The Wild, Wild East: Applying Management Accounting Practices in the Peoples Republic of China

B Y J O N A T H A N S C H I F F, P H . D . , C M A

FOR

MANY COMPANIES, BUSINESS IN

CHINA

REPRESENTS A NEW, EXOTIC, AND

OPPORTUNITY -LADEN FRONTIER.

OPERATING

IN THE COUNTRY , HOWEVER, PRESENTS

A NUMBER OF CHALLENGES AND RISKS, ESPECIALLY IN REGARD TO INTERNAL CONTROLS, THE FINANCE FUNCTION, AND TALENT MANAGEMENT.

n 2012, General Motors sold more Buicks in China than in the United States. The Made in China label increasingly and consistently appears on products in retail stores. Not only do large companies see opportunity in the Peoples Republic of China (PRC) as a site for production, but many small and mid-sized companies also see the country as a critical growth market for their products and/or services. In short, companies need to consider the PRC in their strategic business planning in order to be successful. Success in the country, however, comes with many unforeseen risks, challenges, and pitfalls. In this context, management accounting competence, capability, and acumen are critical parts of the equation that defines success in the PRC. Without a strong, reliable, high-quality management accounting infrastructure, risks to business success in the PRC grow to a level where the entire enterprise and its

investors can suffer. This article will examine findings from a small survey and follow-up interviews with finance leaders working for large multinational corporations (MNCs) that have significant operations in the PRC. The focus will be on internal control, finance, and accounting talent management issues, challenges, and practices. The research tackles the critical success factors associated with executing a winning plan for growing business profitably in the PRC. The results are from more than a dozen U.S.-based MNCs with significant operations in the country. In general, the top financial executive and survey participants have titles including country controller, country CFO, or country finance director. They work in the PRC as expatriates, or expats, and originate from Australia, Europe, and the U.S. On average, they spend about three and a half years in the PRC on this rotational assignment.

M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY

19

WINTER 2013, VOL. 14, NO. 2

INTERNAL CONTROL ISSUES

The internal control environment in the PRC is significantly different and more challenging than in the U.S. The PRC government is still evolving in its role of formulating, legislating, and enforcing rules that support strong internal controls and consequences of not having them in place. Understandably, the legal system for business is in a maturing state and improving, albeit slowly. One MNC financial executive based there said, In the PRC, there is laser-beam focus on execution without the checks and balances we have elsewhere around the world. Additionally, the baseline sophistication of Chinese employees is spotty at best when it comes to business law and, specifically, internal controls practices. What we have become conditioned to expect is not often a part of ingrained manager consciousness in the PRC. The Chinese employees who work for the MNCs we surveyed lack the sophistication of previous generations in understanding what is expected in the workplace from behavioral and cultural standpoints. In secondary and tertiary PRC cities, where growth and opportunity are often strongest, local general managers frequently act as autocrats, and their decisions are rarely challenged. This culture can result in increased instances of local management control override as well as ethical and integrity issues. If management override practices are allowed to grow in frequency, the quality of internal financial controls can be impaired, which leads to financial statement misstatements, increased risk, and significant legal exposure. This effect is reminiscent of behavior in the U.S. before the reform of internal controls following the recommendations of the Treadway Commission, where tone at the top was a focal point, as well as the impact of the Sarbanes-Oxley Actparticularly Section 404, which requires management to report on its responsibility for maintaining adequate internal control over financial reporting and for the CEO and CFO to sign off on that report. An example of weak internal controls among MNCs in the PRC is the significant incidence of fraud with regard to expense reimbursement. What makes it risky and challenging to deal with from a management standpoint is the relatively high frequency of fraud involving

