Rules are dead, people are alive, this is very simple.

Jenny Yip
Project Manager – ECFO Services LTD

In 2014, a Shanghai TV reporter conducted a two-month-long undercover investigation into OSI Group’s Shanghai meat processing plant. The reporter exposed gross violations of hygiene standards on the meat packing lines that were primarily caused by the workers on the line, not following procedures. When one worker was asked about their cavalier attitude towards using expired meat, the worker responded: “Rules are dead, people are alive; this is very simple.”

Rules are dead, people are alive, this is very simple.

The backlash was swift. OSI was immediately ordered to shut down its Shanghai plant leaving its customers, including McDonald’s and KFC, scrambling to find other sources for their meat products. OSI was fined US$3.6 million for the scandal brought on by a lack of enforcement of procedures and a casual attitude for rules.

This culture of flexibility towards procedures is left over from a time when China’s rules were brittle and intended to control access rather than improve efficacy. The expression: 规矩是死的, 人是活的! “rules are dead; people are alive!” means that rules are meant to be broken. From a positive perspective, it is a way of conveying ingenuity and problem solving, which was often required when dealing with China’s rigid bureaucracy. Unfortunately, as China’s economy has rapidly advanced, this attitude towards rules breaking becomes less clever and more debilitating for modern businesses.

Internal controls are critical for all businesses to mitigate risks. Even though the set of procedures implemented in your company might be robust, there is no 100% assurance that all procedures are followed through every single time. By conducting periodic spot-checks on your company’s processes, you reduce opportunities for mistakes and fraud and increase the accuracy of information conveyed to management.

Spot-checking will allow you to understand exactly how the procedures set in place are executed (if at all) and is a fast and easy way to discover noncompliance and weaknesses in the system. If a problem appears when spot-checking, the real magnitude of it might be a lot larger, and it might call for a deeper dive in to adjust and improve.

The fundamentals of internal controls remain the same regardless of location. In China, however, factors such as inconsistent regulatory frameworks or cultural attitudes about rule-breaking require additional layers of control to be put in place. While there have been significant improvements occurring throughout many industries in China, a tendency to be flexible when following rules is still a cultural phenomenon that foreign investors must take into account.

The following are examples of common procedures that are often not appropriately followed and how to spot them:

Purchasing control for contractual prices
This spot check process also works for controlling the selling price as well. Confirm if the prices quoted by suppliers are identical to those agreed upon within the contract. In developing countries like China, many small companies do not have sufficient staff or robust systematic control to ensure that there are no mistakes when invoicing clients.

Control procedure: to ensure that the unit price paid for an item matches the contractual rate, the finance department should compare all prices shown in every invoice with the list of agreed-upon prices. Discrepancies are reconciled with the supplier before payment is processed.
Disruption: The finance department staff did not review if the quoted price is equal to the agreed-upon price or missed the difference before processing the invoice.
Effect of disruption: inconsistent prices lead to inaccurate forecasts, not to mention the cost of overpaying for supplies has on bottom line performance.

Spot check: if there is an ERP system recording the purchases, it can be downloaded and use Excel to run comparable analysis between purchased price with the contract price. If there are no electronic records, sample check purchases periodically. Monitoring the gross profit margin on a monthly basis helps to raise red flags, it serves as a good indicator of the need for deeper analysis but it is not a direct indicator of the disruption (a decrease in profit margins might mean large wastage, mistake when doing inventory count, wrong accounting entry, etc.).

Fapiao control
In China, fapiaos are official proof of purchase of goods and services. They are required to qualify tax-deductible expenses and as supporting documentation for calculating corporate income tax.

Control procedure: all payments to suppliers occur after obtaining fapiao from the supplier. The finance department should only approve payment requests that have a fapiao attached.

Disruption: the supplier asks as a favor this time for the payment to be sent as soon as possible. The supplier knows they should send the fapiao first but explains that they are having problems with issuing the fapiao and promises the fapiao will be delivered after the payment is collected. Finance makes the payment without the fapiao.

Effect of disruption: without proof of purchase, the company cannot offset input VAT against its output VAT; furthermore, the company may not claim the expense thereby increasing corporate income tax exposure. If a shortfall in corresponding fapiao is a chronic problem, this might lead company employees to compensate by purchasing fake fapiao, which could lead to significant fines from the tax authorities if uncovered.

Spot check: before your finance team issues payment, review to ensure that each payment has a corresponding fapiao.

Confirming inventory purchase
Control procedure: the person receiving the purchased inventory should count and make sure that it matches the quantity on the delivery slip/receipt/invoice and needs to sign it and send it to the finance department.

Disruption: the delivery slip is not signed when sent to the finance department.
Effect of disruption: an unsigned delivery receipt indicates a high probability that incoming inspections were not done properly (or even done at all), this directly affects the control on the quantity and quality of the items purchased for production input. Either way, this can lead to longer leads times or unfilled orders altogether.

Spot check: sample check the documents confirming receipt of purchase and check if there is a signature on each delivery slip.
In our next article, we will explore ways to encourage your employees to follow procedures and correct their behavior.