+1 (208) 254-6996 essayswallet@gmail.com

Please read the attached case 8-3 (page 29 -page 43)

3 1/2 page.

– 244 –



Management control of multinational enterprises in

China: a contracting and management accounting








Fortune Ltd – The Balanced Scorecard in a US-Chinese Joint Venture in China

8.2 AB Holdings Ltd – A new incentive scheme

8.3 ECG Ltd – Fraud and the liquidation of a joint venture in China

– 245 –

Case Study 8.1 – Fortune Ltd – The

Balanced Scorecard in a US – Chinese

Joint Venture in China


Fortune Ltd is a U.S.-Sino JV located in Guangdong Province that was founded in 1994

with a 90% equity injection by a USA pharmaceutical manufacturer and 10% equity held by a

Chinese government department. Fortune Ltd was previously a state-owned enterprise before

being acquired by the foreign investor. The US parent company is a large pharmaceutical

company that is ranked in the top ten of generic sales in the world in 2001. Its core products

include global human generics, active pharmaceutical ingredients business, and animal health

business. The group strategy of the US parent is “Making medicine accessible, clear vision,

dedicated leadership and quality people”.

The aim of Fortune Ltd is “to be the leader in China branded generic business in 5 years.”

In 2003, Fortune Ltd has achieved a break-even position and is making profits in 2004. The

main product of the JV constitutes 35% of total sales of the factory, and a market share of 70%

in South China, all of which is domestic sale. Although Fortune Ltd contributes around 1% of

the sales turnover for the US parent, which is comparatively small, it serves as the market

seeker in China for the group. In addition to the regional office in Guangdong, Fortune Ltd is

1 I wish to acknowledge the research assistance of Elaine Feng in the preparation of this case


– 246 –

projecting to set up a branch in Shanghai. Fortune Ltd is hiring 460 staff, 200 of who have

technical background, and there are about 300 secondary graduates.

After the formation of Fortune Ltd, the US parent soon realized that the JV had many

operational problems and concluded that:

– Production staff were still iron-bowl mindset;

– Sales staff were not professionally trained;

– Old product range – mainly list A products, whose selling prices are determined by the

government, resulting in low profit margin; and

– High cost of production and operation activities.

To achieve the group corporate strategies, the US parent must implement a strategic

management system to control this newly acquired JV to achieve desired organizational

outcomes. The main objectives are to motivate employees’ performance; increase in

productivity and operation efficiency; enhance customer satisfaction; and improve profitability


In order to sustain a winning position in the market, Fortune Ltd identified its strategic

competitive advantage (SCA) based on the key success factors analysis (see Figure 1). From

the above the matrix, we can see that the top five key success factors stand out to be the

strategic competitive advantage. The SCA statement of Fortune Ltd is: We will win by having

– 247 –

high quality, good customer service, long-term customer relationship, GMP products (full

range) and high company awareness in Guangdong province.

Insert Figure 1 Strategic competitive advantage matrix

Amidst ongoing evolution of competitors and the external environment, it is important

for Fortune Ltd senior management team to clarify their answer to a fundamental question:

“Why should customers buy from our company?” In order to find the answer to this question,

the senior management team analysis the value proposition of the company. What variables are

most important to our target markets, such as pricing, quality, time, selection, service, customer

relationship and company image (Beiman and Sun, 2003)?

Value proposition can be broken down into business leadership in one of the five major

areas: (i) low cost, (ii) product leadership, (iii) customer solutions, (iv) system lock-in, and (v) a

unique combination of product and service.

From the above SCA analysis, the senior management found that Fortune Ltd.’s SCA is

on the customer service and relationship. So, the value proposition should stress the provision

of complete customer solutions. For this value proposition, customers should feel that the

company understands them and can provide them with customized products and services

tailored to their needs. The value proposition of Fortune Ltd was outlined in Figure 2.

– 248 –

Insert Figure 2 Customer value proposition (Customer retention strategy)


By facing these main problems, the US parent must communicate its vision, mission,

value and strategy to Fortune JV staff, and align the behaviours of managers and low-level

personnel in order to achieve the group’s goal. Therefore, US parent management decided to

implement the BSC approach in Fortune in early 2002. The BSC project was expected to be

rolled out across the manager and above level over the first year – 2002, then across down to all

lower functions and levels from the second year – 2003. The timeline schedule for the

implementation in the first year is shown in Figure 3.

The implementation of the BSC process within Fortune Ltd was supported by a head

office consultant who has helped several of the US parent’s regional offices to implement BSC

and has many experiences in solving the management problems like those in Fortune Ltd. In the

first of a three months stay (January to March 2002) the consultant conducted training sessions

for all director and manager levels. In the second month, he helped the management team to set

up BSC in Fortune Ltd, including objectives and critical success factors. In the third month, he

helped each department to set up their departmental key performance indicators (KPIs) (see

Table 1).

