Its all in the numbers 10 June 09

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Unformatted text preview: FRIDAY,JULY 10, 2009 | BUSINESS DAILY I the edge: It’s all in the numbers YOUR FREE COPY Friday, 10th July, 2009 It’s all in the NUMB3RS II BUSINESS DAILY | FRIDAY, JULY 10, 2009 the edge: It’s all in the numbers FROM THE E DITORS QUOTABLE Q UOTES It’s a numbers game Not being on top of the numbers, as many a failed manager will tell you, can be fatal. Business may be mostly about people and relationships, but understanding the numbers is a necessary skill. And, as this issue of The edge hopes to convince you, number-watching can be an engrossing pastime. There is more to numbers than just keeping score, for one thing. Accountants are called many things: bean-counters, numbercrunchers and spreadsheet jocks amongst them. But, as some of our contributors argue in this issue, the finance function is undergoing great change. It is now a great deal more than just keeping tabs on how the business is doing on behalf of shareholders. Senior financial people are becoming true drivers of the business, using their skills to understand where and how the firm makes money (and where it loses it). Not so long ago, managers were ‘soft’ (handling people) or ‘hard’ (crunching numbers); these days, that is a silly distinction. What about the people who watch the number-watchers? The audit profession, according to some, is in disrepute. After the latest flurry of accounting scandals hit the news, many leaders could be heard asking whether audits are worth the paper they are written on. The edge gives you both sides of the argument. The problems with auditing as it is currently practised are highlighted in these pages; but we also asked auditors to defend themselves. They did so in spirited fashion, which suggests some of them can use words as well as equations to good e�ect. Of course, it’s not just managers who need to be on top of the numbers. Investors often jump in with both feet when assessing risky opportunities, and then wail loudly when the deal turns sour. Much anguish can be saved by a little education in number-gazing. Our contributors tell you how to read between the lines when looking at income statements and balance sheets, and provide guidance on what sort of homework you should do before risking your money. The numbers game has taken on an even greater significance in the depressed market conditions prevailing across the globe. As the bottom line comes into sharp focus again, we think this issue is a timely compendium of insights from business writers, academics and practitioners. There are thoughtprovoking articles contained here, as well as entertaining debates. At the very least, it should convince you that numbers can tell a story. The edge is a joint publication of the Business Daily and Strathmore Business School. OCHIENG’ RAPURO MANAGING EDITOR SUNNY BINDRA CONSULTANT EDITOR The majority of audits, especially those done in Kenya, are just not up to international standards. − Jim McFie, Strathmore, PageIV The world of fraud: Some recent examples Corporate wrongdoing is not restricted to any one country. Like the economy, it is global South Africa probes largest corporate fraud case in its history South Africa financial and law enforcement agencies are investigating a suspected corporate fraud case, worth up to $1.2 billion. What could be South Africa’s biggest corporate fraud was allegedly masterminded by South African businessman Barry Tennenbaum, one of the founders of pharmaceuticals firm Adcock Ingram. The Investigator Specialized Services Group said Tennenbaum persuaded investors to plough money into a pharmaceutical ingredient import business and faked purchase orders from firms including Africa’s biggest generic drug maker, Aspen. previously managed. In addition, he used part of the funds to pay off his personal debt. Let us begin by approximating an audit to a very intimate medical examination being carried out by a lab assistant. − Joe Gichuki, PKF, PageVIII Satyam’s inflated revenues In January 2009, company Chairman Ramalinga Raju resigned after notifying board members and the Securities and Exchange Board of India that Satyam’s accounts had been falsified . Raju confessed that Satyam’s balance sheet of 30th September, 2008, contained inflated figures for cash and bank balances, an accrued interest which was non-existent, an understated liability and an overstated debtors’ position. In a downturn, ine�ciencies become unmasked. Or, as Warren Bu�ett likes to say, ‘When the tide rolls out, you can see who’s been swimming naked.’ − John Kiarie & Nikhil Hira, Deloitte EA, PageIX 150 years for architect of Wall Street’s ‘most brazen investment fraud’ Bernard L. Madoff, a force in Wall Street trading for nearly 50 years, was sentenced to 150 years in prison − the maximum penalty the judge could give him for “extraordinarily evil” crimes in Wall Street’s biggest and most brazen investment fraud. Fleeced investors in the courtroom cheered and applauded as the judge handed down the penalty. The former non-executive chairman of the Nasdaq stock market pleaded guilty to 11 charges including securities fraud, money laundering and perjury, which cost investors more than $50 billion. Stanford indicted in massive US rip-off case Texas billionaire Allen Stanford, three associates and a top Caribbean regulator were indicted on fraud, conspiracy and obstruction charges in an elaborate $7 billion pyramid scheme to bilk investors. Stanford, a flamboyant 59-yearold financier, is charged with orchestrating the fraud through his bank on the Caribbean island of Antigua. He could face life in prison if convicted on all of the charges. Airbus chief questioned over insider trading Airbus chief executive Thomas Enders of Germany has been questioned by French police as part of the corruption probe against the planemaker’s parent company, EADS. In total, 17 French and German current and former bosses or officials of EADS and its main subsidiary, Airbus, are suspected of insider trading between 2005 and 2006. These include nine of French origin, four Germans, two Americans, a Finn and a Briton. According to regulator AMF, Enders sold 50,000 stock options in EADS for a pretax profit of more than $970,000 at around the time that problems were appearing with the flagship Airbus A380 superjumbo jet. Asia Media CEO resigns over fraud claims Cui Jianping, founder and CEO of Asia Media Company Limited, the first Chinese company listed on the Tokyo Stock Exchange, has resigned after taking the blame for embezzling company funds. AMCL announced on its Japaneselanguage website that Jiang had used a deposit of Beijing Kuanshi Network Technology Company, a subsidiary of AMCL, to sponsor a bank loan for Beijing Haitun Technology Company which he The ability to exercise judgement based on ethics will be the one constant that will ensure finance professionals maintain that integrity and successfully navigate complexity and ethical dilemmas. − John Nyakahuma, ACCA, PageXIII Although strategy precedes funds, the latter is key as it greatly determines whether the plan will work out or not − Caesar Mwangi, Sasini, PageXV FRIDAY,JULY FRIDAY,JULY 10, 2009 | BUSINESS DAILY III the edge: It’s all in the numbers VIII XVI XIV It’s all in the NUMBERS IV) What’s wrong with accountants and auditors? Accounting academic JIM McFIE says many audits, including those done in Kenya, are not up to scratch. XV) Corporate strategy re-examined Dr CAESAR MWANGI describes the dos and don’ts of corporate planning in a time of crisis. VI) Did the regulators sleep on the job? No, a Central Bank of Kenya expert says. Regulation couldn’t have prevented the global crisis. XVI) Why the contagion will reach Africa The continent cannot escape the impact of the global financial crisis. VIII) Auditors hit back Practitioners say that to blame them for the meltdown is to fail to understand their role. XVII) Big cats in the house Why large audit firms still take the lion’s share of business. IX) Tighten your strategy, not your belt Why traditional responses to downturns such as hiring freezes and reduced travel won’t do in a long recession. XIX) What the numbers say Carol Musyoka puts the magnifying glass to the numbers from two banking industry peers. X) The good FD can move from scorekeeper to driver The market downturn provides an opportunity for financial directors to raise their game. XI) Buyer beware: Why it is important to do your homework before investing Failure to ask the right questions could lead to bad investment decisions. XII) Accountants, prepare for a make-over The modern FD needs to demonstrate leadership as well as well as financial expertise. XIII) The best route to the top How the evolving finance function is shaping careers of aspiring professionals. XIV) Where to find the money When financiers take to the hills, look for new and unfamiliar types of funding. XI FRIDAY EDITION JULY 10 2009 XVII Chief Executive Officer Linus Gitahi Editorial Director Wangethi Mwangi Group Managing Editor Joseph Odindo Managing Editor Ochieng’ Rapuro Consultant Editor Sunny Bindra Chief Sub Editor Kariuki Waihenya Advertising Manager Julie Kisaka Layout & Design Conrad Karume Acting Photo Editor William Oeri Illustrations Joseph Barasa The edge is available online at The edge is a quarterly magazine published by Business Daily in association with Strathmore Business School IV BUSINESS DAILY | FRIDAY, JULY 10, 2009 the edge: It’s all in the numbers What’s wrong with accountants and auditors? WASHINGTON GIKUNJU talks to DR JIM MCFIE, Strathmore University’s renowned teacher of accounting Such pressures force auditors to tailor their audits according to the amount that clients are willing to pay. For example, some will scale down the size of their audit samples in order to finish the audit within a time that fits a client’s bill. This may be unethical, but unfortunately the international auditing standards do not specify the sample size that an auditor must go through in an audit. Some errors will also arise in an audit process from causes such as carelessness, sickness or even the pressure to meet deadlines. Is the manner of appointment of auditors likely to compromise their objectivity? I t is said that if a chief financial o�cer wants to mislead an auditor, he can almost always do it. Investors do not want to believe it, but modern high profile cases of executive fraud and financial statement manipulations at multinational corporations such as Enron, WorldCom, Arthur Andersen, and India’s Satyam Computer Services have given even more credence to this maxim. Closer to home, shareholders in Uchumi Supermarkets and investors in the stock market have felt heavy losses partly because of the shoddy accounting practices and sloppy auditing that have failed to smoke out corporate fraudsters. Accountants and auditors are also being blamed for the financial crisis that has pushed the global economy into its deepest decline since the Great Depression and many observers reckon the auditing profession is on trial in the court of public opinion. Is it just a matter of the bad cases stealing the biggest headlines, or is there something fundamentally wrong with accountants and auditors? Business Daily’s WASHINGTON GIKUNJU talked to James McFie, long-standing lecturer at Strathmore University and Strathmore Business School. What is the role of an auditor who is hired by an organisation to audit its books? Auditors owe a primary duty of care to shareholders - who ideally ratify or reject their appointment - but the truth is that the management of a firm have a big influence over who is appointed as the firm’s auditors. This in itself presents a potential conflict of interest, as auditors are naturally inclined to bend to accommodate the management’s demands which may compromise the audit quality. Do you think cases such as Uchumi’s and the collapse of three stockbrokers in as many years have dented public confidence in auditors? Dr Jim McFie points out that most CFOs are former auditors, and know how to explain away inconsistencies. LIZ MUTHONI An auditor’s task is to examine the financial statements of an organisation and determine whether each number in the books is accurate and can be relied upon as a true representation of the firm’s financial position as at the date of presentation of the accounts. It is his job to make sure the financial statements are correct. Do you think auditors have played this role competently? understand that it is not always easy for an auditor to identify fraudulent financial statements, especially when the fraud is premeditated. This is because most chief financial o�cers (CFOs) working for the top corporations are themselves former auditors of the ‘big four’ audit companies and know how to cover their tracks very well. The CFOs are extremely intelligent, have all the information on the firm and in most cases know all the audit procedures. They will articulately explain away even the most blatant inconsistencies. Do auditors share some blame for not having raised a red flag over the crisis that hit Western financial institutions? Some auditors have acted unprofessionally by failing to perform their work meticulously, a factor that has lowered the quality of audits and led to presentation of inaccurate audit statements. The majority of audits, especially those done in Kenya, are just not up to international standards. Globally, the vast majority of auditors have played their role professionally and competently. This explains why there are only a handful of bad cases being highlighted in the media out of thousands of firms that are audited every year. It is, however, important to So far, there is no evidence showing that US auditors are to blame for the financial crisis since their audit opinions were guided by the recommended Generally Accepted Accounting Principles (GAAP). There are, however, questions as to whether the subprime mortgage assets were rightly valued in the books of financial institutions. Opinion is split on whether the assets should have been audited based on their book value or whether the ‘mark to market’ valuation (as per current market price) was the appropriate value. The reality, however, is that GAAP is a set of very detailed and rigid accounting rules (listed in a book of about 25,000 pages) and these were complied with to a large extent. It is not even possible to tell whether giving an adverse audit opinion stating that the subprime assets posed a risk to the institutions’ financial stability would have averted or accelerated the financial crisis, a classic example of a dilemma that regularly confronts auditors in their work. The rather unfortunate reality however is that some auditors did not fully understand the complex derivative instruments that were the subprime assets. This is another obstacle that auditors who have to audit firms in extremely diverse economic sectors face everyday. What other factors limit auditors’ performance? When such cases are regularly highlighted in the Press they obviously have a negative influence on the public’s opinion of the audit profession. The public should, however, know that an auditor’s opinion is not a guarantee of the accuracy of financial statements; it is just an opinion which could as well be wrong. In some cases it could be worthwhile to consider seeking a second opinion where there is suspicion of misrepresentation of figures. What recourse do investors have in the case of rogue auditors? They could either sue for compensation or change the auditor. Is there room for to simplify the format in which financial statements are presented? The issue of audit fees that clients are ready to pay for an audit is also a big factor that determines the quality of an audit. Auditors are regularly seeing their fees getting squeezed by corporations that in most cases argue that audits do not add any value to their companies - they want the audits done at the least cost. It is true that the average person may not decipher much from a modern statement of accounts, but unfortunately emerging challenges are pointing to even more complicated international accounting standards. There are already proposals to revise accounting standards to include more details in the financial statements. If the changes are implemented the income statement will show in detail asset revaluation gains or losses, and will change its name to a statement of comprehensive income, while the balance sheet will be called a statement of financial position. FRIDAY,JULY 10, 2009 | �BUSINESS DAILY ���������������������� �������������� V �� ���������������������������������� the edge: It’s all in the numbers VI BUSINESS DAILY | FRIDAY, JULY 10, 2009 the edge: It’s all in the numbers Did the regulators sleep on the job? Recent financial scandals such as that involving Bernard Madoff have brought regulators under heavy criticism for failing to keep pace with the players. Business Daily’s WASHINGTON GIKUNJU spoke with CBK’s director of supervision, ROSE DETHO, for a Kenyan perspective Failure by regulators to keep pace with innovation in the marketplace has been blamed for America’s financial crisis that has now culminated in a global economic recession. Is this criticism fair? Do you think Kenya’s banking regulations are adequate in view of the global financial crisis? It is important to first note that a myriad of factors contributed to the global financial crisis. The genesis of the crisis can be traced to the availability of cheaper credit after 2000. This encouraged banks to undertake riskier projects particularly in the United States. Mortgage lending to the ‘ ’subprime borrowers’’ category, who under stringent underwriting standards would not qualify for credit, increased. These mortgages were further repackaged and re-issued as mortgage backed securities. The securities were sold to investors including other financial institutions in and out of the United States. The quality of these mortgage backed securities substantially declined when house prices fell drastically in the United States. Financial institutions holding those mortgages thus found themselves holding ‘’toxic assets.’’ The regulatory regimes in most of the countries at the centre of the crisis had been developed and sharpened in the years ahead of the crisis. But the unprecedented loss of trust and confidence as the financial crisis spread shook even the hitherto strong markets to the core. The meltdown can therefore perhaps be described as an ‘’extreme’’ event that would have been hard to mitigate from a regulatory perspective. Financial markets are based on trust and confidence and once these elements disappear, it becomes di�cult to stem a crisis. This is why governments have had to intervene and throw their weight behind financial institutions and markets to restore trust and confidence. Therefore, the failure by the regulatory system to keep pace with innovation was but one of the various triggers of the global financial crisis. Do you think the crisis could have been averted had the regulators kept pace with the market players’ innovations? As indicated above, Kenya’s banking regulations have been strengthened considerably in recent years. It is also noteworthy that Kenya’s banking sector continues to exhibit resilience even in the wake of the global financial crisis. However, the regulatory framework is continuously reviewed to take into account market dynamics and global developments. The Central Bank of Kenya will therefore continue to strengthen the banking sector legal and regulatory framework. Is sti�er regulation likely to suppress innovation in a market like Kenya that is arguably too conservative, yet this purist approach appears to be what has shielded even the Western economies that took the least hit from the financial crisis? Straddling the balance between regulation and innovation continues to be a regulatory challenge across the world. However, it should also be noted that the cardinal role of regulation is to protect the public interest/good. In this regard, unbridled innovation can jeopardize public interest leading to a loss of trust and confidence in financial institutions and markets. Strengthened regulation will in fact foster public trust and confidence creating an enabling environment for safe, sound, e�cient and accessible innovations. Is the developing financial supermarket model in Kenya contrary to the ongoing unwinding of financial conglomerates in the West? Ms Detho: “It would have been difficult to avert this crisis by just focusing on the regulatory regime.” LIZ MUTHONI system, which is increasingly getting intertwined, making instability in one part of the system spread quickly across the globe. While developing countries such as Kenya were spared the direct impact of the global financial crisis, they have not been as lucky with the spill-over e�ects that have arisen as the financial crisis translated into an economic crisis in the United States and Europe. It is therefore imperative that trust and confidence be restored in Western financial markets through strengthened regulation to put the Western economies on a recovery path. Is the worst over for world financial institutions? the latter as even the mobile phone money transfer service has shown locally. What do you think regulators can do to keep pace with innovation? Regulators should have a collaborative relationship with market players to keep abreast of innovations. This will facilitate the development of a robust regulatory environment that is responsive to market dynamics. Institutional capacity building through sta� training, knowledge exchanges with other countries and research are also critical in this regard. How would you describe the regulatory environment in Kenya’s banking system, in terms of rigidity and robustness? The ‘’one stop financial services shop’’ model that is developing in Kenya is in response to growing customer needs and sophistication. This need for convenience of receiving services from a ‘ ’one stop shop’’ is evident and growing in other sectors of the Kenyan economy. This may not necessarily be contrarian to trends in the West as Kenyan and Western financial markets are at di�erent stages of development. What safeguards has the regulator put in place to ensure that the emerging one-stop financial shop model does not pose new regulatory challenges? It would have been di�cult to avert this crisis by just focusing on the regulatory regime. More importantly, how risk is assessed and priced is a major weakness in the whole process. In addition, securitization without adequate risk pricing was a major weakness. What is your view on the current e�orts to review banking and capital market regulations in developed economies? Washington Gikunju is a writer with Business Daily There is still not su�cient information to conclusively state that the worst is over for financial institutions particularly in the West. However, the situation has considerably calmed down since the climax in late 2008. The monetary and fiscal stimulus by governments at the centre of the crisis has played a critical role in stabilizing financial institutions and markets. Regulation in an environment of rapid innovation has become a challenge as the former always tends to lag behind These e�orts will invariably foster the stability of the global financial Kenya’s banking sector legal and regulatory framework has been considerably strengthened in the last few years. This follows the period of numerous bank failures in the 1980s and early 90s. Reforms were therefore initiated to strengthen the operational independence of the Central Bank and to enhance corporate governance standards in the banking sector. The Central Bank has also since 2004 upgraded its supervisory approach using proactive risk management approaches. The sector has experienced relative stability in the last three to five years, the global financial crisis not withstanding. Supervisory co-operation and coordination between the di�erent financial sector regulators has been strengthened. A Memorandum of Understanding to guide this co-operation and co-ordination is currently under consideration by the Central Bank of Kenya, the Capital Markets Authority, the Retirement Benefits Authority and the Insurance Regulatory Authority. It is not important to have a one-stop financial shop model because we have diverse requirements, but that the regulators talk and coordinate with each other to reduce or remove any room or laxity in regulatory processes and strengthening institutions. This is what the MoU will do. FRIDAY,JULY 10, 2009 | �BUSINESS DAILY ���������������������� �������������� VII ���� ���������������������������������� the edge: It’s all in the numbers VIII VIII BUSINESS DAILY | FRIDAY, JULY 10, 2009 the edge: It’s all in the numbers The view from the senior auditor’s Since this edition of The edge focuses on finance, we asked senior members of several leading audit firms to give us their thoughts on the role of finance in modern corporate management. Following the numerous recent revelations of corporate fraud, we also asked them for their reactions to accusations that their profession has fallen down on the job. From lab technician to pathologist BY JOE GICHUKI A physicist giving a lecture to a dairy association said, “Let us begin by approximating a cow as a hollow sphere completely filled with milk.” Like our physicist, I want to simplify. Let us begin by approximating an audit to a very intimate medical examination being carried out by a lab assistant. Note that the person doing the examination is not the doctor who ordered the examination, but a lab assistant. Why do I use this analogy? Well, the lab assistant is given access to some very private details about you, some of which even your spouse may never know. Secondly, if the lab assistant finds a problem with you, he is only expected to report it. He is certainly not obliged or even expected to find a cure. But the world in which your financial lab assistant is operating is changing. The unsophisticated young girl who used to come to the lab is now the mayor’s wife. If one was able to speak abruptly before, one must be polite now. Customer power And this is what has happened to companies. The markets are becoming more competitive and customers have been made powerful--by economies of scale, legislation, government protection, or just successful management. To a small auditor, getting a chance to audit one of these big companies is a huge step, full of opportunity. To the employees of a large established one, keeping the client happy is the way to protect your bonus. And so it is that nowadays, even auditors have to go for customer care courses and they use expressions like “total satisfaction” and “delighting the client”. Now that’s an interesting idea: how does one delight a patient on whom one may be carrying out, say, a rectal examination? And how does an auditor delight a company on which he has to render an undesirable opinion? To continue the analogy of the girl a little further, as she grows older, she develops high blood pressure, she has cholesterol build-up and her bone mass is shrinking. What’s more, she likes to drink. A simple, straightforward blood sugar test becomes a bit more complicated. If you fail to observe some of these things then you will be criticised when the results of your test come out. Why, you will be asked, did you not take account of the possibility of a hangover when you could smell the booze on her breath? If you argue that you simply used the recommended procedures, at best you will be dismissed as an inexperienced person, at worst you could lose your job for failing to exercise proper judgment. Thus the auditor is expected not to fail to find a problem that is there. More recently, the question of the auditor being paid directly by the client on whose performance he is supposed to report has also become an issue. A MORI poll in the UK found that the overwhelming majority of respondents believed that auditors are primarily concerned about what other jobs they can get from their clients in services like tax and consultancy and how to keep the audit work for the following year. What was perhaps surprising was that two-thirds of the auditors interviewed agreed with this. With so much money at stake, inevitably, an auditor who is allowed to keep an eye out for other opportunities with the client will eventually lose sight of the ball. In the US, this has been addressed by legal changes that mandate that the auditor of a company regulated by the SEC (basically a listed business) is almost completely barred from doing any other work for the same company or its subsidiaries anywhere in the world. But this is not necessarily an ideal solution, because the best auditor, and the one most likely to spot a real problem, is the one who fully understands the client’s business. Thus, a better solution might be mandatory rotation of a firm’s audit sta�. If we go back to our simple approximation, one might say that there is a risk of allowing a patient to go back to the same lab each time since he may be doing so in the hope that the lab will cover up an insurance risk for a valued client. Yet that same lab will be best able to interpret an unexplained drop in blood pressure. What about technology? Firms are being asked to invest in software that helps them select samples, invade the client’s software to find processing bugs, look for supporting evidence, (like electronic signatures) and carry out various audit tests. But these are merely technological responses to the same relationship between the lab assistant and the patient. Rather than using more technology, the big change in auditing practices will be that auditors will increasingly be required to spend more time with their clients. There will be relentless pressure for them to take a greater share of the responsibility for failure - as great a share as can be Watchdogs or bloodhounds? BY KAIRO THUO Auditors are generally appointed by the shareholders of a company and report to those shareholders. Based on this, there is a common belief among auditors that their responsibility is to the shareholders and not to any other of the users of financial statements (e.g. bankers, lenders, revenue authorities, strategic investors, etc.). However, auditors are always aware that there are other interested parties to whom they owe a moral, if not a legal, duty. Just how far this moral duty extends, and indeed how far auditors’ overall duties extend, have always been matters of debate. Auditors are supposed to certify that financial statements “portray a true and fair view of the state of a�airs” of an organisation. But they are not obligated to investigate the organization’s financial a�airs, rather only to form an opinion based on information and explanations obtained from management. When the management intends to commit fraud and has made preparations to do so, it can be extremely di�cult for the auditors to detect the fraud. Clearly, the auditor only works to create a comfort level and not to provide assurance (this is probably why the term for audit services has been changed from “assurance services” to “attest services”). At the end of the day, an audit does not, and is not intended to, provide guarantees. Hence an auditor is more of a watchdog, telling you that things seem okay, than a bloodhound, telling you that things are going wrong. And to end, a joke about Enron: Q: Why were the auditors never prosecuted? A: They were only seen driving the getaway car. Thuo is a legal and tax consultant with Viva Africa FRIDAY,JULY FRIDAY,JULY 10, 2009 | BUSINESS DAILY IX the edge: It’s all in the numbers chair Auditors: As good as what they get BY NIKHIL HIRA Tighten your strategy, not your belt Why traditional responses such as hiring freezes and reduced travel won’t do in a prolonged recession BY JOHN KIARIE AND NIKHIL HIRA apportioned without their actually being members of