Report No. 37729-IN India Note on Financial Accountability Systems of Selected State Level Power Sector Entities June 2006 Financial Management Unit South Asia Region Document of the World Bank ACKNOWLEDGEMENTS The World Bank has conducted a study on Financial Accountability Systems o f State Power Sector Entities relating to a selected number o f states. This report was prepared and finalized by Vinod Sahgal, Regional Public Financial Accountability Specialist and Manoj Jain, Senior Financial Management Specialist, o f South Asia Region Financial Management Group o f the World Bank. A team o f consultants from Ernst and Young led by Ram Sarvepalli undertook the supporting background and analyticalwork. The study was carried out with the help o f a survey o f stakeholders o f various entities under review (director finance, statutory auditors, internal auditors, members o f the audit committee) and regulators and energy secretaries o f the respective states. The study was conducted through a process o f review and analysis o f publicly available material and financial statements, surveys, interviews and discussions with the relevant stakeholders inthe state level sector entities. The study was conducted with approval from the Government o f India (Department o f Economic Affairs) in respect o f the states where the World Bank has been engaged inthe Power Sector. We gratefully acknowledge the extensive contributions o f each official and coordinator in the various power sector entities for their valuable assistance in facilitating this study. Constructive suggestions were provided by Robert J. Saum and Ivor Beazley o f SARFM. The report also benefited immensely from comments received from Salman Zaheer, Judith Plummer, Rohit Mittal, Rajesh Sinha, Ismaila Ceesay, Ashok Haldia, S.L. Rao, Suresh Prabhu, K.S. Menon and Dharitri Panda and earlier from Bhavna Bhatia. Sheela Bajaj edited the report. Many thanks are also due to Seema Sachdev, Rashmi Goel, Neetu Sharda and Vinaya V. Vemuri for their efficient technical and administrative support. TABLE OF CONTENTS CONTENTS PAGE ExecutiveSummary 1 I. BackgroundandApproach 1 11. InstitutionalFramework 4 111. Resultsof the Study A. How reliableis the financialinformationprovidedbythe entities? 6 B Are the institutionsoffinancial accountabilityworkingeffectively? . 13 C. What are the principalcausesfor institutionaland systemic weaknesses? 25 Iv. LessonsLearnt 27 V. Way Forward Further dialoguewith Power Sector Entities 29 Further dialogue with State Governments 30 Further dialogue with the Central Government 31 Further dialogue with Regulators 33 Further dialogue with the AccountingandAuditingProfession 34 VI. Limitations 36 Annexures Annexure I List ofEntitiescoveredby the Study 37 Annexure I1 Approach to the Study 38 Annexure I11 RepeatedAudit Qualifications 39 Annexure IV L i s t ofAccountingStandardsissuedby the ICAI 40 Annexure V AnnualReportsAvailable for Study 41 Annexure VI CRISIL RatingParameters 42 Annexure VI1 ConceptNotefor the Study 44 Annexure VI11 Questionnaires 50 Annexure E List ofPersonsInterviewed 51 Exhibits Exhibit 1 Audit Qualificationson Account ofNon-Provisioningof Stores 8 Exhibit2 PensionLiability providedas per Annual Report 8 Exhibit3 ImpactofAudit Qualificationson OverallReportedProfitability for 2002-03 9 Exhibit4 Audit QualificationsonAccount ofUnreconciledAccounts 9 Exhibit5 Audit Qualificationson Account ofKeyAccount Captions 11 ....................................................................................................................................................................................... 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CONTENTS PAGE Exhibit 6 Survey onReliability of Information Submitted to Regulators by Licensees 11 Exhibit7 Qualifications for Mis-statement of AssetLiability and Corresponding IncomeExpense 12 Exhibit 8 Closure of Accounts 14 Exhibit9 DifferentApproaches to Depreciation 16 Exhibit 10 Different Approaches to the Same Accounting Caption 17 Exhibit 11 Accounting PoliciesFollowedby Entities 19 Exhibit 12 Qualifications for InternalAudit System 21 Exhibit 13 Number of Qualifications inthe Auditors Reports over a Three-Year Period 23 Exhibit 14 Size of Accounting Captions with Auditor's Non-Qualified Qualifications 23 Exhibit 15 Qualifications for 2002-03 falling below Materiality for Analysis 24 ABBREVIATIONS AND ACRONYMS AAS Auditingand Assurance Standard ADB Asian Development Bank AG Accountant General APDRP Accelerated Power Development and Reform Program ARR Annual RevenueRequirement AS Accounting Standard C&AG Comptroller and Auditor General CAS Country Assistance Strategy CEO Chief ExecutiveOfficer CESC Calcutta Electricity Supply Corporation CFO ChiefFinancial Officer CMD ChiefManagingDirector CPSU Central Public Sector Undertaking Cos Act, 1956 Companies Act, 1956 DFID Department for InternationalDevelopment ESA 1948 Electricity Supply Act, 1948 ESAAR 1985 Electricity Supply Annual Account Rules, 1985 ICAI Institute of Chartered Accountants of India ICWAI Institute of Cost and Works Accountants of India IGAAP Indian Generally Accepted Accounting Principles IUT Inter-UnitAccounts M I S Management Information System MOA Memorandum of Agreement MOP Ministry ofPower MoU Memorandum of Understanding NHPC NationalHydroelectric Power Corporation NTPC National Thermal Power Corporation OECD Organizationfor Economic Cooperation and Development PLF Plant Load Factor SEBI Securities Exchange Board of India SEBs State Electricity Boards SERCs State Electricity Regulatory Commissions T&D Transmission and Distribution EXECUTIVESUMMARY Backvround 1.The power sector in India has witnessed a large number o f initiativesthat focus on operational issues, including aspects o f financial management and accountability, relating to the sector's performance at both central and state levels. Despite improvements such as timely accounting o f transactions and preparation o f financial statements, the strengthening o f primary institutions for financial accountability has not kept pace. The reliability o f financial information provided by power sector bodies at the state level has been o f concern to government and other stakeholders, including potential investors. Thus, there are concerns regarding the quality o f accounting, internal control, auditing, reporting and internal and external scrutiny arrangements. The new Electricity Act, 2003 has created a base for the sector's growth. However, considering the challenges involved and the lengthy period over which benefits would accrue, fresh effort is necessary to further institutionalize governance and financial accountability arrangements. 2. Given the sector's inheritance o f distorted tariffs, theft, political patronage, static skill sets and poor information systems, the challenges were and still are significant. Nevertheless, the corrective steps taken by some entities are encouraging, given the complexities and constraints that these entities have inherited from the erstwhile SEB era. What matters most is strengthening o f the management structure for effective monitoring of performance. A key aspect in performance monitoring and operational transparency is strengthening the financial reporting framework including financial accountability. Moreover, as this sector receives major state subsidies, a sound and transparent system is imperative for financial accountability and governance. This is critical for building investor and public confidence. The study therefore aims at assessing the primary financial accountability systems o f state power entities. Scope and Approach 3. The study examines and highlights systemic issues o f accounting, financial reporting, auditing, disclosure practices as well as capacity and policy gaps in state power sector entities. Sustainable recommendations have been developed to remove roadblocks and strengthen financial management, reporting and disclosure practices. 4. Review and analysis o f public material, financial statements, surveys and discussions with stakeholders have been used to understand operational practices and to report on the level o f subsidies and return on investment. Finally, the study focuses on consensus building with stakeholders on key issues and solutions. 5. The purpose o f the recommendations is to advise the Bank and stakeholders, feeding into the Country Assistance Strategy (CAS), on the quality o f corporate governance, reporting and management answerability for public investment 'in the power sector. Additional work would berequiredto implement some ofthe suggestionsmade inthis study. Page i 6. The Bank began stepping up its involvement in reform associated with the power sector with the Jaipur Conclave o f 1993. Since then, it has supported state-level initiatives, under the Loan Program and provided technical assistance alongside related dialogue in Orissa, Andhra Pradesh, Karnataka, Uttar Pradesh, Haryana, Rajasthan, Tamil Nadu and Punjab. Progress has been mixed, with the increasing realization that institutional change and capacity building for sound corporate governance need long-term measures. Observations 7. Further improvement in corporate governance o f the state power sector is a central issue. For this, new incentives to build institutional capacity for financial management and accountability are essential. Improvements in accounting and control systems have been introduced in several entities from 2001 in particular. These have included unbundling o f state electricity boards (SEBs) and strengthening the accounting and information systems in states such as Rajasthan and Andhra Pradesh. The staff o f the entities is commended for the effort made to strengthen financial accountability. However, the pace o f improvement in these and other states and in related areas needs further attention2with strong leadership. These areas include accounting for fixed assets, receivables and pension liabilities for past services. In some cases, only the symptoms o f the malaise concerning reliable information are beingtreated. The time has come to look at the root o f the problem. Merely unbundling is not sufficient: the unbundled entities need greater autonomy with independent directors, stronger professional management, greater recognition o f the role o f financial management in corporate governance, heightened government scrutiny, and all transactions fully disclosed in the annual financial statements. Most importantly, a modern Management Information System (MIS) with a common operational framework for all entities is essential. This is achievable as India has the technology for transforming legacy systems to integrated systems in line with the best international practice. 8. Accountingand InternalControl: Presently, financial statements do not provide a strong basis for comparing financial performance across entities and states over time. The study reveals that most entities (72percent) follow a combination o f accounting policies laid down by the Indian Generally Accepted Accounting Principles (IGAAP) and those recommended by the Electricity Supply Annual Account Rules (ESAAR), 1985, historically applicable to SEBs. There is no consistency in accounting policies despite legal clarification and transition from ESSAR, 1985 making inter-company comparison difficult. The transition in accounting practice during the reformshas been uneven with unspecified timeframes. 9. Additionally, there i s delayed disclosure o f financial statements, insufficient presentation and absence o f related decision-making. On the average, the time taken for annual book closure was approximately 22 months from the end o f the financial year to sign o f f by the auditors. These delays constitute a violation o f Sections 166 and 210 o f the Companies Act, 1956 and Rule 4 o f ESAAR, which require companies to submit their audited accounts within six months o f the end o fthe financial year. ~~ A.K. Sachan, Secretary, Central Electricity Regulatory Commission, The Economic Times, May 10, 2005: " Mere unbundling and restructuring o f vertically integrated monopolies does not guarantee the desired efficiency improvements.Functional autonomy to the management and their accountability hold the key to avibrant sector." Page ii 10. In this scenario, the quality o f management is the key factor for the growth and operation o f effective financial management and accountability. To achieve this, basic skill sets should be given due priority and brought in line with modern management standards o f the private sector. 11, InternalAudit: The internal audit function exists in most entities but is largely ineffective. Presently, the financial side o f internal audit is better developed than the operational and technical side, that is, energy audit. The primary activities o f internal audit therefore relate to compliance with internal financial policies and procedures governing financial transactions rather than operational efficiencies. The reports generated are voluminous, as they focus on individual transactions rather than systems and practices. As a result, senior management follow-up is limited. But this is difficult to demonstrate given that there are reportedly large transmission and distribution (T&D) losses across the sector. In fact, this function does not advise the management on improving operating efficiency. The lack o f governing principles and practices on internal audit by any national authority is also a significant support gap. The recent emphasis on energy audit is a healthy feature but there are limitations to its effectiveness, given the infrastructure and information reliability concerns. Overall, there is no visible linkage between the operations o f the internal audit function and its impact. One reason may be the lack o f independence o fthe function; absence o f internal auditing standards is another. Inmost cases, the internal audit function reports to the finance director and not to the head o f the entity. There is also a perception o f conflict o f interest and internal audit reports do not always reach the board or the audit committee. 12. External Audit: The process o f appointing external auditors also needs revision. The choice o f auditor can be made more transparent in order to: (i)obtain the required audit capability; and (b) provide a minimumlevel o f fees based on the size o f the entity. Audit reports can be defi~ient.~Adverse audit opinions are not provided even when there are significant deficiencies in the accounts. None o f the entities looked at had a clean report from the auditor over a three-year period. These external audits are conducted by: (a) the statutory auditor recommended by the Comptroller and Auditor General (C&AG); and (ii)by the C&AG as a supplemental audit to review the work o f the statutory auditor. Often, the qualifications reported by the statutory auditor in the audit report and the accompanying "true and fair view", prima facie, appeared contradictory. The qualifications usually pertain to areas such as incomplete or unavailable records, subsidy receivable, incorrect or incomplete opening balances, and weaknesses in internal control. While there are significant accounting deficiencies uncovered by audit, the concept o f materiality is unclear, resulting at times in the audit reports being loaded with trivial issues that could negate the impact and importance o f management and reporting. The repetitive nature o f qualifications i s another feature, dilutingthe management's responsibility towards audit reports and provision o f reliable financial information. It thus leaves many Auditors often issue "subject to/except for" audit opinions with a list of observations inapparentviolation of national standards. Some audit reports often contain a "subject to/except for" audit opinion with a long list of audit observations which may either appear in the audit report or in notes to accounts or in an annexure, the cumulative effect of which may be material enough to warrant issuance of "an adverse or disclaimer" opinion. The auditors of such power sector entities often give an appearance of trying to convey a message to the reader without appropriately qualifying their audit opinion. The Auditing and Assurance Standards Board of the Institute of Chartered Accountants of India (AASB) statement on qualifications in auditor's report requires the auditor to consider the collective effect of all the qualifications taken together in preparing an audit opinion on "true and fair view," such as the case might substantiallyaffect profit or loss ofthe company. Page iii stakeholders confused on the full impact o f audit and the true financial position o f the entities. It also raises doubts on the validity o f the auditor's opinion since material distortions do not lead to an adverse opinion. Furthermore, the supplementary audit done by the C&AG does not have any standard form to clarify whether the opinion given in the statutory auditor's report is qualified, adverse or a disclaimer! 13. Audit Committee: An effective audit committee can be a powerful instrument for public financial accountability. Though nearly 80 percent o fthe entities reviewed as part o f this exercise have formed audit committees, their managements do not see any important role for such independent supervision and governance, thereby making the formation o f audit committees a mere statutory compliance. The roles and powers o f the audit committees across entities have not been clearly defined, with most comprising existing operational directors o f the board. This adversely impacts their effectiveness and independent supervision. Also, despite the need for understanding business issues and their impact on financial well-being, most audit committees do not have members qualified to scrutinize the work o f the external and internal auditors. Neither are they able to question the assertions o f management relating to the stated financial position or the quality o f internal control. Audit committees have thus not explored the causes o f the lack o f reliable information and have also not effectively monitored the reduction o f T&D losses. Clearly, audit committees exist today more inform than substance. 14. Regulatory Reporting: The regulators have demonstrated tremendous patience with the quality and timeliness o f reporting on financial performance and cost information for tariff setting provided by the licensees. The regulators have also periodically expressed serious concern about the reliability o f information provided. This affects the accuracy o f tariff setting and subsidy allocations. The risk o f utility inefficiencies is thereby passed on to the consumer, and subsidies do not reach the intended recipients. The regulators have also expressed the need to: (a) infuse the requisite skill sets into their own organizations to enable adequate study; and (b) enable direct licensees improve their reporting. The need for high- quality professional support to the regulators from the accounting profession (apart from support to the utilities) is the call o f the day. Recommendations 15. The study suggests that the way forward entails three thrust areas. First, corporate governance must be strengthened by appointing independent directors in line with greater autonomy. Second, the MIS must integrate technical and financial information to strengthen the efficiency o f the system. Finally, a program for capacity building across the sector should enable these entities to implement reforms and system-wide improvement. These areas are now brought to the attention o f Government and senior management o fthe respective entities. 