Financial Management in Transitional Economies · ST/ESA/PAD/SER.E/15 Department of Economic and...

ST/ESA/PAD/SER.E/15

Department of Economic and Social AffairsDivision for Public Economics and Public Administration

FINANCIAL MANAGEMENT INTRANSITIONAL ECONOMIES

United Nations • New York, 1999

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FOREWORD

The United Nations General Assembly, in itsresolutions 48/180 and 48/181 of 21 December 1993,encouraged the relevant bodies of the United Nationssystem to foster the environment for entrepreneurship,privatization, demonopolization and administrativederegulation, and to provide policy advice andtechnical assistance to the countries with economies intransition towards their integration in the worldeconomy. Economies in transition include thecountries of Central and Eastern Europe and theformer Union of Soviet Socialist Republics (comprisingthe Baltic republics, the Commonwealth ofIndependent States, and Georgia).

The Department of Economic and Social Affairs of theUnited Nations has sought to assist economies intransition, particularly in the areas of resourcemobilization, public expenditure management andprivate sector development, by a programme ofresearch and publication. At the heart of the transitionprocess is institutional change, not merely change offormal ownership, but a complex and many-facetedprocess of transformation. One of the pillars of amarket economy is use of the commercial calculus inproductive organizations. From their formerpreoccupation with physical quotas, enterprises areadopting and adapting foreign commercial practices inthe appraisal, management, accounting and monitoringof resource allocations, and in the development of newinstitutional structures and processes in finance, lawand taxation. Most of the countries in transition haveliberalized trade and prices and privatized small-scaleunits; much less has been achieved in large-scaleprivatization, enterprise restructuring and financialsector reform. This publication focuses on thechanging role of financial management in these

economies and the factors assisting in or inhibiting itsdevelopment.

Financial management refers first to the institutionalstructure and processes of budgeting, accounting,reporting, evaluation and audit at the micro- ororganizational level, which subdivides into banks, non-banking enterprises and government agencies.Secondly, financial management refers tomacroeconomic issues concerning money supply anddemand, interest rates, control of inflation, trade andthe balance of payments, and associated fiscal issuesconcerning the pattern of public expenditure, internalrevenues, external resources and debt. The contributorsto this publication focus, first, on strategic financialmanagement issues with regard to banking reform,property rights and microeconomic governance, publicexpenditure and revenue, and external financialrelations and, second, on technical and professionalfinancial management issues. A final chapter providesan overview of the main themes.

We are grateful to the consultants who preparedchapters I and II of the publication, Dr. BimalProdhan, Dr. Michael Kaser and Professor MaureenBerry respectively. The publication was completed andedited by staff of the Public Finance and EnterpriseManagement Branch of the Division for PublicEconomics and Public Administration.

Guido Bertucci, Director Division for Public Economics and Public Administration Department of Economic and Social Affairs

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NOTES

The designations employed and the presentation of material in this publication do not imply theexpression of any opinion whatsoever on the part of the Secretariat of the United Nations con-cerning the legal status of any country, territory, city or area or of its authorities, or concerningthe delimitation of its frontiers or boundaries.

The designations “developed” and “developing” economies are intended for statistical con-venience and do not necessarily express a judgement about the stage reached by a particularcountry or area in the development process.

The term “country” as used in the text of this publication also refers, as appropriate, toterritories or areas.

The term “dollar” normally refers to the United States dollar ($).

The views expressed are those of the individual authors and do not imply any expression ofopinion on the part of the United Nations.

The abbreviated references which appear throughout the text are listed in full detail under“References” at the end of each chapter. Footnotes are numbered by chapter.

Enquiries concerning this publication may be directed to:

Mr. Guido BertucciDirector

Division for Public Economicsand Public Administration

Department of Economic and Social AffairsUnited Nations, New York, N.Y. 10017, USA

Fax (212) 963-9681

TABLE OF CONTENTS

Page

Foreword . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . i

Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ii

I. Strategic Financial Management Issues in Transitional Economies

1. The meaning of transition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11.1 Transition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11.2 Strategic financial management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21.3 The speed of transition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

2. The inheritance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32.1 The institutional environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32.2 Financial planning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42.3 Payment systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52.4 The fiscal system . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52.5 Accounting systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

2.5.1 Valuation bases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62.6 Financial data for monitoring performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62.7 The financial inheritance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82.8 Sequencing of reforms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

3. Banking reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113.1 A two-tier banking system . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113.2 Interdependence in the banking system . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113.3 Solvency issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

3.3.1 Capital adequacy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123.3.2 Loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123.3.3 Inter-enterprise indebtedness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133.3.4 Deposit insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133.3.5 Withdrawal of licenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143.3.6 Subsidies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143.3.7 Interest rate and exchange rate management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

3.4 Liquidity issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153.4.1 Payment system reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153.4.2 Capital markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

3.5 Competition and supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153.6 Bankruptcy reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163.7 Legality and financial governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

4. Property rights and microeconomic governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194.1 The politics of ownership concentration and dispersion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194.2 Entitlement as property rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204.3 The economics of ownership dispersion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214.4 Establishment and delineation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

4.4.1 The East German property transfer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224.4.2 Restitution and compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234.4.3 Registration and exchange of title . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

4.4.4 Privatization procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254.5 The finance of privatization and restructuring . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

4.5.1 Enterprise valuation and disposal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264.5.2 Enterprise governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284.5.3 Enterprise finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

4.6 The insidious spread of crime . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

5. Public expenditure and revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315.1 Transforming the tax base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315.2 The magnitude of taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325.3 External standards for taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335.4 The tax regime for foreigners . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 355.5 The reform of individual taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

5.5.1 Personal income taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365.5.2 Property taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375.5.3 Corporate taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375.5.4 Value-added tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375.5.5 Payroll tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 385.5.6 Customs and excise duties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

5.6 Government expenditure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

6. External financial relations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 396.1 Trade, tariffs and subsidies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

6.1.1 States remotest from developed market economies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 406.1.2 The Russian Federation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 426.1.3 The States of the ex-Yugoslav Federation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 436.1.4 The States with “Europe Treaties” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 446.1.5 The Eastern Länder of Germany . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

6.2 The establishment of new currencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 456.3 Exchange rate stabilization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 466.4 Capital movements and international grants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

7. Summary and conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

II. Technical and Professional Financial Management Issues in Transitional Economies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

1. The banking sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 541.1 Banking sector reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 541.2 Unitary banking systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 551.3 Creating a two-tier structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 561.4 Bank accounting and reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58

1.4.1 Bank accounting and reporting in the Russian Federation . . . . . . . . . . . . . . . . . . . . . . . 591.4.2 Bank accounting and reporting in Poland . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60

1.5 Bank financial reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 611.6 Computerizing the banking sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 621.7 Attracting foreign capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 631.8 Restructuring and consolidation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 631.9 Bank supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65

1.10 Training needs and approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 661.11 Training through twinning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 681.12 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70

2. Non-bank enterprises in transition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 702.1 State enterprises in transition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 702.2 Changing the basic accounting model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 722.3 New accounting regulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 732.4 Accounting reform in China . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 742.5 Utilizing accounting information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 742.6 Structural reform of State-owned enterprises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 752.7 Valuation rationale and issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76

2.7.1 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 762.7.2 Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 762.7.3 Machinery and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77

2.8 Accounting and stock market development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 772.9 Stock markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77

3. Professionalism of the accounting and auditing functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 783.1 The rebirth of accounting and auditing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 783.2 The auditing profession in the Russian Federation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78

3.2.1 First steps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 783.2.2 Market expansion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78

3.3 Auditing in China . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 793.4 The auditing profession in Poland . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 803.5 Summary of the status quo . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 823.6 Professional examination requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83

3.6.1 Poland . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 833.6.2 The Czech Republic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84

3.7 Accounting and auditing education . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 843.8 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85

4. Financial management in government . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 864.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 864.2 The budgeting function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 864.3 Planning techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 874.4 Financial planning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 874.5 Budgetary accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 894.6 Budgetary reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 904.7 Budgetary auditing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 914.8 Fiscal auditing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 924.9 Summary of financial management inadequacies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 924.10 Evolutionary status . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 934.11 Restructuring the budgetary process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 934.12 Diversifying budgetary revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 944.13 Revenue-sharing considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 944.14 Privatization proceeds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 944.15 Tax reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 954.16 Planning budgetary expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 964.17 Budget restructuring . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 974.18 Budgetary accounting reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 984.19 Polish budgetary accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99

4.20 Budgetary reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1004.21 Computerization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1004.22 Fiscal auditing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1014.23 Government auditing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1014.24 Training in the role and practice of governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1024.25 Future directions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103

5. Summary and conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104Tables

1. Some essential differences between institutional arrangements in plannedversus market economies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106

2. Comparative charts of accounts for banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1073. Main chart of accounts sections and off-balance sheet accounts for

the Russian Federation commercial banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1084. Example of commercial bank balance sheet in the Russian Federation . . . . . . . . . . . . . . . . . . . 1095. Balance sheet format for Polish commercial banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1126. Income statement format for Polish commercial banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1137. Listing of off-balance sheet accounts for Polish commercial banks . . . . . . . . . . . . . . . . . . . . . . 1158. Charts of accounts for five countries with transitional economies . . . . . . . . . . . . . . . . . . . . . . . 1169. Format of the Russian Federation balance sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11710. Core accounting courses offered at selected Polish universities . . . . . . . . . . . . . . . . . . . . . . . . . 11911. Examples of accounting course listings at the Universities of Gdansk and Lódz . . . . . . . . . . . . 12012. Evolutionary stages of governmental financial management systems . . . . . . . . . . . . . . . . . . . . . 12313. Polish public sector charts of accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12414. Audit powers of tax administration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12515. Penalties for various tax offenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127

III. Overview and conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129

133 1. Accounting reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1312. Banking reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1333. Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137

I. STRATEGIC FINANCIAL MANAGEMENT ISSUESIN TRANSITIONAL ECONOMIES

1. The meaning of transition

1.1 Transition

All countries are, in some ways, in transition—fromlow to more intense economic development, fromagricultural to industrial wealth-creation, from whiteor male dominated societies towards the offer of equalopportunity for all. But the sense in which “transition”is applied in the present paper (which constituteschapter I of this publication) is the transformation ofan economic system from centralized administration toa decentralized market. Neither the starting point northe expected destination are homogeneous—thecommand economy embraced a Soviet-type andChinese, Vietnamese and Yugoslav variants, while themarket economy differs in, say, the United States,Japan and Germany. For the reasons discussed belowin this section, the starting model is of the Soviet type.Financial management at micro- and macroeconomiclevels is crucial to the change because in the Soviet-type system the holding of money or other financialassets did not determine real resource allocation in themanner that it patently does within markets—subjectto a governmental and regulatory environmentintended to promote the common good).

The transitional economies examined in this paper arethose in which until 1989-1991 a single partyorganization held a political monopoly and the Stateadministration had the power to allocate the majorityof economic resources, and in which subsequentdevelopments have been in the direction of politicalpluralism and of private-sector decision-making within“wellfunctioning” markets. Neither the system,beingabandoned nor the future goal can be uniquely definedbut the former can be considered of the reasonablyhomogeneous “Soviet-type”. In the 30 States definedhere as “transitional”, half (the 15 Union-Republics)were part of the Union of Soviet Socialist Republicsuntil late 1991, and in all the others the Sovietauthorities had been instrumental in establishingeconomic institutions immediately after the SecondWorld War. Country histories were not, of course,uniform: Mongolian political autocracy was establishedin the 1920s, two decades before the country adopted aSoviet-type economy; Yugoslavia and the USSR broke

politically in 1948 and Yugoslav enterprise self-management began in 1950 to explicitly differentiateits system from the Soviet type; the Albaniangovernment renounced Soviet suzerainty in 1960 anduntil 1978 looked to China for economic inspiration; in1968, Hungary legislated for economic management tobe based on allocations at the State-enterprise, ratherthan the central plan level. From the mid-1960spolitical diversity erupted and was generally repressed,but economic liberalization increased during the 1980s(notably in Hungary) and it was the free Polishelections of 1989 which turned the political tide.

The “destatization” of both political and economicactivity is broadly perceived as permitting democraticand private enterprise forces to assert themselves, butthose forces had so long been dormant, distorted ornon-existent that positive action had to be taken toestablish the institutions of a “civil society” and of amarket mechanism. It is obvious that transformation istaking place in those 30 countries and in all othercountries which can conventionally be termedpolitically “communist”; it is less clear whether all the“transitions” are towards the models currentlyestablished in industrialized market economies, asRose (1994) argues. Certainly the pace of changevaries widely, as is shown by an attempt to quantify itby the European Bank for Reconstruction andDevelopment (EBRD, 1994b). Twenty-five “countriesof operation” are considered on a scale with amaximum value of four, according to six criteriaembracing the degree of privatization, liberalizationand financial institution-building. Although noneachieves the maximum of 4 in each category, fivecountries merit combinations of 3 and 4 marks: theCzech Republic, Estonia, Hungary, Poland andSlovakia. Eight countries show a range from 2 to 4:Bulgaria, Croatia, FYR Macedonia, Kyrgyzstan,Latvia, Lithuania, Romania and Slovenia. The remain-ing ten in the EBRD fold are shown to be still close tothe starting post, exhibiting at least one score of 1:Albania, Armenia, Azerbaijan, Belarus, Georgia,Kazakhstan, Tajikistan, Turkmenistan, Ukraine andUzbekistan. Outside the EBRD listing, the EasternLänder of Germany (the former German DemocraticRepublic) would doubtless rank 4 on all counts;

2 Financial Management in Transitional Economies

Mongolia is likely to fall in the EBRD’s majority cate-gory (i.e., 2 to 4) and Bosnia-Herzegovina,Montenegro and Serbia are virtually precluded frompurposive institutional change while the present dis-turbed conditions persist.

This paper draws examples from 29 States and oneregion (of Germany) for the analysis of strategic finan-cial management in conditions of systemic transition.Examples may also be valid from countries where theprevious communist economic model is being altered,sometimes radically, but without fundamental politicalrestructuring. The great enlargement and dynamism ofthe private sector in China and Vietnam (which beganin 1978 and 1986 respectively) require analysis, butsimilarity with the thirty post-communist transforma-tions is limited. Two other countries adopted a Soviet-type economy together with a monopoly party in thecommunist mould, Cuba and the Korean DPR: neitherhas significantly changed the parallel structures, butthey have been modified. In the economy, Cubandomestic market liberalization and Korean establish-ment of a foreign economic zone are measures whichhave been taken in transitional countries discussed inthis paper.

1.2 Strategic financial management

The economic system inherited by the transitionalStates did not require monetary instruments at themacro level and constrained the use of money to flowsbetween the enterprise and household sectors, andbetween households at the microeconomic level. As aresult, almost every step in systemic transition involvessome new role for money, and the strategy for intro-ducing those functions virtually embraces transition asa whole. Every transitional government has decon-trolled the majority of wholesale and retail prices.However, the maintenance of some price controls(notably in the Russian Federation, Ukraine,Uzbekistan and Turkmenistan) has vitiated theapplication of other measures. But in all countries,price signals arising from the interaction of demand,supply and expectations thereof are increasinglydetermining resource allocation.

Strategic financial management at the microeconomiclevel relates to property rights, entitlements and incen-tives and at the macroeconomic level to systemic riskin financial intermediation, savings, inflation andexchange-rate stability. It relates also to the conven-tional differentiation of the “money” economy from the

“real” economy, which may be seen as a crucial factorin the transition, because the Marxist theory to whichthe rulers of the Soviet-type economy adhered,endowed the difference with a political interpretation.Marx claimed that the capitalist class which operatesthe market economy obscured its exploitation of theproletariat behind a “veil of money”. The circuit oftransactions concealed the alienation of labour fromtheir entitlement to the product they generated beyondtheir subsistence needs. Once a socialist State hadtaken over the means of production, distribution andexchange, no such “veil” was needed and money couldbe merely the “passive” accountancy of State decisions.Because State distribution could not be achieved, until“full communism” (“from each according to his ability;to each according to his needs”), under “socialism”(“to each according to his work”), some money had tobe “active”, that is, for incentives to work and for thechoice among consumer goods and services.

The first Soviet government seized the opportunity ofthe hyperinflation induced by the chaos of the civil war(1917-1920) to disregard altogether the money mecha-nism for both “passive” use—Lenin saw the national-ized economy as “a single office and a singlefactory”—and in “active” transactions; as theChairman of the Comintern, Grigory Zinoviev,declared in 1920: “we have a way out ... the completeabolition of money. We pay wages in kind, weintroduce free trams, we have free schooling, freethough at present bad-meals, free housing, lighting andso on”.

In adopting a simplistic view of economic relation-ships, Lenin based himself on Engels’ model of asocialist society:

“The proletariat seizes State power and begins by turn-ing the means of production into State property... Thegovernment of persons is replaced by the administra-tion of things, and by the conduct of the processes ofproduction.”

Confronted by worsening hyperinflation and the break-down of the food supply from a still-uncollectivizedpeasantry, Lenin partially surrendered to the market inhis “New Economic Policy” (NEP) of 1921, reintro-ducing a money mechanism and some of the propertyrights abolished under what came to be called “WarCommunism”. But the return was short-lived (Lenindied in January 1924) and the eventual form of theStalinist economy—from 1930 in the USSR and sometwo decades later in Central and Eastern Europe and

Strategic Financial Management Issues in Transitional Economies 3

communist Asia—was closer to War Communism thanto NEP It diverted financial management out of thechannels employed in a market economy in three ways:

• Property rights in land, other natural resources andreproducible capital were expropriated by the Stateand their use was hence allocated by agents(usually, directors of State-owned enterprises)whose principals (typically, planners and ministers)were not motivated by profit;

• The prices which State-owned enterprises paidamong themselves and charged to households andcollective farms were administered and unchangedfor long periods, largely irrespective of changes inrelative costs;

• The money which enterprises used for transactionsother than wages and trivial supplies was not fungi-ble into the money used by households and collec-tive farms.

Each of these principles was logical enough whenapplied within a command economy, but their incon-gruence with those of a market system was alreadydemonstrated in foreign trade (which was one of thereasons why Stalin drew the Soviet economy intoautarky). Post-Stalin governments sought greater eco-nomic efficiency by dismantling a few of the economicinstruments without divesting themselves of a monop-oly of political power.

1.3 The speed of transition

The necessary political changes have been undertakenin 30 States, the range of whose per capita GDP iswide—from Mongolia at one end to the CzechRepublic and the Eastern Länder of Germany at theother. Even at the wealthier end, growth has far togo—threefold if Eastern Germany is to catch up withGDP per capita in Western Germany. In most of thecountries considered in this paper political change hasbeen so thorough as to permit the levelling of theState’s ownership and control down to the norm of therich market economies. In some, hostilities, or theirthreat, have perpetuated a high degree of Stateintervention and postponed decontrol of prices,macroeconomic stabilization and systemic transition.But all have begun to operate financial management inmanners previously unused, i.e. the legitimate andefficient exercise of new property rights valued inmoney terms, which is the focus of this paper. The firststage—the activation of previously “passive”

money—is essentially complete, but many policy andinstitutional issues remain to be solved for financialmanagement to be profitably exercised by householdsand enterprises within a governmental and institutionalenvironment conducive to the common good.

The scale of the transition and the period within whichit is being accomplished is, however, unprecedented.The territory over which political revolution hasalready foreshadowed full systemic transformation ishome to 425 million people, of whom 190 million are,or were until the recent changes, gainfidly occupied.On the eve of those changes the private sector, despiteits toleration in farming and some lowering of barriersto it in the 1980s, generated no more than one-tenth ofthese countries’ aggregate GDP. By mid-1994 therewere 13 States in which the private sector generated 40per cent or more of GDP: Albania, Armenia; Bulgaria,Croatia, the Czech Republic, Estonia, Hungary, Latvia,Lithuania, Poland, the Russian Federation andSlovakia (EBRD, 1994, Table 2.1), to which Mongoliamay be added. Part of the change derived from theemergence and expansion of private entrepreneurs andfarms, part from the privatization of State enterprisesand decollectivization, and part from the entry offoreign firms into production and trade.

The speed of conversion to a market economy variesfrom rapid to deliberately hesitant, but the averagepace is historically quicker than in any but warconditions— a term appropriate also to the transitionfrom a market to a command economy undercommunist parties in the Russian Federation, EasternEurope and Asia. The much earlier transitions intocapitalist societies were never of a “shock” character.In Western Europe it took a century or more. OnlyJapan after the Meiji Restoration and the six dynamicAsian economies (Hong Kong, Malaysia, Singapore,South Korea, Taiwan and Thailand) have shown anacceleration of systemic change close to that of thepost-communist States.

This paper begins with an overview of the inheritancefrom the Soviet-type system, and successive sectionsconsider the transformation of the banking mechanism,property rights, the public accounts, and externalfinancial relations.

2.The inheritance

2.1 The institutional environment

The traditional Soviet-type economic system is best


described as one of centralized planning, implementedadministratively through the issue of direct commandsand extensive detailed instructions. Subordinates pro-vide information and suggestions that may greatlyinfluence commands, yet in principle they have littleautonomy in determining what to do, or even how todo it (Ericson, 1991, p. 12). The size is overwhelming;the State owns all natural resources (land andminerals) and almost all reproducible capital(buildings, machinery, equipment and inventories),and conducts virtually all activity in industry, mining,construction, transportation, wholesale trade,communications, health, research and development,and education. The Soviet State and collective sectorstogether produced over 88 per cent of the value of finaloutput in agriculture in 1986, controlled 98 per cent ofretail trade and owned 75 per cent of urban housingspace. Central control and the priorities of the politicalleadership were maintained through a vast andcomplex structure of overlapping administrativehierarchies that gathered information, disseminatedinstructions, coordinated interactions, managedchange, and monitored, commanded and enforcedperformance through agencies and branch ministries.

Commands, generally based on outdated information,became increasingly unrelated to each other in theprocess of disaggregation and elaboration. Operationalunits responded to assignments by requesting capitaland material resources, thus revealing some informa-tion about their capabilities, much of which was againdistorted in aggregation back up the hierarchy. All thisinvolved extensive bargaining, as the centralauthorities strove for maximum performance withthreats of punishment, while subordinates soughteasier tasks by pleading incapacity.

2.2 Financial planning

Alongside the planning of all physical economic activi-ty ran a parallel process of financial planning. TheMinistry of Finance drew up the State budget, whilethe State Bank drew up the credit plan, cash plans, thebalance of incomes and outlays of households, etc. Asalready noted, money had a very limited role, that offacilitating planned economic activity. Within the Statesector it was merely an accounting entry in the booksof the State bank. Money was only used physically forinteraction where the non-State sector was involved—in particular for wage payments and for consumerpurchases.

Prices had a limited and passive role—used primarilyfor measurement, and accounting and control purposes.Prices, wages, and salaries were administratively setand controlled by hierarchies, according to locationand subordination of the user and intended use, andremained fixed for a long time. Commodity prices weregenerally set on a cost-plus basis, and included plannedprofits, commodity-specific turnover taxes, and han-dling charges. They were meant to cover average costsof production in each branch of the economy, so thatenterprises might be “self-financing”.

The Soviet-type State enterprise had more of a commu-nal focus than a company has in market economies.Health care, training and recreation were often provid-ed for employees, and costs were usually computed soas to cover such services. Part of profits—or of autho-rized losses—was allocated to a fund which went undervarious titles (e.g. in the USSR, successively theDirector’s Fund, the Enterprise Fund and the IncentiveFund). These funds provided premium payments tomanagers and staff, funds for small capital works, sub-sidies for social facilities, and loans and grants toneedy workers. The latter provision was neededbecause social security was predominantly enterprise-based through the trade unions, and loans through thesavings banks were only for limited and specified pur-poses (such as house-building or buying consumerdurables).

Under what could be described as the “classic” Soviet-type system, the profits plan of a State enterprise wasreviewed every year. Like other constituents of a Stateenterprise’s overall plan, it derived from a set oftargets and allocations mostly designated in physicalunits. Finance by itself was not a constraint. Ifinvestment was authorized during a plan-year, profitsnot otherwise earmarked were allotted to contribute tosuch outlay, any shortfall being met by a capital non-reimburseable subsidy. Profits which were earned inexcess of authorized outlays had to be returned to thebudget. In this way, investment was maintained undercentral control and aligned with the physical quantitiesof capital goods required.

Prices were not set to equate supply and demand; theautomatic subsidization or taxation of enterprise fund-ing did not allow them such a role. Nor did they faith-fully reflect costs for two main reasons: one ideologi-cal, the other operational. First, under the influence ofMarx’s analysis of value, production costs representedthe cumulative expenditure on labour: no charges weremade for capital, land or entrepreneurship; moreover,


the central control of employee and management remu-neration meant that payrolls did not represent theopportunity cost of labour. Marx asserted that valuewas created only by “living” labour (i.e. current wagebills) and by the replacement of the “embodied” labourof fixed and working assets (i.e. capital consumption).Based on this argument, no return was payable withrespect either to capital (other than as depreciation), orto land. Private owners of capital and land receivedpayment only from the return to labour. Second, theState-determined prices underlying production costwere rarely adjusted as supply conditions changed: thevery number of goods and services (24 million individ-ual products were reported in the USSR in the 1970s)and classes of wage (by skill, experience and branch)made such overhauls a major bureaucratic task.

That system was very good at mobilizing scarceresources and concentrating on a few clear, well-defined objectives that could be expressed in measur-able, quantitative, and communicable terms, and couldyield large observable changes as outcomes. Pro-grammes in which the human and other costs could beignored, such as the building of major heavy industrialcapacities (1930s to 1950s), the collectivization ofagriculture (1930s), the postwar reconstruction ofindustry, the development of an unprecedented mili-tary-industrial complex (1960s and 1970s), were allexamples of this effectiveness. The system requiredsubordinates to make decisions that had a wide-ranging impact on the capabilities, operations, andcosts of other organizations, in ignorance ofopportunity costs and in pursuit of (sometimesmisunderstood) objectives of superiors. Feedbacks andfine-tunings were blocked by the inflexibility ofplanning.

2.3 Payment systems

The payment systems in the ex-command economieswere inherited, being designed to fulfil the require-ments of planned economies, had no urgency in exe-cuting transactions. A present consequence is that—atleast in the former USSR—money transfer betweenbanks can take several weeks, involving huge implicitinterest costs, complicating banks’ liquidity manage-ment, and weakening overall control over money sup-ply. Due to lack of automation and inadequate telecom-munication facilities, payment systems are often manu-ally based. Settlements between the Russian Federationand other CIS countries are reported as taking months.

The credit float is generally maintained on the books ofthe bank which initiated the payment. However, thenear absence of money markets makes it difficult forthe banks to take advantage of the float.

2.4 The fiscal system

Because, under the Soviet-type system, the governmentowned all industrial and agricultural property outsidethe collective and small household sectors, surplusesextracted from enterprises—and also from households,indirectly—required little codification in formal taxlaw. There was no need for a formal sales tax as pricesfor all goods could be set as high or as low as thegovernment desired, and all enterprise surplusessimply reverted back to the State. Thus luxuries couldbe highly priced, and essentials could be priced as lowas the government desired. Similarly, there was noneed for personal income taxes; the State owned all thecapital stock, set the limits for all wages and salaries,and the enterprises, as agents of the State, couldwithhold any proportion of household income atsource. Depreciation of capital stock was unnecessary,and the State simply authorised all new capitalinvestment by recycling funds to enterprises.Uncertainties remained in the system however; thesestemmed from variability in the technology,availability of inputs, unknowns in inventoryaccumulation, and the lack of information in generaland the intentional distortion of reported infor-mation—all of which made it difficult to predict enter-prise cash surpluses. Not being allowed to hold cash ora bank balance from one accounting period to the next,enterprises accumulated what they had controlover—physical assets and inventories—and falselyreported inputs and outputs.

2.5 Accounting systems

A precondition for capital market efficiency is the exis-tence of a sophisticated accounting infrastructure (Lee,1987, p. 75). Accounting systems in the centrally-planned economies have been rather unsophisticated,because there was no need for such sophistication.

The Soviet-type accounting system had three subsys-tems: (a) a financial record keeping dealing withassets, liabilities, revenues and expenses; (b) astatistical record keeping for aggregate economic data,such as volume of production, costs of production,productive capacity etc.; and (c) an operational-technical record, physically monitoring the movements


of materials and products within the plan (Enthoven,1992).

When the State owned virtually everything, the Statewas stockholder as well as creditor; hence, financialreporting was geared to the needs of the State, whichrequired information for planning purposes.Accordingly, the notion of profit was meaningless,because profit is a function of property rights—it is themeans of dividing the value added between differentstakeholders where these are separate from the enter-prise (including the government within mixedeconomies). Uniformity was the order of the day, andinter-organisation transfer was dictated by the needs ofthe State. Consumer sovereignty was replaced by con-sumer choice among the goods and services whichplanners made available; hence, consumers were notamong the stakeholders as would have been the case inmarket economies.

Command-economy accounting systems are similar togovernment accounting systems in the Western marketeconomies. In making that comparison, it must beborne in mind that such practices are themselveschanging. Practices have two stages, one of data collec-tion about resource use and the other setting targetsand standards. Stage one consists of resource account-ing methods of financial reporting, which acts as a pre-cursor to stage two; the latter is a system of resourcebudgeting for the annual spending round. Traditionallythe cash basis was used in the West for governmentaccounting, as it was in Soviet-type economies. Thisbasis does not use the accruals concept, and recognizesrevenues and expenses when received or paid.Calculating profit is a condition precedent to the shar-ing out of the value added among interest groups.Under the cash basis of accounting, profit cannot becalculated and therefore does not come into question.Accounting and reporting are meant to supply datawhich can be summarized to provide a condensed viewof the aggregate activities of the enterprises region byregion and for the entire economy. In order to facilitatethis, uniformity is essential, and accounting policiesand bookkeeping procedures are laid down in everydetail. Enterprises are treated as “branches” of the cen-tral administration.

Because the State is the only provider of capital, andthe banks are also owned by the State, the commonlyrecognized distinction between debt and equity in mar-ket economies is not prevalent in command economies.Funds flow and cash flow statements are the core, withgroups of assets and sources of funding matched in a

balance sheet layout. Thus investment in fixed assets isfunded by fiends allocated for this specific purpose andmade up to the authorized amount with retainedearnings. Social fluids are formed to provide materialincentives for staff and social welfare. Assets related tothese funds (usually specific bank accounts) are usedexclusively for the purposes for which fluids are set up.Land does not appear in the balance sheet, because theenterprises do not own any land. All ownership of landis vested in the State. Valuation in the commandeconomies was influenced by the Marxian labour theo-ry of value.

2.5.1 Valuation bases. Because the Soviet-type systemdid not utilize the market mechanism, market value isnot relevant for valuation purposes. Valuation is basedinitially on historical book value, subject to infrequentnation-wide revaluations of capital assets to replace-ment value; depreciation is based on the straight linemethod, and often on asset lives assumed to be verylong. Because obsolescence due to changes in demandand in technology were not recognized in earlier Sovietpractice, accelerated depreciation was late in coming.Know-how and goodwill went unrecognized, becauseknow-how is a function of private property (of an intel-lectual type), and goodwill is a function of an additionto market value. Intellectual property in the basicSoviet-type system did not exist as an entitlement, butall countries using the system made provision forrewarding inventors and innovators.

Budgeting and planning were influenced, if only mar-ginally, by local managers; production decisions fol-lowed closely from a central plan; wholesale and retailprices were established centrally; reproducible assetsand land were not owned by the enterprise; and thegeneration of profit was largely beyond the control ofmanagement. Comparability in accounting was ofgreater importance than significance to operation.With the exception of the banks—which were ownedby the State—the sole user of financial informationwas the State. It was hence necessary for receipts andpayments to be totalled only on an annual basis todetermine the amounts to be retained, surrendered ormet by subsidy. As countries moved towards Westernpractice, as in Hungary and Poland, a monthly profitand loss account was compiled, principally to reportturnover tax payable.

For imported materials and machinery, the book valuewas the domestic wholesale price or the foreign pricemultiplied by the official exchange rate and, in lateryears, a coefficient which effectively constituted one of


a set of multiple exchange rates (see subsections 6.1and 6.3), enforceable because of the government’smonopoly on foreign trade and payments. Inventoriesand work in progress are valued at full cost. Provisionsfor expected losses are uncommon.

Because of differences in accounting methods betweenthe market and the command economies (notably inthe field of income recognition, provisions for unpaidaccounts and contingencies and valuation methods),joint venture partners had to have special treatmentwhile Soviet-type practices were in use. Other issueswere the non-convertibility of local currencies andrestrictions on profit and capital repatriation. Afrequent procedure was to restrict profit repatriation toa proportion of the joint venture’s own foreigncurrency earnings (OECD, 1991).

2.6 Financial data for monitoringperformance

Because data were produced as a by-product of theplanning process they incorporated a number of quali-tatively known biases. Enterprises had an incentive todistort reported outputs either upwards to indicate theachievement of plan targets, or downwards where tar-gets had been overfilled, to restrain any rise in subse-quent target outputs. One way of manipulating mea-sured quantity and price changes was to modify theproduct—or its quality. As prices did not clearmarkets, the difference in price between the oldproduct and the new was not a reliable basis formeasuring quality change. This left the enterprise freeto say that the new product was substantially betterthan the old, thus overstating output growth andunderstating the price increase. In a certain sense thepractice was equivalent to the manipulation of stockprices and earnings per share in capitalist systems,which are motivated and driven not on output targets,but on stock price performance.

The “multiple” artificial exchange rates used intro-duced an arbitrary element into the combination of fig-ures for domestic output—or absorption—with figuresfor imports, exports and international factor payments.Indeed, the use of inconsistent crossrates within theCouncil for Mutual Economic Assistance (CMEA)-which was feasible because the implied arbitrageopportunities could not legally be exploited—made itimpossible to establish a consistent trade matrix for theregion. These issues are further developed insubsection 6.3.

Opportunities for bias arose at the aggregate level frommethodological change, (for instance from the inflationadjustment of inventory appreciation), and fromincompletely documented methodological changes(analogous to some Western governments “massaging”unemployment and inflation figures by changing thebasis of calculation). For statistical purposes, “listprices” were used that—even more than in a marketeconomy—could deviate from transaction prices, espe-cially on black or grey markets.

Soviet-type economies drew up their national accountson the Material Product System (MPS), although in the1980s Hungary and Poland conformed to the System ofNational Accounts (SNA). The production boundaryfor Material Product is drawn so as to incorporate onlyeconomic activities which give rise to tangible products(hence the term “material”) and services for their phys-ical distribution to consumers (such as freight trans-port, storage and sale to final users). So-called “non-tangible”—or “non-productive”—services (such aspassenger transport, personal services, banking,insurance, health care, education, scientific researchand the welfare derived from housing) were perceivedas being remunerated from a “redistribution” ofMaterial Product, but not as part of it. The differencebetween Net and Gross was depreciation under eachconcept, but in MPS only depreciation of assetsgenerating Material Product; assets generating non-tangible (nonproductive) services, such as schools,hospitals and housing, had their depreciation chargedas “redistribution”. The divergence of National fromDomestic Product in SNA was paralleled—though notprecisely—by that between Material ProductDistributed and Material Product Produced. In policyterms, the use of Net Material Product (NMP) tomeasure growth for planning and reporting purposes,led to a certain neglect of “nonproductive” activities.Introducing the SNA in countries which formerly usedthe NMP approach is a major undertaking in that itinvolves changed concepts, and changes in themethods of data collection. In a fully planned economyevery enterprise had its targets and had to report theirfulfilment—or otherwise—and, given a set of prices,these figures could be summed to obtain nationaltotals. In a market economy, although all largecorporations have to file accounts for shareholders, andall enterprises for the revenue authorities, neither is anappropriate form for national accounting. Muchreliance is placed on surveys of enterprises and sectors,on the basis of occasional censuses of the relevantpopulations. Newly emerging private enterprises in


transitional economies are similarly required to reg-ister, and the register provides a potential samplingframe for survey-based statistics. In practice, however,there is inadequate compliance with the registrationprocedure and the machinery for conducting samplesurveys is not fully developed, particularly in the caseof very small enterprises. The rapid changes in relativeprices—as well as in product design andquality—during transition also complicates before andafter comparisons of output. For example, a givenreduction in military output reduces total output muchmore if valued when military procurement was largethan at the low prices implied by the difficulty indisposing of production, much of which may beaccumulated in inventories (EBRD, 1993b, p. 105).This inventory accumulation problem is just as true forcivilian output which, after the end of a sellers’market, proved unsaleable following liberalization.

Conventional forecasting in developed market coun-tries depends not only on relatively reliable data butalso on relatively stable relationships between econom-ic variables. In this respect transitional countries en-counter abundant problems. The behaviour of indi-viduals as consumers, workers and entrepreneurs can-not be foreseen on the basis of past relationships.Adaptation can be a very lengthy process. Privateentrepreneurs have incentives to hide private activities,and to avoid paying taxes or social security contribu-tions, meeting legal standards such as minimumwages, or conforming to health and safety standards. Inestablished market economies such practices areassociated with the “black economy”.

Financial reporting to the State as owner, differs fromreporting to private proprietors. In “individualistic”countries such as the United Kingdom and the UnitedStates which are stock-market oriented, the maximiza-tion of stockholder wealth ranks highly among enter-prise objectives; hence, reporting is geared to the needsof primary users such as analysts, current and potentialinvestors, lenders, employees and suppliers. InGermany and Japan, which are not security-marketdominated, financial reporting is geared to the needsprimarily of banks, creditors, and employees, and sec-ondarily of shareholders among whom banks are majorstock holders and lenders at the same time, which isnot permitted in either the United Kingdom or theUnited States.

The financial reporting function is geared to the needsof the major supplier of resources with whom the orga-nization operates. In the UK-US situation, the capital

market provides the finance; hence, the reporting func-tion is geared to the needs of the investing community.In Germany, Japan and Switzerland, for example, thebanks are the major suppliers of capital; thus, creditorprotection comes before any other function of financialreporting. In command economies, the State providesthe finance and all other resources—the needs of theState in the form of uniform information is the pre-dominant function of reporting.

2.7 The financial inheritance

The State bank usually had a near monopoly overbanking and credit. Yugoslavia, which did not conformto the Soviet-type system, allowed banks to be ownedby enterprises. The “monobank” had unlimited capaci-ty to create bank deposits. The State bank and its State-owned affiliates operated the “active” and the“passive” financial circuits already described—the oneserved the household sector which received personalincome in cash, and the other served enterprises whichrequired only book entries showing the credit or debitaccumulated. Banks had little incentive to allocatecredit on a commercial basis, and penalties for non-payment by enterprises were few. Because of the closelinks between the enterprises and the banks, the bankswere effectively the treasury departments of theenterprises.

The role of the monetary system was to finance theproduction plan. The physical plan dictated the finan-cial plan—which was broken down into a budget, acredit plan, and a cash plan. Interest rates andexchange rates had no allocative role. Credit wasextended to enterprises at low fixed interest rates with-out any consideration of risk or maturity. Enterprisesurpluses earned little or no interest, and balancescould not be carried over without higher authorization.As already noted in subsection 2.4, enterprises did notaccumulate money balances but real assets, such asinventories, plant and equipment. The old system leftno role for profits as a motivating factor. Well-performing enterprises found that most of theirsurpluses were expropriated or heavily taxed, whilechronic loss makers found that their losses werecovered by subsidies or credits.

The exchange rate was mainly an accounting device toenable conversions between foreign and domesticprices. Bankruptcy was not a relevant consideration,since the ultimate owner of enterprises as well as thebank was the State. Because all bank credit was deter-


mined by the Ministry of Finance and the incrementdue to Savings Bank depositors could not be re-lentexcept by the Ministry’s authority, the State budgetwas the ultimate source of investment funds.

The risk-adjusted return from investment was not themain focus as it would be in a market economy,because the definition of risk in a collective society isnot the same as in an individualistic society. The terms“accountability” and “checks-and-balances” have adifferent meaning in the Soviet-type economy and inthe market-based system. In the former they relate to aformally-unified plan, and in the latter they involvemultiple owners and multiple stakeholders, and,consequently, multiple mini-objectives.

If transitional economies are to be transformed intowell-functioning market systems, choices have to bemade as to which form of legal structure is appropriate,since western legal models are not homogeneous.Contemporary developed market economies follow oneof two basic legal models: common law, and continen-tal (or Roman) law. Common law is mainly used in theAnglo-Saxon sphere of influence and continental lawin the rest. While continental law is codified and there-fore rigid, common law is based on precedents, andmore readily adaptable to change. As the major capitalmarkets of the world converge through deregulationand instantaneous communication, common law—inuse in the United States and the United Kingdomwhere capital market activities are most intensive—isbecoming more prominent. Stock markets are a proxyfor capital markets. Following privatization, manytransitional economies now have bond markets andmarkets for the newer types of financial instrument(e.g., the Russian Federation oil firm, Lukoil, in March1995 sought more than $300 million in convertiblebonds and approached the United States Securities andExchange Commission for approval for an AmericanDepository receipt issue).

In all systems of law, at all stages, except the primitive,there is a constant conflict between two methods ofinterpretation: the strict and the equitable. The law of anation expresses, in the long run, the character of thenation, and similarity of legal method corresponds tosimilarity in other aspects of social life. The fundamen-tal conceptions upon which Roman law is based are notsimilar to common law. The Romans had, in principle,no case law; the decision of one court did not make abinding precedent if the point arose again. In Centraland Eastern Europe and in the former Soviet Union,the legal system is more akin to structured Roman law.

Moreover, market economies are not homogeneous. Atleast three forms can be distinguished: (a) the UK-USvariety, highly individualistic, where shareholderwealth maximization predominates; (b) theContinental variety of mainland Europe, where societalinterests are used as constraint on shareholder wealthmaximization; and (c) the Japanese variety, whereintercompany holdings and State direction ofmacroeconomic interests are constraints on enterprises.The UK-US variety is seen as short-term performance-oriented, while the others are perceived as longer-termgrowth-oriented (Corbett, 1987; Miles, 1993; Prodhan,1993).

Similarly, the non-market economies of those currentlyin transition were also not homogeneous. There wasmarket socialism of the Hungarian, Polish andYugoslav type, where some degree of decentralizationhad taken place and at the other extreme the USSR,where the system was centralized. As to which modelof market economy is applicable in achieving marketreform in ex-command economies, this is dependent onthe starting point, as well as the kind of market reformdesired. In general, an adaptive system, where learningis possible from experience, is likely to be the most rel-evant system, with adequate checks and balances towhich the decision makers are subject. All societies area mixture of public as well as private sectors. There isno country in the world where everything is in privatehands. At the so-called “night watchman” extreme,public finance would be restricted to national defence,the assurance of law and order, and the upkeep of insti-tutions for market regulation and for assuring thecontinuity and representation of the State. Clearly allmodern states undertake more within the public sector,guided by considerations of welfare, wealth andincome distribution, “merit” goods and market failure,and the only general requirement is having a systemflexible enough to be able to respond to changing cir-cumstances.

While the task is daunting because it reflects a range ofeconomic and institutional issues, the critical questionposed in this paper is the degree of decentralizationwhich is appropriate in the transformation process. Anexample relevant to strategic financial management isthe procedure for dealing with the transition from cen-tralized funding of State enterprises to financial auton-omy. When enterprises, whether State or privatized,can no longer rely on automatic credit for thesettlement of mutual accounts, the bonus for viableexistence falls on the individual corporation to cover


outlays by receipts, to raise new capital and tonegotiate bank or supplier credit. In the sphere ofbanking, transition can follow one of two paths:

• In the centralized approach, the government takesover all non-performing loans and replaces themwith treasury bonds, guarantees or cash. The enter-prise debt is taken over by the banks and is theneither cancelled or sold off, as are the physicalassets of the enterprises. The government mightalso form a liquidation/restructuring agency whoserole can vary from auctioning off of the debts andassets of the enterprises to a semi-permanent agencyentrusted with the restructuring of the enterprises.The government could also declare a moratorium onall indebtedness of certain categories-as many inEast Europe did after the financial crisis of 1930;however, no government has so far taken suchaction in this period of transition. This approachhas a limitation, that is, the State agency might notpossess the necessary insider information onweaknesses and strengths of indebted enterprisesand consequently could be unable to discriminatebetween potentially viable and non-viable firms;

• In the decentralized approach: the role of the gov-ernment is minimized, and instead is assigned tothe creditor banks in cooperation with theenterprises. This requires the design of a suitableincentive system for the creditor banks to take alead in restructuring the troubled enterprises. Debtrestructuring is nudged toward debt-equityconversion to facilitate privatization and to counterthe bias inherent in the thin capital markets whichcharacterize the transitional economies. This ismore of a conciliation process than outrightliquidation. It has some advantages; for instance,the banks are better prepared to collect and processinformation on clients than any government agency.Furthermore, since the banks have incentives torecover funds, they are likely to have strongermotivation to find workable solutions that anygovernment agency.

It has to be recognized that sound prudential regulationcan not be enforced all at once. Vigorous enforcementwill strangle the economy at a stroke. An intermediatestep which is a distinct possibility is a two-part bank-ing system. One part of the system would be subject tostrict norms and supervision, free of inherited badloans, and de facto cut off from the ailing, subsidizedState enterprise sector; in return, it would receive aseal of approval which would enhance its chances of

attracting commercial and household deposits withoutoffering a large risk premium. The other part of thesystem would continue to serve the enterprises thatdepend on building up further arrears for theirsurvival, and would become a State agency responsiblefor financial relations with ailing enterprises. Stockand flow—solvency and liquidity—are related. Newloans extended by the banking system may continue toturn into bad assets. The banks’ lack of experiencewith credit evaluation, the absence of—or inadequacyof—collateral laws, cross-ownership betweenenterprises and banks (this is also true in Germany andJapan, and is not undesirable, as already pointed out),poorly developed accounting rules, weak enforcementof prudential regulation and the uncertainties raised bythe transition process have all contributed to thereluctance of banks to end their “cosy” relationshipswith enterprises. Corbett and Mayer (1991) haveargued that the development of monetary and financialinstitutions in what were then the “reformed” socialisteconomies had simply imitated without change a fewcapitalist institutions which may not have been themost appropriate in view of differences in institutionalstructures between developed and emerging markets.

2.8 Sequencing of reforms

A crucial element in sequencing is the speed of transi-tion from loosened centralized administrative planningand control to the creation of macroeconomic controlssuitable for a market environment (Roland, 1994; VanBrabant, 1993). Simply invoking the “invisible hand”of neoclassical economics is not enough. It may benecessary to go beyond a decentralized price system byexamining the comparative properties of different eco-nomic systems under conditions of bounded rationality(Murrell, 1991, p. 62).

Almost everyone agrees that suitable institutionalstructure is necessary, but there is no consensus on howto create it. While a stable legal framework may benecessary, the existence of such a framework isdependent on a complex web of social traditions andexpectations. Speed may be essential, yet this notionmust be tempered; this is because measures such asinterest-rate policy for macroeconomic stability and formicroeconomic self-regulation, must proceed in paral-lel while the social effects in either field must beassessed. While there is evidence that, at the aggregatelevel, a liberalized financial system can result in bene-fits in the form of mobilization of savings, increased


investment, and faster economic growth, there is alsoevidence that this widens the dispersion of income andwealth, and may contribute to divisions in society.

Both such economic and social effects need politicalpreconditions and have political consequences, whichare crucial in deciding on the pace of transition.Elections in 1994 and early 1995 brought the reshapedcommunist parties into government in Estonia,Hungary, Lithuania, Poland and Slovakia, whileparliaments have resisted more reformist governmentsin Belarus, Bulgaria, Kazakhstan, Kyrgyzstan andRussia. Public support for a “shock therapy” policycould be mobilized—or could be moulded—at an earlystage of political change, as was the case for the“shocks” across the board that Poland andCzechoslovakia were able to apply in 1990 and 1991and the “price shock” that all former Soviet statesintroduced in January 1992; in the Eastern Länder ofGermany, public support was in effect bought byexchanging the GDR currency at a valuation some fourtimes its realistic rate. With the exception of thatregion and of the Czech Republic, the “shock” hasbeen attenuated by easy bank loans, tolerance of taxarrears and poor financial discipline. Gradual reformprovides the screening that facilitates the flow ofprivate savings to good firms yielding high returns:while a high-quality loan portfolio enhances banks’incentives to apply hard budget constraints and extractgreater effort, a low-quality portfolio increases creditorpassivity, since a bank that initiates bankruptcyproceedings risks revealing its own financial weakness.Moreover, closing insolvent enterprises may be amistake, since in a distorted economy, it is difficult toknow which enterprises should be closed.

Although optimal sequencing of financial marketreform is desirable, in many cases these reforms haveto be pursued simultaneously. This is inevitable asthere are strong policy and operational linkagesbetween the development of inter-bank markets and thedevelopment of market-based instruments. Theremoval of credit ceilings, liberalization of interestrates, prudential regulations, and development offinancial and security markets, all can have substantialimpact on the demand for money, the money supplyprocess, and the transmission mechanism betweenmonetary policy and macro-economic aggregates suchas prices, output and the balance of payments. Tominimize the potentially negative social impacts, thesteps necessary include adequate disclosure,improvement of information flow, deposit insurance

and loan guarantees. These issues are the topic of thefollowing section.

3.Banking reform

3.1 A two-tier banking system

Financial sector reform is part of broader structuralreform of the non-financial sector, which is crucial tomacroeconomic stabilization. The first important stepin the transition of the financial sector is the transfor-mation of a monobank system into a two-tier bankingsystem. The State or national bank assumes the tradi-tional central banking functions, focusing onregulating overall credit and interest rates, anddivesting itself of deposit and loan transactions withhouseholds and enterprises, which are transferred tonewly established banks, as has happened in China in1984, Hungary in 1987, the USSR in 1988, Poland in1989, and Czechoslovakia and Yugoslavia in 1990(Sundararajan, 1990, p. 4).

The objective of the two-tier system is two-fold. First,it establishes a central banking system by separatingthe conduct of monetary policy from the allocativeobjectives that are, supposedly, better served by pursu-ing profit maximization through sound commercialbanking; and second, it introduces competition in thecommercial banking sector. There have been difficul-ties in breaking up the former monobank system inher-ited from the socialist system in a way that stimulatescompetition. It was hoped that competition wouldmobilise savings, improve the quality of financial ser-vices and reduce costs of the banking sector. In prac-tice, the monobank system was often broken up hastilyand in a fashion that did little to further these objec-tives. Central banking reform allows monetary policyto play a proper role in macroeconomic regulation,influencing interest rates and exchange rates. All lend-ing and deposit taking are transferred to new commer-cial banks leaving the central bank to take care of itsstandard banking functions, including management ofthe currency. Such transformation evokes a host oflegal and structural issues. For central banking suchissues include the degree of autonomy over monetarypolicy and supervisory functions of the central bank,and the range of monetary policy instruments and pru-dential regulations. The detailed credit plan and cashplan are replaced by various intermediate andoperating targets of monetary policy, supported byappropriate monetary managementtechniques—central bank refinancing quotas, bank


specific credit ceilings, reserve requirements, andmanaging the issue, servicing and redemption oftreasury paper.

For commercial banking the policy issues include whatshould be permissible banking functions (e.g. universalbanks, one-stop banks, banks permitted to own sharesin corporations, specialized banks), the permissibletypes of ownership structure of banks, and rules gov-erning their establishment and approval. Other mattersare: the size, number and geographical distribution ofbanks; the sources, type and level of capital required;permissible capital structures; the distribution of non-performing debts; accounting standards and systems;settlement clearing; payment and electronic transfermechanisms; and staff training for the radically newconditions. The change from an essentially monobanksystem to a two-tier banking system implies a signifi-cant redistribution of power away from governmentauthorities in direct economic management,strengthening the autonomy of the central banks inmacroeconomic management. In the early stages oftransition the newly established commercial banks findtheir ability to compete for deposits and loanscircumscribed by the concentration of the bankingindustry, the limited network of branches, and variousstructural and regulatory impediments.

3.2 Interdependence in the bankingsystem

While the purpose of establishing a central bank is tocreate a stable macroeconomic climate of low inflation,controlled money supply, and a supervisory regime tofoster an orderly growth of the economy, the purpose ofcommercial banking reform is to encourage compe-tition and efficiency to help foster growth in the privatesector.

The long-term success of any banking system rests onthe two pillars of solvency and liquidity. Solvency ofthe system implies that the realizable value of theassets is significantly larger than the market value ofthe liabilities, to the extent that the system can at alltimes meet its obligations to the depositors. This is the“stock” problem. As the major proportion of assets ofthe Soviet-type commercial banks had been the loansportfolio (fee earning business being very small), thelarger the proportion of doubtful debts in the portfolio,the less was the stock of realizable assets; hence, theless solvent was the system. The importance of solven-cy extends beyond a single bank, because solvency is a

matter of confidence, and insolvency in any individualbank can create a contagious bank run threatening thesolvency of the banking system as a whole. Issues insolvency management include strengthening the super-visory power of the central bank and giving it indepen-dence to ensure capital adequacy, minimizing the riskof non-performing loans and reducing unfettered subsi-dies to enterprises.

While solvency is a long-term problem, liquidity is aproblem which preoccupies banks in the short run.Liquidity refers to the need to keep the system liquidand ensure efficient clearing and settlement; this is the“flow” problem. In the initial stages of transition, thisproblem has been generally resolved via generous refi-nancing facilities and credit directed by the centralbank. Such an excessive preoccupation with liquiditycan result in unsound lending practices, and pose diffi-culties for the design of monetary policy. Liquiditymanagement implies the need for an efficient paymentsand clearing system, the establishment of efficientcapital markets where financial instruments can betraded, an efficient transmission mechanism, and thetraining of personnel in all aspects of banking.

When banks seek to maximize profits, they are exposedto problems of liquidity and safety. Thus anuncontrolled banking system is inherently unstable. Toavoid such instability, there is an obvious need for thecentral bank to act as lender of last resort. Thus, thetwo levels of banking—central and distributed—areclosely linked. For example, realistic management ofexchange and interest rates can help both macroeco-nomic management, for which the central bank isresponsible, and commercial banks by making it possi-ble for them to invest short-term surplus fiends prof-itably and thus improve their liquidity management.Similarly, a reliable loans evaluation system can helpcommercial banks in reducing their non-performingloans portfolio, at the same time reducing the systemicrisk of a run on the banks; both instances help the cen-tral bank to achieve monetary stability.

3.3 Solvency issues

3.3.1 Capital adequacy. In a market economy, thebanking system has to ensure that the insolvency ofone bank does not entail a systemic risk. Therefore, thecapital base has to be large enough to withstand rea-sonable loan losses and yet permit each bank to keepup-to-date on its payments obligations. There is a gen-eral agreement in banking circles that financial inter-


mediation requires “a minimum size”. Given the lackof financial markets with which all transitionaleconomies except the Eastern Länder of Germany andHungary started, most governments imposed a mini-mum size requirement. In an attempt to flush out aproliferation of smaller institutions “just pretending tobe banks”, the Russian Federation Central Bankrequired from January 1995 a twenty-fold increase inbanks’ minimum capital requirement. Inflation hadrendered trivial the former threshold of 100 millionroubles—entrepreneurs could choose between buying acar or starting a bank. This new threshold of 2 billionroubles will be raised in stages to the equivalent of 5million ECUs by 1999, which is the present minimumrequirement—set in 1994—for banks in the EuropeanUnion.

A global measure of capital adequacy is provided bythe solvency ratio, defined by the Basle Committee ofthe Bank for International Settlement (BIS), whichdivides risk-weighted assets by capital (with the latteradjusted to include subordinated debt). Classifying bor-rowers into various categories (for instance govern-ment, banks and others) with a corresponding risk-weighting (zero, 20, and 100 per cent respectively,according to BIS guidelines) banks have to back uptheir risk-weighted assets with a minimum of theirown funds. The Basle Committee recommends 8 percent for this purpose. This requirement, with slightlymodified underlying accounting rules, has beenadopted by Hungary and other countries. Latvia, forinstance, has introduced special risk-weights for loansin non-convertible currencies.

However, caution is necessary in the application of BIScapital adequacy ratios. For instance, the correctidentification of “own funds” is problematic so long asloans have not been audited and adequately covered byprovisions. Hence, the first element of any attempt tosolve the problem is the auditing of bank assets toclassify outstanding loans by quality, in order tofacilitate provisioning against potential non-performing assets. Further difficulties may arise inapplying the Basle Committee’s guidelines to thebanking systems of transitional economies becausethese guidelines were developed for western bankingsystems, where the nature of risk and informationdisclosure requirements are very different from that ofthe former Soviet-type systems (EBRD, 1993a, p. 14).Moreover, such ratios ignore (a) the correlation ofreturns between assets, (b) the bank’s exposure tointerest rate risk and inflation risk, and (c) information

relating to off balance sheet items (Tirole, 1994, p.133).

3.3.2 Loan losses. In relation to capital adequacy,another serious threat to the banking sector comesfrom banks being owed large sums of money by ailingenterprises which happen to be their shareholders andmay for the first time be allowed to go bankrupt. Thethreat in this case is the domino effect of bank crashesprecipitating business collapses across the economy.

There are three possible ways in which loan losses canbe treated in the banking system (Fries, 1994):

“Additional funds granted by the government tothe enterprise sector. This is what was done inRomania in 1992, but after some initialimprovement, non-payments emerged again andinflation accelerated in 1993. The time to dealwith the stock problem is when the flow problemhas been reduced to manageable proportions.

