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Capital verification: a Chinese puzzle of auditor liability
Yingfa Lu*, Falconer Mitchell, Chris Pong
June 2012
*Corresponding author
Yingfa Lu,
University of Bristol, 8 Woodland Road, Bristol, UK, BS8 1TN
E-mail: <yingfa.lu@gmail.com>
Tel: +44-1179288409
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Capital verification: a Chinese puzzle of auditor liability
Abstract
Capital verification is a special purpose auditing unique in China. When a new company is initially formed or when the paid-up capital of an existing company is altered, Chinese law requires the company to retain an auditor to provide a certificate verifying the amount of capital that has been actually paid into this company from its investors. This practice provides a lucrative business for auditor, but it also exposes the auditor to a legal liability contingency which causes a direct conflict between auditors and other members of the society. This paper applied duality of structure, social construction of reality and symbolic interactionism to explore the different understandings on capital verification among social agents and how the regulatory intention causes unintended consequences while the society as a whole is undergoing rapid transition from a planning system to the market mechanism. Interviews and a questionnaire survey were performed to empirically triangle the theoretical analysis. Research results illustrate the complicated dynamics surrounding capital verification.
Keywords
Auditor Liability; Auditing Litigation; Capital Verification; China; Regulation
JEL Classification
G32 G38
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Introduction
Capital verification: a Chinese puzzle of auditor liability
The Financial Times reported that in 2011 the value of Chinese companies delisted from US market actually exceeded the capital raised by Chinese companies through IPOs in US market
(Mishkin 2012) and the Halter China index lost 26% of its value in the same year, which are in contrast to the consistent growth of Chinese economy and accompanying demands for new capital. This wave of delisting was largely caused by a series of allegations of accounting irregularities against Chinese companies listed in NYSE, NASDAQ and AMX, which even caused a standoff between US and Chinese authorities when a SEC subpoena for evidence from
Deloitte China was refused. Is questionable financial reporting common among Chinese enterprises? As this is apparently the case in the small sample mentioned above, then why does it happen? There is a growing research interest in investigating and identifying differences in the characteristics of Chinese accounting practice and auditing culture (Simunica and Wu 2009).
This paper seeks to shed light on the unique attributes of Chinese auditing through a theoretic and then an empirical analysis on a special purpose auditing service, capital verification. The auditing failures surrounding capital verification ensured that the young Chinese auditing profession assumed a much higher public profile. The dynamics between auditors, information users and regulators in dealing with these failures has helped to shape the regulatory, market and liability structure of both the auditing practice and auditing profession in China.
The independent auditing was imported into China since the early eighties, originally only serving the enterprises with foreign investment. Then the independent auditing was gradually
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Version 17 June 2012 extended to state-owned entities and other domestic firms. From late nighties, virtually every business entity has to engage an accountancy firm to retain an auditor. Although it was not called auditing, but a similar function, “financial inspection” (Mennicken 2010) has been performed long before the eighties by civil servants in the Chinese government. Budgets and fund usage reports
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could only be signed off after a financial inspection, which was performed as part of the governmental administration of economic affairs. There were no contract between inspectors and the inspected. The business entities could not choose inspectors and usually could not directly hold the inspectors or the government to account if they disagreed with the conducts of inspectors or conclusions of the inspection. In the earlier eighties, China decided to open its door to foreign investment and imported relevant institutional designs to facilitate the inflow of foreign capital, including independent auditing. The first batch of accountancy firms were established by the governments using the same staff resources that previously were government inspectors. The firms were all owned and managed by the government. However at the end of the nineties, as a response to public outcry caused by a wave of auditing scandals, all accountancy firms were privatised. Currently all accountancy firms are owned by individual accountants in the form of limited liability company or partnership. The auditing services provided by these accountancy firms could be classified into two categories: (annual) financial statements auditing and capital verification. The latter is the main concern of this paper.
Since the early 1980s
2
, when starting a limited liability business, the investors are required by law to retain an accountancy firm to issue a report verifying the amount of paid-up share capital
1 At that time, state owned entities dominated the economy. All their funds were provided by the state and they did not produce balance sheets and income statements, but fund resource and usage statements.
2 Sino-foreign Joint Ventures Act 1979. At first capital verification was only required for companies with foreign investment, but was gradually extended to domestically invested companies as well.
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Version 17 June 2012 and its invested form (e.g. fixed assets, inventories, intangibles or cash). Similarly, if an existing company reduces or increases its capital, an auditor’s report is required to certify the amount of the paid-up capital after the changes have occurred (see Appendix I for a sample of capital verification report). These reports are submitted to the business organization registration authorities
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to partially fulfil the requirement to be granted a business charter, which permits a business to commence or continue trading. On the business charter, the amount of the capital certified by the accountant is stated (see Appendix II for a sample of business charter). The charter is required to be displayed at an obvious place in the company’s business premises 4
in order to be easily accessed by anyone has the intention to enter into business transactions with this company. In practice, for those who actually engaged in business with the company, a photocopy of the business charter is usually made available during the contract negotiation process. Government agencies and other regulatory bodies also routinely examine the business charter as a mean of identifying and assessing the economic scale of the business. Essentially, the paid-up capital listed on the business charter has been treated as a permanent banker’s reference (Dworkin 1962; Royal Bank of Scotland 2011)
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indicating the ability of the company to carry out a certain scale of trading and meet its financial liabilities. In an economy as dynamic as China, every year a huge amount of new business organizations are registered and therefore require capital verification (the 2002-2007 annual average exceeded 459000 entities and about
3 State Administration for Industry and Commerce at the central government level in conjunction with its provinciallevel, city-level and county-level equivalents
4 for example, hung on the wall behind the reception desk
5 Interestingly, at the beginning bankers were at the same market with auditors to provide certification of paid-up capital and had been involved in some litigation (High Court of Justice Shanxi Province, 2008, Daqin Company v
Yuqing Company and China Industry and Commerce Bank Xianyan Branch Re Loan Agreement Dispute , File No:
2008 Shan Ming Er Zhong Zi 57; Supreme Court, 2002, Circulation on how financial institutions who have issued untrue or false capital verification reports should assume civil liabilities , File No: Fa [2002] 21). But several years later the auditing firms successfully drove the bankers out of the market and gained monopoly (Minsity of Finace,
1989, A rely about that consultancy firms affiliated to the Chinese Industry and Commerce Bank should not perform capital verification , File No: Cai Kuai Zi [1989] 25).
