International Accounting Standard 21 (IAS 21) - The Invisible virus in the

economic system or a powerful economic weapon

International Accounting Standard 21

The Effects of Changes in Foreign Exchange Rates
Objective
1 An entity may carry on foreign activities in two ways. It may have transactions in foreign
currencies or it may have foreign operations. In addition, an entity may present its financial
statements in a foreign currency. The objective of this Standard is to prescribe how to include
foreign currency transactions and foreign operations in the financial statements of an entity
and how to translate financial statements into a presentation currency.
2 The principal issues are which exchange rate(s) to use and how to report the effects of
changes in exchange rates in the financial statements.
3 This Standard shall be applied:
(a) in accounting for transactions and balances in foreign currencies, except for those
derivative transactions and balances that are within the scope of IAS 39 Financial
Instruments:Recognition and Measurement ;
(b) in translating the results and financial position of foreign operations that are included in
the financial statements of the entity by consolidation, proportionate consolidation or the
equity method; and
(c) in translating an entity’s results and financial position into a presentation currency.

How is the international accounting standard presented as an invisible virus in the economic
system or a powerful economic weapon?

Let's go back in the not so distant past - the end of 2008. In late 2008 in Serbia, there was a
strong depreciation of the dinar (national currency in Serbia). Of course economic analysts
immediately have found different explanations for the fairly strong depreciation of the dinar. In
the early 2008 the euro exchange rate was 82 dinars for a euro, and during 2008, the dinar
(national currency-možda da obrišeš, već si napisao ranije da je to nac. valuta) was even
strengthened against the euro, so that in September the euro was worth about 76 dinars, and then
– a shock! From September 2008 until 31.12.2008. value of the dinar was depreciated to an 88.6
dinars for one euro. Many economists and economic analysts have interpreted this dinar
depreciation in various ways - the withdrawal of capital, an increase in imports, etc. All of this
may have affected the value of the dinar, but it was curious how much the banks benefited by
this weakening of the dinar, and whether there might be something else that might, perhaps have
to be considered when analyzing the weakening dinars. As it is usually the case when you are
looking for one thing, you find quite another. Comparing the quarterly financial statements of
Banca Intesa (one of leading comercial bank in Serbia), I noticed that in the third quarter of
2008, the quarter when the dinar strengthened against the euro, compared to the beginning of
the year, there was a significant positive exchange rate differences (net income/loss on foreign
exchange transactions) of about 3.9 billion. In the last quarter, at the end of 2008, when there
was a significant depreciation (weakening) of the dinar, there was a negative exchange rate
difference which was -8.8 billion, ie. 41% of the interest income!? These are just numbers that
should be explored more. The item net gain/loss on exchange rate differences in the income
statement, is deducted from taxable income or is added on taxable income depending on whether
the item is negative or positive, ie. profit for the year is increased or reduced pre-tax. Here is a
simplified example.
Example 1 - Depreciation of the dinar (year 2008) in 000 rsd

Interest income 21,584,582

Interest expense - 8,347,626
Net profit 13,236,956
Foreign exchange differences -8,793,502
Profit 4,443,454

This simplification of the income statement shows how much negative exchange rate differences
reduce profit at the end of the accounting period in the case of depreciation (weakening) of the
currency. Of course on this reduced tax base we apply profit tax, which in the case of a Serbia
was 10% and after a change in the tax rate is 15%. In example 1, if we exclude the negative
exchange rate difference, according to the tax rate of 10%, tax would amount to about 132
million RSD or about 1.5 million euro. When we include negative exchange rate difference in
the income statement, then the tax is around 4.4 million rsd or 500 thousand euro. This is just an
example of how one accounting category (IAS 21) can significantly affect the operating result
(profit) and it also has strong implications for the overall economic system.

