Companies investing in China face the challenge of how to align strategies between the China branch and the rest of the corporation. The alignment and integration of application software is one of those operating strategies.

Complying with local statutory requirements is a major headache for international rollouts, especially in a country like China, which operates on vastly different social and political systems from the Western world. This continues to be the biggest area of concern for all FI/CO R/3 implementations in China.

What follows is the vital information on the statutory requirements of China's accounting system and the best practices about how you can use R/3 functions to meet these requirements. Compliance with these requirements will ensure the implemented R/3 accounting system is endorsed by the governance authorities in China.

I will describe how China's accounting regulations have evolved over the years; review the unique aspects of accounting standards, tax regulation, and audit requirements in China; highlight the differences and similarities among International Accounting Standards (IAS), US GAAP, and Chinese accounting standards; and provide insider tips on corresponding SAP R/3 solutions to address these statutory differences.

Although the information I provide here is up to date as of this writing, note that the Chinese government is constantly modifying, developing, and publishing new standards and regulations.

Accounting Law of China

The Accounting Law of China (which I'll refer to as "the law") was formulated in 1985 and has gone through several revisions. For all companies operating in China, three basic points of the law are relevant to the implementation of a financial system:

• The fiscal year starts January 1 and ends December 31 of the calendar year. The fiscal year should correspond to the calendar year.
• The reporting currency for bookkeeping is always the Chinese Renminbi (RMB). The RMB is also the measurement currency for transactions denominated in RMB. If a transaction is denominated in other currencies, that currency may be used as the measurement currency. All transactions occurring in foreign currencies must be translated into RMB for financial reporting purposes using the exchange rates quoted by China's central bank.
• The official bookkeeping language is Chinese. Foreign companies are allowed simultaneous use of another language.

Computerized Accounting Requirements

Since 1994, the Ministry of Finance of China (MOF) has published various Computerized Accounting Standards and Regulations to meet the challenges presented by increasing adoption of computerized financial applications and to exert control on financial reporting. One of the regulations has specifically established the account number range standards for operating charts of accounts, with the intention that they will aid the implementation of computerized accounting applications. Companies are strongly encouraged to follow the suggested number ranges shown in Figure 1.

Figure 1

The MOF-suggested number ranges for chart of accounts. The number range description was translated by the author from Chinese and is not an official translation.

Figure 1 The MOF suggested number ranges for chart of accounts. The number range description was translated by the author from Chinese and is not an official translation.

New Enhanced System

The new Accounting System for Business Enterprises (which I'll refer to as "the system") is a comprehensive financial reporting framework that covers concepts, definitions, standards, presentation, and record keeping. Compared to previous accounting standards, it is more aligned with international practices.

MOF intends the new system to be adopted by all large- and medium-sized enterprises in China, eliminating the different treatments in accounting standards based on industries or the form of business enterprises that existed in the past. The new system replaced the Accounting System for Joint Stock Limited Enterprises. Initially, all joint stock limited enterprises other than those in banking, insurance, and some specialized financial industries must follow it.

In addition to the basic statutory requirements described earlier, the following principles are relevant for an SAP FI/CO implementation:

• Accounting principles (e.g., matching): The system defines principles you must apply in preparing financial statements, including going concern, accounting period, and matching principle. For example, the matching principle requires that revenues match expenses on a periodic basis. The matching principle is more pronounced in China than in the US GAAP. In R/3, you can achieve the matching principle by adopting cost of sales accounting and a few other processes, such as the work in progress (WIP) calculation and material ledger settlement. I will go into depth on this later.
• Inventory valuation: The new system takes a US GAAP approach to inventories. FIFO, weighted average, moving average, and LIFO are all acceptable for determining cost. If a standard costing system is used, cost/price variances must be apportioned among ending inventory, WIP, and consumption to arrive at the actual cost. This is important because the majority of the foreign investment in China is in the manufacturing industry. You can meet the standard costing requirements in R/3 via the WIP calculation and the material ledger functions, which I'll discuss later.
• Expense classification: The system requires that expenses be classified into operating, administrative, and financing, and that profit be classified between operating profit, investment income, subsidy income, and several other non-operating income categories. You can see this reflected in the number ranges of the chart of accounts structure in Figure 1.
• Fixed assets and depreciation: Fixed assets include property, buildings, machinery, and vehicles. They also include smaller tools and equipment used in production whose life exceeds one year, and other operating assets not used in production whose cost exceeds RMB 2,000 and whose life exceeds two years. Depreciation of all fixed assets begins when the asset is put into use. The method of calculating depreciation should reflect the pattern of consumption of benefits and can include straight-line, accelerated, or units-of-production depreciation. For a global company in China, the treatment of fixed assets may differ between Chinese statutory requirements and corporate standards.
• External financial reporting: Under the new accounting system, a financial and accounting report includes three components — accounting statements, notes to accounting statements, and a financial condition explanation memorandum. A published financial and accounting report should include the name of the enterprise, the nature of its operations, its address, the date the report is issued, and the names of responsible individuals, including the chief accounting officer and those with legal authority to approve the report. Key financial statements that are required for statutory, external reporting include balance sheet, income statement, statement of cash flow, statement of provision for impairment of assets, statement of profit appropriations, statement of changes in owner's equity, segment reporting statement, and the value added tax (VAT) payable movement table. These statements resemble the type used in the US. However, the content, structure, and format can be quite different. For example, the balance sheet format has the asset section placed in parallel with the liability and equity section on the same page, while the R/3 standard financial statement version has the asset preceding the liability and equity section in a vertical manner. Companies should check with local authorities on specific reporting requirements.

SAP Functionality

SAP provides a wealth of functionalities to meet the transaction and reporting requirements I have described:

• Legal entity and going concern: To meet statutory requirements, set up the Chinese branch as a separate entity. Each municipality, county, or city in China has its own independent set of financial reporting (by the Finance Bureau) and tax collection functions (by the State Tax Bureau or Local Tax Bureau). Therefore, a separate legal entity (or company code) is often required to properly segregate activities by these geographical locations. This may cause a foreign company to have multiple company codes in China — at each location where the firm is licensed for business.
• Fiscal calendar support: You can set up a separate special purpose ledger (China ledger) to reflect the fiscal calendar requirement of basic accounting law if the parent company's fiscal year doesn't correspond to the calendar year. You can assign the Chinese company codes to the China ledger with a fiscal year variant that corresponds to the calendar year. The global-use ledger can carry the corporate fiscal year variant that does not reflect the calendar year. You can perform the necessary period end closing procedures directly in the China ledger without affecting the G/L or the global-use ledger. Vice versa, you can reverse the procedures in G/L for global closing in the China ledger to offset their impact.
• Language support: SAP provides Multi-Display/Multi-Processing (MDMP) for non-Unicode systems to comply with the language requirement. This allows dynamic code page switching on the application server, and therefore permits any combination of standard code pages on one system. The log-on language determines the code page that is active for each user. However, SAP considers Unicode the appropriate development direction and strategy, because Unicode offers a single, consistent, and standard character set encoding for virtually all languages in the world. You can refer to SAP's Unicode Library at www.service.sap.com/unicode@sap. You can also find information about the conversion of existing non-Unicode SAP there.
• Currency support: The local currency of a Chinese company code needs to be RMB to observe the basic accounting law. Therefore, it's advisable for corporations with different global reporting currencies to set up group currency (e.g., USD for US companies or EUR for European companies) as an additional FI currency. You do this by setting up parallel currencies in FI. In R/3 4.5B, the corresponding configuration is in the IMG under Financial Accounting Global Settings>Company Code>Additional local currencies.
• For a global company, the controlling area setting should be one controlling area to cover multiple company codes. It's recommended to have the group currency as the controlling area currency. Having group currency as a parallel FI currency for the Chinese company code gives more transparency during FI to CO postings. It helps to clarify how the corresponding group currency values in the CO module are derived from the originating FI postings.
• Country chart of accounts: You can set up a country chart of accounts and assign it to the Chinese company code. This fulfills the statutory requirements of adopting the MOF-suggested account number ranges for statutory financial reporting. In the G/L account master record, the G/L account number ranges follow the corporate standard chart of accounts guidelines. The alternative account numbers can represent account number ranges that are organized into the country chart of accounts.
• Depreciation area settings: In R/3, only one country-specific chart of depreciation can be assigned to a company code. However, one chart of depreciation can have multiple depreciation areas. You have the option of setting up an additional depreciation area with unique sets of accounts to capture the depreciation for Chinese statutory purposes.
• Negative postings: In China, the accounting method specifies that the reversal of a document decreases the transaction figures on the original side of the account, rather than increasing the opposite side of the transaction figures. The latter is the default method in R/3 for document reversals. You can use the Chinese method by adopting the negative postings functionality offered by R/3. You need to allow negative postings in the configuration of the Chinese company code in the specific document types to be reversed and in the reasons for reversal.
• Cost of sales accounting: Since the Chinese accounting system requires the matching principle to be strictly reinforced, revenue/income should match the corresponding cost of sales/expense for each accounting period for reporting purposes. You can fulfill the requirement by adopting what's called the cost of sales accounting reporting method in R/3. As R/3 by default provides a period accounting method per European accounting standards, this represents a major point of confusion for people who are not familiar with the differences between the two methods (Figure 2).
  
