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Accounting

A Western investor contemplating doing business in Ukraine should anticipate a legal and regulatory framework that extends into virtually every area of activity or endeavour

                                                                                                            Spivak Mykhaylo

 

Development of Financial Market and Accounting Regulations in Ukraine

 

    Research of Ukrainian financial market and accounting regulations requires a great deal of intellectual  efforts and personal experience. At first glance, financial market may seem  not  existing at all, and accounting looks like something confusing and undeveloped. Yet, each of them reflects current economical, political, social situation and serves specific goals, ranging from tax collecting to acquiring of enterprises.

 

    I would like to divide national financial market into two components: banking sector, or market for monetary resources  and capital market. Interrelated in all developed countries, they are almost independent in Ukraine. It means that banks may buy or sell securities, but it’s a minor activity for them; banks may finance some traders, but these are ordinary transactions with total volume 4 times less than that in industry or agriculture. The reason for this is in the sources of  profit from business operations. While  activities of  banking system  do not differs  significantly from those anywhere in the world, capital market acts mainly as a registrar of deals.

   Banking is a two-level  system, with National bank, which ensures stability of  monetary  policy in the country and commercial banks, directly engaged in financing of economy. International experience proves, that  national bank should be independent of political authority, however in Ukraine this do not take place. From its first days, National bank served as a tool for improving negative consequences of economic experiments of Government. As a result, inflation rate reached level of  400% in a few past years and remains 10-15% annually. Only recently,  budgetary and monetary policies were separated and National bank received an opportunity to make weighted decisions.    

    Commercial banks, which are supposed to invest in economics, offer their credit services mainly at  short term basis; often, however, under pressure of Government, these terms may be increased significantly, up to indefinite periods in future. Recent bankruptcy  of the largest bank “Ukraine” is a confirmation for this. It had the widest network in the country and reputation, comparable with that, for example, of Deutche Bank in Germany. Nevertheless, a few hundreds of  millions of dollars of unsecured credits undermined its financial performance and made this bank out of the market. Banking system develops mainly due to services, provided to corporate clients: everyday business transactions, deposits, currency exchange, etc.  Private savings are reported  as constantly increasing, but their amount is still low in comparison with that in business services.  Another side of  activities of commercial banks is  their direct participation in agricultural and industrial enterprises. For example, cultivation of corn is both highly profitable and risky business, which needs adequate investments; unfortunately, many farmers still cannot finance it. Traditional bank loans are not applicable, because of high interest rates; futures contracts do not take place, because of high risks; the only choice is to assure investor in a good return. So, banks finance agricultural farms, but their managers directly participate in all phases of production: up to the delivering of corn to elevator. This practice would dramatically change the overall picture of Ukrainian economy.  First of all, it can not be reported as a kind of the bank services, because financing is provided on the basis of future benefits, but not on the basis of thorough analysis of client’s  business plan and  credit status. At the same time, banks do not attempt to acquire a particular company, because its business has nothing to do with bank’s, although specific projects, if properly financed, seem to be perspective.  This practice results in increasing of economic growth at selected enterprises and in additional sources of extra profit for a bank. Such cooperation is still not a financial group, but it is going to be a basis for it. Moreover, it is a component of active bank’s participation in a capital market. 

 

    The capital market in Ukraine emerged in early 1990s. Since then, it remains very small in terms of number of transactions and volume of total transactions. Only $650 million traded during the period from first to third quarters of 2001. Industry experts view the market as “having the necessary infrastructure, but lacking transparency and enforcement of the corresponding laws.” At my opinion, market lacks also objects of trade, i.e. profitable companies and subjects of trade, i.e. buyers.

 

    It was three distinct stages of the capital market’s development in Ukraine:

 

 1.      The market of issuers (1991-1994)

 The issuers issued, sold, and bought their own securities. This led to natural (and specifically engineered) trade schemes. The customer awareness of the market was minimal. The result was virtually all joint stock companies, created in 1991-1994,  bankrupted, leaving thousands of private investors without any return.

 

2.      Initial stage (1995-1997)

 In this period, investors realized that money lost between 1991 and 1994 would not be regained. The government created the Securities Stock and Exchange Commission to oversee securities transactions. This small-size market was dominated by public venture firms, heavily relying on financial inflows from offering securities to the public. Unfortunately, virtually all stock owners of these venture firms lost their invested money. Naturally, during the period of 1991 – 1997, small (middle class) investors lost  confidence and left the market.