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7000 auditing firms were available to do the work
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). Consequently, the capital certification service provides a valuable market for the auditing sector. It is particularly attractive for smaller auditing firms because the certification of capital is considerably less onerous than annual auditing (most clients requiring certification will not have started trading, so their accounts are much simpler than that of a trading client). Indeed, this service proved to be so profitable that it was reported that some auditors illegally gave out 20-30% commission rate or kickback
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to those helping them to solicit clients or the staff of clients. Some firms even bribed officials from the registration authorities to restrict the competition among accountancy firms and compel clients to choose the service from a specific firm.
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However, the impact of this lucrative service on the accountancy firms took a different turn when the accompanying legal liability started to show its adverse consequence. Since the paid-up capital verified by the auditors is listed in the business charters which are publicly available, the auditors are potentially exposed to the general public, not only their clients, if the figures of paidup capital were not correct. This first happened in 1993 when a chemical factory in Northern
China (Shanxi Province) sold, on credit, an amount of animal food additive of values at
RMB129600 (roughly USD15000 9 ) to a merchant company in a nearby province (Sichuan) and then found that it had been defrauded. The staff buyers from the merchant company hid the goods and disappeared. The receivables could not be recovered and the seller sued the merchant company and its parent company. During the evidence discovery process, it was found that when
6 Calculated based on the data from National Administration for Industry and Commerce (Statistic Department),
2008, National wide report on the development of business entities
7 Data from Ministry of Finance and National Auditing Office investigation files on the Hainan Xinhua CPA firm case, 1992
8 Ministry of Finance and National Administration for Industry and Commerce, 2001, Circulation on further improving capital verification service , File number: Cai Kuai [2001]1067
9 The market exchange rate at the end of 1993 was roughly RMB8.72 = USD1.00, although the official rate was
RMB5.8 =USD1.00, see Wu, Junrong, 2003, Reviewing RMB exchange rate, People’s Daily, Sept. 01, p13
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Version 17 June 2012 the merchant company was registered, the promised capital of RMB812500 (roughly USD94000) which took the form of inventories provided by the parent company was never actually delivered.
However, a capital verification report from a local accountancy firm (Deyang) stated falsely that the amount of capital had been contributed. The chemical factory sued the merchant company, its parent company and the auditing firm that had provided the erroneous capital verification. Since there had never previously been such a civil case against auditors in China, the local court sought advice from the courts at higher levels in the Chinese legal hierarchy. In 1996, the highest court in China, the Supreme Court, published a communication on this case stating that an auditing firm should assume compensation responsibility if false capital verification reports caused damage to its clients or other related parties.
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This ruling from the Supreme Court opened the floodgates to a huge wave of litigation against auditors. A large number of accountancy firms subsequently withdrew from the capital verification service (Ding 2001 pp.170-8). The subsequent media coverage on the sub-standard behaviours of auditors caused political intervention on the auditing industry. The firms were essential all privatised and their connections with the government were severed. The industry established systematic standards and gradually professionalized itself.
In the remaining part of the paper, we will first review prior papers and comparable practice on capital verification, then theoretically analyse the conflicts caused by capital verification. After that we will report the data collection process and the empirical results. Finally, we will draw conclusions and discuss its policy implications.
10 Supreme Court, A reply on how to deal with false capital verification reports issued by accountancy firms, 1996, file number Fa Han [1996] 56
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Comparable Practise and Prior Research
It is not only a Chinese practice to have a requirement on paid-up capital during the authorization of a new company. Germany has had a legal capital regime to protect creditors since the nineteenth century. The European Union required all its member states to establish a minimum capital of 25000 European units for public listed company and a series of capital maintenance rules, such as restriction on dividend distributions.
11 However, Armour (2006) has argued that legal capital is no longer an appropriate means of safeguarding creditor’s interests. He suggested that the pressure from a minimum capital requirement is most likely to be felt by smaller entrepreneurship-driven owner-managed firms. Lifting these rules will reduce the social cost for these business starters. However, in the recent banking crisis, the function of sufficient capital as a buffer for risk has been strengthened. In recent three years, the Basil accord on capital of financial institutions has been given much more attention (Allen et al 2011).
It is also not unique to China that an expert’s opinion on the paid-up capital is required for the incorporation process. The EU Second Council Directive required that “a report on any consideration other than in cash shall be drawn up before the company is incorporated or is authorized to commence business, by one or more independent experts.”
