Financial reporting as a face of your business
01.08.2007
Igor Beloyvan, Alt
As we all know, one of the basic accounting concepts presumes a business to be considered separately from its owner (stakeholder). This principle contributes a lot to our perception of business as alive entity rather than an abstract notion created on paper only. The legal terms “physical person” and “legal entity” also direct us to the fundamental assumption that individuals and legal entities are both operating in the same economic and legislative environment. Implying an individual we have a clear picture of its size, shape and unique appearance but to distinguish one legal entity among the others may be a much harder exercise. The basic identification criteria come to entity’s name, registration number, bank account and tax ID codes. But this data is, however, quite useless to communicate the qualitative features of business which really distinguish it between the others.
Asking myself what can be regarded as business’s recognizable face I arrive at a conclusion that one of the possible answers could be its public financial reporting. As any individual wishes to impress an audience with its good-looking appearance, so the business produces financial information to demonstrate its being successful and reliable. A successful business always finds itself in more favourable conditions regarding an access to cheaper financing for its new investment projects, extended credit periods from suppliers, additional price discounts and the best workforce on the market. In a business world, like in sport and even in our common life, the environment always supports the greatest trying to become a part of their success. From the society’s standpoint auditors are supposed to express an assurance on the fairness of financial reporting to prevent the business from being overoptimistic.
Up to this point we’ve outlined the basic concepts traceable in any healthy economic environment where the business utilizes the benefits of producing true and fair financial statements to stay competitive on the market. The financial reporting in such environment serves as objective measurement of success. But it is not the only one such measurement, of course. Being based on the accounting data the financial reporting just communicates the facts that have already taken place as well as management’s evaluations of some future events and risks which affect the financial position of the business at reporting date. As a result, the financial reporting is always backwards oriented and associated with the past. But the great majority of decisions are motivated by the future expectations. However, there is no predictable future without solid and controllable past. Therefore, consistent and comparative over time financial statements were, are and will always be the issue of paramount importance for success measurement and can fairly be claimed as a face of the business.
Unfortunately, if to consider a weight and attitude to the financial reporting in Ukraine we come to a rather sad conclusion. As for a representative of audit profession, this conclusion gets even worse for me because it makes no sense to discuss the value added contribution of audit if the value of financial reporting itself is close to zero in the eyes of its potential users. It would be reasonable to assume that a price of such audit is also aiming at zero. The price is driven by demand and proposition on the market, of course, and Ukrainian certified auditors can be blamed for such status quo not less than the reporting entities but it is really a subject of separate article.
Having analyzed all the Ukrainian entities from the statutory financial reporting standpoint, in my opinion, they could be classified by the following groups:
- entities which neither prepare nor file their financial reporting (15% of all registered legal entities);
- entities which prepare and file their financial reporting but it is of quite low quality an unaccompanied with independent auditor’s report (65% of all registered legal entities);
- entities which prepare and file their financial reporting and it is accompanied with independent auditor’s report but still of quite low quality (10% of all registered legal entities);
- entities which prepare an file their financial reporting, either audited or not, and it fairly presents their financial position and results for the period and is used in decision taking process by the management, owners and other third parties (10% of all registered legal entities).
Below I would like to share with you some of my ideas on the reasons of such status quo and to discuss the perspectives of financial reporting in Ukraine that is, obviously, much more important.
Thus, how it could be that Ukrainian companies do not want to demonstrate a good-looking face. The first reason is very simple – to have a nice appearance costs money but the great majority of Ukrainian businesses are concerned about their basic survival. The good-looking face is just not the first point in their list of priorities.
In addition, if the face is hidden behind the mask its real appearance is not a subject to care about. During the transition period in Ukraine, which is still going on, the state property has often been transformed into private and corporate forms through quite opaque schemes. Having obtained control over the business in such a way new owners do not hurry to flag about it but instead often try to conceal this fact. This kind of behavior is quite atypical for settled markets with centuries-old traditions of private property protection and case-law legal system. In such conditions the more successful business is the louder its owners advertise it. In Ukrainian reality such openness is associated with the great risk due to large number of those who would wish to dig in the obscure but so recent past. The corrupted legal system and shaky political balance only increase the risk associated with disclosure of information which could be used against the current owners. The evaluation of potential damage from information disclosure just outweighs the possible economic benefits from such disclosure in the eyes of owners and managers.
The significant share of Ukrainian economy is still hiding in shadow making substantial part of transactions outside the statutory financial reporting and financing part of the business through offshore companies outside the country. As a result, the statutory financial reporting of such businesses is quite far from being true and fair lacking any economic sense for their shareholders, management and other interested parties. The audit of such financial statements clearly adds no value to them and is useless from the management standpoint.
