LUMSSEC Conference on Corporate Governance 2930 May 2004

1
LUMS-SEC Conference on Corporate Governance29-30
May 2004

• Transparency in Corporate Reporting
• Presentation by
• Nasim Beg
• Chief Executive
• Arif Habib Investments

2
Institutional Investors Perspective

• and
• Possible Proactive Role

3
Key Issues

• Directors Reports inadequate information
• Transfer Pricing - inadequate disclosure
• Auditors Reports ignore some important issues

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• Some Companies Have Meaningful Directors Reports

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To name a few companies(There are may others)

• Engro
• Fauji Fertilizer
• ICI
• Packages
• Unilever.
•  
•  

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Directors reports of these companies contain
relevant information such as

• Overview of the entire sector
• Production, Sales and other useful information on
  each product both in written and graphical form
• Discussion on financial results
• Safety Environment (important for chemical
  companies)
• Employees relations and Organization Development
• Social welfare activities of the organization
• Financial information of other business segments
  / subsidiaries
• Future outlook
• Information about directors
• Detailed share holding information
• Statement of Compliance with The Code of
  Corporate Governance
• Detailed notes on Financial Statements
• Useful tables showing 5 to10 years performance

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In contrast some companies

• Either give cursory information or completely
  omit key financial information of various
  products / segments offered by the company.
• Omit sales break up
• Directors report is given as a formality
• Discussion of results is limited to just giving
  obvious percentages
• Provide very sketchy business outlook
• In quarterly reports of many companies even cost
  of goods sold break up is omitted.
• Quarterly reports do not provide details of
  events that have material effects, for e.g. if
  loans are rescheduled, investors will not know
  the details until annual report at year end is
  available.
• Very few companies notify the exchange when major
  contracts are signed or similar important events
  when they occur. The public finds out about the
  event months after it has occurred.

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As an aside - Information leakage

• Even some of the best run companies find that
  their financial information leaks out to a few
  persons as soon as board papers are circulated
• Perhaps the remedy is to go public with the
  information at the same time the board papers are
  circulated. (The CFO and CEO sign the papers, the
  numbers should be accurate).

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• Auditors pretend that the real world does not
  exist

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Over Invoicing in putting up Projects

• All of us are aware that during the 1980s and the
  1990s, many projects were put up as there was
  money in setting them up and the sponsors were
  not concerned whether there was any in running
  them.
• Many such companies were listed but got clean
  audit reports - the Auditors were satisfied
  looking at the documents showing padded up prices.

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Over and Under Invoicing in Buying Materials and
Selling Produce

• We are also aware of several listed companies,
  especially in the business of converting basic
  agricultural raw materials into semi-finished
  products, keep the true profits off the books by
  over and under invoicing
• The Auditors seem to be satisfied seeing the
  documents produced to them

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Transfer Pricing

• Other than the transfer pricing that takes place
  in the two previous examples, we have cases of
• multinationals putting up expensive projects
• some multinationals import materials from tied
  sources but at questionable prices.
• The Auditors simply gloss over facts example on
  next slide

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Example of an Auto Company

• The company enters into transactions with related
  parties for sale/purchase of CKDs and components
  and these are priced on arms length basis using
  Transactional Net Margin Method.
• Transactions for purchase of fixed assets are
  priced on the basis of Comparable Uncontrolled
  Price Method.
• Royalty and fee for technical services are
  accounted for at the rates mentioned in the
  respective agreements, duly registered with the
  State Bank of Pakistan.
•  

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Translation

• All this means is that auditors judge fairness of
  transfer prices by comparing two auto companies,
  and satisfy themselves if companies are making
  similar margins.
• This method has serious flaws
• Two organization cannot be 100 similar, they
  produce different range of products, with
  different profitability
• Deletion level is different for different
  products, with normally higher profits for
  higher local content.
• If most of the OEMs (who belong to same country)
  agree on a cartel type pricing policy then all of
  them will end up overcharging.

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Remedies - Directors Reports

• The Institute of Corporate Governance being set
  up should issue a rating of companies based on
  the quality of reporting.
• Institutional Investors should develop a
  discipline of investing only in high rating
  companies.
• Institutional Investors should attend AGMs and
  raise the issue SECP to put pressure where it
  can

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Remedies - Transfer Pricing

• The regulations need to be re-written focusing on
  Pakistan specific issues
• Institutional Investors should not treat anyone
  as a holy cow and question multinationals in AGMs
• The tax department is appears to be ceased with
  the issue. Disclosure of adjustment in income
  needs to be disclosed in the companys report.

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Remedies - Auditors reporting

• I would recommend that the standard audit report
  must include the following
• Whether or not the auditor has applied adequate
  checks to determine that there is no
  over-invoicing involved in the acquisition of
  fixed assets. In the event the auditor has not
  been able to do so, the reasons must be stated.
• Continued

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Remedies - Auditors reporting(continued)

• Whether or not the auditor had applied adequate
  checks to determine that there is no transfer
  pricing involved in any material purchases or
  sales of the company. In the event the auditor
  has not been able to do so, the reasons must be
  stated.
• Please note that I am not suggesting that the
  auditors should provide an assurance that there
  is no over-invoicing or transfer pricing but
  simply report on whether or not they have
  attempted the related verification and the
  results thereof.

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• Thank you