Report No. 2699.5-AZ

erbaijan Financial ccountability Assessment

September 30, 2003

Operations Policy and Services Uni t Europe and Central Asia Region

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BO BSL CAS CFAA COA CPAR CPPR EBRD EU-TACIS

FIAS FSTA FY GFS GFMIS IAS IASB IASC IBTA2 IDA IFAC JMF INTOSAI I-PRSP ISA MOF MTES MTEF NBA OECD PRGF SAI

SPA TlMS TSA

SAC-I1

CURRENCY EOUIVALENTS (Exchange Rate Effective October 2002)

Currency Unit = Manat (AZM) US$ 1 = 4,885 Manat

FISCAL YEAR January 1 to December 3 1

ABBREVIATIONS AND ACRONYMS

Budget Organization Budget Systems Law Country Assistance Strategy Country Financial Accountability Assessment Chamber of Accounts Country Procurement Assessment Report Country Portfolio Performance Review European Bank for Reconstruction and Development European Union - Technical Assistance for Commonwealth of Independent States Foreign Investment Advisory Service Financial Sector Technical Assistance credit Fiscal Year Government Finance Statistics Government Financial Management Information Systems International Accounting Standards International Accounting Standards Board International Accounting Standards Committee Bank-financed Second Institution-Building Technical Assistance credit International Development Association International Federation of Accountants International Monetary Fund International Organization of Supreme Audit Institutions Interim Poverty Reduction Strategy Paper International Standards on Auditing Ministry of Finance Medium-Term Public Expenditure Strategy Medium-Term Expenditure Framework National Bank of Azerbaijan Organization for Economic Co-operation and Development Poverty Reduction and Growth Facility Supreme Audit Institution Second Structural Adjustment Credit State Procurement Agency Treasury Information Management System Treasury Single Account

Regional Vice-president: Shigeo Katsu, ECAVP

Sector Director: Alain Colliou, ECSPS Sector Manager: John Hegarty, ECSPS

Country Director: Donna Dowsett-Coirolo, ECCU3

Task Team Leader: Roberto Tarallo, LCOAA

Azerbaijan: Countw Financial Accounfabilitv Assessment i

TABLE OF CONTENTS

TABLE OF CONTENTS ............................................................................................................... i

PREFACE ..................................................................................................................................... i1

EXECUTIVE SUMMARY .......................................................................................................... V

SUMMARY OF ONGOING FINANCIAL MANAGEMENT INITIATIVES AND CFAA RECOMMENDATIONS .............................................................................................................. X

1 . COUNTRY AND ECONOMIC BACKGROUND ................................................................ 1

2 . PUBLIC SECTOR BUDGETING .......................................................................................... 3

3 . PUBLIC SECTOR ACCOUNTING. INTERNAL CONTROLS AND REPORTING ...... 8 Ministries and Budget Organizations. including the Ministry o f Finance (MOF) ...................... 8 Extra-budgetary Operations and Funds. Including the Oil Fund ............................................... 13 State-owned Enterprises ............................................................................................................ 15

4 . PUBLIC SECTOR AUDITING ............................................................................................ 17

6 . LOCAL GOVERNMENT INSTITUTIONS’ FINANCIAL MANAGEMENT ................ 23

7 . PRIVATE SECTOR ACCOUNTING AND AUDITING ................................................... 24 Enterprise Sector ....................................................................................................................... 24 Banking Sector .......................................................................................................................... 30 Corporate Governance and Financial Accountability ............................................................... 34

8 . FIDUCIARY CONSIDERATIONS IN RESPECT OF BANK-FINANCED PROJECTS

Reliance on Public Sector Financial Management Framework ................................................. 36 Project Financial Management .......................................................... : ....................................... 36 Considerations o f Corruption .................................................................................................... 38

9 . NEXT STEPS .......................................................................................................................... 40

ATTACHMENT 1: CFAA TEAM ............................................................................................. 41

ATTACHMENT 2: MAP OF AZERBAIJAN .......................................................................... 42

Azerbaijan: Counfrv Financial Accountability Assessment 11

PREFACE

This report was prepared after World Bank missions to Azerbaijan in 2002 and 2003 by a Task Team comprised o f Roberto Tarallo, Task Team Leader and Ranjan Ganguli, Financial Management Consultant. A counterpart team, comprising members o f Government, the Chamber o f Accounts and the State Procurement Agency, having been specifically formed for the purpose o f discussion o f both the C F A A as we l l as the CPAR, was engaged throughout the process o f formulation o f this CFAA. In M a y 2003, the Cabinet approved the recommendations contained in this CFAA.

The report i s based o n the results o f interviews and discussions with various public and private institutions as we l l as an analysis o f various data gathered during the missions including copies o f various legislation, instructions and reports. Government and private sector counterparts lent their fill and proactive support to the C F A A missions and engaged with the Bank’s team in a comprehensive dialogue. The Bank i s gratehl for this cooperation.

Objective of Country Financial Accountability Assessment

There i s considerable empirical evidence o f a strong causal relationship from better govemance to better development outcomes’. A country’s financial accountability and procurement frameworks are significant elements o f that aspect o f govemance relating to the capacity o f Government to manage resources and implement sound policy.

A C F A A i s a diagnostic instruments designed to facilitate a common understanding by the borrower, Bank and their development partners o f the borrower’s public and private sector financial accountability framework. In tum this enables the development o f plans to address any issues identified as well as o f appropriate capacity-building programs.

CFAAs also support the Bank in the exercise o f its fiduciary responsibilities by identifying the strengths and weaknesses o f a country’s financial accountability arrangements and the risks that these may pose to the use o f Bank funds. CFAAs are not audits; they are not intended to and do not provide assurance on the specific uses to which Bank funds have been or may be applied.