management. This is one area in which there is currently no realistic analogy between the auditor and the lab assistant, because auditors come after the year is over and the damage, if any, is done. Imagine doing a blood test because your patient had a fever last year! Being able to report on the spot, in real time, will eventually be the only way that an auditor will have any relevance. And for the same reason—taking a greater share of responsibility— auditors will increasingly be required to o�er advice about how to cure the patient. Recent legal opinions in some countries have already begun to treat the management letter, an added-value service that auditors previously o�ered as a nice freebie, as a legal report. In India, the audit report, for certain public companies at least, is not the simple two or three paragraphs common here. Instead, it is a long document that details what the auditors did in each section of the audit, what errors they found and why they have acted on or disregarded the errors. There even seems to be a suggestion that the auditors should o�er ideas as to what could be done about the problems they find. Finally the lab assistant will have become a pathologist or at any rate, a very sophisticated lab assistant. And that’s what we all hope for, don’t we? Gichuki is a partner in PKF Kenya, Certified Public Accountants. An audit can only be relied on if the information that is audited can be relied on—that’s a fact. It’s the auditors’ job to probe the information they are given, verify it and seek the truth in the numbers. It’s not possible to bundle all the corporate scandals and crises of recent years into one pile and state that the auditors are to blame: in some cases the auditors did not do their job properly; in some cases the client withheld information or misled the auditor; and in some cases the standard methodologies and ratios used by the auditing profession and accepted by regulators were found to be wanting. Ultimately, if the client lies and falsifies information with skill, it can be di�cult for the auditor to identify this. The auditor-client relationship is often a di�cult one – after all, the client pays the fee to the auditor essentially to investigate them. It’s like hiring someone to tell you whether or not you are beautiful; you have to be willing to accept that the answer might be negative or it is a wasted exercise. Sometimes companies think that the fact that they are paying for the service entitles them to a favourable opinion. So, it is time to hunker down. Throttle back. Tighten your belt. Cut costs. Maybe not! While those may seem like sensible ways to manage your business in a downturn, don’t just settle for survival. The strongest companies aren’t those that do the most e�ective job riding the waves of the economy but rather those that break the cycle altogether and thrive. When the economy is strong, most companies tend to gather revenues while the gathering is good. They chase growth without fine-tuning their operations. Human resources, product line diversification, inventory and other areas are geared up to make the most of the situation. But when the economy slows, investments that seemed to make sense during the boom years can quickly go bust. Structural costs can balloon. Imperfectly integrated acquisitions and far-flung ventures into emerging markets can start to look questionable. In a downturn, ine�ciencies become unmasked. Or, as Warren Bu�ett likes to say, “When the tide rolls out, you can see who’s been swimming naked.” Balance sheet Perhaps the easiest thing to do in a down turn is to blame everyone and everything other than yourself. It’s also easy to engage in traditional belt-tightening activities such as hiring freezes, expense deferrals, reduced travel and training, and across-the-board budget cuts. But in a deep and prolonged recession, such traditional responses won’t do. Companies must look at structural improvements such as infrastructure optimization and financial restructuring. They must also give more attention to their balance sheet and cash flow. By applying a comprehensive and integrated approach, companies can better manage the overall e�ort to achieve both immediate savings and large-scale improvement. A structural approach to cost reduction can better position a company to protect its margins, capture market share, and capitalize on opportunities such as bargainpriced acquisitions. It can also free up resources to invest in new products and services, marketing, and advertising. These activities can help a company survive the downturn and get a jump on competitors when the economy turns around. Here are some specific steps that can be taken: • Focus on products and services with more consistent demand and less price elasticity. O�ering customers a highquality experience can shore up price realization and give those customers new reasons to be loyal at a time when relationships are tested the most. • Re-examine how you do things and plan for the upturn – which will come! What’s needed But it is imperative for auditors to be independent and to do the job thoroughly and correctly. If they don’t, their reputation will su�er. And for an auditor, the reputation and brand is critical; once lost it can never be recovered. Integrity, independence and quality have become the watchwords of the audit industry. Steps have been taken by all audit firms to ensure that integrity, independence and quality are always in place. Hira is a partner at Deloitte & Touche, East Africa. The views expressed are the writer’s and not necessarily those of the firm. Look at your processes and build in the e�ciencies which will allow you to survive the current market and be well placed for the future. • Determine whether your organizational structure and supply chain is aligned with the brisk business you’ve been doing or with the economic reality that lies ahead. Aggressive hiring, internal promotions or acquisitions in the good times may have created a tangle of organizational layers. A flatter structure may function more e�ciently. • Don’t forget that vendors are in the same boat. There may be savings available through revisiting these relationships, choosing new allies or tightening compliance by existing vendors. • Examine costs that don’t decline as volume falls such as finance, information technology and HR. Employee compensation packages can be reframed to include more performance-driven variable pay relative to base pay. Shifting the mix toward a higher proportion of contract workers for noncore/support functions is another option. • Identify the employees you can’t a�ord to lose and do what is needed to keep high-performing people by your side. At the same time, drop underperforming employees. • Use the downturn as an opportunity to learn more about the macro factors that drive your business. Create a dashboard to map out the scenarios you may face, which indicators will serve as warnings and how you’ll react when those bells are sounded. • Consider whether, in a contracting economy, your company is too large and diversified. Divestitures and portfolio rebalancing are critical tools in the resizing arsenal. However, it’s important to consider the impact that a spin-o� or carve-out might have on sales, the supply chain, and supporting business functions. Contrary to conventional wisdom, we believe a downturn can be not a threat but a great opportunity to gain competitive advantage. By being proactive, companies can gain market share, sustain profitability during the slowdown and surpass investor expectations. And the finance function should be in the lead position to drive the e�ort. Businesses must resist the temptation to cut costs indiscriminately. John Kiarie and Nikhil Hira are partners at Deloitte East Africa X BUSINESS DAILY | FRIDAY, JULY 10, 2009 the edge: It’s all in the numbers The good FD can move from scorekeeper The market downturn provides an excellent opportunity for Finance Directors to raise their game. By JEFF ALUDO T he role of the Finance Director as a strategic advisor becomes more prominent as companies turn to them to survive the market downturn. The complexity of the current global economic slowdown has organisations increasingly looking to their Finance Directors and finance functions to provide the solutions they need to cope with these challenges. Given the complexity and global nature of the current economic downturn, organisations are looking for ways to deal with intricate new realities and turn them to their advantage. CEOs and other members of the executive team must respond to immense pressure coming from a variety of sources, including board members, activists, stockholders, regulatory authorities and customers. The executive teams are dealing with a number of global financial conditions, including fluctuating exchange rates, rapidly changing economies and interest rates, and compliance with a variety of regulations. A bean counter, financier, finance operator, compliance steward, business partner, pragmatic strategist? The ever changing global and local prevailing circumstances are changing the role of the Finance Director (FD). Likewise is the charter of the finance function, which now includes not only reporting unimpeachable financial results and e�ciently funding the business, but also advising the company on strategic planning, operating e�ciency, and ultimately value creation. Companies looking to survive the current market conditions are beginning to recognise the ‘value in the numbers’ and are hence looking to their FDs to be strategic advisors and change agents. Fast changes Few could have predicted the extent, depth and pace of change brought about by the global economic slowdown and the impact it has on the finance function and the role of the FD today. The current economic situation demands that the FDs take a fresh look at the role that their finance function plays within the business and the way in which they drive towards achievement of the business strategy. Over the recent years, we have witnessed many companies su�er the consequences of investment and strategic decisions made without either including the FD Je� Aludo is a Senior Manager in the Advisory Service Practice at PwC Kenya and his finance function’s role in the strategy sessions or clearly evaluating the financial business case. Traditionally, CEOs would rely on marketing and business development people to make significant decisions without taking advantage of the financial analysis tools and insights FDs had at their disposal. Perhaps historically FDs have felt awkward about ‘forcing’ their financial modelling details into the loop at the risk of perception that their intricate approach to numbers may distract the process. Under the current business conditions, the role of the FD demands that value drivers are assessed to ensure the right valueadd initiatives with the appropriate return and payback periods Processing are undertaken. transactions Companieslooking to survive the current market conditions are beginning to recognise the ‘value in the numbers’ hence looking to their FDs to be the strategic advisor and the change agent. Today’s business environment is challenged with the current volatile stock market, reduced direct foreign investment, increasing governance issues, interest rate and currency fluctuations, political risk and regulatory compliance issues. All these factors are putting increasing pressure on the CEO and indeed the executive team to cut costs, boost performance and find news ways to maximise profitability. It would be catastrophic to imagine the impact of a decision not made on solid financial grounding. Balancing the requirement to add value whilst maintaining control in an e�cient way is a constant struggle for today’s FD, against the backdrop of a function that should be evolving by design rather than by default. Two chief hurdles confront FDs in their quest to become e�ective performance advisers. One is the complexity of the modern corporation, as represented by its often multi-locational operations, its voluminous business processes or transactions, and the ine�cient and sometimes haphazard way it has employed technology to link operations. The other is the lack of wellBecoming a rounded business strategic advisor skills among finance Developing a for the business employees, many Addressing vision for the of whom have had global markets future limited training or concerns experience in acting as performance advisers. A study conducted by CFO Research Services (an international research company) indicates that the FD’s role as a performance advisor hinges on finance’s ability to leverage existing technology and to simplify The evolving role of the FD and standardize processes both within finance and throughout the function that he or she leads will have organisation. It is imperative that FDs a new, expanded role requiring new find ways to reduce the time, e�ort tools, skills and ways of working and resources that are expended on e�ectively with all business process the lower value activities and then owners within the enterprise to invest those savings to allow the optimise overall operations. finance function to add more value Leading finance executives are and insight to the business. embracing this change, seeking In this new role, the FD needs to a more active role in improving develop a vision for transforming operations e�ciency and business the finance function to shift from performance management. primarily transaction processing to Today’s FD must exhibit not only solid accounting skills, but operations savvy, leadership, and management expertise. Only then will he or she be prepared to take the organization to the next level—participating in strategic decisions and contributing as a performance adviser. Likewise, in addition to bearing the responsibility for ensuring the integrity of the company’s financial performance, the finance The challenge FRIDAY,JULY 10, 2009 | BUSINESS DAILY XI the edge: It’s all in the numbers to driver working with the company and its business managers and ultimately playing a key role of providing business direction. Reducing complexities in the finance function involves the following: Strengthening performance management, budgeting, and forecasting capabilities. Optimizing cash flow and the use of capital. Improving internal and external reporting Focusing on people and organizational structure within the finance function. Building and maintaining coste�ective controls to ensure regulatory compliance Implementing financial management systems and streamlining processes are only part of the battle to transform finance function towards value addition. Completing the transformation requires building a finance team that knows how to fully utilise technology and what to do with the information those systems and processes yield— much like building a winning auto-racing team depends on having a driver who knows what to do with his car’s high-performance motor. Without a skilled driver who knows how to translate horsepower into optimal braking, accelerating, and steering decisions, the team is unlikely to take many chequered flags. Buyer beware: Why it is important to do your homework before investing in footnotes that few investors were likely to read. The year before the crisis, when Uchumi tapped its shareholders to raise Sh1.2 billion through a rights issue, advisory services firm PricewaterhouseCoopers had warned that the retailer stood no chance of surviving if it did not raise needed cash, but again, the information was not readily apparent and in any case, investors failed to act on it. For investors who are prepared to do their homework, there are guides as to where to focus their e�orts. According to forensic fraud experts at advisory firm Deloitte East Africa, revenue recognition fraud schemes are by far the most prevalent, at 41 per cent of the total. This finding is consistent with earlier studies. Manipulation of various financial statement items account for more