China’s Third Plenary Session:
Implications for Strengthening Deterrence of Accounting Violations†

By: Dr. Mei Gechlik / On: July 31, 2024

Table of Contents

The Third Plenary Decision & the “Socialist Market Economic System”
China’s Newly Amended Accounting Law
A Typical Case Decided by the Supreme People’s Court

Estimated Reading Time

6.6 min

China’s Third Plenary Session: Implications for Strengthening Deterrence of Accounting Violations — Image: Axelle B, *Euros Handshake* (Publicdomainpictures.net)

“Strengthening the regulation of listed companies” and “improving the mechanism for protecting investors” are among the many reform tasks identified in the widely anticipated decision adopted at the third plenary session of the 20th Central Committee of the Communist Party of China on July 18, 2024 (“Third Plenary Decision”). While China’s newly amended Accounting Law may help accomplish these goals, a case decided by the Supreme People’s Court—and selected as a Typical Case (i.e., a case with referential value)—suggests that additional measures are required.

The Third Plenary Decision & the “Socialist Market Economic System”

As indicated by its title, the Third Plenary Decision focuses on “advanc[ing] Chinese modernization” by “further deepening reform comprehensively”. By 2035, according to the decision, a “high-level socialist market economic system will be fully established” and “the modernization of the national governance system and governance capacity will be basically realized”, among other goals.

“The Third Plenary Decision further explains that ‘a high-level socialist market economic system’ is ‘an important safeguard for Chinese modernization’. ”

The Third Plenary Decision further explains that “a high-level socialist market economic system” is “an important safeguard for Chinese modernization”. It is, therefore, “necessary to better utilize the role of the market mechanism to create a fairer and more dynamic market environment” by, inter alia,

“promoting the healthy and stable development of the capital market”;
“strengthening the regulation of listed companies”;
“improving the mechanism for protecting investors”;
“actively aligning with international high-standard economic and trade rules to achieve interoperability and compatibility of rules, regulations, administration, and standards in the financial field […], creating a transparent, stable, and predictable institutional environment”; and
“orderly expanding the opening up of [China’s] capital market”.

All these tasks, together with many others stated in the Third Plenary Decision, are required to be completed by 2029, which marks the 80th anniversary of the founding of the People’s Republic of China.

China’s Newly Amended Accounting Law

In light of these reform tasks, China’s amendment of its Accounting Law in late June was most timely.

As explained by LIAO Min, Vice Minister of Finance, the amendment primarily addresses the problem that penalties for accounting violations were not severe enough to produce a truly effective deterrence effect. Consequently, accounting violations, especially financial fraud by listed companies and ineffective internal financial audits, remained common. In fact, according to the Ministry of Finance, 197 accounting firms and 509 certified public accountants in China were subject to administrative penalties in 2023, a year-on-year increase of 13.22% and 21.77%, respectively. Of these accounting firms, nine lost their practice licenses and 49 saw suspension of their practices. 162 of these accounting firms were fined and/or subject to confiscation of their illegal gains, amounting to nearly RMB 16 million in total.

To more effectively deter listed companies and other entities from committing financial fraud and other accounting violations, the Accounting Law, after its recent amendment, allows the maximum amount of a fine imposed on a “unit” committing these violations—“units”, as defined by the law, can be “state organs, social groups, companies, enterprises, institutions, and other organizations”—to be ten times the unit’s illegal gains (vs. RMB 100,000 before the amendment). The maximum amount of a fine imposed on an individual committing such violations is now RMB 5 million (vs. RMB 50,000 before the amendment).

A Typical Case Decided by the Supreme People’s Court

“With increased penalties, the amended Accounting Law may indeed produce more of a deterrence effect. Yet the real deterrence is likely to arise from potential civil lawsuits brought by parties claiming compensation to cover their losses […].”

With increased penalties, the amended Accounting Law may indeed produce more of a deterrence effect. Yet the real deterrence is likely to arise from potential civil lawsuits brought by parties claiming compensation to cover their losses—usually, considerable—resulting from their reliance on false accounting records. For example, the Several Provisions of the Supreme People’s Court on the Adjudication of Compensation Cases Involving Civil Infringements of Rights by Accounting Firms in Their Auditing Activities (“Accounting Firms Provisions”) allows adversely affected parties to sue the accounting firms whose false audit reports cause these parties’ losses and to claim compensation accordingly.

However, Article 2 of the Accounting Firms Provisions limits such adversely affected parties to only two types: (1) those “who suffer losses from conducting transactions with the audited entity” and (2) those “who suffer losses from engaging in trading activities related to the audited entity’s stocks, bonds, etc.”. The shortcoming of this narrow scope became apparent in a case that was ultimately decided by the Supreme People’s Court. In this case, a Chinese company sought to claim compensation from an accounting firm, on the grounds that it relied on the firm’s audit report—which turned out to be false—of a German corporation to issue loans to a building materials enterprise, whose parent company was fully owned by an entity that was, in turn, owned by the German corporation. The Chinese company suffered losses because the building materials enterprise became insolvent and was unable to pay back the loans in full amounts.

The Supreme People’s Court ruled against the Chinese company because it was not considered to be an adversely affected party, for purposes of the Accounting Firms Provisions, authorized to bring such a lawsuit against the accounting firm. According to the highest court, although the Consolidated Financial Statement included in the audit report listed information about the building materials enterprise and other companies related to the German corporation, the accounting firm’s audited entity was merely the German corporation. As the Chinese company neither conducted transactions with the German corporation nor engaged in trading activities related to the German corporation’s stocks, bonds, etc., the Chinese company was not an adversely affected party as stated in Article 2 of the Accounting Firms Provisions.

Since September 2023, this case has become a Typical Case, largely because the court’s strict interpretation of Article 2 of the Accounting Firms Provisions allows more certainty and predictability as to which parties can bring lawsuits against accounting firms. However, the Supreme People’s Court did indicate in the judgment the following:

Third parties other than the two types of persons [stated in Article 2 of the Accounting Firms Provisions] are not stakeholders protected by law. In the absence of other provisions in [China’s] Tort Liability Law and other laws, it should be determined that the accounting firm [in this case] does not have a statutory duty of care to other third parties.

[emphasis added]

The above paragraph suggests that so long as new legal provisions are adopted to clearly define additional parties to whom accounting firms owe a statutory duty of care, more adversely affected parties will be allowed to hold these firms accountable for their accounting violations. As accounting practices provide a solid foundation for the establishment of China’s “socialist market economic system”, which, as explained above, is an important goal of the Third Plenary Session, legislative initiatives that can more effectively hold accounting firms to stricter standards are likely to be prioritized by the Chinese legislature.

The citation of this article is: Dr. Mei Gechlik, China’s Third Plenary Session: Implications for Strengthening Deterrence of Accounting Violations, SINOTALKS.COM^®, In Brief No. 46, July 31, 2024, https://sinotalks.com/inbrief/202407-english-third-plenary-session-accounting.
The original, English version of this article was edited by Nathan Harpainter. The information and views set out in this article are the responsibility of the author and do not necessarily reflect the work or views of SINOTALKS^®. ↩︎