The International

Journal of
Accounting

Auditing of State-Owned Enterprises in China: Historic

Development, Current Practice and Emerging Issues
Qingliang Tang,* Chee W. Chow,y and Amy Lauz
*University of Western Sydney, Nepean, N.S.W., Australia; ySan Diego State University, San Diego, CA,
USA; and zOklahoma State University, Stillwater, OK, USA

Key Words: Auditing; State-owned enterprises; Reform; China

Abstract: State-owned enterprises (SOEs) play a pivotal role in the Chinese economy. Together,
they manage over 50% of China's national capital. With China steadily moving towards a market
economy, SOEs increasingly are given the latitude to seek external funding, develop joint ventures
and more generally, to operate without direct government involvement. This separation of
ownership and management, in turn, has increased the need to monitor and control China's SOEs,
and audits can play a key role in this oversight function. Despite the potentially important role that
SOE audits can play in safeguarding the interests of the state and external investors, there is a
relative dearth of research on the current state of, and challenges facing such audits. This paper
provides an overview of the historical development of the SOE audit by the Ministry/Department
of Finance, and current SOE audit practices performed by the State Audit Administration/Office.
The main conclusion of the study is that, with ownership of the SOE being further diversified and
the operation of the SOE being completely commercialized (i.e., without any political
consideration), the nature of the state audit office as a government agent is incompatible with
the role of independent auditor for SOEs. SOEs need a non-government third party to verify its
financial statements and audit its business activities to meet the information needs of diversified
interest groups in the SOE including the state, individual or institutional investors, creditors and
employees etc.

Audit of state-owned enterprises (hereafter SOEs) is an important issue. First of all,

China currently has about half a million SOEs (Wang, 1995), which employ more than
50% of China's national capital. Due to their size, SOEs play a significant role in the
Chinese economy. Secondly, from the early 1980s, with the enterprise reform program,
most SOEs have been given increasing autonomy to make business decisions without
substantial interference from the government (Chow et al., 1995; Chen et al., 1997). The
controlling role of the government has diminished and new forms of financial incentives
at the enterprise level have been adopted. One would expect that this change in the

Direct all correspondence to: Qingliang Tang, Lecturer in Accounting, School of Accounting, University of Western
Sydney, Nepean, N.S.W., Australia; E-mail: q.tang@uws.edu.au

The International Journal of Accounting, Vol. 34, No. 2, pp. 173±187 ISSN: 0020-7063.
All rights of reproduction in any form reserved. Copyright # 1999 University of Illinois
174 THE INTERNATIONAL JOURNAL OF ACCOUNTING Vol. 34, No. 2, 1999

organization structure of SOE (from a governmental agency to an independent business

entity) would have tremendous impact on the nature, objectives and procedures of the
auditing of SOEs. Thirdly, it is important because there exists a large amount of embezzlement
involvingSOEs1 andatleastone-thirdoftheSOEsarelosingmoney.Itisexpectedthatauditmay
resolveand prevent these problems, or at least control dysfunctional behavior in SOEs.
Despitethewidelyrecognizedrolethatauditsplayinassuringtheintegrityofaccountingand
financial reporting, only a few studies have addressed auditing issues in the Chinese context
(Huang, 1987; Lau and Yang, 1990; Skousen et al., 1990). While these studies have increased
awareness and understanding of the topic, limited discussion has been provided on the recent
SOEs' developments and reforms in China. Moreover, prior studies only covered general
issues of auditing, such as the auditing system (Huang, 1987; Lau and Yang, 1990), auditing
legislation and enforcement of law (Skousen et al., 1990), but did not attempt to discuss
specifically auditing practices of SOEs.
The primary purpose of this paper is to provide an overview of SOEs' auditing
practices, pre and post the restructuring of SOEs. In addition, it will examine the effects of
the change in the organization structure of SOEs on the nature of SOE's audit and the
issues encountering the audit profession in general.
The remainder of this paper is organized as follows. The next section provides
some background on the practice of auditing of SOEs prior to the SOEs' restructuring.
This is followed by a description of current practices of SOEs' audit, including some real
world examples. The next section discusses some recent developments and related
emerging issues in the audit profession. The final section provides a summary and
conclusion.