– 249 –

Insert Figure 3 The timeline schedule for implementation in the first year

With the implementation of BSC, Fortune Ltd can achieve the following objectives:

First, Fortune Ltd provided training courses to reorientate production staff away from the SOE

mindset and to enhance the professionalism of the sales staff (see learning and growth

perspective). Second, the production and sales staff were made accountable to meet key

indicators associated with the cost of production and customer service (internal business

perspective). Third, sales staff was made aware of the importance of the linkage between

having a good customer relationship, image and reputation such as trust (i.e. how the customer

feels about the experience of purchasing from the company) and the ability of Fortune Ltd to

capture market share in China.

Insert Table 1 Fortune Ltd.’s balanced scorecard performance objectives


BSC has been carried out an implementation in Fortune Ltd since January 2002. During

the BSC implementation, the US parent has achieved the expected results in Fortune Ltd. For

example: the reduction cost of goods sold from 70% to 64% was 1% over target (65%). In an

example of how the BSC helped Fortune Ltd to respond to an unexpected event, a product

packaging quality problem, Fortune Ltd traced the root cause to the operator’s lack of

familiarity and skill in operating the new packaging machine. This was improved after

– 250 –

operators training, machine adjustment, and reinforcement site management (see Figure 4). The

training and contingency plans presents an opportunity for improving the BSC in the future.

Insert Figure 4 Balanced scorecard outcomes

– 251 –


1. What are the theoretical underpinnings of the balanced scorecard?

2. What are the costs of the balanced scorecard in Fortune Ltd.’s case?

3. What were the main reasons for the US Parent to adopt the balanced scorecard in its

joint venture in China? Did the adoption of the balanced scorecard achieve its


4. In what ways may culture impact of the successful adoption of the balanced scorecard

in China? What steps did Fortune Ltd take to minimize this risk?

5. Draw a strategy map that reflects the connections between the objectives under each of

the four balanced scorecard perspectives.

– 252 –

Table 1 Fortune Ltd.’s balanced scorecard performance objectives

Strategic theme: Internal product development

Panel A: Financial

Strategic perspective Objective Measure (CSF) Target (KPI) Initiative

Revenue growth

What we want/ need

to achieve in the

marketplace in order

to reach our

financial goals?

– Operating






– Revenue



– Return on



Grow revenue

from new


– 253 –

Panel B: Customer

Strategic perspective Objective Measure (CSF) Target (KPI) Initiative


What we must do for

customers in order to

achieve the above

marketplace goals?

– Build strong

brand image

– Create brand awareness via introduction

to distributors

– Key products and star products


No. of pubic relationship events:

– Participate in national commercial


– Advertisement in trade magazine or


Survey of company awareness

– Relationship



– Gain sharing


– Competitive


– Best price to quality ratio

– Benchmark with leading products –

quality issue

– Lower COGS (optimize purchasing of

raw materials, higher production volume)

– Protect key products’ prices

– Achieve gross margin price level

– High service


– Information regarding product status

– Speedy and accurate information to


– Products quality, logistic management

– Reduce customers’ complaints

– Delivery on time to customers

– 254 –

Panel C: Internal processes

Strategic perspective Objective Measure (CSF) Target (KPI) Initiative

World class

internal product

What we must “Do

Well” internally to

ensure the

achievement of

market goals?

– Improve cost of


– Est. database

– Material cost control

– Productivity improvement

– Production cycle time reduction

– Facility utilization increase

– 4% GM improvement in 2002

– Production line productivity

– Inventory turn increase between4.5-5

times in 2002

– Production cycle time reduction

– Facility utilization increase 50-70%

– Supplier liaison/

technology transfer

– Reengineering,

research and



– Enhance product development –

Pipeline management

– New technology – introduction

– Identify no. of new or potential


– No. of new technology and material


– Development cycle

time reengineering

– Improve



– Est. customer service function

– Set up customer survey system

– Order fulfilment

– Customer satisfaction survey

– Improve internal

operating system

– Establish database of operation and

improve report system

– Improve planning and inventory control


Set up:

