Category: Private sector

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The audit report: does it really mean anything?

The second oldest profession
Shareholders may not quite realise it but they not only appoint (and can remove) the auditors but the auditors are by law, required to report to them. That is the theory. The practice is that management deals directly with the auditors, fixes their remuneration, challenges them on key concerns they raise and most significantly can recommend their removal. The audit report – even to those who may have some understanding of its nature – has become so lengthy, boring and obscurely complex that it is likely that even the company secretary who reads it at the Annual General Meeting (AGM) does not quite understand what it really says. Richard Bennison, head of audit of KPMG UK in the prestigious monthly publication Accountancy of May 2008 was perhaps only a tad too cynical when he said that “The message of an audit report is, in the vernacular: These accounts are about right unless management have deliberately conspired to falsify them.”

A standard, clean audit opinion issued by the profession can run up to 500 words, about five times more than is required by the Companies Act 1991. How and perhaps more importantly, why did the second oldest profession not known for its literary skills, develop such a love for words with the result that an eight-line report in 1983 became sixteen in 1993 and some 27 in 2007? Has length added anything to shareholders’ understanding of the report or merely shielded the auditors from lawsuits for shoddy auditing work done well out of the sight of the shareholders who appoint them, and whose only communication with the shareholders is their report which is attached to the financial statements circulated with or contained in the Annual Report of the company?

Monopoly
The audit profession has had an unshakeable but arguably necessary monopoly on all companies operating under the Companies Act 1991 as successive Ministers of Finance have failed to trigger the section in the Act which would have dispensed with the need for an auditor. The smallest company then is required to meet the same stringent accounting and disclosure requirements as say, a Banks DIH. Auditors are also helped in another respect by the Companies Act 1991, which simply requires the auditors to state whether in their opinion, the balance sheet and the profit and loss account show a true and fair view. In the repealed Companies Act Cap 89:01 auditors were required to state, perhaps impossibly, whether the accounts showed “a true and correct view…”

Readers of financial statements also need to recognise that while the audit profession will not say it, “true and fair” is a largely undefined term and that within case law and auditing literature there may be more than one “true and fair” view of the state of affairs and results of a business. Add this to the prolixity of the report and we find a complete absence of a key ingredient prescribed by the Financial Reporting Council (UK) for audit reporting: to provide a positive contribution to audit quality. The FRC suggests that for such a contribution to take place it would require audit reports to be written in a manner that conveys “clearly and unambiguously” the auditor’s opinion on the financial statements, and addresses the need of users of financial statements in the context of applicable law and regulations.

The first rule: cover your behind
That is eminently sensible, but is that what auditors really want or do they want to avoid lawsuits which can cripple them? The first thing an auditor seeks to do is minimise his risk including the risk of being sued. Accordingly auditors need to protect themselves and that protection comes at the expense of clarity, brevity and utility. In my decades of auditing experience with a number of international and local firms I cannot recall a single conversation among audit partners identifying communication with shareholders as even the last of their audit objectives.

But if companies legislation is so precise about the report of the auditors, how did we get here?
The first thing to note is that Guyana does not have its own accounting and auditing standards. As members of the International Federation of Accountants (IFAC) dominated by the big firms in the developed world, the local accounting regulator, the Institute of Chartered Accountants of Guyana, is committed to its members adopting and applying the standards set by IFAC. While nationalists (if they still exist) may consider this another form of colonialism, the fact is that international banks and multilateral lending agencies as well as investors, stock exchanges and domestic banks find comfort in financial statements that are prepared and audited to the highest standards of best practice, which are in effect the standards set by the major players.

The initial explosion in the verbosity of the audit opinion was a reaction to what was described as the expectation gap – auditors had to disabuse readers of any notion that the audit was somehow expected to detect frauds or that the auditors were responsible for the preparation and content of the financial statements. The report by the auditors rightly seeks to draw attention to the fact that the management is responsible for the financial statements and that the auditors’ duty is to report on those statements using such methods and techniques as would enable them to report in a most cost-effective (read profitable) manner.