“State take over of bad loans from thecommercial banks at a discount. In Hungary, thegovernment offered to take over most of the badloans from the commercial banks at a discount of20 to 50 per cent. But the banks were reluctant toaccept the losses because of their very fragilecapital position in 1993.

“Financial restructuring combined with con-ditional recapitalization of banks. This is whatwas done in 1993 in Poland where specialgovernment bonds were issued for refinancingthe banks, with the banks enforcing restructuringof State enterprises. In order to tackle the flowproblem and prevent bad loans from re-emerging, it is essential to reduce the number ofunsound credit decisions. This implies a radicalchange in the incentive structures facing bankmanagers. Where privatization is politicallydifficult, commercialization of State bankscombined with the rapid introduction ofprudential regulations and the involvement offoreign banks may result in improvedefficiency.”

It is important to remember that private banking is notnecessarily good banking. Sound banking is alsodependent on sound governance. The development ofthe legal and regulatory framework, as well as corpora-tization and the establishment of governancestructures, such as responsible boards, shouldaccompany recapitalization. The performance of


private banks depends upon the quality of ownership,the quality of supervision of the banking system andthe general business environment.

3.3.3 Inter-enterprise indebtedness. In transitionalcountries which have made real efforts to rein back themonetary expansion and strengthen the banks’ lendingcriteria, a common side effect has been a surge ininterenterprise arrears (see subsection 4.5.3). In manycases, it has been assumed that the State will continueto pick up the bill as in pre-reform days. This has cre-ated a close financial interdependence betweenenterprises— which has short-term advantages for theenterprises concerned—and has made it very difficultfor banks to assess or diversify lending risks.

Commercial banks in the early stage of transitioninherited a large portfolio of non-performing loansfrom the enterprise sector. The legacy of non-perform-ing loans stems from the deterioration in the financialcondition of most state-owned enterprises, reflectingmajor shifts in relative prices—especially energyprices—and declines in the domestic demand forcapital goods, as well as import liberalization resultingfrom a breakdown in the trading arrangements underthe CMEA, and a reduction in subsidies to theseenterprises.

Furthermore, the ownership structure of commercialbanks created additional problems in enforcing pay-ments in that most banks in ex-command economiesare at least partially owned by the enterprises to whomthe banks have loaned monies. Inter-enterprise indebt-edness also makes it difficult for banks to assess ordiversify lending risks in the absence of analyticalexpertise and the lack of sophisticated accounting anddisclosure systems.

Inter-enterprise indebtedness is a product of the oldsystem in which goods were traded according to a cen-tral plan, and money was an insignificant accompani-ment. Thousands of Russian enterprises have been pro-ducing goods they are unable to sell and taking deliv-ery of goods they cannot pay for. It is estimated by theRussian Federation’s federal bankruptcy agency that,in 1994, this indebtedness amounted to 30,000 billionroubles. As subsidies are phased out, and monetary andfiscal policies are tightened to reduce inflation in theRussian Federation, thousands of factory directors havefound a way to evade the government’s new austerityby not paying their suppliers and employees. It has alsobeen surmised that corruption, in the form of bribesgiven to factory managers, induces them to ship goods

for which their enterprises are unlikely ever to be paid.Reformers in the Russian Federation Governmentconcede that these indebted enterprises form apowerful lobby which is pushing for an old stylesolution: lower taxes, easy credits and a freeze on someprices. Bankrupting these enterprises would be aneffective market-based solution, but the socialconsequences in the short run can be ratherunpalatable.

One way to avoid the problem conflict-of-interest inownerships and the threat of non-performing loans,would be the introduction of limits on lending toshareholders to the equivalent of a small proportion ofbank capital. Such limits have been implemented in anumber of countries, including, for example, Latvia,where the maximum exposure of banks to any individ-ual share holding entity is 25 per cent of capital (and50 per cent for a non-shareholder). This lowers expo-sure, improves portfolio diversification and reducesrisk.

3.3.4 Deposit insurance. Deposit insurance and with-drawal of licences are further measures which the cen-tral bank can use in reducing the risk of insolvency inthe commercial banking sector. The two principaleffects of deposit insurance are to eliminate the risk ofa run on bank deposits and of undermining depositordiscipline. The elimination of the threat of a bank runenhances financial stability; however, the reduction ofdepositor discipline, depending on the insured deposi-tor’s coverage cap, can reduce financial stabilitybecause it provides an incentive for banks to takeexcessive risks and encourages risk indifference amonginvestors, as happened in United States in the Savings-and-Loan crisis of the 1980s.

3.3.5 Withdrawal of licences. Another possiblesupervisory mechanism that central banks can apply tothe commercial banking sector is the withdrawal of thelicence to operate as a bank. In the Russian Federation,19 banks in 1993 and another 21 in the first half of1994 lost their licences for for non-compliancereasons.

3.3.6 Subsidies. To maintain stability in the economy,in most countries under the former system, enterpriseswere granted generous subsidies by the State. The cen-tral bank has to balance the objective of reducing infla-tion with the disruptions to the financial and produc-tion systems which radical reform can cause. The regu-latory authorities have to balance the need for efficien-cy (letting market forces play an active part) with that


of safety (which requires appropriate regulation andsupervision). For some enterprises, subsidy reductionand import competition make it impossible to earn asurplus on operations, let alone service their liabilities.There are large portfolios of non-performing loans;and recently, subsidies have been reduced substantiallyin many transitional States. In the Russian Federation,the decision—not yet implemented—to terminate sub-sidized credits to all enterprises except for agriculture,coal mining and the biggest factories has meant thatcompanies face a real prospect of closure unless theyrestructure. In 1994, for example, the RussianFederation was scheduled to spend 10 trillion roubleson coal subsidies, representing almost a tenth of budgetrevenues. Even there, a World Bank report, details ofwhich reached the press in September 1994, proposedthe reduction of subsidies to coal mines from the“clearly unsustainable” 1.4 per cent of GDP in 1994 to1.0 per cent in 1995, and thence by stages to zero in1998. Related attempts were being made to forcecompanies to repay the 42 trillion rouble debts thatRussian State enterprises as a whole had accumulatedwith each other by June 1994, in an attempt to cushionthemselves against the shock of government policies.In a move to make a clear distinction between lendingand subsidies, 6 trillion roubles (3 billion dollars)which started off the year as “credits” earmarked foragriculture were soon incorporated into the 1994budget as straight subsidies.

In Central and Eastern Europe, governments have hadoccasionally to recapitalize state—owned banks, andbanks have remained liquid, drawing on such refinanc-ing and on the confidence of depositors that emanatesfrom explicit or implicit government deposit guaran-tees. A switch to selective and explicit subsidies toState enterprises through the government budget ratherthan the banking system would assist in bankingreform, but it is politically difficult to achieve.

3.3.7 Interest rate and exchange rate management.Until realistic exchange and interest rates are achieved(problems discussed in subsections 4.1 and 6.3), bur-

geoning foreign liabilities and foreign currencydeposits of residents create large solvency risks forbanks, which become apparent when a more appropri-ate exchange rate policy is adopted. To avoid suchinsolvency risk, local currency deposits have to yield ahigher rate than foreign currency rates, to compensatefor the depreciation of the local currency. In theRussian Federation, in 1992 and much of 1993,making money was easy for private banks. They couldborrow roubles from the country’s Central Bank atinterest rates lower than the prevailing rate ofinflation. They could swap these roubles for dollars, sitback while the rouble fell and then use some of thedollars to buy back just enough devalued roubles torepay the Central Bank’s loan. The dollars left overwere pure profit. Since October 1993, this is no longerpossible, as the Central Bank imposed a positiveinterest rate, charging 13 per cent per month—doublethe rate of inflation. It was reported that half the 2,300licensed commercial banks depended for their solvencyon that loophole.

Flexible management of interest rates has proveddifficult in the absence of market-based instruments ofmonetary control. In the old regimes, money andsecurities markets were discouraged due to the fear thatsuch markets would interfere with the central creditplan. Some preliminary attempts have been made tostimulate treasury bills and inter-bank markets. T -billswere introduced in Hungary in 1988 and in Poland in1989. The inter-bank markets in most transitionaleconomies remain thin, illiquid and highly segmented.There are uncertainties in settlement systems, lack ofhigh quality paper for trading and absence of liquiditymanagement by the central banks. Other aspects ofcapital markets are described below.

3.4 Liquidity issues

Resolving the problem of existing non-performingassets does not guarantee that the banks will strive toperform their “allocative” function, or that they will doso prudently. Stock and flow, solvency and liquidityare related. In the absence of an efficient liquiditymanagement system, new loans extended by thebanking system may continue to turn into bad assets.

Problems of liquidity in transitional economy bankingare accentuated by:

• the lack of an efficient payments and clearingsystem;

• the lack of an efficient capital market where fundscan be profitably invested; and

• the lack of an efficient loans evaluation system.


3.4.1 Payments system reform. An efficient paymentssystem permits prompt receipt of payment and pro-motes liquidity management. Banks and enterprisescan be confident that distant business relations can besafely undertaken. Efficient payments systems are goodfor the conduct of monetary policy because they elimi-nate wide swings in the banks’ reserve balances, whichcan lead to difficulties in controlling the monetary baseand the money supply.

The clearing and settlement systems for payments inmost Soviet-type economies were on a gross (item-by-item) basis with no netting or subclearing arrange-ments, reflecting the importance of checking the legali-ty of each payment. Inordinate delays in transmittinginformation bestowed large uncertainties in the amountof banks’ clearing account balances, distorted mone-tary statistics and prudential returns. Reliance on cashtransactions and the slowness of inter-bank transfer isnot only a brake on economic recovery during transi-tion, but facilitates fraud and crime (see below).

3.4.2 Capital markets. The surplus funds stemmingfrom an inefficient payments and clearing system couldnot be invested profitably in the absence of an efficientcapital market, including markets for treasury bills.Further, most borrowers do not have track records, andsystems and procedures within the banks are poorlydeveloped for loans evaluation, all of which result inaccumulation of doubtful debts from newly-grantedloans, or in sing out on promising new prospects.

3.5 Competition and supervision

The replacement of monobank systems with two-tiersystems of banking separated central banking fromcommercial banking. Such deregulation requires super-vision for an orderly functioning of the system.

The growth of the Russian Federation banking sincethe break-up of the old Soviet Union’s State bankingmonopoly in the late 1980s has been prodigious andvirtually unregulated. With 71 per cent return onequity in 1993, banking was probably the mostprofitable sector of the Russian Federation economy.Benefiting from wild currency fluctuations, highinflation and, until recently, extremely cheap centralbank credits, banking in the Russian Federation hasbeen tantamount to “a licence to print money”. But theboom days may be over as the Central Bank has begunto charge high positive interest rates on loans tocommercial banks intended to support industry,

agriculture and the Russian Federation’s northernterritories. By the summer of 1994, the RussianFederation interest rates had swung from being sharplynegative in real terms to being among the highest realrates in the world. On 1 August 1994 the Central Bankreduced the rate at which it lends to commercial banksfrom 12.9 to 12.5 per cent per month; inflation in July1994 was estimated to have been 5.1 per cent.

As the Russian Central Bank comes to grips withbanking supervision and responsible monetary policy,the country’s 2,300 commercial banks may finally beembarking on a transition from a Wild West free-for--all to competition, consolidation and regulation. Russiawas not alone in bank proliferation. The small BalticStates have large numbers of banks for their size: inmid-1993 Estonia had 22, Latvia 57 and Lithuania 23.

The presence of foreign banks can exert a certainfinancial discipline in the banking sector oftransitional economies. In June 1994, President BorisYeltsin gave up attempts to keep western competitionout of the domestic market and reversed restrictions onhalf a dozen western banks licensed to set up fullbanking subsidiaries in the Russian Federation. Thelicences, issued by the Central Bank almost a yearpreviously in an attempt to attract western investmentand banking know-how to the Russian Federation, hadbeen effectively frozen under fierce pressure from somepowerful Russian Federation banks. But, in addition tobringing in foreign banks to raise standards throughincreased competition, the Russian Federation CentralBank has begun to turn to the task of restructuring andmonitoring the health of domestic commercial banks.

Progress in banking supervision has been slow due toweakness in legislation, the time required to adapt thetraditional accounting concepts to the needs of a mar-ket-oriented economy, and the scarcity of personnelwith adequate training. Apart from the fact that mostclients do not have a track record, many standard toolsfor assessing the credit risk do not apply in the RussianFederation, and violence is unfortunately often used asa method of eliminating indebtedness and exactingpayment. The companies which can readily raise bankfinance in the Russian Federation are involved intrading the Russian Federation’s more lucrativeexports. It is easier to start with exporters, with theobjective of encouraging manufacturers, becauseassessing the viability of an export prospect is lesstime-consuming and less technical than for a manufac-turing process. The main hope of harnessing banks toeconomic growth is for the authorities to persevere in


their new-found financial orthodoxy, while making iteasier for banks to lend money to companies—forexample, by improving courts’ ability to handle com-mercial disputes. Meanwhile, the Central Bank, whoseown irregular practices were revealed in an audit in1992, faced the prospect of external supervision of itsown activities. A supervisory council to monitor theperformance of the Central Bank has been proposed inthe draft of a new law which will circumscribe the pre-viously erratic behaviour of the Central Bank, with aview to rendering it more responsive to macroeconom-ic objectives.

3.6 Bankruptcy reform

Banking reform requires the existence of a bankruptcylaw to ensure that failure to repay loans does notthreaten the existence of the banks themselves.Therefore one of the prerequisites of liberalization isthe existence of a bankruptcy procedure so that marketdiscipline can be applied in an orderly fashion.

The goals of bankruptcy legislation can be said to be:

• the imposition of market discipline on enterprisemanagers;

• the specification of the priorities of claimants on theenterprise’s assets in case of default, thus allowingproperty rights to be discharged in an orderly fash-ion; and

• as a by-product of the preceding two goals, anefficient allocation of societal resources.

In the transition period when many of the enterprisesare State-owned, bankruptcy reform is difficult toimplement at a stroke; hence it is applied mainly tosmall-scale enterprises to minimize political disruptionin society. Governments of transitional economies areconsidering some variant or other of the bankruptcylaws in existence in the established market economies.Bankruptcy laws in the market economies are of twotypes: creditor-oriented and debtor-oriented. Until thelast quarter of the twentieth century bankruptcy lawshave been primarily creditor-oriented to maintain sta-bility in the credit system. Thus, if the borrowing orga-nization failed to discharge interest or capital paymentin time, enterprise assets were sold, and the proceedsdistributed among the creditors according to prioritiesspecified in the debt covenant. Variants of this proce-dure are US and UK receivership laws, and Frenchadministrative procedure.

More recently, penalties imposed the systems describedabove have come to be seen as harsh, especially when aperiod of respite could allow a defaulting enterprise tobe reorganized, whereby all claimants might be betteroff in the long run. The United States BankruptcyReform Act of 1978 (Chapter 11) is the forerunner ofthis concept, and many of the Western Europeanmarket economies are adopting variants of this version.In this system, the managers organize structurednegotiations between various groups of claimants.However, the bargaining process can becomecumbersome and lengthy, and abuses do take placewhen bankruptcy is seen as benefiting managers andlawyers at the expense of various stakeholders.

The choice of an ideal bankruptcy law in emergingmarket economies is difficult, yet some form of bank-ruptcy law enactment is essential if market reform is totake place. A balance has to be maintained betweenmarket discipline and societal welfare, especiallywhere large numbers of employees are likely to bemade redundant as a consequence.

Developments in Poland and Hungary are two exam-ples of bankruptcy reform attempts. Poland has optedfor a softer approach while Hungary has gone for theharsher approach of bankruptcy and liquidation. InPoland, there were about 2,000 troubled companies in1992, accounting for about 40 per cent of the total loanportfolio of the nine State-owned banks. Each bankwas expected to take a lead in restructuring about 200to 300 of these troubled enterprises (Dhar andSelowsky, 1994). This conciliation process required thebanks to solicit reorganization proposals from othercreditors-besides investors—and from management. Ifreorganization was not possible, liquidation was pro-posed as a final resort. For organizations that were toolarge, an intervention fund was established tominimize the macroeconomic impact, particularly onemployment. Hungary on the other hand, has initiatedthe use of bankruptcy as the central mechanism forconflict resolution between banks and enterprises. Astrict bankruptcy procedure was initiated in 1992requiring enterprises to file for bankruptcy orliquidation if they were in arrears on any of their debtfor more than 90 days. Out-of-court settlementsminimize litigation costs. As of September 1993, morethan 5,000 bankruptcy and 16,000 liquidationproceedings were outstanding.

A properly functioning bankruptcy code is the ultimateform of sanction against inefficiency and involves min-imal government intervention. Except in Hungary;


bankruptcy laws remain weak and unenforced, andhave little impact in imposing financial discipline inmost transitional States. This has been the case notonly because of limited capacities of the courts and thescarcity of skilled personnel, but also because of theconcern that unfettered mass bankruptcy would createhuge human costs and political unrest in the countriesconcerned.

3.7 Legality and financial governance

Without legality, any shift away from central planningtoward market allocation may lead to economicdecline, inflationary pressure and a polarization inincome distribution, which in turn could unleashpolitical reaction against the reform process. Legalityis associated with the rule of law as opposed to the dis-cretion of leaders. Research in economic history hasemphasized the importance of the rule of law inexplaining economic development. The rapid economicgrowth of 17th century England, for instance, wasbrought about through political change that allowedthe property-owning bourgeoisie to limit thediscretionary power of the sovereign. This process ofinstitutional development is the product of a complexinteraction of cultural, political, and economicvariables (North, 1990).

Legality is based on a mutually consistent set of laws,an independent judiciary and the people’s belief in thestability and enforcement of these laws. Economiclegality refers to laws in the economic domain, exam-ples of which are contract, tax, and bankruptcy laws.Enforcement of completely unfamiliar laws can be dif-ficult. Even if formal rules may change as a result ofpolitical or judicial decisions, informal constraintsembodied in customs, traditions and codes of conductare much more impervious to deliberate policies.

In command-type systems, the discretionary power ofofficials over subordinates, enforced by the politicaldictatorship of the Party, and the reputation effectsfrom personal and often long-run ties were fundamen-tal to decisions and therefore to concepts of legality.The administrative hierarchy was the equivalent of themarket system in coordinating economic activity. Theadministrative allocation of resources revolved aroundthe annual material-balance plan, which emergedthrough extensive bargaining between various levels ofhierarchy. Superiors had the overview, but no detailedknowledge, while subordinates had the detailed knowl-edge but no overview. Bargaining was conducted

around this asymmetric information base. Marginaladjustments were made on the base of the previousyear’s plan. Virtually every organization had an indi-vidual whose main task was to foster informal linkswith other organisations in order to help in the bar-gaining process in obtaining supplies or amendingbudgets and targets (Litwack, 1991, p. 80). The regimedid not consider itself bound by the law; indeed allinstitutions, courts, enterprises and information mediawere all subordinate not to the government, but to thehighest authority in the Party, its First Secretary. Atenuous although possible example of this attitude ismanifest in the event that so far the Russian Federationhas been unable to come to any arrangements over the26 billion dollars it owes foreign commercial banksbecause of its refusal to accept that a bank should beable to seize State-owned assets in the event of default.The foreign debt has elsewhere generally been settled(see subsection 5.3).

In considering legal reform, one of the largest prob-lems is that of consistency in the face of hundreds ofthousands of decrees and regulations of the previousregimes. A psychological difficulty in transforming toa market economy is the inheritance of a belief fromMarxist ideology that “property is theft”; indeed (asexamples in subsection 4.6 show) it often is. Many ofthe new rich have acquired their properties throughinfluence or bribery. In countries where until recentlymost forms of private business were deemed criminal,any successful business person is often deemed to be acrook. Changing people’s perceptions takes time.Transformations to market economies will continue toremain fragile until most citizens believe that the mar-ket delivers the goods to most people most of the time.

The model of a market economy which is being pro-moted in transitional States assumes that an efficientequilibrium can be achieved in a competitive environ-ment. But competitive prices are not sufficient wheninformation can be used to further an agent’s welfareor where information transmission is ineffective orcostly. In a world of product differentiation—achievedin a market economy—consumers gain from increasesin variety, but economies of scale limit the number ofvarieties. The competitive market solution is based ontwo main concepts: (a) producer efficiency resultingfrom competition and the good use of factors of pro-duction, and (b) consumer sovereignty whereby con-sumers exercise choice in what they buy and attempt tomaximize their consumer surplus. To measure the netwelfare gain, a comparison needs to be made between


(a) the bureaucratic costs of organizing the productionof many varieties, and (b) the ability of the marketeconomy to produce the correct balance betweeneconomies of scale and variety.

While the “invisible hand” paradigm commands apowerful position in competing visions of economicreform, factors ignored in this paradigm includelessons of informational economics (Stiglitz, 1989), thelinks between ownership systems and the viability ofcoordinating mechanisms (Kornai, 1990), and anunderstanding of evolutionary economics.

One of the main thrusts of reform is to construct incen-tives for and constraints upon enterprise behaviour thatwill produce better performance than that achievedunder a command economy. In the long run theseincentives will depend on the nature of capital, productand labour markets external to the individual enter-prise, on internal governance and reward structures,and on the interaction between these internal andexternal forces. In the meantime reformers facemanagement, workers and unions whose attitudes,skills and behaviour have been conditioned byincentives and constraints inherited from theadministered economy (Mayhew and Seabright, 1992,pp. 105-106).

In the analysis of transition, enterprise adjustmenthinges on the extent to which the incentives of enter-prise managers have changed. If incentives havechanged decisively in the direction of market-drivenones, then the market tests of profitability and insol-vency to judge the progress of the system can be used.Instituting a price system through the marketallocation of resources, the deregulation of enterprisesand private ownership of enterprises need to besupplemented by an appropriate mechanism to give toowners and creditors some control over enterprises(Carlin and others, 1994). Without such a mechanismfor enterprise control, enterprises without owners,operating in a society without effective laws, can easilyallow managers to privatize the gains and socialize thelosses.

Enterprise control in the former command economieswas not uniform. To encapsulate subsection 4.5.2 in afew words, in Hungary managers had control, inPoland the workers’ council, in Czechoslovakia thestate, and in the Russian Federation the managers,followed by the workers and then the ministries.Enterprise governance in a market economy requires ameasure of external influence, for instance by stock

markets and banks. As stock markets are essentiallyoriented to short-term results, banks are probably thepreferable alternative (Phelps and others, 1993).

A profitable firm is a collection of assets that yieldhigher earnings when managed together than whenmanaged separately. The question of whether the econ-omy’s overall management of its assets is efficient canbe broken down into a series of subsidiary questions:

• the asset bundling question is the choice as to whichassets are managed together an efficient choice;

• the management question;

• the ownership question; and

• the social welfare question.

In economic markets, values are attributed to physicaland property rights in goods and services or to the per-formance of agents. Measuring and enforcing agree-ments in political markets is even more difficult. Whatis being exchanged—between constituents and legisla-tors in a democracy—is promises for votes. The speedof economic change is a function of the rate of learn-ing, but the direction of that change is a function of theexpected payoff’s to acquiring different kinds ofknowledge. It is the mixture of formal rules, informalnorms and enforcement characteristics that shapeseconomic performance. While rules may be changedovernight, the informal norms change only gradually,and it is the norms that provide legitimacy to a set ofrules. Transferring the formal political and economicrules of successful developed market economies tothose in transition is not a sufficient condition for goodeconomic performance. Both institutions and beliefsystems must change for successful reform, since it isthe mental models of the actors that will shape choices.

Issues of strategic financial management merge intothose of property rights—to which the followingsection is devoted. The attitude of the individualtowards power and law is an important determinant ofsuch rights. For instance, for a Russian, power hasbeen more authoritative than law.

Over the centuries, the overwhelming majority ofRussia’s population had practically no property, andwhatever it had could be removed at any time by thearbitrary order of the authorities. Nor could contractuallaw develop, since the right of property is at its core(Vasilev, 1993, p. 73). It should be no surprisetherefore that the financial and industrial groupsemerging today are very often based on kinship or


friendship. Amid these vaguely defined patterns ofproperty and contractual relations, bribes seem quite anatural instrument. It is against such a background thatthe States longest bereft of a market—the successorStates of the Soviet Union—are undertaking a vastenlargement of the private sector, of which divestmentby the State of most of its assets is the crucial element,as the next chapter describes.

4.Property rights and micro-economic governance

4.1 The politics of ownership concentra-tion and dispersion.

During modern times in only one socio-economic sys-tem—the Soviet-type system—has the governmentnationalized the ownership of productive assets to pro-tect and implement its political monopoly.Governments of market economies in wartime andtotalitarian regimes in their fortunately-truncatedtenures of power, have imposed all-embracing controlsover the employment of such assets; these governmentsapplied coercion and asset confiscation to enforce suchcontrol, but did not arrogate to themselves the entiretyof ownership: the facility of private ownership was notwithdrawn. In Soviet-type practice, by contrast, a cru-cial reason for the nationalization of land and of virtu-ally all productive assets was to eliminate all forms ofdecision-making potentially hostile to the government;the other key factor was, of course, the execution of theEngels’ directive cited at the beginning of this paper,“turning the means of production into State property”for “the conduct of the processes of production”.

The political argument for extensive divestment by theState rests on three aspects of countervailing power.The first aspect fosters the establishment of civilsociety,

“that set of diverse non-governmentalinstitutions which is strong enough tocounterbalance the State and, while notpreventing the State from fulfilling its role ofkeeper of the peace and arbitrator between majorinterests, can nevertheless prevent it fromdominating and atomizing the rest of society”(Gellner, 1994).

The second aspect holds that

“if the property is in the form of monetaryclaims, with protection against the actions of

political agents who can effectively destroycapital values through inflating the money issue... individuals can be made more independent,can be secure in more liberties, in a regime thatembodies predictability in the money/goodsexchange rate” (Buchanan, 1994, p. 10).

In these two considerations, the degree to which thestate is “rolled back” from the model of the commandeconomy to that of the market is to be chosen by thesociety concerned: the case for a very substantialdivestment has been accepted in all transitionaleconomies, even whereas in some successor states ofthe USSR and of Yugoslavia—the communist politicalmonopoly has been replaced not by parliamentarydemocracy but by nationalist populism under presiden-tial rule.

The goal of the third aspect is to build a mass con-stituency of owners whose stake would dissuade themfrom surrendering it in any systemic reversal. Thatstake can be obtained in three ways: managers andworkers may be given a preference to purchase sharesat a rebate; citizens may be given vouchers to acquireownership rights in companies; or individuals maypurchase equity interests. The political element arguesfor speed and comprehensiveness, i.e. for “shocktherapy” rather than for gradualism. Shock therapyattempts to preempt the political backlash engenderedby the initial hardships of transition. As a consequenceof the widening of wealth differentials within adeclining real-income trend, a backlash in some Statesled to the election of “extremists”, including membersof the former ruling communist parties. So far,however, no transition to a market economy has beenhalted, whether or not its parliament or governmentincluded advocates of retrogression.

Even before the political revolutions of 1989-1991, aprocess of transition had begun with the enlargementof the non-State sector and by the introduction of a setof entitlements tantamount to ownership. As a rule ofthumb, the larger the non-State sector was, the quickerthe early stage of transition was. A non-State sectororiginated from two sources: some activities remainedafter the waves of nationalization (around 1918 andaround 1930 in the USSR and around 1948 in East andCentral Europe and Mongolia), and some arose sponta-neously from the mid-1960s in waves of “economic .reform” which attempted to establish a “socialist mar-ket”. Thus land was never nationalized outside theUSSR and was farmed, as in the USSR, not only byState enterprises but also by cooperatives and


“dwarfholdings”, while peasant agriculture was neversubstantially displaced in Poland. The other part of thenon-State sector arose from State divestment, of whichthe most extensive instance found was in Yugoslavia,where, from 1952, state productive assets were vestedin the self-managed enterprises in which they werelocated; in Hungary after 1980 State assets in somesmall enterprises were ceded to private owners; and inHungary and Romania from the 1970s, and the 1980selsewhere, joint ventures participated as minority hold-ers in the equity of State enterprises.

After the 1989-1991 revolutions there remains ofcourse a major role for the State in strategic financialmanagement. More detail is given in section 4.3, but itmay be summarized as follows:

“The assurance of a long-term financialperspective for the macroeconomy and ofappropriate institutions and instruments(including the budget and a positive real rate ofinterest) for its implementation;

“Support for industrial restructuring, includingfor small and medium enterprise and appropriatepolicies towards international trade and capitaltransfer;

“A balance between the provision of protectionand the promotion of competition in thedomestic microeconomy, achieved by meanssuch as taxation and control of bankruptcy, fraudand crime;

“The assurance of adequate research anddevelopment in domestic entities, theencouragement of technology transfer fromabroad, and the promotion of revenue therefrom;

“The facilitation of resource transfers whichsupport an active social policy, particularly withrespect to a desired income distribution and theminimization of involuntary unemployment.”

(Benini, 1994, pp. 10-12)

4.2 Entitlements as property rights

Just as the ownership of assets entitles the proprietor tothe derivative income flow or utility, the Soviet-typeState offered certain entitlements to its employees.Many of the entitlements were the “merit” goods andservices distributed by the State in modern marketeconomies, such as free or subsidised education, healthcare and social security. The Soviet Union itself dis-criminated in favour of those who were, or had been,

State employees. Thus those who were not State-employed, such as collective farmers, did not haveaccess to free secondary schooling until 1955, socialsecurity pensions until 1964 and free health care until1969. By directing merit goods and services to itsemployees, the Soviet State both demonstrated its eco-nomic priorities (industrial growth, for which agricul-ture was a supplier of food and labour transfer) anddirected benefits (not only social services but, forexample, gratis holiday stays) to those who would con-tribute more effectively to the chosen branches of pro-duction by being better educated, healthier and restedon vacation. Such prioritization of production had aserious obverse in that health and safety at work wereneglected and the natural environment was badly dam-aged. Other countries modelled on the Soviet systemdid not carry the choice of “entitlement” over “merit”that far, but all accorded State employees some prefer-ences over other citizens. Privatization and the “slim-ming” of government administration (see subsection5.6) have left gaps in social services which the privatesector may come to fill, but not, of course, as meritgoods. Thus, in Russia the share of beds in hospitalsrun by production enterprises dropped from 10 per centin 1989 to 3 per cent in 1993.

The entitlement to job security, the loss of which issocially disruptive, was formerly regarded as a right.Soviet-type institutions offered a variant of the market-based “wage to effort” bargain. Low work effort andleisure in working time were exchanged for low remu-neration. The oft-repeated adage, “We pretend to workand they pretend to pay us”, not only epitomizes such a“social contract”, but the relations of mutual protectionwhereby workers did not strike and managementsecured subsidies for wage-bills unjustified by labourproductivity and other enterprise losses. Thewithdrawal of the “right” to job security by involuntaryredundancy following privatization can, on thesegrounds, still be expected to lead to social unrest in thetransitional States. So far only Romania and theRussian Federation have significantly experienced thatreaction, chiefly among miners.

A corollary to job security was compulsion to remain ina particular post, and all Soviet-type countries expe-rienced some direction of labour, coercion and the useof prisoners for work. At the end of the Soviet-typesystem all such constraints were quicklyeliminated—where they had not alreadydisappeared—but market incentives have not provedadequate to keep staff in what had been low-priority


branches everywhere. Agriculture was one suchbranch. Many of those who worked on farms leftagriculture—particularly because permits were nolonger required for urban residence—leaving behindan elderly workforce and farm buildings andmachinery unsuitable for agriculture. Consequenceshave varied; in Albania and Bulgaria many fieldsremain untilled and buildings and equipment in disusebecause of disputes over ownership, whereas in theRussian Federation, collective and State farms havepersisted because many of the farmers occupying thembelieve they cannot obtain the capital and currentgoods they would need as smallholders. In Romania, somany farmers were the descendants of the originalpeasant owners that there are now six million propri-etors with 20 million parcels of land between them. Inall transitional countries the inefficiency of agricultureposes financing problems for governments in the formof low rural tax revenues (narrowing the tax base, asdescribed in subsection 5.1), subsidization (see subsec-tion 5.6) and protection (see subsection 6.1).

As noted in the previous subsection, dissatisfactionwith the new uncertainties has led voters in the mostrecent parliamentary elections in Hungary, Poland,Slovakia, the Russian Federation and Romania to turnin substantial numbers to the successors of the formerruling parties. Unwillingness to be exposed to suchuncertainties has been a factor in elections and hasresulted in the appointment of presidents inKazakhstan, Turkmenistan and Uzbekistan who hadbeen leaders of the former republican CommunistParties.

4.3 The economics of ownershipdispersion

Diversity of asset ownership allows competitive insteadof imperative criteria to be followed in four arenas ofmicroeconomic decision:

• Financial costs and benefits are in principle deter-mined by prices of inputs and outputs;

• Financial resources are allotted between current andcapital use by the expectation of return on the latterand the opportunity cost of other uses;

• A loss has to be met out of assets, and, failing this,by bankruptcy;

• Financial resources may be attracted from, or remit-ted to, foreign entities on the same criteria as for

domestic enterprises adjusted for current andexpected exchange rates and foreign governmentconstraints and incentives.

Government may influence foreign participationthrough fiscal instruments, regulation, treaty, interna-tional agreement or association within an economicarea. Government influence on the exchange rate needsno rehearsal, but the process of “nostrification”—thecompulsory conversion of foreign-held assets intodomestic ownership, as practised for example, by theCzechoslovak Government between the two WorldWars (Ranki and Tomaszewski, 1986, pp. 7-9)—mustbe noted as the obverse of the practice in the Soviet-type system of first expropriating foreign assets andthen forbidding such property.

Governments and legislatures in the transitionaleconomies are taking measures on five aspects of prop-erty rights:

• The establishment of legal forms of ownership andtheir delineation;

• The protection of—and power toextinguish—property rights with respect togovernment and business entities, households andnon-residents;

• The valuation of assets in two salient cases—massprivatization and market failure;

• The transfer of property rights among proprietorsand power over these pro bono publico; and

• The control of the use of assets by either local orcentral authorities and the policing of such useagainst fraud, crime or illicit monopoly.

Reference is made in the remainder of this subsectiononly to those features relevant to strategic financialmanagement. As was realised from the start (Kaser,1990, pp. 600-604), substantial price decontrol wasneeded before goods and services could begin to betransacted at prices determined by buyers and sellers;its complement was the assurance that the resources sopriced be put to their most profitable uses. This processrequires a system of institutions that provides a sociallydesirable internal coordination mechanism, including acomplex set of incentives for individuals to respond ina particular way to the information conveyed by themarket environment (Frydman and Rapaczyhski, 1994,p. 47).

Such a “coordination mechanism” is considered below.Most enterprises have to adapt to receiving and acting


appropriately upon signals received from suppliers andconsumers of their products and services, instead offrom administrative superiors. The widely-acceptedprocedure for such a transition is privatization intostructures governed by profit-motivated managementand incentive-based remuneration for staff: Optionally,the change in ownership can in itself embrace bothobjectives of governance by providing equity to man-agement and staff, but in all procedures the assetstransferred require valuation and financial arrange-ments for their enhancement or retrenchment. Onlyone transitional economy—the eastern Länder ofGermany—has enjoyed sufficient external finance torestructure State enterprises before privatization. Thenew structure of financial management has to providefor capital funding—essentially asset enhancement orclosure—and for current accountancy of costs,revenues and profits; as is noted below, suchaccounting has been hindered by weak paymentsdiscipline and failure to insist on hard budgetconstraints for newly-privatized and remaining Stateenterprises.

4.4 Establishment and delineation

As already stated in section 2, a Soviet-type economycommonly vested land and other natural resources inthe State and rendered illegal—or subject to punitivetaxation—the use of reproducible capital inconjunction with hired labour. There was nouniformity in this field among the countries subject tocommunist regimes and the transformation of propertyrights, since the disappearance of those regimesconsequentially varies. Nevertheless, three stages canbe identified: (a) general legislation authorizing andprotecting the establishment and exchange of titles; (b)the recognition and definition of any titles held prior tonationalization; and (c) the procedure for divestment.The more complex the issues of change were, the fewerrights had been left outside State ownership. Theextremes were Poland and Yugoslavia, whereagriculture (subject to a maximum holding of 50 and10 hectares respectively) and much small enterprise,remained in private ownership, and Albania, whereonly personal chattels and rural housing withminuscule plots were allowed.

4.4.1 The East German property transfer. Thesimplest case of transition in this arena is that of theformer German Democratic Republic, where FederalGerman law had only to be applied to the new Länder.

The first stage was thus effected virtually at a stroke,with the added advantage that, as valuable as the socialentitlements of the GDR had been, those of the FederalRepublic were better and funded by the public revenueand borrowing power of that Government. All the legalinstruments for proprietorship were thereby put inplace as were all the practicalities of transactions,including access to stock exchanges. It is to be notedthat since reunification no stock exchange has beenestablished in the Eastern Länder—in the light of thelikelihood of merging Western Länder exchanges, thiswas to be expected. Furthermore, German membershipin the European Union assures a still wider dimensionto new owners as part of the single European Market.

The second stage was rendered more complicated bythe political decision to recompense landowners inkind (restitution) rather than solely in money or vouch-ers to buy assets (compensation). Former owners ortheir legal successors could reclaim property expropri-ated by the Nazi regime (1933-1945, mostly Jewish),and under the communist government (1949-1989),although within a limit of area. Excluded from restitu-tion were land subjected to an agrarian reform in 1945and enterprises seized during the Soviet occupation(1945-1949). A law of May 1994 established an 18 bil-lion Deutschemark compensation fund and allowedlandowners the repurchase of their property at belowmarket prices. The establishment of title after so long alapse has meant that judicial decisions on restitution,compensation or rejection are expected to be requiredfor some 15 years, that is to about the year 2005.Claims were registered for 2.8 million property titles;by June 1994, 43 per cent of claims had been settledfor business enterprises and 38 per cent for all others.Settlement rates varied, however, by “Land”: Saxonyhad the highest, with 62 per cent of enterprise claimssettled, but Berlin and Saxony-Anhalt resolved 20 and31 per cent respectively, largely because of the highpre-Nazi concentration of Jews whose descendantshave proved difficult to trace. As elsewhere intransitional economies, land registers had beeninadequately maintained or lost and many claimantswere non-resident.

The third stage was also the simplest among transition-al States, for all State property in the GDR was, evenbefore reunification, transferred to a single agency, theTreuhandanstalt (in July 1990, on the basis of a hold-ing trust established as early as March 1990).

After reunification (October 1990) all former State-owned enterprises were transformed into joint-stock


companies wholly owned by the Treuhand—the largerinto an AG (Aktiengesellschaft) and the smaller intoGmbH (Gesellschaft mit beschrankter Haftung)—ormade over to municipalities. Because the subsequentsale of such companies (after restructuring, asdescribed in subsection 4.5.1) was being obstructed bythe indecision of “restituted” owners, the Treuhandwas authorized by a Law on the Removal of Obstaclesto Privatization of Enterprises and for the Promotion ofInvestment (1991) to sell an enterprise if the formerowner did not furnish a business plan equivalent tothat offered by another. It was also, by a law on specialinvestments, allowed to make dispositions in importantcases without awaiting the outcome of restitution pro-cedures. In both groups, restitution was replaced bycompensation. When the Treuhand was terminated, asenvisaged, on 30 December 1994, its initial stock of12,300 privatizable enterprises had been reduced to 67;some 8,600 had been sold and 3,700 liquidated, but thecost was higher than any other transitional economycould have borne by itself (Carlin in Estrin, 1994). TheTreuhand had incurred a government debt, held by. theFederal Unwelcome Legacy Repayment Fund, of 270billion Deutschemarks (190 billion dollars), and hadimposed 3 million redundancies of an initial workforceof 4.5 million and a total Eastern Länder employmentof 8 million.

4.4.2 Restitution and compensation. Nine other transi-tional States (Bulgaria, the Czech Republic, Estonia,Latvia, Lithuania, Poland, Romania, Slovakia andSlovenia) have enacted restitution to resident citizenswho were deprived of ownership during the SecondWorld War and in the communist period without—orwith inadequate—compensation. Hungary and allmembers of the Commonwealth of Independent States(CIS) explicitly decided against restitution. Albaniaaccepted partial restitution of land, but only up to one-tenth of the pre-collectivization holding, to precludethe restoration of the extreme inequality that hadearlier existed. Restitution to domestic institutions, asdistinct from individuals, has been much more limited;however, including in those States opposed to generalrestitution, most of their buildings have been returnedto religious bodies. Restitution to foreigners, includingformer citizens, has been complicated by bilateraltreaties with communist-period governments underwhich residents in the Western signatory country hadalready received some compensation; only Latviaexplicitly ruled out restitution to foreigners, partlybecause of the emigrant/immigrant problem with theRussian Federation.

All the “restituting” States, plus Albania, Hungary andPoland, authorize compensation to individuals in oneor more of four forms—the allocation of a similar assetor of privatization vouchers, or the payment of moneyor of a lifetime security (such as an annuity or pensionsupplement). Compensation has, however, been ruledout by members of the CIS, on the grounds that thenationalizations of 1918-1932 were too remote in timeand that assets had been profoundly changed in theinterim. Special issues arose in the territories annexedby the USSR in 1945 and now part of Belarus,Moldova and Ukraine, and in two regions of theRussian Federation (Tannu Tuva, incorporated fromquasi-independence in 1944) and Kaliningrad(Konigsberg, annexed in 1945), many of which remainunsettled.

4.4.3 Registration and exchange of title. The secondstage has been completed everywhere or is in processthrough the revival of officially—held propertyregisters. Cadasters for land and registers for realestate were extant everywhere—though not necessarilyup-to date—including in the former Soviet Union; inRussia the State Property Register was made a “ChiefDepartment” (Glavnoe upravlenie) of the StateProperty Management Committee(Goskomimushchestvo). A major problem has,however, arisen for non-tangible assets. Outside theCIS, the establishment of company share registers wasfairly expeditiously made joint ventures with foreignershad to be registered in the communist period andregistration procedures and offices were generally partof preparations for privatization. Of nationwide stockexchanges on a recognized basis, two have marketcapitalizations already equal to smaller capital-cityexchanges of the European Union; thus, Prague at 14billion dollars in 1993 just exceeded Athens (13 billiondollars) and Warsaw at 3 billion dollars equalledLisbon. Budapest was the only other to surpass 1billion dollars, but these Central European exchanges,including Bratislava, are together likely to reach 28billion dollars in 1994, about equal to Vienna’s 27billion dollars in 1993 (London Stock Exchange, 1994,p. 36). A stock exchange will open in Bucharest inmid-1995, the law being already in place. Althoughlegislation to create a Mongolian stock exchange datesfrom March 1991 (its 1993 capitalization reached 300million dollars), it was only in mid1994 that a fillSecurities Law was enacted, providing formalregulation of the financial market. This followed someextreme mishandling of foreign exchange dealings byMongolbank (the Central Bank).


The individual republics of the former USSR hadenacted legislation (uniformly titled “On Securities”)on the eve of secession. Legislation is in place almosteverywhere for stock registrations and transactions,and, although many share dealings take place onbourses set up for commodities, there are now 70authorized stock exchanges in the Russian Federationalone. Those in Moscow, St Petersburg, Yekaterinburgand Novosibirsk are the most active, and transactionsin 1994 were estimated at 3 billion dollars; a unifiedelectronic clearing system is envisaged. Shares ininvestment finds have been of the bearer type, ratherthan nominated, but even named shareholders havebeen fraudulently deleted from company-held shareregisters. A Federal Commission for Securities and theStock Market, overseeing a State Property Register,was set up in November 1994. As mentioned insubsection 3.3, the most notable scandal in the RussianFederation to date has been AO-MMM, a pyramid salebased partly on the attraction of naive lenders bysophisticated media advertising—reportedly spendingthe fantastic amount of 100 million dollars—and partlyon its management by the same individual, SergeiMavrodi, of MMM-Invest, which garnered 3.1 millionprivatization vouchers from 2.4 million people inexchange for its shares. With these vouchers MMM-Invest bought equity in 28 of the most likely profit-makers among privatized forms and advertised in theFinancial Times, on 27 June 1994—a mere four weeksbefore AO-MMM crashed—that it owned between 5and 25 per cent of shares in eleven major Russianprivatized producers. In a further advertisement(Financial Times, 10 April 1995) it claimed substantialholdings in 13 companies and small participation in 13others.

In all Soviet-type economies, retail banking was littledeveloped; as already noted, the takings in State shopsand the wages in State enterprises constituted thedemand for cash between the State sector and thehousehold sector. The latter made almost all theirtransactions in cash, with a “girobank” serviceavailable through savings banks. West German bankssoon took over the GDR Savings Bank and establishedtheir own branches (the Dresdner Bank “went home”to Dresden with no little ceremony), and localnetworks were quickly set up by domestic and foreignbanks in Eastern Europe and the Baltic States, and,already in the 1980s, in Hungary).

By contrast in the CIS, households and private firmscontinue to handle large quantities of banknotes,

resulting in much tax evasion, moneylaundering—especially for narcotics smuggling andprotection exactions—and capital flight. Inflation in allof these countries has led to some “dollarization”. Theratio of dollars—by far the favoured vehicle—toRussian roubles in late 1994 was about the same asdollarization in Peru at the height of its hyperinflationin 1990, although Russian inflation was much moremoderate. Furthermore, it is estimated that a quarter ofthe dollars circulating in the Russian Federation arecounterfeit.

In the CIS the problem of a high ratio of money in theform of notes and coin (Mo) to other forms of money istwofold. Distrusting banks—many of which are con-trolled by criminals—and with scant information onthe viability of newly—established private companies,the public has deposited vouchers and cash ininvestment finds. Such finds are also ready havens forillicit and speculative monies, and the RussianFederation Government, among others, has sought tocurb such use by confiscation. Both factors led to thepolice seizure in August 1994 of billions of roublesfrom Russki Dom Selenga (the last term arussianization of “selling”), whose slogan, “Othersonly promise a better future, we guarantee wealthtoday”, typified the extravagant claims beingmade..The scheme had attracted 1.5 million depositorsbefore judicial closure. The Georgian militia were lessprompt: a find, Achi, had obtained some 10 milliondollars in deposits before its chairman fled with themoney. Excesses like this brought a PresidentialDecree in June 1994 to restrict financial advertisingand a draft law in August for regulation by theMinistry of Finance of the burgeoning Russian stockmarkets (which traded the equivalent of 500 milliondollars in July 1994 alone). Since pyramid selling hadnot been experienced in the communist period, it hadnot been dealt with by legislation. The Russianexperience with AO-MMM was not an isolated case:the Caritas fraud had been as serious the previous yearin Romania. Since 1 January 1995 a licence must beobtained to engage in securities intermediation in theRussian Federation.

Many of the title transfers under privatization arrange-ments were however legally encumbered. A random-ized survey of businesses after “small privatization”found restrictions in the transfer contract of 52 per centin Hungary, 41 per cent in Poland and 28 per cent inthe Czech Republic; the duration of the lease on thepremises occupied was two years or less in 42 per cent


of small businesses in Poland and 33 per cent in theCzech Republic, but only 6 per cent in Hungary.Reporting these findings, Earle and others (1994, pp.255-257) believe that these restrictions were due tounjustified government fears of change of use whichcould lead to “disruptions of supply”. In the short term,rapid resales could lead to speculative real estate mar-kets and pressure to flout zonal planning regulations(as happened in some restituted housing and inmunicipal sales to tenants in Czechoslovakia), butrestriction hinders the restructuring whichtransformation of the real economy requires.

The same survey found that very few of the encum-brances related to the maintenance of an agreed levelof employment (1 per cent in Hungary and Poland,none in the Czech Republic) and none to requiredinvestment. Both these injunctions figured prominentlyin the Treuhand’s privatization in the German EasternLänder—by July 1993 1.48 million jobs and 181 billionDeutschemarks in investment guarantees had beensecured. Such obligations are enforced during theircontracted period by fines; the same financial sanctionsoperate on surplus profit arising from early resale andon any undervaluation of land which may arise in adefined future period. At least one Russian buyer of aTreuhand firm regarded the fine as part of thepurchase price and made over both in one payment (inDeutschemark banknotes brought over in twosuitcases).

Other, more general restrictions exist on land owner-ship. Most of the postwar agrarian reforms remain inplace, foreign purchases are restricted, often to leasingwithout the right of purchase, and some new limits areestablished—such as 300 hectares for land purchasesin Hungary by a law of April 1994.

4.4.4 Privatization procedures. All 30 transitionalStates have at least institutionally completed the thirdstage—the installation of a procedure for privatization.In accordance with 1991 legislation before the breakupof the USSR, each of the CIS created a StateCommittee for the Management of State Property (likethe Goskomimushchestvo of the Russian Federation towhich reference has just been made), charged with allforms of “destatization” (razgosudarstvlenie). TheGerman Treuhandanstalt model, already described,was followed in Estonia, but in the two other BalticSoviet successor States, Latvia and Lithuania, the rolewas filled by existing ministries (ECE 1993, p. 194).Specific Ministries for Privatization were establishedin Czechoslovakia (the two federated ministries being

inherited by the Czech and the Slovak Republics) andPoland (originally called the Ministry of OwnershipChanges) where, however, pre-privatization restructur-ing is in the hands of the Industrial DevelopmentAgency, causing some confusion. In nine States anagency was created with effectively plenipotentiary sta-tus: the National Privatization Agency in Albania, thePrivatization Commission in Armenia, thePrivatization Agency in Bulgaria, the TransformationAgency in Macedonia, the Privatization Commissionin Mongolia, the Agency for Economic Restructuringin Montenegro, the National Agency for Privatizationin Romania, and the Privatization Agency in bothSerbia and Slovenia. Two countries, for a short time,had dual agencies. In March 1990 the State PropertyAgency was established in Hungary to implementprivatization and at the end of 1991 a State AssetsCompany was established to hold equity in 162 large“corporatized” enterprises. The left-centre coalitionGovernment of 1994 soon merged them (under thepresidency of a chairman of the State Bank in thecommunist period). The Croatian Agency forRestructuring was merged in 1993 with the Fund forDevelopment into the Croatian Fund for Privatization.The “Fund” in those titles relates to the otherinstitutional procedure generally adopted of re-founding State-owned enterprises as joint-stockcompanies in which all shares are held by the State, aprocedure known as “corporatization” or“commercialization”. It was adopted in most Europeantransitional States (Bulgaria, the Czech and SlovakRepublics, Hungary, Montenegro, Serbia, Poland,Romania, and Ukraine), but in the Russian Federationcorporatized equity was transferred to an entity withinthe particular branch, e.g. Rosneft for the oil industry,Rosugol for the coal industry. Some governmentsperceived corporatization as permitting them to retainsome direct control over resource allocation or overexports (as with Russian gold and gas), butincreasingly State-owned equity is being sold off in theinterest of widespread privatization.

All governments have provided for the establishmentof investment funds to manage or buy privatizationvouchers, where issued, or to buy into privatizations onbehalf of depositors. In Poland each fund is to be man-aged by foreign companies (such as major accountancyfirms) to hold a substantial part of the equity of the 450to 500 enterprises to be privatized (citizens’ privatiza-tion vouchers, described in subsection 4.4.5) could buyinto the bundle of equities run by a “fund”, not into anindividual privatized enterprise. Nearly everywhere


commercial “fiends” were set up by private investorsand managers to attract vouchers and money for acqui-sition in each “large privatization” scheme. In theCzech Republic a small number of fiends quicklyattained market dominance, some by offering veryattractive promises for the deposit of vouchers withthem—and which still have to be demonstrated in divi-dends. The fulfilment of promises has been slow. Froma high of 3,805 in February 1994 the Prague share(HN-Wood) index dropped to 1,836 in the followingJune. Even so, Standard and Poor raised their invest-ment rating of the Czech Republic at the time fromBBB to BBB+. The first wave of privatization tookplace in a united Czechoslovakia and the distributionof the nearly 1,500 enterprises involved was virtuallythe same as that of the population—two Czechs forevery Slovak. But whereas the Czech Republic wentquickly into a second wave, the next Slovak wavebegan only in September 1994, with the issue, asbefore, of vouchers to be purchased. In the first Czechwave the 185 “investment privatization funds” received72 per cent of the vouchers, but in the second wave,349 such funds attracted only 64 per cent of the vouch-ers. It could be concluded that more citizens were mak-ing their own stock-market choices.

In the Russian Federation a few funds werenationwide: a major one was run by the insurancecompany ARCO, another by the Alpha Bank andanother by the MMMInvest described in subsection4.4.3; the Bank’s advertising was as moderate as thatof the twin MMMs was extravagant. Some funds wererun by local entrepreneurs (e.g. the Ekaterinburg SmallBusiness Administration) and others were promoted bythe regional authority (mainly for privatizationsaffecting the local infrastructure). Sensing the thatdanger funds would buy privatized enterprises forasset-stripping, the Lithuanian Government restrictedany fund’s purchase in a particular firm to 50 per centof the equity; Thomas and Kroll (1993, p. 451) statethat two-thirds of fund managements had assetdisposal as their objective.

4.5 The finance of privatization andrestructuring

4.5.1 Enterprise valuation and disposal. Expectationswere soon dashed that the sale of the majority of theState’s productive assets would yield large sums whichwould contribute to reducing budget deficits or provid-ing budget surpluses. However, throughout, there has

been a close link between monetary stabilization andthe associated processes of restructuring and privatiza-tion. The anticipation of a profit was drawn from theexperience of sell-offs of major public corporations inestablished capitalist economies, notably in the UnitedKingdom in the 1980s; there had been some restructur-ing, financial consultancy and advertising costs, butthe net proceeds had been substantial and hadcontributed to a significant deceleration of inflation. Itwas enshrined in the Unification Treaty of the twoGermanies that the net surplus from the sale of GDRState property would be “exclusively and only”(ausschließlich and allein) for GDR citizens, pro ratato their personal savings at the time of monetary union(Schrettl, 1992, p. 147).

The costs which exceeded receipts were under threeheadings: the direct expenditure on the privatizationprocess; financial and physical restructuring; andsubsidization of current enterprise outlays in a more orless prolonged transition. The first set of costs isstraightforward—some are those incurred in similarprogrammes in Western Europe, but they are mainlyfor the administration of the agencies listed insubsection 4.4.4. The one controversial feature hasbeen the magnitude of spending on Westernconsultancy services. Governments of transitionalStates accepted that the suddenness of the politicalchanges and their lack of experience—Hungary andPoland excepted—in the procedures required formarket institutions demanded external advice. Butlegislatures and voters became concerned at the size ofthe fees levied and the proportion thereby taken ofmoney set aside by international and Westernadministrations. In one case, external consultancieswere afforded a major role: the Polish Governmentcalled for tenders—awarded in late 1993—fromfinancial service firms to manage the score of “funds”which would hold the equity of mixed baskets ofprivatized enterprises; however, a successoradministration was cautious in its implementation.

The second group of costs was and is the subject ofmuch controversy within legislatures, executives andtheir foreign or international advisers: should the Stateundertake restructuring before privatization or shouldit accept a lower price at privatization and leaverestructuring to the new owners? Most governmentshave been prepared to consolidate the outstandingdebts of enterprises and to clean up the balance sheetbefore privatization (“financial” or “passive”restructuring), but few have shown themselves


prepared to undertake “physical” or “active”restructuring. Exceptionally among the transitionaleconomies, the Treuhand has provided the capital forreshaping enterprises as fit for a competitive market,because its statute required it to take account of thesocial costs of unemployment and retraining arisingfrom redundancy and efficiency cutbacks. Privatizationagencies have generally broken up or mergedenterprises into appropriate lots—especially wheredivision is in the public interest to preclude monopolypower—but have not invested heavily in restructuring.Some division has been taken at the instance ofexisting managements, each interested in achieving afeasible span of control—this has been the case,particularly in the Russian Federation. Because manyproducers in the Soviet-type economy wereunderfunded against environmental damage, thedisposal agencies have had to offer indemnities againstrehabilitation costs and future environmental damageto third parties.

The value of an enterprise is the discounted value offuture net cash flows. The cost of restructuring and ofenvironmental repair reduces net flows. A minimum isset by the value of the equipment and buildings soldseparately after closure. If the enterprise is reopenedafter a period of closure, suppliers, clients and goodwillmay have been lost. But the Soviet-type economieswere so isolated from the price relativities prevailing indeveloped market economies, that neither input prices,nor output prices, nor capital-to-output relationships asinherited, bore consistent relationships to those to beconfronted on the world market. This was the casewith or without adjustment for import subsidies orduties, or export subsidies or duties (all four of whichcould be found in transitional trade regimes). Over- orundervaluation of the fixed exchange rate alsocontributed to the vagaries. All transitional economiesliberalized wholesale and retail prices at an earlymoment in transition (some only partly, with addedirrationalities) and allowed the exchange rate to float,sometimes over-, sometimes under-shooting anequilibrium rate. The combination of these actions ledto very wide dispersions of national prices as theyresponded to demand and supply measured against anyexternal norm. Thus a year after the January 1992price liberalization in the Russian Federation, the priceof diesel oil was 35 per cent of the world price atcurrent exchange rates, of aluminum 45 per cent and ofsugar 151 per cent (Flemming and Matthews, 1994, p.68). Prices of equipment were still less amenable tomeasurement at world prices, not only for the inherent

difficulties of equating models and performances, butparticularly because obsolescence, disrepair and ratesof depreciation varied widely. The value of mineraldeposits proved still less amenable to accuratevaluation. The capitalization of Lukoil, the firstRussian oil producer to be privatized, implied that itsproven oil reserves were valued at much less thanWestern oil companies valued theirs, but its likely pro-ductivity in exploiting them was also of course muchlower.