than a third of all fraud schemes identified. Experts say one key number worth a close look is a company’s book value (assets minus liabilities). If the company’s balance sheet overstates the value of assets (like subprime mortgage securities) then the company looks like it is worth more than it really is. The same is true if the balance sheet understates liabilities. One other key number is expected earnings, which companies usually discuss in releasing their most recent financial results. If companies overstate these expected earnings, investors will be likely to pay more for shares and will feel cheated if the company cannot sustain the level of earnings predicted. What’s true in the simplest business transaction is also true in investing: let the buyer beware. A little e�ort beforehand can save a lot of regret later. ANALYSIS BY JAMES MAKAU “The gap in the balance sheet has arisen purely on account of inflated profits over a period of (the) last several years….” his was among the disturbing admissions by Ramalinga Raju, founder and chief executive o�cer of Satyam Computer Services, when he resigned in January. At Satyam, an Indian outsourcing company, as in other previous large scandals, fraudulent accounting was used to mask massive irregularities in the firm’s books. These included the fact that margins were three per cent rather than the 24 per cent claimed, and revenues were 22 per cent lower than the Sh44 billion declared. As the largest case of fraud in India’s corporate history unfolded, pundits were quick to apportion blame, and perhaps rightly so, to failing standards of corporate integrity that now seem to have become the norm the world over. But it’s also clear that investors in Satyam failed to ask the right questions. They were not alone. Whether in the Enron, Tyco, Worldcom or Satyam scandals, the apathy exhibited by investors and shareholders towards the financial statements of these firms up until the eleventh hour remains extraordinary. True, it’s not easy to understand company financial reports. Much of what’s in them reads like Greek to a vast majority of the investing public. And indeed, seasoned accountants and financial analysts from some of the world’s most prestigious firms have also been duped—or have willingly suspended good judgment-- in these scandals. But today, with management in firms willing to hide the truth about their accounts, and auditors either knowingly or unknowingly failing to pass clear judgment on firms that are in the red, investors need to pay keen attention to financial statements. If they don’t, they are James Makau leaving themselves at the mercy of is a writer with the companies they own. Business Daily Perhaps the best recent analogy T A true partner Finance functions need to be adaptive, resourceful and multitalented to deal with an increasingly broad agenda. No longer is it su�cient to be able to demonstrate that an organisation is “in control”. FDs and their teams are under growing pressure to move from being a backward looking ‘scorekeeper’ to a true business partner which adds real value and insight to the organisation. The FD’s objective should be to create a finance function in which employees understand the business in which their employer is engaged and possesses the analytical skills to translate the information at their fingertips into guidance that helps the company create shareholder value. This objective can be met through training existing personnel, hiring new talent from outside the company or by employing the use of consultants to provide the technical know-how. We have to get the finance function believing that it does not exist to be a good finance function but exists to drive the success of the business by helping maximise profitability, immunise the company against non-compliance, and optimise operational e�ciency. to Satyam in Kenya was the Uchumi debacle of 2005, which ended with the company’s almost going bankrupt. In that case, Uchumi—once Kenya’s most profitable supermarket chain—buckled under the weight of mismanagement that included company o�cials’ failure to give investors a clear picture of the company’s financial situation. In assessing the health of retailers like Uchumi nothing is as important as watching closely the valuation and movement of inventory. In Uchumi’s case, the management bought low quality and overpriced goods that then resulted in losses of Sh2 billion in a span of three years as the outlet tried to sell slowmoving inventory to raise cash. Though information about the company’s precarious situation was available in its financial filings, for the most part it was contained What investors need to look out for: Top six most common types of financial statement fraud 1 2 3 Recording of fictitious revenue. 6 Recognizing inappropriate amount of revenue from swaps, roundtripping or barter arrangements. Recognition of revenue from sales transactions billed but not shipped (“bill and hold”). Recognition of revenue when products or services are not delivered, delivery is incomplete, or products are delivered without customer acceptance. 4 5 Recognition of revenue where there are contingencies associated with the transaction that have not yet been resolved. Improper accounting for or failure to establish appropriate reserves for rights to refunds or exchange, liberal cancellation or refusal rights or liberal or unconditional rights of return granted through undisclosed oral or written side agreements. SOURCE: TEN THINGS ABOUT FINANCIAL STATEMENT FRAUD: A REVIEW OF SEC ENFORCEMENT RELEASES, 20002006 DELOITTE FORENSIC CENTER JUNE 2007 XII XII BUSINESS DAILY | FRIDAY, JULY 10, 2009 the edge: It’s all in the numbers Accountants, prepare for a make-over: It’s time to become The modern finance director needs to be persuasive, entrepreneurial and to demonstrate leadership — in addition to being a finance expert and commercially hard-nosed BY RICHARD YOUNG I Richard Young is a freelance writer, editor and conference chair, and former founding editor and publishing director of Real Finance s the idea of a “fabulous finance director” the stu� of mythology? Far from it. If anything, it’s the traditional bean-counter that has disappeared and become the stu� of legend. Great technical accountants have their place, but to take those skills into the boardroom you need vision, leadership, guile and commercial acumen. “We like fabulous FDs,” says Sarah Hunt, who runs EquityFD, a firm that places finance directors into high-growth and private equity-backed businesses. “Fabulous, to me, means someone who is instinctively positive, who says, ‘I’m here to help run a business’, not just be an e�ective accountant. They do what they do for business reasons, not just to develop their finance career.” A fabulous FD wants to be a businessperson, to make tough decisions around the boardroom table, as well as turn out good accounts. “They are focused on the whole game, every aspect of the business, not just the function they are in charge of,” says Hunt. She clearly understands her market. Michael Denny is the recently retired chairman of private equity firm NVM. For him, too, a fabulous FD takes the board discussion to a new level. “Any FD should have all the numbers at their fingertips,” he says. “A good FD is one who does well at reading the trends—one who notices that a bank is behaving oddly, or who sees that a currency is shifting, or a market changing. When the MD or the chairman start talking about opportunities a�ected by these changes, they can provide a context. “But a fabulous FD takes that a stage further,” says Denny. “They get a reputation for being ‘wonderful’ by analysing what’s happening and giving a valuable opinion. That means not waiting for the MD or the chair to come to them for an evaluation of an option — it’s creating options so that the team can make better decisions.” The problem for many accountants is that FDs are rarely seen as fabulous, making it harder for them to be accepted by less enlightened board members as key contributors to the more creative side of decision-making. “Accountants are still unfairly viewed as being behind the times,” says Martin Casimir, executive director at information group CCH. “Despite embracing new ways of thinking and technologies in their professional and personal lives, they are still unable to ditch their stu�y label.” CCH recently conducted a survey into attitudes about the profession, which confirmed that most people really don’t see much that is fabulous about the finance function. Only 28 per cent of the general The ‘fabulous FD’ goes beyond analytical functions. public recognises accountancy as a dynamic profession that embraces new technologies, compared with 53 per cent of accountants. The good news? Accountants’ self-image is definitely edging towards the fabulous. Nearly 80 per cent of accountants under 25 think of the profession as energetic and enthusiastic. Fabulousness shows itself at the first meeting you have with an FD, Hunt argues. Even your CV will demonstrate whether you have those extra qualities to make the grade. Does it contain a record of the finance function and accounting achievements? Or does it list the outcomes at the organisations you’ve worked in? “Being fabulous implies an emotional engagement,” says Hunt. “When a fabulous FD talks, it’s usually about how great their business is and what it has achieved, not how complete their CV looks or what qualifications they have.” Many FDs are reluctant to gush, which in other walks of life is a key component of being fabulous. But that doesn’t mean they need to be dour. “I don’t know whether you’d call it fabulous, but I try to be an optimist in this role, to stay positive whatever the circumstances,” says Jan Long, FD of Kingstown Furniture in Hull. That can be hard as a global recession starts to take hold, but it’s more important than ever at times like these. “At the moment, I am cautious, but it’s hard to shake the feeling that we’re talking ourselves into a global recession by being overly negative,” says Long. “In fact, many businesses can benefit from a period of slowdown — as long as they remain creative, positive and determined.” That’s a sentiment shared by a man who knows a thing or two about being an FD under pressure — Eric Tracey. A former Deloitte partner, he’s best known for taking on the FD role at two extremely troubled companies: Amey, which was facing a collapsing share price and a breakdown of reporting when he was called in; and Wembley plc, which brought him onto the board during a crisis in its US operations. “An FD probably needs to be respected rather than liked,” he says. “If people are swooning over the finance director, he or she is probably not doing the job right. You need someone who can and will say ‘no’ when they have to. That’s quite a skill, especially if you do it right and say ‘no’ in a way that doesn’t just annoy people and cause them to work around you. You have to be able to communicate your decisions clearly and explain them in a positive way that convinces people it was the right call.” what may,” she says. “So the old-fashioned ability to see a problem from all sides and bring to it the objectivity and discipline of the financial angle is critical.” Cash is critical and business acumen is a must in the boardroom. But the other key component of a fabulous FD is an ability to work with the team. “Over the next six months, the two key elements are going to be costs and cashflow — you’ve just got to get on with managing them and not worry about whether you’re seen as fabulous necessarily,” says Kevin French, FD at speciality steel producer United Bright Bar. “But it helps to have a fabulous relationship with your CEO and ops director — that’s how you get the business running day-to-day to deliver on those two objectives.” Remember that if the CEO is highly conservative, that might mean taking on a more outward-facing role. “That doesn’t mean I’d expect to see people pulling circus tricks in the board meeting,” says Hunt. “We’re still talking about FDs, so fabulous doesn’t have to mean flamboyant or over the top. It can mean those things, but that’s down to the individual style of the FD and how well they adjust that style to dovetail with their CEO.” Fair’s fair That’s one of the contradictions inherent in the role. “Fabulous” for a sales director probably means flashy, expansive and daring. But because FDs have a more considered, balanced role, their pursuit of fabulousness has to be more low key. “My style is firm but fair — and although it might or might not be seen as fabulous, the key aspect of a good FD is probably an ability to act as the referee,” says Long. “When you have a di�erence of opinion between the sales and the ops teams, you have to o�er a balanced, informed way of settling things. That becomes particularly pertinent when the MD has a background in one of the disciplines that’s involved in the argument — it’s much harder for someone who has come up through sales to be seen to settle those disputes without bias, so the FD can be fabulous in those situations just by being objective.” To expand on Long’s football analogy, don”t expect to be fabulous in the way of Rooney or Robinho — true fans know when the referee has had a great game because they’ve been relatively anonymous. They ensure fairness and facilitate — rather than break up — the flow of play. “It’s fine to be fabulous and outspoken, but you need to be able to play that referee role come Building bridges Denny can look back on a 20-year relationship with his FD at NVM, Alistair Conn, to see how well that works. “A lot of the additional value that an FD brings is wrapped up in e�ective teamwork,” he says. “A great FD quality is keeping an entrepreneur’s feet on the ground without making them frustrated. I would come up with an idea and if it was bad, or breached regulations, or was unprofitable, then Alistair would always say, ‘No we can’t do that, but what we might be able to do is…’ and give me options. Non-fabulous FDs tend to either just say ‘no’ or, worse, say FRIDAY,JULY FRIDAY,JULY 10, 2009 | BUSINESS DAILY XIII the edge: It’s all in the numbers fabulous How the evolving finance function is shaping careers of aspiring professionals CAREERS BY JOHN NYAKAHUMA ‘yes’regardless.” That level of trust will often elevate not just the board’s decision-making, but the whole organisation. “Fabulous FDs have a true feel for it commercially, so they can work with the CEO to deliver on the strategy,” says Tracey. “At the same time, they must never forget the gatekeeper role that every FD fulfils. There are lots of people, inside and outside the organisation, who are depending on that side of the role.” For Hunt, that willingness to engage with other people in a flexible, creative way is crucial. “Fabulous FDs see value in networking — in making connections and showing a bit of imagination about possibilities in any given situation,” she says. “They don’t just wait for the phone to ring — they’re keen to open up new avenues.” The one area where a standard definition of fabulous intersects with its application to FDs is energy. A senior finance person can be energetic without pulling cartwheels. They can bring vigour and presence, even to the role of referee. “The ideal FD is positive, energetic and keen on finding the right role — not just finding a job,” says Hunt. “You want them to show true self-belief — but it can go too far. Arrogance or overconfidence in an FD is a particularly bad combination. A fabulous FD is good at taking feedback, which can be critical.” Ultimately, we’re talking about FDs who are positive and self-aware, who are good to talk to. “They’re energy givers, not people who suck the life out of a conversation,” Hunt concludes. “Energy is a wonderful thing and everyone wants it. So the FDs who generate it — whether the market is booming or slumping, in good times and bad — are the really fabulous ones.” - ACCA he recent global financial storms have left their mark everywhere