SOE AUDITING BEFORE RESTRUCTURING

Before the economic reforms in the 1980s, businesses in China were operated
and strictly controlled by governmental agencies (state or ministry levels). Operations
of SOEs were conducted according to state plans. The government and its agencies
retained all investment and operating decisions. The managers of these entities had
little incentive and managerial authority to enhance the efficiency of SOEs. SOE was
not regarded as a mere commercial organization in the sense that its objective was to
maximize profit. It was also considered as a quasi-government agent that was required to
pursue the broad social, political and economic objectives of the government. Some
examples of activities conducted by a typical SOE, which may not make business sense,
include:

1. Employment. Consistent with the policy of full employment of the government

before the 1980s, SOEs could not fire redundant or under-performing employees;
2. Production of unprofitable products. An SOE must manufacture products according
to the state plans even though there are no profits for such a product or service;
3. To run unprofitable operations, such as hospital, child care, employee accommoda-
tion, etc.
Auditing of State-Owned Enterprises in China 175

In such a planned economy and financial reporting environment, the main objective
of financial reporting was to provide financial information for the government to
formulate and enforce state economic plans and to control economic activities. In
addition to direct supervision exercised by the governmental unit directly superior to
the particular enterprise, the Ministry/ Department of Finance performed annual ``financial
examination'' of SOEs. Regular audit was not considered necessary under the planned
economy. In the case of central government-controlled SOEs, the Ministry of Finance
was responsible for such an examination (usually performed annually). For local SOEs,
the Department of Finance of a local governmental office is responsible (Lau and Yang,
1990).
The purposes of the financial examination were:

1. to ensure the compliance of business activities with government policies, economic

law and regulation, tax rules or profit submission schemes;
2. to ensure the implementation of detailed state plans, such as production plans,
financial plans, quotas and so on;
3. to ensure integration of state assets and funds and the proper use of these funds.

The financial examination by the Ministry/ Department of Finance served as a

means of direct control and management of the SOE. This was appropriate, as the
cash flows of SOEs were part of the overall cash flows of public finance of the state.2
There was an overwhelming focus on compliance with certain economic and financial
rules and profit/tax submission rather than a verification of financial statements. As the
SOEs were under direct control of the government, there was no need for an independent
audit of financial statements by a third party who provides an independent view as to
whether the financial statements are true and fair. Prior to 1980, independent audit did not
exist.

THE MAIN FEATURES OF SOES AFTER RESTRUCTURING

It has been generally agreed that the government's direct control and management of
SOEs, together with other factors such as an over-centralized national economy, result in
poor performance of SOEs (see, e.g., Tang et al., 1996). In the early 1980s, the
government began reforming the SOEs. The objective of the SOE's reform was to
rejuvenate the SOEs by giving more and more autonomy in making economic decisions
and providing financial incentives to managers and employees of SOEs. Two major
reforms have been adopted for SOEs. They are the contract responsibility system (CRS)
and corporatization.
Under CRS, while the government retains the ownership, the SOE is subcontracted to
selected individuals (managers) to independently run the firm. The managers are rewarded
if the operating targets set in the contract are achieved. The financial incentives for
managers include sharing of the profits in excess of the targeted amount. Unfortunately,
the CRS has not been successful in improving the economic efficiency of SOEs. Liu and
Zhang (1996) discuss several factors contributing to the inefficient and unprofitable
operations. Consequently, the government intends to replace CRS by corporatization.
176 THE INTERNATIONAL JOURNAL OF ACCOUNTING Vol. 34, No. 2, 1999

Corporatization refers to converting SOEs into companies with limited liabilities. After
restructuring, the SOEs would have the following features.

1. There is increasing degree of separation of management and ownership. Although

the government still retains ownership of an SOE or may have majority shares,
there is no longer direct control over the SOE by the government. Most SOEs are
becoming profit centers and investment centers. The decision power now is in the
hands of the SOE's managers or the board of directors.
2. Except for large and key SOEs, operations of most SOEs are no longer subject to
state plans. Rather, profit is the primary goal and is becoming a key criterion to
measure performance.
3. SOEs are now operating in freer markets and are subject to market forces. The
government no longer guarantees a market for an SOE's products and has stopped
subsidizing losses incurred in SOEs. In other words, SOEs have to bear the full
consequences of their operation and investment decisions.
4. The reward of the manager is often directly linked to the performance of the SOE.3
Accounting information is widely used to measure performance.4
5. There is no market for stocks issued by most SOEs. Only a small number of
SOEs are listed companies whose shares are traded on a stock exchange. For
other SOEs, the value of the firm cannot be determined in a free market.
Merger and acquisition of SOEs is not a common practice as there are political
restrictions (e.g., unemployment, transfer of public ownership) as well as tech-
nical problems (e.g., no independent assessors for properties, intangible assets,
etc.).

