SecM106-06 - Annual Report of the Audit Committee of the Board, 2005-2006

Asian Development Bank

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• Langue: English

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Board of Directors Audit Committee

ANNUAL REPORT     OF THE     AUDIT COMMITTEE OF THE BOARD     2005-2006                             31 August 2006  

 

I. OVERVIEW   1. In line with Article 31 of the Agreement Establishing the Asian Development Bank  and Section 12 of the By-Laws, the Audit Committee of the Board (ACB) assists the Board of Directors in carrying out its responsibilities as they relate to oversight of ADBs financial reporting and audits, including internal controls. In accordance with the Terms of Reference (ToR) the ACB satisfied itself that they were appropriate and accorded with ADBs approved policies and generally accepted accounting and auditing standards.   2. The ACB identified a range of audit issues which formed the basis of its Work Program (a list of the audit issues and reports is found in Appendix 1). The ACB met during the period of review (1 July 2005 to 30 June 2006) with staff from the Budget, Personnel, and Management Systems Department (BPMSD), the Controllers Department (CTL), the Department of External Relations (DER), the Office of the Auditor General (OAG), the Office of Administrative Services (OAS), the Office of Cofinancing Operations (OCO), the Office of General Counsel (OGC); the Office of Information Systems Technology (OIST), the Risk Management Unit (RMU), the Regional and Sustainable Development Department (RSDD), the Office of the Secretary (OSEC), the Strategy and Policy Department (SPD), the Treasurers Department (TD), and also with ADB Outside Auditors (Price Waterhouse Coopers − PwC) with whom it met independently as well as jointly with ADB staff. The selected issues were discussed openly and frankly, and on many occasions were supplemented with audio-visual presentations, written handouts and/or written explanations, as requested. 1      Topics to be highlighted in overview for guidance by the Committee   3. Key Issues and Actions. The ACBs key issues and recommendations for the reporting period 2005-2006 were summarized as follows:   (i) Review of the annual financial statements and MD&A (with the Outside Auditors), and the Quarterly Financial Statements and MD&A: Regular review by ACB     (ii) Monitoring of the implementation of the accounting standards including Financial Accounting Standard no. 133 (FAS 133) specifically covering accounting principles and practices in relation to derivative instruments: Continuing periodical review by ACB with both internal and external auditors (PwC).     (iii) Review of the implications on ADB s financial management of increase in ’ unfavorable FAS 133 adjustments and the impact on the net income: Noted temporary nature of loss consequent to interest rate increases and continuing use of pre FAS 133 basis for net income comparisons     (iv) Review of OCR operating income and net income: Regular review by ACB   (v) Review of ADB s risk management capability and monitoring of progress ’ on integrating risk management in ADB: Monitored   establishment of independent risk management unit as first step towards expeditious progress to                                                  1 As in the past, these conversations/meetings were, and shall continue to be recorded for internal Bank historic records. Transcripts are not published or made publicly available.

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developing an integrated risk management framework; for periodic review of progress by ACB   (vi) Review of key financial and accounting systems through information technology: Continuing periodical review by ACB ’ (vii) Monitoring prog ’ ress towards adoption of Managements Assertion and  Outside Auditor s Attestation concerning internal controls over external financial repor ’ ting; and publication of the Assertion and an Attestation  Letter in ADB s Annual Report: Monitoring   attainment of goal to include Managements Assertion in the Annual Report for 2006, with the Outside Auditors Attestation of Managements Assertion due for the 2007 Annual Report.   (viii) Monitoring of measures being taken to address appropriately instances of fraudulent activities by staff: Continuing review by ACB   (ix) Monitoring of the implementation of measures being taken to prevent fraud by consultants in ADB projects: Continuing review by ACB   (x) Monitoring progress towards adoption of cost accounting systems with ADB: Recommended expeditious progress and regular updates for ACB   (xi) Monitoring of travel related cost saving initiatives: Continuing review by ACB  

