proposed detailed accounting standards. Section three examines the accounting reforms in China since the 1980s and provides a description ofthe proposed detailed accounting standards.

Section four provides an assessment of China's detailed accounting standards in light ofthe salient attributes ofthe accounting environment in China. Section five concludes the paper.

CHINA'S ACCOUNTING ENVIRONMENT China's accounting reforms have been largely responsive to the country's enter- prise reform. One cannot put China's accounting reform and the proposed accounting standards in perspective without a succinct understanding of the evolution of enter- prise reform. This section reviews the recent enterprise reform in China since 1978 and determines the types of enterprises that are likely to be the primary targets ofthe new accounting standards.

What are the Targets of the New Accounting Standards?

The industrial reform since 1978 has fundamentally altered the corporate land- scape of China. Specifically, the output value from state-owned enterprises (SOEs) ac- counts for an ever-shrinking portion of industrial output between 1978 and 1995, as noted in table 1. SOE output produced 78 percent of industrial output in 1978 and this percentage was reduced to 34 percent in 1995. In 1992, for the first time, SOEs ac- counted for less than half the industrial production in China. In 1995, SOEs, collec- tively owned enterprises (COEs), individually owned enterprises (IOEs), and enter- prises with foreign investments (FOEs) accounted for 34 percent, 36.6 percent, 12.86 percent and 16.54 percent, respectively, of industrial production.

The implications of these changes for the demand for financied reporting may not be obvious. It is well recognized that the demand for both financial reporting and auditing is significantly infiuenced by, among other factors, the extent ofthe separation between owners and corporate management. IOEs, whose owners are not separated from man- agement, Eire unlikely to have much demand for external financial reporting. Further, because IOEs in China typically obtain loans from external parties who are close friends and relatives, their financial statements usually do not play a significant role in bor- rowing transactions.

COEs, currently contributing the most to China's industrial output, have been the most important driving force in China's economic growth. COEs are comprised mainly of township-village enterprises (TVEs).

The majority of COEs remain small in size and operation (Naughton 1994). TVEs obtain their equity mainly from a group of closely related individuals such as farmers from the same village or commune (Tang et al.

1996, 29).

TVEs' primary source of new capital comes from their retained earnings and further borrowing from their existing shareholders because state policy has prohibited them from borrowing from China's large state banks. Further, due to ideological con- straints, TVEs are unlikely to be permitted to raise capital through public hstings on a large scale, as the limited number of slots for Ustings have always been awarded to SOEs.

Thus, TVEs will continue to be severely constrained by their lack of sources of new capital. 108 Accounting Horizons/June 1998 TABLE 1 Industrial Gross Output Value by Ownership Type (percent) Year SOEs Collectively Owned Individually Owned Others 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 Source:

77.63 78.47 75.97 74.76 74.44 73.35 69.09 64.86 62.27 59.73 56.80 56.06 54.60 52.94 48.09 46.95 37.30 34.00 China Statistical 22.37 21.53 23.54 24.62 24.82 25.74 29.71 32.08 33.51 34.62 36.15 35.69 35.62 35.70 38.04 34.00 37.70 36.60 Yearbook (1993, 414), 0.00 0.00 0.02 0.04 0.06 0.12 0.19 1.85 2.76 3.64 4.34 4.80 5.39 5.70 6.76 8.00 10.10 12.86 (1994, 373-375), (1995, 0.00 0.00 0.48 0.58 0.68 0.78 1.01 1.21 1.46 2.02 2.72 3.44 4.38 5.66 7.11 11.05 14.90 16.54 377), (1996, 403).

A TVE is typically run by a group of people with similar or homogenous preference functions who are also the shareholders ofthe TVE.

From this perspective, TVEs can either be viewed as syndicates (see Wilson (1968) for an economic analysis of a syndi- cate) or depicted as quasi-family businesses (see Weitzman and Xu (1994) who consider Chinese TVEs as vaguely defined cooperatives). These factors together imply that, in the foreseeable future, TVEs' needs for external financial reporting are limited.

