China built its first unified and recognized framework for enhancing internal controls in enterprises with the release of the Basic Standard for the Enterprise Internal Control (Basic Standard) jointly by five relevant ministerial departments in June 2008 and the subsequent issuance of its Implementation Guidelines in April this year.

With an aim of improving corporate governance at Chinese enterprises, the Basic Standard was first announced two years ago, to increase the effectiveness of internal controls and risk management systems. At the time, mainland regulators had yet to finalize the general draft guidelines for the Basic Standard. The recent release of the Implementation Guidelines by the ministerial departments provides the timeliness and guidelines for the application, assessment and audit of internal controls under the Basic Standard.

Firstly, the Application Guidelines for Enterprise Internal Control consists of as many as 18 key elements that companies should consider when implementing the Basic Standard. It provides a basic internal control framework to assist companies in establishing internal control procedures that take the particular characteristics and circumstances of their businesses and operations into account. Next, the Assessment Guidelines for Enterprise Internal Control specifies how companies should prepare their self-assessments on the design and operating effectiveness of their internal control systems, including the content and procedures of assessment, identification and evaluation of internal control weaknesses as well as self-assessment reporting. Lastly, under the Audit Guidelines for Enterprise Internal Control, the effectiveness of companies' internal controls must be validated by accounting firms. It specifies definitions and responsibilities of auditing services, planning, implementation, evaluation of internal control weaknesses, the basis of opinions, maintenance of working papers, and specimen audit reports.

Effective dates of the Implementation Guidelines vary based on the types of companies. Mainland-based firms listed both domestically and abroad will need to comply by January 2011, and January 2012 respectively. Early adoption of the guidelines is recommended by the regulators for all mainland-based large- and medium-sized firms.

The Basic Standard and its guidelines are not entirely new concepts in China, as most firms have a general awareness that effective internal controls can raise the quality and reliability of financial information to facilitate investors' decision making. Nevertheless, there are big challenges in implementing such a standard with less than a year of implementation in a large country with many various maturity levels of enterprises.

One practical challenge related to the adoption of the Basic Standard is the rushed adoption schedule. The compliance should come easier for Chinese companies already listed overseas, e.g., New York, Hong Kong or London, since these companies are mostly well-run industry leaders that already have experience and adequate resources to fully comply with strict overseas regulations, e.g., Sarbanes-Oxley, Hong Kong Code on Corporate Governance, or the Combined Code. On the other hand, non-overseas listed Chinese companies may face challenges in meeting the adoption schedule. These companies in China may not have adequate people skills and resources to comply with the Basic Standard. Nevertheless, the non-overseas listed companies have an extra year to comply with the Basic Standard.

Chinese companies can also be facing technical challenges on the implementation of the Basic Standard. Unlike counterpart legislation in other countries, China's Basic Standard is far more comprehensive, as it does not solely focus on internal controls over financial reporting, but also encompasses non-financial reporting related controls, e.g., operation, compliance, which are also expected to be covered by these Chinese companies.

In addition to the Basic Standard's wide focus, the biggest challenge for the Basic Standard is the unforeseeable risk a company faces should it fail to conform to the standards. Unlike the governance environment in the United States and Japan, at the moment, the regulators have not established an oversight committee for enforcing legal action against boards and management for non-compliance, or an explicit auditing standard for governing the required audits. This makes evaluating any internal control weaknesses and validating the effectiveness of internal controls difficult for accounting firms.

For China to meet and even surpass global best practices in corporate governance there needs to be commitment, independence, and transparency at the Board so that the support and participation from all levels within an enterprise for the implementation of the Basic Standard is visible and can be ensured.

Vivian Chow is a manager for Business Risk Services at Grant Thornton, a member firm with Grant Thornton International Ltd, which is one of the world's leading accounting and consulting firms.

(HK Edition 06/26/2010 page3)