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This rule emphasized valuation rather than assurance and its main purpose was to protect minority shareholders rather than creditors. Eventually EU relaxed this rule to promote business efficiency and
11 European Union, Second Council Directive (77/91/EEC) on formation of public companies and maintenance and alternation of capital, 1976, Article 6
12 European Union, Second Council Directive (77/91/EEC), 1976, Article 10
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Sentella and Turrini (2008) argued that valuations made by independent experts “are costly and do not offer an absolute guarantee of the assets’ real value.
However, it is only in China that an auditor’s certification is required in the legal capital regime.
This requirement created a big market for accountancy firms and subsequently caused a problem of auditor liability. Before the early 1980s, Chinese business enterprises are tightly controlled by the government. In 1980s, these direct controls were loosened and capital verification requirement was initiated as an alternative regulatory measurement to police the market. This is in accord of Power’s (2003; 1997 pp.31-34) view that deregulation might increase the demands on auditing service. Liu (2001) analysed the two Supreme Court reviews affecting accounts’ liability caused by the capital verification service. She pointed out that the capital verification report issued by the above mentioned Deyang firm, which trigged the whole liability litigation wave, accidently contained a guarantee cause, “if later there occurs any business dispute and the
[merchant company] is obliged to compensate the counterpart, we guarantee the sum of the liability to the extent of the verified capital”. She suggested that this guarantee clause “is so impressive that it…distracted the Supreme Court from the core legal issues in the case. Bearing in mind the ‘guarantee clause’, the Supreme Court apparently did not need a second thought before holding the accountancy firm liable”. However, although the Supreme Court’s opinion in the Deyang cases seemed unconvincing, the same court came to a firm conclusion on this issue in a later case.
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The court ruled, “while an accountancy firm may not have a direct legal relationship with the party to the contractual case at issue, its misconduct in issuing a false
13 European Union, Directive 2006/68/EC of the European Parliament and of the Council amending Council
Directive 77/91/EEC as regards the formation of public limited liability companies and the maintenance and alternation of capital, 6 September 2006
14 Supreme Court, A reply on how accountancy firms should assume responsibility associated with false capital verification reports, file number: Fa Shi [1998] 13
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Version 17 June 2012 certificate of capital is to the detriment of the party, as a result of which, the accountancy firm is liable, subsequent to the debtor, to the claims”. A series of papers written in Chinese language acknowledged a wide-spread deficiency of auditing quality when capital verifications were implemented (Liu 2009). However, a large portion of the authors argued that the legal responsibilities applied to auditors were disproportionately heavy (Ye et al 2010). They claimed that the capital verification reports only played an insignificant role leading to the damage and the auditors were dragged into the litigation because of the “deep pocket” strategy used by plaintiffs, rather than the merit of claims. Zhu (2002) observed that the key issue a judge needs to consider while deciding cases involving capital verification reports is whether or not a causeand-effect relationship exists between the false verification report from the accountancy firm and the loss suffered by the creditors of the accountancy firm’s client. Zhu (2002) disagreed that the creditor’s loss and the auditor’s report were too remote and argued that such a cause-and-effect relationship should be expected because the misstatements from auditors misled the creditor to place an erroneous trust on the company’s creditworthiness. Li et al (2000) performed a questionnaire survey on the legal liabilities of auditors associated with capital verification engagements. Their questionnaire focused on the firms’ experiences with litigations, awareness of related laws, and personnel training about legal risk control. It was found that 34% of the respondents had been recently targeted by lawsuits at least once and exhibited a low level of adoption of risk prevention methods, e.g. pre-engagement screening of clients. They concluded that “the issue of legal liabilities of auditors has reached a very serious level. The situation has gravely damaged the reputation and the social status of the accounting profession. The liability crisis threatens the existence of the profession.”
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Samsonova (2009) and Mennicken (2010) analysed the transition of auditing practice and auditing regulation in former-soviet counties. They found that the direct apply of Western-style neoliberalism could cause problems because the infrastructure was built under another tradition and might not match the new design.
Research Objectives and Theoretical Analysis
(a) Objectives
This relatively short-term (about 30 years encompassed the key events described above) and volatile development of capital verification attracts a series of questions. This paper seeks to explore why auditors and auditing information users could not form consensus on the function of capital verification and the allocation of liabilities based on it, and why a well-intended regulatory design causes unintended consequences.
(b) Transition chaos
Capital was, and is still, a relatively new idea in China and its introduction came after a long period of ideology when “capital comes dripping from head to foot, from every pore, with blood and dirt (Marx, 1972)” was widely believed. As almost all funds for business activities were directly supplied by the state according to a planning system for a long time period, it is not surprising for Chinese people to have unsophiscated perceptions on capital. When the capital verification was firstly introduced, China was in the transition from the planning economy to a
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“socialist market economy”. The mode of state governance started to change from direct and strong control to rely more on market self-adjustment and rule of law (Sigley 2006). However, for political reason (Deng 1989), the reform of Chinese government and legal systems was much slower than the rapid adoption of Anglo-american economic institutions. Reformers frequently find that the political and legal infrastructure does not match new economic ventures or ideas, and they are caught up by or trapped in a path dependent system (David 1985). Capital verification was firstly introduced as a government administrative mechanism. Although auditees were paying fees, the examination was imposed on them and they had little say if they disagreed with the auditors. After about ten years into its inception, the indirect third party users of capital verification reports started to seek compensation against faulty capital verification reports, which caused chaos, as these third party users were not intended to be in the original design of the capital verification mechanism at all. To some extend they are the free rider of a new institutional design. The size of their population is vastly larger than that of auditors, which means stronger influence on public opinion and legislative attention.