There is one more very important factor which impacts the quality and meaning of financial reporting – the size of the business. Only the business large enough to control significant market share and playing strong social and political role would care about its public image as an instrument of continuous growth and development. But the Ukrainian economy still fully depends upon monopolies. According to official data 80% of national GDP is created by not more than 200 companies or groups of related companies. This means that the rest 20% is represented by hundred thousands of entities and private entrepreneurs business of which is really very small. For instance, a business with annual turnover coming to 10 ml. US dollars if to be graded by large, medium and small classification would find itself between large and medium in Ukraine. But such business would clearly be regarded small in economically developed countries. In addition, business like this has quite limited opportunities for growth in Ukraine due to high interest rates, low internal consuming capacity and lack of the state supporting programs. In these conditions, small and medium-sized businesses are experiencing hard times trying to invest in their growth. As a result, meaning of their financial reporting is being undervalued for a quite considerable period of time.
Thus, summarizing the reasons why the great majority of Ukrainian entities work with a wry face or without any face at all we can see that the most important of them are objective. As a result, the meaning of financial reporting together with its quality can also be increased only in the normal course of events. Neither legislative instruments nor rigid fiscal policy are expected to contribute a lot to the status of financial reporting. The positive trend could only be caused by business related factors and economic reasons. In conditions of free market economy there is one main and all-powerful engine of progress – competition. Only when all the other resources to gain competitive advantage on the markets of consumption, labor and capital have been exhausted the business will have to concentrate itself on optimization of corporate structure, legalization of transactions and transparency in the eyes of investors and general public. Very first step in this direction is expected to be an introduction of reliable information system which would produce then fair financial information. As a next step, its audit and publication will raise the value of the business due to its positive effect on decisions of shareholders, lenders, clients, government and society as a whole.
In the above clause we have come back to the basic postulates of healthy economic environment after a brief description of objective reasons why they do not work or work partially in Ukraine at the time being. But it, in any case, does not mean that there are no subjective reasons behind current situation and we all should just wait for that magic moment when competition changes it to the better. In Ukraine we have a paradoxical situation when the statutory financial reporting made effective by the government in its current form of National Accounting Standards (NAS) in the year 1999 exists now as a complete orphan having nobody to express any kind of interest to it.
The business related decisions are driven in Ukraine by a lot of factors but not only by the statutory financial reporting. The stakeholders and management also take decisions to govern their businesses based on a range of motives but the statutory financial reporting clearly takes a very last place in this range. The big Ukrainian groups and companies with foreign capital have been preparing their internal financial statements in compliance with International Financial Reporting Standards (IFRS) and have it audited by the firms of “big 4”. The Sate represented by the Ministry of Statistics controls neither the quality of statutory financial reporting nor the discipline of its filing. The other state institutions, such as the State Commission on Securities and Stock Exchange Regulation and the State Commission on Financial Services Market Regulation, restrict themselves to accurate filing of the statutory financial reports supported by the independent auditor’s opinion report that is unqualified in 99% of cases. The Ukrainian certified auditors manage somehow to conduct their audits of statutory financial reporting of companies with revenues numbered in nine digits figures and 5.000 employees just for two days and at a price of about 500 US dollars. The Ukrainian Stock Exchange shows no reaction on publication of statutory financial statements of national gas monopolies but instead appears to be highly sensitive to the comments of Russian Gasprom’s press attaché.
The Ukrainian entities, which try to produce their statutory financial statements in consistency with requirements of the NAS, investing significant resources in its quality and audit look like rara avis on this background being hardly able to answer the question why they are doing this. Their good-looking face can not be valued by the market at fair price due to lack of information for comparative analysis and traditions to look at the face of the business more thoroughly than at the faces of its owners.
Thus, the very relevant questions arise at this point: if the statutory financial reporting does not have its real users why not to abolish it at all? If not, what should be done to increase its status and who is supposed to do it?
The answers to these questions are obvious. First of all, we have to start talking about it, of course, what we engage you to do through comments to this article. Then, to my opinion, the profession itself should make a step forward. We, Ukrainian auditors and accountants, should get organized and determine how we could increase the status of our profession that would certainly lead to raise of our personal income. Probably, some kind of certification should be introduced for chief accountants as well and the rows of certified auditors and audit firms should be screened up and reduced due to their failure to comply with the international standards on auditing adopted in Ukraine since the year 2003. In other words, the qualified skeleton of the profession has to be formed which then will promote its status and stay firm to low-balling prices temptation.