Although the abovementioned reforms have improved efficiency of SOEs (Chang,

1997), new problems have emerged. One of the problem is the self-serving management.
Xiang (1998) states that

[a]s a result of these profound changes, China's large SOEs, either corporatized or still
under the CRS, now significantly resemble modern corporations in the West in that the
SOEs are characterized by a high degree of managerial authority and a separation of
ownership from control. As a consequence, potential agency problems have emerged.

The agency problem is more serious among the SOEs' managers as the incentive
system is short-term oriented. Their primary financial reward system is linked to the profit
performance. As these managers are not allowed to own shares in the SOEs they managed,
there is no long-term incentive.
After restructuring, without direct control and without involvement in day-to-day
management, the government has to rely on the SOEs' financial statements to make
decisions. However, there are growing incentives for the manager to manipulate the
financial information. The manager may inflate the profits to their benefit or provide false
financial statements to conceal embezzlement and other irregular behavior. The financial
statements provided do not represent the true and fair state of SOEs. As a result, relying on
these misleading or false financial information may lead to serious consequences, such as
Auditing of State-Owned Enterprises in China 177

the loss of state funds, the wrong assessment of managers, and the formulation of incorrect
economic decisions and policies.

CURRENT AUDITING PRACTICES OF SOES

Establishing State Auditing Offices

Due to the narrow focus of the financial examination by the Ministry/Department,

these management problems could not be discovered or resolved. By and large, audits
by the Ministry/ Department of Finance tended to be concerned with uncovering taxes,
profits and charges that should be submitted to the government but still retained in the
enterprise (State Council of China, 1986). In addition, there was a lack of independence.
The Ministry/ Department of Finance might have financed the SOE and have been
involved directly or indirectly in making business decisions. They have to consider their
interest when performing the financial examination. Consequently, the examination might
be biased as the examiner has a strong and direct interest in the revenue outcome of the
audit. There are anecdotal stories that some departments of finance would not correct
accounts as long as they achieve the budgeted revenue collections for the current year,
leaving the (uncorrected) detected errors as a hedge for attaining future years' collection
targets.
In responding to these changes resulting from SOE restructuring and particularly in
recognizing the need for a more independent auditing organization, the Chinese Constitu-
tion was amended to create state auditing offices (Audit Administration or Audit office),
and to charge it with this responsibility. Article 91 of the Constitution (1982) states that:
``The State Council establishes an auditing body to supervise through auditing the revenue
and expenditure of all departments under the State Council and of the local governments at
different levels, and those of state financial and monetary organizations and of state
enterprises and undertakings.'' Article 91 also states that: ``Under the direction of the
Premier of the State Council, the auditing body independently exercises its power to
supervise through auditing in accordance with the law, subject to no interference by any
other administrative organ or any public organization or individual'' (emphasis added). In
1983, the Audit Administration under the State Council was officially set up according to
Article 91 of the Constitution. This signaled the beginning of modern state auditing in
China. After that local state audit offices were also established. On 30 November 1988, the
State Council issued the ``Auditing Provisions of the People's Republic of China,'' which
was effective on and from 1 January 1989. As described in Lau and Yang (1990), the 1988
Audit Provisions strengthened the line supervision of the auditing organization structure
and eliminated the dual leadership problem encountered by the state auditing offices. In
addition, the state auditing offices were permitted to establish an internal audit department
or standing agency to perform audits on their behalf.
On 31 August 1994, replacing the ``Auditing Provision,'' the Standing Committee of
the People's Congress adopted the Auditing Law of the People's Republic of China, which
was effective on 1 January 1995. The Auditing Law reinforces the roles and responsi-
bilities of the state audit office. It prescribes the scope and procedure of auditing of SOEs.
More specifically, Auditing Law (Articles 2 and 20) states that the state audit office should
178 THE INTERNATIONAL JOURNAL OF ACCOUNTING Vol. 34, No. 2, 1999

audit financial revenue and expenditure, assets, liabilities, profits and losses of SOEs. In
addition, due to the vast number of SOEs, the Law (Article 21) focuses on the audit of
those SOEs that are considered essential to the national economy (e.g., energy, transporta-
tion, communication, airlines, steel, electricity, defense, hi-tech, and food) and those
enterprises that received large financial subsidies from the government.
Basically, auditing by the state audit office involves the evaluation of the fiscal plans
implemented, reviews of the revenue and expenditures, and assurance of compliance with
the state's financial and economic guidelines, regulations, rules and disciplines (Huang,
1987). Under the Auditing Law of the People's Republic of China, the main objectives of
an SOE audit can be summarized as:

1. Assessing whether the financial revenue and expenditure are true and correct;
2. Assessing whether the transactions and business activities that give rise to the
revenue and expenditure are conducted in accordance with financial and economic
laws and regulations; and
3. Assessing whether public funds are used effectively and efficiently.

