Starting January 1, 2007, the listed companies on the Shanghai and Shenzhen stock will adopt new accounting rules that according to reports are modeled similar to international financial reporting standards (IFRS), which are the generally accepted rules outside of the US. There is one ver big problem. China chosen not to require the disclosure of transactions between businesses under common ownership or management control, known as related parties.

The reason this is a problem is that probably 98% of the listed companies are owned by the state. State ownership could be by the national government, provincial government or municipalities, but it is still the state. The listed company is usually owned by a holding company that has many other unlisted companies. It is common practice to move profits, income, assets and debts in and out of these companies. So the books of a listed company can be easily manipulated to looks like there is a profit when there is none. Also these shell companies are often used by insiders to skim money out of the company.

Normally this does not happen in a western company because there are numerous regulators and a free financial press. But in China, if no one is watching creative accounting is a wonderful thing. It also has a precedent. This was exactly the sort of problem that exacerbated the Asian financial crises. Foreign investors woke up to find that the listed companies assets has been ‘loaned’ out to related subsidiaries owned usually a controlling family. Investors in the rest of Asia are now more cautious. Unfortunately they do not seem to have applied the lessons to China.