(c) The (in)significance of capital verification
There are two explicit reasons why Chinese law requires legal capital and the capital verification report supporting this purpose (Art and Gu 1995). First, the legislators believe that a minimum capital could, as a barrier, exclude rogue traders who do not have sufficient ability or honesty away from the market and prevent them from harming honest traders. Second, the legislators believe that when a supplier or customer trades with a business organization, the paid-up capital
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Version 17 June 2012 shown on the business charter could give information about the creditworthiness of the company and provide assurance to creditors and lenders.
For a number of reasons the Chinese legislators’ faith in capital verification as a reliable indicator of creditworthiness can be viewed as problematic. First , paid-in capital can be in a non-cash form (e.g. fixed assets or inventories) which will lack the liquidity of cash. Indeed, even if initially the capital is in the form of cash it may subsequently be invested in less liquid assets, possibly even intangible such as goodwill. Without knowledge of the assets that represented the capital, creditworthiness cannot be adequately assessed. Second , even when paid-up capital is in the form of cash it can quickly be removed from a company through lending to or investment in another legal entity. As a consequence direct access to the funds counted as capital is lost to trade creditors and lenders. Third , the amount of borrowing and aggregate assumption of trade credit by a company is not reflected in the paid-up capital figure. Excessive borrowing and taking of trade credit may cause deterioration in creditworthiness. Similarly, if a parent company re-invests in subsidiaries, the paid-up capital will be recycled and the aggregated paid-up capitals of all of the group companies will be larger than the original capital funds.
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The credits guarantee power of registered capital could be easily magnified and gives a false image of the creditworthiness of the group companies. Fourth , the historic figure of paid-up capital will progressively be eroded by inflation and while accounting system are designed to maintain the money amount of capital, the purchasing power of capital and the operating capability provided by the paid-up capital will be impaired (Wittington 1983; Tweedie and Whittington 1985). The creditworthiness of a company at the point when it was incorporated might be different from its
15 In Keynesian economics, it is widely accepted that the investment has an amplified effect on consumption and national output.
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Version 17 June 2012 creditworthiness at the point when a business transaction with it is carried out and credit is extended. Thus, creditworthiness assessment cannot be properly based solely on the amount of paid-up capital. Information on cash balances, cash flow and working capital is usually considered more pertinent to the assessment of corporate liquidity (Christensen and Demski 2002 p.45).
(d) Duality of structure, social construction of reality and symbolic interactionism
What is the ultimate force deciding the order of social life? Is it the human agent or actor, or the social structure comprising rules and authoritative/allocative resources? Giddens (1984) argued that the long battle between objectivism and subjectivism should be reconceptualised as a duality
- during the institutionalization of a social system, the individuals and the social force are both playing significant functions. He pointed out that very often the agents have not been treated as knowledgeable as they are (Giddens 1987). The agents relationally position themselves in timespace and their unconscious motives, practical consciousness, and discursive or reflexive consciousness actively influence the micro- and macro- developments of the social life, intertwined with the power of the social structure. Giddens (1985) used the following graph to illustrate the process that the social agent or actor rationalization of their actions and maintain the theoretical understanding of their activities. unacknowledged conditions of action reflexive monitoring of action rationalization of action motivation of action unintended consequence of action
Figure 0, Giddens (1984, p5)
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In a less holistic level, Berger and Luckman (1966) and symbolic interactionism (McPhail and
Rexroat, 1979) dealt with the relationship between subjectivism and objectivism in a similar manner. Berger and Luchmoan (1966) pointed out that knowledge is different from reality.
When individuals forming their understandings of a situation or subject, they have to process signals or concepts based on their world views and sometimes even preferences. The beliefs among “selfs” vary and some might be of some distance from the absolute reality. Blumer (1969) proposed three premises. First
, “human beings act toward things on the basis of the meanings the things have for them”. That is to say the meanings of things are not neutral. Different people may hold different meanings of the same phenomenon if they have interacted with the phenomenon in different ways. The second premise is that “the meaning of such things is derived from, or arises from, the social action the one has with one’s fellows”. Interactionism denies that the meaning is either intrinsic or inherent in people or is decided by outside psychological elements, such as “sensations, feelings, ideas, memories, motives and attitudes”.
“Instead the meaning of a thing for a person grows out of the ways in which other persons act toward the person with regard to the thing”. Thus, the sources of meanings of a phenomenon come from the interactions among people when dealing with it. The third premise is that “these meanings are handled in, and modified through, an interpretative process used by the person in dealing with the things he encountered.” When the meanings are used by an actor, he “selects, checks, suspends, regroups, and transforms in the light of the situation in which he is placed and the direction of its action”. In essence, symbolic interactionism argues that the same thing might have different meanings for different people because they form their own versions of meanings based on their own interactions with the thing and those with whom they are in contact. After the
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Version 17 June 2012 meanings have been formed, they are used in a dynamic way through constant manipulation and transformation. This interaction not only happens between an individual and the things, but among individuals, who communicate with each other to negotiate a shared understanding on a particular thing. Ulmer and Kramer (1998) analysed how the criminal sentencing guidelines of the State of Pennsylvania were implemented differently in three local courts. The authors argued that “the impact of larger scale structures, process, and policies depends on specific local contextual contingencies and the agency of collective and individual actors”. They found that a state level policy would be “followed to different degrees and used in varying ways according to the interests, ideologies, and discretion of local-level individual and organizational actors”. An analogy exists between the situation described above on Chinese capital verification and the application of sentencing guidelines (Ulmer 2005; Ulmer and Kramer 1998). The intended purpose of a policy might be bypassed or manipulated by the parties who are involved in the implementation of the policy and symbolic interactionism theory could be used to explain how this has occurred. Essentially there are four parties in a capital verification engagement: regulator, auditor, the company or auditee whose paid-up capital is verified, and the company’s trading partners who have formed business association with the company and extended credit or loans to it. The purpose of each of these four parties are different and they are likely to hold different belief about the function and meanings of capital and capital verification although these belief will be restricted or reinforced by their observation and perception of all of the other parties. The following table ( Figure 1 ) shows the perceived meanings of capital verification for the four parties involved in the capital verification process and their intentions or motivtions.
