Why care about China's reporting system: China's accounting system--though regarded as on par with Western practices--is criticized by some as deeply flawed. Understanding the Chinese system can provide valuable insight and help evaluate business opportunities in the world's second-largest economy.

• Author: King, Ronald R.
• Position: International Accounting - Statistical data

China has become a global economic force. It's on the radar of many businesses for a variety of reasons, including its population of 135 billion people--nearly 20 percent of the world's population--as well as a huge manufacturing base and an average annual gross domestic product growth rate of 10 percent for the past 30 years.

The United States is China's largest trading partner, accounting for almost $92 billion in exports in 2010, a nearly five-fold increase from a decade earlier. Imports during 2010 were just under $365 billion, or about four times exports to China.

Trade between the two nations and China's overall economy are only expected to grow. Some prognosticators forecast that China may overtake the U.S. in the next 20 to 30 years due to the substantial growth of China's GDP.

Based on these trends and expecta-tions, China is now part of the strategic planning process of many companies. Financial executives throughout the world are exploring how China can be part of their growth platform. Others are investigating how China can offer opportunities for sourcing goods and services, and whether the country represents a looming competitive threat. Standard accounting practices may help guide these decisions.

Function of Standardized Accounting Systems

Generally accepted accounting principles and International Financial Reporting Standards are the primary financial accounting systems used throughout the world. These standardized information systems govern market-driven capitalism and generally serve three important functions: contracting, valuation and administration and control.

The contracting function facilitates trade because the accounting system generates reliable information. This information is used by parties in decision-making and when monitoring the outcomes that result from the choices made. There are many ways financial accounting is used in contracting. These include debt contracts, customer/supplier relationships, compensation contracts and for strategic alliances.

The valuation function involves the use of earnings, cash flows and other financial accounting information to fore cast future values and to anticipate business vulnerabilities. This information is used as inputs to valuation and risk models.

The administration and control function relates to the government's use of financial reports as a means for administration and control of the economy. Financial metrics are used to allocate resources to accomplish policy goals.

State Capitalism vs. Market-Driven Capitalism

China's economic system is referred to as state capitalism. The market-driven capitalism in the West values assets based on market forces, but under state capitalism the government owns and controls key firms and industries that are used strategically to advance political goals.

Companies conducting business in China need to understand the interconnected nature of business, culture and governmental control.

Even as China gradually adopts some market-driven elements, its state capitalism economic system works to ensure that key assets...