Maxim Makarevich
Recently there has been an increasing number of articles where authors are providing the case for prompt adoption of IFRS in Russia, in particular, stressing the need for investments in the Russian economy. Some experts call for the move to a «full» IFRS accounting.
Indeed, it is hard to object to the need for the Russian accounting reform. The question «What should be done?» was answered in the Russian Government Decree #283, dated 6 March 1998, that approved the direction of our reform, i.e. IFRS. Since the ‘what’ question is answered, it is necessary to proceed with the ‘how’ question.
The current debate is focused on the timing of the accounting reform. There have been continuous statements that Russia needs prompt IFRS adoption in order to enhance the transparency of Russian financial statements for foreign investors, that accounting legislation needs to be drastically changed, in particular, new PBUs adopted. The situation is somewhat similar to Soviet-style slogans such as «We must build a new factory by the end of a five-year plan!». There has been too much focus on deadlines rather than on «micro-level» problems, i.e. practical ways of accounting reform at the enterprise level.
The first problem is a human factor.
The fundamental difference between the Russian accounting system (RAS) and IFRS is the fact that, unlike RAS, IFRS provide for the use of judgments.
IFRS (as well as US GAAP, UK GAAP and some other accounting systems) set the financial reporting framework (nature, measurement, presentation, and substance over form, reliability, materiality, etc.) that does not supersede standards governing specific financial reporting issues. Lawmakers acknowledge that standards cannot cover all practical issues, which provides the reason for the use of judgments in financial reporting. The financial reporting framework provides the basis for judgments. Judgments are an important element of Western accounting practices. However, the use of judgments requires high accounting qualifications, which means the knowledge of not only accounting rules but also a number of related areas. For example, transactions involving purchases of options will be presented fairly only if an accountant understands clearly the concept of these financial instruments and the objective of their purchases.
The majority of today’s accountants started working in a system based on rigid instructions from above. Under that system, an accountant was supposed merely to comply with laws, regulations, letters and instructions adopted by lawmakers. Accountants did not have to use their own judgment about accounting treatments for business events and transactions. Those «from above» were expected to know it better how the financial statements should be prepared so that they can provide «a true and fair view» of an enterprise’s financial position. This resulted in the lack of initiative on the part of the accounting profession. Today when asked why they prepare the financial statements, a vast majority of accountants would answer that the financial statements are prepared for tax authorities. Borrowing enterprises would also submit their financial statements to the bank or other creditors.
The requirement to use one’s own judgment as a basis for recording a transaction is a brand new phenomenon in the national accounting system. In fact, this is a new function of the accountant. It might sound a bit too pompous but this new function requires a revolution in accounting mentality. The accountant is no longer in a position of an individual who simply follows rigid instructions from above. The accountant is entitled to use his or her judgment in the financial statements. However, he or she is also obliged to provide sound case for his or her judgment when dealing with an auditor or any other user of the financial statements. What prevents today’s Russian accountants from using their own judgment in the preparation of the financial statements?
Firstly, the problem arises from the fact that the inertness of mentality is typical for a human being. An expert who has been working for ages in a certain manner cannot «change the track» within a month or even a year. («Mentality restructuring» is not only an accounting issue because it arises in overall business management. However, these issues are beyond the scope of this article). To this end, a special note should be given to the Russian MinFin’s Letter, dated 15 March 2001, «On the Application of a New Chart of Accounts». In this Letter, the MinFin takes a «progressive» position by criticizing a passive conservative position of some representatives of the accounting community. The Russian MinFin calls on accountants to adapt to new economic reality and upgrade their qualifications. In its Letter the MinFin kept stressing that the Chart of Accounts is not «a fundamental accounting regulation». The issues of accounting qualification will stay on the agenda for a long time. There can be only one solution, which is enhanced quality of education
Secondly, despite its subjective nature, the judgment must be based on the established financial reporting framework. For instance, IFRS start with the Framework for the Preparation and Presentation of Financial Statements while US GAAP standards are based on the Statements of Financial Accounting Concepts (SFAC), which provide general underlying financial reporting principles. At the moment, Russia is facing a paradox. None of current regulations provides the definitions of basic concepts such as «assets», «liabilities» and «owner’s equity». Financial reporting principles are merely mentioned in PBU 1/98 «Accounting Policies» and the Regulation on Accounting and Financial Reporting in the Russian Federation (MinFin’s Order #34n, dated 29 July 1998). In addition, PBU 1/98, p.7 states that reporting principles (prudence, completeness, substance over form, etc.) must be provided for in accounting policies. As a matter of fact, these underlying concepts should be established by the MinFin. Accounting Policies should provide specific accounting characteristics of a particular enterprise rather than imitate entire sections of PBUs. There is a need for a regulation that would establish basic concepts of financial statements and underlying financial reporting principles. Accountants cannot be required to use their own judgment without a regulation that provides a basis for judgments. A separate Regulation on Financial Reporting Principles, i.e. a «special PBU», can be adopted as such a statutory document. Given long-term and complicated procedures for amending current Russian legislation, it would be undesirable to establish financial reporting principles and basic concepts in the Accounting Law since the Russian accounting system is evolving all the time. It might be reasonable to issue an Instruction (or some explanatory Letter) illustrating the application of these principles. This document would help the MinFin avoid potential inconsistencies in new PBUs.
