By Shaomin Li and Seung Ho Park of the Skolkovo Institute for Emerging Market Studies (SIEMS)
Behind the latest accounting scandals in many foreign-listed Chinese companies lies a widespread problem of data manipulation. It is nicely summed up in a modern Chinese parable: a locally-listed food company makes up a news release saying a flood washed away its turtles – a Chinese delicacy – and later issues another saying the turtles swam back when the flood receded. But the problem also shows up in hard numbers.
China’s economy has grown by an average of 10.5 per cent a year for the past two decades. But between 1 July 1992 and 21 July 2011, its main stock market index posted an annual compound return of a much smaller 4.5 per cent. Over the same period, the S&P 500 grew by an average of 6.4 per cent.
As the commentator Alfred Little has put it, the problem is in “the paper” – all financial information is contained in “paper documents easily forged”.
Our research shows that the poor quality of accounting in China is an extension of a poor governance environment, with its origins in China’s cultural, political, economic and legal systems. After decades of communist rule the state is still trying to establish its legal authority and is unable to enforce the law impartially. The result is that people resort to personal connections and private information to protect their business dealings.
In such relation-based governance – unlike the rule-based governance found in mature markets – it is risky to rely on public information to make investment decisions, as fraudulent accounting goes largely unpunished. Our research indicates that foreign investment in countries with relation-based governance tends to take the form of direct investment – in which the investor has direct access to the company’s information and control systems – rather than portfolio investment.
From a cultural perspective, relation-based governance in China is reinforced by a combination of Mao and Deng. Mao Zedong ruled China according to a radical ideology: being rich was shameful. To achieve his revolutionary goals, he encouraged people to use any means, including breaking the law.
After Mao’s death in 1976, Deng Xiaoping, the architect of China’s reforms, made a complete reversal by calling on the Chinese to make money under the rallying cry, “getting rich is glorious”.
The combination of Mao’s lawless legacy and Deng’s call for enrichment has mutated into a unique culture that encourages getting rich by any means – even if that means cutting corners and manipulating accounts.
How widespread is accounting manipulation among Chinese companies? The image below shows the correlation between cash flow and profits for Chinese and US companies – there is a very close correlation in the US; almost none in China. Very few Chinese companies report a big loss or a big profit.
Reported profit is merely a number on paper, which is easy to manipulate – but cash flow is less easy to forge since it can be verified. Why do most Chinese firms report close to zero profits whether their cash flow is positive or negative?
In the early days of China’s market economy, entrepreneurs had to break the old, non-market rules to conduct business. Many successful entrepreneurs may have used illegal means at some point of their history and could face prosecution if investigated. This has led many to lay low to avoid attracting the government’s attention, given that a big profit or loss could trigger an audit. (At least 30 people listed in the Hurun Report – a yearly ranking of the richest entrepreneurs in China – have been prosecuted during the last decade.)
In a relation-based society like China’s, businesses maintain a cozy relationship with local officials, who would not easily initiate investigations. Nor would it be in the authorities’ interest to do so, given the importance of the corporate sector to local economies. However, once an investigation is triggered, even by an accident, an acquittal is rare. So the best strategy is never to be audited in the first place. In a rare conversation with reporters, Jiang Zemin, the former state leader, revealed the secret of success in China: “men-sheng fa-da-cai,” which literally means “keep silent, make a big fortune.”
When firms rely on capital from family members, fake accounting may not matter as the investors are insiders. But accurate information is vital as Chinese firms grow and turn to public financing. China must make the transition to more rule-based governance, with an improved legal system and higher standards of documentation.
In the meantime, prospective investors should put more weight on cash flow and take a cautious view of profit data when evaluating performance. In fast-growing emerging markets with questionable moral constraints and information quality, a good motto to follow is “all data are guilty unless proven innocent”.
Shaomin Li is Visiting Senior Research Fellow at SIEMS and holds the EV Williams Fellow and Professor of International Business at Old Dominion University. Seung Ho Park is the President of SIEMS and Chair Professor of strategy at the SKOLKOVO Moscow School of Management.
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