Case brief
But the real reason for all the ‘wordiness’ is the fear of litigation, a fear that has dogged the accounting and auditing profession if not as far back as the South Sea Bubble (1720), certainly in cases like Kingston Cotton Mill (1896) which put the auditor as a watchdog not a bloodhound; Hedley Byrne v Heller (1963) which established the principle that when a person makes a statement in a professional capacity, he voluntary assumes responsibility to the person he makes it to unless he has put a disclaimer in his communication; BCCI (1991), referred to satirically as the ‘Bank of Crooks and Criminals International,’ one of the first cases in which the financing of international terrorism was an issue; and more recently, the 2003 Scottish case Royal Bank of Scotland v Bannerman Johnstone Maclay (‘Bannerman’), in which the court ruled that in preparing the audited accounts of their clients, APC Ltd, Bannerman may have owed RBS, one of APC’s creditor banks, a duty of care and therefore liable for any loss suffered as a consequence.

It was sufficient for RBS to show that Bannerman should have been aware that the accounts and audit report would be provided to RBS for the purpose for which RBS relied on them, even though they may have been prepared for a different statutory purpose. Crucial to the court’s reasoning was the absence of any third party disclaimer in the audit report – which has come to be known as the ‘Bannerman’ statement, used by auditors to discourage third parties from relying on the audit. It is widely believed that it was the presence of such a provision that protected Ernst & Young in a £350M case involving German truckmaker MAN and a subsidiary audited by Ernst & Young, which had been bought by MAN.

Not everyone is happy with such a disclaimer, and a suggestion by the Audit Practices Board of the UK to dispense with the Bannerman statement has met with consternation among UK audit firms. The leading accounting body in the UK, the Institute of Chartered Accountants in England and Wales, is convinced that the Bannerman statement remains a strong and integral part of the audit report, and that there is nothing wrong in principle with disclaiming any duty to third parties.

Tax evasion is not a crime?
In Guyana, some auditors give their blessing to accounts which have been accepted by financial houses and the Guyana Revenue Authority (GRA), but which even Alice would consider pure fantasy. During the last decade we saw some high profile receiverships in which businesses went under shortly after receiving clean reports from their auditors, causing massive losses to the banks. The GRA is too often the victim of some of the most spurious accounts imaginable and yet neither the banks nor the GRA has taken any action against any auditor.

Using history as their guide, auditors assume that the chances of their being sued by lenders for negligence in signing off on the financial statements of their clients are about as likely as snow in Guyana. Those auditors who also prepare the tax returns for their clients must know that those returns are relied upon by the tax authorities for the assessment of taxes and that under the Income Tax Act they can be held criminally liable for aiding and abetting in tax evasion.

Since in Guyana it does not appear that tax evasion is a crime then clearly aiding and abetting it cannot be a crime either! Instead of sanctioning those auditors and tax consultants whose product is so egregiously bad, the GRA routinely issues them with annual Tax Practice Certificates that are used as a licence to continue in their ways.

One of the new rights created by the Companies Act 1991 is the right of the shareholder to have the auditors answer at the AGM questions relating to their duties as auditors. So far it is the directors who have been answering those questions and it would be fascinating to witness such an encounter between shareholder and auditor! That little exercise in shareholder democracy may do more for governance than all the hundreds of words in the audit report.

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On the line – Demerara Tobacco Company Limited and Guyana Bank for Trade and Industry 2007

Introduction

Over the course of the next two days corporate Guyana will come alive with annual general meetings scheduled to be held by two of the country’s public companies. Demerara Tobacco Company Limited (Demtoco), a subsidiary of the British American Tobacco, plc. will have its meeting on March 31 and one day later on April 1, the Guyana Bank of Trade and Industry (GBTI), a 61% subsidiary of Edward B. Beharry and Company Limited, will have its annual general meeting. The Companies Act 1991 allows companies six months to hold their AGMs and the companies are to be commended for their early meetings.

GBTI reports a 57% increase in after tax income for 2007 coming after a 51% increase in 2006 while Demtoco has had more modest increases, 34% in 2007 and 14% in 2006. By any measure these are extremely impressive results which are reflected in the performance of the companies’ share prices over the past three years and provide returns that ironically make bank deposits seem correspondingly unattractive. The average deposit account at the GBTI yielded a return of 3.5% while an investor in the shares of the bank earned 33% (26% of which represents capital appreciation) on his shares.