16. Against this backdrop, three cross-cutting issues emerge: (a) human resource management, including skill sets and training; (b) manuals and codes, including a chart o f accounts aimed at a There is also a needto review the existing practices of C&AG audit under Section 619 of the Companies Act, 1956 (as most electricity companies are government owned) in order to see that audit is being done strictly inconformity with statutory provisions. Page iv common framework for accounting and internal control; and (c) incentives to speed up the processof reforms acrossthe sector. 17. The study makes a number of recommendations aimed at capacity building and institutional reforms in governance and accountability. Policy dialogue on the range of issues raised is encouraged with the power sector entities, state and central governments, regulators and the accounting and auditing profession. There is need to further step up dialogue with the key stakeholders. .... 18. Dialoguewith power sector entities: Clean audit opinion over a period Annual reconciliation of accounts with the state government Transactions with related parties disclosed Investments in an integrated accounting system and identifying sources for these .. resources. Active and operational audit committee Incorporationof operational tools for improved financial reporting Disclosure of monetary impact of T&D losses . 19.Dialoguewith state governments: Development of a "Customer Service Charter" as an upfront agreement between the state and the utility's managementon performance, assistance and autonomy. . Hiring of relevant skill sets to enable power sector entities to acquire appropriate financial management professionals5. Monitoring o f progress. ... 20. Dialogue with central government: Application of appropriate common principlesof governance and accountability Design of new incentive mechanisms such as having a separate fund for accelerating financial management improvements. Clarification on statute relatingto accounting policies-Electricity Act, 2003 Chart of accounts ... 21.Dialoguewith regulators: Timelinessand quality of audited financial statements Limitedreview o f ARR filing actuals Laying down of improvement roadmap and its monitoring 5Hiring is an entity wide problemacross States-some of which have had a recruitmentbanfor several years. Another problemis that large numberofstaffapproachingretirement age andthe lossof skills which will occur whenthey retire. Page V 22. Dialoguewith accountingand auditingprofession: ... Choice of auditors Classificationof audit opinions Disclosureon standards of auditing and scope o f audit 9 . Prioritizationbasedon materiality of qualifications Performance evaluation of auditors and adequacy of audit fee structure. 9 Training of C&AG auditors inthe supervision of modern"attest" auditing The Ministry of Power provided comments on the Note to the Ministry o f Finance on 19`h April 2006. These were forwarded to us on 11th May, 2006 by the Dept. of Economic Affairs. The Government's comments and our responsethereon is provided below: Government's Comments "While the Policy Note has definitely suggested a way forward, the Dept. of Economic Affairs should keep in view that these dialogues with stakeholders will be a long drawn process. It is not clear from the recommendations as to which entity would guide and facilitate the dialogues and consequential actions. A dedicated coordinating systems/structure to conduct & conclude the dialogues and evolve atime bound actionprogramwill be required to be identified /set up. The same structure can take up the task o f development of performance indicators, operational plan and monitoringthe progress of implementation. This structure should involve professionals with required skill set and should be given the control over decidingthe incentives basedon achievements." Bank's Response The Ministry o f Power should take the lead for guiding and facilitating the dialogue and consequential actions. In this regard the Ministry of Finance and the Ministry of Company Affairs along with the Comptroller and Auditor General are among the key stakeholders at the Uniongovernment level. Conclusion 23. A corporate governance code for the sector is necessary wherein sound financial information i s central. Traditionally, the sector's senior managementhas emphasized the technical aspects of operational performance rather than governance, financial control and accountability. This bias has led to a high-risk situation where waste o f public funds can be widespread. The study confirms that certain significant aspects of the financial information provided by the state power sector entities are unreliable. This has implications concerning the states' fiscal situation. There is, firstly, the difficulty in assessing the states' liabilities on account of power entity operations. Thus, secondly, while the reported profit based on the financial statements of 25 state entities including two electricity boards i s substantial, audit qualifications on the subsidy receivable from the state governments point to the likelihood ofa substantially changed scenario. 24. The state power sector has been transiting with difficulty from a government dominated administrative style of operation to a commercial mode. This has been induced by legislative Page vi changes in the late 1990s. However, there are other reasons for the continuing weak performance o f power sector entities: (i)lack o f reliable management information including a common framework and chart o f accounts for financial accounting; (ii)poor internal and external accountability systems; and (iii) weak monitoring and evaluation. This impacts decision making within these organizations and related bodies such as regulators. The recently introduced financial accountability institutions such as audit committees o f the board, internal audit (including energy audit), external audit, and regulatory supervision are either ineffective or weak. Efforts are required to build a strong foundation for financial transactions and regular monitoring controls. Even modest improvement in efficiency through better financial information and improved internal control would yield rich dividends, significantly reducing the call on state government resources. Reforms are overdue: corporate governance needs strengthening. Fresh blood from the accounting and auditing profession may be needed to strengthen the capacity of power sector entities and enhance their performance. Page vii I. BACKGROUND AND APPROACH 1. The importance o f the reliability o f financial information provided by power sector entities in India was first raised by S.L. Rao, the author o f GoverningPower6. This is a key consideration in investment decisions given the large capital investments involved, continuing government subsidies and high recurring technical and financial losses. The regulator determines the tariff on the basis o f filings by the entities, based on their books o f accounts. Any mis-statement or unreliable information has adverse repercussions, such as incorrect tariffs, which must be borne by the consumer. Financial information i s the basis o f decision-making for a variety o f stakeholders such as: regulators while levying tariffs; state governments in the case o f subsidies; central governments in the formulation o f policies and reforms; and banks and financial institutions for evaluating the possibility o f disbursing loans. From a governance perspective, reliable financial information is thus crucial not only in decision-making but also control, transparency and accountability. It is one o f the principal responsibilities o f the chief executive officer (CEO) and ultimately the board o f directors. 2. While efforts are under way in many states to introduce sound financial management and improve accountability, a baseline evaluation is worthwhile prior to commencement o f the reform process. The electricity utilities have operated as state government departments and not as autonomous corporate entities, unlike their private sector counterparts, which also come within the purview o f the Companies Act, 1956. Engineer-run public undertakings have focused on investment in utility assets rather than performance evaluation, return on investment and economic merit. Factors such as consumer service, MIS, financial management and supervision have not received high priority. Prior to the commencement o f reforms, the position of these utilities was: Distorted tariffs7: low relativeto costs. Subsidies: no financial discipline; heavy government subsidies. Power theft and large outstandings: poor internal control systems, enabling widespread consumer and employee fraud; technical and commercial losses form 40-50 percent o f electricity generated' in most Indian states; SEBs unable to install effective metering or disconnect non-paying customers' meters - arising from poor internal governance. Patronage and political interference: political mis-use for patronage in employment, undermining the management's control over labor, making it vulnerable to interference in investment and procurement. Civil service employment practices: limited management authority over employees who are generally covered by public service rules and protected by politically influential unions; management cadres, usually recruited from the civil service, tied to government departments with little autonomy. Skill shortages: management strongly engineering-oriented, lacking critical commercial skills (financial control, accounting, auditing, economics, human resources management). 'Publishedby T E N Press S L Rao 2004 ISBN81-7993-033-5 See A Strategyfor SustainedReform in the StatePower Sectors, SouthAsia Energy and Infrastructure Unit,The WorldBank, September2003. * India CountryAssistance Strategy, The World Bank, September 2004. Page 1 .. Distorted demand: power supply inadequate to meet demand, given the low levels o f efficiency and pricing. Poor information: no SEB investment in reliable information systems, operating data, consumer metering and financial management and reporting; systems and records largely manual with virtually no computerization; hence, much data remains in manual registers, scattered across the state, unavailable for analysis and strategic decision-making; regarding assets, as the number o f units in these utilities grow, their records remain untransferred such that assets relatingto particular units lie incompletely unrelated units; besides, with no asset register maintenance, collation o f asset details for SEBs was never a focus area. 3. The Bank began stepping up its involvement in the state power sector reform process with the Jaipur Conclave o f 1993. Since then it has supported state-level initiatives, under the Loan Program and provided technical assistance alongside dialogue, in Orissa, Andhra Pradesh, Karnataka, Uttar Pradesh, Haryana, Rajasthan, Tamil Nadu and Punjab. Progress has been mixed, with the increasing realizationthat institutional change and capacity buildingfor sound corporate governance need long-term measures. 4. Duringthe reform process, a number o f steps have been taken. These include unbundling o f the SEBs into generation, transmission and distribution entities to make the sector commercially viable and accountable, given the enormous subsidies received. Orissa, Haryana and Andhra Pradesh were the first to embark on the unbundling path. Other important initiatives taken by the central and state governments included: introduction o f the new Electricity Act, 2003; repeal o f the Electricity Act, 1910, the Electricity Supply Act, 1948 and the Electricity Regulatory Act, 1998; delicensing o f the generation sector; the APDRP; reducing the fiscal strain on state governments; and attracting private investment. 5. Additionally, State Electricity Regulatory Commissions (SERCs) were created in part for pressurizing the entities to improve the availability and quality o f financial information. The Institute o f Chartered Accountants o f India (ICAI) also took steps to improve the form and content o f accounting and financial reporting. It recommended that power entities develop general purpose financial statements on the IGAAP basis for uniformity in accounting and disclosure. However, these principles and related practices lacked unqualified legal backing and were usually not interpreted consistently, given the lack o f both readiness for change and appropriate skills. 6. Some o f the states that have introduced reforms provide good examples. In the Andhra Pradesh distribution utilities, book keeping has significantly improved, now being done within 10-15 days o f the month's end. This instills greater confidence inoperational decision making as the information i s more realistic than the MIS, which differs from the actual numbers, compiled at the end o f the financial year. InRajasthan, the distribution utilities have completed updation o f fixed asset registers. They are among the few power sector entities, together with some utilities in Andhra Pradesh, which have financial statements ready for audit completion within four months after the end o f the financial year. 7. However, challenges remain in the operational and commercial areas. These include: high T&D losses; operating losses that require huge subsidies and burden the state governments; high employee costs due to adverse employee: consumer ratio; and large borrowings that result inhigh interest costs. Owing to these challenges in the power sector reform process, the benefits will Page 2 accrue slowly. What matters most therefore is strengthening o f the management to effectively monitor and control performance. 8. A key requirement o f performance monitoring and transparency in operations is to strengthen the financial reporting and accountability framework. This would also help ensure governance and management control o f entities, critical for building investor confidence. 9. The study highlights the areas needing improvement in the public financial accountability system. It identifies the gaps and suggests ways to increase the effectiveness o f key institutions concerning the entities, such as the audit committee, statutory audit, and internal audit. The rationale for the study has been explained inthe concept note (Annexure VIII). 10. The objective o f this study is to identify areas for improvement in accounting, auditing, disclosure and reporting practices followed by power sector entities. These include the needto: ... Understand and review accounting and financial reporting processes Analyze the gap in current accounting, financial reporting, auditing and internal control arrangements Report on areas o f improvement Improve the reliability o f information presented in financial statements 11. Thus, the recommendations aim primarily at informing the Bank's dialogue, feeding into the CAS onthe quality o f corporate governance and management o f public investment. 12. The approach to the study i s structured on 27 entities in 7 states (Annexure I), where the Bank i s currently involved, in four phases (Annexure 11). Central public sector undertakings have not been covered. The study analyzes annual reports, other publicly available material and financial statements. Interviews, surveys and discussions with stakeholders in the states and entities were sampled to understandthe practices being followed. 13. Among the key questions examined duringthe study were: . D o financial statements give a true presentation o fthe financial position o f the entity? 1 D o institutions like the board, audit committee, statutory auditor and regulator mitigate the risk o f unreliable financial informationefficiently? 1 H o w does the management view the dissemination o f reliable financial information? 1 What are the constraints inproviding reliable information? 14. The scope o f the study is confined to the quality o f financial information provided by the various power sector entities and does not consider their operational efficiencies. Analysis o f the large T&D losses i s outside the scope o f this study. Annexure VI provides details o f the annual reports o fthe entities studied. For two o f the 27 entities, audited financial statements could not be examined intime. Page 3 11. INSTITUTIONALFRAMEWORK A number o f legislative acts have been passed since 1910 concerning regulation o f electricity supply, setting tariff mechanisms, accounting principles, and generation, and transmission and distributioncompanies. These are: 15. Indian Electricity Act, 1910': This is one o f the earliest pieces o f legislation on electricity supply. It deals with the grant o f licenses and the licensee's powers for electrification o f streets and railways, laying overhead lines, levying energy charges to consumers, supply and use o f energy by non-licensees, protective clauses and provisions for criminal offences and prosecution. The Act regulates the relation between the licensee that is, the supplier o f energy and the consumer. 16. Electricity Supply Act, 19481°: This Act aims at formulating financial norms and a tariff setting mechanism. 17. ElectricitySupply Annual Account Rules (ESAAR), 1985: This is applicable to SEBs and deals with form, preparation (that is, accounting principles) and submission of financial statements. 18. Electricity Act, 2003: It has consolidated the laws relating to generation, transmission and distribution, having repealed" the Electricity Act, 1910, the Electricity Supply Act, 1948 and the Electricity Regulatory Act, 1998. The Act aims at unbundling'* the existing SEBs into separate generation, and transmission and distribution companies. The Act also enables ~ver-riding'~ ~~ For more information, refer source: Guide to the Electricity Laws, Naushir Bharucha, Wadhwa & Co., 2004. "For more information, refer source: Guide to the Electricity Laws, Naushir Bharucha, Wadhwa & Co., 2004. "Section 185 - Repeal and Saving Save as otherwise provided in this Act, The Indian Electricity Act, - 1910, The Electricity Supply Act, 1948 and The Electricity Regulatory Commission Act, 1998 are hereby repealed. Notwithstanding such repeal - (2) (d), All rules made under sub-section (1) of Section 69 of the Electricity (Supply) Act, 1948 shall continue to have effect until such rules are rescinded or modified, as the case may be. l2Schedule XI11(Section 131- 134) deals with the reorganizationof the boards wherein the property of the boards is vested in the state government, who then transfer the property to either a company or a government companyinaccordance with the terms ofthe reorganizationscheme. Section 131(7) explanation: (a) A "government company" means a government company formed and registered under the Companies Act, 1956. (b) A "company" means a company to be formed and registered under the Companies Act, 1956 to undertake generationor transmissionor distribution inaccordancewith the scheme underthis part. I3Section174 - Act to Have Over-riding Effect save as otherwise provided in Section 173, the provisions - of this Act shall have effect notwithstanding anything inconsistenttherewith contained in any other law for the time being in force or in any instrument having effect by virtue of any law other than this Act. (Corresponds to Section 52 of the Electricity Regulatory Commissions Act, 1998). Section 175 - Provisionsof this Act to be inAddition to andNot inDerogation of Other Laws. The provisions ofthis Act are in addition to and not inderogationof any other law for the time being in force. Page4 some provisions o f other Acts such as the Companies Act, 1956, and is itself ~verridden'~ by other Acts such as the Consumer Protection Act, 1986. 