Accounting and Corporate Governance-A Big Bath in China

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Emerald Emerging Markets Case StudiesA “Big Bath” in China: accounting and corporate governance

Mingchuan Ren

Artic le information:To cite this document:Mingchuan Ren, (2011),"A “Big Bath” in China: accounting and corporate governance", Emerald Emerging Markets CaseStudies, Vol. 1 Iss 1 pp. 1 - 6Permanent link to this document:http://dx.doi.org/10.1108/20450621111110663

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A ‘‘Big Bath’’ in China: accounting and

corporate governance

Mingchuan Ren

C hina launched its ‘‘reform and open’’ policy in the late 1970s. Since then China has

been undergoing a transition from a centrally planned economy towards a market

based economy. ‘‘The most obvious milestones in the development of China’s

financial system are the establishment of stock markets in Shanghai and Shenzhen in the

1990s (Child and Tse, 2001).’’ After that some state-owned enterprises (SOEs) started to be

transformed into public companies through initial public offering (IPO). Prior to 1990 Chinahad introduced some changes to its accounting system with the purpose to attract foreign

investment. Since 1990 the stock exchange has emerged as a driving force to change

accounting practice, moving toward western practice. In the late 1990s, there began to

separate financial accounting from tax accounting and to adopt accrual accounting for

financial accounting. Thus, companies were required to estimate the allowance for bad debt

for its accounts receivable. Although some SOEs were transformed into listed companies,

their governance remained basically unchanged because the government kept a lion

share of stocks and thus continued its control on corporate decisions. Unlike that in the

developed world, ‘‘China’s corporate governance institutions are weak by any measure, and

yet it has managed to achieve quite spectacular levels of growth over the last quarter of a

century (Mueller, 2006)’’. China had introduced changes, in a pragmatic way, to its

governance institutions and accounting practices. The situation could be demonstrated by

the following case.

Company C was founded in 1950s to develop military radar systems. In 1980s it moved into

the consumer electronics sector. Prior to the late 1970s, a TV set was a luxury for a great

majority of Chinese households. In the wake of economic reforms launched in the late 1970s,

TV sets and other electronic products started to go into many Chinese households, creating

an increasing market demand. The entire 1980s saw a great shortage of color TV and other

electronic products in the market. In 1985 Mr Chen became the chief executive officer (CEO)

of company C, marking the beginning of an impressive history in which company C rose from

a military industrial company in the relatively undeveloped western hinterland to a star

company in China. Its net assets increased from Rmb40 m to Rmb13.2 bn over the period

from 1985 to June 2004 when Mr Chen retired. In 1997 the company reached its peak in

terms of performance, generating Rmb15.7 bn sales with 25.9 per cent gross margin and

Rmb2.6 bn net income. The company’s color TV became the number one brand in thecountry.

Up to early 1996 China’s color TV industry was highly fragmented, with more than 130

manufacturers. Each manufacturer had, on average, less than 120,000 units of sales.

Only 12 had annual sales of over half a million units, and only 4 had annual sales of more than

1 million units. At the time China’s color TV market was a two-tier market. Foreign brands

served the high-end market and enjoyed a 20 per cent price premium over local brands.

Even with this price premium, foreign brands (Japanese brands in particular) still held a

dominant position in China, especially in urban markets. In late 1995 there was a good deal

DOI 10.1108/20450621111110663 VOL. 1 NO. 1 2011, pp. 1-6, Q Emerald Group Publishing Limited, ISSN 2045-0621 j EMERALD EMERGING MARKETS CASE STUDIES j PAGE 1

Mingchuan Ren is an

Associate Professor at the

School of Management,

Fudan University,

Shanghai, China.

Disclaimer. This case is writtensolely for educational purposesand is not intended to representsuccessful or unsuccessfulmanagerial decision making.The author/s may havedisguised names; financial andother recognizable informationto protect confidentiality.


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of color TV smuggling, which was a significant drag on the stability of TV prices. In addition,

Chinese companies were under increasing downward price pressure from a number of

sources. First, import tariffs were slated to go down in 1996 for small-screen color TVs from

60 to 50 per cent and from 65 to 50 per cent for large-screen color TVs. Second, lured by the

sheer size of the Chinese market, foreign investments in the Chinese TV industry were

red-hot. All ten of the largest TV manufacturers in the world at the time were rapidly

expanding their production in China.

