Due diligence in China

Due diligence, especially at private companies, requires professional skepticism, persistence, and cultural sensitivity when evaluating an investment opportunity in China. Stephen Weatherseed, who has worked in China for 25 years and is managing director at Mazars in Hong Kong, offers these tips:

Find out whether the Chinese company is keeping multiple sets of accounting ledgers. Make sure you’re inspecting the correct set. Keeping different books is common. The Chinese company’s CFO is usually the best person to ask if this situation exists and the reason for it—for example, one set is for Chinese tax reporting and the other is prepared according to international standards for the head office. Wait for the right time to ask, be tactful, and explain why you need it.

Have somebody walk you through different transactions. For example, trace how an order is converted into a sale and then entered into a ledger, to understand how the Chinese company recognizes revenue.

Figure out where a private company gets its working capital. Loans from regular banks have been largely limited to state-owned enterprises in China. Shadow banking is legal and documented, but loans may be tied to the business owner, mature within days of a change in ownership, or have interest rates as high as 30%. Verify inventory turnover to assess how healthy a business is. Also, check for oral agreements to accept any unsold merchandise—a sign the company may be stuffing channels.

Ask multiple, open-ended questions to determine provisions, value allowances, and impairments. Find out who the major customers are and their payment histories, what the terms of trade are, and whether delivery problems are evident. Use documents to help verify information, and be prepared to probe into identified issues. Hire an investigator if you have doubts about suppliers or customers, to verify their existence or the terms of trade.

Hire a Chinese tax specialist to do the tax due diligence. Especially in second-tier cities and more rural areas, personal relationships may determine how much a company pays in local or provincial taxes. Also, tax regulations in China are complicated, change frequently, and are often subject to local variations and implementation.

Be alert to related-party transactions. Related-party transactions may include favorable sales/trade terms or service fees above market level, which may not be “arm’s-length” (commercially justifiable) transactions. These related-party transactions may be subject to challenge and transfer-pricing adjustments by China’s tax authority.

Recognize that traditional business practices may be liabilities not fully accounted for in records. Chinese companies may honor secret agreements to pay commissions. Product warranties, property ownership, or the right to occupy a building may be the result of an unwritten arrangement.

Get an online copy of the company’s filings with the State Administration for Industry and Commerce. SAIC filings often differ from financial statements provided to foreign buyers. Understand the differences.

Tease apart the duties of the Chinese management team. A lean management team and a lack of segregation of duties can harbor a potential for fraud. Check signature stamps, or chops. Double-check margins on transactions.

Set expectations for corporate governance early on. Even before agreements are signed, managers and stakeholders of the Chinese company need to understand what authority and responsibilities they would have and what reporting, reconciliation, and approval processes would look like under new ownership.

—By Sabine Vollmer (svollmer@aicpa.org), a JofA senior editor.