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Actors
Auditors
Non-auditor:
Regulators
Intentions
Capital verification is an extension of assurance service and could bring in more business and revenue. a) Entrance barrier on the economic resource employed by an enterprise; b) A guarantee of credits extended to the enterprise
Fulfil statutory requirements and obtain a business charter
Meanings
Paid-up capital is verifiable
Paid-up capital is a fundamental indicator of the strength and creditworthiness of the company
Non-auditor:
Auditees
Non-auditor:
Third party
Examining the financial strength and creditworthiness of business partners
Figure 1 Intentions and understandings
A figure to be reached to show the financial strength and creditworthiness to potential business partners
The paid-up capital listed on the business charter is a good indicator.
From this table, we derived this proposition:
The four actors have different understandings about the meanings and functions of capital verification.
There are three aspects central to the distinctions in meaning among the groups: first, the assurance of creditworthiness provided by paid-up capital at the point of incorporation; second, the assurance of creditworthiness provided by paid-up capital at the point of actual business transactions; third, the relationship between a false capital verification report and a failed business trading or an unrecoverable credit.
From the table we could find out that on these three themes, the regulators and third party are very similar to each other in their belief in the assurance power of capital verification reports.
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The auditees also have a strong belief in this assurance power although they might be aware of the weakness in the verification process. They could be grouped as a cluster of “nonauditors”.
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In contrast to these three actors, auditors have a more conservative understanding of capital verification, and should be dealt with separately. Based on the above analysis, three hypotheses could be developed from the proposition:
H
1a
The actors (auditors and non-auditors) have different understandings about the assurance provided by paid-up capital at the point of company formation or auditing field work.
H
1b
The actors (auditors and non-auditors) have different understandings about the assurance provided by paid-up capital at the point of actual trading after the company formation or auditing field work.
H
1c
The actors (auditors and non-auditors) have different understandings on the causation between faulty capital verification report and trading loss.
Differently constructed understandings interact with each other. In our case, auditors are expected to react to non-auditors’ perception of capital verification and liability regimes based on it.
H
2
The liability crisis has adversely influenced auditors’ perception on the capital verification business although it has not led to outright rejection by them.
Data Collection
16 We performed ANOVA among regulators, auditees and users on all the four hypotheses. The results showed no statistically significant differences in their responses. In addition, the number of samples in each group is comparatively small. Combining them together could strength the power of our statistical tests.
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We considered using market-based archival analysis, but a large portion of the capital verification service concerns non-listed entities, so we concluded that only using data from the stock exchanges would introduce bias. We also considered case studies to obtain in-depth contextualized understandings, but we were not sure about the homogeneity inside either the auditor group or non-auditor group. We were not confident that we could choose one, two or three representative case study sites. At the end, we decided to employ both interviews for indepth knowledge and a survey for general trend.
Interviews were held with opinion setters to examine deep understandings on the four hypotheses and inform the research instrument design in the questionnaire survey (Ritchie and Lewis 2003 p.148). A questionnaire survey was conducted to extend the breadth of the research and quantify the perceptions from respondents (Blaikie 2000 p.227). The interviewees were all senior and experienced participants in the capital verification process. The interview instrument was designed to allow interviewees scope to express opinions on the topics covered. The questions were therefore largely open-ended in nature. Direct questioning was supplemented by the development and use of a vignette (Ritchie and Lewis 2003) or a small case study (see Appendix
III ). This comprised a hypothetical scenario based on the Deyang case which initiated the issue of liability for capital verification. A set of judgemental questions on it required the interviewee to use this example to address, explain, illustrate and justify their views on capital verification.
Considering the vast geographic coverage of China, rather than working on the whole country, a clustering based sampling method was utilized to choose a typical sub-geographic area as the base for further sampling (Cooper and Schindler 2006). Since Chinese auditors are regulated by
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Version 17 June 2012 the central government and 31 provincial level divisions, the firms and auditors within a province are naturally associated together. The existing communication channels within a province also reduced the logistic difficulty, comparing to select samples from multiple provinces. We decide to select province as the unit of cluster and a province eastern China was identified as our geographic base. The economic development level of this province is relatively advanced and the number of auditing firms and auditors are relatively large. More important, the professional bodies at this province granted research access to us after negotiation.
The interview samples were based on a list of opinion setters recommended by the provincial accountancy body. We also utilized the snow-balling method to recruit new interviewees through existing interviewees or survey participants. All together 34 interviewees were interviewed faceto-face and another 3 through telephone. Within the interviewees, 10 could be grouped as auditors (auditing practitioners or technical staff from the professional bodies) and the other could be treated as non-auditors, including regulators (government and law enforcement agents), auditee (preparers) and the third parties (preparers and bankers).
For the survey samples, we divided the population into two groups: auditors and non-auditors.
For auditors, the province is divided into fourteen areas; each has one city-level accounting professional body. We selected five from them according to the economic development levels.