 

3.      Regulated market (1997-present)

 During this stage, the state tightened control over market participants. The State Securities and Stock Exchange Commission provided basic regulations governing transactions between market participants. At the same time, regulation of companies issuing securities was not enough strong to provide for a transparent market. In 1994-1997  during the period of “mass privatization” (when privatization certificates were distributed to the citizens free of charge, for further exchange for stocks), mutual investment institutions appeared and played the premiere role in soliciting privatization certificates from the population. Resulting cash outflow was almost invisible and  majority of these institutions disappeared forever. Other, according to the State Securities and Stock Exchange Commission, “were transformed into new kinds of mutual investment institutions, providing better protection of private investors.”

 

    The largest meeting place of buyers and sellers is PFTS Stock Trading System in Kiev, with total trading volume $ 300 millions this year and average number of trades 30 per day.

   

 

 

 

Capital market can be divided in two following sectors:

 

The Market of Corporate Stocks

According to the State Securities and Stock Exchange Commission, in October 2001, there is 38,500 joint stock companies, including 12,300 open joint stock companies, the total amount of stock issues were $ 6.3 billion. However, this figure does not represent the capitalization of the market, since only a fraction of these stocks are traded or, at least, in demand.  During the first three quarters of 2001, a total of $ 1,3 billion worth of stock was issued. Of this, only 24 percent represented real financial inflows (the other 76 percent represents re-registration of existing entities.)



 

Government Bonds, T-Bills, municipal Bonds

After the crisis of 1998, municipal bonds are not actively traded on the market. Only a couple of cities, tourist centers on a seaside issued them for improving the local infrastructure: hotels, beaches, roads.  Government securities are traded mainly between government agencies and large companies, they also may be used by buyers for tax purposes.  For example, commercial bank decided to buy a certain quantity of T-Bills, but because profitability did not exceed real inflation rate, bank instead of trying to sell, might use them to pay taxes. Recent tendencies shows that this type of securities becoming more and more popular: two debuting sessions resulted in $40 millions of sales. 

 

    General analysis of Ukrainian capital market shows paradoxical results: while state attempts to follow  American model, attracting private investors, de-facto market is completely closed and tries to reach German/Japan model. The reason for this is not close relations among subjects and objects of the market, but unwillingness of owners to disclose and sell stock to the public because of fear of losing “control” over the company.  As it happens, all profitable enterprises were acquired, partially, or completely, illegally and competition with potential investor, whether it could be small national or a large west investment fund,  may lead to the change of ownership. On  the other hand, no government law can force an individual to buy stock without any perspective to gain a profit, as it take place with majority of traded on market securities. Nominally, all of them are Growing, because no issuer promises to pay a dividend, and income is expected only from difference between present and future prices. But because almost all deals are also nominal, changes in prices and changes in stock indexes can not be taken seriously.  What does it mean “nominal deal” ? Stock market is not abstract, but concrete place, where people earn money from margin. But, because availability of profitable or growing stocks is small, prices of junk stocks have been increasing artificially:  traders sell them to one another imitating investing activities and waiting for real outside buyer. In addition, PFTS Stock Trading System’s officials are also interested in such an imitation, because it creates an image of  working and profitable system.

   

    Among other problems, Ukrainian capital market faces with,  industry specialists distinguish: 

1.   “Flawed investment climate” and the high risk of investing.

2.    Unfinished privatization in many joint stock companies that delude potential investors. (The total charter capital of privatized   companies, with at least 70 percent of a company privatized, is 14 percent of the total charter capital of all companies.)

 3.   “Lack of domestic investment funds, that is, the absence of cash among most  citizens.”

 

   Recommendations how to solve the above mentioned problems can be found in any book on economics; simply, they can be described as “make it different”: improve investment climate, finish privatization… Unfortunately, these banal recommendations require complex scientific approach and hard work, they conflict with interests of many political and economic groups; most likely, they will be dissolved in numerous laws and decrees.  In addition, from historical experience, any change should be simple and crucial, like revolution in Russia. 