Table1. shows data for the six banks that have made foreign exchange losses in 2008, 2009 and
2010-the year. Loss of profit tax of these six banks due to foreign exchange losses for all three
years, totals about 110 million euros. Of course the loss for the country is much higher because
the other banks also had foreign exchange losses, especially banks with foreign ownership
structure. And that is not all, the loss of economies is far greater, but that will be presented
later.
Table1
2008 2009 2010
Banca Intesa -8.793.502 -99.249 -9.925 -7.162.454 -74.702 -7.470 -13.798.805 -130.807 -13.081
Hypo Alpe-Adria -7.932.660 -89.533 -8.953 -3.976.968 -41.479 -4.148 -9.774.712 -92.660 -9.266
Komercijalna banka -3.604.499 -40.683 -4.068 -4.758.595 -49.631 -4.963 -7.371.170 -69.876 -6.988
Société Générale -3.120.284 -35.218 -3.522 -2.933.414 -30.595 -3.059 -5.601.082 -53.096 -5.310
Raiffeisen banka -5.286.122 -59.663 -5.966 -2.669.919 -27.846 -2.785 -5.769.539 -54.693 -5.469
Unicredit bank -3.923.660 -44.285 -4.429 -2.853.871 -29.765 -2.977 -8.469.559 -80.288 -8.029
-32.660.727 -368.631 -36.863 -24.355.221 -254.018 -25.402 -50.784.867 -481.419 -48.142
Source: National Bank of Serbia.
The first column for each year represents the negative exchange rate difference in dinars (expressed in RSD 000),
the second column represents the negative exchange differences in euros (reported in 000 euros), and the third
column represents the loss of profit tax at the rate of 10% in euros (reported 000 euros)

Foreign exchange differences are in fact accounting categories related to exchange rate changes,
and they are governed by the International Accounting Standard 21 (IAS 21). The application of
this standard rather maskes (hiddes) real profits of banks and companies, due to the depreciation
of the national currency, in the case of banks, profit rises because of the application of foreign
currency clause, on the other hand, profit decreases due to foreign exchange losses. In fact, using
the exchange rate losses in case of depreciation of the national currency, we have only the lower
base ie. profit for taxation at the tax rates (companies have a somewhat different situation). In the
case when there is an appreciation of the national currency the opposite situation arises. Banks
profit grows due to foreign exchange gains, however, positive exchange differences are not large.
For instance, at the end of 2011, the dinar has appreciated against the euro by 0.8% compared to
the beginning of 2011. Income tax expense increased as a result of foreign exchange gains due
to the strengthening of the dinar, and amounted to about 5.5 million euro for the six
aforementioned banks.
In recognition of exchange gains/loses in the income statement at the end of the year, foreign
exchange rate at 31.12 is important. If you look at the movement of the exchange rate in Serbia,
it is easy to notice that the weakening of the dinar's value (depreciation) comes in the last quarter.
Can commercial banks deliberately influence the weakening of the dinar and the creation of
negative exchange rate differences? Yes, they can. But all countries are not in identical
situations. For example, in the United States (US) and Germany such situations do not exist.
International accounting standard 21 deals with transactions in foreign currencies or foreign
commerce and it is unlikely, for example, that companies or people in the United States take out
loans in euros and have foreign currency clause as a hedging instrument. Similarly, in Germany,
companies and households borrow in euros. Commercial banks in the United States and
Germany also have the effect of exchange rate changes which affects the operating result, but in
the context of international accounting standards 39. The effect is much smaller. See the
following links that show the financial statements of commercial banks in the United States and
Germany (in terms of the market-leading banks)
 Landesbank Berlin Holding (Nemačka)
http://www.lbb.de/landesbank/en/10_Veroeffentlichungen/10_finanzberichte/010_LBBH/inde
x.html
 Deutsche Bank (Nemačka)
https://annualreport.deutsche-
bank.com/2013/ar/servicepages/downloads/files/dbfy2013_financial_report.pdf#page=328
 Bank of America Corporation, 2013 Annual Report (SAD)
http://media.corporate-ir.net/media_files/IROL/71/71595/AR2013.pdf
 CITIGROUP (SAD)
http://www.citigroup.com/citi/investor/qer.htm
On the other hand financial reports of commercial banks in Russia or other less developed
economies show that net gain/loss on exchange rate differences have an impact on profit before
tax. See financial statements of Unicredit Bank and Sberbank of Russia.
 UniCredit Bank Russia
http://www.unicreditbank.ru/eng/about/reports/2013.wbp
 Sberbank
http://www.sberbank.ru/en/shareandinv/financialresultsandreports/ifrs/
Although we started from the financial statements of commercial banks and pointed how IAS 21
affects the operating result, ie. profits of commercial banks in less developed and
underdeveloped economies, the aim of this analysis is to show influence of the
aforementioned accounting standard on the overall economic system. Companies as well as
commercial banks also follow international accounting rules, and apply IAS 21 in the preparation
of financial statements. For example, the statement Kiril Kravchenko (CEO NIS) about the
company profit of NIS (oil company), says that the profit in 2014 was 42% lower compared to
the year 2013, and that one of the reasons is the negative exchange rate difference of 13,2
billion. This is the best illustration of the devastating effect of the application of IAS 21 on the
economy. Many companies have a profit decrease in its income statement in the year when there
is a depreciation of the national currency, and largely because of foreign exchange losses. This,
of course, has multiple negative effects on the overall economic system.

