Risk Management for Foreign Investors in China

This Q&A session covers some of the basic types of fraud that foreign invested companies in China need to look out for. Further, we briefly outline internal control mechanisms for risk management in China.

Within the text body, you will find clickable resources for details on various aspects of internal controls. 

What are the most common types of fraud that foreign investors are exposed to when doing business in China?

Foreign firms entering the Chinese market should pay attention to daily compliance associated with financial reporting, security of company assets, floor operations, and inventory assessment, among other business activity records.

Asset Misappropriation

• Inventory misappropriation

Inventory misappropriation involves the unsanctioned manipulation of stock or outright theft of inventory.

In China, this type of fraud often takes place through false sales and shipping, with the theft of inventory accomplished by conceiving fictitious purchase orders. Another example involves the local management purchasing unnecessary stock, often in the aim of receiving personal compensation from the suppliers and concealing the additional inventory to avoid raising attention.

• Fraudulent disbursements

Common examples of fraudulent disbursements in China include unsanctioned payments made to staff and suppliers. Utilizing billing schemes, fraudsters conceive fictitious suppliers to channel money to a shell company or a personal bank account.

Payroll schemes, sometimes involving fraudsters creating ghost employees to channel fictitious salary to their own bank accounts, are another common example. Also, very much relevant to the China context, expense reimbursement schemes are sometimes utilized by fraudsters, and by overstating expenses or creating fictitious costs they are able to increase their remuneration.

At the company level, fraudulent disbursements are sometimes utilized for corporate tax evasion purposes.

Corruption

• Conflicts of interest

Foreign companies are exposed to the risks of conflicts of interest when their Chinese subsidiary take part in related-party sales or purchases.

Conflicts of interest sometimes take place through fraudulent purchasing schemes, whereby the local management purchases products or services from a company owned by a friend or relative, or alternatively directly owned by one of the fraudsters involved in the scheme. This form of bid rigging is arguably the most common type of fraud that businesses suffer from in China today. Fraudulent sales schemes are another common example, and there have been instances where the local management sells products to an intermediary company that is colluding with the fraudsters, and the products are sold in a second time to third-party customers at a higher price. The margin on the sale acts as the motive for the crime.

• Bribery

A common example of bribery in China nowadays involves the local management receiving invoice kickbacks from suppliers, in exchange for preferable payment terms or simply as a reward for their ‘loyalty’.

In certain industries, bribes in various forms (gifts, ‘red envelopes’, dinners, etc.) are still sometimes used by sales teams to facilitate business deals, though such examples of malfeasance are less frequent than in the past. Indeed, corruption in its most obvious form is increasingly condemned across the Chinese business environment and this stance is echoed at the very top of Chinese government.

Financial Statement Fraud

• Income overstatements

Income overstatement involves the artificial inflation of a company’s income figures, which is most commonly achieved through fictitious revenue recognition.

A common motive for income overstatement in Chinese subsidiaries is to reach performance targets set by the overseas shareholders. Meanwhile, meeting performance targets often grants local management some performance-based remuneration they would otherwise not have been entitled to receive given the poorer performance of the business.

• Income understatements

Income understatement involves the artificial deflation of a company’s income figures, which is most commonly performed by understating revenues and/or overstating expenses. A common motive for income understatement in China is corporate tax evasion.

What to do if you identify internal fraud?

If a foreign-invested company detects any evidence of internal fraud, especially in cases where a minority shareholder or the general manager may be involved, they should immediately conduct an internal investigation and determine the best way to regulate business risk.

Proper internal control mechanisms are vital to conducting a thorough fraud investigation.

• Start a fraud investigation

Details related to the fraud should be examined using business documents and other paper trails, employees closely related to the relevant department should be interviewed, financial audits and legal reviews conducted, and the person under investigation must be questioned.

It should be noted that the fraud investigation procedure should comply with Chinese laws. The infringement of any citizen’s personal information, personal freedom, and other personal or proprietary rights must not be breached.

• Resolution of internal fraud matters

Internal fraud disputes can be resolved through negotiation and settlement, civil litigation, labor litigation, and criminal prosecution.

Chinese laws entail different procedures and dispute resolution methods to be used according to the type of fraud and the prevalent legal requirements of the company.

Therefore, it is advisable for the company to conduct a full review of legal requirements, anticipate the benefits, costs, and risks before proceeding with an appropriate anti-fraud practice.