Accounting Standards at Bank of China - Essay Example

Analysis of Accounting Standards at Bank of China 0 Introduction This paper is based on the 2005 annual report of the Bank of China (BOC), the oldest and second biggest bank in the People’s Republic of China (PROC). The first part is a critical discussion of the institutional, external, and cultural influences on the bank’s financial reporting systems using the framework of Hofstede (1980/2003; 1991) and Gray (1988). The second part discusses how BOC’s accounting system may be classified in comparison with prevailing reporting systems using Gray’s Values Framework. The third part briefly and critically discusses in relation to the BOC the following statement from Barker of the IASB: “By 2005, there will likely be only two accounting bodies with a dominating influence on global reporting: FASB (US GAAP) and IASB (International Accounting Standards Board)”. 2.0 Institutional, External, and Cultural Influences The PROC (hereafter China) has been undergoing a transformation when the Communist Party decided to open up the country’s economy to the world in 1978. Since then, China has become a socio-economic miracle: a communist-socialist country of over a billion people transforming its economy into the 2nd largest in the world after that of the United States, and an economic superpower that accounts for significant economic developments in the world such as the recent increases in the price of oil, metals, and other commodities to the lowering of production costs for global products such as clothes, appliances, and machineries, amongst many other things (World Bank, 1993; Stiglitz, 2002). The Bank of China Ltd. (hereafter BOC) was founded in 1912, and until the 1949 communist takeover has performed various functions: as China’s central bank, a foreign exchange bank, and a commercial bank specialising in trade finance with branches all over China and in the major financial capitals of the world. After 1949, BOC was turned into a specialised foreign exchange bank. In 1994, it evolved into a state-owned commercial bank; in 2002, its holding company that was majority-owned by the Chinese government was listed at the Hongkong Stock Exchange; and in 2004, it was again transformed into a joint stock commercial bank in preparation for its initial public offering sometime after 2008 (BOC, 2006, p. 2-5). China has a communist form of government and a socialist market economic system with capitalist features: the factors of economic production such as enterprises, land, and capital are owned by the proletariat but managed by the government that allows the people their use and usufruct. Since 1978’s reforms, foreign capital was allowed to combine with the state’s capital resources, which accounts for the influx of foreigners bringing investments into state-owned enterprises established in Special Economic Zones (Naughton, 1995, ADB, 2000). The events in China of the last three decades show a tremendous degree of intellectual and cultural flexibility in accommodating the contradictory ideologies of Marxian communism, socialism, and capitalism (Chen, Kimball, and Feng, 2000). 2.1 Institutional Influences and Consequences The main institutional influence on the BOC is the Chinese Communist Party (hereafter CCP) which rules the Government of China, establishes and controls the legal, professional, and educational systems, enjoys corporate ownership, and regulates capital markets. China is in principle an atheist state, but is currently allowing religious expression within tight limits (Miles, 2007; Micklethwait and Wooldridge, 2000). 2.1.1 Chinese Communist Party (CCP) China’s government follows the Leninist model of government of one ruling party that is the CCP. According to its Constitution, the CCP is the highest and most powerful body, exercising its rule through the National People’s Congress (NPC), which drafts and carries out legislative, executive, and judicial policies through chosen officials. In practice, a State Council headed by the Premier runs the country with the NPC’s mandate to serve in the interests of the people. All major policies are discussed, debated, and approved at the regular NPC meetings, and once decisions are made implementation is swift and universal, such as that of adopting International Financial Reporting Standards (IFRS) by 1 January 2007. Whilst observers find several decisions unrealistic, China’s track record in implementing economic changes provided these do not undermine political autonomy has been enviable (Deloitte, 2006). 