In practice, while the last objective is explicitly stated in the Auditing Law (Article 2),
its implementation is hampered by the lack of specific criteria for measuring effectiveness
and efficiency. It is also difficult for the state audit office as a government agent to make
judgment about SOE business decisions and activities in terms of effectiveness and
efficiency.
The approach for the auditing of SOEs involves the following (Lau and Yang, 1990):

1. Auditing agencies submit their annual plan and work report to their respective
controlling governmental units;
2. SOEs submit their financial revenue and expenditure plan, credit plan from banks,
budget, final accounts and statements etc., to their respective auditing agencies;
3. Audit agencies submit the audit reports including SOEs' comments to their
respective controlling governmental units;
4. When disagreeing with the audit reports, SOEs could appeal and request to be
reaudited;
5. When disagreeing with the reauditing conclusions and decisions, SOEs could
appeal to a court.

A real case is provided in Appendix A as an example of a typical SOE audit report by

the state audit office. The names of the office and the SOE have been disguised. This
report illustrates the main purpose, scope and conclusion of an audit conducted by a
provincial state audit office. It also shows the following required components of an audit
report:

1. Details of audit findings;

2. Whether the auditee has admitted the problems (if not, then the details of
disagreement should be indicated);
3. The auditor's opinion as to how to treat the case, indicating what are the
responsibilities of the people involved, and suggestions for improvement;
Auditing of State-Owned Enterprises in China 179

4. The organizations that will receive the audit report. The main receiving organization
is generally the one which had authorized the audit. (In this case, it was the Office
of the People's Government of the Province.) The audit report also may be copied
to other governmental bodies, such as the higher authority in charge of the auditee.
(In this case, it was the Bureau of Industry of the Province, the Bureau of
Supervision of the Province, and the Bureau of Finance of the Province.)

Under the Auditing Law, the state audit office does not have the authority to take direct
actions against the auditee. Rather, its audit decisions are viewed as recommended
treatments for the case (Auditing Law, Articles 34 and 35). Generally, penalties for
wrong-doings are of three major types: (1) Economic penalties, such as resubmission of
profit, confiscation of property, fines, and termination of funds and/or loans to the auditee;
(2) Administrative penalties, such as correction of accounts, sealing of books and
accounts, public reprimand, and removal from office for responsible persons; and (3)
Criminal punishment (Auditing Law, Article 47). This is also presented in the case (see
Appendix A for details of the case).
While the audit decisions must be implemented by relevant authorities, a report of the
implementation has to be submitted to the Audit Office. On receiving the report, the Audit
Office may conduct a follow-up audit to see whether the recommended actions have been
enforced (Guang, 1993; Wei, 1994).

Assessment of State Audit Offices

In contrast to the Ministry/ Department of Finance, since the state audit office is funded
separately from SOE, it has no direct economic interest in the SOE it audits or the outcome
of the audit. The state audit office appears to be, and is in fact, more independent than the
Ministry/ Department of Finance. As state audits are conducted under the Constitution and
a separate Auditing Law, they have a much stronger legal backing than financial
examinations conducted by the Ministry/ Department of Finance. Furthermore, state audit
offices also differ from the Ministry/ Department of Finance as they are not involved in the
formulation of financial and economic policies.
Since the establishment of state audit offices, many fraud and irregularities in SOEs
have been discovered. Wei (1994), in reporting the 10-year performance of the state audit
office, states that the state audit office discovered more than 25.8 billion yuan of funds not
submitted to the state, 28.7 billion yuan inappropriately used funds, 1615 corrupt cases
and 10,561 corrupt officials.
However, due to limited resources and the lack of qualified auditing personnel, the state
audit offices were only able to audit a small number of SOEs. Since the closure of private
and public accounting firms in 1958, all auditors have been government employees. There
were more than 3000 governmental auditing agencies and nearly 40,000 auditing
personnel in the early 1980s. As there were about 500,000 SOEs and approximately 2
million organizations subjecting to state audit offices' audits, only about 4% of these
organizations were being audited. In other words, some SOEs were not subjected to
appropriate supervision through the use of annual financial audit.
180 THE INTERNATIONAL JOURNAL OF ACCOUNTING Vol. 34, No. 2, 1999

