the growing challenges of corruption in china

17

© 2011 Wiley Periodicals, Inc.Published online in Wiley Online Library (wileyonlinelibrary.com).DOI 10.1002/jcaf.20718

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Jeffrey E. Michelman, John B. MacArthur, and Christina Shea

INTRODUCTION

According to the World Bank (2009), the People’s Republic of China currently has a population of over 1.32 billion people. China’s vast popula-tion and increasing acceptance of capital-ism in pockets of its society are creating exciting significant new profitable busi-ness opportunities for US multinational com-panies (MNCs). An increasingly significant number of execu-tives in US MNCs believe that establishing successful business relations in China is important to their overall corporate strategy. For example, the results of the 2009 US-China Business Coun-cil (USCBC; 2010) Member Priorities Survey reported that 92 percent of the companies that were surveyed put China as one of their top five priorities for global business operations (see Exhibit 1). However, US MNCs establishing business segments in China have to be prepared

to take on additional business risks from operating in a country with a political, regulatory, and economic system that is still very different from most of the developed world. For example, it was reported that in China extant accounting-based security regu-lation provided perverse incen-tives for companies to report distorted financial information; investor protection was poor, with little incentive for listed companies to pay for high-qual-ity audits; and corporate gover-nance was weak (Lawson, Yang, & Yuan, 2009). Dynamic and

effective enterprise risk management (ERM) is vitally important for MNCs operating in China. Although ERM is discussed slightly differently in many contexts, a very useful discussion for accountants can be found in the Com-mittee of Sponsoring Organizations (COSO; 2004) ERM Integrated Framework.

On January 1, 2006, China enacted

a new company law allow-ing businesses to operate as foreign-invested commercial enterprises (FICEs) rather than just as wholly owned foreign enterprises that increased the investment opportunities for US MNCs (Ma, 2006) but did not reduce their risk of doing busi-ness in China. Unfortunately, as business opportunities continue to increase, the risk of conduct-ing business in China has never been greater (cf., Biegelman & Biegelman, 2010). These grow-ing risks became all too evident during 2007, when product

The People’s Republic of China has become a dominant part of the global marketplace, and many US and foreign companies are eager to enter the fast-growing, profitable Chinese marketplace. China does offer many exciting business opportu-nities and financial rewards. But companies also face significant business risks from long-standing business practices entrenched in the Chinese business culture. And those practices conflict with US laws and regulations. How can companies doing business with China achieve success and minimize business risks from corruption in China? © 2011 Wiley Periodicals, Inc.

The Growing Challenges of Corruption

in China

JCAF20718.indd 17JCAF20718.indd 17 8/19/11 1:18:46 PM8/19/11 1:18:46 PM

18 The Journal of Corporate Accounting & Finance / September/October 2011

DOI 10.1002/jcaf © 2011 Wiley Periodicals, Inc.

holder thereof acting on behalf of such issuer, to corruptly do any act out-side the United States in furtherance of an offer, payment, promise to pay, or authorization of the payment of any money, or offer, gift, promise to give, or authorization of the giving of anything of value to any of the per-sons or entities set forth in paragraphs (1), (2), and (3) of this subsec-tion (a) of this section for the purposes set forth therein, irrespective of whether such issuer or such officer, direc-tor, employee, agent, or stockholder makes use of the mails or any means or instrumentality of interstate commerce in furtherance of such offer, gift, payment, promise, or authorization.

The scope of the FCPA means that the importance of the discussion in this article goes beyond Securities and Exchange Commission (SEC) registrant companies to include any US business organization operat-ing abroad or interacting with foreign businesses in the United States. The US and Chinese acceptance of the United Nations Convention Against Corrup-tion (UNCAC, 2000) creates an opportunity to insure bilateral cooperation in reducing corrup-tion in China, but the acceptance of the UNCAC by the Chinese in principle does not guarantee adherence to the convention in fact (Jia, Ding, Li, & Wu, 2009). For example, the UNCAC repeatedly requires transpar-ency as an overriding construct, yet this characteristic is notice-ably absent throughout most of

Practices Act of 1977 (FCPA) and the Sarbanes-Oxley Act of 2002 (SOX), that also apply to MNCs that are listed on the US stock exchanges. For example, the FCPA specifically states (FCPA, 2004):