FOEs (i.e., joint ventures and foreign wholly owned enterprises) in China are gen- erally viewed as business units from the perspective of their parent companies and are, accordingly, subject to reporting requirements ofthe host countries of their parent com- panies. These FOEs report regularly to their domestic and foreign parent companies for management accounting purposes. Furthermore, China's phenomenal success in attracting foreign direct investment in recent years indicates that FOEs' demands for external reporting may have been properly served by the prevailing accounting "guide- lines" for FOEs that had been enacted prior to the release ofthe conceptual framework.

It is argued below that the demand for external reporting is most likely to come from the SOEs. First, virtually all the large industrial and commercial businesses in China are still wholly owned or majority owned by the state. This is evidenced by the sustained state dominance among China's 1,000 largest industrial enterprises in recent years.

Furthermore, with a few exceptions such as Bao-An Industrials, Yan-Zhong Lim- ited and Shenzhen Development Bank, firms listed on the Shanghai and Shenzhen stock exchanges are majority-controlled directly by the state or indirectly by other SOEs and state institutions (such as state-run universities). Significant state ownership is also prevalent among China's companies that are listed in overseas stock markets such Institutional Factors Influencing China's Accounting Reforms and Standards 109 as the Stock Exchange of Hong Kong and the New York Stock Exchange (that is, H- share and N-share companies). The dominance of state ownership among the large industrial and commercial enterprises is expected to continue in the future. This is because the Chinese government currently has no intention to privatize the large in- dustrial firms and has formulated specific policies to ensure that state ownership will be the "mainstaj^ for the large industrial enterprises in pillar industries such as auto- mobile manufacturing, petrochemicals, and iron and steel.

SOEs are characterized by a complete separation of management from ownership in that managerial shareholding in SOEs is virtually zero.

As a result ofthe enterprise reform since 1978, China's large SOEs now possess a high degree of managerial au- tonomy; they significantly resemble modem corporations in the West that are charac- terized by a separation of ownership from control.

In summary, since 1978 China's enterprise reform has fundamentally changed its corporate landscape. The ownership structures of China's Industrial and commercial enterprises are now highly diverse.

The SOEs' share ofthe economy has been shrinking continuously and much ofthe industrial output is currently produced by non-state sec- tors, with COEs now being the largest contributor and FOEs and IOEs playing an in- creasingly important role in the Chinese economy. However, it is argued that SOEs, with extensive managerial autonomy and an effective separation of ownership and con- trol, will become the focus of financial reporting reform. The primary purpose of China's GAAP is not to serve a small number of firms which are already listed or will be listed on overseas stock exchanges. Further, if a firm from China wants to raise capital by listing in the New York Stock Exchange or Tokyo Stock Exchange, it must follow U.S.

GAAP or Japanese GAAP, not IAS.

Next, China's SOE reform is examined to facilitate a further analysis ofthe countrys need for financial reporting.

The Development of the SOE Reforms Prior to 1978, all business enterprises were state owned and these SOEs were es- sentially production units (factories). The managers of SOEs in the pre-reform era had little or no managerial autonomy. The state provided all the financing to the factories and controlled virtually all the investment and operating decisions. Inputs were pro- vided by the state and outputs were sold to the state at the price determined by the government. The government also specified the salaries and wages ofthe workers and managers ofthe SOEs.

All profits were remitted to the state and all losses were covered by the government. The factories simply served the purpose of fulfilling the production quota stipulated by the government. Consequently, the managers of these factories had neither the incentive nor the managerial authority to reduce costs and generate profits.

In such a command economy, the main role of accounting was to assist the government in planning and controlling economic activities.

In 1978, China's enterprise reform program was initiated and restructuring of the SOEs was designated by the Chinese governments as the core of the economic reform.

Instead of privatizing the SOEs, as would later be the pattern for the ex-Soviet Union and Eastern European countries, the Chinese government chose to restructure the SOEs by increasing autonomy in making managerial decisions and by creating financial incentives at the enterprise level.