The State must also say its meaningful word. The Ministry of Finance should initiate an open public discussion on the issues related to quality of the NAS and their real consistency with the IFRS. If we, as a profession, do not reach the point when the NAS would really be compatible with the IFRS and all the distinctions are analyzed and supported with justifiable arguments the Ukrainian statutory financial reporting will never gain the status it really deserves. The current situation with the disclosing notes to the financial statements is totally inappropriate and blocks further development of the profession. To my opinion, there should be no statutory fixed format for the notes. Such approach contradicts to the very fundamental concepts of the IFRS. Disclosing financial information in the notes to financial statements the management should better understand their business and present this understanding in appropriate format instead of filling out the gaps in prescribed format with far absent mind. In addition, every business has its own information to be disclosed and that is why it is not possible to come up with the uniform format of the notes. The general recommendations and comments are very much possible but such a strict regulation just makes dead the whole profession.
Summarizing the above, it looks like a fair conclusion that the low quality and value adding capacity of the Ukrainian statutory financial reporting can be explained by both objective and subjective factors. If we eliminate the latter, this will certainly speed up fading of the objective factors. The time will obviously find a solution for this issue. The only question is whether we wish and have a capacity to speed up this time.
Now, as promised above, let’s get to the prospects. They are, to my opinion, only optimistic for the financial reporting in Ukraine. My optimism is caused by the democratization of our society, business culture development and inevitable integration of Ukraine to the European and world economy. In addition, quite considerable number of Ukrainian big and medium-sized businesses (or groups) are already paying due attention to their financial reporting (often consolidated) as to their faces. They even get their financial information published in the form of printed booklets or on their websites. As a rule, such businesses co-operate with foreign partners, banks and other financial institutions. They enter the free capital and financial markets or arrange IPO. Their shareholders are keen to increase the capitalization value of their businesses as of marketable commodity and to demonstrate their success in the financial reporting.
The owners and management of leading Ukrainian companies and groups have already formed a general understanding of how important it is to report full and fair financial information. These companies invest significant resources to go through the international audit of their financial reporting performed, as a rule, by the firms of “big 4”. The only but key problem is that they invest not in their Ukrainian statutory financial reporting but in reporting produced in compliance with the requirements of the IFRS or US GAAP. This fact is by no means surprising since the great majority of users and readers of their financial information is located outside of Ukraine. This kind of situations makes life of Ukrainian accountants extremely difficult. They have to organize not only the statutory financial and tax accounting but, so called, “international” accounting as well that is regarded to be the only one producing the true and fair results.
As far as can judge, it is only a question of time when Ukrainian companies will start to produce just one single set of statutory financial reports and notes to them for the users within Ukraine as well as for those outside of it. This set of reports will successfully be translated into foreign languages and accompanied by the local auditor’s opinion reports or by the reports of international auditors as extra assurance if the client desires so. To achieve such an ambitious objective both the profession and the government should contribute a lot of efforts. Taking into account their mutual understanding of this final objective we can argue just about a period of time required to realize it on practice.
The State already takes the first steps in this direction having it as a must requirement to submit the statutory financial reporting to the Registrar of Entities. Such a step, without any doubt, will add some discipline to the process of reporting preparation and filing but will not be able to affect its content fro the quality standpoint. The quality of content can be achieved only through the NAS’s improvement. It seems to me, sometimes, that the full adoption of the in Ukraine and removal of all constraints in their practical application would be a radical but justifiable measure. There might be a sense to go exactly this way considering the weak development of professional network and absence of active public professional organizations. Such a radical step will not, of course, lead to immediate results but will, at least, let Ukraine join the international process of accounting standards development and study the huge volume of published material on this subject in the world. It is clear that all the Ukrainian accountants will not magically start at once to prepare the financial statements of their companies in accordance with the IFRS requirements but the entire process will be put on the right rails. The depth of the IFRS’s application will then depend upon the qualification of all the engaged parties – auditors, the State Registrar of Entities and other users of the information disclosed in the financial reporting. We are talking about the normal process of self-education which is completely unreachable at the moment for the majority of the profession’s representatives.
As a final remark, I would allow myself some parting words: dear colleagues, the financial reporting is the most interesting part of the profession you have chosen. Here you have a boundless field for your creativity when searching for the fairest way of presenting and disclosing your financial information. As long as the last source document dated by the 31st of December has been input into your database this is exactly the moment when the financial reporting begins but not ends. In the countries with developed economies the period for financial reporting preparation extends from 6 to 10 months after the reporting date. This time is given for review of the recorded past, evaluation of the future, consultations with all kind of experts and independent audit. I wish you to occupy a position in the business that invests to the quality of financial reporting and then to get so promoted to sign it.
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