© 2000 John Petroff

C- Conversion of financial statement from tradition Russian to International accounting standards

1)- Reasons for the conversion

Conversion of Russian accounting statements is necessary because accounting data of Russian firms is presented in a manner that does not permit an analysis of the type outlined in the following chapters. A few examples will illustrate the importance of this conversion.

Let us start with inventories which in Russian statements include inventory of office and sundry items. This example will illustrate distortions created for an analyst if a complete conversion is not carried out. These office and sundry items are normally consumed over time. There is always a small stock of pencils, paper, drinking cups and other such small objects throughout the year. These items are not held for the purpose of sale and they would not generate cash for debt repayment. Thus, when calculating working capital, current ratio or inventory turnover ratio, they must be excluded. The issue with their presence in the balance sheet is not just that some ratios need adjustment. Their presence distorts the entire balance sheet. Indeed, when a normalized balance sheet is prepared, if this type of inventory is part of current assets, it causes all items to be slightly understated. One solution would be to put this inventory in other current assets, since it does represent an expense which will not need to be incurred next year. In reality there will be approximately the same office and sundry inventory at the end of the following year. Thus, spending for these items this year does not reduce spending next year, nor would it reduce the spending in the year of liquidation. A better solution is to expense miscellaneous items as they are purchased, and not to record them as an asset at all.

Another item which should also be removed from assets is that portion of plant and equipment no longer used in production. If these fixed assets have no salvage value, they should be written off. They are not real assets, they do not contribute to the sales revenue potential of the firm, and their presence is an unnecessary distortion of the firm's wealth. Just as in the case of miscellaneous items in inventory, the issue is the philosophy of what assets represent. In Russian accounting thinking, a constant watch must be maintained over all assets because they are the resources which have been apportioned to that productive unit, and, as such, they represent wealth in the sense that they exist. Inventory is taken repetitively for that purpose. In Western accounting, the focus is not on the assets per se, but on the flows, specifically sales: wealth is the sum of future revenue flows. Thus any item that does not contribute to sales, does not represent wealth and should not be present in the balance sheet.

Another significant distortion in the balance sheet is the presence of losses in the "Actif" (i.e. debit or assets) side of the Russian balance sheet. In virtually all cases, losses are simply a reduction in wealth and should appear as such: a diminution of retained earnings. Again, the Western financial philosophy is oriented toward the future. Let bygones be bygones. Let not artificial amount pertaining to the past distort the picture of the real resources on hand to generate income in the future.

In the conversion process, there is a need to clean up Russian financial statements to leave only what is significant. Another example of excessive detail is the breakdown of expenses payable in the current liabilities. All that is really needed are those expenses payable to 1) banks, 2) suppliers, 3) taxes and 4) other. Only the first three items are normally large enough to appear on a balance sheet. Conversely, items such as salaries owed, insurance payable, social security payable, advances received, and prepaid revenue do not generally amount to more than one or two percent of total assets. Thus, they should all be lumped into one single line as " other ". Except, naturally, if any of these normally small items happens to be very large. Then the balance sheet should be constructed to reflect what is of outstanding importance. A similar clean up is needed in the current assets and inventory categories.

The conversion just described, which eliminates numerous lines, seems to reduce the informational content of the balance sheet. There are distinctions between different types of payables and receivables which are aggregated into a single less meaningful number. But, that impression is only correct if the size of the items is not taken into consideration. Here, the issue is, again, one of philosophy. In the Russian approach, reporting every account balance on the balance sheet seems to achieve the purpose of completeness of information. They appear there only as a matter of compliance with rigid accounting rules of presentation. In Western accounting, rules are determined by their usefulness for clarity of presentation: too much information diminishes clarity.

The third and last issue pertains to the income statement. As previously stated, in the Russian format, the emphasis is on the balance sheet. The income statement contains only two significant lines of information: sales and production costs. These lines are significant because they pertain to the major activity of the business and are determinant of the value of the firm. All other lines are related to other income, other losses, gains on securities, gains on currency and losses on currency, as well as the break down of various taxes paid. For the government of a socialist state, these lines reveal important information on whether or not the firm has entered into some illegal operation. For a financial analyst in a market economy, all of these lines are virtually useless, because they do not serve any predictive function when it comes to forecasting the company's sales and production costs. Throughout the following chapters, evidence of the importance of the different categories of sales and expenses will reinforce the notion that Western accounting serves the needs of the analyst even if it has shortcomings of its own.