Parallel with the complexity of present valuation ofassets and the expected flow of income therefrom (thesupply prices of privatization) are the inadequacies ofpurchasing power to buy them (the demand side). Inthe very first days, it was thought that the monetary“overhang” that had accumulated under the repressedinflation experienced everywhere, save in Hungary,could be absorbed in privatization buying—withbenign effects on domestic inflation. But priceliberalization brought rapid inflation to almost allStates in transition—hyperinflation in the States offormer Yugoslavia, Ukraine and the Caucasianrepublics—and liquidated the overhang. Otherchannels of transferring equity out of State handstherefore had to be established. In the one transitionaleconomy (the Eastern Länder of Germany) whichavoided inflation— in fact prices dropped in the firstyear of change— normal selling—off could be, andwas, undertaken. But there, the plant had to be broughtup to the condition demanded by West German buyers:by 1993 only 6 per cent of privatizations had gone toforeigners (albeit responsible for 10 per cent of bothinvestment and employment guarantees) and 19 percent to management/employee buyouts (with fewinvestment or employment guarantees, as most were ofsmall enterprises, 67 per cent having less than 50 staff.Restructuring and betterment capital, and currentsubsidy were supplied by Federal sources, i.e. thetaxpayers and investors of the Western Länder.

Three procedures for transferring property rights havebeen noted above: restitution, corporatization (com-mercialization), and closure followed by sale of theassets severally. The other channels which have beenemployed in transitional States, as exemplified in theCzech Republic (Earle and others, 1994, p. 259) andPoland (Modzelewski, 1991, pp. 4-5), are:

• Commercial sale by contractual negotiation;

• Commercial sale by auction through:

~ open tender;


~ closed tender;~ closed non-competitive tender;~ open auction;~ closed auction;

• Gratuitous transfer to current user;

• Issue of vouchers (free or at nominal fee) to adefined group (of citizens, of all adult citizens, ofemployees) exchangeable against the equity eitherof an enterprise or of an “investment fiend” holdinga mix of equities;

• Open public offering of equity, either of anenterprise or of an “investment fund”; and

• Controlled bankruptcy.

It is general practice to offer some shares on conces-sional terms to employees (sometimes on a scale whichallows larger offers to managers than to others) even ifthe principal buyer is a foreigner. Thus the proceduretermed “capital privatization” (by mid-1994 used forsome 100 Polish enterprises) divides equity betweensuch insiders, the Ministry of Finance and a “strategicinvestor”, usually a foreign corporation. In “controlledbankruptcy”, used for 850 Polish State enterprises bythat date, the enterprise is formally liquidated andassets leased or given to staff. Leasing has been widelyutilized in the non-farm sector elsewhere, especially forsmall businesses in which employees are unable tomobilize the necessary capital, or with respect to jointventures with foreigners; it is especially favoured in theminerals and agricultural branches, wheregovernments are unwilling to yield ownership rights.In agriculture the long dominance of State andcooperative farming— minor in Poland andYugoslavia, but which oppressed initiative over sixdecades in the former Soviet Union—was cause forparticular difficulty in privatization. In EasternGermany previous owners could regain land incooperatives, but the former State farms were dividedinto leases, which may be purchased outright after 12years. Restitution from expropriation under the Sovietoccupation (1945-1949) was limited to 100 hectares. InCentral Europe voluntary cooperatives were oftenformed when land was returned to owners, whose titlehad only been pooled, not surrendered. In the Balkans,those who held title, sometimes in conflict amongthemselves (as noted in subsection 4.2), took advantageof provincial administrative disruption to seize landand have declined to cooperate in production, andoften even in distribution, with considerable loss ofpotential. In the Baltic States, “reprivatization” to

those in current tenure and restitution to those nolonger in tenure, quickly resulted in a general return topeasant farming (but with “partnerships” fostered inLithuania). In the CIS, resistance to private property inland (its socialization had been one of Lenin’s firstthree decrees in November 1917) left leasing as themain option and most State and collective farmscontinued to exist.

4.5.2 Enterprise governance. Eastern Europe’s fiveclashes with Soviet dominance marked a path forworkers’ roles in present privatization. Tito, seeking todifferentiate Yugoslav socialism from Stali’s after thebreak in 1948, chose enterprise self-management; theleadership of the Hungarian revolt came from the self-styled “workers’ councils” in 1957, and that of thePolish uprisings of 1970 and 1980 frm the Solidaritytrade union. The culmination of the “Prague Spring”on the eve of the Soviet invasion of 1968 waslegislation to vest State firms in “enterprise boards”with a majority of votes allocated to management andworkers. With important exceptions (the EasternLänder and the Czech Republic) there has been a trendtowards “insider” (management and employee) controlin the first four years of change. The growth of capitalmarkets, a rise in household savings and thepenetration of foreign investors will modify this trend,but, for the present, consideration of financialstrategies must take account of a microeconomydiffering in certain respects from that of a developedWestern counterpart.

Among small State-owned enterprises, privatizationhas usually been biased towards the employees of theparticular enterprise. At one extreme, in EasternGermany buy-outs were encouraged by the Treuhandthrough the offer to staff of loans or leasebacks with adeferred purchase option, and in Slovenia the morefavourable the buy-out terms were, the greater the pro-portion of employees who subscribed their vouchers totheir own firm were. On the other hand, in the Czechand Slovak Republics and in Hungary, auctions madeall potential purchasers equal, however, as it turnedout, two-fifths of small enterprises in the CzechRepublic went to insiders, but only 8 per cent inHungary (Earle and others, 1994, p. 249). “Small” pri-vatization is largely complete in those countries and inAlbania, Belarus, Bulgaria, Croatia, Estonia,Kazakhstan, Kyrgyzstan, Latvia, Lithuania,Macedonia, Mongolia, Romania and the RussianFederation.


In the European Union only 7 per cent of the 14 mil-lion existing businesses have more than nineemployees, and those with fewer, generate a quarter oftotal annual turnover. By contrast, in the former SovietUnion 14 per cent of a total of 43,300 enterprises hadmore than 1,000 employees (1 per cent had over10,000 each). A feature of Soviet-type industrialorganization was the existence of proportionately morelarge enterprises than in a market economy andproportionately fewer medium ones, typified in anetwork of contractors and subcontractors supplyingbig firms. The “shortage economy” favoured verticalintegration. Post-communist regimes have partlycountered this structure by splitting off subsidiaries forseparate privatization, but, as the tendency has been toprivatize before restructuring, it is “large” privatizationthat forms the decisive stage in transition to market-oriented institutions.

“Insider” privatization of the relatively large enterpris-es has been fostered by various means, such as thereservation or price discount of a bloc of shares formanagement and workers, or by the deliberate actionof staff in applying their vouchers to their own firm.Twenty two States have used vouchers or plan to usethem; Albania and Georgia are the most recent exam-ples, having issued them in November and September1994 respectively. Although most voucher distributionswere gratis—either to all citizens or to adultcitizens—some money was required in someprocedures (see below).

Of the States in which “large” privatization had sub-stantially been accomplished by mid-1994, the mostextensive insider predominance when the process wasvirtually complete was found in Mongolia, where two-thirds of all privatized enterprises were so controlled.In the Russian Federation, when the first wave of largeprivatization was concluded in July 1994, 103,000State enterprises had been privatized and 13,000 moreprivatizations were in process. There were 40 millionshareholders, that is, more than in either the UnitedStates or the United Kingdom, and the State sector hadbecome smaller than in Italy. Of the 148 millionvouchers issued, 97 per cent had been redeemed eitherdirectly for share purchase or used for buying throughsome 600 investment funds (Kaser, 1995; andLieberman and Nellis, 1995). A second stage thenbegan, in which all shares would be sold for moneyand the money made over to the firm. However, almostfour out of five enterprises in the first stage hadchosen, among the three procedures offered, that which

assured management and staff a 51 per centshareholding-insider equity was the predominantchoice. Although concern about job security led manystaff to place their vouchers in their own place ofemployment, the role of the enterprise director in theSoviet system played a large part. He or she had beenvested with full authority under the principle ofedinonachalie (single-person headship) and weightwithin the troika (three-person group) of the director,the Party secretary and the trade union chairman.Usually that power persists in the privatized firm andsubsequent mergers and expansions can be attributedto the enterprise of such individuals. Thus, thegathering of three Siberian oil producers into Lukoil isreported to be wholly the work of its Director; his firm,with the Russian Federation Government backing, hasbecome transnational by an equity entry of itssubsidiary, Lukoil-Baku, into partnership with theState Oil Company of Azerbaijan for exploiting theGiuneshli deposit in the Caspian Sea. Azerbaijan andthe Central Asian republics were moving in the samedirection. The virtual monopolist of Russian gasproduction, Gasprom, has diversified through thepurchase of shares in more than a hundred privatizedenterprises.

All managers of large firms in the CIS were coopted—if they had not already been—into the local politicalelite, which, as noted in subsection 4.6, was also opento penetration by criminal elements. This set of forcesmade for imperfect competition—particularly by limit-ing new entry and checking any downward tendency inprices—and consequently for an upward pressure onprices in conditions of serious inflation. In countriessubject to hostilities (the Caucasus and formerYugoslavia), local military dictates added to ad hocmanagerial control.

In more ordered countries (Hungary, Poland andSlovenia) insider control was also important. Phelps(in a foreword to Frydman and Rapacynski, 1994, p.xiv, and drawing on their analysis, pp. 158-163),suggests that this could be due to the management-worker devolution that weakening communistgovernments allowed under their styles of “marketsocialism” before the collapse:

“It is a paradox… that it is in a country where rela-tively slow and belated reforms of this type took place,namely the former Czechoslovakia, where the class ofnewly empowered groups was not created, that atransition to ownership of enterprises largely by outsideinterests could go swiftly and smoothly.”


4.5.3 Enterprise finance. Because insider-controlledenterprises rank job security highly, they have takenadvantage of imperfect markets under inflation to pro-tect employment and wage bills: governments havebeen slow to foster new entry or to act against monop-olistic positions. Because governments are unwilling tocountenance unemployment, they have shownthemselves willing to subsidize “loss-making”enterprises while still State-owned (“corporatized” orwith part equity), and after privatization to tolerate taxarrears (Flemming and Matthews, 1994, p. 75) or payabove-market prices for procurement (hiddensubsidies). The impact of enterprise indebtedness fromthe point of view of the solvency of the banking systemhas been considered in subsection 3.3.3. Amongthemselves, enterprises have accumulated debt andneither they nor the authorities have pushed firms intobankruptcy in any significant number. Fan andSchaffer (1994, p. 161) suggest that the low number ofbankruptcies may not be due to “creditor passivity” butto the practical difficulties of pursuing a debtorthrough the courts—indeed some States do not yethave a bankruptcy procedure—and to the low value ofremaining assets when liquidated. On the positive side,and as far as the Polish evidence goes (Gomulka, 1994,p. 197), nine out of ten enterprises are debt-free andinter-enterprise and bank debt is concentrated on amere one-tenth, but these are the “very bad” firms forwhich a government cancellation of debt and the issueof its securities to creditors in lieu—as somepropose—would only postpone “therapy”, for the debtwould re-appear. Data as of the end of 1993 for theCzech Republic, Hungary and Poland show thatgovernment bail-outs to banks to cover bad debtstotalled 6 billion dollars. The situation in the RussianFederation is similar, though several magnitudesgreater. Of inter-enterprise debt of 42 trillion roubles(24 billion dollars at the current exchange rate) on 1June 1994, the bulk was owed by a mere 200enterprises; debts to the government, including taxarrears, were a small share, totalling 9 trillion roubles.So far as Central European data showed as of 1991,enterprises responded to market forces by reducinginventory ratios (Fan and Schaffer, 1994, p. 155);however, this could be attributed to the discovery of“just-in-time” techniques and to the relaxing of the“shortage economy” rather than to the “bite” of apositive interest rate or better financial management.The inherited lack of a procedure for bankruptcy hasnow been corrected in most countries, but very fewproceedings have as yet been instituted. The

International Monetary Fund and the World Bankmade the enactment of approved bankruptcy legislationand the acceleration of privatization a condition offurther loans to Romania; the two corresponding lawswere passed in March 1995, under which 3,000 Stateenterprises will be sold off by mid1996.

Privatization by gratis voucher self-evidently broughtin no “new money”, and was defended on politicalgrounds or on the basis of lack of household savings.Some schemes for nationwide shareholding did involvepayment. The purchase price (equal to 34 dollars) of abook of vouchers in the Czech Republic, when assetswith a book value of 2.2 billion dollars were distrib-uted, proved by mid-1994 to be a bargain at less thanone-twentieth of the average share value obtained. InBulgaria a fee of 500 leva was required for a voucherworth 25,000 leva. A Hungarian scheme begun in 1994offers interest-free loans (to which any citizen is enti-tled on payment of a 2,000 forint fee) up to 100,000forints each (i.e. nearly 1,000 dollars); repayment canbe spread over five years, but the shares, which consti-tute the security, cannot be sold until the debt iscleared; the only gratis vouchers distributed have beengiven in lieu of restitution. Under the Lithuanianscheme the value of the voucher, deposited in bankaccounts of adult citizens, rises with age, and isindexed for inflation; vouchers may be used for hous-ing, land, small or large privatization but must bematched by cash (mostly 5 per cent, but 20 per cent tobuy housing). Many CIS States (Armenia, Belarus,Kazakhstan, Kyrgyzstan and Moldava) made similardifferentiations among citizens in the value of vouch-ers, either designated in money or points. But other(Azerbaijan, Tajikistan and Uzbekistan) did not issuevouchers. The second stage of the Russian large-scaleprivatization, unlike the first, offered no vouchers, butthe Government feared that the domestic capital mar-kets and household saving balances would be unable tomobilize the funds to buy the firms offered at realisticprices. Unwilling to sell off at lower prices or envisagewidespread foreign purchases, it negotiated with a con-sortium of eight domestic banks for a loan whichwould give those banks control of the management andprofits of the companies concerned for a period of fiveyears. Because some of the firms most interesting toforeign buyers would be covered (Gasprom, NorilskNickel, Rostelcom, and the electricity monopoly)Western multinational corporations were disconcerted,and by early April 1995 the final decision had not beenmade.


The inadequacy of “new money” under voucher priva-tization and of financial discipline in insider-controlledenterprises would imply the need for substantialrecourse to capital markets. But, for reasons discussedin section 6, foreign investment-direct or portfolio-hasbeen generally slow to participate, and domestic capitalmarkets are only beginning to do so. Again to citePhelps (in Frydman and Rapacynski, 1994, p. xiv):

“The need to go back to financial markets toraise capital in the future… is substantiallydiminished when the enterprises are given softbudget constraints by the government and hencedo not have to go to the capital market. Thus ahitherto unrecognized connection betweenmacroeconomic stability and genuine propertyrights is brought to light.”

4.6 The insidious spread of crime

The weakness of governments towards enterprisefinancial discipline has led to the call for a “visibleboot” to complement Smith’s “invisible hand”. In theaccepted sense, the “boot” is government regulatoryauthority as well as sound finance, but in current post-communist circumstances it must also mean theassurance of security against crime.

The communist-period inheritance of political monop-oly and a “shortage economy” was of corruptionbecause so much was determined by officialdom and byillicit dealing, since the State made no provision for-oractually persecuted as “speculation”-a privateeconomic sector. Opposition to “the State apparatus”and defrauding it were, in effect, virtues. In the Sovietrepublics other than Russia acts against the State couldbe perceived as “anti-Russian”.

The inadequacy of legislation and the weakness of offi-cial investigative forces allowed financial crime togrow in both financial and property markets. Examplesof the former have been cited in section 4.4.3; theSchneider real estate fraud, uncovered in 1994 in theEastern Länder of Germany, centred on Leipzig, was avery large instance of the latter.

The range of criminal activity in the RussianFederation goes from the equivalent of billions ofdollars in the AO-MMM pyramid down to protectionrackets in small trade. The kiosks which sprang up onurban pavements after price liberalization in January

1992-the Ministry of Internal Trade or municipalitiesheld on to shop premises (which, in any case, were toofew for retail demand)-are systematically visited bygangsters who dictate the price at which goods shall besold and levy dues of some 20 per cent of turnover. Thesame practice rules in services, such as those providedby taxis and cafes. The Moscow Centre for PoliticalTechnology reports that 70 per cent of respondents inthe State sector and 76 per cent in the private sectoradmitted that bribery was habitual and that theyaccepted taking part in it. Even Western joint venturesin the consumer sector are targeted. Penetration by the“mafia”—as popular Russian usage has it—into thelarge enterprise sector may be virtually complete. Onthe one hand, a paper of January 1994 by the Centrefor Analytical Studies, Moscow (reported in Izvestia,17 January 1994) estimated that four out of five privatebanks were under “mafia” control; on the other, thechairman of the Security Committee of the Duma,Viktor Ilyukhin, claimed that criminals control 81 percent of the voting shares of privatized enterprises, andwarned that “the Russian Federation could become thebiggest criminal State ever to exist” (reported in TheEconomist, 9 July 1994). Certainly, the managerialclass, dominant in industry after insider privatization,is integrated with the local political elite, which eitherrivals the “mafia” for power, or shares it in a local“kleptocracy”.

Army demobilization and the collapse of conscriptionhave allowed small arms to become widely availableand, at the other end of the munitions scale, theft ofweapons-grade plutonium could not only destabilizeworld relationships, but bring further funding to theillegal sector. Criminality is as rife in Ukraine as in theRussian Federation, and emissaries of their “mafias”and local criminals affect economic activity in Centraland Eastern Europe. The Moscow State Prosecutor’sOffice reported a 12 per cent rise in premeditatedmurder in the first half of 1994 over the same period of1993, and that the going rate for murdering anentrepreneur was 800 dollars. The break-away Russianterritory of Chechnya is reputedly a seat ofgangsterism, and hostilities there and in theneighbouring Caucasus have allowed the proliferationof organised crime. In Central Asia, the cultivation andtransit of narcotics—a good proportion of which exitsthrough the Baltic States and generates crimethere—constitutes another, and major, element inillicit activity. All these activities contribute to “moneylaundering” and the heavy capital flight from the CIS(see subsections 6.1.2 and 6.4); there can be no doubt


that many purchases of assets in the West-especiallyproperty within the EU, though not necessarily thepurchase from the Treuhand mentioned in section4.4.3-are the fruit of crime.

Both the Russian Federation and Ukraine introducedrigorous anti-“mafia” legislation in mid-1994,including checks on bank accounts, and the UnitedStates Federal Bureau of Investigation (FBI) set up aunit in Moscow to assist the Russian authorities. All,save the criminals themselves, agree that crime shouldbe repressed, but its cost to the economy is not readilyquantifiable. In considering its impact, Flemming andMatthews (1994, p. 80) cite an estimate by Denison(1985, p. 25) that in the United States the rise in crimereduced GDP growth during 1929-1982 by barely 0.1per cent annually, but they point out that he does notallow for “losses that fear of crime brings about bypreventing certain activities from being carried out atall”, which are thus a brake on entrepreneurship aswell as on competition. Another consideration is thatthe levy of “protection money” on sales precludes boththe ploughing back of profits-for the recipient“mafiosi” consume their takings or salt them awayabroad-and the payment of due taxes, for a taxcollector is not as life-threatening as a hoodlum. Theshortfall in tax revenue to which crime contributes istaken up in the next section.

5.Public expenditure and revenue

5.1 Transforming the tax base

Systemic transition involves three changes in the taxbase:

a. From a specified number of State enterprises knownat the start of each tax year (updated for any in-yearchanges), the revenue and expenditure of which arereported to the Finance Ministry-to a much largerand fluctuating number of private businesses inmany of which a responsible “fiscal culture” may belacking;

b. From predominantly direct taxation of State enter-prises-to a new combination of personal taxationand indirect enterprise taxation based on valueadded;

c. From components of income and outlay determinedmostly by the central government (e.g. prices ofinputs, outputs and capital assets and wages)-tovariables which cannot be readily predicted by the

tax authorities in order to verify enterprise and per-sonal tax returns.

The fundamental requirement for change with respectto taxation is that the Soviet-type economy, as alreadyexplained, required “finance to follow the plan”, i.e.that certain “plan indicators” be fulfilled by the agentand that money be assured in accordance with fulfil-ment. Any “maximand” in money terms was for conve-nience—they were “crypto-physical units” (Grossman,1968, p. 8)—and the money itself was not “a bearer ofoptions” (ibid., p. 3). The aggregates upon whichenterprise taxes were levied had operationalsignificance only in relation to the plan, and the taxreceipts themselves served only to articulate the moneycomponents of the plan. Thus, at the microeconomiclevel, “deductions from profits” formed part of theenterprise’s investment plan, being negative ifauthorized investment exceeded profit; the “turnovertax” was the margin between the pre-set wholesale andretail prices, being negative if the latter was lower thanthe former; the Preisausgleich (see subsection 6.1) wasthe difference between the wholesale price and theexport/import price converted at the pre-set exchangerate, being negative as might be required by their rela-tionship. At the macroeconomic level, at least concep-tually if not in practice, such taxes/subsidies ensuredthat agents (government, domestic and foreign-tradeenterprises and households) had sufficient funds tomake the planned volume of purchases from all otheragents. In the sectors using “passive money”, if errorsin planning or implementation left a shortfall in a gov-ernment or enterprise agent, a subsidy was provided; if.a surplus resulted, it was demonetized. In the house-hold and collective-farm sectors, in which money was“active”, a surplus above voluntary saving resulted in amonetary (or inflationary) “overhang”, occasionallyreduced by a currency reform. The USSR experienceda successful confiscation in 1947 and an unsuccessfulone in 1991, and confiscations were undertaken inCentral Europe in the early 1950s.

Transition to market-based profit-seeking changes tax,in the enterprise perspective, from a virtually meaning-less indicator reported to higher authority into a mean-ingful impost on earnings. Evasion through under-statement of the taxable sum—or its complete conceal-ment—or by bribing tax collectors to accept lower orzero payment is readily undertaken, especially wheresuch practices were normal in communist times withrespect to plan fulfilment or the gaining of monetary orbureaucratic advantage. As just noted (see subsection


4.6), the penalties for bribing or evading the taxofficial in countries where law and order are weak areminor compared with the bodily injury or murder thatcan be the price of defying criminal exactors.Moreover, readiness to accept bribes on the official’spart is enhanced by the decline in his or her real salary(consequent on keeping public expenditure low undermacroeconomic stabilization programmes), thewidening of income differentials and the loss of accessto “closed distributors”-shops selling goods andservices in short or zero supply, only to rankingofficials.

An accurate record of the tax base is proving very hardto achieve. It is a major administrative effort merely tokeep track of the new businesses opening, closing andreopening as the private sector develops and as Stateenterprises are privatized, let alone to secure accountsupon which tax may be assessed. A network of taxoffices must be opened throughout the country, powersof investigation and inspection need to be defined, andaccountancy practices established. Powers to examinebank and enterprise accounts should be aligned withbest usage in established market economies. So faronly one country (Kazakhstan) permits anonymousbank accounts-for accounts denominated in foreigncurrency. In the former Soviet Union, dealings in“active” money were in notes and coin, and inter-enter-prise transactions in “passive” money were under notime pressure. As section 3 observes, the inheritedSoviet banking system was primitive-Estonia in 1994became the first of the successor States to introduceelectronic bank transfer and plastic card access tomoney-and, in Central and Eastern Europe, only inHungary did the system approach Western standards.Although bank transfers, and hence records ofpayments, are becoming more general, the frequency ofcash transactions and the inadequacy of accountancypractice continue to favour under-reporting of the taxbase.

5.2 The magnitude of taxation

Faced with a transformation of the tax base and itsunder-assessment, transitional governments have taxedmore heavily those bases from which it can effectivelycollect. However, by placing excessive burdens onthose taxpayers who are accessible to the collector, theyare tempted to resort to evasion or under-reporting.Joint ventures and foreign-owned enterprises andresident foreigners-subject to the sanction of expulsion

or confiscation for fiscal offenses-are generally amongthe full payers, but can suffer commercially in competi-tion with domestic firms and residents who pay less orno tax. Moreover, in the circumstances of “loss-mak-ing” and inter-enterprise debt, the government permitsthe accumulation of tax arrears from enterprises stillunder State ownership or recently privatized. The wideextent of insider privatization and the previous “cosy”relationship—Kornai’s (1990) term—betweenenterprise and supervising Ministry encourage taxremission or arrears as a substitute for outrightsubsidy-giving. The Russian Minister of Finance,Sergei Dubinin, estimated that in the first sevenmonths of 1994 only half of the budgeted revenue wascollected, and for the year as a whole the share mayprove to be as low as 45 per cent. He attributed theshortfall to a greater reduction in industrial activitythan forecast, to tax evasion and to the many ad hoctax remissions and tolerances of arrears. The first ofthese instances highlights the problem of thediscoverable tax base; in 1994, the signs were thatprivate activity was at last increasing faster than it wasfalling in State and large privatized enterprises. Aninspection service capable of monitoring the myriad ofsmall private businesses is not yet in place in the twobiggest successor States, the Russian Federation andUkraine.

Because taxes are set high to allow for at least somelikely non-payment, Russian budget revenue is in itsmain proportions similar to that of the United States:they happen to coincide in each country—18 per centof GDP as federal revenue and 33 per cent of GDP forthe consolidated budget (returns for 1992 in the UnitedStates and for 1993 in the Russian Federation). Ondata from the United Nations (ECE, 1994, p. 119) inCentral and Eastern Europe the share of centralgovernment revenue in GDP was generally belowlevels in developed market economies: in 1993 thepercentages were 14 in Ukraine, 16 in Slovakia, 18 inEstonia and Romania, 21 in Bulgaria, 26 in the CzechRepublic, 29 in Hungary and Poland, and 30 in Latvia;it was, however, 50 per cent in Slovenia. Rather highershares are shown, on data from the EBRD (1994, p.287), for consolidated general government accounts:again as percentage of GDP, 1993 revenue in Bulgariawas 27, in Romania 38, in Slovakia 43, in Poland 44,in the Czech Republic 46, and in Hungary 52. Aprivate Hungarian research body (CIPE, 1994, p. 17)considers tax levels to be excessive:


“The tax system contains many clearly anti-enterprise elements. In addition to the internalstructural contradictions of the tax system, theefficacy of taxes as an economic policy tool isalso in doubt. Through international comparisonit may be seen that in Hungary the ratio of taxrevenues to GDP is at the same level as indeveloped countries having the highest centralre-allocation system.”

5.3 External standards for taxation

International standards are relevant not only to theaggregate level of the government “take” from nationalincome flow but also to the form that those with-drawals acquire. Policy attention is chiefly focused onthe aggregate of government revenue, the structure ofgovernment expenditure, and the budget deficit, sur-plus or public borrowing requirement. The ratio of thedeficit to GDP is a crucial criterion of “convergence”for membership in the European Union as defined bythe Treaty of Maastricht. Ten transitional States inEurope have justifiable expectations of eventual admis-sion: Bulgaria, the Czech Republic, Estonia, Hungary,Latvia, Lithuania, Poland, Romania, Slovakia andSlovenia. The comparative levels of budget deficit andnational debt constitute a single criterion; of the fourcriteria of convergence this is the only one which is notrelated to actual values in existing member States-theother three can only be determined at the time ofintended admission to the Union. The Treaty ofMaastricht defines the deficit required as “not morethan 3 per cent of GDP and a public debt of not morethan 60 per cent of GDP”. It is evident that establishedEuropean market economies (EU members and others)have recently been diverging from this criterion ratherthan converging on it, for the average deficit as percent of GDP was 4.3 in 1991, 5.2 in 1992 and 6.9 in1993 (ECE, 1994, p. 14); the trend appeared to bereversing in 1994.

The target is important for the Central and EastEuropean candidates for EU membership. Data fromEBRD (1994, pp. 281-287) show that on 1993 outturncompared to 1991 the indicator changed in the CzechRepublic from a deficit of 2 per cent of GDP to a sur-plus of 1 per cent; the deficit declined in Poland (6.5 to2.9 per cent); was the same in Bulgaria (15.1 per centin both years) and Romania (1.9 and 1.8 per cent); butincreased in Hungary (2.5 to 7 per cent) and Slovakia(2 to 6.8 per cent). the Russian Federation, a candidate

for only a free-trade area, has shown remarkableimprovement, cutting its deficit from 16.0 to 5.7 percent.

Data from the IMF (1993, p. 86) are available for awider range of countries, but as budgets rather thanactual “outturn”. The grouping of transitional countriesin similar fashion for deficits as percentage of GDP in1991 and 1993 shows declines for Albania, but still ata very high level, from 43.7 to 20.6; for Kazakhstanfrom 7.9 to 6; for Poland from 5.6 to 4.8; and for theRussian Federation from 16 to 10. Seven countriesshow a switch from a surplus in 1991 to a deficit in1993: Azerbaijan from 2.6 to -7 per cent (in the wakeof war with Armenia); Belarus from 3.6 to -7 per cent;Estonia from 4.6 to -0.6 per cent; Kyrgyzstan from 4.5to -4.7 per cent; Latvia from 6.3 to -1.5 per cent;Lithuania from 2.8 to -0.5 per cent; and Romania from0.6 to -6.2 per cent. Stability was exhibited in Bulgaria(a deficit of 8.4 per cent in both years) andTurkmenistan ran a surplus throughout (3.5 and 4.5per cent in those years). The budget deficit rose as apercentage of GDP in Armenia from 1.9 to 47.1 (inconsequence of hostilities with Azerbaijan), Hungaryfrom 2.5 to 5.4; Mongolia from 10.5 to 17.2; Ukrainefrom 15 in 1991 to a range of 15 to 20 budgeted for1993; Uzbekistan from 4.8 to 5.2; and in both theCzech Republic and Slovakia if the comparison is withthe combined Czechoslovakia of 1991 (0.2 to 1.1 and7.2 respectively in 1993 budget terms).

The budget surplus in 1991 in three Central Asianmembers of the CIS was attributable to the inflow offunds assured by the Union Ministry of Finance untilthe collapse of the USSR at the end of that year. Fromthe calendar/fiscal year 1992 each newly-independentrepublic had to find its own resources, although untilmid-1993 the Russian Central Bank assisted with sub-stantial credits. Kaser and Mehrotra (1992, p. 39), whowere on mission to the four Governments concernedthat year, report budget surpluses in 1991 as 4.6 percent of GDP in Kyrgyzstan, 3.4 per cent in Tajikistanand 3.2 per cent in Turkmenistan-but, as shown alsoabove, a deficit of over 5 per cent in Uzbekistan. Inaddition to Tajikistan, two other former Sovietrepublics, Georgia and Moldova, were disturbed bycivil war in 1992, when their budget deficits peaked at35 and 22 per cent of GDP respectively. Military quies-cence in all three, as well as between Armenia andAzerbaijan, began a move towards fiscal normality in1994, but the reactivation of the tax base in nationaleconomic activity and the reestablishment of channels


for collection take time. The IMF did not cover thesuccessor States of former Yugoslavia, but EBRD(1993a, pp. 145-170) shows Croatia as cutting its bud-get deficit from 4.9 to 1.6 per cent, and Sloveniachanging from a surplus of 2.6 to a deficit of -1.8 percent. Patently hostilities in the other Yugoslav succes-sor States created massive deficits from which camehyperinflation, leading to a total destruction of the cur-rency in Bosnia-Herzegovina and the Yugoslav federalstate of Montenegro and Serbia-in one case, theDeutschemark completely replaced the dinar and, inanother, after spiralling to a million-fold monthlyinflation, a peg to the Deutschemark in 1994 began aperiod of stability. Although no GDP ratio is availablefor the former Yugoslav republic of Macedonia, thefloating of the denar after hyperinflation in 1992-1993brought a degree of stability and a better budgetbalance, but-as in those States actually experiencinghostilities-tax evasion and the cost of suchextraordinary expenditures as refugee care and thearmed forces precluded any normal equilibrium.

A caveat must be entered on use of the deficit/GDPratio: GDP declined everywhere at least for two yearsafter the end of communist political monopolies and isstill falling in some economies. Even keeping a deficitconstant shows a rise in the ratio if GDP falls. The nar-rowing of the tax base-let alone shifts in its composi-tion-was accompanied by certain unavoidable increasesin expenditure (see subsection 5.6), such as on socialsecurity, for all transitional States inherited a fairlycomprehensive welfare system. Where hostilities wereinvolved, mass displacements of people, the pros-ecution of the war and the repair of the consequentdamage made extraordinary calls on spending.

In the peaceful and more successful European transi-tional States, the deficit is taken as a public sector bor-rowing requirement, but in the less advanced it islargely monetized. No recent comparable data appearto be readily available on the second element in theMaastricht criterion—the ratio of public debt to GDP-but two general issues are posed. One is the division ofgovernment debt when countries are split, and theother is the degree of debt reduction—by writedown,by long moratoria with interest capitalized or by debt-equity swap. The controversy about federal breakupwas acute within the CIS during 1992-1993, withproposal after proposal being negotiated and then with-drawn. In the event, the Russian Federation undertookto shoulder most of the former Soviet debt in exchangefor assets carried over. The division of Western bank

loans to the former Yugoslavia took three years to itsresolution in the two States capable of servicing debt,Croatia and Slovenia. Poland reached settlement of itsdebt to Western banks at the same time as Slovenia, inSeptember 1994 (both having previously reachedagreement on official debt), and on more favourableterms, the Polish write-down was from 14 billiondollars to 7 billion dollars and the Slovene from 7billion dollars to 4.2 billion dollars. Foreign debtnegotiations by transitional countries are prominently,but by no means entirely, with creditors in developedmarket economies-governments being associated withthe “Paris Club” (first convened in that city in 1981 todeal with Polish non-performance) and banksassociated with the “London Club”. All countriesexcept Hungary and Mongolia have directly orindirectly (by country break-up) been involved in suchdebt moratoria. Hungary has serviced its heavy debtthroughout both periods of crisis (early 1980s and early1990s) and Mongolia’s creditors have been the CMEAcountries, with which it concluded moratoria arrange-ments. the Russian Federation was left at the collapseof the USSR with debts owing to it by CMEA and less-developed countries, still largely unsettled, as well asits own substantial debt. Creditors agree to write-downs (or selloffs at severe discount in the secondarymarket) because “something is better than nothing”and debtors are keen to reach agreement so as to obtain“new money”, either from the market or frominternational sources. However, a bad example is thusset for domestic debtors in transitional States whichencourages arrears, write-downs and write-offs as wellas government recapitalization.

The achievement of macroeconomic stability by con-straining the government deficit within acceptablebounds and by financing any such deficit by borrowingrather than by money issue is significant also forforeign investment. International country-risk assessorsincorporate fiscal magnitudes into their judgementsand influence corporate investors; decisions to transferproduction facilities or technology are made withprospects in mind for inflation and the tax burden; andportfolio investors seek to envisage trends in equityvalues and interest rates. At the extreme, uncontrolleddeficit finance leading to hyperinflation can bringpolitical instability, or reflect such instability, whichadds the dimension of political-risk analysis to theinvestor’s perspective.

Finally, adherence to well-tried tax practices of estab-lished market economies-those of EU countries being


most recommended-encourages foreign investors,because of their familiarity and predictability. Thetransitional economies were so long out of worldcapital markets and direct investment flows-althoughall, save Mongolia and the Central Asian States, hadhad capital inflow prior to the communist period-thatentry has been, or will be, a novelty to most Western“actors”. The need for foreign capital is discussed inthe following subsection, but the more assuranceWestern investors have on the appropriateness to themof the market environment in transitional States, thebetter.

5.4 The tax regime for foreigners

To offer an investor-friendly tax regime-both as to themacroeconomic impact of revenue collection and to themicroeconomic effect of individual taxes-is not to pre-judge the issue of tax concessions for foreigners. It is asimple one: concessions attract useful capital inflowand can introduce competition into imperfectly com-petitive markets even if some tariff protection is main-tained or erected. But the gain therefrom may be morethan offset by stultifying domestic enterprise-new pri-vate firms or privatized State entities-as they are bur-dened with higher taxes. Moreover, just as tax evasionplaces a larger burden on honest taxpayers, the domes-tic firm pays more if foreign competitors are excused.

Four countries have chosen a “level playing field” forforeign and domestic entities alike: Hungary,Mongolia, the Russian Federation and Slovenia.Hungary began its transition with the offer ofexemption from profits tax for firms with an initialcapital of 50 million forints (then some 625,000dollars) at least 30 per cent foreign-owned-totalexemption for the first five years and 60 per cent forthe next five years. But the concessions werewithdrawn for firms registered after 31 December1993. Mongolia’s requirement that foreign investmentbe approved by the Ministry of Trade and Industry isseen by a few as something of a deterrent, but againstthis view there are no impediments on the transferabroad of profits or of the proceeds of asset sales.Buckberg (1994, p. 125) cites the Government’s recog-nition “that increased foreign investment is essentialfor finther economic development… To attract largerforeign investment flows, Mongolia is stressing theachievement of political stability and its strong com-mitment to reform”. Certain advantages are availablein the Russian Federation within designated “special

enterprise zones”, but regulations restricting foreignbanking in that country operate in the contrarydirection. To the extent that criminal penetration hasnot affected some big foreign firms, the latter areperhaps somewhat better placed than those which areunder the shadow of the “mafia”. Slovenia treats allfirms alike, but tax reliefs are provided for newly-established companies and in certain underdevelopeddistricts from which entrants from abroad can of coursebenefit. Lithuania is in an intermediate position, inthat concessions are available to any newly-registereddomestic firm and to all foreign investors, but onlyuntil 31 December 1995.

Many of the tax concessions where they are offered, arerestricted to specified branches or regions and may beseen as part of the government’s industrial restruc-turing policy; those available in any activity or locationprovide a competitive edge over domestic firms, but areall limited in time-“tax holidays”, as they are termed,are often 100 per cent in the first year, or more, andare then scaled down during ensuing periods.Turkmenistan has a variant time limit-a tax holidayuntil the investment is paid off from its profit.Conditions may be imposed to the effect that the profitsexempted be reinvested within the country, or bettertax treatment may be offered on those profits soreinvested.

Tax holidays on corporation or profits tax are providedin Albania, Belarus, Bulgaria, the Czech Republic,Estonia, Kazakhstan, Kyrgyzstan, Latvia, Moldova,Poland, Romania, Slovakia, Turkmenistan, Ukraineand Uzbekistan. Foreign investors do not pay importduties on equipment used for their specific investmentin Croatia, Kazakhstan, Moldava, Romania andUzbekistan.

5.5 The reform of individual taxes

The review of individual taxes undertaken by govern-ments of transitional economies would of course bebased on consideration of the objectives and effects oftaxation and of forms of tax not already employed intheir country. The aims to be achieved include-withinthe prime objectives of paying for government expendi-ture and macroeconomic demand management—theredistribution of income and wealth among householdsand between generations; incentives for the creation ofnew wealth both for individuals and as a return on cap-ital and for altering the ratio of saving to consumption(in either direction), optimizing tax incidence between


producers, consumers and suppliers of factors andinternational parity-because corporate taxes under fis-cal treaties accrue to countries of origin. The objectivesto be minimized relate chiefly to the cost of collectionand to the distortion of economic behaviour-especiallyunder the risk and uncertainty particularly acute inconditions of transition. In post-communist economiesthe aggregate transfer of income through the publicaccounts-including the balance of taxes and subsidies-is of particular importance because of the pastoverwhelming role of the State towards the productivesector. Governments, both national and local, shouldbe seen to have renounced the assumption thatcentralization and reallocation through the budget isthe norm.

5.5.1 Personal income taxation. Direct taxation-andits negative form in cash allowances-as an instrumentof income redistribution or of incentives was nottheoretically necessary for wage-remuneration in aSoviet-type economy. Centralized wage bargainingbetween the planning authorities and the complianttrade unions and the obligation of State entities toimplement the wage structure so determined couldeffect at source the desired relationships. Albania andPoland were the only two countries to go to thisextreme by abolishing direct tax on income derivedfrom a State entity. All others implicitly accepted thatincome objectives were to be obtained through the“wage plan” by setting the personal tax-free allowancehigh in relation to the average wage and theprogression gradient low or zero. Income derived fromnon-State sources was on the other hand quite heavilytaxed, sometimes with a steep progression ordiscrimination against certain sources, such as incomefrom abroad or the income of ministers of religion.Income assessed as derived from “speculation” couldbe confiscated.

All such ideological presumptions have been sweptaway with the command economy-in Hungary, evenbefore the fall of the communist political monopoly, byintroducing Western-style personal taxation in 1988.In introducing forms of income tax appropriate to amarket economy governments have to take decisions inthe fields indicated below.

Keeping in view the ratio of revenue to cost of collec-tion, a procedure for assessing and collecting taxes duemust be established. For income tax, a “pay-as-you--earn” scheme may be appropriate; as privateenterprises proliferate and while accountancy is poor,

the cost of verification and collection is high and taxevasion significant.

Sanctions against non-payment or excessive arrearsmust be seen to be enforced; the prevalence of crimeand the intimidation or bribery of tax officials is com-mon in some post-communist States.

A balance must be struck between the cost of collectionfrom those with the lowest incomes and the tax yield;the non-taxable personal allowance can be set at thestatutory minimum wage-which many countriesestablish-and/or the standard retirement pension, but itmay be politically difficult to lower the limit from thatwhich previously prevailed.

Because all transitional States were and (except for theEastern Länder of Germany and the Czech Republic)remain inflationary, the personal allowance is indexed,but may not be adjusted with sufficient speed. Thus inHungary, the average income doubled between 1988and 1992, but the personal income tax payable tripled.CIPE (1994, p. 19) attributes this largely to insufficientindexation, but also to the withdrawal of the exemp-tions in which the prior tax regime abounded. In theSoviet-type economy interest on government bonds wastax-exempt; its retention (as in Hungary) is perhaps“crowding out” investment in the private sector.

The number of bands for taxable income within whichthe progressive gradient is applied should be relativelysmall; some governments have multiplied the numberof bands to render tax highly sensitive to income dif-ferentials, but the taxpayer may better understand hisor her liability with fewer rates-say, three or four-espe-cially while accountancy standards are poor and cashtransactions predominate.

In the crucial phase of transition when entrepreneur-ship and workforce incentives must particularly be fos-tered, the adverse effects of high tax rates for the topbands are to be set against popular calls to moderatethe considerable widening of income distribution.

Governments have differing views, under the influenceof electorates, on the desirable average incidence.Thus, the tax rates proposed to the Russian Duma forthe 1995 budget were from 5 to 40 per cent, but thedesirable average perceived by CIPE (ibid.) forHungary is 28 to 32 per cent.

A basic withholding tax rate on interest and shareincome assists collection-and makes payment earlier,which under inflation is of course to the government’sadvantage-but, while banking and the capital market


are little used by households, it could deter the spreadof such intermediation, necessary for a developed mar-ket economy.

A capital gains tax should be a usual feature to supple-ment income tax as property ownership broadens.

Because non-cash income was a considerable propor-tion of income derived from private sources in theSoviet-type period-and still is-a decision has to bemade whether to tax some or any of it.

As with all taxes under high inflation, the governmentis put at a disadvantage because the real value of taxwhen received is lower than when the relevant incomeis earned.

5.5.2 Property taxation. In developed marketeconomies, the purpose of property taxation is fre-quently local revenue raising. In the transitionaleconomies the same can apply, but it may also beappropriate to “cream off” rent-seeking activities,especially under imperfect competition. A taxable baseof assets is more predictable and easier to verify than ataxable base of income. Land surveys are either satis-factory or have very recently been updated as a conse-quence of decollectivization and privatization.Productive assets and housing have in the main beenvalued in the course of privatization. It can be arguedthat a move to the more certain tax base of propertywould be effective. But against this, such taxes encour-age capital flight and under-recording of values andsales, and constitute a disincentive to invest. TheRussian Federation has such a property tax; the rateproposed in the Russian budget for 1995 increases itfrom 2 to 3 per cent.

5.5.3 Corporate taxation. More sophisticated accoun-tancy rules and practice are still needed; the accuracywith which profits are assessed remains poor in manyStates. Problems arise in the type and value ofallowances to set against tax; capital investment is gen-erally allowed, but it has been suggested thatallowances be graduated according to the degree ofadvanced technology incorporated. Special allowancesto foreign enterprises for their imports are noted insubsection 5.4.

Corporate—or profits—tax rates seem to have been sethigh at the start of transition in the interest of raisingrevenue when other taxes were more difficult to collect.In the interest of reinvesting profits, some countries arereducing rates—in the Russian Federation from 38 to34 per cent and in Hungary from 40 to 34 per

cent—but insider privatization, whether or notmanager-dominated, has an inbuilt preference fordividends and for the finance of anyinvestment—especially while real interest rates arenegative—by borrowing. No clear picture seems yetavailable on the extent to which borrowing may dis-place the use of retained earnings, hence increasing“gearing”. A reversal of the decline in fixed capitalformation is urgently needed; the decline has beencontinuous during 1990 to 1993 in Albania, Bulgaria,Croatia, Hungary, Romania, Slovenia and theYugoslav Federation (Montenegro and Serbia), anddiscontinuous in Belarus, the Czech Republic, Latvia,Poland, the Russian Federation, Slovakia and Ukraine.Savings were only 1.3 per cent of GDP in Mongolia in1992 and, even in Hungary, it had fallen to 12 percent.

Corporate taxes do not yet conform in detailed applica-tion to the practice of developed market economies.Departures in many countries include the non-allowance of loss carry forward, of depreciation-at leastin full-and of interest on long-term loans. The effect ofwriting off non-performing bank loans and of inter-enterprise debt is, of course, to reduce profits subject totaxation and hence the revenue to the budget.

Kouri (1993, p. 50) has calculated the effectivemarginal tax rates on income from capital as theproportion of the pre-tax return on capital going to taxinstead of to the investor. In only seven States was theproportion less than 90 per cent-Estonia being thelowest at 75 per cent and Albania the highest of theseat 88 per cent, with Latvia, Hungary, Poland, theCzech Republic and Slovakia in ascending rank inbetween. Under 95 per cent were Macedonia, Slovenia,Georgia, Bulgaria, Romania and Lithuania, andbetween 96.5 and 99.8 per cent were Turkmenistan,Kyrgyzstan, Armenia, Moldova, the RussianFederation, Tajikistan, Uzbekistan, Kazakhstan,Belarus, Ukraine, Azerbaijan and Croatia. In compari-son-and of course benefiting from much lower infla-tion-the United States rate is 63 per cent.

5.5.4 Value-added tax. The Soviet-system turnover taxwas deliberately designed to conceal competitive costdifferentials. Its replacement by Western indirect taxesis necessary to complement price liberalization, so thatprice signals can be correctly received by producersand consumers.

States seeking membership in the European Unionhave introduced VAT as a necessary preliminary to


their candidature, but, in fact, all except Albania andMongolia have already applied it in replacement of theformer turnover tax; Mongolia introduced a 10 per centsales tax in 1993. All the CIS members applied VATfrom January 1992, then at the uniform rate of 28 percent; however, from January 1993 most chose a rate of20 percent, while others retained 28 per cent and someallowed a lower preferential rate. There is however astatement of intent to reharmonize. Standard rates inCentral and Eastern Europe in January 1994 were atscales rising from 18 per cent in Lithuania andRomania to 20 per cent in Hungary, 22 per cent inBulgaria and Poland, 23 per cent in the CzechRepublic and 25 per cent in Slovakia.

VAT is preferable to a general sales tax in that onlyfinal (not intermediate) goods and services are taxed,but accountancy requirements are high, especially asparallel accounts are needed on an accrual and a cashbasis. To simplify recording, the CIS members operateVAT on a cash basis only and traders are assessed onthe gross margin of sales less bought-in items. A moresophisticated procedure, which measures value addedat each stage of processing or movement, is to alloweach reporting entity to deduct the VAT it has paid.Because most East European VAT rates are high (incomparison, say, with rates within the EuropeanUnion), sales are often made without receipt to avoidtax; in Hungary CIPE (1994, p. 20) proposes a narrow-ing of the margin between standard and preferentialrates.

5.5.5 Payroll tax. Under the Soviet-type system, socialsecurity was financed by a payroll tax, but no actuarialbase was calculated; payments were met from currentpremiums, with the State as guarantor in case of deficitand absorbing the margin in the case of surplus. The“pay-as-you-go” principle is followed in the UnitedStates and the United Kingdom, instead of one inwhich premiums are calculated actuarially. In thelonger term many governments are planning atransformation of the bulk of social security intoautonomous insurance schemes, but currently rates ofpayroll tax (social security contributions) are high tocover the needs of the social safety net duringrecession. Between 1982 and 1992 the Hungarian ratehas risen from 25 to 44 per cent. In the RussianFederation the payroll tax is 39 per cent.

Because a payroll tax increases the cost of labour to theemployer, wage bills are under-reported or staff arerequired to work as self-employed. Calculating theincrement in labour income implied by the imposition

of a payroll tax mark-up, the EBRD (1993b, p. 49) hasapplied to the gross income the rates of income tax andan estimated incidence of VAT to show the effectivemarginal tax rate in most transitional economies.Compared to 65 per cent in the United Kingdom, 63per cent in Japan and 62 per cent in Germany andbelow 50 per cent in the United States (because tax inthis country is less for social security, and insurancepays for more, its corresponding rate is lower), therange is vast, from 10 per cent in Macedonia to 85 percent in Croatia. Rates under 50 per cent are shown (inascending order) for Turkmenistan, Albania, Moldova,Tajikistan, Uzbekistan, Estonia and Azerbaijan; belowthe 65 per cent rate are Lithuania, Latvia, Armenia,Bulgaria, Romania, Kyrgyzstan, the RussianFederation, Poland, Slovenia and Ukraine; rates arestill higher in Slovakia, the Czech Republic, Belarusand Hungary.

The tendency for enterprises to supplement the socialsafety net by keeping more employees on the payrollthan efficient operation required has already beenmuch moderated, except in the CIS economies, and itshows up in high rates of registered and unregisteredunemployment. Nor do enterprises maintain nursery,education and health care facilities-the outlay onwhich, by adding to selling prices, was in effect asupplementary tax burden.

5.5.6 Customs and excise duties. Customs duties werelevied in the Soviet-type system only on the fewimports made by other than State enterprises. Exciseduties had been merged into the turnover tax.Privatization and non-discrimination among enterpris-es required a universally-applicable tariff, and the abo-lition of turnover tax required that any tax supplemen-tary to VAT be specified as excise (or other designatedform). Due to this change in the import tax base, dutieshave become an important factor in revenue raising,but their function is fundamentally the same as inmarket economies; this is also true with respect tolicense and other fee income. Except for contraband-the volume of which is intolerable in the CIS andBalkan States-goods crossing a frontier are identifiableand can be valued by government inspectors. Mostdeveloping countries rely on import/export duties for aconsiderable part of their revenue because they arecheaper and more comprehensive in relation to the taxbase than income or enterprise taxes. All, however,particularly in the CIS, are subject to considerableevasion.


5.6 Government expenditure

The other channel for reduction of budget deficits is, ofcourse, the trimming of expenditure. Because therecession which has accompanied transition bringsunavoidable increases in social security payments-especially in unemployment benefits (which under theSoviet-type system was paid only in the GDR) andpensions (since more workers choose retirement). In aneffort to moderate the rise in pensions payments, thePolish scheme will index them to the retail price indexfrom 1996 (originally planned from 1995), rather thanto the average wage. Recession and the exposure ofnon-competitive enterprises to the market evokepressures on government to continue previous policiesof subsidization, and, in the new conditions, to toleratetax arrears as a substitute for subsidies. Generally,however, the financial management of governmentexpenditure requires no more than the prudent controlof expenditure and the avoidance of abuse, which gounder the name of “good housekeeping”.

Certain expenditures which were substantial in thecommunist period have been moderated. Defenseexpenditures are a major element, but combined withthe decrease in armaments exports-to members of thenow defunct Warsaw Pact and to certain developing,non-aligned States-have caused unemployment andfactory closure or restructuring in the military indus-tries. The administrative apparatus has been slimmedby the abolition of many controls and the privatizationof State enterprises. Governments have cut down theirown investment programmes, but this-particularly ininfrastructure-may evoke higher capital expenditure inthe future, not only to make up for repairs and replace-ment not undertaken but to bring quantities and qualityto the levels required for a modern, competitive econo-my. In the Russian Federation, for example, the EBRDestimates that an investment of 4.5 billion dollars isrequired to bring roads up to European standards. Ashorter-term deferral of expenditure has been effectedin the Russian Federation—of wage payments to civilservants in particular—in order to show a lower budgetdeficit than underlying commitments justify.

Many governments are moving expenditures off bud-get, either via units with autonomy of expenditure sup-ported by a fee-for-service basis, or by privatization;thus, a small part of the Russian road investment men-tioned above could be recouped by tolls. More far-reaching is a draft Russian Law on Privatization ofHealth Facilities, Pharmacies, Medical Supplies andPharmaceutical Industries whereby the out-patient ser-

vices (“factory polyclinics”) of State or privatizedenterprises and many public-access health-care facili-ties will be offered three choices of conversion: notfor-profit agencies, limited partnerships (on the lines ofthe United Kingdom National Health Service Trusts)or joint-stock companies. Users of the new entitieswould reimburse the cost of health-care provisionthrough their insurance or by government subsidy. Incertain cases where governments have retained allshares in corporatized enterprises, demands forrecapitalization (as in the case of Hungarian banks) orfor investment funding may arise (e.g. for oil, but notgas pipelines in the Russian Federation, whereTransneft remains in State ownership).

Of all the changes in government expenditure, themost crucial in strategic financial management hasbeen the withdrawal of subsidies to productionenterprises in the State sector (see subsection 3.3.3). Areview of the evidence from pre-privatizationenterprises in Czechoslovakia, Germany, Hungary andPoland (Aghion, Blanchard and Burgess, 1994, p.1341) shows that incentives for firm-level restructuringwere generally strengthened when firms stoppedreceiving State subsidies (i.e. were put on strict budgetconstraints). This factor was strengthened by strongdeclines in demand for the output of State enterprisesin Eastern Europe.

Measures taken included divestment of non-productionactivities (such as health care, leisure services and edu-cation). To the extent that these activities are neitherdiscontinued nor taken over by private operators orinsurance companies, the effect is to transfer the gov-ernment’s expenditure from a subsidy for production(in the Soviet budget “expenditure on the nationaleconomy”) to social expenditure (“social and culturalmeasures” in former Soviet practice). But more impor-tantly, firms were shown to have “unbundled” non-coreand non-performing activities, as enterprises would beexpected to do in order to maximize the value of theirfirm-or to demonstrate managerial skill to sell else-where. Simplifying their argument, these firms foundthat they could either defeat others who saw themselvesas stakeholders (workers and local officials) or co-optthe majority to change by the assurance of equity afterprivatization. Governments assisted in the expectationof a positive equity value-where its money had beenmade over as loans rather than grants—by writing offenterprise debt pre-privatization. In Germany,however, the Treuhand wrote off only 70 per cent of


historical debt, the remaining 30 per cent remaining asan incentive to efficient financial performance.

The tapering off of subsidies as State-owned enterpris-es are privatized does not end the demand for govern-ment expenditure on the production sector. As in mostdeveloped market economies—including those takingpart in the Common Agricultural Policy of the EU-agriculture is likely long to remain a net recipient offunds from government. Outlays are required forrestructuring in advance of privatization, on theprivatization process itself (see subsection 4.5.1) andon infrastructure, while income is forgone by toleratingtax arrears or paying above-market prices forprocurement (see subsection 4.5.3). The demonstrationof uncompetitiveness in foreign trade as the economybecomes more open evokes subsidies even after privati-zation, a matter which is discussed below.

6. External financial relations

6.1 Trade, tariffs and subsidies

Comprehensive price determination by the State, with-out any requirement for those prices to clear the marketat either wholesale or retail level ineluctably led to thedivergence of domestic price relativities from thoseprevailing in world markets, however accurately theexchange rate—also solely determined by the govern-ment—might have equated the aggregate value ofdomestic currency and that of foreign currencyinvolved in external transactions. In fact, as officialexchange rates were almost always over-valued inSoviet-type economies, a domestic-currency subsidywas required for exports and a levy needed on imports.The magnitude of those subsidies and levies was nearlyalways modified by the application of official multipleexchange rates (see subsection 6.3) and by black-mar-ket transactions in banknotes, the discount on whichwas greater than the difference between the official rateand that indicated by purchasing power parity. Becauseall currencies were strictly non-convertible, there wasmuch “switch” trading in undisbursed balances underbilateral clearing arrangements. The United NationsEconomic Commission for Europe appointed an agentto negotiate use of such switch balances, some of whichrequired many buyers and sellers to complete a“circuit”. The rates at which deals were eventually con-cluded constituted yet another set of implicit exchangerates at variance with the official rate.