Wei (1994) also indicated that the main concern of the state audit office was fraud and
irregularities rather than verification of financial statements. Furthermore, the priority of
state audit offices was the auditing of expenditure and income of the government
departments rather than audit of SOEs as a whole. This priority is consistent with Articles
2 and 20 of the Auditing Law which specify clearly the responsibilities of the state audit
office.
On the other hand, as the SOE is not a company that is governed by the Company Law,
it does not have to provide audited financial statements under the provision of the
Company Law. Only a relatively small number of SOEs have been transformed into listed
companies which were subject to the listing rules which require audited financial
statements. Consequently, for most SOEs, no formal audit of financial statements is
required and no independent opinion is provided as to whether these financial statements
are true and fair. Although there might be some tax audit from the Department of Tax, this
is only for tax purposes, and this audit is not intended to verify financial statements. Given
the relaxed requirement for the state audit office's audit and a strong incentive for the
managers to manage earnings,5 the financial statement figures are very likely to be
fraudulently manipulated6 and unreliable. Economic policy and decision based on these
unaudited financial statements may again have the same problems, which were encoun-
tered when the Ministry/ Department of Finance was performing the financial examination
as discussed in the previous section. In other words, the establishment of the state audit
offices did not overcome the SOEs' managerial problems.
As the state audit offices do not have sufficient resources to perform audit for all SOEs,
audit becomes highly selective. For those that are not selected, the audit office has no
responsibility for any failure of business and other problems such as misleading or
fraudulent financial statements. As a result, a state audit office may prefer to choose low
audit-risk SOEs and avoid high-risk SOEs.

FUTURE DEVELOPMENTS

Permitting CPAs to Audit SOEs

The above problems cannot be resolved simply by increasing the budget of the state
audit offices. In addition to the limited resources of the state audit offices, there is a
fundamental conflict between SOEs after restructuring as a commercial organization and
the state audit office as a government agent. Given the position of the state audit offices,
they are unlikely to provide unbiased views and to perform appropriate verification of
financial statements and business activities.
With further economic and enterprise reforms, the general structure of SOEs would
lead to:

1. further separation of management and control;

2. further diversification of ownership;
3. more transferable ownership;
4. increased degree of commercialization of the business operations.
Auditing of State-Owned Enterprises in China 181

Diversification of the ownership of SOEs would be inevitable. The Chinese govern-

ment encourages other investors to purchase SOEs' stocks. Some SOEs have already
transferred share ownership to individual, institutional and foreign investors. As a
result of diversified ownership, there will be other users of financial statements, such
as non-governmental investors, commercial banks that are also becoming independent
from the government direct control, employees and unions. Before restructuring, jobs
were guaranteed in SOEs. Salaries and wages were fixed and not adjusted according
to SOE performance. Consequently, employees were rarely interested in financial
position of SOEs. However, this is no longer the case. Employees and trade union
can invest in SOEs and are becoming interested in the financial statements issued by
SOEs.7
However, to develop the users' trust in the SOE's financial statements, independent
audits have to be performed on these financial statements. The independent audit
professions, which can provide unbiased views on the financial reports have to be
established. The state audit office cannot perform an independent audit due to its
relationship with the state or central government. It can only represent the interest of
the government and cannot represent interests of other investors and interest groups in the
SOE. Therefore, audit of SOEs by the state audit office would reduce the credibility of the
audit reports perceived by non-government users.
Further market reform would cause the operation of SOEs to be completely commer-
cialized, i.e., the business activities are not subject or linked to any political consideration
and state social and economic policies. Consequently, any form of governmental inter-
ference with business activities, including state auditing, would be viewed as inappropri-
ate. There are some well-publicized cases that audits by the state audit office were highly
politically motivated. The state audit office might be under political pressure when
performing the audit and its independence might be compromised.8
It is argued that SOEs should be audited by a non-government third party. The existing
Chinese certified public accountants (CPAs) can take over the audit for all SOEs. The
Chinese CPA system was revived due to the economic reform (Huang, 1987). The roles
and responsibilities of CPAs and CPA firms are defined in the 1993 Law of Certified
Public Accountants. CPA firms were employed for doing assets valuation and annual audit
for Sino ± foreign joint ventures, companies and occasionally some SOEs assigned by state
audit offices. The laws, however, are silent on requiring all SOEs, especially those not-
corporatized, to be audited by CPA firms. If the CPAs' audits can be required and extended
to all SOEs, the following benefits may be realized.