     I would like to discuss the most important and easiest to implement solution: to create transparent and effective technology of ownership. Companies must have market value and buyers should pay for it, no more and no less. In general, on capital market, this action does not differ from that on any other markets; the only thing to do in Ukraine is to establish rigid rules how to became an owner: how to evaluate an assets, how to issue stock, how to sell, how to register a deal. Still, legislation is approved for a marketplace  itself, but not for traders and objects of trade. Could you imagine a customer who knows everything about planning, supply chain, management of the nearest supermarket but have no idea how to buy food there ? Moreover, that food could be sold at different prices, depending on personal decision of management.

     For example, highly profitable and largest Ukrainian and European manufacturer of tires “Rosava” was sold for a book price of $ 400 millions, market price, however was, at least $ 2 billions; results were announced 4 days after the deal; deal was proven to be legal.  If such deals like this will appear again, Ukrainian capital market would play the role in future, it plays now: just legally approved place for registration of ownership. It means, that first reason why companies come into capital market in Ukraine is to register changes in ownership, because according to civil law it should be done there: on PFTS Stock Exchange, on local exchanges.  But without the exact knowledge how these changes were made, this registration is useless, moreover, it undermines the image of the capital market as a whole. 

    Transparent ownership legislation will make possible to determine strategy of developing of the capital market, to evaluate which model exists or must exist in Ukraine. Whether we should continue attracting small shareholders, thereby attempting to stimulate cash flow from personal savings into industries (USA model of capital market), or preference should be given to financial groups, as it takes place in Germany or Japan. The structure of ownership will show whether sources of company’s financing are public or not, whether it would borrow from stockholders or somewhere else.  

     Second role, the Ukrainian capital market could play, is to be the marketplace for international companies willing to buy stocks in relatively cheap local firms. Although this role requires much broader and separate discussion about investment climate in Ukraine, importance of such marketplace is difficult to underestimate.

 

    A foreign investor contemplating doing business in Ukraine should anticipate a legal and regulatory framework that extends into each area of activity or endeavor.  A notable characteristic of this framework is characterized by two features. The first feature is that Ukraine's laws, particularly in the commercial sector, are still in a relative state of flux. This means that changes to laws and regulations occur on a very frequent basis. The second feature is that, as a result of this state of flux, there is often conflict between (and even within) different laws, regulations, decrees, etc. Such conflict and inconsistencies can also be experienced in Western countries, but with far less frequency. As a result of the conflicts that are generally inherent in the Ukrainian legal framework, precise and definitive interpretation of a particular point or legal concern can often be difficult to obtain.

   Traditionally, Ukraine was always described as a country with a "code-based" legal system that is generally found in continental Europe (in contrast to a common law-based legal system found in the UK, Canada and the USA). Many experts also describe it as being close to Latin-American legal system. Unfortunately, these seemingly comfortable descriptions fail to reflect the real situation where Ukraine's legislation consists of several relatively stable codes and numerous laws and regulations. Certain areas, like Accounting Regulations,  are particularly prone to inconsistencies and conflicting provisions, appearing with increasing frequency since 90-s.  The reason for this is inability of  Government to provide sound economic politics and its desire to create conditions, under which collection of taxes and penalties would be easiest and most effective.  In addition, total number of institutions, engaged in all those kinds of activities, which can be described as tax/penalty collection, exceeded that of party and state organizations under communism. Accounting became the most unstable, most confusing, and even most expensive part of  business; thousands of employee waste working time, studying new standards, laws and decrees. However, tactically, this Governmental approach is perfect, because it fills  state budget and feeds, for example, millions of pensioners or 40% of population.

   The newest example, illustrating state fiscal policy, is a procedure of adoption of International Accounting Standards this year. Theoretically, this would enable companies to cut financial statements preparation costs, especially in case of consolidating financial statements of enterprises that have operations in different countries. But in practice, this led only to mechanical changes in names and quantity of accounts; inconsistency between Ukrainian and international standards remained on the same level. Enterprises, however, spent giant sums of money, training employees at state educational centers, buying new literature, paying penalties and losing productive time.

 

Main differences between Ukrainian and International Accounting Standards.