Then all auditors based in these five areas were selected as our survey samples. A questionnaire was distributed to these auditors while they were attending a compulsory continuing education session in their areas and was collected immediately after the session. The research participants completed the questionnaire during the course and this improved the response rate. For non-
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Version 17 June 2012 auditors, a random sample was selected from the register of holders of an accountancy license
17 while they were attending two training sessions. Due to the size of the sessions, the number of respondents from the non-auditor group is smaller than the auditor group. Overall, 913 questionnaires were sent out; 594 were received and 470 usable for data analysis (the remaining were incomplete), generating a response rate of 65% and usable rate of 51.48%. Within the 470 usable questionnaires, 367 were from auditors and 103 from non-auditors. A typical auditor would have been working in this role for 8.89 years (sd = 4.57) and a typical non-auditor has
8.28 years of experience (sd = 5.11).
In the interview and the survey, besides variables directly about the four hypotheses, we also collected demographic information of the participants (see Appendix IV for a description of the data collection instruments used).
Research Results
The empirical data generally supports the hypotheses. To avoid duplication, the results on H
1a and H
1b
will be reported together. Then we will deal with H
1c
and H
2
.
Stakeholder perceptions of the function and meanings of capital verification (H
1a
and H
1b
)
(1) Interview evidence
17 By law, everyone needs to obtain a license to be employed as bookkeeper, financial manager, etc. working in business, non-for-profit organizations, government and other organizations. Auditors are not in this category and registered separately.
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The strong majority opinion of the interviewees (23 out of 33 interviews who commented on this) was that the capital verification system had several useful functions. It seems there was a shared understanding of the necessity for capital verification although different stakeholders had different understandings of why capital verification had to be retained. A technical officer from a professional accountancy body summed up this view as follows.
“There is a problem about honesty throughout the business world. The requirement of capital verification could drive some dodgy traders away.”
A lawyer confirmed this opinion with a statement that reflected the naivety of many stakeholders on the issue.
“Capital is the guarantee for future debts. Members of society trust and rely on the capital registration system. People use registered capital to evaluate the strength of a company.”
Preparers and investors were also very positive about the value of capital verification to them. A typical managerial response was as follows.
“The capital is important. It is a reference for the investment and a guarantee for a deal. I check registration documents about capital to learn the scale of my clients or partners.
The capital is like gold and silver, it is something real.”
An investment banker made the point that one had to differentiate between new and established companies when considering the worth of capital verification.
“For a new company, the amount of capital is a major indicator. However, for mature firms, I rely more on financial statements.”
There was evidence of self-confirmation (Festinger, 1957) that emerged from the interview data.
Some interviewees pointed out that capital verification was widely used in other aspects of the
Chinese regulatory regime and could not, therefore, be removed easily. For example, several
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Version 17 June 2012 interviewees cited the system of granting a building licence. According to building law, a building company with a larger amount of capital could be granted a certificate to build a skyscraper, but a building company with a smaller amount of capital would be refused such permission. Another interviewee pointed out that, even for the auditors, if they want to take IPO engagements, the auditing firms are required by law to have a certain amount of minimum capital. In their views, capital requirements have been widely used in the operation of society. A capital verification report has more significance than just a file in the corporate formation process.
The minority of interviewees (10 out of 33) who held negative opinions about capital verification argued in this way because they felt that the assets representing capital keep changing. One auditor illustrated the lack of security that is created in a capital verification report.
“An investor could invest his money today, complete the incorporation process tomorrow and take back his money the day after.”
Thus, to this group the verification of capital at one point in time is meaningless as it has no tangible function.
Although there is a shared understanding about the necessity of capital verification, there was a dissonance for many interviewees on auditor’s technical ability. For capital verification to be considered useful the capability of those conducting the verification had to be positively recognised by stakeholders to the process. Interviewees were asked about their views on the technical ability of the auditors to examine and certify the capital and its corresponding assets and liabilities. The majority of opinion on this issue was negative. Some interviewees pointed out
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Version 17 June 2012 that, to make a judgment about whether an investment action has been concluded, the key issue is the confirmation of ownership transfer. Except for real estate and transportation vehicles which have a state registration system, the ownership transfer process for other assets is difficult to examine and is easily reversible. This means that capital verification, in respect of the underlying assets, attracts a high risk of abuse that is difficult to reveal.
A minority of interviewees reconciled the dissonance by arguing that the technical ability of auditors could be improved to a level where auditors could reasonably verify paid-up capital. An auditor expressed this position as follows.
“Till now we have at least three versions of auditing standards on capital verification.
Along with the standards improvement process, most technical difficulties have been solved and loopholes blocked. There might still be some technical problems, but I am sure we could fix them very soon.”
Another auditor insisted,
“If an auditor performs all the procedures required by auditing standards, the capital could be verified. I do not think there is a systematic risk. The only problem is the willingness to fully implement the standards.”
Thus, while the practice of capital verification is generally considered valuable there was also some considerable doubt expressed about some aspects of its operation.
(2) Survey evidence
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Respondents were asked to express (on a 5-point Likert scale with 5 representing very strong support and 1 representing a very negative view) their opinions on the extent to which capital verification certificates assured that the certified company had the stated amount of capital both at the date of certification and at subsequent dates. The results are provided in Figure 3a and 3b below.