1. The audit reports issued by CPAs may have more creditability, as the CPAs are
viewed to be more independent and are subject to less political pressure than a state
audit office.
2. A CPA firm is more likely to add audit value to the business of the firm as the audit
would be conducted from a pure business point of view.
3. It is unlikely that the budget of state auditing services would be increased
significantly and the limited resources of the state audit office may be used more
efficiently and effectively by focusing solely on governmental departments'
expenditures and income.
182 THE INTERNATIONAL JOURNAL OF ACCOUNTING Vol. 34, No. 2, 1999

4. All SOEs would be subject to audit, either by CPAs or Certified Public Auditors
(some Chinese CPAs are called ``certified public auditors'').
5. The substantial SOEs' audits could strengthen the development of the auditing
profession in China.

However, there are a number of problems that should be resolved regarding the audit of
SOEs by CPA firms. First, CPA firms should be de-affiliated from any governmental units.
As most CPA firms are historically affiliated with governmental or educational institu-
tions,9 there is a concern of whether the CPAs are really independent when performing the
SOEs' audits (and other audits as well). The affiliated relationship may affect the CPAs'
judgment and decision and create a perception of lack of independence. The de-affiliation
is required and it is expected that all de-affiliation should be completed in the near future.
However, as the process has been very slow,10 it is suggested that only de-affiliated CPA
firms should be allowed to do audit for SOEs. Second, CPA firms should develop auditing
standards about regulation compliance audit.11 This is because the traditional role of the
CPA audit is to verify the financial statements rather than discover fraud and irregularities
which is an important part of the audit of SOEs. The current professional auditing
standards appear inadequate to guide the latter audit.12 Third, audit of SOEs is a
potentially huge market and is a real challenge to CPA firms. More qualified and well-
educated professional accountants are needed. This is crucial to strengthen and to improve
credibility of SOEs' audit. The target may be achieved by professional and educational
efforts, government support and other means, including the cooperation of the interna-
tional accounting community such as the Big Five accounting firms and the International
Federation of Accountants.
In addition, the following revisions of the 1994 Auditing Law and the 1993 CPA Law
and the professional auditing standards regarding SOE audit are required.

1. Revision of Article 91 of the Constitution and Articles 2 and 20 of the Auditing

Law. Such a revision would indicate, to the effect, that the financial statements of
commercial SOEs (i.e., those that have a separate legal entity status) should be
audited by a non-government third party (i.e., CPA firm).
2. Revision of the provision in the Auditing Law about economic and efficient
auditing. Economic and efficient auditing, if it is done correctly, can be very
beneficial to the audited organizations. However, there is a lack of clearly defined
criteria to perform and evaluate this type of audit. The law should be revised
to provide guidance and criteria for performing the economic and efficient
auditing.
3. Revision of the CPA Law. Under the 1993 CPA Law, a CPA firm has no
responsibility to undertake an audit of SOEs. A provision should be incorporated
regarding audit of SOEs by CPA firms. In addition, it should specify the objective
and basic procedures of SOEs' audit. Furthermore, the principal role and
obligations of a CPA firm for such an audit need to be stated.
4. Revision of auditing standards. Current auditing standards should also be revised to
guide the practice of SOE auditing. The main changes would be those regulations
relating to compliance test procedures (beyond financial statements).
Auditing of State-Owned Enterprises in China 183

SUMMARY

This paper has provided an overview of the historical development and current practices in
the audit of China's SOEs, and offered some observations on current developments and
future challenges. The relationship between the SOE after restructuring and the state audit
office is also examined. It is obvious that developing a uniform and high level of audit
assurance for China's vast number of SOEs in particular, and its economic institutions in
general, will be a most challenging undertaking. Among the issues that need attention are the
development of a sufficient number of trained auditors and accountants, uniform audit
standards, and an institutional framework to support the auditors' exercise of independent
judgment.

LIST OF RELEVANT CHINESE ECONOMIC AND FINANCIAL LAWS AND REGULATIONS

Audit Administration. 1986, Notice of the Audit Administration on Audit of Economic