With 17 production lines concentrated in one place, company C ran the largest and most

efficient color TV production operations in China. Its capacity at that time was at least double

that of the second largest Chinese manufacturer. It was also the largest manufacturer for

many key TV components, such as plastic injections parts, electronic components and

remote controls and had built a very close relationship with key component suppliers in the

industry. As a highly vertically integrated company located in the western hinterland, the

company enjoyed a cost advantage and earned the highest profit margin among all

domestic color TV manufacturers. Its net profit margin was around 20 per cent, far ahead of

most of its domestic rivals. It enjoyed a high level of brand awareness and a high quality

image among domestic brands.

In 1994, company C did an IPO on the Shanghai Stock Exchange. But, after IPO, the

company remained a SOE in the sense that the government continued to hold 53 per cent of

its shares. In 1998, it contributed about 15 per cent of its provincial GDP and about half of the

gross industrial output of the city where it was located. Across China the company employed

more than 30,000 people. To monitor the performance of SOEs, the government establishedsome criteria including the increase of assets and enhance of profitability. Although the

criteria were established, the practice of executive appointment had been largely at

administrative discretion, with decisions made behind closed doors:The emergence of the

notion of ‘governance’ in China was accompanied by a critique of the system of socialist

planning and associated forms of government. One of the hallmarks of socialist planning,

and the system of government in China in general, was the combination of rewards and

punishments, quotas and reliance on administrative commands. Commencing in the 1980s,

critics of the system argued that administrative intervention was overly heavy-handed

(Sigley, 2006).

Notwithstanding its strong position in the Chinese TV market, company C was faced with an

increasingly competitive market in the mid 1990s. Industry estimates in 1995 indicated that

domestic manufacturing capacity was as high has 35 million units, more than doubledomestic sales of color TVs. Exports were believed to absorb only 4 million units at the time,

leaving a considerable overhang of excessive capacity in China. By early 1996 company C

was holding an inventory of around 1 million units with a total estimated value exceeding

Rmb2bn.

On March 26, 1996 company C took action and fired the first shot in a price war, announcing

price reductions for all its 1700-2900 color TVs ranging from Rmb100 to Rmb850. Some

domestic rivals followed company C’s suit while others did not. As a result, the former group

gained and the latter group lost market share. Within several months after price war,

company C’s overall market share had increased from 16.68 to 31.64 per cent, rising to

35 per cent in 1997. As expected, foreign brands stayed away from price war. Sony and

Panasonic, for example, both decided to take the high road, focusing on quality and

functionality.Before the price war, imported and joint venture products accounted for 64 per cent of the

market and local manufacturers for only 36 per cent. After that the market share of domestic

products significantly increased, accounting for a total of around 60 per cent by the end of

1996. In 1997 eight out of the top ten best selling brands in China were Chinese. Company C

had become one of the best selling color TV brands in China, with market shares at

35 per cent. Only two foreign brands, Panasonic and Philips, muscled into the top Ten, each

with about 5 per cent of the market share. On May 21, 1997 the company’s share price

reached Rmb66 per share.

PAGE 2 jEMERALD EMERGING MARKETS CASE STUDIES j VOL. 1 NO. 1 2011


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The first ever large-scale price war drastically changed the landscape in the industry in favor

of Chinese companies. However, the industry as a whole continued to be dogged by the

excessive capacity. According to industry reports, company C’s inventory of Color TVs had

risen to 5 million units in 1998 when it launched another major price war, cutting prices by

another 10 per cent. But this time the price cuts did little to increase its market share and

instead squeezed its profit margin considerably.

In order to improve the situation, the government made the decision to change CEO. On May

15, 2000 Mr Chen was asked to retire from his CEO position and became chairman of the

board. At the time company C’s share price dropped to Rmb12.5 per share. But it should be

noted that in China the share price might not be used as a reliable performance measure.Over the period from 2000 to 2005, China recorded a high-economic growth, but the

Shanghai Stock Exchange Index, the main stock market index in the country, declined from

about 1,400 points at the beginning of 2000 to around 1,000 points in June 2005. It reached

its period peak in June 2001 at about 2,250 points. It has been noted that:

[. . .] to understand the economic behavior of Chinese firms and Chinese stock market, one must

first understand the role of government and its influence on the firm’s economic activities. During

the economic transition, local governments serve multiple roles: providers of public service,

agentsof China’s central government to monitor listed firms, andmajorshareholders of listedfirm.