With inflation close to 15% in 2007, the depositor would have seen the real value of his/her deposit decline by about 12% while the investor’s return, which includes cash income by way of dividends and the increase in the market price for the share, amounts to a healthy 16%.

The lesson is that it is far more attractive to own shares in a reasonably profitable company than to put money in a bank account. The Guyana Stock Exchange (GSE) has not had the desired effect of increasing the number of public companies and with most of Guyana’s public companies being held by controlling shareholders the options for investment in Guyanese companies are limited. But with the removal of exchange controls, the operation of the CARICOM Double Taxation Treaty and the introduction of the CARICOM Single Market and Economy (CSME), there is no reason for limiting the options to Guyana.

It is true that the GSE has outperformed the regional exchanges since its inception in 2003 but much of that is due to what are called market corrections which are unlikely to continue unless all the companies on the Guyana Exchange can match the 2007 performance of Demtoco and GBTI.

Graph of share price movements

Source: The Guyana Association of Securities Companies and Intermediaries Inc., weekly trading reports

Demtoco

Turnover has barely managed to keep abreast with inflation increasing by 16% but the increase in the profit after tax is due to a 30% increase in gross profit – sales less cost of sales – as a result of two price increases in the year which unlike the increases in the price of rice and flour hardly earned a comment in the national press. There is little analysis offered by the Chairman in his one page report or by the Managing Director, neither of whom commented on any impact VAT may have had on the company’s product and performance. The company paid three interim dividends in 2007 amounting to $21.38 per share and is proposing to the shareholders a final dividend of $15.85 making a total of $37.23 giving shareholders a return of 17% on the average market price of the share during the year.

The group gets more however, having charged the company more than $600 million dollars for management services, royalties and technical and advisory services to what it is now no more than a marketing company. The company continues to justify a royalty for a product that can be bought almost anywhere outside of Guyana and seems able to justify exorbitant management services when all the company does is bring in a product sold mainly through at most a handful of distributors.

The balance sheet of the company shows a healthy situation with the company being able to make available to its fellow group companies more than $400 million dollars at the end of the year of which only 60% earns interest at the rate of 4% per annum.

Once again the company does not disclose the number of employees nor does it include anything on corporate governance. Readers will recall one past Country Manager publicly proclaiming defiance to any suggestion that it should comply with Corporate Governance Guidelines until these become legally binding prompting a rejoinder that corporate governance is not a matter of law but best practice (Stabroek News 22/5/04).

Financial Highlights

2007 2006

Change
G$M G$M G$M %
Gross turnover 4,574 3,933 641 16
Cost of sales (1,906) (1,880) (26) 1
Gross profit 2,668 2,053 615 30
Other operating income 20 18 2 12
Operating expenses (920) (772) (148) 19
Profit before taxation 1,768 1,299 469 36
Taxation (895) (648) (247) 38
Profit after taxation 873 651 222 34
Ordinary shares in issue (‘000) 23,400 23,400
Earnings per share (in dollars) 37.29 27.82
Dividends declared per share 37.23 27.75

GBTI

The report by GBTI is far more comprehensive than Demtoco’s, running to 86 pages of material and lots of pictures including two Ministers of Government. Unlike Demtoco the Bank produces a full page Statement on Corporate Governance and eye-catching Financial Highlights although the reader has to go through nineteen pages before s/he finds these.

All the indicators are positive in favour of the shareholders if not the depositors in the bank. Shareholders receive a return of 33% in dividends and capital appreciation, while depositors of interest bearing accounts earned 3.5% (3.4% in 2006) and the average of all depositors 2.6% (2.5% in 2006). Share prices during the year increased by 26% on an increase in earnings per share of 57% and if the bank’s outlook for itself and the economy is shared by investors, then it is quite possible that there will be a further movement in share prices over the next few months.

The company reports accumulated provision for loan losses amounting to 96% of its non-performing portfolio, having written off $831 million in 2006 but only $20 million in 2007. From a profit and loss account perspective the provision for loan losses declined by $70 million which has augmented the profits for the year.