Description Group N Mean Mid SD
K-S p
T-test
T p
Mann-Whitney
U p H1a/b
Assurance at field work date
Assurance after field work date auditor non-auditor auditor non-auditor
356
97
348
95
3.85 3
3.33 3
1.95 3
2.18 3
0.59
1.06
0.70
0.79
.000 4.683 .000 12711.5 .000
.000 -2.628 .010 13932.5 .005
Figure 3a Assurance on levels of capital given by capital verification reports
Y
Y
Figure 3b Histograms illustrating the responses from auditors (1) and non-auditors (0) on the power of assurance provided by capital verification at the time of field work and after the field work
The results show that auditors have, in general, strongly favourable opinions on the value of the capital verification report at the time it is carried out. This contrasts markedly with the predominantly negative interview results from auditors (see below for a possible explanation).
Non-auditors are also, on balance, favourable in their views of the report at this time (although their views are markedly less positive than those of the auditors). For capital verification reports used at dates after the verification has been carried out the views of both groups falls below the
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Version 17 June 2012 mid-point of the opinion scale and the auditors record the most critical average rating. The differences in ratings between auditors and non-auditors are statistically significant on both issues.
The existence of a causation relationship between faulty capital verification reports and damages suffered by report users (H
1c
)
(1) Interview evidence
All interviewees agreed that the association between the victims’ damage and faculty capital verification was not strong, but interviewees’ opinion split on whether a denial of causality between faulty capital verification and subsequent damage associated with related business failure could be established. 15 interviewees said no causality and 17 on the side of yes, but all interviewees agreed that the association was weak if it exited at all. In their view, lenders and sellers on credit should not rely solely on capital verification when lending and extending trade credit. Indeed they felt that where the date of lending or trading was distant from the formation date of the company (i.e. the capital verification date), the reliance on the capital was particularly irrational. The capital verification report was not viewed as providing any long-lived guarantee of a company’s creditworthiness.
Although the great majority of interviewees agreed that the causality with damages was weak, but the leading opinion was that, in principle, the auditors should still be held liable if they had
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Version 17 June 2012 committed wrongdoings in making their capital verification. Once again, the participants found ways to reconcile the dissonance. An auditor summed it up as follows.
“If the auditors did something wrong, they have to be punished, otherwise no one will follow the standards.”
A minority of interviewed auditors found ways to evade liabilities by pointing out that in certain cities, the local governments had attempted to attract as much investment as possible. Auditors were encouraged, or even required, to turn a blind eye to the possible differences between a promised investment of capital and the actual amount subsequently paid-up. These governments mobilized auditors, banks, foreign exchange authorities, and company registration authorities to form a chain to speed up the attraction of local investment. Sometimes these participants even worked in the same office. In these circumstances, the auditors were easily misled about their liability and those of the local governments.
Some auditors argued that the relationship between the auditors carrying out the capital verification and auditors doing annual auditing should be re-considered. They asked, if the auditor who verified a company’s capital is different from the one who carries out annual auditing, whether the liability related to the capital verification should be passed on to the annual auditor. An interviewee stated as follows.
“The annual auditing also covers capital, and even in a more thoughtful way. After the annual auditing, the amount of capital should have been re-examined and the liability should be passed along.”
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(2) Survey evidence
Respondents’ opinions on the degree of causation between faulty capital verification reports and report user damages are provided in Figure 4a and 4b below. Again a five-point Likert scale was used with low scores indicating the opinion that any causation relationship is weak.
Description Group causation
K-S T-test
N Mean Mid SD p T auditor 352 1.99 non-auditor 96 2.66
3 0.77
3 1.00
.000 p
-6.047 .000
Mann-Whitney
U
10346.5 p
.000
H
1c
Y
Figure 4a Degree of causation between faulty capital verification reports and damages
Figure 4b Histograms showing the responses from auditors (1) and non-auditors (0) on the association between capital
verification report and users’ loss
These results largely confirm the interview evidence and suggest that on average the respondents considered that any causation between faulty capital verification reports and damages is weak.
The auditor’s rating of this issue is markedly lower than that of the non-auditors and the difference is statistically significant.
Auditor attitudes towards new capital verification engagements (H
2
)
(1) Interviewee evidence
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When the auditors and those who had knowledge of auditing practise were asked whether auditors were actively taking new engagement about capital verification, the almost uniform answer (17 out of 18) was “no”, even for auditors from smaller firms. An auditor said directly,
“We only perform the capital verification as goodwill to our annual auditing clients. The revenue does not match the risk.”
(2) Survey evidence
The views of the auditor respondents on their willingness to undertake new capital verifications are presented in Figure 5a and 5b below. Ratings are based on a 5 point Likert scale with the low point indicating strong willingness to accept new capital verification engagements.
Description Group N Mean Mid SD
Effects of litigation (-) auditor 352 3.39 3 .87
T
8.423 p
.000
Figure 5a Willingness to take on capital verification engagement
H
2
Y
Figure 5b Histogram showing the auditor’ responses about the deterrence on new capital verification engagements by litigation risk
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The results show, on average, a negative view among the auditors in respect of accepting new capital verification engagements. However the mean and median responses are close to the midpoint and 64% of respondents gave ratings at the points of 2 or 3 (i.e. no prevention from new capital verification engagements), although the one sample t-test result is significant at 0.05 level.
Thus, litigation risk has not resulted in the blanket rejection of capital verification work throughout the auditor constituency. These findings contrast somewhat with the total rejection of new work by the auditor interviewees.
Experience and perceptions
In the above analysis, the interview results on H
1a
, H
1b
and H
2
do not align well with the corresponding survey results. One possible explanation is that the interviewees are opinion formers and are more likely to have more experience in auditing and in preparing and working with financial statements. They are also more likely to be at a higher level of organizational hierarchy (Carpenter et al 1994). We tested the association between the length of experience and the despondence to research questions ( see Figure 6 ).
