Today's accounting in China is strikingly different from 30 years ago.
In western countries, there appeared to have been relatively little interest in the accounting system used in China before the 1970s (Zhou 1988). The language barrier and differences in culture may have contributed to this lack of interest, but other factors include the low level of participation and involvement in the world economy in the pre-reform communist regime. Before China changed its policy to accept foreign investment in the 1978, there had been little need to know about how accounting information was produced or used by Chinese companies. It was well known that Chinese companies had been following an accounting system based on the Soviet Union's system of uniform accounting that was designed for a state-owned, centrally-planned socialist economy. The general impression was that the form and purpose of the Chinese accounting system were different from accounting practice typically used in most other countries (Davidson 1996).
Since the introduction of the "Open-Door" policy for trade and investment in 1978, there has been a dramatic increase in the amount of international trade and foreign investment. China's centrally-planned and controlled economy has been transformed to a market-oriented economy with a socialist characteristic. The Ministry of Finance (MOF) realized that dramatic changes would also be needed in the accounting system to conform to, or indeed even to allow the new economic system to work. The basic function of accounting information shifted from implementing macroeconomic planning and safeguarding national assets to decision making by enterprise management and external markets. China's accounting system is currently undergoing a complete revision as a result of a decision to adopt business practices used in international accounting practice.
In 1992, China promulgated its first accounting standard draft called the Basic Accounting Standard. It was built on the concepts and characteristics adopted by IASC, FASB and other national standard setter. In February 1993, the Ministry of Finance of China started another project to formulate detailed accounting standards. The project, funded by the World Bank, employed Deloitte Touche Tohmatsu International as an international consultant and also involved a number of accounting experts from China. The result of the project came to be 30 detailed accounting standards which brought China's accounting practice into further conformity with IAS.
Between 1991 and 1997, China experienced double-digit GDP growth. In 2000, China's GDP amounted to $1,078 billion, keeping a steady growth of 8.0% from that of 1999. Though China is moving towards a Western-style accounting standard, some major differences still exist due to different political philosophy and system. There is a big demand from foreign investors for compatible financial information. China's accounting environment, both now and in the future, is a focus of all existing and potential investors.
Among all the major trading partners, Japan and U.S. are ranked first and second. We feel a need to compare the accounting standards used in these three countries. Fortunately, two of our three group members are originally from Mainland China and the other is from Japan. Therefore we are able to be exposed to more materials while doing the research.
II. LEGAL BACKGROUND OF THE THREE COUNTRIES
Economic reforms in China that began in the 1970s have brought about structural changes in the national economy. The government has moved from being the owner and manager of the large majority of enterprises to serving mainly as the macro policy maker. A large number of enterprises are now privately owned and managed. The joint stock company is recognized by the state as the desired way to reform original state enterprises (Tang 2000).
Under the Accounting Law enacted in 1985 and revised in 1993, the Division of Administration of Accounting Affairs (DAAA) of the Ministry of Finance is responsible for setting accounting standards that all companies must follow. In 1993, the DAAA published "Accounting Standards for Business Enterprises" (ASBE), a conceptual framework designed to guide the development of new accounting standards. These standards will eventually harmonize domestic practices as well as harmonize Chinese practices with international practices. Members of the Chinese Institute of CPAs must state in their audit reports whether or not the reporting enterprise has complied with ASBE. The China Securities regulatory Commission (CSRC) regulates China's two stock exchanges: Shanghai, which opened in 1990, and Shenzhen, which opened in 1991. It sets regulatory guidelines, formulates and enforces market rules, and authorizes initial public offerings and new shares. In 1998 an Accounting Standards Committee was created within the DAAA. That committee has primary responsibility for developing the standards, subject to MOF's approval.
To realize its ambitious modernization plan, China needed capital and advanced technology. This led China to adopt a policy to attract foreign direct investment. By the end of 1997, China had approved 303,000 projects of foreign capital, with a total contracted amount of $742 billion. During the period, Chinese companies started to raise funds on the international capital market by issuing shares and bonds.
China realized that its old accounting system could no longer meet the demands for financial information from lenders, outside investors, investment bankers, or financial analysts. It considered trying to adapt the traditional accounting system as the basis for market-oriented accounting. But in the end it decided to abandon most of the traditional accounting system and adopt a system developed elsewhere in market economies. In 1989, the Ministry announced a policy that Chinese accounting standards would conform to international accounting practice (Chen 1989).
