China Crisis Caused by Accounting?

Here's the darndest thing to gain my attention in a while. Forbes suggests that regulations to make Chinese accounting comparable to--but not exactly of the same standard as--worldwide standards (e.g., IASB) may cause stock market turmoil. Skeletons in the closet brought out into the sunlight by firms which have performed bookkeeping sleights of hand may shock. After all, the Chinese are famous for "creative accounting" in keeping three sets of books: one for the tax man, one for the external auditor, and one for internal use. Although moving towards international accounting conventions is of course a worthwhile long-term goal, expect some fireworks in the meantime. With the average P/E ratio in China being a whopping 63 according to Forbes, things are bound to get interesting:

Behind the recent, gut-clenching stock market volatility in China is a disquieting reality: China's rotten accounting. If you thought the Shanghai index's 8.8% drop in late February was bad, wait until a bunch of rickety Chinese companies collapse.

That's the dour outlook from ace China-watcher Brian Hamilton, who runs stock research firm Sageworks in Research Triangle Park, N.C. "Investors in China tend to buy and sell according to price movements, not fundamentals," Hamilton says. "But too often with China's stocks, there are no fundamentals to be found..."

But Hamilton thinks that move still won't stop market swings. That's because investors are about to see much more detail on China's corporate earnings, and the picture may not be pretty. With its accession to the World Trade Organization in 2001 China promised to open up its accounting sector to foreign accounting firms. China decreed Jan. 1 that its listed companies must book their profits under a new set of accounting rules. But what's eventually unearthed just might set off panics among small investors.

The new rules are based on--but not identical to--the international accounting standards increasingly used in most markets. That means much more detail in a secret economy, where even the most basic line items like debt and development costs were hard to come by, says Stephen Chipman, an expert on China's financial systems at Grant Thornton. Now companies will have to do things like quickly write off obsolete inventory and uncollectible receivables. That's a novel concept there.

Financial fraud has been plaguing China's effort to mingle freewheeling capitalism with its murky centrally planned economy. The country's police recently announced that they have uncovered 400,000 cases of economic crimes and arrested 370,000 suspects over the past seven years, recovering $12.9 billion. The harsh prison sentences meted out to Enron's Jeffrey Skilling and WorldCom's Bernard Ebbers are nothing compared with the sentences Chinese authorities handed two embezzlers: Zhou Limin, a former branch president of China Construction Bank, and Liu Yibin, an accountant, will be executed for filching $25 million.