To rejuvenate the SOEs, the state has experimented with various measures in the past 17 years (1978-1996).

These measures can be broadly classified into two categories:

the contract responsibility system (CRS) and corporatization. 110 Accounting Horizons/June 1998 The Contract Responsibility System The CRS was introduced to expand enterprise autonomy and to provide financial incentives to both workers and managers of SOEs by relating their compensation to performance. The SOEs were first converted from factories (production units) into cost centers where managers were supposed to minimize the cost of production while the state handled pricing and distribution ofthe products.

Later, with further decentraliza- tion and price liberalization, SOEs were turned into profit centers where the SOE man- agers obtained authority to make decisions on product pricing, material sourcing, prod- uct mix, marketing and distribution. Thereafter, SOEs were forced to compete in the market and profit becsime an important performance measure for the SOE managers.

By the end of 1993, more than 90 percent of SOEs were governed by the CRS.

Now most large and medium-sized SOEs have been awarded the authority to make some invest- ment decisions (subject to certain guidelines).

The CRS system is typically implemented as follows. The state sets a profit target for an SOE (or specifies a profit-sharing rule between the SOE and the state) and al- lows the enterprise to retain the profit in excess ofthe target. The SOE under CRS has discretion in using retained profit (subject to guidelines).

Accounting profit here serves as a contract variable for specifying profit-sharing rules between the SOEs (the manag- ers and employees) and the state (the shareholder), and thus accoimting has played an important role in the implementation ofthe CRS.

Several versions ofthe CRS have been experimented with by the Chinese govern- ment, although the essential idea remains vinchanged: granting managerial autonomy to SOEs and applsdng profit-sharing rules to motivate the managers and employees within the confines of maintaining state ownership.

Corporatization ofthe SOEs Corporatization refers to converting SOEs into companies with limited liabilities and joint-stock firms (termed the "shareholding system," in general). SOEs before corporatization are not legal entities separate from the state and, thus, the state as the shareholder ofthe SOEs besirs unlimited liabilities.

The first shareholding company, Beijing Tianqiao Department Store, was formed in July 1984. In October 1984, the experiment was expanded to some large and me- dium-sized SOEs.

Corporatization had a low profile imtil late 1991.

The establishment ofthe two stock exchanges in China (the Shanghai Securities Exchange and Shenzhen Stock Exchange) played an instrumental role in promoting corporatization. Table 2 provides some descriptive statistics on China's two stock exchanges. An SOE must be converted into a shareholding company with limited liabilities before the SOE can issue shares to the public and before these shares can be listed on the stock exchanges.

The objective ofthe recent corporatization drive in China is to revitalize the SOEs on a large scale by protecting SOE management from government interference. The major effect of corporatization is that it transforms state factories for which the state has unlimited liability into legeil entities with limited liability. This limits the state's exposure to potential liability and lays a foundation for implementation of the Bank- ruptcy Law.

Corporatization also helps to clarify the property rights ofthe SOEs, which will help facilitate raising of capital, restructuring ownership and other reorganiza- tions.

What corporatization can actually accomplish, however, remains to be seen.

China's Enterprise Income Tax Law, promulgated in 1994, imposes a standard cor- porate income teix rate of 33 percent on all large and medium-sized SOEs. Prior to the Institutional Factors Influencing China's Accounting Reforms and Standards 111 TABLE 2 China's Stock Markets 1990 1991 1992 1993 1994 1995 1996 Panel A:

Shanghai Stock Market Number of Listing A 7 7 B Market Capitalization A 1.25 2.92 (Billion jruEin) B Panel B:

Shenzhen Stock Market Number of Listing A 6 B Market Capitalization A 8.1 (Billion yuan) B 29 8 67.9 3.6 24 9 44.4 3.1 101 22 206.8 12 75 19 125.1 8.4 169 34 248.1 11.6 118 24 102.4 4.6 184 36 243.4 9.2 127 34 87.7 7.2 288 43 535.9 19.1 230 43 402.5 20.6 * All figures refer to year-end data.

