When East meets West.

Before your company heads to China you need to know how to play by Chinese rules - and they keep changing. Here's a first-hand report on its complex business climate.

The 50 delegates for last year's People to People International Program were about to leave Shenzhen, China, for their return flight to Hong Kong when torrential summer rains trapped them in their hotel, recalls Alvin Carley, delegation leader, and Lynford Graham, a delegate. The group watched in amazement as the water level rose up to car roofs and people floated by in makeshift wooden rafts, umbrellas in one hand and briefcases in the other.

Clearly, it wasn't the best traveling weather. But the delegates cheerfully made the best of it. Their afternoon meetings were canceled, so they lectured to each other instead. And in the end, the rain stopped and they made it to the airport in the nick of time, Carley reports. That was the exciting end to an eye-opening two weeks in China to talk with Chinese government officials, businesspeople and educators. Here's what the delegates learned from their adventures.

These days you can hardly pick up a business magazine or financial newspaper without seeing a story about the newest "investment haven" - China. And with good reason, because the reforms of recent years have turned a cloistered socialist economy into a huge potential marketplace. China's gross domestic product in 1994 was estimated at nearly $520 billion, with a growth rate of 12 percent, but many experts think the economy may actually be several times larger. In fact, some sources have predicted China's economic parity with Japan by the year 2000, and with the United States a few years afterwards.

With U.S., European and Japanese market growth at modest levels, such an opportunity couldn't have come at a better time for foreign investors. You always hear about America's largest companies, such as Ford, IBM and Boeing, making inroads into the Chinese market, but plenty of smaller businesses are also pondering China's investment potential. These technology companies, service businesses and niche manufacturers need direction on what to expect and how to accomplish their objectives with more modest resources. The rules of business in China are different from those in the United States, and they're changing very fast, so whether your company is large, medium or small, you'll need to do a great deal of analysis and create contingency plans before you jump in.

Recently, we returned from meetings in Beijing, Shanghai and Shenzhen as members of a two-week People to People International program. We talked with a variety of Chinese professionals, including practicing public accountants, employees of international finance companies, the Shenzhen Stock Exchange, representatives of the Ministry of Finance, the State Taxation Department and educators from the Shanghai University of Finance and Economics.

Before the program began, we agreed to focus on certain issues important to financial - executives investment alternatives, financing, taxation, financial reporting and currency restrictions - and communicate our findings. As members of the first delegation of this type, made up of nearly 50 educators, auditors and corporate financial executives from 11 countries (of whom a dozen were Financial Executives Institute members), we found the program provided rare direct meetings and one-on-one opportunities to share knowledge and increase mutual understanding between ourselves and Chinese accounting professionals. These meetings gave all of us an opportunity to put our understanding of Chinese accounting thought and culture in perspective with the current economic boom.

TURBULENCE AHEAD

We discovered that the China of today is vastly different from the China of a few years ago and is evolving rapidly. By the year 2000, we'll see a substantially more developed China. But expect lots of bumps along the way. This past year alone has seen at least three major trade crises. If history is any indication, we'll continue to see brinkmanship in negotiations, but the mutual economic needs of these two great nations will, in the end, encourage resolutions.

The pace of development means financial executives need more than ever to know China's critical business pressure points. Veterans of previous foreign- investment frenzies will find the China experience different from that of the Commonwealth of Independent States, Central Europe or Latin America. China has created a unique "socialist-market" economy, inviting investors to bring their capital, technology and other skills and create a "partnership" with China. Make no mistake: This isn't yet a free market economy, but the ministries are committed to creating policy and a regulatory environment that will attract partnership capital to stimulate economic advancement.

Because the changes underway involve deep ideological issues (moving from a communist to a market-based economy) and cultural changes (the shift from a rural to an urban society), the transition needs some structure, lest China repeat the turmoil in the Soviet Union.

That's the task of the nation's State Council which, through the Ministry of Foreign Trade and Economic Cooperation, tries to control growth, dampen inflation and avoid "boom-bust" cycles. Past political and economic invasions of China by other nations have also given the country a strong cultural impetus not to lose control of the economy to one nation, industry or key service provider. Since China's market potential is so vast today, competitors have plenty of room to share the wealth and enjoy profits.

The encouragement of open competition and sometimes the state's direct intervention to disperse contracts and economic power among potential competitors is a theme that recurs in many sectors. Such actions tend to prevent concentrations of power, but may later increase competitive pressures by preventing early dominance or leadership in markets.

THREE WAYS TO GET THERE

There are three major ways to be a part of China's economic expansion: direct investment, joint ventures and stock ownership. Direct investments and most joint ventures will qualify for special tax incentives, such as a two-year tax hiatus followed by a three-year 50-percent tax reduction. [See "Playing Favorites" on page 46.] These incentives provide a significant inducement to attract foreign capital. Direct investments are now permitted in which the foreign investor provides all the capital, subject to Chinese rules and official approval. These companies are called wholly foreign-owned entities.

