Annual audit of a company

A financial audit is an objective examination and evaluation of an organization’s financial statements to ensure that the financial statements are a fair and accurate representation of the reported transactions.

Almost all companies in China receive an annual audit of their financial statements, which includes checking the income statement, balance sheet, and cash flow statement, among other things, as the first step of annual compliance.

While this process is tedious, it provides companies with a good opportunity to conduct internal financial health audits to optimize tax efficiency, financial structure, and processes, and internal controls to prevent fraud.

Why are annual audits important for business?

When businesses with foreign investment began to be established in China, many of them were not familiar with the peculiar Chinese accounting standards and tax rules. Thus, incorrect accounting or tax returns have become widespread, and especially common among small and medium-sized files.

Thus, the annual audits provided the FIE with a good opportunity to identify errors in its reporting of day-to-day operations and to improve its financial statements in accordance with Chinese accounting standards, as well as to ensure the proper presentation of its accounting data. This, in turn, contributes to better business decision-making based on an accurate representation of their financial and tax situation.

To this day, the annual audits continue to serve as a great opportunity for the FIE to recheck its tax liabilities, identify unnecessary tax payments that may be refunded, and improve its accounting system. Although an annual audit report is generally not required in current practice, by law it is a necessary requirement for all FIES.

In addition, there are various other reasons for FIES to be audited annually. In some cases, an audit may be a necessary step or allow the firm to better prepare for a particular business operation. In other situations, constant changes in the external environment make auditing a reasonable business decision. Below we will discuss the most common considerations.

A mandatory condition for the repatriation of profits

Generally speaking, the FIE can only repatriate profits once a year after completing the annual audit and tax compliance process. During this process, the tax authorities will use annual audit reports to ensure that the business complies with local laws and regulations, and will also check whether corporate income tax (CIT) has been paid on distributable profits. At the same time, the tax authorities will confirm the maximum amount of profit that can be repatriated, based on the net profit indicated in the financial statements.

Required by the foreign headquarters for the purposes of consolidation of the group

If the law requires the foreign headquarters to complete the audit, the domestic subsidiary will also be required to provide an audit report if the assets or revenue of the domestic company within the Group of Companies reach the reporting threshold provided for by foreign regulations.

Required for customs and tax investigations

In cases where the tax or customs authority initiates an investigation in connection with irregular records, or when a whistleblower reports this to the authorities, the company under investigation may be required to submit an audit report for a certain period in a short time (subject to an analysis of each specific case, but usually about 10 days). This is especially true in lower-level cities, where tax or customs authorities rely heavily on audit reports to learn about the financial condition of a business and its potential liabilities.

At such a time, if the company does not submit an updated audit report, this may delay the overall process or lead to additional costs, since the report must be prepared as soon as possible. This can lead to a tense, error-prone environment, and gives companies less chance to correct discrepancies in their financial statements.

Preparation for amendments to accounting standards

Starting January 1, 2021, several new accounting standards will apply to all organizations that have adopted the Chinese Accounting Standards for Commercial Enterprises (CAS). These changes will mainly relate to revenue and lease accounting. After being audited, companies can better understand their current financial and accounting structure, as well as the discrepancies between the old and the new, in order to make the necessary adjustments in a timely manner in the next year.

Audit can Help you Better prepare for the COVID-19 business climate

As China becomes stronger and more resilient in the wake of the ongoing COVID-19 pandemic, the repatriation of profits from China is becoming more common among FIES, considered necessary amid supply chain disruptions and the rare distribution of remote employees around the world. As a result, an audit report certified by an independent qualified Certified Public Accountant (CPA) firm can complement the headquarters in managing and monitoring the FIE’s financial position.

Moreover, only those companies that remain vigilant and actively seek to reduce their mistakes will be able to survive and thrive in the new environment, and an audit is a good way to identify internal shortcomings and make corrections at the appropriate time. Companies can use the annual audit to improve their internal control and risk management systems.

What does the annual audit include?

Although the requirements for the audit report may vary from region to region, the auditor generally conducts a systematic review of the following aspects:

Capital verification

The auditors will examine the cash reserves, checking whether this is consistent with the accounting records and whether the retained cash ratio is consistent with the stated total amount of capital. The bank reconciliation process will also be a focus at this stage, and the auditors will examine two aspects. First, whether the relevant entries in the books are consistent with the bank records (i.e. balance check, transit deposit, loans, etc.) and, second, whether there are any inactive accounts.

Inventory and valuation of assets

The auditors then examine the items in the warehouse and the fixed assets to determine if this is consistent with the ledger entries. An examination will be conducted to determine whether the documentation and tax audit report is complete for the disposal of written-off products/ assets, idle products/assets, and defective products. The auditors will also restate the impairment of the assets as necessary.

Checking your account

Auditors will check the account to verify the registered transactions. As for the lender’s rights, this will focus on:

Accounts receivable – AR) – checking the amount; assessing the risk of bad debts by analyzing the aging of the AR and the financial situation of the debtor;
Other receivables – timely collection of them in order to avoid unnecessary losses and tax risks;
Accounts receivable in advance-transfer of income forward in accordance with regulations and verification of the need for profit adjustments.
With regard to debt, the following aspect will be considered:

Accounts payable – checking the amount; checking the correctness of accounting and the estimated amount;
Other payables-regardless of whether there is a long-term unpaid balance or potential tax risks.
Evaluation of interested party transactions

The auditor will also review transactions with related parties to assess whether these payments were made on time, whether the supporting documents are complete, and whether there are any outstanding balances waiting to be cleared. Similarly, the auditor will assess whether transfer pricing is consistent with the arm’s length principle to avoid potential tax adjustments and penalties.

Checking expenses

The auditor will also check whether the relevant company invoices and other documentation of the recorded expenses have been received. The auditor will assist businesses in ensuring that any interim expenses are recorded in the account by the end of December and that all accrued expenses are properly recorded in the books.

For pre-tax deductible expenses, deductible limits, and R&D expenses, the supporting documents will be checked and evaluated to ensure that the thresholds are met, and the deductions made will be accurate for final verification.

Analysis of financial statements

Financial reporting is important not only for determining tax liabilities but also for firms ‘ understanding of their financial situation. Auditors usually focus on analyzing the balance sheet and the income statement to identify the capital structure, profits, costs and expenses, and losses, etc.

Preferential tax assessment

Under current legislation, businesses can conduct a self-assessment of whether they are eligible for CPN benefits and retain the relevant documents for potential future review by the tax authorities. This simplifies the process of obtaining CIT benefits but also increases tax risks in cases where there has been a misjudgment. In this way, auditors will usually help assess the relevant qualifications during the annual audit.

Last Posts

Legal system in China

Date 14/10/20 - Steps to set up a company in China Content: 1. How the legal system works in China 1.1. Legislative function 1.2. The consignment 1.2.1. Executive / administrative function 1.2.2. Judicial function 1.2.3. In places How the legal system works in China The legal system of the People's Republic of China (PRC) is

Chinese Civil Code: Implications for E-Commerce Companies

Date 14/10/20 - Steps to set up a company in China Content: What is the Civil Code? What are the implications for ecommerce? How does the Civil Code apply to e-commerce in China? Some Frequently Asked Questions 1. Do we have "contracts" in e-commerce? Since when am I legally bound and protected? 2. What is