Mutual Funds

Accountant

Vol # 38

EDITORIAL OFFICE The Pakistan Accountant Chartered Accountants Avenue Clifton Karachi (Pakistan) UAN: 111-000-422 Fax: (92-21) 9251626 E-mail: [email protected] Website: www.icap.org.pk

P U B L I C ATIONS COMMITTEE Chairman Abdul Rahim Suriya,

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Editorial

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President’s Page

May - June 2005

Abdul Rahim Suriya, FCA

Zafar Iqbal Sobani, FCA

Mutual Funds

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Mutual Funds - Some Unique Issues

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Investing in Mutual Funds

Nasim Beg, FCA

Altaf Noor Ali, ACA FCA

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Vice-Chairman Ahmad Saeed, FCA

Mutual Fund Nadeem Butt, ACA

Members Sophia Ahmed, ACA Murtaza Ahmed Ali, FCA Muhammad Murtaza Ali, ACA Faisal Imran Hussain, ACA Asif Jamal, FCA Fazal Mahmood, FCA Muhammad Mahmood Marfatia, ACA Adnan Ahmad Mufti, ACA Ahmed Akhter Qazi, FCA Shakil Akhtar Qureshi, FCA Abdul Rab, ACA M. Arshad Siddiqui, FCA Zeeshan Tayyeb, ACA

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Investing in Mutual Funds Rizwan Razzak, ACA

Hedging Instruments

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Hedging Instruments in the Petroleum Industry: A Brief Survey Herald A. Osel

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Hedge Funds Challenging Conventional Investment Management Mohammad Shoaib Jan Memon, ACA

Banking

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Advisors Bilal Masood Fariya Zaeem

Operational Risk Management in a Bank: Easier said than done! Danish Ahmed Siddiqui, ACA

Federal Budget 2005-06

THE COUNCIL

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Distortions in an Investor Friendly Budget?

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Proposal to bring more services into GST Net

Council and Office Bearers President Zafar Iqbal Sobani,

Issue # 3

FCA

Executive Director: Moiz Ahmad, FCA Secretary: F. H. Saifee, FCA Publications Coordinator: Asad Shahzad

Abbas, FCA

Information Technology

Vice Presidents Hidayat Ali, FCA Asad Ali Shah, FCA Members Imran Afzal, FCA Syed Ahmad, FCA Muhammad Shoaib Ansari A. Husain A. Basrai, FCA Mujahid Eshai, FCA Nasimuddin Hyder, FCA Dr. Tariq Hassan Khaliq-Ur-Rahman, FCA Dr. Faizullah Khilji Fazal Mahmood, FCA Masud Muzaffar Abdul Rahim Suriya, FCA Syed Mohammad Shabbar Zaidi,

Adnan A. Mufti, ACA

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Flowcharting and Accountants Noor-ul-Huda Ashraf, FCA

Human Resource Management

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Attributes of a Successful Manager Amirali Kassim Merchant, FCA

Institute News

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Obituary Sk. Hashmat Ali

SAFA Conference

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SAFA Conference Tasneem Yusuf, ACA

IFAC News FCA

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IFAC eNews

Health News

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Constipation: Prevention and Treatment Dr. S. M. Wasim Jafri

Students’ Section

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The Brilliant Scholar - Irfan Ghani Interviewed by Shakil Akhtar Qureshi, FCA

Pakistan Accountant can be downloaded from Institute’s website at www.icap.org.pk The views expressed here do not necessarily represent the official policy of the Institute.

Editorial Mutual Funds Never in their wildest of dreams had the three Boston securities executives who pooled their money together to create the first official mutual fund in 1924 imagined how popular these would become for channelizing savings. Today, not only in the developed world where trillions of dollars are invested in these Funds, but also in developing countries like Pakistan mutual funds are growing at a galloping pace and have become an important vehicle for investing one’s savings. People with small savings or those preparing for their retirements are particularly attracted towards these funds. It is not difficult to understand why mutual funds are so popular in these classes of investors. Empirical evidence indicates that these groups of investors are generally bad at picking stocks. Mutual Funds provide them with an easy way out. One is not required to be an expert on the hundreds of thousands of stocks that these funds own. Furthermore, they are easy to use, could be liquidated quickly in times of need, and have unique diversification capabilities that help in keeping the returns up and the risks down. In Pakistan, the Government of Pakistan (GOP) ventured into this industry in 1960s by establishing the National Investment Trust (NIT) and the Investment Corporation of Pakistan (ICP). However, in 2002 the GOP decided to privatize the two funds. ICP is now operating in the private sector, and the privatization of NIT is slated for 2005. A number of private sector companies have also entered into this industry.

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Privatization and the entry of the private sector have rejuvenated the mutual fund industry in Pakistan. Not only the number of funds has substantially increased but also a number of new products have been introduced, and the net assets value of the funds is estimated to have increased by five times in just three years. The regulators too have been active, and have enacted rules and regulations to provide all the players a level playing field. However, Mr.Nasim Beg, FCA has highlighted in his article published in this journal a number of anomalies in these rules and regulations that need to be redressed. Industry analysts are predicting a very bright future for these funds, and the interest of the general public is expected to increase manifold in them. It is therefore essential to strengthen the regulatory framework governing these funds and make it more effective. On its part the industry should not only follow religiously the code of corporate governance in Pakistan, but also voluntarily adopt the international best practices. This would boost the confidence of the investor in mutual funds, and in the capital markets of the country.

Abdul Rahim Suriya, FCA Chief Editor

May - June 2005

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President’s Page Pakistan Accountant has been regularly bringing its issues on very interesting topic and the current issue on Mutual Funds in Pakistan perspective is a very important theme. Mutual Funds are a vital component of the financial market for mobilization of savings Their incredible popularity in advanced countries is recognized, Mutual Funds have also progressed significantly in emerging economies and our neighboring country India is excellent example reflecting the gigantic growth in the regime of Mutual Funds in last few years. In Pakistan Mutual Funds have evolved at a cautious pace, however for the last three years the fund management industry has progressed at a very fast pace with the participation of private sector in this industry which was run exclusively in the public sector and was unfortunately working with lot of red tapism generally associated in the public sector. Now the focus of the industry is tilting towards open end funds from closed end funds, several new products have been introduced and others are in the process of being rolled out. These Mutual Funds are now developing the quality man power resources who are working with them and this will result in the Mutual Fund industry poised for significant growth in the next few years. We have, on several occasions, witnessed the crisis in the Stock Exchanges and bleeding of the common investor who opted to enter in the highly bullish market for making some quick money. Mutual Fund industry development at fast pace will go in long way to facilitate these investors and they can use this vehicle to channelise their savings for achieving steady return. One important thing which should be borne in mind is the role of regulators and their efforts to evolve the Code of Corporate Governance and best practices for the mutual industry and it is heartening to note that at present all the players in the field are, by and large, playing proactive role which will add great value to mutual fund industry, it is also heartening that a few members of ICAP are associated with the mutual industry in key position and are contributing exceedingly well. ICAP elections process which started in February was successfully completed in June with nail biting finish, the election also witnessed high turnout of members on electoral day which has been the hall mark of our last few elections and it reflects close attachments our members have with ICAP., the new Council will be meeting in due course as we have received the name of government nominees after which the two regional committees in South and North will

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start their business. I congratulate the newly elected members and wish them great success. The current four years term of the council was a very challenging one as a result of the global events which brought accounting profession in the focus, these events have benefited the accounting profession in a big way as International Federations of Accountants took a lead in revisiting the issues relating to the profession and other accounting bodies followed it and this process is still going on. The accountancy profession in Pakistan under the lead of ICAP has also taken number of initiatives in this regard which are shared with our members through our publication and web site and I am thankful for the whole hearted support we have got from all of you .Our coordination with the front line regulators is excellent and has resulted in bridging the gap of trust to quite an extent. ICAP’s resources have been strengthened specially in the human resource area, the members are feeling this change and I am confident, in future, the results of the improvements which are taking place will be more visible to all the stakeholders, however this is not the end of story as the reform process will need to carry on to face the challenging of complexities in businesses. I will like to share, in this regard, that in last council meetings we have taken a few bold decisions in the area of education in order to attract the good entrants in the profession which will enable in increasing the size of membership which currently is not in line with the demand of our professionals in the country and outside Pakistan specially developed countries. The council has also recently allowed the professional firms engaged in auditing practice the use of foreign names in combination with their local name, these reforms will strengthen us to face the global challenges. In the end, I would like to place on record admirable support from all the council members specially the Vice Presidents from South and North and the Regional Committees members. I would also like to thank the ICAP management team for their admirable support to me and I am very confident that this new team under the leadership of Executive Director will be able to cope with the challenges of future.

Zafar Iqbal Sobani, FCA

May - June 2005

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Mutual Funds

Mutual Funds

Some Unique Issues Nasim Beg,

FCA

Most readers of this journal are reasonably well informed about the advantages of investing through mutual funds. However, there are some issues unique to mutual funds that should be of special interest for professional accountants.

the market value. This would be at the cost of the rest of the investors in the fund as their interest will be diluted. A similar logic will apply for someone leaving the fund, where the person must be paid fair market value rather than historic cost.

Income Tax

Daily Financial statements: The NAV based accounting makes it a must to draw up daily financial statements with full accruals so as to ensure determination of accurate NAV. Some mutual funds subject themselves to a continuous audit throughout the year so as to ensure accuracy, as errors cannot be undone once units have been issued or redeemed.

Most professional accountants will know that mutual funds are not taxed provided they distribute 90% of their income. However, what is generally not realised is that this is not an ‘exemption” but simply a mechanism for avoidance of double taxation. A person investing directly in the market would pay tax on dividends received. If, however, the person went through a mutual fund and the fund suffered tax on the dividend received by it and in turn the investor also were to suffer tax on the income distributed by the fund, it would amount double taxation of the same income. The tax law is designed to avoid this anomaly.

Net Asset Based Accounting The Net Asset Value (NAV) is an important aspect of mutual funds. An investor buying or selling a share (unit or certificate) of a closedend mutual fund through the stock exchange needs to know the underlying true market value of the share so as to make an informed decision. In the case of open-end funds, the units are issued and redeemed on NAV based prices. The NAV is the market value of the portfolio of assets/securities less any liabilities; and the NAV per unit is the NAV of the fund divided by the number of its units in issue. The point to note is that the assets of a mutual fund are valued at market and not at “cost or market whichever is lower”, which is what is considered prudent for most other situations. The reason for using market value is that anyone buying into or exiting from a mutual fund must be treated fairly with respect to the true value of the portfolio. The significance of this is illustrated by the example in the following paragraph. If we assume a fund was set up a few years ago and it continues to hold the shares bought by it then and that the market value of the shares today is three times the original cost. If we also assume that the original size of the fund was Rs. 1,000,000,000 and it had issued 100,000,000 units at Rs. 10 each, the market value of the portfolio today will be Rs. 3,000,000,000 and the NAV Rs. 30 per unit. In the event we valued the portfolio at historic cost and consequently the price of Rs. 10 per unit, a person joining the fund today with say Rs. 1,000,000 would get 100,000 units instead of 33,333 units (if market value was applied). In other words, this new investor would get an undue benefit by paying a lower price and becoming a 1.0% owner of the portfolio instead of 0.33% owner at The Pakistan Accountant

Element of Profit or Gains included in NAV Having addressed the matter of the importance of issuing and redeeming units of an open-end fund on the basis of an accurate marked-to-market NAV, another interesting aspect from the accounting view point is of the treatment of certain elements included in the NAV. Each time new units are issued one could simply take the entire proceeds of the issue to the capital account of the fund as this would be new capital coming into the fund. However, this would pose a problem as, at any point in time, a fund will have some realised and unrealised income and gains (or losses), thus the distributable amount of income per unit (if any) at that point in time, will be diluted by the new units that are issued (albeit at NAV and therefore not impacting the overall worth per unit). The way to manage this is to work out the break-down of the net assets. Assuming that some new units are being issued at this point in time but there has been no issue or redemption since the beginning of the financial year prior to this, then the net assets at this point in time will comprise of the capital at the beginning of the financial period, some amount in the Income Statement (profit or loss resulting from realised gains or losses, income such as dividends etc., less expenses) and an unrealised surplus or deficit on the valuation of the assets (being marked to market). The NAV per unit applicable to the new entrant will be apportioned between the Income Statement and the Capital Account in proportion to their relative weight in the net assets. Thus if an investor comes into an open-end fund on the last day of the financial year, the person will buy into the income (or the loss) accrued for the financial year and will be entitled to get some portion of this back by way of dividend that may be declared after the close of the year. May - June 2005 05

Mutual Funds This new entrant will be entitled to the dividend distribution for the year (at par with other unit holders) and the Income Statement will have the capacity to accommodate this new entrant’s entitlement as it would have been credited with the element of income this person has bought while coming into the fund. Once the dividend is paid out, the NAV will drop to the extent of the dividend. Thus a person remains indifferent as to when he or she enters or exits an open-end fund (expect to the extent of tax impact, if any, on dividend). On the other hand, the dividend distribution capacity of the fund is not impacted by dilution. Element of income at redemption stage: Similar to the principle applied at the entry stage, a person exiting the fund gets full NAV and takes the accrued earnings with him or her. This means that the dividend distributable out of the Income Statement is reduced in proportion to the number of units redeemed, thus the amount distributable per unit remains undisturbed.

Timing of NAV based prices The NAV based prices are designed to ensure that all unit holders of a fund are treated fairly at the time of any investor joining or leaving the fund. Since the NAV based price reflects the marked-to-market valuation of the portfolio of the fund, one expects that the by using this price we will achieve the objective. However, in view of the price volatility of the underlying assets, by the time we act in the market after an investor comes in, the prices in the market may have moved up, thus the fund would pay more than it has recovered from the new investor. This would be at the cost of the rest of the unit holders. The best way would be to charge the new entrant the exact purchase cost and not the historic NAV, however this is not practical, thus the next best way is to charge the NAV based price next fixed after the person joins the fund. In this manner the new entrant cannot deliberately attempt arbitrage against the fund by trying to buy units at a historic price when the market may have moved up. Similarly, a person exiting the fund is best paid off at the price determined after the application to redeem has been

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lodged so as to avoid deliberate arbitrage by exiting at the historic price when the market may have fallen. Mutual funds can favour some clients by bending the rules in this regard, something we must guard against.

Transaction Costs Having dealt with various issues in trying to ensure that we have a fair (to everyone) system for allowing entry into and exit from a mutual fund, there still remains one important issue which is not widely recognized. This relates to the transaction costs of buying or selling securities in the market such as brokerage and custodian’s movement charges etc. When some new entrant comes into the fund on an NAV based price, it is assumed that the fund will be able to buy more securities out of the new entrant’s money by buying these at the prices used for working out the NAV. Even if the fund is able to, (we assume that some times it will pay more and at times less, thus averaging out over time), it will still have to suffer transaction costs that would not have been included in the NAV, as the NAV reflects market prices without brokerage etc. These transaction costs should be ideally be recovered from the new entrant. Funds following best industry practices estimate these transaction costs as a percentage of the NAV and add these on to the NAV for determining the issue price of the units. The transaction costs are separate to any sales load a fund may charge for paying towards distribution costs. The sales load recovered in the issue price is retained by the management company and paid out in form of selling commissions etc. However, the transaction costs that are recovered are paid to the fund enabling it to offset the costs it will suffer. Based on this rationale the transaction costs should also be recovered from exiting unit holders so that the fund does not suffer these costs while selling securities to pay off the exiting unit holder. This would be achieved by deducting the estimated costs from the NAV. However, if a fund is at a growing stage, i.e., it has net inflows, it is not likely to be selling securities to pay off exiting unit holders, thus it need not recover this cost. In fact it may have some

surplus left over from the transaction costs recovered from new entrants as there will be some redemptions and therefore somewhat lesser amount of securities to be purchased as a result of the net cash received from the proceeds of issues less redemptions.

Valuation of Debt Securities As has been elaborated earlier, it is extremely important that all securities in the portfolio of a mutual fund are valued at market. However, the NBFC Rules, which govern mutual funds, have their origin in a set of earlier rules which were structured with listed shares in mind. The Rules require listed securities to be valued at the price at the stock exchange and unlisted securities at cost or break-up value. Corporate bonds (TFCs) are listed but rarely traded at the exchanges. Thus the last price recorded at the exchange can be quite outdated and at times does not even account for in part redemption of the TFC. These prices are therefore not representative of true market value at which these are traded at between financial institutions outside the exchange. Government bonds are not listed and it would be totally inappropriate to value these at historic cost. Most mutual funds value these at true market but in violation of the Rules, thus the audit reports of such funds get qualified by their auditors. On the other hand some funds are known to have treated government bonds as “Held to maturity” under IAS 39, thus totally flouting the NAV principle and yet their accounts do not get qualified – Perhaps the accountant community needs to be a bit more alive to the matter and propose some remedial measures for having the Rules and the IAS brought in line with ground realities. About the Author: Mr. Nasim Beg is a Fellow Member of the Institute of Chartered Accountants of Pakistan. He is the Founder and Chief Executive Officer of Arif Habib Investments. Readers are welcome to contact him at: [email protected]

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Mutual Funds

Investing in Mutual Funds Altaf Noor Ali,

Think of a group of people who collectively decide to contribute funds with an intention of making a return by investing the pool prudently in financial securities - primarily in shares of companies listed on stock exchange. The above is a practical illustration of what ‘mutual funds’ are all about. In a slightly sophisticated way, it is simply a legal arrangement where by a group of investors contribute funds with the specific objective of investing it in securities. You may be wondering why should one be bothering about ‘mutual funds’ when you can just about walk in any bank and deposit almost immediately your entire funds there in any of the so-called ‘attractive’schemes such as certificate of investments etc. Alternatively, you may also invest in National Saving Schemes, which offers Khas Deposit Certificates, or Defence Saving Certificates. The advantage of doing so is that you can go for whoever is offering you the best ‘rate’ and lock your funds. It is easy and relatively riskfree. Isn’t it? Panel -1 Net Asset Value: To compute NAV of a close-end mutual fund, we simply take the total of ‘shareholders’equity’and divide it by the number of shares. For example, the total of shareholders’ equity of Al-Meezan Mutual Fund at 30 June 2004 was Rs. 1,127,312,058 (the same as net assets). On that date, there were 77,500,000 shares outstanding (Note 12). This means on that date its NAV was 1,127,312,058 divided by 77,500,000 = Rs. 14.54 per share. True. However, you need to see what happens after you lock your funds. Whoever has promised you to pay a certain ‘rate’, whether it is an established bank or a government saving institution, they would not sit on your money. They need to invest funds where it earns a return not only to keep Johnnies like us happy but also to make something above it to keep making all those high-rise buildings and immaculate offices. And where do you think they invest? They either loan it out to businesses who promise to pay them even higher, or invest it in capital market. And its in the capital markets (of which stock exchange is an example), where you find ‘closeend’and ‘open-end’ mutual funds in which these institutions invest heavily, hoping that at the end of the day they will pay The Pakistan Accountant

ACA

peanuts to depositors like us and keep the cake for themselves. You do not have to believe me. We will discuss only one representative example. Just pick up the Annual Report 2004 of Al-Meezan Mutual Fund Limited, a close-end mutual fund listed on the Karachi Stock Exchange, and go to ‘Categories of Shareholders as of 30 June 2004’ on page 33. You will find that on 30-6-04, the general public held 21% only of its shares, whereas banks, development finance institutions, insurance companies and other institutions held 79%. Specifically, these included names like Meezan Bank Limited (2%); Meezan Islamic Fund (12%); Al-Meezan Investment Management Ltd. (14%); NIT & ICP (4%); Pak Kuwait Investment Company (Pvt) Ltd. (19%); State Life Insurance Corporation of Pakistan (3%); and 10% held by Union Bank Ltd, Faysal Bank Ltd., Muslim Commercial Bank Ltd., Prime Commercial Bank Ltd., PICIC Commercial Bank Ltd., and Dawood Leasing Company Ltd. The last 15% was held by provident funds, corporate bodies etc. The bottom line here is that if you are a little ambitious than a conservative deposit holder, to start with, you may as well consider investing a part of your funds in a mutual fund in your quest for finding better ‘returns’ than a bank deposit. As time goes by, with an experience of couple of accounting cycles, you are likely to grow in confidence. Investing in Mutual Funds may sound a bit risky to a new comer as there is no promise of a pre-determined ‘rate’, but you can be sure that the level of risk you are accepting is no different then that of the banks who invest in them. Assuming that you feel confident enough to explore this topic further, remembering the difference between ‘closeend’ and ‘open-end’ mutual funds can be helpful. As a rule, you will find a ‘close-end’ mutual fund only to be listed on stock exchanges in Pakistan, primarily because the holders of its shares or certificates can buy and sell it without any reference to the company (except for registering change in ownership), just like any other security traded on the stock exchange. For example, if you wish to buy 1000 shares of AlMeezan Mutual Fund Limited, only a holder who has already got it can sell it to you. The funds involved in the transaction would not go to the Fund directly. Does it mean that all mutual funds listed on Stock Exchanges in Pakistan are closeend Funds? Certainly! May - June 2005 07

Mutual Funds On the other hand, for open-end mutual fund, no buying or selling in its securities can take place without direct reference to the Fund. For example, National Investment Trust is an open-end mutual fund. If you wish to buy its 1,000 certificates, you may do so only by going to one of its designated branches or dealers; whatever agreed price you pay would go directly to NIT on whose behalf a certificate of ownership will be issued to you. This is also true for the rest of open-end mutual funds like Al-Meezan Islamic Fund, for which you need to contact the Fund or its authorised dealer directly. You may be longing to figure out: which type of Fund would be suitable for you? Well, I personally like ‘close-ends’ and the reason is that most of them are available at a discount to their Net Asset Value (see panel-1) whereas open-ended mutual funds are normally quoted at their NAV or at a slight premium. So, if I can buy a close-end at a discount of almost 20 to 35%, what is the need of going for an open-end fund, each with its own way of working, especially when the returns are also quite competitive? Secondly, you can invest relatively smaller amounts in closeends. For example, on 24 August 2005, Abamco Composite Fund Limited, another close-end fund, was traded between Rs. 6.45 and Rs.6.85 per certificate. Buying 500 or 50,000 of

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Facts about Close-end Mutual Funds: Market capitalisation = Number of shares x Closing price. Example: PICIC Investment Fund had 284.125 million shares and its closing price on 24-8-05 was Rs. 13.95. Therefore, its market capitalisation was = 284.125 x 13.95 = Rs. 3.963 billion. Similarly, the market capitalisation of close-end mutual fund as a whole on 24-8-05 was Rs. 31.4 billion. its certificates can be as easy as calling my stockbroker and within ‘seconds’ he can confirm the purchase transaction to me. I need less than Rs. 3,500/= to buy its 500 certificates. On the other hand, I would only get less than 7 units of Atlas Income Fund, an open-ended fund whose offer price that day was Rs. 516.54 plus a time consuming trip to its offices and filling out some forms. Let us now try to gain some idea about the close-end mutual funds listed on the Karachi Stock Exchange. You will find stock quotes in almost all newspapers and you will have no difficulty in finding the headline ‘close-end mutual funds’ under which all such funds are listed. On 24-8-05, there were around 22 Funds listed there. Panel-2 shows the close-end mutual funds listed on Karachi Stock Exchange on 24-8-05.