– Database of operation and report


– Planning and inventory control


– Distribution system management

– 255 –

Panel D: Learning and growth

Strategic perspective Objective Measure (CSF) Target (KPI) Initiative

Stable high

talent workforce

How do we enable


systems and culture

to achieve the

internal and market


– Up-grade skill of


– Professional training

– Responsible and commitment


– Competency development

– Master training plan

– Training courses and hours

– Performance evaluation

– Competency model

– New hiring program

– Improve internal

and external


– Internal newsletter

– Team building

– Willingness to share information

and knowledge

– Further promote efforts to open

communication barriers among

divisions and business partners

– Publish internal newsletter

– No. of employee communication


– No. of customer communication


– No. of users for BSC

– Supervisory training

– Benefits program

– Commitment and

result oriented


– Implement job description for all


– Performance management

– Open minded approach and


– Willingness to change behaviour

– Positive thinking culture

– No. of implementing job description

for all levels

– No. of improving projects

– No. of SOPs reviews

– No. of new ideas implemented

– 254 –

Figure 1 Strategic competitive advantage matrix

High 10

Low 0

Diversified products

On time delivery

Short lead time

High quality

Good customer service

Long-term customer relationship

GMP products (full range)

High company awareness in Guangdong


Drug a-strong market share in Guangdong


Sales networking

Technical know-how on production

Knowledge of business

Strategic goal

Restructured management team

Advanced equipment

Good government relationship

Responsible employees

Strong support from corporate

Team working


Low 0 5 10 High

Ability to beat competitors

V al

u e

to c

u st

o m

er s

– 255 –

Figure 2 Customer value proposition (Customer retention strategy)

Sales multiple and bundled products

Provide exceptional before and after sales service

Deepen relationships with customers through visits and sales meetings

Capture and retain customers to be lifetime customers

Deliver goods to customers at speedy and high-service distribution

– 256 –

Figure 3 The timeline schedule for implementation in the first year

Schedule Jan,02 Feb,02 Mar,02 Apr,02 May,02 Jun,02 Jul,02 Aug-Dec,02 Jan,03 Feb,03

1. Trainning from consultant

2. Set up balanced scorecard

– objectives & CSFs.

3. Develop departmental KPIs &

complete KPI form – directors

4. Review all the directors’ KPIs


5. Develop individual KPIs &

complete KPI form – managers

6. The directors & mangers discuss

and agree upon the KPIs

7. HR complete all the BSC & KPI


8. Mid-year review on results of KPI

– director & manager levels

9. Adopt “Plan Do Check Act” sessions

10. Year-end review on results of KPI

– director & manager levels

11. KPI measurement – all levels

12. Summit the total company KPI

review to the corporate

– 257 –

Figure 4 Balanced scorecard outcomes

Internal business process perspective:

Problem: One of product packaging quality

problem which happens at March 2002

Results: Innovation-the new procedures

have been created, reported quarterly since

2nd half of year

Good customer relationship

Reinforcement QMS

and product quality

Educated and provide training

courses for production and

sales staff

Reduce to cost of goods sold Financial perspective:

Problem: High cost of goods sold

Results: about 4% reduce (1% over target)

Customer perspective:

Problem: Keen local competition (7000

firms in China)

Results: keeping on stable market share

due to products price regulation controlled by China government.

Learning and growth perspective:

Problem: Production staff have SOE

mindset and sales staff are not professional


Results: reinforcement training for both

staff that could make to give up

SOE mindset and have a good

moral for them.

– 258 –

China Case Study 8.2 – AB Holdings

Limited – A new incentive scheme


AB Holdings Limited (the “Group”) was established in the early 90s and successfully listed

on the Main Board of the Stock Exchange of Hong Kong in the Mid 90s. The principal activities of

the Group are the trading of the electronic components and assist some famous brand names of

television to enter the China market. At the early stage of 2000, the Group diversified its businesses

into wireless applications protocol (WAP) business and telecommunication services.

In early 2001, the Group entered into a joint venture with a Hong Kong company to form a

new company called CD Ltd for the purposes of promoting telecommunication services in China. The

strategy of CD Ltd. is to become leading provider of telecommunication services in the Southern

China. The detailed structure is shown in Figure 1. In August 2001, CD Ltd formed an equity joint

venture (EJV) called ThreeG Inc. with two China partners. As a result of this, the Group owns 18.33%

(55%*33.33%) of effective holdings of the EJV because the shareholding distribution is strictly bound

by the telecommunication regulation of the PRC.

The core businesses of the EJV are broadly divided into three categories as follows:

1. Selling of calling cards in several regions of the Mainland China (i.e. Beijing, Shanghai,

Guangdong and Fu Jin);

2. Selling of internet service traffic through the establishment of the data centres in Beijing and

Shanghai; and

3. Operating as an internet service provider (ISP) and web server hosting business.

2 The names, data and dates of this case have been slightly changed in order to preserve the anonymity of the firms involved. I wish to acknowledge the research assistance of Ray Shaw in the preparation of this case study.