Relationship o f the C F A A to the CAS, lending program and pol icy dialogue with the Government In light o f projected major increases in o i l revenues, the authorities have two basic objectives for pol icy reform in the next few years. The f i rs t i s to create a public sector that manages efficiently the country’s natural resource wealth and delivers on key social and economic services, critical to the reduction o f poverty. The second i s to remove impediments to growth and employment in the non-oil sectors.

Kaufmann, Kraay and Zoido-Lobath (1999). “Governance Matters”. World Bank Institute Policy Research Working Paper 2 196

Azerbaijan: Counfrv Financial Accounfabilitv Assessment iii

The Government’s Interim Poverty Reduction Strategy Paper (I-PRSP) o f M a y 2001 demonstrated i t s intention to improve the country’s economic management system with a view to enhancing i t s effectiveness, converting i t more fully to functional management, reducing the administrative structure, and raising the level o f professionalism and responsibility o f government employees. The IMF’s and Bank’s Joint Staff Assessment o f the I-PRSP expressed the view that corruption, particularly administrative corruption, had been a major constraint to Azerbaijan Republic’s economic growth and poverty alleviation and that the recent and ongoing initiatives offered an important opportunity to improve govemance in the Azerbaijan Republic.

One o f the main principles o f the Government’s Poverty Reduction Strategy i s to restructure the system o f public expenditure management with a view to improving the effectiveness o f the expenditures., As outlined in the I-PRSP and with respect to institutional reforms and improving the management o f the budget process, the Government plans to: include al l expenditures o f government agencies in the budget, including social funds, and execute payments through a treasury single account (TSA); establish an overall budget package and expenditure guidelines for Government agencies; set up an integrated process for the submission o f budget plans and reports; update the budget classification; introduce international accounting standards; introduce a more efficient system for reporting on budget execution; publish on a regular basis more extensive information on budget execution to ensure transparency o f budget revenues and expenditures.

The CAS o f November 29, 1999 (supporting Azerbaijan’s development agenda for the period FY00-02) identified the area in need o f the most urgent attention to be comprehensive public sector reform and improved governance. The main thrust o f the CAS was therefore assistance to the Government in implementing i t s public sector reform agenda to improve public sector management.

Consistent with the I-PRSP and the CAS, as wel l as the IMF’s three-year Poverty Reduction and Growth Facility (PRGF), the reform program supported by the Bank- financed Second Structural Adjustment Credit (SAC-11) currently under implementation seeks to: (i) improve transparency and accountability in public financial management, including the establishment o f the supreme audit institution; (ii) strengthen the tracking o f poverty-reducing public expenditures, and monitoring o f their impact on poverty; (iii) improve strategic priority setting and transparency o f medium-term public expenditure and investment programs; (iv) introduce transparency and financial discipline in the energy sector, including fiscalization o f quasi-fiscal activities: (v) reduce conflicts o f interest and corruption in the business environment, including enforcement of regulations, separation of regulatory and commercial functions, and tax and customs; (vi) improve transparency, financial discipline and competition in the banking sector; and (vii) improve the privatization process. Clearly, there are many issues addressed by a C F A A that are o f relevance to the Bank’s dialog and program with the Government. Thus SAC-I1 contains explicit references to the C F A A as well as to various issues that fal l within the scope o f th is diagnostic. The link to the SAC-I1 explains the timing o f CFAA: approval by the Government of Azerbaijan o f plans for the preparation o f the C F A A - including the establishment o f a

Azerbaijan: Countw Financial Accountability Assessment iv

counterpart team and approval o f the C F A A / CPAR Initiating Concept Memorandum (ICM) - was required prior to Board presentation o f SAC-11. SAC-I1 second tranche conditions include the provision o f evidence o f satisfactory implementation o f the action plans resulting from the C F A A and CPAR.

Discussions on preparation o f a new CAS for FY03-05, which wil l continue to focus on poverty reduction, has started and will refer to the reform measures identified by the C F A A and agreed-upon with the government and the donor community.

Finally, i t should be noted that a significant amount o f analysis o f assistance to develop Azerbaijan’s financial accountability framework has already been undertaken and is underway by various organizations, notably the IMF, FIAS, the Wor ld Bank, the USAID and the EU-TACIS. I t was not the intention that this C F A A should revisit these areas anew, nor was it to formulate separate recommendations. Rather, this CFAA summarizes these analyses and interventions whilst also identifying those areas not yet addressed.

Scope and terms o f reference of CFAA

The scope and terms o f reference o f the C F A A was articulated and agreed both intemally within the Bank and extemally with an Azerbaijan counterpart team in the C F A A / CPAR I C M dated February 19,2002.

Acknowledgements

The C F A A team wishes to acknowledge the extensive and grateful cooperation and assistance received from the staff o f the various institutions who contributed to the CFAA, including officials and staff o f the Government, state agencies and enterprises, private sector institutions, and bi-lateral and multilateral organizations. Grateful thanks go also to the Bank’s SAC-11, IBTA2 and FSTA task teams as well as the IMF’s Fiscal Affairs Department and FIAS for their considerable research on which a significant proportion o f this C F A A i s based. In addition: Akbar Noman, Azerbaijan Country Manager, and Farid Mamedov, Operations Officer, provided invaluable in-country assistance and information in carrying out the CFAA; Nigar Aliyeva, Team Assistant in the Bank’s Baku Office, provided support with logistical arrangements for the mission; John Hegarty, E C A Regional Financial Management Adviser, Ida Muhoho (ECSPS), Christian Petersen, Azerbaijan Country Economist, and peer reviewers, Mozammal Hoque (OCSFM) and Andrew Mackie (Consultant), offered invaluable comments and inputs; and Ana Cristina Hirata assisted with the editing and formatting o f the report.

