Using IAS to Manage Small Businesses

Eugeny Pappinen

International Accounting Standards (IAS) that have been developed for the past 15-20 years represent one of the generally accepted norms of economic thinking. These standards are a formal language of business communication. They enable enterprises to assess the financial position and economic potential of their counterparties, without giving effect to specific national accounting features. IASs disclose many aspects of the firm’s economic life and «X-ray» its operations.

IASs are primarily intended to ensure transparency and fair representation of the firm’s economic position. These functions are especially crucial for Russian businesses.

The task of financial management is to maintain and increase the wealth of shareholders and investors and exercise control over the assets. Cash flows tend to result in conflict of interests of different people and social groups, as well as in disputes arising from redistribution of property and spheres of economic influence. Investors and shareholders are primarily concerned about their capital maintenance.

Alfa-Telecom was set up in 1995 with Western capital. Telecominvest, the company’s majority shareholder, has been pursuing Western-style economic policy since the beginning of operations. Staff recruitment procedures were rigorous, with a focus on professionalism and non-abusive personality, thus building a team of accountable and decent employees.

The next step towards business manageability was implementing US GAAP-based dual accounting system.

In implementing US GAAP, Telecominvest holding company’s managers were primarily driven by the holding company’s consolidation needs. US GAAP financials of subsidiaries were consolidated and sent to the Western shareholders.

On the one hand, Telecom-invest used US GAAP to meet shareholders’ requirements and, on the other hand, to get access to the US capital market.

Now most Russian companies are trying to master IAS in order to enter into international capital markets, raise Western credits or set up a joint venture similarly to the way the holding company operated at its early stage. Consequently, they provide disclosures for their Western counterparties and potential investors, rather than for their own purposes.

Using IAS accounting in building budgeting and operating control systems

The underlying principles of the IAS accounting system are faithful representation, timeliness, prudence and usefulness, which enables the enterprise to achieve openness and transparency. It is hard to overestimate the importance of these two elements for successful business operation.

Our company’s US GAAP-based accounting system uses primary data from Russian accounts.

The US dollar is our reporting currency. The reporting period is a month and quarter. Revenue and costs are determined under the accrual basis. Non-current assets and equity are measured at their historical cost and denominated in US dollars. Depreciation rates are those recommended by US GAAP (10-25% for non-current assets).

The operating margin, which is pre-tax profits plus depreciation, is a major indicator of the company’s financial performance for the period. We think that in the current environment, this indicator provides the most adequate picture of the company’s true financial performance for the period and its capacity to perform investments using internal resources.

As time goes by, the Russian accounting system becomes better and better. However, there are still significant drawbacks such as:

1. certain expense items are charged to production costs at inadequate statutory rates. For example, current statutory per diem rates for business trips are only two dollars per day (55 rubles), advertising expenses are only allowable up to a certain limit, and employee training expenses must not exceed two per cent of the payroll fund. Fiscal restrictions, on the one hand, impede dynamic business development and new market entry, on the other hand, they provide managers with incentive to violate tax legislation;
2. inadequate statutory rates of depreciation charges. For example, current statutory annual depreciation rates for motor cars amount to 12-14%, i.e. it is assumed that no overhaul and replacement will be required for seven-eight years of continuous operation;
3. the true value of assets purchased during high inflation periods is understated. For example, the carrying amount of our company’s Nissan Almeira made in 1997 is only about three thousand US dollars while its real market value is no less than US $10,000. This fact often enables bad-faith managers to find different excuses and write off understated assets and then sell them at a huge profit.
4. allocation of expenses between production costs and profits. Under current regulations of the Russian Ministry of Finance, enterprises cannot increase production and selling costs and decrease taxable profits to the amount of certain expense items which are directly related to operating activities but are not clearly unavoidable. For example, production and selling costs cannot include fees of organizers of seminars on market development issues because, in terms of fiscal interpretation, these expenses are not related to current operating activities and, thus, cannot be treated as essential to the firm’s operation.

Hopefully, the accounting reform performed by the Russian Government and Ministry of Finance with involvement of international bodies will result in the convergence of national and international accounting systems in the next 3-5 years.

Since 1 January 2000, significant changes have been made in the structure of national balance sheets and income statements, thus bringing these components of financial statements closer to international standards. One balance sheet problem, in particular, has been solved. Before 2000, current and prior period losses incurred by the enterprise were reported on the face of the asset side of the balance sheet, rather than recognized as a decrease in equity. This resulted in the overstatement of balance sheet total to the extent of losses! This fact led to non-existent «virtual» assets and an overstated balance sheet total.