See review questions Q-7C1.1 through Q-7C1.6.

2)- Steps in the conversion

The conversion of the Russian accounting statements involves some or all of the following steps. Some modifications can be carried out directly with the numbers as they appear in the statements. Others require additional information which must be obtained from the firm. The types of additional information needed are discussed in the following section. Here, only the mechanical consequences are listed one by one.

a) In the balance sheet:

- combine all forms of cash into one amount: for the outside analyst, it does
not matter whether cash is in a rouble account or a currency account; this
distinction is only useful in the case of a foreign currency trading company.
- combine all trade receivables into one amount: notes receivable are shown
separately from open account customers only if two very different groups are
involved, as may be the case in some construction firms.
- deduct and show separately any allowance for bad debt.
- combine any receivables from owner with payables to owner and transfer to
the equity section: additional information is necessary to carry out this
modification because the receivables plural and payables plural from the
owner, must pertain to the same individual; it is, however, a practice in Russia
for stock not to be subscribed for a long period of time, while the shareholder
receives an advance on distribution of capital: clearly in this instance, the
receivables plural from the owner is not a real one, and should be eliminated
from the assets.
- combine all other receivables with other current assets: an explanation for this
adjustment has been presented above.
- combine all forms of merchandise inventory: maintaining a distinction between
raw materials, work in progress and finished goods is only necessary where
either raw materials or work in progress are large relative to finished goods;
sometimes, even in productive companies, that is not the case and the
distinction is not useful.
- exclude any amount of miscellaneous items inventory by entering it as a
current year expense: this adjustment has been discussed above.
- exclude any amount of unsealable merchandise from inventory by writing it off
to expense: this information would need to be obtained from the firm.
- exclude from fixed assets any amount of worthless fixed asset by writing it off
to expense: information from the firm is also needed here.
- eliminate any loss appearing in the assets by deducting it from retained
earnings.
- combine all forms of trade payables and show separately from other payables:
as for receivables above, a distinction between notes payable and open account
payables is an important distinction used only in very few industries.
- combine different forms of provision and show them separately from reserves:
indeed, one will recall that provisions are set up under GAAP to deal with an
undesirable situation that may take place in the future as a result of actions in
the past, such as warranties for products sold; whereas reserves pertain to
planned expenses for the future; in Russian practice, both of these items seem to
be quite often large, as they also are in European firms.

b) In the income statement:

The modifications are:
- deduct returns, rebates and discounts from gross sales if not already shown
and if obtainable from the firm: these items are commonly shown in western
accounting because they carry important information about the quality of sales
and the nature of sales strategy.
- deduct any non-operating income from sales revenues: in particular, if there
has been a sale of a fixed asset, that amount should be shown as other income;
the information will usually not initially appear in the balance sheet.
- show cost of goods sold as a deduction from revenues, thus revealing gross
profit: the cost of goods sold should contain only direct expenses and an
allocated overhead expense, depending on the practice in the industry; no
period expense, i.e. general and administrative expense, should be there;
depending on the industry, selling expense may also appear as a separate item.
- enter operating expenses, isolating significant amounts as needed, and deduct
from gross profit to show net operating income.
- show interest expense (net of interest income, if significant) and deduct from
earnings before interest and taxes to show earnings before tax and other
income.
- show other income (or non-operating income net of non-operating loss) in one
amount and deduct from profit before tax.
- show corporate income taxes and deduct from profit before tax to show profit
after tax.

c) In both statements:

- round all numbers to no more than 5 significant digits.
- state all numbers in thousands, millions or billions of a currency and eliminate
the last 3, 6 or 9 digits from all numbers as needed.
- verify that rounding does not create a summing error in the totals.
- line up all numbers, right-justified. See Note N-7C3.1.

See review questions Q-7C2.1 through Q-7c2.4.

3)- Additional information needed for the conversion

As already suggested, to convert Russian accounting statements to GAAP statements, it is first necessary to obtain the following additional information from the firm.

a) For the balance sheet:

- market value of securities listed as marketable securities at end of year
- irrecoverable accounts receivable, or estimate of overall bad debt
- inventory representing miscellaneous supplies
- unsealable or non-existent inventory listed on balance sheet
- non-current inventory on the balance sheet
- receivables from employees outstanding for several years with little
probability of repayment
- prepaid expenses such as advertising, rent, insurance, legal retainer fees
and licenses not already recorded as such
- accrued revenue, such as on long term contracts not yet recognized
- non-operating fixed assets
- method used for depreciation allowance and its calculation
- portion of earnings or loss (net of dividends received) related to
investment in unconsolidated affiliated companies
- allowance for intangible assets loss of value
- amortization of capitalized expenses (i.e. organizational expenses )
- current portion of long term debt not yet shown as such
- accrued expenses such as interest, taxes, utilities, selling commissions,
pension costs, royalties, legal fees and salaries not yet shown as such
- deferred income, such as tax refunds or sales not yet completed
- break out of the various types of capital (common stock, preferred, paid
-in, treasury)
- balances of each shareholder's payables and receivables
- identification of reserves (i.e. amount related to past results) distinct from
provisions
- identification of contingencies giving rise to provisions

b) For the income statement:

- current portion of revenue on long term contracts
- revenue recognized this year but which necessitates additional steps for
completion of sale
- non-operating revenues
- break out of cost of goods sold from production cost, and general and
administrative expenses
- break out of general and administrative expenses in remaining production cost
in following:
- salaries
- advertising
- depreciation
- maintenance and repair
- pension cost
- research and development
- taxes other than corporate income tax
- interest expense
- corporate income tax
- other

c) For balance sheet information to be added in notes if necessary:

- contingencies and current year material events
- inventory method and comparison of inventory cost to current market
value
- leasing
- leasehold improvements

See review question Q-7C3.1.

4)- Adjustment for inflation

At present, there are two GAAP methods for showing the effect of inflation on financial statements: constant dollar and replacement value. The replacement value is not realistically applicable because of the need to price all assets by an outsider. The use of an index, by contrast, can be a convenient way to adjust prior year statements for inflation. Each number in the prior year(s) balance sheet and income statement is divided by the index (with the current year as base year with an index of 1). A monthly recalculation with a monthly index would be better in hyperinflation periods such as the one in Russia in 1994 (but neither index nor monthly company figures are obtainable by an outsider). By inflating prior year numbers, the prior year statements of a Russian firm can be made useful for comparison.