   

Low-Value Assets

Until now the Ukrainian accounting standard on inventories includes the term “low-value assets” (it may be some objects of furniture and fixtures, computer equipment, instruments and so on). In spite of the fact that their useful lives may equal several years (3, 5 or even more), their value may be written off in accordance with the entity’s accounting policy, for example, at the moment of putting them in production. It may seem ridiculous, but the IAS balance sheet may include a rather large amount of fixed assets while the Ukrainian balance sheet may include a very small amount or even nothing. This is because of the significant accumulated depreciation and immediate expensing of low-value assets. Initial value of low-value assets cannot be revalued and so they can’t be impaired.

 

Asset Measurement

According to Ukrainian accounting principles, assets should initially be measured at their cost, that is on historical basis. Their historical measurement can’t be changed except for the following: capitalizing of subsequent expenditures for property, plant and equipment or diminishing their initial value in a case when part of the equipment is put out of use. Until now there is no special standard on intangible assets, they could not be revalued, their amortization could not be changed, they could not be estimated annually and there could be no recognition of impairment of  intangible assets.  In addition, fixed assets’ useful lives cannot be changed and depreciation costs and the net book value are formed on the basis of their useful lives, as set by the Government.  For example, according to the accounting regulations, useful life for computer equipment is equal to 10 years, but in reality it should be much lower and this type of equipment is usually being written off faster under IAS.

 

Hyperinflation and Lack of Adequate Disclosure

Being prepared on historical cost basis of accounting, Ukrainian financial statements ignore the effect of inflation, though the economy suffers from it; only property, plant and equipment could (but usually would not) be revalued. As a matter of fact, throughout the 1990s property, plant and equipment and their depreciation were revalued several times on the basis of adopted indexes, but without revaluation on the replacement basis, their balance-sheet value cannot be considered as fair. Finally, there is difference between Ukrainian accounting standards and the IAS, concerning disclosures. Ukrainian accounting legislation does not contain such a wide range of items requiring disclosure of  financial statements, which in turn, are very rarely presented to the public. As it was mentioned above, lack of transparency of ownership and financial activities of companies is one of the most  serious obstacles in developing of the capital market in Ukraine.

 

    Of course, analysis of national accounting principles is impossible without brief description of taxation policy in country. A legal entity in Ukraine is required to pay tax  at rate 30% of profit. However, income from certain activities is subject to higher rates of taxation; e.g. income derived from brokerage operations (40%), and lotteries, casinos and other gaming and gambling businesses (60%).

    Transactions involving the sale or realization of any goods, labor or services in Ukraine are subject to value added tax (VAT) at a rate of 20%. VAT is calculated and paid on the basis of the value added at each level of production. VAT must be remitted on the difference between the VAT received from purchasers and that paid to suppliers and with respect to other production costs. 

     Disposition of certain  relatively expensive or popular items (autos, furs, coffee, alcoholic drinks, beer, tobacco) is subject to excise tax.  In addition, an enterprise pays municipal, industry’s  (e.g., “exploitation of land resources” for mining), special (Chernobyl, road construction) taxes at a total rate 5-15% of income. The terms “income before taxes” and “expenses” are rigid, their calculation is standardized and penalties for violations in calculation of taxable income generate 5% of state budget. Financial accounting data are used primarily for tax reporting purposes (in 93% of all legal entities) and for the safe-keeping of assets (33%).

    Tax avoidance is high and estimated 50-70% of GNP. For majority of specialists this is one of the most important economic problems and their recommendations are varying from decreasing of taxes to strengthening of state control. Another statistical data are missing, however: proportion of tax generating enterprises. Among them, only 20% are private companies, another 80% are legacy of Soviet economics, industrial giants, fully controllable by Government:  metal plants, refineries, food processing factories, etc. Avoiding taxes in this field is impossible without approval of state officials. Problem, therefore is not in high rates or low control, but again in the lack of transparency of companies’ financial activities and ownership. Certainly, it is possible to name other problems and their possible solutions, but all of them are minor. Major is business itself.    

    For example, some people may propose decrease taxes. I am entrepreneur and know that those who didn’t pay, wouldn’t pay anyway, because any sum is greater then zero, especially with the ten years’ experience of tax avoidance. So, tax collecting should be strengthened. Yes, but it’s already rigid, additional pressure means additional  budget costs and …nothing more.  Of course,  to the great extent, tax rates are important, but the most important is possibility of doing business normally, without perpetual conflicts with law and tax authorities. 