– 259 –

Insert Figure 1 Organization structure of AB Holdings Ltd

Taking the advantage of the strong ties between the Company and China Telecom, the rate of

subscription to the internet bandwidth service to the PRC is good. However, the profit is very slim due

to the strong competition. Although the turnover of the EJV increased from HK$4.5 million for

twelve months ended 30 June 2002 to HK$17.55 million for the year ended June 2003, the loss from

operations increased from HK$10.05 million in 2001/02 to HK$19.2 million in 2002/03. It can be

seen that there are significant changes between the two fiscal years. For accounting of associated

companies, a share of the loss of the EJV is incorporated into the consolidated financial statements of

CD Ltd. and ultimately affects CD Ltd.’s financial results. Currently, the turnover of the EJV was

around RMB19.5 million in the last year (to June 2004), and the net loss was about RMB2 million for

the same period.

As detailed in the turnover model in Figure 2 below, the cash generated from ISP traffic

volume and calling card sales is passed directly from the distributors to the local agents of China

Telecom and Unicom. The proceeds due to the EJV are booked as accounts receivable and the amount

is derived from the traffic volume reports and calling cards sales reports which are prepared by the


Insert Figure 2 Telecom services distribution model



Collection of accounts receivable

From the turnover model in Figure 3, the agent obtains the calling card sales from the

distributors and the traffic volume from the service providers to produce the relevant reports for

onward transmission to the EJV together with cash. Even though the cash collection cycle as

explained in Figure 3 requires 4 months in total, the EJV accepts the rules of the game as the business

potential is large when the market of the Mainland China is opened as a result of China’s accession to

– 260 –

the WTO. More businessmen entering the China market will use more telephone cards.

Insert Figure 3 Cash collection cycle

The main problem facing the EJV is in the collection of account receivable. The cause is

twofold: the lengthy receivables practice in China and the fact that the submissions of turnover reports

to the EJV are generally late by up to four months. First, it is a common practice in the Mainland

China using invoice accounting. The duration of the receivables is very long. This imposes problems

to the EJV because the risk of the debt becoming bad is therefore extremely high. From the past

records, the EJV has set 10% of bad debts provision for the receivables. The management of the EJV

has estimated that the receivables outstanding for four months typically are 100% written off.

Second, the delayed submission of turnover reports stems from the nature of the telecom

contracting arrangements in China. The EJV has contractual relationship with the service providers

only, but not with the agent. The agents can only be appointed by one of the two major traffic

suppliers. The EJV can do businesses with one of them. Monopolistic environment are very clear as

the local companies that are supported by the Government always dominate the market. The agents

are designated by the service providers, China Telecom and Unicom. The service provider pays the

commissions to agent, one agent serves many telecommunication services companies at the same

time, and they may not be willing to boost the turnover of our company without additional benefits.

As there is no contractual relationship between the agent and the EJV, thus the former has no

fiduciary duty to submit the financial reports at a manner of earlier reply due to the urgent needs of

the latter. Though the distributors are nominated by the EJV, they will never report the sales of cards

to EJV directly. Consequently, the agent is the only one simultaneously acting as the information

collector i.e. collecting the traffic usage report from service providers and the analysis of sales of

calling cards from distributors and as the information conveyer i.e. conveying the same to the EJV.

Current incentive scheme

The EJV has an incentive scheme for the marketing staff which comprises a small percentage

of commission with maximum of RMB5,000 per staff per month. After an evaluation, however it was

– 261 –

found that the current scheme was not attractive and did not motivate the marketing staff to sell more.

As for the agents and distributors, there is formal incentive scheme or commission reward scheme

since there is no contractual relationship between the EJV and the agent, the EJV and the distributors.

Proposed incentive schemes

Marketing staff and distributors. An incentive scheme has been proposed to address the

accounts collection problem that focuses on both the internal and external agents working with the

EJV. Internally, a new incentive scheme is proposed to encourage the marketing staff to sell more

calling cards to the licensed distributors (the distributors). Externally, an incentive scheme is aimed at

encouraging the distributors to sell more calling cards to the retailers. For the incentive schemes to the

marketing staff and the distributors, the commission is to be calculated based on the increased number

of sales of the calling cards to end-users (see Table 1). It is assumed that the more the calling cards of

the Company are available in the markets, the more the probability the cards will be sold to the end-

users. Commission is calculated based on the increased number of calling cards sold to the end-users.

Agents. The proposed incentive scheme for the agent comprises a commission that is

calculated based on the shortened number of days of submitting the reports and remitting the cash to

the EJV (see Table 2). Since the agent is assigned by the service provider with no contractual

relationship with EJV, an additional clause will be added to the contract entered between the EJV and

the service providers and is subject to approval by the latter.

