China has historically cut itself off from interaction with the global business community for all but the last thirty-eight years. During this isolation, Chinese society and businesses developed their own morality, ethics, cultural leanings, and business practices.
Philosophically, culturally, and business-wise Chinese companies operate on a different plane than businesses in other areas of the world. As a result, the methodology of performing forensic due diligence in China can vary widely from that performed in other countries.
Forensic due diligence in China is challenging and requires a comprehensive knowledge of the country’s complex accounting, legal, and business issues. Alan Refkin and David Dodge will provide you with the tools necessary to delve deep into the business and financial fabric of corporate China, allowing readers to pierce the wall of secrecy surrounding Chinese businesses.
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Piercing the Great Wall of Corporate China
How to Perform Forensic Due Diligence on Chinese Companies
By ALAN REFKIN, David Dodge
iUniverseCopyright © 2016 Alan Refkin and David Dodge
All rights reserved.
The Due Diligence Process
Due diligence is the research and analysis of a company or organization done in preparation for a business transaction. This investigation is designed to confirm or dispute facts that have been presented by parties to the transaction, with the goal of preventing unnecessary harm should these facts prove to be in error and to uncover material facts that may not have been disclosed.
There are two primary categories of due diligence:
standard due diligence
forensic due diligence
Standard due diligence serves a broad range of interests. It employs a one-size-fits-all set of procedures to analyze all or a portion of a specific company or organization. Forensic due diligence is a much more comprehensive analytical process that requires corroborative verification prior to something being accepted as fact. According to Forensico, forensic due diligence uncovers red flags by going beyond the stated disclosures and conducting a substantive analytical process to uncover the accuracy of disclosures, the reliability of reported performance, the appropriateness of internal controls, and undisclosed risks.
Within each due diligence category, the following are the most common types of due diligence performed:
financial due diligence
legal due diligence
operational due diligence
Financial Due Diligence
Financial due diligence is the process of understanding and validating financial information, both historical and projected. Financial due diligence may include reviewing historical accounting records and practices, verifying critical historical financial data, identifying potential accounting irregularities, and reviewing and stress-testing the company's financial model. This is the most frequently utilized category of due diligence.
Financial due diligence is commonly separated into two primary categories:
Historical financial results reflect what's already been achieved and recorded. Financial statements are generated and compiled from transactional accounting records and documentation like sales invoices, purchase orders, inventory records, bank statements, and tax returns. These statements generally reflect how the company has performed during a specific period of time and the financial position of the company on a specified date.
Other supplementary financial statements, such as statements of cash flow or shareholder equity, are required for publicly traded companies. These may be prepared by management, or they may be reviewed or audited by an independent accounting firm. Analyzing the processes and principles used to prepare financial statements and the level of scrutiny that's been applied both internally and externally can provide critical guidance about the reliability and accuracy of such statements.
Financial due diligence should also involve a thorough analysis of a company's expected future operating results. This information is most frequently obtained from internally prepared corporate projections. Projections are most often in the form of a financial model that uses fundamental assumptions involving the factors that drive the company's business to produce a set of projected financial statements.
A financial projection is highly subjective by nature, as it typically involves making informed estimates about multiple factors, such as market demand, market share, expected sales volumes, pricing, cost of materials, labor costs, tax policies, availability and cost of capital, and innumerable other microeconomic and macroeconomic factors. Each of the underlying assumptions should be reviewed in detail and tested for reasonableness, and the model as a whole should be stress-tested using a wide range of assumptions.
When operating in China, both historical and forward-looking financial due diligence must be taken into consideration. This is because of the frequent use of deceptive accounting practices, which are commonly employed in China. These include manipulation of tax reporting , off-the-books cash transactions, false documentation, nonexistent customers, and other fraudulent financial practices.
Legal Due Diligence
Legal due diligence is the process by which legal professionals determine both the status and the consequences of an intended transaction. The status is comprised of the details of the transaction as well as their context. This helps expose hidden risks or liabilities, and it sets the stage for a determination of consequences. The consequences portion of legal due diligence determines how things will change as a result of the contemplated action. In addition, attorneys will determine if there are any impediments that would prevent the closing of the contemplated transaction.
Legal cross-border due diligence 6 or due diligence that takes place in more than one country, takes into account not only Chinese legal requirements but also the legalities that pertain to another country. On occasion, these may not be in alignment, and conflicting legal requirements may arise. For those conducting legal due diligence in China, we always advise retaining a Chinese law firm that is familiar with the legal intricacies of both business and finance law. They can help to obtain a resolution to many of the complex issues that accompany cross-border transactions.
