China WFOE Maintenance and Compliance Guide (12) – Statutory Audit of the Financial Statements of WFOE and RO in China

Statutory Audit in China

Under current legislation, all Foreign Invested Enterprises (FIE) such as Wholly Foreign Owned Enterprises (WFOE), Joint Ventures (JV), and Representative Offices (RO), are required to be audited on an annual basis. This statutory requirement has to be met prior to business license renewal every year.

The deadline for the filing of annual audits is by the end of April of the following year (ie: your 2007 audited accounts must be filed latest by April 2008). FIEs can only distribute and repatriate their profits back to their home country after the annual audit and settlement of their relevant income tax liabilities.

Annual audit of FIE statutory accounts must be conducted by a firm of Certified Public Accountants registered in the PRC under PRC regulations. Previously, only local Chinese CPA firms were permitted to perform the audit function, and international accounting firms were not allowed to enter Chinese audit field directly. Since 1992 international accounting firms were given permission to establish joint-venture accounting firms with local practitioners.

What are the key areas of annual audits?

When a CPA performs an annual audit, in deciding on the appropriate audit procedures for income statement and balance sheet accounts, the auditor should assess the risk of error and fraud in those accounts. What are the key areas they are most concerned about ? We can divide this into three areas:

How to present profit?

The sales figure is a critical part of a review. Usually the following issues are the control objectives: Sales cut-off check ensures that all valid sales are shipped, recorded and properly billed; customer contracts are properly setup, approved, invoiced, priced and executed; pricing is accurate, updated and monitored by management; and gross margin is appropriate on all sales transactions.

How to present cost?

Cost of sales/revenues should represent all transactions for products shipped or services provided during the year and be properly recorded. This requires a thorough costing system review. Since this is a complex issue, please contact us over this matter if you are experiencing difficulties.

What are the revenue & cost accruals?

Expense / cost is not recognized on a cash flow basis, but at the time of its contribution to revenue. A cut-off test is often employed to check if revenue and cost are properly accrued at the year end.

These concerns are based on one important accounting principle – prudence. Recently, there is a developing trend of FIEs, instead of recording profits, reporting a loss. With this growing, the tax bureau and government are devoting more effort in auditing FIEs. As a result, if a company reports profits below the industry average or is in deficit in consecutive years, the auditors will monitor the possibility of any potential attempt to conceal profit to evade taxes and will evaluate transfer pricing issues within related party transactions.

Another issue that needs to be catered for, especially for 2003 audits is that in line with China WTO agreements, the PRC Central Government promulgated its “Revised Uniform Accounting System” and “Basic Accounting Standard for Foreign Investment Enterprises” at the beginning of 2002, which effectively brought a new accounting system into China. Companies should adjust their accounts when there is a conflict with the new standard. For further information, please contact our pertinent regional office for detailed advice.

How to prepare for the annual audit?

Conducting a sound internal review prior to annual audit is a good idea. Make sure your bank reconciliation report is completed for bank accounts, that petty cash has no major discrepancies, and conduct a complete check of accounts receivables and accounts payables. An overall inventory stock take at the year-end is also a must for manufacturing entities.

The company should review its financial policies, such as depreciation method, costing system, pricing policy, not only for the purpose of annual audit, but also for good future internal management.

Please have all these following available for the auditor before they arrive:
Accounting Vouchers, Account Books, Warehouse Records, Financial Statements, Tax Filing Records, Bank Statements, Invoices, Contracts, Vendor Statements, and other relating document and reports. If you can check some of these items yourselves prior to audit, you may well pre-identify some problems themselves.

How are representative offices audited?

All representative offices (excepting those that have tax exempt status) should be audited by a Chinese CPA each year.
Because ROs taxable income is determined by three methods: the cost-plus method, the actual revenue basis, and the deemed commission method, these different areas will be monitored by the auditors for the purposes of adjusting the taxable income of the representative offices as follows:

1) The Cost-plus Method

The Cost-plus method is popularly used to calculate the deemed taxable income. All expenses incurred by or related to the representative office must be included in the office expenses to calculate the deemed taxable revenue (deemed taxable revenue = office expenses / 85%). The expenses include the rental, transportation, telephone, salary, office purchases, entertainment, etc., regardless whether they are paid from the RO or directly from its head office. Our clients often put forward questions such as “If the office rental or salary of the expatriate is paid by the head office, should they be recorded as the expenses of the representative office?” Undoubtedly, they are the expenses of the representative office. Another notable point are salaries paid to resident Chief Representatives – instead of paying part offshore and part in China, the entire salary of the Chief Representative or Representative should be included in the representative office¡¦s expenses, regardless whether he has traveled to China.

2) The Actual Revenue Basis

Detailed contracts signed between the head office and its affiliate company showing the commission rate or detailed service fee amounts and other documents should be provided to the auditors. The auditors will also investigate any undisclosed transactions to determine if there is further taxable income.

3) The Deemed Commission Method

All the contracts relating to the agency services performed in China should be provided. If the commission is not stated in the contracts, 3% deemed commission will apply.

Based on the adjustment of the taxable income in the audit report, the annual Business Tax (“BT”) and Foreign Enterprise Income Tax (“FEIT”) filing should be completed within four months after the end of the tax year. The Chinese tax year is a calendar year, i.e. from 1st January to 31st December. Please note in the event of delinquent of annual FEIT and BT filing and payment, a surcharge for overdue tax payment equivalent to 0.05% per day on the overdue taxes will be imposed.

After the tax authorities review the audit report and the annual filing returns, the tax authorities will issue a notice that either the representative offices should pay additional tax, is correct in it¡¦s calculations or is entitled to tax refunds.

How to choose an Auditor for Your China Operation?

Most small to medium FIEs are prefer having accounts audited by a reputable accounting firm with international standards, while at the same time, cost and benefit factor are also issues to consider.

In addition, in view of the complexity of the China tax regulations, it is recommended that foreign investors should keep themselves abreast of any new rules and the constant changes to these regulations. Your Accounting Firm should demonstrate a commitment and depth of knowledge to you as well as showing they are capable of understanding international business.

Representative Offices (RO) are one of primary, and least expensive mechanisms for the foreign investor to establish business in China. As such they are enormously popular, however, the tax treatment and related regulations to RO are quite different than that of Wholly Foreign Owned Enterprise¡¦s. (WFOE).

There have been recent changes made to tax regulations for Representative Offices. During 2003, The State Administration of Taxation (SAT) issued Circular (2003) No.28 in April, and the Beijing Local Tax Bureau (BLTB) issued Jingdishuifa (2003) No.333 accordingly. The new regulations were actually effective from July 1, 2003, although actioned immediately in Beijing there has been a timed approach to enforcing these on a national basis – however these new regulations will generally apply from 1st March throughout China so be prepared. Your tax consultant should be advising you, if not contact us.