Measures that have been taken to realize that objective include the following:
1. The first accounting standard drafted was called the Basic Accounting Standard. It is similar to IASC's Framework and FASB's Conceptual Framework to a certain extent. The purpose of this first standard was to serve as the basis for future development of accounting standards. China learned from other countries the importance of agreeing initially on basic accounting concepts and qualitative characteristics.
2. The ministry of Finance engaged an international accounting firm as an adviser to the accounting standards-setting program. Among other things, this accounting firm introduced and explained accounting standards of major countries and international organizations. The firm continued to serve as advisers during the early stage development of individual standards.
3. Two advisory committees were established. One consisted of international accounting experts and the other consisted of Chinese accounting experts. Each of these groups commented on drafts on individual accounting standards.
The number of listed companies has increased from 13 in 1990 to 1,132 at the end of 2000. More listed companies are expected. Companies that have issued B-Shares (traded in China and overseas) must follow International Accounting Standards (IAS). Companies that have issued H-Shares (traded in Hong Kong only) may follow either IAS or Hong Kong accounting standards. Companies that have issued A-Shares (traded in China only) must follow accounting standards promulgated by the PRC Ministry of Finance (Chinese GAAP).
After the basic accounting standard was promulgated in 1992, China quickly published approximately 30 p
roposed accounting standards. The Ministry of Finance hoped to complete numerous accounting standards within three years. In that way, the Ministry could quickly bring China's accounting in line with international standards. This idea soon proved to be overoptimistic. After eight years of wrestling with various obstacles, China only issued eight accounting standards.
Despite the revolutionary economic changes that were made, the political system witnessed little changes. The supreme legislative body is the National People's Congress. Next is the State Council, which has the authority to approve regulations, administrative rules, and decrees issued by the various Ministries and Commissions under its authority. The third level of the Chinese government consists of Ministries such as the Ministry of Finance which has the authority to issue detailed regulations applicable to all enterprises throughout China.
The Basic Accounting Standard clearly identifies three groups of users of financial information: the government; investors, creditors, and other relevant parties outside the enterprises and management. Compared with the framework of other countries, this is an obvious difference. Conceptual frameworks in other countries state clearly that the special needs of government and management are subordinate to the overriding focus on investors and creditors. But China's Ministry of Finance indicates that accounting standards must serve all three groups. Of course, an accounting system that satisfies all three groups must be significantly different from a system that focuses on outside investors. In that case, China definitely could not simply adopt accounting principles developed in other countries where accounting is designed primarily for outside investors-to satisfy government and enterprise management equally well (Tang 2000)
The accounting system in Japan was influenced mainly by those of the United States and Germany. During the modernization, western bookkeeping was introduced into Japan through the importation of books from western countries. After World War II, a major change occurred in the orientation of corporation financial reporting by the introduction of the Securities Exchange Law and revisions in the Commercial Code. Moreover, the Japanese Institute of Certified Public Accountants (JICPA), the Investigation Committee on Business Accounting Systems that later became the Business Accounting Deliberation Council (BADC), and Tax Bureau and National Tax Administration Agency were formed. This new regulatory system was based on the system of the United States and its purpose was to protect investors.
In general the Japanese accounting is characterized as statutory control, uniformity, conservatism, and secrecy (Tu, Chang, Lee, Regional Accounting Study Web site). These are resulting from the influences of its culture, government, and legislations such as "the Triangular Legal System".
The major standard setter is the Business Accounting Deliberation Council (BADC), an advisory body to the Ministry of Finance (MOF).
There are three different laws that prescribe financial accounting in Japan: the Commercial Code, the Securities Exchange Law, and the Corporate Income Tax Law. Even though each law has different purposes, all of them have strong influence on the accounting practices. These laws are firmly interrelated in their accounting objectives. This is described as "Triangular Legal System" which means three different corporate accounting practices exist in Japan.
First, the most important part of Japanese accounting is the Commercial Code. The purpose of the Commercial Code is to protect creditors. The Code was enacted in 1890, based upon the philosophy of continental European laws. It provides some limited number of accounting requirements. Because the Code overrules the GAAP, BADC statements, JICPA Accounting Committee Reports, and other laws such as the Tax Law should be consistent with the Commercial Code's accounting requirements.