The product-specific differentials between wholesaleand retail prices were absorbed by the turnover tax, insuch a way that there were as many tax rates as therewere domestic products; subsidies were, however,made on an industrial-branch basis requiring inter-enterprise transfers. Similarly, the product-specific dif-ferentials between domestic and foreign prices weremet by subsidy or levy, the set of which became knownby the term used in the GDR, the Preisausgleich,which implied that there were as many exchange ratesas there were traded goods and services. Under the“shock therapy” form of transition—a combination ofliberalizing domestic prices, floating the currency anddecontrolling current payments (“internal convertibili-ty”)—domestic prices would, under the ideal scenario,clear the market. Trade would take place as compara-tive advantage indicated, and the exchange rate wouldtend to equilibrium. Where current account convertibil-ity was allowed but price decontrol was only partial, asin the Russian Federation after 1992, some domesticprices were kept below the approximations to worldprices which other decontrolled prices were attaining.Export duties were imposed to absorb the extraordinaryprofit which would otherwise accrue to domestic sellersof pricecontrolled products. The Russian Governmentreinforced such duties by the application of exportquotas in the case of oil, a product for price controlkept domestic prices far below the world level. Theissue was one of sequencing (see subsection 3.8); theseand other imperfect applications of market-orientedinstruments dogged even the most rapid of transitionsand many governments chose “gradualism” or inertiarather than “shock”. Nor could domestic enterprises,previously protected by the State monopoly of exportsand “monopsony” of imports, quickly reachcompetitive levels permitting them to operate under aregime of free trade and open economy. Indeed, soinefficient were some industries that if their inputs andoutputs were revalued at world prices they were value-subtracting, rather than value-adding. Some industrieswere close to world competitiveness, as Hughes andHare (1992) were the first to show, but in Poland, forexample, they suggested that a quarter of all industrialenterprises should be closed and two thirds of themrestructured to reach a profitability compatible with thenew market environment. Agricultural produce is aclaimant for protection, as it in most developedeconomies (see Government expenditure above).

At the same time as institutions and regulations wererapidly changing, so was the composition and directionof trade. To the very eve of the political changes of


1989-1991 trade in the countries concerned wasseverely distorted from that which would have beengenerated by a market environment. The situations inwhich States found themselves at the start of transitionfall into five groups. Ranked roughly in their approxi-mation to the European Union, the first group compris-es all the ex-Soviet republics, Mongolia and Albania(with the caveat that the Baltic States stand out fromthat group in likely candidature for EU membership);the second is the Russian Federation by itself (theworld’s largest State by territory with a Federation of88 components); the third is the ex-Yugoslav States;the fourth those with “Europe Treaties”; and the fifththe Eastern Länder of Germany (already within theEU). Three countries, Kazakhstan Turkmenistan andTajikistan, have not dismantled the State-tradingapparatus taken over from the Soviet system, and theirneighbours, Kyrgyzstan and Uzbekistan, have gone tothe other extreme of virtually complete liberalization;the other transitional States employ some or all of thefollowing means: import duties, export taxes,quantitative restrictions (QRs) on imports or exportsand subsidies-in the last paragraph of subsections 6.1.1to 6.1.5 each country’s tariff and QR regime (EBRD,1993b, pp.33-38) is noted.

6.1.1 States remotest from developed marketeconomies. In the most extreme difficulty wereAlbania and Mongolia. They had largely cutthemselves off from market economies, both bypreference for fellowcommunist donor States, butwhereas the former had lost China as protector in 1978and then retreated into isolation with investmentdeclining throughout the 1980s, in the latter Sovietcapital inflow was so important that in the 1980sMongolia registered the highest investment rate in theworld. Mongolia exemplifies the two-gap, “crowding-out” theory, having both a foreign exchange gap and asavings gap to fill. To fill the first gap it took so muchexternal aid-30 per cent of its GDP in the late 1980s(Buckberg, 1994, p.123)-that it closed the second gapand “crowded out” domestic saving-as shown by thesubsequent rate of government savings of 1.3 per centof GDP (Mongolian Government, 1993, p.5). WhenAlbania opened up and Mongolia transferred as muchas it could of its trade to market economies—followingthe collapse of the Soviet economy—the foreignexchange gap was enormous and external aid wassupplied, with Italy in the lead for Albania and Japanfor Mongolia. In 1992, 25 per cent of governmentrevenue was foreign aid in Albania and 36 per cent inMongolia. Mongolia achieved a balance of payments

surplus in 1993, but with a current account deficit stillat 7 per cent of GDP. In 1992 Albania had a currentaccount deficit of a staggering 69 per cent of GDP.

In the same group, the Soviet successor States otherthan the Russian Federation may be counted. As notedin subsection 5.3, the Union Ministry of Finance madegrants to Union-Republics where revenue fell short ofexpenditure. For six such Republics, Azerbaijan,Kazakhstan, Kyrgyzstan, Tajikistan, Turkmenistan andUzbekistan, this permitted an inflow of capital whichoffset the low—and declining—rates of saving,unfortunately the capital productivity demonstratedwas much below the Soviet average (Easterly andFischer, 1994). When the USSR broke up, theseRepublics lost their capital inflow and had aninheritance of poor assets in low output economies.The other republics in the group were at higher percapita GDP levels—the three Baltic States and perhapsGeorgia were better off than the RussianFederation—but also faced serious balance-of-payments disequilibrium when the USSR wasdismantled. None had significant hydrocarbon depositsand they depended on the Russian Federation for oiland gas—and to a smaller degree on Azerbaijan,Kazakhstan and Turkmenistan. Because Russian pro-duction of both products has been declining, and bothare readily saleable in Western markets, the RussianFederation demanded payment for its deliveries inconvertible currency and at prices rising over timetowards the world price. Subsection 4.5.1 has notedhow the Russian domestic price of oil was keptartificially low after the January 1992 price decontrolof most other goods; the other CIS economies sought tomake payment at that price and in roubles. TheRussian Federation made some concessions to CISmembers, but withdrew rouble financing via bankcredit gradually, and completely by mid-1993. It madeno concessions to the Baltic States, which had notjoined that Commonwealth, but they were able to gainbalance-of-payments support from the West and bene-fited from the return of gold deposited in Londonbefore their annexation by the USSR in 1940. In addi-tion, all eight ex-Soviet republics inherited negativetrade balances both on the intra-USSR account andwith foreign countries-the exception was Belarus,which was in equilibrium with other Soviet republics.In 1987, revalued at world market prices and into USdollars, the sum of intra-Soviet and foreign visibledeficits as a share of GDP in each republic werearound one-fifth and a quarter in the Baltic States,Georgia and Moldova, 13 per cent in Armenia, 5 per


cent in Belarus and 2 per cent in Ukraine (Smith,1994, p.54). Severe and generalized recession astransition began-as well as hostilities in the Caucasusand Moldova-reduced export capacity by more thanimport demand, whether or not “internalconvertibility” made those imports legal or illegal.Capital flight rendered the external accounts of thesecountries still more precarious.

After the Russian Federation terminated the “roublezone” (as subsection 6.2 describes) trade with the restof the CIS shrank-by 16 per cent for imports and by 36per cent for exports in 1993 compared to 1992 andtheir trade—the Russian Federation included—withnon-members by 26 per cent for imports and 3 per centfor exports (ECE, 1994, pp.102-104). Some of thisshrinkage was attributable to payments difficulty, butsome was also due to the establishment of customsboundaries around them where none previously existedand to the imposition of quotas on either imports orexports. The relationship was abruptly changed by thecreation in September 1994 of an Interstate EconomicCommittee with executive authority by the CIS, withAzerbaijan and Turkmenistan abstaining. It promises avirtual economic union, in which the RussianFederation, with 50 per cent of the vote, holds a veto,but cannot impose its sole will, for major decisionsrequire 80 per cent of the votes. The decision byAzerbaijan and Turkmenistan to remain apart may beattributable to their export potential in oil and gas, theinvolvement of Western firms in such development,their opposition to Russian intrusion into overall con-trol of the Caspian Sea and their separate foreign poli-cy towards Iran and Turkey (partly to assure the transitof their hydrocarbons otherwise than via the RussianFederation). The cooperation may lead to the CISacting as one in their external relations, includingrelations with the EU; indeed, the Russian DeputyPrime Minister in charge of the economy, AleksandrShokhin, spoke of the agreement as “roughlyequivalent to the European Union”. The immediateprospect was difficult, one element of which was thatthe non-Russian members of the CIS were in structuraldeficit with outside countries (another element beingexchange control, discussed in subsection 6.3); in 1993their aggregate exports fell by 16 per cent, moresharply than in 1992, despite increments by four ofthem, Moldova, Kyrgyzstan, Tajikistan andTurkmenistan (in the latter’s case due to oil and cottonexports), and they failed to restrain imports, whichwere 12 per cent greater. The largest economy of thegroup, Ukraine, suffers from capital flight, which

might be described as “capital hover”, because some atleast could be attracted back once the currency isstabilized, and as large privatization begins (seesubsection 6.4). In the latter case, the “stalled” break-up of collective and State farms could reintroduceagro-business, for it was in Ukraine that largescalecommercial farming began in Tsarist times. Belarus isseeking an economic union with the RussianFederation, but the latter’s Government is cautious, forfear of disrupting the disinflationary trend evident inearly 1995.

The three Baltic States signed the Baltic Free TradeAgreement in September 1993, which should fosterintra-group trade from its currently low levels; itexcludes agriculture and allows the maintenance ofexport duties on certain key raw materials (e.g. metalsfrom Lithuania, timber from Latvia and quartz sandfrom Estonia). Their principal partners are theScandinavian members of EFTA and agreement hasbeen reached with it and the EU that their free tradeagreements with EFTA will be respected on partners’adhesion to the EU. While their biggest recent incre-ments have been among themselves and with thedeveloped market economies (38 per cent increase inexports and 76 per cent in imports in 1993), they haveraised turnover with all other partner groups; Latviaand Lithuania have assured an overall trade surplus,but Estonia was in deficit in 1993.

The Black Sea Economic Cooperation group, formedin June 1992, serves information and trade promotionobjectives; a protocol of 1993 envisages the establish-ment of conditions which could lead to free trade areas.Members are Albania, Armenia, Azerbaijan, Bulgaria,Georgia, Greece, Moldova, Romania, the RussianFederation, Turkey and Ukraine. The EconomicCooperation Organization, limited to contiguous Stateswith Islamic majorities, includes the five Central Asianmembers of the CIS and Azerbaijan; in March 1995 itestablished four agencies for member services, a tradeand development bank, an airline, and shipping andreinsurance companies.

Summarizing tariff and quota restrictions regulations,in Albania customs duties range from 10 to 25 per centand quotas are imposed for the import of certainconsumer goods and for the export of primarycommodities. Armenia has neither tariffs nor QRs onimports, but requires licences for some exports.Azerbaijan has a limited number of QRs on bothimports and exports. Belarus has a tariff with ratesfrom 3 to 40 per cent, and no QRs on imports but some


on exports. Estonia has no tariffs, having abolished itsexport tax in July 1993, and sets quotas for only threeclasses of imports (alcohol, motor vehicles andtobacco). Georgia has a tariff in the range of 5 to 40per cent but removed its QRs in March 1992.Kazakhstan has retained the Soviet-type foreign trademonopoly/monopsony, but allows open general licenceto about 30 per cent of turnover. Kyrgyzstan hasneither tariffs nor import quotas, but has some QRs onexports; there are free economic zones on its and theChinese side of the frontier. Latvia has both importtariffs (15 to 20 per cent) and export taxes, but no QRs.Lithuania similarly has no quotas, but has duties onimports up to 25 per cent and on exports up to 50 percent. Moldova has duties on both imports and exports,and quotas on exports. Mongolia has abolished exporttaxes and quotas, but retains them on imports. Withcivil war restricting the Tajik government’s scope formanoeuvre, trade is still administered by theauthorities as in Soviet-times, but smuggling is rife.Turkmenistan, though wholly peaceful, is not dis-similar; some liberalization began in 1992, but has lit-tle affected QRs and duties on exports, largely becausecotton and oil are its dominant products. In Ukraine,the tariff on imports runs from 5 to 25 per cent, but onexports up to 100 per cent. Uzbek import tariffs wercabolished on 1 January 1994, but QRs on exportsremain.

6.1.2 The Russian Federation. Because the RussianFederation has been increasing its visible tradebalance—from 5 billion dollars in 1992 and 16 billiondollars in 1993 to 20 billion dollars in 1994 (ECE,1995b)—it differed from the rest of the CIS, in whichit accounted for 80 per cent of turnover. This was,however, an inadequate guarantee for the future, firstbecause almost four-fifths of its exports were of oil andgas (both of which suffer from inadequate pastinvestment), and, second, because the surplus wasachieved mainly by reducing imports (by a huge 27 percent in 1993). Its underlying foreign-trade problem isnevertheless that of the CIS members just described,but looming larger are trade with its former partners inthe CMEA and trade with the rest of the world. Theimprovement of its terms of trade with the rest of theCIS has, of course, been at the expense of the deterio-rat:cn of theirs; Ukraine in particular has been willingto grant its firms credit to assure the maintenance ofsales from under-capacity plants to the RussianFederation.

Like States elsewhere in the CIS, the RussianFederation is not a member of GATT, but is accordedmost favoured nation treatment by most partners. Inthe Russian Federation and in other CIS countries, thegovernment has a free hand in setting tariffs, subjectonly to retaliation, and in subsidization, subject only toanti-dumping action by partners. In the short timesince independence from the USSR, the RussianFederation has briefly given subsidies to imports—tooffset the precipitous decline in the exchange ratewhile the cost-of-living index was soaring and realwages rapidly declining—and continues to subsidizeexports. In the case of its major export, oil, the marginbetween the controlled domestic price and the foreignprice at what has come to be an overvalued exchangerate (see subsection 6.2) is so large as to require theimposition of both export quotas and a high exportduty (5.5 dollars per barrel, between 30 and 40 per centof 1993-1994 prices). Such, however, is the corruptionamong administering officials that quotas are boughtand sold, and the duty evaded. Foreign oil companiesengaged in productionsharing joint ventures arereported as complaining that they are at adisadvantage, being virtually the only exporters to paythe duty in full.

In 1991, the year the CMEA was untidily wound up,Soviet exports to CMEA members fell 41 per cent andimports by 52 per cent. The collapse continued afterthe division of the USSR, and Russian sales to thesame countries declined 33 per cent in 1992 and a fur-ther 8 per cent in 1993; Russian imports fell even moreprecipitately, by 50 per cent in 1992 and 46 per cent in1993 (ECE, 1994, p.95). Except for a modest upturn in1993, trade with the developed market economiesfollowed the same pattern. Because with respect to bothgroups imports fell more than exports, the visible bal-ance was positive throughout, and little, if any, of theearnings were repatriated. The Russian CustomsCommittee estimated non-repatriated export earningsas 10 billion dollars in 1993, against 15 to 20 billiondollars in 1992. This fall was partly due to a diminu-tion in the share of barter trade—estimated by thatsame Committee as 25 per cent of imports and 13 percent of exports in 1992 to 5 per cent each way in 1994(ECE 1995b)—which was often a cover for non-repatriation of foreign sales. As in Ukraine,privatization—the second stage of which is to be formoney, not vouchers—and rouble stabilization couldattract back capital now “hovering” (see subsection6.4).


Trade could be broadened by reviving it with formerCMEA States when they emerge—as some already aredoing. But as of 1993 these States were still cuttingback on imports from the Russian Federation, exceptfor spare parts and semi-manufactures required forplant originally imported from the USSR. Somecategories of non-food consumer goods showedbuoyant demand, but they accounted for less than 1 percent of total exports. Trade with the developed marketeconomies could be assisted by better market access;the EU is aware of the help that this would be and hasstated the aim of securing a free-trade-arearelationship, but without any further stage towardsmembership.As subsection 6.4 notes, a substantialamount of services is provided free to Russianenterprises under EU national and internationalprogrammes of assistance.

Import tariffs on oil average 15 per cent—as statedabove—and some other products are subject to both atariff and quota restrictions on export. Customsofficials have been known to determine the value of animport as its sales price within the Russian Federation,rather than its purchase price abroad, so as to augmentrevenue. As this practice seems to be applied toforeigners, the supplementary tax may compensate forinformal exemptions made to favoured (or “mafia”-connected) shippers.

6.1.3 The States of the ex-Yugoslav Federation.Slovenia experienced hostilities for just a few days andhas operated as a normal economy since. Trade wasaffected only in 1991, when both exports and importsmodestly declined; it more than recovered in exports in1992, but faltered the following year, when a remark-able recovery in the constrained East European marketwas more than offset by a decline in trade with markececonomies. It is seen as a potential member of theCentral European Free Trade Agreement, the Visegradgroup (see subsection 6.1.4) and a good candidate forEU membership. Its neighbour, Croatia, has had someof its territory occupied and has been involved in thewar in Bosnia-Herzegovina, and it has run visibledeficits throughout 1991-1993; its exports have foundlittle success in either the transitional or the marketeconomies, and with declining home production butconsumers used to Western goods, its imports havegreatly risen (by 52 per cent in 1993 alone). The for-mer Yugoslav Republic of Macedonia has not beeninvolved in hostilities, but has been severely affected bythe United Nations embargo on trade with Montenegroand Serbia—and, hence, on transport as well as export

earnings—and the closure by Greece of its ports togoods destined for Macedonia. It has, on much lowerturnover, moved from a visible deficit to a smallsurplus in 1993. The Federative Republic ofYugoslavia (as distinct from the defunct FederativeSocialist Republic), comprising Montenegro and Serbiaat the time of writing, remains under the UnitedNations embargo. Bosnia-Herzegovina subsists underthe burden of civil war, supported by humanitarian aidsent through United Nations agencies and the EU.

There are no quota restrictions in Croatia but bothimports and exports are taxed, the average tax being 18per cent and 8 per cent, respectively. Macedonia hasquota restrictions on both imports and exports, but notariffs. Slovenia has a general tariff of 4.5 per cent andquota restrictions only on 2 per cent of import items.The embargo on Montenegro and Serbia and the warin Bosnia-Herzegovina have brought a combination ofState administration and contraband.

6.1.4 States with “Europe Treaties”. The CentralEuropean and Balkan States with Treaties ofAssociation with the EU have an expectation of mem-bership in the Union, though some years after theenlargement to include other market economies on 1January 1995—perhaps not until the beginning of the21st century. In the interim they have enhanced accessacross the EU’s Common External Tariff and a signifi-cant liberalization of the quota restrictions previouslyimposed. The EU limits have not however been liftedon products for which the transitional economies haveparticular comparative advantage and underutilizedcapacity—steel and textiles under quota and foodstuffsunder the CAP Taking up these opportunities, all saveBulgaria and, recently, Hungary, have been able toexpand their exports to the EU—as they have also toother developed market economies—more thancompensating for the loss of trade formerly conductedunder CMEA auspices. Thus the Czech Republicincreased its exports to developed market economies by26 per cent in 1992 and 20 per cent in 1993, whilethose to other transitional economies dropped by 33and 1 per cent respectively. Hungary, after an earlyhead start-because it had been “marketizing” itseconomy before the fall of the communist regime-witha 21 per cent export rise to developed marketeconomies in 1991, saw the rate slacken to 9 per centin 1992 and decline-by 21 per cent-in 1993. Importscontinued to rise throughout, making the visible deficita regular feature. Poland was remarkable in its first


year of “shock therapy” as early as 1990, in gainingWest European markets in place of domestic andCMEA buyers, but subsequent export growth has notbeen continuous and, being overtaken by the growth ofimports, showed a trade deficit in 1992 and 1993.Romania, slow at the beginning because of thedisturbed domestic conditions of 1990 and 1991, hassubsequently made small gains in its Western exports.Bulgaria, beset by political division and governmentalinertia, experienced export declines to all groups(transition, developed market and developing marketeconomies) in 1991 and 1993, but made a bettershowing in 1992.

Reciprocal concessions are made among members ofthe “Visegrad” Agreement (the Czech Republic,Hungary, Poland and Slovakia). It was intended to cor-rect the incongruity that arose after they signed“Europe Treaties”, e.g. that goods traded among them-selves would meet less favourable tariffs or quotas thanbetween one of them and the EU. The Agreement cameinto force in March 1993 and an eight-year transitionis envisaged to a complete free trade area in non-farmgoods. Once a quota restriction is lifted or a tarifflowered, a member undertakes not to reverse thedecision; nor will a member allow domestic taxes tocreate barriers to infra-area trade.

Bulgarian tariffs were generally revised and reduced inJuly 1992; quota restrictions remain on the export ofonly six primary commodities. The average tariff in theCzech Republic is only 5 per cent; quota restrictionsremain only on imports of agricultural goods and on afew exports. Hungary’s import duties average 11 percent and a few quota restrictions remain. The Polishtariff average is higher, 18 per cent, and there are noquota restrictions-their removal was part of the `shocktherapy’ that Poland pioneered. There are some importquotas in Romania and import duties range from 10 to30 per cent. In Slovakia, a few quota restrictionsremain on imports and on exports, and the averageimport tariff is only 5 per cent.

6.1.5 The Eastern Länder of Germany. Upon unifica-tion the former GDR became part of the EU and sub-ject to its trade regime. A few transitional arrange-ments were made to encourage the maintenance oftrade with partners in the then USSR, but its collapseand that of the CMEA, both in 1991, largely withdrewthe demand. Eastern Länder exports to othertransitional countries suffered not only because of those

institutional changes but also because of the recessionamong partners, including the reduction of militaryprocurement under the also-defunct Warsaw Pact. Ameasure of the change that took place is that whereasimports had constituted 18 per cent of GDP in theformer GDR in 1989, they were over half as much,soon after 1992.

The most important factor in the recession of EasternLänder productive enterprises in the face of WesternLänder competition was the extraordinary overvalua-tion of the GDR mark for conversion into theDeutschemark (as noted in subsection 6.2). Easternenterprises could not compete on price or quality termswith Western consumer goods or financial services.Among the factors were pent-up demand of Easternhouseholds for a “taste of the West” (much glamorizedby Western television and spiced by enforced isolationfrom such goods), the networks and size that Westernbanks and insurance could immediately provide (theDresdner Bank forthwith reopened in Dresden), andlower efficiency and lack of actual competition in thecommunist/CMEA period. Recession was accentuatedby Treuhand closures—in its early phase—and by thedrop in ex-CMEA deliveries cumulated on each other.These reduced demand for investment goods and,when any restructuring was undertaken, orders forequipment were mostly placed in the Western Länderby the Treuhand in advance of privatization or by newWestern Länder managers (drafted by the Treuhand orinstalled by new Western proprietors). Western Länderexports to the Eastern Länder delayed the onset of theWestern Länder’s own recession, which cyclically andin harmony with other OECD economies should haveoccurred after the 1980s boom. Subsidizing therestructuring in the East cost the Western Länder somuch—in higher taxes and in high interest rates tosustain government borrowing—that the recessioneventually came, and thereby delayed WesternEuropean recovery. When, however, the EasternLänder began to emerge all the more competitive fordownsizing-perhaps too “lean” for potential futureexpansion—they checked the West-to-East flow.Indeed, when West German recovery seemed to start inthe first half of 1994, no contribution to it was made bynet exports, for exports were well exceeded by imports;growth came entirely from construction and stock-building. From 1995, Western Länder exports toEastern Länder are likely to fall, and significant tradein the reverse direction should begin.


6.2 The establishment of new currencies

The break-up of three federal States, Czechoslovakia,the USSR and Yugoslavia, and the absorption of theGDR into a Federation brought new currencies in all ofthem, although attempts were made, and have beenrenewed by its Interstate Economic Committee, for apayments union within the CIS.

The Czechoslovak koruna was divided at the end of1992 into the Czech koruna and the Slovakkoruna—both of which had existed as designationsduring the Second World War. The Czech currencyremained stable, but that of Slovakia depreciated.

The rouble remained in the Russian Federation, whichin July 1993 demonetized all banknotes issued before1993, thereby completing the change from the Sovietto the Russian rouble. This forced the other successorStates—except Georgia and Tajikistan, which continueto use Russian roubles—to establish new units wherethis had not already been done. Two of the units weretitled a “coupon” to indicate that during a period ofhigh inflation the unit was transitory and would bereplaced by a “definitive” unit when monetarystabilization had been achieved. The Ukrainiantransitional unit, introduced in 1992, is formally a“coupon” but is known as the karbovanets, confusinglybecause it is the Ukrainian name for the rouble, but theeventual stable currency would be termed the hryvnia.In 1993 Belarus issued a coupon, popularly known aszaichik (“little hare”), from the picture on the notes,but an agreement on monetary union with the RussianFederation in January 1994 and the CIS economicagreement of September 1994 foreshadowed a return tothe Russian rouble. The Central Asian republics, otherthan Tajikistan, separated their currencies during1993—into the Kazakh tenge, the Kyrgyz som, theUzbek sum-coupon and the Turkmen manat. TheUzbek sum-coupon was avowedly a temporarycurrency and the “definitive” sum was introduced in1994, and the separate Tajik rouble was introduced inMay 1995. In the Caucasus, Armenia introduced thedram and Azerbaijan the manat in 1993. None of thesecurrencies have yet been stabilized, but there was aperiod (1993-1994) during which the Russian roublebecame overvalued, because domestic inflation over-took its depreciation. The Russian Federation remainsthe only successor State with current accountconvertibility, which has facilitated the capital flightnoted in subsection 6.4.

Against the situation described above, the experienceof stability in the Baltic States is salutary (Lainela,1993). Estonia reverted to the title of its currency, thekroon, used between 1920 and its annexation to theUSSR in 1940; Latvia returned to the lat, as usedbetween 1924 and 1940; and Lithuania to the litas,used between 1922 and 1940. Estonia and Lithuaniahave undertaken not to allow the issue of money toexceed bullion and foreign exchange reserves, peggingthe kroon to the Deutschemark and the litas to a basketof currencies. The Latvian lat shadows theDeutschemark, but is not pegged to it.

In former Yugoslavia, that stability can only beclaimed by the Slovene tolar, which was born duringthe disintegration of Federative Yugoslavia without aname-the notes issued bore numerals but no currencydesignation. War conditions caused all the othercurrencies to depreciate to the point of the extinction ofthe Bosnian dinar and the Serbian dinar. In Bosnia-Herzegovina the only tradeable unit is theDeutschemark, and in Serbia, the hyperinflation wasended with the introduction of the “new dinar” peggedto the Deutschemark. The Macedonian denar hassignificantly depreciated.

Finally the GDR mark was replaced in July 1990,under the terms of the German Economic andMonetary Union, with the Deutschemark at the contro-versial rate of 1:1 for banknotes and small amounts ofsavings and 1:2 for larger savings and for stocks(assets and liabilities): In the light of the deficiency ofEastern labour productivity with respect to that in theWest, both rates represented an excessiveovervaluation. In each of the following years realproductivity—defined as GDP per employedperson—remained well below 50 per cent of WestGerman productivity (i.e. the 1:2 ratio): 38 per cent in1990, 33 per cent in 1991 and 40 per cent-due toTreuhand closures and migration of the more efficientworkers to Western Länder—in 1992 (Burda andFunke, 1993, p.2).

The reasons for the Western (i.e. the Federal)Government’s overshoot of the exchange rate waswholly political, and its welcome by the GDR popula-tion was misguided. Rarely in history have votersacquiesced in short-run gain for medium-run loss. Inthe immediate term, Easterners got 1 Deutschemarkfor their mark instead of some 25 pfennigs as theproductivity ratio and long-term market ratesindicated. By Economic and Monetary Union, theEastern Länder lost the power to devalue, which every


other transitional government retained-or, in the caseof divided states, seized. In the medium term theysuffered searing capacity closures and unemployment-double that of the Western Länder—and the inflow ofWestern Länder goods and services (banks andinsurance were taken over by Western Ländercounterparts), as noted in subsection 6.2; in the longerterm, they may regain their home market but are nowhandicapped by high labour costs. Wages by 1994 werethree-quarters of the Western Länder level because theWestern trade unions, organized on an “industrial”basis, first displaced the discredited communist tradeunions of the old GDR and then extended theirnationwide bargaining to their new members and theiremployers. Western Länder employers were very readyto see their potential competitors forced to pay higherwages. The Eastern trade union members were notaverse to collaborating in getting more pay, but thiswas another case of short-term gain for long-term loss.It is in the labour-intensive products and processes thatthe Eastern workforce had had comparative advantage,which was then eroded by pay rises approaching theWestern level. They feared, when a Western firmbought a Treuhand plant, that they would become a“long work-bench”, that is transferred to processes inthe combined enterprise in which the value-added waspredominantly wage cost.

6.3 Exchange-rate stabilization

Multiple exchange rates were the rule in the Soviet-type system, not only in the obvious division of a com-mercial rate from a tourist rate, but by the applicationof a series of “coefficients” to wholesale prices in orderto adjust them to those paid abroad for exports andimports (Kaser, 1980). However, such practices arenow a thing of the past in all transitional economies.The CMEA economies, as noted in subsection 2.6,allowed disorderly crossrates of which traders in mem-ber countries took advantage to the detriment of com-parative advantage.

Reference has been made in the preceding subsectionto the path followed by new currencies. The Albanianlek, the Bulgarian ley, the Mongolian tugruk and theRomanian leu have devalued, but in a controlled man-ner. Among the other transitional States, only theHungarian forint has been stabilized. “Internalconvertibility” (current account liberalization) wassoon introduced in Hungary, Czechoslovakia andPoland. Already by mid-1993, the currency had been

allowed to float in Albania, Armenia, Azerbaijan,Belarus, Bulgaria, Croatia, Kazakhstan, Kyrgyzstan,Lithuania, Moldova, the Russian Federation, Slovenia,Turkmenistan and Ukraine. A managed float operatesin Latvia, Macedonia, Moldava, Mongolia, Romaniaand Uzbekistan. The Czech and Slovak koruny arepegged to a currency basket, with a special clearingarrangement between them. Poland adopted a“crawling peg” with its “shock therapy”: initially, in1990, the zloty was devalued each month by 1.8 percent with respect to the US dollar, but by late 1994 therate of “crawl” had been reduced to 1.5 per cent. InMay 1995 a managed band was introduced-withinwhich the zloty could float-at a monthly depreciating“crawl” of 1.2 per cent. Following a devaluation inMarch 1995, the Hungarian forint, which is pegged toa 30;70 weighted basket of the US dollar and the ECU,went on to a “crawling peg”, of 1.9 per cent monthlyup to June and of 1.3 per cent thereafter. As noted inthe preceding subsection, the Estonian and Lithuanianunits were pegged to an external standard.

After the collapse of CMEA and its clearing scheme of“transferable roubles” there was much discussion of aCentral European Currency Union (see Drabek, 1992and references therein), but this undertaking was still-born. The institution of a Currency Union with the CISwas also taken up by a number of Western experts (seeEichengreen, 1993), but may now have been overtakenby the creation in September 1994 of the InterstateEconomic Commission which will consider paymentsrelations among members (Turkmenistan and Ukrainewithholding adhesion).

6.4 Capital movements and internationalgrants

Reference has frequently been made in this paper tocapital flight. Albania, Hungary, Kyrgyzstan, Latviaand Lithuania have abolished capital control, orreduced it to a very liberal degree. Elsewhere capitalcontrols are in place (EBRD, 1993, pp.33-38), andexchange control over current transactions is more therule than the exception. Outflows, including “laun-dered” money, are substantial from the RussianFederation and Ukraine. The Russian Federation hassought partly to counter the “dollarization” of theeconomy by forbidding domestic transactions to beeffected otherwise than in roubles, though the purchaseand sale of foreign currency ostensibly for currentaccount remains; Ukraine reimposed the rationing of


foreign currencies in November 1993, but allowstightly-controlled auctions (D4browski, 1994, p.121).Estimates vary widely but seem to show that in theRussian Federation capital flight peaked in 1992, theyear of maximum inflation. The lowest estimates arethose of the IMF which estimated 13 billion dollars in1992 and 8 billion dollars in 1993; as mentioned, theRussian Customs Committee estimated unrepatriatedexport earnings at 15 to 20 billion dollars in 1992 and10 billion dollars in 1993; statistics supplied byWestern banks to the BIS show that depositors in theformer USSR put 5.8 billion dollars in their accountsin 1992 and 2.3 billion dollars in 1993. Cumulativelysome 30 billion dollars are believed to be held abroadby Russian residents and citizens. In 1993, the peakyear of Ukrainian inflation, one estimate had 12 billiondollars escaping abroad. Attracting this money backmust depend on relative monetary stability and theavailability of securities—notably equity in privatizedenterprises and in the government bonds now beingused to monetize debt. In July 1994 the Chairman ofthe Russian Central Bank hinted that an amnestymight be offered for illegal acts in gaining foreigncapital assets against roubles, but subject to a tax oninward remittance (a 23 per cent rate was beingmentioned in Moscow at the time).

Many States in transition have, as already noted,offered tax concessions to attract foreign investmentand all have made promotional arrangements for suchinflow. The net inflow to the Central and EasternEuropean States in 1993 was estimated at 3.5 billiondollars, of which 2.3 billion dollars went to Hungary;the Russian Federation was estimated to have received400 million dollars and Ukraine 100 million dollars.The contrast between the attraction of Hungary, which,by the end of 1993, had accumulated 6 billion dollarsof foreign capital and China, which had 15 billiondollars, and the cumulative aggregate of a mere 1.7billion dollars in the Russian Federation speaks foritself.

Private non-corporate money inflow is also significant.Convertible currency brought into Poland from citizensof the former USSR, either to buy consumer goods orto deposit funds, was cited as the reason for theincrease in the money supply in the summer of 1994and for the National Bank to refuse to cut the interestrate as the maintenance of the economic upswingseemed to demand. Remittances by emigrant workersbrought into Albania 330 million dollars in 1993, or

more than the visible export earnings of 125 milliondollars.

Grants, technical assistance, bilateral credits andmultilateral credits have added further inflowsthroughout the period of transition so far. The ECE(1995b) estimates show the changing composition ofsuch inflow as private-sector sources increase. Private-sector foreign investment committed by the end of1994 totalled 117.8 billion dollars, covering 215projects in the transitional economies, each of morethan 10 million dollars. However, much of this verylong-term investment—82 billion dollars is inKazakhstan and the Russian Federation, mostly for oiland gas exploration and development Funds to be spentwithin the first four years of a project (totalling 17.2billion dollars) show a different country ranking:Hungary has been the most successful, receiving 27 percent of the total, followed by , Poland, 24 per cent; theRussian Federation, 15 per cent; Kazakhstan, 14 percent; and the Czech Republic, 8 per cent (ECE, 1995).

The ECE (1995b, p.149) estimates the financial flowsfrom private sources to Central and Eastern Europe tohave amounted to 6 billion dollars in 1990, 5.7 billionin 1991, 6.1 billion in 1992, 14.3 billion in 1993 and11.5 billion in 1994. Also in 1994, the inflow was 3.6billion dollars gross through capital markets, 3 billionnet as foreign direct investment (FDI), 500 million asnet portfolio investment and 4.4 billion as othercredits. Corresponding annual estimates for the formerSoviet Union were 15 billion dollars when it was still aunitary State in 1990, but only 7.6 billion in 1991, 14.1billion in 1992, 5.8 billion in 1993 and 3.1 billion in1994; the latter originated mainly as 1 billion dollarsof FDI and 1.9 billion as other credits, and only 200million dollars in portfolio investment as State firmswere privatized. Official flows, from the same source,to Central and Eastern Europe were 2.9 billion dollarsin 1990, 7.9 billion in 1991, 5.3 billion in 1992, 2.4billion in 1993 and 500 million in 1994. Also in 1994,500 million dollars were grants, 400 million werebilateral credits and 2.2 billion were multilateralcredits; 1.9 billion came from the IMF. For the FSUthe annual estimated amounts were 5.5 billion dollarsin 1990, 8.6 billion in 1991, 500 million in 1992, 5.3billion in 1993 and 5.2 billion in 1994. In the latter,these were 2.4 billion dollars in grants, 100 million inbilateral credits, 1.2 billion in multilateral credits and1.5 billion from the IMF.

Among the many criteria relevant to the reversal ofcapital flight and the attraction of foreign investment


are political instability (including a foreseeable rela-tionship between local and central authorities andamong central authorities); a normal legal frameworkfor the foreign investor (including security from fraudand crime); predictable and stable taxes, fees and tar-iffs, currency liberalization (including the repatriationof capital and of profit); and a “level playing field” forforeign companies. Forces for instability, as discussedin this report, are often allied to pressure for protectionby the domestic private sector as new firms and priva-tized enterprises restructure to meet the new condi-tions. The task of governments and their externaladvisers is to balance those many factors in the actualand foreseeable conditions of the States concerned.

7.Summary and conclusions

Societal changes are continuous, yet their magnitudesvary from country to country and from time to time.Transitional economies are those in which the rate ofchange is acute and puts severe strain on the economyand society; they are typified in the ex-commandeconomies transforming themselves towards market-driven incentives in the 1990s.

In order to adopt effective financial management as itis known in developed countries, important transfor-mations are necessary in countries presently describedas in transition. These transformations are undertakenwith the objective which can broadly be described as aneclectic amalgam of the OECD economies. Despitemuch discussion by governments, legislatures, compa-nies, consultants and academics, the paths to thatobjective are perceived as neither uniform nor deter-mined a priori; moreover, the speed, content anddesirable order of the actions necessary to achieve itare all the subject of debate. Nevertheless, there ismuch agreement on the reforms that are needed and oninterpreting the evidence of the changes alreadyintroduced.

This paper has presented, in a comparative context, themeasures that transitional economies have applied intheir financial-management strategies, which arealmost always macroeconomic and societal as well asmicroeconomic and individual-centred. Strategicfinancial management concerns theseinterdependencies in their longer-term outcomes. Acommon objective is a general acceleration of financialsettlement systems, and many transitional economiesexperience severe problems of bad inter-enterprisedebts, non-performing loans and tax arrears as a

consequence of price and trade liberalization andgovernment “desubsidization”. However, it would bepremature to impose moratoria or bank recapitalizationas short-term solutions which try to alleviate thesymptoms before the causes of underlying instabilityhave been identified and eradicated, so that domesticenterprises are able to ensure their own liquidity andstakeholders in them are able to monitor performance.Furthermore, if economic activity remains in recession(as all these transitional economies experienced after1989), a sophisticated financial intermediation is lessimportant than the assurance of demand to underwriterestructuring and survival. Finally, since the bulk ofinvestment must eventually be financed by domesticresources mobilized by banks and non-bank financialinstitutions, policy measures to attract foreign lendinginstitutions should not crowd out the flow of savingswhich domestic entities can appropriately generate andallocate.

The paper has addressed the strategic and policy issuesrelevant to creating an economic and institutional con-text in which financial management can fruitfully beexercised; this cannot be a “quick-fix” approach. Indeveloped countries, the foundations for competitivemarkets have been built over decades or even centuries,although there is a temptation for many reformists toforget this long gestation process. Such evolution of themarket systems includes the evolution of law andproperty rights, security markets, corporate autonomyand accountability, the role of commercial banks andthe enterprise sector and many others.

The paper began with a discussion of the notion oftransition, of financial management and of the rele-vance of strategy in longer-term economic develop-ment. This was followed by an overview of those inher-itances of ex-command economies which influence theaccounting and information systems necessary for thesuccessful implementation of reforms. Commandeconomies were centralized and virtually State-owned.“Commands” were based on information which wasoften outdated. Prices were arbitrarily set to meet theneeds of the planners, and finance was no constraint.Such a system was effective in mobilizing resourcesand concentrating on a few clear and well-definedobjectives; but it did not serve the individual needs andaspirations of its citizens well, nor could it accommo-date multiple objectives in a pluralistic society.Valuation bases were mainly on historical costs andaccounting systems were almost primitive. Informationsystems did not provide much help for enterprise man-


agers because they were backward-looking and weregenerated as a by-product of the planning process.

Banks and other financial institutions are the corner-stone of any strategy for “marketizing” the function ofmoney. Issues in banking reform (discussed in section3) are the usefulness of a two-tier banking system-replacing the monobank-and their interdependence.The stability of a banking system requires efficiencyand solvency. The issues discussed in the area of effi-ciency include permissible banking functions, permis-sible ownership structure and the rules governing theentry and exit of banks. The issues on solvency includ-ed the distribution of non-performing debts, account-ing, payments and settlement systems, as well as theassurance of appropriate skills among employees offinancial institutions; the major concern is one of capi-tal adequacy in the light of perceived risk.

The recapitalization of banks and the participation offinancial institutions in enterprise restructuring hasbeen a characteristic of strategy in five transitionalStates—Poland, Hungary, Slovenia, Estonia andLatvia—but a further round of debt “workout” could beneeded if incentives and skills are not matched amongenterprises in general. The paper went on to examinerelationships in the enlarging private sector and withthe diminishing, but newly-regulatory, public sector.

The existence of property rights is a prerequisite forindividualized rewards and incentives and mostgovernments of transitional countries recognize this byundertaking a substantial privatization of State-ownedassets.

Essential as a transfer of property rights is to create acritical mass of profit-oriented economic activity form-ing capital in accordance with prospective efficiency,paradoxically it may not apply to banks, at least in theearly stages of privatization. This is because the recapi-talization of a State-owned bank can be more readilydefended than of a private bank in a democratically-elected legislature. It is also because private banks maybe established—or taken over—by criminal andfiuudulent persons or groups, both to exploit thepotential to create credit for illicit dealing and toconduct external transactions to escape exchange orfiscal controls, such as capital flight or tax evasion. Inanalyzing the role of the transfer of property rights ingeneral, the paper saw the extension of privatization asbroadly parallel to the extension of modern marketpractices.

Monetary rewards and incentives are eroded by domes-tic inflation and exchange-rate depreciation, low infla-tion being one of the yardsticks of efficiency in macro-economic management. As the paper detailed, bothrevenue and expenditure in the public accounts arereshaped by changes in the economic system and by aconsequential variation in economic activity. Whenmost external economic relations have been liberalized,trade and capital flows should enhance competitivenessand efficiency in the economy. Particular problemshave, however, arisen from the creation of new curren-cies as separate States were established and from theinitial instability of all currencies.

The central recommendation of this paper isattainment of compatibility with the motivations,incentives and objectives of market-based financialmechanisms. While these may be subject to particularnational requirements, the key issue is to assure thateconomic institutions be transnationally consistent andcompatible in order to facilitate integration into aworld market economy. Money is the mosthomogeneous unit of transfer both between and withineconomies. The attainment of its full characteristics offungibility and transferability is the prime objective ofstrategic financial management.


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II. TECHNICAL AND PROFESSIONAL FINANCIAL MANAGEMENTISSUES

IN TRANSITIONAL ECONOMIES

Introduction

This chapter—which consists of a paper on the subjectissues—addresses the technical and professionaldimensions of financial management issues affectingenterprises, both State-owned and private, as well asgovernment proper in transitional economies.Transitional economies are those countries, mainly inCentral and Eastern Europe (CEE), which are in theprocess of transforming their command economies intomarket-driven ones. The term also covers, to someextent, China’s introduction of certain marketmechanisms overlaid on the existing system,sometimes referred to as market socialism.

The term financial management is broad since itcovers budgeting, accounting, auditing, and selectedtopics. In addition to the present Introduction, thischapter consists of four sections. Section 1 considersfinancial management issues in banking enterprisesbecause development of this sector is essential foropening up and nurturing a free market system; specialattention is paid to the bank restructuring process, riskmanagement and the role of banks in capital flows.Section 2 examines enterprise financial managementin the non-banking sectors, considers the variousdifficulties posed for cash flow planning and businessbudgeting, and evaluates the role of accounting inprivatization and the development of capital markets.Section 3 considers the status and professionalizationprospects for the accounting and auditing functions.Section 4 is devoted to financial management ingovernment proper. The chapter concludes with aSummary and general assessment.

Each section commences with a general description ofthe system which existed as the transitional processbegan. This clarifies the threshold level, gives someindications of the stage of maturity of the system fol-lowing Dean’s (1988b) model; and helps to explainsome anomalies which persist in current practices. Toset the stage, this Introduction concludes with thefollowing brief review of the typical features of

accounting in planned economies.

Because the accounting function is generally condi-tioned by the culture within which it operates, some ofthe distinctive features of accounting in plannedeconomies are described so as to identify, in broadterms, the scope of accounting modifications and train-ing needed for transitional countries.

In market economies, enterprise accounting is gearedto the needs of entrepreneurs who exercise judgmentsabout volume, composition, and resale prices of outputbased on market information about consumer prefer-ences. Consequently, effective financial management isessential when enterprise survival depends on main-taining commercial viability through expanding profitsunder demand-constrained conditions. In plannedeconomies, on the other hand, the State enterprisedirector operates under resource constrained conditionswith the main objective of expanding output to meetcentrally-planned production targets. Some of theessential differences between these two types ofeconomies, affecting the accounting function, are listedin Table 1.1

Where social considerations prevail, such as maintain-ing full employment, financial viability is not a vitalissue for a State enterprise. Generally, the State couldbe expected to assume responsibility for covering lossesincurred in meeting assigned responsibilities, such asproduction quotas, as well as eventually writing offunrepaid bank credits. Many small entrepreneursapplying for credit in eastern Europe today are slowlygrappling with the concept that loans have to be repaidrather than ignored as in the past. Maximizing wages,not profits, is a major motivating factor particularlywhere, as in Hungary and Poland, workers’ councilsparticipate in management functions. Because “beatingthe system” in various ways is endemic, internal con-trol assumes increased importance.

1All tables in this chapter appear together,before “References,” at the end of the chapter.


Under central planning, enterprise accounting formspart of a series of subsystems contributing to anaccounting for the economy as a whole. Each subsys-tem is connected through common or harmonizedcharts of accounts, accounting and bookkeepingmethodology, and reporting formats laid down by aState authority, usually the Council of Ministers or theMinistry of Finance. The accounting function thereforerepresents an important tool in national economicadministration. The enterprise chief bookkeeper actsprimarily as a State comptroller, responsible for actingin the interests of the State and therefore not an inte-gral member of the management team serving theenterprise director.

In exercising the control function, considerable atten-tion is concentrated on satisfactory performance ofprescribed procedures, particularly since there is per-sonal material responsibility for errors which strength-ens low tolerance of ambiguity and resistance tochange. The potential for expanding the use ofaccounting information for decision-making, ratherthan treating it as merely a repository of documentaryevidence, is diminished for a variety of reasons includ-ing (Bailey, 1988, pp.15-16):

a. The accounting function has low prestige, does notcommand high pay, and therefore neither attractshighly qualified personnel nor recommends itself asa management information source;

b. The central authorities (who are generally econo-mists) and enterprise management (which usuallyconsists of specialists) have little or no training inaccounting and finance as a rule, and do notappreciate accounting’s useful potential;

c. Centrally processed data is usually compiled innonmonetary terms rather than in monetaryaccounting units;

d. Due to lack of computerized equipment, accountingdata which could be useful is processed slowly and,consequently, is not available in a timely fashion;

e. Because accounting technology does not keep upwith the times, the data it provides could be irrele-vant and unreliable; an example is the lack ofaccounting for price-level changes under inflation-ary conditions; and

f. Accounting data may be incomplete because not alltransactions flow through the system, particularlywith respect to the enterprise’s bank account. ForState control purposes, enterprises are kept cash

poor and all receipts and payments must bechannelled through their particular branches of aState bank. Usually the bank keeps the subledgerdetails of the receivables and payables while theenterprise maintains one third-party general ledgeraccount. A net debit balance in this account wouldbe treated as net receivables or a net credit balancetreated as net payables on the balance sheet. Thebank only releases cash to an enterprise for specificpurposes such as meeting a payroll and only after ithas checked out the details against someauthorization such as the enterprise’s plan. Further,the bank does not customarily issue a detailed bankstatement, although it will confirm a bank balance.

Additional financial management problems for enter-prises and banks are detailed below. Very briefly sum-marized, the banks’ main functions are to act as agentsof State control in the receipt and payment of cash.Except for specialized institutions, they do not serve asinvestment bankers or venture capitalists and have verylimited experience with credit risk evaluation.

Where so little emphasis or dependence is placed onthe usefulness of accounting information, the account-ing function is so standardized, and enterprisefinancial reports are generally not made available tooutsiders, that there is little reason to promote theemergence of an accounting and auditing profession.Poland is one of the few countries in Eastern Europe tohave maintained an Association of Accountants with aprogramme which granted diplomas to thoserecognized as “expert accountants.” This diplomaqualified them to check the accounts of Stateenterprises, typically during release time from regularemployment as State enterprise chief accountants, toensure compliance with regulations. This examinationdid not include internal control review, audit riskassessment, statistical sampling, and overallassessment of financial condition, results, and cashflows typical of independent auditors’ activities in amarket economy.

Lastly, the accounting function is usually the leastdeveloped in government proper. There are at least twomain contributing factors: the first, that the importanttask of planning the economy, as expressed in thenational budget, is performed by macroeconomists whodo not use accounting data; the second, thatGovernment operations are not subject to challengeover their economy and efficiency, although lip service,may be paid to those considerations. A third considera-tion is the common problem in market economies of

Technical and Professional Financial Management Issues in Transitional Economies 55

attracting personnel to improve government financialmanagement and stimulating the general public to takean interest in it and make an issue of it.

1.The banking sector

1.1 Banking sector reform

Banks and similar financial institutions (collectivelydesignated as “banks” for convenience) play a criticallyimportant role in the economy as a whole and businessin particular. They not only act as channels for privateand commercial cash flows, for example, but also worktogether with governments and regulatory authoritiesto achieve monetary policy objectives. As aconsequence, one of the first requirements intransforming an economy and establishing a newfinancial system is to restructure the banking sector.That is, banks have to evolve from subordinate units ofthe State administration to independent commercialcompanies exercising increasingly importantinfluences on the functioning and development of amarket economy. This process takes place in twostages: the first, creation of a two-tier system of centraland commercial banks; the second, restructuring andconsolidation. At the same time, accounting andreporting systems for banks have to be redesigned so asto meet the needs of the new institutionalarrangements. This provides an opportunity forstandardization of procedures and improved overallcontrol, through computerized operations. Thismassive effort is complicated by the need for trainingin almost all functions and at almost all levels. Afterfive years, most of the newly emerging democracies arestill in transitioning stages.

Section 1 proceeds with an overview of the unitarybanking systems in place in the CEE commandeconomies prior to the transition period, the process ofcreating new commercial two-tier structures, and thedifficulties connected with the existing staff’s lack ofrelevant banking skills. The diagnostic assistance ofinternational accounting and consulting firms in ana-lyzing bank management needs is illustrated by thePolish experience in privatizing its banking sector. Tohelp appreciate the benefits of speeding up evolution-ary processes, the new accounting, reporting, and man-agement information systems for Polish banks is con-trasted with that of the Russian Federation which is ata less developed stage. Extensive computerization andthe use of standardized charts of accounts has generallyfacilitated bank modernization. The banking diversity

which has started to develop throughout the region canpartly be attributed to alternative approaches torestructuring and consolidation. The section concludeswith consideration of bank supervision as well as over-all training needs, and approaches to them, in thebanking sector.

1.2 Unitary banking systems

Until the late 1980s, Eastern European banking sys-tems were unitary, consisting of a central bank with,possibly, some specialized institutions in addition. InHungary, for example, there were three: the ForeignTrade Bank, an investment bank and a savings bank.In Poland there were five: the Bank for Food Economy,servicing the State-owned agricultural and food pro-cessing industries; the household savings bank; thetrade bank, primarily offering short-term trade credits;and the Export Development Bank.

A somewhat different situation prevailed in the SovietUnion where, for many years, the banking system com-prised three main banks: the State Bank of the USSR(Gosbank USSR), which acted as a central bank and asa commercial bank for the State enterprises; the Bankfor Foreign Trade of the USSR (VneshtorgbankUSSR), which handled all external banking operations;and the Construction Bank (Stroibank USSR) whichhad sole responsibility for capital investment under thefive year plans. A fourth bank, the State Savings Bank(Sherbank USSR) operated under Gosbank’s supervi-sion (Essinger, 1994, p.334).

While the functions of the central bank varied some-what from country to country, the activities of theNational Bank of Poland (NBP) were not atypical.After consultation with the Ministry of Finance (MoF),the NBP would examine the production objectives andinvestment requirements of the Government’s centraleconomic plan. The NBP and MoF would then estab-lish a credit policy designed to enable State enterprisesto meet their targets. The NBP was also the country’slargest commercial bank, dispensing about 90 per centof the credits to the State-controlled sector. Until thehousehold savings bank (PKO BP) was established in1987, the NBP also functioned as the national savingsinstitution, conducting more than 65 per cent of house-hold and business transactions (Essinger, 1994, p.226).

Following new banking regulations passed in 1987, theSoviet Union introduced a new system as of thebeginning of 1988, providing for six main banks, two


of which were new while the other four were modifiedfrom the previous institutions. The two new bankswere Agroprombank USSR, providing finance, credit,and settlement services to the agricultural sector, andZhilsotsbank USSR, established to provide finance forhousing construction, social service facilities, anddevelopment of sports, municipal and consumer facili-ties. Gosbank’s functions were limited to central bank-ing; Vneshtorgbank’s role was broadened and it wasrenamed the Bank for Foreign Economic Affairs of theUSSR (Vnesheconombank USSR); Stroibank was alsoassigned broader duties to provide finance and credit toindustry, construction, transport and communication,

and was renamed Promstroibank USSR; whileSherbank USSR loosened its ties with Gosbankand—not renamed—succeeded to the 80,000 or soindividual savings banks comprising the previoussavings bank system. An overview of the Sovietbanking system as of mid-1989 is illustrated in Figure1. In August 1991, the Soviet Union was disbandedand the various republics started to adopt their ownbanking systems. In succeeding sections, emphasis isplaced on the Russian Federation.


1.3 Creating a two-tier structure

Creating a new commercial banking sector consists oftwo basic processes: privatizing the existing State-owned banks and introducing new private banks intothe economy under the provisions of enabling legisla-tion. Decoupling the central bank’s political depen-dence and commercial activities is essential for thebanking system to evolve into a mechanism for creditallocation and financial intermediation which is mar-ket-driven and market-responsive. This would leavethe central bank with functions similar to those inWestern countries. That is, issuing currency, acting asthe country’s central clearing institution, serving as thecountry’s banker, and refinancing and supervising thebanking system. The latter function involvesmonitoring the banks’ financial statements, reserverequirements, interest rates, and commercial conduct(Essinger, 1994, p.228).

Among the first countries to pass new banking lawstowards the end of the 1980s were the People’sRepublic of China (PRC), the Russian Federation,Hungary, Poland, Bulgaria and Czechoslovakia, withothers following closely behind. Amendments had tobe introduced later as the realities of trying to operatefinancial institutions in transitional economies beganto sink in and legal loopholes became obvious. Some ofthe difficulties which had to be resolved included(Go»“mbiowski, 1994, pp. 82-84):

a. whether or not some bank functions could beperformed by non-banking institutions;

b. whether or not the National Bank should pay inter-est on the compulsory reserves maintained bycommercial banks. In inflationary periods, which alltransitional economies were going through,commercial banks were suffering real lossesthrough holding idle reserves while, on the otherhand, governments with budget deficits were anx-ious to avoid financial obligations;

c. whether or not the tax authorities should be allowedaccess to depositors’ accounts information;

d. how to assure the independence of central bankadministration from political pressures.

The process of privatizing the existing State-ownedbanks followed a fairly consistent approach because ofthe strong similarities in the various transitional bank-ing systems. Essentially, regionally-organized banks

were split off from the central bank and licensed asuniversal commercial banks, inheriting the physicalbranch networks, staff, and the loan and depositaccounts of the former monobank. Poland’s experiencehelps to illustrate the growing pains in the early daysof the new regional banks.

From the start, Poland’s nine regionally organizedbanks were hampered by two basic and interrelatedproblems, their corporate client orientation and theirlack of experience in modern commercial bankingGo»“mbiowski, 1994, II, p.86). Most State enterprises,having lost their traditional markets, were in severefinancial difficulty and conserving cash to meet pay-rolls rather than to pay interest or principal falling dueon debt. Furthermore, it was not unusual for loansfrom the State to be forgiven or converted into equityduring the days of a managed economy. Consequently,enterprise managers did not recognize State debtrepayment as representing a real liability orresponsibility. The cash-flow problems of the bankswere aggravated by the regional structuring of bothindustry and banking. For example, shipbuilding wasconcentrated in the north, coal mining and steel worksin the south, and textiles in the centre, just southwestof Warsaw in Lodz. With entire regions in recessionand stagnation, and banks regionally organized, therewas no mix of bank clients with varying degrees ofliquidity in the regions that were hardest hit. Bankmanagement did not have either the expertise orresourcefulness to cope with the situation since most oftheir experience involved receipt and expenditure offunds and monitoring of enterprise transactions againsttheir budgets or production plans. Also, low salaryscales did not attract new personnel.

To help identify appropriate courses of action, thePolish Ministry of Finance commissioned three inter-national accounting and consulting firms in the fall of1991, to carry out diagnostic studies of each of theregional banks. Their main findings and recommenda-tions fell into three categories, two of them having todo with the specific functions of strategic planning andrisk assessment, the other with management overallGo»“mbiowski,1994, II, pp. 87-88):

a. With few exceptions, the banks had no strategicdevelopment plans, typically making short-termoriented decisions. For example, they perceivedhigh margin loans to be the most profitable line ofbusiness without taking into account emergingcompetition and consequent shrinking margins.They needed to decide how they wished to position


themselves, what specializations they shoulddevelop, and whether they should proceed individ-ually or seek out a partner, perhaps from overseas;

b. The banks were criticized for lack of prudence ingranting and monitoring credits. On a sample basis,receivables from the largest debtors were analyzedfor collectability and, as of mid-1991, uncollect-ability was estimated at about 25 per cent on theaverage, including 55 per cent for one of the banksalone. Among the recommendations were, checkingon credit-worthiness monthly rather than quarterly;monitoring the degree of credit committed to par-ticular branches of the economy; and assessing thetotal amount of loans extended to interconnectedclients as well as the credibility of other banks inwhich they placed deposits. The functions of theeconomic departments in the banks needed to beoverhauled, as they were primarily oriented towardsreporting on past operations. They should, as in theWest, be studying on a daily basis not only credit-related risk but also such other risk factors aschanges in the central bank interest rate, exchangerates, and the bank’s liquidity position;

c. The new role of the banks in the economy called fora number of changes in bank management andprocedures. In particular, two new functions neededto be developed: marketing and assets management,and—through the creation of new departments—information systems and planning. By consolidatingsome of the existing headquarters’ departments,needed centralization could be brought about as wellas more collective decision-making on some keyissues. Instead of one small headquarters running asmany as 40 or 50 branches, smaller branches shouldbe grouped for supervision by four or five largerbranches run by specially appointed vice-presidents.In effect, this would be very similar to the way Stateenterprises were organized into associated groups inthe 1980s and before that into “unions”(zjednoczenia).