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Mutual Funds

Panel 2: Additional Notes 1. Price behaviour of last 52 weeks. We take PICIC Growth Fund (PGF) as an example and see that during last 52 weeks, its price oscillated between Rs. 37.50 and Rs. 79.95 – a fluctuation of 2.13 times from its lows (during this time PGF declared an interim stock bonus of 25%; it may have touched Rs. 79.95 with 25% stock dividend included in that price). The lesson here is that market gives an opportunity to invest at a reasonable price to a patient long-term investor. Buying it ex-bonus ex-interim around Rs. 45 would give you a gain of Rs. 5 per certificate at 24-8-05 closing and gross final dividend of Rs. 3.50. Total gain=Rs.8.50 or 17.8% of Rs. 45. Not bad! 2. What is EPS? Earning per Share is computed by taking the profit after tax for the year and dividing it by the number of outstanding shares. Example: Meezan Balanced Fund MBF earned Rs. 146.636 m for the year ended 30 June 2005. On that date, it had 120 m shares. Its EPS 2005 was = 146.636 divided by 120 = Rs. 1.22. 3. What is P/E? Price Earning ratio is computed by taking the closing price and dividing it by EPS. The P/E for MBF on 248-05 = 8.80 divided by 1.22 = 7.25 times. It can be said that its present price equals its current earnings of 7.25 years. Buying good stocks at lowest P/Es is a goal of every sensible investor. Where is the NAV? Earlier, I said that most close-end mutual funds are available at a discount to its NAVs. Let us validate this point and have a look at Panel-2 to see if you can spot the NAVs? You may be thinking of a misprint, since the column for NAV information of each Fund is missing in the Panel. The truth is that there is no misprint. Simply put, the NAV of close-end mutual funds is not a part of the daily stock quote. Infact, NAV of each Fund is notified by the management of the Fund to the Stock Exchange on a weekly basis but you may not find such information readily available in the newspapers [The daily NAV of Abamco and Al-Meezan related close-end (and open-end) funds can be found from their websites www.abamco.com and www.almeezangroup.com respectively. ‘The News’daily, also prints NAV of some funds in its business section]. I could not access the latest NAV of all the Funds, of those with me follows. Panel-3 shows that most of close-end mutual funds are available at a discount.

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What are the 2005 yields? The close-end mutual funds yield is an important matter for an investor. Panel-4 shows how they fared for the fiscal year 2005. It is a valid question to find out if the close-end funds will continue to perform similarly in 2006. For this, the investors need to understand the direct relationship between the closeend mutual funds and the stock market. When market performs better, so do most mutual funds. The reverse is also true. The market goes down and the returns are anaemic.

Panel 3: Additional Notes 1. NAV = Net Asset Value = Total of Shareholders Equity. This is actually NAV per share. To find it you take Shareholders Equity and divide it by number of outstanding shares. 2. Discount. The closing price of Abamco Composite on 248-05 was Rs. 6.45. On that date, its NAV was Rs. 10.54. The NAV was higher than Market Value by Rs. 4.09. This means it was selling at a discount = 4.09/10.54 = 0.388 or 38.8%. Buying at scrip at a discount from NAV is ‘safe’ for the investor. However, investor should be alert about too steep discount. In this case, no final dividend for 2005. It paid 12.5% as interim dividend, reasonable given its price.

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Mutual Funds

Panel 4: Additional Notes 1. Distributions = Cash Dividends, Stock Bonus, or Right shares issued during last three years. Example: In 2004, Pakistan Premier Fund announced a 12.5% Cash Dividend, 25% Stock Bonus, and 50% Rights (an option to subscribe an additional share for every two shares held).

Conclusion:

2. Net Dividend = For individuals there is a 10% at source deduction hence the difference between dividend and net dividend. Example: Pakistan Strategic Fund declared a cash dividend of Rs. 1 but an individual investor would only get Rs. 0.90.

As a courtesy to my readers, I must also disclose that I own some of the close-end funds mentioned in this article and that I carry out investment research for my clients.

3. Average = The average of high and low prices during last 52 weeks. Example: Abamco Growth Fund = high + low divided by 2 = Rs. 31+ Rs. 19 divided by 2 = Rs. 25. 4. Yield = Net Dividend divided by Average Price. Example: Golden Arrow = 1.80 divided by 6.65 = 0.2707 or 27.07%.

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In this article, we have explored values of close-end mutual funds through NAV and Yield approaches. Feel free to use the format here to update position.

About the Author: Mr. Altaf Noor Ali is Chartered Accountant practicing in his own name. Readers are welcome to contact him at: [email protected]

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Mutual Funds

MUTUAL FUND Nadeem Butt,

ACA

A fund operated by an investment company that pools / raises money from shareholders and invests in a variety of securities, including stocks, options, bonds and money market instruments.

Each shareholder ’s investment is priced at a net asset value representing that share’s portion of the collective investments of the fund and at which price shares may be purchased or redeemed (sold).

A mutual fund stands ready to buy back (redeem) its shares at their current net asset value, which depends on the total market value of the fund's investment portfolio at the time of redemption. The US name for mutual fund is “Unit Trust”.(refer table attached)

Professional portfolio investment managers, usually called the AMC ( Asset Management Company), decide to buy, sell or hold securities in an attempt to take advantage of current and future market conditions. Investors profit through increases in the fund's share price (appreciation) and through the distribution of dividends. All owners in the fund share in the gains or losses of the fund.

The two principal types are closed-end and open-end mutual funds. Shares in closed-end mutual funds, some of which are listed on stock exchanges, are readily transferable on the open market and are bought and sold like other shares. Open-end funds sell their own new shares to investors, stand ready to buy back their old shares, and are not listed. Closed-End Fund - A type of investment company that has a fixed number of shares that are publicly traded. The price of a closed-end fund share fluctuates based on investor supply and demand. Closed-end funds are not required to redeem shares and have managed portfolios. As open-end investments, most mutual funds continuously offer new shares to investors. These funds offer investors the advantages of diversification and professional management and enables its shareholders to pool their funds for professional management as a single investment account. A mutual fund, or an open-end fund, sells as many shares as investor demand requires. As money flows in, the fund grows. If money flows out of the fund the number of the fund’s outstanding shares drops. Open-end funds are sometimes closed to new investors, but existing investors can still continue to invest money in the fund. In order to sell shares an investor usually sells the shares back to the fund. If an investor wishes to buy additional shares in a mutual fund, the investor must buy newly issued shares directly from the fund. Mutual Funds have a low minimum investment amount, can be bought or sold any business day. The Pakistan Accountant

How the fund invests is determined by the fund's objectives. The mutual fund's prospectus details this type of information plus information on any fees, the management company and other relevant data. They offer investors a variety of goals, depending on the fund and its investment charter. Some funds, for example, seek to generate income on a regular basis. Others seek to preserve an investor's money. Still others seek to invest in companies that are growing at a rapid pace. Funds can impose a sales charge, or load, on investors when they buy or sell shares. Many funds these days are no load and impose no sales charge. If you wish to invest in a mutual fund you should get answers of the following: 1. 2. 3. 4.

What area or instruments does the fund invest in? What has been the long-term rate of return? How much return has been varied in the past? How does the fund’s performance compare with that of the underlying market? 5. Is the fund seeking income or capital growth? *Past performance is not indicative of future results. And before selecting a fund to invest in you should learn: 1. How to read a fund prospectus 2. How to assess a fund manager's investment style and its impact on your returns 3. How to evaluate fees and expenses 4. How to evaluate risks 5. How to calculate return on investments May - June 2005 11

Mutual Funds

1.HOW TO READ A FUND PROSPECTUS Key Elements of a Mutual Fund Prospectus are: Date of issue—First, verify that you have received an up-to-date edition of the prospectus. A prospectus must be updated at least annually. Minimum investments—Mutual funds differ both in the minimum initial investment required, and the minimum for subsequent investments. Investment objectives — The goal of each fund should be clearly defined — such as income with preservation of principal or long-term capital appreciation. Be sure the fund’s objective matches your objective. Investment policies — A prospectus will outline the general strategies the fund managers will implement. You’ll learn what types of investments will be included, such as government bonds or common stock. The prospectus may also include information on minimum bond ratings and types of companies considered appropriate for a fund. Be sure to consider whether the fund offers adequate diversification.

Fees and expenses — Sales and management fees associated with a mutual fund must be clearly listed. The prospectus will also display the impact these fees and expenses would have on a hypothetical investment over time.

change. Value stocks held in the portfolio over a period of time may become growth stocks and vice versa. Other research may give a more current and accurate account of the style of the fund.

Tax information — A prospectus will include information on the tax status and implications of a fund’s distributions, and whether they will be treated as dividend income or capital gains.

3. HOW TO EVALUATE FEES AND EXPENSES:

Investor services — Shareholders may have access to certain services, such as automatic reinvestment of dividends and systematic withdrawal plans. Be sure to read the prospectus and ask questions about items that you are not sure about before investing.

2. HOW TO ASSESS A FUND MANAGER’S INVESTMENT STYLE AND ITS MPACT ON RETURNS: Some fund managers follow an investing "style" to try and maximize fund performance while meeting the investment objectives of the fund. Fund styles usually fall with in the following three categories.

Risk factors—Every investment involves some level of risk. In a prospectus you’ll find descriptions of the risks associated with investments in the fund. Refer to your own objectives and decide if the risk associated with the fund’s investments matches your own risk tolerance.

Fund Styles: w Value: The manager invests in stocks believed to be currently undervalued by the market.

Performance data—You’ll find selected per-share data including net asset value (NAV) and total return for different time periods since the fund’s inception. Remember that past results do not guarantee future performance. When evaluating performance, look at the track record of a fund over a time period that matches your own investment goals.

w Blend: The manager looks for a combination of both growth and value stocks.

The Pakistan Accountant

w Growth: The manager selects stocks they believe have a strong potential for beating the market.

To determine the style of a mutual fund, consult the prospectus as well as other sources that review mutual funds. Don't be surprised if the information conflicts. Although a prospectus may state a specific fund style, the style may

Mutual funds charge some amount for their services. Of course, these charges will affect the amount of money you’ll have someday. The secret is to evaluate the full potential of an investment—the amount you keep after paying the fees. Here’s a simple strategy to help you get started: 1.Understand fees and expenses. 2.Compare charges that apply to mutual funds. 3.Consider redemption fees or rates (difference of buying selling) Shareholder Fees These fees are paid directly from the share-holder's account and may include: Sales Charge This fee, also called a "load," is paid to the shareholder's investment professional as compensation for acting as the intermediary between the fund company and the investor. Front-end Load This load is imposed at the time of the purchase. It is shown as a percentage of the fund's offering price (the fund's price per share, which includes the front-end sales charge). Exchange Fee This fee is levied to help defray the administrative costs associated with exchanging from one fund to another within the same family, within the same class of shares. Often, a fund will allow a certain number of free exchanges before imposing this fee. May - June 2005 12

Mutual Funds Redemption Fee In an attempt to discourage frequent trading in and out of a fund, a redemption fee may be imposed. This fee may be eliminated after the shares are held within a fund for a certain amount of time, such as 30 or 60 days. This fee can apply to redemptions as well as exchanges out of a fund. Account Fee This may be applied to help cover the administrative costs of maintaining an account. For example, some funds may charge an annual fee. Annual Fund Operating Expenses These expenses are deducted from the fund's assets and typically cover ongoing costs associated with running the fund itself. These may include the following: Management Fee This is often the largest operating expense and it covers the costs associated with the professional management of a fund's portfolio. Other Expenses These include miscellaneous custodial, legal, accounting, and other administrative expenses associated with operating a mutual fund. Adding it up — Total Annual Fund Operating Expenses Now that you know what your fund is paying for and how you're being charged, you need a way to evaluate and compare these costs. The tool for this job is the expense ratio and it generally appears in the "Total Operating Expenses" line at the bottom of the Annual Fund Operating Expenses table in the prospectus. Simply defined, the expense ratio is the percentage of a fund's average net assets (assets minus liabilities), which is spent on operating expenses during a fiscal year. For instance, if a fund has assets of Rs.500 million and annual operating expenses of Rs.10 million, the expense ratio in this case would be 2%. The Pakistan Accountant

The expense ratio excludes shareholder fees and some other charges such as portfolio trading costs. Because portfolio transaction costs are not always paid separately from the cost of buying or selling securities, they do not appear in the fund's expense ratio. Anything that affects operating costs can have a bearing on the expense ratio. When you're examining expense ratios among funds, be sure you're comparing apples-to-apples — because the average costs of managing different types of investments can vary dramatically. And, while expense ratios make it easy to evaluate the costs of similar funds, don't forget to compare a figure that's even more important in your investment decision: total return. "No Load" Doesn't Mean "No Fees" Although mutual funds labeled as "no load" don't have an up front sales charge that does not mean they are free of other charges. No-load funds may carry purchase fees, redemption fees, exchange fees, and account fees. And, of course, shareholders of almost all funds are subject to the indirect costs associated with annual operating expenses.

4. HOW TO EVALUATE RISKS Different mutual funds have inherently different risk characteristics and should not be compared side by side. A bond fund with below-average risk, for example, should not be compared to a stock fund with below average risk. Even though both funds have low risk for their respective categories, stock funds overall have a higher risk/return potential than bond funds. Mutual funds face risks based on the investments they hold. Following is a glossary of some risks to consider when investing in mutual funds.

Call Risk. The possibility that falling interest rates will cause a bond issuer to redeem—or call—its high-yielding bond before the bond's maturity date. Country Risk. The possibility that political events (a war, national elections), financial problems (rising inflation, government default), or natural disasters (an earthquake, a poor harvest) will weaken a country's economy and cause investments in that country to decline. Credit Risk. The possibility that a bond issuer will fail to repay interest and principal in a timely manner. Also called default risk. Currency Risk. The possibility that returns could be reduced because of a rise in the value of the currency against foreign currencies. Also called exchange-rate risk. Income Risk. The possibility that a fixed-income fund's dividends will decline as a result of falling overall interest rates. Industry Risk. The possibility that a group of stocks in a single industry will decline in price due to developments in that industry. Inflation Risk. The possibility that increases in the cost of living will reduce or eliminate a fund's real inflation-adjusted returns. Interest Rate Risk. The possibility that a bond fund will decline in value because of an increase in interest rates. Manager Risk. The possibility that an actively managed mutual fund's investment adviser will fail to execute the fund's investment strategy effectively resulting in the failure of stated objectives. May - June 2005 13

Mutual Funds Market Risk. The possibility that stock fund or bond fund prices overall will decline over short or even extended periods. Stock and bond markets tend to move in cycles, with periods when prices rise and other periods when prices fall. Principal Risk. The possibility that an investment will go down in value, or "lose money," from the original or invested amount.

5. HOW TO CALCULATE RETURN ON INVESTMENTS You make money from mutual fund investment when: w The fund earns income on its investments, and distributes it to you in the form of dividends.

w The fund produces capital gains by selling securities at a profit, and distributes those gains to you. w You sell your shares of the fund at a higher price than you paid for them The average annual return for a mutual fund is stated after expenses. The expenses include fund management fees. Average annual returns are also factored for any reinvested dividend and capital gain distributions. To compute this number, the annual returns for a fixed number of years (e.g., 3, 5, life of fund) are added and divided by the number of years, hence the name "average" annual return. This specifically means that the average annual return is not a compounded rate of return. In addition to this appreciation in the sale price of the fund share / unit over that period is also part of the profit.

ARE UNIT TRUSTS DIFFERENT FROM MUTUAL FUNDS? From an investment perspective, there are no major differences between unit trusts and mutual funds. Both are professionally managed portfolios which invest in a wide variety of financial instruments.

About the Author: Mr. Nadeem Butt, ACA qualified from Gardezi & Co., Lahore in 2001. Presently he is working as Head of Internal Audit & Budget Depts. at TAQ Logistics. Readers are welcome to contact him at: [email protected]

The key difference between the two lies in the legal structure: Unit Trusts

Mutual Funds

Form of establishment

Trust

Limited liability company

Beneficiary

Unit holder

Shareholder

Governing law

Trust law

Company law

Legal document in which the rules are laid down

Trust deed

Company's articles/ bye laws & custodian agreement

Who protect investor interests

Trustee

Custodian (but according to the custodian agreement and articles / bye laws).

Who owns or holds the fund assets

Trustee holds the assets for the benefit of the investors

The mutual fund company owns the assets and Investors are shareholders of the company.

Who is liable

Trustee

The company has limited liability; directors can be liable.

The Pakistan Accountant

May - June 2005 14

Mutual Funds

Investing in Mutual Funds Rizwan Razzak,

Looking for investments?

income and some

growth from

ACA

your

few of them calling them as balanced fund. However, as the market grows we may witness products with complex and sophisticated investment strategies and overlapping asset classes.

The big problem: You typically can’t have your cake and eat it too. The higher the return on an investment, the greater the risk. Mutual Funds are the tools to diversify risk and earn decent returns.

We appreciate regulators recognition of the sensitivity of the industry. In accordance with the NBFC Rules, a fund manager cannot advertise in any form unless the proof of advertisement is approved by the regulators. However, there is still a lack of awareness about the concept of mutual funds among the masses that needs to be taken up by the regulators and the industry players.

Who isn’t?

Thanks to the break of the bear spell over the stock market that catalyzed the rebirth of mutual funds in Pakistan. It now promises to be one of the fastest growing industries in the financial sector. The economic overturn of the country after 9/11 has played significant role in the boost of this sector. Once reluctant corporate giants are now the leading investors in the mutual funds. The concept of mutual fund is very simple. It replicates a prudent single individual by pooling the resources to exploit the underlying asset class more efficiently and effectively. Securities and Exchange Commission of Pakistan introduced Investment Companies and Investment Advisers Rules, 1971 and Asset Management Companies Rules, 1995 to regulate open and close end funds. Although not comprehensive, however these were the initial steps in regularising the fund management industry in Pakistan. Later in 2003 The Non-Banking Finance Companies (Establishment and Regulation) Rules, 2003 were introduced that not only combined scattered regulations governing nonbanking financial sector but also tried to be more comprehensive then the predecessors individual laws. This shows progression and commitment of the regulators for the sector. However still the issues of benchmarks for fund return, addressing accounting and reporting issues and standardised risk control measures for investment in other than stock sectors are few of the concerns that need proper attention. In Pakistan, at present 14 open end and 20 close end funds are under operation. Many more are in pipeline and several are in conceptual phase. Most of them are plain vanilla funds investing purely in capital markets or money markets and a The Pakistan Accountant

Scaring from the past experience of investment companies scams, most of us still conceive mutual funds as the new version of such companies. Mutual Funds are different from our nightmare investment companies in terms of their regulations, supervision and professional management. Nevertheless, the investments in mutual funds are not free from risk. Before you invest in any mutual funds, be it stocks or bonds, it is important understand all the risks. The greater the risk, the greater the potential return. Unfortunately, there are quite a few types of risks to consider. Market risk is the risk that your individual stock, bond or mutual fund will decline if the stock or bond market declines. There is the risk that bad news about a single company will tumble its stock price. Similar there may be a situation wherein a rumour or the social or political issues nosedives the market. In such a situation the fund manager would not be able to prevent the loss however; if the asset class of a fund is adequately diversified you may witness reduction of loss in comparison with its benchmarks and peers. On the bond side, you face interest rate risk. Bond prices move in opposite directions to interest rates. So when rates rise, bond prices fall. There also is inflation risk. The income you get from your bonds through the years, may not keep pace with rising costs. Credit risk is the danger that the issuer of a money market instrument could go bankrupt. May - June 2005 15

Mutual Funds Due to influx of new and giant corporate and financial sector players in the market, there is a sign of good healthy competition in the industry. However, on the other hand this would also be a test of investors’ preference. Although the fund’s return would top the investors’ choice however, it is not as simple as it appears; there are a few things that require deeper digging especially in our nascent market:

WHAT DOES THE FUND INVEST IN? Does the fund invest in stocks or bonds? Does it invest in large, medium-size or small companies? Does that fund invest in growth stocks or undervalued stocks? Does the fund invest in bonds for income? These all questions have relevance to your investment goals and risk preferences. Stock funds tend to involve more risk then the bond funds and trading stock funds riskier then the stock funds having strategy to invest in undervalued and growth stocks.

WHAT ARE THE FEES? The level and method of charging load may also have impact on your choice. Do you have a choice of a front-end or back-end load, or is there an ongoing level load? A load is a commission. The higher the load the longer it would take to make your absolute returns in line with the fund returns.

PRICING METHODOLOGY: Is the fund has forward pricing mechanism or it announces the offer and redemption prices in advance? Generally, stock funds or the funds having significant equity asset class follow forward pricing mechanism to avoid arbitrage against the fund. On the other hand, bond funds may advance pricing mechanism as the underlying market is not volatile and any expected move in the interest rates may already being digested over in the The Pakistan Accountant

market before its official announcement. The fund having pricing policy protecting the interest of the unit holder is the preferred choice.