In the past few years, the Russian MinFin has issued a large number of regulations, primarily PBUs, that are very close to IFRS «in their style». Contemporary Russian accounting legislation declares explicitly or implicitly many IFRS principles (relevance, reliability, materiality, going concern assumption) as well as new accounting concepts (market value, contingent liabilities, post-balance sheet events, consolidated financial statements, etc.). Indeed, the fact that these regulations have been adopted is an important step in the accounting reform. However, Russian enterprises have rarely been using these innovations in practice. Therefore, there is a large gap between the statutory accounting system and Russian practice. So when comparing the Russian accounting system to IAS, it is necessary to consider a tripartite link: IFRS – RAS – Russian practices.
Many experts regard the accounting reform as merely a reform of accounting legislation. They believe that once a new regulation comes into effect, accountants would immediately make relevant changes in their accounting system and another stage of the reform would be over. In theory, this is correct. However, if you used to be an accountant or auditor, you know it only too well that this is not as obvious as it looks. Considering an issue from a macrolevel perspective is, no doubt, important but one should not forget about the need for a link between the macrolevel and microlevel (or theory and practice), which is not always available in Russia.
So how are things going «at the enterprise level»? (The facts given below are based on the practical experience of the author and his colleagues working as auditors in large Russian companies).
Unfortunately, new accounting legislation (the one which is not related to tax legislation) does not seem to ‘reach’ accountants. Selective application of these accounting innovations can be identified under close scrutiny. There is a certain pattern where innovations are implemented if they either are hard to ignore (e.g. changes in the format of financial statements as per MinFin’s Order #4n, dated 13 January 2000, that supersede the previous format (MinFin’s Order #97, dated 21 November 1996)) or relate to the previous elements of financial statements (accounting for materials – PBU 5/01, fixed assets – PBU 6/01, etc.). In most cases, regulations are ignored if they introduce new elements of financial statements or expand the enterprise’s capabilities.
For example,
- PBU 7/98 «Post-Balance Sheet Events», PBU 8/98 «Contingencies», PBU 11/00 «Information on Affiliated Parties» and PBU 12/00 «Segment Information»;
- PBU 6/01 «Fixed Assets Accounting» permits accountants to use their own judgment in determining the useful life of fixed asset items and their depreciation method;
- under current legislation, an enterprise can change the format of financial statements at its own discretion (subject to compliance with general reporting rules), i.e. the format of financial statements approved by the MinFin is not compulsory but recommended;
- Russian MinFin’s famous Order #112, dated 30 December 1996, governing consolidation reporting procedures for groups of companies.
The list is not exhaustive but it is beyond the scope of this article. The thing is that very few companies have been applying these regulations in practice. PBU 7/98 and PBU 8/98 that came into effect on 1 January 1999 should have become operative for 1999 annual financial statements. As a matter of fact, even if some company followed these PBUs in the preparation of its annual financial statements, this was prompted by an auditor while a vast majority of accountants ignored these Regulations.
Under the Regulation on Accounting and Financial Reporting (Order #34n, dated 29 July 1999), groups of companies are supposed to prepare consolidated accounts. The fact that the concept of consolidated accounts has been introduced in the Russian accounting system changes the qualitative characteristics of a set of financial statements prepared by enterprises with subsidiaries, which, no doubt, enhances the relevance (i.e. usefulness) of these accounts for potential users. Consolidated financial reporting by Russian enterprises is specific in that there are no statutory users of consolidated accounts, i.e. these accounts are not filed to tax authorities or other government agencies. Therefore, not all group accounts are properly prepared. Groups of companies preparing consolidated accounts face insufficiently developed Russian legislation (the Methodical Guidance on Consolidated Reporting (Order #112, dated 30 December 1996) covers only broad consolidation issues), which makes Russian companies seek internationally accepted solutions. The mixture of Russian statutory requirements and internationally accepted solutions results in some hybrid financial statements based on Russian accounting rules and international consolidation principles.