It shall also be unlawful for any issuer organized under the laws of the United States, or a State, territory, possession, or commonwealth of the United States or a politi-cal subdivision thereof and which has a class of securities registered pursuant to section 12 of this title or which is required to file reports under section 15(d) of this title, or for any United States person that is an officer, director, employee, or agent of such issuer or a stock-

recalls of Chinese products reached alarming levels. The Mattel product recall case is most interesting, as not only did the company close operations in a number of plants due to a lead paint scandal, but the local plant manager committed suicide in shame (Sommerville, 2007). Of particular concern, a number of these recalls were linked to bribery. Most significantly, the Chinese government wanted to show their concern for this issue and executed Zheng Xiaoyu, China’s leading food and drug official, for taking bribes. The government felt it was important to symbolically show its strong position against bribery and poor safety (Schwartz, 2007).

Although US and other for-eign MNCs operating in China are regulated by international laws and regulations, there are two important United States fed-eral laws, the Foreign Corrupt

China’s Prominence in Overall Company Strategy

One of many non-key priorities, 6% Not a priority, 2%

Top priority, 18%

priorities, 74%Among top five

Source: USCBC, 2010, p. 5.

Exhibit 1


The Journal of Corporate Accounting & Finance / September/October 2011 19

© 2011 Wiley Periodicals, Inc. DOI 10.1002/jcaf

SOX requires companies to assess internal control systems in relation to a framework such as the COSO Internal Control-Integrated Framework (IC-IF) (COSO, 1992), the Enterprise Risk Management-Integrated Framework (COSO, 2004), Internal Control over Finan-cial Reporting—Guidance for Smaller Public Companies (ICFR-SPC) (COSO, 2006), or the CobiT Framework (IT Gov-ernance Institute, 2007). Since the FCPA (2004) only requires management to “devise and maintain a system of internal accounting controls” and SOX (2002) requires management to be “responsible for establish-ing and maintaining internal

controls” and to have com-pleted a report “about the effectiveness of their inter-nal controls based on their evaluation,” management has a variety of options on how to approach these requirements. It is impor-tant to emphasize that management’s choice of an internal control model to ensure compliance with regulatory requirements

is not nearly as important as the consistent application of a model that both provides an effective yardstick for measur-ing internal control effectiveness and prevents the opportunity for internal control compromises. Further, Association of Certified Fraud Examiners data on occu-pational fraud shows corporate corruption to consistently be reported in only approximately 25–30 percent of US organiza-tions (Peterson Kramer, 2009). A program of internal control that prevents and detects these viola-tions consistently is far more likely to be viewed positively by regulators if they find unde-tected corruption.

Chinese society (Xinhua News Agency, 2009).

This article outlines the importance for US MNCs to use their existing internal con-trol model effectively when operating in China. Specifi-cally, the use of well-designed internal controls and corporate governance will help to pre-vent violations of the UNCAC, FCPA, and SOX regulations by mitigating risk. Although there are several alternative models available to effectively measure internal control success, it is critically important to choose an effective internal control model that is embraced by man-agement and one that is actively applied from the board of direc-tors (BOD) all the way to consultants, distributors, and agents representing the company domesti-cally and in China. Man-agement and corporate controllers, in particular, should pay attention to the depth of this commitment by both employees and those acting as indepen-dent contractors or other third parties operating in China on behalf of the organi-zation and report any material internal control deficiencies that result from a failure to properly implement the model. Corporate controllers should be particularly vigilant in review-ing the effectiveness of the internal control system in Chi-nese segments.

The remainder of the article is organized as follows. The importance of embracing busi-ness opportunities and mitigating risks in China is considered next. Five characteristics of an effec-tive internal control model are then introduced and discussed. In the next section, examples are given of how the internal

control model could be adapted for effective fraud and corrup-tion detection and prevention in China. The concluding section presents final thoughts.

EMBRACING BUSINESS OPPORTUNITIES AND MITIGATING RISKS IN CHINA

US and other foreign MNCs considering investing in the developing business world of China should be made aware that although the potential to make large profits exists, there is also a significant amount of business risk involved. Chinese business opportunities are often accompa-nied by serious corporate gover-nance issues that could cause the

executives of US MNCs to face criminal or civil penalties, as well as corporate embarrassment, from FCPA or SOX violations. Corporate controllers, in par-ticular, can help their companies enhance corporate governance and mitigate business risk in their China operations by imple-menting a strong system of inter-nal controls that manages busi-ness risk in their organization. By being alerted to the many inherent risks from conducting business in China, foreign MNC management should require an effective internal control model in their Chinese operations and use it to effectively manage this risk.