              II. BACKGROUND   A. Terms of Reference (ToR) of the ACB   4. During 2005-2006, the ACB operated under its new ToRs (see Appendix 2 ), which were approved by the Board of Directors on 11 April 2005, with the inclusion of risk management, procurement policies and procedures as part of its review of internal controls.   B. Composition of the ACB   5. For the period 1 July 2005 to 30 June 2006, the ACB membership comprised Directors Patrick Pillon (Chair since October 2005, replacing Michele Miari Fulcis whose term ended 30 September 2005), Chaiyuth Sudthitanakorn, and Paul Speltz, and Alternate Directors Batir Mirbabayev, Atsushi Mizuno (replacing Richard Moore) and Richard Stanley.   C. ACB Meetings   6. Between 1 July 2005 and 30 June 2006, there were 13 formal meetings, including one working session with the Controller on the Financial Statements prior to discussion with the Outside Auditors. The meetings were also attended by other Directors, Alternate Directors and Directors Advisors as Observers.   7. The ACB appreciates the support provided by staff in implementing its ToR. In particular, it acknowledges the staff in CTL and TD for their input in clarifying the financial statements, including net income allocation and net income reduction, explanations of embedded derivatives and issues related to FAS 133, and progress towards providing a Managements Assertion and

 

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Attestation Letter; SPD, TD and RMU for their contribution to risk management issues; OAG for executing audits according to its work program and for monitoring the implementation of past audit recommendations and implementing anticorruption measures (together with OAG, BPMSD, and COSO); OGC for clarifying a variety of issues; OCO for clarifying matters relating to cofinancing; OAS, BPMSD, RSDD and DER for implementing and monitoring cost saving measures in relation to staff travel; BPMSD for updating on progress with implementation of a cost information system; OIST for clarifying developments and security measures in respect of internal control systems; and OSEC for briefing the ACB on the budget of the Administrative Tribunal.     III. FINANCIAL STATEMENTS AND AUDIT ISSUES   A. Outside Auditors Audit Plan for 2006 and Accomplishments in 2005   8. Noting with satisfaction the timeline for the 2005 statutory audit, the Committee endorsed the Outside Auditors Strategy for 2005, which included a review of the internal audit function within OAGF. The Outside Auditors, PricewaterhouseCoopers (PwC) considered this an important review as part of ADBs internal control environment. PwC also needed to review the efficiency and effectiveness of OAGF because PwC rely on the work and activities of OAGF for certain aspects of the annual statutory audit and intend to do so in coming audit cycles.   9. PwC reported as a result of the review that the internal audit function was of a high standard, comparing favorably with the internal audit functions of similar organizations in the United States and Europe. PwC pointed out that it was best practice for the Auditor General to report directly to the ACB, rather than through the President, but they acknowledged that there were reasons specific to ADBs current organizational structure and procedures for the existing reporting line, and recommended that the balance of communication between OAG, ACB and the President be reassessed from time to time.   10. In the context of its ToR, the ACB expressed its expectation to meet independently with PwC, and invited them to table issues directly with the ACB at any time. PwC welcomed the invitation as good practice, and in fact, during the year did hold informal communications with ACB members.   ’ B. Outside Auditors Recommendations Implementation Report as of 31 July 2005   11. Submission of the Recommendations and Implementation Report for 2004 had been delayed due to the appointment of a new team of Outside Auditors. PwC advised that they were working with OAG on an improved timetable for future review over the next four years, focusing on an expedited process for IT controls, in particular. The ACB commended OAG and OIST for their actions taken in implementing the recommendations.   C. Outside Auditor s Recommendations Implementation Report as of 31 December ’ 2005   12. The ACB reviewed the Implementation Report, noting that a large majority of recommendations had been implemented, and acknowledged the status of recommendations contained in the Report.  

