Chinese companies must adopt sound accounting practices to regain investor confidence overseas

In the past couple of years, hundreds of small Chinese firms flocked to list in the US market, hoping to raise more capital while avoiding the arduous and lengthy listing process in the Chinese stock market. US investors were enamored with the prospect of buying a piece of the booming Chinese economy and rushed to pick up these firms.

However, the passion of US investors has started to fade in the wake of the recent accounting scandals of a few Chinese firms. Shareholder litigation against Chinese firms began to emerge in the second half of 2010, and gained significant momentum in 2011. According to a recent report by NERA Economic Consulting, 39 securities class action lawsuits were filed against Chinese or China-linked companies in 2011, up from 10 in 2010.

The risks posed for overseas investors investing in Chinese firms are that they cannot trust the financial statements without knowing the management. The incentives and monitoring mechanisms used in the US or other developed capital markets to motivate and discipline management is less effective in China as it is a transitional economy.

Although only a few firms have real accounting issues, the rest of the Chinese US-listed firms are bearing the brunt because investors perceive that fraudulent practices may be systemic in China's financial system. According to Halter Financial, the USX China index is down 20 percent since January 2011, while the Nasdaq Composite Index is up 5 percent and the Dow Jones Industrial Average has risen 7 percent. Investors have become far more cautious about Chinese firms listed in the US, while investment bankers have started to express their concerns over China-based IPOs.

According to a recent BDO poll, 80 percent of the investment bankers said the Chinese accounting scandals have led them to increase their due diligence on China-based offerings.

It is therefore difficult to understand how a good and honest Chinese firm can grab market attention, especially when the entire Chinese sector is under a cloud. One solution is to establish an effective corporate governance and financial accounting reporting system, and demonstrate it to the market.

The following steps are necessary for companies to establish an effective corporate governance and financial accounting reporting system.

Companies need to establish an effective board of management. A key attribute of an effective board is that a majority of its members should be independent directors. This makes the board more independent and allows it to provide a higher level of corporate governance to shareholders.

To have an effective board, it is also necessary to have an audit panel made up of independent and experienced financial professionals.

Companies also need to come up with an effective executive compensation plan for motivating and monitoring managers. For this it is important to have a compensation committee comprising mostly of independent directors. Firms also need to disclose in great detail how the executive compensation structure has been designed.

In addition, a recent study from the University of Minnesota shows that a performance-based executive compensation plan can serve as a substitute governance mechanism tool for Chinese firms, especially when the direct control of the government is weak. Thus, firms should also consider such a plan as it better aligns the interests of the managers and shareholders.

By basing the compensation primarily on the firms' financial performance, managers have more incentive to maximize the shareholders' interests than to seek their own private interests.

Another new development in the executive compensation reform is to include claw back clauses in the compensation plans. Claw back clauses refer to those provisions under which the managers have to return their compensations if it has been paid out on the basis of financial performances that are later found to be inaccurate.

It is also crucial to restructure and strengthen the monitoring roles of shareholders. Firms need to maintain transparent disclosure channels and actively seek advice from institutional investors.

Last but not least, obtaining services from highly reputable auditors is recommended. Auditors' opinions have been shown to provide strong signals and warnings to investors/debt holders of a possible default by the firm. Investors may feel more confident if the companies are audited by reputable auditors.

The US market provides great financing opportunities for Chinese firms who want to avoid the lengthy listing process in China. By establishing and demonstrating an efficient corporate governance system, good Chinese firms can still attract investors even in a market full of negative sentiments.

The author is an assistant professor at the School of Accountancy, Southern Illinois University, Carbondale.