The first negative effect is the reduction of budget revenues due to the reduction of profit tax
revenues. Serbia has raised profit tax rate from 10% to 15% but due to foreign exchange losses,
tax base was decreased and increasing tax rates do not contribute to raising significant tax
revenues from corporate profit, evan, often leads to the reduction of profit tax. Also, if a
company has a credit, foreign exchange clause in the case of currency depreciation increases the
cost in the income statement and further reduces the profits i.e. the tax base.

Another negative effect is the fall in stock market indices, and thus reducing the income of
individuals and hampered the ability of companies through stock market operations to provide
the necessary capital. We can not trust in ROA (return on asset) and ROE (return on equty)
because the profit before tax decreased due to IAS 21 in a situation when we have a
significant depreciation of the national currency.

The third negative effect is refracted through the currency mismatching ie. situations when
revenues are in the national currency and liabilities (loans) are in foreign currency. The budget of
each individual is reduced due to increased expenditure, as a consequence of the depreciation of
the currency, and thus consumption is reduces, which ultimately leads to a decrease in tax
revenues. Of course, now is reduced value added tax (VAT), excise taxes, etc. - consumer taxes
and fees.

The consequences of IAS 21 are increasing deficit in budget, which is followed by restrictive
fiscal policy in order to reduce the budget deficit (recommended medicine for recovery), and of
course, a negative effect on the growth of gross domestic product, employment, living standards,
etc ... How does it work in practice ? First, international accounting standard create problem in
terms of the reduction of the gross domestic product and a decrease in tax revenue. Due to this,
budget deficit is growing. Then, borrowing is rising to finance deficit in budget. Public debt is
growing and the next is an urgent call to the International Monetary Fund (IMF) as the duty
doctor who applies restrictive fiscal policy no matter of disease. Generally known methods of
treatment when you let the blood (reduces aggregate demand) to anemic persons (economies)
for the purpose of healing. Do I blame the IMF? NO! IMF sees problem in high budget deficit,
and they attempt to solve the problem. What do not economists of IMF see? They do not see the
devastating effects of IAS 21 in the developing and underdeveloped countries. I do not blame
IMF because I've never noticed that any of the world's economists pointed to this problem, and
initiated the change of the international accounting standards. The initiative this time must
come from an economist, not of those who are engaged in accounting. But to get back on
topic, I reproached myself personally, if I did not inform the the public about the knowledge
about this.