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D. Outside Auditors Management Letter (Internal Control Memorandum for the year Ended 31 December 2004)   13. The Committee noted the Management Letter issued on 8 July 2005, which had been supplemented by the Status Report as of 31 July, issued on 30 August 2005.     ’ E. Review of the Financial Statements, Management s Discussion and Analysis (MD&A) and Internal Controls with the Outside Auditors   14. The ACB endorsed the draft Financial Statements for 2005 for the Board of Directors to recommend for adoption by the Board of Governors.   15. The ACB noted developments in the Financial Statements for 2005 with respect to OCR and ADF resources, FAS 133 adjustments, loan loss provisioning, loans in arrears, and the accounting treatment applied to special funds, such as the Asian Tsunami Fund.   16. In respect of provisioning, PwC recommended that ADB should record specific loan loss provisions based on discounted expected future cash flow methodology, to comply with FAS 114, rather than on the basis of the risk rating of the loans, which is ADBs existing methodology. The ACB was informed that RMU will be developing a new provisioning policy, to be submitted to the Board for consideration in the second half of 2006, and the provisioning methodology would be discussed at that time.   17. Assurance was given to the ACB that ADB will continue to make management and financial decisions based on operating income (net income before FAS 133 adjustments), rather than statutory net income, which includes FAS 133 adjustments. The ACB expressed concern that the unrealized loss of $308 million reported in the statutory net income, which was due to FAS 133 adjustments, might be perceived negatively by the market and shareholders. The ACB was assured by PwC that the volatility in the statutory net income, resulting in such unrealized gains or losses, was temporary and caused by the fact that ADB did not apply hedge accounting. It did not mean that ADB had had a bad financial year.   18. Recognizing the complexity of accounting for embedded derivatives, and the importance of this matter to their Capitals, the ACB requested a presentation to clarify these issues. On inquiring whether there was a plan to move towards hedge accounting, the ACB was informed that while there was no plan for ADB to move to hedge accounting, ADB adopted Statement of Financial Standards (FAS) No. 155, Accounting for Certain Hybrid Financial Instruments and Amendment of FAS Statements No. 133 and 140. With the adoption of FAS 155, all hybrid financial instruments that contain embedded derivatives that would otherwise be required to be separated under FAS 133 are now valued in their entirety, and thus, ADB has ceased the bifurcation (separation) process under FAS 133. Efforts are being made to bring PwC to ADB more often to discuss such issues; videoconferences could also be held with them.   19. The ACB was informed that the operating income for 2005 was $418 million, compared with $389 million for 2004, and ACB welcomed the increase after a few years of continuous decline.   20. The ACB expressed concern about negative net resource transfers in OCR, which have continued except for a brief period in 1997-1999, leading to a situation where ADB receives more in repayments, prepayments, and interest earned than it disburses to some DMCs, and

 

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proposed that this matter be further discussed, together with ways of increasing loan disbursements.   21. PwC stated that the   audit work had been satisfactorily completed, and that an unqualified audit opinion on the account for 2005 has been issued. They stated that no significant deficiencies or material weaknesses in the design or operation of internal controls had come to their attention.    22. During its audit, PwC had found some weaknesses pertaining to IT security, which Management had already started to address. PwC recommended encrypting messages between Oracle and Swift to eliminate any possible exposure to non-authorized amendments of payment data.   23. PwC recommended that a structure for knowledge transfer in OAGs management be put in place to ensure continuity after the departure of the current Auditor General and Director, OAGF.   F. Review of the Quarterly Financial Statements   24. Meetings of the ACB were convened to discuss the quarterly financial statements, for the periods ending 30 June 2005 and 30 September 2005, monitoring in particular the net income and the impact of FAS 133 adjustments.   25. Quarterly Financial Statements (period ending 30 June 2005). Observing that there was a 5-month period from the beginning quarter in which ACB did not have financial data for the given quarter, the ACB expressed concern at the delay in circulation of the quarterly financial statements and asked if something could be done to expedite the availability of these figures. After a presentation by the Controller, the ACB noted the challenges of providing timely financial figures due to the legacy systems, and remarked that OIST was committed to their accelerated upgrading and integration. They   identified as an issue for follow-up by the ACB the progress of upgrading the capacity of OIST to support CTL, in particular expeditious transactions for the timely production of figures.   26. The ACB was concerned at the decline in operating income for OCR for the first six months of 2005. It recommended improving the levels of already BOD approved but not disbursed loans by about 10% to build up the portfolio and increase income.   27. The ACB proposed circulating the Executive Summaries of the quarterly financial statements to the full Board; however, since they contained information that was potentially sensitive, it was decided after much debate, that it was appropriate for now to maintain the confidential nature of the document.   28. Quarterly Financial Statements (period ending 30 September 2005). At the request of the Chair, the Controller elaborated on the ongoing work and changes in the accounting methods from the cost method to the equity method for ADBs equity investments in certain limited liability corporations. The ACB also sought clarification on the figures for loan loss provisions and loan loss reserves, as well as increase in administrative expenses.   29. At the request of the ACB, the Treasurer gave an update on OCR income. The ACB   inquired when the declining OCR income level would be likely to turn around, and was

