May 2022

How to Prepare for an Effective Annual Audit in China

By Dezan Shira & Associates

Whether an audit is effective or not can make a big difference in a company’s governance and development in the long run, though it is not easy to identify the audit’s effectiveness right after the process.

From the company’s perspective, an effective audit can help maintain its financial health and offer advice on how to improve certain processes. To be more specific, an effective audit can do the following:

  • Ensure that financial statements of the company present a true and fair view of its financial situation
  • Reveal irregularities and suboptimal business practices
  • Identify risks in different functional areas
  • Offer advice on improving internal processes

An effective audit should also adhere to a schedule with minimal disruption to the company.

To achieve audit effectiveness—besides choosing a qualified audit firm—it is vital for companies to prepare in advance. An audit will be more meaningful for companies if auditors have adequate time to analyze accounts and evaluate control procedures, instead of being occupied with simple checks. This article is designed to provide some practical guidance based on Dezan Shira’s professional on-the-ground experiences.

What Do Companies Need to Prepare in General?

For companies, preparing for an annual audit goes beyond simply providing the accounts and ledgers. In general, companies can help to improve the audit effectiveness by taking the below measures:

1. Make a Thorough Inventory of the Assets—Before the auditor conducts a spot check of the company’s assets in the substantive audit, companies should make a full-scale stocktake of the assets by themselves to verify the existence and completeness of their assets. This is especially recommended if companies never check their assets on a regular basis. 

Companies should arrange cash count, inventory count, and fixed assets inspection. If obsolete inventory items, idling assets, and defective products are found during the check, they should let the auditors know and start to think about making impairment assessments.

The thorough stocktake is suggested to be arranged as close to year-end as possible. Otherwise, companies may need to provide stock-in and stock-out information to roll back or roll forward to reconcile the actual stocktake results and year-end accounting books.

2. Arrange Confirmations—Bank confirmation is a primary focus in verifying the bank balance of the financial audit. Before commencing the auditor’s investigation, companies should prepare relevant information in advance, including bank statements, bank reconciliations, bank balance, borrowings, guarantees, time deposits, bank mailing address, contact number, etc. This will shorten the time spent at this stage and provide the auditor with a good impression.

Besides bank confirmations, auditors may arrange confirmations for the current accounts to verify the existence and accuracy of the selected amounts, such as the related-party balances and transactions, trade receivables and payables, inventory on consignment, advancements to employees, etc. Companies should check accounts with current customers before the annual audit if they didn’t do this regularly. This will save much time for their auditors.

3. Analyze Recoverability of Receivables (Credit Risks)—Credit risk analysis on financial assets often involves management’s judgment. While many companies find it difficult to conduct such an analysis, it is essential to assess financial assets' recoverability, such as trade debtors.

Under the newly effective accounting standard on financial instruments, the expected credit loss model should be adopted when making the analysis. The accounts receivable aging analysis alone is no longer sufficient for impairment assessment of financial assets.

Companies should make clear accounting policies on what factors are to be taken into consideration when assessing credit risks, looking for reasonable and supportable forward-looking information available to the management, and determining the risk of default.

If there are indeed such default risks based on companies’ self-evaluation, they will likely be noticed and inquired about during the audit. Companies are advised to think about how to justify the risks when being asked.

4. Prepare for Expense Checking—Companies need to obtain and maintain tax-deductible expense vouchers, which in China are mainly VAT invoices. Companies are suggested to check and prepare relevant invoices and other documentation in advance.

When year-end approaches, also look for invoices that should have been but are not yet obtained, to try and see if there is any chance to get them ready before the financial audit. Should companies fail to obtain legitimate expense vouchers before filing the annual Corporate Income Tax (CIT) returns, relevant expenses will become non-deductible for CIT purposes in the current year.

Relevant taxes must be withheld for outbound expenses paid to overseas vendors, or else such expenses will not be pre-tax deductible.

Besides obtaining VAT invoices and other legitimate tax-deductible vouchers, companies should also make full provision of the expenses in their accounting books, irrelevant of whether or not they have received the VAT invoice. All expenses should be properly recorded before the end of December.

Remember to bind your accounting vouchers and keep them tidy and organized. By making a good impression on the auditors, companies should expect fewer questions from the auditors.

5. Analyze Profits, Justify Fluctuations—Companies should analyze their profit ratio in advance in case there are significant changes found for essential indicators, such as gross margin fluctuations or selling expenses increase. Companies should have valid explanations to justify the fluctuations as such irregularities will be noticed by their auditors and lead to queries during the audit.

6. CIT-Related Preparations—Under the current policy, companies decide whether they are qualified for certain CIT incentives based on their self-assessments. This simplifies the process of enjoying tax incentives but increases potential tax risks where there have been misjudgments. Auditors generally will help to make CIT-relevant evaluations in the annual audit, although they do not express an opinion in this regard.

Companies should prepare relevant sub-ledgers and gather and retain supporting documents for such items in advance. On the other hand, they are advised to carefully examine if they have exhausted all possible tax reductions.

7. Make Sure Relevant Staff Are on Duty—As introduced above, beyond providing documentation before the actual audit, companies should prepare for offering additional information and details behind the figures, which requires close support of all key staff during the audit.

Thus, companies should plan around the audit to ensure that all key finance and accounting staff and other key staff of the operational teams haven’t booked time off and have a general free schedule during the audit. Ideally, these staff should be available at any time when required.

Additional Preparations for 2021 Effective Accounting Standards

Starting 1 January 2021, several new accounting standards have been applied to all entities that have adopted the Chinese Accounting Standards (CAS) for Business Enterprises, including the CAS No. 14 regarding revenue, CAS No. 21 regarding leases, and accounting standards regarding financial instruments (CAS Nos. 22, 23, 24, and 37).

