Local idiosyncrasies in China to consider when creating an internal control system for your business

Though many foreign companies may feel it is easier to transplant

their own internal control systems to their China business without

making the necessary adjustments, they may find sooner rather than

later that cultural differences and a unique way of doing business in

the region can significantly complicate the process.

China has its own distinctive business nature, and simple cultural misunderstandings can lead to major difficulties. Issues that require an effective internal control system, such as corruption, labor disputes, tax liabilities and expense reimbursements, may be more complicated due to language and cultural barriers than in the investor’s country of origin.

In general, China’s legislative framework for internal control largely mirrors the equivalent legislation in the United States. However, specific legal features particular to China, such as company chops, need internal control systems that might not be utilized in most Western nations.

In practice, the internal control mechanisms to protect assets, smooth business operations and prevent risks used normally in other countries do not translate well into China operations. Foreign managers encounter many internal control problems on a regular basis.

Certain business operations considered low risk in other regions, end up becoming high risk in China because of its particular business culture. Those risks, which carry serious legal consequences for the company, can be easily overlooked by foreign managers.

The firm’s management should take into consideration the cultural and environmental differences when establishing an internal control system and limit the business risks in China. The core principles of internal control may not be too different, compared to other countries, but a special approach is required in China.

A unique characteristic of Chinese business is the company chops, also known as stamps or seals. Chops are used to legally authorize documents -the equivalent of a signature in the West- and are engraved with a company’s registered legal name.

A person who has possession of a chop usually exercises the authority to use it. The risk of misuse of company chops is rather high, and even if the intention is not malicious, it may lead to undesirable losses.

 

On the other hand, it is not uncommon for employees who suspect they will be terminated, to seize company chops as a bargaining chip for negotiating severance.

It is fundamental to establish security protocols to ensure chops are being used appropriately. One control is dividing responsibility for chops among key personnel, such as chairman of the board, as well as establishing a hierarchy of which senior management permits to use a given chop in the event that the regular holder is unavailable, and recording the time, date, and reason each time a chop is used or accessed from the company’s safe.

Some of the most vulnerable business areas to corruption and fraud are sales, billing, and collection because they involve the transfer of money and physical goods. It is crucial that the control process in those areas is efficient and thorough.

 

In small companies, sales are usually responsible for signing contracts. There is no separation of duties between salespersons and contract signers, where fraud can happen especially when revenue triggers a salesperson’s bonus.  A salesperson may choose to fabricate false contracts where the client of the contract does not really exist. An alert to check contract authenticity is when there is no payment received for a contract signed a long time ago.

Another area prone to vulnerability are receivables, a related part of sales operation. Receivables should normally be cleared on-time based on credit terms offered to your clients. However, in China, this is frequently not the case, as clients may deliberately delay the payment and irresponsible employees may choose not to follow up delayed payment as long as they get their salaries paid. It is not uncommon that receivables get aged for an exceptionally long period, enough to cause a liquidity problem.

Setting clear price ranges for different products is also important. Depending on the industry, some products may have a set price, while others may have room for negotiation. If this is the case, businesses should establish firm scales for which employees can sell a specific item, whether it is a certain range for all sales or different ranges based on the quantity sold.

The risk of corruption can be minimized during the sales process when there are clear price parameters, and an employee cannot offer a client a lower price for a product in return for a personal side payment or other favors.

In this circumstance, a possible control protocol could be to set a rule that senior management must first approve any sale outside of the standard price range. Companies should establish different credit limit thresholds for clients based on considerations such as their size and the length of the relationship, to avoid selling to an entity that will not be able to pay for the product.

Once executed, the employee responsible for the sale should provide the proper information to be added to the inventory, shipping, and invoicing processes. Businesses should record any item shipped out with the relevant invoice, as well as ensure that their financial accounts are consistent.

As with selling, companies should establish standard price ranges for purchasing processes. Companies ought to routinely compare the expected cost of the item with the actual cost, though the exact cost may differ when making the actual purchase.

When the price of an item is significantly higher than the estimated cost, this difference should be evaluated to determine whether the value was miscalculated, or if employees in charge of purchasing are invoicing falsely. To prevent fraud, steps in the purchasing process can be divided among staff.

In a perfect world, persons responsible for payments should be different from those physically receiving and handling the goods. Staff rotation is as well an effective way to avoid fraud risks.

Another common situation in China that could represent a fraud risk is the expense reimbursement process. In many cases, local employees tend to ‘use up’ all expense provisions by providing work-irrelevant fapiao. Even when there is no provision, some choose to claim improper reimbursement or submit fake fapiao.

Claiming expenses in the incorrect accounting period affects accounting reports and accuracy of cash flow budgeting of your business. Existing internal control procedures used in western countries for managing expense reimbursement are not sufficient to cover all those local intricacies.

This issue can be solved by analyzing and understanding your business historical data. Fapiao's should always be checked for validity based on predefined criteria.

There are mobile expense management applications, like “Xi Bao Xiao”, that managers can use to establish in advance a protocol for valid fapiao's. Only eligible fapiao's will be accepted and a predetermined amount will be set for claims. Any amount larger than the limit previously set, will need to be approved.

A company can require employees to upload fapiao's to the mobile application within 2 hours of issuance, leaving employees little room to collect fake fapiao's and claim expenses irrelevant to business activities.

Businesses in China, manufacturing ones in particular, should set in place systems to monitor and standardize inventory. Although most manufacturers have software to facilitate this process, inventory managers should still make physical checks to account for human error, fraud, and other mistakes.

For small and medium companies, especially those with overseas headquarters and small staff, internal HR controls are important. Relationships are a crucial part of the business culture in China and having trusted employees on the ground is essential. However, terminating an under-performing employee can be problematic.

When recruiting employees, firms should develop a thorough screening process to identify and hire strong candidates. As CV fraud is more common in China than in the West, including fake or exaggerated university degrees or work experience, managers responsible of hiring should conduct background checks on potential candidates to ensure their legitimacy.

Another key HR control point is the administration of labor contracts. HR managers should not only pay close attention to the effectiveness of the contract clauses, but also make sure the written labor contract is signed and renewed in time. For instance, an employee would be entitled to double salary if the labor contract is absent for one month. 

Establishing a business presence in China requires investors to pay close attention to the local idiosyncrasies. Developing an internal control system that takes into consideration the particular business culture of the country and the risks that are associated to the region will ensure the health and longevity of the company.

A strong internal control system should always include structural checks and balances to prevent risks and guard against fraud and corruption.

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.

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