After considering the consultants’ recommendations,the Ministry went ahead with the next stage of banktransformation which consisted in transforming thenine regional banks into joint-stock companies wholly-owned by a particular State entity—in Poland’s case,the Treasury. It also built many of the proposedchanges into the design of the new accounting,reporting and management information systems, whichare described below. The banks were now subject to thecommercial law which allowed for the appointment of

supervisory boards to monitor management as well asfor the eventual sale of shares to third parties. It alsomeant that they needed new accounting and reportinglegislation to meet their new role in the financialworld.

1.4 Bank accounting and reporting

Accounting and reporting for banks and similar finan-cial institutions is almost invariably differentiated fromthat of other commercial enterprises because of thespecialized nature of banking activities. It is also regu-lated, usually by relevant provisions of banking actsand requirements of supervisory authorities.Commonly, banks are required to follow standardizedor harmonized recording and reporting proceduresbased on specially designed charts of accounts whoseuse may or may not be mandatory, depending on thecountry involved.

For members of the European Union, bank reportingfollows the amended Fourth Directive (bis) of 8December 1986 which established uniform, but verylimited, sets of alternative balance sheet and incomestatement formats. These paralleled the basic (1978)Fourth Directive’s rules on company law for non-financial corporations dealing with the content,valuation, and presentation of their annual accounts.To produce these reports, computerized bankaccounting systems in Western Europe makewidespread use of a standardized chart of accounts(SCA), summarized in Table 2.

The SCA’s structure resembles charts of accounts com-monly found in countries with Anglo-Americanaccounting traditions where accounts are usually listedin the sequence that they appear in the balance sheetand income statement. In continental Europe, on theother hand, accounts are generally grouped into classi-fications depending on some shared characteristic.Usually, a maximum of ten groups is provided for,with first-digit decimal identification numbers for eachindividual group running from 0 to 9. This differencein basic design is illustrated in Table 2, where the SCAand the Polish chart of accounts for banks, BPK 93,appear side by side. The Polish accounts are classifiedinto ten groups; four because the constituent accountsare involved in like types of transactions (groups 1through 3 and 5); three because of their nature, that istheir line item description (groups 0, 4, and 6); twobecause of their financial statement classification(groups 7 and 8); and one (group 9) for off-balance


sheet items, that is for transactions which are notrecorded formally in the accounts.

Poland, together with its fellow members of theVisegrad group (the Central European Free TradeAgreement) of transitional economies (Hungary, theCzech Republic, and Slovakia), aiming at eventualmembership in the European Union, has incorporatedinto its banking regulations general congruence withthe amended Fourth Directive (bis, 1986) as well aselements of International Accounting Standard (IAS)30, “Disclosures in the Financial Statements of Banksand Similar Institutions.” A brief description of thePolish approach will follow that of the RussianFederation which, by late 1994, was at a less developedstage. This contrast between the two could be useful foridentifying the bridging mechanisms which may beemployed at various transitioning stages.

1.4.1 Bank accounting and reporting in the RussianFederation. In the Soviet Union and other managedeconomies, the framework of bank accounting andreporting reflected, congruently, banking’s main func-tions of acting as an agent of State-centralized controland redistributing funds. As stressed earlier, bankerswere not involved in making investment decisionsbased on credit ability and neither loan interest norprincipal were necessarily construed by either borroweror lender to represent actual liabilities but possiblypotential grants or State equity investments. As acorollary, banks did not have to be concerned abouttheir own financial viability and, further, theiraccounting information systems were not designed toaccumulate or process related data. This situationchanged, however, in 1988 when the Soviet Unionembarked on banking reforms—continuing in theRussian Federation—which essentially established forthe first time in its history a requirement that profitand loss accounting be included in bank informationsystems.

As of late 1994, all Russian Federation banks must fol-low the Rules of Accounting and Reporting for Banksof the USSR, issued on 30 September 1987 (Enthovenand others, 1994, p.79). This legislation, with subse-quent amendments, requires that all banks use aspecial chart of accounts and sets of financialstatements produced by the Central Bank. This bankchart of accounts—first enacted by the USSR StateBank on 16 February 1990—differs from those used inother economic sectors in various respects. Forexample, account classifications differ. The owners’resources are listed first and liabilities are emphasized

rather than assets; also, assets are listed in decreasing,rather than increasing, order of liquidity.

The chart consists of 26 sections of balance sheet andmixed accounts and 10 sections of off-balance sheetaccounts, some of which apply only to central banksand have been omitted in the listing provided in Table3. The chart’s design was heavily influenced by thefact that it was developed by the central bank which,being accustomed to a unitary system, retained manyfeatures of a centrally-planned economy. In particular,some of the terminology is outmoded and it is far toodetailed, containing, for example, many Statesettlement accounts corresponding to line items in theState budget. A positive feature of the chart, from atraining aspect, is that it does provide a bridge fromthe old system to the new and does not, therefore,confront the existing bookkeeping staff with heavyretooling needs. However, a revised chart is notexpected to appear until sometime in 1996 and thisextended delay means that bank information systemsare not serving the best interests of their users.

The roots of the old managed system are evident inRegulations for Compilation and Submission ofFinancial Statements of 1988, as amended by theUSSR State Bank on 18 October 1991 (Androsov andGolubovich, 1993, p.199), in which the main emphasisis placed on the balance sheet. Under the legislation,banks compile annual financial statements with the fol-lowing components (idem):

Form No. Statement

1 Balance sheet

2 Profit and loss statement

3 Allocation of profit

3-a Capital investment

4 Availability and movements of fixed assets

5 Bank assets, other resources and tied assets

113 Embezzlements and miscalculations

Two other documents are attached to the annual state-ment, a summarized statistical statement of commis-sioned objects, fixed assets, and the use of capitalinvestments (form 2 ks) and a short explanatory note.Commercial banks submit the annual reports from


their headquarters to the Russian Central Bank (CBR)department in their locality by 1 February after thecalendar year-end closing, or by 10 February if thereare affiliates. Balance sheets are also drawn up daily,using a CBR-authorized format. For central bank con-trol purposes, monthly balance sheets must be submit-ted to the CBR—with a consolidated one also if thebank has representative offices, subsidiaries, orbranches—together with an aged analysis of borrowingand forwarding of resources for certain balance sheetaccounts.

An example of a Russian commercial bank balancesheet with a listing of off-balance sheet accounts ispresented in Table 4.

The Table is based on 1991 balance sheet data for oneof the Russian Federation’s largest bank, theCommercial Bank for Innovation (MENATEP). Amore comprehensible and considerably abbreviatedWesternstyle balance sheet format, using the samedata, is also included in Table 4 for contrast.MENATEP was taken public in December 1990 andlater issued shares which were available for purchaseby physical persons, the first such opportunity inRussia—and the former Soviet Union—in the secondhalf of the twentieth century (Androsov andGolubovich, 1993, p.202).

Criticism of the existing accounting and reporting sys-tems for banks includes the following (Enthoven andothers, 1994, p. 83):

“The underlying inadequacy of current bankaccounting systems, limited understanding offinancial statements, rudimentary accountingprinciples, and the absence of appropriatereporting and supervisory guidelines constitutesignificant dangers for the financial system. Themain weakness in the current system relates tothe fact that financial statements do not present afair picture of bank performance, solvency,profitability, and liquidity to depositors,shareholders, and third parties, and do notdemonstrate that banks satisfy prudentialcriteria.”

Recognizing the need to raise accounting and auditingstandards in the banking sector, the RussianGovernment prepared a four-stage plan for accountingreform (Enthoven and others, 1994, p. 84):

a. To adapt the existing system so as to bring it intoline with international practices with respect to

principles and presentation;

b. To disseminate instructions to make financialstatements congruent with the new standards;

c. To draft a new chart of accounts and detailedinstruction manuals by a set deadline; and

d. To prepare a calendar to carry out a detailed reformof the accounting system over a two to three yearperiod.

While all transitional economies have different sets ofneeds, the experiences of the Visegrad countries withspeedier institution of bank accounting reforms couldbe useful for others.

1.4.2 Bank accounting and reporting in Poland.Polish bank accounting and reporting is governed bythe President of the NPB’s Instructions, No. 1/91 dated12 February 1991, on the topic of standardized princi-ples of bank accounting. Financial institutions arerequired to use the chart of accounts for banks (BKP91, now BKP 93) in accordance with the NBPPresident’s Instructions No. 24 of 31 October 1990.However, they are free to modify the basic chart (illus-trated in Table 2) to meet particular circumstances, aslong as they do not deviate from the standardizedreporting formats.

In designing a standardized chart, one of the mostbasic considerations is determining the informationneeds of the users of the accounting and reporting sys-tems who depend on the chart for foundations. A firstpriority can be drawn from the introduction to IAS 30which recommends that bank financial statementsinclude presentation of a commentary covering suchmatters as the management and control of liquidity andrisk. This is because of widespread interest in, and con-cern for, the topics of bank solvency and liquidity, aswell as the relative degree of risk associated with dif-ferent types of activity. In identifying bank informationsystem users and their needs, detailed below, this con-cern takes first precedence (Jarugowa and others, 1994,p.60):

• Bank managers, as a tool for analyzing financialstructure and risk control;

• The stockholders of domestic and foreign banks, aswell as the general population;

• The monetary authorities, for carrying out monetarypolicy and checking its effects;

• The General Inspectorate of Bank Supervision; and


• Auditors and bookkeeping inspectors.

In the technical construction of the chart, there are twotypes of accounts, general and designated (Jarugowaand others, 1994, p.67). General accounts identify dif-ferent types of operations and are disaggregatedthrough the use of four numerals. The first provides theaccount group classification, the second thesubaccount, the third the type of subaccount, and thefourth details of the type of subaccount, as in thefollowing example:

Numerals

1 Group classification: Operations with monetaryassets and with financial entities

11 Subaccount: Central bank

110 Type of subaccount: Current operations withcentral bank

1100 Detail of subaccount type: Current nostro account(that is, the bank’s account with the central bank,in contrast to a loro account which would be acustomer’s account with the bank)

Designated accounts represent descriptive details pro-viding additional information to facilitate financial andmonetary analysis. Nine designated accounts areallowed for in the chart (Jarugowa and others, 1994, p.69), the first two of which are used in preparing thebalance sheet and income statement and form part ofthe design of Table 2:

1. The currency, domestic or foreign, in which thetransaction is denoted;

2. Whether the partner to the transaction is a residentor a non-resident;

3. The type of opposite entry;

4. The period of the transaction’s original contract;

5. The settlement period remaining;

6. The terms of the transaction’s fixed or variablediscount rate;

7. Refinancing by the NBP;

8. Classification of the economic entity (enterprise,partnership, etc.); and

9. Credits guaranteed or not guaranteed by the State.

1.5 Bank financial reporting

IAS 30 requires that banks present a balance sheet andan income statement, each providing certain disclo-sures. In addition, certain other categories of informa-tion, listed below, should be reported:

a. Contingencies and commitments, including off-balance sheet items;

b. Maturities of assets and liabilities;

c. Concentrations of assets and liabilities;

d. Losses on loans and advances;

e. General banking risks; and

f. Assets pledged as security.

The balance sheet should present groups of assets andliabilities by nature (i.e. line item identification), andlisted in order of liquidity. Whether liquidity should bein ascending or descending sequence is not specified.The income statement should group income andexpenses by nature, rather than function, disclosing theamounts of their principal types. The Standard alsoidentifies certain specific line items which shouldappear in the balance sheet and income statement,although banks are free to add others.

Poland’s balance sheet and income statement formatsfor banks, illustrated in Tables 5 and 6, generally con-form to the 1986 Fourth Directive (amended) and toIAS 30. In fact, the Standard’s requirements areexceeded by the Polish provisions for a mandatorythird statement, illustrated in Table 7, which presentsthe status of off-balance sheet accounts.

The financial statements also include a three-partannex (Annex D) providing the following information(Jarugowa and others, 1994, p.85):

D-1: Details of the prior year’s profit;

D-1: Details of the profit confirmed for the prioryear, and its distribution;

D-2: A listing of securities and their overevaluations, if any; and

D-3: General information about the bank’smanagement and organizational structure.

In addition to the published annual reports, the NBPimposes a number of internal reporting requirementsaimed at strengthening overall control as well as facili-tating financial and economic analyses. Mainly, theseconsist of monthly and semiannual reports, includingcertain annexes (Jarugowa and others, 1994, pp. 86-


87).

The monthly reports, together with Annexes A and B,are used by the Central Bank to analyze monetary poli-cy in the light of the growth of money and credit in thedomestic economy as well as the turnover of financialtransactions by Polish residents overseas. Annex A is afive-part document which considers the distribution ofcredits and deposits across economic subjects, that is,the financial and budget sectors, etc., according tobasic time periods for payment, as well as informationabout securities. Annex B also consists of five sectionsand is used by the General Inspectorate of BankSupervision (GINB) for evaluating solvency and liq-uidity as well as for analyzing the safety of the bankingsystem, that is, the degree of risk. The semiannualreport includes a presentation of costs and revenues aswell as a multi-step statement of the bank’s financialresult.

The other main monthly reports involve two series offorms: Z and K. The series Z forms, 1 through 4, rankthe varying degrees of creditworthiness of economicsubjects, identifying those against whom reparation-liquidation processes have been instituted. The CentralBank has, therefore, a considerable amount of propri-etary, centralized, and valuable credit information atits disposal. The monthly K series forms report on themonth-end status of agricultural credits (K-1) andcredits for housing construction (K-2).

Banks are also required to submit economic informa-tion to the NBP, on a separate series of formsnumbered F1 through F6, falling into three majorgroupings:

a. Balances at the end of the reporting period for:

• selected elements of the bank’s assets andliabilities (F-1);

• investments transferred between banks (F-2); and

• assets of non-budgetary funds and foundations (F-3).

b. Information about interest rates used during thereporting period for:

• domestic currency credits (F-4);

• domestic currency deposits (F-5); and

• foreign exchange credits and currency deposits ofresidents (F-6).

c. Monthly information about average exchange rates

for basic convertible currencies, such as US. dollars,German marks, British pounds sterling, and Frenchfrancs, used in currency transactions during thereporting period.

In summary, Poland has established a comprehensivesystem of internal and external financial reporting aswell as an internal information system designed to pro-vide data to management and the bank supervisoryauthority that would help in evaluating financial condi-tion and risk as well as compliance with micro- andmacro-monetary policies. While this is a significantachievement, much needs to be done in the areas ofstaff training to carry out the new systems as well assupervision of actual operations: as discussed later.

1.6 Computerizing the banking sector

The complete overhaul taking place in bankaccounting and reporting, combined with theavailability of funding from various internationalsources, provided transitional economies with anexcellent opportunity to computerize bankingoperations. Some of the larger banks in the Visegradcountries chose proprietary mainframes to realize theirpriority of making clients whole-bank, rather than one-branch, customers. Other reasons why such banks needexpensive, centralized approaches with large,continuously updated databases include: ability to learnin real time what and where cash balances are so as tomanage liquidity ratios; opportunity to offer a range ofservices at as many locations as possible; and tightrequirements for data security and very high reliability(Business Central Europe, October 1993, p. 36).

Komer…ní Banka carried out considerable marketresearch with many firms over a long period beforedeciding on a 100 million dollar integrated IBM main-frame system to foster a global customer orientation.Despite considerable advance planning, however, theconversion period was six months behind scheduleand, with its millions of accounts, the system started tosuccumb to volume problems which entailed work ontuning applications and transfer to a more powerfulmainframe module. It has successfully pushed its waythrough to pilot programmes, which include opticalkey cards, interactive voice response and a billboardsystem in branches (Business Central Europe, October1994, p. 58).

Local banks, with more restricted operations and highvulnerability to the poor telecommunications infra-


structure that plagues the region, as well as largerbanks taking a lesser global view of their dispersedclients, have selected distributive systems—such asUnix-based systems—over mainframes. These areoperating systems designed to enable computers tocommunicate with each other more easily and makeuse of the considerable amount of common softwareapplications available. Such users include the RussianFederation’s State savings bank, Sherbank, whoseautomation cost somewhat under 130 million dollars;the Czech National Bank; „eská SpoÍitelna, the Czechsavings bank, which increased the number of its fully-automated branches from 330 to 640; and Hungary’slargest savings bank, OTP, with over 400 branches(Business Central Europe, October 1994, p.58).

Installation problems in transitional economiesresemble those experienced elsewhere, such as theusual technical glitches and training difficultiesassociated with an older workforce quite unfamiliarwith modern information technology, but with theaddition of cultural dimensions. Personnel from theUnited States and the United Kingdom who installedCeska Spontelna’s custom-made Octagon system, forexample, were unfamiliar with the different hierarchyof personnel they encountered and had to learn tochoose words very carefully because of terminologicalmisinterpretations. They were also unaccustomed tothe volume of changes that occurred in the Czechaccounting and banking regulations which seemed torequire system-updating frequently. Other trainingissues and approaches are discussed in subsection 1.12.In the meantime, during the restructuring and reformactivities of the indigenous banking systems,transitional economies were being opened up to privatebanks and financial institutions in order to attractbadly needed foreign capital.

1.7 Attracting foreign capital

The process of attracting foreign capital requireslicensing approval from a responsible State authority,such as in Poland the president of the NBP in consulta-tion with the Ministry of Finance and in Hungary theState Banking Supervisory Authority. Conditions laiddown in the banking laws include mandatory legalstructures (usually joint stock companies), and mini-mum capital requirements (e.g. 25 million dollars forbanks in Hungary, 6.2 million dollars [5 millionECUs] in Poland), but were tightened up to restraincompetition in those countries where the domestic

banking system was in serious difficulty. Poland, forexample, added new requirements for thoroughbusiness plans, three-year financial projections, anddetailed information about shareholders, and deniedbranch banking facilities except to the two foreignbanks which were already operating before the bankinglaws were amended. In the Russian Federation, a newdraft banking law having its second parliamentaryreading in December 1994 would permit only thoseforeign banks licensed before November 1993—whichhad already started operating—to deal with localclients and would not allow any increase in the numberof foreign banks licensed, currently 11 (The MoscowTimes, I I December 1994, p.53).

The most numerous private banks are in the RussianFederation where 2,000 or more institutions styled ascommercial banks had sprung up by mid-1993,perhaps only two dozen of them with solid financialfoundations (Business Central Europe, June 1993,pp.40-43). In Hungary as of mid-1994, there were 37banks, 6 specialized financial institutions and 256savings cooperatives (Hungarian Chamber ofCommerce, 1994, p.16). At the same time in the CzechRepublic, there were 55 banks and more than 300investment funds (The Economist, 22 October 1994,p.92). Poland had licensed seven Western banks bymid-1994 while six more still wait with applicationswhich have been pending long beyond the legal six-month limit, some up to two years (Business EasternEurope, 22 August 1994, p.4). Two of the nineregional banks spun off from the NBP have beenprivatized; one is in the privatization process, and theremaining six are targeted for privatization by the endof 1997. The six specialized banks, including the PKOBP national savings bank, which is the only institutionto offer mortgage loans, are still State-owned. Over thepast five years, some 94 licenses have been issued forprivate banks with some 80 in operation. By far themost numerous—about 1,600—are the cooperativebanks which mostly, although not exclusively, servethe agricultural sector. They offer a full range ofservices and often they provide the only bank in someof the smaller towns.

1.8 Restructuring and consolidation

The growing diversity in the transitional banking sys-tems of Central and Eastern Europe can be attributedboth to differences in restructuring programmes them-selves and to the influences of individual programme


managers. Experiences so far point to the crucialimportance for effective results of initial, well-devisedplans, and strong will and support to carry themthrough. This was the approach taken by the CzechRepublic which was firm at the outset in clearing thebalance sheets of valueless assets, injecting new capitaland getting banks into private hands quickly. TheKomercni Banka—widely considered to be the mostsuccessfully transformed bank in Central Europe—pro-vides an impressive case study of government effort toensure the survival of a transitional economy’sindustrial and manufacturing base (Business CentralEurope, October 1994, p.42).

At the start of the transition, Komer…ní had no retailbase and it inherited almost all of the outstandingCzech industry loans which were minimally securedand generating little interest revenue. Writing them offwas not possible because there were virtually no loan-loss reserves. Maintaining them, on the other hand,posed another type of problem. They were mainly long-term credits and Komer…ní had no long-term financingsources. The dilemma was solved with three mainsteps: (a) the inherited loans were commercialized byraising interest rates 400 percent, a move which wouldallow for a 7 per cent margin on new loans; (b the oldloans were secured by collateralizing assets at 120 percent of their previous value; and (c) the bank stoppedissuing the inter-company “perpetual” loans, whichhad previously constituted a form of trade financing,and quadrupled the interest rate to 23 per cent on thosetrade loans still outstanding. The State very heavilyunderwrote the write-offs and recapitalization neededfor the credit squeeze policy required to meet thegovernment’s macroeconomic objectives but whichtook its toll of Komer…ní’s Czech industry client base.

By 1992, Komer…ní’s net interest revenue constituted73 per cent of net revenues enabling the bank to buildup loan-loss reserves which were also tax deductible.After a full audit by a Big Six international accountingfirm, Komer…ní was privatized in the first wave ofvouchers which put 50 per cent of its equity into thehands of individuals and about 200 investment funds.Two years later, in 1994, it had 429 branch outlets, 80per cent of its deposits were corporate accounts, and itcollected some 23 per cent of all deposits in the CzechRepublic. At that time, it depended on interbank andcentral bank funding for only about 25 per cent of itsrequirements and dispensed about 30 per cent of allcommercial lending, 60 per cent of this to private sec-tor clients. Komer…ní itself suffered from the shortage

of long-term financing which affected the entireregion, particularly in those countries with higherinflation rates where loan money was scarce and, whenavailable, was usually only offered for the short (3months) or medium (6 months) terms. Komerdnicould, however, obtain foreign bank financing whichallowed it to offer seven- or eight-year loans, givingCzech banking a unique feature.

As the Komer…ní case illustrates, the two basic andinterrelated problems in restructuring commercialbanks across the entire region had to do with resolvingthe treatment of bad debts and deciding how to carryout the required recapitalization which this entailed. Itis estimated that, in 1992, the collective bad debts inthe balance sheets of Hungarian, Polish, Czech, andSlovak banks were somewhere in the region of 12 bil-lion dollars, or possibly anywhere from 20 per cent to40 per cent of the outstanding bank loans. These fourcountries, as well as Slovenia, tried various but similarsolutions, that is, either placing some of the bad debtportfolios in special “hospital” banks or setting uprecovery departments in commercial banks (BusinessCentral Europe, June 1993, p.36). In Komer…ní’s case,help was provided by the Czech “loan hospital”Konsolidacni Banka (Business Central Europe,October 1994, p.43). Poland took a somewhat differenttack. Following the detailed analyses of their creditportfolios by consultants, referred to earlier, the ninecommercial banks went ahead in early 1992 to identifyassets which fell into the doubtful and loss categories,creating loss reserves of 50 per cent and 100 per centrespectively, and then set up work-out departments todetermine what could be salvaged. These departmentshad to be staffed by foreign and domestic consultingfirms due to the lack of qualified and experienced per-sonnel (Essinger, 1994, p.235). Because of the generallack of professional factors or reputable debt collectors,banks have resorted to various ways of trying to realizereceivables. These include: publication of debtors’names, addresses and amounts owed in thenewspapers, presumably for psychological effect, atleast; efforts to sell receivables; and debt/equity swaparrangements. It should be pointed out that the banksare not alone in suffering credit risk. It is not at allunusual for business enterprises, public or private, torequire up-front cash payment for sales or services,both because of the credit squeeze and the wave ofunscrupulous business behavior which accompaniedthe breakdown in the political system.

Shoring up a bank’s equities-side balance sheet, and


how to accomplish it, is as much a political decision asan economic and financial one. The banks have to begiven new financing in order to make them moreattractive to potential buyers and to boost their capitaladequacy ratios. A popular approach has been to issuebonds but this pushes up government spending, run-ning counter to International Monetary Fund (IMF)requirements that governments decrease deficits. Anegative aspect of recapitalization is that it allows thebanks breathing space to continue their old habits oflending to their former—and financiallyhopeless—corporate clients and thereby restarting thecycle of reserve loss provisions.

In transitional economies, at least two formidable road-blocks hamper assessment of the net realizable value ofreceivables and collateral; one is the lack of centralizedcredit information, and the other the absence of collat-eral registration as well as other difficulties with estab-lishing ownership title. After several years of trying toperform with due diligence through various informalmeans, the banks had, by 1994, become rapidly com-puterized and were starting to collect credit informa-tion systematically and to share it on a limited basis.For example, the Union of Polish Banks was building adatabase on bank deposits and expected soon to haveaccess to police data on certain documentation. Theirmain objective in searching for available data basesand trying to link them up was to develop a fairly com-plete package of information about clients’ credit histo-ries, their current payment records, and document reli-ability (Gazeta Bankowa, No. 44, 29 October 1994, p.6). The extent to which banks could be expected toshare credit information with outside parties, particu-larly competitors, is another matter. Furthermore, theconcept of freedom of access to certain information,publicly available elsewhere in the world, is foreign tothose in the bureaucracy who view knowledge as powerand the basis for authority.

The processes of registering ownership title and collat-eral are likely to take considerably longer. A start hasbeen made in Hungary, Poland and the Czech Republicby a US-based firm which is computerizing the realestate ownership records of certain municipalities. Thistask involves preparing detailed lot maps to make surethat all the existing property is inventoried, as well asploughing through hand-kept records which are notnecessarily complete or up-to-date. Once titles can beinsured, and long-term money becomes available,mortgage banking should be able to make headway.The main incentives for municipalities to fund the land

registration research were the perceived benefits ofincreased property taxes through complete tax rolls andthe opportunity to shift to ad valorem assessmentrather than imposing a flat rate as at present.Registering collateral, on the other hand, has no suchrevenue producing potential to attract public fundingand little if any progress is reported while credit is stillin the doldrums. The best lenders can do in the mean-time is to take whatever practical steps they can todetermine whether prior liens may exist on propertyoffered as security.

Bank consolidations constitute a form of restructuringbecause more financially sound partners can help toshore up their shakier colleagues. Consolidating alsoprovides the benefits of economies of scale, allowsdevelopment or sharing of branch networks and per-mits the consolidated entities to finance out of theircombined resources projects which they could notattempt individually, such as larger restructuring pro-jects and participation in certain privatizations.Consolidation also represents an important defensestrategy for coping with foreign competition.

Domestic bank consolidations, as well as drawing inmore foreign investment through foreign bank partici-pation in the economy, are basic planks in the“Strategic Plan for Poland” drafted by economist andFinance Minister Grzegorz Kolodko. With thecooperation of the NBP, two approaches have beentried to carrying out this strategy, neither particularlysuccessful. One was the NBP president’s attempts todevelop strategic alliances between domestic andforeign banks, which stirred little interest in the Westeven though pairing with a domestic partner waspresented as a necessary condition for speeding upapproval of banking licenses. The other approach wasto offer a block of shares to a foreign bank whenprivatizing an attractive domestic bank. The selectedcandidate was the Bank Slaski whose shares, offered at25 dollars each, were to be traded on the Warsaw StockExchange in January 1994. The Netherlands INGBank purchased a 25 per cent interest, at the issueprice, for 56 million dollars, and the issue was heavilyoversubscribed. Because of the massive public interestand various inadequacies in the infrastructure, very fewshares had been released by the time trading started.Those who were lucky enough to get them benefittedby the huge rise in their market value to 300 dollars,causing an outcry from the general public over severalissues—including the familiar one in privatizationexercises that foreigners received undervalued national


assets. Two outcomes were that the Minister of Financeresigned over the affair and Polish banking stagnatedfor most of the year until a wave of mergers occurredin the late fall of 1994 (Central European BankingReview, October 1994).

1.9 Bank supervision

With new banking laws and accounting regulations inplace, the restructured central banks in most transition-al countries now have the basic infrastructural condi-tions they need for effective bank supervision. In fact,however, basic questions are being raised about thedegree of implementation of this essential function aswell as the quality of the supervisory personnel(Business Central Europe, October 1994, pp. 52-54).Out of four tightly-bunched countries in the region,bank supervision has informally been rated as best inthe Czech Republic, followed by Hungary, Poland, andSlovakia.

The Czech Republic’s ranking was based on thequality of its new laws passed in July 1994, whichdetail unacceptable practices and related prescribedpenalties, and provide for a new mandatory depositinsurance plan. In addition, supervisory staff areundergoing extensive training aimed at bringing themup to relatively sophisticated standards.

Hungary also has stringent laws, but bank supervisionsuffers from a tripartite division of responsibilitybetween the State Banking Supervision (SBS), theNational Bank of Hungary (NBH), and the Ministry ofFinance (MoF). Under the Financial Institutions Act, aregulatory system was provided for to be administeredby an independent body, the SBS, which was to per-form both off-site monitoring of information gatheredby the NBH and on-site reviews by bank examiners.The SBS was not, however, provided with theresources to carry out its mandates, since its staff num-bers only 100 and it has no on-site inspectors.According to one of its officials, the agency needs atleast 2,000 to 3,000 more personnel plus some experi-enced and well-paid managers, although the WorldBank’s estimate of personnel needs is more modest.

The SBS was supposed to be administered by the min-istry without portfolio but, after this ministry wasclosed down, the task was assigned to the MoF eventhough it lacks banking experience. Further, it placedthe MoF in a conflict-of-interest situation because itwas already a tax collector and held over 80 percent

equity interests in some of the largest banks which ithad heavily supplied with capital reserves. The NBH,on the other hand, through its data gathering ensuresthat banks are liquid and oversees their foreignexchange transactions, and it has resources that theSBS lacks but not the jurisdiction. A practical way outof the dilemma, in view of the HungarianGovernment’s budget constraints, would be to amendthe Financial Institutions Act so as to merge the SBSand the NBH. However, this would still defeat theAct’s intention to establish independent supervisionand, thus, points up the problems transitioningeconomies face when they lack the financial means toimplement superior strategies.

In Poland, bank supervision is conducted by the NBPthrough its arm of the General Inspectorate of BankingSupervision. It has a growing number of well-trainedstaff, ample legal resources at its disposal, and strongsupport from the NBP’s president. The NBP hasalready applied to liquidate two banks—one export andthe other cooperative—and put about 50 cooperativebanks under administration because of poor financialcondition. Four of the larger, Stateowned banks arealso in trouble, but politics will probably deter the NBPfrom taking action further than public announcement.

In Slovakia, bank supervision is the responsibility ofthe Central Bank’s supervision department. With astaff of only 13 it is both inadequately staffed andtrained to meet the needs of the growing bankingsector, but political instability and budget constraintsprevent practical remedies from being found at present.

1.10 Training needs and approaches

Technology transfer is one of the most importantadvantages associated with foreign bank penetration intransitional economies, at least from the viewpoint ofthe host countries. The fact that training is needed inalmost all areas of banking is evident from the multipleand various problems exhibited to a greater or lesserextent across the entire region. Because small businessis the greatest loser, market economies cannot be builtup through the main mechanism of smallentrepreneurs until they can get adequate access toworking capital. First priority, then, needs to beaccorded to putting the banking sector into properworking order.

Some of the most severe problems are to be found in,but are not exclusive to, the Russian Federation where,


as mentioned earlier, there are over 2,000 self-styledcommercial banks. Many of them are undercapitalizedand may be wholly-owned by factories, or groups offactories, which view them as external treasury depart-ments with ability to obtain cheap credits for theirowners on the interbank currency markets. Generallyless than 10 per cent of their resources are in the formof loans to individuals and small companies for invest-ment projects and working capital, while significantamounts are placed in correspondent accounts withother banks and the interbank credit market. Mainlybecause the investment climate is perceived as toorisky, with three- and four-digit inflation rates, coupledwith limited understanding of and experience with riskassessment, bank profits are usually earned from feesrather than loan interest. Fees, which can be relativelysubstantial, may be charged for all manner of bankingservices such as opening accounts and acceptingdeposits. The savings bank, Sherbank, is the largestand most significant source of long-term loans-whichcould be defined as over six months depending on theenvironment—and it has been under heavygovernment pressures to make such funding availableto certain industrial sectors (Business Central Europe,June 1993, pp. 40-43).

Elsewhere, with relatively more developed bankingsectors, banks generally prefer to deal with large, rela-tively risk-free companies, and are targeting large pri-vatized firms and foreign joint ventures. Small busi-ness loans are considered too small to be profitable aswell as too risky. Banks have no history of small busi-ness lending, the would-be borrowers themselves havelittle or no experience with borrowing money and, asdescribed previously, little if any credit data isavailable. When loan money is available, verysignificant amounts of collateral are usually required,mainly in the form of cash, tangible assets or realestate with title, as well as very high interest rates, acombination which puts bank borrowing beyond smallbusiness means. For many high-level bank managers,attention has to be focused on working out problemloan portfolios with no time to consider building upnew markets such as small business lending. In themeantime, preferred bank investments are governmentsecurities where no underwriting is required and theinterest rates earned are comparable to what could becharged for loans. As a result, credit-starved businessesco-exist with banks afloat with unavailable financialresources.

Most of the training in modern banking operations, in

order to improve management and increase capitalflows, has taken the traditional approaches of coursesin banking schools, use of financial consultants for on-the-job training, and sending staff to correspondentbanks in the West. Poland has tried two less traditionalmethods both of which were successful and are beingadopted elsewhere. They are the bank “windows” smallloan programme, designed by Chicago’s South ShoreBank, and the twinning programme funded by theWorld Bank.

Windows is a joint lending programme established inlate 1990 by the Enterprise Credit Corporation (ECC),a wholly-owned subsidiary of the Polish-AmericanEnterprise Fund, in cooperation with 10 Polish banks.By early 1994 it had trained some 75 loan officers and30 local staff in making loans of up to 75,000 dollars,an amount subsequently increased to 500,000 dollars,although few loans exceed 100,000 dollars, on thebasis of evaluation of the loan purposes, analyses ofprojected cash flows and background character checks.The programme gets its name from the fact that loanapplicants had to go to a particular counter, or window,in the cooperating bank. Bank cooperation was essen-tial because the ECC did not have a banking license.By mid-1994, some 3,400 loan commitments had beenmade and there were 1,525 active borrowers with anaverage loan of about 28,000 dollars. The ECC notonly provided the training but it also paid the salariesof those bank staff who worked in the windows pro-gramme until this subsidy was removed in 1994 whenit was apparent that the banks could make their ownway and were building up their small loan business.Many of the banks have now withdrawn from the pro-gramme for this and other reasons and ECC is continu-ing to serve small business financing needs throughestablishing loan production offices in communitieswhere it previously operated loan windows.

In the Czech Republic and Slovakia, a windows-typeprogramme was not so successful for two main rea-sons: first, some short-term, small loans money wasavailable elsewhere; second, loan applicants wererequired to attend training sessions in preparing busi-ness plans before loan application decisions weremade. For the more sophisticated borrowers this wasconsidered to be largely a waste of time, while thoseless sophisticated felt cheated if, after investing time intraining, their loan applications were turned down. Theunderlying reason for requiring the two-day trainingexperience was the expectation that borrowing wouldbe for start-up businesses in view of the lack of entre-


preneurial activity over the previous 40 years.However, the few loans that were made—to about 2 percent of the some 2,000 people who took thecourses—went to established businesses or to thosewho had already come in with detailed business plans.This experience points up the need for a thoroughthinking through of such large-scale operations tomake sure that there is congruency between theconstituent parts.

The small loan programme of the Hungarian-American Enterprise Fund, also established in late1990, involves joint arrangements with twocommercial banks. Once again, banking partners hadto be found because the Fund did not have the bankinglicense it needed to make loans. Further, it did nothave the resources to invest 25 million dollars, theminimum capital requirement, to establish a bank. Atotal of 5 million dollars was set aside to fund loans inthe range of 10,000 to 100,000 dollars to beadministered by the participating banks. Loan loss riskwas divided equally between the Fund and the banksfrom loans made out of the Fund’s initial 5 milliondollar investment. The banks assumed full financialresponsibility, however, for losses on loans madesubsequently out of the proceeds of repayments. Thesmall loan programme is still in operation; the Fundprovides training and assistance to borrowers asneeded, and also pays for staff training in cash flowlending. Much of the instruction is provided by theInternational Management Centre in Budapest.

The Bulgarian-American Enterprise Fund’s smalllending Kompass programme is closer to the Polishmodel and was also designed by the South Shore Bank.The joint lending program was established with fourbanks; the Fund committed 5 million dollars to theproject and the first loans were made in September1994, the local bank staffs being assisted by two SouthShore Bank staffers.

The various American Enterprise Funds in these coun-tries also operate smaller loan programmes with anupper limit of 20,000 dollars, although most lending isfor considerably smaller amounts. They are usuallyadministered directly by a fund, or its agent, andresemble the type of small lending activities typicallycarried out by Western banks, but which have yet totake hold in the transitional economies. Because thefunds are concerned with capital maintenance, allexchange risk remains with the borrowers with loansdenominated in dollars. Borrowers have yet anotherinconvenience to accommodate, namely compliance

with foreign exchange laws in both taking out andrepaying foreign currency loans. In Poland, for exam-ple, it is a very complicated procedure when a paymentfalls due to determine exactly how much domestic cur-rency has to be exchanged, to make arrangements forthe transfer, and to make sure that the lender isnotified of the transfer of funds in a timely fashion.

1.11 Training through twinning

A second, non-traditional, training approach whichdoes not, however, have the advantage of unlockingflows of working capital, is the “twinning” programmedeveloped in Poland by the World Bank. Twinningarrangements are aimed at building strong institutionalarrangements between entities carrying out similaractivities while, in this process, skills are transferredfrom the more experienced to the less experiencedpartners. It differs from more traditional technicalassistance programmes in several important ways: itprovides a broader range of services over a longer peri-od of time, typically several years rather than severalmonths; it allows the more experienced partner to passon lessons learned during its own earlier developmentas it works through early stages with its new partner; itgives the less experienced partner the chance to tapinto the resources it needs and which are not usuallyavailable to a consulting firm; the experienced partnerusually has many backup personnel available to step inwhere and when needed; and the less experienced part-ner has easier access to the commercial services thatthe senior partner can provide (Essinger, 1994, pp. 75-76).

Foreign banks were asked to bid on the following scopeof work, and contracts were signed in the late spring of1992 (Essinger, 1994, p.76):

a. Development of a strategic planning capability andpreparation of an initial strategic plan and support-ing business plans;

b. A review and revision of the existing organizationalset-up and the introduction of budgeting systems, tobuild a structure and internal financial andmanagerial tools conducive to realizing theobjectives identified in the strategic plan;

c. Strengthening of the banks’ credit function bydeveloping prudent and credit policies and proce-dures, and building of an asset- and liability-man-agement capability;


d. Assistance in the automation of the banks’ opera-tions and building of management informationsystems;

e. Building of marketing and human resource devel-opment capabilities, strengthening and moderniza-tion of the banks’ internal audit function, anddevelopment of large-scale staff and managementtraining programmes.

By the summer of 1992, teams from foreign banksstarted to work with their partners-seven of the nineregional banks which had been split off from the NBPThe partners were the following (Essinger, 1994,p.230):

Bank Depozytowo-Kredytowy w Lublinie SA—Bank ofIreland

Bank Gdabski SA w Gdarisku—NMB Postbank

Bank Przemyslowo-Handlowy SA w Krakowie—ABNAmro-Bank NV

Bank Zachodni we Wroclawiu SA—Midland Bank

Powszechny Bank Kredytowy SA w Warszawie—Instituto Bancario Sao Paolo di Torini

Pomorski Bank Kredytowy SA w Szczecinie—Unibank A/S

Wielkopolski Bank Kredytowy SA w Poznaniu—Allied Irish Bank

Although the scope of work was designed in discretemodules, it soon became evident that adjustments hadto be made in the order of things. For example,training called for in the final module had to be startedbefore the first module because the host managementwas quite unfamiliar with routine concepts in strategicplanning. Delays were also experienced through lan-guage, terminology and translation difficulties, particu-larly during the early stages and when attempts werebeing made to document existing structures. Workingthrough strategic planning exercises enabled some ofthe host banks to appreciate the risks inherent in therapid expansion of branch networks on which they hadalready embarked as well as to decide about whichoperations to specialize in. Different approaches weretaken to organizational restructuring. Some banks


decided to pull control in to the centre while othersopted to move it out somewhat.

Training trickled down through the system through theintroduction of planning and budgeting in thebranches. The unfamiliarity of top management withtransfer-pricing and branch-profitability analysis led toother solutions being adopted for the short term, suchas lowering credit ceilings available to branches andtying branch merit pay to achievements againstbudgets. Impressive progress was noted instrengthening the credit function by standardizingcredit application forms, completing new creditmanuals, drafting manuals for dealing with problemloans, and introducing loss classification systems.However, improvements were constrained by the poorquality of management information and humanresources difficulties. Few banks had started to addresstheir overstaffing of undercapable employees and lackof personnel with quality-risk managementcapabilities.

Because risk management is what the banking business

is all about, this is the training area which demandstop priority. As Figure 2 illustrates, risk—defined asthe volatility of future income and how it affects thevalue of the firm, from the banker’sviewpoint—underlies balance sheets and varioustransactions. To manage it requires a basicunderstanding of accounting and finance and theapplication of various analytical tools such as thosecurrently being employed in some American andEuropean banks. In fact, quantitative approaches torisk management are increasingly taking hold inWestern banking to the extent that a managing directorin the risk management group of a major US bankforecasts that bank financial statements should sooncontain a new paragraph in which risk managementauditors certify to shareholders that accepted risk-management principles and methods have been appliedon their behalf (The Economist, 10 April 1993, p. 4).

Academic training to bring transitioning bankers up toa basic level of competence in modern banking callsfor banking diploma programmes, such as those


offered by the University of Phoenix, USA (CentralEuropean Banking Review, June/July, 1994, p.4). ThePhoenix programmes currently offered in Hungary aredesigned to meet the advanced education needs ofworking professionals and are held during eveninghours at accessible locations. Banking Diploma I intro-duces fundamental financial concepts and analysis infour, six-week courses in financial accounting, busi-ness analysis, executive management in the globaleconomy, and cash flow analysis. The follow-up pro-gramme, Banking Diploma II, provides advanced-levelanalytical tools to help identify and monitor the risksassociated with loan transactions. The four courses forthis diploma are: macroeconomics for business deci-sion-making, projections and the lending decision,loan structuring and pricing, and loan management.

1.12 Conclusions

A well-functioning banking sector is critical for transi-tional economies seeking to nurture free markets, par-ticularly when would-be entrepreneurs are reluctant toagree to equity financing. So, it is in the first order ofthings to teach bankers how to extend credit, teachlenders how to apply for it and comply with its terms,and provide the conditions for the circulation of loancapital. Basing the new structure on well thought outand designed accounting, financial, and managementinformation systems is an essential element of theprocess.

The difficulties of restructuring the banking sector andretraining its staff mirror those experienced in otherparts of the changing infrastructure. That is, the prob-lem of mind-set: opening eyes and explaining both“how” and “why,” is usually the most necessary but themost tedious and lengthy first step to tackle in buildinga sense of business, rather than bureaucratic, thinking.Until these business decision-making qualities areencouraged, there is little if any appreciation of theaccounting function’s basic role in the financial man-agement process. This is mainly because of the manydecades in which that process was restricted to book-keeping and non-analytical activities. As the Polishexperiences illustrated, the redesign of banking infor-mation systems was heavily influenced by Westernconsultants from the accounting and banking commu-nities who ensured that essential accounting-relatedpriorities were integrated into the banking databases.As a result, banks can generate reports for such essen-tial purposes as helping the NBP assess monetary poli-

cies and the financial community evaluate credit.While bridging systems, that is those that make agradual transitioning in order to ease the retrainingprocess, may be appropriate in early stages, there needsto be a fairly speedy—say two- to three-year effort tomake major overhauls. Otherwise, the banking sectorwill be lagging significantly behind other sectors and,thereby, dysfunctional.

The “twinning” and “loan-windows” programmes inPoland demonstrate the value of having training pro-grammes delivered on site by experts providing hands-on advice to those individuals who need and use it.Major drawbacks to conventional sessions in classroomsettings have to do with whether appropriatecandidates were selected for training and whether theenvironment to which they return will encourage, oreven tolerate, application of what the trainee haslearned. Behavior modification is usually moreeffective when the trainer can be observed on the job.In a banking setting, for example, the trainer showshow to evaluate credit risk by using data drawn fromthe bank’s accounting and finance records inconjunction with, say, a prospective borrower’sbusiness plan. The need for a basic understanding ofaccounting and finance in risk management shouldmake the importance of accounting apparent to thebanking community. Bankers, in turn, could beexpected to pass on their concerns about good record-keeping and financial management to their prospectiveborrowers. Without computerized operations, bankingreforms would be considerably hampered.Computerization expansion has been adversely affectedless by financing problems than by technical ones. Amassive amount of effort is needed to update thetelecommunications networks across the whole Centraland Eastern European region.

The question of banking expansion through opening upthe sector to foreign competition is a vexing one, par-ticularly in the medium term when domestic banks arebeginning to find their way. Different countries havefollowed different philosophies but, overall, domesticbanks have, to some degree, adopted internationalaccounting and finance-based banking practices.

2.Non-bank enterprises intransition

2.1 State enterprises in transition

The introduction of political and economic reforms in


the CEE region some five years ago led to significantchanges in the external and internal conditions withinwhich State enterprises operate. Externally, there weredrastic alterations in the institutional arrangementsunder which State enterprises functioned. Internally,enterprise managers were forced to redefine theirobjectives and their operating methods in the face ofconsiderable business uncertainty. Virtually for thefirst time managers had lost their twin anchors ofseller’s markets and guaranteed financial support. Nowthey were confronted with tight monetary policies andunsalable goods and services. The need for soundfinancial management came to the forefront.

The process of shifting from a planned to a marketeconomy brought on similar problems across theregion; that is, plummeting demands for goods andservices, high inflation, layoffs and risingunemployment, and the drying up of cash flows. Formost transitional governments, a major priority was tocurb inflation. In Poland and elsewhere, theapproaches taken were to introduce stringent fiscal andmonetary policies connected with loosening pricestructures, cutting back on subsidies and restructuringtaxation systems. The policy makers in governmentseemed to believe that the market mechanism itselfpossessed some mystical power to help enterprisesstruggle through the difficulties of the transition. Theyalso failed to realize that development of marketmechanisms could take some time and that variousinterim measures were called for. Firms, whetherpublic or private, were largely left to their own devicesto operate in an unstable and ambiguous environmentwhere the command economy model had beenofficially abandoned but a functioning market economywas not yet in place.

For businesses attempting to cope with the transitionaldifficulties, the State enterprises were under the heavi-est pressure, not merely because they were the maineconomic force. When economic reforms began, theywere already in financial trouble; the government con-tinued to regard them as a main source of public rev-enue, and State enterprise managers—most of whomwere not accustomed to competitive conditions—hadlimited decision-making ability, particularly inHungary and Poland where the workforce enjoyed cer-tain managerial prerogatives.

The initial financial problems of State enterprisesstemmed from overdue loans for investment projects,both enterprise—initiated as well as directed by theState. As inflation flared, bank interest rates—which

were variable, not fixed-skyrocketed, and neither inter-est charges nor the monthly principal installmentscould be paid, mainly because of poor business condi-tions and very low liquidity. As economic reformsbegan to take hold, the financial condition of Stateenterprises appeared to go through several phases.

In the introductory period, usually the first year,mounting inflation produced accounting profits, eventhough sales volumes had started to fall, because rela-tively low costs of earlier acquired goods or productswere matched against inflated sales revenues. The arti-ficiality of this appearance of partial prosperity was notapparent because none of the transitional countries hadintroduced, or were encouraging, inflation accounting.In the second stage, that is for the next two years,financial problems started to accelerate. Foreign anddomestic demand was reduced, particularly in the mar-kets of the Council for Mutual Economic Assistance(COMECON). Trying to collect receivables and paythe workforce became main concerns. Liquidity prob-lems were aggravated by the lack of loan money andhigh interest rates coupled with high collateral require-ments.

Payment bottlenecks which seem even after five yearsto be prevalent everywhere, present a major impedi-ment to market transformation, that is, lack of timelysettlements of amounts due between enterprises,between enterprises and banks, and between enterpris-es and the government. Governments caught in amoney squeeze increased pressures on State enterpris-es— which were still their main revenuesources—through heavy tax burdens, including incometax, a tax on the value of fixed assets, and a tax on theincrease in average pay rates over a defined limit.Enterprise response was to try to avoid holding assetswhere they could be accessed by the government, suchas in banks. Special price concessions were offered forcash payments and it was common for cash to bemoved around in various containers and by variousforms of transportation. Enterprise managers kept uptheir formal and informal networks, loaning andborrowing cash between themselves under emergencyconditions and potentially disguised for accountingpurposes. Networking represented one of the reasonswhy more firms did not go bankrupt. Another was taxevasion, coupled with the inefficiency of the fiscalauthorities in collecting taxes.

Limitations on management’s decision-making abilityhave to do primarily with the role played by the work-force. In some countries, such as Poland and Hungary,


major decision powers were assigned to workers’ coun-cils. With the rise of trade unions in Poland during the1980s, a situation—commonly referred to as aBermuda Triangle—prevailed where power was sharedby three groups: management, the workers’ councilsand the trade unions. Any major decision affectingworkers’ rights, employment conditions, and pay rates,for example, could cause workplace paralysis untilmeeting the payroll became a priority considerationwhen planning cash flow. It also motivated managersto seek corporatization, that is, having the enterprisebecome a corporation or limited liability company withthe State Treasury as the sole shareholder, as a firststep in the privatization process. The State enterprisewould be removed from the public enterprise registerand be reregistered as a company subject to theCommercial Code. Management would then be subjectto considerably less labor pressure, although subject tothe oversight authority of a Supervisory Board onwhich the workforce would be represented.

Management also faced pressures from above. Duringthe first three years of the transition, Poland’s Ministryof Industry and Trade reshuffled 86 per cent of indus-trial enterprise management positions (Gotembiowski,1994, I, p.145). Of this total, 23.4 per cent of the man-agers were removed at the initiative of the enterprise’sfounding authority, and 76.6 percent at the initiative ofthe workers council. Among the limitations on theirauthority, enterprise directors most frequently citedunstable legal regulations, economic system rules, lackof funds and capital, high interest rates on bank loans,trade union intervention, and employee pressure.

Management views on the main factors considered inassessing their performance from below and aboveassumed the following criteria: improvement of eco-nomic and financial results, enterprise financial condi-tion, steady growth in employee earnings, better eco-nomic effectiveness, problem-solving ability, andenterprise restructuring activities. The threads thatconnect these criteria are demonstrations that theenterprise can survive and become more viable so as toguarantee employment and provide revenues for thegovernment and workforce. Because these areperceived to be the main criteria for judgingmanagement effectiveness they would also be the maincriteria underlying enterprise financial management.

In transitional economies, generally, State enterpriseshave suffered critical survival problems. Empiricalresearch in Poland identified the following obstacles toenterprise development under growing market condi-

tions (Goiembiowski, 1994, I, p.143):

a. High investment risk, mainly caused by changes insocio-economic policy as well as the lack of long-term development planning;

b. Excessive taxation of the State enterprise sector;

c. Preferential treatment to accorded private businessin the initial transition period;

d. Infrastructural inefficiencies of the introductorymarket mechanisms;

e. Inherited financial investment debts; and

f. Insufficient information about the availability ofaccessing foreign development assistance.

Clearly, much of the responsibility can be attributed tothe lack of vision by new governments, coupled withthe political instability characteristic of early reformperiods.

To summarize, in the initial stages of economic reformthe main goal of State enterprise was to try and sur-vive. Managers had long enjoyed sellers markets andsoft loans or other subsidies which were often convert-ed into equity, as well as directed strategies. In the nextstage—which lasted several years, depending on theenterprise’s particular situation in the economy or therelative severity of economic conditions—a mainobjective was to achieve financial liquidity while tryingto find a market niche. In the third stage, which somecountries have not yet reached, market share expansionand profits maximization—hallmarks of a more devel-oped economy—become the main goal. It is only thenthat financial management, as the concept is under-stood in market economies, can employ the moremature practices of integrated budgeting, or planningand accounting, both financial and managerial.

2.2 Changing the basic accounting model

In the command economies of the Central and EasternEuropean (CEE) region and China, the basic account-ing model was fund-based as it is, for example, in localgovernmental accounting in the United States. Thismeans that groups of assets are shown on an enterprisebalance sheet matched up with corresponding groupsof funding sources. From a bookkeeping standpoint, asingle transaction affecting more than one fund groupwould require several sets of bookkeeping entries to


reflect the effects of the transaction on the differentfunds.

The basic balance sheet for a State enterprise, based onfund accounting, would resemble the following (Berryand Ðwiderska, 1992, p.18):

ACTIVE PASSIVE

Fixed assets and Fixed assets fund

investments in process

Circulating assets Circulating assets fund

Special purpose assets Special purpose funds

Loss for period Profit for period or or

Distribution of profit Coverage of loss

In shifting to a market economy, it follows that thefinancial statements of State enterprises should becommercially—rather than fund-oriented. Thisinvolves introducing some radical changes to thecomplicated bookkeeping system as well as basicconcepts of commercial accounting and reporting inorder to permit expanded and improved financialmanagement techniques. In particular, the changes inthe basic financial and management accountingsystems should facilitate the process of harnessing theaccounting function to the financial management of theenterprise.

In Poland, the basic shift in accounting models com-menced with the law of 31 January 1989 (DziennikUstaw No. 26, poz. 152). Three of its major provisionswere to change the revenue realization principle to afull accrual basis; to eliminate the main correlationsbetween the sources and uses of funds in the book-keeping system; and to establish a new tax in the formof a dividend payable to the State Treasury based onthe amount of the State’s investment which was accu-mulated in a newly-created charter fund (funduszza»oócielski).

The main structural change was to sort the funds, rep-resenting the sources of assets on the balance sheet,into two groups—the charter fund and the enterprisefund. The calculation of these two beginning balanceswas complicated and the formula undoubtedly relatedto maximizing the State’s dividend. The dividend per-centage was set annually in the State Budget Law, tak-ing two main factors into account—the interest ratecharged by the Polish National Bank and the percent-age of net profit anticipated in the coming year for theeconomy as a whole. The dividend was accounted foras a deduction from net profit after taxes and could,therefore, put the enterprise into a loss position. It hadto be paid to the State Treasury, however, withoutregard to the enterprise’s financial position. Havingconverted the governmental fund accounting model toone more resembling a commercial model, the stagewas set for the design and introduction of majorchanges in the basic accounting regulations.

2.3 New accounting regulations

As all the transitional economies started down the longroad to the market—many of them in the direction ofassociate membership in the European Union—itbecame evident that significant changes would beneeded in the accounting and reporting regulations soas to make them congruent with the functioning of amodern society based primarily on private ownershipprinciples. For most countries, this process hasinvolved two stages—getting an initial version in placewhile elaborating a more comprehensive set of finan-cial laws. In Poland, the first new accounting regula-tion was issued as an instruction from the Ministry ofFinance in the fall of 1990 and put into effect as of 1January 1991 (Dziennik Ustaw No. 10, poz. 35). Acomprehensive accounting law was passed, on 22September 1994, after much discussion in the Polishaccounting community.

All countries in the CEE region, with the exception ofPoland, require standard charts of accounts. Thesenational charts are diverse, depending on a particularcountry’s prior experiences with charts of accounts, aswell as on the source of advice from outside accountingexperts. The basic charts of accounts for five differentcountries (Bulgaria, the Czech Republic and Slovakia,Hungary, and the Russian Federation) are listed inTable 8 for comparison purposes. The Polishexperience has been, however, that bookkeepers andaccountants, long accustomed to working with stan-


dardized charts of accounts, were uncomfortable abouttheir responsibilities in a less restricted set of circum-stances. As a result, the Association of Accountants inPoland sponsored a model chart of accounts whichmany enterprises have adopted on a voluntary basis.

Although most countries adopted balance sheets almostidentical to those used in countries conforming to theEuropean Union’s Fourth Directive, the new Russianbalance sheet—according to 1993 supplementarymodifications to the accounting and reportinglaw—shows some of its old roots as illustrated in Table9. For example, it has retained the familiar category ofsmallvalue, short-lived items in the current assetsclassification; also, it includes reserves for doubtfulaccounts among the liabilities, because of the fact thatthey have credit balance. This account should be,according to Western practice, netted against theaccounts receivable item. These reserves, incidentally,represent new practice for the Russian Federation.Under the previous system, bad debts could not berecognized unless legal efforts to collect unpaidamounts had proved fruitless. This is still generally thecase for tax purposes in former command economies.In the Czech Republic, the fiscal authorities areconsidering allowing tax relief for unpaid collectibles,mainly because Czech businessmen are voicing strongopinions about the negative effects of taxing unrealizedsales, particularly during the widespread andprolonged cash crunch.