The use of well-designed internal controls and corporate governance will help to prevent violations of the UNCAC, FCPA, and SOX regulations by mitigating risk.




is significantly affected by the integrity and ethics of both its BOD and top management. SOX encourages companies to adopt a corporate code of ethics for employees to follow, yet this eth-ical tone from the top is likely to resonate throughout the company only if top management and the BOD “walk the talk.” Since the introduction and continuance of global operations are strategic decisions, the management of the associated business risk for UNCAC, FCPA, and SOX com-pliance should be integrated into the internal control model.

Second, the internal control model must be developed to encourage transparency of opera-tions and continuing regulatory compliance. As is commonly said, “Sunshine is the best disin-fectant.” China, in particular, is a country noted for opaque busi-ness dealings where the friend-ship engendered by guanxi (see Exhibit 3) can quickly become misapplied as government offi-cials or budding entrepreneurs seize opportunities for illicit per-sonal benefit.

Third, the internal control model must specifically address business risk as both a threat and an opportunity. As a result, cor-porations should not be intimi-dated by such threats as FCPA violations when there are sig-nificant opportunities for upside market share, cost reduction, and increased profits. Rather, by understanding the risks from undesirable activities such as bribery, management can intro-duce specific internal controls to mitigate these risks.

Fourth, the internal con-trol model must take a holistic approach to identifying risk, and, in this regard, the risk of a “small bribe” should not be ignored as it detrimentally affects the overall integrity of

tives for establishing effective internal controls and gover-nance policies as part of their strategic planning process. The internal controls, strategy, and governance policies lay the foun-dation for the other four internal control model characteristics that are shown as radiating from the center in Exhibit 2.

OVERVIEW OF THE FIVE INTERNAL CONTROL MODEL CHARACTERISTICS

First, the success of imple-menting corporate strategy and governance should be monitored by the internal control model (COSO, 2009). In this sense, the BOD and top manage-ment are forced to consider the impact of internal control risk as part of their strategic planning and governance processes. An MNC’s internal control model

EFFECTIVE INTERNAL CONTROL CHARACTERISTICS

Conducting business in China often presents business risks that are outside the foreign MNC’s normal decision-making process of risk management and control. In particular, the need to obtain approval from govern-ment officials who have only recently been exposed to capital-ism will facilitate myriad oppor-tunities for bribery. As a result, management and corporate controllers, in particular, should ensure that the internal control model being used adequately incorporates five major charac-teristics that will provide robust fraud detection and prevention. These five crucial internal con-trol model characteristics are presented in Exhibit 2, which shows the central role of MNC BOD members and top execu-

The Role of Internal Control in Reducing Risk

Internal Controls,

Risk as a Dynamic Influence

Holistic Approach to Understanding Risk of all Sizes

Business Risk as a Threat & Opportunity

Transparency of Operations

Strategy & Governance

Exhibit 2




Implementing internal con-trols required under SOX Section 404 offers both a way to combat the threat from UNCAC/FCPA violations and an opportunity to use the internal control frame-work to monitor dysfunctional behavior. The Institute of Inter-nal Auditors (2008) introduced guidance for management of internal controls under SOX Section 404.

Although SOX Section 404 is often maligned for its focus on minutia rather than signifi-cant executive misconduct (cf., Krell, 2005), UNCAC/FCPA violations can run the gamut from employee involvement in accepting minor bribes to major bribes and/or kickbacks. MNCs outside the United States have increasingly found value in using

tion process takes place with foreign partners and customers, the potential risk of UNCAC, FCPA, and SOX violations likely increases. In particular, top management must be aware that without effective internal controls, personnel in China will likely find ways to circumvent adherence to both the UNCAC and the FCPA rules through the use of agents and other interme-diaries. As a result, the internal control model must be carefully designed and applied vigilantly to make sure that the incentive and monitoring systems required under SOX and other regulations are implemented to produce both legal and ethical behavior in China by all employees, as well as all agents and other third parties.

the organization. Whereas the risk assessment of a single viola-tion might be small, the model must be concerned with the potentially devastating aggrega-tion of individual risk events. Each small violation is akin to the proverbial small hole in a dyke wall in the Netherlands that, unattended, eventually widens until the integrity of the entire wall is catastrophically compromised.