See review question Q-7C4.1

5)- Example of conversion

AO BOOM is a medium size department store located in Moscow (See Note N-7C5.1). It was incorporated in 1992. It sells clothing, shoes, leather goods, household goods, electronics, books, souvenirs and some fancy foods. Approximately 60% of the merchandise is imported. It occupies a surface of 1,600 square meters and employs 130 full and part-time employees. It 1993 its capital was increased from 3,500,000 roubles to 6,000,000 roubles. Its stock market price has risen from less than $1.00 to over $6.00 over the period of one year. The financial officer of AO BOOM has approached the Glinka bank with a request for a revolving line of credit of 2,000,000,000 roubles. The store has also applied for a three year term loan of 10,000,000,000 roubles to finance its proposed selling floor modernization program. The program would put carpets in all clothing and apparel sections and replace old display windows. To conduct the financial statement analysis, the credit department of Glinka Bank has converted the Russian financial statements of AO BOOM into GAAP financial statements. Table T-7.1 AO BOOM Russian accounting Balance Sheets (thousands of roubles) . . 1993 . 1994 ASSETS . . . . I- Fixed assets . . . . Intangibles 26 26 687 650 Amortization 37 . . . Fixed assets 5109 3588 10880 9134 Depreciation 1520 . 1746 . Unpaid capital . . . 768 Accounts of shareholders . 1757 . 3964 Investment . 268 . 1492 I- total . 5639 . 16008 II- Inventory and Expenses . . . . Production inventory . 677 . 5669 Misc. inventory 156 114 1545 1023 Amortization 42 . 522 . Work in progress . 39 . 80 Prepaid expenses . 307 . 572 Finished goods . 23 . 532 Inventory 67826 49434 631604 502701 Amortization 18392 . 128903 . Selling cost . 169 . 1208 Tax on price increases . 26 . 3220 II- total . 50790 . 515005 III- Liquid assets . . . . Receivables clients . 1343 . 9649 Receivables taxes . 12 . 11732 Receivables personnel . 97 . 105 Receivables directors . 7042 . 46974 Advances paid . - . - Short term deposits . 6820 . 28207 Petty cash . 183 . 2912 Bank account . 6618 . 29672 Bank account current . 15650 . 88563 Other liquid assets . 5286 . 25888 Other working capital . 15 . - III- total . 43066 . 243702 Total assets . 99496 . 774715 LIABILITIES & EQUITY . . . . I- Own capital . . . . Statutory capital . 3500 . 6000 Reserves . 1038 . 6726 . . - . 1172 Special provisions . 29012 . 249933 Targeted financing . 211 . 529 Shareholder's accounts . 726 . 1514 I- total . 34487 . 265874 Long term bank loan . 432 . . Long term debt . 5600 . 3466 II- total . 6032 . 3466 III- Current liabilities . . . . Short term bank credit . 890 . 16750 Payable suppliers . 50019 . 464956 Payable for labor . 1597 . 3378 Payable for insurance . 407 . 4790 Payable extra-budget . 34 . 368 Payable for budget . 1059 . 8594 Payable other . 4380 . 4319 Advances received . 1 . - Prepaid revenues . 378 . 2142 Reserves for payments . 212 . 78 III- total . 58977 . 505375 Total liabilities/Equity . 99496 . 774715 Table T-7.2  AO BOOM Russian accounting Income Statement 1994 (thousands of roubles) Sales 442070 Production costs -124655 Results from sales 317415 Results from other sales 6779 Other income 92520 Other losses -23053 Gain on securities 375 Gain on currencies 52300 Loss on currencies -10426 Profit (loss) 393660 Income tax paid to budget 130548 Reserves for insurance fund 117 Allocation: retained earnings 170906 usage fund 76016 charitable goals 70 other goals 16046 Table T-7.3  AO BOOM GAAP Balance Sheets (thousands of roubles) . . 1993 . 1994 ASSETS . . . . Cash . 27737 . 147035 Marketable securities . 6820 . 28207 Accounts receivable clients . 1343 . 9649 Inventory . 50594 . 510577 Prepaid expense . 195 . 4428 Other current assets . 7166 . 58811 total current assets . 93856 . 758707 Fixed assets 5109 3588 10880 9134 less depreciation 1520 . 1746 . Investment . 268 . 3964 Intangible assets . 26 . 650 Total . 3882 . 13748 Total assets . 97739 . 772455 LIABILITIES/EQUITY . . . . Accounts Payable . 50019 . 464956 Short term bank credit . 890 . 16750 Taxes Payable . 1059 . 8594 Prepaid revenues . 379 . 2142 Accrued expenses . 212 . 78 Other short term liabilities . 6418 . 12855 Total current liabilities . 58977 . 505375 Long term bank loan . 432 . - Long term loan . 5600 . 3466 Total long term liabilities . 6032 . 3466 Capital . 3500 . 6000 Paid in capital . -1031 . -746 Reserves . 1038 . 7898 Provisions . 29223 . 250462 Total equity . 32730 . 263614 Total liabilities/Equity . 97739 . 772455 Table T-7.4 AO BOOM GAAP Income Statement 1994 (thousands of roubles) Sales 442070 less: cost of goods sold 108439 Gross profit 333631 less: expenses . Rent 6000* Depreciation 216* Overhead (salary) 5000* Earnings Before Interest and Taxes 322415 less: Interest expense 5000* Profit before taxes and other income 317415 plus: other income 76245 Profit before tax 393660 less: income tax 130548 Net Profit (loss) 263112 * these items should be obtained from the firm, but in this case they were estimated. Source: The data presented in this example is actual, but the names have been modified upon a request of the company.

The following steps were taken for the conversion.

a)- To convert the balance sheet from Russian into GAAP standards

All items from both the balance sheets may be separated into two groups as follows:

1- Those which have an analog in another type of statement

2- Those which have no strict analog

b) To convert the income statement from Russian into GAAP standards

Similarly to the balance sheets above, all items from both the income statements may be separated into two groups as follows:

1- Those which have an analog in another type of income statement

2- Those which have no strict analog in the income statement

6)- Assessment of the effects of conversion

If we analyze the conversion of the Russian financial statements to GAAP statements in the previous exercise, the following conclusions can be drawn with respect to each of the goals of accounting and the limitations of accounting.

a) Relevance:

Several items which are meaningless such as miscellaneous inventory or unproductive fixed assets are normally eliminated in the process of conversion. This definitely makes the balance sheet more relevant. Likewise, in the income statement, other income and loss are given less importance, while an expense break down, more: this is also a major improvement resulting from the conversion.

b) Objectivity:

Objectivity would be increased if the numbers were more verifiable and less subject to estimation. The conversion of the balance sheet caused a number of lines to be combined and thus less verifiable. But, in the income statement, the reverse took place as more detailed information appeared for expenses. If it is agreed that the income statement information is more important than that of the balance sheet. The conclusion is that there is an improvement as a result of the conversion. (However, the new numbers in the expense break down should be real numbers obtained from the firm, and not, as in this textbook case above, numbers that have been entered for illustration purposes.)