Caution should also be exercised when examining bal-ance sheets prepared under new regulations as theunderlying accounting principles might differ fromthose generally accepted elsewhere. Some of theaccounting provisions of the Law on Accounting No.563/1991 of 12 December 1991, of the then Czech andSlovak Federal Republic, contain a number of itemsthat are neither in accordance with internationalaccounting standards, nor, as it happens, withgenerally accepted accounting principles in the UnitedStates. These include:

a. Interest is not imputed on long-term receivables orpayables which are non-interest bearing or carry anunreasonably low interest rate;

b. Except for the lease of major segments of a busi-ness, virtually all leases are accounted for as oper-ating leases;

c. The direct costing method may be used for inven-tory valuation;

d. Deferred taxation accounting is only required fordepreciation and amortization differences when acompany is consolidated. It is not required for othertemporary differences or in other cases;

e. The completed contract method is used for long--term construction, manufacturing and service con-tracts, or as otherwise provided for in the contract;and

f. Unrealized foreign exchange gains on foreign cur-rency transactions are not recognized in incomeuntil realized.

2.4 Accounting reform in China

New accounting standards were introduced in Chinathrough four accounting regulations released in 1992by the standard-setting body, the Chinese Ministry ofFinance. Their stated purpose was “… to improve theaccounting of stock companies and interests of theinvestors and creditors …” (Winkle and others, 1994,p. 52) and intended to accelerate the socialist marketreform movement. The fourth of these regulations,issued in December 1992 and effective as of 1 July1993, applied to all Chinese business enterprises inorder to standardize practice and make Chineseaccounting more congruent with international princi-ples. While there continues to be a high degree of gov-ernmental control over the accounting function, moreaccounting decisions are now permitted at the enter-prise level.

Some differences between the Chinese accountingstandards for business enterprises and accounting prac-tices generally accepted in the United States, should benoted, for example, by those considering joint ventureoperations. These differences include (Winkle and oth-ers, 1994, p. 55):

a. No provisions exist for lower-of-cost-or-market, ormark-to-market, valuations of certain assets-strictadherence to the historical cost convention isrequired;

b. Issues of imputed interest, lease obligations, andcontingent liabilities, among others, are notaddressed;

c. Certain subsidiaries whose line of business is con-sidered unsuitable for consolidation may beexcluded. Consolidation is otherwise required wherethe parent enterprise has a 50 per cent interest ormore. In the United States, more than 50 per cent is


specified in such cases.

A complete revision of the accounting standards andupgrading of the accounting profession is currentlyunderway, supported by a 2.6 million dollar loan fromthe World Bank, and spearheaded by one of the largeinternational accounting firms in cooperation with theMinistry of Finance, to meet a target date of 1995(Winkle and others, 1994, 52).

2.5 Utilizing accounting information

The motivations underlying the restructuring of theaccounting function went beyond satisfying the needsof the fiscal authorities and enterprise oversight bodies.There was some general expectation that the informa-tion the newly designed systems would produce wouldprove helpful for important decisions. At the presenttime, however, the benefits are not too clear. Twosweeping and significant infrastructural changes havebeen taking place: small- and large-scale privatizationand the development of stock markets. The role ofaccounting information in enriching these activitieshas not been demonstrated and may be attributed to afew key factors: (a) at the beginning of the reforms,government officials and the general public wereunable to read and interpret financial statements; (b)the data processed by the new systems consisted ofbalances accumulated under the old regime and thevaluations they contained probably did not reflecteconomic realities; and (c) privatization amounts andstock offer-prices were based on considerations otherthan accounting-based data, such as prices that themarket would bear. In large-scale couponprivatizations—such as in the Czech Republic andRussia—accounting data did not really enter into theequation. When it did—in the Czech Republic—bookvalues were used as the speediest and least costlysolution to the valuation quandary. Arguably, the mostsystematic approach to enterprise valuation occurred inGermany during the pre-privatization financialrestructuring of former East German State enterprises,in an attempt to assure their financial viability. Thisprocess is described in the following subsection.

2.6 Structural reform of State-ownedenterprises

A first step in transforming State-owned enterprises(SOEs) into private enterprises is to change their legalstatus from public sector bodies to private companies.

Germany took a unique approach by effecting thechange in one piece of legislation rather than on anindividual basis. Under the Treuhandgesetz(Trusteeship Act), SOEs were converted into privatelimited companies and conglomerates into joint stockcompanies as of 1 July 1990. The main reason for thisoverall change in legal status was to speed up the own-ership transformation process so as to facilitate devel-opment of the market sector.

Another major step, taken by most of the CEE coun-tries, was to revalue the new companies’ assets and lia-bilities as part of a financial restructuring plan. Insome countries, such as Poland, attempts were made tofinancially restructure privatizing enterprises in orderto make them more attractive to investors beforechanging their legal status, whereas in Germany legalstatus change generally occurred first. InCzechoslovakia, it was omitted altogether to avoid thedifficulties of the revaluation process and pass on thefinancial restructuring problems to the investor. Onceagain, a speedy opening up of the market sector wasthe main objective. The German rationale was to pro-vide the privatized enterprises with minimum capitalso as to be financially viable. Further, it was argued,investors, whether domestic or foreign, would requirefinancial information presented in accordance withinternational standards and conforming to theEuropean Union’s Fourth and Seventh Directives con-cerning financial reporting and consolidated accounts.Accordingly, the German process was dual in nature inthat it adjusted the basic accounting model to that fol-lowed in West Germany as part of the balance sheetrevaluations.

The German experience with bringing the formerSOEs into the general market economy was affected byeconomic, financial and social factors not generallyfound elsewhere. For example, domestic and foreigninvestment capital was available and, consequently, theuse of privatization vouchers was not considered neces-sary; the banking system was well developed and soonreached into the new Länder; and there were function-ing, sophisticated capital markets. Quite unique wasthe need to consolidate two currencies, which compli-cated the valuation process. Different conversion rates,for example, were needed for different balance sheetelements. Most importantly, perhaps, the West GermanTreasury could be called on to assume some of thefinancial burdens of the privatization exercise. Themechanics of the restructuring process, and the valua-tion problems that had to be addressed were common


in other countries. Further, all transitional economiesfaced the constraints of trying not to curtail living stan-dards, working out difficulties over lack of a compre-hensive social safety net, and trying to enable as manySOEs as possible to survive the transition.

The German approach to the latter difficulty was toprivatize some SOEs with all or part of their existingdebt but translated into new capital. Doubtful loanswere transferred, usually, to the privatization agency(Treuhandanstalt) to pursue potential collection.Moreover, interest rates under the old regime did notreflect risk and there were no collateralized loans inthe western sense, except for the assets they financed.Also, loans usually had long maturity periods andmight well be forgiven eventually. Consequently, asmentioned in section 1 (which deals with the bankingsector), the necessity to repay loans was not wellunderstood or accepted.

From an accounting standpoint, however, EastGermany and some other countries such as Hungaryand Poland had always tolerated small and medium-sized private enterprises, primarily in the services andhandicrafts sectors. Consequently, there was someexisting spirit of entrepreneurship. More importantly,perhaps, all the planned economies had double-entrybookkeeping systems, many of them built essentiallyalong German lines. They also had comprehensiveinventory systems which facilitated efforts to value orrevalue assets and liabilities.

At least four major accounting-related problem areasface those engaged in economic reorganization: valua-tion issues, consolidation methods, cash flow analysis,and firm-structure questions. Valuation issues are con-sidered in some detail below. Consolidation methodshave to do with the fact that the balance sheets of thevarious SOEs which constituted a combine, were sim-ply added together without elimination of intra-com-bine activities. Furthermore, combine membership andthe trade ties that connected the individual constituentSOEs, made it difficult to assess the potential stand-alone strength of a particular SOE after its combinehad been disbanded. Cash flow analysis, lastly, ran intotrouble in drawing a line between where the Stateended and the SOE began, a problem related to firm-structure questions. This stemmed from the way thatSOEs were financed by State-determined, plannedcredit lines or funds which were directly contributed oradministered by State agencies. These credits wereintermingled with the cash flows generated by the SOEitself. Clearly, a cash flow statement designed in the

format recommended by International AccountingStandard No. 7, would be needed to help assess aprivatizing SOE’s potential for future cash flowgeneration.

2.7 Valuation rationale and issues

A main objective of establishing fair values for theassets and liabilities of a privatizing SOE is to helpestablish a selling price. In Eastern Germany, this goalwas linked to another, that is, to ensure that each SOEor conglomerate was capitalized at the minimumamount required under the appropriate company legis-lation. A company with more than the minimumcapital would be required to turn the excess over to theTrust Agency. Conversely, one with a capital deficitwould have an equalization claim against the Agencylisted among its assets. In general, the capital balancewas calculated as the difference between revaluedassets and revalued liabilities, following westernaccounting conventions. However, some exceptions togenerally accepted accounting principles (GAAP) werepermitted in order to maximize the possibility ofcreating the minimum capital balance, thereby easingthe strain on the Trust Agency. A notable exception toGAAP was permitting internally created goodwill,trademarks and brands to be valued at the lower ofreplacement cost or fair value taking technologicalmaturity into consideration. Under western GAAP,only purchased intangible assets are usually permittedto be listed as balance sheet assets. Evaluationconsiderations and solutions with respect to particularbalance sheet items follow.

2.7.1 Land. In the German Democratic Republic, com-bines paid a single lump sum for permanent user rightsto the land made available to them. In other plannedeconomies, user rights were granted to SOEs by theState without charge. In nearly all cases, land was pub-lic property and, therefore, was not listed by the userson their balance sheets. In Eastern Germany and else-where, there was no functioning property market toestablish fair values. As a surrogate, the GermanMinistry for the Economy provided special sets ofcoefficients for land valuation; these set the basic valueof land at DM85/sq.meter multiplied by coefficients ofland quality and potential or actual uses or purposes.This same approach to land valuation, particularly inagriculture, is used elsewhere in the world (includingLithuania, for example). Values arrived at through useof these coefficients were considered to represent pre-


liminary estimates—not to exceed three years—untilreal estate markets developed sufficiently to permitvaluation corrections. An additional factor which hadto be borne in mind was the potential for land valuedecreases due, for example, to restitution claims,environmental protection costs, and liability for wastedisposal. Such provisions were either netted out againstthe land’s gross value or shown among the liabilities.In the calculations, attention to the potential effect onequalization claims played a role.

2.7.2 Buildings. Attempts were made to valuebuildings at market, however determinable in theabsence of independent transactions, either reduced byan allowance for future required maintenance or atgross with a special reserve for the expected futuremaintenance costs. This reflected the general failure inthe past to perform building maintenance or carry outmajor repairs. Further, the straight-line depreciationmethod commonly used provided for life spans whichwere about four or five times longer than in WestGermany. So, even if the buildings’ book valueswere—more by coincidence than anythingelse—realistic, depreciation allowances were veryinadequate.

2.7.3 Machinery and equipment. In the GDR, machin-ery and equipment acquisitions had been recorded atplanned prices (Industrieabgabepreise). These werecalculated as production costs (gesellschaftlichnotwendige Selbskosten) plus or minus premiums orsubsidies and plus the producer’s profit margin.Periodically, most recently in 1985, required revalua-tions of planned prices were made in the accountingrecords, using standard coefficients. The 1990privatization valuations of machinery and equipmentestimated current reproduction or replacement costs,adjusted by a depreciation allowance to approximatefair market value. Alternatively, other sourceinformation considered more reliable or appropriatecould be used, such as data from catalogues and salesat auction. Items which could no longer be used had tobe valued at their disposal amounts. Special valuationproblems were posed by items of a unique orspecialized nature or which were not otherwise widelytraded, as well as items with outdated technologies. Insuch cases, educated guesses or special depreciationcharges had to be resorted to.

2.8 Accounting and stock marketdevelopment

Transitional economies need mature stock exchangesfor at least two major reasons (BCE, February 1995,p.38): to help finance private sector growth and to helpin determining market prices for newly privatizedenterprises.

The experience of the Warsaw Stock Exchange (WSE),which opened in 1991 and within two years hadbecome the fastest growing market globally, shows thatfinancial information about traded firms plays little, ifany, role in investment decisions. Rather, the retailinvestors—who made up about 50 per cent of the400,000 or so investment accounts at the end of 1993,and who tended to act in concert—stimulated marketvolatility through seemingly irrational trading, such asbuying when reported earnings were less than expect-ed, or showing no interest in new offerings with poten-tial growth and profitability. This behavior hasdiscouraged institutional investors who could provideneeded stability.

Another factor is the presence or absence of regula-tions. Closed-end mutual funds face prohibitive tax lawdifficulties and Poland’s State pension plan would haveto be restructured in order to attract pension fundinvestors. Furthermore, a newly enacted 0.2 per centstock transaction tax introduced by the Ministry ofFinance and levied on the seller, would discouragelarge volume trading.

2.9 Stock markets

By the end of 1994, the WSE had slid to penultimateplace—only above Turkey—in the rankings ofemerging markets.

Perhaps emerging markets need stock exchanges likeNASDAQ. As a sign of increasing diversity, theBudapest Stock Exchange signed a cooperation agree-ment in late 1994 with the French futures exchange,Matif, to develop a derivatives market (BCE, October1994, p.61).

The Prague Stock Exchange (PSE), which lists some1,000 companies and is policed by the Ministry ofFinance, has been suffering from concerns over taxregulations and secret trading (BCE, October 1994,p.69). Much of this stems from the requirement thatevery legal transaction has to be registered at theSecurities Centre (SCP) for a uniform fee regardless ofthe value of the transaction. Larger traders can benefit,therefore, from bulk transactions. Prices are publishedif transactions are conducted on the PSE or the over--


the-counter system (RM systeme), which had 470stocks in the system by October 1993 (BCE, October1993, p.57). Direct trade prices are not published, how-ever, if transactions occur off-market. This leads toconcern about possible insider trading and, as a conse-quence, the PSE is anxious to outlaw direct tradingbetween companies and institutions. Their recommen-dation is that a Securities Commission should be estab-lished along the lines of the United States’ SEC and itsrole be limited to that of share-ownership registration.

A further area of concern relates to inadequate disclo-sure of company information. Because analysts feelthat financial data provided through the PSE does notpermit sufficient evaluation, they are reduced to travel-ling around to the companies for on-the-spot assess-ments. This situation has stimulated interest in provid-ing publicly available independent information on allfirms as a service to the investing community. With thesecond wave of voucher privatization imminent—almost doubling the listings by adding an additional800 companies—calls for market regulatory reformhave assumed some urgency.

3.Professionalization of theaccounting and auditingfunctions

3.1 The rebirth of accounting andauditing

The accounting and auditing needs of the newlyemerging market economies made it possible for thesefunctions to start taking on professional status. Forsome countries the process has been faster than forothers. Two factors which seem to make a differenceare the particular country’s accounting tradition andthe amount of political support that nurturesprofessional development.

This section commences with case studies of threecountries at different levels of professional maturity;Russia, China and Poland. Russia, with virtually noprofessional tradition and a high degree of politicalinstability, is at an early stage. China has a long tradi-tion in professional accounting and auditing, althoughnot in recent decades, and currently enjoys governmentsupport; consequently, its stage of development appearsto be more advanced. Poland has maintained a profes-sional association of accountants since the early part of

this century, except for the war years, and has had gov-ernment backing of its restructuring activities; it is oneof the professional leaders in the region. These casestudies show the effects of the environment on profes-sional development while at the same time disclosingsome apparent training requirements.

The case studies are followed by a description of theprofessional examination requirements in the CzechRepublic and Poland so that their more advanced train-ing needs may be better appreciated. The CzechRepublic’s use of a heavily-weighted case study in thewritten part of the examination is a novel approach totesting a candidate’s ability to use academic training ina decision-making environment.

Expansion of accounting and auditing training at theuniversity level is illustrated by examples of coursesoffered in Poland. This is followed by a short descrip-tion of training approaches used by audit firms.

The section concludes with a summary of what traineesneed to learn, what trainers should consider in thetraining process, and the role that governments orother supervisory organizations should consider in con-nection with professional training programmes.

3.2 The auditing profession in the RussianFederation2

In Russia, development of the auditing profession isstill in the very early stages—a situation which may beattributed to a number of key factors. For decadesRussia was alienated from societies where the account-ing and auditing professions assume leading roles inthe economy and, as a result, there is widespread andgeneral lack of understanding about the nature and sig-nificance of these functions. In any event, the State hasalways enjoyed pervasive power and a history of verti-cal administrative relationships checked by higherlevel inspectors. Also, politically unstable conditionshave delayed the passage and implementation oflegislation to put these new professions on a soundfooting. Until the need for a more mature professionbecomes evident in Russian society, progress is likelyto be slow. A decade has already passed since the earlymoves towards perestroika in 1985 and pessimists do

2Drawn from Mustafa and Krylova (1995),and Enthoven and others (1994), pp. 71-75


not anticipate much acceleration in the tempo withwhich accounting and auditing move towards moreadvanced professionalization.

3.2.1 First steps. The emergence of Soviet-Westernjoint ventures in the latter part of the 1980s opened thedoor for creation of an auditing function differingsomewhat from other control organizations. Under thefirst joint-venture regulations, issued in 1987, joint -venture audits had to be performed by so-called inde-pendent auditors, restricted to Soviet commercialauditing organizations practicing for a fee. To that end,a government institution, named INAUDIT, under thecontrol of the Ministry of Finance, was established toperform statutory audits of banks and other financialinstitutions, as well as of certain enterprises, on a feebasis. Its main audit goal, congruent with its institu-tional affiliation, was investigation of fiscal compli-ance. The so-called “Big Six” major internationalaccounting firms were subsequently permitted to enterthe market to provide management consulting andfinancial auditing services.

3.2.2 Market expansion. The rapid growth in newenterprises at the beginning of the 1990s, coupled withthe lack of professional oversight, provided opportuni-ties for proliferation in both the number of peopleclaiming to be auditors and the number—estimated atover 2,000—of new auditing firms. The lack ofbarriers to market entry, particularly with respect toquality control, coupled with the general public’s lackof sophistication in financial affairs, continues to raiseserious concerns about consumer protection.

Efforts to pass audit legislation have been ongoing forseveral years but impeded by a deep-rooted division ofopinion over the audit function’s main purpose and,therefore, where the supervisory authority should lie.One school of opinion holds that auditing should besubordinated to the National Tax Service which reportsto the President. Another holds that the auditingprofession should be controlled by an Audit Chamber,reporting to the Supreme Soviet; the Chamber wouldexercise substantial control over the audit function,resembling the former Committee of People’s Control.A third school of opinion holds that auditing shouldcome under the jurisdiction of the Solicitor General. Itis therefore evident that there is little, if any, officialsupport for the creation of a relatively independentauditing body. The draft of a comprehensive audit law,prepared in cooperation with experts from the largestRussian and international accounting firms, as well asthe United Nations, and covering such elements as

auditors’ qualifications, certification and licensing,was in fact vetoed by the President in late 1993 overthe question of its relationship with the National TaxService.

In the meantime, the Ministry of Finance initiated aprocess to create a conceptual framework for auditing,based on legal rather than private sector initiatives,and requiring the use of international auditingstandards. A conceptual framework should, of course,be an integral part of new audit legislation, or at theleast, congruent with it. However, there is currently nosuch guarantee because two independent groups, one inthe executive and the other in the legislative branch,are developing their own versions of an audit law.They are the President’s Audit Committee and theState Duma’s Committee on Budget and Finance.

The profession operates under the Temporary Rules ofAuditing in the Russian Federation, approved byPresidential decree No. 2263 on 22 December 1993(Enthoven and others, 1994, p.73). Under these tempo-rary rules, all individuals engaged in auditing practicehad to be certified by 1 October 1994, and all auditingfirms by 1 January 1995.

Auditing may be carried out by auditing firms—whichincludes foreign auditing firms and jointventures—and certified auditors who hold a speciallicense and are listed in the State Register of Auditorsand Auditing Firms. Professional certification andlicensing is carried out by special certificationcommissions, based on the following requirements: adegree in economics or law from a university or similarinstitute, or a specialized vocational training school orcollege, plus three years’ experience, obtained duringthe prior five years, in accounting or auditing or in theteaching of accounting and finance. The executivebranch has complete control over auditor certificationand licensing, as well as considerable oversight ofauditing practice, through the pertinent institutionalarrangements. State oversight is coordinated through aspecially-created Auditing Committee which reports tothe President. This Committee writes all the principalrules, setting the licensing and certification procedures,for example, as well as the fee rates for required auditson behalf of a court or public prosecutor. However,audit certificates, which currently exceed 3,000 innumber, may be issued by three different authorities:the Ministry of Finance, the Federal Committee onControl of Insurance Companies and the Central Bank.This is related to the fact that there are four differenttypes of licenses to practice: a general audit license and


three specialized ones for banks, insurance companies,and stock exchanges and investment funds. Thus, thetrend has been set early for the auditing profession todevelop along specialized lines rather than thegeneralist approach mainly followed elsewhere.Auditors are restricted to related activities such asaccounting, auditing, financial analysis or consulting,and are required to report to the authorities anystatutory violations uncovered during an auditengagement. Roots of the old system are visible in theauditor’s personal financial responsibility in the eventof losses resulting from the violation of any requiredaudit procedures; in such an event, the auditor wouldhave to pay a penalty as well as cover the costs of anew audit and reimburse both the State and the auditeefor any losses suffered.

3.3 Auditing in China3

Independent auditing has a long history in China,starting from its roots in governmental auditingtradition several millennia ago. In the more recentpast, independent auditing was introduced throughoutChina by turn-of-the-century entrepreneurs from manynations. The profession flourished until the upheavalsof the Second World War and ensuing politicalchanges, which resulted in its being abolished in theearly 1950s. As elsewhere, re-orientation of theeconomy towards market conditions and the emergenceof private ownership brought about the profession’srebirth.

The roots of the present system lie in tentative rulesconcerning the establishment of accounting consultantfirms, issued by the Ministry of Finance in December1980, following the 1979 law on Chinese/foreign equi-ty joint ventures which was designed to encourage for-eign investment. The main purpose of the temporaryaccounting rules was to control tax payments, which iswhy it was considered essential that auditing berestricted to Chinese nationals. Other auditing objec-tives were to certify the investments made by all partiesto a joint venture, and to examine the venture’s annualreport as well as its final accounting report uponliquidation.

It was during the second wave of economic reform,starting in 1985, that the profession’s role wasstrengthened through the Law on Regulation of

Certified Public Accountants of the People’s Republicof China, issued by the State Council in 1986. With theexpanded focus of accountability systems in State-owned enterprises, and increasing investments inprivate firms, the audit mission also broadened inscope. Public accountants had to verify the amount ofcapital subscribed to new companies and to audit theresponsibility contracts when they were both signedand completed. The expanded audit scoperequirements gave impetus to the founding of theChinese Institute of Certified Public Accountants(CICPA) in 1988. This received official recognition inthe CPA Law of the People’s Republic of China,approved by the National People’s Congress in October1993. By the end of that year, CICPA had some 37,000members, and there were about 2,400 CPA firms aswell as 25,000 CPAs.

The 1993 CPA law represented the culmination of ayear-long drafting effort in which dominant roles wereplayed not only by Chinese government representativesbut also by experts from the six major internationalaccounting firms, as well as others, primarily fromHong Kong, Japan, the United Kingdom, and theUnited States. The law is a very comprehensive pieceof legislation containing seven chapters whose majortopics, among others, deal with general principles,examination and registration, scope of activities andcodes of conduct, and legal liability. The responsibilityfor directing and monitoring the CICPA, CPAsgenerally, and CPA firms is shared by the centralGovernment’s Ministry of Finance and the financeauthorities of local governments. The formulation ofauditing standards, however, is under the jurisdictionof the CICPA, subject to final approval by the Ministryof Finance which is the licensing authority.

Development of quality auditing standards is a prioritytask of the CICPA, which anticipates a three-yearendeavor to formulate a modernized set of general,field work and reporting standards. Because generallyaccepted auditing standards form the core of auditpractice, lack of such standards or even basic under-standing of some key auditing concepts represents afundamental weakness in professional standing.Attention has to be directed to, and training prioritizedfor, internal control study and evaluation, audit riskand materiality, internal auditing, and the confirmationprocess.

A second major task assigned to the CICPA is organiz-ing the nationwide CPA examinations which havebeen held three times—in 1991, 1993 and 1994.3Relies mainly on Zhang (1995)


Candidates for the examination must have alreadycompleted a higher education degree of approximately165 semester-hours, although no particular major fieldis specified. At the present time, four topics are tested:accounting, auditing, financial management and taxa-tion, although it is planned to increase the number ofexamination parts to nine in order to reflect the widescope of knowledge required of a CPA. Passing rateson the examinations have varied considerably, withonly 5 per cent passing the first one in 1991, 50 percent in 1993, and 25 per cent in 1995. Professors ofaccounting and auditing are exempted from two partsof the examinations. A reciprocity agreement permitsoverseas accountants to take the examinations, and 500accountants from nine foreign countries did so in 1994.

3.4 The auditing profession in Poland

Poland was the first transitional country in the CEEregion to issue and implement new accounting regula-tions, and to announce its plans for establishing anindependent accounting and auditing profession. Somefour years later, Poland is arguably the region’sfrontrunner with respect to the degree of professionaldevelopment and the richness of its academic account-ing programmes. At least two important contributingfactors may be identified: a long tradition of profes-sional association among the accounting and financeworkforce, and the strong backing of the supervisoryauthorities.

The Association of Accountants in Poland, whichtraces its roots back to 1909, not only brought togetherits members for exchanges of theories during itsfrequent meetings but also provided some considerabletraining opportunities. During the period 1958-1986,for example, cumulative attendance at various trainingcourses numbered just under 675,000 as detailed below(Berry and Ðwiderska, 1992, p. 5):

Courses Enrolment

Enterprise accounting 67,905

Data processing 80,154

Professional diploma training 63,857

Specialty courses 335,082

Conference courses 88,780

Advanced classes 38,482

674,260

Following the 1982 economic reforms, a consultingservice in finance and accounting was established inPoznan, primarily to assist State-owned enterprises inimproving their cost accounting systems to complywith new demands by the State for increased financialviability. This service proved very popular, completingover 3,000 engagements in its first year, and wasquickly imitated elsewhere; it is staffed mainly byaccounting instructors from local institutions.

Despite the growing opportunities for financiallyrewarding careers in the accounting and finance fields,particularly in the 1980s, accounting courses generallyattracted few candidates. For example, the Universityof Gdansk had only 12 students registered for 50 avail-able places in accounting courses in the early 1980s,while the nearby Technical School of Economics inSopot had barely enough students to organize oneaccounting class. At the Central School of Planningand Statistics in Warsaw—now renamed the ChiefSchool of Business (Szkola G1ówna Handlowa) whichwas its prewar title—not one student majoring in thatfield accepted employment in accounting and data pro-cessing over a three-year period (Berry, 1985, p. 93).

The main reasons for this lack of motivation to studyaccounting or to consider the field as an attractivecareer opportunity can be attributed to accounting’slow social prestige plus the then poor pay and workingconditions. It also had strong associations with entre-preneurship which were politically not acceptable. As aresult, students usually majored ineconomics—particularly in foreign trade which offeredopportunities for foreign travel and experience.

Under the prior system, State enterprises were requiredto be audited annually by qualified personnel who werecertified as expert accountants. To obtain the diploma,among other requirements, candidates had to passqualifying examinations and satisfy certain educationaland experience requirements. They were then enteredon the register of experts maintained at the Ministry ofFinance. To a certain extent then, Poland had the basicinstitutional arrangements for establishing an indepen-dent profession already in place when the politicalchangeover occurred. However, auditing was neithertaught nor tested as a separate discipline or functionand certain auditing standards did not exist. The expertaccountants who performed State-enterprise auditswere, for the most part, chief accountants at other Stateenterprises on unpaid leave. While the basics of inde-


pendence were observed, the auditing function mainlyconsisted of detailed reviews of bookkeeping records tomake sure that there were no legal violations. Thenotions of materiality, risk assessment and statisticalsampling would have been quite foreign, particularlysince the auditors had personal material responsibilityin the event of failure to detect malfeasance.

The new birth of Poland’s auditing profession receivedits impetus from the law of 19 October 1991 on theauditing and publication of financial statements as wellas expert auditors and their self-government.4 The self-governing body, the National Chamber (Krajowa Izba),and its structural arrangements were formally inaugu-rated at the profession’s constitutional convention inJune 1992. Two of the main advisory groups to theAssociation of Accountants in Poland and the Ministryof Finance on the topics of professional organizationand auditing practice, were the Institute of CharteredAccountants in England and Wales, with financialassistance from the British Know-How Fund, and thegovernment of North Nadrenia and Westphalia. TheFrench profession, through the France-PolandFoundation, provided specialized training in auditingbanks and insurance institutions.

Within the next 18 months, almost 9,100 individualsregistered with the Ministry of Finance as qualified topractice. During the same period, just under 600 pro-fessional offices (chambers), as well as some 330 enti-ties which registered their qualifications to audit finan-cial statements, commenced auditing operations. In themeantime, various groups within the NationalChamber were working to develop practice standardsand the principles for verifying professional work,while the State Examination Commission developed aplan for professional examinations. Under thecircumstances, it was inevitable that problemsregarding due care and quality of performance wouldarise.

A review by the National Chamber financial statementaudits in 1992 disclosed that the quality of audit workwas much worse than had been anticipated. The mostfrequently encountered problems were as follows:

a. Failure to notify the National Chamber that theyhad undertaken an audit, in violation of the code of

ethics;

b. Undertaking an audit without having required spe-cialized knowledge, such as auditing computerizedrecords without having any knowledge of data pro-cessing;

c. Issuing an opinion, whose format was not inaccordance with professional standards;

d. Omission of certain required contents of the auditreport;

e. Errors in compiling and filing audit documentation,particularly with respect to working papers; and

f. Failure by entities authorized to perform audits tonotify the National Chamber of changes, asrequired, in organizational structure or manage-ment.

Two main conclusions were drawn from this survey:(a) the need for systematic improvements inprofessional knowledge—particularly in operating apractice; and (b) the need to intensify efforts to buildan understanding among practitioners of the newprofession’s goals, duties and operating conditions. Inaddition, because audit work deals almost exclusivelywith bookkeeping records, expert auditors the NationalChamber opined—should feel a moral obligation tohelp the Association of Accountants in Poland in thetraining of the new accounting workforce.

Some 33 matters had been reported to the DisciplinaryCommittee, of which 27 were in the preparatory stagesof initiating proceedings.

New legal provisions, effective as of 1 January 1995,introduced certain improvements in the institutionalarrangements.5 The main innovations provide that:

a. The National Chamber will maintain two registersof expert auditors: those who have earned thediploma and those that have the right to practisetheir profession. Previously, those who wereengaged in other activities were automaticallyremoved from the rolls whereas now they will stillbe registered as inactive members;

b. Audit activities may be carried out under three legalforms of organization: sole practitioners, civil

4Drawn from Jan Bal½ski (1994). “Il KrajowyZjard Bieglych Rewidentów”, RachunkowoÑƒ, Marchpp. 109-112

5Drawn from Projekty Ustaw ORachunkowoÑƒi l Bieglych Rewidentach (1994),RachunkowoÑƒi, September, pp. 373-374


partnerships with all partners qualified as expertauditors, and legal persons, such as sharecompanies or cooperatives, in which the majority ofmanagement members as well as the supervisoryorgans are certified auditors;

c. Those expert auditors who do not have a highereducation degree have, until the end of 1998, theright to continue to practise without having to takean additional examination At that time, they willhave to decide whether or not they wish to continuein the expert auditor career;

d. Not only individual expert auditors, but alsoenrolled auditing firms, must be members of theNational Chamber. This makes them subject torules set for audit practice, to the code of ethics andto the jurisdiction of the Chamber’s DisciplinaryCourt.

3.5 Summary of the status quo

In summary, the Polish case illustrates the headstartbenefits of having a professional association in placewhen restructuring is designed and implemented.Russia was the most poorly placed among the countriesstudied, because of the political instability combinedwith real conflict over auditing’s role in society andwhere oversight authority should be lodged. China’smore developed status can be attributed to governmentsupport of market socialism and of the accounting andauditing profession as a tool in helping it meet its over-all social and economic objectives. That considerationhas not yet taken hold in the Russian Federation.

Poland is the only country to have assessed the qualityof audit performance and openly found it seriouslyflawed. Part of the problem is that the existing expertaccountants had little understanding of, and no experi-ence in, modern auditing. Another contributing factorwas the relative ease with which one could get on theMinistry of Finance’s register. The registration ruleswere, apparently, elastic enough to admit candidateswithout formal accounting education. Indeed, whenevaluating the quality of audit work it was found thatabout one-third of the practitioners were quite unfamil-iar with the auditing literature distributed by theAssociation of Accountants in Poland. Furthermore,keeping the registration rules elastic, at least initially,represented one line of defense for the local auditingprofession which was fearful of being swamped byoverseas competitors. Stiff examination requirements,

described in the following subsection, should help toimprove quality control.

3.6 Professional examinationrequirements

Of the three countries surveyed, the Russian Federation has not yet instituted examinationprocedures, and those in China are relatively modest.Poland, on the other hand, has started to implement anambitious series of written and oral examinationswhich should have the effect of improving overallquality. These provisions are detailed below. TheCzech Republic has also commenced the professionalexamination process, and details of its approach followthose of Poland for purposes of comparison andcontrast. A unique feature of the Czech system is theinclusion of a heavily-weighted case study as a part ofthe written examination so as to test a candidate’sdecision-making ability in a professional situation.

3.6.1 Poland6.The professional examination arrange-ments for expert auditor (EA) candidates wereannounced on 21 December 1993 by the NationalCouncil of Expert Auditors (NCEA) in agreement withthe State Examination Commission (SEC). The exami-nation is oriented towards the problems of enterprises(whatever their legal form), financial institutions,insurers, and budgetary units and undertakings. Thefirst examination series was scheduled for the fall of1994.

The examination is organized into three oral and sevenwritten parts. The oral parts start off the examinationcycle: the first deals with information systems andprinciples of data processing connected with testingability to make use of computers, the second deals withexamination of the problems of auditing financialstatements and practicing the EA profession, and thethird deals with the topic of management economics.

Written examination topics are:

a. Financial accounting and reporting, includingfinancial analysis;

b. Management and cost accounting;

c. Finance, including financial planning;

d. Civil, labor and commercial law (laws on economic

6Based on RachunkowoÑƒ, February 1994


activities, commercial code, formation andbankruptcy, foreign currency, securities, budgetary,banking, and insurance);

e. Tax law-I (laws on tax obligations, tax procedures,taxes on goods and services, excises on gamblingand wagering, and customs);

f. Tax law-II (laws on local fees and taxes, Treasurycharges, income taxes on legal and physical per-sons, international agreements regarding doubletaxation, taxes on wage increase, dividends, andinterest on capital); and

g. Financial statement audits and other EA services.

Examination candidates must be Polish citizens whosatisfy three conditions: (a) they are legally able tofunction and have full civil liberties according to theirown hand-written statement; (b) they have not beenconvicted for economic criminal activities, for falsifi-cation or for offenses and transgressions of a criminalnature connected with the Treasury, based on a certifi-cation from the Ministry of Justice’s Central CriminalsRegister, (c) they have a higher education degree, asdocumented by an authenticated copy of the diploma.

The examination may be taken in two stages as well asfor a third time if the candidate did not pass at leastfour of the parts. The first parts that candidates mustpass are the first oral computer-related examinationand the written examinations on financial and manage-ment accounting. They are then free to take theremaining oral and written parts in any sequence.

The conditions for taking the final part, the profession-al examination, are: passing all other parts of theexamination; credit for two years’ professional practiceexperience to acquire the ability required of an inde-pendent accounting practitioner; and satisfactory com-pletion of a two-year apprenticeship in an entity autho-rized to perform financial statement audits, with thecbjective of acquiring the ability required of an EA.This apprenticeship may take place after completingall parts of the examination with the exception of thefinal, professional part.

3.6.2 The Czech Republic7. Professional examinationsare given twice a year—in the spring andautumn—and consist of two parts: a written part,

weighted at 70 per cent of the grade and lasting amaximum of six hours, and an oral part, weighted at30 per cent of the grade and lasting no more than twohours.

The examinations focus on testing both theoreticalknowledge and the capacity to apply such knowledge toaudit activities, to the extent required for practicing theauditing profession in the following areas:

a. Accountancy and financial management, andanalysis of financial statements, including consoli-dated financial statements;

b. Approaches and methods used for reviewingfinancial statements, application of mathematicaland statistical methods for review, control in con-ditions of an electronic data processing environ-ment, and developing and reviewing an internalcontrol system of accounting units;

c. Commercial, tax and financial laws.

The written part of the examinations consists of a testfocused on knowledge of the required subjects, with amaximum weighting of 30 points, as well as a casestudy with a maximum weighting of 40 points.Applicants may only take the oral part of the examina-tion if they achieve a minimum number of points oneach of the two parts of the written examination. Theoral examination, weighted at 30 points in total, con-sists of a number of questions drawn from a questionpool and answered before a Board of Examiners. TheBoard is composed of four members, two of whom arerepresentatives nominated by the Ministry of Finance,and two, nominated by the Chamber of Auditors, whoare drawn from experts in economic and legal theoryand practice. To pass the oral part, a. candidate mustachieve a minimum score on each question. Providingthat a minimum score has been achieved on each ques-tion in the oral part, and each of the two written parts,a total score of at least 50 points out of 100 representsa passing grade on the examination as a whole.

3.7 Accounting and auditing education

Rapid growth in the fields of accounting and auditingcreates great demands for education and training,demands which are being met, however inadequately,in a variety of ways and from a variety of sources. InRussia alone, it is estimated that some 2 millionaccountants and bookkeepers need retraining; in addi-tion, at least 300,000 professional positions will be

7Drawn from Chamber of Auditors, CzechRepublic (1994), Examination Rules of the Chamber ofAuditors of the Czech Repubic.


available each year for the next five years. Under thecurrent educational system, however, only about 5 percent of the potential demand can be satisfied by newentrants into the workplace during that same period(Mustafa, 1995). The situation in China may shortly beshowing similar trends. In both countries, the problemis exacerbated by difficulties in attracting recruits to afield which for decades has had a negative image.

Efforts to cope with education and training needs havebeen varied in both approach and source, with a con-siderable amount of resources being provided to theCEE region by Western Europe, and to a lesser extent,the United States. Unfortunately, the rich array of edu-cational programmes which were put in place sufferedin various ways from the basic fact that the donors’motives were not particularly altruistic. That is, someof the major exporters of accounting systems—such asFrance and the United Kingdom, which have very dif-ferent views about the world of accounting—werequick to perceive the opportunities in the CEE regionfor the large-scale competitive advantages associatedwith providing free, or highly subsidized, training intheir own particular accounting model. As a result,there has been little, if any, training coordinationbetween donors. Further, host countries or institutions,as the case may be, sometimes faced limited choiceswith respect to, say, course contents or materialsbecause the donors were only promoting their ownpublishing houses or suppliers. Also, there have beensome evident cultural mismatches between donors andhosts, such as installation of case-law based systems incode-law countries. In the long-run, however, some ofthese problems will undoubtedly work themselves out.From the standpoint of effectiveness and efficiency,however, those host institutions which evaluatedalternatives and chose what appeared to be the mostfavorable of competing options fared better.

In the CEE region, there has been a noticeable shiftduring the past five years from reliance on foreign lec-turers and trainers in universities and other institutionsof higher learning to strengthen and enrich courseofferings with national instructors. Nonetheless, out-side material assistance has proved invaluable~due tothe pressing budget problems generally prevalent.

In Poland and elsewhere, there have been widespreadimprovements in accounting-programme design, astrengthening of instructor training and retraining,concentration on the production of new texts, and theenrichment of accounting teaching methods (Jarugowaand Marcinkowski, 1994, p.19). Almost all of the

departments of economics and management in themajor universities now offer courses in accounting, asituation which differs radically from that some tenyears or so ago. Also, new attention is now being paidto auditor training and procedures which are congruentwith the European Union’s Eighth Directive. A listingof the core accounting courses and the related semesterhours involved for some noted Polish institutions ispresented in Table 10. With considerable help fromcertain countries (such as Canada, France, Germanyand the United States), as well as programmes fundedby the EU required and elective courses in accountingand auditing have been added, or restructured, inaccordance with Western practice. This effort was alsoaided by overseas apprenticeships for faculty orstudents completing their last year. Examples ofcurrent course listings for a relatively small accountingprogramme at the University of Gda½sk, and a muchlarger one at the University of ºódó, are presented inTable 11 as an illustration of the metamorphoses whichhave been taking place in the academic accountingworld. The relatively small number of accountingmajors, however, is cause for concern. Further, unlikesome Western universities, particularly in the UnitedStates, introductory accounting courses are notrequired by other faculties.

Professional recruiting and training by auditing firms,particularly the large international ones in the CEEregion, has had to be modified from approaches inother geographical areas because of the relative lack ofsophistication in decision-making situations.8 This isparticularly important in the auditing field and is wide-ly held to be a first consideration. In general, the “BigSix” firms encourage staff to enroll in accounting andauditing correspondence courses emanating from theUnited Kingdom, which lead to an ACCA diploma.The staff study on their own time but the firms usuallyfund their courses if satisfactorily completed. One ofthe firms sends its local staff to its main training head-quarters in the United States and another to theNetherlands. Others send selected local staff to over-seas branches for on-the-job training. The expatriatestaff are often fluent in the local language, frequentlybecause of family background.

From the local staff’s perspective, one of the commentsmost often made has to do with the foreign work ethic,

8Based on interviews conducted in the CEEregion in the fall of 1994


that is, the expectation of heavy workloads and longworking days and the requirement that attendance atprofessional meetings be taken as annual leave withoutreimbursement of expenses by the firm. The concept ofmaking an investment in one’s position is slow to takehold in an environment where it has never been putinto practise.

3.8 Conclusions

A common feature of transitional economies is thesymbiotic relationship between expansion of privateenterprise and increased demand for accounting andauditing services. Yet another common phenomenon isthe scarcity of candidates for positions in these profes-sions—mainly due to negative perceptions of theirpotential for interesting and rewarding careers.Consequently, recruiters and trainers need to be partic-ularly sensitive to the ways in which potential candi-dates are identified and selected, and career opportuni-ties are presented.

In the accounting field, workforce shortages can bepartly alleviated through computerization, which isnow widespread in the CEE region. It is at the profes-sional levels of chief accountants and other accountingmanagement personnel, as well as in auditing, thatdemands are the heaviest. Retraining may present asmany challenges as training newcomers to the field, ifnot more.

Accountants and auditors, most fundamentally, have toexpand their conceptual base. That is, they must devel-op new functions, in particular, those connected withmaking major decisions under risky, ambiguous cir-cumstances. They have to appreciate the internal auditfunction and evaluation of internal controls as well asbe trained in valuation techniques. All of this is inci-dental to, or concurrent with, assimilating the underly-ing strategies of auditing standards.

Trainers, particularly those from other cultures, need totake the accounting laws and environment into consid-eration when planning all courses, especially those atthe most basic levels. One of the most frequentlyencountered inadequacies in training programmes isthe lack of local familiarity by the trainers and, there-fore, inability to provide the training at the appropriatelevel of understanding. Another is the comparativelack of government understanding and involvement intraining programmes. It is up to those charged withoversight of the accounting and auditing profession to

set training priorities by developing and analyzing listsof training needs. The various training programmesshould be coordinated for two main reasons: to providefor congruency between them and, at the same time,meet goals set for the profession. Special attentionshould be paid to the trainers themselves, that is,whether they have been appropriately selected andwhether they are under pressures—such ascompetitiveness or commercialization—which mightwork against the best interests of their clients.

4.Financial management ingovernment

4.1 Introduction

This section considers past and present financial man-agement practices in government, as well as the futuredirections these practices may take. It commences witha review of how the three essential financial manage-ment functions—budgeting, accounting, andauditing— were carried out in the former commandeconomies. This is necessary not only to appreciate thepoints of departure for the transitional economies butalso to understand how much of what went on beforecan be traced in current approaches. The inadequaciesof the former financial management systems are thensummarized and their evolutionary stage is assessedusing Dean’s (1988) model.

Developments which have taken place in budgeting,accounting and auditing in the transitional economiesduring the past five years are described in connectionwith the following specific topics:

a. Government budgeting: diversifying revenues,controlling expenditures and adopting the pro-gramme concept;

b. Government accounting and the use of charts ofaccounts in government;

c. Computerization and its usefulness in governmentoperations, particularly those involving fiscaloperations;

d. Central/local government relations and theimplications for revenue sharing;

e. Government auditing and the concept of externalaccountability; and

f. Training programmes to develop appropriate skills


in governance.

The section ends with a summary and assessment ofthe status and future implications of financial manage-ment processes.

4.2 The budgeting function

In the former command economies, budgeting—generally referred to as planning—was the corefunction underpinning socialist financial controlsexercised horizontally and vertically throughoutsociety. In general, the main objectives of thesecontrols, while varying in detail or expression fromone country to another, were to:

a. carry out economic strategy based on nationaleconomic criteria;

b. contribute to the improvement of the constituents ofexpenditures and revenues;

c. help enforce economy; and

d. ensure protection of State property (v. Grumbkow,1984, p.57).

Two basic budgetary principles dictated the institution-al arrangements for meeting these objectives: “bud-getary compliance”, or coordination of the budget intoall economic activities, and “democratic centralism”,or incorporation of the receipts and expenditures oflocal budgets into the overall State budget (Jaruga,1987, p. 106). The approach taken in the GermanDemocratic Republic provides an illustration.

In the GDR, financial control was carried out by threemain groups to whom a secondary set of goals, withinthe framework of the main objectives, was assigned;that is, to:

a. determine the most effective national economic planappropriations;

b. find the most rational ways and means of fulfillingand exceeding the plan; and

c. ensure State law and order (v. Grumbkow, 1984,p.57).

The three main control groups were State organs,administrative organs whose activities involved finan-cial control, and organizations with specific controlresponsibilities. The first group consisted of the toplevel of State government and administration, theParliament (Yolkskammer), district governments

(Bezirkstage), and national agencies of the circles(Kreise), towns, town districts, and municipalities.There were two main ways in which control was exer-cised at this top level—through the process of drawingup and carrying out their budgets, and through the dis-charge function which acquitted the ministerial andlocal councils of their responsibility for carrying outbudgeted activities and making use of plannedresources.

Administrative organs whose activities related in someway to financial control constituted the secondgroup.They included the State Planning Commission,all ministries and similar central State organs, andcouncils of the districts, circles, towns, town districts,and municipalities. These organizations bore jointresponsibility for financial control in the entities theysupervised.

The third group had specific responsibilities for overallcontrol, financial control, or information, and wereindependent of, and therefore not responsible for, thosethey controlled. This group included the Workers andPeasants Inspection which was an organ of the StateCentral Committee and the Council of Ministers; theMinistry of Finance, including the State audit function;all banks; the State Office for Prices; and the StateCentral Statistics Office.

4.3 Planning techniques9

Planning techniques varied widely within and betweencommand economies, not only because of different setsof management models and economic activities butbecause of the diverse approaches taken by variousplanning bodies. Czechoslovakia had the most stableplanning techniques in the region, mainly due to itsspecial law on economic planning. This law specifieddifferent types of plans, including economic develop-ment plans, for both the Czech and Slovak Republicsindividually as well as the Federation, and for supervi-sory and public organizations as well as regional plansfor national committees. Particular units preparedfinancial plans which formed the basis for federal andrepublic budgets and the nation’s foreign currency andmonetary plan.

9This section relies heavily on Gajl (1986),pp. 77-92.


Planning was divided into three time-frames: longterm (10 to 20 years), medium term (1 to 5 years) andannual. Component subsidiary plans varied accordingto the time period covered. A five-year plan, forexample, included the following elements: productionand sales for all branches of the economy, science andtechnology development, investment outlays, technicaland material supplies, employment and wages,financial, price increases, foreign trade, and growth inquality of living conditions. The law also laid down theorganizational structure of the State PlanningCommission and other planning authorities at variouslevels of government.

In the other neighboring command economies withoutthis type of legislation, normative planning techniqueswere laid down by an authoritative body, such as theState Planning Commission (SPC) in Poland. There, aselsewhere, the planning function was dichotomized;economic planning was performed by the SPC andfinancial planning by the National Bank in cooperationwith the Ministry of Finance. All three bodies workedto some extent in tandem to effect congruity betweeneconomic and financial plans, with the Council ofMinisters arbitrating any related difficulties.

Poland’s national economic plan was issued in twostages. In the first, various alternatives were drawn upand presented for discussion purposes, Parliamentselecting a preferred version. In the second, the planwas completed after additional discussions and analysisas well as coordination with international partners,including fellow COMECON members. After the planwas confirmed by the Senate, the budget was publishedand adopted in the form of a budget law.

4.4 Financial planning

The annual and multi-year socio-economic plansformed the basis of financial plans of various kinds,not all of which could be accommodated in the annualbudget law because of their size and variety. For exam-ple, financial planning covered most, if not all, of theactivities of State-owned enterprises (SOEs) whichwere the mainstay of the economy. Their operationalfinancial activities fell outside of the budget but certainelements were fitted into the socio-economic plan.These elements included payments to the StateTreasury (also known as the State Budget), out of prof-its; increases in funded depreciation (that is, matchingcharges for depreciation expenses with payments to theState for fixed asset replacement purposes or as a

charge for fixed asset use); and payments to the SOEsby the State for various types of subsidy. Also includedwere price supports for certain products (such asinfants’ clothing) whose retail prices were kept verylow in the public interest.

Financial planning covered at least three main areas—credit, balance of trade and purchasing power. Creditplans prepared in command economies served a dualpurpose: (a) they allowed banks to evaluate the generaleconomic situation as well as that of particular socio-economic groups who might make use of credit; and(b) they provided for operational division of financialresources in the form of anticipated credits. In effect, acredit plan projected the financial resources to be madeavailable to banks and how they were to be used. InPoland, the National Bank of Poland (NBP) preparedthe credit plan and forwarded it to the Minister ofFinance for presentation to the Council of Ministers forapproval. After 1982, this prerogative fell to theParliament. Credit planning had other featureselsewhere. In Czechoslovakia, the annual credit planestablished criteria for granting credit and also setcredit limits. Should certain SOEs not agree with thoseparameters, supervisory organizations could arbitratebetween them and the national bank.

Balance of trade planning was carried out in mostcommand economies by the Ministry of Finance, theForeign Trade Ministry in Poland, and the Council ofMinisters in Romania. The basic elements of the planwere forecasts of foreign purchases and sales, involv-ing the so-called “transfer rouble,” the common unit ofaccount used within the COMECON, or hard curren-cies for non-COMECON trade. One of the main pur-poses of this plan was to budget foreign currencyreserves.10

The basic financial plan of inflows and outflows,referred to as a balance sheet, usually had the follow-ing components (Gajl, 1986, p. 91):

10Influential members of COMECON couldalleviate their own foreign currency needs throughcontracts with weaker members payable in convertiblerouble credits. Items to be delivered under contract(such as component parts) would be specified asacquisitions from designated sources requiring hardcurrency settlement by the subcontractor.


Inflows

a. Financial accumulation of SOEs for the period

b. Balance of foreign trade turnover

c. Cash payments for depreciation charges by SOEs

d. Budget revenues

e. Retirement fund revenues

f. Increases in the funds of financial and insuranceinstitutions

g. Growth in the population’s monetary reserves

h. Credit payments by the general public and thenon-socialized economy

i. Other

Outflows

a. Current outlays: (i) budget; (ii) retirement fund; (iii)workplace and cooperative funds; (iv) credits for thegeneral public and non-socialized economy

b. Outlays for accumulation: (i) investments;(ii) capital repairs; (iii) increase in inventories

c. Other

d. Reserves

This balance sheet was on a macroeconomic scale and,therefore, did not identify specific contributing orrecipient parties. It merely provided a general basis fordrawing out inferences or conclusions. More specificswere provided in other subsidiary plans.

A third financial plan provided a statement of the gen-eral public’s income and expenditures to allow assess-ment of purchasing power and thereby, assist in assess-ing the money supply. Its components were generallyas follows (Gajl, 1986, p. 92):

Inflows

a. Net payroll

b. Social services

c. Transfers for use by the general public

d. Credits

e. Other

Outflows

a. Purchases fund for acquisition of goods

b. Payments for services

c. Taxes

d. Repaid credits

e. Other

f. Changes in inventory levels of contributions andcash

For those economies where local authorities had theirown budgets, the central financial plan included trans-fers in the form of receipts and expenditures betweenthe local and central treasuries. During the 1980s, cen-tral governments began to exert heavy pressure onlocal levels to assume more of the financial burdens inorder to ease the growing strain at the centre. By themid-1980s, self-financing percentages of local budgetsin four neighbouring countries were as follows (Jaruga,1987, p. 107):

Local budgetself-financing

Country percentage

Poland 20

Soviet Union 25

Czechoslovakia 35

GDR 40

4.5 Budgetary accounting11

Budgetary accounting for government institutions informer command economies mirrored the diversitywhich then existed-and persists around the world—inaccounting for government. That is, some countrieskept simple cash records of receipts and disbursements;others, notably the GDR, adopted a form of cameralaccounting which incorporates some accrual featuresinto cash accounting and provides side-by-sidecomparisons of budgeted (Soll) and actual (Ist) lineitem amounts; while Poland—in the minority amongcommand economies—had used double-entry accrual

11This section draws on Jaruga (19887), pp.111-113


accounting for government since the early 1950s.

In Poland, budgeted revenues and expenditures werestructurally organized as follows (Cewe, 1978, pp. 18to 24):

a. By division (dzial), that is, according to a basicactivity or branch of industry. For example:

01 Industry

31 Construction

40 Agriculture

b. By section (rozdzial), that is, according to definedgroups or activities within a particular division. Forexample, sections within the division 70 LocalEconomy (gospodarka komunalna):

7221 Street cleaning7262 Street lighting

c. By paragraph, that is, by line item definition ofdefined sources of budgetary revenues and types ofbudgetary outlays. For example:

42 Inflows from material servicesfor the general public

45 Inflows from the sale of goods11 Salaries and wages outlays35 Utilities (energy) outlays

Budgetary accounting in Poland was organized in sucha congruent fashion that periodic reports could be for-warded to supervisory organs, comparing actual andbudgeted revenues and expenditures by reference tobudget divisions, sections, and paragraphs. Becausethere was no necessary correlation between the waybudgeted amounts were estimated and the way theywere accounted for, budgetary accounting’s potentialfor future-oriented decision making was limited. It did,however, provide for after-the-fact control andaccountability by being budget-integrated.

The reason why budgetary accounting was largelyunderdeveloped in command economies had to do withits classification in the nonproductive sphere of theeconomy which consumed, rather than created,national income. This distinction carried through toaccounting-system design whereby revenue generatorsengaged in the material production sphereappropriately used double-entry accrual-based systems.In examining the functions that budgetary units carriedout, it is evident that double-entry systems which kepttrack of receipts and expenses by programme wouldhave been the most appropriate. Services generally

provided to the public at large included overall Stateadministration, finance and insurance, justiceadministration, internal security, and a wide range ofscientific activities. Programmes provided forindividual citizens included health, education, andwelfare (Jaruga, 1987, p.108), and considerable sumswere expended in sports and the arts. Budgetaryaccounts designed to match budgeted and actualprogramme costs would, of course, have helped in theanalysis of economy and efficiency in the use ofbudgetary resources. However, only in the GDR wasany overt recognition given to harnessing the account-ing function to help in the financial management of theeconomy. Budgeting personnel at the central level weretrained in macroeconomics and, in so far as they usedaccounting data in their planning, they generallyobtained it from the State Statistical Office.

The case for programme budgeting and budgetaryaccounting strengthens when considering the organiza-tional arrangements for service delivery. Generally,three types of government institutions constituted thenonproductive sphere: “budgetary units”, “budgetaryentities”, mainly in Poland and Czechoslovakia; and“auxiliary undertakings”, also known as “auxiliaryenterprises”. “Budgetary units” were fully funded bythe State and their services (listed above) were provid-ed free of charge to the recipients. Budgetary entitiesprovided services partially funded by the Statealthough, theoretically, they were supposed to generateenough revenues to cover their costs; this shows a clearneed for accrual-based, double-entry accounting on aprogramme basis in order to set break-even fee scales.These services typically included a variety of activitiesranging from nursery schools to various recreationalpursuits. Auxiliary enterprises were the most self-suffi-cient of the three groups, and were established asfinancially and organizationally separate entities tocarry out various sets of economic activities for relatedbudgetary units. An example was a workshop attachedto a technical school for automobile repairs, and main-tenance instruction and training. Generally, theseauxiliaries covered their costs through revenuesalthough some received State budget subsidies.

Several differences in accounting practices and institu-tional arrangements distinguished budgetary entitiesfrom auxiliary enterprises. For example, budgetaryentities did not include depreciation on fixed assets intheir operating expenses. Auxiliaries did, but had toforward to the State budget matching cash (deprecia-tion funding) to cover the expenses. Theoretically,


depreciation funding was to provide for asset replace-ment. Also, if budgetary entities underspent theirappropriations in any one year, the underexpended bal-ances could be carried forward as in cameral account-ing. The benefit of this arrangement was that itavoided the phenomenon of year-end spending to useup quotas by deadlines. Auxiliaries were allowed toretain profits in the form of special-purpose funds, andwere also permitted to apply for bank credits.

