New directive gives external auditors autonomy

Newly appointed Governor of National Bank of Ethiopia (NBE), Mamo Esmelealem, signs his first directive which gives autonomy to external auditors in banks.

Experts commended the new directive citing that it properly follows the full implementation of International Financial Reporting Standards (IFRS) in conjunction with tightening the assignment and responsibility of auditors.

The ‘appointment of external auditor of bank directive no. SBB/86/2023’ which replaced the 1996 directive becoming effective as of February 1st stated that auditing experts and bankers in order to tighten the control on financial institutions, might increase their audit expenses and expand the responsibility of auditors. The directive now demands auditors to have IFRS based knowledge. To this end, in the new lease of doing business certified auditors should have IFRS certificate or have a specialty on IFRS, a requirement that was not set before.

“Besides the IFRS certification, auditors should have practical knowledge on the area,” Tilahun Tesfaye, expert on IFRS and a finance consultant at I Xcel Financial, Management and IT Consultation Company, underlined.

“For instance NBE has its own law regarding provision for bad loans and on the IFRS financial instrument. There is a condition of expected credit losses resulting in the recognition of a loss allowance before the credit loss is incurred. So the auditors should have knowledge on expected credit loss calculation,” he added. The directive indicated that assessment of the adequacy of provisions held for non-performing loans and other outstanding assets as per IFRS and the NBE directive before annual accounts of a bank are finalized and dividends paid to shareholders, “the audit should also cover and ascertain that loan-loss provisions and day one gain/loss recognition are reflected in fair value estimates and have been carried out properly as per IFRS.”

He also stated that the new directive added that auditors should have experience and technic on fair value measurement.

“In the current experience, historical cost of an asset was measured on the audit, while a fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date under

current market conditions,” he explained. Knowledge on actuarial valuation is also the other new concept included on the directive. The directive imposed a requirement that the audit team as a group must have an adequate and comprehensive IFRS knowledge as evidenced complemented with an IFRS training certificate. In addition, the audit manager and engagement team members shall have necessary qualification and adequate experience in a bank audit that are sufficient to the risk, complexity and peculiar nature of their work and ensuring if the required audit quality standards as specified under International standard on Quality Management 1 (ISQM1).

The directive stated that audit teams must have expertise in the computation of expected credit loss (credit modeling) and actuarial valuation and/or the auditor use of the work of external experts who have adequate knowledge and expertise on the same. The directive also stated that experts have to have adequate knowledge, understanding, and training of fair value estimation and is able to check the robustness of the processes for determining fair value of assets and liabilities, and also to evaluate key assumptions and inputs that a bank has used in its valuations. Regarding the appointment of external auditor the directive stated that a bank shall appoint external auditor through a competitive bid and shall hire the same auditor for another two more years without competitive bid and must also not hold office for more than three consecutive years in a bank.

The directive article 4.5 stated that an external auditor may be appointed through competitive bid for a maximum of two consecutive terms; that is six years. It added that a bank through a competitive manner may consider and appoint an external auditor who served for two consecutive terms only after lapse of three consecutive years from the last date of engagement of the external auditor.

“In my view the new directive has put a strong stand regarding impartiality of the auditor or the team regarding connection or affiliation with the bank directly or indirectly, which is crucial in undertaking a clear and proper audit on any given bank,” an audit expert commented on the current directive. The audit team members are not supposed to be employees of the bank to be audited from at least the last three years, and for the particular external auditor, its partner or its staff members must not be shareholders or employed directly or indirectly by its first degree relatives.

Article 5.7 indicated that for any audit firm, its partners, directors, manager and members of the proposed audit team must not be insolvent or declared bankrupt by court, and must also not have been convicted by the court for any criminal offences as well as found in default of any bank or other financial institutions inclusive of tax obligations. External auditor, its partners or its audit team members as well as their associates must also not operate any deposit account and must not be direct or indirect borrowers and/or foreign currency user of assigned bank except at arm’s length.

The directive clearly gives a monopoly for the Office of the Auditor General of Ethiopia or its appointee to carry out the audit of state owned banks.