Operational Due Diligence
Operational due diligence is the process by which due diligence is performed on the fundamental elements that drive a company's underlying business. Operational due diligence may include an examination of items like the company's business model, facilities, products, pricing, distribution network, supply chain, human resources, and competitive landscape, among others. The purpose of operational due diligence is to provide the party performing the diligence — such as an underwriter, investor, or acquirer — with comfort and independent verification that the information provided by the company, and being relied on by the party performing the diligence, is materially accurate and complete.
Due Diligence Procedures
Every company and every assignment is unique, with procedures tailored to each individual project based on the requirements of the party commissioning the due diligence — and regardless of whether the commissioning party is an underwriter, an acquiring company, an investor, a company's board of directors, or an altogether different entity. However, there are standard procedures that are commonly applied in the performance of forensic financial due diligence. Not every procedure is applicable to every company; in employing these procedures, you'll need to take into account the specific type of company involved, as well as the established goals of the forensic due diligence assignment.
Historical Financial Statement Review
The following procedures are standard for historical financial due diligence:
Review the company's financial statements for the last three fiscal years (monthly or quarterly, if available) to include income statements, balance sheets, and statements of cash flow and shareholder equity.
Analyze period-over-period fluctuations in key accounts on the financial statements.
Analyze key metrics including, but not limited to, gross and net profit margins, operating expenses as a percentage of revenue, current ratio, debt ratio, return on assets, day sales outstanding, and inventory turnover. These should be compared period-over-period and relative to comparable companies.
If applicable, speak with auditors about key accounting issues.
Obtain reconciliations of all key accounts, if available. If the company's financial statements are audited, obtain these schedules, which are a standard part of the audit process.
Review a list of the company's bank accounts and balances by period.
Obtain bank statements and confirm bank balances directly at the bank. See chapter 11, "Independent Procedures," for an in-depth discussion of the bank confirmation process.
Review accounts-receivable aging and analyze the age of receivables based on industry, geography, and other relevant factors.
Review methodology to calculate bad-debt expense for reasonableness and proper application.
Verify the existence and validity of sample key customers . See chapter 11, "Independent Procedures," for an in-depth discussion of the customer verification process.
Review inventory listing and movement schedules.
Perform a physical observation of the inventory, including test counts and comparing the results to inventory records.
Review previous inventory-count procedures and results.
Review procedures for calculating reserves for obsolete or slow- moving inventory, and proper application of those procedures.
Review the makeup of "other receivables" for unusual items, as this is a common catch-all account for Chinese companies where material items may be hidden.
Review other current asset accounts, such as prepaid expenses and deposits, as necessary.
Review the company's list of property and equipment.
Understand depreciation methodology and analyze property relative to governing accounting principles.
Verify the existence and ownership of property, equipment, and land-use rights. See chapter 11, "Independent Procedures," for in-depth discussion of the fixed-asset verification process.
Review other appropriate long-term asset accounts.
Review a listing of accounts payable, noting concentrations, related parties, and other trends.
Review taxes payable and verify that taxes are accrued in accordance with applicable taxation policies.
Verify income and value-added tax (VAT) amounts with government filings. See chapter 11, "Independent Procedures," for an in-depth discussion of the tax verification process.
Review other appropriate current liability accounts.
Review debt agreements, noting items like collateral arrangements, acceleration clauses, conversion features, and contractual attributes that could trigger special derivative accounting treatment under US GAAP (generally accepted accounting principles), as well as other material elements.
Review the makeup of other payables for unusual items, as this is a common catch-all account for Chinese companies where material items may be hidden.
Inquire about and review off-balance-sheet contractual commitments, such as purchases or construction commitments.
Inquire about and review contingent liabilities — including, but not limited to, pending litigation, underfunded pension plans, and potential product liability.
Understand the shareholder's equity structure — including, but not limited to, issues like the effect of dilutive securities.
Review a list of sales by customer and analyze for concentration of sales, period-over-period fluctuations, and other notable trends.
Review a list of sales by product and analyze for notable trends.
Methodically review cost of goods sold, including the allocation of labor and overhead, and the use of LIFO (last in, first out), FIFO (first in, first out), or other methodologies.
Review profit margins by product and compare period-over-period trends with available industry information.
Examine the components of SG&A (selling, general, and administrative) expense detail for each period, comparing period-over-period, relative to comparable companies.