FUND RETURNS: The past performance of the fund reflects the fund manager’s capability of rowing the boat. Stable returns over a longer period is more important then peaks of a short period followed by trough. The asset class of the fund may perform well due to some alien conditions and in turn the fund may perform well. However, as soon as the triggering conditions are no longer in the field the fund’s return may show nosedive effects. Take an example of from our markets, if a fund having asset concentration in PSO Stock, its returns shoot up as soon as we hear the announcement of its privatisation due to market expectations of having its pricing over its fair value. However, as soon as the government put off the decision of its privatisation or the company is sold off below the expected market price, the market would dilute its price to its fair level. Although quiet riskier, this also give rise to an opportunity to earn good returns by playing with the market. Nevertheless, focusing too much on a mutual fund's past performance is also not advisable. While it's easy to get swept up in the latest investment trend, relying solely on past results rarely leads to success. Instead, ask yourself, "Is this a good investment right now?" There may be situations where bond funds may be outperforming the stock returns. The advisable thing is to review a fund's return against the return of its stated benchmark and its peer group over the most recent three- year period. Then consider how the asset class as a whole has fared during this period. If the asset class has performed well recently, consider whether now is the right time to invest.

Harvesting the field in the favourable conditions is not a big task. Anyone can reap the benefits in bull markets. You may be looking for one who can sail your boat during tumbling times. One should also take into account the fund’s performance during down markets. How much the fund asset shrinks during such period? Do the funds NAV falls in line with the market index or its peers or it falls more rapidly then the market index or its peers? Naturally, the one who can provide you decent returns in all weathers would be the preferred choice.

PAYING TOO MUCH IN EXPENSES Costs matter. Fund expenses - the costs of running a fund, measured by its expense ratio - come directly out of the fund's income and can significantly dampen your return. Over time, a seemingly small difference in expenses can have a big effect on your nest egg. Managers of high-cost funds have to earn higher returns in light of expenses just to outperform their low-cost peers. Mind it there might be some expenses whose dilution effect to the fund’s earnings could not be picked from the naked eyes, you might require to go deep into the waters to see such effects. All else being equal, it is recommended to avoiding funds with high expenses.

ACCOUNTING TREATMENT FOR THE INCOME AND EXPENSE ITEMS: Being new and specialised industry, lack of standardised accounting treatments / pronouncements may have significant impact on the fund returns. Book returns may not correspond to the implicit returns and may result in enronimism. May - June 2005 16

Mutual Funds Mutual funds being specialised industry require standardisation of accounting procedures for its major class of transactions. In certain cases, generally accepted accounting principals may provide flexibility for presentation however, from mutual fund's perspective it may not be the case. Like a fund may not defer the valuation of its securities for the year end as it has to announce the net asset value of the underlying asset frequently or it may not adopt a certain IAS in toto to avoid distortion in the net asset values of the underlying assets. In such a scenario, the fund that adopts the accounting policy that fairly reflects the net asset value of the assets would be the preferred choice in comparison with the book return. Further, the matter should not be left in abeyance. We should not wait for the eruption of accounting scam. Being the involvement of people hard earned money, issues should be taken up by the SECP and ICAP more proactively.

FUND SIZE Every fund category has a range of assets under management where, all other factors being equal, fund managers have their best chance to compete against their peers. In general, it's best to avoid funds with really small asset bases. And, it's generally best to avoid small cap funds with large amounts of assets under management. Selecting the right-size fund is no guarantee of success, but it can enhance your prospects for a better return.

PUTTING TOO MUCH IN FOCUSED FUNDS Focused funds concept is new to our environment due to limited market size. However, as the size of the market grows we would witness emergence of focused funds. Focused funds are limited to a single sector or The Pakistan Accountant

even in the case of very large market cap companies limited to a single company. Investing too much in the focused fund is exposing you to volatile returns. Focused funds are subject to greater volatility than diversified funds because they fail to completely diversify security and sector risk.

RISK CONTROLS Risk controls are policies such as limits on stock or sector weights. Although, NBFC Rules address this issue to a basic extent however, it is really an internal risk control policy and its effective implementation that provides security and disciplined returns to the investors. They set the playing field for a fund and ensure that the portfolio manager seeks to generate returns in an efficient manner. Being the investor in the fund you have the fullest right to learn about what types of risk controls portfolio managers use while exercising options to buy or sell specific securities. The more risky or volatile the investment category, the more important it is to have these controls in place.

NOT KNOWING WHO IS MANAGING YOUR MONEY How long has the fund manager been running the fund? If the fund manager is new, you might want to go with a manager with a longer-term track record. After all, your hard earned savings should be in the safe hand. A loss of profit is bearable as against the loss of capital. A fund's prospectus should clearly identify who makes the investment decisions. Be wary of investing in a fund with a novice manager or a faceless team whose compensation

might not be aligned with the performance of your fund. In some scenarios, committees manage some funds. So if one of the co-managers leaves, it‘s not that big a deal.

OVERLOOKING EXCESSIVE DEMANDS ON YOUR MANAGER'S TIME The next issue is that a successful fund manager could be promoted to run multiple funds or chair multiple committees, or become chief investment officer for the firm. It's important to revaluate whether the manager is going to be focused enough on your fund. Start by reviewing how many funds your manager is managing, and in what roles. The better money management firms give their best managers ample support so they can devote sufficient time to managing your money.

THE BOTTOM LINE: No doubt mutual funds are the best tool for earning decent return with risk diversification. Entrance of new fund managers and growth of the sector would witness a number of opportunities knocking your door. With a number of mutual funds to choose from, the selection process can be overwhelming. Being aware of these issues, should help narrow the field. About the Author: Mr. Rizwan Razzak is an Associate Member of Chartered Institute of Management Accountants, UK and the Institute of Chartered Accountants of Pakistan. He is presently serving as Chief Financial Officer of RUSD Investment Bank Inc, Labuan, Malaysia. Readers are welcome to contact him at: [email protected]

May - June 2005 17

Hedging Instruments

Hedging Instruments in the

Petroleum Industry: A Brief Sur vey Harald A. Osel

A basic building block for economic success of every company is the management of the risks inherent to its business activities. Risk is closely associated with uncertainty and the extent to which probabilities could be attributed to the occurrence of future developments FN1. With respect to prices the magnitude of risk could be expressed in terms of price volatility. The prices of primary importance to each economic enterprise are the interest rate in the capital market, prices for goods and services sold and received, exchange rates, as well as the market value of the company (e.g. expressed in terms of the market capitalization of the company’s shares). Techniques to manage the risk associated with the fluctuations of these prices have further been developed, which resulted in the creation of a variety of hedging instruments.

Hedging

A hedge basically aims at initiating a market transaction in order to dispose of the risks of price volatility. The company’s philosophy and attitude towards risk management, trading and hedging is typically reflected in its Risk Management Policies and Procedures FN2. An integrated oil company for example with the entire upstream production of crude being processed in the refinery experiences two offsetting price risks – i.e. a natural hedge - and might opt not to use additional hedging instruments. Alternatively the oil company might run its up- and downstream divisions as completely independent profit centers, which are requested to hedge its relevant price risk. The oil company might go for an alternative scenario and hedge only a fraction of the total production but not 100%, which could again form part of the Risk Management Policies and Procedures. A competitive spot market for the underlying commodity as well as an associated market for derivative securities forms the basis for applying hedging technology. Markets for hedging instruments could be highly organized such as in an exchange for stocks and commodities or otherwise be governed by individual over-the-counter (OTC) transactions. The basic concept of hedging is to hedge risks originating from a present transaction in the physical market by simultaneously initiating an equal and opposite position for a future transaction in the futures market. The Pakistan Accountant

In case price fluctuations of the hedged position (e.g. oil) could be fully offset via price fluctuations of the hedging instrument (futures, options and others) a perfect hedge would have been achieved. In reality a perfect hedge often represents only a theoretical possibility. One reason for this being that the price of the hedged position respectively underlying commodity and the price of the hedging instrument do not move in tandem. That difference between the price in the physical, cash market and the price of the hedging instrument is called the basis and the risk associated with it is known as the basis risk. Crude oil, refined products and natural gas represent the underlying commodities in the Petroleum Industry for which hedging instrument could be used. Futures, options and swaps, as well as forward contracts represent the standard hedging instruments.

(1) Forward Contracts Forward contracts represent over-the-counter transactions with a varying degree of standardization. Forward contracts essentially represent an agreement to buy or sell a commodity such as oil at a specific future date. Physical delivery of the oil traded is required upon agreed terms as stipulated in the contract. Forward contracts could be further indorsed and traded on to other market participants, which could result in a large number of transactions known as Strings and Daisy Chains. As forward contracts are traded over-the-counter the risk of non-fulfillment of the contract remains. In case of a hedging instrument that trades on an exchange a clearinghouse would guarantee fulfillment, which provides additional liquidity for that hedging instrument.

(2) Futures Futures are standardized contracts, offered to the general public while being traded over an exchange. Buyers and sellers are connected at this exchange via a clearinghouse, which matches the longs (buyers) and the shorts (sellers).The clearinghouse charges a margin for its services but guarantees the fulfillment of the futures contract, which makes futures a much easier negotiable asset. Companies interested in trading futures contracts often interact with the clearinghouse via a clearing broker. Conversations between the client and broker are regularly recorded. May - June 2005 20

Hedging Instruments The futures contracts traded in the petroleum industry are for crude oil, oil products such as heating oil or unleaded gasoline, as well as natural gas futures. Other energy futures are also available for electricity. The principle energy futures exchanges worldwide are the NYMEX (New York Mercantile Exchange or the “Merc”) and the IPE (International Petroleum Exchange) in London. Futures contracts are further traded on other exchanges such as the SIMEX (Singapore International Monetary Exchange). Most energy futures traded on the NYMEX require upon expiry the physical delivery of the underlying commodity at a predefined delivery point. The paper barrels originally purchased with the futures contract consequently turn into wet barrels upon the expiry date of the future. With the IPE alternative delivery methods - especially cash settlement upon expiry of the contract as it was the case for a financial futures – are more common. For a futures contract requiring physical delivery (e.g. at NYMEX) the purchaser of that contract is consequently not responsible for storage of the petroleum, i.e. the costs of carrying, up to the future point of delivery FN3. The same could be valid when purchasing commodities on the basis of a forward contract. Prices of contracts on a forward basis plotted against time represent on a graphical basis the forward curve. The forward curve, nevertheless, not only includes costs of carrying but also the price expectations of the market participants. If futures prices for closer month are higher than for later month – e.g. May 35 $/bbl, June 30 $/bbl - the market is said to be inverted. Even though costs of carrying would point towards rising prices the overall price decline is what causes an inverted market, which is The Pakistan Accountant

also known as trading in backwardation. Inverted futures markets are linked to the expectations of market participants for prices in the cash market for the underlying commodity to fall. Otherwise if later month trade at a premium over closer month the market is referred to as trading in contango, which is linked to the expectation of rising prices in the cash market. The link of the futures to the physical market provides the confidence that prices on both markets tend to move in tandem, which is a prerequisite for a futures contract to serve as at hedging instrument for the physical commodity.

Hedging Example – Futures An oil company sells crude oil today, Sep. 15, for physical delivery on Dec.1, at prices prevailing at the date of delivery. The company is concerned about falling prices and wants to lock in the price offered by a futures contract today for deliveries in three month, i.e. Dec. 15, which is 39 $/bbl. The company consequently sells 3month futures on NYMEX on Sep. 15. Going short in futures (i.e. selling futures) thereby constitutes a contract that gives the right to sell in future at today’s price of the futures contract. On Dec.1 the physical transaction takes place at a price of 39.5 $/bbl. The company subsequently has to close its futures position and buys futures at Dec.1-prices of 39.5 $/bbl as well. Futures for same underlying, contract quantity are first sold and then

bought, i.e. offsetting positions are traded back-to-back. A standard NYMEX futures contract requires physical delivery at the end of its term. In case the originally sold futures contract would not be offset and bought back the physical delivery of oil would be required on the basis of the futures contract and the company would have to sell oil twice, once in the physical and once in the futures market. (See Table) In this example the hedger has sold oil, -which in the language of traders is usually referred to as going short of oil – and ultimately bought futures, i.e. he goes long of futures. This type of transaction is also known as a short hedge. The basic aim of the short hedge is to protect companies such as oil producers from falling prices in the physical, cash market by originally selling futures and locking in the prices for future sales. A hedge where oil should be purchased at a future date and futures would first be bought and then sold would be a long hedge. A long hedge aims at protecting the buyer of oil from rising acquisition costs for oil. The buyer intending to purchase oil in future consequently buys futures now in order to try to fix the price of oil at the future delivery date. At that future date and the then prevailing prices the oil buyer would, nevertheless, have to ultimately sell futures in order to avoid physical purchase upon expire of the futures contract.

The following table should visualize this concept: Physical Cash Market Credit/(Debit) Today: Sep.15 Delivery: Dec.1

Sell at 39 $/bbl sell at 39.5 $/bbl

Hedging Costs Net Sales Price

Hedging Futures Market Credit/(Debit)

(buy at 39.5 $/bbl) (0.5 $/bbl)

39 $/bbl

May - June 2005 21

Hedging Instruments

ADP & EFP The buyer and the seller of the futures contract could agree upon an Alternative Delivery Procedure (ADP), which deviates from the standardized futures contract in which case the clearinghouse would not generally guarantee for fulfillment of the contract. In case the exchange of an equal and opposite position is directly achieved between buyer and seller during the trading period of the future the associated transaction is known as Exchange of Futures for Physicals (EFP). The EFP contract trades futures for physicals under conditions other than what is defined with respect to the delivery point of the exchange traded future. An EFP agreement shows some similarity with an Alternative Delivery Procedure (ADP), which is a provision in the futures contract that allows for delivery conditions in alternation to the futures contract. Whereas with an EFP a transfer of title, nevertheless, takes place such transfer is not part of an ADP. The IPE has successfully developed a Brent crude oil future, which requires physical delivery based on an EFP with an option for a cash settlement. The Brent futures contract with a combined cash settlement plus EFP mechanism for deliveries is meanwhile traded on the SIMEX, as well as on the Merc (NYMEX).

Hedgers, Speculators & Arbitrageurs The basic concept of hedging is to offset a position in the physical market with an equal and opposite transaction in the futures market. To otherwise buy oil in the physical and the futures market or to sell vice versa is sometimes humorously referred to as a Texas hedge. Rising or falling prices consequently result in this scenario in gaining or loosing twice, as there are no equal and opposite positions involved. The Texas

The Pakistan Accountant

hedge ultimately represents a highly risky form of speculation but not a hedge. In contrast to a hedger a speculator enters into open position trading. The speculator for example sells at 39 $/bbl in the futures market and speculates on buying back later at a lower price, e.g. 38 $/bbl leaving him with a profit margin of 1 $/bbl. Position trading consequently aims at taking advantage of changes in absolute prices of a futures contract. Spread trading of futures represents another trading activity for a speculator, which aims at profiting from changes in relative prices of futures contracts. Unlike with position trading - where the speculator goes either short or long in futures - in case of spread trading a short and a long position is acquired. These positions are held in different futures contracts relating to same or similar underlying commodities. The spread consequently comprises of two opposite and equal positions in the futures market. The speculator could gain or loose once the relative prices of the futures contract change FN4. The market participants in the futures market that are required for a company to finalize its hedging transaction are usually not the speculators but hedgers searching for an opposite coverage. A third group of market participants could be the arbitrageurs, searching to profit from price differences for same products in different markets. Arbitrage is an inconsistency that should not exist in perfect markets. However, in case of less than perfect markets arbitrage provides a riskless (risikolos) profit opportunity thereby pushing prices towards perfect market conditions.

Costs of Trading Futures The costs of trading futures for the hedger on an exchange such as the NYMEX basically comprise of a deposit, a variation margin and the broker’s commission. An initial or

original margin respectively a deposit is a payment the clearinghouse could request from its customers in order to prove and provide financial security. If not required the deposit would be returned (including interest) at the close out of the futures contract. During the trading of the futures a difference between the original cost of the contract and the daily closing or settlement price arises. That difference is known as the variation margin. A negative margin represents a loss a positive margin a profit. The hedger holding the futures contract has to pay the negative margin on a daily basis. In case payment was not received funds provided by the deposit would be utilized. The clearinghouse receives all negative margins and distributes it to the holders of the positive margins on a daily basis. The daily balance for the clearinghouse is consequently always zero. All positions in the futures markets are consequently valued daily on the basis of market clearing prices, i.e. they are marked-to-market. Contracts such as futures and options are known as derivative securities or derivatives as they derive their value from an underlying asset or commodity such as for example crude oil.

(3) Options Options are standardized contracts that could be traded via an exchange or as an over-the-counter (OTC) traded option. Options on physical assets are sometimes referred to as real options. Exchange traded energy options are generally options on an underlying futures contract. On the NYMEX options on all energy futures contracts are available. The IPE offers options on Brent crude and gas oil futures. A nonstandardized OTC option could otherwise be based on any energy market. Options are short-term contracts with a maturity of for example up to half a year. For crude oil and oil products futures and options are usually traded at the same exchange. May - June 2005 22

Hedging Instruments

Types of Options Different types of options could be distinguished further such as American or European options. An American option could be exercised during each day of the validity of the option at prices of the day, whereas a European option could be exercised only at the due date. Asian options further provide the right to execute the option during every day of its term but at an average price with reference to a stated period. The main difference between options and futures is that options provide the right but no obligation to buy or sell. For that right an option premium has to be paid. The purchaser of an option is thereby called taker whereas the seller is called granter or writer. An option could further constitute the right to sell, which is a put option or to buy in case of a call option. The combinations of buy/call, buy/put, sell/call and sell/put are the four basic positions of option trading. Straddles, strangles and spreads further represent combinations of call and put options - or just calls respectively just puts - with varying contract terms. Complexly structured options, - which do not represent a usual or standardized option contract – are also referred to as exotic options. In trading terminology the converse of an exotic contract would be a vanilla or plain vanilla position.

Option Value The option premium – describing the total value of an option – consists of an intrinsic value and a time value also referred to as extrinsic value. The intrinsic value describes the value of an option in case it could be immediately exercised. When prices for Brent crude oil in the physical market were for example USD 35 bbl and the strike price of a call option was USD 34 bbl – respectively USD 36 bbl for a put option - the intrinsic value of the option was USD 1 bbl. These options are further described as in-themoney due to their positive intrinsic value. Otherwise – in case an option – has no intrinsic value it is known as The Pakistan Accountant

out-of-the-money unless the value in the physical market coincides with the strike price (here USD 35 bbl), which refers to an option trading at-themoney. During the period between issuance and expiry of the option a time period during which a potential for favorable movements of oil prices in the physical market – or prices of the underlying commodity in general - exists. The value associated with this potential is the extrinsic value of the option. Once an option has expired that extrinsic value is zero and only the intrinsic value of the option remains. Option pricing models have further been developed in context with the Black-Scholes Model originally designed for financial, stock markets FN5. Black further adapted this model – known as the Black ’76 Model - so as to evaluate options on forward positions such as in the commodity markets. The purpose of option pricing is to calculate a theoretical, fair value that provides in the long run for a break even between traders FN6.

Hedging Examples – Options (I) An oil producer intends to sell oil – i.e. he goes short in oil - at a future date and wants to lock in a price of 35 $/bbl in order to be protected against falling prices in future. Consequently the producer goes long in options and buys a put during the current period with a strike price of 35 $/bbl. In case prices rise above the strike price of the option he could let the put expire and sell at the higher price in the physical market. That short hedge – going long in the current period in the futures market but short in the physical market for future deliveries - otherwise provides the producer with the opportunity to fully participate in any upside potential by paying an option premium in return. (II) An alternative strategy for the producer intending to sell oil in future in the physical market could be to sell a call at 35 $/bbl for which he could receive a call premium. A pay out for the producer

would only occur when prices in the physical market are higher than the strike price of the call and the buyer of the option requests fulfillment of the contract. By selling the call the producer consequently receives a call premium but has given up the upside potential beyond the strike price of the option. (III) Assuming now a consumer who wants to buy oil at a future date and intends to lock in prices. The typical long hedge for the consumer in this case would be to buy calls in order to be protected against rising prices. (IV) Alternatively the consumer intending to purchase oil in the physical market at a future date - could sell puts and receive an option premium for assuming a granter’s position. In case of rising prices the taker of the option would further not execute his option rights. Only in case of falling prices the put would have to be fulfilled. When selling puts the consumer consequently limits his possibility to fully participate in the downside potential associated with falling oil prices.

(4) Oil Price Swap An oil price swap is an instrument that is designed to provide protection against fluctuating prices. Swaps are no classical hedging instruments in the sense of establishing equal and opposite transactions in the cash and futures market but could provide the price stability required for hedging. Price swaps represent an agreement between two parties to interchange a predetermined series of payments.

Plain Vanilla Swap The exchange of payments between seller and buyer of an oil price swap consists of a fixed amount, Af, and a variable amount, Av. The balance of the two amounts determines the actual payout, which is settled in certain intervals such as every month or quarter. May - June 2005 23

Hedging Instruments The seller of the price swap – usually a trading company or bank – agrees to pay a fixed amount, Af, to the buyer of the swap - an oil company - for which the seller receives a premium. That fixed amount, Af, is the product of an agreed locked-in price, P, and a notional quantity of oil, i.e.: Af = P * Qn. The variable amount, Av, is paid by the oil company to the trader and is the product of an indexed price, Pi, and same notional quantity of oil, i.e.: Av = Pi * Qn. The daily average of WTI (West Texas Intermediate) futures contracts on the NYMEX during a stipulated period could serve as an example of such an indexed price. The type of oil price swap described above is also referred to as a plain vanilla swap FN7.