    Accounting is essential for any business, perfect (at a given point) accounting standards create a basis for stable and profitable work. I can’t claim, that IAS are perfect, or they are key for solution of all economic problems. But because successful businesses use them, it’s make no sense to keep old or create something new (especially every quarter) in Ukrainian accounting standards. Simple, but complete adoption of IAS will remove artificial obstacles for companies (inconsistencies in financial regulations), relieve working force from useless operations (e.g., double bookkeeping of documents for financial, VAT and tax accounting )  and create transparent business environment (disclosure of financial statements on financial market, impossibility to avoid taxes due to announcing of financial results, etc).   

   

    Development of financial market and accounting regulations are two most important factors for Ukrainian economy to succeed.  While the first ensures proper financing of business, the second is a basis for its normal functioning, and they both suffer from instability and confusing legislation. It sounds paradoxically, but highest economical growth in Ukraine was reached right after the removing of ideological barriers in economics. Just imagine: all legislation remains communist, all accounting standards and tax regulations are still applicable only for state enterprises, but a giant number of private companies appear and work in this seemingly unfriendly environment. This environment, however has a great advantage: it is stable and predictable. And only thing to do, is to apply international experience. Unfortunately, Ukrainian Government, still provides communist economics politics. The core of this politics is not in ideology, but in desire to control everything in the country, especially cash flow. Undoubtedly, this is essential for surviving of certain economical groups, but it’s fatal for business. The nature of Ukrainian economy satisfies all requirements for successful development, confirmation for this is that economy still works and grows (since 1990, this year is first positive growth of 2%.)  The best example is my company, which sells industrial equipment and have 14 employees.  Among those, 2 are accountants, although under Soviets or with IAS,  one would be more then enough.  This is because we should work in perpetual cooperation with state tax administration, pension fund, state insurance company, state statistic administration, tax police, economic police, customs, fire department, etc: monthly, quarterly, semiannual, annual reports, audits, statements.

Minor changes in forms of financial reports and other documents appear each month, and in order to avoid fines and penalties accountants cooperate informing each other current news. Recent example: changes in the form of payment order.  This is a document for monetary transaction, which remained unchanged almost 50 years. Now somebody decided to eliminate certain figure from it and obliged all enterprises to introduce new form in 4 days. Even such a small company as my, makes at average 6 transaction per day; upgrading accounting software means losing, at least 4 hours of working time, money for upgrade and business opportunities if it’s a big, dynamic company.  How, do You think, West financial market would feel in this situation ? Nevertheless, we still work and make profit. Taxes, experience, competition in this respect are not so important, opportunity to work in predictable environment and to use stable, perfect accounting standards is crucial for business success. This will lead also to proper financing of business (i.e. development of financial market), because removing uncertainties in accounting regulations means also removing uncertainties and risks in business. Banks or shareholders will know to whom they lend money, companies will do they job, state will help all of them and receive some reward.

  

 

 

 

                                                                                                Spivak Mykhaylo

 

 

 

   

 

Sources

 

 

1.      International Center for Accounting Reform, http://www.icar.ru

2.      Ernst&Young, Kiev Beacon Monthly Newsletter on Legislation, Affecting Business in Ukraine, http://www.eycis.com

3.      Deloitte&Touche,  “TaxBreaks Ukraine”, weekly overview http://www.deloitte.ru

4.      USA Business services for NIS, BISNIS news and publications about Ukraine,  http://www.bisnis.doc.gov

5.      Arthur Andersen, “Doing business in Ukraine”, Legal News,       

      http://www.arthurandersen.com/website.nsf/content/EuropeUkraineResources

6.      McKinsey,  “An economic Iron Curtain”  http://www.mckinseyquarterly.com

7.      KINTO Investments & Securities, Ukrainian Stock Market Weekly Review. http://www.brama.com/

8.      Ukrainian financial server, news and publications about Ukrainian financial market http://www.ufs.kiev.ua

9.      USAID, current activities and analysis of situation in Ukraine 

       http://www.usaid.gov/country/ee/ua/        


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