Source: The data for the period of 1990 to 1994 are obtained from Mok (1995, 24.5) whereas the data for 1995 and 1996 are collected fi-om Securities Markets Herald (1995,1996).

enactment of this law, the profit target or the profit-sharing rule was determined by the state's negotiation with the SOEs on an individual basis, which caused the effective income tax rate to vary substantially across firms. As far as profit sharing with the state is concerned, the introduction of the Enterprise Income Tax Law, at least in theory, eliminates the difference between SOEs under two different systems (CRS and shareholding) and firms within the same system, thus leveling the playing field.

However, differences still exist between SOEs under the two different systems.

Managers of shareholding companies in general have more managerial autonomy, par- ticularly in the area of investment decisions and profit distribution, than do managers of firms under the CRS. Corporatization has been designated by the Chinese govern- ment as the preferred path for the further reform of SOEs.

In essence, the SOE reform process since 1978 can be viewed £is a gradual decentrali- zation in the management of state enterprises; management authority has shifted from government bureaucrats to SOE managers. From a managerial control perspective, the reform ofthe Chinese state enterprises can be seen as a process of converting state facto- ries (production units) in the command economy into cost centers, profit centers and more recently investment centers. As a result of these profound changes, China's large SOEs, either corporatized or still under the CRS, now significantly resemble modem corpora- tions in the West in that the SOEs are characterized by a high degree of managerial au- tonomy and a separation of ownership from control. As a consequence, potential agency problems have emerged. Managers of SOEs can make decisions that promote their own interests but that damage the interest ofthe shareholders (the state in the case of SOEs).

Accounting has an important role to play in alleviating these agency problems.

THE ACCOUNTING REFORMS This section examines how financial reporting in China has evolved as a response to the enterprise reform. Emphasis is placed on the development of accounting 112 Accounting Horizons/June 1998 regulations pertinent to SOEs, as SOEs are considered to be the primary targets for the proposed detailed accounting standards.

Phase I (1978-1992): Before the Release of the Conceptual Framework Prior to 1978, China's economy was dominated by SOEs which were essentially production units (factories) to fulfill the state's stipulated production quota. The ac- counting system at that time, imported from the then Soviet Union, was primarily macro- oriented in that it primarily assisted the state in economic planning, implementing state economic policies, and controlling the means of production (Adhikari and Wang 1995).

The accounting standards used by commercial and industrial enterprises were rigid and uniform (see Zhou (1988) and Tang et al.

(1996) for a more detailed description of accounting practice in the pre-reform era). The accounting system was fund-based, linked with taxation and filled with strict and detailed rules (Davidson et al. 1996).

Thus, the practice of accounting was essentially bookkeeping in nature.

By the end of 1984, China had absorbed U.S.$3 billion of foreign direct investment (FDI).

In response, China's accounting reform commenced in March 1985 wdth the es- tablishment of "The Accounting Regulations for Joint Ventures" (the 1985 Regulation).

The 1985 Regulation provided necessary accounting guidelines for joint-ventures oper- ating in China and for attracting further foreign investment thereafter. From an ac- counting perspective, these regulations for the first time introduced Western account- ing practice to the firms operating in China, representing a radical departure from the traditional fund-accounting (see further discussion on this in Chow et al.

(1995)).

China furthered its accounting reform in 1992 with the enactment by the Min- istry of Finance of two sets of new accounting regulations. The first, "Rules for Enterprises with Foreign Investment," came into effect on July 1, 1992 to super- sede the 1985 Regulation. These rules applied to all enterprises with foreign in- vestments. These new regulations broke the link between financial accounting and taxation, and brought the Chinese accounting for FOEs into close conformity with international accounting practices (Tang et al. 1995).

The second, "Rules for Experimental Shareholding Corporations" (effective on January 1,1992), was applicable to all corporatized companies (including the listed companies) and was enacted as a response to the recent corporatization drive of the SOEs.

