Closer look at Banking and Finance
Abdulmenan Mohammed is a seasoned accountant and well-known commentator in Ethiopian print media. Currently based in the UK, Abdulmenan is works for a premium property management company as an accounts manager. Before moving to the UK for education, he worked for an audit firm, where he was able to rise to a level of an audit manager. He is ACCA certified and holds master’s degree in financial management from Edinburgh University, in England. More than a decade in the UK, Abdulmenan, nevertheless, stayed close to the issues back home in Ethiopia. Furthermore, since 2010, he has become an active participant and commentator in Ethiopian print media; especially on business and financial matters. While back home for a vacation, Asrat Seyoum of The Reporter caught up to Abdulmenan to discuss current issues in Ethiopia’s banking and finance sectors. Excerpts:
The Reporter: As you know, since 2014, the Ethiopian lawmakers have passed a proclamation instituting what is called the International Financial Reporting Standards (IFRS) replacing the so called Generally Accepted Accounting Principles (GAAP). Can you explain the basic difference between the two accounting principles and what it means to the process of preparing and presenting financial statements?
Abdulmenan Mohammed: To begin with, GAAP is not really a codified and organized set of standards. It was composed of mostly accounting principles practiced in the US; it was not exclusive to US standards but just accepted rules from around the world. For instance, in Ethiopia, the set of standards thought at higher learning institutions and the ones practiced in the professional environment are often a blend of the US and UK standards. At times, you have industry specific standards adopted from personal experiences of professionals. So, largely, we had a scattered set of standards in use in Ethiopia. Hence, what IFRS seeks to accomplish is collect all the accounting and audit standards and devise one unified templet and guideline for accounting and audit. In fact, it is not limited to accounting only; auditing as well will have specific set of steps and standards to follow while auditing financial accounts under IFRS. For instance, there are specific steps to follow when an auditor goes through a financial account; there are also sets of standards to refer to when an auditor verifies a financial reporting is really up to the standards. What you need to know is every country or industry had its own set of financial reporting standards for many years; and now IFRS would be that common accounting language among the global community. So, what it means is that there is an international body that would research and adopt accounting and audit principles. And Ethiopia would have to follow that body and keep up with these evolving set of standards.
Since the enactment of the law, Ethiopian institutions are now in the process of migrating to this new set of standards. But, the migration is proving to be quite difficult, what does the international experience show?
No doubt it was a long and difficult process. You see, countries had already adopted accounting principles that fits their unique situation. The set of standards were tailored to country-specific needs; so the issue was debated fiercely even in the UK. Mind you, for the UK and other advanced nations compliance to the IFRS is relatively easier since most of the crafters of these new standards are from these nations. But, for developing countries like ours, since most of these standards are developed in the context of the advanced economies, compliance could prove to be difficult. Most of these financial and accounting standards do serve a purpose in the advanced world. But, developing nations lack these basic financial sophistications. Furthermore, some of standards included in the IFRS could also have contradictions with other laws and proclamations of developing nations. For instance, the standards could be in conflict with some of the regulatory frameworks put in place by the National Bank of Ethiopia (NBE) to protect the banking sector. Sometimes, it is like taking laws from other nations and trying to implement it to a local context; it is incredibly difficult.
If the previous standard were as disintegrated as you say they were how then is the world communicating with respect to finance?
You have to know that most of these advanced economies had a unified set of unique standards applicable within in their own national territories. So, what had been happing is that companies had to adopt the local standards wherever they operate. This is partly due to lack of centralized standards. If certain companies do business in two or more nations they will be forced to operate with the standards of each nation. That being the general rule, most of these standards in advanced nations are quite similar to one another. On top of that, the respective accounting and audit bodies in these nations have had constant communications over the years thus leading to the adoption of this common standard. When you come to our situation, the demand for financial information is not that big to begin with. Most of these financial reports are consumed either by the company’s management and shareholders or by some government bodies. There is rarely the need to share such reports beyond our national borders; so the push factors to find a common accounting terms with the global community did not as such exist since now.
What about the tax authority and financial reporting for tax purposes…?
There is financial report and there is tax report. The tax authority is the intended consumer of the tax reporting. Ethiopia had a tax law for so many decades now and that proclamation kept evolving taking into consideration the changes in the nation’s tax base. What this law actually does is codify the way the taxpayer should organize its accounting books and how to present that information for tax purposes. So, the outcome of this report is tailored to the tax authority and no other groups. If you take shareholders, stock markets (if there is any) and the like they require a different set of financial information; completely different from the one prepared for the tax authority. This difference emanates from the simple truth that the tax proclamation has a unique goal in sight. It could be that about collecting taxes more effectively or encouraging investment or bring about income redistribution. Financial reports, on the other hand, could be concerned with performance of that company and valuation of its assets and that sort of thing.