The implementation of new accounting standards is likely to pose new challenges to the accounting work of relevant enterprises and could impact their daily business decisions, internal control, financial performance, and other aspects.

Companies that are obligated to adopt the new CAS but have not yet, due to their insufficient understanding of the accounting standards or practical difficulties, should seek professional advice as early as possible to see how they can prepare.

Even companies that have adopted the new CAS will still need to prepare for the extra queries and documentation requirements from auditors regarding the implementation details of the new accounting standards.

For example, as a lessee, based on CAS No. 21, your auditors may need you to provide the amortization table for lease liabilities and depreciation schedule for right-of-use assets. They may also ask you to explain and justify the discount rate you have been using and how you calculate the implicit interest rate in the lease.

Special Considerations Due to COVID-19 Pandemic

Under China’s zero-tolerance approach in combating the COVID-19 pandemic, the following have been some special considerations in the country:

Travel Restrictions

Strict quarantine and travel restrictions are applied whenever there is an outbreak, which will be of comparatively high frequency during the audit season when the cold environment is more suitable for virus survival and transmission.

To prepare for this situation, companies are advised to start the preliminary audit and formal audit as early as possible especially for those whose auditors are based in a different city from them. This way they leave enough buffer time in case of sudden travel restrictions.

Business Continuity

Even though the global economy is in recovery mode and uncertainty over COVID-19 is no longer the foremost economic concern to many executives, the pandemic has still taken a toll on businesses. Companies may suffer cash flow difficulties because it takes longer to collect the debt from the customers. The reliability of income and cash flow forecasts may become questionable due to unexpected developments associated with the pandemic in certain areas.

Under this situation, auditors will pay special attention to business continuity or “going concern” during the annual audit. Companies might be asked questions like, “Have you assessed the impact of COVID-19?” or “How did the management respond to the changing economic conditions?” If significant, this information may even be disclosed in the financial reports of the company.

To prepare, companies should analyze in advance about the following:

1. If they have sufficient liquidity to remain solvent through the pandemic and beyond
2. If they have any access to financial support from the parent company or a banking facility not yet utilized
3. If they are qualified for any government assistance or relief

Internal Control, Fraud

Besides the impact of domestic travel restrictions on annual audits, the travel restriction between China and the rest of the world may result in foreign general managers being stuck outside of China, which in turn will affect the implementation of the internal controls and cause disruption in the reporting line.

Moreover, the company management may have a greater incentive to override controls due to increased pressure on growth under COVID-19 or to correspond to changes in the business environment, such as inflation and supply chain disruption.
All of these will lead to a higher risk of irregularities and fraud.

Accounting Digitalization

Accounting digitalization, or tech-powered accounting solutions, means the use of information technology to optimize the finance and accounting processes. “Shift to digital” has been an emerging trend, especially since the outbreak of COVID-19.

Different from other preparations that are directly related to the annual audit and can be made right before the process, accounting digitalization is more like a long-term investment that has multiple benefits, including making the financial audit easier and more effective.

To be more specific, compared to traditional methods, finance and accounting technology has advantages in efficient allocation of work hours, accurate accounting through real-time capture of information and computerized calculation, system integration with compliance/reporting mechanisms, and more optimal (rather than one time) use of company data.

For example, a lot of information that needs to be prepared for the audit, such as how much money is owed to each vendor and the aging schedule/accounts receivable aging for each outstanding transaction, can be displayed on a searchable accounts payable list. This information itself is delivered from a specific module of the tech-powered accounting software, which in turn gets populated automatically from the digitalized expense management app.

Another example relates to fixed assets management. Important questions during audits include: What information does the company have about its fixed assets? How far have they depreciated? What is the nature of these assets? All of this information will be pulled directly from the fixed assets module of the tech-powered accounting software and displayed on a fixed assets list.

At the very least, going digital results in most documentation being accessible online, thus saving auditors and executives from rifling through filing cabinets at the financial year-end. For companies that haven’t adopted the finance and accounting technology, they are well-advised to think about it for next year or sooner. Newer tech-enabled accounting solutions are no longer prohibitively expensive or difficult to use. For companies that use an accounting service provider and don’t have highly complex requirements in terms of processing or reporting, flexible platforms now exist, whose access is part of the services provided by accounting providers to smaller firms, sometimes with only minimal upfront setup fees.

In Summary: Getting the Most Out of Annual Audits

An effective audit is beneficial to a company’s management and development in the long run. To pursue audit effectiveness, close collaboration between the auditor and the auditee is needed.

Companies can better prepare for this by conducting necessary self-checking, preparing needed accounting and tax documentation, analyzing core finance issues, and preparing for auditors’ inquiries in various aspects. This helps the organization minimize the disruption of the annual audit on their business operations and enables a more comprehensive audit that can help senior management gauge the efficiency of the financial workings of their company.

To get the most out of the annual audit, companies should take the chance to improve their internal controls and review related-party transactions. This is especially important for smaller companies that don’t have a designated team to handle these matters and don’t have separate internal control reviews and transfer pricing assessments. These companies should integrate these value-added reviews into their annual audit processes.

Given this, auditors will likely increase the risk assessment level and come up with more inquiries, more tests of controls, and more substantive tests. Companies should be mentally prepared to get ready for collaborating with the auditors more closely for the additional inquiries and tests.

This article was originally published in the magazine, Annual Audit and Compliance in China: Get Ready for 2022, published by Asia Briefing, as well as published in China Briefing, both of which are produced by Dezan Shira & Associates. The firm assists foreign investors throughout Asia from offices across the world, including in China, Hong Kong, Vietnam, Singapore, India, and Russia. Readers may write to [email protected] for more support.
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