Finally, because of China’s rapidly changing environment, the internal control model should not merely take a snap-shot of business risk at a point in time; rather, the model must be characterized by the continu-ous monitoring of the dynamic risk interrelationships. For example, as the MNC negotia-

Guanxi: The Art of Social Networking

Guanxi is central to Chinese society and is critical to doing business successfully in China (cf. Tang & Metwalli, 2003, p. 54), yet its misuse can become central to facilitating corrupt business practices (cf. Ansfield, 2007). It is often linked with the concept of social capital or connections and is descriptive of the span of relationships that describe one’s business contacts. As the guanxi network is expanded, it becomes a symbol of the individual’s level of friendship with his or her business associates. It is based on a closely held belief of mutual support whereby “if you help me, I will help you,” which creates a reciprocal obligation. Favors should only be created if they can be repaid. Unfortunately, the concept of guanxi is often misapplied by both westerners and many Chi-nese as they hope to gain illicit personal benefits from a business relationship.

Gift giving is often against the lawa and, hence, to give a token of appreciation to a business contact or customer has increasingly become an activity that is done privately, which has led to cronyism, nepotism, and opaque relationships. Further, the Chinese culture does not foster the concept of privacy, yet to photograph the act of gift giving violates a Chinese custom that encourages the concept of clandestine exchange. As China moves forward, a void has developed between the political (communism) and economic (capitalism) systems, which creates the belief in many government officials and private entrepreneurs that capitalism at all levels, including “kickbacks and bribes,” is merely a part of the juxtaposition of these two contradictory systems. McGregor (2005) described this phenomenon as “eating the emperor’s grain,” whereby employees of both government and industry see the widespread corruption at an institutional level and embrace it as an acceptable cultural norm. This corrupt prac-tice is not an application of the fundamental concepts of guanxi. When applied appropriately, guanxi should not facilitate or allow illicit payments as an acceptable practice.

a For example state and federal employees in the United States are often forbidden from accepting gifts (cf. http://www.justice.gov/jmd/ethics/generalh.htm for restrictions on United States government employees).

Exhibit 3




all “non-employees” maintain an ongoing respect for local, global, and US laws and regula-tions and comply with the cor-porate code of ethics.

Transparency of Business Dealings

In China, guanxi, the Chinese art of relationships or “social capital,” is something that is effectively used to support Sino-American relationships yet is often applied without transpar-ency (see Exhibits 3 and 6), whereby the finesse of guanxi becomes a depiction of both cronyism and nepotism. MNC management must stay engaged in all transactions and remem-ber that Chinese nationals will often push to take advantage of the void that has been created between the politics of commu-nism and the economics of capi-talism. In this sense, US MNCs need to understand that they can reduce the opportunities for viola-tions of the FCPA by making sure that both employees and business

IMPLEMENTING THE INTERNAL CONTROL MODEL IN CHINA

The implementation of the internal control model in China is illustrated for each of the five characteristics.

Strategy and Corporate Governance

Companies can help pro-mote an ethical corporate cul-ture in China by adopting and meticulously following a strong code of ethics. In addition, the BOD and management must analyze, discuss, and decide what level of business risk is acceptable for their operations in China with the aid of the company’s ERM system. The selected level of risk should be integrated into the company’s overall corporate strategy. In particular, the BOD should be involved in discussions of how Chinese agents and other third parties will be used and how internal controls will be implemented to make sure that

the models developed for SOX compliance in managing overall multinational operations (Cap-pelletti, 2009). Hence, an effec-tively developed internal control model will help to mitigate the impact of a variety of previously insignificant individual regula-tory infractions that might be considered merely a minor inter-nal control deficiency, yet when viewed from an organizational perspective might cumulatively amount to a significant internal control deficiency or, ultimately, a material weakness.

The SEC and the US Department of Justice (DOJ) have steadily increased their vig-ilance against corporate trans-gressions by seeking out, investi-gating, and punishing companies committing FCPA violations, as illustrated in Exhibit 4. An effec-tive internal control model is the most important structure for companies to use to help prevent corporate violations and to avoid punishment by US regulatory authorities.

All MNCs, including those with operations in China, need to apply an effective internal control model to both prevent and detect UNCAC and FCPA violations. Corporate control-lers can provide assistance to both the BOD and manage-ment of MNCs by monitoring relationships with outsourced operations, suppliers of wholly owned manufacturing enti-ties, and Chinese manufactur-ers of goods that are imported into the United States or for distribution in other locations around the globe. However, if regulation violations exist, it is far better to have them identified by management than by govern-ment investigators. China con-tinues to be an area of high risk for FCPA violations (see Exhibit 5).

