Implementing an Internal Control System for your China business
For many small to medium size companies in China it is difficult to
implement an efficient internal control system to eliminate the possibility
of corruption or fraud. But when executed correctly, these measures
can improve the internal control environment and help reduce
opportunistic behavior by employees and managers.
During the past few years, the Chinese government has tightened up their regulations on corporate corruption and has implemented new legislation to reduce fraudulent practices that might have been common in the past.
It may be tempting for some companies to try to avoid the heavy load of paperwork involved in processing employee expense claims as long as the amounts seem reasonable, but a strong internal control procedure and documentation leave managers in difficult positions to engage in corruption activities.
For firms with weak internal controls, it is hard to detect corruption risk and implement the necessary measures to avoid it. Generally, reimbursements are paid, though the process is not properly supervised. A lack of expense claim controls creates several risks including additional tax liabilities for the business, opportunities for employee fraud and uncontrolled budget spending.
Some companies are willing to take these business risks because it can be time consuming and costly to implement the correct internal control system. Nevertheless, there are simple but effective ways a firm can adopt to improve their expense claim process.
A better internal control environment has the potential to limit corruption activities, such as insider trading, fake fapiao submission or misappropriation of company’s assets. Internal controls can be integrated into daily operations and into the corporate culture. This type of corporate environment could reduce managers’ incentive to engage in misconduct. That is, a high-quality control environment establishes the importance of internal control throughout the firm.
Because of industry and firm characteristics, some companies are more vulnerable to fraudulent operations. Better internal controls will help businesses to identify corruption-related risks, while targeted control activities and supervision will hinder fraud at the early stage.
A control system requires companies to develop policies and procedures related to their various business activities. For example, better internal controls will pre-assess the main risks in addition to related party transactions and will implement a documentation procedure along the transaction chain; this will facilitate future double-checks.
Those procedures increase the possibility of detecting the misbehavior's of managers or employees. In addition, better internal controls make business transactions more transparent. Information transparency facilitates the monitoring of staff and the reduction of misconduct.
The monitoring measures of internal control systems require companies to supervise and separate the power of managers in the major financing and investing activities. This could reduce their ability and incentive to abuse their position for private benefits.
In China, some of the most common business risks can arise when expense claims fail to produce all the required documents to be deducted from a company’s revenue for Corporate Income Tax (CIT) purposes. This may result in the firm paying unnecessary taxes.
Additional tax liabilities can result when an employee is reimbursed without having the procedures in place to thoroughly check for supporting VAT fapiao. Incorrect fapiao information, missing supporting documents, such as contracts, and fake fapiao are some of the most widespread practices that can cause a company to increase their tax liabilities at the end of the year.
Foreign companies face mandatory annual tax adjustments by an external auditor, who will ensure that all supporting documents for employee expense claims are submitted. If any expense claims are found to be missing documents or unqualified, the business will not be able to deduct those expenses from its CIT. If expenses are staff’s personal expenditures, the company will need to pay individual income tax in addition to any fine for the tax shortage.
Another case of internal fraud or corruption is when an employee is given the authorization to make purchases on behalf of the company but uses this purchasing ability for his or her personal benefit. Generally, empowering managers gives the company the opportunity to run more efficiently. However, this requires employees to act with integrity and exercise their best judgement.
Without an internal control system for expense claim procedures, corrupt employees will try to claim fake fapiao, duplicate fapiao or fapiao that are irrelevant to business activity, for their own financial gain, and would probably go unnoticed after abusing their privilege.
In China, it is not uncommon for employees to try to fully utilize their travel budgets by collecting fapiao irrelevant to the business. Accountants and managers can identify bad actors by comparing the date on the fapiao with when it was uploaded to the system. Often, just having an internal control for expense claim procedures is a significant deterrent for fraudulent behavior.
Expenses incurred by employees have an impact on the management functions of an organization. These payments are often recorded by projects, cost centers and departments to measure the performance or profitability of an activity. It is easy for expenses to get passed as overhead without proper controls. This completely removes them from any kind of management metric used to oversee costs and grow the business.
When left unchecked, staff could abuse the lack of control and spend excessively on things such as travel, ultimately impacting the profitability of the company or a client. Most companies will set limits for employees depending on their seniority which allows them to exercise a degree of autonomy when on the job. This is both beneficial to the company and often essential for getting the job done.
The implementation of expense claim controls requires a company to execute steps in the process to evaluate employee’s activities systematically while still allowing them the autonomy to do their job.
It is essential to define staff member’s budgets and issue company policies regarding allowances for travel and other activities in advance and communicate them clearly. The organizational structure for authorizing expenses is meant to ensure that expense claim controls work.
Expense claim software can be used by managers to set soft limits for expense claims submitted by employees. This creates an alert if the staff exceeds their daily allowance or travel budget and requires special approval. In addition, employees should be required to submit supporting documents for business expenses. Generally, this is an official fapiao with the company’s correct tax information but could include contracts and other papers.
Depending on the type of company, the authorization of expense claims may require a manager’s signature and approval before they are processed by accountants. Managers are responsible for checking whether all expenses are in accordance with business activity and if the supporting documents are included before accepting the expense claim.
In some cases, managers or authorized persons approve expenses without carefully reviewing the expense claims, risking costly mistakes. There are several software tools that allow managers to do this type of administrative work efficiently and at their convenience, enabling them to perform the task more thoroughly.
It is crucial that employees provide the original fapiao and the supporting documents to the accountant for bookkeeping. It is up to the accountant’s discretion whether additional papers to establish the transaction legitimacy are required. Once the authenticity is confirmed, expense claims can be entered into the accounting system and become deductible for corporate income tax purposes.
Expense claim software allows accountants to efficiently scan the QR code on fapiao to check their authenticity and whether the fapiao has been claimed before.
In order to control cash flow and manage budget spending, managers and accountants should monitor the booking of expenses against the internal budgets set by management.
Exceeding deductible limits causes all expenses to incur additional 25% CIT. For this reason, accountants should be monitoring tax deduction limits for expense claims. Identifying this early allows businesses to control their spending and maximize their deductible amounts for a given period.
Once the expense claim is authorized, the expenses get submitted to accounts payable. The amount gets recorded in the accounts receivable and the accountant and manager then decide when to make payment based on the company policy and cash flow requirements.
There are software tools that help businesses implement the correct internal control system and facilitate the process of collecting documents and verifying their authenticity. This allows managers and employees to do their job properly, without additional and complicated paperwork.
For medium to small companies in China, it is important to evaluate and identify the corruption or fraud risks they face, and how they can reduce opportunistic behavior by employees and managers. Consulting with a financial professional on how to implement an efficient internal control system can assist in establishing the necessary measures to better manage these risks.
Should you have questions about implementing internal control systems within your China company, complete the below inquiry form with your questions and comments.
DISCLAIMER: All information in this article is verified to the best of our ability and is assumed to be correct at time of release; however, Woodburn Accountants & Advisors does not accept responsibility for any losses arising from reliance on the information provided within. The information provided is for general guidance and does not replace specialized advice.