There are two types of accounting in China: Tax or Fapiao Accounting – but one is better than the other

Some problems business’ face are not easily traced back to the accounting methodology, writes Lily Li

Fapiao accounting refers to recognising revenue and costs solely based on available fapiaos (the official receipts that are issued and received for goods or services in China). Accountants do not conduct bookkeeping until they issue output fapiaos or receive input fapiaos – and from there, they generate the required financial statements and calculate a business’ tax liability.

Many outsourced accountants choose to perform accounting on the basis of fapiaos because it is the simplest way to meet tax compliance requirements in China and enables them to perform bookkeeping and tax filing services for as low as 500 RMB per month.

However, accounting on the basis of fapiaos often result in the business paying tax early – hurting cash flow – and in some cases incorrectly calculating tax liability resulting in either overpaying taxes or penalties for underpaying taxes. Most costly to businesses, however, is not having financial data which resembles the actual financial state of the business.

This method of accounting does not comply with the Peoples Republic of China Generally Accepted Accounting Practices (PRC GAAP). The PRC GAAP requires that businesses accrue their expenses and revenue in the correct accounting period and produce accurate financial reports. This is often not the case when performing bookkeeping solely on the basis of fapiaos.

When an accountant performs accounting on the basis of fapiaos, financial reports do not accurately reflect the profitability of a company for a given period. Financial reports reflect when fapiaos were issued instead of when the goods or services were actually delivered together with their associated costs, as is required by PRC GAAP.

Businesses typically issue fapiaos once payment has been received and upon client’s request. However, PRC GAAP requires revenue to be recognised when good or services have been delivered. In example 1, accounting on the basis of fapiaos results in wrongly recognising revenue in Q1 based on the fapiao being issues before good or services are delivered and overstating their profits by 1,000 and overpaying their Q1 quarterly CIT by 250.

If the business reports a loss at the end of the whole financial year, early paid 250 CIT needs to be claimed back in the following year. This often requires the tax authorities to conduct a full scope tax audit to prove the business indeed incurred losses before refunding CIT.

The same can be said for Q2 in which goods or services are actually delivered; the accountant is understating Q2 profits. The business is concealing its true profits both from management and the tax authorities by not correctly accruing its revenue and expenses according to PRC GAAP.

In addition to improperly reporting revenue and expenses, accounting on the basis of fapiaos often leads to transactions, for which fapiaos were never issued, to be missing from financial statements. Perhaps the customer didn’t need a fapiao, or the sale was for export, in which case a fapiao is not required. The accountant would have no knowledge of these missing transactions and would underreport the revenue on the P&L statement. In Example 2, the accountant underreports revenue by 9,800 and also understate profits by 9,800 leading to a loss of 4,800.

One of the most basic compliance requirements in China is that the balance sheet matches bank balances. In order to ensure the business remains compliant, the accountant will book the revenue for which a fapiao was never issued on balance sheet indefinitely. In Example 2, the 9,800 of missing revenue will be reported on the balance sheet under deposits, pre-payments, or other business liabilities.

As of mid-2016, the tax authorities employed new legislation to monitor the revenue and expenses flowing through business bank accounts in order to compare them with their declared tax liability. Any unreported revenue, for example, the revenue booked in the “other” category on the balance sheet, will encourage the tax authorities to audit of the business. Businesses will be fined according to the severity of tax shortage, e.g. the shortage of over 2,000 VAT and CIT in Example 2, all the way up to five times the amount of the shortage.

Some of the problems businesses face as a result of fapiao accounting, such as the lack of accurate financial data, can easily be diagnosed by managers. Others, such as those affecting the business’ cash flow and tax liability, are not as easily traced back to the accounting methodology.

Speak to your accountant to begin accruing your business transactions according to PRC GAAP and asking about an appropriate tax strategy is a great place to begin. This is often enough to start the discussion about improving your businesses finances and making sure your business stays on track.

Lily Li is a former CFO of multinational enterprises and Managing Partner of small business platform, Axel Standard.