The recent "company law" (July 1994) and 1993 reforms of the unified tax law have outlined more clearly the accounting and tax requirements for such enterprises. The relevant ministries grant permission to do business based on a written business plan, and the state may grant a lease for any land needed, but generally for no more than 50 years. Up-front lease payments for land leases are common. If your company is a direct investor, carefully consider your projected balance of payments at the company level and your needs for foreign-exchange and domestic currency in your overall forecasts and contingency plans, since you'll probably need a projected positive balance-of-payments position to get your business proposal approved. Approvals may also rest on your enterprise's plans to import any necessary raw materials viewed as scarce in China.

Companies contemplating independent operations may also find challenges in trying to go it alone in China, particularly when dealing with labor or culture issues. You'll often need local management to secure labor cooperation and the necessary factors of production, and that's what a Chinese joint-venture partner can offer you. One way or another, many wholly foreign-owned entities are in partnership with Chinese interests.

In an equity joint venture, the partners establish a limited-liability corporation, with the foreign partner providing at least 25 percent of the registered capital. On the other hand, with a cooperative joint venture, you may contractually agree on the form and capitalization, and the venture may have a long life or a life limited to a specific project, which is common in cooperative joint-venture agreements to build roads and buildings or to extract natural resources. Joint ventures begin with a feasibility study that evolves into a joint proposal of the parties to local officials, the Beijing ministries and the Bank of China for approval.

Partners are often former state enterprises that have been privatized. In fact, some businesses have been unnerved to discover their business partner is a holding of the People's Liberation Army, a significant economic entity with widespread business interests in China.

While any intangibles you contribute (patents, technology, etc.) count toward your joint-venture contribution, they're currently limited by the recently effective company registration regulations in the new company law to 20 percent of the total registered capital, regardless of their market or relative value. Since technology and know-how are often major factors in the joint-venture plan, this 20-percent limitation may lead you to contribute more hard assets than you'd otherwise expect, so you may wind up understating the net economic assets you contribute and therefore overstating the rates of return for the joint venture. Accounting principles may also encourage higher apparent rates of return by limiting the enterprise's ability to take certain write-downs (see box).

Once the business plan is approved, the state obtains the land and leases it to the enterprise. It's unclear what happens when leases expire or are prematurely canceled. Shortly after our visit to the world's largest McDonald's restaurant in Beijing, its lease was abruptly terminated to make way for a large commercial venture. Because of the publicity, the state eventually began negotiations to address the matter, but be aware that there are still gray areas here.

Companies commonly use local investment advisors to begin new or joint ventures, because local ministries, provinces and financial institutions form a maze of regulations and relationships that companies must understand and surmount. Whether they're institutions or individuals, advisors can also help facilitate the cultural expectation of getting to know your business partner by first learning your concerns and then introducing you to the right individuals. In an environment where consensus and negotiation have historically stood in for formal contracts, and in the absence of an established, functioning legal system, personal relationships are especially important. A good advisor will know your potential markets, your product and the labor issues that might be involved in your venture. But be careful when checking references on individuals. Unfortunately, the local banking, accounting and legal professions aren't developed enough to provide independent references on personal advisors.

Obtaining the best business advice doesn't always guarantee your proposed venture will be approved. China has recently denied large corporations permission to establish "assembly-only" plants, but encouraged them to consider integrated manufacturing operations and larger and more technologically sensitive undertakings. Transferring the latest technology is often an important factor in gaining approval for ventures. Successful proposals typically also offer foreign (hard) currency inflow, managerial expertise and a commitment to use local labor.

On the human-resources side, you'll find a severe shortage of accountants, financial managers and auditors in China, especially those experienced with market-economy transactions and international accounting and financial-reporting practices. Hundreds of thousands are necessary to meet current and future needs - far in excess of the 25,000 or so accountants in China today. This isn't surprising in such an enormous country after 45 years in economic isolation.

While a dramatic change in attitude has taken place since the reforms of the late 1970s, accounting has historically been rooted in information-gathering and compliance reporting designed to measure the government's production and taxation goals. Accounting was based on the sources and applications of funds concept and borrowed many features from the Soviet system. That system, needless to say, had little to do with the profit concept or accounting systems created to report financial positions or the results of operations. So don't assume the fundamentals are in place yet.

Chinese enterprises, including equity and cooperative joint ventures, must be audited by Chinese CPA firms, which are regulated by the state. Traditionally, many experienced auditors have audited only state-owned enterprises, working through the local province or city authorities and the state audit bureau to report to the governmental entity overseeing the audited firm. The new market-economy business environment has generated a need for private-sector CPAs and more frequent reporting. The existence of complicated business transactions and the complexity of many new and also foreign accounting standards, as well as the increasing risk of fraud and corruption, are challenging the auditors' skills. In response to the influx of foreign capital, the large international auditing firms have established joint ventures with Chinese CPA firms to bridge the growing needs for international accounting, tax and securities listing expertise.