This complicated relationship gives rise to a unique phenomenon in the Chinese stock market:

local governments intimately dance with listed firms to the tune set by the central government

(Chen et al., 2008).

It was very unfortunate that the new CEO stayed in office for only about eight monthsbecause he failed to meet the government’s expectation either. As a consequence, Mr Chen

was called back to take the rein of company on February 10, 2001.

Soon after resuming the role as CEO, Mr Chen took a bold move by selling hard in overseas

markets. In November 2001 he signed a contract with company X as the sales agent in the

US market. Initially, company X was a small firm run by a local Chinese. By making the best

use of company C’s low price of TV sets, company X later emerged as the fifth largest color

TV supplier in the United States. In 2002 and 2003, company C’s overseas sales reached

Rmb780m and Rmb5.04 bn, increasing 11 and 6.5 times on a year-on-year basis,

respectively. In 2003 the export revenue was 35.7 per cent of its total sales. But company C’s

increase of sales was accompanied by a swelling accounts receivable, particularly those

with company X. One can find detailed information in company C’s financial statements over

the period from 2001 to 2005 and the footnotes about its accounting policy on accounts

receivable in 2002, 2003 and 2004, respectively (see Exhibit).

From the financial statements, one can find that company C’s increased sales was eclipsed

by a swelling accounts receivable and an increasing inventory. At the end of May 2004

the company’s share price dropped further to Rmb7.06. In July 2004, Mr Chen had to retire

once again. And the new CEO was reappointed. At the end of 2004 the new CEO cleared

the table by announcing a big write-off, mainly for accounts receivable of company X and the

write-down of inventories. As a result, company C incurred a loss of about Rmb3.7bn for that

year. The share price closed at Rmb3.54 on December 31, 2004.

Keywords:

Accounting,

Accounting practices,

Corporate governance,

China

References

Chen, X., Lee, C.W.J. and Li, J. (2008), ‘‘Government assisted earnings management in China’’, Journal

of Accounting and Public Policy , Vol. 27, pp. 262-74.

Child, J. and Tse, D.K. (2001), ‘‘China’s transition and its implications for international business’’, Journal

of International Business Studies , Vol. 32 No. 1, pp. 5-21 (First Quarter).

Lawrence, S. (1999), ‘‘Too manymothers-in-law’’, Far Eastern EconomicReview , Vol. 19No.2, pp.12-13.

Mueller, D.C. (2006), ‘‘The Anglo-Saxon approach to corporate governance and its applicability to

emerging markets’’, Corporate Governance , Vol. 14 No. 4, pp. 207-19.

Sigley, G. (2006), ‘‘Chinese Governmentalities: government, governance and the socialist market

economy’’, Economy and Society , Vol. 35 No. 4, pp. 487-508.

VOL. 1 NO. 1 2011 jEMERALD EMERGING MARKETS CASE STUDIESj PAGE 3

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Exhibit

Company C’s financial statements from 2001 to 2005 are provided below, together with thefootnotes on accounts receivable for 2002-2004. The financial statements received clearaudit reports throughout five years (Tables AI-III).

Footnotes on accounts receivable (A/R), 2002-2004.

2004 footnotes

At the end of 2004, the total A/R owed by company X was Rmb3,839 m, among which

Rmb295m were within one year; Rmb3,513m one to two years; Rmb31 m two to three years.The company X was currently experiencing financial difficulties and was having trouble

Table AI Income statement (Rmb million)

2001 2002 2003 2004 2005

Sales 9,515 12,585 14,134 11,539 15,0612Cost of sale 8,321 10,711 12,083 9,887 12,619Tax and surtax 58 26 7 18 33Gross margin 1,136 1,848 2,044 1,634 2,409þOther incomes 87 66 55 13 192Marketing expense 1,033 1,414 1,386 1,111 1,666Administrative expense 246 356 460 4,021 340Financial expense 278 17 71 22 113Operating income 22 127 182

23,507 309

þ Investment income 120 78 33 2169 253Non-operating income 230 2 52 4 42Total income 112 207 267 23,672 2982 Income tax 22 31 60 14 5Minority interest 1 1 22 5 8Net income 89 176 206 23,681 285Earning per share (Rmb) 0.041 0.081 0.095 21.701 0.132

Table AII Balance sheet (Rmb million)