Azerbaijan CFAA: Execufive Summarv V

EXECUTIVE SUMMARY

1. A s an independent nation for only ten years, Azerbaijan is s t i l l in political and economic transition. Azerbaijan shares al l the formidable problems o f the other countries o f the former Soviet Un ion in making the transition from a command to a market economy, but i t s considerable energy resources brighten its long-term prospects. The Constitution o f the Republic o f Azerbaijan, ratified by popular referendum six years ago in November 1995, contains a western system o f checks and balances aimed at securing separation o f powers among the legislative, executive and judiciary branches o f the government. Azerbaijan has begun making progress on economic reform, and old economic ties and structures are slowly being replaced. Important challenges need to be overcome if future growth prospects are to be realized and provide for rapid expansion o f employment and income opportunities as wel l as a decline in poverty: the non-oil sector remains constrained by slow progress with financial discipline and efficient management in public utilities that together generate a significant quasi-fiscal deficit; weaknesses in public sector governance, the judicial and financial systems, and slow progress in privatization o f large enterprises also deter non-oil investment; and delivery and quality o f infrastructure and social services have deteriorated, especially in the rural areas. Approximately 50% o f the population l ives below the poverty line. .. 11. In the area o f the country’s financial accountability framework, Azerbaijan has already received and continues to receive a considerable amount o f analysis, advice and assistance, particularly in the areas o f public financial management from the IMF, the World Bank, U S A I D and lately, the European Union. This C F A A summarizes the analysis performed to-date as well as any associated advice and development assistance and also identifies areas hitherto un-addressed and provides a framework to address issues arising.

Public sector budgeting

iii. There are many areas of weakness with the particular bottom-up approach adopted for budget formulation, including: poor economies o f scale; inflated budget demands with no link to output; the use o f norms o f expenditure; and the influence of the sectoral departments o f the Ministry o f Finance. However, and as promised in the I- PRSP, the government has started to improve the management o f the budget process, the most significant elements o f which include: the publication o f a Medium-Term Public Expenditure Strategy (MTES); the enactment o f a new Budget Systems Law (BSL); the development o f a Medium-Term Expenditure Framework (MTEF) for 2003-2005; and the development o f a Pubic Investment Program (PIP).

iv. Public sector budgeting has been and continues to be the subject o f considerable analysis and support, particularly from the IMF and the Bank, and the Bank continues to support reforms through the ongoing SAC-I1 and I B T A 2 operations.

Public sector accounting, internal controls and reporting

v. The Azerbaijan Government has engaged in extensive fiscal and monetary reform and has made notable improvements with respect to the establishment o f a Treasury, the

Azerbaijan CFAA: Executive Summarv V i

closure o f numerous bank accounts, the establishment o f a Treasury Single Account, and the centralization o f cash management functions. The Ministry o f Finance is thus able to produce more reliable and timely information on the government’s fiscal operations using a GFS-based classification. However, considerable scope remains for further improvement o f the Treasury systems and procedures; cash management and commitment controls need to be strengthened; and there is a need to generate more meaningful and timely reports. The Treasury has therefore embarked on the implementation o f a modem Treasury Information Management System (TIMS) to assist the government in achieving these and other improvements with the continued support o f the IMF and World Bank, particularly through SAC-I1 and IBTA2.

vi. Extra-budgetary operations o f ministries and Budget Organizations (BOs) pass through the Treasury and are subject to standard Treasury accounting, internal control and reporting requirements. After the enactment o f various laws, the specialized social h n d s - Social Protection, Disabled Person’s Fund and Employment Fund - are now merged; eleven o f 85 extra-budgetary funds are included directly in the 2002 Budget; al l other extra-budgetary funds wil l be included from 2003; and thus from 2003, only the Oil Fund and the Social Protection Fund will remain extra-budgetary. The Oil Fund in particular has been the subject o f considerable external analysis, particularly by the IMF and the Bank, and the government has been very responsive and transparent in devising its governance and financial management arrangements: the Supervisory Board comprises representatives o f government and civ i l society; i t i s audited annually; and unaudited financial information on the operations o f the Oil Fund i s published and reported widely.

Public sector external auditing

vii. The Supreme Audit Institution (SAI) o f the Azerbaijan Republic is the Chamber o f Accounts. Although this institution was foreseen in the Constitution, the relevant law establishing the Chamber o f Accounts was only passed in 1999 and the Chairman o f the Chamber o f Accounts only appointed in June 200 1. In view o f the fairly recent formation o f the Chamber o f Accounts as well as the comparatively limited experience o f key senior post-holders in matters o f auditing, there i s a considerable amount o f capacity- building to be done. The Bank i s actively supporting the strengthening o f the Chamber o f Accounts most notably with advice on the law and intemal regulations governing the Chamber o f Accounts, but also with technical assistance financed under IBTA2.

Public sector internal auditing

viii. In an attempt to reduce the negative impact o f the duplicative control and audit investigations performed, the President issued a decree in 1999 which abolished al l public sector intemal inspectiodcontrol departments with the exception o f the: M a i n Department o f Public Finance Control (MDPFC) in the MOF in respect o f public finances; the Ministry o f Taxes in respect o f matters within i t s jurisdiction; and the National Bank o f Azerbaijan (NBA) in respect o f its role as banking supervisor. Thus at present, no ministry, committee nor other central executive power bodies has a proper intemal audit function in the normal sense o f the term- being an appraisal activity established within an entity performing a service to the entity including, amongst other

Azerbaijan CFAA: fxecutive Summarv v i

things, examining, evaluating and monitoring the adequacy and effectiveness o f the accounting and internal control systems. N o r are there any plans to introduce internal audit in any of the ministries whilst at the same time addressing the earlier concerns of harassment, inefficiencies and corruption.

Legislative scrutiny of public sector jkancial management

ix. A Parliamentary Commission recently formed by the merger o f the two Parliamentary Permanent Commissions on Economic Policy and Budget Issues has the remit to scrutinize the public finances. Information provided to Parliament i s generally not considered comprehensive enough to generate a meaningful debate in the Parliament for informed decisions on the government’s budget proposals and execution. The information provided is highly aggregated and i s not based on full classification details. Partly in recognition o f the above, and as discussed elsewhere in this report, the government has embarked on a program o f reform, significant elements o f which includes a recently revised and enacted Budget Systems Law (BSL) as wel l as significant improvements in the MOF’s accounting and reporting systems, both o f which will go a long way towards remedying the above issues.