small amounts of money. Another risk is the rapid change in regulations for businesses and the inconsistent enforcement by local government officials. A key guanxi (relationship) sometimes trumps the law. This cultural effect manifests itself in crucial financial reporting practices. For example, revenue recognition is a particularly sensitive issue for some companies. Local general managers are wont to recognize revenue too aggressively in order to meet the numbers that drive their incentive compensation and individual reputation. This issue is made more challenging because of the subtleties, inconsistencies, and vagaries of contract law in the PRC. Precipitous changes in local tax law cause MNCs in the PRC to move headquarters or operating facilities rapidly. Some of the MNCs we surveyed have moved more than once over the last five years. These relocations are often very lucrative in regard to tax-law compliance and cash flow, but they drive hidden costs of stress, disruption, and discontinuity. In one of our surveys, we asked MNCs to rank their top risks in the PRC: 1. Questionable paymentsPayments to local officials by companies are not uncommon in the PRC. To mitigate this significant risk, MNCs must increase education, communication, and vigilance with respect to the Foreign Corrupt Practices Act (FCPA). Compliance is crucial. 2. Use of agentsThese well-connected players are often used to facilitate negotiations with governmental agencies related to regulatory compliance, including tax. 3. Expense reportingThe high levels of employee churn and low dollar value of specific instances of noncompliance with guidelines make it difficult to manage the risk of fraudulent expense reporting. 4. Tax complianceComplexity, dynamic change, and multiple jurisdictions make this a challenge to execute efficiently and effectively. In addressing some of these issues, companies have found that even if their finance and accounting staff in the PRC speak English, it is critical for understanding and change that careful and faithful translation into Mandarin (or Cantonese) is required for internal controls training. This is particularly important for the nonac-

M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY

20

WINTER 2013, VOL. 14, NO. 2

counting and finance headcount whose English skills may be weaker than those of their management accounting colleagues. Case studies rooted in Chinese culture, issues, and environment can be helpful to improve understanding during training, but very few are available.
I N T E R N A L AU D I T I S S U E S

Internal audit is another key aspect of the internal control puzzle. Like elsewhere in the world, internal audit practices are not consistent in terms of mission and focus. It is interesting, and perhaps ironic, that much effort is spent on defining the role and responsibilities of the independent audit function, but, in contrast, there is virtually no parallel standardization with respect to how the internal auditors should spend their time. Some PRC-based internal audit groups within an MNC spend 60% of their time on financial auditing to support independent auditors. In contrast, other MNCs operating in the PRC spend up to 60% of their time in an operational audit role driving efficiency and effectiveness goals. Given the importance of internal audits role in the context of the overall internal control structure, it may be more important to design an internal control function for the PRC that is aligned with the specific risk profile for company operations in the PRC than to just emulate and extrapolate what the internal audit staff does elsewhere in the world. This differs in particular from the internal control environmental perspective. We expect more than 7% growth this year in the PRC. In more than one sense, much of the PRC is a highly competitive, untapped market. These effects result in a riskier environment that can really make it the wild, wild East! James Doty, chairman of the Public Company Accounting Oversight Board (PCAOB), alludes to this in his quote from the August 17, 2011, edition of Hedgeworld News when he talks about possible joint ChineseU.S. inspections of Chinese audit firms: Chinese companies have been punished in capital markets because investors have no way of knowing whether audits can be relied upon, and Chinese regulators realize inspections [by the U.S.] would be mutually beneficial. This effect has placed increased pressure on the

internal audit function and management accountants who view the independent audit function as part of a broader internal control structure. Unfortunately, when it comes to interrelated facets of internal control, you are only as strong as your weakest link. From a finance and accounting organizational perspective, the reporting line for the PRC-based finance leader is an important element in the internal control structure. Most finance leaders within an MNC in the PRC report directly to the country manager or general manager (see Figure 1). According to the respondents, this reporting line enables responsive decision making in a rapidly evolving business environment. Interestingly, survey respondents reported risk mitigation and control, as well as the flexibility to act quickly and decisively, as priorities in organizational design.

Figure 1: Reporting Line of the

PRC Finance Leader

56%
General Manager

22%
Regional or Corporate CFO

22%
Dual Reporting

PRC Finance Leader

FINANCE

AND

A C C O U N T I N G TA L E N T

DEVELOPMENT ISSUES

As in the rest of the world, finance and accounting functional performance in the PRC depends on the quality of the people who serve under the CFO section of the organizational chart. When seeking to operate and grow in the PRC, there are several issues that organizations should consider: 1. Chinese finance and accounting professionals often do not have the type of traditional loyalty to employers that is more common in the U.S. and Europe. This is a result of growing opportunities for experienced talent, especially those with MNC experience in significant operations in the PRC. Also, very aggressive global entities always offer bigger and better

