China's New Accounting Standards A Brief Guide

Key features and impact of the New Accounting Standards

Convergence with IFRS

Most of the newly issued standards and revised standards make reference to the equivalent IFRS and adopt the principles and treatments similar to its international counterpart. The standard dealing with income taxes is an example. Previously, most enterprises adopted the tax payable method - where the determination of income tax expense for the current period is based on the income tax payable for the current period. The new standard requires enterprises to recognise the deferred tax asset or liability using a balance sheet approach, which is consistent with International Accounting Standard 12 Income Taxes. Other examples include financial instruments (including certain investments), which adopts the same principles as IFRS with regard to classification and measurement.

As a result, the financial statements prepared in accordance with the New Accounting Standards will be more comparable with those prepared in accordance with IFRS than they would have been in the past, further minimising the discrepancies between them. Overseas investors and users of financial statements will understand the financial statements of Chinese enterprises better and the cost of re-preparing financial statements for Chinese enterprises when applying for an overseas listing will be reduced.

Fair value measurement requirement

The New Accounting Standards introduce the requirement of fair value measurement in many areas, such as business combinations that are not under common control, some financial instruments, share-based payments and, under certain circumstances, investment property. Before the revision, debt restructurings and non-monetary transactions were carried at book value and any gains arising from these transactions were not allowed to be recognised. Whereas under the New Accounting Standards, these transactions will be measured at fair value and gains that meet certain criteria will be recognised in the income statement. These requirements may introduce greater volatility in reported results of entities. In practice, the determination of fair values may not be easy for many entities especially when a quoted price in an active market does not exist and various valuation techniques are required.

Accounting treatment for important accounting issues

In the past, apart from the Tentative Directive on Consolidated Accounting Statements, there was neither formal accounting standards nor comprehensive and detailed guidelines, in China, in the areas of business combinations and consolidated financial statements. Therefore, accounting treatments for similar business combination transactions may have varied across different enterprises causing much confusion and inconsistency. The issuance of the standards on 'Business Combinations' and 'Consolidated Financial Statements' will fill in the gap in this area, providing comprehensive and more authoritative provisions and guidelines on these important accounting issues.

Accounting treatment for new issues

New concepts such as financial instruments, investment property and share-based payments introduced by the New Accounting Standards will significantly change the current accounting practice. Under these new standards, derivative financial instruments will be recognised on the balance sheet instead of only being disclosed in the notes to the financial statements. Meanwhile, in response to the emerging trend of incentive share plans provided by listed companies, the new standards require all shares and share options granted to employees to be measured at fair value and expensed in the income statements.

Standards relevant to specialized industries

In response to the recent booming development of certain industries (for example, the financial sector) in China, the New Accounting Standards also include a number of standards that are relevant to those specialized industries. For example, the four standards on 'Financial Instruments' will have a huge impact on accounting practices in various financial institutions. Similarly, the standards on 'Direct Insurance Contracts' and 'Re-insurance Contracts' will affect participants in the insurance sector. These standards will greatly satisfy the demand for a set of comprehensive accounting guideline as a result of the rapid development of these industries. In addition to those mentioned, the "Extraction of Petroleum and Natural Gas" and 'Biological Assets' are standards that are issued specifically for enterprises operating in the petroleum and gas industry and agriculture industry respectively. These industry-specific standards are aimed to support the sustainable development of these industries.

Impairment of assets

The new standard on 'Impairment of Assets' introduces the concept of an assets group (similar to a cash-generating unit under IFRS), and provides detailed implementation guidance. However, unlike previous accounting regulations in China which allows the reversal of impairment, under certain circumstances, the new standard specifies that any recognised impairment loss for fixed assets and intangible assets cannot be reversed in future accounting periods. This requirement may have great influence in practice. It should be noted that the restrictions on impairment loss reversal does not apply to inventories, trade receivables and bank loans, as well as some types of investments, as this concession is not included in the standards on 'Financial Instruments' and 'Inventories'.

Detailed requirements on disclosure

One of the key features of the New Accounting Standards is to provide users of financial statements with more relevant accounting information. The requirement of fair value measurement itself reinforces this objective. Furthermore, the New Accounting Standards make reference to IFRS, which require the disclosure of useful information such as earnings per share and segment reporting. In relation to financial instruments, a detailed disclosure on the enterprise's financial risk exposure is now required. In respect of accounting policies and accounting estimates, the basis for the determination of significant accounting policies and accounting estimates is required to be disclosed. In addition, new standards have other stricter and more detailed disclosure requirements, which aim to provide users of financial statements with more transparent information that will facilitate their economic decision-making.

Recommendations to enterprises

There are huge differences in accounting concepts and practices between the New Accounting Standards and the current accounting regulations in China, and in some areas it will constitute a fundamental shift. However, the impact of the New Accounting Standards may be different from one enterprise to another. With the effective date of the new Accounting Standards being January 1 2007 for listed companies, time is of the essence. Hence, it is important for enterprises to be familiar with the requirements of the New Accounting Standards and plan in advance for the conversion.