Local government institutions

x. Azerbaijan i s organized according to a two-tier administrative system (central government and sub-national governments comprising rayons, cities and municipalities, and one autonomous regioddistrict). Local executive power i s assigned to governors, who are appointed by the President. The Constitution defines the roles o f municipalities which, among others, impose taxes and approve their own budgets. A clear division of responsibilities between different levels o f government i s s t i l l emerging and Azerbaijan i s in the process o f establishing municipal governments.

Private sector

xi. The accounting framework o f the enterprise sector is fairly undeveloped and remains essentially unchanged from the time o f the Soviet Union in the form o f a fixed chart o f accounts, fixed bookkeeping methodologies and procedures, as we l l as fixed format accounting books and records. Accounting standards were directed towards the calculation and collection o f taxes as wel l as the compilation o f statistics rather than for the purposes o f managing and evaluating businesses. However, and since the collapse of the Soviet Union, the development o f different guidance and standards on accounting has created confusion because o f differences o f principle between the texts as wel l as omissions o f guidance on particular issues. This confusion, particularly given the close l i n k s between a company’s accounting and tax profit, is regarded a significant challenge to foreign companies wishing to invest in Azerbaijan and thus as an impediment to the growth o f foreign direct investment.

xi i . The Accounting Methodology Department established within the M O F has devised a program and action plan for the reform o f Azeri accounting standards however, whilst the program’s objectives are generally sound, program design and implementation could benefit from external assistance. The recently-initiated EU-TACIS project to assist in the introduction, development and application o f international financial reporting

Azerbaijan CFAA: Execufive Summarv Vii i

standards in the non-banking sector could help to fill this need by providing institutional support to the Ministry o f Finance in the planning, drafting and implementation o f new accounting standards in accordance wi th I A S as well as the development o f a comprehensive training program and support to selected enterprises to help them effectively adopt and implement the new standards.

x i i i . All jo int stock companies, and other legal entities exceeding prescribed thresholds are required to have an annual audit by an independent auditor or audit firm. The audit profession i s overseen by the Chamber o f Auditors which issues audit licenses, establishes auditing standards and monitors the performance o f auditors. There is scope to strengthen the private sector auditing framework by primarily adopting International Standards on Auditing and amending the legislative framework to eliminate conflicts o f interest inherent in the stated remit o f the Chamber o f Auditors.

xiv. The banking sector has been and continues to be the subject o f considerable analysis and the recipient o f considerable assistance from the development community, notably the IMF, the Bank and the EU-TACIS. There i s scope to strengthen further the banking sector by, primarily: coordinating the ongoing development o f banking accounting standards led by the NBA with the prospective development o f non-banking national accounting standards led by the MOF with a view to reconciling and eliminating differences between the core non-banking accounting standards; and establishing clear criteria by which auditors are deemed acceptable or otherwise to conduct the audits o f banks and banking institutions.

Fiduciary considerations in respect of Bank-financed projects

xv. In view o f the analysis presented in this CFAA, it i s clear that there i s a need for substantial strengthening in the areas o f budgeting, treasury management, financial reporting, internal auditing and external auditing. Most o f these needs have already been recognized and there are already plans and operations underway to address them (refer to immediately following summary matrix). At present however, there are sufficient concerns about the operation and integrity o f the country’s public sector financial management framework that i t would be inappropriate to place a blanket reliance on this framework for the purposes o f satisfying the Bank’s fiduciary financial management requirements. Reliance on any particular aspect o f the country’s financial management framework for the purposes o f satisfying the Bank’s financial management requirements would need to be established on a case-by-case basis by reference to the specific financial management arrangements o f the institutions involved. This i s not to say that the Bank’s current approach o f routinely “ring-fencing” Bank-financed projects and supporting the establishment o f so-called project implementation units i s appropriate, but rather in view of the ongoing and significant assistance being given to the government o f Azerbaijan in the strengthening o f its public sector financial management fi-amework, Bank teams should now be strongly encouraged to explore the possibilities o f relying o n parts o f that framework for the purposes o f satisfying the Bank’s fiduciary financial management requirements. The recent appointment by the Bank o f a Financial Management Analyst in i t s Baku office should help to address and coordinate this issue.

Azerbaijan CFAA: Executive Summaw ix

Next steps

xvi. A matrix summarizing ongoing financial management initiatives and CFAA recommendations immediately follows this executive summary. The CFAA i s intended to act as a unifying tool to bring the Government, the Bank and the donors around the table with a view to design a medium term reform program, prioritizing the actions to be taken, and assign funding and support responsibilities. In M a y 2003, the Cabinet approved the recommendations contained in this CFAA.

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Azerbaiian CFAA: Countrv and Economic Backaround 1

1. COUNTRY AND ECONOMIC BACKGROUND

1. The Republic o f Azerbaijan i s located in the southeastern Caucasus region of western Asia. Azerbaijan was part o f the Russian Empire from the early 19th century to 191 8, brief ly an independent republic from 191 8 to 1920, and a part of the Soviet Union from 1922 to 1991. On August 30, 1991, i t declared its independence from the Soviet Union. Azerbaijan covers an area o f 33,440 square miles (86,600 sq. km), has a population o f approximately 7.8m and includes two administrative divisions with special status, the autonomous Republic of Nakhchivan, which i s separated from Azerbaijan proper by southern Armenia, and the autonomous district o f Nagomo-Karabakh (Qarabag). The capital and largest c i ty o f Azerbaijan i s Baku.