19. Companies Act, 1956: This applies to companies registered under the Companies Act, 1956. It provides the form, content, disclosure requirements and accounting policies to be followed by companies while preparingtheir financial statements. 14Section 173 - Inconsistency in Laws --Nothing contained in this Act or any rule or regulation made thereunder or any instrument having effect by virtue of this Act, rule or regulation shall have effect in so far as it is inconsistent with any other Provisions of the Consumer Protection Act, 1986 or the Atomic Energy Act, 1962 or the Railways Act, 1989. (Corresponds to Section 49 of the Electricity Regulatory CommissionsAct, 1998). Page 5 111. RESULTSOF THE STUDY 20. The study was undertaken because o f the critical need for reliable financial information, especially as the power sector receives major government subsidies. This need is particularly important with regard to the audited financial statements o f power sector entities and the information, which they file with the regulators. As a sizeable proportion o f these entities are in the public sector, their standards are considered to be low in corporate governance, financial accountability, transparency arrangements and auditing. This causes concern as the quality o f financial information i s a major consideration for both private and public stakeholders - compounded by highcapital investment and recurringtechnical and financial losses. 21. A number o f stakeholders have addressed the problem o f reliability. Inthe process, they have contributed to a better understanding o f the reasons v i s - h i s business and regulatory requirements. Some o fthese initiatives include: ..... A study on the power sector accounting bythe ICAI'' Rating exercise by the Ministry o f Power (MOP) on the quality o f information (as part o f a bigger exercise on performance) Demand by independent regulators for high-quality information from the licensees Unbundlingo f SEBs into separate corporate entities or profit centers Introduction o f the new Electricity Act, 2003, which tries to combine the legislation relating to generation and distribution by doing away with the Electricity Act, 1910 and Electricity Supply Act, 1948. 22. These initiatives have placed greater emphasis on the reliability o f financial information and the performance o f the power sector. However, progress has not kept pace with the dynamics o f the business environment; the changes exist more in form than in substance. There appears to be a divergence between what is stated by power entities and ground reality. This is particularly true o f financial statements and disclosures to the public and regulators. Given stakeholder sensitivity, sound financial management and disclosure practices are needed for greater accountability with incentive-based performance. A. How reliableis the financial informationprovidedby the entities? 23. An analysis o f the financial statements o f power sector entities provides an insight into the current system o f reporting and accounting practices followed. There are several areas o f concern: 24. Status of investments in fixed assets: Investment in fixed assets and capital work-in- progress such as plant, machinery, buildings, (that constitute 56 percent o f total investment in the selected entities), is not fully supported by the records. Here again, it is necessary to authenticate operating conditions and values -based on the estimated useful life o f these investments. The basic reason for this state o f affairs was the absence o f a system requiring that the integrated entities maintain a fixed asset register. Hence, the records o f these assets, built up over many decades, lie scattered across numerous accounting units, with no centralized system o f cost, 15Study on Accounting inthe Power Sector, ResearchCommittee, Institute o f CharteredAccountants of India, 2002 ISBN:81-87072-78-4 Page 6 location, or specification o f individual assets. Rajasthan is one o f the few states that have nearly . completed updatingthe fixed asset registers for all power sector entities. A review o fthe financial statements brings out the audit reservations onthe existence . o f assets o f the entities. An analysis o f the annual reports shows that: over 72 percent o fthe entities examined did not maintain proper fixed asset records. Seventy-two percent o f the entities did not carry out physical verification o f fixed assets over a two-year period and 56 percent over a three-year period. 25, Subsidy receivable confirmationand provision: The subsidy receivable amounts inthe balance sheets of the entities represent the subsidies that are recoverable from the respective state governments. The amounts receivable on this account (constituting 14 per cent o f total assets) are unconfirmed and, hence, their realizable value is uncertain. One such example is the case o f Rs 4,386 crore stated as being owed by the Government o fRajasthan to the state's power sector entities on March 31, 2003, which is not acknowledged in any public document by the government or authorized by the state assembly. Duringdiscussions with the energy secretaries o f state governments, it was seen that the amount reflected as recoverable from the state government in the power sector entities' books o f account was not the amount that the state government planned, proposed or was willing to pay or admit as a liability. In fact, in the state government's accounts, usually no liability is reflected in the statement o f liability on account o f the power sector entities, in accordance with the cash basis o f accounting used. Often, there are memoranda o f accounts and the amounts receivable are used as tools for negotiation by the entities with the state government. This is done in order to get periodic state support and to settle loans including those provided by the government. The issue is: D o the financial statements reflect the financial well-being o f the entity and its operations, or are they just negotiating tools in the hands ofthe management? 26. Discussions with the auditors, statutory as well as from the C&AG's office, indicated that a confirmation o f this amount i s usually not sought by the entity or provided by the state governments. However, for Punjab in 2002-03, the C&AG did qualify the year's income o f Rs 3,558 crore on account o f government subsidy and also the total outstanding receivable o f Rs 5,470 crore reflected inthe balance sheet. Ofthe 12 entities, which had "subsidy recoverable" as a line item in their balance sheets during 2000-03, only four had this amount qualified in the audit report, while the others asserted that this amount was recoverable. Thus, the reliability o f overall information, especially without confirmation o f such large receivables, needs careful consideration. 27. Valuation of stores and inventories: A crucial part o f year-end book closing is provisioning and adequacy o f inventories. The amounts reflected as inventory o f stores (2.4 percent o f total assets) are not always supported by periodic physical verification o f existence and .. assessment o f operating worthiness, for the absence o fwhich the following reasons are cited: Insufficient information Absence o f procedures like aging analysis and physicalverification o f stores Absence o f identification o f slow-moving stores Page 7 Exhibit 1: Audit Qualifications on Account ofNon-Provisioning of Stores 28. Pension/post-retirement benefit liability provision in books: Among the many liability captions in the entities i s future pension and post-retirement benefit liabilities due to employees. Most entities either do not provide or fall short in the amount provided which is paid incash when due. However, inaccordance with Accounting Standard 15 issuedbythe ICAI, this liability is to be determined on the basis o f an actuarial valuation (Le. the process used by an actuary to estimate the present value o f benefits to be paid in the future). A review o f the financial statements reflects that most o f them do not provide for the liability on an actuarial basis. The significance o f the liability amount can be gauged from the fact that during unbundling, the liability on account o f pension and post-retirement benefits was over r Rs4,400 crore in Andhra Pradesh as an example'6. Therefore, a significant gap exists between the actual liability and the figures reported in the financial statements. Further, this warrants attention since there is often lack o f clarity about whose liability this relates to -the new entity or the state government. An example is the ongoing dispute in Delhi between the state government and the newly formed entities for staff liability o fthe erstwhile Delhi Vidyut Board employees. Exhibit2: PensionLiability provided as per Annual Report Amount in Rs (crore) CommentsofAuditor Source: Annual Reports for financial year 2002-03 o f entities. Note: * In case o f JVVNL (Jodhpur), staff liability is a negative figure o f Rs 7.09 crore due to mis- classificatiodnon- reconciliation which is not inthe accounting principles. 29. Impact of auditor qualificationson profitability: Inaddition to the issues noted inthe balance sheets o f the entities, there were qualifications in the financial statements o f the 25 entities, o f which 40 percent had the reported profit either turned to losses or where the reported losses increased by 80-100 percent. Further as shown in Exhibit 3, based on the reported quantified qualifications applied to the combined reported profits for 2002-03, the profits decrease by over 38 percent for the year". l6Haryanareportedly over Rs. 1100 crores " These adjustments may warrant a detailed investigation-for amore accurate adjustment to the profit and loss account which is beyond the scope of this study. Page 8 Exhibit 3: Impact of Audit Qualifications on Overall ReportedProfitability (2002-03) Amount in Rs (crore) Under/ Over Source: AnnualReportsof entities for financial year 2002-03. Note:The above states cover 27 entities of which financial statements for the year 2002-03 are available for only 17 entities. 30. Key reconciliations: The basic control activity in the book closing process is reconciliations. This has been missing in the accounting practices o f the entities and is evident from the repetitive references in the audit reports. Based on the review o f 17 power sector entities during the three financial years from 2000-2003 (and for 24 entities over two years), the auditors have made many references on account of incomplete and unreconciled accounts in two and, in some cases, all the three years. These indicate a weak review and reconciliation system, thereby undermining the credibility o f the data generated. The issues are: Exhibit 4: Audit Qualifications on Account ofUnreconciledAccounts nreconciledloans and advances .................................................................. nreconciledsub ontrol accounts A key area is the case of inter-unit accounts (IUT) that have not been reconciled and qualified by the auditor in 44 percent o f the entities (11 out of 24) repeatedly over three years. In this caption, a large number o f unreconciled issues are usually parked. Inter- unit reconciliation can be explained by an example. A state sector entity has two areas: Region A and Region B. Region A transfers some stores amounting to Rs 1,000 to Page 9 Region B. Region B receives the stores but does record that in its books. As a result, at the time o f closing the books, the situation would be as follows: Books of RegionA Head Office Account Dr. 1000 To Stores d c 1000 Books of RegionB N o entry recorded by B. Books of Head Office Stores a/c Dr. 1000 To RegionA d c 1000 Region B d c Dr. 1000 To Stores d c 1000 Note: Region A's account is reconciled and would be knocked o f f (Le. 1000Dr.would be knocked off against 1000 Cr) during consolidation. However Region B's account would remain unreconciled (i.e. against 1000 Dr there is no corresponding Cr to knock it off). As a result, the consolidated financial statements o f the entity on the asset side would . show inter-unit(B) account 1000 (an asset in books only) and the auditors would qualify this sayingthat the inter-unit accountshave not been reconciled. Bank reconciliation not done or incomplete and qualified by the auditor in all three years for 32 percent for the entities (8 of 25). Auditor's report qualified on account o f incomplete records for subsidiary and control accounts for a fourth o f the entities reviewedduringall three years. 31. Maintainingsubsidiary records: Several entities have failed to update or complete their subsidiary records when closing their financial statements. As a result, control accounts at the head office are closed without reconciling them with the subsidiary accounts at the various circles/units and consolidated journal entries are passed at the head office, thus raising doubts about the authenticity o f the numbers. Besides, in some entities, statutory records such as cost records are not maintained or are incomplete. Financial statements based on incomplete .. subsidiary records raise questions about the reliability o f their information. An analysis o f audit concerns on completeness or proper maintenance duringall three years reviewed showed that: Over 28 percent o fthe entities did not maintainproper cash books. . Twenty-four percent o f the entities did not maintain adequate records relating to stores and spares. Over 28 percent o f the entities did not have adequate costing records. 32. Additionally, there are other key accounting captions such as fixed assets, sundry receivables and payables, where the auditors have questionedtheir reliability. Page 10 Over 2 years All 3 years Area No. of Entities YO No. ofEntities YO Absence of confirmation from sundry debtors 9 ........................................................................................................................... 36 7 28 Absence of confirmation from sundry creditors .................................................................................. ....................................................................................................................................................................................................... 12 48 9 36 Fixedassets physical verificationnot carried out 18 72 14 56 33. Reliability expressed by the regulator on financial information submitted by licensees: The independent regulators have demonstratedtremendous patience with the quality and timeliness o f reporting by the licensees. For the annual revenue requirement (ARR), due in the end o f December, the licensees are required to submit the audited numbers o f the prior year (ending March 31) with actuals and projections for six months. Inthis regard, the regulators have expressed serious concerns about the reliability o f information provided (Exhibit 6). The question therefore remains whether further patience is warranted, given the direct impact on the accuracy o f tariff setting and subsidy allocations. Besides, the impact o f the inefficiency o f the utility passed on to consumers and subsidies reaching the intended recipients are not quantifiable. This has a bearing on the regulators' concerns with: the quality o f the books o f accounts and reports filed for setting tariffs; and (ii)assessing public interest issues such as the true cost o f operations and the level o f service provided to customers. For this, the regulators need to have the requisite skill sets to study and direct licensees to improve their reporting. Exhibit 6 tabulates the findings o f a survey on the reliability placed by the regulators on financial information presented by the utilities. Exhibit6: Survey on Reliability of Information submittedto Regulatorsby Licensees Reliability Index 1Bad 2 3 4 5 Total YO Poor OK Reasonable Excellent Yo YO % Y O % Accuracy 50 33 17 100 Reliability 83 17 100 Timeliness 33 50 17 100 Yo 34. A further example o f this concern i s Punjab. The regulator has recommended various steps to the Punjab State Electricity Board (PSEB) to improve the reliability o f information, by an order dated May 23, 2003, pointing out that the PSEB has not complied or has partially complied with the directives issued under the earlier tariff order dated September 6, 2002. Some areas o f non- compliance or partial compliance re-raised by the regulator are: 8 Improvement in MIS to provide consistent data with accurate details, explanation o f the basis for projections and data sources. 8 Energy audit report to be submitted at the end o f each quarter with the action taken report after fixing accountability. 8 Fixed assets and depreciation register to contain complete details of assets for enabling the board to estimate the depreciation on assets. Page 11 35. Matching assetdliabilities of unbundled entities: With the recent unbundlingo f the sector, there are still many dealings within the sector's unbundled entities (stores, staff, spare equipment, etc). It is important that the books be segregated in substance and not, as in the Rajasthan entities, where assetdliabilities and corresponding income and expenses have been booked in different utilities. The Rajasthan Rajya Vidyut Prasaran Nigam Ltd. (RRVPNL) obtained a loan o f Rs 730 crore in its name and then transferred it to the JVVNL causing the loan to be understated with current liabilities being overstated. Exhibit 7 highlightsthis. Exhibit 7: Qualifications for Mis-statementof AssetlLiability and CorrespondingIncome/Expense Entity N o Detail of AssetLiability N o Detail of Income/Expense RRVPNL 1. FDR of Rs 20 crore pertaining to 1. Interest income pertaining to RRVPNL shown in books of RVUNL RRVPNL shown in books of RVUNL (2002-03). (amount not quantified). 