Responsibility of Head of Unit on Termination of Office.
Audit Administration. 1988, Regulations of the Audit Administration on Audit of
Contractual Responsibility for Industrial State-Owned Enterprises.
Chinese Institute of Certified Public Accountants (CICPA). 1997, Independent Auditing
Standards.
Department of Administration of Accounting Affairs (DAAA), Chinese Government.
1992, Accounting Standards for Enterprises. English version. Publishing House of Law.
Department of Administration of Accounting Affairs (DAAA), Chinese Government.
1993, Interpretation of Accounting Standards for Enterprises. Chinese Press of Public
Finance and Economy.
National People's Congress, China. 1985, Accounting Law of the People's Republic of
China.
National People's Congress, China. 1994, Auditing Law of the People's Republic of
China.
National People's Congress, China. 1993, Company Law of the People's Republic of
China.
National People's Congress, China. 1993, Constitution of the People's Republic of China.
National People's Congress, China. 1993, Law of the People's Republic of China on
Certified Public Accountants.
State Council of China, 1986, Document No. 92. Provisions on General Examination of
Tax, Finance and Prices of Commodities.
State Council of China. 1987, Regulations for the Implementation of the Law of the
People's Republic of China on China±Foreign Equity Joint Ventures.

APPENDIX A. CASE ILLUSTRATION

A.1. Audit Report Regarding State-Owned Factory Da Zhou

State Audit Bureau, *** Province

Reference No. ******* Date:*******
184 THE INTERNATIONAL JOURNAL OF ACCOUNTING Vol. 34, No. 2, 1999

This Bureau has conducted an audit for annual accounts of 1995 for state-owned
Factory Da Zhou, in order to implement the resolution of Audit Administration in 1996
regarding strengthening auditing, facilitating reform and maintaining economic order and
continuing financial and economic regulation compliance audit. The following is a
summary of the main findings.
1. Management had intentionally increased the cost of products and reduced current
year profit by 180,000 yuan.
Evidence: Cost of product C2 for the month of December should be calculated using
weighted average method. But the Head of the Factory and the Financial Controller
instructed the staff to use standard unit cost, which increased the cost of goods sold by
180,000 yuan and reduced the profit by 180,000 yuan.
2. Management had intentionally delayed recognition of sales revenue by 450,000
yuan; as a result, the current year profit was reduced by 120,000 yuan.
Evidence: During the audit, we found a record indicating that 85 units of finished goods
(Product G2) were shipped out on 27 December 1995, but there was no sales record. The
sales person and the accountant said that the sale was recorded on 6 January 1996 under
the instruction of the Head of the Factory.
The Financial Controller and the Head of Sales and Purchase Department were also
involved in the manipulation of accounts. Sale of Product B2 was recognized on 17
January 1996 when payment was received rather than on 25 December 1995 when the
goods were shipped.
3. Management had deliberately treated the overhaul expenditure (which should be
capitalized) as administration expense and then had written it off as a current expense, so
that current profit was reduced by 250,000 yuan. This was also done under the instruction
of the Head of the Factory and the Financial Controller.
4. Management had deliberately concealed its investment of 10.2 million yuan in an
associated factory in accounts receivable (i.e., not recorded in an investment account); and
the profit on the investment of 1.45 million yuan for this year was recorded in accounts
payable.
The Head of the Factory had manipulated its accounts. This was a breach of
Accounting Law of the People's Republic of China, of Enterprise General Financial
Principles, of Accounting Standards for Enterprises and Accounting System for Industrial
(manufacturing) Enterprises. The sales person, the accountant, and the Financial Controller
also had breached the relevant provisions in the Accounting Law, as they had failed to
resist the pressure from the Head, and failed to report the manipulations to the higher
authority. However, all of them have confessed and submitted written reports about the
wrong doings. They have promised never to do it again.
Enclosed, please find a copy of the audit decision and of the audit notice.
Cc: The Office of the People's Government of the Province; The Bureau of Supervision
of the Province; The Bureau of Finance of the Province; The Bureau of Industry of the
Province

A.2. Audit Decision Regarding State-Owned Factory Da Zhou

To: The Factory Da Zhou

Auditing of State-Owned Enterprises in China 185

During the audit, it has been found that the accounts of Factory Da Zhou were seriously
distorted (the details are summarized in the Audit Report). These activities were in breach
of financial and economic regulations and rules, and you have admitted all these wrong
doings. According to the Accounting Law of the People's Republic of China, Enterprise
General Financial Principles, and Accounting Standards for Enterprises and Accounting
System for Industrial (manufacturing) Enterprises, and other relevant rules, we have made
the following decisions:

1. The Factory had reduced current profit by 2 million yuan in the accounts. The
Factory must pay an additional income tax of 0.91 million yuan to the tax office
within * days and pay a fine of 107,000 yuan as well.
2. The Factory must transfer 93,000 yuan profit to the statutory surplus reserve (this
amount is determined by the current profit);
3. The Factory must pay an additional dividend of 270,000 yuan
4. The Factory must pay a special fund charge of 180,000 yuan.
5. The Factory must also correct its accounts for this year and next year within 28
days.
6. The Head and the Financial Controller of the Factory had deliberately breached the
financial and economic regulations and rules. We notice that they have made the
confession and promised to correct these problems. We recommend that the higher
authority take appropriate actions against the responsible persons in order to enforce
the financial and economic regulations and rules and to maintain economic order.

