With foreign investors acquiring local firms in China and Russia in unprecedented scale and scope, an important question arises: to what extent do firms in these countries with a communist legacy follow the international accounting standard in their financial reporting? Or, more bluntly, can foreign investors trust the profit figure they provide? Researchers at the Institute for Emerging Market Studies (IEMS) based in Moscow and Beijing have been studying this issue extensively and found that financial misreporting is quite common and follows a unique pattern in the two markets that are not seen elsewhere.

That accounting fraud is rampant in China and Russia is not new news and has for some time been one of the biggest concerns for foreign investors in the countries. A recent news story reported that scammers in China have found a new level of fraud: they created a fake bank. To help investors assess the quality of accounting of their investing targets, analysts have made great efforts to study accounting fraud in the two countries. Unfortunately, so far most of the studies have focused on the listed firms, as it is easy to get financial information from them. But these studies provide little help to foreign direct investors, who, in addition to making greenfield investment, mainly acquire privately owned, unlisted firms. And one of the worst nightmares for an investor is to be cheated in the target firm’s finances.

Patterns of profit misreporting

In the above-mentioned IEMS study on the quality of financial information in major emerging economies, researchers focused specifically on the unlisted firms to examine the patterns and reasons of financial misreporting. They used large-scale statistical data from Brazil, China, India and Russia to examine this issue and found a unique pattern of profit misreporting. Both Brazilian and Indian firms reported high profit margins (11% and 13%, respectively) commensurate with their high national economic growth rates (10% and 14%, respectively). The Chinese firms and Russian firms, however, reported profit margins much lower (4% and 3.6%, respectively) than their high national economic growth rates (14% and 13%, respectively), implying that firms in China and Russia substantially under-report their profit.

Furthermore, the unlisted firms in China reported a profit (3.8%) that is less than one-third that of listed firms (12%), indicating a severely abnormal profit reporting pattern. In Russia, unlisted firms also reported lower profits than their listed counterparts (2.9% versus 4%, respectively).

These numbers indicate that firms, especially unlisted firms, in China and Russia under-report profits. Both economic theories and empirical studies indicate that due to the higher risk and greater difficulty to invest in unlisted firms, they generally earn higher profits than listed firms. Thus the fact that the unlisted firms in China and Russia reported profits substantially lower than their listed counterparts shows that they hide profits.

The reported profits of the unlisted firms in China and Russia show huge spikes that peak at a small positive value near zero – the breakeven point: most of the unlisted firms reported a tiny positive profit, and few firms registered losses or large gains. The pattern implies one thing: these firms want to show a nearly zero profit. In other words, firms in China and Russia tend to avoid showing gains or losses.

Reasons of profit misreporting

What the researchers found is intriguing: while Wall Street worries about profit over-reporting, what has occurred in China and Russia is profit and loss hiding. But why do they do this? Further analysis reveals that this unique pattern of profit misreporting in China and Russia primarily resulted from the political and economic environment undergoing rapid transition from communism to market. First, both China and Russia abandoned the communist practice of an indirect tax system in which taxes were deducted before people got their wages. Naturally, people did not react to the newly established direct taxes enthusiastically. This anti-tax attitude, which was further strengthened by the state’s declining ability to provide social goods, is a major reason businesses hide profits from the state. Responding to this anti-tax sentiment and the declining state revenue, the state created even more high taxes. This has made the firms view the state as predatory.

Another unique reason of profit and loss hiding is the lack of legitimacy of private wealth in both China and Russia. When both countries embarked upon economic liberalisation, in order to revitalise stale state-owned firms, the government handed many of them over to private hands. The well-connected and powerful got rich in unprecedented speed and scale. However, while private business was allowed, old anti-business regulations held on. Many business people, in order to operate and grow in the new market economy, were forced to break the old rigid communist rules. Bribery and corruption was not uncommon. As a result, the first generations of wealthy business people felt insecure because of their ill-gotten fortune and their law-breaking past. The authorities can easily accuse them of economic crimes.

Fully aware of its power to bring down almost any business people, government officials can handily use their discretion to act against any business people who have caught their attention, either inadvertently or deliberately. So business people in these countries have adopted a 'lay-low' strategy. Do not show much profit, for it attracts envy and high taxes; do not show losses either, as the state never believes in losses and will send auditors to scrutinise the firm, which will pose a whole new set of problems. Once accused, the chance of acquittal is virtually zero.

Perhaps no one knows this secret better than the former president of China, Jiang Zemin. In his news conference in 2000, the former president of China followed the rule of 'silence is golden' and replied little to reporters’ questions. After being prodded repeatedly by reporters, he lost his temper and revealed the secret of success in China: “men-sheng fa-da-cai!”, or "keep silent, make a big fortune!".

Implications for business and policymakers

What are the implications of such profit misreporting for business and policymakers?

For the private firms, there is a dilemma. On the one hand, to survive in such a business environment, it may be necessary to hide the true financial information; on the other hand, to grow, they need external financing, and to do so accurate financial data is a prerequisite. The key to solving this dilemma is more in the government’s hand than that of private firms.

Most Chinese and Russian firms hide their true financial data not because they are intrinsically more unethical than their counterparts in Brazil and India, it is the overall political and economic environment that induces them to adopt such a strategy. Thus, the first implication of our study is that the state should adjust the tax policies to make taxes more affordable, fair and consistently enforced.

In addition, both the Chinese and Russian governments should recognise that one of the root causes of massive earnings manipulation by firms is the lack of a free market for information and the cultural legacy of years of communist rule and indoctrination. If the government manipulates and filters information at the societal level, why can’t firms manipulate their earnings information? To improve the accuracy of information, a free market that allows competitions among different information providers is necessary. A more important – and more difficult – task is to nurture a culture of honesty and trust.

In order to alleviate the fear of the wealthy, the Chinese and Russian governments may consider implementing an amnesty program that gives immunity to owners of assets, which may have been gained illegally in the early stages of the reform. The Russian government has taken measures to limit the judiciary review of the 1990s privatisation deals, alleviating the major concerns of many Russian business people. The Chinese government has not formally addressed it yet. The current debate in China about forgiving the 'original sin' precisely focuses on this somewhat urgent issue. Of course, how to balance between reducing the insecurity of the rich and alleviating the anger of the underprivileged, low-income population remains a delicate task in both societies.

For investors, when evaluating a firm’s performance, they should never take the face value of the accounting profit, for it can be easily faked as compared to cashflow data, which is harder to forge since it can be cross-referenced with the firm’s bank account (assuming, of course, the bank is genuine and does not collude with the firm in forging!). So investors should give more weight to cashflow data and take a more critical view on accounting profit figures. When it comes to financial data, especially financial data from a rapidly growing market with known poor information quality, the motto 'all data are guilty unless proven innocent' serves well.

Shaomin Li is professor of international business at Old Dominion University and visiting fellow at the Institute for Emerging Market Studies (IEMS). Seung Ho Park is the president of IEMS and professor of strategy at the Skolkovo Moscow School of Management.