Accounting for those three types of institutions in theState budget was as follows (Jaruga, 1987, pp. 112-113). For fully-supported budgetary units, the Statebudget included planned receipts and expenditures,under the so-called gross budgeting method. The esti-mated expenditures were calculated to encourageeconomy, particularly by penalizing units for buildingup inventory and receivables balances, through use ofthe following formula:

a. Accrual cost of services to be provided, calculatedby applying budgetary coefficients, i.e. normative(standard) quantities of services times normativemonetary costs per quantity;

b. Add:

Beginning accounts payable balance plus Normal level of inventory

c. Deduct:

Beginning inventory balance andBeginning accounts receivable balance

d. Equals planned budget expenditures.

Theoretically, the reliability of the budgetary coeffi-cients was supposed to be tested against actual costsand quantities of services provided. In practice, howev-er, there was little interest in developing cost account-ing techniques or using cost or other accounting datafor that matter.

The so-called net budgetary method was used for bud-getary entities and auxiliary enterprises, that is, theprojected revenues and expenses were netted out andthe projected surplus or deficit was entered in the Statebudget as a revenue or expenditure line item.

4.6 Budgetary reporting

Budgetary financial reports were mainly intended foruse by various government bodies, such as the CentralStatistical Office, the fiscal authorities, the NationalBank, the State Audit Service, the executives of various

“spending” ministries, and certain workers’ groups.Their content, format and frequency varied from coun-try to country as did the jurisdictionalauthority—usually the Central Statistical Office or theMinistry of Finance. Because the main purpose ofbudgetary reporting was to provide statistical data formacroeconomic control purposes, reporting formatswere standardized. To facilitate the reporting process,the official forms usually included some identifyingdata, such as chart of account numbers on certain lineson the form to indicate where data from the accountswere to be entered.

Budgetary reports prepared at the local level providedthe nucleus for additional reports consolidated atincreasingly higher levels of government.Consolidation was merely additive, however. Noadjustments were made to eliminate matching inter-organizational receipts and expenditures which is thepractice in Western corporate consolidations. Thereports generally included a variety of statements, suchas statements of budgetary receipts; budgetary expen-ditures; budgeted and actual payrolls; inventories,receivables, and payables balances; actuals versus bud-geted normatives for certain items; and off-budgetreceipts and expenditures. It was also usual to includea statement of year-end general ledger balancesreferred to as a balance sheet. As is evident, thiscollection of statistical data did not represent afinancial management report which would provide apicture of stewardship of national resources.

4.7 Budgetary auditing

In command economies, the audit function is sub-sumed under the general area of economic control andmay be carried out by different organizational entitiesfor different purposes. In the former Soviet Union, forexample, there were at least three separate sets of insti-tutional arrangements: internal control over subordi-nate entities by superior organizations; external controlthrough the banking system; and oversight by theControl and Audit Administrations (CAAs) organizedat various levels within the Ministry of Finance (Berry,1984, pp. 436-438).

The CAAs had three main client groups: ministries,departments, State committees, and other administra-tive units; the Ministry of Finance, or a departmentimmediately below the CAA’s authority level; andGosbank. Internal control reviews conducted by super-visory administrative units were conducted indepen-


dently, rather than coordinated through a SupremeState Audit Service (such as the General AccountingOffice in the United States).

In planned economies with a State audit service, suchas Poland’s Supreme Audit Chamber (NIK), audit ofthe national socio-economic plan and the State budgetperformance was the responsibility of the ChiefAuditor. A brief survey of NIK and its mission andinstitutional arrangements in the early 1980s serves asan illustration (Kurowski and Sochacka-Krysiak, 1990,pp. 265-283).

The responsibilities assigned to Poland’s State auditservice (NIK) were similar to those in marketeconomies, although it lacked the institutionalindependence from governmental bodies which shouldbe guaranteed to those functioning as State internalauditors. For example, NIK’s activities were based on adefined work plan presented to the Polish Parliament(Sejm) and the State Council. Its audit engagementscould be self-initiated or be directed by order of theSejm, the State Council, or the president of the Councilof Ministers. Review of facts or documents forming thebasis for decisions handed down by State supervisoryorgans could only be carried out if directed by one ofthese three authorities.

NIK enjoyed the usual rights of access to records andother evidence it needed to conduct its activities. Itcould call on experts if needed, take part in the engage-ment, and convene a meeting of the auditee’s employ-ees at which they could be required to furnish writtenor oral clarification of the auditee’s affairs. Auditees,on the other hand, were expected to provide workingspace to conduct audit activities, as well as a telephoneand transportation services if necessary and available.Auditor independence was also an issue. An auditor,commonly referred to as an inspector, was not to par-ticipate in an engagement if audit activities, or poten-tial audit results, could affect his/her rights or obliga-tions, or those of a spouse, relative or close associates.In the event of adverse audit findings, such as a threatto safety, lack of good management, waste or careless-ness in the use of resources, NIK had the right to issueorders immediately to the auditee’s management tocorrect the situation. These orders had to be carried outeven though the auditee might be in the process ofappealing the decision to NIK’s president. Shouldmanagement delay taking corrective action, the auditorwas empowered to issue a written order with aspecified time limit.

Institutionally, NIK issued written reports directly tothe Parliament, as is common for a State audit service.These reports were of three types: (a) an annual reporton its activities; (b) analyses of how the national socio-economic plan and the State budget had been carriedout; and (3) presentation of the audit results forengagements carried out at the instance of the Sejm,the State Council, the Council of Ministers, and anyother clients.

4.8 Fiscal auditing12

Fiscal authorities, which were organizationallyseparate from the Ministry of Finance in Poland,performed not only tax-related audits but were alsoresponsible for setting administered prices for goodsand services of local importance, if set prices for themwere not otherwise in general use (Kurowski andSochacka-Krysiak, 1990, p. 295). It would be fair tosay that the term “audit” was synonymous with theconcept of control, with heavy emphasis on legalcompliance.

In Poland, the tax departments (literally, tax chambers:izby skarbowe) carried out their audits in accordancewith annual plans as well as unplanned reviews andengagements requested by the public prosecutor.Employees of the Ministry of Finance or the taxdepartments who were authorized to carry out fiscalaudits enjoyed considerable discretion in selectingauditees for examination. They did, however, need theconsent of the organization which had jurisdiction overthe financial control of the client before commencingthe audit. As in the case of NIK, auditors had toobserve the regulations governing professional inde-pendence. It was also customary for the auditee to pro-vide working space and other amenities such as accessto a telephone and to transportation.

The fiscal auditor’s main responsibility was to reliablyand objectively attest to the factual status of auditedmatters, and to determine the causes of any irregulari-ties and transgressions as well as those responsible forthem. The auditor had the usual rights of access towhatever records and proofs that were needed, includ-ing the assistance of experts such as expert accoun-tants. An important point of concentration was the wayin which the accounts were kept, in particular, the

12This subsection is drawn from Kurowskiand Sochacka-Krysiak (1900), pp. 294-306


methods of physical inventorying of the assets and lia-bilities. Holding particular individuals personallyresponsible-from a financial standpoint-for their cus-todianship of State enterprise assets, was an importantelement of socialist management. Physical counts hadto be made in the presence of the appropriate custodianwho signed his/her agreement on every inventorysheet. Usually, if the custodian was absent, the assetscould not be removed. This is why department storecounters, for example, would be closed and roped off ifthe sales clerk were out sick.

During the course of their examinations, the auditorscould make use of secret—that is, unpublished—regulations which they could cite, but not disclose, tothe auditee, thereby adding to the ambiguity of the taxassessment process. At the written initiative of theauditor, management could be required to issue ordersto correct certain situations, or otherwise refuse inwriting to do so. In serious situations, the auditor wasrequired to notify the public prosecutor or the securityservice immediately.

At the end of the engagement, the auditor provided theauditee with a written statement (protocol) of the find-ings. The latter could provide the auditor with awritten explanation, or delay doing so for seven days.An alternative was to issue a report instead of aprotocol.

In summary, the State and fiscal auditors-both general-ly referred to as inspectors-enjoyed considerable auditrights vis-d-vis the auditees, concentrated on legalityissues related to following regulations, and could citeauditees for infringements without detailing the foun-dations.

4.9 Summary of financial managementinadequacies

Although planning techniques were relatively welldeveloped, the accounting function was not harnessedto help in the financial management of the economy.This was mainly due to the general perception thataccounting was a purely bookkeeping activity forarchiving historical records. The lack of institutionalconnections between the economist planners and theaccountants meant that there was no necessary correla-tion between the ways in which planned amounts werecalculated (often through the use of econometric mod-els), and the ways they were accounted for.Accordingly, accounting records could only disclose

that budgeted, versus actual results, were similar ordifferent to budget, but not why they were. This meantthat accounting information had little relevancebecause, although it could provide limited feedbackdata, it did not offer the predictive ability which couldhelp planners budget better. Although lip service waspaid to the need for cost control and efficiency in gov-ernment, budgets were not constructed by programmedetailing the financial objectives of each set of budget-ed activities. Constructing the accounting systems sim-ilarly by programme could have helped in determiningwhether these financial objectives were being met.

External accountability was virtually nonexistentbecause politicians were not subject to criticism fortheir financial decisions, unless it were consideredpolitically expedient, and there was no free press.Financial reports, including the balance sheets ofStateowned enterprises, were treated as confidentialdocuments and not available externally. In any event,they would not have provided a reliable picture ofnational resources stewardship because of the faultyway in which they were packaged-duplicatetransactions were not eliminated in the consolidationprocess.

The State internal and fiscal auditors, who would haveotherwise formed part of an external accountabilityfunction, were heavily oriented towards issues of con-trol and legal compliance. Consequently, there wasconsiderable emphasis on auditees’ obligations but lit-tle consideration of their rights. The punitive nature oftheir operations did not, therefore, build up the respectfor the public audit service that is needed in an orderedsociety. Further, the State audit service lacked institu-tional independence as well as freedom of actionbecause the government could restrict its scope ofactivities.

4.10 Evolutionary status

Before examining the sweeping changes that started totake place in governmental financial management dur-ing the late 1980s and early 1990s across the Centraland Eastern European region, it would be useful toconsider the general level of maturity of financial man-agement systems in government proper at that time,based on Dean’s model of the evolutionary stages ofgovernmental financial management systems, set outin Table 12.

In accounting, budgeting and auditing, most countries


studied were in the basic stage of emphasizing regular-ity and control. That is, procedures were in place tomake sure that regulations were followed, responsibili-ties could be fixed and historical records maintained.Little of an analytical nature was provided for, budget-ing and accounting activities were segregated, theaccounting function was not involved to any extent inmanagement decision-making, and auditors did notconsider such procedures as risk assessment or statisti-cal sampling. Some, notably the GDR, had movedalong the continuum into the second stage where theaccounting, budgeting, and auditing functions wereinvolved in the managing of governmental finances.However, little progress into the second stage was evi-dent because of the overriding importance of controlfunctions in the command society. After reviewingsome of the changes which have taken place in the lastfive years, Dean’s model is referred to again as a vehi-cle for measuring progress and highlighting trainingneeds.

4.11 Restructuring the budgetaryprocess

The process of dismantling government control overthe economy under conditions of instability and eco-nomic crisis creates an emergency situation for thebudgeting function. In the initial stages of economicreform, the simple priorities of raising revenues wher-ever they may be found and cutting back expendituresto the greatest degree possible tend to dominate strate-gy in governments that are struggling to carry outunfamiliar tasks in ambiguous circumstances andunder competing political pressures. Russia coped withthe situation by operating without a budget for 1992and 1993 and bringing in a 1994 budget half-waythrough the year. Inevitably, some conditions have tostabilize before attempts can be made to start refiningbudgeting techniques so as to develop reliable revenueestimates to form the basis for rational expendituredecisions. While the transitional economies in the CEEregion adopted broadly similar approaches to effectingthe changeover, implementation measures and speedsof application varied. Important influences were thestrength and sources of social pressures applied, aswell as the degree of political consensus andcommitment.

Common problems which new governments experi-enced when trying to prepare revenue and expenditureestimates were falling output, high levels of unemploy-

ment and inflation, and accumulated budget deficits.Some countries, notably Hungary and Poland, hadmassive foreign debt obligations to meet. During thepast five years, most transitional economies have notbeen able to balance their budgets, mainly because ofover-optimistic revenue targets—due to unfulfilledassumptions about increased economicperformance—rather than over-budget spending. Lackof political stability could also have been aninfluencing factor, for example in Hungary, Poland,Romania, and Russia (Deloitte, Touche, Tohmatsu,1994, p.5). The Czech Republic, on the other hand,which enjoyed greater political stability, managed tokeep down inflation while balancing its budget moreclosely.

4.12 Diversifying budgetary revenues

A pattern of gradually diversifying revenues and shift-ing from direct to indirect taxation options has startedto emerge in the transitional economies. In the process,a number of issues had to be resolved-for example, howto restructure revenue-sharing arrangements, how touse the proceeds from privatization sales, and how toraise and collect taxes. Prior experiences were aninfluential factors.

4.13 Revenue-sharing considerations

Revenue sharing, that is, uni- or bi-directional flows ofrevenue between the central and local authorities, wasa common feature of command-economy financing.The mainly uni-directional flows for tax revenues inthe People’s Republic of China provides one examplewhile the mainly bi-directional flows in Lithuania—aformer Soviet republic-provides another.

One of the main reasons for China’s recent overhaul ofits national tax system was to achieve more significantcontrol over tax revenues by the central Government(The Economist, 18 March 1995, p. 15). Fiscalrevenues constituted some 30 per cent of China’s GDPat the time economic reforms commenced, in the late1970s, under an arrangement whereby local authoritiescollected taxes and forwarded a fixed quota to thecentral level. This fixed amount, however, remainedunchanged while economic growth expanded, resultingin a one-third drop in the percentage of total tax rev-


enues allocated to the central Government. The situa-tion was exacerbated by local tax incentives to newenterprises, excusing them from taxes due to the cen-tral Government. One of the main features of the newstructure is a 17 per cent value added tax (VAT),which replaces other turnover taxes, of which onlyone-quarter is allocated to local governments. There isalso a standardized 33 per cent tax on corporateprofits. Most importantly, the direction of the taxallocation payments will be reversed, that is, paymentwill in the future go from the central to the local levelsthrough national tax offices to be established locally.This arrangement should also give the centralGovernment more opportunity to control localeconomic policies, particularly those related to fiscalmatters; if successful, increased tax revenues could beused to reduce the budget deficit as well as form thefinancial basis for national unemployment and welfaresystems. Until some social safety nets are in place, thebadly needed rationalization of large SOEs will not beattempted on a large scale.

The budgets of former Soviet republics were fullyintegrated at the “All-Union” level, an arrangementwhich continued until various members declared theirindependence. For Lithuania, this occurred in March1990. Previously, Lithuania transferred portions of itsmajor revenue sources-turnover, income and profitstaxes-to the Union and, although budgetary resourcesflowed back from the central Government, providing,inter alia, the main funding for the social security sys-tem, the Union generally benefitted from net positivetransfers.

With independence came new and different sets ofopportunities and obligations considered in Lithuania’sbudget law of July 1990. On the revenues side, a profittax, a personal income tax and a tax on fixed assetswere introduced, and land tax rates were increased. Anenterprise profit tax was initially set at a high effectiverate, although subsequently a reduction was allowedfor those profits retained for investment purposes. Thisapproach has been applied elsewhere, most recently inHungary. The tax on the fixed assets of SOEs is, essen-tially, a charge for the use of State capital, and,similarly, the land tax is a land use charge paid byState enterprises which occupy State-owned land.Leasing land from the State is also common inagriculture. As the new government developed animproved sense of revenue planning, the revenuesstructure started to develop into a more mature patternof decreased direct taxation and increased indirect

taxation. In 1991, the turnover tax was replaced with avalue added tax which started to assume majorimportance as a revenue component. To replace theprevious Union budget funding, an extra-budgetarysocial insurance fund was set up to finance the systemfrom a 30 per cent payroll tax together with a 1 percent payroll tax levied on employees.

4.14 Privatization proceeds

Whether or not to include the proceeds from privatiza-tion disposals of State property in State budget rev-enues is a controversial issue because it convertsinvestment into consumption, emotionally expressed as“selling the family silver to pay one’s way.”

In general, transitional economies tried to avoid usingprivatization proceeds for operating needs. In theCzech and Slovak Republics, the proceeds from smallprivatization auctions were deposited in eachrepublic’s National Property Fund. They were toremain there, frozen, for two years; afterwards theycould be deposited in the banking system, although usefor budgetary purposes was prohibited (Frydman andothers, 1993, p. 79).

In Lithuania, cash receipts from the sale of SOEs andhouses flow, respectively, into an EnterprisePrivatization Fund and a Housing Privatization Fund.Under a decree of July 1992, Parliament may allocatesome of the Enterprise Privatization Fund revenues fora number of purposes which would have the effect ofdecreasing budget burdens, but not necessarily decreas-ing outlays for operating expenses. These purposescould include paying domestic debt, promoting hardcurrency investments and exports, recapitalizing Statebanks, or improving infrastructural facilities scheduledfor privatization. Any balance would be allocated toprivatization-related outlays. The HousingPrivatization Fund revenues were to be shared, 30 percent going to the State for new housing financing and70 per cent to local governments to assist those inneed.

In Bulgaria, the municipal authorities are permitted toretain 50 per cent of the proceeds from privatization ofmunicipal assets, but may only use these funds for debtrepayment and investment purposes, and not for cur-rent expenditures (Frydman et al., 1993, p. 27).Small-scale privatization proceeds are to be split threeways: the companies themselves receive 40 per cent; aState or municipal investment fund receives, 30 per


cent; and the remaining 30 per cent is allocated forforeign debt payment purposes (Frydman and others,1993, p.31). In large-scale privatizations, 20 per centof the shares of privatized State enterprises, as well asother contributions, are deposited in a mutual fund.The Council of Ministers may then allocate the fund’sresources to capitalize the social security fund, financefree share distributions to Bulgarian citizens,compensate former owners, maintain an AgriculturalAssistance and Development Fund and a State Fundfor Reconstruction and Development, as well as otherpurposes (Frydman and others, 1993, p.30).

4.15 Tax reform

In planned economies, taxes levied on SOEs constitutea major element of budgetary revenues. As the social-ized economy became less and less able to bear themain tax burden, transitional economies were forced tostart the process of tax restructuring. Despite the pas-sage of almost five years, the results are very unevenacross the CEE region (Business Central Europe,September 1994, pp. 68-69). The main criticisms fallinto various categories, for example:

a. The lengthiness of the tax reform process-inBulgaria, for example, personal and corporate taxlaws drafted in 1991 had still not been adoptedthree years later;

b. Ambiguities and inconsistencies in the new tax lawswith insufficient details about essential elements ofthe legislation;

c. Paucity of explanatory information supplied totaxpayers, with the exception, however, of Hungaryand Slovenia which keep taxpayers informed andallow them more latitude in meeting taxobligations;

d. The self-assessment schemes generally adoptedplace too much burden for compliance on the tax-payers. On the other hand, certain loopholes existsuch as the lack of requirement to register for taxpurposes in Russia and Slovenia;

e. Lack of flexibility in the periodicity of tax pay-ments, particularly when earnings are seasonal orwhen taxpayers cannot collect from their customers,which is a region-wide phenomenon.

In short, the new tax laws should be clarified, andmore recognition needs to be given to taxpayers’ rightsto confidentiality, certainty about tax obligations,

updated information, and an impartial and speedyappeals process.

The seriousness of the inadequacies of fiscal reform ismirrored in the fact that problems with the fiscal baseand poor control over collections constituted two of thethree main reasons for shortfalls in budgetary revenues(Deloitte, Touche, Tohmatsu, 1994, p.5), namely:

a. The fiscal base was neither adequate nor wellstructured, mainly due to excessive reliance ontaxation of the State sector as well as direct taxes ingeneral;

b. Poor fiscal control over tax evasion and non-pay-ment of taxes generally; and

c. The continuing recession-which depressed sales andtaxable income-and consumer spending con-centrated on lower-taxed necessities rather than onhigher-taxed durable goods.

China, however, has been slow to act because the situa-tion is aggravated by political considerations (TheEconomist, 18 March 1995, p. 16). The SOEs are stillviewed as the main source of State budget revenues,even though many of them are not operating profitably,and the central Government will not consider large-scale privatization as a way of improving financial per-formance. It is, however, ready to sell smaller firms orrestructure larger ones into joint stock companies inwhich employees could become shareholders, wherethere would be less potential for massive lay-offs andno subsistence incomes.

The pressure in the Russian Federation to restructuretaxation—in particular corporate taxation and theexcess wages tax—stems from two main concerns: thefact that investment is virtually at a halt and that therehas been a 25 per cent decrease in industrialproduction (Business Central Europe, October 1994, p.67). The new strategy being considered is to lowercorporate tax rates and to step up tax collection efforts.The latter is an urgent problem because collectionswere 45 per cent below budget for the first half of1994, which meant that expenditure plans were cutabout one-third across the board.

The tax on excess wages originated in Hungary some15 or more years ago and was designed to link payraises with productivity increases. State enterpriseswere fined, in the form of an onerous tax, if the aver-age pay increase exceeded a specified growth inproductivity. This strategy was adopted by Hungary’sneighbors and soon found favor as a new tax measure


with the productivity link abandoned. Under theRussian tax laws in effect at the end of 1994, compa-nies have to pay a tax of 38 per cent on wages whichexceed six times the minimum wage, whether or notthey are earning profits. Although such a tax has anti-inflationary value, its effect is to discourage firms fromtrimming staff and employing a smaller but more high-ly-paid and efficient workforce because it would driveup the average pay rate. In Poland this tax was liftedfrom privatized enterprises and private firms, and theCzech Government is considering its removal as notbeing appropriate in an emerging market economy. Ithad been expected that the Russian Federation’s newtax laws would remove the tax also; in the event,however, it has been raised under recent legislation toapply to wage increases higher than four times thenational average wage, rather than six times as before.

The value added tax, now virtually universallyadopted, has more than filled the gap in companyincome taxes, representing a very significant revenuesource. Personal income tax is another phenomenonwhich increases the tax burden on the general public.

Coupled with developing new revenue sources is theproblem of ensuring cash flows through acceleratingthe process of tax collection. All the transitionaleconomies have a calendar fiscal reporting year,although Poland allows a taxpayer to choose a differentfiscal period. Most countries require tax installments tobe paid monthly in advance, or quarterly in certaincases, depending on the amount of the tax liability.Generally, estimates are based on the prior year’sliability; in Bulgaria they are based on taxable profitsin the prior quarter and in the Russian Federation onestimated current year’s profits. Filing and finalpayment is usually required by 31 March of thefollowing year. A system of personal withholdingtaxes, with frequent deposits of withheld taxes by theemployer, is now a commonplace feature oftransitional economies.

To combat the problem of chronic tax evasion, certaininnovative measures had to be considered, includingthe experiences of other countries. In Mexico, forexample, a tax of 1.8 per cent of the value of a firm’sfixed assets is imposed on companies which do notreport any taxable income for a specified number ofyears. Poland’s approach has been to institute aprepayment tax based on gross sales. Companies haveto file tax returns in order to claim any refunds of theseprepayments.

4.16 Planning budgetary expenditures

Budgetary-expenditure planning is as much a politicalas an economic and financial exercise under mostcircumstances. In the transitional economies, such asthose which were previously republics of the formerSoviet Union, public services that were previously theresponsibility of the “All-Union” budget have to beprovided for—such as national defence, policeprotection, and the foreign service apparatus. For thoseapplying for foreign economic assistance, internationalorganizations, such as the World Bank, impose budgetdeficit limitations which severely limit the room tomanoeuvre. For others, such as the Russian Federationand China, inflation poses yet another threat targetcontrol.

China’s inflation rate—currently about 27 per centannually—threatens not only budget control but alsocontinued economic growth. Out-of-control spending,mainly by large SOEs, is the main contributing factor.These enterprises, which account for over 50 per centof industrial output and employ over 110 million work-ers, come under heavy pressure from the workforce toincrease pay rates as prices rise. This, of course,increases the money supply which, by the third quarterof 1994, was 37 per cent higher than a year earlier.The fear of worker unrest is a basic problemhampering the central Government’s attempts to bringinflation down; another is the fact that banks arecontrolled by local authorities. With some 45 per centof the SOEs operating at a loss and over 3 millionemployees not being paid regularly, the banks will notbe allowed to cut back the flow of enterprise credituntil a comprehensive social security system is inplace.

As Dean’s model (Table 12) illustrates, the second evo-lutionary stage in governmental financial managementsystems is marked by clearer, better justified and moreunderstandable budget presentations. Such anapproach is greatly facilitated if some generalframework is used to identify what objectives are beingpursued in the proposed expenditure plans. In maturebudgeting systems this is referred to as programmebudgeting, a maturity level which none of thetransitional economies has yet reached. State budgetingin Poland, however, takes place within the frameworkof an overall economic strategy, titled “Strategy forPoland” and authorized by the present Minister ofFinance (Rzeczpospolita, 5 August 1994, p. 5).Expenditure estimates are not, however, grouped byprogramme as is evident from the following short


description of considerations that guide budgetplanning actions.

The Polish Government’s budget strategies for 1995were defined in its budget proposal to Parliament as:upholding economic growth tendencies, reducing the1995 inflation rate to 16 per cent, and limiting bankfinancing of the State budget deficit. Heavy emphasisis placed on controlling budget outlays in view of thelimited possibilities for raising budget revenues.Expenditure priorities in the longer term would includereforming the social security system, restructuring thehealth protection sector, reforming the central adminis-tration and limiting the so-called gray area of unreport-ed economic activities. However, budget realities placesignificant limitations on such initiatives.

About one-half of the budget outlays leave little roomfor discretion. These include servicing the public debt,subsidizing the social security fund, settling withbanks, and providing subsidies for local authorities aswell as some agencies and funds. Additional costs arethose of the President’s chancellery, the Parliament,the Senate, the Supreme Court and the State AuditService. Of the remaining 51 per cent of potentialoutlays, about 23 per cent was set aside for raising thesalaries of government employees to help maintaintheir real value in the face of rising consumer pricesand to try and deal with the widening gap betweenremuneration in the public and private sectors. Thisleaves about 28 per cent for investments, subsidies andother non-pay expenditures. Consequently, absolutelimits have to be placed on total budget outlaysalthough Ministers and province governors (wojewody)have some discretion over how the totals may bestructured. Such discretion is subject to two limitations,however: (a) certain defined outlays cannot be changedwithout permission of the Minister of Finance; and (b)limitations set on pay, as calculated under obligatorymethods, cannot be exceeded.

A further essential element in progressing to a higherevolutionary level of governmental financial manage-ment is logically structuring the budget itself.

4.17 Budget restructuring

The organizational structures of budgets should beclosely connected with those of governments and otheradministrative units. This is the case in Poland, wherebudgetary accounting and reporting is uniformly orga-nized for all local authorities, budgetary units, bud-

getary enterprises/workshops and auxiliary entities.Uniformity consists of like organizations using thesame charts of accounts, standardized budgetclassifications, and standardized accounting principlesand reporting formats. Essentially, three main types ofactivities underlie budgetary accounting practice.Financial planning of budgetary receipts andexpenditures, at the local level, is performed by thegroups charged with their receipt and disbursement;these groups keep track of what was raised and whatwas spent, by comparison with financial plans, throughbudgetary accounting. Furthermore, the tax authoritiesare included in the budgetary accounting process intheir role as collectors of both taxes and non-taxbudgetary incomes. At the central level, budgetplanning and evaluation is consolidated in the Ministryof Finance which, like all other budget-supported units,uses budgetary accounting to record its financialactivities.

The budget law of 5 January 1991 distinguished twotypes of budgets: State and local. Both types continueto organize revenues and expenditures into the tradi-tional classifications: (a) Divisions, according to thebasic areas of activity in the national economy; (b)Sections, according to defined groups of organizationalunits or types of budgetary tasks; and (c) Paragraphs,according to defined sources of budgetary revenues aswell as types of budgetary outlays.

Four other sets of data appear in a separate division ofbudgetary classifications: (a) the excess of revenuesover budgetary outlays; (b) the budget deficit; (c)inflows from the sale of obligations and State or localtreasury bonds, shares and other securities; and (d)inflows and outflows from loan transactions.

However the budget document is formatted, thereshould be symmetry with the organization of budgetaryaccounting to facilitate comparisons between plannedand actual amounts which will provide both feedbackand predictive ability. This means that the economistplanners should be involved in joint training sessionswith budgetary accountants so that each can betterappreciate how their respective functions should meshand be of mutual assistance. It is only when the bud-geting system has been overhauled to meet the new setsof requirements in transitional economies-with theparticipation of accounting information system design-ers-that choices can be made about the most appropri-ate budgetary accounting system design to adopt.


4.18 Budgetary accounting reform

Countries undergoing major shifts in cultural values,such as those in transitional economies, have an arrayof alternative models to consider when redesigningtheir public sector budgeting and accounting systems.This is because governmental accounting has a richer,more varied evolutionary history and methodologythan its private sector counterpart due to the fact thatindigenous systems of accountability and control overthe public purse tend to reflect more closely the citi-zenry’s value systems. Design alternatives includeunderlying principles, bookkeeping techniques, coordi-nation of the main financial management functions,organization of the system’s elements, reporting sys-tems and formats, and auditing arrangements and for-malities. In making its choices, each country should beguided by its own sets of priorities and stage of politi-cal and economic development so as to avoid theanachronism syndrome (Dean, 1988b, p.164), that is,the adoption of reforms which are not consistent withthe host country’s evolutionary state and therefore donot best serve its needs.

Over the course of centuries, four budgeting and book-keeping methodologies have evolved: cash, cameral,modified accrual, and accrual, with the latter rapidlygaining popularity around the world. For efficiency,long-term potential uses should be considered whenmaking system choices. Design, installation and train-ing are all costly; accordingly, the entire processshould be carefully thought through. Dean’s listing ofthe characteristics of more advanced evolutionarystages of government financial management (Table 11)provides useful guidelines.

Whichever type of bookkeeping and budgetingmethodology is selected, a basic design feature wouldbe to devise an account numbering system whichwould link these two functions together. Prior toGerman reunification, for example, both Germans usedthe cameral accounting and budgeting approach firstdeveloped by mercantile economists in the 17th and18th centuries. This is a cash-based system which inte-grates budgeted revenues and expenditures with theaccounting system through the use of the same identi-fying numbers for budget line items (Berry, 1987). Thecameral system has certain accrual features because itprovides for carry-forwards of prior and current years’unused budget receipts and outlays, and also accom-

modates multi-year budgeting.13

Cameral nomenclature is evident in the new Bulgarianchart of accounts-very similar in design to theFrench—which is integrated in the sense that it can beused for both private and public sector entities.Because of this dual purpose, accounting is on theaccrual basis. Selected accounts are as follows(Republic of Bulgaria, 1992):

Account Account No. Title

630 State budget expenses

641 Expenses of budget-financedenterprises

642 Expenses of non-budget-financedenterprises

741 State budget revenue

742 State budget revenue for distribution

743 Amounts carried over from priorperiod budgets

744 Extra-budgetary revenue

Poland, which has integrated its budgeting andaccounting systems, on an accrual basis for over 40years, has the potential to move its government finan-cial management systems further along the evolution-ary path because the basic structures in place areadaptable to modification. A short description of Polishbudgetary accounting follows.

4.19 Polish budgetary accounting

In Poland, the main objective of budgetary accountingis to supply numerical information, expressed in mone-tary terms, about how budgeted activities were carriedout. This function is considered essential for budgetanalysis work, planning and control, and for other pur-poses connected with making decisions of an economic

13Refer to Berry (1987) for a comprehensivedescription of German cameral accounting techniques.


nature.

In order to facilitate comparisons between budgetedand actual revenues and expenditures, the Minister ofFinance provided two charts of accounts in December1991, listed in Table 13. One is to be used by localauthorities, and the other by the budget units, budgetentities, and auxiliary enterprises.

Budgetary accounting is governed by a number of reg-ulations: first of all, it is covered by the decree of 5January 1991, article 51, which established the budgetlaw; accounting comes under the order of the Ministerof Finance of 15 January 1991; charts of accounts areincluded in the Minister of Finance order of 30December 1991; and budgetary reporting is covered inthe Minister of Finance order of 14 January 1992(Bakalarska, 1993, pp. 14-15). The following sevenbasic principles of budgetary accounting are specified(Bakalarska, 1993, p. 20):

a. Economic transactions must be entered completely,systematically and chronologically in the reportingperiod to which they belong;

b. Transactions must be recorded in accordance withtheir substance rather than the form in which theyare presented;

c. Switching categories of balance sheet or incomestatement items is not permitted;

d. Data necessary to establish an entity’s financialsituation must be reported individually, whereasother times may be grouped;

e. Assets and liabilities, as well as data influencing thefinancial result, must be valued at purchase price(transaction amounts) or production cost;

f. Reserves are to be created, and revenues of futureperiods segregated, so as to ensure the reality of thefinancial result;

g. Continuity of the entity’s existence is assumed.

Accounting and reporting is uniformly organized forall local authorities: budget units, that is, those that arebudget-dependent, budget entities that generate somerevenues, and auxiliary enterprises which attempt to beself-sustaining. That is, like types of organizations usethe same charts of accounts, standardized budget clas-sifications, and standardized accounting proceduresand reporting formats, in order to integrate the budget-ing, accounting and reporting functions.

The procedures for ensuring that transactions are

accounted for in the same way as they are budgeted,and that the budget and actual comparisons are accu-rately reported constitute part of the defined duties ofthe Chief Accountant, laid down by the Council ofMinisters’ instructions of 2 May 1991. Basically, theChief Accountant is responsible for checking the legal-ity of documentation, making sure that transactionshave budget authorization and do not exceed budgetedamounts, and preparing as well as analyzing budgetreports. There are also six additional sets of duties. Thefirst covers all aspects of the bookkeepingprocess-documentation flows, preservation and main-tenance, protection of the entity’s property, and generalsupervision of the accounting staff. The second coversvarious aspects of financial management, that is: mak-ing sure that disbursements are budget-authorized;ensuring that agreements entered into by the entity arefinancially sound; protecting monetary assets; ensuringtimely collection of receivables; and investigatingquestionable claims. The third has to do withanalyzing the uses of resources allocated from thebudget, or other extra-budgetary resources at theentity’s disposition. The fourth identifies certainactivities carried out within the framework of internalcontrol. The fifth has to do with directing the work ofsubordinate organizational units and their employees.The sixth entails preparing proposals for internalregulations issued by the management which have todo with the accounting function; in particular, thisinvolves the organization’s chart of accounts, theprocessing of accounting documents, and the principlesof carrying out inventory-taking and making sure thatall is accounted for. A system of signature verificationsexists to show that the chief accountant has performedthese duties.

Various penalties are provided for in case of failure toobserve the budgetary regulations. These include repri-mands as well as monetary penalties handed down byappointed investigative commissions. Depending onthe seriousness of the infraction, a monetary penalty isusually calculated as a multiple of the average monthlysalary in the socialized sector of the economy.

4.20 Budgetary reporting

Budgetary reporting is covered by the Minister ofFinance order of 14 January 1992 and its purpose is tosupply user needs for analysis, planning, control andother economic decisions (Bakalarska, 1993, p.210).Essentially, the reporting system matches the organiza-


tional structure of the budget and reports consist of aseries of official forms, 10 for local governments and12 for the State. The reporting frequency depends onthe type of information furnished. Monthly reports areprovided on budget receipts and outlays, identifyingbudget classifications by division, section, paragraphand line item, and comparing annual planned amountswith actual year-to-date figures. Semi-annual andannual reporting forms concerning revenues andoutlays are organized in the same fashion but havecolumns showing amounts in excess of, or under,budget.

Each reporting entity forwards its reports to the nexthigher supervisory authority so that an entire packageeventually arrives at the Ministry of Finance, withcopies provided to the State Audit Authority (NIK).Local authorities file annual reports on their budgetperformance directly with the Ministry of Finance, list-ing account balances at the beginning and end of theyear, as well as off-balance sheet data.

The process of streamlining budgetary accounting, andimproving the quality and timeliness of budgetaryreporting owes much to the widespreadcomputerization of government which has acceleratedin the CEE region over the past five years.

4.21 Computerization

Both central and local governments in the CEE regionhave been significant purchasers of computer hardwareand software since 1990. By the end of this decade, thePolish government alone expects to have investedabout 1 billion dollars on computer solutions (BusinessCentral Europe, October 1993, p. 36).

Two of the main user needs relate to improving taxcollection and updating the Central Statistical Offices.In efforts to identify the tax base and increasecollection, Poland’s Ministry of Finance, for example,ordered the Poltax system with application estimatesranging between 80 million and 200 million dollars;the Czech and Slovak Governments invested 13.5million Deutschemarks in a large number of networkedRS/6000 Unix workstations, while, by 1993, theHungarian Government was considering bids for a sys-tem budgeted at 29 million dollars. To modernize sta-tistics gathering and processing centrally, Hungary haslaid out 9.5 million ECUs, Romania 3 million ECUs,and Poland 10 million ECUs.

In other applications, the Czech Republic invested in a

15 million dollar system for its State Health InsuranceCompany, and Poland 14 million dollars for theForestry Administration. More generally, a hugedemand is growing across the region for investment inthe computerization of social security administrationsas well as geographical information systems and landregistries so as to introduce comprehensive andrational property tax assessments and other benefits forthe growing real estate markets.

Computerization has not proceeded smoothly,however, with serious problems emerging from publicsector contracts having to do with lack of sophisticatedbuyers, lack of established buying procedures, anddifficulties in applying standards guidelines.Experience in Poland and the Czech Republic showedthat there were unrealistic expectations on the part ofthe buyers and insufficient experience in systemsintegration on the part of the suppliers. As a result,both the Polish and Czech tax administrations ran intosignificant installation problems and delays. Lack ofestablished procurement procedures meant thatpurchaser requirements were not well defined andopportunities existed for conflicts of interest. Somecountries, recognizing the urgent need to control callson the public purse, have instituted new governmentprocurement regulations in the recent past. However,there has probably been much waste of effort andmoney as governments have scrambled to acquire newtechnologies without clear ideas on what was needed.In cases where computerization funding came fromWorld Bank loans or the European Union’s PHAREprogram, the potential for misuse of funds wasconsidered in the stringent procurement guidelines thatare applied. Otherwise, where governments-such as theCzech Republic’s-favor open systems, application ofstandards guidelines has been very difficult to achieve,pointing up the need to forge understanding andacceptance of responsibility and accountability amonggovernment officials.

4.22 Fiscal auditing14

The practice of fiscal auditing reflects some of theinadequacies of new tax legislation referred to earlier.That is, the tax laws are open to various and

14This subsection relies on Deloitte ToucheTohmatsu International (1994), pp. 7-17, and BusinessCentral Europe, September 1994, pp. 68-69.


conflicting interpretations, the taxpayer is oftenuninformed, and the appeals system may be so vagueor protracted that some may find it more convenient toattempt on-thespot negotiations. Under suchconditions, there is potential for over-exertion ofauthority by the fiscal auditors, particularly where, insome jurisdictions such as Slovakia and Russia, finescollected are redistributed among the tax inspectors.

In most countries throughout the world, the audit pow-ers of the fiscal administration are broad, and this is soin the case of eight countries in the CEE region, listedin Table 14. Old ways of doing things are reflected inthe general lack of provisions for advance taxpayernotification, except for Hungary and Slovenia, and thepower, generally, to enter and search taxpayers’homes, which was a feature of the previous politicalsystem.

The taxpayer selection basis is an important considera-tion when a main audit objective is to maximize taxcollections. This result is more likely to be achieved iftaxpayers with a high probability of yielding signifi-cant audit results are targeted for an in-depth reviewrather than trying a broad brush approach over a widefield.

Fines and penalties, detailed in Table 15, tend to besevere and may, as in Bulgaria, be levied against com-pany officers and the accountants rather than the com-pany itself. The way that fines and penalties areassessed and calculated may be perceived asinequitable or somewhat illogical. Generally, there isconcentration on form over substance regarding taxlaw violations. In Russia, for example, tax evasionactivities of a fraudulent nature, such as overstating thesize of the workforce in order to evade the excessearnings tax—which can be accommodated somehowwithin the confines of the tax laws—may escapeheavier penalties levied on unwitting mistakes inrecording transactions. Further, the calculation of thepenalty is based on the value of the underlyingtransaction involved rather than on the avoided taxamount. While fear of retribution may constitute astrong motivation for accurate and timely tax liabilityreporting, a sense of fair play needs to permeate theinstitutional arrangements. In Poland, the function ofombudsman-similar to the Swedish model-wasestablished a number of years ago to review andprocess citizens’ complaints about officialdom, and itsState audit service (NIK) is authorized to carry outappropriate reviews. Those who investigate taxpayercomplaints would be useful members of trainee teams

involved in improving the fiscal auditing process.Because each transitioning country has its own valuesystems, local trainers should be the ones to provideguidance about optimizing auditor/taxpayer relationsduring the conduct of fiscal reviews.

4.23 Government auditing

The accountability concept, that is, the obligation ofofficials and employees who manage public pro-grammes to render an account of their activities to thepublic, has been an inherent feature of governingprocesses throughout much of recorded history (GAO,1994, p.8). Indeed, in some advanced societies—suchas Germany—governments are still required to beofficially discharged by Parliament after the accountshave been audited by the State audit service (Berry,1987). In the United States, the General AccountingOffice (GAO), in defining what the accountabilityconcept entails, also outlined the underlying objectivesof State auditing (GAO, 1994, p. 8.):

“The need for accountability has caused ademand for more information about governmentprogrammes and services. Public officials,legislators, and citizens want and need to knowwhether government funds are handled properlyand in compliance with laws and regulations.They also want and need to know whethergovernment organizations, programmes,andservices are achieving their purposes andwhether these organizations, programmes, andservices are operating economically andefficiently.”

This definition goes beyond the typical State audit pro-cedures followed in the transitioning economies ofassuring that the auditee’s financial reports are fairlystated in compliance with applicable laws and regula-tions. It adds two additional objectives to the GAO’saudit process, known as comprehensive auditing:determining that the entity is managing or utilizing itsresources in an economical and efficient manner andpromptly reporting instances of inefficiency or disec-onomy; and determining whether the desired results orbenefits of the governmental programme are beingachieved, or whether the programme is effective.Throughout the community of governmental auditors,the concept of comprehensive auditing is becomingmore and more universal.

For government auditors not trained in concepts of


external accountability, the notion that the main objec-tive of government accounting and auditing is to aidgovernment’s main management functions, i.e.decision making, planning, and control (Most, 1991, p.240), may take time and training to root. To someextent then, government accountants and auditorsshould be involved in public expenditure decisions andtheir evaluation after the fact. According to thePlowden Group in the United Kingdom, thesedecisions include (Most, 1991, 240):

a. to determine what the country can afford over aperiod of years, and what part is properly the con-cern of government;

b. to decide the relative importance of one kind ofexpenditure over another, and how each should befinanced; and

c. to introduce the greatest possible degree of stabilityinto the incidence of government revenues andexpenditures.

While some of these decisions, particularly the last,may be outside the province of the accountants andauditors, part of the auditor’s responsibility would be tocomment on them as a part of an after-the-fact auditreport so as to provide some input to guide futureplans.

Comprehensive auditing requires special trainingbecause it is a combination of a financial audit, a com-pliance audit and an operational audit. It is in the latterarea that the closest correlation may be found to evalu-ating public expenditure decisions. This is becauseoperational auditing examines the effectiveness of pro-grammes, such as providing job skills to the unem-ployed, or responding quickly and efficiently to burglaror fire alarms, in both nonmonetary terms of whetherdesired results are being achieved, as well as inmonetary terms of getting value for money. Thisspecial training is often allied to systems design andanalysis as part of a series of general managementcourses. Often, examining the books and records mayconstitute a very small part of a public programmeaudit engagement. Consequently the governmentauditor has to develop new ways of analyzing and newaudit tools. Much of this type of training is conductedby the State audit services of a number of countriesincluding the GAO in Washington, DC and membersof the European Union, among others.

Finding, training and retaining professional staff haslong been a perennial problem in developing countries,

and the transitional economies are no exception.Because accountants and auditors should form the coregroup in government financial management(Gujurathy and Dean, 1993, p. 188), this is aparticularly vexing problem: particularly, as in the caseof transitioning economies, when the accounting andauditing functions do not enjoy high esteem.

As Gujurathy and Dean (1993) found, drastic salarydifferentials between the public and private sectorsconstitute one of the major reasons for the acute short-age of good staff. Others reasons include: poor workingconditions, lack of appreciation for audit efforts by thegovernment officials receiving reports and perceivedlimitations for career advancement. Attracting andtraining staff is a lengthy and costly process, butretaining staff can be even more challenging. Forsome, government service is viewed as a trainingexercise which provides a candidate with a goodbackground for advancement in the corporate world. Incountries where superior candidates are rare,disincentives to leave employment early, such ascontracts, do not usually represent viable options.Under such conditions there may be no ready solutionsexcept to subcontract services which do not involveconfidentiality, or could otherwise be entrusted tocertified public accountants-an approach taken in somecountries, such as the United States. The situationcould be expected to stabilize, gradually, as workingconditions in the public sector start to gain theascendance over those in the private sector.

4.24 Training in the role and practice ofgovernance

The governments of transitioning economies have ben-efitted from an outpouring of assistance from manyquarters in redefining the role and practice of gover-nance. From the standpoint of financial managementin government, considerable funding has been and stillis made available, through such facilities as trainingcentres, universities, lecture programmes andon-the-job training in host government departments.These efforts have been facilitated by the links whichexist between various governmental organizations suchas Voivodship Assemblies of Local Authorities, theNational Assembly of Local Authorities, theAssociation of Polish Cities and the Union of SmallTowns in Poland. Economies of scale can be achievedin joint training sessions with the added benefit of thesharing of experiences between participants.


The Polish Foundation in Support of Local Democracy,established in 1989, provides one example of an inte-grated system of training aimed at improving the gen-eral level of government. As a not-for-profit founda-tion, sponsored by such international groups as theUnited States’ Agency for International Development(AID) and the European Union’s PHARE, it has, withthe assistance of universities and foreign local govern-ments, among others, provided a variety of trainingfacilities to literally thousands of local governmentemployees and politicians in its brief history.

Professional accounting bodies, particularly those frommember countries of the European Union, have alsobeen very active in financial management trainingwhich has not been restricted to government employ-ees. Private sector accountants from transitionaleconomies, for example, have had the opportunity toparticipate in public sector audits overseas as part oftemporary, on-the-job training exercises. One of themost valuable aspects of this approach has been thehands-on learning it provides in a real-world setting.This same appreciation has been expressed for thetraining provided by the GAO in Washington, DC aswell as other State audit services elsewhere in theworld. Training in ethical issues in government, whichis an essential element of accountability, should be adomestic concern because it is culture-specific and,therefore, values-dependent.

4.25 Future directions

Budgeting strategies are still generally dominated byemergency thinking in the CEE region, thushampering continued improvement of financialmanagement in government proper. This means thatcertain political, social and economicconditions—particularly inflation control and socialsafety net provisions—have to stabilize beforerefinement of budgeting techniques to diversifyrevenues, control expenditures, and adopt aprogramme approach, can start to fall into place.

Most of the structured efforts have been in the area ofrevenue diversification with the most success creditedto the introduction of value-added tax. This is becauseVAT does not require identification and pursuit of thetaxpayer, implementation is fast, and ease and speed ofcollection is more or less assured depending on thereliability of the tax base. It has, however, been blamedfor adverse economic effects, particularly with respectto goods and services with higher VAT rates. Fiscal

reforms, on the other hand, have generally been criti-cized for their ambiguous and punitive aspects whichwork against increasing tax collections, as do the activ-ities of some tax administrations.

Controlling expenditures, on the other hand, hasreceived less analytic attention because across-the-board cuts avoid the need for reasoned and painfuldecisions, particularly political ones. Until more analy-sis is given to the structure of expenditures, introduc-tion of a programme concept will have to wait.

The financial management aspects of central/local gov-ernment relations find expression in the assignments ofresources and responsibilities and the revenue-sharingarrangements that support them. Generally,transitional governments in the CEE region haveperceived political decentralization as having a majorfinancial advantage; that is, an opportunity to shiftpublic service burdens and financing from the centralto the local level. Leaving local authorities to fend forthemselves financially, without start-up beginningfunds, while at the same time assuming responsibilityfor such major outlays as public education, had the sidebenefit of speeding the privatization of locally-ownedsmall enterprises and stores. This ground-up approachis, of course, the basis of a market economy; however,it did not necessarily lead to loss of central control, thatis, putting real economic power in the hands of thelocal populations. In Lithuania, for example, localcouncils are freely elected and set their own budgets.However, the central government has the power toremove elected officials if it disapproves of theirpolicies. Similar tensions over revenue-sharing exist inChina.

Government accounting, a major service ingovernment proper, cannot achieve greater potentialuntil the planning and budgeting-function problemsare resolved and a programme concept adopted.Although accounting has been included in trainingprogrammes for government, there has been too muchattention to descriptions of government accounting inother countries rather than help in planning indigenoussystems. The existing integrated system in Poland, forexample, is very similar to the previous one even in thedefinition of government accounting objectives. Tohelp remedy the situation, government planners andaccountants in government proper should have somejoint training sessions in system design and use inorder to develop a wider appreciation of theirrespective functions and how they complement eachother. As is true elsewhere in the world—particularly


in developing countries— developing qualified staff isa major problem for the traditional reasons of low pay,low status, and the perception of limited potential foradvancement. This situation should gradually changeas the financial management function itself matures.

The government audit service suffers from the samestaffing problems as the accounting and financial ser-vice and there are general complaints about under-staffing. As the concept of external accountability takeshold, the role of the State audit service should becomemore pronounced, offering an attractive career. Thetraining programmes offered by various State auditservices-notably the GAO in the United States-shouldbe very beneficial in fostering professionalism amongthe trainees. They can then act as advocates foradvancing the interests both of their own organizationsand governmental activities in general.

The widespread availability and use of computers ingovernment has had many beneficial effects, particu-larly in the area of tax administration. So,computerization financing has been one of the morebeneficial of the many investment opportunities offeredto transitional governments by various internationalorganizations. Where considerable efforts have yet tobe attempted, however, lies outside the world ofelectronic technology. That is in the area of buildingbridges between the governing and thegoverned-particularly with respect to ethics, includingconflicts of interest and accountability. Variousopinion polls show that, generally, public trust ingovernments in the CEE region is low, suggesting thatemphasis on external accountability should be foremostwhen considering the priorities to be given financialmanagement issues in government.

5. Summary and conclusions

As experience all across the CEE region has shown,one of the principal deterrents to development andgrowth in the transitional economies is the generallack of financial liquidity. Until the banking sectorbecomes more efficient in opening up the existingbottlenecks to permit the free flow of funds, businesswill grow, but slowly, from its stagnating state. Theeconomies where loan capital is made available at areasonable price, and in Poland’s “windows”programme, are those which show greater promise inreaching a more advanced stage of markettransformation. The other significant lesson drawn

from the banking sector is the improved performancewhich results from hands-on learning on the job wherethe trainers understand the local business climate andwork alongside the trainees to demonstrate by doingwith learning by imitation. The banker’s current use offinancial information in the credit-granting approvalprocess may well be one of the most important waysthat an understanding of and appreciation foraccounting-based financial information may be dif-fused throughout the host environment.

At the enterprise level, private businesses are, as mightbe expected, more familiar with the uses of accountingdata, particularly in the larger firms. At the grass roots,however, accounts are likely to be very rudimentary innature and on a cash basis. The sole owner-entrepre-neur, as in most places in the world, has a good graspof his or her affairs and tends to operate more or lessby instinct. One of the hardest concepts to explain tothose small businesses applying for loans is the natureof the term “equity”, mainly because they have neverseen a balance sheet and cannot guess its purpose.

Certain alternatives to larger-scale investment-such asleasing-and obtaining funds through borrowing onreceivables, or selling them, are now becoming moreavailable, particularly in the Czech Republic. However,the fact that the VAT, and other regulations, virtuallydestroyed the leasing momentum in Poland, points tothe necessity for government officials to take a longerand wider view of the adverse economic effects of cer-tain revenue-raising initiatives.

The beneficial effects of accounting on the develop-ment of stock markets is still in the future. For newlyemerging democracies, the stock market resembles alottery or game of chance where investors are onlyinterested in short-term capital gains and follow eachother like lemmings to purchase what are touted to begood buys. Virtually the only financial indicator thatthe general public is aware of is the price-earningsratio; and it is that ratio that is featured prominently inprospectuses and other offers to buy securities. Theheavy requirements of the Warsaw Stock Exchangeconcerning accounting disclosure were borrowed fromthe large markets in London and New York. Their usein nascent securities markets, although necessary forconsumer protection, has proved of little valueotherwise.

In the professional auditing field, certaincountries—such as the Czech Republic, Poland,Hungary and, to some extent, China—have put new


institutional arrangements into place. However, auditquality has been severely criticized within the Polishaccounting community. Thus, much remains to bedone with respect to auditor training and raising publicawareness of the value of the auditor’s review andreport. This will evidently be a long-term exercise.

As for government, some advances have been made inrestructuring the budgeting, accounting, and auditingfunctions but, once again, much more remains to bedone. As in the private sector, government auditorsneed to be completely retrained in the comprehensiveaudit and programme approach. It goes without saying,that the non-finance government officials still havevery limited understanding of government financialmanagement. Consequently, cross-training

programmes need to be put in place where closerassociations develop between the different functions ingovernment so that each enriches the other.

Considering the relatively short space of time whichhas elapsed, one could claim that significant progresshas been made, even though it may not be too appar-ent. It must be kept in mind, that all these activitieshave been taking place against a backdrop of, at times,considerable chaos. For all the participants, it hasrequired tremendous effort to understand what a mar-ket economy is all about and to select the best possibleapproaches under the circumstances.


TABLES

TABLE 1. SOME ESSENTIAL DIFFERENCES BETWEEN INSTITUTIONAL ARRANGEMENTS

IN PLANNED VERSUS MARKET ECONOMIES

INSTITUTIONAL FEATURES PLANNED ECONOMIES MARKET ECONOMIES

Integration of economic activities State economic planning Market mechanism

Resource allocations Political considerations Economic considerations

and investment decisions

Dimensions of industrial Technical Commercial and technical

Main enterprise objective Output expansion Profit maximization

Price determination Centrally controlled Economic considerations

Principal (basic) means of production Socially owned Privately owned

SOURCE: Derek T Bailey, ed. (1988). Accounting in Socialist Countries. London, Routledge, pp. 2-8.

Technical and Professional Financial Management Issues in TransitionalEconomies 129

TABLE 2. COMPARATIVE CHARTS OF ACCOUNTS FOR BANKS

Western European Standardized

Group Chart of Accountsb Group Poland–BPK 93a

0 Vacant 0 Fixed assets

10 Cash and bank accounts 1 Operations with monetary asset andwith financial entities

15 Time-limited investments/deposits

20 Credits/loans 2 Operations with non-financial entities

30 Investments (in trade turnover) 3 Operations with budgetary entities

35 Investments (own domestic shares-non-trade)

40 Fixed assets 4 Securities

50 Other clearings 5 Various operations

60 Capital and own resources 6 own and assimilated resources

65 Profit and loss accounts

70 Bank accounts and investments 7 Cost accounts

75 Clients’ accounts and investments

78 Credits received

79 Accruals


80 Other clearings 8 Income accounts

90 Off-balance sheet accounts 9 Off-balance sheet obligations granted

and received

SOURCES: Alicja Jarugowa et and others, 1994. RachunkowoÑƒ Banków Komercyjnych. Warsaw, Centrum Edukacji IRozwoju Biznesu, (a) pp. 176-189, (b) pp. 190-192.


TABLE 3. MAIN CHART OF ACCOUNTS SECTIONS AND OFF-BALANCE

SHEET ACCOUNTS FOR THE RUSSIAN FEDERATION COMMERCIAL BANKS

Chart of Accounts Section Number* Chart of Accounts Section Title

I Bank Funds

III Monetary Resources

V Foreign Transactions

VI Budget-Sponsored Institutions

VII Investment Finance

IX Securities

X Credit and Clearing Transactions

XIII Public Organizations

XIV Citizens’ Savings, Deposits and Bank Accounts

XVI Long-Term Investments

XVII Other Long-Term Investments

XVIII Settlements with Banks and Other Outside Resources

XIX Centralized Accounts for Pension Settlements

XX Interdivisional Clearing

XXI Debtors and Creditors

XXII Bank Fixed Assets and Operational Expenses

XXIII Diverted Resources

XXIV Bank Revenues and Expenses

Section Number* Off-Balance Sheet Accounts Section Title

II Collaterals

III Leasing Transactions

IV Clearing Documents


V Documents and Values Covering Foreign Transactions

VI Long-Term Crediting Documents

VII Sundry Values and Documents

IX Debts Written Off as a Loss

X Securities

*Sections applicable only to central banks omitted.