in the world. In the past few months the global economic downturn has had farreaching impacts on businesses of all types and sizes and will have major implications for people who aspire to follow business and finance careers. The one issue that people can be certain of is that in a tough new business world, organisations will be placing even greater demands on qualified accountants. The Association of Chartered Certified Accountants (ACCA) and the research company BPRI Group recently surveyed chief financial o�cers, partners and senior accountants in Africa, Europe and Asia to discover how they believe business will have changed in five years’ time as a result of the global economic downturn; what demand they think there will be for qualified accountants in 2014; and what skills will be needed. The survey took place earlier this year, when 750 business executives across eight countries were interviewed by phone. Our resulting report, Accountancy: The future outlook, shows that chief financial o�cers, partners and senior accountants around the world are very concerned about the future financial stability of clients and customers, with 87 per cent believing that businesses will be cautious in giving credit. The overwhelming majority believe business will be more wary of risk-taking and that raising funds will be more di�cult as a result. If raising finance is more di�cult, the report suggests, accountants will need to be more resourceful in coming up with solutions. Globally, 63 per cent of respondents expect to see an increase in demand for accountants, not only because they see an upturn in business, but also because many feel accountants are essential for business to deal with a long term tougher trading climate. The research shows that successful accountants of the future will still need technical competence — such competence remains an essential requirement. But they will also need to develop the rounded businesses skills developed by studying the ACCA Qualification, including those linked to strategic planning and personal e�ectiveness. The technical skills they will need to master include John Nyakahuma is risk management. They the head of corporate will need to be able to help organizations manage development, ACCA risks by being able to look T at all the various uncertainties that exist across an organization, and to help management to reduce the threat posed by any future significant risks. Two other financial skills frequently identified as likely to be in more demand both relate to organizations’ ability to take e�ective decisions in an uncertain world. Seventeen per cent of those surveyed expect strategic scenario planning to be more in demand in five years, while 14 per cent think the same of skill in improving the use of data or knowledge. Similarly, significant numbers of CFOs, partners and senior accountants also foresee increased demand for project modelling and costing skills (10 per cent of the total). By applying data within sophisticated models, skilled accountants can generate information of real use when evaluating potential investment decisions and ensuring that scarce resources are applied e�ectively to maximise returns. increased demand in five years. This type of so-called ‘softer’ skill is particularly important in modern business, where accountants are expected to communicate e�ectively both internally and externally. The research also uncovers a growing global expectation that accountants will fill relatively complex roles – with financial professionals being expected to have skills in enterprise risk management, strategic scenario planning and the improved use of data. There is also a need for a quality that cannot be added to the skill set, but is equally important. It is the need for ethics within the finance function, and the responsibility that senior finance sta� have in ensuring sound ethical practice within their organization. It is business leaders as individuals who – alongside the e�orts of professional membership bodies and regulators – must drive the integration of ethical values into board and senior management decision-making, and into organizational culture. Thus companies can improve brand values with customers, strengthen relationships with banks, investors and suppliers, and add to their appeal as employers of choice. Tomorrow’s professional accountant faces an everincreasing set of competing values and complexities. Given that financial markets thrive on accurate and freely available information, the integrity of those who prepare that information is paramount. The ability to exercise judgement based on ethics will be the one constant that will ensure finance professionals maintain that integrity and successfully navigate complexity and ethical dilemmas. ACCA’s aims With this in mind, as a professional body, ACCA aims to: • Re-assert what it means to be a finance professional. • Help ensure that the accounting profession continues to provides variety, intellectual challenge and a high reputation so that we can attract the best talent to our ranks. • Beware of the risk of ‘de-professionalising’ accountants by avoiding the use of blunt regulation at the expense of professional judgement. • Promote the role of the accounting professional as an individual who can help businesses and individuals manage risk, simplify complexity, foster entrepreneurship and create value. • Maintain our values of professionalism. In all this, we continue to strive for higher standards and help build a global accounting profession. In other words, we seek to ensure that each ACCA member makes ‘a good accountant’ – and also ‘an accountant that’s good’. Needed: ‘softer skills’ Skill in the area of accounting for the knowledge held in an organization is also expected by one in ten participants to be in greater demand. The view reflects the increasing importance of intangible assets in the modern business world. Nearly one in ten of all respondents believe that skill in building relationships in business and with stakeholders will be in Eastern Africa XIV XIV BUSINESS DAILY | FRIDAY, JULY 10, 2009 the edge: It’s all in the numbers When financiers take to the hills, look for new and unfamiliar types of funding GEOFFREY IRUNGU explores avenues of financing that are available to companies in hard economic times C ompanies in need of financing can still turn to traditional methods, but they could also be making more use of some unfamiliar instruments, experts say. At a time of slow economic growth and high inflation, innovation and pragmatism may be not just advisable but essential, the experts warn, in order to weather the current climate. “When cash is tight, financiers take to the hills,” says Mr Abdirahman Abdillahi, a lecturer in CFA studies at Strathmore University. “Check bank sources, deposits are flat. Demand for credit is healthy. There is a mismatch between supply and demand for funds.” To be sure, some Kenyan firms with strong fundamentals are still successfully opting for bank loans. Mr Abdullahi notes that “borrowing costs are still pretty good and one can get funds at 12 per cent for a year if he or she is savvy.” Mr John Ngumi, CFC Stanbic director of investment banking in Africa, reckons that while banks may be cautious in a downturn, there is no particular di�erence between good and bad times as long as a firm’s books are in order and its cash flow is good. However, banks have become stricter in their lending conditions, convinced that many borrowers may face di�culties in making repayments. Indeed, a significant number of banks have increased their provisions for bad and doubtful debts and have even written o� some of their loans as borrowers hard-hit by the economic slump fail to meet their debt obligations. Raise funds Another traditional source of financing is corporate bonds. Kestrel Capital draws attention to the corporate bonds that are in the pipeline this year, including Safaricom, KenGen and Centum Investments, indicating that cash-rich firms can still use bonds to raise funds. But CMA prescribes tough conditions for a company wanting to issue a bond. For example, it requires that an organization show adequate generation of funds from operations compared to its debt level in order to demonstrate that it has enough cash to meet payments as they fall due. In the event that an organisation does not meet the financial requirements for a bond issue, a guarantor is the only way out. One other major traditional source of financing is equity—in such forms as rights issues for publicly-traded firms and initial public o�erings for private ones. The downside here, however, is that the valuation may not be as good as it would be during an economic boom. Indeed, analysts believe the current weak market, which has seen the Nairobi Stock Exchange 20-share index lose about 20 per cent in the year to date (though it has recently been gaining ground), is the reason no local firms are looking at rights issues or IPOs as an avenue of raising money. Before the downturn several companies had For companies that cannot tap into traditional financing sources, or prefer a different route, experts say that socalled mezzanine financing, which combines elements of equity and debt, can be an appealing option. Geo�rey Irungu is a writer with Business Daily said they were planning on IPOs, but only bread maker DPL Festive Ltd has been brave enough to go ahead with the plans. One alternative to appealing to the public is a private placement. “Though the equity market is rather subdued, I say private placements can be done with the right project,” Mr Abdillahi says. “Take for instance someone who is doing a power project. With Kenya su�ering from a power deficit, it is likely to draw interest.” Variations on some of the above financing methods are also becoming more popular. O�cial statistics show that the uptake of overdrafts and commercial paper facilities has been rising steadily. Strong firms can also use their own internally generated cash, redirected from reserves into working capital. For companies that cannot tap into traditional financing sources, or prefer a di�erent route, experts say that so-called mezzanine financing, which combines elements of equity and debt, can be an appealing option. Currently mezzanine financing is not widespread among public firms in Kenya. In a past interview Mr Christoph Evard, a specialist at DEG, a German development institute, said, “Mezzanine is still almost unused in East Africa, and, outside of the financial experts’ circles, often unheard of. The know-how is still not deep enough within the banks’ mid- and lower - level financing teams, and thus educating the companies takes a long time.” He said, however, that he strongly believed that “the time is ripe for mezzanine to play a prominent part in transactions in this part of the continent.” Mr Evard is responsible for structuring and managing DEG’s equity and mezzanine investments in Africa, excluding the financial services and infrastructure sectors. He recently conducted a workshop on mezzanine finance in Nairobi as part of educating finance experts on such products. According to DEG, preferential shares — which rank ahead of common shares in their claim on a company’s assets – come at the top of the chain of products under mezzanine finance in East Africa. They are followed by convertible bonds and subordinated debt. There are only two preferential share issues listed on the Nairobi Stock Exchange. The two both belong to the Kenya Power and Lighting Company, with one set at four per cent and the other at seven per cent – in which the percentage refers to the fixed dividend payment. However, some listed companies such as Kenya Orchards hold preferential shares which are not listed on the NSE. Standard Chartered Plc holds preferential shares in its Kenyan subsidiary, but these are also not listed. “The preferred source of funding will depend on the risk profile of the project,” Mr Abdillahi said. “A risky project should have more equity, perhaps 100 percent equity. A project with solid cash flows can a�ord high leverage.” When it comes to deciding what form of financing a corporation should seek, expert advice is essential, according to Mr John Kiarie, a partner at Deloitte East Africa. He said recently that multinationals—even when they have financial experts within their enterprises— seek expert advice or second opinions on these matters while small and medium-sized businesses generally do not. “SMEs will find that they can benefit from an examination of the contracts they enter into through seeking expert advice,” Kiarie said. “This can simplify the negotiation process such as when they are seeking funding.” FRIDAY,JULY 10, 2009 | BUSINESS DAILY FRIDAY,JULY XV the edge: It’s all in the numbers Corporate strategy re-examined Caesar Mwangi, CEO Sasini, takes MWAURA KIMANI through the dos and don’ts of corporate planning in a time of crisis I n recent months, most local corporations have shelved or cut back on planned projects as reduced cash has proved a big shock to their planned strategies. How to push through growth plans despite increasingly slim corporate purses has emerged as the biggest challenge for executives this year. In an interview with Business Daily on weaving finance into the company strategy, Dr Caesar Mwangi, managing director of listed agricultural firm Sasini, said recent events in both the global and local economies have brought to the fore just how the two––finance and strategy— are inseparable. Financial strengths “Although strategy precedes funds, the latter is key as it greatly determines whether the plan will work out or not,” said Dr Mwangi. He added that the challenges of running a company in the prevailing environment, in which demand for goods and services has dropped amid rising operational expenses, has redefined the role of the finance function in a company, putting it at the centre of the strategy process. Traditionally, the role of the chief financial o�cer has been seen as comparable to that of a discipline master in an educational institution, only in this case the CFO must ensure that the company’s revenues and expenses do not get out of line. For CEOs trying to plan for the uncertain future and operating in the volatile present, Dr Mwangi proposes a re-examination of strategy. He warns that new projects and opportunities should be pursued with extreme caution. “Look to the financial strengths of your own company, compare that with the views of the finance people,” he said. “This is what will determine the strategy you adopt.” With the economy showing little signs of swift recovery, analysts reckon that business managers will rely more on strategy and not the economy to jumpstart profit growth. And this will require a company-wide approach driven from the top by the CEO and the finance chief, said Dr Mwangi. According to management experts, CEOs often find themselves reviewing their previous strategy in order to adjust it to their company’s current financial strength. “There is nothing wrong with rescheduling plans, postponing or doing away with others at the expense of the company’s survival,” said Dr Mwangi. “Today, any strategy must be attractive and viable enough to justify the use of any company shilling, ” CFO magazine’s Global Business Outlook Survey of finance executives, conducted quarterly with Duke University’s Fuqua School of Business, shows more than half of CFOs surveyed in the second quarter of this year were involved in planning cuts in sta�ng, capital spending, and research and development, improving working capital processes and forecasting cash flow. Dr Mwangi said that any company strategy must be reviewed periodically to incorporate assumptions based on current knowledge. “That’s when finance people again come in, to quantify the strategy for implementation without which the plan could come a cropper,” he said. Euromoney says corporate executives are increasingly coming to terms with the need for extreme and urgent actions. Among