The directive added that the external auditor or any partner must have to be licensed by Accounting and Auditing Board of Ethiopia.

Article 6.3 also said no bank shall remove or change its external auditor/s already appointed and approved by the National Bank, without the prior written approval of the National Bank.

“This is one of the key articles that give’s power for external auditor to undertake proper auditing on a bank. In the past auditors were considerate of their jobs when it came to clearly enforcing their opinions as they may have been easily disposed of by the bank. However based on this article auditors may have a say if a bank demands to fire them from their contract,” auditors who in the past were fired in a similar scenario explained their relief of the new directive to Capital. “Now the bank will not have an independent position to terminate a contract with auditors. The new directive gives more power for auditors to undertake their responsibility independently,” they explained.

The directive article 7.4 indicated that to conduct its audit on a group basis; and if board of directors or management of a bank imposes a limitation on the scope of the auditor’s work, the audit shall not accept such a limited scope.

The directive also gives a right for the external auditor to report to the regulatory body if any such needs arise.

Article 10.3 states that an external auditor shall report directly to the National Bank on matters arising from the audit including but not limited to insolvency, illiquidity, acts of fraud or theft and others that auditor deems significant to the regulators function due to its nature or potential financial impact. In the past auditors provided the finding to the bank but now they are responsible to report to the NBE, which is crucial for prudency in the sector, audit experts opined. The external auditor is responsible to focus on the recoverability and the carrying value of loans, investments and other assets shown in the financial statements; and also identification and adequate disclosure of all material commitments and liabilities. “The external auditor is expected to independently verify and validate the framework, structure, key assumptions and inputs and processes used for fair value estimations; and ensure that the valuation practices by a bank are consistent with IFRS as adopted in Ethiopia,” the directive said. According to the directive an auditor is expected to have coverage of reasonable and appropriate number of branches and/ or sub branches of a bank. Experts said that it is also another area that would make the service expensive but they commented that the central bank should at least mention a percentage of branches that shall be covered by the audit.

Tilahun told Capital that the article will be one of the reasons that will lead auditors to demand more fees since they are expected to cover reasonable branches unlike the current experience. Similarly, he agreed with other experts that NBE was expected to put specific figures regarding the number of branches that shall be covered on the audit.

Mulugeta Asmare, President of Goh Betoch Bank, accepted that the new directive to make auditors more autonomous, even though technically at the current stage banks still assign external auditors as an independent body.

He said that it is relative to state on the notion of the new directive making auditors more expensive, “So far the external audit expense is not cheap but based on the new directive auditors will come with an additional burden, time and professionals that would have more expenses which will finally be covered by the client or banks.” “The directive take in to account the implementation of IFRS on a full manner like the actuarial valuation, which is currently carried out by oversea companies mainly who come from Kenya. So auditors are now expected to include this service on their auditing that is one of the reason the expenses shall be increase,” he explained. He said that the issuance of the new directive is timely since the sector is becoming international and capital market is coming. “Producing comparable and internationally sound financial statement is crucial since we are going to international market and embark stock market. It is must to conduct auditing as per the IFRS standard that is internationally acceptable,” he said. “Perhaps it seems challenging and places additional pressure on banks and since we are new, a balance sheet is a testimony for a firm when we are doing business at the stock market. So it needs to keep international standards and carry out the necessary professional auditing,” he explained. Mulugeta, who served on different financial firms at top leadership positions, told Capital that the directive has imposed a high role on the bank’s management to carry on their day to day operation more prudently.

On its preamble the directive mentioned that the directive is put in place to increase reliance on the work of external auditors and is believed to enhance quality and effective risk based supervision, and to ensure that external audit is performed by qualified and independent auditor.

At the current condition the audit expense of a bank is very insignificant compared with total expense and the experience of other countries. “There is high competition between auditors due to that banks expense is very small,” the sector experts said. The experts argued that banks pay audit fee similar to what auditors get paid at any factory.

Auditing experts stated that the directive is very strong but on a positive end demands auditors to be qualified on their capability and knowledge.