With investigations in the United States regarding the use of back door listing of Chinese companies on US markets, it's worth taking a little time to understand financial practices in China. If you can get a decent understanding of how companies operate in the country (whether or not they IPO) you can take precautions to ensure your investment is sound. Here's a list of practices you might want to check for before parting with your money.
Tax avoidance is very common in China, most small and medium sized enterprises have complex systems designed for this very purpose and even large scale enterprises are not immune. It's important to know how much of liability your company may be facing before handing over your cash.
Multiple Sets of Accounts
This practice is extremely common, and while the usual purpose is to try and reduce tax obligations they may also be concealing dodgy business practices within the organisation too. Official accounts are prepared and submitted electronically, whereas the unofficial copies tend to be kept manually. They are often impossible to reconcile.
Off Book Revenue Received
Because China's tax system is not fully automated the country has implemented something known as the "fa piao" instead. Which is an official receipt that shows tax has already been paid on the sum received, many companies offer discounts or rebates based on not issuing a "fa piao". While this is common practice, it means that any revenue received will not be shown on book unless a "fa piao" was issued. This means the company may have far larger revenue streams than accounts demonstrate.
Deferred Revenues
While not strictly tax avoidance many companies will hold off booking revenue until the following tax period to minimise tax liabilities on earnings, it's a poor practice and makes it harder for an outsider to grasp the true level of sales in a business.
Off Book Employees
It's not just revenues that fail to appear in the books, often employees aren't officially registered - which can leave the company open to major losses if the authorities work it out. (Chinese employers are required to make multiple contributions to welfare funds and medical funds, which aren't paid to off book employees).
On the flip side it's not unknown for fictional employees to appear on the books and be paid a salary, or for an individual employee to appear on the books multiple times in different jobs too, driving up the wage bill for fraudulent activity.
Phantom Assets/Shareholder Assets
Under reporting and over reporting of assets is widespread, sometimes due to misreporting and in other cases straight fraud. Due diligence is vital to understand the true situation, as often a company may "mix" it's assets with those of shareholders or executives.
Contract Enforceability
Many contracts in China aren't worth the paper they're written on, because of a relationship focused culture often people's word is what makes things run smoothly. You need to ensure (particularly in the case of a takeover) that contracts are enforceable and valid.
VAT Reporting
Another area of regular fraud and confusion is VAT compliancy, many companies either underreport by accident or because they are trying to dodge the tax bullet.
Investing in any developing market requires a level of caution, you should conduct thorough due diligence and always have your potential investments investigated by local professionals (who have no relationships with your target company) as well as international teams if at all possible. China offers great opportunities, but not without risks. Prudent investment in Chinese business requires much more time and effort than in developed countries.