2. Loans of Rs 730 crore obtained by the company in its own name but transferredto other companies of erstwhile RSEB; resulting in loans being understated and current liabilities overstated(2002-03). JVVNL 1. No loan details available with the 1. Interest expense of Rs 41.8 crore company (2002-03). bookedwithout loan detail. 2. Details of loan againstFDR not available 2. Interest expense of Rs 0.22 crore (2002-03). bookedwithout loan details. AVVNL Details of loan against FDR not available Interest expense of Rs 0.22 crore (2001-02). bookedwithout loan details. 36. Other issues: These relate mainly to audit qualifications. In some cases, the auditors' qualified report, either on the income statement or the balance sheet, does not clarify its actual intent. Thus, such audit qualifications have limited impact. Also, if no segregation or prioritization o f qualifications i s presented, the importance and relevance o f issues raised is usually lost. Moreover, some auditors indicate that the accounting policies were not reviewed, thereby creating serious doubts about the quality o f the audit. Page 12 B. Are the institutionsof financial accountabilityworking effectively? 37. It is now amply clear that concerns about the reliability o f financial information provided by state power sector entities are justified and the government needs to tackle this seriously. Stakeholders need to build pressure to make the organizations accountable for their performance. Institutions such as the management, board and audit committees and, to some extent, the regulator play important roles in financial reporting, disclosure, internal control and governance. The functioning o f these institutions and their impact on the information generated for various stakeholders have been studied here: Board and Audit Committee: 38. Recent developments in the power sector in particular and the corporate world in general (Enron, Worldcom, etc) have forced entities and regulatory bodies worldwide to revamp their accounting and financial reporting systems. In India, the Securities Exchange Board o f India (SEBI), with mandatory provisions on corporate accountability (Clause 49), has placed a higher responsibility on the management, board and the audit committee regarding financial reporting. Recent trends show an improvement in financial reporting and disclosure practices followed by the power sector entities, and this is reflected in their annual reports (Exhibit 10). However, systemic and procedural issues remain at the organizational and the sectoral level that need to be tackled. This will enable the power sector entities to be at par with the financial reporting and disclosure practices followed elsewhere inthe corporate world. 39. Concept of audit committee: This relatively new concept in the Indian corporate scenario was introduced in the Companies Act, 1956 by an amendment in 2001. Apart from being a statutory requirement, the audit committee is an effective tool for corporate governance. It is an autonomous committee separate from the management o f the entity. After the unbundling o f the SEBs into companies, nearly 80 percent ofthe entities have formed audit committees. The role o f the committee is to carry out a supervisory function and provide independent opinion to the board on matters relating to financial and risk management. Audit committees o f the board have been set up in almost all cases to meet the requirements o f enabling legislation, but they are largely ineffective. While the current audit committee members are operational directors o f the entities, they are not active in the audit committees. Independent members who are professionally qualified are not associated with this important supervisory function. The board is therefore not confident that the management's financial information provided to the government, and the wider public, represents the underlying facts and this fear i s confirmed by the external auditors. Nor i s there any assurance that management controls operate effectively or that operational matters are attended to with due diligence. The audit committee should place special attention to the system o f metering, billing and collectiono f receivables. Management: 40. Book closing procedure followed by the management: The management has stipulated accounting policies and standards for the entities. In some states, professionals are hired for accounting positions. However, there are delays in presenting financial statements to the public (averaging 22 months after the year-end compared to the standard six months). An analysis o f the time taken by various entities to release their financial statements shows an average time lag o f 10-12 months. This makes it difficult to understandthe financial position o f the organization in a timely manner. Page 13 Exhibit 8: ClosureofAccounts Time taken by entities to close the books ( months) 2000-01 2001-02 2002-03 Less than 6 0 0 5 6-8 1 1 3 13-15 4 1 3 16-18 2 7 0 19-21 2 3 Morethan 22 15 9 2 Total 25 25 18 Number of entities, which hadnot closedtheir books 2 2 5 Annual reportsnot available 1 1 4 Total 27 27 27 41. According to Sections 166 '*and 210'' o f the Companies Act, 1956, the books o f accounts should be closed within six months o f the close o f the financial year. A reading o f Rule 420o f ESAAR, 1985, which deals with the compilation and submission o f annual accounts, also requires this. Thus, the management has a clear task o f closing the books o f accounts within a specified time frame. 42. Disclosures: These are vital to the user of financial statements. Proper disclosure is essential as it not only makes financial statements comprehensible but also highlights the significance o f the captioned items. However, the current disclosure practices being followed by various power In accordance with Section 166(1), every company shall hold, each year in addition to any other meetings, an annual generalmeeting and shall specify the meeting as such inthe notices calling it; and not more than 15 months shall elapse betweenthe date of one annualgeneral meeting of a company and that of the next.This period may be increasedby three months (provided it is not the first annual generalmeeting), for any specialreason, by the Registrar. l9Inaccordance with Section210(3), the balance sheet and the profit and loss account shall relate inthe case of any subsequent annual general meeting of the company, to the period beginning with the day immediately after the period for which the account was last submitted and ending with a day which shall not precede the day of the meeting by more than six months or incase where an extension of time has been granted for holding the meeting under the second proviso to sub-section (1) of Section 166, by more than six months andthe extensionso granted(provided it is not the first annualgeneralmeeting). 20 Every board shall at the end of each financial year, compile its annual accounts for that year and, within six months from the end of such financial year, submit the said annual accounts and the auditor's report thereonto the CentralElectricity Authority andto the concernedstate government. Page 14 entities are inadequate and diverse. The reason for this is ambiguity in the application o f the statute. Although the boards have been unbundled into separate entities (which are registered under the Companies Act, 1956), they continue usingthe provisions of ESAAR, 1985, especially in those areas which are inconsistent with the Companies Act, 1956. Some o f the disclosures required to be made under the Companies Act, 1956 are: . Significant accounting policies adopted in the preparation of financial statements .. (whereas in ESAAR, 1985 only deviations from policies specified need to be disclosed). Disclosures to be made under Schedule VI. Other disclosures to be made, for instance under Section 292A relating to the audit committee and Section 217 relatingto the Director's Report. 43. The ESAAR, 1985 does not require any o f the above disclosures as the disclosure requirements are designed primarily to meet the information needs o f the government and regulatory authorities. As a result, entities that are better prepared make disclosures under the Companies Act, 1956. In contrast, those companies that are not in a position to generate the requisite information take shelter under ESAAR, 1985. Such an environment creates confusion as it results from disparate and inadequate disclosures, caused in turnby the practice o f disclosure of only certain items under ESAAR, 1985 and others under the Companies Act, 1956. For example, trade receivables under and over 180 days have to be disclosed under the Companies Act, 1956 whereas there is no such requirement under ESAAR, 1985. Companies, which have a mechanism to generate such aging o f receivables often provide these disclosures. 44. For transparency and better understanding o f the operations and financial position, companies increasingly make voluntary disclosures in their annual accounts. These are often placed under the management discussion and analysis section to address issues such as: ... Roles and functioning o fthe internal audit department Major business plans to be carried out duringthe financial year Steps taken to bringabout effective corporate governance Corporate social responsibilityscore card 45. A standard practice among Private Indian and international power sector companies is to disclose the following parameters, which only a handful o f the state government entities comply with: Composition o f audit committee - 54 percent disclosure Responsibility o f audit committee - only one entity among the 27 disclosed this Powers o fthe audit committee -none o fthe entities disclosed this 46. Assortment of accounting'policies:Unless common accounting standards for the sector are accepted and enforced, financial information will continue to be o f poor quality. In line with the unbundling process, various SEBs have split into generation, transmission and distribution companies registered under the Companies Act, 1956. However, financial statements are prepared according to standards that may not meet legal requirements and/or recommendations of the appropriate professional body in India. Thus, some conform to the requirements o f the updated Companies Act, 1956; some to the ESAAR, 1985 while the vast majority (72 percent o f the entities sampled) select accounting polices from both sources o f legislation resulting in an assortment that inhibits comparison o f financial performance between entities and over time. Given that archaic financial reporting systems are adopted by the SEBs, adherence to applicable Page 15 standards has not been possible. A timeframe has also not been established to adopt the standards o f the accounting profession in India. There is an urgent need to improve the quality o f the books and records of the entities particularly for operating assets, bank reconciliation and payroll costs, includingpension obligations. 47. One o f the major issues relating to accounting policies is depreciation. The Electricity Act, 2003 requires compliance in financial reporting by power sector companies. This Act has an overriding effect in cases o f inconsistency with the Companies Act, 1956 but does not provide guidance on computation of depreciation based on the economic life o f assets. This has created confusion in power sector accounting and reporting. Thus, power sector companies (primarily state owned) engaged in the same business and using similar assets, apply different rates o f depreciation, thereby creating variations in profit statements. The C&AG therefore asked the MOP to provide necessary clarification and ensure consistency in the financial statements o f power sector companies. One Central Public Sector Undertaking (CPSU), in its accounts for 2004, applied the rates o f depreciation for tariffpurposes as laid down by the electricity regulator; another CPSU applied the rates of depreciation prescribed under Schedule X N of the Companies Act, 1956, which are substantially higher than the first case. For the former, the profit impact (overstatement) was over US$lOO million for the FY 2004.21 Exhibit 9 further analyzes how different stakeholders treat this policy. Exhibit 9: DifferentApproachesto Depreciation Management Auditor C&AG Regulator Policy % Comments on % Comments on % Comments on % Followed Entities Caption - Entities Caption Entities Caption Entities (i)Charged in 67% (i) Qualified 35 % No comment. 100YO Recommended 17 % accordance with Caption captionto be rates prescribed qualifiedon accountedfor on under ESAAR, accountof IGAAP basis. 1985. undedover statement. (ii)Charged in 16 Yo accordance with No comment. 65 % No 83 Yo However, rates prescribed captionis under the qualified on CompaniesAct, account of 1956. incomplete recordsand (iii)Chargedusing 6 Yo underlover amix ofrates statement. prescribedboth under the CompaniesAct, 1956and ESAAR, 1985. (iv) Not disclosed 11% Source:Annual Reports andresponseof regulators to questionnaires. Note: The regulator has suggestedthat accountingstandards issuedby ICAIbe compliedwith. 21India:Report on Observance of Standards and Codes (ROSC) -Accounting and Auditing, The World Bank, December 2004. Page 16 48. Exhibit 10 highlights some significant captions for which different approaches are used by various mandatory bodies for an accounting caption. Exhibit 10: DifferentApproaches to the Same Accounting Caption FixedAssets Management Auditor C&AG Regulator Policy % Comments on % Comments on % Comments on % Followed Entities Caption Entities Caption Entities Caption Entities (i) recorded Assets 61 (i) Qualified 6 No comment. 100 Recommende 33 at historical cost, Caption d captionto less depreciation. qualified on be accounted accountof for on (ii)Replacedfixed underlover IGAAP asset not 12 (ii)Qualified 6 statement. basis. withdrawn from books. No recommend- 67 ationonthis (iii)Notdisclosed 17 (iii)No 88 caption. comment However, captionqualified on accountof non- maintenanceof fixed assets register, under1 over statement and nophysical verification. Management Auditor C&AG Regulator Policy % IIComments on % Comments on % Comments on % Followed Entities Caption Entities Caption Entities (i)Indirectexpense i) Qualified 23 No comment. 100 Recommende 33 capitalizedinratio Caption d captionto of indirect cost qualifiedon be accounted chargedto revenue account of for on and capital. underlover IGAAP statement. basis. (ii)Indirect expense 11 (ii)Qualified 6 No 67 chargedon best recommendat judgment basis. ion onthis caption. (iii)Indirectexpense chargedon standard 1 NO comment. 71 rates. 23 However captionqualified (iv) Material issued on accountof at standardrate. incomplete 22 recordsand underlover (v) Not disclosed 11 statement. Page 17 Management Auditor C&AG Regulator Policy % Comments on % Comments on % Comments on % Followed Entities Caption Entities Caption Entities Caption Entities (i) cost At 6 (i)Qualified 12 No comment. 100 Recommende 17 Caption d caption to (ii)Standardrates 34 (ii)Qualified 6 qualified on be accounted account of for on ($Weighted underlover IGAAP averagerate 39 No comment 82 statement. basis. (iv) Not disclosed 22 No 83 However, caption recommendat qualified on ion on this account o f caption. incomplete records & underlover statement. S I Auditor C&AG % I Comments on % Comments on % Followed Entities Caption Entities Entities (i)Liability funded 12 No comment. 100 Recommende through a trust or Caption d caption to LIC. qualified on be accounted account of for on @)Actuarial 11 (ii)Qualified 29 underlover valuation statement. basis. No comment. 59 (iii)Actualliability However, 11 No 83 caption qualified recommendat on account of ion on this (iv) Estimatebasis 11 incomplete caption. records and (v) Notdisclosed 39 underlover statement. I Subsidy Management Auditor C&AG Policy % Comments on % Comments I % % Followed Entities Caption Entities on Caption Entities on Caption Entities (i) Amount receivedas 11 (i)Qualified 41 &- Recommen- 17 grant creditedto comment ded caption appropriate account. to be accounted (ii) Subsidy accounted 17 for on on accrualbasisto (ii)Qualified 12 IGAAF' earn a surplus of 3 basis. percenton capital No comment. 47 However, base. No 83 caption qualified recommend 5 on account of -ation on (iii)Subsidycredited incomplete this caption. to capitalreserveand records& subsequentlyadjusted underlover as income. statement. (iv) Not disclosed 67 49. Sections 616 and 211 of the Companies Act, 1956 relate to sector-specific laws (Electricity Act, 2003 in this case), and allow the SEBs to interpret and continue with practices and policies. Hence these companies report under different accounting policies because of lack of clarity in the laws. Exhibits 9 and 10 show that on account of these differences, varying standards of accounting and auditing are usedinthe reporting of financial statements. 50. A review of audit reports, balance sheets, profit and loss accounts and accounting policies followed by the power sector entities, showed the lack of uniform accounting policies required by both the Companies Act, 1956 and ESAAR, 1985. There is, instead, a mix of the two, causing inconsistency, which has renderedinter-company and sectoral comparison difficult. Exhibit 11: AccountingPoliciesfollowed by Entities I Statutes followed I I 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% *Assortment asystem whereinpoliciesare pickedup for different or same caption items from boththe CompaniesAct, 1956 and ESAAR, 1985 - 5 1. The ICAI had produced a white paper titled: `Study on Accounting in Power Sector' in 2002. The study related to: (i) existing legal framework of power sector entities; (ii)applicability of the IGAAP; (iii)the current form o f financial statements and accounting policies and their comparison with IGAAP; (iv) recommendations to bring the accounting practices in line with IGAAP; and (v) roadblocks in implementingthe recommendations. However, this has had little impact, giventhe challenges. 52. Management information system: An integrated IT approach with end-to-end solutions should be the objective to cover both technical and commercial data.22 The present system generates both datasets separately, creating large discrepancies with room for fudging numbers. Transmission and distribution losses could thus provide totally different figures from the two separate sources. Distribution companies in Andhra Pradesh have made considerable progress in financial MIS in which a significant part i s now generatedthrough the accounting system after the implementation of a monthly book consolidation process. This should be shared widely across the country. In most entities, the reporting process is poor, especially in the MIS, which is not integrated with the 22 A report on this subject (IT solutions) prepared by a committee headed by the CEO of Infosys Technologies is available with the MOP. The present study does not recommend any particular system. Instead, the Central Electricity Regulatory Commission (CERC) may wish to explore this area to create a uniform approachto MIS andreporting. Page 19 accounts, and finance function and uses separate channels. Moreover, as the MIS i s required for quick decision-making in a dynamic environment, it cannot be generated from the financial reporting system, which is characterized by significant time lags inreporting. 