Groups of companies where subsidiaries prepare IFRS – or US GAAP-based financials also prepare consolidated accounts in compliance with these standards. However, in this case they are driven by IFRS or US GAAP requirements rather than by Russian statutory requirements.
We have to state that many accountants are quite passive in their perception of innovations. They are trying to follow only minimum reporting requirements in order not to make things more complicated.
It should be noted that the quality of financial statements or any other product is driven by end users and capabilities of the preparer/producer. In other words, the producer always makes a product which is in demand and which it is able to produce. The higher the customer’s needs, the higher quality will be sought by the producer, otherwise nothing will be sold. The above considerations regarding the passive nature of accountants provide evidence that the «producer» is unwilling to supply a high-quality product. However, when considering the issue, one should not forget about the demand for this product on the part of the users. Who is the consumer of financial statements? Who sets quality standards for financial information?
Tax authorities have always been and still remain the major user of Russian financial statements. That is why accountants are upset about innovations separating financial and tax accounting. That is why, due to their «uselessness» for tax authorities, PBUs 7/98 and 8/98 have not been applied in practice. By separating financial and tax accounting, the MinFin seems to be telling accountants that, in addition to tax authorities, there are other users which are interested in financial accounting rather than tax accounting interpretation of business processes. But where are these users, an accountant would ask, what would they like to see in my financial statements? The change in the user of financial statements should provide the incentive for proper attitude of accountants to their product. Things will not change while the Russian Tax Ministry remains the only user of financial statements.
Let’s look at p.12 of the IASC Framework «The Objective of Financial Statements», which says: «The objective of financial statements is to provide information about the financial position of an enterprise. This information is useful to a wide range of users in making economic decisions». The Framework also gives a list of these potential users: investors, employees, lenders, suppliers, customers, government and public. Where are these users in this case? Why don’t accountants acknowledge that the financial statements are prepared for these users?
The primary user of financial statements has always been the owner of the business, i.e. a shareholder. If the owner is involved in running the business on a day-to-day basis (the owner is the manager), the financial statements are, in effect, prepared for himself/herself (there will be no other users in a simple case). Accordingly, there is no need for some predetermined statutory reporting rules. In fact, these are management accounts. Uniform reporting rules are required in cases where a preparer of the financial statements (manager) and their user (shareholder) are different individuals, which is typical for large businesses. In this case, the financial statements are an element of shareholder control of the managers. This assumption (the financial statements are an element of control) leads to the shareholder interest in financial statements. That is why, the shareholder is interested in obtaining accurate and transparent financial statements. Is the link between the shareholder and manager relevant for this country? Do Russian shareholders show such interest? In practice, shareholders of large businesses look at Russian financial statements in a rather formal way. Of course, Russian financial statements are reviewed and approved at the annual meeting but they are not used in making management decisions (i.e. financials are not used for their intended purpose!). Additional information (in effect, management information) is generally prepared specially for the decision-making process. What is the reason for such a distinction? Why isn’t it possible to prepare the financial statements that would be useful in making decisions right away? The problem is that, as mentioned above, in the view of many directors and accountants, Russian financial statements are prepared solely upon request of the Tax Ministry and, thus, driven primarily by the needs of the latter agency. This is fair in many respects. In fact, many elements for tax purposes are taken directly from accounting records such as the tax base for property tax assessment, accounting revenue as the basis for assessing the road users’ tax, etc.
No matter how fast the accounting reform would go, the requirements of the Tax Ministry that is responsible for implementing the government fiscal policy will always be different from those of accounting standards. This is how things stand in most countries, which is natural: there have always been differences between financial and tax accounting. So the accounting reform should not be linked to the tax reform. The solution of the problem (i.e. breaking up the «psychological» link «financial statements – the Tax Ministry») might be, for example, giving up the requirement whereby enterprises have to file their financial statements to the Tax Ministry. It is not quite clear why tax inspectors need the financial statements. In countries that are generally referred to as civilized ones, a taxpayer files only tax returns to tax authorities since these documents contain all tax related information and calculations. Of course, a tax inspector is entitled to check support documents for tax calculations. Therefore, taxpayers must keep all the necessary documents within a statutory period of time.