Enterprises should create working plans as early as possible to identify practical steps that focus on the conversion. These steps may include:

i. providing training to management, finance and accounting personnel to ensure that they understand the requirements of the New Accounting Standards;

ii. revising the accounting policy manual and establish detailed implementation guidance for complex accounting issues;

iii. identifying key changes arising from the New Accounting Standards and any related transitional adjustments;

iv. undertaking an impact assessment on the New Accounting Standards and its effect on financial statements;

v. establishing communication plans for investors and other market analysts and advising them of the potential impact of the New Accounting Standards as soon as possible. For example, a warning announcement to the market may be necessary where profits may be significantly lower than market expectations as a result of implementing the New Accounting Standards. Similarly, an unfavorable adjustment may reduce an entity's distributable retained earnings to such a level that could cause a change in the entity's dividend policy;

vi. allocating internal resources, establishing systems and collecting relevant information to meet the requirements of the New Accounting Standards, which may include:

(a) resetting the book-keeping systems and the system for financial reporting according to the requirements of the New Accounting Standards;

(b) establishing the methods and systems for determining fair value: for example, collecting quoted price information in an available active market, creating computation models and employing valuation experts;

(c) for enterprises with diversified business operations or situated in multi-locations, identifying business and geographical segments and collecting information for segment reporting;

(d) setting up a system to trace derivative financial instruments;

(e) for banks, creating a model to estimate the present value of expected future cash flows to assess impairment losses for customer loans, and

(f) in accordance with the presentation and disclosure requirements of the New Accounting Standards, comparative information or restatement may be required;

vii. modifying and improving internal control system to embrace the changes introduced by the New Accounting Standards. For instance, there is a need to establish internal controls to monitor transactions dealing with derivative financial instruments. It is important to note that, these changes do not only affect the day-to-day transactions, but may also influence important accounting estimates made by enterprises. An example is the new standard on 'Impairment of Assets', which provides a more comprehensive and detailed guidance on determining whether an asset has been impaired under the standards; whereas other new standards often require fair value measurement in many areas. Accordingly, enterprises may need to revise their internal control systems to accommodate these new changes, and

viii. consulting a professional for assistance where there is doubt.

It is without doubt that accounting and financial reporting will be the most heavily impacted functions in an entity as a result of the New Accounting Standards. However, it is important for enterprises to consider the impact of the new standards on other areas of the business as well, such as risk management and operating strategy. For example:

i. 'Business Combinations' may have an impact on future acquisition plans;

ii. 'Share-based payment' requires share options to be expensed, therefore, management may need to assess the financial statement impact of the enterprise's share options incentive schemes, and

iii. funding and hedging strategies may need to be reconsidered.

Therefore, it is imperative for enterprises to evaluate the impact of the New Accounting Standards and formalize action plans as early as possible.

Comparing New Standards with IFRS

Although the New Accounting Standards have fundamentally converged with IFRS, a few exceptions are still acknowledged in certain areas arising from considerations given to some specific situations in China. Key differences include:

i. reversal of impairment losses: under IFRS, the reversal of impairment of assets is permitted under certain circumstances. But the new standard on 'Impairment of Assets' requires that any recognized impairment loss for fixed assets and intangible assets cannot be reversed in future accounting periods. However, it should be noted that this requirement does not apply to inventories, trade receivables and bank loans, as well as some types of investments, as this concession is not included in the standards on 'Inventories' and 'Financial Instruments';

ii. the adoption of fair value measurement: the New Accounting Standards introduce the requirement of fair value measurement in many areas, but not all standards adopt the fair value model. For example, the standards on 'Investment Property' and 'Biological Assets' only require fair value measurement when certain criteria are met. These are special considerations provided to accommodate the practical circumstances in China as fair value could be difficult to determine, which is different from IFRS where the fair value model is more generally adopted;

iii. the New Accounting Standards include topics that are not addressed in IFRS: for business combinations under common control, the new Chinese standard on 'Business Combinations' requires the 'pooling of interests' method, whereas such transactions are scoped out of IFRS 3 'Business Combinations'. Other examples include the standard on 'Extraction of Petroleum and Natural Gas' for which there is no equivalent standard under IFRS. Similarly, there are specific provisions in the standards on 'Direct Insurance Contracts' and 'Re-insurance Contracts', which are not included in its IFRS;

iv. specific Chinese Accounting Standards without equivalent IFRS: this refers to the standards on 'Exchange of Non-monetary Assets' and 'Debt Restructurings'. These are separate standards in China that adopts principles consistent with those under IFRS, however, there is no equivalent separate standard under IFRS;

v. IFRS standards that are not included in the New Accounting Standards: this mainly refers to IFRS 5 'Non-current Assets Held for Sale and Discontinued Operations'. There is no equivalent standard in China, and

vi. remaining differences in some accounting treatments and disclosure requirements: for example, under IFRS, the revaluation model is allowed for subsequent measurement of fixed assets. Other examples include certain disclosure requirements on related party transactions.

Future developments

It is understood that as part of the new system of Chinese Accounting Standards, the MOF will issue application guidance to the New Accounting Standards. The application guidance will provide comprehensive interpretation on the New Accounting Standards and will be further accompanied by some illustrative examples. At present, the New Accounting Standards will be applicable to listed companies with other companies also encouraged to adopt. It is expected that in the long-term, the application scope of the New Accounting Standards may be expanded gradually based on the implementation results and eventually, all large and medium sized enterprises may be required to adopt the new standards. The new standards signals China's continued integration into the global economy by further lifting investor confidence and improving the investment environment, while at the same time they are pushing forward the country's corporate and financial reform.