So, what could you tell me about the specific differences between GAAP and IFRS with regard to the output which is the financial report?
If you look at IFRS, what it does is it gives you specific rules as to how to prepare financial reports. For instance, there are some many methodologies as to how one can calculate assets values or financial investments. In the past, professionals were free to cheery pick between different methodologies and that will make the overall product uneven. For instance, even in Ethiopia, the terminologies chosen by accountants while preparing financial reports could vary greatly: some reports could say “inventory” while others say “Stock”. This happens when the set of reporting standards are acquired from different countries. It lacks uniformity. However, the advantage of IFRS is that there are codified steps to follow while preparing financial reports. And that will bring about increased uniformity among reports. For example, if you look at an IFRS based financial report for five firms and GAAP based reports for another five, the end result would probably be similar in structure and terminology in the IFRS based five reports. Meanwhile, this is not true for GAAP. On the other hand, under IFRS-based financial reporting, the level of information that is provided to the customer would increase tremulously. The disclosure rate for GAAP-based reporting was quite low.
With regard to real value estimation could there be a difference between two?
It is possible. One thing I can tell you is that GAAP did not really have uniform methodology to estimate certain values such as depreciation on fixed assets. Mostly, it depended on the practice that the accountant is more familiar with, in his previous work experience. For instance, if we see financial assets like shares the value estimation could vary greatly depending on accountant’s inclination to use par value or the market value. It is really the discretion of the accountant to choose any of the methodology. However, under the IFRS, we are talking about unifying all these methodologies and following a uniform practice.
What about the academic curriculum, could IFRS affect the education sectors?
We regard to the academic curriculum, and if we are talking about our curriculum, even with the GAAP, it was really difficult for graduates to connect with the real world application of the accounting principles. I don’t know how it is now, but in my day, most of what we were thought at school was based on accounting books from the US. On the other hand, when we left school, we came to realize that most of Ethiopia’s accounting standards were copied from the UK; that was a big problem. Even then, the curriculum in itself, although reliant on US textbooks, it was not really designed in way that follows a certain system. Furthermore, what is thought at schools in Ethiopia is not really up-to-date. You see, these standards are just like laws; they keep evolving through time to fit the existing conditions in the business world. So, when we come to IFRS, the academic institutions have to really think long and hard. They need to focus on IFRS books now. Nevertheless, I also sympathize with the institutions since it will require huge investment to replace all these books and also to keep an updated knowledge stock; as I told you the standards are highly dynamic they keep changing from time to time.
What should be then the role of the Ethiopian Accounting and Audit Board? Shouldn’t the education system be an important area in the migration to IFRS?
As far as I know, the Board is so far focused on the awareness creation and training. Yes, it is important; yet again there is a need to move to more specific technical trainings and supports for these institutions. So, they have to think about these things. I also have my doubts if the Board has adequate professionals and resources to provide technical support to somewhat 30 universities in the country. Nevertheless, the Board is expected to stir higher learning institutions to adapt their training courses to the new IFRS system. As I said before, the curriculum is also expected to provide an up-to-date course material and keep up with changes in the IFRS world. You see, that is why accounting professionals choose ACCA; the course modules are always up-to-date with developments in the IFRS. Since I came back, I have meet some colleagues of mine in the business telling me the great difficulty they are facing to even find professionals to assist with IFRS system.
Let’s talk about the banking system. Let me give you two potentially conflicting stylized facts about the baking industry in Ethiopia. For one, the banking sectors have always been characterized as having excess liquidity with the regulator NBE constantly devising instruments to tackle that. On the other hand, we see a scenario where business in Ethiopia unable to access credit from the banking system. What is the story there?
To give you context, let’s go back to 7 or 8 years back where banks in Ethiopia were suffering from excess liquidity. This scenario prompted NBE to adopt the 27 percent NBE-Bill instrument, which far down road managed to suck out this excess liquidity and bring the baking system to that appropriate liquidity level. For many years, excess liquidity was no more an issue to the banks; in fact, at some point, NBE was forced to institute some measures to help build up liquidity in the banking sector. Now, I think last year, we again are hearing of excess liquidity. Yes, on the other hand, there is shortage of credit. So, we need to ask why credit is in short supply in an industry where there is ample capacity to lend. In the first place, the shortage in credit is largely caused by the rather strict requirement of banks to provide credits to their customers. Yes, in some instances, shortage of liquidity might have played a role in driving the credit shortage; but in most cases it is the banks’ strict requirements in the form of loan guarantees that is causing the shortage. Currently, the banks do have capacity to lend. They can even tell you that there is shortage of borrowers; borrowers that can qualify as per their loan requirements. Some of these requirements like collaterals and project plans and as such can be a bit stringent; but it is not the problem of the banks alone. Generally, there is inadequate credit information regarding borrowers. This has to be strengthened for banks to relax their stringent requirements. In this, we can mention the absence of national ID system which can serve as a guarantee for some loan packages. So, as the information system becomes more reliable and accessible, banks can provide credits based mainly on the merit of the business plan and not the collateral guarantee. At this point, for instance, banks are not in a position to provide personal loans to customers because of the lack of dependable national ID system and based on that a comprehensive credit history of borrowers.