2. As an independent nation for only ten years, Azerbaijan i s s t i l l in political and economic transition. The Constitution of the Republic o f Azerbaijan (the “Constitution”), ratified by popular referendum six years ago in November 1995, contains a western system o f checks and balances aimed at securing separation o f powers among the legislative, executive and judiciary branches o f the government. The Constitution provides for a unicameral parliament (the National Assembly or Milli Majlis), a president, and a prime minister.

3. Fol lowing the break-up o f the Soviet Union and until the mid 1990s, Azerbaijan’s economy suffered a dramatic output collapse, with a cumulative real GDP drop o f about 60 percent, accompanied by hyperinflation, sharp currency depreciation and rapidly depleting foreign exchange reserves. These difficult ini t ial conditions largely reflected the collapse of the Soviet Union and related trade and transport l inks , sharp negative terms-of-trade shock as suppliers moved to market pricing, the mil i tary conflict over the Nagomo-Karabakh region, and large fiscal deficits financed by money creation.

4. Azerbaijan has only recently begun making progress on economic reform, and old economic ties and structures are slowly being replaced. Fol lowing President Aliyev’s succession to power in 1993 and the cease-fire in Nagorno-Karabakh in July 1994, the Government launched a comprehensive stabilization and structural reform program in 1995, supported by the IMF and IDA. Prospects for growth were further improved by the negotiation o f 19 production-sharing arrangements (PSAs) with foreign f i r m s that have thus far committed $60 bi l l ion to o i l field development and should generate the funds needed to spur future industrial development. During the past five years, Azerbaijan has made significant progress in securing macroeconomic stability, price and trade liberalization, as wel l as in land and small-scale enterprise privatization. Real GDP growth averaged 7.1 percent during 1996-2000.

5. Azerbaijan shares al l the formidable problems o f the other countries o f the former Soviet Union in making the transition from a command to a market economy, but i ts considerable energy resources brighten its long-term prospects. Important challenges need to be overcome if future growth prospects are to be realized and provide for rapid expansion o f employment and income opportunities as well as a decline in poverty: the non-oil sector remains constrained by slow progress with financial discipline and efficient management in public utilities that together generate a significant quasi-fiscal

Azerbaijan CFAA: Countrv and Economic Backuround 2

deficit; weaknesses in public sector governance, the judicial and financial systems, and slow progress in privatization o f large enterprises also deter non-oil investment; and delivery and quality o f infrastructure and social services have deteriorated, especially in the rural areas. Approximately 50% o f the population lives below the poverty line.

Azerbaijan CFAA: Public Sector Budsefins 3

2. PUBLIC SECTOR BUDGETING

Current situation

6. Budget formulation in Azerbaijan i s govemed primarily by the Budget Systems Law (BSL). I t begins with the issue o f budget circular in January o f the year preceding the relevant fiscal year, followed by a specification o f o f the state’s medium-term economic and social development pol icy in February, budget requests from municipalities for state subsidies by M a y 1, presentation o f the draft budget to the Cabinet o f Ministers by September 10, to the President by September 25, and presentation of the budget to parliament no later than October 15 with a view to approving and enacting the central budget by December20 and the local budgets by December 25. The budget circular for current, non-development budget assigns responsibilities and detailed timetable for budget submission by the l ine ministries and organizations and by the M O F offices at the district level. The budget for government expenditure i s prepared in four stages: (i) central operations, (ii) central administrative expenditure, (iii) central operations in the districts, and (iv) district administrative expenditure. In stages (i) and (ii), the headquarters o f line ministries and organizations prepare their own office budgets, collect the budget proposals o f budget organizations located at the center, consolidate these, and forward them to the concerned sectoral division o f the MOF for scrutiny. In stages (iii) and (iv), the budgets o f organizations at the district level are coordinated by the regional offices o f the MOF, which collect and apply initial scrutiny to the budget proposal o f the central institutions located in the district. These are then forwarded to the MOF sectoral departments for finalization.

7. which include:

There are various weaknesses with this approach o f bottom-up budget formulation

0 Poor economies o f scale. Current budget formulation process militates against efficient delivery o f services. This i s due to the fundamental structural weakness under which the decisions on financing requirement for the delivery o f a service i s irrationally distributed between central l ine ministries and the district offices o f the MOF. For example, the Ministry o f Health has hospitals al l over the country but the budgets o f the hospitals and medical establishments in the districts are neither influenced nor controlled by the Ministry o f Health even though the hospitals are under the administrative control o f and answerable to the Ministry o f Health on the quality o f the service rendered. Direct participation o f the MOF district office in budget formulation o f a l l agencies at the district level dilutes their ability to challenge the budget bids on any ground other than the simple check o f the norms applied and arithmetical accuracy. Thus the Ministry o f Health plays a very limited part in the preparation and i s only kept informed o f the budget proposals o f a hospital in the district.

0 Inflated budget demands with no link to output. Budget users inflate their demand for funds as they are not bound to the discipline o f fkaming their budgets within a preset expenditure envelope. Thus the demand for funds typically exceeded availability o f funds by a factor o f three. N o systematic prioritization o f

Azerbaijan CFAA: Public Sector Budsefina 4

activities i s undertaken at any level, nor i s any attempt made to align expenditure proposals with the output expected. Since al l demands cannot be accommodated within the limited resource envelope, the MOF is compelled to make adhoc cuts and advise budget user to meet their shortfall f rom extra-budgetary sources.

0 The use o f norms o f expenditure. The budget is based mainly on approved norms o f expenditure items. Routine adherence to norms o f expenditure can lead to budget users selecting options that generate larger bids in preference to cheaper and more realistic options - such as bidding for larger number o f incidence of inpatients than outpatient altematives because the former would inflate the budget bid.

0 The influence o f the M O F as compared to l ine ministries. The crucial phase o f negotiating the budgets o f a l l budget users i s performed not in the budget department o f l ine ministries but rather in the sectoral departments o f the MOF. This undermines the accountability o f the l ine ministries.