c) Comparability:

One should be able to compare all numbers from one year to the next. The conversion does not improve comparability of financial statements. Moreover, a major problem of lack of comparability is inflation, and nothing has been done to correct for inflation. Thus, there is no improvement on this count. In fact, there could be deterioration because some of the balance sheet numbers are more aggregated.

d) Clarity:

By having fewer items that stand out in the balance sheet, clarity has certainly been improved. However, the large number of items in the expense of the income statement is offset by the reduction of marginal other income and loss items. On balance, this is a significant improvement. [Note that Russian accountants disagreed with this conclusion because they were used to their balance sheet format and removal of some of the details made them think that some information was lost.]

e) Importance:

Large amounts such as Inventory stand out in the GAAP balance sheet. By contrast, various small amounts in current assets of the Russian balance sheet have disappeared into Other Current Assets.

f) Emphasis of content over form:

By eliminating insignificant lines, the form is indeed given less weight. Thus, there is a definite improvement here.

g) Generality of purpose:

Anyone looking at the statements can make sense of them and that the statements are not intended for one particular purpose or group. Russian financial statements are primarily intended for the tax inspector. Consequently, all the various tax amounts, as well as the basis for their assessments, are well in evidence. All this has been combined or eliminated after the conversion. The additional clarity that results, makes statements useful to a larger audience. There is an improvement here also.

After reviewing each accounting goal, let us look at accounting limitations.

h) Monetary expressions:

This limitation of accounting data suggests that quantitative aspects, not
elements of quality are present in the numbers. The conversion does not help in this respect.

i) Oversimplification:

This limitation stems from the aggregation that is necessary to achieve the goals of clarity and importance. In the process of conversion, even more aggregation is now taking place in the balance sheet, but the reverse in the income statement. However, if greater weight is put on information contained in the income statement, then there would not be a lessening of this limitation. All in all, it is a toss up.

j) Subjective estimation:

This limitation addresses the issue of items affected by management decision, such as the life of an asset. The conversion does not offer an improvement in this area.

k) Historic irrelevant valuation:

This last limitation is primarily pointing at LIFO inventory and fixed assets on the balance sheet. Neither of these items has been improved by the conversion.

On balance, considering that in a few areas there is some worsening, but in a large number there are major improvements, one must conclude that the conversion is a significant improvement especially in meeting goals as they are stated in Western accounting.

See review question Q-7C6.1.

7)- Recommendation for adopting new accounting principles in Russia

If an outside analyst must carry out modifications to the accounting numbers a company provides, it seems clear that there is something wrong with the method of presentation of the data. Any modification carried by an outsider makes the data inferior to data available from the firm itself in the desirable format.

The Russian accounting profession is currently in a straight jacket in its role of preparer of financial information. The accounting rules do not come from the practitioners themselves to make their work more efficient and useful, but from the tax authorities and from the ministry of finance. The interests of those who set accounting rules are at odds with the interests of the large number of users of financial statements.

It is of utmost importance that two sets of accounting numbers be prepared: one for tax purposes and another for financial purposes. In the second domain, a new set of accounting principles must be worked out by the Russian accounting profession, so that financial statements be relevant to outside investors and management. Already some industries, such as banks and gas companies, are restating their annual report using all GAAP rules. Likewise, banks are also restating the financial results of their loan applicants. Several computer programs offer the possibility of keeping the accounting of Russian firms on Russian and GAAP bases simultaneously.

The rules of accounting adopted need not be identical to any particular set of rules used in the West, although it is probable that by joining the world community of accountants, Russian accountants will want to set rules compatible with those of other countries. That in itself is not of great importance, but it would ease the work of many if comparability between Russian and foreign firms is not impeded. That seems to be the reason banks are using GAAP as they want to enter the world banking community and be evaluated by foreign investors in the same manner as foreign banks with which they compete for funds outside Russia.

It would seem important that Western accounting rules not be blindly adopted. New rules of Russian accounting need to reflect domestic needs (as well as meet the exigency of comparability). To this end, it is urgent that the Russian accounting profession be finally freed from the dictatorship of tax authorities and Ministry of Finance pronouncements.

See review questions Q-7C7.1 through Q-7C7.3. See research assignment R-7.6.

Previous: Problems

Next: Readings