53. Repetitive qualifications and management attitude: It is evident from the number o f qualifications repeated every year that the management is not interested in solutions because o f 1 A large number o f trivial issues identified for qualification as a result o f which the management does not focus on them. 1 Auditors often use the reduction in the number o f qualifications as a bargaining tool for additional work. 1 A perception that, as the C&AG appoints the auditors, qualifications/ "paras" are included intheir reports that would otherwise form part o f the C&AG's post-audit report. 1 A number o f qualifications lackedmanagement focus and materiality and hence received no attention. 1 Over-auditing o f entities (four different types o f auditors - statutory, internal, supplementary and cost) has resulted in a number o f observations ("parasyy) being given out by different auditors. Given the number of observations ("paras") and their perceived relevance, the managements club issues together, seen largely as non-value-adds, resulting indilution o f focus. 54. Book keeping (Chart of Accounts): The maintenance o f books o f accounts in most state power entities is not structured to meet the demands o f a dynamic commercial organization. Hence, accurate and timely information in the required manner i s not provided. In a study on book keeping in six distribution entities, the following reasons are cited: 1 Four out o f the six entities followed the ESAAR, 1985 chart o f accounts meant only for integrated utilities. 1 Only one entity had structured its chart o f accounts to meet the cost accounting rules, this beingmade possible by a skilledteam handlingthe corporate accounts. 55. One view suggests that the problem gets aggravated because the number o f professionals engaged in the closure o f books and preparation o f financial statements is small compared with the number employed inthe accounts and finance function. This affects the quality and timing o f financial reporting and compliance with regulations. 56. None o f the six distribution companies have an online integrated accounting function. Only one entity uses a small accounting package "Tallyyyto consolidate accounts, while others use Microsoft Office-based "Excel". Also, given the advancements in technology and computers, the manpower in power sector entities is ill-equipped to handle any integrated computer-based accounting and reporting system. Hence, the lack o f technologically skilled accounting personnel is a limitation. 57. Besides, none o f the entities have a training program designed for refresher and advanced courses to enhance finance skill sets concerning new accounting standards and computers. There i s thus a lack o f both qualified personnel and skill sets required for a healthy financial reporting system. Discussions with the entities also revealed that they do not have monthly and annual book closing checklists or sign-off procedures. Page20 InternalAudit 58. Internal audit function: In most cases the management has set up an internal audit function but it appears to be ineffective: (i) continuing high T&D losses across states; (ii) materiality low o f transactions; (iii)an approach that focuses on transactions rather than processes; and (iv) large accounting irregularities, reported by the external auditors, that seem to have been missed (or kept out) by the internal auditors. It may thus be necessary to strengthen the internal audit function in line with best practice in the Indian public sector and a reporting relationship directly with the audit committee o f the board. At present a large percentage o f the entities' internal audit processes are not commensurate with the size and nature o f the entity. This is evident from most statutory audit reports that refer to the Manufacturing and Other Companies (Auditors' Report) Order and point out that the internal audit function is not commensurate with the size o f the company. Other aspects such as incomplete recordshooks, incomplete/absence o f reconciliation procedures especially relating to IUT and bank accounts also show the ineffectiveness o f the function. The effectiveness o f the function is further diminished due to the conflict o f interest in the current reporting structure where the function reports to the director (finance) instead of the audit committee. The issues that have surfaced inthe study are listedbelow inparas 59-64. 59. Internal audit and the size of the entity: Statutory auditors for several entities have pointed out that the internal audit function is ineffectiveand not commensurate with the size o fthe entity. Period Over 2 years Over 3 years Number of entities 15 13 Total number of entities 25 25 Percentage 60 52 60. Scope of internal audit: In most cases, the scope o f internal audit has been limited to financial transactions and book keeping. With the lack o f skill sets and a sponsor in top management, the scope and approach does not extend to processes and operations o f the entity. Consequently, the key aspect o f energy audit for reconciliation o f numbers regarding power input and billing remains outside the scope o f the function. 61. Skill sets: The internal audit function in a number o f entities is manned by ineffective and uncooperative staff. This reflects the management's lack o f commitment and expectation vis-a- vis the function and raises the question o fthe relevance o f skill sets inthe function. 62. Reporting structure: Presently, in all entities, the internal audit function reports to the director (finance) instead o f the audit committee, thereby undermining its own functioning and effectiveness. This reporting pattern can also influence the internal audit report presented to the board. 63, Reconciliationprocedures: A review o f the financial statements reveals that most entities were unable to complete reconciliation procedures before the closure o f books. This is evident from the repeated qualifications in the audit reports. The areas where reconciliation procedures were incomplete or absent are: ....Inter-unit accounts. Bank reconciliation. Reconciliationo f the physicalcount o f stores with book records. Reconciliationo f subsidiary records with control ledgers. Page21 64. While the survey shows that most entities do have reconciliation procedures in place, a review o f the annual report indicates that none o f these .procedures are followed effectively. This inturnraises the issue o fthe application of internal auditing standards. ExternalAudit 65. Choosing the auditor: For power sector entities within the purview o f the Companies Act, 1956, the auditor has to be selected from a panel set up by the C&AG. Since these entities (especially for transmission and distribution) have operated like government departments, and audited by the C&AG until corporatization, their experience is limited to smaller firms. However, the choice o f auditor should include consideration o f knowledge and capacity to undertake the audit. Besides, the audit fees which power entities pay would seem low if compared with audit fees paid by other entities o f similar size ifrelated to revenue. Insome cases empanelled auditors have refused to audit distribution entities, given their spread and size, as the audit fees do not even cover traveling expenses to audit locations. This arrangement o f audit would clearly generate sub-optimal audit quality. Budgets for audit fee need to be reviewed and enhanced where appropriate. 66. Number of qualifications:In line with the scope o f work envisaged the auditor's opinion in the financial statement provides an independent and objective assessment o f the financial statement presentation o f an'entity. The qualifications in the opinion are meant to provide information on the factors that impact the business and financial position. Not one o f the 2323 entities examined was able to secure a clean audit opinion from its external auditors. The financial statements o f power sector entities carry a plethora o f qualifications that require complex study, yet the auditor pronounces the financial statements as "true and fair". Inmost cases, audit opinions are heavily qualified --both by the entity's private auditor and the C&AG. Inthe case of Uttar Pradesh and Rajasthan over 100 qualificationswere made by the auditors. While there has been some improvement in the number o f qualifications over the years, this aspect appears to be a recurring feature. Given the number o f qualifications and related aspects, it i s surprising that there was not a single "adverse" opinion or "disclaimer o f opinion" in these financial statements. (This space has been intentionally left blank) 23 Of the 27 entities reviewed, two hadnot submittedtheir annual auditedfinancial statements for FY 2003- 04 and in two other cases the entities were electricity boards rather than entities incorporated under the Companies Act, 1956. Page 22 Exhibit 13: Number of Qualificationsinthe Auditors Reportsover aThree-Year Period Uttar Pradesh* (4) 275 Orissa*** (7) 92 ~ Andhra Pradesh (6) ~145 ~ Ebjasthan** (5) J I 1 Punjab (1) 42 ~ 0 50 100 150 200 250 300 350 12000-01 W 2001-02 02002-03 Note: *For Uttar Pradesh the books o f KES have not been closed for 2000-03. For UPJVNL the Annual Report for 2002-03 and for UPPCLtheAnnual Reports for 2000-01 and 2002-03 are not available. **Annual Report for RRVUNLfor 2001-02 is not available. ***Annual Reports for NEESCOL for 2001-02 and in the case of GRIDCOL for 2002-03 are not available. The books for NEESCOL, CESCOL, WEESCOL and SEESCOL have not been closedfor 2002-03. 67. This provides a rough idea of the number of qualifications and the numerous accounting captions recorded by the audit01-s~~. Keepingtrack of their impact and understanding the overall financial position of an entity is thus quite a challenge. 68. Unquantifiable qualificationsand reporting of impact of qualificationson the financial statements: In most audit qualifications the auditor pronounced the impact on financial statements as "non-quantifiable" without giving any amount against them. Usually, these non- quantifiable qualifications are on account o f events, which impact the business but, given the situation, are not quantifiable. However, in the power sector entities, these non-quantified qualifications get repeated annually. For 2002-03, of the 17 entities analyzed, non-quantified qualifications related to 56 percent o fthe total funds invested which amounted to Rs 83,717 crore. Exhibit 14: Size of AccountingCaptions with Auditor's Non-QuantifiedQualifications & capitalwork-in-progress 24The number of qualifications is but one indicator-the levelof materialityo fthe issues raisedis another. Additionally delays in finalization of accountsare another factor to take into account before comparing performanceamong entities. A more detailed investigationwas outside the scope ofthis study. Page 23 69. Quality of qualifications: Financial reporting must principally provide intelligible statements and not be difficult to comprehend. This is clearly an issue, given the number o f audit qualifications that need to be considered, before arriving at the overall financial position. Apart from this, a recurringcharacteristic was the reporting o f immaterial qualifications. 70. While the concept o f materiality is subjective, such immaterial qualifications, which do not actually impact the "true and fair" view o f the auditor, undermine the significance o f really important qualifications and lead to significant issues getting lost. For the record, it can be mentioned that the quantified qualifications o f 17 entities for 2002-03 were either under Rs 10,000 or less that 0.5 per cent o f the operational revenues (referred to as "Materiality for Analysis" - MfA). The analysis shows that only 42 percent o f the qualifications would remain in the audit report ifmaterial qualifications alone were considered for reporting purposes. Exhibit 15: Qualifications for 2002-03 falling below Materiality for Analysis Qualifications State Number Total (Le. below MfA YO 100%) ................................................................................................................................................................................................................................................................ Punjab 18 69 26 Rajasthan 87 ................................................................................................................................. 72 121 .................................................................................................................................................................................................................................................... ............................................................................................................................................. Andhra Pradesh 4 9 42 " ................................................................................................................................................................................................................................................................ Orissa 11 58 19 ................................................................................................................................................................................................................................................................, Uttar Pradesh 5 50 10 Karnataka 4 50 8 Total 129 . 58% 226 :s for the financial year 2002-03. 71. Items such as environmental liabilities cannot always be quantified. In these cases the auditor's judgment on their impact must prevail. Page 24 C. What are the principalcauses for institutional and systemic weaknesses? 72. Several factors are responsible for institutionalweaknesses. Socio-political, institutionaland cultural factors require re-interpretation o f the incentive structure. Problems related to manpower, process and technology can be overcome by giving them greater attention. Above all, it must be kept in mind that unbundling of the SEBs requires extensive preparation and groundwork. It appears that the role of accounting, auditing and internal control in managerial responsibility i s inadequately appreciated by the senior management, which in fact i s answerable for both financial and operational performance. This may be partly due to the government's selection and recruiting procedures. It is therefore imperative that the government recognizes the role of accounting, auditing, control, management information and good corporate governance in improving sector performance. 73. People: Power entities are presently deficient inthe manpower resources required to meet all finance and accounts functions. The shortage o f skilled personnel relates to developing effective MIS for decision making, ensuring timely closure o f books, reconciling various accounts, completing and updating statutory records (like fixed assets registers) and other subsidiary records (like loans and advances registers). The following findings emerged from the responses to questionnaires used inthe study: 1 Entities with employees not exceeding 500 only have 4 percent comprising qualified professionals whereas for entities with more than 500 employees, the figure is approximately 5 percent. 1 For internal audit, entities with up to 100 employees have only 15 percent comprising professionals whereas for entities with more than 500 employees, the figure is approximately 3 percent. 74. Employee mind-set and training: The power entities do not have a system that recognizes merit or an evaluation based on performance and results25. Since promotions are time- bound, their personnel lack the incentive to improve, innovate or be creative. Additionally, since the management has often been drawn from the civil service, there are strong ties with the administration that reduce independent decision making. Assessment o f training needs has not been built into the human resource management system o f the entities. Thus, monitoring o f skills and refresher andtraining programs have not been accorded priority. 75. Autonomy: Even though the SEBs has been unbundled, some still lack financial and . operational autonomy. Financial Autonomy: The SEBs has unbundled in form but not substance. Most resultant entities are still controlled by the erstwhile directors. In Rajasthan, where the SEB has been unbundled into five entities, all have only one finance director. Similarly in Uttar Pradesh, out o f the four entities, three have the same finance officer. On the other hand, distribution companies in Andhra Pradesh have the autonomy to undertake a number o f initiatives in . finance and accounts and in implementing an online accounting system. OperationalAutonomy: The existing unbundled entities also lack operational autonomy. For instance, in one state the directors o f an entity are members o f the audit committee o f another 25This is reportedly a systemic problem across governmentsand state owned entities. Page 25 entity. In other cases, entities have a common chairman for their audit committees. An example o f this is Rajasthan's two entities: RRVPNL and AVVNL. A similar situation exists in Orissa for the two entities: North Eastern Electricity Supply Company o f Orissa Limited (NEESCOL) and Western Electricity Supply Company o f Orissa Limited (WESCOL). 76. Resources for capacity building: Historically, given that the finance and accounts function has not been at the core o f the "engineer driven" business, there i s significant resource constraint26on new investments and system upgradation. Further, inthe reforms phase, emphasis has been laid on improvement in technical rather than financial systems. Accordingly, with limited resources, utilities have not been able to implement various measures mandated by the regulators, often creating a hostile regulatory environment. 77. Incentives for improving reliability of financial information: Inthe present scenario there are no incentives available to the entities for providing reliable information. The MOPneeds to introduce an incentive scheme where entities, which provide reliable information, are given some recognition or credit. Such entities should be given higher weightage when funds are released under the APDRP. This will encourage healthy competition among the existing entities to provide accurate and fair financial information. 78. Computer literacy: The level o f computerization i s very low in the entities, as seen from the ratio o f personnel to computers and the use o f accounting software. This is extremely unsatisfactory in the dynamic operating environment and the management's need for decision making. Responses to the questionnaires substantiate this: 1 Only 36 percent o f the entities have a ratio o f one finance person to one computer and 27 percent have a ratio as highas 5-6 persons to one computer. 