Terms and Types of Swaps The buyer and the seller of an oil price swap could be individual companies in the petroleum industry. An oil company as buyer of the swap and a trading company respectively bank as the seller provides an alternative combination. Oil Company and trader swapping fixed and floating liabilities, nevertheless, represent the standard scenario. Oil price swaps usually are non standardized, over-the-counter transactions while futures and options are exchange traded. Other types of swaps are occasionally exchange traded in the futures market. Options on swaps – known as swaptions – are sometimes issued further. For swaps, which are not exchange traded no clearinghouse guarantees for the fulfillment of the contract. A high rating and financial standing of the companies involved consequently represent a prerequisite for trading price swaps. The Pakistan Accountant

While over-the-counter transactions such as forward contracts are linked to the fulfillment of the contract in kind an oil or gas price swap otherwise does not demand physical deliveries. Price swaps are usually long term agreements with a typical duration in the order of one to ten years. Price swaps consequently protect the oil company on a long-term basis from prices falling below the locked-in price – e.g. 30 $/bbl –, as the trader of the swap has to compensate the company for the loss occurred. When prices move otherwise above the lock in price the oil company generates the full sales value in the physical market but has to pay to the trader the surplus price generated with reference to the agreed upon, notional quantity of oil. Swap Agreements could further be varied and designed so as to express a floor or collar agreement. An oil price floor represents an agreement whereby the oil company ensures a minimum oil price by concluding a contract with a trader who in return for that guarantee receives an upfront premium. In case the company wants to be protected against market prices falling below a floor price but also intends to save on that upfront premium the oil company could enter into a collar contract with the trading company. This type of agreement provides for a floor price as well as a ceiling price above that the company passes on all upside to the trader. A type of swap that is of further importance to the downstream petroleum industry is the refining margin swap. This sort of swap aims at simultaneously hedging the price of the refinery output products as well as the price of input crude. Consequently crude is purchased and products are sold for an equivalent forward period, which contributes to locking-in the refinery margin.

Literature / Footnotes: FN1: For a more detailed discussion on uncertainty (i.e. knowing the possibility of a future outcome but not the probabilities) and risk (i.e. knowing the probabilities) and the associated management strategies see e.g. M.Hamberg, “Strategic Financial Decisions”, Liber AB, Malmo, 2001, p. 91-118. FN2: A description of the concept of Risk Management Policies and Procedures is provided in J. Wengler, “Managing Energy Risk: a nontechnical guide to markets and trading”, Penn Well, Tulsa, 2001, p. 47- 69. FN3: A brief, quantitative description of commodity futures and the associated costs of carry is provided by Y.-D. Lyuu, “Financial Engineering and Computation. Principles, Mathematics, Algorithms”, Cambridge University Press, Cambridge/UK et al., 2002, p. 166-67. FN4: For an overview on speculation and spread trading see: S. Errera, S. L. Brown, “Fundamentals of Trading Energy Futures & Options”, 2nd ed., Penn Well, Tulsa, 2002, p. 53-74. FN5: An introduction to calculating a risk premium on the basis of the Capital Asset Pricing Model, as well as to the valuation of options in the financial market is provided by e.g. R. Pike, B. Neale, “Corporate Finance and Investment Decisions and Strategies”, 4th ed., Prentice Hall / Pearson Education Ltd., Harlow et al., 2003, p. 331-366 and 398-425. FN6: For a brief introduction to option pricing in context with commodities in the energy markets see e.g.: M. Lynch, “Options Strategies” in J.E.Treat (ed.), “Energy Futures Trading Opportunities”, 3rd ed., Penn Well, Tulsa, 2000, p. 178-194. FN7: For an overview of other types of swap agreements in the energy market see C. Mason, S. Jones, “Swaps”, in: “Managing Energy Price Risk”, Risk Publications, London, 1995, p.81-96. May - June 2005 24

Hedging Instruments

Hedge Funds

Challenging Conventional Investment Management Mohammad Shoaib Jan Memon, ACA, ACCA

The hedge fund industry has experienced enormous growth in the last several years growing by some estimates from as few as 300 funds in 1990 to more than 8,700 funds today. They have become highly visible in the global markets and the financial press, and are stated to command up to $950 billion in capital. The article briefly describes a hedge fund, investment strategies and performance analysis supporting the importance gained by hedge funds in global financial markets.

Hedge funds strategies

Description

Some of the common hedge funds strategies adopted include:

An investing glossary defines hedge funds as follows: “A fund, usually used by wealthy individuals and institutions, which is allowed to use aggressive strategies that are unavailable to mutual funds, including selling short, leverage, program trading, swaps, arbitrage, and derivatives. They are restricted by law to a maximum number of investors per fund, and as a result most hedge funds set extremely high minimum investment amounts. As with traditional mutual funds, investors in hedge funds pay a management fee; however, hedge funds also collect a large percentage of the profits (usually 20%).” Hedge funds, therefore like other established alternative investments including real estate, commodities, venture capital and private equity are thought to provide access to returns that are uncorrelated with traditional investments and superior risk-adjusted returns.

Difference between mutual funds and hedge funds The essential difference between the two asset classes is what can be called as "investment freedom." Essentially, hedge funds can invest in anything they want. On the other hand, mutual funds are highly regulated and have very specific investment guidelines. Typically, with mutual funds, the investor knows exactly what he is getting into and therefore are one dimensional. However, the same can't be said of hedge funds. The fact that they can invest in many different strategies, ideas, or assets allows hedge funds to produce positive returns in any investment climate. However, this freedom also makes it that much harder for the average investor to understand hedge funds. The Pakistan Accountant

Hedge funds employ variety of investment strategies, some of which use leveraging and derivatives while others are more conservative and employ little or no leverage. Many hedge fund strategies seek to reduce market risk specifically by shorting the equities or derivatives. Their returns over a sustained period of time have outperformed standard equity and bond indexes with less volatility and risk of loss than equities carry.

Aggressive Growth: Invest in equities expected to experience acceleration in growth of earnings per share. Generally high P/E ratios, low or no dividends; often smaller and micro cap stocks which are expected to experience rapid growth. Includes sector specialist funds such as technology, banking or biotechnology. Distressed Securities: Buy equities, debt or trade claims at deep discounts of those companies which are in or facing bankruptcy or reorganization. Profit from the market’s lack of understanding of the true value of the deeply discounted securities and inability of those institutional investors which cannot own below investment grade securities. Results are therefore generally not dependent on the direction of the markets. Emerging Markets: Invest in securities issued by businesses and/or governments of countries with less developed economies that have the potential for significant future growth. Macro: Aim to profit from changes in global economies, typically brought about by shifts in government policy which impact interest rates, in turn affecting currency, stock, and bond markets. Market Neutral - Arbitrage: Attempt to hedge out most market risk by taking offsetting positions, often in different securities of the same issuer. Focus on obtaining returns with low or no correlation to both the equity and bond markets. May - June 2005 25

Hedging Instruments Opportunistic: Investment theme changes from strategy to strategy as opportunities arise to profit from events such as IPOs, sudden price changes often caused by an interim earnings disappointment, hostile bids, and other event-driven opportunities.

The average US hedge fund has also outperformed the average US mutual fund for the past five years. The highest returning US hedge funds significantly outperformed the highest returning US mutual funds, and the worst performing US hedge funds fared better than the worst performing US mutual funds. This can be noted as follows:

Special Situations: Invest in event-driven situations such as mergers, hostile takeovers, reorganizations, or leveraged buy outs. May involve simultaneous purchase of stock in companies being acquired, and the sale of stock in its acquirer, hoping to profit from the spread between the current market price and the ultimate purchase price of the company.

Comparison of Best and Worst Performing US Hedge Funds and Mutual Funds 5-Yr Net Compound Annual Returns, 3rd Quarter 99 to 2nd Quarter 04 Mutual Funds Hedge Funds

Value: Invest in securities perceived to be selling at deep discounts to their intrinsic or potential worth. Such securities may be out of favour or undervalued / not followed by analysts otherwise. Fund of Funds: Invest in other hedge funds rather than directly investing in securities such as stocks, bonds, etc. These underlying hedge funds may follow a variety of investment strategies or may all employ similar approaches. Because investors’ capital is diversified among a number of different hedge fund managers, fund of funds generally exhibit lower risk than do single-manager hedge funds exhibit. Broadly speaking hedge funds can be considered to be less regulated investment pools, generally with a limited number of investors that may invest in any class as well as derivative securities and use long and short positions, as well as leverage. A distinguishing feature of hedge funds has been the routine use of long or short positions to offset market risks and isolate arbitrage opportunities, although these opportunities are not without their own specific risks. Hedge funds are therefore considered on an overall basis to be more nimble and dynamic in their trading strategies than traditional mutual funds.

Hedge funds performance analysis

In aggregate, hedge funds have provided superior returns and lower statistical risk than the S&P or mutual funds in most multi-year periods. An analysis against significant world indices is as follows: Global Hedge Fund Net Returns 1 January 1998 - 31 December 2004 Style/Strategy

Net Compound Standard Annual Return Deviation

Sharpe Ratio

Van Global Hedge Fund Index

16%

MSCI World Equity

6.6%

16.1%

0.3

S&P 500

12.4%

15.2%

0.7

Average Equity Mutual Funds

10%

15.7%

0.6

Lehman Brothers

8.1%

4.4%

1.3

Aggregate Bond index

Soure: Van Hedge Fund Advisors International LLC.

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8.8%

1.5

Top 10 Top 10% Top 25% Bottom 25% Bottom 10% Bottom 10

39.9% 28.6% 21.3% -0.6% -5.9% -14.0%

28.8% 13.4% 9.4% -4.0% -7.2% -28.1%

Source: Van Hedge Fund Advisors International LLC.

The level of excess returns produced by hedge fund portfolios reflects the average success of their investment strategies. The key to success of hedge funds lies in their ability to exploit structural inefficiencies in the markets. They also enjoy an edge in transforming market inefficiencies into returns largely because hedge fund managers are focused, and generally avoid risks outside of their areas of expertise. The typical performance based fee structures for a hedge fund attracts the industry’s best talent and provides significant incentive to identify and focus on winning strategies. Moreover, managers often have a proportion of their own money invested in the fund. It is also the case that the typical fund operates in a much less constrained environment than large institutional funds and the decision making tends to be more streamlined and less committee oriented, contributing to an overall nimbleness.

Conclusion

Hedge funds portfolios have therefore produced risk adjusted returns and excess returns that are superior to traditional investments with low correlation to fundamental asset classes. The structure of hedge fund industry and growth in supply of market inefficiencies, suggest that advantages of hedge fund investments are not likely to diminish soon. Hedge funds are therefore expected to grow in significance and increasingly challenge conventional investment management in the years to come. This memorandum is based on information available to public. No representation is made that it is accurate and complete and does not provide any investment advice. Specific credit is given to Dion Frediland and Magnum Funds for use of certain information. About the author: Mr. Shoaib is an associate member of the Institute of Chartered Accountants of Pakistan. Currently he is working in Banking and Capital Markets Group in Ernst & Young London Office. He can be contacted at: [email protected]. May - June 2005 26

Banking

Operational Risk Management in a Bank: Easier said than done! Danish Ahmed Siddiqui,

Operational risk management is not a new concept. However, it was not until the turn of the century that the stakeholders especially the regulators started to pay close attention to the operational risk management practices adopted by the banks. Especially the 9/11 acted as a catalyst in generating interest in the operational risk management. The dreadful incidence of 9/11 unearthed the reality that in general the firms had adopted a somewhat laid back approach to operational risk management; many did not have a comprehensive disaster recovery plan, some did not have enough geographical space between their offices, some lacked redundant technology and others (including New York Stock Exchange) did not have the physical back up infrastructure. In this backdrop the Basel Committee on Banking Supervision ("the Committee") issued a document titled "International Convergence of Capital Measurement and Capital Standards" more commonly known as the revised Basel Capital Accord II in June 2004 and for the first time introduced the requirements for the adopting banks to measure the operational risk and allocate capital for it!1 Implications of allocating capital for operational risk forced the managers to reconsider their risk management practices and take action in order to minimize the capital allocated to operational risk thus optimize the return on capital.

Definition of Operational Risk

The Committee defines the operational risk as: "the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events". This definition includes legal risk, but specifically excludes strategic and reputational risk. Definition of risk is important as it enables the management to draw boundaries and separately identify the operational risk from other business risks - thus ensuring capital allocated for the risk reflects the correct level of operational risk - and to take practical decisions in implementing an operational risk management framework.

Operational Risk Management The Framework The Committee suggested an operatoinal risk management framework in its paper "Sound Practices for the Management

The Pakistan Accountant

ACA

and Supervision of Operational Risk" issued in December 2001. The framework analyses the risk management, which is generally seen as a continuous process, into the following identifiable steps:

Diagram 1: Risk management framework

Identify the operational risk

Identification of operational risk is critical as it forms the basis for implementing the next blocks of the framework. If management fails to identify a risk, it is not likely to establish measurement, monitoring and controlling mechanisms for such risk! Identifying the risk involves a detailed review of the management practices with a view to identify potential for losses without considering the related controls and mitigating factors such as insurance. A bank may choose to identify risks based on the "loss events" and for a bank with more than a single business line it might be more useful to identify the loss events for each business line. A typical example would be "loss due to regulatory action in corporate finance" or"damage to physical assets in retail banking" etc. By identifying the risk consistent with their internal accounting definition of loss into various loss categories, bank can trace the loss data, clearly segregate the operational risk from credit or market risk and develop models to analyze the risk thus implement a measurement, monitoring and control mechanism.

May - June 2005 27

Banking

Operational Risk Type

Frequency

Severity

Clients, products and business practices

Low to Medium

Medium to High

Internal fraud

Low

High

External fraud

Medium to High

Low to Medium

Damage to physical assets

Low

Low

Execution delivery and process management

High

Low

Business disruptions and systems failure

Low

Low

Employment practices and workplace safety

Low

Low

Source: Basel Committee on Banking Supervision, 2001a, Operational Risk, Consultative Paper 2 January. The risk identification process must be ongoing and open to review based on new risks posed by a changing environment or changing aspects of the products and services. Best practice is to have the Board of Directors' approval for all the new products and services and a periodic review of the existing practices by internal and external audit, moreover, increasing number of banks have established dedicated risk management units which have a direct reporting line to the Board of Directors.

Tools that banks use to identify the operational risk include: w

Self or risk assessment; a bank assesses its operations and activities against a menu of operational risk events. This process is internally driven and often incorporates checklists and/or workshops to identify the strengths and weaknesses of the operational risk environment.

w

Risk mapping; in this process, various business units, organisational functions or process flows are mapped by risk type. This exercise can reveal areas of weakness and help prioritise subsequent management action.

w

Key risk indicators; risk indicators are statistics and/or metrics, often financial, which can provide insight into a bank’s risk position.These indicators should be reviewed on a periodic basis (often monthly or quarterly) to alert banks to changes that may be indicative of risk concerns.Such indicators may include for example the number of failed trades,staff turnover rates the frequency and/or severity of errors and omissions.

w

Threshold/limits; and typically tied to risk indicators, threshold levels (or changes) in key risk indicators, when exceeded, alert management to areas of potential problems.

w

Scorecards these provide a means of translating qualitative assessments into quantitative metrics that can be used to allocate economic capital to business lines in relation to performance in managing and controlling various aspects of operational risk.

In a consultative paper on Operational Risk issued by the Committee in 2001 the operational risk has been categorized into the above seven categories with indication of their frequency and severity based on the data collected. The above table classifies risk into broad categories and definition of low medium and high frequency across different risk types may not be consistent (i.e. "low" frequency for internal fraud is not equal to a "low" frequency of damage to physical assets!), however, a bank may use the above table as a starting point for identification the potential risk in its business or each business line. Frequency and severity data given here may assist the management in focusing on specific risks and assessing the likely impact of these risks on their bottom line, however, in all such analyses the peculiarities of individual businesses should be given due considerations. The Committee emphasized that low frequency high severity events should be given due significance in identification process - bear in mind that Barrings went down because of an internal fraud and various problems were identified in business practices adopted by Enron during the bankruptcy proceedings! Although, in these cases actual loss was driven by the market or credit risk exposures, taking on such risk could have been avoided in a low operational risk environment. The Pakistan Accountant

May - June 2005 28

Banking

Measure the operational risk Some bank managers argue that due to the lack of consistent and reliable data and suitable statistical models, it is a futile exercise to attempt to measure the operational risk. They believe that the focus should be on managing the risk based on the qualitative assessments rather than attempting to measure or quantify it statistically or through proxy measures. Others are of the opinion that measurement of operational risk should be the part of overall risk management framework and attempts should be made to measure the risk in order to facilitate communication of risk to investors and regulators and to provide meaningful information to the stakeholders allowing them to compare the risk profile of the bank with its peers and over different periods. The Basel Capital Accord II requires the banks to quantify their exposure to operational risk and presents three methods to calculate operational risk capital charge (i.e. quantify the operational risk). Banks have the option to choose any of the following methods considering their individual sophistication and risk sensitivity and subject to their respective regulator's approval:2 w w w

Basic Indicator Approach Standardised Approach (and Alternative Standardised Approach) Advanced Measurement Approach

Basic Indicator Approach Under this methodology the capital charge is equal to the average over the previous three years of a fixed percentage (denoted alpha) of positive annual gross income. Figures for any year in which annual gross income is negative or zero should be excluded from both the numerator and denominator when calculating the average. The charge may be expressed as follows: KBIA = [(GI1…n xa)]/n Where KBIA = the capital charge under the Basic Indicator Approach The Pakistan Accountant

GI = annual gross income, where positive, over the previous three years n = number of the previous three years for which gross income is positive a = 15%, which is set by the Committee, relating the industry wide level of required capital to the industry wide level of the indicator. Gross income is defined as net interest income plus net non-interest income. It is intended that this measure should: (i) be gross of any provisions (e.g. for unpaid interest); (ii) be gross of operating expenses, including fees paid to outsourcing service providers; (iii) exclude realized profits/losses from the sale of securities in the banking book; and (iv) exclude extraordinary or irregular items as well as income derived from insurance. This methodology is the most simple of the three methodologies presented and there are no prerequisite conditions for a bank to use it. This is based on the premises that the level of revenues of a bank can be used as a proxy to assess the complexity of its operations and thus can be used to estimate its operational risk. Insurance revenues have been specifically excluded from the computation recognizing the fact that the operational risk of insurance business is very different from that of banking business. w

Standardized Approach (and Alternative Standardized Approach)

In the Standardised Approach, banks' activities are divided into eight business lines: w w w w w w w w

Corporate finance Trading & sales Retail banking Commercial banking Payment & settlement Agency services Asset management Retail brokerage

Within each business line, gross income is a broad indicator that serves as a proxy for the scale of business operations and thus the likely scale of operational risk exposure within each of these business lines. The capital charge for each business line is calculated by multiplying gross income by a factor (denoted beta) assigned to that business line. Beta serves as a proxy for the industry-wide relationship between the operational risk loss experience for a given business line and the aggregate level of gross income for that business line. It should be noted that in the Standardised Approach gross income is measured for each business line, not the whole institution, i.e. in corporate finance, the indicator is the gross income generated in the corporate finance business line. The total capital charge is calculated as the three-year average of the simple summation of the regulatory capital charges across each of the business lines in each year. In any given year, negative capital charges (resulting from negative gross income) in any business line may offset positive capital charges in other business lines without limit. However, where the aggregate capital charge across all business lines within a given year is negative, then the input to the numerator for that year will be zero. Those banks that are unable to disaggregate their gross income into the other six business lines can aggregate the total gross income for these six business lines using a beta of 18%. The total capital charge may be expressed as: KTSA={∑years 1-3 max[∑(GI1-8 x ß1-8),0]}/3 Where: KTSA = the capital charge under the Standardised Approach GI1-8 = annual gross income in a given year, as defined above in the Basic indicator Approach, for each of the eight business lines ß1-8 = a fixed percentage, set by the Committee, relating the level of required capital to the level of the gross income for each of the eight business lines. The values of the betas are detailed below. May - June 2005 29

Banking Business Lines

Beta Factors

Corporate finance (ß1)

18%

Trading and sales (ß2)

18%

Retail banking (ß3)

12%

Commercial banking (ß4)

15%

Payment and settlement (ß5)

18%

Agency services (ß6)

15%

Asset management (ß7)

12%

Retail brokerage (ß8)

12%

The Alternative Standardised Approach ("ASA") A bank may be permitted by its supervisor to use the ASA if it can satisfy its supervisor that this alternative approach provides an improved basis by, for example, avoiding double counting of risks. However, once a bank has been allowed to use the ASA, it will not be allowed to revert to use of the Standardised Approach without the permission of its supervisor. The Committee does not envisage that large diversified banks in major markets would use the ASA. Under the ASA, the operational risk capital charge/methodology is the same as for the Standardised Approach except for two business lines - retail banking and commercial banking. For these business lines, loans and advances - multiplied by a fixed factor 'm' - replaces gross income as the exposure indicator. The betas for retail and commercial banking are unchanged from the Standardised Approach. The ASA operational risk capital charge for retail banking (with the same basic formula for commercial banking) can be expressed as: KRB = ßRB x m x LA RB Where KRB is the capital charge for the retail banking business line ßRB is the beta for the retail banking business line LARB is total outstanding retail loans and advances (non-risk weighted and gross of provisions), averaged over the past three years m is 0.035 For the purposes of the ASA, total loans and advances in the retail banking business line consists of the total drawn amounts in the following credit portfolios: retail, Smal and Medium Entrprises (SMEs) treated as retail, and purchased retail receivables. For commercial banking, total loans and advances consists of the drawn amounts in the following credit portfolios: corporate, sovereign, bank, specialised lending, SMEs treated as corporate and purchased corporate receivables. The book value of securities held in the banking book should also be included. The Pakistan Accountant

Under the ASA, banks may aggregate retail and commercial banking (if they wish to) using a beta of 15%. As under the Standardised Approach, the total capital charge for the ASA is calculated as the simple summation of the regulatory capital charges across each of the eight business lines. Advanced Measurement Approaches (AMA) Under the AMA, the regulatory capital requirement will equal the risk measure generated by the bank's internal operational risk measurement system using the quantitative and qualitative criteria. Use of the AMA is subject to supervisory approval. Diversification benefits might be factored in under certain circumstances and allocation of risk to subsidiaries also needs to be supported by empirical evidence and approved by the relevant supervisors. The appropriateness of the allocation methodology will be reviewed with consideration given to the stage of development of risk-sensitive allocation techniques and the extent to which it reflects the level of operational risk in the legal entities and across the banking group. Supervisors expect that AMA banking groups will continue efforts to develop increasingly risk-sensitive operational risk allocation techniques, notwithstanding initial approval of techniques based on gross income or other proxies for operational risk. This approach provides maximum facility to the banks that have enough resources to implement sophisticated systems to gather and process operational risk data and demonstrate that they have the capability to reasonably estimate the operational risk based on actual risk factors rather than proxies. Robustness of statistical techniques currently used to model the operational risk is questionable as these suffer mainly from a lack of sufficient real life data against which a model can be tested. A bank may benefit (or is most likely to benefit) from implementation of such statistical models as it can achieve a lower capital charge for operational risk, however, due to the resource requirements it is beyond the reach of most of the smaller to medium sized banks and thus puts them in a disadvantaged position compared to other giant players in the market.

