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Conceptual Framework for Performance Audit of a Development Finance Institution

By Muhammad Akram Khan, Director General, Auditor General's Office, Pakistan.

1.    Introduction

The main objective of this paper is to develop a framework for auditing the performance of a development finance institution (DFI). The case of National Development Finance Corporation (NDFC) Pakistan has been cited to illustrate the conceptual framework.

The financial institutions are audited usually, by firms of Chartered or Certified Public Accountants under the banking companies laws of the country. The scope of audit by external auditors is defined by the law itself. Their main objective is to express an opinion on the financial statements of these institutions, review their internal controls and assess their provision for bad and doubtful debts. In brief, the external auditors do not report on the overall performance of these institutions. Thus, there is a gap in the auditing practices which presents a challenge for the government auditor who wants to report on the performance of nationalised financial institutions. For the performance audit of financial institutions the government auditor has to develop an inventory of indicators which he may adopt as audit criteria.

2.    Performance Against Objectives.

In the above perspective, the foremost concern of a performance auditor is to assess performance of a DFI against its objectives. For example the objectives of NDFC Pakistan, are:

1. To promote industrial expansion and economic growth in the country by providing financial and technical assistance and consultancy services, for the establishment of new enterprises as well as for the balancing, modernisation, replacement and expansion of existing enterprises and financing working capital requirements.
2. To identify, promote and develop new projects and investment proposals.
3. To assist the government in rehabilitation of sick and problem projects.
4. To administer and supervise the loans provided by the government and foreign institutions to projects in the country.

The auditor would keep in view the following questions and try to find out answers for them:

1. What was the total financial assistance provided by the NDFC?
2. What was the extent of this assistance for wholly new projects? (A ratio of funds provided for new ventures and for BMR may be a useful indicator).
3. How much employment did these finances help to generate?
4. What was the direction of investment? Did it substitute imports or increased exports and to which extent? Did it increase the supply of necessities of comforts or luxuries?
5. What was the nature of technology used? Did it help to improve local technology, or assisted import of technology from abroad? Was the technology labour intensive or capital-intensive?
6. What was the nature of consultancy services? What was the quality of staff employed on this work? In all, how many orgainsations approached NDFC for consultancy services? How effectively did they use the advice provided by the NDFC? (The end-use department's work may help to understand it).
7. What was the volume of working capital assistance? What was the ratio of this assistance to total assistance provided? What was the ratio of assistance for new investments, BMR and working capital? (Trends for a few past years may be a helpful guide for formulating an opinion).
8. What was the extent of assistance for different maturities? An analysis of loans for long, medium, and short term may help in finding out the priorities of the Corporation. (A preference for long-term or medium term investment for generating additional capacities may be in line with the overall socio-economic goals of the country. But there is no rule-of-thumb in this regard).
9. How many investment proposals were identified and promoted by the NDFC? What was the response of the entrepreneurial class? (In case the response was lukewarm, a peep into the reasons may be useful).
10. How many sick units were rehabilitated by the assistance of the NDFC? A comparison of the financial condition of these units before and after the assistance may be a useful guide. Could we assign their rehabilitation to, exclusively, the assistance of NDFC? (There may be other factors, such as international market, seasonal variations, or tax structure of the country etc.)
11. What was the extent of NDFC's cooperation in getting, administering and supervising government and foreign loans for projects in the country?

3.    Earnings

The earnings of a DFI like any other bank, consist of: (a) Interest income from loans, securities, debentures etc. (b) Other operating incomes, such as dividends from equity-participation, and (c) Non-operating incomes, such as fees and commissions etc.

An analysis of earnings of a DFI from different sources is one of the primary indicators of the efficiency of fund utilization. The auditor would tabulate the banks income from different sources, listing in detail the types of loans securities, debentures and units in which equity-participation has been done.

Following type of analysis would help in evaluating the earnings pattern of the corporation :-

1. What is ratio of earnings from the three main categories stated above?
2. What is the average rate of return from different sources? (This would help in determining the opportunity cost of funds deployed in one direction. No hard and fast rules can be laid down in this regard, however. A bank may be constrained to invest in low-return government securities for reasons of a higher liquidity and sure yield. Although it would remain a bankers prerogative by virtue of his experience and expertise to decide about elements of a "prudent mix" in fund utilisation, the above analysis may high-light any persistent imbalance and may suggest need for improvement in earnings by a change in policy).
3. What has been the extent of equity-participation? Could it substitute interest-bearing assistance?