Another contributor to the substantial after tax profits of the Bank is the reduced effective rate of tax it pays for the year – at 18% it is half the effective rate paid in 2006 and results from more than $300 million in interest earned being “not taxable”. The normal rate of corporation tax is 45% and if the effective rate had remained at 36%, after tax profits would be $170 million less.

Loans

A bank’s contribution to national development can be measured by its lending to key sectors of the economy. The sectoral analysis of the bank’s loan portfolio shows agriculture accounting for a mere 7.64%, a further reduction from the 9% in 2006. By contrast the share of the portfolio to the services sector has increased from 38% to 43%. Nationally agriculture accounts for approximately 25% of GDP. While the Bank was once considered the rice farmers’ bank (other than GNCB), some operators in the sector lament that the Bank has been taking a very harsh line on borrowers in the rice sector. Indeed this makes it somewhat paradoxical that the Bank won a bid to manage the EU G$1.6 billion facility to increase the efficiency and sustainability of the rice sector.

The loans to deposit ratio has declined slightly from 28% to 26% despite having won the bid and having received $825 million interest free under the Scheme. The Scheme comes to an end in June of this year but the annual report is unclear whether interest will then become payable on the amounts drawn down.

Highlights

2007 2006

Change
G$M G$M G$M %
Net Income before taxes 976 788 188 23.86
Net Income after taxes 796 506 290 57.25
Total assets 42,981 35,742 7,238 20.25
Total deposits 37,408 31,326 6,082 19.41
Loans and advances 9,745 8,745 1,000 11.43
Return on Average Assets % 2 1
Return on Average Equity % 66 42
Earnings per share $ 19.89 12.65

In their outlook for 2008 and beyond, the Chairman and the CEO were both upbeat about the prospects for the country, reflected in the extension of their branch network and new Head Office to be constructed during the year. Neither mentioned the events in Lusignan (January 26) or Bartica (February 17) and the consequential threats to the economy. It would be interesting to see which one of our two companies would be impacted more directly if the country does not solve events of that nature.

Finally, the results for both entities show how the tax system can be worked in favour of corporate taxpayers with the range of “tax shelters” that are available. Individuals, bound by a single personal allowance and a tax rate of 33⅓ %, can only read with envy.

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A bridge over the river – a dream come true

Recently a Berbician friend in anticipating the opening of the Berbice Bridge within the next few months exuded that for her – she is about 50? – a Bridge has been a dream she entertained since she was a girl. It will be a major accomplishment in infrastructural development in this country and will probably mark the high point of the legacy of President Bharrat Jagdeo.

Compared with other capital projects undertaken in this country since Independence, it does not rank among the most expensive but the Government will rightly see it as one of the most significant capital projects undertaken during the PPP/C’s watch.

The opening of the Bridge will mark the end of a bad dream for Berbicians living in Region 6 especially those whose experiences and tales of being stranded on one side of the Berbice River waiting to cross to the other can easily fill volumes. There have been several criticisms of the Bridge including its financing, location and type. Financing will come from the private sector after some strong persuasion by the Government which itself will make no direct financial input; the location has been criticised on environmental and technical grounds; the nature of the Bridge which like the Demerara Harbour Bridge built by Forbes Burnham in 1978 is a floating bridge.

Welcome Relief

The Bridge will soon be a reality and the Government will deservedly take the credit for the achievement which coming so soon after the Lusignan Massacre will be a welcome relief. Despite the fact that the Bridge is touted as a private-sector project its chief spokesperson and key player has been Mr. Winston Brassington of NICIL, the holding company of Government entities, with the company itself being much less visible. The role of NICIL which should have come to an end after financing had been secured appears to have been extended though at some stage soon the Bridge Company would need to find its voice.

Expect therefore that the Bridge will feature prominently in the 2008 Budget Speech [see follow-up article below] and in public pronouncements. Still it would be un-Guyanese-like not to have critics waiting to see whether their fears will be vindicated while those private sector investors will no doubt be nervously looking to see how the numbers will turn out and whether their investment will produce the returns they expected. For Berbicians more concerned with living their dream, that would be the last thing on their minds.