SOURCE: A. Androsov and A. Golubovich, (1993). Financial Reporting and Accounting in Russia. Moscow, ARGOFinancial Services, pp. 117-185


TABLE 4. EXAMPLE OF COMMERCIAL BANK BALANCE SHEET IN THE RUSSIAN FEDERATION

BALANCE OF ACCOUNT (thousand roubles)

Account

Number Name of Account Assets Liabilities

1 2 3 4

010 Authorized Fund . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 555886

011 Reserve Fund . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92448

012 Special Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230

016 Economic Incentives Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 894

31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5030

050 Precious Metals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71

060 Foreign Currencies in Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . 391 . . . . . . . . . . . . . . . . . .

070 Current Accounts in Foreign Currencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9452

072 Accounts with Foreign Banks . . . . . . . . . . . . . . . . . . . . . . . 11356 . . . . . . . . . . . . . . . . . .

073 Accounts of Foreign Banks, Companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

075 Deposits in Foreign Banks . . . . . . . . . . . . . . . . . . . . . . . . . 15042

076 Other Foreign Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . 6804 . . . . . . . . . . . . . 20609

78 Creditors (Letter of Credit—Foreign Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7238

161 Correspondence Account in the State Bank . . . . . . . . . . . . 371168

191 Investments in Shares of Joint-Stock Companies . . . . . . . . 103335

199 Marketable Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12939

345 Clearing Account of State Enterprises and Organizations . . . . . . . . . . . . . . . . . . . . . 434700

355 Loan Account of State Enterprises and Organizations . . . . 962417

417 Loan Account of Collective Fisheries . . . . . . . . . . . . . . . . . . 1500

461 Clearing Account of Co-Operatives Producing Consumer . . . . . . . . . . . . . . . . . . . . . . 3081

465 Goods Clearing Account of Youth Technical Development Centres . . . . . . . . . . . . . . . . 716

466 (NTTM) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52

467 Clearing Account Alliances of Co-Operatives


Joint-Stock and Limited-Liability Companies—Clearing . . . . . . . . . . . . . . . . . . . . . 579519

468 Accounts

Small Companies Arranged by Individual Persons—Clearing . . . . . . . . . . . . . . . . . . 35982

471 Accounts

Loan Accounts of Co-Operatives Producing Consumption . . 95107

475 Goods

Loan Accounts of Youth Technical Development Centres . . . . 430

continued


continued

477 (NTTM) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1042349

478 Joint-Stock and Limited-Liability

Companies—Loan Accounts

Small Companies Arranged by

Individual Persons—Loan . . . . . . . . . . . . . . . . . . . . . . . . . . 39468

603 Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 447

619 Current Account of Foreign Companies . . . . . . . . . . . . . . . . . 4667

620 Loan Accounts of Other Enterprises . . . . . . . . . . . . . . . . . . . 5998

644 Overdue Debts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 541

652 Current Account of Individual Enterprises . . . . . . . . . . . . . . . 6224

654 Loan Accounts for Joint and Individual Leasing Contracts . . . . 200

695 Loan Accounts for Individual Enterprises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108

700 Current Accounts of Trade Unions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26868

711 Current Accounts of Public Organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95

712 Savings of Citizens . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360

713 Credits Granted to Citizens Involved in Individual Labour . . . . . . . . . . . . . . . . . . . . 365180

714 Holdings and Deposits of State Enterprises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330

715 Holdings and Deposits of Co-Operatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

716 Current Accounts of Citizens Involved in Individual Labour . . 744

720 Loans to Individual Persons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 685

722 Letters of Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52747

822 Limited Check-Books . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120500

823 Loans Granted to Other Banks

824 Loans Received from Other Banks

Resources Available on Reserve

Account in the USSR State . . . . . . . . . . . . . . . . . . . . . . 239693


825 Bank

Resources Transferred to Enterprises, Participation

In Their Economic Activities . . . . . . . . . . . . . . . . . . . . . . . 2504

890 Settlements Between Branches of the Bank . . . . . . . . . . . . . . 5397 . . . . . . . . . . . . . . 5397

904 Other Debtors and Creditors . . . . . . . . . . . . . . . . . . . . . . . . 92589 . . . . . . . . . . . . 170367

940 Operational Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

941 Anticipated Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

942 Low-Value and Quick-Depreciation Items . . . . . . . . . . . . . . . . . . 3

950 Resources Diverted out of Profit . . . . . . . . . . . . . . . . . . . . 153160

980 Profit and Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153160

TOTAL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3286651 . . . . . . . . . . . 3286651

continued


TABLE 4. EXAMPLE OF COMMERCIAL BANK BALANCE SHEET N THE RUSSIAN FEDERATION

(continued)

OFF-BALANCE SHEET ACCOUNTS (roubles)

Account

Number Name of Account Amounts

9921 Liabilities under Short-Term Loans (1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1158337763-00

99211 Liabilities under Short-Term Loans (2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208600-00

9925 Warranties, Securities Issued by Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122500000-00

9945 Part of Authorized Fund Unpaid by Bank Shareholders . . . . . . . . . . . . . . . . . . . . 43413710-58

9959 Strict-Reporting Forms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 584599969-40

9960 Sundry Values and Documents (Shares, Bonds) . . . . . . . . . . . . . . . . . . . . . . . . . 135804950-00

9961 Sundry Values and Documents Handed out on Accountability Terms . . . . . . . . . . . 5880000-00

99731 Forms of Shares, Bonds, Savings Certificates of Commercial Banks

Intended for Release (1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56890300-00

99732 Forms of Shares, Bonds, Savings Certificates of Commercial Banks

Intended for Release (2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8603000-00

9983 Received Permits to Issue Shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 990000000-00

TRANSITION TO A WESTERN SYSTEM OF PRESENTING BALANCE SHEET

Assets Liabilities

Cash 5421 . . . . . . . . . . . . . . . Due from banks

Due from Banks Total . . . . . . . . . . . . . . . . . . . . . . 756804

Total . . . . . . . . . . . . . . . . . . . . . 518066 Sight . . . . . . . . . . . . . . . . . . . . . . . 4


Sight . . . . . . . . . . . . . . . . . . . . . 397566 Time . . . . . . . . . . . . . . . . . . 765800

Time . . . . . . . . . . . . . . . . . . . . . 120500 Clients’ Deposits

Advances and Loans . . . . . . . . . . . . . 2159464 Total . . . . . . . . . . . . . . . . . 1509856

Overdue Depts . . . . . . . . . . . . . . 120500 Sight . . . . . . . . . . . . . . . . . 1144350

Securities . . . . . . . . . . . . . . . . . . . . . . 103335 Time . . . . . . . . . . . . . . . . . . 365510

Long-term Holding . . . . . . . . . . . . . . . . . 2504 Other Creditors . . . . . . . . . . . . . . 203757

Reserve Deposit at Other Liabilities . . . . . . . . . . . . . . 13624

The State Bank . . . . . . . . . . . . . . . 239693 Share Capital . . . . . . . . . . . . . . . 555886

Other Debtors . . . . . . . . . . . . . . . . . . . 104928 8 Reserve & Special Funds . . . 93564

Other Assets . . . . . . . . . . . . . . . . . . . . 153240 Profit & Loss Account . . . . . . . . . 153160

Total . . . . . . . . . . . . . . . . . . . . . . . . 3286651 Total . . . . . . . . . . . . . . . . . . . . 3286651

SOURCE: A. Androsov and A. Golubovich (1993). Financial Reporting and Accounting in Russia. Moscow, ARGOFinancial Services, pp. 203-205.


TABLE 5. BALANCE SHEET FORMAT FOR POLISH COMMERCIAL BANKS


ASSETS

I. Monetary resources and financial subjects:

1. Cash

2. Central Bank

3. International financial organizations

4. Bank foreign departments and branches

5. Operations with participation by banks and

other financial subjects

6. Operations with foreign exchange offices

7. Operations with post office institutions

II. Non-financial subjects

8. Credits for basic non-financial subjects

9. Credits for private persons

10. Credits for other subjects

III. Budgetary and nonbudgetary units:

11. Credits for the State Budget

12. Credits for community budgets

13. Operations with nonbudgetary

administrations and funds

14. Operations with community funds

IV. Securities (transferable, nontransferable,

constituting guarantees)

V. Various operations

15. Cashing and receivables collections accounts

16. Temporary accounts

17. Regulating accounts (interperiod clearings)

18. Various debtors

LIABILITIES

I. Financial resources and deposits of financial

subjects:

1. Bank issued travelers checks and notes

2. Central Bank

3. International finance organizations (debts)

4. Departments and branches

5. Operations with participation by banks

6. Operations with participation by foreign

exchange offices

7. Operations with post office institutions

II. Deposits of nonfinancial subjects

8. Deposits of basic nonfinancial subjects

9. Deposits of private persons

10. Deposits of other subjects

11. Special purpose funds

III. Deposits of budgetary and nonbudgetary units

12. State budget

13. Community budgets

14. Operations with nonbudgetary

administrations and funds

15. Operations with community funds

V. Bank issued securities

VI. Various operations

16. Internal clearing accounts

17. Inter-bank clearing accounts

18. Income of future periods


SOURCE: Alicja Jarugowa and others (1994). RachunkowoÑƒ Banków Komercyjnych. Warsaw, Centrum Edukacji i RozwojuBiznesu, pp. 108-109.


TABLE 6. INCOME STATEMENT FORMAT FOR POLISH COMMERCIAL BANKS

COSTS REVENUES

A. Costs of operations with financial subjects:

Interest

from operations with the National Bank

from operations with internationalorganizations

from operations with other financialsubjects

Provisions

Costs of operations with clients:

Interest

from operations with enterprises

from operations with private persons

from operations with other nonfinancialsubjects

Interest on deposits

Provisions and other costs

Costs of operations with budgetary and non-bugetary units:

Costs of operations with the State budget

Costs of operations with community budgets

Costs of operations with nonbudgetary units

Costs of operations with securities:

Other operating costs

A. Revenues from operations with financialsubjects

Interest

from operations with the National Bank

from operations with internationalorganizations

from operations with other financialsubjects

Provisions

Revenues from operations with clients:

Interest

from operations with enterprises

from operations with private persons

from operations with other nonfinancialsubjects

Provisions

Revenues from operations with budgetaryand nonbudgetary units:

Revenues from operations with the State budget

Revenues from operations with communitybudgets

Revenues from operations with nonbudgetaryunits

Revenues from Operations with Securities onBank’s Own Account

Other operating revenues

B. NET BANK PROFIT B. NET BANK LOSS

C. General costs:

Personal outlays

Operating costs

Costs of non-operating activities

Taxes and fees

C. Collateral revenues


continued


continued

COSTS REVENUES

D. GROSS OPERATING PROFIT D. GROSS OPERATING LOSS

E. Write-offs for amortization and provisions:

Write-offs for amortization

Provisions for receivables from financialsubjects

for unpaid receivables

for difficult receivables

for doubtful and litigious receivables

Provisions for receivables from non-financialsubjects:




Write-downs for financial depreciation ofsecurities

Write-offs to funds

E. Resolutions of provisions:

Resolutions of provisions for receivables fromfinancial subjects:




Resolutions of provisions for receivables fromnonfinancial subjects:




Resolutions of provisions for the financialdepreciation of securities

Provisions of reserves for funds

F. NET OPERATING PROFIT F. NET OPERATING LOSS

G. Extraordinary costs:

Bad debts written off

Decrease in securities’ values in connectionwith waiver of other extraordinary costs

G. Extraordinary revenues

Increases in securities’ values in connectionwith waiver of other extraordinary revenues

H. GROSS PROFIT H. GROSS LOSS

I. Profit taxes

J. NET LOSS J. NET PROFIT

SOURCE:Alicja Jarugowa and others (1994). RachunkowoÑƒ Banków Komercyjnych. Warsaw, Centrum Edukacji iRozwoju Biznesu, pp. 102-103.


TABLE 7. LISTING OF OFF-BALANCE SHEET ACCOUNTS FOR POLISH COMMERCIAL BANKS

DomesticCurrency

ForeignCurrency

Resident

Non-resident Resident

Non-resident

I. 1. OBLIGATIONS TO FINANCIAL SUBJECTS

2. OBLIGATIONS FURNISHED FINANCIAL SUBJECTS

3. Short-term lines of credit

4. Guaranteed documental credits

5. Credits incumbent on other institutions

6. Guaranteed checks

7. Other obligations

8. OBLIGATIONS RECEIVED FROM FINANCIAL SUBJECTS

9. Short-term lines of credit

10. Guaranteed documental credits

11. Credits guaranteed by other institutions


II. 13. OBLIGATIONS FURNISHED NONFINANCIAL SUBJECTS

14. Open guaranteed credits

15. Open documental credits - export

16. Open documental credits - import

17. Receipt for payment


III. 19. BUDGET-RELATED OBLIGATIONS

20. OBLIGATIONS FURNISHED

21. OBLIGATIONS RECEIVED

22. Credits for housing construction guaranteed by the State budget

23. Budget-guaranteed central investments

24. Other State-budget guarantees

IV. 25. FOREIGN CURRENCY OPERATIONS

26. CASH-EXCHANGE OPERATIONS

27. Purchased domestic currency to be received

28. Purchased or borrowed foreign currency to be received

29. Sold domestic currency to be disbursed

30. Sold or loaned foreign currency to be disbursed

V. 31. SECURITIES OPERATIONS

32. Securities to be received

33. Securities to be disbursed

34. Receipt for issuance

VI. 35. TECHNICAL ACCOUNTS

36. Exchange items (foreign currency accounts)

37. Equivalent value of exchange items (domestic currency accounts)


SOURCE: Alicja Jarugowa and others (1994). RachunkowoÑƒ Banków Komercyjnych. Warsaw, Centrum Edukacji i RozwojuBiznesu, pp. 108-109.


TABLE 8. CHARTS OF ACCOUNTS FOR FIVE COUNTRIES WITH TRANSITIONAL ECONOMIES


TABLE 9. FORMAT OF RUSSIAN BALANCE SHEET

ACTIVE PASSIVE

I. Capital assets and other non-liquid assets

Intangible assets:

historical costs* (04)

amortization* (05)

net

Property, plant and equipment:

historical cost* (01,03)

depreciation* (02)

net

Equipment for installation (07)

Capital investments-in-progress (08)

Long-term investments in securities (06)

Transactions with owners (75)

Other non-liquid assets

Subtotal I

I. Source of enterprise’s own assets

Stock capital (85)

Reserve fund (86)

Special fund (88)

Project financing and investments (96)

Lease obligation (97)

Transactions with owners (75)

Unused profit of previous years (87)

Profit:

current year* (80)

used* (81)

unused profit of the current year

Subtotal I

II. Current assets

Raw materials (10, 15)

Animals growing and on feed (11)

Small value short-lived assets:

historical costs* (12)

depreciation* (13)

net

Work-in-progress (20,21,23,29,30)

Prepaid expenses (31)

Finished goods (40)

Inventory:

sales price* (41)

mark up* (42)

purchase price

Distribution expense (44)

Added value tax for acquired goods (19)

Other current assets

Subtotal II

II. Long-term liabilities

Long-term bank credit (92)

Long-term borrowings (95)

Subtotal II

continued


continued

ACTIVE PASSIVE

III. Monetary assets, transactions, other assets

Transactions with debtors:

for goods, projects and services (45,62,76)

notes receivable (62)

with subsidiaries (78)

with federal budget (68)

with employees (73)

with other debtors

Advances to vendors and contractors (61)

Short-term investments in securities (58)

Cash:

cash-on-hand (50)

bank account (51)

hard currency account (52)

other cash accounts (55,56,57)

Other circulation assets

Subtotal III

Losses: previous years (87)

Total balance (sum of 080, 330, 340, 350)

III. Payments and other liabilities

Short-term bank credit (90)

Bank credits for employees (93)

Short-term borrowing (94)

Transactions with creditors:

for goods, projects and services (60)

notes payable (60)

wages (70)

social security (69)

property and personal insurance (65)

with subsidiaries (78)

non-budget payments (67)

with federal budget (68)

with other creditors

Advances from customers (64)

Unearned revenue (83)

Reserves for future payments and expenses (89)

Reserves for doubtful accounts (82)

Other short-term liabilities

Subtotal III

Total balance (sum of 480, 520, 770)

* These numbers are not included in the totals.

SOURCE: Russian Federation, Ministry of Finance (1993). The Supplement and Changes to the Regulation onAccounting and Reporting in the Russian Federation, June 4. Moscow, the Accounting Library.


TABLE 10. CORE ACCOUNTING COURSES OFFERED AT SELECTED POLISH UNIVERSITIES

SOURCE: Alicja jarugowa and Jerzy Marcinkowski (1994). Nauczania RachunkowoÑƒi w PolskichEkonomicznyc Uczelniach Wyzsóych, RachunkowoÑƒ, February, p. 20.


TABLE 11. EXAMPLES OF ACCOUNTING COURSE LISTINGS

AT THE UNIVERSITIES OF GDA¼¼SK AND ººÓDòò

Lect. Prac. Lect./Disc. Various

UNIVERSITY OF GDA¼¼SK

Department of Production Economics

Accounting area: 15 faculty

Economic analysis area: 8 faculty

Accounting majors: 45

Additional basic accounting courses:

Financial Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60 . . . . . 30

Specialized elective courses:

Bank accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 . . . . . 30

Auditing accounting records and financial statements . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Legal bases of accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

International accounting standards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

Financial auditing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . X

Financial analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60

Microcomputer utilization in accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . X

UNIVERSITY OF ººÓDòòDepartment of Economics and Sociology

Areas of Specialization:

Economic Cybernetics and Informatics;

Management and Marketing.

Teaching faculty: 8 plus 3 technical personnel

Accounting majors: 60

Economic Cybernetics and Informatics:

Basic courses:

Accounting information systems design . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 . . . . . . 30

Financial analysis-I . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Financial analysis-II computer assisted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

International accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Auditing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Auditing in a computerized environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

continued


TABLE 11. EXAMPLES OF ACCOUNTING COURSE LISTINGSAT THE UNIVERSITIES OF GDA¼¼SK AND ººÓDòò

(continued)

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Lect. . . . . . . . . . Prac. . . . Lect./Disc. Various

Elective courses:

Budgetary accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Bank accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Accounting for insurance institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Tax accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Modern accounting theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Computer-assisted financial decisions lab . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Management and Marketing

Core courses:

Introduction to accounting . . . . . . . . . . . . . . . . . . . 30 . . . . . . . . . . . 45

Financial accounting-I . . . . . . . . . . . . . 15 . . . . . . 15

Management accounting-I . . . . . . . . . . . . . . . . . . . 15 . . . . . . . . . . . 15

Required Courses for Accounting Majors:

Accounting for costs and results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Financial accounting-II . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Management Accounting-II . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Financial reporting and analysis . . . . . . . . . . . . . . 30 . . . . . . . . . . . 30

Financial management . . . . . . . . . . . . . 30

Accounting information systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Auditing-I . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . X

Utilization of microcomputer techniques in accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Lab

International accounting . . . . . . . . . . . . . . . . . . . . 30

Auditing-II . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Lec./Prac.

Elective Courses for Accounting Majors:

Seminar 7: (limited to 120 hours)

Market valuation of an enterprise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Modern accounting theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Tax accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Accounting system organization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Computerized analysis of statistical data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Lab

continued


continued

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Lect. . . . . . . . . . Prac. . . . . Lect./Disc. Various

Cybernetics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Information systems in enterprise management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Structural and ownership transformation . . . . . . . . . 30

Enterprise reform and bankruptcy proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Joint ventures in Poland and internationally . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

The securities market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Bank accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30


Governmental accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Inflation accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Financial accounting and reporting in concerns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Computer-assisted financial statement analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Lab

Computerized accounting systems design . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Lab

Useful microcomputer systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Lab

Data protection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Lab

Negotiation procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

New forms of work organization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Marketing tasks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30


Accounting for small firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Decision games . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Optimizing enterprise management decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Foreign currency and customs policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

International trade law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Computer-assisted decisions under uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Lab

SOURCE: Alicja Jarugowa and Jerzy marcinkowski (1994). Nauczania RachunkowoÑƒi a PolskichEkonomicznych Uczelniach Wyószych, RachunkowoÑƒ, February, pp. 20-21.


TABLE 12. EVOLUTIONARY STAGES OF GOVERNMENTAL FINANCIAL MANAGEMENT SYSTEMS

SOURCE: Adapted from Peter N. Dean (1988). “Governmental Financial Management in Development Countries”, inGovernmental Accounting and Auditing: International Comparisons, James L. Chan and Rowan H. Jones, eds.Buckenham, Croom Helm, pp. 149-174.


TABLE 13. POLISH PUBLIC SECTOR CHARTS OF ACCOUNTS

A. Chart of Accounts for Local Governments

Account

Numbers

Balance sheet accounts

133 Current budget account

134 Bank credits

140 Other monetary assets

222 Budgetary revenues clearings

223 Budgetary expenditures clearings

224 Settlements with the State budget

901 Budgetary revenues

902 Budgetary expenditures

Off-balance sheet accounts

991 Planned budgetary expenditures

992 Planned budgetary expenditures

993 Clearings with other budgets

B. Chart of Accounts for other Budgetary Units,Budgetary Institutions and Auxiliary Activities

Group

0 Fixed assets

1 Monetary assets and bank accounts

2 Clearings and claims

3 Materials and merchandise

4 Costs by nature and their clearings

5 Costs by type of activity and their clearings

6 Products

7 Revenues, Taxes and Subsidies

8 Funds, reserves and financial results

SOURCE: Barbara Bakalarska (1993). RachunkowÑƒ Jednostek i Zakladow Budóetowych oraz GospodarstwPomocniczych. Warsaw, Fundacja Rozwoju RachunkowoÑƒi w Polsce, pp. 21-23.


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Act XVIII of 1991 on Accounting (1994), in HungarianRules of Law in Force, Nr V9-10. Budapest, VerzalCo. Ltd.

Androsov, A. and A. Golubovich (1993). FinancialReporting and Accounting in Russia. Moscow, ARGOFinancial Services.

Bailey, Derek T, ed. (1988). Accounting in SocialistCountries. London, Routledge.

Bakalarska, Barbara (1993). RachunkowoÑƒ JednostekóiZakladow Budóetowych oraz GospodarstwPomocniczych. Warsaw, Fundacja RozwojuRachunkowoÑƒ i w Polsce.

Bali½ski, Jan (1994). “II Krajowy Zjazd Bieg»ychRewidentow”, RachunkowoÑƒ (March), pp. 109-112.

Berry, Maureen (1984). “Accounting in SocialistCountries”, in International Accounting, H. PeterHolzer, ed. New York, Harper & Row, pp. 409-452.

(1985). “The Current Status of the AccountingProfession in Poland”, Soviet and East EuropeanAccounting Bulletin, Vol. XIII, No. 2, pp. 92-100.

(1987). “Financial Accountability in West GermanGovernment”, in Advances in InternationalAccounting, Kenneth S. Most, ed. Greenwich, JAIPress Inc., pp. 39-84.

Berry, Maureen and Gertruda Krystyna Swiderska(1992). The Reshaping of the Accounting Function inPoland. London, Pergamon Press, pp. 1-23.

Business Central Europe, June 1993.

October 1993.

September 1994.

October 1994.

Business Eastern Europe, 9 May 1994.

22 August, 1994.

Central European Banking Review, June/July, 1994.

October 1994.

Cewe, Józef (1978). RaschunkowoÑƒ Budóetowa.

Warsaw, Wydawnictwa Szkolne i Pedagogiczne.

Chamber of Auditors, Czech Republic (1994). Act onAuditors and the Chamber ofAuditors of the CzechRepublic. Prague.

Comptroller General of the United States (1994).Government Auditing Standards, 1994 Revision.Washington, General Accounting Office.

Czech and Slovak Federal Republic (1991). Law onAccounting No. 563/1991 of 12 December. Prague.(English translation by Arthur Andersen & Co. SC.)

Dean, Peter N. (1988a). “Government AuditingStandards in Twenty-Five Countries”, in Advances inInternational Accounting, Vol. 2, Kenneth S. Most,ed. Greenwich, JAI Press Inc., pp. 231-244.

(1988b). “Governmental Financial Management inDeveloping Countries”, in Governmental Accountingand Auditing: International Comparisons, James L.Chan and Rowan H. Jones, eds., Buckenham, CroonHelm, pp. 149-174.

Deloitte Touche Tohmatsu international (1994). MeetingTax Obligations in Central and Eastern Europe.Budapest, International Bureau of FiscalDocumentation.

Enthoven, A.J.H. (1988). “The Future of InternationalStandards in Government Accounting”, in Advancesin International Accounting, Vol. 2, Kenneth S. Most,ed. Greenwich, JAI Press Inc., pp. 207-230.

Enthoven, A.J.H. and Jaroslav V Sokolov and Valery VKovalev (1994). Doing Business in Russia and theOther Former Soviet Republics: Accounting andFinancial Management Issues. Montvale, TheInstitute of Management Accountants.

Essinger, James (1994). Eastern European Banking.New York, Chapman & Hall.

Frydman, Roman, Andrzej Rapaczynski, and John S.Earle (1993). The Privatization Process in CentralEurope. London, Central European University Press.

Gazeta Bankowa, No. 44, 29 October 1994.

Gajl, Natalja (1986). Models Zarz�dzania iFinansowania Prz“dsiebiorstw Uspolecznionych.Warsaw, Panstwowe Wydawnictwo Naukowe.

Gol“mbiowski, Janusz W (1994). “Transforming thePolish Economy”. Warsaw, Warsaw School ofEconomics. Vols. I and II.


Gujarathi, Mahendra R. and Peter Dean (1993).“Problems of Recruiting and Retaining QualifiedGovernment Accountants and Auditors in DevelopingCountries”, in Research in Third World Accounting,R. S. Olusegun Wallace and others, eds. Vol. 2.London, JAI press Ltd., pp. 187-200.

Jaruga, Alicja (1987). “Governmental Accounting,Auditing, and Financial Reporting in EasternEuropean Nations”, in Governmental Accounting andAuditing: International Comparisons, James L. Chanand Rowan H. Jones, eds. Buckenham, Croon Helm,pp. 105-121.

Jarugowa, Alicja and others, 1994. RachunkowoÑƒBanków Komercyjnych. Warsaw, Centrum Edukacjii Rozwoju Biznesu.

Jarugowa, Alicja and Jerzy Marcinkowski (1994).Nauczania RachunkowoÑƒ i w PolskichEkonomicznych Uczeln iach Wyzszych,RachunkowoÑƒ (February), pp. 19-25.

Kurowski, Leon and Hanna Sochacka-Krysiak (1990).Kontrola Finansowa: Organizacja i Funkcjonowanie.Warsaw, Pa½stwowe Wydawnictwo Ekonomiczne.

Most, Kenneth S. (1991). “The Role of Accounting in thePreparation of Public Sector Decisions in DevelopingCountries”, in Advances in International Accounting.Vol. 4. Kenneth S. Most, ed. London, JAI Press Inc.,pp. 237-247.

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Republic of Bulgaria; Ministry of Finance (1992).Accountancy Act and National Chart of Accounts.Sofia.

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v. Grumbkow, Gunter (1984). SozialistischeFinanzkontrolle. Berlin: Verlag die Wirtschaft.

Winkle, Gary M., H. Fenwick Huss, and Chen Xi-Zhu(1994). Accounting Standards in the People’sRepublic of China: Responding to Economic Reforms.Accounting Horizons. Vol. 8, No. 3, September, pp.48-57.

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III. OVERVIEW AND CONCLUSION

The previous chapters provide a detailed picture of thecontext in which financial management takes place intransitional economies, factors in the economic andpolicy environment which have hindered or hastened thedevelopment of financial management, and insights intocurrent institutional aspects. This overview andconclusion will reiterate significant themes with regardto the government role in financial reform and inaccounting reform, and to the key role of the bankingsystem and of banking reform.

Financial management is a service primarily to thefinancial stakeholders-owners, creditors and the taxauthorities, who need to know what their “agents” aredoing with their money. This is as true in a centrally-planned economy as in a market-oriented economy. Thedevelopment of financial management is driven by therequirements of the financial stakeholders, whoseidentity changes in the transition from central planningto market-oriented planning. In economies movingtoward the market, and with a higher private share ofproductive activity, the need is for entrepreneurs and forentrepreneurial information, so financial management isprogressively recast to serve their needs.

An inhibiting factor has been the spread of the so-called“grey economy”—unregistered, non-taxpaying and notsubject to accounting norms and standards. The growingsize of the grey economy is an issue, for instance inHungary, where it is estimated to be responsible for 33per cent of GDP.

The growth of entrepreneurship, and hence of financialmanagement, is easier in countries in which some sectorsof the economy remained in private hands, since thisprovides a core of entrepreneurs who move into the“new” sectors opened up for entrepreneurship. In othercountries, the suppression of entrepreneurship was socomplete, and cultural values had for so long discouragedprivate entrepreneurial activity, that the re-emergence ofthe entrepreneurial function has naturally been slower,and financial management will develop at acorresponding pace.

In the latter case, the government has to take a strongerlead. The government cannot itself establish a market-only buyers and sellers can do that—but it can (a) createthe minimum legal and regulatory infrastructure, (b)decontrol prices and the free flow of goods so that pricescan respond to supply and demand, and (c) lead opinion,not least by showing its own commitment to the marketby privatizing its own assets and activities.

Transitional economies have made uneven progress in

establishing legal support for their emerging marketeconomies. New property laws have been introduced, butthey are still subject to restrictions, and implementationlags, particularly with regard to the establishment ofreliable land registration as a basis for transfers of titleand security for loans. Most countries have reformedtheir contract law and introduced new commercial codes,but there is a general paucity of remedies for breach ofcontract due to lack of a commercially-trained judiciary.Similarly, laws have been introduced coveringbankruptcy and competition in several countries, but arerarely applied or enforced. Company laws exist but areoften unclear.

Most transitional-economy governments have decon-trolled the majority of wholesale and retail prices.However, the emergence of economic prices whichequate supply and demand depends also on managers’knowledge of markets. Lack of experience, as well aslack of regulation of monopolies, have often resulted insupply/demand imbalances and wide dispersion of prices,so resource allocations are not yet determined by accurateprice signals. In some countries, subsidies are retained onkey items, such as food, medical care, rent, education,transport or fuel, as is the case in the Russian Federation,Ukraine, Uzbekistan, Turkmenistan and Mongolia.However, these administered prices are subject tocontinuous adjustment, and thus are moving towardeconomic pricing.

With regard to privatization, in most of the transitionaleconomies the level of State ownership and control hasbeen brought down to typical levels of the rich marketeconomies. The EBRD (1994) study of 25 transitionaleconomies in Eastern Europe and the former SovietUnion showed that the private sector generated 40 percent or more of GDP of 12 countries by mid-1994. AsProdhan and Kaser point out (chapter I), this is a rate ofchange paralleled only by the dynamic Asian economies.

According to Berry (Chapter II), reform has been easedby tapping financial know-how from the Western coun-tries, in particular the international accounting andconsulting firms, and by collaborations of various kinds(joint ventures, “twinning”) with Western banks.

This was least difficult in the East German Länder,which had access to know-how in their own country andlanguage. In other transitional economies, there arecontinuing problems of assimilation or adaptation ofconcepts and practices from other cultures. In Russia, forinstance, initial bank accounting reforms preserved manyfeatures of the old State system; this facilitated training,


but reduced—or delayed—the benefits of a more radicalchange. The political urgency of the transformationprocess has made it tempting to adopt foreign practiceswholesale, and this is sometimes welcomed by foreignconsultants who find it much easier to recommend whatthey know and are familiar with than to work with theirhosts in finding viable local solutions. There is someconcern that a wholesale approach is notpractical—effective policies are always country-specific.

The most difficult part of the process comes after policieshave been promulgated and laws passed. The benefits ofgreater efficiency then depend on the responses ofentrepreneurs and enterprise managers. Muchrestructuring turns on the introduction of managementincentives, whether by corporate bankruptcy or takeoverfollowing inefficient operation, or individual rewards andpenalties linked to performance; China, for instance, hasconcentrated on the latter. There has been a series ofexperimental reforms in enterprise management, whichhave tried to retain the residual powers of the State whilegiving managers more autonomy and rewards for goodperformance and/or penalties for bad performance. In1979, a system of profitsharing was introduced, whichallowed firms to retain a fixed proportion of their profitsand pay the rest to the State. The proportion rosegradually from 8 per cent to 22 per cent15. From 1985,the State stopped collecting depreciation funds andallowed these to be retained and reinvested by theenterprise at the discretion of the management.

How to reconcile equity with efficiency remains a leadingissue in most transitional economies. Equity calls for thedistribution of public assets to the people at large, not tothose who are most able to pay for them as a consequenceof their-illegal-amassing of wealth in an earlier regime.This implies free or near-free distribution of shares, as inseveral voucher schemes. Efficiency, however, requiresthat effective control of assets be in the hands of thosewho have entrepreneurial vision of how they can be mostproductively used. For this to take place, enterprises mustbe offered to the highest bidders and potentialentrepreneurs must be able to borrow. In voucherschemes, ownership is too dispersed for effectivegovernance, which leaves power in the hands of themanagers. However, if vouchers are tradeable-at the risk

of adding to inflation-and the trading machinery is inplace, it can be expected that property rights willeventually gravitate to those who value them highest.The equity goal is still served as the initial holders ofvouchers sell them at higher prices which final holdersare willing to pay; so, in theory, everyone gains.

In the initial phase of privatization, it was expected thatcapital markets would discipline managers who failed tomaximize the market values of their enterprises by thethreat of takeover. Pending their development, corporategovernance would be exercised by holders of majorityshares such as banks, investment funds and parententerprises, all of which would have the necessarybusiness expertise. They would monitor the performanceof enterprises, provide strategic inputs, and replacemanagers who were ineffective or corrupt.

In practice in many countries, managers and otheremployees have taken advantage of the interval betweenthe breakdown of State control and the emergence of newmarket-oriented controls to capture corporatedecision-making for themselves, and to block the issue ofshares to outside interests. In some cases, enterpriseassets have been sold off at low prices to new companiesowned by the managers, a form of “spontaneousprivatization”. Even where the central privatizationagency tries to introduce competitive bidding for theenterprise, the incumbent managers have a majorinformation advantage over other potential buyers, whichthey can reinforce by selective release of information andby “cooking the books”—i.e. using accounting methodswhich undervalue profits and assets—and/or outrightfraud. Mejstrik and Burger (1994, p. 210) say that, in theCzech Republic, the privatization process has been moreor less controlled by managers, following the dismantlingof State controls. Most managers are said to be operatingwithout contact with their new owners.

This is one of the more worrying tendencies in severaltransitional economies. While managers are gainingcontrol of their enterprises, the countervailing power ofshareholders is not being established or is even beingreduced. In some cases, minority shareholders, eveninstitutional shareholders like investment funds whichwere set up to provide professional backstopping of themanagement team, are being excluded from the man-agement process. In Slovenia, for instance, some man-agements are said to get perpetual proxies from pre-sumably ignorant small shareholders so as to maintaintheir dominance at annual general meetings. One mightexpect that equity-holding managers would try to max-imize the value of the firm, and that shareholder/man-ager agency problems would be reduced. On the contrary,managers maximize the benefits to themselves, of whicha share in the bottom line may not be the most

15Not all of this waspersonal reward—some of theretentions were provisions forresearch and development, butthese still added to thediscretionary power of themanagers.

Overview and Conclusions 148

significant.

The more pressing problem is with the exploitation ofminority shareholders by insiders. Investment fiends,even if they have adequate equity, do not have the ana-lytical and managerial resources to participate in theboard meetings of large numbers of companies. InSlovakia, for instance, a survey of investment fiendsfound that two thirds of them aimed to establish controlin not more than ten enterprises (Schmognerova, 1994,p. 229). One answer lies in better company law andcapital market regulation for the protection of investors,and in stronger enforcement.

1. Accounting reform

The authors of both papers describe the role ofaccounting in pre-transitional economies. In general,enterprises aimed to meet the State-planned physicalproduction quotas: accounting was used mainly to recordcash flows between enterprises and the non-State sector,that is, the payment of wages, and purchases fromhouseholds. Accounting was nothing more thanbook-keeping. All transfers of goods and servicesbetween State-owned firms were recorded by debits andcredits in the respective accounts at adminis-tratively-determined prices, based on estimates of theirlabour cost (omitting the opportunity cost of land andnatural resources16 and actual import costs (which wereat multiple artificial exchange rates). Firms could expectto be provided with whatever cash might be needed tocover any deficits, while any cash surpluses weresiphoned back to the State which controlled the bankaccount of the enterprise and handled certain transac-tions itself. Not being allowed to hold cash or a bankbalance from one accounting period to the next, enter-prises accumulated what they did have control over-physical assets and inventories—and falsely reportedinputs and outputs. When production was above thequota, it was under-reported not only to hide the surplusand hold it against future under-production (or for saleon the black market), but also to avoid targets beingraised. Vice versa, under-production was over-reported

so as to show that targets were achieved. Alternatively,the firm could claim a quality increase (Prodhan andKaser).

The prestige and power of accountants in the marketeconomies17 may be contrasted with the low status ofaccountants in the centrally-planned economies, whichis, however, rapidly rising in the transitional era. Theenterprise chief bookkeeper (the term “financial man-ager” overstated the role) was effectively a State comp-troller, operating according to State rules, and not part ofthe management team, as in market economies.

Accounting standards were set centrally and in greatdetail to meet planning needs; they were generally fol-lowed meticulously—although not necessarily honestly.Accounts were kept typically on double entry principles,and this added to the self-checking accuracy ofaccounting summaries. The accounting year usuallycoincided with the calendar year, and accounts wererendered to the State at the end of each year. Accountswere kept mainly on a cash basis, though Poland was anearly user of accrual accounting (Berry). Apart from thisoutstanding example, there was no matching of revenues(including accrued revenues) with expenses (includingaccrued expenses), so there was no measurement ofprofit.

Profit measurement has three purposes: to guide deci-sions on profit distribution, on output prices, and on

16The cost of capital was, inprinciple, included throughdepreciation of the capitalexpenditure. However, capitalexpenditure consisted only ofthe labour costs incorporatedin the asset. There was noconcept of opportunity cost ofcapital.

17“Accountants…stand tothe world of corporate businessmuch as the lawyer stood to the19th century world of rich men’sproperty. They are the priesthoodof industry: the morefragmented and diversified acompany becomes, the moreimportant becomes the man [sic]who can disentangle thethreads of profitability thatholds it together. Few people in avast company are in a position tosee over the tops of the trees. Anable accountant can, and fromhis knowledge comes his power.”(Anthony Sampson, Anatomy ofBritain, 1962, p. 466).This waswritten before the informationrevolution, but the latter hasnot affected the importanceattached to those responsiblefor financial management.


investment. None of these purposes applied in a cen-trally-planned economy. Distributions (to the solestakeholder) were not based on profit but on cash avail-ability. Prices were based on technical coefficients, whichwere only loosely founded on actual costs or profits. Theother potential use of profit measures—to guide resourceallocations—also did not apply, since allocations weremade on grounds of physical “needs” as estimated by thecentral planners. Similarly, there was no need forconsolidated accounts of groups of companies. Withinenterprise groups there was no elimination of intra-grouptransfers, and it is unlikely that this could have beendone effectively at higher levels of aggregation.

A feature of Soviet-style enterprise accounting was theuse of separate funds, each with its own assets and lia-bilities. The rules on what should be paid into each fund,and what could or should be paid out, were set by theState. This is similar to government accounting in mostcountries. In the market economies, the typical enterpriseoperates as a single fund, into which all receipts flow andfrom which all payments are made. Segregated fundsreflect the limited autonomy of their managers and, moreparticularly, the diversity of functions of the Soviet-typeenterprise, e.g. the social welfare functions required aseparate social fund.

Assets were recorded at their historical cost and depre-ciated on the straight-line basis, as prevails in accountingin market economies. The main difference was that assetlives were assumed to be longer, partly because Sovietplanners were not subject to the principle ofconservatism—they were not concerned with the dangersof overstating profit. Certain assets, such as land, mineralrights, intellectual property and goodwill were not paidfor, and accordingly they did not appear in Soviet-stylebalance sheets.

There was no practical distinction between equity capitaland loans, since nothing was repayable unless cash flowsallowed it. Banks had no credit intelligence and verylittle experience in credit-risk evaluation or loanmonitoring. Downstream, there was no bankruptcy or therecycling of resources to other managers; the onlypossibility was internal restructuring.

There was a failure to deal with inflation at the enterpriseaccounting level. The evidence from those countrieswhich have applied current cost accounting indicates thehighly distorting effects of GAAP18 historical costaccounting at even low rates of inflation maintained overa period of years. The impact of this distortion in terms

of misguided resource allocations is not known- norcould it be known unless all alternative allocations werereflected in inflation-adjusted accounts. However, ifeconomies rich in accountantssuch as the UnitedKingdom and the United Statesbaulked at theintroduction of inflation-adjusted external financialreports, this cannot be recommended for the transitionaleconomies, which are struggling with a lack ofaccounting and auditing skills.

The lack of a competitive environment and the loss ofCMEA markets precipitated a plummeting demand forgoods and services and loss of government revenue.“Managers lost their twin anchors of sellers’ markets andguaranteed financial support” (Berry). The transitionalstage began with enterprise illiquidity, layoffs, debtdefault, tax evasion and high instability in the politicaland economic environment. Personal opportunism andcorruption flourished in an environment in which lawand order appeared to have broken down. The old rulesno longer applied, and the new rules had not been set orwere not understood or were not enforced.

During the transition, inflation produced artificial prof-its19, which were often masked by declining sales. Inmany cases, profits were not matched by cash balances ascash flows were recycled into higher-cost working capitaleven if inventory and receivables had been kept at thesame physical levels. This might in some cases have beenoffset by reductions in physical inventory as managersfound that their material inputs were more available andstockpiles could be reduced. On the other hand, theliquidity crunch and high interest rates led to mountingaccounts receivable.

The transfer of social responsibilities to government—even if, in a context of mounting fiscal deficits, theresponsibilities are not met’—has been widely complet-ed, and has thus eliminated the need for enterprises to

18Generally acceptedaccounting principles

19Artificial profits arisewherever outputs are sold atcurrent price levels, while inputsare charged at the (lower) pricelevels at the time they wereacquired. The overstatement ofprofit is greater in proportionto the asset-intensity of the firmand the amount of inflation ofprices over the periodsinceacquisition. This is offset by theinflationary gain on(non-indexed) net credit to thefirm.


maintain non-commercial funds. This is reflected in thenew charts of accounts officially promulgated in severaltransitional economies. Funds may still be of importancewhere enterprises continue to hold monies assigned toemployee pensions, but these may be taken off enterprisebalance sheets and re-registered in the names ofappointed trustees.

Accounting reform has been driven primarily by (a) thedesire of transition economy governments to bring theiraccounting standards into line with the rest of the world,where the needs of private investors and creditors areparamount, and (b) new needs for State revenue. Alltransitional economies have shifted from direct taxationof enterprises as the main source of State revenue toindirect taxes—VAT in particular—and individualincome taxes. In Hungary and Poland, monthly accountswere introduced, principally to report turnover taxpayable (Prodhan and Kaser). Poland, which had a longexperience of accrual accounting, introduced in 1989 acompulsory dividend—in other words, a tax—onState-owned enterprises, calculated on the basis of theamount of State investment (Berry).

“Western-style” accounting was introduced in jointventures and in privatized enterprises to meet the needsof foreign investors. Since investors expect their capitalto be maintained, and that dividends should come onlyout of genuine profit, accrual accounting is a necessity.A special feature of joint venture accounting was therecording of foreign exchange transactions-apart fromtheir conversion to domestic currency for inclusion in theordinary accounts—because profit repatriation wascommonly limited to a proportion of the joint venture’sforeign exchange earnings (Prodhan and Kaser).

The main tool in the economic transformation is theapplication of modern techniques of financial analysisbased on accrual accounting. Neither the cash basis norcameral accounting provide owners and their managerswith measures of profit, its breakdown over product lines,or meaningful analysis of variances between budget dataand actual results. Full accrual accounting is the onlybasis for executive decision-making where economicefficiency is an important objective. However, itsintroduction is resisted by business where it results inhigher tax liability due to profits from sales which are notyet collected, or even collectible. Generally acceptedaccounting principles require loanloss provisions to becharged against profit—the fiscal code should allowthese expenses to be correspondingly deducted fromassessable profit. Czech businesses, for example, face taxassessments which make no allowance for doubtfuldebts-they are seeking tax relief from this anomaly.

The mobilization of resources is also dependent on

financial standards. The supply of external resources forinvestment is a function of risks and returns, as seen byinvestors. Perceived risk is substantially reduced bytransparent access to information, in a meaningfullystandardized form in which it can be read and used byinvestors. The widespread adoption of GAAP andinternationally recognized standards of reporting anddisclosure are key factors in the attraction of foreigninvestment and the development of capital markets.

2. Banking reform

Both papers highlight the importance of financial man-agement in enterprises in the financial sector, principallythe commercial banks, because of (a) their role, interalia, as intermediaries between suppliers of savings andusers of investment funds, and (b) their no less importantrole as intermediaries and apostles in the disseminationof market philosophy.

According to surveys, entrepreneurs repeatedly rank lackof access to capital as their foremost problem. Despite thetendency of entrepreneurs to “monetize” their problems,and the consequent need to interpret survey results withcare, there appears to be no doubt that the emergence andthe growth of enterprises— especially small andmedium-sized firms—is significantly constrained by lackof credit at a price that the entrepreneur can afford topay. Berry comments that market economies are built upthrough the main mechanism of small entrepreneurs, butthat this cannot happen until they can get adequateaccess to working capital. In the early stages, someentrepreneurs get credit from informal sources such asfamilies and friends—as in the early development ofHong Kong— but this is not available to all potentialentrepreneurs and is liable to be inappropriately allocatedon non-commercial criteria. Even if credit is formallyavailable, it must be accessible to the entrepreneur andon terms that can be met from cash flows: in thetransitional economies, interest rates were, initially, oftenimpossibly high.

This is very relevant to the question of sequencing ofreforms. Some minimum package of financial sectorreform is necessary at an early stage of transition to setthe framework for credit allocations based on prospectiveprofit (Roe, 1992; Borish, 1995).

The importance of the banking sector is also implicit inBerry’s opinion that “the bankers’ current use of finan-cial information in the credit-granting approval processmay well be one of the most important ways that anunderstanding and appreciation for accounting-basedfinancial information may be diffused throughout thehost environment”. The supply of reliable financial


information is driven by demand, and a principal sourceof demand is from credit-granting agencies which arethemselves constrained to make a profit.

The reform of banking in the transitional economies hasa number of common elements as follows:

a. The separation of commercial banking functions(deposit-taking, lending, foreign trade facilitation,etc.) from central monetary authority functions(monetary management, clearing mechanisms,serving as banker to the government and to otherbanks, refinancing other banks, supervising financialinstitutions, and research), i.e. the creation of atwo-tier structure, as in China (1984), Hungary(1987), USSR (1988), Poland (1989) andCzechoslovakia (1990);

b. The introduction of the “winds” of competition byderegulating commercial banking, licensing newentrants subject to capital adequacy and otherrequirements, and admitting foreign banks, as in theRussian Federation from mid-1994;

c. The restructuring of banks, including the appraisal ofinherited portfolios of loans and investments, and lossprovisioning;

d. Privatization of State-owned commercial banks, e.g.on a regional basis, as in Poland, and greaterautonomy given to the central bank;

e. Training and professionalization of bank staff, e.g. bythe introduction of banking diploma programmes;

f. The introduction of strategic planning into com-mercial banks, and their reorganization to reflect themarketing function, as well as assets management,liabilities management, risk management andinformation support systems;

g. Central supervision of bank liquidity and solvency,based on law, standardized reporting and early-warning systems;

h. the introduction and mandatory use of new market-oriented charts of accounts, based in most cases on theEU amended Fourth Directive (1986) and/or theInternational Accounting Standard No. 30;

i. computerization and networking, subject to thelimitations imposed by the telecommunicationinfrastructure;

j. The spread of branch banking, inter-bank paymentsystems to speed the transfer of money (which tookseveral weeks in the former USSR), and a wideningrange of services;

k. The emergence of capital and money markets.

Bank accounting reform in Poland from 1991 has beencontrasted with that of the Russian Federation. Poland,like other countries seeking entry to the EU, adoptedmost of the requirements of the Fourth Directive (1986)and International Accounting Standard No. 30. Theforms have been adopted and the concepts translated, butmuch training is still needed. Russian bank accountingreform, though it started in the Soviet era (1988), hasbeen criticized (e.g. by Enthoven and others, 1994) for itsfailure to present a fair picture of solvency, liquidity andprofitability. Russia is considering the German/Japanesemodel of banking. A four-stage plan of reform has beenlaunched.

Accounting reform provides a good opportunity forcomputerization and several transitional economies areengaged in computerizing their operations. Large banksin Central Europe are installing integrated systems bywhich head office databases are continuously updated forbranch operations. This facilitates overall liquiditymanagement, decentralization of services, and super-vision of customers having accounts with severalbranches. Problems include poor telecommunications andfrequent changes in regulatory regimes, as well as thelogistical problems of training large numbers of staff.

The transfer of responsibility for financial viability fromthe State to the individual bank cannot be successfulwithout a strategy for eliminating from the bank’sbalance sheet the dead weight of non-performing loans,mainly to SOEs. These bad loans are estimated toaccount for between 4 per cent (in Estonia) to 50 per cent(in Albania and Bulgaria) of total loans (Borish 1995).The debtor enterprises cannot be privatized while theyhave so much outstanding debt, while the bank cannotwrite off loans before the firm has been assessed forpossible turnaround; nor can it show a good balancesheet and raise fresh capital for lending.

There is no consensus on how to deal with non-per-forming loans: transitional economies have used variousapproaches (Dhar and Selowsky, 1994). One approach isto do nothing. This allows inflation to reduce the realburden of debt (which is almost always a fixed monetaryamount)— the bank loses and the enterprise gains. If theenterprise finds a viable line of business, it can startrepaying past loans. However, doing nothing may not bethe best option for the economy if the enterprise fails toturn around. A second option is to recapitalize the banks,but it is argued that doing this before they haveincentives to allocate the new capital on a commercialbasis compounds the error, or even rewards the error.The government can protect the depositors by taking over(“carving out”) all the bad loans at their face value andreplacing them by treasury bonds, guarantees or cash.The government then sells off the loans for whatever they


fetch. This is equivalent to recapitalization, and may donothing to make bank managers more commercial,unless the bank is privatized.

A third option is to undertake bank and enterpriserestructuring simultaneously. This may be led by thegovernment (the centralized approach) or by the banksthemselves (the decentralized approach). In the central-ized approach—as in Romania—the government selectsenterprises in critical financial condition, isolates themfrom the banking system, and transfers the responsibilityfor their management to a central restructuring agency.The agency examines the possible future viability of eachenterprise, and makes recommendations on liquidationor privatization. The government supports restructuringby allowing an interest rate policy which provides anadequate margin, as in the Czech Republic, where theKomer…ni Bank was able to build up loan loss reserves,and eventually be privatized.

The decentralized approach attempts to solve the prob-lem by offering incentives to the banks to restructuretheir troubled clients. In Poland, for example, banks arerecapitalized by the Government and managers are givenequity stakes. This motivates them to maximize debtrecoveries and to move toward their own privatization.Debt-equity conversions give the bank managers controlover the debtor enterprises. The bank then solicitsreorganization proposals from other creditors, fromoutside investors or from the enterprise managers—theso-called conciliation process. Nonviable enterprises arewound up or, if they are politically sensitive, temporarilykept afloat by subsidies from a Government InterventionFund. The main danger in this approach is that ofcollusion between the bank and the enterprise at theexpense of the Government. The incentive design iscritical. All restructuring is difficult and lengthy, andrequires commercial acumen and skills which are inshort supply. Nevertheless, the alternative is unselectiveliquidation, or worse—a domino collapse. Thesuperiority of a decentralized approach is predicated onthe rationale that incentives are easier to apply and moreeffective at the bank level than at the government agencylevel.

Loan hospitals and work-out departments have similarobjectives-to maximize the return from bad loans—whether by foreclosure, which is rare, by selling the loanat a discount, or by working to turn around the debtorfirm and enable it to restart loan service. Berry points outthat the preoccupation with problem loans prevents otherdevelopments such as small and medium-size enterprisebusiness. Work-outs also suffer from the usualconstraints of high administrative cost and high riskattaching to small undiversified firms. Governmentinterest policy and inflation are also important

constraints.

Liquidation of irretrievably nonviable enterprisesremains problematic. In the transition period, while theState still owns most enterprises, it is difficult to imple-ment bankruptcy reform. Prodhan and Kaser contrast theapproaches of Poland and Hungary. In Poland, asmentioned above, nine State banks were given respon-sibility for restructuring 2,000 enterprises which wereilliquid. If this was resisted by the enterprises, or provedimpossible, liquidation was the final resort. In Hungary,a strict procedure was initiated in 1992, which requiredan enterprise to file for bankruptcy or liquidation if itdefaulted on any debt for more than 90 days. Out-of-courtsettlements with creditors parallel the Polish conciliationprocess.. Except in Hungary, bankruptcy laws remainweak and unenforced, due to the social implications aswell as to the lack of capacity for the process.

The prudential regulation and corporate governance ofbanking activities are treated separately from those ofnon-banking activities. New laws and accounting regu-lations underpin bank supervision, which is beingstepped up in the Czech Republic, Hungary, Poland andSlovenia. Berry emphasizes the importance of indepen-dent and expert supervision with no conflicts of interest.

An issue highlighted by Prodhan and Kaser is that ofcapital adequacy. The international standard defined bythe Basle Committee of the Bank of InternationalSettlements has been adopted by some countries—suchas Hungary and Latvia—but they warn that the calcula-tion of regulatory ratios depends on the underlyingaccounting classifications, such as the categorization ofassets according to their risk characteristics, and theloan-by-loan assessment of loss provisions. Moreover, theconventional capital adequacy ratio does not cover otherkinds of risk such as interest rate risk, risk attaching tooff-balance sheet items and portfolio concentration risk.It is important, for instance, to limit exposure onindividual accounts—this improves diversification andreduces risk.

Another common issue is whether some bank functionscould be performed by non-bank firms, or by firms underthe control of non-bank firms. In the Russian Federation,many banks are set up and controlled by industrial firmswhich use them as conduits for relatively cheap financefrom interbank currency markets. Conversely, banks takeequity stakes in industry; though this has worked well inGermany and Japan, these cases may be exceptional.Cross-ownership complicates the supervision of bankliquidity and solvency, and is not recommended in thetransitional economies. It is concluded that they shouldgenerally aim for an arm’s length relationship betweenbanks and non-banks.


Another issue is the depoliticization of banking. Despitethe success of some Asian economies with highlyinterventionist governments—such as South Korea—theprevailing orthodoxy is that the transition to the marketimplies that banks should be allowed to make lendingdecisions according to their perception of market risksand returns, without subordination to political direction.However, in the aggregate, bank decisions haveimportant macro-effects for which politicians are heldresponsible; they are, of course, also blamed for themicro-effects. The issue of shared responsibility is mostprominent at the central bank level: while many Westerncountries have achieved separate autonomy for theircentral banks, the transitional economies are still subjectto an instability which requires strong central controlover the banking sector, but not a control which is subjectto populist pressures.

3. Conclusion

Financial restructuring and the development of newfinancial management institutions and practices havebeen driven by the political urgency of economic trans-

formation under deteriorating social conditions and, inthe Visegrád countries, by the desire to meet the admis-sion requirements of the European Union. The Stateaimed to create a market economy through stabilization,liberalization, deregulation, privatization, bankingreform and enterprise restructuring. Since price liberal-ization resulted in rapid inflation, the “big bang” reformrequired simultaneous price stabilization. According toProdhan and Kaser, the shock therapy of massive Statedisinvestment was intended, inter alia, to pre-empt thepolitical backlash engendered by the initial hardships oftransition. The counter-argument is that a gradualistapproach allowing more time for the development offinancial, banking, legal and accounting services, andmore time for training, retraining and natural attrition,might have pre-empted much of the hardship (see, forinstance, Metcalf and AmbrusLakatos, 1992). Akyuz(1994, p. 22) comments that, while serious economicmacroeconomic disorder, such as hyperinflation, mayrequire shock therapy, the same approach to structuraland institutional change causes more shock than therapy.On the ideal pace of financial reform andinstitution-building, the jury is still out.


REFERENCES

Akyuz, Yilmaz (1994). “Reform and Crisis in theTransition Economies”, in Privatization in theTransition Process: Recent Experiences in EasternEurope. UNCTAD, Geneva.

Borish, Michael S. and others (1995). “Banking Reformin Transition Economies, in Finance andDevelopment, September. World Bank, Washington.

Dhar, Sanjay and Marcelo Selowsky (1994). “Dealingwith the Bad Debt Problem in Transition Economies”,in Finance and Development (June). World Bank,Washington.

EBRD (1994). Economic Transition in Eastern Europeand the Former Soviet Union Transition Report(October). European Bank for Reconstruction andDevelopment, London.

Enthoven, A.J.H. and others (1994). Doing Business inRussia and the Other Former Soviet Republics:Accounting and Financial Management Issues. TheInstitute of Management Accountants, Montvale.

Mejstrik, Michael and James Burger (1994). “Vouchers,Buy-outs, Auctions: the Battle for Privatization in theCzech and Slovak Republics”, in Privatization in theTransition Process: Recent Experiences in EasternEurope. UNCTAD, Geneva.

Metcalf, Gilbert E. and Lorand Ambrus-Lakatos (1992).“The Optimal Rate of Privatization in DynamicEconomy”, in Public Finance in a World ofTransition, Pierre Pestieau, ed., Proceedings of the47th Congress of the International Institute of PublicFinance, St. Petersburg, 1991. Supplement to PublicFinances, Vol. 47 (1992), pp. 172-183.

Roe, Alan (1992). Financial Sector Reform inTransitional Socialist Economies. EconomicDevelopment Institute, Washington.

Schmognerova, Brigita (1994). “Privatization inTransition: Some Lessons from the Slovak Republic”,in Privatization in the Transition Process: RecentExperiences in Eastern Europe. UNCTAD, Geneva.

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