2.1.2 Regulatory Bodies Amongst the executive bodies strengthened by the NPC after 1978 are administrative units that supervise and regulate enterprises such as the BOC, which has a dual personality as a financial institution and a business enterprise. BOC is licensed as a financial institution by the China Banking Regulatory Commission (CBRC) and registered as a state-owned business enterprise with the State Administration of Industry and Commerce (SAIC). As a banking institution, it is subject also to the regulations of the Ministry of Finance (MOF) (Cai, 1999). As regards ownership (BOC, 2006, p.53), BOC is majority (79.9%) owned by the Chinese government through Central SAFE Investments Limited, also known as Huijin (BOC, 2006, p.74). The rest are strategic investors – Royal Bank of Scotland (9.01%), Singapore-based Asian Financial Holdings (4.3%), and Union Bank of Switzerland (1.5%) – and other minority shareholders such as the Asian Development Bank (0.23%). Bank management reports to a Board consisting of representatives of the strategic investors, executive directors, and CPP officials (including one in-charge of Party discipline). 2.1.3 Other State-owned Banks BOC “competes” with other state-owned banks, the larger Industrial and Commercial Bank of China and the slightly smaller China Construction Bank and the Agricultural Bank of China (Lustgarten, 2006). All four banks are based in Beijing to keep them closer to the government that owns and controls them. 2.1.4 External Influences Perhaps one of the most influential external forces on the NPC and ultimately on BOC to adopt ambitious globalisation policies and standards was China’s entry to the World Trade Organisation (WTO) in 2001. If China is to become a global trading partner, it has to adopt global standards of commerce according to the rule of international law. China has been adjusting not only to WTO trading rules but also to production, manpower, environmental, and accounting standards. However, the CPP-NPC is wary of too many reforms being implemented too quickly, especially in the issues of human rights and transparency. Recent controversies on the accessibility of the Internet have highlighted this issue. The Chinese government justified this as a necessary measure of governance to keep over a billion people under control. While some see this as a sign that China is not really determined to open itself to globalisation, others view this as a gradual effort of transparency. The issue, however, is whether democracy would work in China given its history, culture, and size (Lu, 1999). 2.2 Cultural Influences Hofstede’s fifth dimension – Long-term Orientation or LTO, based on Confucian dynamism – was added after conducting a study developed with Chinese employees and managers (Hofstede, 1991). 2.2.1 Long-Term Orientation Hofstede’s analysis for China has LTO as the highest-ranking factor (118), normal for Asian cultures. This indicates a societys time perspective and an attitude of persevering; that is, overcoming obstacles with time, if not with will and strength. China’s score is higher than the average (85) for other Asian countries. BOC’s report emphasises the bank’s history, and the letter to shareholders has a patient tone in discussing China’s economic growth, the presence of strategic investors contributing to more solid future growth, and the much-awaited initial public offering (IPO) that has been going according to plan for the last ten years. He ends his message by thanking the employees who “shoulder the historic mission of carrying forward the Bank’s hundred year business” (BOC, 2006, 4-5). 2.2.2 Collectivism The Chinese rank lower than any other Asian country in the individualism (20 compared to a 24 average). Hofstede (1991) argued that this may be due to the emphasis on a collectivist society by the Communist rule, where loyalty is paramount and not being faithful to Party ideology and the directives from the government is severely punishable. This is why in BOC’s report (BOC, 2006, 4), the Chairman thanks all the employees, the bank’s investors (especially the government for almost everything good), the popular support, and the quality of managers for its continued success. Audited financial statements are signed by four executives (Chairman, President, Head of Accounting Function, and Accounting Department Head) , and the report contains the photographs of 31 directors, senior executives, senior managers, and officials (p. 57) who keep the bank and its employees true to the CCP’s ideology. The section (p. 54-61) on Work Force Maintenance highlights the bank’s human resource programmes and collectivist values as it shows how it fosters strong relationships where everyone takes responsibility for fellow employees who are part of the group. 