PIECEMEAL CHANGES

In July 1994 China implemented a conceptual framework document, "Accounting System of the PRC Concerning Foreign Funded Enterprises," stating the broad tenets and objectives of accounting information and reporting for wholly foreign-owned entities, economic joint ventures and cooperative joint ventures. These broad rules include use of the calendar year end for all enterprises; the accrual and matching principle; historical cost; consistency in principles from year to year; and the accurate and timely recording of transactions.

The document also provides some broad guidance on applying these rules to specific accounts. Plus, more than 20 individual domestic standards of accounting for China are currently on exposure and may be enacted in the near future. Clearly, much change in this area is forthcoming. The thinking is that China won't simply adopt existing International Accounting Standards Committee standards, nor will it use the generally accepted accounting principles of any particular country, although it's recognized this would speed up conformity with current accounting thought. The process of change is likely to be more piecemeal - adopting a few standards as they're studied and deemed appropriate for China's circumstances. In the meantime, here are a few areas that can be troublesome:

The entity concept. Historically, the principal business of a geographical region or province was designated the reporting entity and made responsible for the education and health care of its citizens, as well as employment and production. The state is now carving out these social and economic units so they can run as independent businesses, so they're just now encountering ideas like the Western concept of the entity.

The risk is that some newly formed businesses may appear to be profitable, even though losses are being transferred to other entities or state enterprises through undisclosed related-party transactions or non-market transfer prices. In fact, more than 40 percent of the state sector enterprises aren't yet profitable or need subsidies. The importance of transfer-pricing approaches, the treatment of intercompany accounts in consolidation and equity accounting and the need to disclose related-party transactions are new ideas, and it'll take some time for them to be understood and consistently applied.

Going concern. While the Chinese recognize the idea of a going concern in their new accounting standards, Chinese business has had little practical exposure to the concept of a non-going concern. The government often heavily subsidizes its enterprises to support employment and social order. Protections to owners and creditors afforded by U.S. Chapter 11 bankruptcy proceedings have no apparent counterpart in China, but recently, the government published some brief guidance covering the order of satisfying liabilities during the liquidation process.

Conservatism. The former Chinese accounting system didn't need to accrue for unrealized losses. After all, if companies didn't sell their inventories right away, they could store just about anything and use it for some other purpose later. Similarly, accounting principles assumed the state always paid its debts - eventually. Thus, Chinese enterprises don't generally provide for lower-of-cost-or-market inventory adjustments or the creation of allowances for bad debts. The newly revised law for foreign-funded enterprises permits a provision for bad debts, but only up to 3 percent of ending accounts receivable. Writeoffs of damaged or useless inventory are required, but inventory write-downs for reasons related to lower-of-cost-or-market considerations must first be cleared with the overseeing state agency. Since some writeoffs are more difficult to make, profits from operations may appear higher than they would under more conservative principles.

Taxation. Under the prior Chinese system, taxation was a fundamental purpose of the accounting system, with no external financial investors to consider. The concept of book-tax differences is now beginning to surface; however, tax bills are still based primarily on reported income. And many questions remain on interpreting the newly enacted revisions of the unified tax law provisions for businesses and individuals.

DON'T NEGLECT THE BIG PICTURE

In addition to paying attention to the nuts and bolts of financial reporting, you need to closely monitor broader business factors and issues to stay on top of things in China. Some areas of current interest include:

Banking and foreign exchange. Although foreign banks, credit institutions and venture capitalists are establishing a foothold in China, the Bank of China still plays the central role in managing currency flows and granting credit. Strengthened by the April 1, 1994, regulation on foreign exchange, the State Administration of Exchange Control oversees foreign-exchange policies. Domestic Chinese enterprises must now conduct all foreign-exchange transactions through the Bank of China or a designated bank. Foreign businesses will meet their exchange needs by first liquidating any foreign-exchange account balances. Companies may then use swap centers to meet any additional exchange needs. The banks or overseeing ministries may block balance-of-payments deficits projected at the company or the joint-venture level. This will add financial-management challenges to operating in China.

Swift policy changes. Sometimes major policy changes can have unintended consequences. For example, the Chinese government, recognizing the dual-currency rate system was impeding rapid business development, unexpectedly eliminated the "official" currency rate as of January 1, 1994. At the time, a large state-owned enterprise was in the process of privatizing. It had been carved out of a larger entity and was in the middle of creating historical-cost financial statements so it could list its securities and raise capital on an international stock exchange. Because of the government's actions, the company's dollar-denominated liabilities nearly doubled to respond to the new market currency rate, while historical cost assets were still stated at the old "official" rate. The company's equity was wiped out - not very attractive for a first securities listing. The government subsequently began policy-level discussions on reinstating the official rate.

