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China SOE Accounting — BAAP Not GAAP Applies

If the last two years of crisis in investing in Chinese companies proves anything, it's that any Chinese company that pays more tax than it should, documents every transaction and practices the most forensic accounting methods is the one with the calmest, happiest investors. Such companies are very rare among the thousands invested in by private equity, and not very common among publicly-traded ones, if securities regulators in the US and Hong Kong are to be believed.

Chinese companies, especially private ones, live under a cloud of suspicion their books are cooked, while their auditors turn a complicit blind eye. While that cloud hovers, it will remain impossible for Chinese private companies in large numbers to successfully sell their shares to the public through an IPO. Chinese companies already listed are not much better off. For many, their share prices remain seriously depressed because of investor doubts about the accuracy of the financial accounts.

For PE firms, it represents a very painful dilemma. To have any chance to IPO, their portfolio companies will often need to pay more tax. But, doing so makes the companies less profitable and so much less attractive to the capital markets. Pay first and pray for an IPO later is pretty much the current PE exit strategy in China.

What a refreshing change, therefore, it is to encounter the financial accounts of a Chinese state-owned enterprise ("SOE"). By Chinese standards, their accounts are often clean enough to eat off. SOEs often seem to take pride in paying as much tax as possible. Rather than hiding income, they seem to want to exaggerate it.

Why do SOEs operate this way? It could be argued that tax-paying is their form of national service. Most SOEs pay no dividends to the state, even though the state is the majority, indeed often the 100% owner. Or perhaps SOEs are trying to set a righteous, though generally ignored, example of dutiful tax compliance?

In fact, the heavy and perhaps over-scrupulous tax-paying can also be seen as the result of a system of diligent, almost fanatical record-keeping practiced inside SOEs. Everything bought or sold, every Renminbi moving inside or outside, is tabulated by the SOEs large team of in-house bookkeepers. Note, I say bookkeepers, not accountants. An SOE has many of the former and few, if any, of the latter.

That's because SOEs also operate by their own set of accounting standards. I call it "Chinese BAAP", or "bureaucratically accepted accounting principles". This is, needless to say, as different from GAAP as any two financial tracking systems could possibly be.

Under Chinese BAAP, the purpose of the annual financial statement is to produce a record that bureaucratic layers above can use. This means especially the administrators at SASAC, the government agency that owns and manages most SOEs. SASAC's job is to make sure that SOEs are (a) increasing output while operating profitably; and (b) not engaged in any kind of corrupt hanky-panky.

Of the two, SASAC is probably more concerned that government property is not being pilfered, misappropriated, wasted or diverted to pay for senior management's weekend gambling junket to Macao. This isn't to say that such things can't occur. But, the accounting system used by an SOE is designed to be so meticulous, so focused on counting and double-counting, that bad acts are harder to do and harder to hide.

If I could bill out all the time I've personally spent during 2013 studying and complying with SOE payment procedures, I'd probably have at least 100 billable hours by now. I should bill the SOE for all this time, but figuring out how to do so would probably take me another 60 hours.

The main purpose of all the rules seems to be to keep a very solid tamper-proof paper trail of money leaving the SOE. This is a far cry, of course, from accounting, at least as its understood outside China. The way assets are valued, and depreciated, follows a logic all its own. One example: an SOE client of ours bought and owns a quite large plot of suburban real estate outside Chengdu. Its main factory buildings are set on top of it. The land is booked at its purchase price as an intangible asset on the company balance sheet. Under Chinese BAAP, this is apparently allowed.

To meet SASAC-imposed growth targets, SOEs are known to boost revenues through a kind of wash-trading. Profit isn't impacted. Only top-line. BAAP turns a blind eye.

Every SOE is audited once-a-year. Few private companies are. The main purpose of the audit is not only, as under GAAP, to determine accurately a company's expenses and revenues. It's also to make sure all of last year's assets, plus any new ones bought during the current audit year, can be located and their value tabulated.

From the standpoint of a potential investor, while the logic of Chinese BAAP may take some getting used to, an SOEs books can be understood and, for the most part, trusted. There should be little worry, as in private sector companies, that there are three sets of books, that sales are being made without receipts to escape tax, and that company cash flows through an ever-changing variety of personal bank accounts. SOE management, in my view, wouldn't know how to perpetrate accounting fraud if they were being paid to do so. They've grown up in a system where everything is counted, entered into the ledger, and outputted in the annual SASAC audit.

An investor who takes majority control of an SOE, as in the two deals we are now working on, would want to transition the company to using more standard accounting rules. It would also want the company to avail itself, as few seem now to do, on all legal methods to defer or lower taxes. In short, there is good money to be made in China going from BAAP to GAAP.