Examine the components of interest expense and verify that the interest expense is commensurate with the debt load and the terms of debt agreements.
Examine any extraordinary or nonrecurring expenses.
Financial Projections Review
The following procedures are standard for projected financial due diligence:
Evaluate the assumptions the company used to compile its financial model, comparing this to industry standards, the company's historical performance, and other relevant metrics.
Evaluate the company's capital requirements based on its expected financial results.
Conduct a stress-test model using a reasonable range of values for critical inputs.
The following lists provide documentation that should be requested from a company when conducting standard operational due diligence, as well as procedures that must be performed. As with the financial due diligence lists, these should not be considered all-encompassing or applicable to every situation. Each company, industry, and geographical area has its own distinctive characteristics that should be considered when preparing a due diligence information request list and a customized set of procedures.
Obtain an organizational chart and staff structure by department.
Obtain the articles of incorporation, bylaws, and other pertinent organizational formation documentation for the company.
Obtain the articles of association.
Determine whether the chairman or other executives of the company have previously been officers or directors of any other enterprise.
Obtain a departmental listing of employees that provides their names, job titles, compensation, stock options, and length of service.
Obtain a distribution channel and sales network chart.
Obtain a list of the company's competitors that includes a description or estimate of their operation, size, location, revenue, and market share.
Obtain sales information on the amount of business provided by a franchiser, agent, or direct seller.
Obtain a list of who in the company is responsible for contact with the company's main clients.
Obtain a description of the company's business process, along with important elements or components of that process.
Determine the adequacy of corporate insurance coverage, to include product liability.
Obtain information on the company's advertising strategy and the carrier or media designated to implement this strategy.
Obtain contact information for the company's legal counsel, primary commercial banking provider(s), and auditing/ accounting services provider.
Perform a SWOT (strengths, weaknesses, opportunities, and threats) analysis.
Obtain business and/or operating licenses, industrial qualification certificates, and certificates of authority.
Obtain capital verification reports , capital increase reports , and any related asset-appraisal documentation.
Obtain the corporate organization code certificate.
Obtain the company's tax registration certificate.
Contracts and Documents
Obtain documentation for corporate ownership, securities, transport-vehicle licenses, patents, trademarks, trade secrets, copyrights, and other intellectual property (IP) and intangible assets, to include the date filed (if pending), the organizational body issuing the patent, and the date issued.
Obtain income tax returns and payment documentation for the previous fiscal year and the most recent quarter.
Obtain copies of the sales-tax return for the previous fiscal year, along with the sales-tax return and payment documentation for the current month.
Obtain documentation for internal controls, to include policies and procedures for finance, inventory, purchasing, production, and sales.
Obtain a list of regulatory agencies that have authority over the company's business operations, as well as a copy of the regulatory permits issued to the company and proof of corporate regulatory compliance.
Obtain documentation for corporate insurance, to include product liability insurance as well as key-man insurance for key executives.
Obtain copies of résumés for key management as well as the board of directors, as applicable.
Obtain copies of employment contracts.
Obtain documentation on collective-bargaining agreements, along with side letters.
Obtain copies of non-compete and/or confidentiality agreements.
Obtain copies of the company's personnel policies, consulting contracts, employee-benefit contracts, profit-sharing plans, health plans, contracts with unions, employee stock-option plans, option agreements, performance bonus plans, and other employee benefits.
Obtain copies of workers' compensation policies.
Obtain closing contracts related to the acquisition or deposition of an asset over the past three years.
Obtain a list of company contracts documenting the customer, value of the contract, terms, and payment schedule.
Excerpted from Piercing the Great Wall of Corporate China by ALAN REFKIN, David Dodge. Copyright © 2016 Alan Refkin and David Dodge. Excerpted by permission of iUniverse.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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Table of Contents
Chapter 1 The Due Diligence Process, 1,
Chapter 2 Corporate Records and Documents, 20,
Chapter 3 Operations, 32,
Chapter 4 Other Common Documentation, 43,
Chapter 5 Outside Parties, 51,
Chapter 6 Human Resources, 69,
Chapter 7 Financial Due Diligence in China, 83,
Chapter 8 Competition, 111,
Chapter 9 Legal, 117,
Chapter 10 Government Relationships, 123,
Chapter 11 Independent Procedures, 137,
Chapter 12 Piercing the Great Wall, 164,
Appendix A: Sample Due Diligence Report, 169,
Appendix B: Disclaimers, 237,
About the Authors, 261,