Enclosed: a copy of the audit report.

Cc: The Office of the People's Government of the Province; The Bureau of Supervision
of the Province; The Bureau of Finance of the Province; The Bureau of Industry of the
Province
Provincial State Audit Office (seal)
Date: ***

NOTES

1. For example, it has been reported that from 1986 to 1996, state funds of 337 billion yuan were
embezzled to the supposed overseas branches of SOEs, which actually were controlled by
individuals (Dong Hua Newspaper, 18 December 1997), and the amount of embezzled state
funds that had been transferred overseas in recent years was estimated at US$10 billion a year
(The Chinese Herald, 24 June 1997).
2. That SOE cash flows were part of the overall cash flow system of the state was a feature of the
centralized economic structure before reform. Under that system, the business finance of the
SOE was treated as an integrated part of public finance. This also has a fundamental effect on
financial reporting and accounting system in China prior to reform (see Chen and Yu, 1994 for
a discussion about the relation between the centralized finance structure and accounting
system).
3. Tang et al. (1996) describe the rewarding system under CRS and there is a clear and direct
association between firm performance and personal financial benefits. A contractor who fails
to meet the targets specified in the contract is liable for financial penalties. If the results surpass
186 THE INTERNATIONAL JOURNAL OF ACCOUNTING Vol. 34, No. 2, 1999

the agreed-upon targets, the excess profit is divided between the state agency and the
contractor.
4. Relying on accounting measurement necessitates special auditing practices for SOEs, i.e.,
audit of contractual responsibility. The purpose of the audit is to see whether the operating
targets contracted had been actually achieved. The audit includes an overview of financial and
non-financial information. Such an auditing is often conducted by the state audit office, but
may be performed by an internal audit office or subcontracted to a CPA firm. See `Regulations
of the Audit Administration on Audit of Contractual Responsibility for Industrial State-Owned
Enterprises' and `Notice of the Audit Administration on Audit of Economic Responsibility of
Head of Unit on Termination of Office' for detailed procedures of such auditing. And also, Li
(1995) provides an example of such an auditing.
5. The current accounting system provides sufficient flexibility to allow earnings management.
One example is making no provision for bad debts, as Chinese accounting standards only
provide for a maximum limit on such provisions, but do not require such provisions to be
made. Depreciation charges, expenditures for overhaul and maintenance, staff training and
R&D activities also may be minimized to inflate short-term profits (Chen et al., 1997).
6. See the case in Appendix A for examples of negligent or fraudulent manipulation of
accounting and financial information.
7. Use of financial statements by diversified users is certainly taken into account by accounting
reform. For example, Chen and Yu (1994) argued that as fund sources for SOEs are
diversified, financial statements should reflect the equity interest of all investors besides the
state, so that the traditional format of balance sheet, which only reflects fund flow of the state,
should be abandoned and the international format of balance sheet should be adopted (Chen
and Yu, 1994). Unfortunately, the impact of diversification of ownership on auditing has not
been seriously considered yet.
8. One example was the audit of the Disabled Foundation. The audit was triggered due to the
widely circulated assertion that the Disabled Foundation might be engaged in improper or
even illegal commercial activities. This was a politically sensitive case because it involved
high-ranking officials in the government. Another example was the recent case of the audit of
a company that illegally raised huge amounts of fund. The investigation proved extremely
difficult as high-ranking officials in the government and the party were involved (one member
of the Political Bureau, Chen Xi Tong who was involved has been eventually convicted and
sent to jail).
9. For example, the first accounting firm in Shanghai was set up by the Finance Department of
Shanghai and was affiliated with the Department until today.
10. For example, by the end of 1996, a total of about 6700 accounting firms had been established
in China; only a handful of them were independent, private partnership structures (Dai et al.,
1998).
11. Many differences are found between financial statement auditing and the regulation
compliance audit. For example, evidence from sampling is generally not accepted for fraud
auditing in China.
12. Chinese professional auditing standards, which are based on International Auditing Standards,
focus on audit of financial statements rather than discovering of fraud and irregularities. See
the new set of auditing standard issued by The Chinese Institute of CPA (CICPA), 1997.

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