them are paying down debt, reducing costs, slashing expenditures, husbanding cash and wrestling with how to maintain access to credit while strengthening capital structures. When it comes to raising funds to roll out a strategy, Dr Mwangi said, it’s the circumstances and nature of the project that determine the most viable and economical sources. “Cash should be raised only when it’s extremely clear the money can be deployed e�ectively,” said Dr Mwangi. “Timing is crucial to ensure the company does not end up with idle funds.” “Strategy is a function of scanning the external environment and identifying existing opportunities which must be in line with the financial position of the firm,” he added. Corporate executives are increasingly coming to terms with the need for extreme and urgent actions . Among them are paying down debt, reducing costs, slashing expenditures, husbanding cash and wrestling with how to maintain access to credit while strengthening capital structures. Dr Mng’s Ds n D’ts Dos Be very clear on the strategy and the steps of implementation. Quantify all the financial inputs that will go into the strategy. They should be specific to ensure efficiency and accountability in the financial process. Identify the alternative sources of inputs as well as the finances to run the strategies. This should be guided by the cost of accessing this capital gauged against the expected return of the investment or strategy. Have a fixed time-plan; otherwise you may drag out adoption of the strategy and the environment may change, rendering the plan less viable. Have clear roles on the crafting of the strategy as well as on its implementation in order to avoid lapses and overlapping of duties which could bring conflict and failure of the plan. The finance function of the firm must be wholly involved from the start as its finances which will determine whether the plan will be rolled out. Don’ts Never have a one man-strategy. Always involve others as their exclusion could turn out to be a costly affair. Never base strategy on unexamined assumptions, especially with regard to financing. Never fail to review the strategy from time to time. Review will bring to the fore unexpected facts, especially ones based on prior considerations that may have been made in a time of uncertainty. Do not be afraid of changing strategy in the light of new information like scarcity of funds. But always communicate changes. There is nothing wrong with shelving, dropping or even postponing a strategy. Do not copy others blindly as the circumstances leading to their perceived success could be different from those of your company. Mwaura Kimani is a writer with the Business Daily XVI BUSINESS DAILY | FRIDAY, JULY 10, 2009 the edge: It’s all in the numbers Why the global wrecking ball will reach Africa Financial integration means that problems in one country ultimately affect all BY JOSEPHINE KIBE The current global recession began far away in the US, caused by severe problems in the housing, credit and financial markets which resulted in significant losses. The US subprime mortgage crisis contributed significantly to the recession. Many experts trace the origin of this crisis to President Clinton’s administration, which helped minorities and low income consumers to obtain home mortgages. Although this was a well-intentioned initiative intended to assist borrowers whose incomes, credit ratings and savings were not good enough to qualify for conventional loans, money flowed to people who couldn’t a�ord to pay it back. Rapid innovation in financial instruments made credit risk easier to trade. The proliferation of credit risk instruments was driven in part by an assumption of frictionless, uninterrupted liquidity. This, of course, left credit and funding markets more vulnerable when liquidity did recede. The result was a credit crunch driven by the rise in defaults on subprime mortgages. Financier George Soros regards financial-market swings as a “wrecking ball” that can be seen “knocking over one economy after another.” Ripple effect Some people feel that Africa will not be adversely a�ected as the continent does not engage much in trade with the United States. Others feel that, because of the integration of the global market, Africa will be not be spared. I believe Africa will be significantly a�ected by the economic crisis. Perhaps this may not be felt very much in the short run, but the e�ects will be evident in the longer term. The financial globalization process involves the integration of a country’s financial system with international financial markets and institutions. Such liberalisation has brought numerous advantages to countries that previously could not access capital and also to countries that wanted to accumulate capital by investing in international assets that would yield high returns. But financier George Soros regards financial-market swings as a “wrecking ball” that can be seen “knocking over one economy after another.” Financial integration also brings about volatility of the economies involved, such that if a huge financial player is a�ected (the US in this case), there will be a ripple e�ect that will hit other financial players, directly or indirectly. The role of foreign banks, as far as mobilisation of savings and maintaining liquidity in the financial market, is significant. The challenge that Africa faces with regard to the Josephine Kibe is a PhD (Economics) candidate at Fordham University, NY, USA. She is the former Director of Executive Education at Strathmore Business School. crisis is that if a parent bank in the United States or Europe is su�ering, it may have an e�ect on a subsidiary in Africa. The e�ect may not be as tumultuous as the kind seen in Europe and US because indigenous African banks tend to keep their loans on their own balance sheets and the market for derivatives is almost non-existent. Another major impact is the reduction in portfolio inflows. There has been evidence that in the last three years, private capital flows have been rising in Africa more than in any other part of the world. Investors brought US$36 billion into Africa in 2007, almost double the 2005 figure. The increase in Foreign Direct Investment contributed to the continent’s average growth rate of more than five per cent. The current global credit crunch will lead to a decline in capital flows as investors are unable to access credit and there is currently a general reduced appetite for risk. For poor countries in Africa,foreign remittances are another crucial issue. In the case of Mali, remittances from abroad, especially from France, have helped build 60 per cent of the infrastructure. Mali is ranked among the 49 least developed countries in the world. Remittances to Africa, worth $40 billion a year according to the United Nations, could be an early casualty of the global financial crisis. Many Africans living and working abroad are likely to lose their jobs or will have to tighten their budgets because of the crisis. For some Africans back home, such remittances are no luxury — they are used to provide for basic needs such as food and healthcare. Many African countries rely on O�cial Development Assistance from the developed world to provide for basic needs such as food, water and medicine. Africa su�ers from preventable diseases such as tuberculosis, malaria and HIV/Aids that claim hundreds of lives every day, and the financial crisis may lower financial assistance to help millions of people access treatment. Different views Some see things di�erently. Central Bank of Kenya Governor, Prof Njuguna Ndung’u, is among those optimists who are of the view that the impact of the crisis will not be felt much in Kenya. However, a sector like tourism is likely to be among the first casualties. Tourism accounts for 10 per cent of the GDP (the third largest contributor, after agriculture and manufacturing). A sharp drop in the number of tourists is already being felt, and will definitely leave Kenya worse o� in terms of tourism revenues and will a�ect the country’s foreign currency position. President Wade of Senegal argued that the problem is a problem of the ‘rich’ and doesn’t a�ect the average African. According to the country brief provided by the World Bank, Senegal is a poor country with a GNI per capita of $840. The rationale that Wade provides is that the amount of investment needed to feed people and create jobs in Africa is a small fraction of the money being spent on the global financial crisis. The flaw in his argument is that the ‘average African’ may be infected or a�ected by HIV/Aids, depend on remittances from abroad to cater for his/her basic needs, is in need of financial capital to start a business (and cannot do so because of the credit crunch), will be a�ected by increased taxes because of the shortfall of tourism revenue, and relies on raw material production, demand for which is badly a�ected in western markets. More importantly, the revenue that Africa gets from the developed world represents a huge proportion of its total income, though in terms of global trade it may seem a small percentage. According to Ethiopia’s prime minister, the current financial crisis will have little e�ect on his country either, his reasoning being that Ethiopia’s financial structure is not liberalised and its economy is not intertwined with western economies. Yet Ethiopia is a country that faces acute famines and relies on extensive aid to curb this catastrophe. As recently as July 2008, the UN was involved in e�orts of sending food to the starving population Already, Africa is seeing tight access to liquidity and an increase in the cost of borrowing. Africa’s banking sector will be a�ected because major banks in Africa are still foreign-owned. This means that credit will not easily be available, prompting low capital formation. Being a major importer of capital goods from the developed world also presents a challenge since the dollar has been strengthening against major African currencies. Additionally, exports from Africa are bound to decline because of the credit crisis. To add to the current problem, several African countries are su�ering signs of macroeconomic imbalances quite independent of the financial crisis. This will add to the growing budget deficits of African countries. In short, the e�ects are already evident and I believe that a prolonged global financial crisis will a�ect Africa very seriously. FRIDAY,JULY 10, 2009 | BUSINESS DAILY FRIDAY,JULY XVII the edge: It’s all in the numbers Big cats in the house EMMANUEL WERE examines why large audit firms still take the lion’s share of business T he global economy is showing signs of recovery, but questions linger as to what role external auditors could have played in averting the crisis. Charged with the duty of examining financial statements and issuing a verdict on whether companies are on a solid financial footing, external auditors now find themselves under the microscope. They gave many firms, especially financial institutions in the developed countries, a clean bill of health—only for the companies to subsequently collapse with billions of dollars of liabilities or worthless assets. Now, the relationship between auditors and companies seems set to change. Auditors are becoming more cautious and spending extra hours going through the balance sheets, while companies are pressing more frequently for assistance in protecting their operations. “The auditor is obviously under greater scrutiny and they have to do additional work to satisfy that assets are not misstated,” says Mr Richard Njoroge, a partner in the assurance division of Price waterhouseCoopers (PwC). Tightened grip Njoroge adds that the credit crisis has made directors look again at the way they conduct their business and they have engaged their auditors in the process of identifying potential risks. Companies in Kenya, faced with the same concerns as their peers worldwide, say reputation is still key in hiring external auditors. “The big four start o� with an advantage,” says Mr David Somen, executive director of listed ICT firm Access Kenya. “And then it is a question of talking to the other Kenyan companies who use the auditors to see what they say.” The “Big Four” audit firms in Kenya are PricewaterhouseCoopers, Deloitte, Ernst and Young and KPMG, who over the years have tightened their grip on the local audit market. Indeed, these four audit firms have the lion’s share of the audit business of companies listed at the Nairobi Stock Exchange. Due to the fact that they operate franchises known the world over, and have adequate personnel and well-trained professionals, these four companies start as strong favourites when the audit committees of most companies’ boards make their choice. Audit committees usually consist of directors who are not involved in the day-to-day running of the business, in order to ensure an independent opinion on the management of the business. The same holds true for the audit firms, which have to be regarded as unbiased and independent of the management to ward o� any possibility of a conflict of interest. “Independence of auditors [from] senior management is necessary to ensure the quality of the audit as there is no guarantee of a next appointment,” says Mr Joshua Oigara, finance director at Bamburi Cement. In the audit business the most important resource are the people. A well trained and experienced workforce means that there is a wider pool of talent for the auditing firm to o�er the client. The big four have fought to maintain their dominance by luring fresh talent from the universities with attractive starting packages. In the last two years, the starting salary for a graduate has shot up from Sh70,000 to Sh85,000, which has served to attract the top talent. “We consider if the audit firm has the right people, with the right skills and with proper tools to deliver the expectations in a timely manner,” says Oigara. The external audit can take up to two months depending on the size of the company. The process involves giving an opinion as to whether the appropriate checks and balances have been put in place by the company’s own auditors. For listed companies, a timely audit is crucial because most sectors have a deadline by which they must present their audited financial results. Failure to beat the deadline means that they incur a penalty from the regulator. But while such concerns may make the services of large, established auditing firms more attractive, the high costs of such firms’ services, coming at a time of economic slowdown, may also o�er an opening to smaller companies. Some mid-tier audit firms have been making a comeback by buying franchise licences so as to be associated with the world’s biggest and most prestigious firms. Smaller firms One of the companies that have gone this route is PKF International, which joined forces with Kassim Lakha to form PKF Kenya in 2002. Most recently, HLB Ashvir converted to RSM Ashvir after signing a signing a deal with the world’s seventh-largest accounting firm, RSM International. “We are growing in stature and in character and it’s just a matter of time before we start winning the big deals,” said Ashif Kassam, the managing partner at RSM Ashvir. Kassam said most clients are attracted to smaller firms because of their lower costs, personalised services and the improved quality of their audit work, which he says is at a par with that o�ered by the top firms. The lower costs are attributed to low overhead compared to the top four, while the improved standards are attributed to the expertise the smaller firms can call on through a global professional network. Emmanuel Were is a writer with Business Daily XVIII XVIII BUSINESS DAILY | FRIDAY, JULY 10, 2009 the edge: It’s all in the numbers ������������������������ ������������������ ������������������������� ���������������� FRIDAY,JULY FRIDAY,JULY 10, 2009 | BUSINESS DAILY XIX the edge: It’s all in the numbers What the numbers say: A closer look at two competitors CAROL