Pearson r
Auditor experience * causation
Non-auditor experience * assurance at field work
Non-auditor experience * assurance after reporting
Figure 6 Effects of length of experience
-.127
.359
-.264
Kendall's tau_b
-.120
.345
-.260
Spearman's rho
-.146
.409
-.309
Sig. (2tailed)
<.05
<.01
<.02
For non-auditors, the results suggest that there are positive association between the length of experience working with financial statements and the assurance power of capital verification report at the field work date and negative association between the experience and the power of
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Version 17 June 2012 assurance of capital verification at or after the reporting date. The longer the users working with financial information, the less trust they have on the assurance after the point of field work and the more belief on the assurance at the field work point. For auditors, there is a possible negative association between the length of auditing experience and the causation between faulty capital verification report and damage; however the r, tau and rho are all quite small, which suggests that the link is weak.
Conclusion and Policy Implications
In this paper, after considering the transition chaos in the Chinese context and utilizing duality of structure, social construction of reality and symbolic interactionism, we argue that the participants of capital verification (particularly auditor versus non-auditors) have different perceptions on key aspects of capital verification, which causes an on-going conflict between auditors and non-auditors. The conflicting beliefs changed the initial design of capital verification.
Empirical results show that the opinions of stakeholders in the capital verification process differ on both the value of capital verification reports and on their significance when audit work has been faulty. Their views reflect many of the arguments used in real litigations. No consensus is apparent on capital verification practice and its implications for those involved in it. Auditors, and those non-auditors with longer financial experience, hold the more extreme opinions favouring the worth of capital verifications at the time of their conduct and against their worth at subsequent dates. They consider their reports to have a limited shelf life. As might be expected
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Version 17 June 2012 auditors show less support than other stakeholders for the existence of a causation link between faulty capital certifications and other party damages. It remains puzzling that a practice with evident technical frailties still attracts considerable support from its stakeholders. Many auditors remain ready to take on new engagements.
The ups and downs of capital verification in China provide an important lesson for public policy.
As discussed above, from the accounting or economic perspectives, the service has little convincing rationale at all. However, it started, it developed, it created operational problems because of its own success. It caused many unintended and dysfunctional consequences, and it is still evolving. It shows the real world can have great complexity. It is very hard to observe its underlying dynamics and therefore it can be a great challenge to keep a public policy directed in a way which achieves only its intended aims.
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Appendix I
Specimen Capital Verification Report
XYZ limited company (in the process of formation),
We have examined your paid-up capital as of January 5, 2012. It is the responsibility of the shareholders of your company to provide true, lawful and complete evidence about the paid-up capital, and guard the safety and completeness of your assets. Our responsibility is to express an opinion on the situation about the paid-up capital. Considering the circumstances of your company, we conducted necessary certifying procedures, including examinations according to the Chinese Auditing Standards 1602 – Capital Verification .
The article of incorporation and by-laws of your company state that your registered capital should be $1,000,000, to be paid in by all the shareholders on or before January 5, 2012. Our examination shows, as of January 5, 2012, your company has received paid-up capital at the value of $1,000,000, including $400,000 in cash and $600,000 in fixed assets and inventories.
[…]
Auditor
Date
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Appendix II
Translation with illustrative entries
Business Legal Person Charter
Registration Number: ASDF0000123
Name : ABC Factory Co.
Registered office : 10 People Road, XYZ City, 100810
Legal representative : John Doe
Category of enterprise : Privately owned limited liability
Scope of trading : Paper manufactory; paper import and export
Starting date : January 15, 2012
Company duration period : 20 years
Registered Capital
Paid-up Capital
Issuer (stamp):
: RMB3500000
: RMB3500000
Administration for Industry and Commerce,
Government of XYZ City
Issue date : January 10, 2012
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Appendix III
A vignette or mini case study used in data collection. It was printed on a cardboard to be shown to the research participants.
Settings
A chemical factory could not recover the money from sales to a trading company, which had gone bankrupt. One of the documents used for the company’s registration process two years ago, certification of paid-up capital produced by an auditing firm was found not to comply with the truth. The inventories that were stated as transferred into the company had not been really transferred. The chemical factory sued the trading company, its parent company and the auditing firm.
Questions
5.1 Can the capital verification report assure the solvency of the trading company at the time of the publication of the report? And at the time of the business transaction?
5.2 Shall the auditing firm compensate the chemical company?
5.3 Shall the auditing firm pay for the sales money, or the gap between the wrong figure of paid-up capital listed on the verification report and the real figure of paid-up capital?
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Appendix IV
Research Instruments
Main questions asked in the questionnaire survey and interviews:

Can capital verification assure that the certified company possess a certain amount of capital at the date of the auditing field work?

Can capital verification assure that the certified company possesses a certain level of creditworthiness after the date of incorporation?

Is there any causality between faulty capital verification reports and the damage suffered by third parties?

Do auditors have the technical capacity to verify paid-up capital?

Have the liabilities related to capital verification prevented auditors from accepting new engagements?
In the survey, a 5-point Likert scale was used. Demographic information of research participants was also collected, including,
For auditors,
 positions, e.g. partner, manager
 working area, e.g. auditing, capital verification, forensic accounting
 major clients, e.g. listed companies, SMEs
 working experience in years
 auditing firm size
For non-auditors, similar information about their positions within their employers, types and sizes of their employers, and experience working with financial information measured by years were also collected.
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