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. Last Updated: 07/27/2016

Financial Disclosure: What Is to Be Done?

Transparency and disclosure of information are among the most important principles of good corporate governance. Disclosure of financial information is of paramount importance for both the shareholders of an enterprise and for potential investors.

The Institute of Corporate Law and Governance, during the preparation of corporate governance ratings for 30 major Russian companies -- whose combined capitalization accounts for almost 90 percent of total market capitalization -- conducted a detailed analysis of the level of financial disclosure of these companies and of their auditors' reports. This analysis yielded some interesting results and conclusions.

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The single most important improvement in companies' corporate governance records in 2000 and the beginning of 2001 has been in financial reporting. In more than half of the companies rated by ICLG there have been improvements in financial accounting; moreover, five of the country's largest companies (Yukos, Sibneft, Gazprom, LUKoil and UES) published financials in 2000 that conform to U.S. GAAP or International Accounting Standards. In 2001, many major companies started publishing their accounts according to IAS (or U.S. GAAP) not only at the end of the financial year, but also every half-year and even every quarter.

However, our research also shows that, in the majority of cases, public companies tend not to disclose in their financial statements all the important facts of their business activities. As a result, investors or potential investors are not provided with sufficient information to make well-grounded decisions on whether to invest in a company or not. Thus, for example, not one of the 30 companies released accounts in which the attached explanatory notes conformed to Finance Ministry requirements. It is the job of a company's auditor to draw investors' attention to such things, as comprehensiveness and clarity of financial information are the basis of any investment decision.

Only in Sibneft's audit by the accounting firm Arthur Andersen is it pointed out that the explanatory note does not include all information that is required to be disclosed by law.

The conclusion to be drawn from this is that there must be stricter monitoring of auditors' work, both by the Finance Ministry and by professional associations.

Currently, from the perspective of outside shareholders, a company audit is often little more than a waste of company funds, due to existing rules that unfortunately mean that shareholders are only entitled to read audit report conclusions -- containing the auditor's judgement on the validity of the company's accounts. The most informative part of an auditor's report is the analytical section, which adduces all accounting and legal violations uncovered by the auditor. And this only goes to the company's top management.

Thus, you have a somewhat peculiar situation in which those who have committed violations are the only ones privy to information regarding those violations -- and moreover, at the expense of all the shareholders.

This is graphically illustrated in Inaudit's audit report of Lenenergo accounts for 2000: "The accounts presented conform to accounting principles etc. ... Proposed recommendations, comments and corrective account entries, made on the basis of the audit, are contained in the reports sent to the executive board."

The obvious conclusion to draw is that the analytical section of audit reports should be made available -- at the very least -- to members of the board of directors, and preferably to all shareholders.

The absence of strict requirements regarding what should be included in an audit report means that investors do not have a clear idea of what information they should expect to find in an auditor's report.

Thus, for example, PricewaterhouseCoopers in its audit of AvtoVAZ's accounts for 2000 notes the unsatisfactory financial state of the company, but does not do this apropos of Gazprom in its audit report for the same year. Another example concerns the well-known accounting firm Yunikon/MC, which apropos of Bashinformsvyaz's accounts for 2000 states:

"The conducted audit has uncovered shortcomings in the system of internal control, accounting and observance of current legislation. ... In our opinion, the accounts, with the exception of the abovementioned points, are valid; that is, they are prepared to ensure the statement of assets and liabilities in all their substantive aspects."

So in short, everything was fine except for the fact that the accounts violate established rules, monitoring is not being carried out effectively and there are legal violations.

In our opinion, normative requirements for the conclusions to the audit report should be precisely formulated and approved; in particular, concerning the answers to certain questions that should be mandatorily included.

Being principled as an auditor seems to carry certain risks. For example, PwC in the conclusions section of its audit of Rosneft-Purneftegaz for 1998 quite rightly draws attention to the fact that "the company's current obligations significantly exceed its current assets" and that "deals are concluded to the benefit of Rosneft." (The application of transfer pricing.)

At the next general shareholders' meeting, at the instigation of the disgruntled controlling shareholder of Rosneft, a decision was approved to change Purneftegaz's auditor -- replacing PwC with Arthur Andersen. The latter has issued positive audit reports for 1999 and 2000 without any commentary or reservations. This is in spite of the fact that research conducted by ICLG suggests that in 1999 and 2000 the above-mentioned risks not only continued to exist, but actually increased. In 1999 and 2000, Rosneft not only purchased oil at transfer prices, but also bought from Rosneft-Purneftegaz the majority of its assets and now leases them to the company.

A possible solution would be the introduction of a system of mandatory annual rotation of auditors, in order to increase the independence of accounting firms from the companies they audit.

In conclusion, audit reports cannot provide investors or creditors with detailed and complete financial analysis of a company's accounts. This function can and should be performed by other bodies, independent both of the companies and the accounting firms. For example, by ratings agencies and investment analysts, although there are also serious questions regarding the objectivity of the latter.

However, there is also room for improving the quality of audit reports, primarily by changing the rules on what is to be included in the report and by raising audit standards. Stricter monitoring of auditors' work could also play an important role.

I believe that we need to focus on the "What is to be done?" rather than the "Who is to blame?" in order to improve both the level of financial disclosure and quality of audit reports.

Dmitry Vasilyev, former chairman of the Federal Securities Commission, is executive director of the Institute for Corporate Law and Governance. He contributed this comment to The Moscow Times.