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encouraged to hear that forecasts were being made that allocable net income will be positive and is projected to increase in 2006.   30. Responding to a question from the ACB on whether the concentration of the loan portfolio in certain countries is a high risk, the Treasurer responded that there is a risk, but ADBs capital adequacy is proportionate to the risk; it can sustain that risk and maintain its high rating. The ACB noted that such risk issues would be examined under the new RMU head, with results to be reported directly to the ACB in a timely fashion.   31. The ACB with the input from outside auditors (PwC) satisfied itself that, like other MDBs, ADB takes a very conservative approach to financial investments. It noted that in 2006, the investment policy framework may be discussed by the Board.   32. The ACB commented that Management is aware of the need to test the ongoing financial implications of such new policies and MTS II.   33. The ACB appreciated the cooperative, open discussion on OCR income and the ongoing quarterly financial statements with both TD and CTL present, finding it most constructive and helpful.   G. Review of the Proposed Work Program of the Office of the Auditor General   34. The ACB expressed its satisfaction with the status of implementation of OAGs Work Program for 2005, and reviewed and endorsed OAGs Work Program for 2006, noting in particular the continued importance to audit ADBs Resident Missions, as well as additional audits required in relation to the new procurement guidelines.   35. Responding to the ACBs requests for copies of audit reports, the Auditor General proposed that, in addition to the annual Audit Recommendations Implementation Report (ARIR) , in 2006, OAG would prepare a semi-annual report ( Audit Recommendations Semiannual Report ) (ARSR), containing only findings and recommendations, but not the status of implementation.   36. Taking into consideration new demands that would be made on OAG, the ACB expressed concern about OAGs staffing situation, which limited the number of audits that can be done, and it requested the Auditor General to submit a note to the ACB on OAGs current resources and additional resources it needs to fulfill its 2006 and future work programs. The Auditor General informed the ACB that measures were being taken to prepare for a replacement when he retires.   37. In response to an inquiry from the ACB, the Auditor General said he would review how OAGs program will fit into and support MTS II.   H. Review of the Major Activities of the Integrity Division for 2005   38. The ACB reviewed and endorsed the Report. It congratulated the integrity division for the good work achieved, noting that the divisions output compared favorably to those of its comparators, especially considering its tight staff and financial resources.   39. On harmonization, the ACB asked if cross debarment was possible between MDBs. The Auditor General explained that this issue is being reviewed, but it would be a challenge, as it

 

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depended on the MDBs establishing standard procedures, terms, definitions and sanction policies. Some issues are still being worked out, such as publishing the list of sanctioned companies. ADB Auditor General said that he personally would not feel comfortable with automatic cross debarment at this stage, but it could be done on a case by case basis, and this was under consideration.   40. Observing that operations staff are not explicitly required to access the list of sanctioned entities to ensure compliance with it, the ACB felt strongly that this should be a requirement. Although COSOs role is to check compliance with the list, they felt that this was not sufficient, and that operations staff should also be accountable for such compliance.   I. Audit Recommendations and Implementation Report (ARIR) as of 31 December 2005     41. The ACB was satisfied with the results; however, it noted that five highly critical recommendations in the ARIR were past their original target dates, with most pertaining to OIST. It noted that progress is being made, but proposed that Principal Director, OIST be invited to brief the ACB on progress to date on OIST activities, including remaining ARIR issues.   42. As requested by the ACB, the Auditor General gave them a copy of a note on OAG staffing, and the ACB undertook to help OAG resolve its staff shortage.   J. Update on Framework of Committee of Sponsoring Organizations of the Treadway Commission (COSO)   43. The Controller provided the ACB with an update on the Integrated Internal Control Framework Strategy and clarified the consultative role of the World Bank in working with ADB on the COSO Framework project, as an alternative to contracting the task to an outside firm. He said that using the World Bank not only capitalized on its experience, but it minimized the costs to ADB, and helped build up the internal capacity of concerned departments to handle the project.   44. The Controller explained that a joint task force was being established early in 2006 to work with PwC with the objective of taking the necessary steps to have their opinion on Managements Assertion on the adequacy of ADBs internal control over external financial reporting for Fiscal Years 2007 and 2008, and also to prepare a first Managements Assertion for the 2006 Annual Report. He reminded the Committee that the US SEC had granted an extension of the SOX 404 deadline for one additional year to 2007 for foreign private issuers. 2     45. The ACB asked to be updated regularly on the progress, in particular on the proposed next steps in the process, subsequent to Managements approval.   K. Establishment of An Independent Risk Management Unit   46. The ACB has been closely monitoring the establishment of the risk management unit (RMU), discussing with staff the scope, functions, location, structure, staffing and Terms of Reference (ToR) of the proposed RMU.   47. Clarification was provided to the ACB on the role of the RMU in providing an independent credit opinion to the Credit Committee and/or Management, as well as the composition of the                                                  2 ADB is not subject to the Sarbanes-Oxley Act (SOX).

