The Chinese government requires asset valuations whenever an organisation holding state-owned property and other assets wishes to transfer an interest in those assets. This means that valuations are sought by state-owned enterprises (SOEs), government bodies, domestic joint ventures, Sino-foreign joint ventures (JVs) and other such entities holding state assets. Assets in this context include fixed, current and intangible assets.

The state asset regime is governed by the State Asset Administration Bureau (SAAB), part of the Ministry of Finance, and valuations are mandatory for a range of circumstances including setting up investment vehicles where assets will be acquired or contributed, restructuring existing enterprises, reporting for accounts purposes, asset disposals, listing on the stock exchange and liquidation.

It is during the establishment of a joint venture or other investment vehicle that overseas investors often encounter asset valuation issues. Disagreement over the value of the contributions has regularly been a major problem cited by overseas companies setting up joint ventures in the PRC. Taking control over the process and the appointment of suitable valuers can be critical in facilitating a satisfactory outcome.

In the case of JVs the China party often contributes a range of assets including land, buildings, plant, machinery, trademarks, inventory and other current assets. Occasionally, technology and business goodwill can be contributed. The foreign partner's contribution may be in the form of cash, plant, machinery, technology and know-how, trademarks and inventory and these may also be subject to a valuation.

The Process
Of immediate importance to potential investors in the PRC is that once values are reported to the SAAB by the local valuers they are subject to the "90% rule". This rule effectively means that the value of the assets cannot be changed, plus or minus 10%, and many overseas firms have been caught by this regulation.

There are sometimes ways to get around the rule but generally it is better to avoid the problem to start with by considering how to approach asset values early in negotiations or discussions.

Something apparently as innocuous as a letter of intent can be the trigger for the Chinese party to begin the process of valuation, instruct a valuer and finalise values. Foreign investors are therefore often advised to clearly agree at the beginning of discussions with potential partners the circumstances in which an asset valuation will be triggered and the basis behind the values.

Asset valuations are carried out by local firms that are licensed to carry out the valuation of state-owned assets for reporting to the SAAB. To date wholly owned foreign firms have not secured a full licence despite procedures being in place to allow applications.

However, foreign investors should note that a number of factors work to push the Chinese valuer to a value in favour of the Chinese joint venture partner, often to the detriment of the foreign investor. For example Chinese valuations firms work on a set fee scale that is based on the values reported – a higher value therefore generates higher fees.

Chinese valuers are always under the threat that their licence will be withdrawn if they under-value state assets. In other common situations their local licence has been granted by a government authority which is also connected to the State assets being valued. As a result of these factors there are a small number of international valuation practices operating in China carrying out (parallel) valuations for overseas clients.

Generally the involvement of international valuers is at the request of foreign investors wishing to establish an independent assessment of the assets to international standards. These firms can assist by providing guidance on the process and valuations of the assets which are to be introduced into the proposed joint venture company by the Chinese party. This valuation report and supporting schedule of assets is produced to facilitate negotiations and agreement with the Chinese party. The best results often occur when two valuers representing each of the parties work alongside each other to ensure consistent approaches and information.

Valuation Approaches
The standard international valuation approaches – comparison with the prices paid for similar assets (market comparison), calculating the present value of earnings (the income approach) and depreciating the current replacement cost (the cost approach) - are all specifically proscribed in the relevant PRC procedures and are recognised by local valuers and the SAAB.

In terms of "bases" of value the Chinese authorities have spend a considerable amount of time reviewing the definitions applied in Europe, Asia Pacific and North America. The China Appraisal Society is a member of the International Valuation Standards Committee and the definitions for market value and market value for existing use are often met in Chinese valuation documents.

So how are these methods and bases applied for fixed asset valuations?

• Transaction Approach
A major characteristic of the Chinese market is the high volatility in markets and local economics that leaves interpretation of older information almost meaningless. From inflation rates of over 25% in 1994 we have seen deflation (prices falling) in recent years. Low volume of transactions within certain sectors or regions, rapidly changing tariffs, unique local taxes, lack of transparency for sales and an in-built tendency to control centralised information also make useful interpretation of available information at best difficult.

As a consequence foreign valuation firms place little credence on using market comparables outside of the main cities and industrial areas. While this method is generally well known by local valuation firms they have a tendency to dismiss this approach because of the difficulties in interpreting the data and in addition it is sometimes hard to get it accepted by State authorities as a basis for valuation of State owned assets.