Going forward

8. As promised in the I-PRSP, the government has started to improve the management o f the budget process. The practice o f adoption o f the budget prior to the beginning o f a new financial year will be continued. In addition, there are plans to: include in the budget al l expenditures o f government agencies, including social funds; establish an overall budget package and expenditure guidelines for govemment agencies; set up an integrated process for the submission o f budget plans and reports; update the budget classification; introduce intemational accounting standards; improve the system for making changes in tax rates, social contributions, customs duties, and other compulsory payments; introduce a more efficient system for reporting on budget execution; publish on a regular basis extensive information on budget execution to ensure transparency o f budget revenues and expenditures.

9. A Medium-Term Public Expenditure Strategy (MTES) published by the Government, outlines the priorities for consolidated public expenditures (i.e. including the Oil Fund) and the corresponding expenditure allocation path for the next three years (these years, leading up to the materialization o f substantial o i l revenues, are o f crucial importance). The Strategy stipulates implementation and governance arrangements for those consolidated public expenditures, as wel l as key institutional and pol icy reforms envisaged in the public expenditure area during this period. The rules and principles that would determine the magnitude o f expenditures out o f the Oil Fund during these three years are formulated, together with a timeframe for the fiscalization and eventual elimination o f utility subsidies. Within this strategic framework and on the basis o f ongoing PRSP work, the Government wil l formulate consistent medium-term expenditure programs for the social sectors and a three-year Public Investment Program (PIP) by end- September 2002.

10. The government developed the fol lowing medium-term consolidated budget, including Social Funds, Oil Fund, Privatization Fund and revenues and expenditures of budgetary organizations, for 2000-2005:

Azerbaijan CFAA: Public Sector Budaefina 5

Revenue

Expenditure

Economic classification

Personnel Emoluments Wages and salaries Employer's Contribution

Purchases o f goods and services Transfers t o households

Social Protection Fund Transfers to Households f r o m State Budget

budget project loans O i l Fund

Capital expenditure

All other items

Primary expenditure

Debt service interest principal

Functional classification

State operating functions General State Service Defence Courts, law enforcement, security

Social and welfare functions Education expenditure Health expenditure Social Protection and Social Security

State Budget Social Protection Fund

Culture, arts and religion Economic Services

Housing and Public Services Fuel and Energy Affairs Agriculture, Forestry and Fishing Industry and Construction

2000 2001

5739 5755

4955 5467

1090 1195 1084 1187

6 8 1150 1196 1563 1633 1341 1355 222 278 698 954 314 289 384 661

0 4 303 289

4804 5267

151 200 93 92 58 108

1118 1265 261 303 485 533 372 429

2731 2821 909 931 205 210

1514 1570 173 216

1341 1354 103 110

898 1177 93 82 0 -2

170 171 13 14

2002 2003 budget forecast

bn Manats

6455

7347

1524 1502

22 1430 1957 1515 442

1728 404 988 336 479

7118

229 115 114

1601 436 609 557

3377 1082 270

1896 381

1515 128

2076 95

1 248

18

7224

7845

1616 1603

13 1816 2135 1808 327

1530 324 5 64 642 591

7689

158 92 66

1864 551 683 630

3798 1216 301

2115 307

1808 166

1895 116

0 279

82

MEDIUM-TERM EXPENDITURE FRAMEWORK, 2000-2005 (CONSOLIDATED BUDGET)

Investment 517 791 1488 1130 1573 1638

2004 forecast

7655

8747

1849 1835

15 1961 2323 1983 340

1926 389

1021 515 511

8570

177 98 78

1920 571 746 603

4228 1339 390

2308 325

1983 192

2404 127

0 344 24

2005 forecast

857(

9408

2008 1992

1f 2183 248s 213C 353

2015 465

1022 525 515

921 1

198 114

84

2038 598 796 644

4635 1432 505

2490 354

2136 208

2562 139

0 395 28

Azerbaijan CFAA: Public Sector Buduetina 6

State Budget State Oil Fund Net foreign financed project loans

Transport and Communications Other economic affairs and services

Other Items Expenditure not included in major groups Employer contribution to SPF Extrabudgetary expenditure Privatization Fund expenditure (extrabudgetary)

2002 2003 2000 2001 budget forecast

bn Manats

2004 2005 forecast forecast

~ ~~

MEDIUM-TERM EXPENDITURE FRAMEWORK, 2000-2005 (CONSOLIDATED B U D G E T ) F l

Deficit 784 288 -892 -622 -1091 -8381

133 0

3 84 102

3 208 273

-277 202

10

126 4

661 118

3 205 280

-269 194

0

165 336 988 172 52

293 370

-327 250

0

425 142 564 223 64

288 61 1

-322 0 0

37 90 515 525

1021 1022 240 258 96 104

194 178 577 598

-383 -419 0 0

OI

0

1 1. With the support o f SAC-11, a new BSL has been approved by Parliament and has been enacted and became effective o n January 1, 2003. The B S L inter alia: (i) covers al l relations with state extra-budgetary funds, including the Oil Fund; (ii) provides for complete accounts o f extra-budgetary revenues, expenditures, and surplus balances as per economic and functional classification levels; (iii) ensures the full and transparent reporting to Parliament as well as to the media and public o f these accounts in the budget process; and (iv) stipulates that any resources drawn from the extra-budgetary funds, other than for meeting the State Oil Fund's o w n administrative expenses, shall be channeled through the State Treasury. The Law also establishes a firm link between local budgets and the central consolidated budget and prevents local self-governing bodies from borrowing outside the central budget. Separate comprehensive estimates o f extra- budgetary revenues and planned utilization wil l also be provided as wel l as revenue and expenditure estimates for investment projects.

12. and the 2004- 2007 MTEF and PIP for Cabinet approval before September 15,2003.