4.    Investment Policy

Performance audit of investment policy of the DFI is a key element in the auditor's report. He would enlist main features of the policy from any policy statements or would try to infer them from decisions of the board of directors. As an example, one of the principles of general investment policy of the NDFC is:

"NDFC will make investment decisions after careful evaluation of each project on the basis of sound investment criteria and standards. It will provide financial assistance only to those projects which are financially sound, technically feasible and economically viable and which are capable of making contribution to the economic development of the country".

Obviously this requires a feasibility study and its detailed review by the NDFC. The NDFC caters, mainly for public sector enterprises and there is an increasing evidence of a large number of ailing industrial units. It becomes all the more imperative for NDFC to study the profit and cash-flow projections of the units proposed for investment by the NDFC. In such circumstances, the auditor should look into the quality of the forecasts submitted by the borrower, the method and quality of examination by the lender and should report about the failure of the lender in properly scrutinizing the feasibility study. Some of the guidelines in this regard are suggested below:

The auditor should try to find out answers for the following questions:

1. Has the feasibility study been projected fort a reasonable period in the future? (Usually, international financial institutions require profit projections for 5 years).
2. What were the assumptions on which profit projections had been based? How far did they prove to be true in practice?
3. What is the current volume of production sales and profits? How do they match with the projections?
4. What is the break-even point? What is the level of production that would produce profit?
5. What are the factors which may subject the projections to a high degree of risk, such as long-term contracts at fixed prices etc.?
6. Reports of the Chairman, Boards and Directors and external auditors may be scanned critically to read between the lines. They may stimulate thinking in certain directions which could lead to important clues about future profitability.
7. Did the projections take into account such factors as inflation, increasing labour costs, energy shortages?
8. h) Projection of sales is usually based on past sales, general economic and industry conditions, relative product profitability, market research, pricing policies, advertising plans, quality of sales force, degree of competition, production capacity, etc. The auditor should critically see the basis of the sales projection and examine how far the weight age to the above elements seemed to be proper. No quantitative scales can be prescribed, however,
9. Different elements of cost may be stated as percentage of the sales in the past. This would give an idea of their proportions. The future projections should take into account these proportions plus expected rate of inflation in any particular element. The auditor should see if the cost was not disproportionately depressed to give an optimistic view.
10. Besides profitability projections, the lending banker is also interested in satisfying himself that the borrower would be able to generate adequate cash flows to pay back the principal as well as interest on due dates. For this, lender would like to assess cash-flow projections. As a first step he would see past cash-flow forecasts and compare them with actual results in the past. Secondly, the cash flow forecast would be broken down in proper span, usually a month or fortnight. The lender bank would appraise the appropriateness of the time span in relation to the size of the business, size of loan requested and the repayment plans.

5.    Lending Risk

The auditor would look into adequacy or otherwise of the securities held against funds but the usual analysis to measure extent of bad and doubtful debts proceeds on the following lines:

1. Advances are checked in the light of (i) security held (ii) documentation of the loan (iii) past behaviour of the borrower.
2. The real value of bank capital and reserves is arrived at by adding capital and reserves and deducting 50% of the 'doubtful' advances and 100% of the bad debts. The banks in Pakistan are required by the State Bank of Pakistan to set aside a part of profits as provision to meet the above loss, so that the real value of the bank's capital does not erode.
3. Similar analysis is also carried out in respect of "Investments".

Another mathod to measure banks' credit risk is to work out ratio of net loan losses to average loans. By 'net loan losses' is meant loan losses adjusted for recoveries from loans that had been previously charged off.' A ratio

which is low (approximately % to ^of one per cent or less) or declining over a period of years would indicate a minimal risk strategy. A high or rising ratio would indicate a low quality loan portfolio.

Calculation of 'risk adjusted margin' provides another tool to measure the degree of risk involved by the organisation. It is calculated by the following method:

An increase in the 'risk adjusted margin' shows that the bank is following a sound risk policy.

Investment of a DFI in Securities is evaluated in the following manner:

Book value (-) Market value = Difference

A positive ratio is considered favourable while a negative ratio is treated as a sign of weak securities portfolio.

6.    Liquidity

Liquidity represents closeness of business assets to cash. A nearness to cash represents an assurance to depositors that they would be able to obtain funds for their deposits under almost all circumstances.

