Relevant Issues of IFRS Adoption by Russian Banks

The London-based International Accounting Standards Board has been developing International Financial Reporting Standards. So IFRS are not laws issued by the government of one or more countries. Instead, these are a set of standards whose objective is to unify accounting principles used by enterprises and other organizations for financial reporting all over the world.

So why does a question arise about the cost-effectiveness of and need for adoption of international standards in different countries? What are the benefits of IFRS adoption by individual banks? I think that the benefits of IFRS-based financial reporting by Russian banks are as follows:

• Opportunity to raise foreign investment. Obviously, IFRS-based financial reporting does not mean that the Bank will definitely raise additional resources. However, other things being equal, the Bank can rely on foreign capital. Many financial institutions now provide loans only upon the presentation of IFRS-based financial statements. For example, when providing loans, the European Bank for Reconstruction and Development requires audited annual financial statements that comply with IFRS.
• Information openness and transparency of financial statements, as well as an element of improved image of the bank. Preparing financial statements based on international standards improves the bank's image and raises confidence of domestic investors.
• IFRS-based financial statements meet information needs of internal users in making management decisions. Historically, the Standards have been developed based on the needs of specific users, thus taking into account the usefulness of information for management decision-making process. So IFRS-based financial statements are regarded as one of the key elements of corporate governance.

The move to International Financial Reporting Standards is quite relevant for many Russian banks because the move to financial reporting in compliance with international standards is scheduled for the beginning of 2004 in the Bank Reform Program.

According to Mrs. Tatiana Paramonova, First Deputy Chairman of the Russian Central Bank1 , the Bank of Russia is planning to issue instructions that govern bank accounting and reporting in compliance with international standards. «16 quite important instructions have been prepared», she said. According to Mrs Paramonova, «if financial statements are prepared and they show that a bank»s capital falls below the statutory amount, such banks will definitely have problems«. She did not rule out the case where some banks »will either have to go out of the market or, if the law is enforced, they will have to be liquidated or transformed into another legal entity".

According to Mr Oleg Viyugin, First Deputy Chairman of the Russian Central Bank2 , «IFRS-based financial statements will not come into legal effect as from 1 January 2004: changes need to be made in legislation». According to Mr Oleg Viyugin, IFRS-based financial statements prepared by banks will officially come into legal effect as from 2007, i.e. when most Russian enterprises will move to IFRS. According to Mr Oleg Viyugin, the Central Bank's Board of Directors have recently decided to simplify the procedure for IFRS-based financial reporting. Now the banks will not have to file both Russian statutory accounts and IFRS-based financials. They will merely provide IFRS reconciliations using formulas as developed by the Russian Central Bank.

The IASB stresses in its documents that «financial statements should not be described as complying with IFRS unless they comply with all the requirements of each applicable Standard». In accordance with §38 of IAS 1 «Presentation of Financial Statements»: «Comparative information should be disclosed in respect of the previous period for all numerical information in the financial statements. Comparative information should be included in narrative and descriptive information». So, the Bank will have to prepare IFRS-based financial statements for 2003 in order to obtain an unqualified audit opinion in respect of 2004 financials.

In addition, Russian banks tend to prepare IFRS-based accounts in order to prevent risks arising from reporting bank problems. Those banks, which have already prepared financial statements in compliance with international standards, have made the difference. The preparation of IFRS-based financial statements enables banks to take measures to be in line with the Russian Central Bank's capital adequacy requirements. The practice proves that differences arise primarily from the size of capital. There are banks where the difference arises from a large number of financial assets (i.e. the need for setting up provisions for potential losses or devaluation of assets). Conversely, there are banks that are subject to revaluation surplus under international standards, e.g. when applying IAS 29, Financial Reporting in Hyperinflationary Economies.

In those cases where Russian statutory accounts have indirect warning signs of certain problems, as a rule, the latter are becoming more evident in the bank's IFRS-based financial statements: for example, equity deficit, lower profitability, etc.

