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The Importance of Internal Controls in China

In an increasingly interconnected global economy, more companies are looking to expand their business operations abroad in new markets, with many companies expanding into China over the last decade. While the market poses significant and risk, the opportunity available in the Chinese market continues to attract new business and encourage the growth of already established businesses. With geopolitical tensions rising and many companies considering how to de-risk their entities, internal controls are becoming more important and requires very careful consideration.

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What are Internal Controls?

Internal controls are accounting and auditing processes, policies and procedures a company implements in order to ensure the accuracy and reliability of financial reporting, to safeguard assets, and increase operational efficiency.

By implementing internal controls, a company creates a framework for risk management and mitigation of risks, in both an operational and financial sense. Here’s a breakdown of internal controls:

Internal Controls: What Does it Consist Of?

  • Control Environment: In order for an audit to be conducted effectively, it requires the support of everyone in the organization. It encompasses the integrity, ethical values, and competence of the people in the organization, as well as management’s commitment to the control framework.

In the context of having an entity in China, it is crucial that the top management take the internal controls seriously, as the importance needs to filter down to the employees. Culturally, the way an audit is approached is generally different than the way it is approached in many Western countries.

  • Risk Assessment Process: This involves identifying, analyzing, and evaluating the various risks that a company faces. Understanding the potential risks allows for the development of controls to mitigate or manage them better.
  • Internal Control Activities: This requires the actual implementation of policies and procedures that are put in place to mitigate risks and achieve the organization’s objectives. Examples of this can include the segregation of duties, approval processes, physical security measures, and IT controls.
  • Information and Communication: Companies need an accounting system that is producing quality financial information, as such effective communication of information both internally and externally is crucial for ensuring an audit is carried out correctly. This component ensures that relevant information is identified, captured, and communicated in a timely and accurate manner.
  • Monitoring Activities: This involves ongoing assessment of the internal control system’s effectiveness. It ensures that controls are operating as intended and identifies any problems or deficiencies that need to be addressed.Market Entry Ad resized final

Benefits of Effective Internal Controls in China

  • Reduced risk of errors and fraud: if internal controls are carried out correctly the implementation can significantly reduce the likelihood of errors occurring as well as reduce instances of fraudulent activities.
  • Enhanced financial accuracy: internal controls enhance the accuracy and reliability of financial statements, which in turn provides stakeholders with confidence in the organization notes financial reporting. This is especially relevant where the headquarters are based abroad, and the subsidiary is based in China.
  • Increase in operational efficiency: generally, after an internal audit is carried out it can result in more enhanced operational efficiency which can in turn save the company in both time and costs.
  • Increase in confidence: once internal controls have correctly been carried out, there is an increase in stakeholder trust and confidence in the financial integrity of the organization.

What is the Auditor’s Role When Performing Internal Controls?

In China it is the responsibility of the external auditor to measure the effectiveness of internal controls. The auditor makes an assessment of whether controls and processes are correctly implemented.

In a Chinese context evaluating internal controls may involve

  • Management of chops – who keeps them, approval processes to be followed, how the record of chopping is kept etc.,
  • Bank payments – who retains control, who approves payment (ensuring a separation of duties).
  • Reimbursement processes – implementation of a policy related to classification, evaluation is being followed, approval flows etc.

Why Should You Ensure Your Internal Controls are Properly Implemented in China?

With many companies often headquartered out of China with the subsidiary in China it is often difficult for the headquarters to maintain complete control of the entity in China. Aside from cultural differences, there is a difference in work environments and work processes this may result in mismanagement or a misuse of internal powers, of which the headquarters may not have a full understanding.

In some cases, there are instances of misused company chops, unauthorized payments being made, and reimbursement processes not being correctly followed. In order to prevent such instances from occurring in your Chinese entity, the implementation or review of internal controls can ensure that the risk of mismanagement is reduced.

Having a Partner in China

There are endless benefits to having an administrative or outsourced partner in China. From the understanding of regulation, to reduced risk and simply making things easier, if you are a foreign company with an entity, you should consider having a reliable partner.

MSA has been operating in China for more than a decade and has helped companies with their accounting, finance and administrative needs. Get in touch with us right away and let us handle all your business needs.