Monitoring the Operational Risk Monitoring the risk involves regular reports to the adequate level of management e.g. daily reports of processing errors to line managers, weekly/monthly summary of operational effectiveness and efficiency to department heads, monthly/quarterly assessment of actual and potential losses due to operational errors (including internal audit reports) and external/regulatory reports should also be circulated to senior management and board of directors. Board should also review all the related reports submitted to bank's supervisors. May - June 2005 30

Banking Reports can be quantitative or qualitative in nature e.g. sensitivity analysis, results of self assessment surveys, internal audit assessments or quantitative data on errors trends etc and should clearly communicate the risk levels to the management and board. With additional requirements of more disclosure to the investing public it is increasingly important to have adequate monitoring systems in place that can generate reliable timely information for internal and external use.

Controlling the Operational Risk As the risk cannot be eliminated, management attempts to reduce it to an acceptable level. It can accomplish this by either insuring it internally or transferring it to an external party (in which case it exchanges its own operational risk with a third party risk) in the form of an outsourced operation or buying insurance on employee infidelity. Opting to handle risk internally or externally is a management decision based on the specific circumstances of the business and management style. For example most banks run large internal control departments while fund managers outsource almost all data processing to external service providers. However, most of the operational risks have to be managed internally thus management invests significant time and resources to internally ensure that the operational risk is within acceptable levels. This requires a system of regular compliance review and sufficient documentation of approval and authorization to ensure accountability. Control activities should be considered as part of the operating/business processes of the bank and should involve all level of personnel. Management should ensure adequate segregation of duties and pay due attention to operational disruptions such as information system failures etc. If the management uses a The Pakistan Accountant

service provider for any part of its operations it should have policies and procedures to ensure it is not exposed to significant risks of the service provider. Such policies may include service provider selection criteria, due diligence procedures before selection and ongoing monitoring of the activities of the service provider, regular performance reviews and clearly documented service levels agreements etc. Committee of Sponsoring Organizations of the Treadway commission ("COSO") has developed a framework for internal control which can provide a good reference point for establishing adequate system of internal control. However, internal controls should be highly tailored to suit the business needs and operational facts of individual bank.

Issues and Implications of the Basel II Basel II marks a significant milestone in management of operational risk as it forces quantitative measurement of the risk. However, it has been criticized for its simplistic approach to a significantly complex problem. Use of gross revenues as an indicator of operational risk (as suggested by basic and standard approaches) is not quite acceptable to many risk managers and the use of standard beta factors to measure risk tends to ignore the differences of quality of earnings among different banks. Alternative Standardized approach does allow banks to use gross advances as a proxy for risk in their retail and corporate business lines but even this does not quite resolve the problem for banks that see themselves at a disadvantaged position compared to ones that can use advanced measurement approach and use their own indicators and measures of risk. Furthermore, the risk measures of various business lines are simply

added together to arrive at the overall risk measure of the bank in standardized approach which implies that the diversification of the revenue streams has no impact on operational risk of the bank; an assumption that might not be considered theoretically sound by many. Basel II envisions a more active role of the local bank supervisors in operational risk management and banks are required to obtain approvals of their supervisors for adopting any of the suggested measurement approaches. Supervisors are also required to monitor the banks to ensure they are correctly applying the selected approach. However, most of the regulators, especially those in the developing countries, do not have the capability and resources to carry out the task which may lead to divergent practices within a marketplace and make it an uneven playing field. More practical implications of the Basel II involve the real business impact on small banks especially those in underdeveloped countries. Large sophisticated banks with resources to implement the advanced measurement approach will be able to measure the operational risk with increased precision using better indicators of risk than revenue or advances portfolio. These banks will be in a position to keep their operational risk at a low level notwithstanding their revenues or portfolio while for smaller banks increase in revenue or advances portfolio will mean an automatic increase in operational risk! This would put the smaller banks in a disadvantaged position and restrict their ability to lend money and generate revenues for per unit of capital compared with their larger counterparts. Some see this as a force that would catalyze the merger and acquisition activity in the banking sector over the next few years and may harm local institutions. May - June 2005 31

Banking Basel II is a product of a committee that has no representation from the developing world and thus it is not surprising that the document tilts the tables in favor of large sophisticated banks that mainly operate in developed world and does not consider implications for the smaller banks operating in underdeveloped countries. As these banks will have higher operational risk they would need more capital to support their activities which will reduce return on equity and make it difficult for these banks to raise funds thus forcing them to merge with the larger banks. Smaller local banks serve various local needs which might not be seen important by the larger banks e.g. funding small business activities in local countries. Larger banks have access to international markets and may not see the local risky projects as worthy options. Thus merger and acquisition activity may lead to a lack of much needed funding in the developing countries as this money is more likely to be diverted to the "less risky" projects in the same country or another country. This dearth of funding is likely to have adverse implications for the economic prosperity of the developing countries. These issues are being actively debated by the banks and supervisors alike. Even in USA the SEC has notified that it expects only its top seven largest banks to implement the new accord. China has decided to only selectively adopt the new accord; an approach termed as Basel 1.5! Quantitative impact studies are being conducted to assess the potential impact of implementing the new accord on the financial system and banks are working closely with the supervisors to be able to implement the accord on due date, however, there is still uncertainty in the market as to the utility of measurement of operational risk and adequacy of the measurement approaches suggested by the accord. The Pakistan Accountant

Reference:

Conclusion Operational risk management has recently come to focus and practices have only recently been started to be actively debated. Basel Committee has made great efforts in improving the operational risk management and the revised Basel Capital Accord II marks a significant step towards measurement of certain risks faced by banks and it has successfully focused management attention on the operational risk. Although measuring operational risk remains a complicated problem surrounded by various issues, a better focus on the topic is likely to lead to some solutions in the future. Implications of the accord for the banking system are significant as the risk charge for operational risk would have a direct impact on competitive advantage of smaller banks. Supervisors in under developed countries have a great responsibility of ensuring that the interests of local banks and local financial systems are not jeopardized by the implementation of the accord which has been drafted by G-10 countries to mainly suite their financial systems and economic interests.

1. The Basel Committee on Banking Supervision is a committee of banking supervisory authorities that was established by the central bank governors of the Group of Ten countries in 1975. It consists of senior

representatives

of

bank

supervisory authorities and central banks

from

France,

Germany,

Luxembourg,

Belgium, Canada, the

Italy,

Japan,

Netherlands,

Spain, Sweden, Switzerland, the United Kingdom and the United States. It usually meets at the Bank for International Settlements in Basel,

where

its

permanent

Secretariat is located. 2. Description of the approaches has been taken from the Basel Capital Accord II. Please refer to the Basel Capital Accord II for full description and detailed guidance on all the approaches.

About the Author: Mr. Danish is an associate member of

the

Institute

of

Chartered

Accountants of Pakistan. Currently he is an Executive in Global Capital

Markets

Group

in

PricewaterhouseCoopers London. Danish also worked in Karachi and Bahrain offices of Ernst & Young. Readers are welcome to contact him at: [email protected]

May - June 2005 32

Federal Budget 2005-06

Tax Amendments in Finance Act 2005

DISTORTIONS IN AN INVESTOR FRIENDLY BUDGET ? Adnan A. Mufti,

It is rare that the business community in Pakistan happens to be a key advocate of the Government and more particularly of Central Board of Revenue (the Board). It is but, happening today. The other day when I was attending a Post Budget Seminar jointly hosted by the Federation of Pakistan Chamber of Commerce & Industry (FPCCI) and Karachi Sales Tax Bar Association, I was amazed to hear a key business leader of the apex trade body carrying compliments for the Board and saying; “I was wrong in my early perception. CBR is an angle”. Undoubtedly, the businessmen have reasons to be jubilant over the taxations measures announced in the Finance Bill 2005. With the textile and leather industries getting the much desired breathing space which was now perhaps overdue in the post WTO regime – the zero rating of sales tax on the entire chain of products, the much talked about relief has been provided by the Government. Besides zero rating of 5 major products, other major announcements of the Finance Bill 2005 were extension of time limit for adjustment of input tax from 3 months to 12 months, reduction in time limit for maintenance of records to 3 years, fixation of time limit of 90 days for the Collectors to dispose refund applications filed under section 66 and admissibility of payments made through credit cards for the purposes of section 73 of the Sales Tax Act, 1990 (the Act). Despite the aforementioned incentives announced in the Finance Minister’s Speech, the climax cannot be called as over until we actually come across the Budget Documents and the relevant notifications. As soon as I saw the underlying data, I was confirmed that on the contrary, the taxation amendments would make the implementation even more difficult and perplexed. That exactly happened later on. Immediately few days after the Budget was announced amid thumping applause form the business community, the Budget which was initially termed as “Investor Friendly Budget” started receiving severe criticism from taxpayers, who ascertained the actual substance after settling the dust. In the ensuing paragraphs, we shall look upon various aspects of, what we reckon as, major distortions of this Investor Friendly Budget:

Extension of 12 more items under 3rd Schedule The Third Schedule to the Act specifies items which are charged to tax at the retail price fixed by the manufactures The Pakistan Accountant

ACA

for such products. For sometime this provision was made applicable to importers but this time, it has again restricted only to manufacturers. The ‘retail price’ vehicle under section 2(27) of the Act read with 3rd Schedule thereof is a distortion of Value Added Tax (VAT) concept. The idea is to recover the entire tax leviable on a particular product from the manufacturer instead of following the VAT machinery and recovering the said tax from all sectors of the supply chain and thus documenting the economy till retail level. Now, induction of consumer items like Toilet & laundry soap, Detergents, Shampoo, Toothpaste, Shaving cream, Perfumery and Cosmetics, Biscuits, Confectionery, Tea, Powder drinks, Milky drinks, Footwear confirms that the Government has miserably failed to extend the tax net to the intermediaries namely, distributors, wholesalers and retailers and therefore decided to make the manufacturer the single escape goat. This manifests we are moving again in the reverse gear.

Input Tax Carried Forward As a, probably, biggest uncomprehending move, the benefit of carry forward of input tax has been withdrawn and now the taxpayers would need to seek for refunds for so much input tax as it left after adjustment of output tax for a tax period. This reflects that there remains a hidden hand in the policy corridors of the Revenue Authorities which desires the taxpayers to continue fighting the tax machinery and do not focus on business and trade. The biggest drawback of the amendment, besides the hide and seek game usually involved in refund processing, lies where the excess input tax on purchases / imports is not refunded to the taxpayer on time and he also makes the sales of relevant goods on credit. At this point of time, the taxpayer would surely suffer double taxation – a concept never entertained by the modern VAT theories. As another ambiguity, the Refund Rules do not suggest procedures which would be followed for processing and sanctioning applications for excess input tax. In the wake of the potential problems including the time limit within which the relevant refunds would be paid to the registered persons, it is highly suspected taxpayers would resort to ‘tax planning’ for avoidance of excess input tax. May - June 2005 33

Federal Budget 2005-06

Conviction by Special Judge By virtue of the newly amended section 33(5) of the Act, non payment of tax due in 60 days from the date of issuance of related notice by the Assistant Collector shall render the accused convicted by a Special Judge and could also be liable to imprisonment of 3 years and with fine.

Default Surcharge In a highly unexpected and unwarranted move, the term ‘additional tax’ has been substituted with that of ‘default surcharge’. Surprisingly, a plain reading of the newly drafted provision projects the following areas of concern: a)

Perhaps the revenue forgot that such harsh provisions, as are already incorporated under section 37-40B of the Act, have miserably failed to ‘deter’ the taxpayers to remain compliant with the tax laws. Strictly speaking, apart from tax fraud, non payment of alleged tax could be due to multiple reasons. It is, therefore, suspected that this provision could be misused by the revenue officers for harassment of taxpayers. b)

Penalty for non compliance with Section 73 The provision of section 33(1)(16) suggests a penalty of higher of Rs. 5,000 or 3% of the tax involved in case payment is not made in the manner prescribed under section 73 of the Act. At the very outset, the penalty is quite harsh especially in the backdrop when non compliance of section 73 makes the entire claim of input tax inadmissible in the hands of registered buyer. In short, in the presence of the existing provision, there was no need to introduce another penal section in the statute. It may be noted that in the past the Board had held that section 73 only applies to transactions between registered persons. Simultaneously, it is high time for a clarification from CBR regarding non invocation of the aforesaid penal provision in case of transactions between registered and non registered persons since in the absence of any such notification, this provision is likely to be misused by the department. The Pakistan Accountant

c)

The change of name from ‘additional tax’ to ‘default surcharge’ could be intended to make the numerous case laws non applicable in fresh disputes. Since the superior courts have discussed the situations / application of additional tax in most of the cases, the underlying idea of the policy makers in the Revenue Division could well be to change the name of the levy thereby making those judgments non applicable and anfractuous on technical grounds. The section provides levy of default surcharge if the registered person does not pay the tax due or any part thereof, whether wilfully or otherwise. These wordings of the substituted provision suggests as if the intention of the legislature is to surpass and negate the ruling of the recent Honourable Supreme Court of Pakistan regarding non applicability of additional tax, if the revenue fails to prove any malafide, mens rea or willful on the part of the taxpayer. The previous section contained an explanation at the end whereby ‘tax due’, for the purpose of computation of additional tax, would exclude the amount of penalty. The newly replaced version of section 34 does not contain any such explanation which could mean that from now onward, the departmental demand of default surcharge could be a composite of principal tax and penalty. If this is allowed, perhaps it would result in extreme imbalance in the statute and the miseries of the taxpayers would be doubled.

Scrapping of Adjudication Collectorate The scheme of keeping Executive Collectorate separate from that of Judicial was indeed a positive step, though it did not result in desired relief to the taxpayer. A good plan practically became ill founded when the officers sitting under the Revenue Division kept interchanged / transferred from Executive to Judicial Collectorates and vice versa. This resulted in harassment and denial of justice of the taxpayers. According to CBR’s own sources, since the ultimate purpose of separate Collectorates did not succeed, there was no justification of maintaining it further. On our part, we would rather say that a fine scheme has been dismantled just due to wrong doings of few officers and the corrupt bureaucracy. The basis of taxation laws lies in equity and fair play. We should not delegate the powers of a Judge to a Station House Officer (SHO). With the detecting agency now empowered to decide cases as well, one can only dream of justice being done in his case. Hence, there is a need for immediate restoration of the said scheme with specific stream of officers holding the charge of Judicial Collectorate.

Time Limit for opening assessments Previously, the time limitation for opening of cases in terms of sections 45A and 36 was five years. This time limit was in consonance with the requirement of maintenance of books and records as mentioned in the Act. The Finance Act 2005 has reduced the time period for maintaining records from five to three years. However, a corresponding amendment has not been incorporated in section 45A and 36 of the Act. In the wake of this inconsistency, a taxpayer (especially corporate entities) would invariably be required to maintain sales tax records for five years instead of three years. May - June 2005 34

Federal Budget 2005-06

Disposal of Cases by Collector (Appeals) By virtue of fresh amendment, the Collector (Appeals) has been bound to pass orders within 90 days from the date of filing of appeal or equally extended period. In our view, this amendment can only become effective and fruitful if the aforesaid time limit is made as a directory provision instead of mandatory. To facilitate this process, reference could be made to various judgments of Customs, Excise & Sales Tax Appellate Tribunal whereby the Appellate Tribunal has taken cognizance of late decisions by the officers of CBR and held that revenue officers were bound to dispose of the case within the prescribed time.

Mandatory Payment of 15% tax As a clear deviation of what is claimed to be taxpayers’ friendly policies, the Office of Collector (Adjudication) has been dismantled thereby making the Office of Collector (Appeals) as the forum where first stage appeals would lie. To make the things more complex and cumbersome, the taxpayers would be required to make a mandatory payment of 15% of the impugned principal tax before preferring such appeal to Collector (Appeals). It would not be out of context to mention that in few case relating to Income Tax, the superior courts have held that first stage appeal cannot be burdened with any fees. It is worthwhile to note that the mandatory payment of 15% of alleged liability before preferring appeals was done away with in Income Tax Ordinance 2001 vide Finance Act 2004. However, the corresponding provision, as contained in section 45B(4) of the Act, is still very much intact and applicable and has now made a significant place in the statute. It is imperative that, in order to streamline fiscal laws and to provide cheap and speedy justice, condition of The Pakistan Accountant

mandatory payment of 15% in section 45B should be withdrawn forthwith.

Tax Refunds The Finance Act 2005 has prescribed a maximum time limit of finalisation of refund applications under section 66 as 90 days from the date of filing the relevant claim. It is imperative that a corresponding explicit provision is added to the statute whereby delayed refunds may carry 6% interest to the taxpayer if his claim filed under section 10 or 66 are not finalized within 90 days. These unambiguous wordings of section 67 are intended to bring desired relief to the taxpayers. Secondly, a significant inconsistency and disparity between section 34 and section 67 of the Act. In accordance with section 34, a registered person is penalized for additional tax @12% or 18% p.a if he fails to pay off the tax liability on time. On the other hand, failure of the department to pay off the due tax refunds would only cost it 6% p.a. It is proposed that the interest rate on delayed refund be enhanced to atleast 12%.

Tax Return for Retailers Since the year 2004, the Retail Tax is collected in terms of the Special Procedures Rules which require a minimum value addition of 10% on purchases a retailer makes in a particular tax period. No inputs are allowed anymore to such retailer, as the tax paid becomes the final discharge of his liability. However, a perusal of the tax return prescribed for retailer would reveal that a specific Column No. 11 for refund has been prescribed, which is complicating the stream. It is, therefore, imminent that the tax return be modified to bring it in harmony with the Special Procedure.

Service Tax The government is making all possible efforts to bring the services in the tax net. In the original draft of the Finance Bill 2005, the financial services

rendered by banks and financial sector were proposed to attract Central Excise Duty, adjustable under VAT mode. However, with the reported late minute intervention of Governor State Bank of Pakistan, the move was deferred till a ‘reasonable time’. Services contribute a sizable portion of our GDP. Hence, there is a need for a proper and thoughtful study before they are brought under the Service Tax Regime. The facts, however, depicts a very bleak picture on the contrary. In the year 2000, eleven services were brought under the Sales Tax Regime through Provincial Ordinances promulgated by respective provinces. Till the year 2004, there was a total chaos with respect to taxability of subject services, adjustment of relevant inputs against output tax of Federal Legislature, value of services, etc. The only hope emerged in the year 2004 when Special Procedure Rules 2004 were enacted and specific definitions of taxable services, value of service, time of service, levy and other allied matters were notified. Inspite of such promulgation, various provisions of Service Tax are self contradictory. For example, the definition of the term ‘value of service’ has been defined to mean “Gross amount charged or the consideration in money received by the service provider from the clients or customers or members for providing or rendering taxable services”. A plain reading of the definition would deduce the apparent conflict hidden in the definition. Gross amount charged to customers could, at times, be different than what the service provider receives from them. For instance, a service provider could bill his customer for Rs. 10,000 (excluding sales tax). However, he might end up in recovering Rs. 8,000 (excluding sales tax) from his client. What would be the value of taxable services keeping in view the aforesaid situation in consideration? May - June 2005 35

Federal Budget 2005-06 Secondly, a proviso of the term ‘value of service’ asserts that in case the consideration for providing taxable service is in kind, it would be the open market value of the service that would be taken for sales tax purposes. Evidently, one could not easily determine market value of the service rendered. Therefore, there is a need to modify such conditions before they are misused by the departmental auditors for harassment of taxpayers.

Tax Payment on Advances through ‘Advance Payment Receipt’ A perusal of the rules read in conjunction with the definition of ‘time of supply’ in terms of section 2(44) of the Act, instigates the following key question / anomalies: a) The preamble of the rules (Rule 107), suggests that the rules ‘shall apply to all the registered persons receiving advances against their taxable supplies’. On the contrary, Rule 110 of the rules prescribe that ‘a registered person at the time of receipt of advances may issue a serially numbered “Advance Payment Receipt” in the format as prescribed in Annexure- A to this Chapter. The sales tax invoice…………….may be issued at the time of actual delivery of goods.” It appears that the preamble is not in harmony with the remaining rules as the latter provide an option / discretion to the taxpayer to either issue advance payment receipt or not? Keeping in view the provision of section 23 read with section 2(44) of the Act, one might construe as if the aforesaid option applies to only those taxpayers who do not wish to issue a ‘tax invoice’at the time of supply. However, there is a need to clarify the issue for better understanding of the taxpayers and the tax practitioners.