The issue of noncompliance of Russian Accounting Principles (RAP) with International Financial Reporting Standards has been under discussion since the start of the reform in Russia. Fundamental discrepancies between IFRS and Russian accounting system arise from a historical difference between final objectives of the use of financial information. Financial statements prepared in compliance with IFRS are used by investors as well as other enterprises and financial institutions. Financial statements that used to be prepared in compliance with the Russian accounting system were primarily intended for government regulatory agencies and national statistics bodies. There are two fundamental differences between RAP and IFRS:

• The substance over form, one of IFRS compulsory principles, has been declared in the Russian accounting system but not always applied in practice. In accordance with IFRS, the substance of transactions or other events is not always consistent with that which is apparent from their legal or contrived form. Russian accounting principles are based on strict compliance with legal requirements, i.e. they focus on the form, while international standards that are designed to reflect the economic reality of transactions focus on the substance. Bills of exchange payable by third parties is an example where the form prevails over the substance in Russian accounting,
• The second striking difference is cost accounting schemes. Accounting for income and expenses is performed on the accrual basis in accordance with IFRS while RAP require both the accrual basis and cash basis. International Accounting Standards require compliance with the accrual basis of accounting, under which the effects of transactions are recognized when they occur and not as cash (or its equivalent) is received or paid. The need for having appropriate documentation often does not enable Russian enterprises to recognize all transactions that relate to a certain period, which results in untimely recognition of these transactions in terms of IFRS. The timing difference in recognition of transactions also arises from RAP noncompliance with the substance over form principle.

The above differences manifest themselves in line items of the balance sheet, income statement and other reports.

IFRS-based financial statements include the following five components: balance sheet, income statement, a statement showing changes in equity, cash flow statement, explanatory notes, including accounting policies. So there are no significant differences in sets of financial documents under Russian and international standards. There are some differences in the presentation of information in each statement as well as disclosure requirements on the face of these statements and in the notes.

The problems related to the preparation of financial statements in accordance with international standards should be distinguished from those related to keeping accounting records in compliance with international standards. Now Russian experts do not have a unanimous view as to what should be subject to the reform. Most experts believe that financial statements must be reformed while some think that the accounting system as a whole, including day-to-day records, should be subject to the reform. It seems to me that instructions issued by the Central Bank are intended to solve issues related to accounting record-keeping. International Financial Reporting Standards are primarily designed to solve issues related to the preparation of financial statements without prescribing accounting rules, charts of accounts, etc. in their Russian meaning.

At the moment where accounting records are kept in accordance with RAP and the Central Bank has not yet changed regulatory framework, banks that will have to prepare IFRS-based financial statements can go either way:

• keep dual accounting records recognizing transactions at the same time both in accordance with Russian and international accounting standards (different software is used for this purpose).
• use Russian statutory financial statements and restate them to IFRS by means of reconciliation procedures.

The current accounting system does not support the accounting for transactions in line with international accounting rules. Russian accounting treatments do not record all information required by IFRS, i.e. there are differences in the degree to which information is recorded and disclosed, differences in the way documented recognition of debts and cash is recorded as well as ambiguity of data interpretation in respect of certain types of transactions.

So, it is necessary to provide a bank with tables based on a standard set of data in order to perform the restatement. The tables should provide the terms of transferring information [to IFRS accounts] in respect of each line item (in the balance sheet, income statement, etc.). The preparation of data is done on the basis of the trial balance that is produced from Russian accounting records and an extensive income statement. The restatement method is based on the so-called «reconciliation tables».

The first stage of restating financial statements is the reclassification of line items in the RAP-based balance sheet and income statement, i.e. adjustments are made to reveal the economic substance of a transaction in cases where the Russian accounting system does not provide this information. These adjustments follow from the substance over form principle.

Using the table that matches second-tier balance sheet accounts and internal groupings of second-tier accounts to line items of the extensive IFRS-based balance sheet, all line items of the Russian statutory balance sheet are posted to groups in accordance with IFRS, for example:

• a bank«s portfolio of notes receivable can be classified as either »Loans and Advances to Customers« or »Trading Securities" in IFRS financials,
• contra-asset accounts (accumulated depreciation, provisions for potential losses on loans) are taken from the liability side of the Russian statutory balance sheet to the asset side of the IFRS-based balance sheet to reduce corresponding asset-side balance sheet line items.

The next stage is the elimination of account balances that are atypical for IFRS. In accordance with IAS 32, Financial Instruments: Disclosure and Presentation, a financial asset and a financial liability should be offset only when an enterprise intends either to settle on a net basis, or to realize the asset and settle the liability simultaneously. Adjustments are made both to offset line items in the asset and liability sides and perform changes in the income statement, for example:

• reporting so-called related transactions (loans secured and funded by deposits) and swaps of interbank loans according to their economic substance. Generally, such transactions are not exposed to credit, interest or currency risk and provide, in substance, commission (non-interest) income.
• elimination of inter-branch sales.
• interest income earned from a transaction is reduced by the amount of interest expense incurred in respect of the transaction with the balance posted to the section «Commission and Other Income».
• Reporting past-due interest and interest accrued in compliance with the Central Bank«s regulation #39 on the face of the balance sheet. Interest receivable, an asset side of the book-entry (Dr. 47427 Cr. 47501) is charged to »Other Assets« while a liability side of the book-entry is reported in the section »Capital and Reserves" and treated as interest income in the income statement. The similar treatment applies to interest payable. So, the accrual basis of accounting for income and expenses is implemented in the preparation of financial statements.