However, despite certain progress in national accounting reform, three major problems are still outstanding, which impedes and will continue to impede the move towards international standards and a more transparent national accounting system that reflects adequately economic reality:

• poor public and business morale;
• tax-driven national accounting system;
• most Russian managers and accountants do not understand the objectives and tasks of the national accounting reform, they do not have IAS professional experience.

When implementing a Western-style accounting system in our company, we specified objectives and tasks of restatement of financials, decided which format of financial statements should be used and reconciliation spreadsheets should be produced.

Several spreadsheet files were created to reconcile data from national accounts to US GAAP financials. Restatement procedures have always been quite easy and they meet our current business requirements in terms of cost-benefit approach.

Multi-page spreadsheet deliverables are eventually restated into three major components of financial statements, such as Balance Sheet, Income Statement and Cash Flow Statement. The output, with notes, is then submitted to our shareholders for monitoring and consolidation purposes. This work is performed on a quarterly basis.

Analytical tables required for operating management and the company’s annual budget are produced daily on the basis of US GAAP financial statements.

The budgeting system is one of the most important implications of US GAAP financials implementation in our company. The budgeting system provides basis for most management decisions. Annual meetings of shareholders approve the company’s annual budget. Its major control components are US GAAP-based Balance Sheet, Income Statement and Cash Flow Statement.

Since one of the enterprise’s strategic tasks is generating cash flows for investment in business development, shareholders focus primarily on the following items in assessing the financial performance:

• Income Statement – operating margin which is pre-tax profits plus depreciation. This item represents internal sources of financing;
• Cash Flow Statement – net cash flow from operating activities which is a source of cash for investments;
• Balance Sheet – movements in equity and debt-to-equity ratio.

This is the way one of the IAS underlying principles, i.e. usefulness, is implemented in practice. The lack of numerous items «flashing before the eyes of shareholders» enables the users to focus on three major criteria, thus facilitating management decision-making process.

For example, if book profits from the national Income Statement are used to analyze the enterprise’s sources of financing, two additional calculations will have to be performed: the costs to the extent of current period profits (so-called «withdrawn funds») should be deducted from, and depreciation accrued for the period should be added to the book profits. Under a more conservative analysis, it is also necessary to deduct the difference in statutory depreciation rates which represents «imputed» costs that are not covered as a result of the company’s operating activities but will have to be incurred when replacing non-current assets.

The operating analysis of two key indicators, such as operating margin and net cash flow from operating activities, will be most useful. Changes of the margin over time reflect cash flows of the company in the capacity of an investor. The decrease in the margin often provides evidence of worse market conditions and need for more stringent cost control.

Changes of net cash flow from operating activities provide information about the company’s liquidity. The decrease in net cash flow provides evidence of either worse market conditions or more active repayment of debts.

In the first case, cost reduction measures are taken and in the second case, the company’s management seeks improved level of financial leverage, i.e. debt-to-equity ratio.

Fair representation is achieved through quarterly monitoring of the company’s budget. Fair representation is ensured through comprehensive coverage of cost items, use of reasonable depreciation rates and cautious accrual of expenses. Period costs shall include all actual costs incurred by the company. They are accumulated from all expense accounts in the national accounting system, including accounts of costs payable out of profits.

Thus, the company’s financial performance reflects economic reality rather than book profits «on paper». The operating margin, being an intermediate indicator used for monitoring purposes, enables managers to react promptly to its changes over time.

If the total amount of some cost item is not known as at the balance sheet date, the prudence principle is used, i.e. the maximum amount of costs is accrued and relevant adjusting entries are made in the next accounting period, as needed. The profit tax is not underestimated because it is reported with regards to actual accruals made in the national chart of accounts.

A more detailed analysis of the firm’s financial position is performed using the cash flow statement on a daily basis.

A monthly cash flow statement is produced on the basis of a daily cash schedule. Using this tool of financial management, it is possible to obtain current information about the firm’s total cash balance, cash inflows and cash outflows, net cash flow from operating activities and, accordingly, about the amount of investments that the company is capable of financing in the near future.

Budgeted vs. actual performance analysis is performed as regularly as required for operating control purposes, which results in the timeliness principle implementation.

Now my colleagues and I cannot imagine a way of making informed and reasonable strategic decisions without having the budget. Efficient operating control is impossible if the enterprise does not use the above monitoring techniques.

The transparency of the company’s cash flows and fair representation of its reports are achieved through the use of the budgeting system based on financials which comply with international accounting standards. Analytical data used in the budgeting system are simple and clear, reflect true financial performance and can be obtained as often as required. Thus, our budgeting system implements four major principles of international accounting standards: fair representation, timeliness, prudence and usefulness, which make our business more manageable and adaptable to changes in the external environment.

Eugeny Pappinen is a Chief Financial Officer at OAO Alfa-Telecom, Petrozavodsk.