The Pakistan Accountant

b) The last sentence of Rule 110 prescribe that “no tax shall be payable at the time of issuance of tax invoice in pursuance of advance payment receipt issued by the registered person on which tax has already been paid at the time of receipt of advances.” A study of the above in the light of section 2(44) of the Act would mean that a registered person receiving payments would not be liable to pay anything further in respect of future supplies since all the tax must have been paid at the time of supply (receipt of advance). In other words, we understand that in case of advance receipts, the supplier (recipient of advance) is liable to offer all the advance receipts for tax purposes and no exception is permissible under the statute in this respect. In this respect, we are also enlightened by Sales Tax General Order (Part – 1) wherein it has been held that: “…sales tax is chargeable if the amount is received in advance. Although this concept is clear, problems arise when full payment is not received and only some percentage of the actual amount is received in advance.……… It is, therefore, clarified that sales tax for a tax period should be charged only on that portion of money which is received ….” Inspite of the above, the format of the ‘Advance Payment Receipt’ prescribes the following additional 2 columns besides the column of “Amount of Sales Tax Involved”: w Amount of Sales Tax received in Advance w Balance amount of Sales Tax Payable (if any)

Based on our understanding of law as aforesaid, we understand that the ‘Amount of Sales Tax Involved’ would invariably remain equivalent to ‘Amount of Sales Tax received in Advance’. Accordingly, in the absence of any relaxation in payment of output tax on advances, there would be no “Balance Amount of Sales Tax” since the recipient of money would have already discharged all his liability to the extent of advances. However, the last 2 columns in the format of the Advance Payment Receipt, as prescribed in the rules, contradict the last sentence of Rule 110 of the rules, section 2(44) of the Act and the Sales Tax General Order (Part – 1). c) In most of the cases, the recipient of advance does not know the ultimate goods which would be adjusted against such receipts. This uncertainty hold on the ground till the supplier receives a confirm Purchase Order with complete specification and quantity of goods to be bought. In that scenario, the prospective supplier would not be able to define ‘description & quantity’ of the future goods on the face of Advance Payment Receipt at the time of receipt of advance. Hence, there is a need to either modify the said Format or to allow the registered person not to fill in the unwarranted columns for lack of information. About the Author: Mr. Adnan Mufti is a Partner in Shekha & Mufti, Chartered Accountants. He is a member of Publication Committee of ICAP and Chairman of Technical & Research Committee of Karachi Sales Tax Bar Association (KSTBA). Readers are welcome to contact him at: [email protected]

May - June 2005 36

Federal Budget 2005-06

Proposal to bring more s e rvices into GSTNet Abbas, FCA

The Central Board of Revenue (CBR) proposes to bring more services into the general sales tax (GST) net subjecting these services to the Central Excise Duty in GST Mode. Before any final decision is taken in this regard, I would urge, in the best interest of our country to analyze the existing revenue collection from the service providers and to make objective cost-benefit analysis of the proposal [net revenue collection vs. additional expenses (Registration, maintenance of records filed, audits, litigation etc.) on net collection) of the proposed levy of GST on more services. Each proposed service to be taxed is to be analysed individually. As we are all aware that if adequate net revenue cannot be generated out of a particular service, it will be an exercise in futility resulting not only in a net loss to the country's exchequer but also reduced concentration on the tax collection from the existing registered persons. For all this consequence, the one responsible, for the final decision should owe an explanation for the foreseeable waste of the scarce resources since the decisions cannot be left to the caprice of the regulators or outside agencies neither having insight of the VAT mode in the context of our peculiar economy nor the conditions and business practices (ability of the indirect tax payer of passing of the indirect tax burden to the final consumers) prevalent in the country. The problems being faced with the existing registered persons are manifold and in a number of cases are pending with adjudication and at appellate forums. The last year's reasonably low collection from the following services (as reported in the daily, Business Recorder dated February 17,2004) from all the four provinces reflected the error of judgment to bring these services to the tax net in the past. Services

Tax Collection During 2002-03

Luxurious clubs Laundries & dry cleaners Marriage halls, lawn Beauty parlours, clinics, slimming centers

00.58 million 02.44 million 07.63 million 14.45 million

The following services have, however, on the face of it shows considerable revenue. Hotels, restaurants, fast food & caterers Courier services Advertisement on television Custom agents The Pakistan Accountant

717.00 million 416.70 million 214.15 million 241.79 million

But except for the Custom agents, all of the above services were already subjected to un-adjustable excise duty and provincial duties wherever applicable. All such direct and unadjustable revenues were replaced by VAT mode of Sales Tax which allowed input tax adjustment, particularly on electricity which form substantial part of Hotel, Restaurant and fast food Industry. If the above tabled contribution is net collection then reasonable otherwise the CBR need to wok out the figures of net collection, i.e., output tax charged by the above services less the same if claimed as input tax by the recipients of the services in making their taxable supplies. This net collection then be compared with what the government was already earning on the excise duty and provincial taxes (wherever applicable) on such services so as to arrive at the incremental revenue. As regards contribution from Custom agents are concerned, the entire payments of sales tax by custom agent is the input tax of importers which is adjustable against the supplies by such commercial importers and in case of importers of raw materials against the supplies of finished goods by the manufacturers. So the ultimate (net) contribution from custom agents seems to be ZERO. However, the state has incurred expenses on the registration of custom agents, maintaining voluminous record of their monthly returns filed, maintaining their files/profile, and expenses on audit and matters arising out to be dealt with by the adjudication/collectorate etc. This shows that the CBR has to give serious thought before bringing in those services against which the buyers of these services will have the undeniable rights under VAT mode to adjust against their output tax due. The appropriate cost benefit analysis should, therefore, be conducted. Further documentation of the economy should be done only if the desired results can be foreseen with substantial accuracy. The economy of Pakistan has already been burdened with the futile exercise of Survey in the name of documentation. The failure of the government to document the retail sector is a ground reality. The cost-benefit analysis, therefore, prevail over the mere documentation of economy. A gradual, steady and careful fiscal approach is the dire need to boost the economy. The professional firms of accountants, consultants and lawyers, particularly large and medium sized firms provide services mostly to the large and medium sized companies that are already registered under the Sales Tax Act (except few service providers) 1990. If sales tax is charged by these professional firms to the buyer of the services, they may argue to claim this payment as input tax (the CBR may finally, under the logical pressure from concerned quarters, allow such adjustments and the cost of such adjustmentsmay go unnoticed). May - June 2005 37

Federal Budget 2005-06 The admissibility of input tax paid on services is, however, disputed. Section 7 read with section 8 may be interpreted in favour of the registered person and input tax paid for the purpose of making taxable supplies will have to be allowed. The root cause of any taxable supply is the carrying on of that business which makes the taxable supply. If there is no business there is no supply at all. All activities of a business-whether manufacturing, selling, finance or administration or for that matter any other relevant activities, must be put together to generate taxable or nontaxable supplies. It transpires that any activity whether consultancy, audit, taxation, legal services etc. are acquired for the business then it is for the purpose of making supplies. Any input tax paid in acquiring such services will have to be allowed. This is the gist of VAT mode, in my opinion. This finally may mean ZERO net revenue from such service providers (the tax paid on services does not, generally, result in the proportionate increase in the value of supply made by the recipient of services) plus cost of registration, maintenance of the records and profile of such service providers, cost of audit, cost on adjudication and appellate officers etc. This fact need to be explained to those pressure group urging that such services be brought under tax net. The CBR is already short of sufficient staff to cater to the need of audit and other matter pertaining to the existing registered persons. The experience has shown that adding an army of auditor is not likely to result in increasing the revenue. However, it is likely that the auditors, taking the advantages of various vague provisions of the law, may generate more personal revenues. It has been tried at various forums to convince the government to simplify the law and make them clear. The back-door, purely budget oriented and hurriedly introduced legislation is not only causing problems to the honest tax-payers but also creating problems for the CBR in the form of unwanted disputes. It is, therefore, more important to build an effective system of taxation incorporating simplified and duly legislated tax laws. The audit being important component of The Pakistan Accountant

any system of control is effective only if introduced as a moral check and future guide to improve rather than a punitive tool in the hands of auditors allowing them to detect irregularities to the extent necessary to serve their purpose only. The purely punitive tool may only teach the registered persons to accumulate means and commit acts to meet such punishment on a net profit basis.

section 22 and 23 of the Sales Tax Act may not be practically followed. As regards indenting services, such firms whose commission is received from the foreign principal will have to be exempted. By zero-rating their supply the CBR may lose as the input tax paid need to be refunded plus cost of registering them and maintaining their records/profiles etc.

So far as the small sized firms are concerned, they also provide the services to the already registered persons and impact of bringing them into net would be almost the same as with the large and medium sized firms. If by all means, the CBR is forced to bring in more services into GST net, it should atleast go for a gradual implementation with a justified policy for both- the suppliers of goods and the providers of services. A good number of the firms' gross revenue is not over Rs.1.0 million. Since the government has already exempted retailers having turnover of not over Rs.1.0million such small sized firms need also be exempted on the basis of their gross fee. Furthermore, turnover tax scheme may be extended to the service providers whose annual revenue is Rs.1.0million and over but do not exceed a certain sum. The definition of wholeseller need be amended to accommodate their exemption or to qualify for turnover tax as the case may be since in most of the cases their receipts are subject to at source income tax deduction. The above step will enable the CBR to generate more revenue by making least efforts and with minimum expenditure.

It is interesting to note that the Sales Tax Act 1990 still has its firm roots in the repealed Sales Tax Act 1951 which primarily dealt with sales tax on manufacturers in Pakistan. The categories such as importer, wholesaler, distributor and retailer of goods were also brought under sales tax net under the Sales Tax Act 1990, which were all exempt under the repealed act. The Sales Tax Act 1990 was, however, not modified to cater to the requirements of taxing these further categories. Issues relating to invoices, maintenance of records etc. cropped up. The present sales tax rate of 15% would be exorbitant to the services providers. The service providers would hardly benefit from the GST mode, as they would hardly have any input tax to adjust rather they would suffer as a result of competition since they would not be abl;e to pass on the burden which is the fundamental of GST Mode. It is, therefore, important to bring in a distinct legislation on services before bringing more service to sales tax net.

Furthermore, the government needs additional/modified enactments to exempt the service providers from a number of provisions of sales tax act 1990 since they are not practical. By traditions and under the Income Tax Ordinance 2001 such professional firms are allowed to account for their revenue on receipts basis due to inherent risk in the receipts of such profession. Therefore, the supply, time of supply and a number of other provisions may not practically be applied in case of such firms. The revenue is not frequent and not on daily basis. The requirements of

Mr. Abbas is a fellow member of the Institute of Chartered Accountants of Pakistan. He is in practice under the name and style of Abbas & Co., Chartered Accountants since September 1994. He has specialized in the Sales Tax Laws and Systems Consultancy. He is a member of Technical Advisory and Quality Control Review Committees.

About the Author:

May - June 2005 38

Information Technology

Flowcharting and Accountants “One Picture Is Worth Ten Thousand Words” Attributed to Fred R. Barnard, (Advertising Executive 1921) who said it was a Chinese Proverb. Noor-ul-Huda Ashraf,

FCA

Definition

charts provide a comprehensive system description and,

“A flowchart is a graphical representation of the definition, analysis, or solution of a problem in which symbols are used to represent operations, data, flow, equipment, etc.”

therefore, can be used effectively in;

Flowcharting is a tool originally developed in the computer

w defining areas of responsibility;

w orienting new personnel;

industry, for showing the steps involved in a process. Flowcharting

is

diagrammatically

probably

the

representing

oldest

system

method

of

processes

(or

sequence of activities). A flow chart is a pictorial description

w identifying key accounting controls; and w evaluating the efficiency of system procedures.

of how accounting transactions flow through a system. Flowcharts clearly and graphically convey work processes,

The auditors’primary purpose for preparing a flow chart is to

process controls, decision flows, time flows and paper flows.

understand the system in order to identify the key control

A flowchart is a diagram made up of boxes, diamonds and

attributes--those attributes that achieve control objectives. As

other shapes, connected by arrows - each shape represents a step in the process, and the arrows show the order in which they occur. They are frequently used to visually document how a job is being done and compare it to how it should be done. Because there is no better way to illustrate a process, flowcharts are no longer the domain of engineers and auditors. Flowcharts are to managers and business owners what spreadsheets are to accountants.

Overview of Flowcharting A flowchart is a method for documenting and understanding

an audit tool, the flow chart is an excellent tool that helps internal auditors perform the study and evaluation of the organization’s systems of internal accounting control. This can efficiently point out cases of under/over control and processing

redundancy.

A

flowchart

can

visually

communicate procedures, controls and the sequence in which they occur. The advantages of using a flowchart to document a system are as follows:

the flow of a system. A flowchart is a pictorial description of how transactions flow through a system. Flow charting help to ensure documentation of important aspects of the

w Flowcharts are easier and less time consuming to understand than a narrative.

accounting system and recognition of system control points. Flow charts conveniently describe complex relationships because they reduce narrative explanations to a picture of

w Flowcharts make it easier to represent flow of transactions using standardized symbols.

the system. They visually communicate attributes and procedures, and the sequence in which they occur. Flow

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w Flowcharts are easier to update. May - June 2005 39

Information Technology

Flowcharting Symbols & Their Uses There are dozens of different symbols used in flowcharting which are confusing for the users of flowcharts. Following table contains suggested symbols for use in the Internal Audit Department at Beaconhouse Group:

S. No.

Title

1.

Process

Use it to represent an event which occurs or is controlled. Typically this will be a step or action which is taken. In most flowcharts this will be the most frequently used symbol.

2.

Decision

Use it to represent a decision point in the process. Typically, the diamond contains a question that will require a ‘yes’ or ‘no’ response and branch to different parts of the flowchart accordingly.

3.

Data Input / Output

Use a skewed rectangle to represent a point in the process where data is entered or retrieved.

4.

Manual Input

Indicates manual input of data into the system under review.

5.

Manual Process

Indicates a manual procedure which should be described on the flowchart and referenced to an operation.

6.

Automatic / Pre-defined Process

Use to represent when an automatic event takes place. This usually occurs as a result of external influence and will trigger some action or process to occur.

7.

Disk Storage

Use to represent a database stored on a computer system.

8.

Document

Use to represent a report or document produced from the computer system.

9.

Multipart Document

Use to represent a document with multiple pages.

10.

Display

Indicates a computer display screen (CRT or PC) used for input, output, or inquiry purposes.

11.

Connector

Use it to represent a point at which the flowchart connects with another process on the same page. The name or reference for the other process should appear within the symbol.

12.

Terminator

Use to represent the beginning and end of a flowchart. It can also be used to highlight an interruption point in the flow when an external influence might be present.

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Symbol

Description

May - June 2005 40

Information Technology S No.

Title

Symbol

Description

13.

Permanent File

A triangle is used to denote a permanent file. Typically the basis for filing or order of the files is shown within the triangle.

14.

Temporary File

An inverted triangle is used to highlight a temporary file where documents may reside in a particular order or location for a short time only. Typically the basis for the filing is shown as text within the symbol.

15.

Flow Line

Show the connection between steps and the direction of the process flow.

16.

Information Line

Alternate relationship between two or more symbols / information flow.

17.

Off-Page Connector

Use when a flowchart is spread over pages. It is used to show how and where the pages are connected with the linking label/number shown in the symbol.

Types of Flowcharts A flowchart is essentially a picture of a process. Auditors have been using flowcharts for decades as a tool to detail management processes in order to evaluate internal controls. The following types of flowcharts may be used by auditors: Basic flowcharts quickly identify all the major steps in a process. They are used to orient a team with the major steps by just giving a broad overview of the process. Systems flowchart - Depicts overall or broad flow of operations (minimal detail). They may show the flow of data or the sequence of operations of a system. Sometimes they include all steps to process data into information. Procedures flowchart - presents the steps in a process.

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Document flowchart - depicts the flow of documents through specific processing steps. Program flowchart - A more detailed flowchart that illustrates specific steps in a computer run. Network Diagram - A network diagram can show the layout of anything from a small network to a world-wide network. You can use hyperlinks between charts to show the overview (organized by region, department, or office) and then the finer details to show the actual hardware and connections. Process Flowchart - A process flowchart is the most common type of business diagram, and it is used to communicate any idea that consists of a series of steps. These types of diagrams truly demonstrate that a picture is worth a thousand words. It is so much easier to learn a new task by following a process flowchart than it is to understand 10 or

15 paragraphs of text that describe the same thing. Process flowcharts examine the process in great detail. They provide a comprehensive listing of all the major and sub-steps in a process. Deployment Flowchart - A Deployment chart is used to show a process or procedure as it flows through different departments or uses different resources. Deployment flowcharts are similar to Process flowcharts in that they are very detailed but also indicate the people who are involved in the process. This could be very useful when the process involves cooperation between functional areas. Opportunity flowcharts highlight decision step and check point. They are used for very complicated processes because they highlight specific opportunities for improvement.

May - June 2005 41

Information Technology

Flowcharting Benefits and Limitations

w As flowcharts complex they ‘spaghetti’.

Benefits w Portrays the logical "flow" between tasks

w No obvious mechanism for proceeding from one level to the next.

w Visually successful in communicating the sequence of tasks

become more can resemble

w What is done can easily get lost in the detail of how it is done.

w Easy to know the sequential impact of changes

Flowcharting for Auditors

w Easy to spot redundant operations & other inefficiencies

For decades, accountants and auditors have used flowcharting as an audit tool to understand and evaluate systems for their clients.

w Training tool for new employees w Spot internal control weaknesses w Helps the auditor see the “whole picture” w Better Communication w Effective analysis w Effective synthesis w Proper program Documentation w Effective coding w Systematic debugging w Systematic testing Limitations w Task start and finish dates are not known. w The duration of tasks are not known. w Resources needed are not known. w Lacks the incorporation of resource constraints. w Physical locations of tasks are not known. w Difficult to distinguish importance of tasks. w Different levels of detail can easily become confused. The Pakistan Accountant

Following is process overview for building flowcharts: w Auditors interview employees, write-up narratives of the interviews and then flowchart the process. w Subsequent interviews and followups result in adjustments to the original flow chart. w Eventually, a revised detailed flowchart of the process is produced as explained by employees and confirmed by management. w Then management’s signatures are obtained attesting to the accuracy of the flow chart and the process under review. w From that flowchart, auditors identify where the controls were weak and the processes required changes. w The flowchart analysis of controls helps to design an audit work program that would test those controls to ensure that they were operating as designed. w As a by-product of the evaluation of internal control, management usually requested a copy of the flowchart for use in orientation training for new employees.

In the 1980’s new flowcharting tools were introduced which made the standard flowcharting template a dinosaur. The software was easy to use and made modifications as easy as the click of the mouse. While the software made it easier, it is clear that management is finding that flowcharting was not only a science but a combination of science and art.

Flowcharting Guidelines and Standards Clarity and simplicity in presentation are essential. Mistaken use of extreme detail may tend to conceal rather than expose key points. However, narrative explanations should be kept brief. In most cases, the combination of the flow chart and a narrative description tends to be far superior to either document alone.

Drawing a Flowchart • Decide what activities are to be shown and the purpose of drawing the flowchart. • Obtain the information needed to draw the flowchart. • A flowchart proceeds from top to bottom and from left to right. • Use arrow heads to show the direction of flow and improve clarity. • A flowchart may be of any size but keep dimensions and be as neat and tidy as possible. • Put a title on each chart identifying the process that it illustrates. (For example: "Order Entry Process"). • Put the author's name and the date on each chart. May - June 2005 42

Information Technology Only transactions/documents with control significance should be shown (i.e., control over authorization, recording, safeguarding, reconciliation, and valuation). This can generally be accomplished by including only those activities within an application where data is initialized, changed, or transferred to other departments. For a process to be flow charted, it must be broken down into its component parts, namely actions and decisions. Also, the name(s) and position(s) of the people performing the transactions should be indicated for each action. The names of each document should also be included within the document symbols. The auditor usually obtains information necessary for preparing or updating flow charts by interviewing personnel at each site about procedures followed, and by reviewing procedure manuals, existing flow charts and other system documentation. Sample documents are collected and each department involved is questioned about its specific duties. Inquiries can be made concurrently with the performance of transaction reviews, particularly when flow charts are being updated. If possible, the auditor should observe the process.

Documentation Techniques The first step in flowcharting involves obtaining an understanding of the system. This involves documenting how transactions are processed and assets are safeguarded. The documentation process involves understanding how the system works and the nature of the transactions processed. Typically, auditors prepare an overview which may come from the following sources:

w Accounting and administrative policy and procedure manuals, charts of accounts

q What is done when errors are found?

w Policies

q When was an error last found and describe the type of error?

w Laws and regulations w Prior audit working papers

w Follow one procedure at a time to a logical conclusion.

Interviewing Employees Interviewing responsible personnel is a productive way to obtain information about how the system or process operates. Strong interviewing techniques are important. It is important to select the right employees to interview. If an employee is responsible for an entire function, questions should be directed exclusively to him.

Cradle to Grave Approach It is best to document the system from the beginning of the process. It is much easier if employees begin at the beginning. The interviewer should clearly explain the objectives of the interview before asking any questions. It is important that the interviewer control the interview and not allow the employee to wander “off track.” Use the following guide for obtaining the necessary information: w Ask each employee: q What procedures performed?

are

q What records they maintain, including unofficial records q What documents are processed and what documents are prepared? q From whom are the documents received?

w Narrative descriptions of the system

q What information is recorded on the documents, and what is the source of the information?

w Interviews with employees responsible for the system

q To whom are the documents sent?

The Pakistan Accountant

q What error detection methods are used?

w Ask to see documents described by the employee, and relate them to information received. This may help to identify inaccuracies or incomplete answers. w Ask about the impact of changes in routine during slack or busy periods, vacations or sickness. w Be careful not to oversimplify or over-elaborate.

Avoiding the Common Pitfalls of Detailed Flowcharting w Develop a detailed flowchart only when it is required. w Complicated detailed flowcharts cannot be drawn accurately on a first attempt. Rough out an initial draft. Eliminate all irrelevant, confusing information. w Too little detail may not provide a meaningful analysis. Clearly understand how the flowchart will be used before preparing. w Large complex systems cannot be presented in a single flowchart. Prepare separate flowcharts tied together by an overview flowchart. w Provide an overview flowchart for complex detailed flowcharts. This provides the reader an opportunity to understand the overall process before attempting to understand the detailed process and flow. May - June 2005 43

Information Technology

Tips for Preparing Flowcharts w Create a flow chart beginning at a high level on the first draft. As you look at each of the operations or processes, fill in the detail. Do not be concerned about getting all the detail on the first draft (this is an iterative process). w Refrain from trying to analyze and fix a process until it is completely flow charted. w Review your chart. Does it show the proper flow of information or operations? Does it reflect sequential and simultaneous events? Does it accurately capture what really happens? Are all major decisions reflected? w When the operations and decisions are charted as they actually happen, analyze the process to determine possible improvements. You should concentrate on eliminating unnecessary or

inefficient steps or highlight major control weaknesses such as lack of segregation of incompatible duties, no approval of key events, lack of accountability. w Involve all people actually involved in the process in order to get accurate perceptions. w Have a manager or supervisor of the actual operations review and attest to the accuracy of the completed flow chart. w Clearly indicate the starting and ending points of the process, using the standard terminator symbols. w Keep the direction of flow consistent. Avoid confusion by keeping your flow lines moving from top to bottom and left to right.

include trivial sub-steps of one task while treating another equivalent task as a whole. If one-step or task needs to be analyzed in detail, make a separate chart illustrating that sub-process. w Avoid crossing flow lines. In a welldesigned chart, flow lines will not cross each other. If two lines must cross, use a "bridge" (also known as a "line hop") to show that the lines do not intersect. w Make sure there are at least two outcomes from every decision diamond. w Label your flowchart components. Use active verbs to label activity steps and questions to label decisions. Clearly label the outcomes from a decision diamond in terms that answer the question.

w Number your steps. w Know your symbols w Break the steps down to a consistent level of detail. Don't

Sample Process Flowchart

w Create charts that flow form the top to the bottom of the page w Try to fit flowcharts on as few pages as possible About the Author: Mr. Noor-ul-Huda Ashraf has been working as consultant to various companies after qualifying in 1991 from

Fords

Rhodes

Robson

Morrow, Chartered Accountants. His specialization is in Business Process

Reengineering

and

Information Systems Management. Currently he is working as General Manager Energy at Beaconhouse Group.