  
  
  

  Figure 2

  Reconciliation of profit and loss statement (P&L) between period accounting and cost of sales accounting

Figure 2 Reconciliation of profit and loss statement (P&L) between period accounting and cost of sales accounting. * Includes material consumption, production costs, stock changes, production order variance, manufacturing cost center variance

In the period accounting approach, the system breaks down the operating results by revenue and cost element. This makes it possible to recognize which factors of production cause the costs that are incurred. You then can compare the total costs to the total revenues earned for the period. The costs of products produced in the period but not yet sold (increase in stock: Stock changes -1,000) are added to the sales revenue (Net revenue - 9,500), as illustrated in Figure 2. The services produced in previous periods and sold in the period under review (reduction in stock, which is not in this example), are deducted from the sales revenue. The sum, together with the capitalized internal activities and the changes to work in progress (Inventory change in WIP: -1,500), yields the total result for the period (Total output:
-12,000).

The more market-oriented cost-of-sales approach compares the costs to the corresponding quantity structure of the revenues. Revenues are only compared to the costs incurred for the quantity of goods or services sold and gross profit is reached as difference of these two. When products are sold from stock, it may be that the costs were incurred during a previous period. In this reporting approach, no distinction is made between different cost elements. Instead, resource usage is divided according to the functions such as production, sales and administration, general and administration, etc. By dividing the company into key functions, you can show why costs occurred and display their economic purpose.

SAP R/3 aids the reporting according to the cost-of-sales approach by introducing a special purpose ledger called "cost of sales accounting ledger" (COS ledger) and an additional characteristic called "functional area." Transaction figures of this ledger are organized by functional area. To activate cost-of-sales accounting for a company code, define and assign a substitution rule that derives the appropriate functional area from relevant FI or CO postings. You can use Report Painter/Report Writer to develop reports such as P&L based on the report library established on the totals table GLFUNCT of the COS ledger.

One cost element in R/3 can be used for multiple economic purposes (e.g., salary cost element can incur both in production, SD, and general and administrative areas). With the COS ledger, you do not need to distinguish the purpose on the cost element level. The economic purpose is demonstrated and derived by the cost object associated with each transaction. As you see in Figure 2, period accounting and cost of sales accounting can be reconciled with each other. For more detail on how this works, refer to the Download Section of the SAP Financials Expert Web site at www.SAPFinancialsExpert.com.