Second, The Security and Exchange Law (SEL) requires the registrants to file annual report and semi-annual reports with the MOF, with copies to the stock exchange where the securities are listed (JICPA web site). The financial statements prepared under the Security and Exchange Laws and relevant regulations are in major areas equivalent to those prevailing internationally.
Third, the Corporate Tax Law provides very detailed guidance originally for tax purposes. Also, the law is used as accounting guidance in the areas where no accounting standards exist. Thus, the Tax Law and its implementations are an important source of the GAAP in Japan. The Law provides methods to calculate taxable income and record expenses in the books of account. The corporate tax is computed in conjunction with the Commercial Code. Taxable income under the Tax Law should be reconciled with adjusted income under the Commercial Code.
The social system in Japan has been formed mainly by a public government, while in the United States it has been formed mainly by private sectors.
Japanese corporations tend to focus on long-term profits. Japanese corporations emphasize on developing new products, and expanding businesses and market shares rather than on making profits for stockholders. Moreover, stocks of a corporation are often held by another large corporation or group corporation, not by individual stockholders.
c. The United States
The accounting standards in the United States are classified as the Anglo-Saxon model. In Anglo-Saxon model, the purpose of accounting is to communicate useful information for decision making to various investors. Consolidated financial statements are of great importance for them, because shareholders are the major source of finance. Thus, the U.S. system emphasizes the true and fair characteristics in the accounting standards.
The accounting standard setting in the United States was developed since the Stock Market Crash in 1929. In the aftermath of this event, the Securities and Exchange Commission was created in 1934 to protect the interests of investors by ensuring true and fair disclosures. The SEC is a governmental agency to regulate the issuance and trading of securities by corporations to general public in the U.S. Also, the SEC generally allows the private sector organizations to establish the accounting standards. However, the SEC underpins the authorities of the standards. The Commission carefully supervises the standard-setting process and responds to Discussion Memorandums and Exposure Drafts issued by Financial Accounting Standard Board (FASB) (Skousen, 1998).
The FASB has been the designate organization in the private sector of setting standards of financial accounting and reporting. These standards are recognized by the SEC and the American Institute of Certified Public Account (AICPA). The FASB does not have enforcement power while the SEC has statutory authority to establish financial accounting standards under the Securities Exchange Act. The FASB is part of a structure that is independent of all other business and professional organizations. The FASB issues Statements of Financial Accounting Standard (SFAS), and Statements of Financial Accounting Concepts that states a framework within which a specific accounting standard can be developed (Skousen, 1998).
As another important organization that influences the U.S. financial accounting standard, American Institute of Certified Public Accountants (AICPA) is the professional organization of practicing CPAs. Prior to the formation of the FASB, accounting principles were established by AICPA. Even though the FASB took the place as the official standard setting organization, the AICPA continued to have a great impact on the establishment of accounting standards. The
responsibilities of AICPA are quality control and standard setting besides certification and continuing education for CPAs.
Thus, the accounting system in the United States heavily relies on the private sectors rather than the public sectors. The FASB in the United State plays a role in balancing between theoretical correctness and practical acceptability.
III. MAJOR ISSUES
Accounting consists of three broad areas: measurement, disclosure, and auditing. When we compare the accounting standards of the three countries, we are going to cut in from the same three areas.
Measurement is the process of identifying, categorizing, and quantifying economic activities, or transactions (Choi 1999). The accounting standards must ensure a degree of consistency in asset valuation, profit measurement and cash flow measurement, so that the public can be assured that the financial statements have been presented in conformity with those principles and are therefore reliable sources of data (Rask 1998). When we are making measurement, reliability and relevance are the two key concepts for decision usefulness. In China, there are two factors that have great impacts on this issue. One is the "responsibility system", which has been a dominant concept in China for many years. Accountants are required to provide reliable information to discharge their responsibility, mainly the custodianship responsibility. The other is the concern of the government and public regarding the truthfulness of accounting figures. Enterprises are often blamed for providing false accounting information. Numerous management fraud cases surfaced in recent years. This led to a judgment that reliability must be put before the relevance in developing China's accounting standards. In this section, we are going to compare the measurement of depreciation rules, inventory valuation, research and development, business combination and goodwill.
