An 'accounting revolution' is brewing in China.

• Author: Pacter, Paul
• Position: Financial reporting

It's hard to think of many national political leaders who have had profound effects on their country's accounting. Perhaps that could be said of Franklin Delano Roosevelt, who, in the early 1930s, spearheaded the creation of the U.S Securities and Exchange Commission (SEC), which, in turn, caused the American Institute of Certified Public Accountants (AICPA) to form an accounting standards committee. That committee has evolved into the Financial Accounting Standards Board (FASB).

The same could also be said of Deng Xiaoping, who, as head of China's Communist Party, led the Chinese government from 1978 until 1989. Deng undertook major economic reforms that opened the country to international trade and foreign direct investment, privatized agricultural activity and created such market institutions as a banking system and stock exchanges.

Before the reforms began in 1979, accounting in China reported on whether production goals and cost plans were being met. Today, accounting systems focus on providing information to investors and creditors. Even state-owned enterprises, which continue to dominate the economy, now look a lot like profit-oriented businesses, with outside shareholders, managers and others demanding relevant and reliable financial information with which to make capital allocation decisions.

China's Capital Markets Today

China's economy is big--to match its size. It has 1.3 billion people (20 percent of the world's population), a land area of 9.3 million square kilometers (virtually identical to the U.S.) and a gross domestic product of US$2.6 trillion (fourth in the world behind the U.S., Japan and Germany). GDP growth in 2006 was 11 percent, and is expected to be slightly higher in 2007.

China's capital markets include two securities exchanges--one in Shanghai and one in Shenzhen. In 1992, there were 50 listed companies. Today there are nearly 1,500, with a market cap of around US$3 trillion (larger than Deutsche Borse and just a little smaller than Nasdaq, Euronext and Tokyo).

For most of those companies, only a minority of shares actually trade publicly. The majority is still held by the state. Levels of institutional investment are low relative to Western securities markets. Only a small minority of the listed companies are audited by international auditing firms.

Financial Reporting in China

By law, all companies must prepare financial statements using Chinese generally accepted accounting principles (GAAP). The principal...