Last year (at 31.12.2014) dinar depreciated 5,3% against the euro, 16.42% against the dollar and
6.96% against the Swiss franc. Based on this relationship of dinar and other currencies, foreign
exchange losses will be quite large. Unfortunately, during the year 2015 there will be new attack
on the economy through foreign exchange losses, when the Fed (Federal Reserve) raise its
benchmark interest rate, which means that it will strengthen against the euro. Since the dinar will
weaken against the euro and the euro will weaken against the dollar, this means that dinar will
depreciate stronger against the dollar than the euro. All who have obligations in dollars will meet
high costs in terms of servicing their obligations. It will be interesting to see off explanations for
future depreciation of the dinar in the second half of 2015. So far, the Serbian economists were
raced in bringing meaningless causes and reasons for the depreciation of the national currency,
no one notices the deleterious effects of IAS 21. One of the last explanation that comes from the
National Bank of Serbia (NBS), claims that for stability of the dinar particularly is important to
ensure the operation of the Smederevo steel!? This last explanation, which comes from NBS,
from the monetary sector, particularly worries me because, not because of Alice from
Wonderland, she is already, unfortunately, fell into a coma reading the previous text about Fiat. I
am worried because of Harry Potter who came to visit Alice from wonderland. If Harry Potter
hears about this magic from NBS and the Government of Serbia in connection with the economy,
he will leave the school in the UK to study the Serbian economic magic.

IAS 21 is an economic weapon, which is imperceptible, yet very powerful. As long as

International Accounting Standard 21 (IAS 21) in its present shape and form is in the force,
developing countries and least developed countries, or rather all countries except the G7, will
have serious economic problems. It will be especially interesting to see events with fiscal
revenues in Russia in this year. In fact at the end of the year (31.12.2014.) Russian ruble
depreciated against the euro by 34.25% against the dollar by 41.9%. Today (March year 2015)
ruble is recovering and such a scenario can hide the main problem - the negative effect of IAS 21
on fiscal revenues.

Also, it will be very interesting to see the announced sale of Serbian national company Telekom.
In fact, it is more important to consider the period of implementation of the contract on the sale
of the company than potential sales price of Telecom. Why? First, if sales would be early in
2016, then the IAS 21 through its negative effects will melt most of the capital from the sale of
state-owned telecommunications company Telekom. Second, if the realization of sales would be
at the end of 2015, the Government may with clever policy of spending capital from sale of
Telekom, neutralize the negative effects of IAS 21. Suppose that the government, as in previous
cases of sales of large state systems, will have a special foreign exchange account at the National
Bank of Serbia. This way, the Ministry of Finance may in agreement with NBS prevent
significant depreciation of the dinar at the end of the year. It would be even advisable that
national currency dinar slightly strengthenes (appreciates) against the euro in order to mitigate
the negative effects of exchange rate differences due to the strengthening of the dollar against the
euro. This way, we can increase revenues during fiscal year 2016. Otherwise we will have a new
reduction in pensions and salaries.

The NBS and Fiscal Council are represented by very professional people, and I hope that after
this text they will realize a totally new dimension, and will not allow the creation of new
economic problems which are the result of IAS 21. Although, honestly, I still worry about Alice
from wonderland and Harry Potter.

The negative effect of IAS 21 can be reduced or even completely neutralized if the central bank
intervenes in the foreign exchange market (at 30.12 and 31.12), in order to closer value of
national currency at the beginning of the year. This way, we would prevent large losses on
foreign exchange. Commercial banks would still make profit during the year in the situation
when we have depreciation of the currency through binding of its assets through foreign currency
clause, but at the end of the year they would paid far higher profit taxes.

What are the situations in question, speaks to that the cost of intervention of say 100 million euro
in the foreign exchange market, in the case of Serbia, would returne more than ten times trough
increase in tax revenues. Serbian economy has lost 16.5. million euro of profit tax revenue from
one company due to foreign exchange losses in 2014!

This analysis is addressed to many economists from developing countries where the
problem is very pronounced and also, analysis has been sent to the addresses of
economists from developed countries in order to initiate a comprehensive initiative on
changes to IAS 21.