Under the current tax law, China applies the straight-line method. Any modification to the provision must be approved by the State Tax Administration. In China, accelerated depreciation allowance applies only to the oil and gas industries for a faster recovery of exploration and exploitation expenditures,
In Japan, the methods of depreciation include the straight-line method, the declining balance method, the sum-of-the years-digits method, and the unit-of-production method. Although different methods are allowed for depreciation charges, it is common to use the declining-balance method and apply useful lives that are specified by the income tax law. The unit-of production method can be applied only to the assets that value will decline in proportion to the use of the assets and which total units of production are predictable. Accumulated depreciation is deducted from the cost of each class of asset or it may be shown as aggregated amount and deducted from the total of depreciable assets.
3. The United States
The United States permits both accelerated and straight-line depreciation methods. Estimated economic usefulness determines depreciation period. The depreciation method used in any specific instance is a matter of judgment and conceptually, should be selected to most closely approximate the natural pattern of use expected from the asset. The basis of cost recovery property must be reduced by the cost recovery allowed and by not less than the allowable amount (Skousen,1998).
According to standard accounting principles, inventories are recorded at the historical cost of acquisition or production and disclosed at historical cost in accounting statement (Tang 2000). Book value is not adjusted for fluctuations in market value. Thus, obsolete inventory is carried at cost. Under the current tax regime, China allows the following costing methods: FIFO, LIFO and weighted-average. The lower of cost or market method is not permitted. (Lin 1999).
Inventories are valued at either cost or the lower of cost or market. The following inventory valuation method can be used: individual cost, FIFO, LIFO, weighted-average cost, moving-average cost, and latest purchase price. Market value is usually the repurchased price, which differs from market value interpreted in the United States.
3. The United States
The United States relies on historical cost to value tangible and intangible assets. Revaluations are not permitted, except after a business combination accounted for as a purchase. With regard to inventory valuation, LIFO, FIFO and average cost methods are permissible and widely used. LIFO is popular because it can be used for federal income tax purpose. However, if LIFO is used for tax purpose, it must also be used for financial report purpose. Lower of cost-or-market method is acceptable, but the market value is the current replacement cost that should not exceed net realizable value and must not be less than net realizable value reduced by normal profit margin.
Research & Development
Cost, associated with research and development ar4e usually expensed when incurred. But in some circumstances, companies are allowed to capitalize such costs.
Research and development costs will be charged to expense when incurred, in the financial statements for fiscal yeas beginning on and after April 1, 1999. Research and development costs have been allowed to be accounted for as deferred charges, which amortized over five years. The Commercial Law states that a joint stock company may or may not capitalize research and development costs. If the company capitalizes the costs, the cost should be displayed as one component of deferred charges and amortized within five years, which are artificially determined. The Business Accounting Deliberation Council is now deliberating issues related to research and development costs. The Council is expected to clarify, among others, accounting for software development costs.
3. The United States
Because of the uncertainty surrounding the future economic benefit of research and development activities, the FASB concluded that research and development expenditures should be expensed in the period incurred. For computer software, all costs incurred up to the point where technological feasibility is established are to be expensed as research and development costs.
Accounting for business combination is quite recent in China. Uniform accounting policies must normally be followed. The purchase method is normally required to account for business combination
Business combinations other than the consolidations may be accounted for by either the pooling-of-interest method or the purchase method. However, it can not be clearly distinguished between purchase and pooling-of-interests methods in Japan. Mergers are usually affected by an exchange of shares between an acquired company and an acquiring company, and are generally accounted for in accordance with the Commercial Law and Corporation Tax Law in a manner similar to the purchase method of the United States. Increases in stated capital are determined based on the face value of stock to be exchanged with acquired equity, so that excess of net assets over the increased stated capital is displayed as an additional paid-in-capital.
3. The United States
Both purchase and pooling-of-interests method can be used in the United States. But they are not alternatives: pooling-of-interests must be used when the combination meets the criteria specified in GAAP. For example, in order for an acquisition to be a pooling-of-interests, 90% or more of the exchange has to be in the form of voting stock. Sinc
e these criteria are rather stringent, most business combinations are accounted for by the purchase method.