Total SEC/DOJ Matters Initiated: 2002–2010

3 1 3 6 7

17

9 11

19

4 5 3

7 6

21

16

32

28

0

5

10

15

20

25

30

35

40

45

50

DOJ

SEC

2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: Urofsky (2011).

Exhibit 4




FCPA Enforcement in China

Company Status Amount of Agreement Activity

RAE Systems Inc.

Settled the SEC enforcement action in 2010.

RAE entered a nonprosecu-tion agreement with the DOJ. According to the terms of the agreement, RAE will pay a mon-etary penalty of $1,700,000; strengthen its compliance, book-keeping, and internal control standards and procedures; and report periodically to the DOJ on its compliance with the agree-ment over the course of its three-year term.

After acquiring its interest in KLH in 2004, RAE instructed RAE-KLH personnel to stop paying bribes, but it did not institute sufficient internal controls or discontinue the system of cash-advance reimbursements that facilitated the bribery practices into 2008 at both RAE-KLH and RAE-Fushun. The joint ventures improperly recorded cash advances connected to bribes as business fees and travel and entertainment expenses, false information that was integrated into RAE’s consolidated financials. In addition to cash bribes, both companies provided luxury gifts to employees of state-owned entities, such as notebook computers, jade, fur coats, appli-ances, suits, and expensive liquor. In 2006 and 2007, RAE-KLH made two improper payments totaling nearly $350,000 to a consultant who funneled money to employees of the state-owned Dagang Oil Field and other government officials in exchange for business contracts.

UTStarcom, Inc.


UTStarcom entered into a nonpros-ecution agreement with the DOJ, agreeing to pay a $1.5 million penalty, implement rigorous inter-nal controls, and cooperate fully going forward.

UTStarcom paid for more than 225 overseas “train-ing” trips for employees of Chinese government-owned telecommunications companies. In actuality, the trips were primarily for sightseeing. UTStarcom arranged for the all-expenses-paid trips to destinations including Hawaii, Las Vegas, and New York to obtain and retain customer contracts and then improperly recorded the trips as training expenses.

Control Components, Inc.


CCI was also charged with two counts of violation of the antibribery provi-sions of the FCPA based on pay-ments to employees of the China National Offshore Oil Company totaling approximately $58,500 and pleaded guilty to the three-count indictment. CCI agreed to pay a criminal fine of $18,200,000 and a special assessment of $1,200, create and adopt an anti-corruption compliance code, and enter a three-year term of orga-nizational probation, during which time it will retain an independent corporate compliance monitor.

CCI senior executives approved, and in some cases personally made, payments totaling approxi-mately $4.9 million to officers and employees of numerous state-owned customers for the pur-pose of influencing the award of contracts and project technical specifications. From these pay-ments, CCI derived approximately $31.7 million in net profits. During the same period, CCI made corrupt payments of approximately $1.95 million to employees of privately owned companies. In total, CCI made approximately 236 corrupt pay-ments in more than 30 countries. Companies involved in China were: Dingzhou Power (China), Datang Power (China), China Petroleum, China Resources Power, China National Offshore Oil Company, and PetroChina.

Exhibit 5

(Continues)




FCPA Enforcement in China (Continued)


Avery Dennison Corporation

Settled two SEC enforcement proceedings.

Disgorge profits in the amount of $273,213 plus prejudgment inter-est of $45,257 and pay a civil pen-alty of $200,000.

Avery China attempted to pay Chinese government officials kickbacks in order to receive authorization for contracts involv-ing products used in road com-munication and safety.

ITT Corporation Settled the SEC enforcement action in 2009.

Without admitting or denying the allegations in the SEC’s complaint, ITT consented to the entry of a final judgment permanently enjoin-ing it from future violations of the FCPA, and agreed to disgorge $1,041,112, together with prejudg-ment interest of $387,538.11, and to pay a $250,000 civil penalty.

Nanjing Goulds Pumps Ltd. (NGP), a subsidiary of ITT paid directly and through third parties indi-rectly made illicit payments to Chinese government officials of state-owned design institutes that assisted in the design of infra-structure projects to insure that they recommended NGP water pumps for the projects.

Oscar H. Meza Pled guilty in 2009.