1 36 percent o f the entities use basic accounting software (such as Tally) and 64 percent use MSoffice (Excel and Word). 79. Sanctions framework: Since the SEBs are state undertakings, a strong operating sanctions framework for stakeholders' benefit does not exist, be it (i)employees for non-performance or negligence;(ii) auditors for inadequacy o f audit; and (iii)management for delivery o f targets. With this lack o f pressure on accountability, stakeholders operate without operational and regulatory requirements. 80. Internal audit: The issue presently is a lack o f standards for internal audit, auditor's skills and tools for assessing the technical aspects o f losses attributed to transmission and distribution. The conflict o f interest between the head o f the internal audit function, who reports to the finance director, and the external auditors must be resolved. 81. Audit committee: Audit committees o f the board have been set up in line with legal requirements but are largely ineffective in almost all cases. The directors on the audit committee are operational heads, and hence do not undertake a mutual supervisory function. The independent members o f the committee do not possess professional qualifications associated with this important function. The board cannot therefore assume that information provided by the management i s accurate. This doubtful scenario applies to the government and the public as well. 26The constraint is likely more of quality ofresourcesthan of quantity.. Page 26 IV. LESSONSLEARNT 82. A major lesson learntby the Bank is the importance of strengthening the institutions of public financial accountability in any reform process that involves large public investment. The need for unqualified audited financial statements within some reasonable time frame was not sufficiently empha~ized.~~ This was clearly underemphasized in the policy dialogue preceding the power sector reforms duringthe 1990s that led to unbundling o f SEBs. No comprehensive assessment o f the institutions o f public financial accountability was made; accurate, fair and timely financial positions o f the entities was not generated; nor were proper account balances produced. Thus, concerted effort and time will be needed for these problems to be fully resolved. As observed earlier, these entities are unbundled "de jure" but remain bundled "de facto". Karnataka proves the point, whereby the four distribution companies remain under a common senior management. Most entities still continue to have qualified audited financial statements. 83. In spite o f their commercial significance and customer service orientation, the culture o f the organizations remains bureaucratic. Unless this culture changes substantially, many issues would remain unaddressed. The system needs overhauling to shift it from a political and civil service environment to one, which is performance oriented and financially sustainable. In this regard, an independent observer has pointed out that the lenders should be more stringent in their statement o f conditions for development assistance to the sector. Another observer has suggested that privatization is the only answer, given the long-standing organizational culture prevailing across the system and lack o f autonomy vis-a-vis the government. Yet another believes that the time has come to emphasize the role of corporate governance for all public sector entities just as it is for listed companies. This is particularly so for public interest entities,28 such as in the power sector, funded by large sums o f public money. 84. The study validates the hypothesis that the financial information provided by the power entities is unreliable. This conclusion is based on: (i)findings o f the desk review o f published material; (ii)responses to survey questionnaires and discussions with the officials o f the entities; and (iii)other key stakeholders. Among the more glaring facts, which have come up, is the impact o f audit qualifications on profitability reflected in the annual reports o f the entities. If these qualifications are given effect then, in 40 percent o f the entities, the reported profit would either turn to losses or the reported losses would increase by 80-100 percent. One o f the crucial indicators for measuring the reliability o f financial information is the "true and fair" view of profit and loss and the state o f affairs (Le. balance sheet) o f the entity. However, apart from such major variation in the reported amounts after giving effect to audit qualifications, there is the question o f operational efficiency and recoverability o f 83 percent o f the total assets (Le. fixed assets, subsidy receivable and stores). These being suspect due to incomplete records and weak controls, it would then be fair to say that the financial information provided i s unreliable and a serious cause for concern. 27Additionally adequatetime andresources requiredfor the prioritizedset of reformactions were not provided inthe institutional development plans. 28 In India, public interest entities could include all listed companies (equity/debt), banks, financial institutions, mutual funds, insurance enterprises and companies with turnover in excess of a specified limit per year, companies with borrowings in excess of a certain limit and all holdinglsubsidiary companies of these. The ICAI Council has enunciated a similar definition for Level-I enterprises in connection with prescribing simplified accountingandreportingrequirementsfor small- and medium-sizedenterprises. Page 27 85. A number o f reasons can be given for this poor state o f affairs. Lack o f reliable financial information systems, poor accountability and weak controls are the key aspects that impact decision making within the organizations. The existing accountability institutions such as the management, internal audit, external audit, audit committees and the regulators are either ineffective or weak intheir present state. 86. Accordingly, adequate emphasis needs to be placed inthe reform process on the systems and institutional needs relating to the generation o f reliable and timely financial information for better financial accountability in the entities. The emphasis has to be similar for reduction o f T&D losses, commercialization, better consumer services and improved MIS. In Orissa for example, after several years o f reforms, the entities have still not been able to sort out the gap exceeding Rs 1,000 crore in receivables/payables between the companies. Further, issues regarding financial information led to one o f the private players "abandoning" the company, because o f which its accounts have not been approved and closed by the board meetings for the past four years. 87. Another key factor is the effort for change management. A wide and deep initiative on institutional capacity building can generate commensurate results, as in the case of Andhra Pradesh. This has to be considered along with the "tone set at the top" by the political establishment. Senior management o f the entities and Government (representing the owner) need to give priority to this important aspect o f reform. 88. The central and the state governments, representing the shareholders and the public, have a significant role. They may choose not to tolerate the inefficiency and work on efforts required to incorporate basic practices and strengthen systems o f financial accountability. It is widely believed that a modest reversal in the existing high level o f T&D losses2', from improvements in financial information and lack o f controls, would pay rich rewards and disentangle significant resources of the state governments. 29Reportedly over 35% insome cases Page 28 V. WAY FORWARD 89. Lack o f attention to financial accountability and management control i s a symptom o f the malaise in the sector. Poor financial reporting and systems enable vested interests within and outside the utility to continue to: (i)inappropriately access public resources; and (ii)tolerate incompetence and neglect o f work. Though this is a subset o f the larger governance problem in the sector, its solution i s unlikely to be independent o fthe sector's governance problems. 90. Duringthe study the various stakeholders clearly pointed out the "late-start" o f improvement in the financial and reporting systems. It was emphasized that reliable and timely financial information is a key component o f the overall reform program and a mainstream dialogue one, rather than a supporting one. The template for corporate governance for the public sector has yet to be promulgated. The power sector could be the point for departure. The appointment o f independent directors i s a case inpoint. 91, The way forward would require dialogue and action on major issues with stakeholder groups: state and central governments, the sector entities, regulators and institutions. A principal challenge is to change the traditional administrative/bureaucraticmindset3' o f the entities towards more managerial and performance orientation. This raises the question o f the skills and background that are critical for the selection o f the CEO/CMD. Empowering the finance function by appointing a financial management professional as the CEO/CMD may help since the medium-term challenges faced by these utilities are largely governance and finance oriented. Other solutions may emerge in a focused brainstorming session with stakeholders. One commentator has suggested that competitive selection o f Finance Directors including consideration o f outside candidates might also be considered. 92. The objective o f the recommendations stated below i s to enhance the institutional capacity o f the sector to strengthen governance and operational organization concerning people, processes and technology. Further dialome with power sector entities 93. The entities are the key stakeholders in the process o f improvement and are in the best position to implement operational plans. Long-term players are required in management to be held accountable for their actions or inactions. There is also an argument that senior managers from the private sector should be inducted on a selective basis to infuse a sense of financial discipline and accountability inthe system. . Some major actions could be: Clean audit opinion over a period: The sector entities should seek to eliminate all qualifications and aim for a clean report over a period o f time, say three years. This objective would put pressure on the management to work towards the removal o f repetitive qualifications and o f the non-material ones. 30Insome SEBs, the chief accountant'sjob was performed by engineers and the chief accountantis even designatedas chief engineer-accounts. Page29 . Reconcileaccounts with the stategovernment on an annual basis: The numbers related to subsidies is usually significant and, hence, action to confirm this amount would . provide significant assurance. Disclose transactions with relatedparties: This aspect would again address the issue o f non-reconciled accounts in the state government power sector as a whole, leading to . improved assurance across the entities. Invest in an integrated accounting system: This single item can have the most significant impact on the quality and reliability o f financial reporting information. With an integrated accounting system, there are more opportunities to link in with operational systems and thus reduce manual interventions in the accounting process. Entities often do understand the importance for this because o f other interests. Besides, being an internal effort, it may end up beingde-prioritized. Create an active and operational audit committee: Most o f the entities studied have audit committees whose members are usually operational directors, thereby removing any element o f independence and supervision. Given its supervisory functions, which are now even more important in the changed business environment, the audit committee needs to be made more effective by: (a) appointing independent directors; (b) providing a clear charter for the audit committee; (c) ensuring that the internal audit function report to the audit committee instead o f the director finance or chairman (as is . usually the case); and (d) placingthe reports o fthe audit committee inthe public domain. Incorporate the operational tools of improvedfinancial reporting: The entities should aim at developing appropriate tools in the form o f checklists for consolidation and book closure, reconciliation procedures, responsibility matrix and other related issues to ensure accuracy, completeness and timeliness o f financial reporting. Additionally, another aspect that is lost with movement o f personnel i s the reporting processes followed by the units for monthly and annual book closure. This can be streamlined, strengthened and . documented for which an important startingpoint is the revamp o fthe chart o f accounts. Disclose monetary impact of T&D losses: In order to be more transparent on this account, rather than disclose the units lost, the entities should disclose the monetary loss . that the shareholders incur on this account (or a loss range, ifrequired). Adherence to the statute on book closure: Clean audit opinion and an integrated accounting system are essential. With this, the entities also need target timely closure o f books and adherence to Sections 166 and 210 o f the Companies Act, 1956 that calls for the adoption o f accounts within six months o f closure o f the books o f accounts. Further dialopue with the state povernments 94. The state government being the owner o f equity, and usually also the manager o f these . entities, has to play a significant role, especially inpolicy making for the sector's efficiency. Development of a customer service charter: This would address unclear operational areas, which can be used by the entities to ascribe actions to the government and, conversely, applied by the government to pull up the management for its actions and Page 30 decisions. For this, a customer service charte?l should be put in place, with the followinginmind: - Being primarily an agreement between the state government and the entity, the charter should set out expectations, roles, commitments and responsibilities,with the focus on deliveryofefficientandhigh-qualityserviceto the customer. - The government should lay down service levels expected from the entity wherein: (i) the subsidy commitment, its delivery mechanism and timing is clearly articulated: and (ii)the roles and degree of financial and operational autonomy are defined upfront,thereby addressingany issues ofstate governments not providingautonomy. - Getting the customer involved in service standards brings about transparency and adherence to delivery requirements. It also provides the public a mechanism to pressurize the parties to the agreement and become accountable for their actions or inaction. - The charter can includethe T&D loss statement, which explains how much was lost (in units and cost), andthe processby which this is to be mitigated,through either (i) additional tariff burden on the customer or (ii)government subsidy impacting the . taxpayer. Hiring of relevant skill sets: This will allow power sector entities to recruit suitable qualifiedprofessionalsfromthe financialmanagement community. Amongthe key issues citedby sector entities is their inabilityto recruitthe relevant skill sets on account of state government embargos on recruitment and their inability to offer market compensation. Thus the state governments may consider the Andhra Pradesh model, wherein appropriately skilled professionals were hired as consultants for 1-3 years, thereby impartingthe requiredskills to managethe functionmore efficiently. Monitoring of progress: The state governments need a system for follow up and monitoring of the program to strengthen the institutional capacity for financial accountability. For this, the governments should place the issue of improving the reliability of financial information on the regular agenda of their boards. Such monitoringwould show the entities that the state governments are serious about getting fully involvedin improvinggovernance and accountability. Further dialoguewith the central povernment 95. The central ministries, beingthe primarypolicymakingbodies and sources of funding, play a key role in nudgingforward the steps being taken by the state governments and sector entities. No doubt, lending to the sector without enhanced conditionality on the quality of financial informationwould be imprudent. Lenders need to be more vigilant. For example, they should not accept qualified audit opinions, as in the case of listed companies (Clause 49 of SEBI). Similarly, the appointment of independent directors on the boards of all power sector entities would strengthen the quality of governance and accountability. Another issue of corporate governance that requires attention is the manner in which auditors are appointed - external and 31Thisis an expansionofthe conceptofthe purchaserproviderreportedinthe Karnataka State: Public Financial Management andAccountability Study, February2004. Page 3 1 internal, One observer pointedout that the appointment of external auditors should rest with the boardandhavethe C&AG's concurrence. . Some ofthe principalactionareasthat canbe pursuedbythe Bank are: Application of appropriatecommonset of principles of governance and accountability: The power entities have a significant involvement with the public regarding:(i) of usage public funds (investodshareholder); (ii)impact of services on the public at large (customer); and (iii)use of publicly raised funds (public banks/ development funds). Basically, the profile would be similar to the publicly listed companies. However, it is evident that the corporate governance principles applicable to publicly listed entities do not carry weight inthe public entities, which have the least supervisory obligations. In view of this, some of the mainobligations applicable to publicly listed companies (such as the recently notified revised Clause 49 of SEBI) should also be made applicable to these public sector companiesand include: - Assertions by the CEO and CFO on the operation and adequacy of internal controls over internalfinancialreporting. - Appointmentof independenthon-executivemembers of the audit committee and the board. - Minimalcharter of the audit committee. Design new incentive mechanisms such as Accelerated Power Development Reforms Program (APDRP): While it is still being debated as to how far such schemes are effective and can be monitored, there may be some scope of incorporating important parameters into the CRISIL ratings, done by the MOP. These ratings build in certain incentives for disbursal of funds under the APDRP. Among the rating parameters considered are factors on financial risk analysis, others and the progress in attaining commercial viability (Annexure VII). However, some of the current parameters on "others" are not as measurableas for other areas. Accordingly,the following