MUSYOKA puts a magnifying glass to the figures of two finance industry peers, and comes up with some interesting observations A t the Kenya Commercial Bank Annual General Meeting held in May this year, the shareholders, at management’s request, approved the merger of the mortgage subsidiary S&L (Kenya) Limited with the operations of the main bank. This will leave Housing Finance as the only distinct mortgage finance provider in this market. The reason given for the merger was to reduce costs that had arisen from having two di�erent boards of directors, board committees, sta�, o�ce space, systems and processes. But sometimes the story behind the story can be unearthed from analysing the numbers. Let us review the recently published unaudited financial statements for the first quarter of 2009 to gauge the performance of the two mortgage providers. When the banks publish their first quarter financial results, they are also required to provide the previous year’s first quarter results as well as the end of the previous year’s results. So this year, we see March 2009, December 2008 and March 2008 performance displayed for our analysis. What one needs to keep in mind is that the December 2008 numbers reflect a full year of performance and therefore when looking at the Balance Sheet numbers for March 2009, they reflect growth over December 2008 numbers and not March 2008 numbers, an error that is often made by reporters in the media. A good example is S&L where a section of the media reported a growth in loans and advances from Sh6.3 billion in March 2008 to Sh10.4 S& L (Kenya) Limited Shs Millions Loans & Advances (Net) Customer Deposits Balances due to Group Companies Gross Non Performing Loans Total Capital to Total Risk Weighted Assets billion in March 2009, a 64 per cent growth. However, we should actually look at the closing position in December 2008 of Sh9.2 billion to Sh10.4 billion March 2009 which is actually a more reasonable 12 per cent growth in loans in the first quarter of this year. Compare this to Housing Finance who grew their loans by Sh867 million or 8.3 per cent in the first quarter of the year. Analysts of financial institutions usually look deeper at the balance sheets to reveal what funded the loan growth of an institution. Housing Finance increased its customer deposits in the first quarter by a notable Sh545 million, or 5 per cent growth. S& L on the other hand, remained flat on its deposits which at the close of 2008 were Sh4.5 billion, the almost exact same position at the end of March 2009. So what, pray tell, funded S&L’s loan growth? If you look at S&L’s balance sheet you will notice that over half of its liabilities are balances due to group companies - in simple speak, deposits placed by its deep-pocketed parent Kenya Commercial Bank. These deposits increased by Sh1.7 billion, from Sh5.8 billion in December 2008 to Sh7.5 billion in March 2009, a 29 per cent growth! Assessing the total loan book (which is the performing and non-performing loans), the deposits from the group companies have funded 65 per cent of the total loans for S&L! I am not going to hazard a guess as to whether S&L is paying market rates for these deposits, which any prudent opportunity cost driven Financial Controller at KCB should be demanding, but it says a great deal about the S&L strategy when the funding options are driven by a parent/ subsidiary relationship rather than the market norm of growing deposits and strengthening the institution’s depositor base. Good books, bad books Turning to how the two institutions managed their bad debt book, Housing Finance’s total non-performing loans dropped by Sh30 million (or 2.5 per cent) from December 2008 to March 2009 while S&L’s non-performing loans increased by 140 per cent or Sh659 million in the same period. In the non-performing loan book, borrowers are simply no longer repaying the principal and/or the interest and thus the bank is not registering any income in the form of interest. As we have observed with other institutions in the banking industry, such an extremely significant increase in non-performing loans can be caused either by one or two large borrowers whose loans have gone bad, or a portfolio of smaller borrowers. If the latter is indeed the case, and it may very well not be, then this demonstrates some weakness in the credit regime within the institution. Nevertheless, S&L returned an impressive growth of Sh142 million (79 per cent growth) in interest income from their performing loans and advances in March 2009 over the same quarter in 2008. Housing Finance also registered a remarkable growth of Sh103 million (44 per cent growth) in the first quarter of this year, vindicating the current management’s turnaround strategies over the last three years. Before you ask, when analysing the Profit and Loss Statement, a financial analyst now looks at March 2008 and compares that to March 2009 simply because an income statement is an annual report demonstrating performance for the year under Mar 2009 10,428,621 4,504,060 7,520,676 1,221,523 14.4% 320,836 11,285,633 10,633,693 20,578 1,933,770 41.13% 336,114 Dec2009 Mar 2008 9,254,068 4,504,397 5,848,982 563,415 14.9% 917,362 10,418,665 10,088,797 20,997 2,096,801 43.17% 1,085,605 6,332,893 3,498,090 3,631,642 438,236 19.4% 178,554 8,283,288 9,457,474 18,334 2,457,886 15.81% 233,198 Interest income Housing Finance Loans & Advances (Net) Customer Deposits Balances due to Group Companies Gross Non Performing Loans Total Capital to Total Risk Weighted Assets Interest income review, while a Balance Sheet reflects the cumulative performance of a financial institution over the period of its existence since inception. Finally, it can be surmised that the KCB decision to merge S&L into the main bank might have been driven by the latter’s capital adequacy ratios. The CBK Prudential Guidelines are crystalclear on the need for banks to maintain a solid capital base to support their lending practices. Simply put, a bank is required to allocate a certain amount of capital for every advance that it makes depending on its risk weighting. Government securities are regarded as risk-free lending and therefore attract a zero weighting of risk and no capital allocation; a loan to an individual or a company will attract 100 per cent risk weighting if it is not secured by cash. A residential mortgage however, attracts only a 50 per cent risk weighting. Reviewing S&L’s Total Capital to Total Risk Weighted Assets, there has been a steady decline from 19.4 per cent in March 2008, to 14.9 per cent in December 2008, to 14.4 per cent in March 2009 - compared to a statutory minimum of 12 per cent. This demonstrates that unless there is a capital injection into the institution it will probably be unable to lend further by the end of 2009. Conversely, Housing Finance, due to a Rights Issue in mid-2008, enjoys healthy capital adequacy ratios of 41 per cent in March 2009 compared to 15.8 per cent same time last year. Such high capital adequacy ratios are a double-edged sword however, as shareholders demand a return on that capital and the only way to obtain a higher return is by advancing more loans which reduces the ratio. It is unfortunate that once S&L’s operations are merged with the KCB we will no longer be able to analyze their separate performance, but as a division within one of the four biggest bank balance sheets in the country, the mortgage book can only grow even bigger as it will have no deposit constraints or capital adequacy ratios to contend with. Furthermore, the challenge is now on KCB management to leverage its large countrywide network to provide mortgages to Kenyans and draw on the specialized knowledge within the S&L team to embed mortgage lending as a product across its network. So what do the numbers encapsulated in the financial statements tell a reader? Firstly, a bank can only grow its loans and deposits as fast as its capital permits it to. A well capitalized bank is essentially poised for growth. Conversely, a bank’s capital will be on a negative trajectory if it is making bad loans that cause it to make higher provisions which impact on its profitability and subsequently its retained earnings. Secondly, a bank that has a healthily diversified customer deposit base that funds its loan growth will be sure to succeed as it is not beholden to the whims of one particular provider that can pull its funding and hold the bank’s management to ransom. A bank’s balance sheet therefore exhibits management’s strategy to undertake business, whose success, or lack thereof, is demonstrated in the profit and loss statement. Carol Musyoka is a financial consultant and a columnist with Business Daily XX BUSINESS DAILY | FRIDAY, JULY 10, 2009 the edge: It’s all in the numbers Why economists failed to predict the global Some economists argue that a free-market bias in the profession, coupled with outmoded and simplistic analytical tools, blinded many of their colleagues to the danger T here is a long list of professions that failed to see the financial crisis brewing. Wall Street bankers and deal-makers top it, but banking regulators are on it as well, along with the Federal Reserve. Politicians and journalists have shared the blame, as have mortgage lenders and even real estate agents. But what about economists? Of all the experts, weren’t they the best equipped to see around the corners and warn of impending disaster? Indeed, a sense that they missed the call has led to soul searching among many economists. While some did warn that home prices were forming a bubble, others confess to a widespread failure to foresee the damage the bubble would KNOWLEDGE cause when it burst. Some economists are @ WHARTON harsher, arguing that a free-market bias in the profession, coupled with outmoded and simplistic analytical tools, blinded many of their colleagues to the danger. “It’s not just that they missed it, they positively denied that it would happen,” says Wharton finance professor Franklin Allen, arguing that many economists used mathematical models that failed to account for the critical roles that banks and other financial institutions play in the economy. “Even a lot of the central banks in the world use these models,” Allen said. “That’s a large part of the issue. They simply didn’t believe the banks were important.” Over the past 30 years or so, economics has been dominated by an “academic orthodoxy” which says economic cycles are driven by players in the “real economy” -- producers and consumers of goods and services -- while banks and other financial institutions have been assigned little importance, Allen says. “In many of the major economics departments, graduate students wouldn’t learn anything about banking in any of the courses.” But it was the financial institutions that fomented the current crisis, by creating risky products, encouraging excessive borrowing among consumers and engaging in high-risk behaviour themselves, like amassing huge positions in mortgage-backed securities, Allen says. As computers have grown more powerful, academics have come to rely on mathematical models to figure how various economic forces will interact. But many of those models simply dispense with certain variables that stand in the way of clear conclusions, says Wharton management professor Sidney G. Winter. Missing the mark: Many economists did spot the housing bubble but failed to fully understand the implications, says Richard J. Herring, professor of international banking at Wharton. Commonly missing are hard-to-measure factors like human psychology and people’s expectations about the future, he notes. Among the most damning examples of the blind spot this created, Winter says, was the failure by many economists and business people to acknowledge the common-sense fact that home prices could not continue rising faster than household incomes. Says Winter: “The most remarkable fact is that serious people were willing to commit, both intellectually and financially, to the idea that housing prices would rise indefinitely, a really bizarre idea.” Although many economists did spot the housing bubble, they failed to fully understand the implications, says Richard J. Herring, professor of international banking at Wharton. Among those were dangers building in the repo market, where securities backed by mortgages and other assets are used as collateral for loans. Because of the collateralization, these loans were thought to be safe, but the securities turned out to be riskier than borrowers and lenders had thought. Mathematical models In a highly critical paper titled, “The Financial Crisis and the Systemic Failure of Academic Economists,” eight American and European economists argue that academic economists were too disconnected from the real world to see the crisis forming. The authors are David Colander, Middlebury College; Hans Follmer, Humboldt University; Armin Haas, Potsdam Institute for Climate Impact Research; Michael Goldberg, University of New Hampshire; Katarina Juselius, University of Copenhagen; Alan Kirman, University d’Aix-Marseille; Thomas Lux, University of Kiel; and Brigitte Sloth, University of Southern Denmark. “The economics profession appears to have been unaware of the long build-up to the current worldwide financial crisis and to have significantly underestimated its dimensions once it started to unfold,” they write. “In our view, this lack of understanding is due to a misallocation of research e�orts in economics. We trace the deeper roots of this failure to the profession’s insistence on constructing models that, by design, disregard the key elements driving outcomes in real world markets.” The paper, generally referred to as the Dahlem report, condemns a growing reliance over the past three decades on mathematical models that improperly assume markets and economies are inherently stable, and which disregard influences like di�erences in the way various economic players make decisions, revise their forecasting methods and are influenced by social factors. Standard analysis also failed, in part, because of the widespread use of new financial products that were poorly understood, and because economists did not firmly grasp the workings of the increasingly interconnected global financial system, the authors say. One result of this, argues Winter, who is not one of the authors but agrees with much of what they say, is to build into models an assumption that all market participants -- bankers, lenders, borrowers and consumers -- behave rationally at all times, as if they were economists making the most FRIDAY,JULY FRIDAY,JULY 10, 2009 | BUSINESS DAILY XXI the edge: It’s all in the numbers financial crisis devised in recent years, including securities built upon pools of mortgages, turned out to be poorly understood, the authors say. Credit default swaps, a form of derivative used to insure against a borrower’s failure to repay a loan, played a key role in the collapse of American International Group. Rather than accurately analysing the risks posed by new derivatives, many economists simply fell back on faith that creating new financial products is good, the authors write. According to this belief, which was promoted by former Federal Reserve chairman Alan Greenspan, a wider variety of financial products allows market participants to place ever more refined bets, so the markets as a whole better reflect the combined wisdom of all the players. But because there was not enough historical data to put into models used to price these new derivatives, risk and return assessments turned out to be wrong, the authors argue. These securities are now the “toxic assets” polluting the balance sheets of the nation’s largest banks. “While the economic argument in favour of ever new derivatives is more one of persuasion rather than evidence, important negative e�ects have been neglected,” they write. “The idea that the system was made less risky with the development of more derivatives led to financial actors taking positions with extreme