Language. While China has a common written language, the dialects of the North (Mandarin) and South (Cantonese), as well as 900 local dialects, are different enough to impede communication. English, while now taught extensively, is still not readily understood in conversation. But the Shanghai University of Finance and Economics has recently instituted English as the official classroom language for many of its accounting courses, which also use Western textbooks. Many different efforts are underway to enhance general business communication, including the mandatory study of Mandarin (the "official" Chinese language) for the southern Chinese, continued emphasis on English and a growing interest in Esperanto.

Other issues. Many other issues will affect your ability to effectively invest in China, including such fundamentals as infrastructure weaknesses. China needs more and better public transportation, highways and modern buildings, as well as general and preventive maintenance for longer facilities life and reliable, compatible network communications. You need only commute for three hours over 17 kilometers in Shanghai, amidst traffic and bicycle gridlock, simultaneous road, building and sewer construction and searing heat and humidity to come away with a very personal image of the challenges of rapid economic growth.

NEXT STOP: CAPITALISM

A number of possible future directions exist for the Chinese economy. With continued growth, contained inflation and political stability, the economy should continue to become freer, as well as more self-regulating and sustaining. Most sources agree the economic reform movement is now unstoppable. The speed at which the government will allow change to take place seems to be the one unknown variable.

However, the growth in crime and corruption, due to the widening gaps in wealth in Chinese society, are seen as a challenge to traditional Chinese values, and some Chinese people resent the rapidity of change. Attracted to large cities in search of high construction job wages, large numbers of semi-skilled but motivated workers from rural provinces are being absorbed into the economy unevenly, creating homelessness, unemployment and social welfare challenges for some large cities. In Shenzhen, a special economic zone, we were struck by the border-like restrictive measures used to control the flow of Chinese citizens in and out of the zone. Only Chinese with proper papers were permitted to enter the zone, but foreigners could move in and out without restriction. Clearly, these social issues must be addressed to ensure a stable environment for nurturing further growth.

While firms such as Motorola and Volkswagen A.G. have been cited for their early investment commitment and "go slow" approach to developing successful China operations, the continued challenges of the growing economy are encouraging shorter-term thinking. Given the risks of political changes, a developing legal system, inflation of more than 20 percent in the cities, leased rather than purchasable land and other factors, it's natural for companies to compensate by simply raising the required rate of return in the investment decision process. Expectations of quick returns are raised by early-year tax concessions and long-term concessions for some export-based, technology-intensive or infrastructure projects. But the government's watchful eye - manifested through the proposal and approval process, exchange controls and a cultural belief that 10 percent to 15 percent is a fair rate of return - may dampen those expectations. Despite all this, the Chinese market remains an extraordinary opportunity for many American businesses.

RELATED ARTICLE: NO EXACT TRANSLATION

Recent years have brought vast changes to China's accounting rules, and they'll continue to evolve for some time. Still, some Western accounting concepts don't have Chinese parallels, such as accounting for or disclosure of contingencies; disclosure of changing prices' effects; subsequent events reporting; accounting for government grants; subsidiaries in hyperinflationary countries; retirement plans; and segment financial reporting.

Plus, in several areas, Chinese investment-enterprise practices differ from more familiar International Accounting Standards Committee procedures or U.S. generally accepted accounting principles. These include:

* Marketable securities. These are reported at historical cost.

* Financing leases. There's no mention of applying present-value concepts like capital-lease treatment to the asset and obligation. The cost is generally stated in the lease. The interest component of payments may not be recognized under current regulations.

* Fixed assets. Interest on loans prior to placing the asset in service is capitalized. Ministry of Finance guidelines set methods (generally straight-line), salvage value and useful life. Foreign enterprises may use accelerated methods.

* Intangibles. Preoperating costs are deferred until operations begin and are amortized over five years or more. Other intangibles are amortized over their useful lives or at least 10 years.

* Investment in subsidiaries. The rules are flexible, but a 25 percent ownership triggers the equity method for foreign companies.

* Revenue recognition. This is often closely tied to cash receipts.

* Reserves and staff welfare costs. Reserves were frequently used under the socialist system to match sources and uses of funds and ensure the budget was spent. Foreign entities now follow familiar IASC/GAAP rules. Chinese and most foreign enterprises must deduct housing allowances and pension costs as well as any government-required reserves after taxes in the income statement.

- LEG and AHC 

Mr. Graham is associate professor of accounting and information systems at Rutgers University in Newark, N.J. Mr. Carley is practice professor of accounting at the University of Pennsylvania's Wharton School in Philadelphia.