A recent IMF report indicted that some 30 to 40 percent of the overall outstanding loan portfolio of private commercial banks is held in the so called 27 percent NBE-Bill. Given the projection of its destructive consequences back when it was first announced, how are the banks surviving the impact NBE-Bill?
First of all, back when the NBE-Bill directive was first announced, the banks in Ethiopia were really swimming in excess liquidity. So, based on my estimates, during the first three, the instrument sucked out the excess liquidity that was building up in the system prior and running to 2010. So, in those days, even after providing adequate credit, the banks were not really squeezed by the NBE-Bill requirement. But after that, you can see the Bill has started to impact the sector especially around 2013 and 2014. Meanwhile, the first NBE-Bills approached maturity relieving some of the strain building up in the banking system. Now, if you see the past 2 or 3 years, owing to the maturity of some portion of the Bills, the overall net effect of the requirement has been really static. As you know, the first five years, the outstanding NBE-Bill was growing at a phenomenal rate since the movement was only in one direction: from banks to NBE. But, in the recent years, the net growth of the NBE-Bill outstanding has slowed down as some of the matured Bills were playing an offsetting role.
But, this is true when we consider the principal of NBE-Bills; however, the interest rate that the Bill pays out and the interest rate the banks charge to raise the deposit they are investing in the Bill indicate a loss for the banks. How about that?
Consider this; banks mainly have two types of deposits: saving and current. Current deposit are type of deposit that banks don’t pay interest on; meaning it is almost cost them noting to acquire that deposit. If you see, the statistics, about 65 percent of the deposit that is raised by Ethiopian banks currently is current deposit. So, the bulk of what they loan as NBE-Bill is the deposit they raised via current deposit types. And that is why they were able to stay afloat. If they pay 7 percent interest on all deposits and loan to NBE at 5 percent they go bankrupt in no time.
So what do you think should be the future of NBE-Bill?
At this moment, I think the Bill has reached a level where it is having the ideal kind of impact in the banks’ operation. Further extension of this Bill might generate a negative consequence for the banks, in my view. My greatest, concern, however, has been the allocation of the credit in the economy. The original argument is for this fund to be funneled to Development Bank of Ethiopia (DBE) and to be allocated for long term projects. So, we have to really ask if this loan was used for the intended purposes. Now, the Bill is roughly about 70 billion and out of this 50 billion is channeled to DBE. According to recent information, only half of the 50 billion is loaned to agriculture and other priority sectors; so where is the rest of that money? It is used by DBE to purchase treasury bills, indirectly financing government expenses indiscriminately. This leads one to question if the NBE-Bill should have been that high in the first place; is 70 billion birr required to fund the said projects. Anyway, now, should this requirement be abandoned the regulator has to think how to return this fund to owners (the Banks) and how they are going to dispense it as a loan without instigated inflation.
On the other hand, DBE, as policy bank which was allocating the fund collected via the NBE-Bill instrument, is said to be facing problems in recent years with rising NPL and loan recovery. Should DBE face further difficulties, do you think there will be blow bank on the banking sector through NBE-Bill?
Yes, it is possible. In fact, the banks bought Bills not directly from DBE but from NBE. And NBE could absorb the losses there and settle the banks claims should DBE face problems. Nevertheless, as nation and one financial system, the impact would definitely be felt since it a huge fund. The saving grace is that DBE is not a deposit collecting entity and as such there might not be a run-on-bank type of risk; yet the NBE would defiantly be forced to step in and bailout the bank if need be. But, the impact is certainly big enough to be felt in the financial system.
What is your take of the current DBE performance and its future?
From a financial stand point the bank faces risk if its loans keep failing. It even stands to wipe out its capital base, in its worst case scenario. Nevertheless, as policy banks we also know that it is highly vulnerable to the political situation and the success of the projects it has financed. On the other hand, its recent trouble with its NPL which is about 40 percent speaks volumes about the policies of the government which led bank to finance projects which were prioritized by the government policy. So, it begs the question, why agricultural and manufacturing projects prioritized by the government and financed DBE are not performing. Furthermore, the NPL also reflects on DBE’s internal loan evaluation procedure; if the bank followed the right procedures in providing loans to projects in these prioritized sectors. Is the bank prudent in assessing projects which have accessed loans? Or has it been compromised somehow? These questions have to be answered.