M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY

21

WINTER 2013, VOL. 14, NO. 2

deals to key finance and accounting staff. Therefore, it is imperative for MNCs to have an effective strategy to retain key and high-potential finance and accounting staff, particularly those proficient in tax, financial reporting, and transfer pricing in the PRC. To address this effect proactively, some of the top MNCs in the PRC go to great lengths to engage, develop, and build positive, close relationships with staff. 2. For younger finance and accounting staff, domestic university preparation for the working world is often lacking. First, the academic instructors in the PRC are often insulated from the real world. As a result, students depend on textbooks and case studies largely written by U.S. authors. Students graduate armed with a variety of technical skills but lack the savvy, exposure, and context to interact effectively in the business world. Second, graduates often lack the soft skills (such as influencing, active listening, and emotional intelligence) that are critical to becoming an effective business partner. They are often in need of significant orientation to work in the global business world that is appropriate for them and addresses the specific needs of this population. 3. New hires in the early career stage of finance and accounting are recruited from a variety of sources (see Table 1). Students in the PRC choose undergraduate programs based on the integration of company internships into the program. According to the MNCs in the survey, the primary new-hire strengths were: N Analytic ability, N Enthusiasm, N Strong work ethic, N Increasing proficiency in English, and N Superior motivation. In contrast, new-hire weaknesses cited most often were: N Overly ambitious, N Unrealistic expectations, and N Absence of influencing skills. Respondents indicated that Chinese finance and accounting staff are generally hardworking, possess many admirable values, and are eager to learn. This domestic talent will eventually provide a reliable

Table 1: Sources of New Hires for

MNCs in the PRC

Undergraduate Large CPA Programs Firms 44% 32% Other MNCs 23% Graduate Programs 1%

human capital pipeline of finance and accounting leaders to serve in the PRC. 4. Location of workplace is also a very important consideration for younger staff. The strong preference is to work near ones ancestral home for a variety of deeply seated cultural preferences, including family and marriage. As a result, the idea of moving younger staff around the country and the broader Pacific Rim region every two to three yearsas is common for high-potential staff in other countriesis more challenging in the PRC. This should change over time. 5. A multiyear job rotation in the PRC has emerged as the golden ticket for high-potential staff at many global companies. It is hard to imagine the next generation of senior corporate executives at MNCs not having hands-on experience there. As a result, companies need to rigorously plan these rotations of serious strategic and competitive value. Additionally, and not surprisingly, a European or U.S. rotation for Chinese managers is equally critical in building bench strength and effective succession planning for the next generation of financial and business leaders. Multinational companies selecting their management accounting leader, with titles such as PRC-CFO, PRCcontroller, or PRC-finance director, for a rotational assignment in the PRC should consider the characteristics of the right person for the job. The right person, who is often one of the highest-ranked, non-Chinese employees on the management team, needs a very strong and diverse skill set including, but not limited to, the following: 1. Deals effectively with ambiguity; 2. Possesses strong people skills; 3. Learns quickly; 4. Embraces change; 5. Leads by example;

M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY

22

WINTER 2013, VOL. 14, NO. 2

Figure 2: Issues Impacting Management Accounting in the PRC

Opp o

rtun ity R ich n

nt Tale ess

rn Chu

Control Environment

Management Accounting Roles and Responsibilities in the PRC

Strategic Importance

tura Cul

rs cto l Fa

Reg ula t and ory Co Acc mple ele rati xity, A ng C mbi han guit ge y,

6. Promotes teamwork; 7. Deals effectively with complexity; 8. Communicates, educates, and influences

purposefully; 9. Listens actively; and 10. Thinks strategically.

U N D E R S TA N D I N G
THE

RISKS

This article has outlined findings pertinent to organizations considering building or expanding business operations in the Peoples Republic of China. Figure 2 provides a glance at many issues that have been analyzed here. The diagram provides a view toward summarizing, identifying, and understanding some of the risk areas associated with building business in the PRC and how the management accounting community can support the successful realization of objectives and goals in this exciting, dynamic, and opportunity-rich

market. A sophisticated, realistic, and sober view of business opportunities in the PRC can evolve directly from understanding a variety of management accounting issues and practices as they are currently evolving there. Our roles as management accountants are pivotal for companies to take advantage of the growth opportunities in the PRC and more broadly in the Europe, Middle East, and Africa (EMEA) region. We have the tools, influence, and integrity to help assure management that our new ventures will come to fruition profitably as part of the strategic planning process. I Jonathan Schiff, Ph.D., CMA, is a professor of accounting at Fairleigh Dickinson University. He also advises large global organizations. Jonathan is a member of IMAs Bergen-Rockland-Meadowlands Chapter. He can be reached at schiff@fdu.edu.

M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY

23

WINTER 2013, VOL. 14, NO. 2