Consistent with the new BSL, the Government intends to prepare the 2004 budget

13. The Bank i s providing incentives and assistance in respect o f public sector budgeting through SAC-I1 and IBTA2. More specifically, second tranche conditionalities o f SAC-I1 which have now been met included the fol lowing measures to improve transparency and accountability in public financial management:

0 Cabinet approval o f Medium-Term Expenditure Framework for 2003-2005 ;

0 Cabinet approval o f Public Investment Program for 2003-2005 consistent with Medium-Term Expenditure Framework;

0 Cabinet approval o f 2003 budget consistent with Medium-Term Expenditure Strategy and Framework, and prepared according to key provisions o f new Budget Systems Law (calendar, comprehensiveness, documentation and

Azerbaijan CFAA: Public Secfor Buduefinu 7

disclosure), publication o f 2001 budget execution, and implementation o f 2002 budget according to new Budget L a w as applicable; and

0 Integration o f al l remaining state extra-budgetary resources into the state budget with the exception o f the Oil Fund.

14. The recently approved Bank-financed Second Institution-Building Technical Assistance credit (IBTA2) wil l finance institution-building technical assistance to help the Government to set up a PIP and to build appraisal capacity for the investment program by setting up a Public Investment Appraisal Division (PIAD) in the Ministry o f Economic Development. The TA will assist

0 the Government to develop a Public Investment pol icy framework to reflect the needs o f he population and priorities o f the Government and consistent with the Government’s PRSP. Based on this pol icy framework the TA will help the Government develop an investment strategy to prioritize sectors and project classes including a negative l ist if warranted and set up the capital budgeting criteria and procedures consistent with the strategy. Based o n this strategy the TA will help the Government to identify a series o f projects and an implementation schedule spread over a number o f years;

0 the Government to develop policies and procedures for treating unsolicited projects and rules for their inclusion in the PIP. Sufficient flexibility would be built in the project l i s t and schedule, so that it can be reviewed in light o f developments in the country and elsewhere and modified as required;

0 to set up the methodology and the operating policies and procedures ( including environmental assessments) for appraising and approving projects that are proposed for the PIP;

0 the Government to search for, locate and recruit the appropriate technical and management human resource skills needed to staff the project appraisal fbnction so that the P I A D can be adequately staffed;

0 to educate and train the project appraisal staff so that they know the procedures to be followed and have the capability to fol low these;

0 in conducting demonstrative project appraisals to illustrate and educate by example, how the project appraisal process i s to be implemented;

0 in preparing a functional design o f the appraisal process to identify softwarehardware needs and assist in i t s procurement and installation.

Azerbaijan CFAA: Public Sector Accounfina, Internal Controls and Reportins 8

3. PUBLIC SECTOR ACCOUNTING, INTERNAL CONTROLS AND REPORTING

Ministries and Budget Organizations, including the Ministry of Finance (MOF)

15. In common with other countries o f the former Soviet Union, Azerbaijan had a system under which Ministries operated their own bank accounts and financial management systems and provided information to the Ministry o f Finance and other designated authorities under relevant statutory and other normative instruments. The M O F did not have a Treasury but rather the National Bank o f Azerbaijan (NBA), the country's central bank, managed the implementation o f the Budget and performed al l cash operations.

16. Fol lowing i t s independence in 1991, the Azerbaijan Government has been engaged in an extensive fiscal and monetary reform program aimed at, amongst other things, improved fiscal management and applying internationally accepted public sector accounting practices. Significant improvements have already been achieved in public sector resource management including: (i) the establishment o f a Treasury and entrusting it with the responsibility o f managing the execution o f the Budget - in addition to the Central Treasury in Baku, 85 Regional Treasury offices have been established throughout the country; (ii) the closure of numerous bank accounts of ministries and BOs and the establishment o f a Treasury Single Account at the NBA; (iii) centralizing the cash management functions o f the State Budget knded organizations in the Treasury.

17. The comparatively recent creation o f the Treasury (1997) enables the M O F to produce more reliable and timely in fomat ion on the government's fiscal operations using a GFS-based classification. The Treasury produces monthly, quarterly, and annual reports on a cash basis covering the budgetary and extra-budgetary fiscal activity o f the central government and local governments. In 1999 i t introduced reporting requirements for three extra-budgetary funds and for externally financed development projects so that reports on the fiscal activity of the general government can be produced. Reconciliation with budget appropriation and bank accounts appears effective and timely. However, the manual processing and recording of fiscal transactions i s cumbersome.

18. In recognition o f the problem o f accumulating payment arrears, commitment controls were introduced in 1999, and an inventory o f the stock o f payment arrears accumulated before 1999 was compiled. However, in cases o f under-budgeting for uti l i t ies, services are not shut o f f once the budget appropriation has been used and spending agencies accrue arrears without registering commitments. Another concern i s that many budget organizations, especially those providing health and education services, charge fees or otherwise collect and spend revenues that are outside the budget process. In principle, these transactions are now processed through the Treasury and included in Treasury reports. In practice, however, i t i s not known whether al l o f these transactions are processed by the Treasury. Finally, in 1998 and 1999 problems were encountered with the privatization process and other revenues outside the budget process. In order to meet the deficit target, other planned spending had to be reduced and budget arrears increased.

Some problems with Treasury reporting and expenditure control remain.

Azerbaijan CFAA: Public Sector Accountinu, lnfemal Controls and ReDortina 9

19. improvements:

The establishment o f the Single Treasury account has resulted in the following

0 a reduction o f idle balances and better cash management by putting all Government resources under control o f the Treasury;

0 better controls during budget execution. Treasury checks whether budgetary expenditures are in accordance with the approved budget, within the specified spending l imits and funds allocations, prior to approving an expenditure transaction; and

0 more comprehensive accounting and fiscal reporting, thereby contributing to better financial management.

20. However, considerable scope remains for mher improvement o f the Treasury systems and procedures. Cash management needs to be strengthened, commitment control has to be more rigorously implemented and there i s a need for significant improvement in the capacity to generate meaningful and timely reports. The Treasury has therefore embarked upon the implementation o f a modern Treasury Information Management System (TIMS) to assist the govemment in achieving these and other improvements.

