New standard for firms to put mainland on international stage
Auditors of all mainland-listed companies will have to give their opinions on the effectiveness of internal controls in the firms they are dealing with. This requirement takes effect on July 1 with the introduction of the mainland's first enterprise risk management standard.
The practice now is to give an opinion on the company's financial reporting only.
Based on the COSO Financial Controls Framework, the Basic Standard for Enterprise Internal Control is being co-launched by the Ministry of Finance, National Audit Office, China Securities Regulatory Commission, China Banking Regulatory Commission, and the China Insurance Regulatory Commission.
Medium and large private companies are also being encouraged to adopt the standard, but exemptions are expected.
According to Vivian Wong, manager of the risk department at Shinewing CPA, the standard will require auditors to look at internal controls in five areas: the company's internal control environment and whether this fully supports the system; risk assessment and its effectiveness; control activities, whether the company has control activities to implement the system; information and communication; and monitoring.
These five elements are identical to the COSO framework, which is used globally as a basis for internal controls by companies.
'There is no clear indication as to why China has decided to implement this standard now. But it is likely that the authorities want to keep pace with other countries, such as the United States, where they have implemented internal control rules for several years,' Ms Wong said.
Premier Wen Jiabao's recent pronouncement that Shanghai and Hong Kong will become China's two international finance centres also necessitates the strengthening of internal controls within mainland-listed companies.
'China is bringing its listed companies in line with international practices on internal controls. If it is eager to become part of the global economy and its major cities to become international finance centres, then the corporate governance standards of mainland-listed companies should be at a world-class level,' said Doman Wong, director, Risk Advisory Services, Baker Tilly Hong Kong.
For auditors working in mainland-listed companies, the standard's implementation would be a benchmark, Ms Wong said.
'There are internal control systems in use, but they aren't formal or written down, so the introduction of the standard will mark a big change.'
To ease the burden, auditors should start talking to the management of listed companies now and help to educate them about the importance of an internal control system.
The key concepts in the standard related to controls over the safeguarding of assets, the establishment of antifraud controls and the setting up of a fraud reporting mechanism, Mr Wong said.
'Companies affected by the standard will be required to define their policies on rewards and penalties for certain employees in order to support the implementation of internal controls.
'These employees, including accountants, will have their performance, with regard to internal controls, taken into account during staff performance appraisals. This will affect boards of directors, management, as well as the responsible persons.'
Once the standard comes into play, observers are expecting substantial changes with regards to the practice of internal control within mainland-listed companies.
'I anticipate that their corporate governance level will increase because first, management and the employees responsible for monitoring internal controls will be assessed on their performance regarding internal controls. They will have to work their best in order to achieve the objectives and targets of the company in relation to internal controls,' Mr Wong said.
'Secondly, because the central government is motivated to strengthen the corporate governance standards of all those listed companies within the mainland, in future those companies will also have to report their corporate governance standards in the corporate governance report within their annual reports.
'They are being given the initiative to follow world-class standards in terms of corporate governance.'
Any challenges in the standard's implementation will likely be related to difficulties during the preliminary stages of implementation. Drawing a parallel with experiences in the US, when the Sarbanes-Oxley Act was announced in 2002, Mr Wong said that mainland-listed companies might also experience difficulties in implementing the standard's requirements.
'In the US, companies had increased costs in the first two to three years after Sarbanes-Oxley was implemented because they had to document the internal controls. In the preliminary period with China's new standard, listed companies and their accountants will encounter similar difficulties,' he said.
'For the ongoing maintenance of good internal control systems, top management's support by boards of directors will be crucial in order that the standard is successful in promoting risk assessment, risk management and corporate governance. It is a board responsibility and commitment.'