• Income Approach
The income approach, where the value of an asset is linked to the benefits of future ownership, has not gained wide acceptance within the valuation community in China. In many cases it is not "sanctioned" by Chinese valuation firms and authorities, particularly when it might mean the recognition of redundancy or other permanent diminution in value of a state asset.

Normally this methodology is based on a future cash flow model and again the high degree of volatility in prices and markets means that any large number of assumptions within a model cannot be easily quantified to any degree of accuracy. Additional problems include the fact that expected rates of return can vary significantly between different analysts and it is very difficult to get accurate historical accounts for most Chinese businesses.

Consequently this method is applied sparingly by international valuation firms. Local valuation companies and authorities almost always reject this type of valuation.

• Cost Approach
The cost approach is widely understood and accepted by Chinese valuation companies and authorities alike. Information on costs is readily available, there are published standard price books for most types of machinery and Chinese valuation firms apply standard depreciation periods for different types of machinery on a straight-line basis.

As with any standard formula there is little application of the effect of individual circumstances and economic obsolescence is rarely considered in the depreciation rates adopted. Overseas purchased equipment also presents a problem to local valuers since they rarely bear in mind the regional pricing mechanisms of multinationals, differing exchange rates and contrary inflation rates.

Asset Disposals
In the early 1990s there was a certain gung-ho element within the vast foreign investment community in China. Some investors were more concerned with a need to sign a deal and get into this potentially vast marketplace than with research and due diligence. As a result some companies today are considering the prospect of perpetual losses and looking for solutions to extract themselves from these ventures. The problem is that the very lack of initial care that may be causing the failure of the investment may also hinder any prospect of recovery of funds or assets.

By far the greatest hurdle to any assessment of value or actual disposal of property, plant and equipment in China is the issue of control of the assets. In many cases this is because the foreign party failed to set out clear procedures for the possibility of dissolution of the company. A valuer appointed by a foreign party (either a liquidator or the asset owner) to provide an assessment of value will almost look more deeply at the issues surrounding the assets than at the assets themselves. Removal of portable assets is all but impossible unless the local partner has given written permission.

Another consideration is the benefits or tax breaks that the JV took advantage of in terms of import duties. The local customs office needs to approve all transfers of such equipment and this is not readily forthcoming especially where a dispute with a local partner is involved. Without the appropriate documentation transport of equipment even across provincial boundaries can prove impossible.

Finally, overseas investors are sometimes unfortunately surprised at the pace of change within China. For example a collection of Grade A houses for senior management bought by a major international telecommunications company in Beijing turned into Grade C houses (with corresponding values) in less that 10 years simply because so many better competing estates had been built in the period.

Other Points on the Valuation Environment in China
Local valuation firms often started life as specialist accountancy departments of central government ministries or regional administrations. As a result they can have a narrow view to the application of standard formula and struggle to reflect obsolescence or other non-cost factors in values.

Local valuation firms will value all of the assets including floating, fixed and intangible assets for official asset valuation reports. Occasionally this causes a problem since you cannot be sure of the allocation of values to the asset classes.

There are many challenges to valuation in China but some specific hazards for machinery valuers are the difficulty in reconciling the very brief asset registers, differentiating between acquisition date and date of use (sometimes many years apart) and the highly unusual allocations.

For example, a valuer could not reconcile the historical costs in the asset register of a particular facility with the known replacement costs especially for overseas purchased equipment. After much discussion he discovered that the accounts department had allocated the total cost of major projects across the individual components by using the weight of the components only.

Getting It Right...
China is moving towards recognised international standards and there is certainly a movement within the PRC profession to accept more modern techniques.

Banks and financial institutions avoided valuations for lending but the huge bad loan portfolios of the major banks since the economic crisis of 1997 have encouraged a more realistic review of operations.

Foreign-invested corporations listing in China, the insurance market opening up, increasing activity and professionalism of investment funds and the increasing awareness by local firms of the accurate value of assets as integral part of future business success are all having an impact on the perception of the valuation profession in China.

For the foreseeable future the best assurance is to carry out a parallel asset valuation alongside the local valuation firm, so that values obtained can be discussed and, if necessary, adjusted, prior to official submission, or get both parties to jointly appoint an international valuation practice to then project manage the local valuation firm.

Finally do not forget that in a joint venture situation, the Chinese party in the negotiations may use disagreement over the valuation as a tool for leverage on other aspects of the business, or may even use the lack of agreement on valuation as an excuse for calling off talks without losing face.

Written by Chesterton CBB China For further information, contact: kate.mcmurtrie@chesterton.co.uk