2.2.3 Power Distance Chinas significantly higher Power Distance ranking of 80 compared to the other Far East Asian countries’ average of 60, and the world average of 55, indicates high inequality of power and wealth within the society. Hofstede (1991) argues this condition is not necessarily forced upon the population, but rather accepted by the society as their cultural heritage. This score is surprising in China, where communist rule aimed for equality of power, at least in theory. This perhaps reflects what takes place in practice, where Confucian heritage leads the people to have a tremendous level of respect for authority, a fact that the annual report reflects in the respectful captions of honorary directors, directors, and senior managers, whose educational credentials are highlighted to establish their level of authority and source of power (p. 54-56; Liu and Wei, 1996). 2.2.4 Uncertainty Acceptance China’s score (35) reflects a culture and recent history where uncertainty has become a way of life, leading to a greater tolerance, relativism, and that allows currents to flow side by side in harmony. This explains why the Chinese are more phlegmatic and contemplative, and not expected by their environment to express emotions. The higher (60) average for the other Asian countries studied by Hofstede can be explained by differences in recent history (greater freedom), form of government (democratic), and capitalism (liberal) that shaped these people and their cultures. BOC’s report, on the contrary, displays a tendency for Uncertainty Avoidance with its risk management system (p. 64), an organisational restructuring to boost efficiency (p. 61), and a Corporate Governance Team composed of representatives from strategic investors, i.e., foreigners, to help them out (p. 62-65). This is obviously part of the signal to stakeholders (and potential shareholders) that BOC is taking steps to join the world’s business community as a transparent, emerging and strong player (Chen, 2000). 2.2.5 Balanced Masculine-Feminine One obvious cultural change resulting from half a century of communism in China is the egalitarianism between men and women1. The result is that China’s culture as shown by the score (50) seems evenly balanced between Hofstede’s masculine and feminine spectrum, which means an absence of gaps between men’s and women’s values. The BOC report shows that only 6 of 31 (or 20%) in top and senior management are women, but they dominate photographs of employees going about their business in the bank. 2.3 Symbolism in the Report The annual report’s inside front cover (p. 1-2) shows young professionals of varied nationalities (east and west, black and white), which is not unique for a bank that has been around for almost a century. Perhaps, in preparation for its coming IPO, the mark of a new beginning, the bank chose this image to signify the bank’s youthfulness, prudent risk-taking, and long-term orientation, and with the message that it may be old, but it has the youthful energy to meet demanding business needs and adapt to change. The cover and the page before the Chairman’s message have golden images that are much appreciated in Chinese culture as a symbol of wealth and prosperity (Lardy, 1999, p. 25; Yeh, 1988). 3.0 Classification of the Accounting System at Bank of China 3.1 Chinese Accounting and IFRS Companies in China are at a significant crossroads, as the government in 2002, a year after the country’s membership in the WTO, agreed to impose on state-owned business enterprises the standardisation of financial reporting systems by 1 January 2007. This can be likened to the Big Bang that revolutionised the London Stock Exchange in 1984 or the European Monetary Union that launched the Euro in 1999 (Nouy, 1999). Prior to standardisation, China’s accounting system was based on several standards: the Accounting Standards for Business Enterprises (ASBE), the Accounting System for Financial Institutions (ASFI), the Accounting System for Foreign Investment Enterprises (FIE), and the Accounting System for Joint Stock Limited Enterprises (JSLE), all collectively known as PRC GAAP that was developed by the MOF with the help of the Chinese Institute of Certified Public Accountants (CICPA) in 1992 (Ng and Pacter, 2002, p. 2-3). In 1993, the government tasked the accounting firm Deloitte Touche Tohmatsu (hereafter Deloitte) to develop a body of Chinese Accounting Standards in line with international practice based on IASC, unifying all systems into ASBE and ASFI. This was done by 2002. In November 2005, the MOF announced that by early 2006 a unified standard will be issued to harmonise ASBE with current IFRS literature and will become mandatory for all listed Chinese enterprises from 1 January 2007. ASBE was finally released on 15 February 2006 and took effect recently. These standards are substantially in line with IFRS, except for modifications which reflect China’s unique circumstances and environment (Deloitte, 2006). As early as 2005, BOC claimed (BOC, 2006, p. 6) that financial results presentation already complied with