These rules for shareholding companies were the first set of rules to incorporate intemational accounting practices into reporting requirements for China's domestic en- terprises (i.e., enterprises without foreign investment) (Tang et al. 1995). Thus, they helped reduce the disparity between accounting rules for domestic enterprises (prima- rily companies listed on China's two stock excheuiges with A-shares—those issued to domestic investors only) and those for enterprises vdth foreign investments.

Prior to the enactment of the "Rules for Experimental Shareholding Corporations," the accounting regulations for SOEs had followed the accounting system for state-owned industrial enterprises. This system, issued in 1958, remained unchanged until it was revised in 1985. In 1989, a set of comprehensive accounting guidelines for industrial SOEs entitled "Accounting Regulations for State Industrial Enterprises" (1989 Regula- tions) was released by the Ministry of Finance. The 1989 Regulations essentially sum- marized the prevalent accounting practice of the industrial SOEs at that time and re- tained most of the traditional fund-based methods (Tang et al. 1996).

To summarize, during the first phase of the accounting reforms, China made con- siderable progress in improving its financial reporting for enterprises with foreign Institutional Factors Influencing China's Accounting Reforms and Standards 113 investment. The promulgated accounting regulations, designed for a market economy, have facilitated China's economic reform by providing the necessary accounting infra- structure for market transactions and for attracting foreign investments.

The account- ing regulations for an SOE were governed by the traditional accounting system, except for the corporatized SOEs, which were required to follow Western accounting prac- tices from January 1,1992.

Therefore, before the conceptual framework was released, accounting practice varied among enterprises with different types of ownership, dif- ferent industrial sectors and different business purposes (Xinhua, December 3, 1992, quoted in Winkle et al.

(1994)). Consequently, there was no unified accounting frame- work that could be applied to all types of enterprises in Cbina.

Phase n (1992-present): The Establishment of the Conceptual Framework and 13 Industry-Based Regulations for SOEs China's first "accounting standard," The Accounting Standards for Business Enter- prises (ASBE) was issued in 1992 and became effective on July 1, 1993.

The ASBE in principle apply to all Chinese business enterprises and they supersede all previously promulgated "accounting regulations." Under ASBE, all SOEs (both corporatized and those under CRS) are required to follow international accounting practice, eliminating tbe difference in practices between corporatized SOEs and those used under the CRS.

Further, for tbe first time, all enterprises of different ownership structures in Cbina are subjected to a unified accounting framework.

Tbe introduction of ASBE was consid- ered tbe most significant achievement of Cbina's accounting reforms since tbe 1980s in that it signaled tbe end of traditional accoimting in Cbina and brought Cbina's account- ing practice into close conformity witb IAS (Tang et al.

1995).

Tbe key difference is that ASBE require a strict adherence to historical cost methods and an explanation of the profit distribution plan in the income statement or the footnotes (Winkle et al. 1994).

ASBE essentially comprise a conceptual framework rather than operational standards, thus they are expected to serve as a guide for formulating the detailed accounting stan- dards (see Davidson et al.

(1996) who compared ASBE with the conceptual framework of Canada, the United States and the International Accounting Standards Committee). In considering tbis shortage of operational standards, the Ministry of Finance enacted 13 industry-specific regulations applicable to SOEs (wbich also came into effect on July 1, 1993).

The 13 industries are manufacturing, merchandising, transportation, transporta- tion (railway), transportation (airline), agriculture, postage and communication, real es- tate development, construction, banking and finance, insurance, tourism and catering, and foreign economic co-operation. These industry-based regulations inberit many of tbe rigid and uniform rules from China's traditional methods of accounting and imbed these rules in the western accounting framework (Chow et al.

1995).

These regulations specify rigid rules for recording transactions, charting accounts and detailing the format of finan- cial statements. These industry-specific rules are transitory and are expected to be re- placed by tbe 30 detailed accounting standards to be released soon.