degrees of leverage, and the danger of this has not been emphasized enough.” When certain price and risk models came into widespread use, they led many players to place the same kinds of bets, the authors continue. The market thus lost the benefit of having many participants, since there was no longer a variety of views o�setting one another. The same e�ect, the authors say, occurs if one player becomes dominant in one aspect of the market. The problem is exacerbated by the “control illusion,” an unjustified confidence based on the model’s apparent mathematical precision, the authors say. This problem is especially acute among people who use models they have not developed themselves, as they may be unaware of the models’ flaws, like reliance on uncertain assumptions. Much of the financial crisis can be blamed on an over reliance on ratings agencies, which gave complex securities a seal of approval, says Wharton finance professor Marshall E. Blume. “The ratings agencies, of course, use models” which “grossly underestimated” risks. “Any model is an abstraction of the world,” Blume adds. “The value of a model is to provide the essence of what is happening with a limited number of variables. If you think a variable is important, you include it, but you can’t have every variable in the world.... The models may not have had the right variables.” The false security created by asset-pricing models led banks and hedge funds to use excessive leverage, borrowing money so they could make bigger bets, and laying the groundwork for bigger losses when bets went bad, according to the Dahlem report authors. At the time, few people knew that major financial institutions had become so heavily leveraged in real estate-related assets, says Wharton finance professor Jeremy J. Siegel. “Had they not been in that situation, we would not have had the crisis,” he says. “We may not even have had a recession.... Macro economists really hadn’t talked about it because these structured financial products were relatively new,” he adds, arguing that economists will have to scrutinize the balance sheets of major financial institutions more closely to detect mushrooming risks. Lessons not learnt Prior to the latest crisis, there were two well-known occasions when exotic bets, leverage and inadequate modelling combined to create crises, the paper’s authors say, arguing that economists should therefore have known what could happen. The first case, the stock market crash of 1987, began with a small drop in prices which triggered an avalanche of sell orders in computerized trading programs, causing a further price decline that triggered more automatic sales. The second case was the 1998 collapse of the Long-Term Capital Management (LTCM) hedge fund. It had built up a huge position in government bonds financially favourable choices. Clearly, he says, rational behaviour is not that dependable, or else people would not do self-destructive things like taking out mortgages they could not a�ord, a key factor in the financial crisis. Nor would completely rational executives at financial firms invest in securities backed by those risky mortgages, which they did. By relying so heavily on the view of humans as rational, the paper’s authors argue, economists ignore evidence of irrational behaviour that is well documented in other disciplines like psychology and sociology. from the US and other countries, and was forced into a wave of selling after a Russian government bond default knocked bond prices down. “When there’s a default in one kind of bond, it causes reassessment of all the risks,” says Wharton economics professor Richard Marston. “I don’t think we have really fully learned from the LTCM crisis, or from other crises, the extent to which things are illiquid.” These crises have shown that market participants can rely too heavily on the belief they can quickly unload securities that decline in price, he says. In fact, the downward spiral can be so rapid that it leaves investors with losses far larger than they had thought possible. In the current crisis, he says, economists “should get blamed for the overall unwillingness to take into account liquidity risk. And I think it’s going to force us to reassess that.” Academics also are beginning to reassess business-school curricula. Wharton management professor Stephen J. Kobrin recently moderated a faculty panel that talked about a wide range of possible responses to the crisis. Among the issues discussed, he says, was whether Wharton’s curriculum should include more on regulation and risk management, as well as executive education programmes for regulators and other government o�cials. Kobrin said he believes many academics share “an ideological fixation with free markets and lack of regulation” that should be reexamined. “Obviously, people missed the boat on a lot of the risks that a lot of financial instruments entailed,” he says. “We need to think about what changes are needed in the curriculum.” Traditional derivatives Even if an individual does act rationally, economists are wrong to assume that large groups of people will react to given conditions as an individual would, because they often do not. “Economic modelling has to be compatible with insights from other branches of science on human behaviour,” they write. “It is highly problematic to insist on a specific view of humans in economic settings that is irreconcilable with evidence.” The authors say economists badly underestimated the risks of new types of derivatives, which are financial instruments whose value fluctuates, often to extremes, according to the changing values of underlying securities. Traditional derivatives such as stock options and commodities futures are well understood. But exotic derivatives Feedback Please send your comments and observations to [email protected] ����� XXII �������������������������������������� BUSINESS DAILY | FRIDAY, JULY 10, 2009 the edge: It’s all in the numbers ���������������������������������� FRIDAY,JULY FRIDAY,JULY 10, 2009 | BUSINESS DAILY XXIII the edge: It’s all in the numbers Biased expectations: Can accounting tools lead to, rather than prevent, executive mistakes? A ccounting techniques like budgeting, sales projections and financial reporting are supposed to help prevent business failures by giving managers realistic plans to guide their actions and feedback on their progress. In other words, they are supposed to leaven entrepreneurial optimism with greeneye-shaded realism. At least that’s the theory. But when Gavin Cassar, a Wharton accounting professor, tested this idea, he found something troubling: Some accounting tools not only fail to help businesspeople, but may actually lead them astray. In one of his recent studies, forthcoming in Contemporary Accounting Research, Cassar showed that budgeting didn’t help a group of Australian firms accurately forecast their revenues. In a second paper,he found that the preparation of financial projections KNOWLEDGE added to aspiring @ WHARTON entrepreneurs’ optimism, leading them to overestimate their subsequent levels of sales and employment. “It’s been shown in many studies that people are overly optimistic,” Cassar says. “What’s interesting here is that, when you use the accounting tools, the optimism is even more extreme. This suggests that using the tools, which a lot of academics and government agencies say is good practice, can lead to even bigger mistakes.” “Firms that saw the most improvement in their forecasts were ones that operated in the most uncertain environments, as measured by the variability of revenue. Arguably, these firms most needed the guidance.” On review, the firm’s accountants had seemed to do everything right. They had prepared budgets and put systems in place to get timely performance reports that could then be factored into the company’s future budgets and plans. As two big highway jobs foundered, the losses showed up promptly in the monthly reports. Even so, company executives failed to take remedial action. “The project managers said that the losses would turn around, but they didn’t,” Cassar says. “On both those jobs, they went over budgeted costs by 50 per cent. Those two jobs resulted in the demise of that company.” But it wasn’t the accounting systems that were the problem. It was the users. “No one would take responsibility because the cost of doing that was losing your job,” Cassar says. “The irony is that, in the end, everyone lost their jobs.” Cassar’s study enabled him to assess whether budgeting and internal reporting have helped other firms more than they did his former employer. He examined a group of about 4,000 companies, all with less than 200 employees, surveyed by the Australian Bureau of Statistics. Managers of these firms were asked whether they prepared budgets and internal reports and also were asked to provide revenue forecasts and in future years were asked to provide subsequent performance. The agency followed the firms over four years. Thus its data showed how close they came to meeting their forecasts. Cassar suspected that doing either budgets or internal reports -- or, better yet, both -- might improve a company’s forecasts. “The presence in a firm of a budget preparation activity should result in improved forecast accuracy because the systematic collection of a broad range of information should allow for a more accurate assessment of future performance,” write Cassar and his co-author, Brian Gibson, an accounting professor at Australia’s University of New England. “However, budgeting in itself may not improve forecasting accuracy, because budgeting without internal reporting is a meaningless formal control system.” When Cassar and Gibson crunched the numbers, their prediction was borne out: The impact of budgeting alone was trivial, improving forecast accuracy by less than two per cent. But internal reporting made a real di�erence, improving accuracy by about 8.5 per cent. Arguably, these firms most needed the guidance. Cassar’s second study, titled “Are Individuals Entering Self-Employment Overly-Optimistic? An Empirical Test of Plans and Projections on Nascent Entrepreneur Expectations,” built on the findings of his first one. Here, he wasn’t interested in whether accounting tools merely helped entrepreneurs; he wanted to know whether they could distort their thinking. His curiosity grew partly from his knowledge of the field of behavioural economics, which marries the insights and methods of psychology and economics. Behaviouralists have documented a number of mental shortcuts and biases that can lead people to depart from the logic that traditional economic orthodoxy would suggest. One of the concepts, for example, introduced by Nobel Laureate Daniel Kahneman and co-author Dan Lovallo, is that “an inside view” can distort decision making. A person who adopts an inside view becomes so focused on formulating his particular plan that he neglects to consider critical outside information, like other people’s experiences in pursuing the same goal. “Individuals form an inside view forecast by focusing on the specifics of the case, the details of the plan that exists and obstacles to its completion, and by constructing scenarios of future progress,” Cassar summarizes. “In contrast, an outside view is statistical and comparative in nature and does not involve any attempt to divine the Robust systems He is not suggesting that anyone ignore accounting activities and techniques. Investors and regulators expect firms to implement robust accounting systems. And they should, he says, because financial reports provide a detailed map of a business and its performance. But Cassar believes that businesspeople -- especially entrepreneurs, who bet both their reputations and personal wealth on their ventures -- should understand the limitations of accounting estimates as well as how common human tendencies, like optimism, can lead to their misinterpretation. Cassar’s first study, titled “Budgets, Financial Reports and Manager Forecast Accuracy,” set out to the test the usefulness of some basic tools in the accounting kit. It sprang from his work experience before he attended graduate school, when, as an accountant for a builder in his native Australia, he watched the company’s gradual decline into bankruptcy. “My first job was as a financial and managerial accountant for a civil construction firm,” he says. “My second, 18 months later, was working for the [bankruptcy] receiver of that same company.” future at any level of detail.” Doing financial projections for an entrepreneurial venture, Cassar realized, entails the creation of an inside view. The entrepreneur builds a storyline of success in her head and then plays it out in her spreadsheet, showing rising sales year after year. “Humans are good at storytelling and building causal links,” Cassar notes. “They think, ‘I’ll go to college, I’ll write a business plan, I’ll raise some capital and then I’ll go public or sell out to a big competitor.’ There’s a probability attached to each of these steps, but they don’t think about that. They put all the links together and evaluate the likelihood of success at a much higher probability than is realistic.” Consider the approximately 400 aspiring US entrepreneurs whom Cassar studied. On average, they believed that their ideas had about an 80 per cent likelihood of becoming viable ventures, though only half actually ended up becoming businesses. Of the entrepreneurs who realized their plans, about 62 per cent overestimated their first-year sales, and about 46 per cent overestimated what their employment would be at the end of year one. Employment, unlike sales, implies both costs and benefits, perhaps explaining the lower jobs figure, Cassar notes. As a company grows it needs more employees, but it also has to pay them. So far, none of this seems radical. Yes, entrepreneurs are optimistic. They have to be if they are undertaking the risks of starting a business. But when Cassar started to sort through the entrepreneurs’ use of common accounting and planning techniques, he uncovered surprises. Financial projections People who did financial projections were the most likely to overestimate the future sales of their ventures. In other words, “the same management activities that entrepreneurs rely on to cope with uncertainty appear to be causing individuals to hold optimistic expectations,” he writes. Interestingly, writing a business plan also led to optimism about the likelihood of success, but it didn’t lead to overly optimistic expectations because it’s also “positively associated with the likelihood that the nascent activity will become an operating venture,” he adds. Put another way, people who write plans are more likely to start companies, thereby justifying their optimism. One group turned out to be more realistic than the others -entrepreneurs who had received money from real sales. “This demonstrates the benefit of actually making sales in improving the rationality of financial sales expectations,” Cassar notes. Uncertain environments And used together, the two techniques improved forecast accuracy even more, by about 12 per cent. “Collectively these results suggest that internal accounting report preparation improves forecast accuracy. In addition, although the accuracy benefits from budget preparation appear limited, the improvement is greater when both budget preparation and internal account reporting are used,” Cassar and Gibson write. What’s more, the firms that saw the most improvement in their forecasts were ones that operated in the most uncertain environments, as measured by the variability of revenue. ����� XXIV ��������������| FRIDAY, JULY 10, 2009 BUSINESS DAILY ����������������������� the edge: It’s all in the numbers ���������������������������������� ...
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This note was uploaded on 05/14/2010 for the course CBA CIM202 taught by Professor Lesrobertson during the Spring '10 term at UBC.

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