both PRC GAAP and IFRS and would require only minor modifications in succeeding years to comply with applicable portions of ASBE by 2007. What makes China’s (and the BOC’s) accounting standards unique is the fact that China is a social market economy where the state has a majority ownership of most enterprises, even those listed in the stock exchanges. For example, because of China’s evolving market economy and developing accounting profession and the practical circumstances of Chinese enterprises as state-owned and egalitarian enterprises, the MOF has not adopted certain IFRS conventions, notably the use of fair value (Deloitte, 2006). Whilst IAS 16 allows a revaluation model for measurement of fixed assets and intangible assets, ASBE 4 and ASBE 6 only allow the cost model. The same holds true for land use rights, where IAS 40 restricts accounting to the fair value model where the land use rights meet the criteria as an investment property. And unlike IFRS 3, ASBE 20 includes and addresses within its scope business combinations involving entities under common control, although the latter does not cover reverse acquisitions. Whilst there is no exemption for state-controlled entities under IAS 24, state-controlled entities under ASBE are not regarded as related parties simply because they are state-controlled. There are admittedly certain differences between the new ASBE and IFRS, which is why ASBE has not been prepared for enterprises operating in special industries such as the extractive, banking, and insurance industries or for small enterprises. Nevertheless, BOC has presented its financial statements in compliance with most of the provisions of IFRS. Some examples where the BOC’s current accounting practices differ from the new standards that comply with IFRS are the following (BOC, 2006, 75-76): (1) Except for the equity investments held for trading in overseas operations, BOC currently accounts for equity investments at cost less impairment. Under new ASBE, equity investments other than investments in subsidiaries, associates and investments held for trading will be classified as available-for-sale securities. BOC plans to classify and account for other equity investments as available-for-sale according to the new Standards and those investments with active market quotation will be recorded at fair value with gains or losses reported in shareholders’ equity. (2) BOC currently accounts for investment properties at cost less impairment. Under new ASBE, these assets can either be measured at fair value or at amortised cost less impairment. The method cannot be changed once selected. BOC plans to account for investment properties using fair value. (3) BOC currently accounts for early retirement benefits on a cash basis when paid. Under new ASBE, a liability is required to be recorded at actuarially determined value of future early retirement benefits payable to employees who have commenced early retirement, with changes in the value of this liability reported in the income statement. (4) BOC currently accounts for its investment in subsidiaries using equity accounting method in the Banks financial statements. The main reasons why these would take time are rooted in the notion of fair value accounting in an economy controlled by the state: as majority owner, it wants to maximise profits, whilst at the same time as a tax collecting agent, it wants to maximise tax revenues. Using fair value accounting could undermine one or the other goals of the state as owner and tax collector. This is a conundrum arising from a situation where the owner, dominant market player, and the regulator are one and the same: the Chinese government. 3.2 Gray’s Accounting Values An analysis of the BOC report shows accordance with Gray’s framework (1988) for a theory of cultural relevance in accounting. Some key aspects of Chinese culture can be discerned from BOC’s accounting practices consistent with Gray’s four hypotheses (Gray, 1988; Nobes, 1998). 3.2.1 Compliance The Notes to the Financial Statements contain several references to government directives from the MOF, CBRC, and SAIC. These directives, known as Yinfa (p. 75ff), Caijin (p. 79ff), Caikuaihan (p. 77ff), Caibanjin (p. 86ff), Caijinhan (p. 86ff) and Yinjianfu (p. 107) cover aspects such as treatment of debt-equity swaps, financial restructurings, share capitalisation, and debt securities. Compliance with these regulations and standards such as PRC GAAP and IFRS show familiarity with top-down statutory control and legal prescriptions, a characteristic of a strong collectivism, low uncertainty avoidance and high power distance culture (Gray, 1988; Radebaugh et al., 2006; Nobes and Parker, 1995). 