The bad debts of the EJV per last financial year was approximately 10% of the trade debts

which was RMB2 million. From Figure 4, the curves representing the estimated amount of bad debts

can be received back from RMB300,000 up to RMB1,900,000 and the proposed amount of

commission can be paid to the agent from RMB100,000 up to RMB1,267,000 if the number of days

of reporting and remitting can be shortened from 10 days to 90 days respectively. The gap difference

between the two lines is the expected net benefit to the EJV upon implementation of the proposed

incentive scheme.

Insert Table 1 Proposed incentive scheme for marketing staff and distributors

– 262 –

Total incidental cost (the commission) to the increased revenue is 12%. It seems justifiable.

However, other additional costs, such as implementation and restructuring costs also need to be taken

into consideration. The normal time for the delay in submitting the reports and the cash remittance is

three months. From the financial reports, the annual bad debts written off is RMB2 million. The more

the days shortened, the more the commission to be paid but the more the bad debts can be reduced.

Insert Table 2 Proposed incentive scheme for the agent

Insert Figure 4 Cost and benefit analysis of the incentive scheme agent


1. What were the regulatory and contractual challenges faced by QT Ltd in China?

2. To what extent were these challenges imposed on QT Ltd? What were the payoffs for QT Ltd

entering China?

3. What were the other business environment challenges faced by QT Ltd?

4. What are the advantages of the proposed incentive scheme?

5. What are the assumptions of the marketing manager and distributor incentive scheme? Are

these assumptions valid?

6. What are the assumptions of the agent incentive scheme? Is the net benefit a reasonable

forecast given the assumptions behind the scheme?

7. What are the alternative control mechanisms that EJV can use to motivate its marketing staff

and other staff in the venture?

– 263 –

Figure 1 Organization structure of AB Holdings Ltd

AB Holdings Ltd. NG Inc.(H.K. company)

55% 45%

CD Limited China Authority TI Ltd.

(A Shanghai-based Co.)


33.33% 33.33%

ThreeG Inc. (EJV)

– 264 –

Figure 2 Telecom services distribution model

Service Providers

1) China Telecom

2) Unicom













Sale of traffic

Receipt of cash

Share of profit

R = Retailer


– 265 –

Figure 3 Cash collection cycle

120 days Retailers End user

Joint venture



Cash flow ultimately affects

the financial result

of the company.

Cirection direction

– 266 –

Figure 4 Cost and benefit analysis of the incentive scheme agent












1 – 10 1 1 – 2 0 2 1 – 3 0 3 1 – 4 0 4 1 – 5 0 5 1 – 6 0 6 1 – 7 0 7 1 – 8 0 8 1 – 9 0

N um ber of days shortened

V a lu e ( in R M B ‘0 0 0 )

C om m ission P aym ent A dditional C ollections D ue to B ad D ebt R eduction

– 267 –

Table 3 Proposed Incentive Scheme for Marketing Staff and Distributors

Panel A: Marketing staff

Number of telephone

cards sold by each

marketing staff

Commission paid on the

next 1000 cards sold

beyond each level

(RMB per card)



cards RMB RMB









1,000 (1)

1,100 (1.1)

1,200 (1.2)

1,300 (1.3)

1,400 (1.4)










• Average annual sale of telephone cards

• Total value of the telephone cards sold per year

• Share of revenue by the EJV

• Average annual revenue from sale of telephone cards for the EJV

• Average sale of telephone cards per month

• Number of licensed distributors (Approximately)

• Average sale of telephone cards per month per licensed distributors

• Number of marketing staff

• Targeted increased revenue (Approximately double the existing)

• Total commission paid to our marketing staff

• Total commission paid to the licensed distributors

• 600,000 pcs

• RMB65,000,000

• 30%

• RMB19,500,000

• 50,000 pcs

• 10

• 5,000 pcs

• 5

• RMB18,000,000

• RMB360,000

• RMB1,800,000

– 268 –

Panel B: Distributors

Number of telephone

cards sold by each

licenced distributors

Commission paid on the

next 1000 cards sold

beyond each level

(RMB per card)



cards RMB RMB








1,000 (1)

2,000 (2)

3,000 (3)

4,000 (4)

5,000 (5)









– 269 –

Table 2 Proposed incentive scheme for the agent

The shortened

no. of days

Total annual

commission to be paid

% of bad debts

can be received

Total bad debts



1 – 10

11 – 20

21 – 30

31 – 40

41 – 50

51 – 60

61 – 70

71 – 80

81 – 90




























– 270 –

China Case Study 8.3 – ECG Group –

Fraud and the liquidation of a joint

venture in China


ECG Group is a multinational enterprise that is involved in supplying building control

systems to construction industry projects throughout the world. ECG Group has two main subsidiaries

in the US (ECG US) and Singapore (ECG Sing Ltd). With a burgeoning construction industry, China

provided an opportunity for ECG Group to expand its overseas operations. ECG Sing Ltd first

developed its presence in 1990 when a representative office in Shanghai was established for

coordinating selling and engineering activities. Contracts were signed between ECG Group and the

client. The purpose of the representative office was to act as a liaison office between client and the

head office. Periodically, head office sent engineers to provide local engineers with product updates.