The Pakistan Accountant

May - June 2005 44

Human Resource Management

ATTRIBUTES OF A SUCCESSFUL MANAGER Amirali Kassim Merchant, FCA

It may be stated at the very outset that the word MANAGER as used in this write-up means "any person who manages" and that he may be of any RANK / DESIGNATION / STATUS. Man by nature is imperfect, in the real sense of the word, as the Creator Himself has retained the divine power of perfection with Him. In a product manufacturing industry following is the generally acceptable HIERARCHY of the MANAGERS who contribute most significantly, through their respective disciplines, in the material progress thereof. 1. Procurement Manager (both for local as well as imported raw materials / supplies). 2. Production Manager (also called Plant/Works/Factory Manager) 3. Sales Manager 4. Marketing Manager 5. Personnel Manager 6. Human Resources Development Manager 7. Public Relations Manager 8. Finance Manager 9. Manager – CISA (Certified Information Systems Auditor) 10. Manager – Internal Audit -Risk Assessment and Evaluation If a significant number of the below stated ingredients are found in a manager, these would be construed as a Manager, with virtues and as such he, in my humble opinion, is a successful Manager.

I. CONTEMPORARINESS IN THE FIELD OF DEVELOPMENT, IN HIS PROFESSION We are today in the world of innovations which in turn have emerged with new things coming up in operations. A successful manager, to my mind and as the expression of an independent opinion, is one who keeps a timely pace with the development in his profession.

II.

EXPANSION OF HORIZONS

With rapid changes taking place in the social /mercantile /industrial and other environments, as of today it has now become imperative to have a broadened outlook, groomingup, and a wide exposure to the multiple facets, within a given discipline. The Pakistan Accountant

III. A WELL CONCEIVED 'TIME PLANNER’ & THE RELATED CYCLE Of the ladders leading towards the success of a Manager, the above stated ingredient in my opinion, emerges to be of pioneer / torch bearing / and one which is crowned with famous dictum 'if time is lost, everything is lost". In other words, Time Management in an. ideal manner, itself speaks of the degree of success of a Manager. What it means in a practical sense is the ensuring of an equilibrium in his multifarious engagements of the day, week, quarter, biannual and annual events taking place, of his regular professional package of the work to be executed/ handled most efficiently. In short, he as the Head of a given department must be able to apply his time to the required cycle.

IV. MANAGERIAL DECISIONS: IN THE CONTEXT OF TIME, SOUNDNESS & EFFECTIVENESS Gone are the days, when people used to ponder over a long/abnormal period, by way of an interval between a. proposal having been presented and a decision either to implement or give-up used to take place. Although the phenomenon as described above may be witnessed in common among the Departments of any Government organization, in a developing country, such a negation has no place in the functions of a successful Manager of today. It would not be out of place to mention here that among the important duties which have been delegated to a manager, his ability to take, timely, sound and effective decisions, is the CORE of it. The simplest, among the list of so many examples to substantiate our contents of this para is: his ability to take a timely and sound decision as to "whether to make, or buy, whether to borrow or raise additional share capital".

V. APPLICATION OF LAW IN ‘SPIRIT, RATHER THAN IN LETTERS' A Manager of today, if he wants to be successful, in relation to his subordinates, must exercise his managerial authority, in the absolute context of what could be the best beneficial judgement in the larger /supreme administration/ reigning of May - June 2005 48

Human Resource Management his team (which may be small, medium or large). What it means is that he must exercise a restraint against the use / application of his prerogative, resulting into an embarrassment inconvenience / harm, to any of his team members. If he is wise and farsighted, then be must remember that "a slave of today may be the king of tomorrow”.

VI.DELEGATE AND TRUST To manage the Departmental affairs most successfully, it is necessary that the authority conferred upon a Manager be delegated in a suitable manner among his team members. Too-much concentration of authority or its retention in a significant manner by a manger himself may not result into a smooth running of his Departmental affairs. A time may come when he is completely bogged down in routine affairs or matters of an insignificant nature, directly leading to the application of an unproductive time and result. Such a situation is undesirable for a Manager both in terms of the rank he is holding as well as the duties he has been entrusted with. Another factor in relation to the delegation is that of trust. The fact that a Manger has delegated a part of his authority among his team members, equally implies on his part that. the requisite degree of trust has been reposed in them. Trust is the reflection of the degree of confidence, which a manager has in his team and that the same is built up in the due course of time. In short it is hereby emphasized that a successful Manager never works in a unilateral manner as well as in an environment of SINGLENESS. The more the smoothness on his part of delegating trustworthiness among his team, the more the prospects, .for his departmental success.

The Pakistan Accountant

VII.LISTENING TO THE TEAM GRIEVANCES A successful Manager is one who never considers himself as the SOLE MONARCH of his kingdom, under a belief of "MY SHIP, MY ORDER" and such an attitude is undoubtedly to result, sooner of later, in his downfall. It is therefore necessary that he must listen, very carefully, patiently, sympathetically and impartially to all the GENUINE COMPLAINTS being brought to his notice by his team either individually or collectively.

VIII. WINDOW DRESSING /MATERIAL CONCEALMENT A Manager is viewed in the context of his duties, as the man reporting to higher authority, and. there is an absolute FIDUCIARY relationship between him and his higher authority Window Dressing" is the concept of a. material concealment. A Manager must exercise complete care that there is no material concealment while presenting true picture to the Management.

IX.ACCEPTANCE OF CRITICISM A KEY TOWARDS FUTURE CORRECTION It is not necessary as a matter of prudence, that whatever a Manager does is free from : incorrectness, fault or mistakes. To err is human and that an error free work is very rare. Negative / faulty outcome of a delegated job is bound to arouse criticism from the Management. This must not cause any pessimism or disappointment to a Manager. Successful Manager must gladly accept the criticism, which in my opinion is a source of strength in rectifying faults, if any as of today, as a better destination of tomorrow.

X. HANDS ON COMPUTER Computer literacy has become indispensable these days, hence each Manager must be fully conversant with atleast the following: a) b) c) d) e) f)

MS Word MS Excel MS Power Point MS Access Outlook Express Use of Internet

In addition to what has been elaborated in the preceding paragraphs following being in an ABRIDGED manner supplementary ingredients to augment or provide a fillip to the contents of this write-up. 1. Requisite degree of an acumen in visualizing the impact of his planned strategies. 2. An ever-readiness for an ALTERNATIVE line of action/standby under any EVENTUALITY, or where deviation is expected to accrue from a defined path of any contemplated action. 3. Ability to read ACCURATELY (and if not accurately then much nearer thereto) the MIND of the Management. 4. Unshattered CONFIDENCE in his own talents, skills and dexterity. 5. RESULT-ORIENTATION being the sole supreme goal to be chosen by him. 6. Ability to positively ASSERT of all his CONVICTIONS. 7. He is a problem SOLVER and not its CREATOR. 8. He is responsible for FUTURE LEADERSHIP. He identifies and nurtures future Leader, as his timely REPLACEMENT. May - June 2005 49

Human Resource Management 9.

He is a NEGOTIATOR.

very

strong

10

.He defines/EXPLAINS the tasks. His team FOLLOWS the path drawn by him, for the accomplishment thereof.

1. Duties are his DESTINY. In other words, he never grumbles for any of his rights, of which he may have been DEPRIVED of. 2. He always SERVES and that he never RULES.

11.

He never SURRENDERS to the pressure.

3. He ADHERES to all the COMMITMENTS made by him.

12.

He is responsible for EFFECTIVENESS. What it means is that efficiency is doing a RIGHT THING whereas effectiveness means doing the thing in a rightful manner.

4. NO FICKLE MINDEDNESS in the decisions taken by him and absolutely no COMPROMISE there against.

ETHICAL ATTRIBUTES Each Manager, in addition to being a TECHNOCRAT, which undoubtedly his job demands, is equally, expected to posses some ETHICAL ATTRIBUTES in order to soften/ease the burden of his onerous/cumbersome duties. These ethical attributes have been stated as under:-

He passed matriculation Examination from the then East Bengal Secondary Education Board, Dacca in April 1954 and graduated in Commerce from the Dacca University in 1958 and secured First Position. He obtained SEATO Scholarship and did his Masters in Arts in 1961 from the University of the Philipplines and then proceeded to U.K. to join M/S PricewaterHouse in London.

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9. He never INFLICTS pain, he always BEARS the pain. 10. He leaves behind himself ASSETS/LEGACY and not any LIABILITY.

CONCLUSION

5. An ever-readiness to ACCEPT responsibility in the event of FAILURE, if any.

Having discussed the above stated "ATTRIBUTES11 of a successful Manager. I am of the opinion that he has to develop these not simply by being a part of the Management, but also by an -equal application of;

6. Achievement of success is just like an ILLUSION to him, whereas failure, if any, (in his tasks) is an EYE-OPENER.

(a) (b) (c) (d)

7. NEUTRALITY is the only justice, which he administers.

Institute News

Mr. Sk. Hashmat Ali born on 07 September 1939, Benaras in the Province of U.P. British India, arrived in the former East Pakistan (now Bangladesh) in 1947.

8. He has an abnormal degree of PATIENCE and BROAD MINDEDNESS.

Tact, Exposure, Groom, Systematized application of mental faculties, and (e) Humbleness / Submissiveness in approach

OBITUARY On having passed C.A. Final Examinations of ICA (Eng. & Wales) in 1966 he was admitted to membership of that Institute in October 1966. Mr. Sk. Hashmat Ali was admitted as an Associate Member in April 1967 of the Institute and was admitted to Fellowship on 23 July 1977. He was a very senior member of the Institute. He had joined the EPIDC in February 1967 and subsequently joined James Finlay & Co., Ltd., Chittagong in April 1967 as Chief Accountant. In 1971 he came over to West Pakistan and proceeded to Zambia to join M/s Timber Merchants of Zambia where he served for around 3 years. In December

1975 he joined the IBRD (now World Bank) Oil Palm Project of the Ministry of Agriculture and Natural Resources, E.C.S., Nigeria where he served for few years. He returned to Paksitan in December 1978 and than he joined M/s Pakistan Gum & Chemicals Ltd. where he worked upto 1980. He again joined M/s James Finlay plc. in 1981 where he served until 2001. Mr. Sk. Hashmat Ali expired on 23 April 2005 due to post surgical complications which resulted in coma and eventual death. He left behind a widow and two daughters.

May - June 2005 50

SAFA Conference

SAFA CONFERENCE

Tasneem Yusuf, ACA

The South Asian Federation of Accountants (SAFA) conference jointly hosted by Institute of Chartered Accountants of Pakistan (ICAP) and Institute of Cost and Management Accountants of Pakistan (ICMAP) was held at Karachi on May 6 and 7 2005. The theme chosen for the conference was “Transformation of Accounting Profession”. About 1,000 local and 45 foreign delegates attended the conference. The inaugural session took place at Sheraton on the evening of May 6, 2005. Dr. Ishrat Hussain, Governor of State Bank of Pakistan, graced the conference by being the chief guest. Chairman of the conference organizing committee, Mr. Khaliq-ur-Rahman presented the welcome address. The SBP governor kept his tradition of closely interacting with the professional accounting bodies of Pakistan and the large gathering of professional accountants, bankers, businessmen and regulators both from within the country and from India, Bangladesh, Sri Lanka and Nepal were fortunate enough to listen to his highly thought provoking and lively address to the participants. The chief guest dwelt at length on the macro and micro economic issues with which the developing countries particularly in the SAARC region are faced. He emphasized that with the removal of quota restrictions, the European Union countries need to take structural reforms and remove rigidities with regard to goods and labour markets. In the SAARC region, the governments and the exporters need to take measures to capture the increasing market share by enhancing productivity, improving quality and cutting costs. The SBP governor identified 3 key risks to the global economy, namely (1) further sharp increase in oil prices, (2) continued fiscal and current account imbalances in USA and (3) sluggish demand in Japan and the European Union. The keynote speaker on the occasion was Mr. Abbas Ali Mirza, partner of Deloitte and Touche (M.E). The participants were fortunate that the Pakistan Consulate in Dubai, after great persuasion and phone calls, granted him the visa to The Pakistan Accountant

visit Pakistan. He presented his views on International Accounting Standards (IAS) and International Financial Reporting Standards (IFRS). His first slide which stated that the suicide rate among ICAEW members was higher than the national average caught everybody’s attention and from that moment onwards his unique presentation kept the participants fully involved and attentive. There was a lot of food for thought in his presentation for all the participants. The learned key note speaker, in view of his vast knowledge and involvement with several Task Force and Committees, had complete command over the subject and he very ably discussed the problems being faced in the implementation of several IASs, the changes in the IFRSs that he saw forthcoming in the future and the challenges being faced by the professional accountants the world over. Mr. Mirza gave a practical demonstration to the relevancy of the theme of the conference “Transformation of Accounting Profession” by transforming himself from a highly competent and technically sound accounting professional into a highclass singer as after the inaugural session, he thrilled and amazed the participants with his songs. His performance was contrary to the popular belief that ‘we accountants can only deal with numbers!” He had complete command on the traditional “key notes” as well. For me it was difficult to judge whether Mr. Abbas Ali Mirza excelled as a keynote speaker or as a singer. Others who spoke on the occasion were the SAFA President, Mr. Muhammad Nurul Hassan of Bangladesh; SAFA Vice President, Mr. Sunil Goyal of India; SAFA Advisor, Mr. Badruddin Fakhri of Pakistan; ICAP President, Mr. Zafar Iqbal Sobani and ICMAP President, Mr. Muhammad Rafi. The technical sessions were held on the 2nd day of the conference. Unlike in the past, the technical sessions were divided into 2 groups and the participants were given the choice to attend any 3 sessions either at Sheraton or at Pearl Continental (PC). Full credit goes to the organizers for giving choice to the participants. The last session was held at Sheraton and all the participants were required to attend the same. May - June 2005 51

SAFA Conference

Technical sessions The following subjects were covered in the technical sessions held at PC. 1) Opportunities for Accountants in the post - WTO Regime Mr. Mohammad Hanif of Pakistan presented this paper. The thrust of his paper was about the changes under the WTO regime that on the one hand offered good opportunity to expand and grow, while on the other hand posed serious threats and challenges to the developing economies. With globalization in many aspects of life, the financial reporting system across the globe is governed by the IASs and IFRSs and now the trade and industry would be governed by the WTO rules and regulations. He was of the view that the accountants of Pakistan were yet to gear up to the challenges of WTO. 2) Role of Accountants in Poverty Alleviation through Capacity Building Professor Dr. Muhammad Habibur Rahman of Bangladesh presented his paper on “Accountants Role in Poverty Alleviation through Capacity Building”. He highlighted the role of NGOs, particularly of BRAC and Grameen Bank to address the problem of poverty alleviation in Bangladesh. These and other NGOs have greatly contributed in helping the poorest of the poor to become self-reliant through community cooperation, training, skill enhancement etc. The learned speaker suggested that accountants through cost and waste controls and by introducing effective accounting systems can help in enhancing the productivity and profitability to reduce poverty. He suggested that the accountants could identify small groups of entrepreneurs for designing human resour ce development programs to address their The Pakistan Accountant

problems. The accountants can identity the capabilities of individual men and women who are the real assets of an enterprise and the nation. By utilizing these talents, resources cab be put to optimum use to reduce poverty. 3) Recent Developments in Professional Reporting Standards and their Implications Mr. Reyaz Mihular of Sri Lanka presented the paper. Mr. Reyaz is a renowned accounting professional and is frequently seen at numerous international accounting seminars and conferences where he has presented his papers. His presentation was in the most practical manner punctuated with humorous comments. He discussed the inadequacies and inconsistencies of the IASs, the emerging trends including the convergence of US GAAP and moving off balance sheet items onto balance sheet items like intangibles, customer lists and brands. In light of the changing scenario, the session chairman was of the view that we need to “unlearn, learn and re-learn” to keep ourselves abreast of the constant changes that are taking place in the reporting and auditing regulations.

Sessions held at Karachi Sheraton Hotel and Towers covered the following topics 1) Diverse Roles of Professional Accountants Mr. Nadeem Mustafa Khan of Pakistan, another eminent speaker, presented this paper. His paper covered (i) background – change, (ii) diverse roles, (iii) skills, (iv) meeting the challenge and his concluding remarks. The learned speaker very ably and interestingly covered the entire spectrum of the diverse role of professional accountants. The main emphasis of his paper was that one has to look to the future, be adaptive to the changing world and provide the

infrastructure that is most supportive to the people. Accountants are new getting out of their traditional role of book keeping and finance and getting more involved in business decisions like marketing and sales, customer service, R&D and HRD etc. In order to meet the new challenges, accountants must continue to strive to enhance their skills to be successful in the future. 2) Education, Training and Research Mr. Kashi Prasad Khandelwal of India presented the paper on this subject. The learned speaker emphasized the need to structure the education and training of the future accountants in such a way as to meet the demands of standardization and globalization of the auditing and accounting reporting standards, corporate governance, information technology etc. He very ably dealt upon the present education and training system in India and the plans to re-design the system to cater to the future needs of the profession, business and industry. 3) Professional Ethics and Social Responsibilities Dr. Jamaluddin Ahmed of Bangladesh was the speaker at the 6th technical session on the subject “Professional Ethics and Social Responsibilities”. Dr. Jamaluddin discussed the background of ethical issues facing the profession, the need for ethics, common misconceptions, the reasons why people tend to act unethically and the fundamental principles of professional conduct. He emphasized the need for professional independence and adequate fee structure to enhance the level of compliance to the code of professional ethics. The speaker distinguished the difference between auditors and other professionals and why it is more important for an auditor to conduct himself at a high professional level as the statements certified by auditor are used and relied upon by various stakeholders such as the shareholders, bankers, creditors, credit rating agencies and customers. May - June 2005 52

SAFA Conference After each technical paper, two panelists very briefly commented on the paper, which was followed by questions and answers and concluding remarks by the session chairmen. The eminent scholar and Chairman of SEC of Sri Lanka, Dr. Dayanath Jayasuriya and Mr. Asad Ali Shah of Pakistan jointly addressed the 7th and last session on “Auditors in Changing Regulatory Environment”. Dr. Jayasuriya discussed the corporate responsibilities and the role of the regulatory bodies to have in place systems that would alert them to emerging problems and to take corrective measures before it is too late. Mr. Asad Ali Shah in his address underlined the need for auditors to keep themselves abreast of the challenges faced by them on account of significant changes in the new and

revised International Standards on Auditing (ISAs). The changes would apply to all financial statement audits and all audit firms. The changes anticipate more emphasis on inspections by the regulators. He stressed the need for the auditors to enhance their learning requirements and make greater use of specialists. The changes lay greater emphasis on detection of frauds and errors put in place effective risk and quality control standards and which would involve more independence, professional ethics and quality learning. Changes will continue and an auditor has to increase his level of competence to keep pace with the changing world. The event concluded with remarks and vote of thanks by Mr. Abdul Rahim Suriya, Vice Chairman of the conference organizing committee. This was followed, on popular demand, by

another round of songs by the keynote speaker and singer Mr. Abbas Ali Mirza. The conference included trips for the foreign dignitaries to places of historical and cultural importance, fishing off the coast of Kaemari and shopping trips around the city. It was a great sense of pride for me when all the foreign delegates praised the hospitality shown towards them by the host Institutes and all its members.

About the Author: Ms. Tasneem Yusuf is an associate member of the Institute of Chartered Accountants of Pakistan. She is also a member of the Association of Chartered Certified Accountants. She can be contacted [email protected]

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The Pakistan Accountant

May - June 2005 53

IFAC eNews

IFAC eNews 1. Education Committee Extends Comment Period for Auditor Competence ED IFAC's Education Committee has extended the comment period on its exposure draft (ED), Competence Requirements for Audit Professionals, until August 15, 2005. The proposed International Education Standard is designed to ensure that audit professionals have the necessary knowledge, skills, values, ethics, and attitudes to perform competently and carry out their public interest responsibilities. The proposed standard will apply to all professional accountants, not just the audit engagement partner, who have a substantial involvement in the audit assignment and who are responsible for making significant judgment decisions contributing to the overall audit opinion.

2. IFAC Strengthens Code of Ethics for Professional Accountants The IFAC Ethics Committee has issued a newly revised Code of Ethics for Professional Accountants, which establishes a conceptual framework for all professional accountants to ensure compliance with the five fundamental principles of professional ethics - integrity, objectivity, professional competence and due care, confidentiality, and professional behavior. Under the framework, all professional accountants are required to identify threats to these fundamental principles and, if there are threats, to apply safeguards to ensure that the principles are not compromised. The framework applies to all professional accountants, whether in public practice, business, industry or government. The Code is effective from June 30, 2006, and early adoption is encouraged.