The next stage is the measurement of assets and liabilities. This follows the recognition of financial assets and financial liabilities at fair value. Measurement techniques for assets and liabilities are prescribed in IAS 39, Financial Instruments: Recognition and Measurement, IAS 32, Financial Instruments: Disclosure and Presentation. Let's give some examples:

• Mark-to-market revaluation of quoted share portfolios (that was required prior to the adoption of Directives #1054-У); as well as mark-to-market revaluation of euro-bonds, Gazprom and Sberbank promissory notes (income from trading in securities).
• an IFRS requirement to set up provisions for loans and similar debts. In practice, banks have to set up additional provisions for the devaluation of assets to the extent which is several times as high as profit calculated under Russian accounting standards.

Receivables from business transactions are charged to expenses or investment line items in order to comply with a principle where an expense is recognized immediately in the income statement when an expenditure produces no future economic benefit or when, to the extent that, future economic benefits do not qualify, or cease to qualify, for recognition in the balance sheet as an asset. Generally, an amount can be classified as an expense or investment with reasonable certainty without having documents required by Russian legislation and regulations. Employee benefits payable for unused vacation can be given as an example.

The next stage of adjustments is charging cash flow book-entries to different line items of the income statement, e.g. payroll expenses, general and administrative expenses, taxes paid, etc.

A special note should be made that some prior period book-entries will have to be reversed, for example, the recovery of accrued income and refund of accrued expenses.

It also should be noted that if IFRS-based financial statements are prepared for the first time, there is a need for so-called «reversals». For example, provisions for loans issued in the previous accounting period are charged to reduce the prior period capital rather than current period earnings. The same goes for depreciation charged on Property, Plant and Equipment.

A separate labor-intensive stage is making adjustments in accordance with IAS 29, Financial Reporting in Hyperinflationary Economies. Adjustments for inflation might require significant time costs and special software showing the term structure of actual costs of non-monetary items and cash flows. Inflationary processes result in different cash values of the same assets and liabilities depending on the time when they arise. Such discrepancies can materially misrepresent financial statement data. It is necessary to adjust historical money amounts in order to eliminate this drawback of financial statements prepared in an unstable currency. There are several indicators of hyperinflation for financial reporting purposes. Price changes can be expressed in the consumer price index. The National Statistics Committee publishes a monthly price index in Russia. I would like to point out that 2001 financials were prepared in Russia using inflationary accounting principles.

IAS 29 approach constitutes restating all financial statement line items (including comparative information) in terms of the general purchasing power of the reporting currency at the end of the reporting year. Monetary items are not restated because they are already expressed in terms of the purchasing power of rubles current at the balance sheet date. Non-monetary items are as follows: Property, Plant and Equipment, intangible assets, inventories, investments, equity line items.

The impact of IAS 29 application on financial statements depends on the inflation level and the structure of assets and liabilities of the company. For example, the bank purchases two buildings: one – for 50 thousand conventional measuring units at the beginning of 1999 and the second – for 100 thousand conventional measuring units in late 2001. Due to inflation, prices have doubled over the three years that have passed since the purchase of the first building. So IAS 29 application has a positive impact on the bank«s earnings in cases where non-monetary assets were purchased long ago while the bank»s equity has recently been paid in and failed to devalue. If the bank had the cash intact rather than purchase the building, its losses from reduced purchasing power (monetary loss) would have amounted 50 thousand for three years. Unlike monetary assets, monetary liabilities are advantageous for the bank in a hyperinflationary economy because they reduce expenses by deferring payments.

Cash flows should also be expressed in terms of the purchasing power of money current at the balance sheet date in the cash flow statement.

The next stages of the restatement of financial statements are the preparation of a statement of changes in equity and cash flow statement. The above adjustments to the balance sheet and income statement are taken into account when preparing a statement of changes in equity and cash flow statement.

I have not listed all possible types of adjustments. In particular, I have not focused on adjustments related to the application of IAS 12, Income Taxes, for example, deferred taxation.

Irina Bavarskaya is Head of Credit Organizations Audit Department of Intercom-Audit. She can be contacted by telephone (095) 937 3451 or e-mail ipintcom@redline.ru.