However, it was soon apparent that the representative office model was restrictive and not

able to carry the potential demand and growth for the systems that were built by ECG Group.

Consequently, ECG Group decided to expand its operations through a joint venture. This enabled the

expansion of both its manufacturing and selling activities. In 1994, ECG US formed a joint venture in

Shanghai to manufacture building systems equipment (Realton JV). The US subsidiary formed an

alliance with a local manufacturer in building instruments and started operations in 1994. The joint

venture encountered problems in the years that followed and ended up in liquidation (see Figure 1).

Insert Figure 1 Timeline for development of joint venture (Realton JV)

3 The names, data and dates of this case have been slightly changed in order to preserve the anonymity of the

firms involved. I am grateful for the assistance of Cliff Tse in the preparation of this case study.

– 271 –

Legal and strategic framework

The joint venture was formed between ECG US and CIG Ltd (a Shanghai listed company),

with shareholdings of 60% and 40% respectively. Part of the joint venture agreement was that ECG

US would supply technology and train local engineers, while the China partner would undertake to

market ECG Group’s products. The joint venture was formed to explore the production of building

system equipment such as air-conditioning valves and the fire-safety equipment that is used in

building construction projects (see Table 1). ECG US appointed the general manager and the local

joint venture partner appointed two assistant general managers (See Figure 1).

Insert Table 1 Partners in the joint venture

Insert Figure 2 Organization structure of Realton (Shanghai) JV Ltd


The joint venture began to manufacture goods in 1994, and customers immediately

complained about products not meeting their specifications. Product sales were weak, and the US

partner requested remedies. In mid-1997, the US partner adopted the general manager’s advice to stop

manufacturing products due to the lack of sales. The general manager also hired his own team of sales

managers. In 1998 and 1999 sales grew, but the general manager died of heart attack in April 1999.

From that time until September 1999, no new general manager was appointed. Operations continued

without leadership and the accounting numbers were not reported. Sales managers took up contracts

upon their own authority. The acting general manager divided the company into separate groups that

worked for his own benefit.

In January 2000, the finance director for the Asia-Pacific region discovered an unrecorded

liability of US$560,000. Losses accumulated to US$690,000, and prospects for continuing the

operations were not good. The finance department, which had previously been under the control of the

general manager, had generated fictitious transactions involving goods or services. The order book

was falsified to show good sales prospects, but 90% of the contracts secured were making losses and

the finance manager did not have to report the irregularities. In China, each company has two

– 272 –

common seals that are used in place of authorised signatures: a contract common seal and a company

common seal. Individuals who hold either of these common seals can represent the company in

banking transactions and contracts. In this case, hidden contractual obligations were endorsed with the

contract seal without the need for a valid signature.

Independent auditors were subsequently brought in and they discovered that the holding

company for local joint-venture partners had set up parallel companies to compete directly with the

joint venture, using the foreign investor’s own technology and market information and diverting the

most profitable contracts to their own operations. Without independent auditors to review the books

and records, headquarters may never have discovered such activities (see Figure 3).

Memo A to Vice President of ECG US from the Asia-Pacific Finance Director

I am presenting the following findings of why some contracts are signed between CIG and a

trading company called YEFA, which operates under CIG.

In auditing the books and records of Realton JV, it has been discovered that Realton JV has

been using a trading company controlled by CIG, Realton JV’s parent company, to transact

businesses. In addition to quasi-contracts signed between customers and CIG, a service contract has

also signed between CIG and Realton JV. The purpose of the transaction is that a trading company is

to handle the importation of foreign equipment while arranging disbursement of US dollars to ECG

US. The trading company will receive renminbi or other currency at an inflated exchange rate to

cover their service fee.

– 273 –

Figure 3: Transactions without a trading company. When Realton JV obtained the business

license, their business scope was the manufacturing of building systems equipment. At present, their

business scope does not include any project installation and management. This hinders Realton JV’s

development into project management because the Chinese government does not allow any foreign

importation of equipment or customs clearance of equipment.