In February 1993, the Ministry of Finance of China started a three-year project to formulate detailed accounting standards. The project, funded by tbe World Bank, em- ployed Deloitte Toucbe Tobmatsu International as an international consultant and also involved a number of accounting experts from China. The end result of the project will be an enactment of 30 detailed accounting standards which are expected to be appli- cable to all enterprises in Cbina. Tbe exposure drafts of these detailed standards have been released in several batches for comments (as reported in table 3). 114 Accounting Horizons/June 1998 TABLE 3 Exposure Drafts of the Detailed Accounting Standards The First Batch (Exposure 1994) Balance sheet Capitalization of borrowing costs Inventories Investments (revised later on) Income statement Payables Receivables The Second Batch (Spring 1995) Banking industry Fixed assets Intangible assets Long-term construction contracts Owners' equity Research and development Statement of cash flow The Third Batch (Summer 1995) Accounting policies/estimates Consolidated financial statements Deferred charges Foreign exchange Income taxes Revenue recognition Subsequent events The Fourth Batch (Autumn 1995) Contingencies and Commitments Donations and govemment grants Related party disclosures Employee benefits Reorganizations and liquidations The Fifth Batch (March 1996) Barter trade and other nomnonetary transactions Business combinations Futures contracts Insurance industry Investments (including associates), revised Leases Source: Harris and Ray (1996, 57).

Although the ASBE are supposed to guide the formulation of the detailed account- ing standards, a comparison of the proposed detailed accounting standards and ASBE reveals the following differences. First, the proposed detailed standards require lower- of-cost-or-market (LCM) for inventory valuation and mark-to-market valuation for short- term investment. Second, ASBE together with the industry-based accounting regulations continue to exhibit a continued bigh degree of governmental/administrative control; the Institutionat Factors Influencing China's Accounting Reforms and Standards 115 detailed standards permit much discretion by removing many of these controls (espe- cially for SOEs).

For example, under ASBE, for SOEs and shareholding companies, the selection of depreciation methods and the estimation of useful life were administered hy government regulations; further, the amount ofthe provision for doubtful accounts could not exceed a maximum percentage ofthe amount of year-end accounts receivable.

These regulations are no longer required under the detailed standsirds. The proposed detailed accounting standards intend to be more prudent with the application of the LCM rule, as well as to be more flexible in the choice of accounting policies and esti- mates.

These proposed detailed accounting standards will move China's accounting practice closer to IAS than have ASBE (Tang et al. (1995) and Harris and Ray (1996)).

Differences still exist between the detailed standards and IAS.

For example, under the proposed detailed standards, only a calendar fiscal year end is permitted and seg- ment disclosure is not required. Further, China's proposed detailed standards contain accounting rules on liquidation, which are not present in IAS.

Nonetheless, these dif- ferences are relatively insignificant.

AN ASSESSMENT OF THE PROPOSED DETAILED ACCOUNTING STANDARDS Beyond any doubt, enterprise reform in China has produced the demand for inves- tor- and creditor-oriented information. The introduction of western accounting prac- tices seems natural as they are in use in many market-oriented economies. This might lead to the perception that Intemational Accounting Standards should be appropriate for these SOEs. This can be one ofthe reasons why conformity with IAS was specified as the overriding objective for formulating China's detailed accounting standards.

However, a careful analysis ofthe specific context of China, within which the pro- posed detailed accounting standards are supposed to be applied, suggests that certain salient attributes of China's accounting environment deviate sharply from what is typi- cally presumed under IAS.

The lack of professional and independent auditing is prob- ably the most important attribute. The implications of this attribute for setting ac- counting standards are explored below.

The Lack of Professional/Independent Auditing The IAS are primarily Anglo-Saxon in philosophy and permit a significant amount of discretion in financial reporting. The implementation of IAS requires professional judgment from management as well as fi-om auditors. Professional independence and enforcement of standards have been identified as the two critical issues in intema- tional auditing (Stamp and Moonitz 1982). Audit independence, the essence of the auditor's attesting function, is a crucial pre-condition for China's detailed accounting standards. Below it is argued that auditing independence in China will not become a reality in the foreseeable future.