To report on the adequacy of a DFI's liquidity the auditor would undertake the following exercise:

1. He would work out the ratio of loans to total assets, and would prepare maturity stream of these loans.
2. He would see how much of the DFI's assets consist of saleable securities and bonds, etc. What is their market value? Does it considerably differ from the par value?
3. Another test of liquidity is to examine the borrowers earning flows. This approach, though of limited practical utility, suggests that the more profitable the operations of the borrowers are, the greater their ability to make interest payments and fulfill their obligation towards the DFI. The auditor may examine the earning flows of the problem customers.
4. Another indicator of liquidity could be the frequency and extent to which the DFI had to resort to central bank for re-finance to ensure liquidity.
5. Loan-deposit ratio is also used to indicate level of a bank's liquidity. This ratio shows how fully a bank has been 'loaned up'. A high loan-deposit ratio shows that a bank has a large proportion of its interest
6. earning assets in loans and a small proportion in securities. Because loans are not as easily sold as securities, a high loan-deposit ratio would indicate that a bank would have comparatively low liquidity.

There is an important caveat in this regard: A high liquidity leads to fall in earnings. In recent years the bank analysts have been giving a greater importance to earnings than to liquidity. This is all the more true about development financial institutions whose number of depositors is considerably low.

7.    Interest Rate Policy

Banks are deeply involved in interest rates. Interest rates are both a cost and a source of profit for them. They pay interest on their deposits and charge interest on the funds lent. The difference between the two rates forms a major source of their income. The banks use a considerable leverage, keeping in view the conditions in the financial market, in the interest rates paid and received. In fact the dexterity of an efficient bank manager lies in the skilful management of bank rates spreads. An analysis of the bank rate spread helps the auditor evaluate the bank rate policy of the bank for different categories of deposits and advances.

Interest rate spread is measured in the following manner:-

Both these rates are further worked out as under:-

Another measure of interest rate spread is the 'spread elasticity'. It means the change of interest rate on average interest earning assets to the change of interest rate on average interest paying liabilities. It is expressed as a ratio and provides a concise summary of the interest rate policy of the DFI The ratio of spread elasticity of 1.00 would indicate that the DFI is in balance with its interest rate environment. A spread elasticity of less than one indicates that the DFI is speculating on the future course of interest rates. The DFI has positioned itself so that the earnings would benefit if interest rates declined. Under these circumstances, interest paid for liabilities would tend to drop more rapidly than interest rates received from assets and earnings would be enhanced. A spread elasticity of more than 1.00 would reflect the reverse position than the above.

8.    Profitability

Profitability is the chief indicator of a DFPs success. The assets and earnings of the DFI may be growing over years independently. But the profitability may be declining. The profitability of the DFI is measured in the following manner:-

Profitability, thus calculated, gives a real measure of the DFI's efficient deployment of its resources.

Another measure of profitability is:

Return on equity x capital ratio which shows that profitability of assets is equal to the profitability from equity times the capital ratio of the bank.

The return on equity is calculated below:

Earnings before securities transactions
          Shareholder's equity

And capital ratio is worked out as following:-

Shareholder's equity
Total assets

A rising capital ratio indicates a growing strength in the DFI's capital position.

9.    Staff Policies

The performance of a DFI is also measured in terms of its policies, about its own staff and the staff of the fund users. For example, one of the policy elements of the NDFC on its staff development is:

"NDFC will build up efficient and competent organization with staff especially qualified and trained in their respective fields of discipline. As far as possible, NDFC will make arrangements for advanced training of its professional staff with local and foreign institutions and training agencies".

It would be of interest for the auditor to ascertain the extent to which the above policy was followed in practice. He would examine the percentage of staff trained, training facilities made available and the quality of the personnel newly recruited.

A DFl also examines quality of staff employed by fund users because it is one of the objectives of these institutions to promote standard managerial practices in those organizations as well. For this purpose, the DFIs insist on fund users to employ professionally qualified staff. They even help them by arranging training for their staff. An efficient and trained management would show prudence and care in the utilisation of the funds and thus would contribute towards the objectives of the DFIs.

An auditor would look in to these aspects in some detail. He would see the standards laid down by the financial institution for its fund users in respect of staff policies. He would a/so see the extent to which these standards were followed.

10.    Concluding Remarks

The above is a bare outline of the conceptual framework for performance auditing of a DFI. Techniques of auditing may be developed keeping in view the framework discussed above. However, a lot depends on the skill and shrewdness of the auditor plus a willing cooperation and interest of the auditee. Nothing significant would ensue if the auditor and auditee are not properly motivated.