Case Study: Internal Control Review for subsidiaries in China

What is an Internal Control Review (ICR)?

The goal of an ICR is answering to the question whether an internal control is established and sufficiently executed in a company. The main emphasis herein relies on the specific management and control processes used across multiple functions inside an organization. This contrasts with the mandatory annual audit, which mainly accounts for a reliable financial reporting, whereas an ICR focuses on which control processes exist, how they are implemented and what possible deficiencies and enhancements might exist.

Why an ICR?

An ICR is not mandatory for smaller companies, unlike listed companies that are required by law to conduct separate internal control audit regularly, however, there might be some arising issues, where conducting an ICR is beneficial for the management of the pertaining company. The following list includes exemplary issues, where an ICR might offer great benefits to a firm.

1) In-transparency of the business activities conducted by the subsidiary

  • After a merger or acquisition to better understand the acquired company
  • Cultural or language barriers between parent company and subsidiary abroad
  • Determining sources of unusual high costs or expenses

2) Change of key elements in the business environment

  • Change of core management or key employees
  • New laws pertaining the business activities or accounting, taxation of the firm
  • Bribery or fraud investigation against company personnel

What are the benefits of an ICR?

Relating directly to the above-mentioned reasons, there are many aspects in which the ICR can enhance a company’s way of doing business. Some exemplary ones are listed below.

  • Ensuring compliance to relevant accounting laws
  • Identifying and solving issues in a short period of time
  • Increasing the efficiency of the business operations
  • Increasing the transparency of the subsidiary’s operations for the parent company

Why is an ICR especially important for foreign companies in China?

There are many challenges faced by foreign companies when doing business in China. The different legal system and business environment make it hard for these companies to engage in business and achieve their intended goals. Whereas in Germany, the ICR enjoys a high recognition for its ability to address the challenges of in-transparency and accountability inside a firm, many firms operating in foreign markets for example in China do not employ an ICR to reduce risk and increase compliance of their subsidiary’s business activities abroad. The following arguments should present the benefits of an Internal Control Review, especially when doing business in China.

  • Cultural & language barriers: Coordinating and managing the actions of the subsidiary becomes much more complicated for the parent company, due to the Chinese language and different cultural background of their employees. This challenge is even increased by the time shift and changing of employees.

=> An ICR might help to document and review the actions taken by the employees and managers of the subsidiary and provide improvement proposals for the parent company.

  • Complexity of the legal system: The Chinese law and taxation system might seem in-transparent for western managers. The lack of legal knowledge might result in some compliance risk by not adhering to all the prescribed norms for foreign businesses, especially since non-compliance is punished in China with high fines, that might even result in banning the company from the market.

=> The Internal Control Review helps to reduce risks of non-compliance by evaluating the business processes inside the organization regarding the relevant laws.

Case Study:

Background:

Our client is a medium-sized multi-national company with a specialization in innovation and technology related services. Their subsidiary in China engaged us to conduct an audit to affirm the compliance of the documentation processes with Chinese accounting standards, which are constituted by article 13, 14, 15 and 17 of the Chinese Accounting Law.

During our audit, we first collected information on the existing company’s documentation policies of their Chinese subsidiary, interviewed relevant personnel, reviewed the relevant accounting documents and did cross-sampling tests on their practical implementation. This process is graphically displayed in the following flow-chart:

Learning from praxis: our findings from the ICR

During the depicted Internal Control process, we found several compliance issues.  Among them are some typical that foreign companies face when doing business in China, especially when it comes to the right documentation procedures for business activities.

1. Improper use of “Fapiao” for the documentation of business transactions

“Fapiao” in China, contrary to many other countries, is a way, in which the government can monitor the payable value added tax (VAT) on each transaction. Therefore, all businesses are required by law to provide a “Fapiao” to each customer. However manually creating these receipts is very time-consuming and they are often not filed correctly. During our audit we found that the client’s subsidiary often received improperly filed “Fapiao”, where the issuer, receiver and reviewer was stated incorrectly. Furthermore, the reimbursement received from employees were non-compliant with certain business policies, but were accepted any ways. These reimbursements were often times stamped as being paid with “petty cash”, where as in reality the amount was paid by the Legal Representative of the company. This seemingly small issue might however generate problems during the annual audit or when handling these expenses for accounting purposes.

Our suggestion: Reject non-compliant “Fapiao” and ask the seller to correct or reissue the Fapiao the right way. Stamp every issued Fapiao with the according stamp correctly

2. Paper documentation policy issues

In the audit we found several issues regarding the employed paper documentation inside the firm, ranging from the incomplete collection of supporting documents with bank slips due to an office relocation, to an outdated paper authorization policy, causing numerous compliance issues with confidentiality and accuracy. The inter-departmental exchange of vouchers for stock movements was sporadic, resulting in difficulties for timely financial reporting. A major compliance issue for the client arose exactly from these seemingly small “mishaps”. Because the bookkeeping vouchers have not been filed appropriately with supporting documents, the key in of the accounting record in the employed SAP system was missing, alongside a monthly tax filing, resulting in in-transparency about the actual stock of goods.

Our suggestion: Train staff, improve internal procedures to file vouchers with supporting documents, and file all the documents as accounting books. Update the office address that is registered in the bank account. Collect all the bank slips and attach the supporting documents to them.

3. Non-compliance in settling small-amount payments by the Legal Representative

The role of a Legal Representative in a WFOE is a critical one, because all his activities will be seen as the actions of the entity itself. In one instance, the Legal Representative account was being used to settle small-amount invoices e.g. reimbursements by transferring monthly payments to it. Because this is not compliant to Chinese law, it  poses a major risk to the company.

Our suggestion: For the payment of small amounts, a company Ali-Pay account would be more suitable, than using the personal account of the Legal Representative.

Our conclusion:

In summary the Internal Control Review is a very useful tool to increase the transparency and compliance with pertaining laws of companies. Especially when doing business in China, the choice to conduct an ICR can mitigate compliance risks and provide useful insights as well as improvement suggestions to the company. Our exemplary findings from the audit show, that the documentation of business operations is prone to get neglected, which can result in high fines by the authorities for non-compliance. The research also uncovered an otherwise overseen compliance risk by paying small amounts from the personal account of the Legal Representative. Finally, based on our findings, we have suggested some key changes to our client, that should help them to achieve a greater efficiency of the subsidiary. The quality of the findings and suggestions are key to the effectiveness of an ICR, thus it makes sense to employ a knowledgeable third party for conducting an Internal Control Review.

If you are interested in more information about audit and the Internal Control Review, we recommend you these two articles about it:

Why does your company need a regular health check?

The annual compliance review – Audit in China

                                    Amanda Liu

Amanda has more than ten years of experience working in professional services for China’s accounting, tax, finance, internal control and business sectors. Prior to joining ECOVIS she worked in a Hong Kong-based financial and tax consulting firm. She has provided internal control advisory, audit, accounting, tax and financial compliance advisory as well as financial due diligence services for both mainland and MNC enterprises. Clients she served include companies from real estate, manufactoring, IT, media, consulting, culture and other sectors. Amanda holds a Master’s degree in Finance Management from China Renmin University. She is also a non-executive member of the Beijing Institute of Certified Public Accountants (CPA).

please contact:  amanda.liu@ecovis-beijing.com

Ecovis Beijing is the trusted tax and legal advisor to several embassies and official institutions in China. It specializes in mid-sized international companies and is focused on tax & legal advisory, accounting and auditing. If you’re interested in finding out more about tax, audit and legal, give us a call: +86 10-65616609 (Dw 811/806) or contact us directly via service@ecovis-beijing.com