Permanently enjoined him from future similar violations and ordered him to pay $30,000 in disgorge-ment and prejudgment interest of $26,707.

Authorized the payments (referral fees) by Faro Shanghai Ltd.’s country manager to employees of state-owned companies to obtain contracts.

Siemens Aktiengesell-schaft (Siemens AG)

Consented to the entry of a final judgment enjoining it from commit-ting further FCPA violations without admit-ting guilt or denying allega-tions in 2008.

Paid $350 million in disgorgement and agreed to the imposition of an independent monitor for up to three years. In addition, Siemens AG agreed to pay criminal fines of $450,000,000 outside the United States and �496,000,000 to Ger-man authorities. Further they agreed to pay $100,000,000 to the World Bank over 15 years to help with anticorruption efforts.

Alleged to have made corrupt payments and kickbacks to a number of government officials, including those in China. Further, Siemens AG allegedly engaged in systematic efforts to falsify books and records and circumvent internal controls to permit the corrupt payments to occur.

Shu Quan-Sheng

Pled guilty in 2008.

$386,740 disgorgement and 51 months in prison.

Offered bribes to Chinese govern-ment officials to induce the award of a hydrogen liquefier project.

Faro Technolo-gies Inc.

Two-year deferred pros-ecution agree-ment in 2008.

$1,100,000 criminal penalty and agreed to an independent compli-ance monitor for a period of two years. Also agreed to pay disgorge-ment of $1,411,306 and prejudg-ment interest of $439,637.32 in civil penalties.

Made corrupt payments to employ-ees of Chinese state-owned or controlled entities on several occasions. The payments were made to secure contracts and were routed through an interme-diary to “avoid exposure.”

Exhibit 5

(Continues)




FCPA Enforcement in China (Continued)


Lucent Tech-nologies Inc.

Two-year deferred prosecution agreement, admitting to the alleged misconduct in 2007.

$1,000,000 penalty and agreed to adopt new, or to modify existing, internal controls. Agreed to cease and desist from further viola-tions of the FCPA and implement an FCPA compliance protocol as well as pay a civil penalty of $1.500,000.

Paid all expenses and often per diems for approximately 315 trips to the United States by numerous Chi-nese government officials as well as providing various educational expenses for other government officials. The trips and educational expenses were intended to procure contracts for the provision of com-munications networks systems.

Paradigm B.V. Nonprosecution agreement, 2007.

$1,000,000; agreed to implement internal controls and cooperate fully.

Paradigm’s subsidiary used an agent to make commission payments and pay expenses for travel to repre-sentatives of a subsidiary of the China National Offshore Oil Com-pany (CNOOC).

Si Chan Wooh Pled guilty in 2007 with sen-tencing sched-uled for April 26, 2010.

Agreed to pay $40,000 in disgorge-ment, interest, and civil penalties.

Wooh conspired with Schnitzer Steel to make payments to officers and employees of government-owned customers in China to induce them to purchase scrap steel.

Schnitzer Steel, Industries, Inc.


$7.7 million in disgorgement; $7.5 million in fines

Paid bribes and kickbacks to gov-ernment-controlled and privately owned steel mills.

Diagnostic Prod-ucts Corpora-tion


$2.8.million in disgorgement; $2.0 million in fines

Payments made by employees of sub-sidiary in Tianjin to hospitals that were disguised as commissions.

GE InVision Technologies

Nonprosecution agreement, 2005.

$589,000 in disgorgement; $1.3 million in fines

Payments were made by sales agents and/or distributors to Chinese gov-ernment officials in order to secure or retain business.

Adapted from Urofsky (2011).

Exhibit 5

associates in China keep transac-tions open to public scrutiny.

Business Risk as a Threat and an Opportunity

After the MNC BOD and top management determine their

business strategy for China, risk measures must be established that determine the risk boundar-ies (cf. Risk Management: AS/NZ 31000, 2009). Companies must choose objectives that will maximize their opportunities in China without exceeding their

corporate risk threshold. As management sets various goals and objectives for its corporate operations in China, they should be consistent with the estab-lished strategic objectives and risk boundaries (cf. Krueger, 2009). Corporations must




identify various events that could occur in China that would cause significant risk for the organization or a greater chance of violating UNCAC or either the FCPA or SOX regulations that may include brainstorming focus-group sessions, involv-ing ERM personnel, corporate controllers, and other managers. For example, transactions in China that involve state-owned enterprises (SOEs) or where gift giving is expected can lead to situations that increase the MNC’s risk of violating US regulations.