Figure 4: Transactions with a trading company. Realton JV has turned to CIG for assistance,

using a trading company to contract for projects that Realton JV cannot transact because the scope of

business is restricted under the present business licence. There are two types of contracts customer

can enter into: $US and renminbi denominated contracts. For the $US contracts customers can sign

contract with CIG/YEFA. In return CIG is signing service agreements with Realton JV that will entail

the placement of orders with ECG US. Once CIG collects money from customers (in renminbi) it

arranges a reimbursement to ECG US for the order amount that Realton JV is due to pay ECG US.

Under this transaction, Realton JV receives renminbi for the difference between the contract amount

and the purchase cost (after setting off the service fee that is received by CIG/YEFA). For renminbi

contracts, the customers remit money to Realton JV, which is then passed onto CIG. CIG assists in

the remittance of the equivalent US$ to ECG US when it receives the renminbi from Realton JV.

The inter-company reconciliation between Realton JV and ECG US shows a balance of

US$1.863 million due by Realton JV. Out of that amount, US$109,000 is owed by CIG/YEFA in that

customers have not paid CIG/YEFA. There is no contractual liability between ECG US and

CIG/YEFA because Realton JV has placed orders directly and CIG will settle the amount when

monies are directly received from customers.

I hope that the above report will help us to gain an insight into the background of the

problem, because it appears that the trading company has been taking away Realton JV’s profit.

Whether someone has ‘cooked the books’ will be left to the auditors to determine.

– 274 –

Insert Figure 3 Transactions without a trading company

Insert Figure 4 Contracts handled through a trading company

Memo B to the Vice President of ECG US from the Asia-Pacific Finance Director

When the joint venture changed its business nature from manufacturing activities with more

than RMB1.4 million of imported equipment, obsolete spare parts amounting to RMB1.98 million

were not written off in accordance with the accounting standards ruling at the time. Also account

receivables amounting to RMB568,000 were unaccounted for. It is uncommon to issue invoices to

collect dues for which a tax invoice is raised. Controlling these activities mainly calls for action from

the sales managers.

Table 2 shows a summarised balance sheet for the best estimate of the carrying value based

on the balance value as at 31 July 2001. In determining the estimate, a prudent view is taken

notwithstanding the disposable value in the fixed or current assets. No adjustment has been made for

payable items because any error will end in a gain and that is not on par with the prudent view.

Internal audit views are taken into consideration on the assets value. The analysis reveals the


– The depicted capital value of RMB11 million should be reduced to RMB2.9 million

(which represents 23.3% of the original share capital).

– The depicted net assets RMB6.7 million should be net liabilities of RMB1.5 million.

Insert Table 2 Reconciliation from China GAAP to US GAAP

Realton (Shanghai) JV Ltd, 31 July 2001


By end of February 2001, after the presentation of the irregularities in the financial

– 275 –

statements, the US party resolved to liquidate Realton JV on the understanding that sixty percent of

the shareholding in the company was enough to pass the resolution in accordance with US liquidation

law. However, the Chinese partner refused to agree to the cessation because the Chinese bankruptcy

law stipulates that all joint venture partners must agree to the cessation of business. In addition, the

Chinese partner maintained that the accounting records were proper according to Chinese Generally

Accepted Accounting Principle (GAAP). Consequently, the Chinese partner requested US$200,000

for mismanagement by the US partner.

Many parts of the review noted differences in accounting estimates for asset valuation, which

meant that historical costs were recorded for the non-use of manufacturing facilities, thus resulting in

the write-off of US$1.38 million. Eventually, the Chinese joint venture partner agreed to a payment of

US$100,000 in compensation. An employee meeting was held to announce the closure of the joint

venture and a meeting was held on the next day to start the year-long liquidation process. Liquidation

commenced with an employee meeting that explained that the company was to be wound up. In the

following weeks, a liquidation committee was formed by one Chinese general manager appointed by

the board of directors, one finance manager and one legal advisor.

There were several difficulties in negotiating the liquidation of the joint venture. These were

related to the Chinese culture, inadequate preparation of the foreign partner and other tactics used by

the Chinese partner. First, in every meeting, the Chinese partner claimed that it could manage to

revive the company. In a few discussions, the Chinese participants indicated they would never close

the joint venture because they would lose “face” in their immediate social contacts with friends and

relatives. Second, when the US acting chief representative paid visits to the Chinese partner in

Shanghai he returned with empty hands because either no meeting had been scheduled by the Chinese

partner or no agenda for negotiations had been tabled. Adding to the complexity was that the parties

did not speak the same language and no documents were properly prepared until at a later stage when

the Chinese general manager assisted in interpretation and translation during meetings.

Third, the US acting chief representative had replaced the general manager who was removed

from office in December 2001. No formal re-registration approval was sought from MOFTEC.