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Credit Committee and the RMUs sign-off function, and the power of the President, as its Chair, to delegate the Chair as appropriate to relevant Vice-Presidents.   48. The ACB took particular interest and expressed concern over the hiring of a suitable and highly qualified, experienced RMU head. ACB members emphasized the different and highly specialized skills set and experience required of an RMU head in overseeing, among others, (i) country risk credit assessments; and (ii) the risk asset review function of credit assessment of commercial companies. It emphasized the importance of the RMU head being given a high degree of authority over staffing as well as influence in decision making, in the interest of credibility, while at the same time maintaining the process of checks and balances contained in the reporting line structure.   49. Before RMU head came on board, Director General, SPD proposed proceeding with the risk mapping process with assistance from a consultant. The ACB was disappointed at the proposal to hire a consultant before recruitment of a permanent head of the RMU and emphasized that costs should be minimized. Nevertheless, it asked that staff proceed expeditiously with preliminary risk mapping and the appointment of the new head of RMU, stressing the importance of choosing the right person with due care.   50. During its meeting with the newly appointed Head, RMU, in May 2006, the ACB inquired whether he had true independence, and whether he had met with all the Board members to seek their views on risk management. ACB stressed the need for Head, RMU to report directly to the President and to spend time alone with him. The ACB assured Head, RMU that it would fully support him, and recommended that he develop a close relationship with the ACB Chair for support in his independent role.   L. Internal Controls (Information Technology) - Update   51. Principal Director, OIST provided ACB with an updated implementation status report on the Outside Auditors Recommendations relating to internal controls in information technology. The ACB expressed its satisfaction at the progress in the implementation of the SWIFT Intrusion Prevention System, an area in which ADB had been particularly exposed. Other progress included the recruitment of a full time Security Specialist earlier in the year, and the engagement of a security consultant to develop a security policy and an implementation plan for all guidelines and procedures under the policy, for completion by the end of the year.     52. The ACB was satisfied with progress made in this area and asked that the ACB be given regular updates on continuing progress.   M. Update on Cost Information System   53. Director, BPBM presented the objectives, scope and progress of the cost information mechanism, explaining how it differed from cost accounting. To date, the findings included comparisons among regional departments on staff costs, consulting services and mission travel.   54. The ACB asked how information on business travel is being analyzed. Director, BPBM responded that monthly reports are submitted to heads of departments showing the breakdown by program category, by department, by division and by country. A monthly report on senior staff travel is also submitted to Management. Next steps in 2006 include better monitoring of business travel trends by country, including regional and nonregional travel, and travel of RM

 