parameters canbe modifiedto makethem more measurableandtransparent: CurrentParameters .. ModifiedParameters Current qualityof .. . Timelinessofbook closure - audit informationsystems. opiniondate. . Consistencies in Number and significanceofaudit informationreceived. qualifications. Extentto which the Independenceofaudit committee- .. utilitieshavebeenableto appointment of independentaudit computerizetheir systems. committee members. Size andexistenceofunreconciledIUT. SERC directiveson quality of information,ifany. Extentofusageofcomputer applications for: (i) energy flow monitoring; (ii)customerbilling systems; (iii)complaints management; (iv) accountingsystem; and (v) other uses. Page 32 Another aspect, which can be addressed, is the weightage o f "others", which currently is marginally over four per cent in the overall rating. This can be suitably increased to reflect the importance and focus on reliability o f information. The central government could also explore other avenues like allocation o f additional power to incentivise the . state government power sector entities. Clarification on statute relating to accountingpolicies -Electricity Act, 2003: The central ministry could issue a clarification in unambiguous terms about the statute to be followed and its related policies. This can be done by way o f an order or by introducing new rules in the Electricity Act, 2003. Given the implementation issues, clear timelines . needto be provided, within which the transition needs to be achieved.32 Chart of accounts: A common chart o f accounts would assist in consistency o f financial information provided to the government, management and regulators. Further dialoguewith remlators 96. Can anything be done to improve the regulator's effectiveness? The SERCs are amongst the few bodies that can generate adequate responses from the sector entities. They can impose conditions aimed at improving the reliability o f information and advances in MIS. The areas . where dialogue can be opened include: Timeliness and quality of auditedfinancial statements: The regulator can demand that ARR filings carry the prior year's figures from the audited financial statements. Many licensees file unaudited numbers, even though the Companies Act, 1956 mandates that the entities must ready their audited accounts within six months o f the end o f the financial year. Audit qualification should be read carefully and entities reprimanded for . providing unreliable i n f ~ r m a t i o n ~ ~ . Regulators could allow an amount in the tariff for improvement o f accounting systems and then monitor for improvement. Limited review of ARRfiling actuals: The ARR filing meant to provide the numbers based on actual performance for the six months ending September 30th. The regulators may demand that the auditors subject this to a "Limited Review". This is similar to entities listed on the stock exchange, which are required to have their quarterly numbers subjected to a limited review by the auditors within a month o f the end of the quarter. This step would lessen the scope for any "adjustments" that the licensees perform and . also make the projections for the six months more realistic. Laying down an improvementroadmap and its monitoring: This mode for laying down areas o f improvement in reliable and timely information (as done by the Punjab reg~lato?~)can put pressure on the entity to get its house in order, in addition to laying down a transformationtimeline within which to get results. 32As the ElectricityAct, 2003 supersedes all existing acts and rules there is a needto review the sections in the Companies Act, 1956 related to accounting policies and depreciation so that there is harmonious constructionbetweenthe two inthese matters. 33Incases where penalizing an alreadybankrupt entity by deductingfunds is unlikelyto yield goodresults other measureswould needto be explored. 34 See note on reliability expressed by regulatorson financial information submitted by licensees in Section IIIA. Page 33 Further dialome with the accounting and auditiw profession 97. The need for a clear cut and common statement o f accounting policies35 and financial reporting is paramount. So long as there are conflicting rules, the quality o f financial information will remain problematic. Amongst the institutions that the Bank can work with are C&AG, the I C A I and the ICWAI. The profession could prepare a template for accounting reforms needed in the power sector and a manual o f procedures that are required for implementing a more modern systemo f financial management, control and accountability. Areas where dialogue can be opened include: 1 Choosing the auditor: The choice o f auditor can be made more transparent in order to: (i)gettherelevantcapacity, and(ii) provide a minimumlevel of fees based on the size o f entities. This can be similar to banks, where the auditor for the head office must have a minimum number o f partners (15). Also, fees are based on the total asset size.36 A similar framework can be developed for the power sector entities to improve the quality o f audits. 1 Classificationof audit opinions: The C&AG's report issued to the sector entities does not sufficiently project the degree/seriousness o f qualifications by the auditor. A classification pattern on the lines o f clean, qualified, adverse and denial o f opinion would be a fundamental input for the financial statements. 1 Disclosure on standards of auditing and scope of audit: The C&AG's report included in the entities' annual report does not refer to the standards o f auditing that have been followed and is a basic gap inunderstanding the financial statements, since the scope and approach o f the audit i s unclear. This is so in supplementary audits, where an audit is performed by the C&AG after a chartered accountant has issued an audit opinion. Disclosure o f this would provide a better understanding o f financial statements. The C&AG's reports on the power entities should also be disclosed in the C&AG's annual report to the legislature. Prioritization based on materiality of qualifications: Usually, when the C&AG is the prime auditor, there are a large number o f qualifications. The manner in which the qualifications are presented may often lead to important issues and significant qualifications being missed. However if these same are prioritized and classified, a better understanding o f the financial statements will result. In particular, a common understanding on what is a material error for financial reporting needs to be articulated. 1 Performance evaluation of auditors: The I C A I has started initiatives on peer review mechanisms. However, there is a need to significantly enhance this effort in order to bringabout consistency inadherence to standards o f auditingand reporting. ''This study does not recommend that accounting standards for each sector be different from those that apply to general purpose financial statements that is, Indian GAAP. However, the regulators may recommendadditional reporting requirements. Here too a common set of requirementsacross the states is advisable. 36See footnote 36 of India: Report on Observanceof Standards and Codes ( ROSC), Accounting and Auditing, The World Bank, December2004. Page 34 . Trainingof C&AGauditors in modern "attest" auditing:Giventhe advancementsmade inaccountingand auditingstandardsover the last few years, a revisedtrainingcurriculum for the auditorsto upgradeandupdatethe skill-setsshouldbe a priority. Government's Comments The Ministry of Power provided comments on the Noteto the Ministry of Finance on 19`hApril 2006. These were forwardedto us on 11th May, 2006 by the Dept. of Economic Affairs. The Government's commentsandour responsethereonis providedbelow: "While the Policy Note has definitely suggested a way forward, the Dept. of Economic Affairs should keep in view that these dialogues with stakeholders will be a longdrawn process. It is not clear from the recommendations as to which entity would guide and facilitate the dialogues and consequential actions. A dedicated coordinating systems/structure to conduct & conclude the dialogues and evolve a time bound actionprogramwill be requiredto be identified/set up. The same structure can take up the task of development of performance indicators, operational plan and monitoringthe progress of implementation. This structure should involveprofessionalswith required skill set and should be given the control over deciding the incentives based on achievements." Bank's Response The Ministry of Power should take the lead for guiding and facilitating the dialogue and consequential actions. In this regard, the Ministry of Finance and the Ministry of Company Affairs along with the Comptroller and Auditor General are among the key stakeholders at the Uniongovernment level. 98. In conclusion, given the various actions listed above, there is a requirement to improve the reliability of financial information emanating from the state power sector. It would help if the central government developed a monitoringsystem for trackingprogress. For this purpose, the Bank could, in consultationwith the central government, develop a set of performance indicators for improved results and outcomes. It would also help ifthe accounting and auditingprofession took concurrent responsibility to emphasize to the government that infusion of professional accountingskills is fundamentallyimportantto the state power sector. Page 35 VI. LIMITATIONS 99. As tasked, the work discussed in the earlier sections is based solely on information from the Bank, power entities and also limited discussions with the key stakeholders o f these entities. In this regard, the ultimate responsibility for accuracy and completeness o f data shall lie with the respective organizations. There is no opinion or any other form o f assurance on the functioning o f any power entity. 100. The results o f the work, the responses to the questionnaires, and other discussions held with various stakeholders comprise the evidential matter that has been relied upon while performing the task. The report has not been discussed with the entities analyzed at this stage. However, it has been discussed with the Union Government-Ministry o f Finance, Ministry o f Power and officials o f the Comptroller and Auditor General o f India. The formal response o f the Government o f India has been incorporated inthe body of the Report. 101. The intention i s to disseminate the results o f this work with the stakeholders including the management o f the entities involved. The views o f these entities and state governments would enrich the quality o f the debate and understandings to support the way forward being proposed in this Report. Inthis regard it is important to note that this study is more about the institutions o f public financial accountability (that are a common requirement) than the internal management systemso fthe entities that may vary across the states and the entities themselves. Further work is necessary for a greater appreciation o f the internal Management Information Systems (MIS) and procedures o f the entities. Page 36 ANNEXUREI List of Entitiescovered by the Study PSEB Punjab State ElectricityBoard Rajasthan RRVUNL RajasthanRajyaVidyut UtpadanNigamLimited RRVPNL RajasthanRajyaVidyut PrasaranNigamLimited JVVNL (Jaipur) Jaipur Vidyut VitranNigamLimited JVVNL (Jodhpur) JodhpurVidyut VitranNigamLimited AVVNL Ajmer Vidyut VitranNigamLimited Orissa OPGCL OrissaPower GenerationCorporationLimited OHPCL OrissaHydroPowerCorporationLimited GCOL/GRIDCO GridCorporationof Orissa Limited NEESCOL NorthEasternElectricitySupply Company ofOrissaLimited WESCOL WesternElectricitySupplyCompany of OrissaLimited SESCOL SouthernElectricitySupply Company ofOrissaLimited ~ CESCOL CentralElectricitySupply Company ofOrissaLimited Andhra Pradesh APPGCL Andhra PradeshPowerGenerationCorporationLimited TCAPL TransmissionCorporationofAndhra PradeshLimited EPDCAPL EasternPower DistributionCompany of Andhra PradeshLimited SPDCAPL SouthernPowerDistributionCompany ofAndhra PradeshLimited CPDCAPL CentralPowerDistributionCompany ofAndhra PradeshLimited NPDCAPL NorthernPower DistributionCompany ofAndhra PradeshLimited Karnataka KPCL KarnatakaPower CorporationLimited KPTCL KarnatakaPowerTransmissionCorporationLimited KREDL KarnatakaRenewableEnergyDevelopmentLimited Tamil Nadu TNEB TamilNaduStateElectricityBoard Uttar Pradesh 1JPRVlJNT. Uttar PradeshRajyaVidyut UtpadanNigamLimited UPPCL UttarPradeshPower CorporationLimited UPJVNL UttarPradeshJal VidyutNigamLimited K E S Kanpur ElectricitySupply(subsidiary) Page 37 ANNEXURE I1 Approach to the Study Phase I -Assessment of Requirements The aim was to: (a) perform a high-level assessment o f the existing financial reporting and auditing related processes; and (b) understand implications o f revisions that might be undertaken by the power entities based on recommendations. The activities, which were carried out under this phase, are listed below: 1 Discussions with key stakeholders to understandexpectations. 1 Review o f financial statements, accounting policies, and annual reports, etc. 1 Identification o f applicable statutes / acts and relationships between various stakeholders, for example power entity and the regulator. PhaseII-Development of Questionnairesand DesktopReviews In order to gain an insight into the existing financial reporting and audit related processes and practices followed by the power entities, customized questionnaires were developed and administered. These questionnaires were backed by visits to select SEB locations that included conducting interviews and holding discussion meetings with key process owners at the power entities listed above. The following table presents the level o f participation undertaken by the entities inthe various states inthis process. States INo. of IEntity Type* IQuestionnaire Questionnaire YOReceived I I I *S=SEB, G=Generation, T=Transmission,D=Distribution. This phase also entailed desktop reviews, which covered review and analysis o f the financial statements, annual reports, ARR filing, and other related material for the purpose o f the study. Phase III-Collation andAnalysis On receipt o f responses to the questionnaires, information was collated, tabulated and analyzed for drawing conclusions on the currently operating procedures followed by the power entities. Based on an understanding o f the processes, analysis o f responses to the questionnaires and SEB visits, gaps were identified. Good practices and improvements were recommended for redesigning and streamlining the financial reportingrelated processes. PhaseZV- Discussionsand Completion of the Report The study was discussed with key stakeholders, and their comments were incorporated in the report. Page 38 ANNEXURE I11 RepeatedAudit Qualifications Repetitio over 3 Repetition Qualifications years YOternwer 2 year,YOterm Proper subsidiary books not maintained 6 24 8 32 Non- compliancewith accountingstandards AS2 6 24 9 36 hS6 10 40 13 52 IAs9 II 4 16 4 16 AS10 6 24 7 28 AS12 5 20 9 36 8 32 11 44 owards the value of assets and liabilities as per the transfer scheme have not been provided, therefore these balances are 5 20 5 20 subiect to adiustments. Inter-Unit Reconciliation not carried out 11 44 14 56 urrent Liabilities & Current Liabilities one of the balances have been confirmed for sundry. II Icreditors. 9 36 12 48 IFixed assets I No physical verification carried out 14 56 18 72 Fixed assets register not maintained or is not properly kept. 11 44 15 60 Current Assets & Loans and Advances Advances under the head loans and advances have not been reconciled and confirmed, and are long outstanding. 4 16 8 32 Procedure for physical verification of stores is inadequatehot carried outheports not made available to the auditors. 5 20 9 36 'Under/overstatement o f stock of material 4 16 6 24 No management system to determine unserviceable stores 8 32 11 44 one o f the balances for sundry debtors have been confirmed 7 28 9 36 Bankaccounts not reconciled 8 32 10 40 i Cash intransit i s neither confirmed nor reconciled 4 16 5 20 Other Qualifications The internal audit system is not commensurate with the size andnature ofthe business 13 52 15 60 nternal control procedures are not commensurate with the size ofthe company and the nature o f its business 5 20 8 32 ISeveral accounts under the head cauital advances: c m x /liabilities and current assets have not beenreconciled 4 16 6 24 Page 39 ANNEXUREIV List of Accountinp Standards issuedby the ICAI Accounting Standards AS-1 Disclosure of accountingpolicies AS-2 Valuation of inventories AS-3 Cash flow statements AS-4 Contingenciesand events occurring after the balancesheet date AS-5 Net profit and loss for the period, prior period items, and changes in accounting oolicies Page40 ANNEXURE V Annual Reports Available for Study J Annual reports available I * Annual reports not available I8 Booksnot closedI Page41 ANNEXUREVI CRISIL Rating Parameters On an overall basis the weightage used is as follows: Parameter Original Revised External 40 30 -State government parameters 20 17 -SERC related parameters 20 13 Internal 60 70 -Business risk analysis 25 27 Generation 6 6 Transmission & Distribution 19 21 -Financial risk analvsis 30 23 Other 5 Progress in attaining commercial viability I, NA I I155 1 The key aspects evaluated under each o fthe areas can be summed up as follows: (a) State Government - Progress in reforming the sector interms o f milestones laid down inthe Memorandum o f --- Understanding (MoU) / Memorandum o f Agreement (MOA)with MOP. Progress inattaining 100 percent rural electrification. Track record interms o f subsidy payment. Timeliness in release o f funds obtained under the APDRP scheme by the respective state --- government to the utilities. Structural adjustment support provided to the sector. Success in increasing revenue realization through implementation o f anti-theft measures. Success in terms o f increasing generating capacity, either in the state sector or through creating an enabling environment for private producers. (b) State ElectricityRegulatoryCommission(SERC) -- Timeliness in terms o f issuingtariff orders. Actual implementationo f tariff orders as well as other directives that may be contained in - the order. Nature and scope o fthe tariff order, which would include both tariff and non-tariff issues. (A negative mark of 2.5 is assigned to states that areyet to set up an SERC.) (c) BusinessRisk Analysis - Performance o f the power plants in terms o f PLF, availability factor, auxiliary power - consumption. Progress in distribution reforms with respect to key areas like metering all 11kV feeders, energy audit and increasing the quantum o f units billed on a metered basis. Also, the scoring against the energy parameter has been capped at 2.5 out o f a maximum o f 5 since comprehensive energy audit is possible only after all distribution transformers and - consumers are also metered. Manpower levels, both absolute compared to normative parameters, as well as their - trends, with a negative marking o f one incase the trend is adverse. Aggregate technical and commercial losses. Page42 (d) FinancialRiskAnalysis ----- Coverage o f costs through revenues. Track record o f debt servicing. Trends inreceivables and power purchase / fuel creditors. Progress interms o f fundingpension and gratuity liabilities. Projected performance over a one-year time horizon. (e) Others - --- Current quality o f information systems. Consistencies in information received. Filingwith SERC. Extent to which the utilities have been able to computerize their systems. (f)ProgressinAttainingCommercialViability - Gap between ARR and ACS both in absolute and percentage terms. Further ARR is computed on the basis of cash collections since it is cash flows alone that enable an utility to meet operational expenditure, service debt and invest the surplus, if any in - modernizationand expansion projects. Trends in cash loss reduction compared to 2000-01 as base year. Page43 ANNEXURE VI1 Concept Note on Public FinancialAccountabilitv Assessment of State Power Sector Entities(CPN) I.Introduction 1. The India CAS identifies the power sector as a key sector on the reform agenda linked to India's development priorities. The Bank is heavily engaged in this sector, in terms o f both investment and adjustment lending operations. The portfolio o f investment projects includes six projects, one each at Orissa, Uttar Pradesh, Rajasthan, and Andhra Pradesh, and two at the center, with overall commitments inthe US $ 1.5 billion. Some $ 600 million have been disbursed up to FY 03. Procurement o fgoods and services constitutes a significantpart o fthese investments. 