– 276 –

Legally, no agreements could be reached, and the time for getting to know each other was limited to

the meeting table. In each meeting, the Chinese partner reminded the chief representative that he

knew nothing of Chinese and of the company’s business. Often, the Chinese participants demanded

proof of the chief representative’s legitimacy in conducting business meetings. Finally, in China it

was typical at the time for correspondence to be sent by fax and for messages to be relayed by

telephone conversations. These mediums of communication were more common than the use of

email. Consequently, the confidentiality of the US partner’s intentions was breached when fax

messages were read by the Chinese partner’s representatives.


Management fraud is a widespread problem for foreign businesses in China. Foreign investors

rely on local management personnel in China for the same reasons that they do elsewhere in the

world. Local managers are more familiar with the distinctive features of the local market, business

environment and culture. The difficulties of doing business in the Chinese language are also a

compelling reason for using local management personnel or expatriates who can speak local

languages and communicate with headquarters as necessary. Consequently, foreign companies that

invest in China typically manage their Chinese business at a great distance from their own

headquarters. This situation creates numerous opportunities for management fraud, as evidenced in

this case study.

– 277 –


1. What were the various weaknesses in the internal control system in this case?

2. In what ways could the situation have been avoided?

3. In what ways did Chinese accounting practice interfere in the transition of the joint venture

from a manufacturing entity to an engineering service company?

4. How can the process of liquidation be more effectively managed?

– 278 –

Figure 1 Timeline for development of joint venture (Realton-Shanghai)

June 1994


of joint




of control



Conversion to

engineering co

to install

control valves






– 279 –

Figure 2 Organization structure of Realton (Shanghai) JV Ltd

General manager

(US appointed)

Assistant general manager (2)

(Chinese appointed)


dept (15)

Sales dept



resources (5)


office (3)

Manufacturing (3)

operation ceased

– 280 –

Figure 3 Transactions without a trading company

Customers in




Foreign contracts US$

cannot be signed

Realton JV Need to apply for

import license and

foreign exchange

– 281 –

Figure 4 Contracts handled through a trading company

RMB contract


Foreign contract US$10





Payment of PO by US$8

*Invoicing for commission

US$(10-8) – US$0.125 service

fee = US$1.875 x 8.3 =





CIG charged for service fee

US$10 x 1.25%=US$0.125

Purchase orders

US $8


– 282 –

Table 1 Partners in the Joint Venture

Partners to the joint


ECG US (60%)

CIG China Ltd (40%)

Core business Building automation

Proven track sales records in

the US

Temperature control instrument

A Shanghai listed company with

strong sales in building

automation products in China

Origin United States China

Contribution Contribute 60% of capital and

supply technology and train

local engineers

Contribute 40% of capital and

market ECG Groups products

Partner strategic aim To secure a profitable return on


To share a stable return to

complement its main business

– 283 –

Table 2 Reconciliation from China GAAP to US GAAP

Realton JV, 31 July 2001

Mgt accounts Statutory Adjustments Estimated (Dec.)

YTD Accounts (Estimated) Value Inc. %


Tangible assets 3,603,581 3,546,917 -1,982,372 1,564,545 -81%

Fixed assets 3,603,581 3,546,917 -1,982,372 1,564,545 -81%

Inventory 5,194,114 10,160,632 -4,369,072 5,791,560 -43%

Construction in progress 191,587 -191,587 –

Organizational expenses 611,827 -611,827 –

Other deferred expenses 257,177 -257,177 –

Debtors-net trade 5,245,987 5,676,409 -567,641 5,108,768 -10%

Debtors – inter-company 430,423

Advances to suppliers 225,367 -225,367 –

Debtors – other 4,385,216 788,089 -39,405 748,685 -5%

Creditors – net trade -1,721,147 -1,721,147 -1,721,147

Creditors – inter-


-11,103,472 -12,665,924 – -12,665,924

Creditors – other -2,601,835 -222,029 – -222,029

Taxation -134,433 -134,433 – -134,433

Net current assets -305,148 3,167,557 -6,262,076 -3,094,520 -198%

Assets employed 3,298,433 6,714,474 -8,244,448 -1,529,975 -123%

Share capital

Capital reserve 18,481,095 18,481,095 – 18,481,095

Exchange variance -165,837 -165,837 – -165,837

Reserves – revenue b/fwd -10,839,298 -6,707,410 – -6,707,410

YTD transfers to revenue


-850,939 -1,549,220 – -1,549,220

Asset written-down


-8,244,448 -8,244,448

Total equity 7,742,131 11,158,172 2,913,723 -74%

– 284 –

Cash in hand and at bank 4,443,698 4,443,698 – 4,443,698

Total debt 4,443,698 4,443,698 4,443,698

Capital employed 3,298,433 6,714,474 -1,529,975 -123%

– 285 –


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