A large majority of the Chinese economy is controlled by SOEs, but an increasingly important entity will now be the FICEs. United States MNCs that are increasingly developing the FICE structure in China must be careful when dealing with SOEs or government officials because the expected under-the-counter payments made to these entities or officials would fall under the FCPA antibribery provisions. In addition, US MNCs must be careful when giving gifts during Chinese business transactions. There is a fine line between

acceptable gift-giving practices and gift-giving practices that are considered to be illegal under the FCPA antibribery provisions. Therefore, MNCs must be cau-tious to avoid violating the FCPA regulations when various occa-sions arise in which the company is expected to provide gifts to its Chinese associates, employees, agents, and customers. The inter-nal control system is particularly important in this case, as MNCs should not walk away from trad-ing opportunities because of the business risks involved in these transactions. Rather, the internal control model should be used to both manage and mitigate these risks. A properly designed system of internal control will help managers to determine an acceptable risk appetite that facilitates acceptance of proj-ects at a specified risk level that is consistent with the MNC’s strategy.

A Holistic Approach to Risk Assessment

When assessing an orga-nization’s ethical and legal risk, MNCs must examine the relationship among the various business risks within Chinese segments. For example, weak corporate governance and inter-nal controls in Chinese segments will lead to a greater amount of overall corporate risk and a greater likelihood of FCPA and SOX violations. Violating the provisions of SOX is one of many risks that companies should keep in mind when oper-ating in China. Mitigating the risk from bribery in China is difficult because the Chinese government controls a large portion of the economy and has ties to most individuals through either SOEs or local govern-ments. Moreover, because of

Top Ten Business Challenges in China 2010

Exhibit 6




the dual distribution of national and local control of SOEs, US corporations need to understand that business risks occur at both government levels of their SOE relationships in China and should not focus solely on a single gov-ernmental entity. This risk is par-ticularly acute in China, where the government has focused on enhanced accountability for corruption at the federal level, yet the majority of China’s cor-ruption occurs at the local level (Biegelman & Biegelman, 2010). Violations by low-level Chinese employees can create significant FCPA violations, and the aggre-gation of relatively small control deficiencies will likely become material internal control weak-nesses. Taken by them-selves, small risks that are undetected by the system of internal control can be viewed as unimportant, yet when aggregated they can create a large threat to an organization.

A Dynamic Model of Risk Management and Monitoring

Although Chinese companies have often lacked proper internal control struc-tures, this is changing in form if not in substance as a result of the passage in 2008 of The Basic Standard for Enterprise Internal Control (China’s SOX), which was effective from July 1, 2009, and was to be enforced initially for listed companies, while encouraging early adop-tion by other large and medium-sized unlisted companies, (cf. PricewaterhouseCoopers, 2008). In particular, as Chinese seg-ments of US MNCs experience both rapid internal change and changes in the business relation-ships through the use of agents

and other third parties, the risk of internal control violations escalates. Corporate control-lers can help MNCs respond to the risk of violating the internal control provisions of the UNCAC, FCPA, SOX, or emerging Chinese regulations by ensuring that management in China has created training pro-grams to teach employees effec-tive corporate governance poli-cies and to educate employees about US, UNCAC, and Chinese laws and regulations. Chinese accountants are often unfamil-iar with operating in a strictly regulated business environment where laws are closely enforced and the importance of avoiding violations of the FCPA and SOX

reporting provisions. China has a long history of passing laws without enforcing them (Jia et al., 2009). Chinese accoun-tants and managers should be educated about the importance of both accountability and trans-parency in the application of US generally accepted accounting principles. Finally, the internal control model should be updated in an ongoing manner to ensure that its structure and control applications are appropriate for the current circumstances.

Although SOX has spawned new legislation that protects whistleblowers from corporate retaliation, foreign employees

may not be covered under the legislation. Initially, the courts in the United States did not pro-vide any support to employees outside the United States, but in O’Mahoney vs. Accenture Ltd. in 2008, the US District Court in Manhattan did provide protection when the infraction took place in the United States (Berkowitz & Sutton, 2008). However, it is less likely that Chinese employees will come forward with information about illegal bribes or actions they witness in China. As a result, other communication incentives should be applied appropriately within Chinese segments. Corpo-rate controllers should help com-pany management and the BOD

create communication mech-anisms that can be used anonymously by company employees in China to help mitigate the risks of FCPA, UNCAC, or SOX violations occurring within the organi-zation. To help MNCs’ BOD and managers develop a dynamic and effective inter-nal controls and governance, ten keys to avoid the impact of corruption in China are summarized in Exhibit 7,

together with the corresponding five internal control model char-acteristics.