2001 2002 2003 2004 2005

Cash and cash equivalent 1,646 1,005 1,122 2,065 1,249Accounts receivable 2,881 4,220 4,985 2,180 3,084Inventories 5,941 7,193 7,006 6,013 4,767Other current assets 3,779 2,841 4,424 1,654 3,229Total current assets 14,247 15,259 17,537 11,912 12,329Long-term investment 152 139 39 158 144Fixed assets 2,764 2,802 3,337 3,117 2,826Intangibles 474 470 442 434 524Other long-term assets 1 0 9 28Total assets 17,638 18,670 21,364 15,649 15,824Short-term loans 85 1,622 2,706 2,670 1,305Notes payable 2,436 2,356 2,854 1,485 1,832Accounts payable 2,064 2,074 2,367 1,768 1,973Other current liability 292 2324 164 52 645Total current liability 4,877 5,728 8,091 5,975 5,755

Long-term liability 0 0 80 85 19Deferred income tax 8 6 4 4 3Total liabilities 4,885 5,734 8,175 6,064 5,777Minority interest 11 11 57 130 256Capital 2,164 2,164 2,164 2,164 2,164Capital reserves 4,066 4,081 4,081 4,086 4,136Profit reserves 4,830 4,860 4,904 4,903 4,904Retained earnings 1,682 1,821 1,983 21,698 21,413Total equity 12,742 12,926 13,132 9,455 9,791Total liability and equity 17,638 18,670 21,364 15,649 15,824



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in servicing its debt. In considering the situation, company C had filed a lawsuit to aLos Angeles court and the case was now under court investigation. Given that the normalway for company C’s A/R could not truly reflect the situation, the Board decided to set asideRmb2,597 m as a bad debt allowance for company X. Without such a charge, the totalallowance for bad debt would have been Rmb360 m. Thus, the net impact on net incomewas Rmb2,237 m (Table AIV).

2003 footnote

A/R increased considerably over 2003 with the biggest increase related to company X,whose A/R was Rmb4,447m, among which Rmb3,512m were within one year andRmb934m between one and two years. On December 31, 2003 the company C hadinventory of more than Rmb7 bn after writing down approximately Rmb300 m (Table AV).

2002 footnotes

In 2002 company C’s A/R stood at Rmb4.22 bn, with that owed by company X accounting forRmb3.83 bn. The company reported a 27 per cent decrease of A/R relative to that in 1999(Table AVI).

Discussion questions

B Since the 1990 opening of stock exchanges, China started to use financial statements todetermine the performance of listed companies. What were company C’s performancefrom 2002 to 2004 and the quality of reported earnings?

Table AIII Statement of cash flow (Rmb million)

2001 2002 2003 2004 2005

Operating cash flow 1,373 22,988 2744 760 1,421Investing cash flow 21,023 893 2252 190 2920Financing cash flow 2222 1,445 1,103 231 21,325Net cash flow 128 2650 107 919 2824

Table AIV 2004 year-end A/R and allowance for bad debt (Rmb million)

Age groups Rate (%) Amount Allowance

Within one year 0 1,223 01-2 years 10 3,520 2,5672-3 years 30 34 323-4 years 50 3 24-5 years 80 – –Over five years 100 5 5Total – 4,785 2,605Net A/R – 2,180

Table AV 2003 year-end A/R and allowance for bad debt (Rmb million)


Within one year 0 4,141 01-2 years 10 934 932-3 years 30 4 13-4 years 50 – –4-5 years 80 4 3Over five years 100 0.6 0.6Total – 5,083 98Net A/R – 4,985

VOL. 1 NO. 1 2011 jEMERALD EMERGING MARKETS CASE STUDIESj PAGE 5


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B Most listed companies in China were carve-outs from their parent SOEs and thegovernment continued to control the majority of their shares and thus the top decisions.In this context, what were the agency problems between the principal (the government)and the agent (the CEO)?

B The company C changed its accounting policy for accounts receivable by doing a bigbath in 2004. Try to explain the accounting policy change in terms of China’s businessenvironment in general and company C’s circumstance in particular?

Table AVI 2002 year-end A/R and allowance for bad debt (Rmb million)


Within one year 0 4,213 01-2 years 10 5 0.52-3 years 30 – –3-4 years 50 4 24-5 years 80 0.006 0.005Over five years 100 0.8 0.8Total – 4,224 3.3Net A/R – 4,220


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Accounting and Corporate Governance-A Big Bath in China