Auditing ofthe SOEs, resumed in 1983, is msdnly conducted by auditing firms that are either state audit bureaus (see Tang et al. (1996, chapter 10) for a description of state audit bureaus) or state-owned auditing firms. In fact, it is a common practice to have an SOE's audit conducted by an auditing firm which belongs to the same ministry.

In such a system, auditors play the role of agents for the state audit bureau and bear little economic consequences for their improper auditing behavior. Auditors may often bend the rules to please their clients or to pursue their own interests.

In a relation-based (or connection-based) economy like China's, pressure on an auditor's independence (say 116 Accounting Horizons/June 1998 from local government and from managers ofthe SOEs) could be substantial. The au- diting organizations in China contrast sharply with partnership-type firms as exempli- fied by the intemational Big 6 accounting firms. Thus, it may not be rational for the auditors to behave professionally by strictly adhering to established auditing rules.

In essence, there is a lack of economic incentive for auditors to be independent in China.

There is also an absence of mechanisms to preserve the independence of auditing firms.

The severe shortage of qualified accountants and auditors in China further hinders the development of professional auditing (Winkle et al. 1994; Graham 1996). It has been estimated by the Chinese government that China's economic reform will need hundreds of thousands of additional accounting professionals in a decade, far exceeding the current 25,000 CPAs.

Three national CPA training centers, albeit planned for sev- eral years, are yet to be established. Further, the vast majority ofthe existing 25,000 or so CPAs in China are neither professionally trained nor famihar with Western account- ing practices (Graham 1996).

One might argue that the accoxmting regulations for FOEs functioned well before the release of ASBE.

This is partly due to the fact that FOEs in China and the Chinese firms listed in overseas stock markets are typically audited by the intemational Big 6 accounting firms.

One could then suggest that perhaps all the SOEs in China should be audited by the intemational Big 6 accounting firms.

This could be a valuable solution to accounting reform in China; the practice would be a combination ofthe new accounting standards with auditing conducted by the Big 6.

However, this solution, although pos- sible in the long-run, is not feasible in the foreseeable future. First, it is very unlikely (nearly impossible) for China to open up the market for auditing SOEs (part of financial service sector) to intemational accoimting firms because of political considerations and nationalism. Even if this proposal were acceptable to the Chinese government, it may not be realistic for the intemational accounting firms to come up with enough resources to undertake the auditing of more than 100,000 SOEs and, at the same time, maintain the quality of their auditing.

In sum, it is unrealistic to expect independent/professional auditing to be attain- able in China in the foreseeable future. This implies that the proposed accounting stan- dards will have to operate without independent/professional auditing.

The Implications of the Lack of Independent/Professional Auditing for Accounting Standard Setting The lack of independent auditing has profoimd implications for accounting stan- dards formulation. First, without independent/professional auditing, the application of the detailed accounting standards may not be able to generate financial statements with "a true and fair view." Cases of successful applications of creative accounting and evidence of excessive eamings management, even in countries with a mature and well- developed auditing profession (see Naser 1993), indicate the severe vulnerability of IAS in China's accounting environment. It is likely that the fiexibility in the detailed ac- counting standards will provide opportvinities for managers to engage in aggressive eamings management, reducing (even eliminating) the probability of showing "a true and fair view." Therefore, the lack of independent/professional auditing can potentially neutralize the intended objective of prudence and turn the fiexibility into a "land of opportunities" for eamings manipulation.

Further, the fiexibility permitted by China's proposed detailed standards can provide enterprise managers with more opportunities to weaken the control by shareholders and Institutional Factors Influencing China's Accounting Reforms and Standards 117 to pursue their own interests.

The concern about the lack of independent auditing may be further complicated by the dominance of SOEs and a corporate environment with rampant corruption. For example, an SOE manager could intentionally write off "good" accounts receivable from his/her friends as "bad." This implies that in an accounting environment like that of China, the accounting flexibility permitted may impede the effectiveness of accounting in protecting a compan^s assets (the stewardship function of accounting).

