Sarbanes-Oxley and U.S. Businesses in China

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By Hank Bourg

May 19 – The Public Company Accounting Reform and Investor Protection Act of 2002 commonly known as Sarbanes-Oxley or SOX after the two authors of the bill, was enacted on July 30, 2002 in response to several major corporate and accounting scandals, the most infamous being the meltdown of energy giant Enron.

Sarbanes-Oxley includes some of the most far-reaching reforms of American business practices since the Depression Era and it not only apples to U.S.-based parent companies, but subsidiaries organized outside the borders of the United States. This means that U.S. business operating in China must remain compliant, challenging them to design and maintain their internal control structure in an accounting and reporting environment that is early in its development and is rapidly changing.

Many Chinese accountants and local Chinese CPA firms lack the expertise and experience to establish, maintain and review internal control systems. Despite these challenges, when contemplating an entry into the China market, SOX compliance should be considered with equal importance as the location and legal structure of the proposed China operations. Early internal control design and implementation in tandem with proper organization under Chinese laws will contribute to a smoother transition and earlier success.

Sarbanes-Oxley is arranged into eleven titles each with their respective sections. From a corporate compliance perspective there are five sections with the most relevance: sections 302, 401, 404, 409, and 802. Of these sections, section 404 has the most relevance to U.S.-China businesses and the largest impact on corporate financial reporting and internal control implementation, maintenance and assessment.

Section 302 requires senior executives, usually the Chief Executive Officer or the Chief Financial Officer, to take individual responsibility in the form of financial statement certifications as to the accuracy and completeness of financial reporting in connection with the periodic reporting requirements of the Securities and Exchange Commission. Managers of U.S.-China businesses have the responsibility of reporting internal control weaknesses to senior executives in an immediate and timely manner.

Section 401 requires that financial statements be truthful and presented in a manner that does not contain inaccuracies. These financial statements must reflect all material off-balance sheet liabilities, obligations or transactions. As such arrangements are not unusual with Chinese operations; managers of U.S.-China businesses must be aware of the reporting requirements and communicate such transactions in a timely manner to senior executives.

Section 404 requires management to publish an “internal control report” as part of each annual financial report required by the SEC. The report must emphasize the responsibility of management for the establishment and maintenance of an adequate internal control structure and procedures for financial reporting including an assessment of the effectiveness of the internal control structure and procedures of the registrant for financial reporting. Many Companies have adopted internal control frameworks as proscribed by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). COSO is a private non-profit organization that provides guidance to executives over corporate governance, business ethics, internal control, enterprise risk management, fraud, and financial reporting. Relevant to Section 404 compliance, COSO has established an internal control model with which companies and organizations may design and assess their control systems.

Assessment of the internal controls requires tests of the effectiveness of such controls periodically throughout the year upon which the annual report is issued. Material weaknesses identified, if any, and action plans to remedy such weaknesses must be included in the assessment. Foreign subsidiaries including those organized in China are not exempt from this requirement.

Section 409 requires registrants to disclose information on material changes in their financial condition or operations in a specific time frame upon discovery of such changes. These disclosures are to be easy to understand and supported by quantitative and qualitative information as appropriate. As is the same as the section 302 requirements, managers of U.S.-China business have the responsibility of reporting such changes to senior executives in an immediate and timely manner under section 409 as well.

Section 802 imposes penalties including prison terms for altering, destroying, concealing, or falsifying records and documents with the intended purpose to obstruct or influence a legal investigation. This section also imposes penalties including imprisonment on any accountant who knowingly and willfully violates the requirements of maintenance of all audit or review papers for a period of five years.

Although Sarbanes-Oxley primarily focuses on companies registered with the SEC, privately held companies should consider compliance with an eye to a future IPO (generally advised to be 12 months in advance) or possible M&A with a listed company. The value of either type of corporate transaction can be greatly enhanced with foresight to SOX compliance.

Also, certain provisions of Sarbanes-Oxley apply to private companies including their foreign subsidiaries. Managers of U.S.-China business should be aware of these provisions which include:

  • Penalties for retaliation against whistle-blowers
  • Penalties for destroying or tampering with documents
  • Extension of the statute of limitations for securities fraud
  • Bankruptcy does not discharge financial obligations arising from securities law violations
  • Increased criminal penalties for mail and wire fraud
  • Potential officer and director bans for securities law violations

Hank Bourg is a U.S. certified public accountant and the head of the North American desk at Dezan Shira & Associates. For comments or inquiries, please contact him at