3.2.2 Uniformity Several points already cited (§3.1) show the bank’s desire to conform with IFRS and PRC GAAP not only because of globalisation and accession to the WTO, but to prepare for the much-awaited IPO to sell portions of the company to the public. This aspect of BOC’s accounting naturally proceeds from the familiarity with a centrally planned government where directives issued from above are followed without question, which leads to a cultural trait of high power distance, collectivism, and uncertainty acceptance (Roberts and Salter, 1999; Chow, Chau, and Gray, 1995). 3.2.3 Optimism The report’s statements regarding GAAP compliance, financial restructuring, growth of the Chinese economy and effect on the bank’s profits, the performance of workers, bank’s products, and the support of customers reflect much optimism that they overshadow every cautious note and statement about risks (p. 5), over £1 billion in non-performing loans write-offs (p. 74), and the growth of troubled accounts (p. 93). The fact that 288 outlets were closed in 2005 due to poor performance is just a small footnote (p. 2). China’s low individualism, uncertainty avoidance, and masculine-feminine balance predict a conservative cultural character, but these factors seem dominated by the strong collectivism driven by the country’s rapid economic growth and the desire to establish harmony, a strong Confucian trait, with its neighbours and their standards (Gray and Vint, 1995; Chow, Deng, and Ho, 2000). 3.2.4 Secrecy The voluminous information provided in the report gives the impression of transparency, but a closer study shows a lack of clarity in two critical points of BOC’s operations. The first relates to the buyer of some £30 billion worth of non-performing loans, an entity identified as Cinda (p. 74), not defined elsewhere, in line with the bank’s financial restructuring. A similar shroud envelops transactions with so-called Related Parties and Associates (p. 121-123), which is linked with Huijin, also known as the Chinese Communist Party. As is well-known in Chinese banking circles (Kambayashi, 2007), most of these related party transactions end up as non-performing loans that are circulated by the central bank as fresh capital (p. 74 and p. 93) or sold to subsidiary companies as China Orient Asset Management (p. 95). This evident secrecy is consistent with Gray’s framework for a high uncertainty acceptance, power distance, and collectivist culture (Gray, 1988, Nobes and Parker, 1995). 4.0 Critical Discussion on FASB and IASB Barker’s statement that “By 2005, there will likely be only two accounting bodies with a dominating influence on global reporting: FASB and IASB” seems to be an accepted fact at BOC. This is evident from the bank’s claim that it is working towards adopting PRC GAAP and IFRS, the latter of which has been the basis for the ASBE for which China has just demanded mandatory compliance effective 1 January 2007. China is being helped by the IASB in developing its system to comply with IFRS (Deloitte, 2006). FASB of the U.S. and IASB of the U.K. are leading global efforts to harmonise and standardise accounting standards into the International Financial Reporting Standards (IFRS). However, as already seen (see §3.1 above), the new ASBE is not mandatory for financial institutions such as BOC, the problem being the treatment of such issues as related party transactions and fair value arising from the conflict of interest between the government as owner, regulator, and tax collector. The BOC acknowledges the importance of harmonisation and compliance with accounting standards in this age of globalisation, where investments flow from anywhere in the globe. In view of its pending IPO where parts of the company will be sold to foreign investors, the bank sees the need to be professional, conforming to global standards, conservative, and transparent. China’s cultural traits, however, show that there would be some difficulties unless external factors compel it to make substantial changes as to allow its accounting system to match global expectations. Accomplishing this would not be simple. What complicates the matter is that China knows that the U.S. is not in a hurry to harmonise US GAAP with IFRS (Kambayashi, 2007). In fact, China has been even more ambitious despite not making harmonisation mandatory for financial institutions. Knowing China’s culture and history, it would not be farfetched to assume that it would wait until most of the world, especially the U.S., harmonise their accounting systems with IFRS, not just because China can afford to do so with its deep pockets, but because its long-term orientation, strong collectivism, deep desire to maintain harmony and balance in the world, and its inability to find a quick solution to the ownership conundrum of its state enterprises give it a perfect excuse to do just that. 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