There is another user such as a stock exchange. Currently, stock exchanges are the major users of financial statements in international capital markets. A company that is willing to get listed on, say, the London Stock Exchange, must provide UK GAAP – or IFRS-based financial statements. Why do Russian stock exchanges shut their eyes to the financial statements of Russian enterprises that fail to comply with some provisions of Russian accounting legislation? Because there is a line of enterprises willing to get listed on Western stock exchanges while issuers are nearly forced to Russian stock exchanges.
So there is a vicious circle: users regard the financial statements as tax-oriented accounts and, therefore, request some additional information about issues of interest. So they do not claim to be potential users of the financial statements. In their turn, accountants do not see the users of their financials other than tax authorities. Therefore, as the next 31 March (sort of a Judgment Day) is getting closer, accountants are trying to prepare the financial statements that would cause no objection on the part of tax authorities.
Based on the above information, I will take the liberty of saying that there are no prerequisites for successful accounting reform at the enterprise level: accountants are not interested in changing the accounting system. The Russian MinFin has been changing the object of accounting without performing the «reform» of the subject, i.e. an accountant. PBUs and other regulations should be issued with extensive implementation guidance, illustrative examples and explanations regarding the need for a new regulation. Accountants should have a uniform understanding as to why a specific regulation is adopted and why the resulting financials would become more meaningful for users. It is necessary to train qualified employees who are capable of making a high-quality product. Of course, professional accounting bodies should become involved in this process.
On the other hand, it should be noted that high-quality financial statements will never be prepared until there are sufficiently empowered interested users. Accountants will be interested in preparing high-quality financial statements only subject to rigid requirements of shareholders, banks, stock exchanges and other users.
In addition to a human factor, there is one more important issue. Being very close to the Anglo-American system, IFRS focus on the external environment of the enterprise (unlike continental accounting models such as German, French, etc. that are driven by internal factors). The influence of external factors on the financial statements manifests itself in the concepts of fair value, present value, deferred taxes, market value of the enterprise’s equity and its financial investments, etc.
IFRS drafters primarily come from European countries and the USA. When developing standards, they draw their conclusions based on the environment of their enterprises. Russian economic environment differs significantly from the Western one. These differences largely manifest themselves in the lack of mature commodity and financial (especially stock) markets, which prevents adequate business valuations based on fair value. Given references to the fair value of assets in most IFRS existing objective difficulties of its measurement question the use of this value.
The lack of mature stock market does not enable enterprises to calculate the average market yield on some types of equities and bonds, risk-free interest rates and other market indicators that are used to determine the present value of enterprise assets.
The above paragraphs prove that virtually all the calculations of fair and present values in today’s Russia will be incomparable. The financial statements using such values will be exposed to misrepresentation and, accordingly, they will become less meaningful and useful in making economic decisions. For example, it is virtually impossible to apply IFRS 36, Impairment of Assets, in Russian environment because this standard is based on the use of fair and present values. One of the most significant problems is the preparation of consolidated financial statements because IFRS 27 requires to carry assets and liabilities of subsidiaries included in the consolidated financial statements at fair value. IFRS 17, Lease, is on a full present value basis.
These facts prove that if Russia adopts IFRS «in their original version», it will not be feasible to implement many of these standards in practice. Why does Russia need the move to IFRS? If this move is performed just for the sake of the move, the Russian MinFin could easily adopt a Resolution approving IFRS as national Russian standards. I do not think that we should try to «fit» Russian economic environment to IFRS. It is necessary to understand clearly that standards are designed to reflect economic reality and not vice versa. Consequently, only when Russian economic environment is similar to that in Western countries, IFRS application will become feasible in Russia. Now it is necessary to adopt standards that would help enterprises prepare meaningful financial statements in the existing environment. For example, I think it might be useful to adopt a PBU that is similar to IFRS 29 «Financial Reporting in Hyperinflationary Economies». The financial statements of enterprises would become more meaningful if they are restated in terms of the purchasing power of the Russian ruble current at the balance sheet date.
Maxim Makarevich is a Senior Expert at ZAO «UNICON/MS Consulting Group». He can be contacted by phone (095) 319 6636 or e-mail: makarevich@unicon-ms.ru.