• Standard costing: If the company uses standard costing, you can use the Material Ledger (ML) to automatically track the cost/price variance by material by transaction and allocate the variance between the consumed inventory (cost of production, cost of good sold) and ending inventory (semi-finished, finished goods, and WIP). ML uses the standard cost for preliminary valuation and collects and tracks the variance on all receipts during the period. At the period end, the ML redistributes/settles the total variance between ending inventory, consumption in the next manufacturing level, and consumption to sales. In the ML settings, select settlement control 3 to calculate periodic unit price by single-level or multi-level settlements. This method aids the compliance of the matching principle. For an illustration on how this works, refer to supplemental material on the SAP Financials Expert Web site.
• Inventory valuation: If parallel valuation functionality is activated, you can use ML to valuate the inventory for multiple purposes — for example, for Chinese statutory valuation, group/consolidated valuation, or profit center valuation. You then can use profit center valuation to account for transfer pricing between profit centers for management reporting purposes. Further, having local currency and group currency as the parallel FI currency provides the ability to reconcile between G/L and ML postings.
• Statutory reports generation: By using Report Painter, Report Writer, and the COS ledger, you can simulate statutory reports within R/3. Unfortunately, Chinese statutory reporting is mostly based on account-based accounting, which assumes that the accounting ledger contains all financial information needed. By comparison, R/3 is an integrated system and its submodules such as CO, Materials Management, or Production Planning contain vital financial details. Because of such differences in data organization methodologies, it's very difficult to use R/3 to generate the statutory reports. Some R/3 clients in China simply purchase local accounting software (Kingdee Software, UFsoft) to print the statutory reports. They use R/3 as the online transaction processing application and management reporting repository, while manually or automatically loading the data into the local software to produce statutory reports. It's still possible to use R/3 tools to generate and print statutory reports; however, it requires quite extensive ABAP/4 programming. Report Painter and Report Writer do not suffice because of format limitations and operational data availability.

Tax-Related Statutory Requirements

Another governmental body, the tax bureau, enforces tax regulations. Some tax regulations are unique to China. Currently three types of invoices are used in China:

• Normal invoice, used if the business partner (e.g., customer or vendor) does not take part in the VAT refunding process. Small companies that don't generate certain levels of revenue sometimes fall in this category.
• Business tax invoice, used if invoices are service related
• Special VAT invoice, used if invoices are related to production. At present, VAT income makes up 50 percent of China's annual tax, generating the biggest tax revenue.

To issue an invoice to customers for sales of goods, companies are required to buy the software application called the Golden Tax System and the preprinted physical invoices from local tax bureaus. While issuing a VAT invoice, the Golden Tax System prints a 64-digit code ("mi ma": secret code) on the invoices.

The Golden Tax Project was launched in 1995 by the Chinese tax authority in a bid to crack down on tax fraud by forged VAT invoices. By the end of 2002, all companies were required to install the Golden Tax System for issuing special VAT invoices.

SAP China developed an interface solution for uploading R/3 into Golden Tax (Microsoft DOS version). After you issue the invoices, certain information can be downloaded into R/3. The latest Microsoft Windows version of the Golden Tax system no longer allows outgoing or incoming interfaces, so no automatic data transfer is possible with this version. For the overall invoice printing and management solution for China, refer to SAP note 192898.

Audit-Related Statutory Requirements

To reduce data exchange incompatibility issues and improve the use of accounting data generated from numerous types of accounting software, the Chinese Quality Inspection Bureau and the Standardization Administration of China published "Information Technology: Financial Software Data Interchange Standard (Code: GB/T19581-2004)" on November 4, 2004. It is to be implemented nationwide starting January 1, 2005. The standard stipulates specific requirements on data interfaces, including the data elements, content, and form of the output file in either .txt or XML format. It aims to facilitate the communication of data among different types of accounting software. Every business operating in China that has adopted a financial software application is required to have the ability to produce the financial data according to the standard. The relevant training materials and other testing standards and systems are in development.

Shanghai, which is the pioneer of government reforms and projects, introduced the Shanghai Financial Software Interchange (Code: DB31/T270-2002) in early 2002. Each company is required to comply with this standard issued by Shanghai Quality Inspection Bureau. More than 60 companies have submitted their interface modules/data extract programs to the bureau for testing and approval, with the majority of them being the software companies themselves. Several R/3 clients have developed custom interface programs themselves and passed the testing. So far, SAP China hasn't officially released any standard interfaces for R/3 to comply with Shanghai's interface standards.