When considering an investment in a venture operating in China, whether it be a partnership, acquisition, shareholding stake, securities purchase or other form of transaction, it is important to conduct due diligence to minimize risk, assess competitive advantages and identify growth opportunities.

Corporate fraud is an international problem but recent cases in China have shown even large, well-resourced accounting services firms have been duped by, or complicit in, misleading financial information and other fraudulent practices. Accounting irregularities have appeared in U.S.-Listed Chinese companies, with the ripple effects of impropriety reaching investors all over the world.

Despite the risks, China remains a high growth emerging economy and is largely outperforming ailing European and American markets. Shrewd investors will continue to seek choice opportunities in the Chinese market as long as this growth continues. It is prudent to take a multi-faceted approach to due diligence and ensure that you have a clear and well rounded picture of your target investment.

This due diligence primer discusses some of the main types of due diligence that should be conducted in this environment. It will help investors avoid common pitfalls and adjust their approach strategy to take into account the unique nature of the Chinese business environment.

Basic Checklist for Foreign Invested Entities

The following documents are a base check list that should all be covered to ensure a foreign invested entity in China is operating legally and has appropriate permits and approvals. Note different requirements for a Wholly Foreign Owned Enterprise (WFOE), Joint Ventures (JVs) or Representative Office (RO):

1. Articles of association (WFOE, JV)
2. Organisation cerificate (RO, WFOE, JV)
3. Business license (WFOE, JV)
4. Registration certificate of foreign enterprises permanent office in China (RO, WFOE, JV)
5. Capital verification report (WFOE, JV)
6. National and local tax certificates (RO, WFOE, JV)
7. Tax documents for any preference or exemption (RO, WFOE, JV)
8. Approval notice for bank account (RO, WFOE, JV)
9. Signature card for bank account (RO, WFOE, JV)
10. Office rent contract or certificate of real estate ownership (RO, WFOE, JV)
11. Contact details of the financial department or cashier (RO, WFOE, JV)
12. Accounting policies (RO, WFOE, JV)
13. Custom documents (RO, WFOE, JV)
14. Copies of passport of the investor(s) or business license of the parent company (RO)
15. Photocopies of the ID card or passport of the chief of the board (RO)
16. Certificate of the chief representative salary (RO)

Financial Due Diligence

Accountancy

Thorough financial due diligence is an important basis for understanding a company’s business operations and identifying potential accounting irregularities. It is important to be alert to the practice of keeping multiple accounting books. There have been cases of companies holding up to three or even more sets of books in order to reflect different financial positions to different parties.One overestimates profit to attract potential investors, another underestimates profit in order to avoid tax, and a third book reflects a fair representation of the company’s financial situation for internal use.

Other important accounting considerations when operating in the Chinese business environment include:

• Analyze fixed assets: are they reflecting the reality of the company’s operations? Assets may be overestimated or have inaccurate depreciation. Ensure that the company is the true contractual owner of the fixed assets;
• Accounts receivables: confirmation with clients is essential in order to double check the target company’s explanations of total billing. This process should also apply extra scrutiny to a company’s aged receivables balance. Where applicable, suppliers should also be verified;
• Cash position should be confirmed through a letter from the banks, and in some cases sending it to the regional headquarters may be preferred;
• Check other payable and liabilities: analysis should be done on salaries, social insurance payments or liabilities such as pension payments for former employees; In some cases, higher salaries are negotiated in exchange for underpaying social insurance obligations;
• Business expenses: check the authenticity of invoices.

Taxation

Beyond accounting issues, China has a complex taxation system and regulatory environment requiring a close examination of a company’s overall situation and liabilities. The various possible corporate and legal structures each have different tax issues and risks to address. The tax environment is constantly evolving; new national tax regulations may have different levels of implementation or amendments in various localities.  Companies may have entered into informal agreements with local government representatives that contradict national regulations or are legally unenforceable. Unpaid tax obligations can significantly change a company’s profits and losses if it plans on coming into full compliance with tax regulations.

It is also important to keep in mind the following questions when conducting due diligence on tax issues:

• How does the PRC GAAP differ from the accounting standards normally used by the investor? Do these issues have the potential to create confusion about the overall financial position of the target investment?
• Do transfer pricing issues or exposure to transfer pricing apply to the company in question?
• What are the applicable preferential tax rates based on the company’s industry or operational scope, and what is the extent and time length of these preferential rates?
• Is the company in compliance will all foreign exchange regulations?
• Is the company fulfilling its withholding tax responsibilities?
• If applicable, are all customs regulations being followed?