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staff to HQ. Data on travel for CSPs, loans and TAs are available, and similar analytical data on travel to seminars and conferences are also available.   55. The Chair requested staff to inform the ACB when such data are available so that a discussion on this item can be included in the ACBs work program.   N. Review of Travel Related Cost Saving Initiatives   56. As a follow up to the ACBs review of the selection process of the in-house travel agency, AMEXCO, the ACB was briefed on the performance of the travel agency. The ACB noted that AMEXCO had turned around its earlier negative performance for mission travel within a 3-month period, obtaining a satisfactory rating by 31 August 2005, based on a survey of mission travelers. Notwithstanding these improvements, the ACB expressed dissatisfaction at the apparent failure of ADB to avail of the cheapest fares for official travel.   57. Principal Director, OAS reported that a new travel policy was in the final stage of preparation and the final draft for formal review was expected to be completed in late 2005. It would focus, among other things, on tighter controls in the implementation of ticketing according to the best prices available, as well as refining accountability for official travel, which would rest with heads of departments rather than with the OAS Travel Section.     58. With respect to mission travel accountability, staff outlined measures to increase the monitoring of mission travel, primarily the mission approval authority for seminars/conferences and interagency consultations; and the External Invitations Registry (EIR) a web-based central repository of external invitations received by ADB professional staff, which was launched in July 2005. The EIR was created by OIST and DER to address the problem of duplicate attendance at some external events and absence of a coordination mechanism.   59. The ACB commended staff on the development of the EIR and encouraged its use to ensure judicious attendance at seminars and conferences by staff. However, the ACB expressed doubts about adequate monitoring of consultants attendance at seminars, and controls over their other activities, and alerted BPMSD to the need to address these.     60. The ACB suggested making available to Board members records of staff participation on missions per country on an annual basis, and that, as an exercise in accountability, BPMSD might want to review and monitor the utilization of the business travel expenses including, for example, the data on most traveled staff in ADB. The ACB also asked BPMSD to consider exercising tighter controls over mission travel by analyzing business travel utilization by program category, focusing more on operations related travels.    O. Reporting of Cofinancing Operations   61. Responding to a request for clarification from the ACB on the reporting of cofinancing figures in the Preliminary Statement of ADB Operations in 2005 , Principal Director, OCO, presented cofinancing definitions, recording methodology, reporting and cofinancing figures for 2005.   62. Noting that the cofinancing figures for 2005 appeared to be high, the ACB inquired whether there was any double counting. Principal Director, OCO assured the ACB that there is none within the organization, but it may occur between MDBs jointly financing a project, as some MDBs may list some official lending as cofinancing.

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  63. The ACB expressed concern at the outdated and unclear definition of cofinancing, suggesting that OCO review the definition, ensuring that it will be consistent with the definitions used by other MDBs. In addition, the mandate of OCO is not clear, which does not do justice to the work carried out by OCO, and ACB suggested that it be reviewed.   P. Presentation on Budget of the Administrative Tribunal   64. At the request of the ACB, The Secretary provided an overview of the background and structure of the Administrative Tribunal (ADBT), as well as OSECs oversight role in administering and supporting ADBT, including announcing its decisions.   65. The ACB asked whether OSEC was in a position to control ADBTs budget, and was informed that it was very difficult to control aspects of the budget such as the number of preparation days of the judges, which is a major expense. However, a reporting system has now been introduced so that the judges can exercise self control in reporting their hours of preparation. In 2005, ADBT introduced a new process of holding oral hearings (in Tokyo), which also added to the expenses.   Q. Disclosure of ACB Annual Report   66. In the interest of promoting the transparency of the institution, the ACB decided to make its Annual Report for 2004-2005 publicly available. The ACB agreed in principle that while the 2004- 2005 Annual Report  including the appendices  contained nothing too sensitive to disclose, the decision would be made on a case-by-case basis to delete (or blacken out) the names of firms and/or individuals, the inclusion of which might compromise them, or ADB, or cause embarrassment.     67. The ACB again agrees in principle that the 2005-2006 Annual Report does not contain information that is too sensitive for public disclosure and recommends that the Board approve its public release.   IV. REPORT ON STATUS OF IMPLEMENTATION OF ACB RECOMMENDATIONS   68. The ACB reviewed the Report on Status of Implementation of Audit Committee Recommendations. The current status is attached as Appendix 4. (To be completed after guidance from the ACB).   V. AUDIT COMMITTEE RECOMMENDATIONS   69. The main new recommendations for the ACBs next reporting period ending 30 June 2006 may be summarized as follows:   •  Monitoring of the implications of FAS 133 adjustments on the statutory net income reported on a FAS 133 basis.   •  Monitoring prepayments and any associated possible impact on operating income.   •  The establishment of an integrated risk management framework (IRMF) in ADB, under the Risk Management Unit.