FINAL THOUGHTS

In 10 to 15 years, the two largest economies in the world will be the United States and China, followed by India, accord-ing to the National Intelligence Council (2008). In the years to come, US MNCs will have many business opportunities to earn great rewards in China and other BRIC countries (Brazil, Russia, India, and China) to help achieve their strategic goals and objec-tives, but they will also face

Chinese accountants and manag-ers should be educated about the importance of both accountability and transparency in the application of US generally accepted accounting principles.




significant business risks. As part of a well-designed ERM sys-tem, an effective internal control model is an important tool that companies should use to help manage risk in China in order

Ten Keys to Avoiding Corruption in China Using the Internal Control Model

Internal Controls, Corporate Strategy, and Governance

1. Corporate strategy and policies should clearly indicate a zero tolerance for corruption, and top management actions must reflect the highest ethical standards.

2. Risk assessment of business dealings in China should be systematic as part of the enterprise risk management model, and it should be able to identify the corruption risk exposure from all areas of potential business dealings of the Chinese segments.

Transparency of Operations

3. Understand that the lack of transparency by Chinese national and local governments facilitates opportunities for corruption particularly when transacting business with SOEs and ensures that the internal control model is designed to identify and prevent transparency deficiencies.

4. Understand that guanxi is part of the Chinese culture and does not equal corruption, but rather misapplication of guanxi often does, and train US managers and employees to be sensitive to this and other unique aspects of the Chinese culture; for example, it is usually better for a US manager not to directly confront a Chinese man-ager with a fraud issue but to use a Chinese national as an intermediary to avoid a perceived assault on the manager’s integrity that is a very delicate matter and would force the manager to “lose face.”

Business Risk as a Threat and an Opportunity

5. While internal controls should effectively identify corruption threats, they should not be so tight that they elimi-nate opportunities for unique and profitable business opportunities.

6. Be aware that the inconsistencies between the Chinese communist political environment and the capitalist eco-nomic environment create both opportunities for profitable business and incentives to facilitate corruption and ensure that the internal control model mitigates the resultant additional business risks.

Holistic Approach to Understanding Risks of All Sizes

7. Employ sufficient numbers of well-trained professional internal auditors and management accountants in the Chinese segments as they are the “eyes and ears” of the internal control model to detect small and large fraud and corruption violations at all hierarchical levels in the Chinese segments.

Risk as a Dynamic Influence

8. Understand that the use of independent agents and other third parties does not remove US MNCs from the risk of FCPA, UNCAC, or SOX violations and penalties and ensure that the internal control model also monitors the activities of independent agents and other third parties.

9. Understand that China has many laws but very little enforcement and implement training programs to teach Chinese national managers, accountants, and other employees about effective corporate governance policies and internal controls as well as educating them about the importance of US laws, regulations, and penalties.

10. Understand that the rapid growth and change taking place in the Chinese economy creates a dynamic corrup-tion environment and ensure that a dynamic system is in place to swiftly update the internal control model to address new corruption threats as they develop.

Exhibit 7

to achieve their goals and objec-tives. As US MNCs venture into the business world of China, they also must protect themselves with solid corporate governance and internal control systems, in

order to avoid violations of Chi-nese, UNCAC, FCPA, and other US laws and regulations and, ultimately, to achieve a higher rate of business success for its stakeholders.




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Jeffrey E. Michelman, PhD, CPA, CMA, is a professor of accounting and director of the Flagship Pro-gram In International Business at the University of North Florida. He has published articles on internal controls, corporate governance, and management control in both the international and US contexts. John B. MacArthur, PhD, FCCA, is the Kathryn and Richard Kip Professor of Accounting and Cost Manage-ment at the University of North Florida. He has written extensively in the accounting literature, including articles in the international accounting and cost management areas. Christina Shea has a master of accountancy from the University of North Florida and a master of science in decision and information sci-ence from the University of Florida. She is the president and owner of Shea Realty Group, a commercial and residential real estate brokerage company in Ponte Vedra Beach, Florida.


the growing challenges of corruption in china

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