Operational and Investigative Due Diligence

Even if an investor conducts thorough accounting, tax, and financial due diligence on a potential target, investigative and operational due diligence can help verify a company’s provided documentation through firsthand inspections and assessments.

The case of China Biotics, a formerly U.S.-Listed Chinese company, demonstrates how operational due diligence is a particularly important preparatory step. China Biotics’ auditor, BDO, resigned in mid-2011. In their submission of an 8-K to the United States Securities and Exchange Commission (SEC), BDO citied irregularities that it believed could constitute illegal acts. Included in the auditor’s resignation letter was the revelation that when examining the bank statements of China Biotics, BDO staff members were directed to what is believed to have been a fake bank website designed to deceive the auditors into confirming false bank information.

Taking into account the potential misrepresentation of a company’s financial position creates an even greater need for comprehensive operational and investigatory due diligence. Due diligence confined primarily to reviewing financial statements and other company documents is unlikely to provide all vital information for a potential investor, and is inadequate to provide a complete picture of a company’s operations. 

It is important to keep in mind that any introductions arranged by the target company will be restricted to whatever this company wishes you to see and hear. Do not to put too much stock into these sorts of meetings and introductions, since they will most likely be designed to create the most positive picture possible of your target.

Site Visits

In addition to face-to-face meetings it can be useful to conduct independent investigations into a company’s suppliers and customers. Can you independently verify their volumes of sales or purchases from suppliers? Can you secure interviews with lower level staff or security guards at factories or facilities? Sometimes interviewing lower level personnel who have not been coached on what to say to investors can help in getting a truer picture of the target in question.

An effective strategy to get the most out of site visits and investigative due diligence is to have multi-function team consisting of operational, legal, environmental, financial and human resources experts. By assembling a team with complimentary specialties the combined intelligence can help reveal more information than may be gathered by individual analysis. A legal team can be crucial in investigate due diligence, but also is necessary to do a thorough examination of  a variety of important issues, including business structure and scope, Intellectual Property (IP), and land use, among others.

Legal Due Diligence

In an environment that lacks financial transparency with disincentives to disclose contingent liabilities, legal due diligence can helpdetermine a target’s attractiveness and ensureall contractual agreements are solid and in order. Special focus should be given to the following issues while taking into account China’s young legal system:

Target structure/industry classification

Confirm the company possesses all necessary business licenses and permits. The ownership structure of the company should be verified to determine if there are any hidden owners or partial shareholders. Special attention should be paid to this; verbal agreements can be legally enforceable in China. The Chinese government also has various classifications for industries in China: encouraged, neutral, discouraged, and forbidden. Determining the classification of your target will help you determine if and with what stipulations an investment can be made, as well as identify any possible tax benefits the target may be entitled to.

Land use rights

While land in China technically cannot be owned by an individual, the right to use land and own any property on that land can be purchased. Confirm that the company in question owns the land use rights itself and that these rights are not owned by third parties or parent/affiliate companies of your target. Common problems include unenforceable informal arrangements between companies and local officials, land improperly zoned for current use, or mortgaged land and buildings detracting from the target company’s overall value.

Intellectual property

Systems for intellectual property protection have been strengthened in recent years, but there is still progress to be made. Companies can underestimate the value of their own IP and therefore do not take the necessary legal steps to protect it. An investor should confirm its target has proprietary rights to any technology when applicable and check all corresponding trademarks and patents.

Environmental Due Diligence

Given China’s strict environmental standards and the focus on environmental protection in the 12th five-year plan, environmental due diligence should be conducted where applicable.

Some important issues to consider concerning environmental due diligence issues in China include:

• Company’s holding of all appropriate environmental permits;
• Examining any potential outstanding liabilities or costs due to environmental contamination or degradation;
• Ensuring land included as part of any deal is not contaminated (soil sampling can determine this);
• Clarifying what environmental management systems a company has in place;
• In the case of land containing factories, examining wastewater management and waste disposal capabilities and procedures;
• Investigating any existing arrangements with a locality’s governing environmental body.

Our Role

S.J. Grand has a trained team of legal, audit and tax professionals with experience in cross border transactions and due diligence. Our combination of international and local talent allows us to both guide companies entering the Chinese market or conducting their first transaction, while having a comprehensive understanding of the local regulatory environment to help ensure full compliance.

Contact your local S.J. Grand representative today for more information.