The Louis Berger Group, the consulting firm out of the USA, contracted to undertake the feasibility study of the Bridge considered the Berbice River a major physical obstacle to communication between New Amsterdam and Georgetown and a key constraint on national economic development. With some of the most productive agricultural lands located in Region 6, the cost of moving goods and produce out of that region has been enormous with constraints and delays in vehicles being able to cross the River.

Optimism

The Study was optimistic about the Bridge’s potential for revitalising the region, making its produce more competitive, providing employment opportunities, attracting investors and just perhaps reversing the brain drain. Perhaps a bit over-optimistically it even contemplates a reduction of fares by the minibus operators since the Bridge will reduce the down time they now spend using the ferry.

Indeed Mr. Brassington has said the tolls for crossing the Bridge will not be higher than ferry fares “on average” and that fares will be paid on one side of the bridge while tolls will only be collected for vehicles and not passengers. Mr. Brassington in March 2006 projected a reduction in the fares in the latter half of the concession period with most of the initial financing being repaid for the project.

Over the decades, the region has witnessed significantly large population decreases but recognising it as its heartland, the PPP has since its return to power in 1992 committed itself to greater attention there whether in education, agriculture or infrastructure with significant investments in the Berbice Campus of the University of Guyana, the massive Skeldon Sugar Modernisation Project and rebuilding of the main roads leading from Mahaica to Rosignol and New Amsterdam to Crabwood Creek.

Sore need

Writing in Business Page of March 12, 2006, this columnist noted that a Bridge was sorely needed while a consultant who advised against investing in the Bridge conceded that as a project it was excellent, much needed and long overdue. The challenge for the company is whether the projections and assumptions underlying the project, particularly in relation to traffic and revenues, do in fact materialise or whether they are simply too optimistic.

For the user, such considerations pale into irrelevance when matched against the usefulness of the Bridge to them.

Budget 2008

At this time of the year, attention usually turns to the National Budget in which the Government signals its intention on policies, revenues and expenditures for the year. Some were even expecting that the 2008 Budget would have been presented this past Friday. But with the Lusignan Massacre still on the minds and lips of everyone and with no success at apprehending any suspects, the Government may have found it difficult to deliver an upbeat account of its stewardship and spending plans in the midst of fear and uncertainty.

The Government has up to March 31 to present the Budget although it would be ideal for the Budget to be presented before the year begins. Instead all we have had from the Minister of Finance is a request last month for the National Assembly to authorise some $9,398,373,968 to cover overspending by the Government which itself followed a similar request in November for $8,679,412,56.

Consultations

Overspending never reflects well on managers since it is evidence of inadequate planning and foresight. We will return to this matter in a subsequent column but for now there should be some concern about the failure of the Minister of Finance once again to consult with stakeholders prior to the Budget. Such consultation was standard fare with past Ministers of Finance who at least gave an audience to labour, consumers, business and even welcomed inputs from professionals.

It is true that the real benefit of those consultations was lost because the exercise was mere photo-opportunism. But the solution lay in enhancing, not dispensing with the process. In other words use the information gathered as far as could be done, explain why others were not feasible and build relationships with the stakeholders. Instead we seem to be throwing away the baby with the bath water.

President Jagdeo, who still exerts an unacceptable level of influence over the Ministry of Finance felt it necessary to appoint two Ministers in that Ministry and it is hard to believe that neither of them can meet with stakeholders who after all pay the taxes that fund the Budget. A Government that takes pride in its democratic credentials does not normally make changes without at a minimum advising the public and offering reasons.

In fact, in his last Budget speech former Finance Minister Saisnarine Kowlessar lauded the views of the private sector bodies, labour unions and ordinary Guyanese, thanking them for their contributions, which we [the Government] value highly. Has that now changed and if so by whom?

Troubling attitude

If the change is due to a new approach by Minister Dr. Ashni Singh this column wishes to place on record its strong displeasure at such high-handed behaviour. I recall publicly commending the appointment of Dr. Singh as ushering in a new, positive era and was actually criticised for going overboard in my praise of the Minister.

There have been concerns recently that the Minister is obsessed with concealing information to which the public have a right, such as data on inflation and VAT collections. I am sure the Minister does not need to be reminded that there is no monopoly on wisdom and the people must never be excluded.