Because business combination is a relatively recent development in China, uniform accounting policies must be followed. Any goodwill must be amortized over the period benefited. Use of the immediate write-off method is not permitted.
Only purchased goodwill is allowed to be recognized, while self-established goodwill is not allowed to be recognized. In general, goodwill is not recognized unless the acquired entity has already had investments in the stock issued by the acquired entity. The Commercial Law states that goodwill should be amortized over five years. The Business Accounting Deliberation Council amended Accounting Principles for Consolidated Financial Statements on June 6, 1997. The amendment stated that goodwill recognized on acquired subsidiaries in consolidated financial statements will be required to be amortized within twenty years in the near future.
3. The United States
Under revised Exposure Draft of FASB of February 2001, FASB made significant changes relating to goodwill, deciding that goodwill would no longer be amortized. The carrying amount of goodwill would be reduced only if it was found to be impaired of was associated with assets to be sold or otherwise disposed of. And it would be tested for impairment in a manner different from how other assets are tested for impairment. FASB also prohibits use of the pooling-of-interests method for business combinations initiated after the issuance date of the final statement.
The development of disclosure systems parallels the development of accounting.
Disclosure standards and practices are influenced by legal systems, sources of finance,
Political and economic ties, level of economic development, education level, and culture.
Financial reporting and disclosure are affected by source of finance. Japan and China have the same background with respect to source of finance funds and investments for the corporations, i.e., banks provide funds and investments for the corporation.
In China, every industry has its own accounting standards, known as industry-based accounting. State-owned enterprises make financial reports and disclosures in need of the government. For those privatized companies, managers need to report to the Bureau of line industries. In addition, private investors take greater risks in equity markets due to the relatively limited disclosure and reporting.
By contrast, in Japan, banks can have very significant influence on the finance of the corporation, and they can be both creditors and owners. Accordingly, the managers must primarily report to banks and other "insiders", and they have to provide the financial reports and disclosures that meet the needs of banks and other "insiders". Therefore, the shareholders and private investors protection is inadequate in this country.
In the United States, most of the investments are provided by private investors or shareholders. Therefore, the outside investors are most important and corporate management must primarily answer to the shareholders. The predominance of shareholders control results in more extensive and timely financial reporting and disclosure in the U.S. compared with those in Japan and China. The United States provides extensive and strictly enforced shareholders protection. Investors are provided with material information and are protected through monitoring and enforcement.
Political and economic ties also affect the financial reporting and disclosures.
In China, central government has a strong control over the accounting system, financial reporting and disclosure. Some financial information is confidential and is not required to provide to the public. Relatively low financial reporting disclosure levels are consistent with systems of corporate governance and low economy levels. In contrast, Japan has a little different situation. The central government also has a strong control over the business system, reporting and disclosure affairs. Therefore, public financial reporting and disclosure are less developed. Secrecy is kept in the industrial group and some financial information is restricted to release to the public. In the United States, state law provides guideline of business behavior. The developed economy brings out more developed accounting systems and more comprehensive financial reporting and disclosure. What's more, central government has less control over the accounting systems and requirements for financial reporting and disclosure in accordance with flexible corporate structure incorporated in state level. As a result, extensive and timely disclosure is required to provide to the public in free-market economy.
Regarding culture and education level's influence on financial reporting and disclosure, in China, collectivism dominates the business system as well as accounting affairs including financial reporting and disclosure. A preference for uniformity is consistent with a preference for strong uncertainty avoidance. In some cases, on contrary, information reporting and disclosure are restricted to avoid conflict and competition in society in the United States, individualism is emphasized and independence dominates between individual and business. With a high educational level, a complex technical report on financial information and a highly developed disclosure components can be understood and used competently. By contrast, Japan also has a high education level, but this factor has been outweighed by the effect of cultural and religious roots on financial reporting and disclosure. Accordingly, interdependence prevails over independence in personal and corporate relation.
With respect to components of financial reporting and disclosure, the three countries provide the following similarity and differences.
In China, accounting period is required to be the calendar year concerning financial reporting. A typical financial reporting and disclosure include the following parts:
1. Balance sheet
2. Income statement
3. Statement of changes in financial position (or cash flow statement)
4. Notes including accounting policies, and some supporting schedules
5. Comparative financial statements are required
6. Consolidated financial statements are required in case of 50% percent or more ownership except for enterprises not s