Most Chinese companies that use the VIE structure have chosen to list on U.S. stock exchanges and use U.S. Generally Accepted Accounting Principles (U.S. GAAP). Some Chinese companies using the VIE structure have listed on other exchanges, most significantly in London, Toronto, Hong Kong and Singapore. While Canada just converted to IFRS, London, Hong Kong, and Singapore have been using it for some time.
U.S. GAAP, has specific rules for variable interest entities (the term VIE actually comes from U.S. GAAP). These have been improved over time and require extensive disclosures about the VIE and the judgments made in deciding to consolidate the VIE in the financial statements. IFRS did not specifically deal with the concept of VIEs, yet the rules were broadly enough written that some companies concluded that they could consolidate VIEs under IFRS. Disclosures are often absent, and it is almost always difficult to determine whether the company actually owns what it claims to be subsidiaries.
There has been a long project underway to improve IFRS to better deal with questions of whether an entity should be consolidated. In recent years there has been an effort to converge IFRS with U.S. GAAP to facilitate full convergence in the near future. The IASB released IFRS 10, Consolidated Financial Statements on May 12, 2011 that introduced new guidance on consolidation. The new approach combines concepts of power, exposure, and power over variable returns to determine whether an investor has control of an investee. The new rules take effect from January 1, 2013 with earlier adoption permitted.
The rules are complex and like the U.S. rules, do not specifically deal with the way VIEs are structured in China. PwC just released a 75-page book on the new rules in both English and Chinese. I rushed to read it, figuring that if they would go through all the effort to translate something this complex they would find the time to write at least one example of a Chinese VIE, but they did not. There is a major task awaiting someone to determine whether the present VIE arrangements will meet the new standards. This looks like a great project for one of my student’s master’s thesis.
The good news is that the new standards require significantly enhanced disclosures of consolidated VIEs. PwC’s book has a three-page disclosure checklist. These disclosures may provide some real surprises to investors who were unaware of the structural risks in their investments. Unfortunately, the new disclosures are not required until periods beginning on or after January 1, 2013, which means that we will not be seeing them until 2014 unless companies choose to early adopt. Regulators should pressure companies using VIEs to early adopt those standards, particularly for those that attempt to IPO in the next two years.