China’s audit regulations – Filings shortly due

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Getting prepared for your annual audit inspection

By Chris Devonshire-Ellis

BEIJING, Dec. 19 – All foreign invested businesses in China are required to prepare annual financial statements, including balance sheets and income statements for their annual Chinese audit. Such accounts must be in accordance with the Chinese accounting standards for business enterprises – there are now no differences between standards for domestic and foreign enterprises. Foreign companies, including their legally responsible persons, must take full responsibility for the truthfulness, legitimacy and completeness of these financial statements. These documents must be completed ahead of the submission of consolidated accounts for tax purposes by the end of April every year, for the financial calendar year ending the previous December 31.

These statements will be used for computing the taxable and distributable profit. Accordingly, an annual audit by a firm of certified public accountants registered in the PRC is required under Chinese law.

There are a number of areas where you need to take particular care and where there are some differences between Chinese and Western accounting practice. These are guidelines only as every business is different.

Audit items often queried by Chinese independent auditors

Adjustments for foreign related payment income
If the foreign company has paid overseas insurance for their expatriate employees, it should be noted that this is not tax deductible unless it is recorded as a salary payment and with IIT paid. Foreign sourced income should be provided for by providing evidence of foreign taxes paid with the relevant foreign documentation. Otherwise, foreign taxes may be accrued by the foreign enterprise.

Related party transactions and transfer pricing
If your business had any transactions with related parties, you must make sure that these were at arm’s length and with adequate documentation to substantiate the charges/income, so that the results were not materially affected by related party transactions that were not in the ordinary course of business. Pay particular attention to transfer pricing issues. Tax officials reserve the right to adjust transfer prices, interest charged by related parties based on market prices or even based on the prescribed profit margin. Transfer pricing should not be used as a mechanism to reduce the amount of profit retained in China. If you abuse this and are caught – the tax bureau regards this as tax evasion and the penalties and repercussions can be severe.

Withholding obligations
If the business made or accrued in its costs or expenses any payments, such as rental (including office and expatriate housing), royalty charges, interest, services or management fees for services performed in China by foreigners (individuals or organizations), pursuant to related contracts and agreement, the relevant withholding obligation should be provided for on an accrual basis. This means 10 percent withholding enterprise income tax and 5 percent business tax apply (the tax rate may be different according to individual cases). These charges shall be accompanied by substantial evidence – otherwise they are not deductible. All the above debts in foreign currency also need to be registered with SAFE prior to approval for remittance.

Input VAT
The VAT invoice must be verified by the tax bureau within 90 days as from the invoicing date, otherwise it cannot be deducted. Furthermore, if you have any unusual loss of inventory, then the VAT input related to the inventory previously credited has to be reversed in the period when the loss is recognized.

Export VAT
Export VAT refunds for the year should be reconciled with the tax bureaus within three months of the end of the year. Businesses should register all export receivables of the previous year with the bureau. Failure to do so may result in the export sales being deemed as domestic transactions, subject to output VAT if the payment for export sales is not received and related documents are not presented within the deadline.

Stamp duty
Although not a material issue with much cost, businesses should not forget to pay stamp duty on all books, records and applicable contracts. Fines for non-compliance outweigh the dutiable value.

General accounting treatments on significant audit areas

Trade debtors
Generally speaking, China’s GAAP rules allow enterprises to make a bad debt provision without any percentage limitation. However, there may be tax implications for such debts as well.

Long-term debt investments
Long-term debt investments of businesses should be recorded at cost and based on the actual payments. Any interest should be accrued based on the face value of the investments and applicable interest rate, and recorded in the amount of “other receivables.” The premium or discount on acquisition of the investment needs to amortized over the holding period under either the straight-line method or the effective interest rate method. Long-term investments that mature within one year need to be reclassified as short-term debt investments.

Fixed assets
All fixed assets should be recorded at cost or revalued amounts in accordance with the approved contract, then approved by the local National Administration Bureau of State-Owned Assets or local finance bureau if the assets were state-owned before they were eventually contributed to the Foreign investor. When computing the depreciation, a residual value of not less than 10 percent should be taken into account. If not, the rate needs to be approved by the relevant tax bureau. All construction in progress items should be transferred into fixed assets when they are put into use with any interest expenses and associated exchange gain/loss also being capitalized. There are specific regulations on what should be capitalized, and you must follow these. Fixed assets are recorded at a lower book value and recoverable amount at the end of the accounting period. A provision for impairment of assets is made for any difference between the book value and the lower recoverable amount.

Intangible and other assets
Intangible assets are amortized on a straight-line basis over the beneficiary/investment period of not less than ten years (there is no set term for other deferred expenses). Intangible assets should be recognized and recorded at an objective value, i.e. for purchased assets at the purchase price, for self-built assets at cost except for research expenses. Intangible assets are recorded at lower book value and recoverable amount. If the recoverable amount is lower than the book value, provision for impairment on intangible assets should be made for the difference.

Pre-operating expenses
Expenses and exchange losses during the start-up period can be charged to the profit and loss account in one lump sum during the first month after commencing operations.

Deductible expenses
Entertainment expenses are allowed – but no more than 0.5 percent of turnover for manufacturing companies with annual turnover of less than RMB15 million, and 0.3 percent for those with annual turnover of more than RMB15 million. Commissions paid to individuals should be no more than 5 percent of turnover.

Reserve funds
For WFOEs, not less than 10 percent of the after-tax profit should be appropriated to the General Reserve Fund. Appropriations to other funds should be made in accordance with the Articles of Association and a Board resolution.

Mandatory company fund allocations
Prior to the annual audit, and the subsequent settlement of taxes with the tax bureau, there are items that need to be calculated and presented in the accounts as mandatory fund dispersals. These include amounts to the company’s enterprise expansion fund, thereserve fund, and staff and workers welfare and bonus fund.

By law, WFOEs need to specify the amount for the reserve fund in its articles of association. This must not be less than 10 percent of after-tax profits, and must be contributed to until a ceiling is reached, being the equivalent of 50 percent of the total registered capital in the company. Once this amount is achieved no further amounts need to be contributed to the reserve fund. The amounts for the other funds do not need to be specified – an anomaly that means businesses rarely contribute towards them.

Special attention to stock inventories
For both trading and manufacturing companies, inventories must form a significant proportion of total assets. Auditors will therefore pay close attention to the existence and valuation of such stocks. The inventories valuation can be clearly identified from the purchase invoices or cost calculation sheet. But auditors will also take care to confirm the existence of the inventory and how stocktaking is carried out. The following steps should be followed:

  • observe whether the stocks are neatly kept, whether bins are properly labeled, and whether large items are properly piled and marked
  • check that counting is systematic and that precautions are taken to ensure everything is counted and counted just once
  • pay attention to high value items
  • investigate whether discrepancies arise between the physical count and stock records
  • note any items that appear to be damaged, obsolete or slow moving, so as to ascertain whether adequate provisions for loss has been made

Some businesses may have omitted a stock take at year-end. If so, roll-back procedures can also be carried out to check the stock movements in the intervening period and ensure the year-end balance.

For stock valuation, FIFO and specific identification methods are recommended for China.

If you have questions or require assistance with your annual audit in China, please email us at

The January 2008 issue of China Briefing will also be an annual audit special issue with further detail about audit compliance. Subscription is available here.