3. Ethics Committee Invites Comments on ED on Network Firms The Ethics Committee has issued an exposure draft (ED) proposing revisions to the definition of a network firm in the IFAC Code of Ethics for Professional Accountants. Network firms are required to be independent of an audit client of a firm within the network. The ED, Proposed Revised Section 290, Independence - Assurance Engagements, proposes changes that would classify a firm as a network firm of another firm if the two share a common brand name or if they share significant professional resources or revenues, profits, costs or expenses.

The Pakistan Accountant

Comments on the ED are requested by September 30, 2005. To download the ED, please visit http://www.ifac.org/EDs.

4. IAASB Issues New Standard on Review of Interim Financial Information To further enhance consistency in auditor performance and reporting, the International Auditing and Assurance Standards Board (IAASB) has issued a new standard: International Standard on Review Engagements (ISRE) 2410, Review of Interim Financial Information Performed by the Independent Auditor of the Entity. The new ISRE contains standards and guidance on the inquiries and analytical and other review procedures that the auditor performs to conclude on such interim financial information. The standard is effective beginning December 15, 2006.

5. IAASB Invites Comments on Proposed Standards on Auditor Reporting The IAASB is seeking comments on exposure drafts of two proposed International Standards on Auditing (ISAs) designed to further enhance the quality of auditor reporting. Proposed ISA 701, The Independent Auditor's Report on Other Historical Financial Information, addresses auditors' reports for a wide variety of engagements, including reporting on a single financial statement or a specific element of a financial statement. Proposed ISA 800, The Independent Auditor's Report on Summary Audited Financial Statements, provides new standards and guidance on the criteria to be used and the procedures to be performed in an engagement to report on summary financial statements. Comments on the exposure drafts, which can be downloaded at http://www.ifac.org/EDs, are requested by October 31, 2005.

6. 2004 IFAC Annual Report Available Online IFAC has issued its 2004 Annual Report . The report highlights IFAC activities to develop the global profession. These include initiatives to strengthen standard setting, to identify and address the needs of small and medium practices and professional accountants in business, to reach out to developing nations, and to encourage quality performance by all accountants. May - June 2005 56

IFAC eNews

7. IFAC Expands Support for Developing Nations IFAC's Developing Nations Permanent Task Force is continuing its work to build the capacity of the accountancy profession throughout the world. To assist in the establishment and development of professional accountancy bodies, the task force is developing a tool kit that will provide guidance on the essential elements necessary for a successful accountancy organization, including guidance on relations with government, membership requirements, education and training, and regulation and standard setting. The task force is also providing comments on a number of key projects by IFAC's standard-setting boards and committees and other international standard setters to ensure they give due consideration to issues relevant to developing nations. For more information on these and other initiatives, please visit the Developing Nations Permanent Task Force's home page.

8. IFAC Comments on IASB Project on Accounting Standards for SMEs IFAC has responded to the International Accounting Standards Board's (IASB) staff questionnaire on possible modifications of the recognition and measurement principles in International Financial Reporting Standards (IFRSs) for use in IASB standards for small and mediumsized entities (SMEs). The questionnaire was published for public comment in early April 2005. IFAC's preferred outcome for the SME project, as explained in the response, is a "substantial simplification of IFRSs for SMEs, both in terms of disclosure and presentation as well as recognition and measurement." The response sets out a package of simplifications that IFAC The Pakistan Accountant

believes will "both serve the public interest as well as respond to the circumstances of SMEs and those external users interested in their general purpose financial statements." IFAC's response may be downloaded from the IFAC website. The IASB questionnaire and other responses to it are available on the IASB's website at http://www.iasb.org.

9. Information on National Regulatory Frameworks Available as Part of IFAC Compliance Program As a result of Part 1 of the IFAC Member Body Compliance Program, Assessment of the Regulatory and Standard-Setting Framework, IFAC's compliance team has collected information from more than 145 member bodies on the roles of IFAC member bodies and other organizations (including government, regulatory or other appointed authorities) with respect to: a. Setting auditing, accounting, ethics, public sector and education standards; and b. Regulating profession.

the

accountancy

Over 50 responses to Part 1 have now been posted to IFAC's website and additional responses will be posted in the next month. The responses provide insight into the differences in the regulatory and standard-setting frameworks in place in member body countries. Click here to view the responses. Part 2 of the Compliance Program, the member body self-assessment of compliance with IFAC's Statements of Membership Obligations, will be launched later this year.

10. Keynote Speeches on International Accountancy Issues Available on IFAC's Website Visitors to IFAC's website (http://www.ifac.org) may view more than a dozen speeches presented over the last few months by IFAC President Graham Ward, IFAC Chief Executive Ian Ball and other IFAC leaders to IFAC member bodies, regional accountancy organizations, governmental bodies, and investor groups on a range of topics including the profession's role in serving the public interest, building an investment climate of trust, and promoting strong corporate governance. The speeches are available in the Media Center (http://www.ifac.org/MediaCenter) as well in the Articles and Speech Library (http://www.ifac.org/Library). For more information about any of the items mentioned above or for other information about IFAC, please contact [email protected].

About IFAC IFAC is the worldwide organization for the accountancy profession dedicated to serving the public interest by strengthening the profession and contributing to the development of strong international economies. Its current membership consists of over 160 professional accountancy bodies in 119 countries, representing more than 2.5 million accountants in public practice, education, government service, industry and commerce. The organization sets international standards of ethics, auditing and assurance, education and public sector accounting and issues guidance to encourage high quality performance by professional accountants in business.

May - June 2005 57

Health News

Constipation: Prevention and Treatment

Dr. S. M. Wasim Jafri

Constipation is a very common symptom at all ages, especially in the elderly. However, at any age if it develops as a change of bowel habit, it needs thorough evaluation by a physician who would then seek a gastroenterologist's opinion for further tests like sigmoidoscopy / colonoscopy (passage of a flexible tube through rectum for examination of rectum, sigmoid and other parts of large intestine to diagnose or rule out problems like carcinoma, stricture, etc). Blood in stools almost always necessitates through examination by a gastroenterologist. The following discussion regarding constipation is in the absence of any serious cause and is referred to the habitual constipation or as a result of dietary modification.

Constipation Constipation is a symptom, not a disease. It is frequently caused by a disturbance of how the colon (large intestine) works. The normal functions of the colon are to: w Remove water from the waste material that passes from the small intestine into the colon; w Serve as a storage area for waste material, and; w Help move and expel stool from the body. Constipation may occur because:

constipation) or enemas (medicine in liquid form or water given through anal orifice or back passage to help passing stools). The treatment measures listed below are explained in more detail in the following paragraphs: w Eat a diet high in roughage (fibre); w Eat regular meals; it is especially important to have breakfast; w Take bulking agent with meals and follow with a full glass of water. Begin with: l

1-2 tablespoons miller bran three times a day or;

l

1-2 heaping teaspoons Metamucil (Ispaghula husk) three times a day;

w Do not take harsh (stimulant) laxatives except as directed; w Establish regular daily bowel habits; DO NOT ignore the urge to have a bowel movement; w Allow 15 minutes after breakfast to sit on the toilet - do not strain; w If there has been no bowel movement after 48 hours, take 1or 2 tablespoons Milk of Magnesia at bedtime. If unsuccessful, the dose may be increased the next evening;

w Too much water s removed by the colon, causing dry or hard stools;

w If now bowel movement occurs after three days, use a glycerin suppository or, if necessary, you may take a small tap water enema;

w Stool moves too slowly through the colon, or;

w Exercise daily;

w The patient is unable to expel stools.

w Whenever possible, avoid medications that contribute to constipation. DO NOT stop taking any prescribed medications unless approved to do so by your physician.

Normal bowel habits among healthy people vary greatly from three times a day to three times a week. In some individuals, constipation may refer to infrequent bowel movements (less than three in a week). While troublesome, constipation is usually not serious. It should be treated and corrected to reduce abdominal discomfort and other related symptoms and to prevent the development of complications. Untreated chronic constipation may lead to or aggravate more serious problems such as haemorrhoids (Piles) or fecal impaction (partial blockage due to hard stool).

Measures to Treat Constipation The goal of treatment is to re-establish normal bowel habits without the use of laxatives (tablets or syrups used to treat The Pakistan Accountant

Proper Diet The first treatment for constipation is to eat a high fibre diet to provide natural bulk in your daily food intake. Dietary fibre, often called roughage, is a portion of food that passes through the intestine and colon almost unchanged. Undigested fibre holds water to keep the stool soft and adds bulk which helps move stool to the rectum. Most eat a lot of roughage and this is often a major factor in frequent bowel movement. An increase in dietary fibre generally results in a softer and bulkier stool which can be passed more easily. For details, consult your physician. May - June 2005 58

Health News

Bulk Agents Bulk agents are very useful in addition to dietary fibre to restore and maintain regularity. These include bran and psyllium (Ispaghula husk).

Bran Unprocessed bran, known as "millers bran," can be purchased at a health food store as an inexpensive source of fibre. Bran is the outer coating or shell on grain which is removed during processing white flour. It has very little taste. Wheat, oats and brown rice are common source of fibre. This may be used to supplement to fibre content of bread. Start with one or two tablespoons of bran in a glass of juice or water and gradually increase to three times a day with meals. Start slowly to allow your digestive system a chance to get used to increased fibre. Bran tablets are also available - one tablet equals approximately two grammes dietary fibre. Drink a full 8-oz glass of water with the tablets. You will find both fine bran and coarse bran available. Purchase the coarse bran because it holds water better. With an increase in dietary fibre of the addition of bran to your diet, you may notice a temporary increase in bloating, fullness, abdominal cramps and gas. DO NOT STOP USING THE BRAN! Symptoms will lessen the bowel habits improve and usually disappear within 2-3 weeks. If discomfort is significant, it may be necessary to temporarily reduce your amount of fibre intake, then again gradually increase it as your body usually adjusts to the additional fibre. Do not give up if success is not achieved immediately. Bran will not have any effect on stool already in the colon. It must mix with food in order to absorb water and increase stool volume. Depending on how long you have had constipation, improvement may take a few days to several months. Sometimes it is helpful to empty the bowel with a laxative before starting the high fibre and bran diet. The Pakistan Accountant

Commercial Bulk Agents

Adequate Fluid Intake

Commercial bulk products provide natural or synthetic fibre which softens the stools, increases the bulk and makes the stool easier to pass.

It is especially important to drink fluids with any bulking agents, either bran or the psyllium products. Drink at least eight (eight ounces) glasses every day, including one glass with each meal. However, fluids alone will not promote normal bowel function because the small intestine can absorb all of this fluid. A high fluid intake without a high dietary fibre and bulk intake will only result in increased urination.

Psyllium is a natural dietary fibre made from ground husks of psyllium seed, which has the ability to hold water and form bulk. Psyllium holds water better than bran, so smaller amounts are needed to be effective. Metamucil, Fybogel, Ispaghula husk, Isogel of psyllium. Synthetic or man-made bulk forming products, such as Citrucel Tablets are similar to psyllium. They work the same way and may cause lass gas. Many pharmacies sell generic brands of bulk agents which are less costly. Begin by taking one or two rounded teaspoonfuls of powder one or two times a day with meals. These agents are very safe and if you are not getting the desired results, you should increase the daily dose. Mix rapidly with water or juice and drink immediately, followed by drinking a large glass of fluid. Again, it may be a few days to several months before the desired effects are seen. It is important to be aware that harsh stimulant laxatives are sometimes added to bulking agents. These are harmful to take regularly and should be avoided. You must ask your physician if you are not sure a harsh laxative is included in the product you are using. Some individuals experience increased difficulty with gas and bloating when they use these products. This becomes less of a problem when bowel habits improve. So as with natural fibre, do not give up if success does not occur immediately. Once the need for bulk agents has been established, use should continue indefinitely unless bulking agents are replaced by equal amounts of natural fibre in the daily diet.

Use of Suppositories and Enemas Avoid all harsh (stimulant) laxatives that contain cascara, senna and castor oil. Some of these products include Dulcolax, Skilax. Prolonged daily use of these agents can be habit-forming and may damage your bowel. A glycerin suppository may be used during the retraining period to stimulate the urge to have a bowel movement. Glycerin suppositories inserted into the rectum provide a mild irritant to help pass the stool. You should gradually decrease this practice until you no longer need it. Sometimes the above measures alone are not effective and a laxative may be required. If a laxative is necessary, it is best to use one such as Milk of Magnesia. Other magnesium products may be recommended by your physician. These are effective, inexpensive and safe. They may be taken as needed or even regularly without fear of becoming dependent on a laxative. When using Milk of Magnesia, start with two tablespoons (30 ml) by mouth in the evening. Results from the laxative are likely to occur the following morning. It is very important to measure the dose carefully. Too little may not work, too much may cause watery diarrhoea. You will need to experiment to find the right dose. For example, if two tablespoons do not work, increase the dose to three. If three tablespoons cause diarrhoea, try two tablespoons. It takes time and patience to find the right dose. By trial and error one can find the right amount to take, but it may take several weeks. May - June 2005 59

Health News If you do not have a bowel movement for three days after beginning the retraining programme, you may use a single 250 cc (one cup) enema. If an enema is necessary, use tap water. I would recommend that you consult a physician before the use of enemas.

Medications Some medications slow the movements of the colon and may cause constipation or make it worse. Medicines that you can buy in the drugstore without a prescription and which should be avoided include: antacids containing aluminum hydroxide (for example Aludrox) or bismuth (for example, Pepto Bismol), antihistamines (for example, Benadryl) and iron. When buying medicine off the shelf in the drugstore, ask your pharmacist for help in choosing a drug that does not make constipation worse. It is important to discuss your medications with your physicians as there are a number of prescription drugs that may cause constipation. Do not stop taking any prescribed

medications without approval from your physicians.

Habits It is extremely important to have regular habits to re-establish normal bowel function. Establish a regular routine based on your own schedule. Try to have a bowel movement at the same time every day. The activity of the colon increases after waking up in the morning and after eating, so the urge to have a bowel movement is usually greatest after breakfast. Get up early enough in the morning to eat breakfast, exercise, and sit on the toilet. This should become a daily routine. Promptly obey all urges to have a bowel movement - do not delay or postpone a visit to the bathroom as the urge will disappear. Repeated ignoring of an urge will change your normal sensation in the rectum and can lead to constipation. Avoid over stressing. If you feel stool in the rectum but cannot expel it, you

may find it helpful to apply external pressure by pushing with your hand placed in front of the rectum or just behind the rectum. Whenever possible, plan in advance for changes in your daily routine. Constipation often occurs during travel, vacation or stressful situations. Take bulk agents and glycerin suppositories with you in case you need them.

Regular Exercise Exercise increases muscle movements of the colon and promotes normal bowel habits.

About the Author: Dr. S. M. Wasim Jafri, FRCP, FRCPE, FRCPG, FACP, FACG Ibn-e-Sina Professor, Chief of Gastroenterology Chairman, Department of Medicine The Aga Khan University Hospital, Karachi.

Subscription Rates THE PAKISTAN ACCOUNTANT CA STUDENTS (After Completion of Training Period) Annual Subscription Rs. 150 The students whose training period is continuing are not required to pay any subscription.

OTHERS Annual Subscription Rs. 200

The Pakistan Accountant

May - June 2005 60

Students’ Section

The Brilliant Scholar

Mr. Irfan Ghani

Interviewed by Shakil Akhtar Qureshi, FCA

Mr. Irfan Ghani, a vanquisher of FOUR GOLD MEDALS in final exam of Chartered Accountancy held in December 2004, says, "January 31, 2005 was one of the most special days in my life. It was WONDERFUL, MARVELLOUS, AND AWESOME. I never expected such a grand finale. Only passing the exam within my training period would have been quite satisfying but having done it with four Gold Ones was a real blessing of Allah. I have secured gold medals before but to secure four of them in the final exam of Chartered Accountancy is something very special, a pleasure not describable".

Education:

w September 98 – June 2005 : Chartered Accountancy from Institute of Chartered Accountants of Pakistan w June 98 – June 2000 : Graduation – Economics, English Literature and Statistics (Optional), from Punjab University, Lahore. w June 96 – June 98 : Intermediate from Government College, Lahore

Awards: Chartered Accountancy w Gold medal in Management Accounting – Final Examination w Gold medal in Advanced Taxation – Final Examination w Gold medal for overall performance in Module F – Final Examination w Gold medal for overall performance in Module E & F – Final Examination w Gold medal for overall performance in Foundation Examination Graduation w Gold medal for highest marks in English Literature Intermediate Silver medal for 2nd position in Lahore Board

I nterests and activities:

w English Literature – Classical and contemporary, snooker etc.

Training:

w July 2000 to-date : A. F. Ferguson & Company, Chartered Accountants E-mail address: [email protected] The Pakistan Accountant

After the announcement of exam results on January 31, 2005, he was invited to share coverts of his effulgent accomplishment in professional examination of Chartered Accountancy. He stated, "Chartered Accountancy is not easy with one’s articles going along with one’s studies. Passing the exams in straight attempts is blend of many factors mainly honesty with your studies and work, prayers of parents and friends and most importantly Graces of Allah Almighty". His explicit riposte to assorted questions put to him is replicated vide infra for the readers of Pakistan Accountant in general and enlightenment of Chartered Accountancy students in particular. Q. Why did you choose Chartered Accountancy profession? A. When I did my matriculation I had a faint idea that I do not have the making of a scientist. With my schooling and family background I knew nothing about the profession of Chartered Accountancy. What I liked was English Literature. In the free period before joining Government College I asked my teacher of Literature "What is Chartered Accountancy?" to which he replied "I do not know much about it but have heard that it is something very professional, difficult and adventurous." I knew my teacher to be very selective about the use of words and these three adjectives appealed to me so much that I decided to join the ‘elite force’. Q. How did you plan your studies at school / university / RAET institution and final level examination of Chartered Accountancy? A. I have never been a truant when it comes to studies. The studies did not require much planning during the school, college or RAET days. The only requirement for full time studies is to revise daily whatever has been taught in class. The planning is crucial when a CA student enters a CA firm. His life is split apart in many a segment. The fight between his conscious and sub conscious begins, whenever he is loyally performing his duties as a trainee student his sub conscious keeps on nagging him and weighing him down about his studies. It is time for him to realize that his studies require conscious planning. I made it my habit to study regularly planning for the month of Ramadan which was coinciding with my study leaves before exams of Module F. I made a promise to myself that I will study eight hours a week during the period from the announcement of the result of Module E to my study leaves for Module F – approximately 14 months. I took classes for Management May - June 2005 61

Students’ Section Accounting and Business Finance Decisions quickly after my passing Module E so that I had sufficient time to revise the syllabus and understand the concepts. The most important thing which I understood very late in Module E is the fact that good performance in one subject and poor performance in other subjects undermines one’s chances of passing the final exam. All the subjects are equally important and hence after recognizing this fact I tried to give equal time to every subject – every subject is tested for 100 marks and D grade in Auditing or Taxation is as detrimental as it is in Financial Reporting or Business Finance Decisions. Q. To whom do you owe this enviable achievement i.e. your own hard work, your schooling / university / RAET / audit training background, your parents or sheer luck? A. Luck and blessing of parents are the things that are indispensable in every wake of life. I used to thank Allah a few days before exams that I was lucky enough that I was able to prepare for the exams as I intended to without any untoward incident. After every paper I used to thank Allah that I was able to perform in the examination hall and negotiate with uncontrollable variables outside the hall, variables like weather, traffic, etc. Allah is so beneficent that He does not let us feel our insecurity in this world against the factors which we cannot control, if we study hard and do our part (the factor which we can control) our luck would shine on us. A man is thankfully not alone in this world. I was supported well by my mother, my family and friends. I would like to name two Chartered Accountants, Hammad Ali Ahmad and Khawar Meer, colleagues of mine, who inspired in me self belief that I could strike gold. I owe this success to their believing in me and making me prepare for this coveted award. The Pakistan Accountant

Q. Did you aim for distinct position / GOLD MEDAL in final level examination of Chartered Accountancy well before exam? A. Although my colleagues asked me to plan for gold medal but the only thing I could do to aim for it was try to cover the whole syllabus diligently. You do not know whom you are competing against. I tried to understand what I was studying and enjoyed it thoroughly. The same amount of effort is required for passing the final exams, the ‘over and aboves’ are very welcome. Q. Did you expect securing GOLD MEDAL after final exam? A. I could not tell how my papers would have looked through the eyes of the examiner. I received medal when I did not expect it in Intermediate, CA Foundation and Graduation but did not get it when I expected to get one in Financial Reporting in Module E. Hence I decided not to expect anything golden this time although at heart I believed all my papers especially that of Management Accounting went very well. Q. What is your advice to other students of Chartered Accountancy to excel in exam? A. Well I am not in a position to advise anyone because every student is different and peculiar in many respects. However, if I narrate my own strategy it was very simple; study honestly and seriously because my career depended on it, take my work as trainee student seriously as I have a commitment with the firm, ask my mother to pray for me and take good eight hours sleep before every paper. Many things I have mentioned may not seem related to success in CA but I have said before, Allah is the One who compensates and rewards for things He likes – honesty, commitment and dedication.

Q. Are you satisfied with education and training scheme of ICAP? If not, what are your suggestions? A. ICAP education and training scheme has been recognized world over by different professional bodies of accountants which in itself is good evidence that the scheme is worthwhile. But my main grievance is with the examination system when an unsuccessful candidate cannot get personal appraisal of his paper even if he is willing to pay for it. Many students make the same mistakes in the examination hall time and time again but never know the cause of their failure and as a result lose their selfconfidence. Many students with extraordinary track record leave Chartered Accountancy despondently after repeated failures not because they failed but because they did not know why they were failed. Q. What do you want to do for the country in general and chartered accountancy profession in particular? A. My dream is to see Pakistan as a true Islamic State and as a stepping stone I intend to find an economically viable solution to the problem of "riba" and insurance - apart from changing their name instead of substance. I believe that there is a solution as Islamic community thrived more in the olden times of Khulafa than it does now, what we lack is belief in Allah. As for chartered accountancy profession I would really like to play my part to bring it at par with the standards of accountancy profession in the developed countries. About the Author: Mr. Shakil Akhtar Qureshi is a fellow member of ICAP and member of Publications Committee, Accounting and Auditing Standards Committee and Educational Research Faculty of ICAP. Readers are welcome to contact him at: [email protected] May - June 2005 64