Conceptually, this raises the question of a proper balancing of different objectives of financial reporting in different accounting environments. In Anglo-Saxon countries, the availability of independent/professional auditing and other mechanisms (such as effective judiciary systems) can effectively protect companies' assets from embezzle- ment and other frauds. It is thus justifiable to specify "the true and fair view" as the most important objective of financial reporting. That is, assuming that the true income and financial position of a company are given (by-and-large exogenous to, or indepen- dent of the choice of accounting rules), the best accounting system is the one that best reflects the true income and financial positions of the company.

In an accounting environment characterized by both a lack of independent/ profes- sional auditing and a rudimentary judiciary system, rigid and uniform rules, which depend less upon independent auditing, can offer better protection of the assets. In addition, linking accounting with taxation may be desirable because tax auditing can be conducive to ensuring the integrity of the financial auditing. In this way, accounting rules do affect the income and financial position, both of which are supposed to be re- ported upon by way of accounting statements.

From this perspective, the combination of ASBE with the 13 industrial-based ac- counting regulations may be considered preferable to the proposed detailed accounting standards. Alternatively, China's new accounting standards may be modified by re- moving the added flexibility that does not fit the specific context of China. For instance, the problem can be mitigated by disallowing the LCM for inventories, as well as by restoring certain restrictions on accounting policy choices and accounting estimates.

Further Implications The experience of China's accounting reforms sheds light on several significant issues in intemational accoimting. The first is the accounting harmonization debate.

Professional/independent auditing is available in only a small number of Anglo-Saxon countries (and to a lesser extent in Japan and German). In nearly all developing coun- tries and most economies in transition, auditing will probably remain rudimentary in the foreseeable future. Thus, caution should be exercised when exporting IAS to those economies without independent/professiond auditing.

A second issue relates to the role of financial reporting in economies without inde- pendent auditing. We must question which role is more important: equity valuation, contracting or asset protection (mitigating the threat of managerial corruption in gen- eral).

These roles may be interrelated but they can also be in conflict with each other (Gjesdal 1981).

Further, the usefulness of accounting has to be evaluated with the development of other mechanisms in mind. For example, even if China has the most advanced ac- counting system, but its judiciary system is unreliable, the enforcement of the accounting rules will be questionable, potentially rendering the accounting standards consider- ably less effective. This illustrates the importance of evaluating accounting issues in a 118 Accounting Horizons/June 1998 specific context and the necessity of investigating the interactions of accounting and other corporate governance mechanisms within that context.

By doing so, new insights about accounting may be obtained.

CONCLUSION This paper attempts to put China's accounting reforms into perspective by exam- ining the changes in the accomiting environment of China. The recent economic re- form, particularly the enterprise reform in China, has profoundly altered China's cor- porate landscape. China's companies now exhibit a considerable range of ownership structures.

China's accounting reforms started with the enactment of regulations governing the enterprises with foreign investments, which provided the necessary accounting in- frastructure to assist the Chinese govemment and enterprises in attracting foreign direct investment. These accounting rules for FOEs were in close conformity with IAS.

China's phenomenal success in attracting foreign direct investment indicates that the FOEs' need for accounting must have been at least adequately served.

Accounting regulations for the SOEs have been lagging behind management re- form in the SOEs. The enterprise reforms have transformed SOEs from production units to investment-center-type enterprises that closely resemble modem corporations in the West.

This has generated a demzind for the Western approach to financial report- ing. ASBE together with the 13 industry-based regulations have moved China's ac- counting practice of China's SOEs closer to IAS. The enactment of the proposed de- tailed accounting standards, expected to be promulgated shortly, will bring China's accounting practice into further conformity with IAS.

However, the accounting environment, within which the detailed standards will be appUed, differs considerably from what is typically presumed by IAS.

The lack of inde- pendent/professionsil auditing in China implies that the proposed detailed IAS-based steuidards may be counterproductive in the specific context of China.

This raises ques- tions about the proper role of IAS in developing countries and in trsinsitional economies with rudimentary auditing infrastructure, and suggests that caution needs to be exer- cised on the issue of accounting harmonization.

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