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Emerald Emerging Markets Case Studies

A Big Bath in China: accounting and corporate governance


Mingchuan Ren

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A Big Bath in China: accounting and


corporate governance

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Mingchuan Ren

Mingchuan Ren is an
Associate Professor at the
School of Management,
Fudan University,
Shanghai, China.

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 Chinas
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 China
had 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, Chinas 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 companys color TV became the number one brand in the
country.
Disclaimer. This case is written
solely for educational purposes
and is not intended to represent
successful or unsuccessful
managerial decision making.
The author/s may have
disguised names; financial and
other recognizable information
to protect confidentiality.

DOI 10.1108/20450621111110663

Up to early 1996 Chinas 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 Chinas 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

VOL. 1 NO. 1 2011, pp. 1-6, Q Emerald Group Publishing Limited, ISSN 2045-0621

EMERALD EMERGING MARKETS CASE STUDIES

PAGE 1

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.

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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 established
some 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 double
domestic 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
Rmb2 bn.
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 Cs 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 Cs 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 companys share price
reached Rmb66 per share.

PAGE 2 EMERALD EMERGING MARKETS CASE STUDIES VOL. 1 NO. 1 2011

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 Cs 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.

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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 Cs 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 firms economic activities. During
the economic transition, local governments serve multiple roles: providers of public service,
agents of Chinas central government to monitor listed firms, and major shareholders of listed firm.
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 months
because he failed to meet the governments 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 Cs 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 Cs overseas sales reached
Rmb780 m 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 Cs
increase of sales was accompanied by a swelling accounts receivable, particularly those
with company X. One can find detailed information in company Cs 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).

Keywords:
Accounting,
Accounting practices,
Corporate governance,
China

From the financial statements, one can find that company Cs increased sales was eclipsed
by a swelling accounts receivable and an increasing inventory. At the end of May 2004
the companys 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 Rmb3.7 bn for that
year. The share price closed at Rmb3.54 on December 31, 2004.

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), Chinas 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 many mothers-in-law, Far Eastern Economic Review, Vol. 19 No. 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 EMERALD EMERGING MARKETS CASE STUDIES PAGE 3

Exhibit
Company Cs financial statements from 2001 to 2005 are provided below, together with the
footnotes on accounts receivable for 2002-2004. The financial statements received clear
audit 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
Rmb295 m were within one year; Rmb3,513 m 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

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Sales
2Cost of sale
Tax and surtax
Gross margin
Other incomes
2Marketing expense
Administrative expense
Financial expense
Operating income
Investment income
Non-operating income
Total income
2Income tax
Minority interest
Net income
Earning per share (Rmb)

2003

2004

2005

176
0.081

14,134
12,083
7
2,044
55
1,386
460
71
182
33
52
267
60
1
206
0.095

11,539
9,887
18
1,634
13
1,111
4,021
22
23,507
2169
4
23,672
14
225
23,681
21.701

15,061
12,619
33
2,409
19
1,666
340
113
309
253
42
298
5
8
285
0.132

2001

2002

2003

2004

2005

1,646
2,881
5,941
3,779
14,247
152
2,764
474
1
17,638
85
2,436
2,064
292
4,877
0
8
4,885
11
2,164
4,066
4,830
1,682
12,742
17,638

1,005
4,220
7,193
2,841
15,259
139
2,802
470
0
18,670
1,622
2,356
2,074
2324
5,728
0
6
5,734
11
2,164
4,081
4,860
1,821
12,926
18,670

1,122
4,985
7,006
4,424
17,537
39
3,337
442
9
21,364
2,706
2,854
2,367
164
8,091
80
4
8,175
57
2,164
4,081
4,904
1,983
13,132
21,364

2,065
2,180
6,013
1,654
11,912
158
3,117
434
28
15,649
2,670
1,485
1,768
52
5,975
85
4
6,064
130
2,164
4,086
4,903
21,698
9,455
15,649

1,249
3,084
4,767
3,229
12,329
144
2,826
524

9,515
8,321
58
1,136
87
1,033
246
278
22
120
230
112
22
1
89
0.041

2002
12,585
10,711
26
1,848
66
1,414
356
17
127
78
2
207
31

Table AII Balance sheet (Rmb million)

Cash and cash equivalent


Accounts receivable
Inventories
Other current assets
Total current assets
Long-term investment
Fixed assets
Intangibles
Other long-term assets
Total assets
Short-term loans
Notes payable
Accounts payable
Other current liability
Total current liability
Long-term liability
Deferred income tax
Total liabilities
Minority interest
Capital
Capital reserves
Profit reserves
Retained earnings
Total equity
Total liability and equity

PAGE 4 EMERALD EMERGING MARKETS CASE STUDIES VOL. 1 NO. 1 2011

15,824
1,305
1,832
1,973
645
5,755
19
3
5,777
256
2,164
4,136
4,904
21,413
9,791
15,824

Table AIII Statement of cash flow (Rmb million)

Operating cash flow


Investing cash flow
Financing cash flow
Net cash flow

2001

2002

2003

2004

2005

1,373
21,023
2222
128

22,988
893
1,445
2650

2744
2252
1,103
107

760
190
231
919

1,421
2920
21,325
2824

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

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2003 footnote
A/R increased considerably over 2003 with the biggest increase related to company X,
whose A/R was Rmb4,447 m, among which Rmb3,512 m were within one year and
Rmb934 m between one and two years. On December 31, 2003 the company C had
inventory of more than Rmb7 bn after writing down approximately Rmb300 m (Table AV).

2002 footnotes
In 2002 company Cs A/R stood at Rmb4.22 bn, with that owed by company X accounting for
Rmb3.83 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 to
determine the performance of listed companies. What were company Cs performance
from 2002 to 2004 and the quality of reported earnings?

Table AIV 2004 year-end A/R and allowance for bad debt (Rmb million)
Age groups
Within one year
1-2 years
2-3 years
3-4 years
4-5 years
Over five years
Total
Net A/R

Rate (%)

Amount

Allowance

0
10
30
50
80
100

1,223
3,520
34
3

5
4,785
2,180

0
2,567
32
2

5
2,605

Table AV 2003 year-end A/R and allowance for bad debt (Rmb million)
Age groups
Within one year
1-2 years
2-3 years
3-4 years
4-5 years
Over five years
Total
Net A/R

Rate (%)

Amount

Allowance

0
10
30
50
80
100

4,141
934
4

4
0.6
5,083
4,985

0
93
1

3
0.6
98

VOL. 1 NO. 1 2011 EMERALD EMERGING MARKETS CASE STUDIES PAGE 5

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

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Within one year


1-2 years
2-3 years
3-4 years
4-5 years
Over five years
Total
Net A/R

Rate (%)

Amount

Allowance

0
10
30
50
80
100

4,213
5

4
0.006
0.8
4,224
4,220

0
0.5

2
0.005
0.8
3.3

Most listed companies in China were carve-outs from their parent SOEs and the
government 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)?

The company C changed its accounting policy for accounts receivable by doing a big
bath in 2004. Try to explain the accounting policy change in terms of Chinas business
environment in general and company Cs circumstance in particular?

PAGE 6 EMERALD EMERGING MARKETS CASE STUDIES VOL. 1 NO. 1 2011

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