2. The power sector is a consumer o f very large subsidies. Subsidies amount to over Rs 30,000 crore per annum. There are concerns regarding the accounting, internal control, auditing, reporting and scrutiny arrangements - internal and external in relation to generation, transmission and distribution companies across India. The Bank has identified a number o f constraints to sector performance. These constraints include poor financial information and weak corporate g~vernance.~'Efforts have been underway in many states to improve system performance, including unbundlingand privatization. The performance o f the sector remains below par inmany states. Utilities often continue to provide poor service to customers, particularly in the rural areas.38 Technical and financial losses (example unmetered billings) remain high (estimated at 40-50 %), threatening fiscal stability. There is also lack of transparency regarding such losses and o f the activities o f some o f the entities. Annual financial statements are often late or incomplete. Audit reports are mostly qualified. 3. Entities in the power sector are either statutory bodies (SEBs), or corporatized government owned entities established with the unbundlingo fthe SEBs, Go1owned public sector corporations (NTPC, POWERGRID, NHPC etc.) and some private utilities (Reliance Energy, TATA Power, CESC, private discoms in Orissa, Delhi etc.) under the jurisdiction o f the Companies Act, 1956. The SEBs must comply with the reporting requirements o f the Electricity Supply Act and are expected to comply with specified accounting rules that may be stipulated in the incorporating statute. Inthis environment, there is a highrisk o f information asymmetry. The process o f public hearing o f A W t a r i f f issues by the electricity regulators i s a positive development over the last few years. It puts the information on costs, subsidies, and operational performance in public domain, thereby putting the appropriate pressures on the entities to improve availability and quality o f information. . 4. Studies undertaken in the past on the financial viability o f the power sect03~uncovered a number o f problems. For example, tariffs are often below expected full cost recovery, operating efficiencies are low, and staffing levels in many utilities are among the highest inthe world. For instance, there is increasing awareness o f theft, poor billing and collection procedures. The types o f remedial action necessary to improve performance have also been highlighted. But sustained progress and results on the ground are not yet evident. One reason may be the insufficient stress 37TheWorld Bank,SouthAsia Energyand InfrastructureUnit, Strategy Paper, November2002. 38While over Sopercent ofvillages have electricity, it is estimatedthat only 35percentof householdshave access. 3yExample: (i) `Restructuring the Power Sector': a study carried out by ICICI for the Go1 January 2000 ; and (ii) the `Study on Accounting in the Power Sector' by the Institute of Chartered Accountants, New Delhi, Research Committee, First edition, April 2002. Page 44 laid on the link between sound financial management and accountability and sector-wide performance. Nevertheless, recommendations from these studies have had some positive result. The need for modernization in several areas has beenwidely acknowledged including accounting and reporting arrangements. A new Electricity Act, 2003 incorporating incentives for performance has recently been approved by Parliament. 5. The ICAI has made efforts to improve the form and content o f the accounting and financial reporting arrangements4' in the sector. Yet, it i s widely believed that these functions (including financial reporting) have not been operating satisfactorily at many public sector undertakings (companies and boards) in the sector. There may be systemic issues o f financial accounting, accounting policies:' reporting, and auditing with significant capacity gaps requiring further attention. These areas would be o f likely interest to the sector strategy and dialogue and will also help inbuildingup the FMcomponent infuture investment projects. 6. The study looks at issues o f public financial accountability with emphasis on "disclosure" from a corporate governance per~pective.~~For instance, do entities provide sufficient information on pension obligations, contingent liabilities, guarantees etc? The overall purpose is to enhance the effectiveness o f the system o f public financial accountability and management o f power sector entities at the state level. This would also entail a limited study o f the role o f the regulatory bodies and other oversight committees. The emphasis will however be on those aspects o f disclosure such as accounting, financial reporting and auditing arrangements that may not have been examined inprevious studies. 11.Rationale 7. . The rationale for undertakingthe study is the following: The reliability o f financial information, especially the audited financial statements o f the power sector entities warrants continuing attention o f the GoI, state governments and donors. All power companies are required to file annual revenue requirements to the regulator. The returns filed must be based on the books o f accounts. Do the "books" . provide a sound and consistent basis for measuring entity performance and fair presentation o f financial statements? The power sector is a major consumer o f government subsidies -explicit and implicit. State government guarantees can be substantial. The reliability o f cost information is a . key factor for the decision-making process in the setting o f tariffs. I s the regulator satisfied with the quality o f financial information provided by the entities? A large part o f the power sector is in the public sector - where corporate governance, financial accountability, transparency arrangements and auditing are widely perceived to be below par. 4uICAI has done astudy on prevailing accountingstandards inthe sector and acomparisonwith nationalstandards. 4'For example, review of how the accountingpracticeshaveevolvedon the change from boards, to corporatizationto privatization. 42The OECD principles of corporate governance recognizes the need for timely and accurate disclosure on all material matters regardingthe entity including the financial situation, performance, ownership and governanceof the company. Of the 15 elements of corporategovernance, set out by consultantsat McKinsey, six relate directly to aspects of public financial accountability. These are: board guidelines; board committees such as audit committees; disclosure requirements; accounting standards; independent audit; access to information;andtimely disclosurerequirementsto regulators. Page45 The quality ofjnancial information on power sector entities is a key consideration for . investors given the large capital investments involved and higher than necessary recurring technical and financial losses. Reforms have been undertaken in certain states, such as privatization o f distribution companies. The time is right to examine lessons learnt, and assess whether improvements in financial accountability (including reporting and external auditing) and . overall performance have ensued. Also, whether they can be demonstrated as benejts of privatization. Post Enron, the importance o f fair presentation o f audited financial statements has become a global issue, Are there any lessons for the Indian power sector? Are there any . significant institutional constraints that impact on public financial accountability? Why do most entities have qualified audit opinions? Limited information available to the public on the extent to which major public sector undertakings (including electricity boards) are meetingthe entities stated objectives. 111.PurposeandScope 8. The primary purpose o f the recommendations will be to inform Bank dialogue [feeding into the Country Assistance Strategy (CAS)] on the need to improve quality and fairness o f reporting and overall answerability for the management o f public investment inthis sector. A key objective is the identification o f recommendations aimed at improving the standards and practices associated with sound financial and audit reporting. 9. The scope would cover the primary institutions o f financial accountability - a thorough study o f accounting (both policy and practice), reporting and auditing arrangements (including audit committees) and to a more limited extent related government scrutiny arrangements for public entities. This work will include a broad assessment o f the entity systems supporting the preparation o f timely and reliable financial i n f ~ r m a t i o n . ~ ~ 10. The institutional framework for public accountability will be reviewed. Benchmarking with best practice (from public and /or private sectors) would assist in highlighting areas for further improvement. The backdrop o f the corporatization drive in the sector may offer opportunities for identifying areas where adoption o f good practice from other jurisdictions may be very useful. 11. The present accounting and auditing regulations demand a C&AG audit o fthe SEBs under the provisions o f the Electricity Supply Act. The C&AG o f India appoint the statutory auditor for all government companies (majority owned by GoI). , Buthow effective are these arrangements? Distribution companies (some o f which have majority private holding) are audited by private auditors instead o f the CAG. As part o f this study, we would review the system o f a pointment o f private auditors, including consistency instandards, and determination o f their fees! Issues o f transition resulting from the move towards privatization should be o f interest. Timeliness o f financial reporting would be a case inpoint for comparative performance. `'Work on assessment of financial managementsystems in powerutilities has alreadybeendone underthe Bank's current projects. 44The provisions of the Electricity Supply Act prevailwherever the provisions of the CompaniesAct, 1956 are inconsistentwith the Electricity Supply Act. Page46 12. The states o f greatest interest would be Uttar Pradesh, Orissa, Karnataka, Andhra Pradesh, Punjab, Tamil Nadu and Rajasthan. There are approximately 29 entities (of which two are statutory entities) operating in these states. In some o f these entities, financial losses are being reported; and, in many cases, "up to date" accounts are not readily available, audit reports are qualified, and therefore the a "true and fair" financial position of an entity i s difficult to assess conclusively. This, in turn, raises questions regarding the reliability o f information for financial management and accountability. 13. Note: Scope exclusions - legislative scrutiny, detailed review o f MIS, human resource issues and allegations o f corruption inthe system. IV. Methodology Review o f existing material available at the Bank, consultations with task teams and consultants, including those involved with the study on governance in the power sector in order to develop an appreciation o f existingknown concerns with audited financial statements and related information and to seek advice on matters o f significance. Develop a list o f all the entities inthe sector (public and private) at the concerned states with a profile o f the investments involved, ownership, governance arrangements and annual audited financial statements o f the individual entities. Establish contact points at the governments and entities involved as appropriate, and discuss methodology with officials of the state and the regulator to get input and modify as appropriate. Research requirements (including standards and codes) for accounting, disclosure, auditing and public scrutiny; specified in the relevant legislation, regulations, rules, I C A I pronouncements etc. Research on what constitutes sound standards, codes and practices relating to accounting, disclosure, auditing, and scrutiny practices in other jurisdictions - national and international in consultation with Organization for Economic Cooperation and Development (OECD) pronouncements etc Examine relevant reports based on recent studies on the power sector in India (central and states), including those prepared by other development agencies such as Department for International Development (DFID) and Asian DevelopmentBank (ADB). Collect and examine relevant accounting, disclosure, auditing and reports submitted by power sector entities to the boards of directors including audit committees, government, regulator and /or the public. Examine whether the above reports meet the requirement o f sound practice in the context o f good governance and public accountability. Page47 . Hold discussions on the systemic accounting, reporting and auditing issues with the concernedentities inthe sector. Note: A list of specijc tasks to be undertakenis enclosed in Attachment I. v.outputs 9 Note settingout the results o f the study: . Key PFA issues relating to: The institutional framework for public financial accountability and management in the . . power sector - with focus on accounting (policy and practice), reporting, auditing and related disclosure policies and practices; The related operating procedures with reference to "sound practice". Recommendations for improving Bank dialogue (sector strategy including FM components) on sector-wide performance (feeding into the CAS) in terms o f better accounting, reporting and auditing arrangements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 48 Attachment SpecificTasks that will be undertaken: . Effectiveness o f Accounting, Disclosure, and Financial Reporting To identify and examine the requirements for accounting, disclosure and reporting specified in the legislation, regulations, rules, etc. for their appropriateness in the .. context o f sound financial reportingand transparency. To identify the reporting arrangements for the executive, to the regulator, and the public inresponse to the previous point. Assessment o f main issues for the Bank relating to accounting, financial reporting and disclosure requirements and institutional arrangements and practices for enhancing reliability o f information. Effectiveness o f External Auditing .. To identify and examine the requirements for external auditing specified in the legislation, regulations, rules etc. for their appropriateness. . To identify the reporting arrangements made by the external auditors to the boards of directors, the executive, and the public inresponse to the previous point. Assessment of the main issues relating to the auditing arrangements in place - external and internal including the effectiveness o f audit committees where applicable. . Government Scrutiny To identify and examine the arrangements for government scrutiny over the power . sector companies including disclosure requirements specified in legislation, regulations, rules etc, for their appropriateness and transparency. To determine the extent to which the arrangements such as departmental oversight, internal audit etc. are exercised and effective as a basis for government monitoring and control. Page 49 ANNEXUREVI11 Questionnairesdevelopedby the World Bankas part of the Study of FinancialAccountabilitvSystemsof Power Sector Entities inIndia. 1. Statutory Audit Questionnaire covers the following asDects: a. Background b. Approach C. Audit risk d. Planning e. Internal controls f. Execution g. Audit report and qualifications h. Reviewby C&AG 1. Disclosure j. Joint auditors 2. Internal Audit Questionnaire covers the following aspects: a. Overview b. Functioning c. Internal control d. Training e. Reporting 3. Audit Committee Questionnaire covers the following aspects: a. Overview b. Composition C. Functioning d. Roles/responsibilities e. Powers f. Review ofinternalcontrol 5 Statutory audit 4. Finance Head Committee Questionnaire covers the following aspects: a. Overview b. Policies and practices C.Training d. Computerization e. Consolidationof accounts f. Financialreporting g. Controls h. Disclosure 5. Regulatory Commission Questionnaire covers the followinp aspects: a. Quality of financial information b. ARR filing c. Other information received bythe regulator from the power entities and needs to be filled by the ChairmadMember of Regulatory Commission. Page 50 ANNEXUREIX List of Persons Interviewed R.S.Mann, Chairman, Punjab State Electricity Regulatory Commission. Y.C. Satyavadi, PrincipalAccountant General, C&AG, Punjab. SurinderPal, Member,Andhra PradeshElectricity Regulatory Commission. R.K.Aganval, Director, Finance, RRVPNL. Anand Joshi, Chief Controller of Accounts, RRVPNL. Shanti Prasad, Member, Rajasthan State Electricity Regulatory Commission. M.S.Palawat, ChiefController ofAccounts, JVVNL. M.Sahoo, Joint Secretary, MinistryofPower. C. Srinivasa Rao, Director, Finance, Central Power Distribution Company of Andhra PradeshLimited. Smt.Ajanta Dayalan, Secretary, Punjab State ElectricityRegulatoryCommissions. A.K. Aganval, General Manager, Finance, Punjab State Electricity Board. S.L. Rao, Chairman, Board o f Governors, Institute for Social and Economic Change, Bangalore. K.S.Menon, Additional DeputyComptroller andAuditor General ofIndia, Office ofthe Comptroller and Auditor General (CAG) New Delhi. Mr.Suresh Prabhu, Member ofParliament (Former UnionMinisterofIndustry,Environment and Forests, Chemical and Fertilizers, Heavy Industries and Public Enterprises and Power). Page 5 1