21. include:

K e y pol icy actions that are currently being pursued by the MOF / Treasury

0 implementation o f a transaction based Treasury Information Management System (TIMS) embodying a new chart o f accounts conforming with the GFS methodology;

0 implementation o f effective Public Expenditure Control Regulations to manage the level and timing o f expenditures and the extent o f arrears, including: (a) Financial Control (i.e. the approval and authorization stages o f proposals to spend public moneys before a commitment is entered into); (b) Accounting Control (i.e. including the certification o f claims for payment before a payment i s made); and (c) Audit Control (Le. the ex post review o f expenditure undertaken);

0 improvements in Cash Management and Budget Execution including instituting effective forecasts o f monthly and weekly expenditure requirements and revenue collections; and

0 reduce reliance on physical movements o f cash in the Budget Revenue Collection and Execution processes by effecting general payments o f Government through electronic movements between bank account balances through the banking system rather than cash movements.

22. The IMF provided init ial technical assistance to the Treasury in the development o f a new budget classification structure, a chart o f accounts and the hnctional specifications for a fully functioning treasury system through an expert resident in Azerbaijan. The IMF also provided advice to the MOF/Treasury on issues o f Budget

Azerbaijan CFAA: Public Sector Accountinu, Internal Confrols and Reporting 10

Execution, Cash Management and Treasury Operations. Subsequently the U S AID, through a competitive bidding process, selected a systems integrator to select application software in accordance with the functional requirements devised with the assistance o f the IMF and to supervise its implementation, including testing. I t is anticipated that the USAID-financed assistance wil l include the fol lowing activities:

0 Review existing budget classifications and coding structures and develop and design a revised structure and chart o f accounts conforming with the IMF- GFS classification methodologies and suitable for both budget preparation and implementation.

0 Assist in the development o f the legal regulatory and operational framework and develop detailed guidelines, procedures, regulations, forms and operating manuals for budget execution processes required at a l l levels o f Treasury operations to implement the Treasury System and for payroll management.

0 Assist in the development o f methods to improve forecasting o f expenditure requirements and cash management.

0 Develop the fiscal reporting system o f Treasury and improve linkages between the Treasury fiscal reports and MOF analysis.

23. Second tranche conditionalities o f SAC-I1 include measures to improve strategic priori ty setting and transparency o f medium-term public expenditure and investment programs, including: the publishing o f quarterly financial and budget execution statements satisfactory to IDA, i.e., with expenditures (other than administrative expenses) in accordance with the Consolidated Budget, and financial flows in accordance with Governance and Management Framework.

Treasury Information Management System

24. The overall design o f the TIMS system wil l be based on the IMF recommendations for the Government Financial Management Information System (GFMIS). The core functional processes and information flows associated with the system are shown schematically below.

Azerbaijan CFAA: Public Secfor Accountina, lnternal Controls and Reporfina 7 7

Core Functional Processes and Information Flows - Treasury is responsible for making payments;

Flrcal Rep

.I

I

I\

f

1 R E A S U R Y

I

f n

0 r m

t I

n M

0

a n

c

e n

0

m

t

S Y

t

m

I

e

-

S

Paymenh through

SWIFT _ I i.

7

Online Transactmns & Balances

through SWFT

x -

r------7

I , I

v Commercbl

Banks (Regional Branches]

25. would be used by:

The Treasury Information Management System would be the core GFMIS and

0 the Central Treasury and the 85 Regional Treasury offices to perform comprehensive accounting functions and to undertake budget implementation and generate reports for use by respective offices;

0 the Cash Management Department to forecast and monitor cash flows and determine cash l imits for budget organizations;

0 the Central Treasury to access data o f a l l the treasury offices for quality assurance and other purposes and to carry out consolidation and generate reports for macro fiscal management purposes;

0 the Budget Department o f the MOF to obtain reports for instance on the status o f actual expenditures; and

0 the Chamber o f Accounts to access financial transaction data for auditing purposes.

26. In a fully automated accounting system, as it exists in most developed countries and several middle income countries, the basic accounting processes are automated and data captured only once as an accounting transaction progresses through the system. Such a system, introduced along with a modem budget classification system and an appropriate

Azerbaijan CFAA: Public Sector Accountina, Internal Controls and RePodinins 12

chart o f accounts, enables expenditures and revenues to be recorded at a very detailed level and related to specific programs and projects. Data recorded at this level can be directly used for program and project management. This data i s also easily amenable to cross classification in other ways as required for financial analyses. In the absence o f an automated accounting system data recording is not at as detailed a level and more important, cross classification o f data to other schema is very cumbersome and therefore seldom carried out. Further more the introduction o f an automated accounting system would ensure completeness o f data capture (that i s no transaction would be processed outside the system) and rigorous application o f a l l relevant financial controls to a l l transactions processed by the system. The information contained in the system data bases would provide the MOF and other core financial agencies a foundation for a comprehensive management information related to the country’s financial resources. The information contained in the data bases would be available to other core government agencies o n a as required / approved basis. In addition, the system would provide usefu l financial information to the ministries, spending units (in their respective areas) to enable them to better manage their work programs.

27. The TIMS system wil l encompass the functional requirements for the budget implementation and accounting processes and would cover the appropriation, commitment, funds allocation, and payment processes for both the investment and current budgets. Specifically the budget execution system would have a capability to:

Record init ial budgets and inform spending ministries about their initial budget appropriations as approved by the legislature, keep a record o f ini t ial budgets, revised budgets, and budget transfers, for a typical government ministry/ spending unit.

During the course o f a year distribute appropriation and commitment authorization in fomat ion to ministries/ spending units and to record commitments incurred by a ministry against the approved limits and the appropriation.

Keep a record o f the amounts o f funds allocations against the appropriations and any changes thereto.

Record expenditure against commitments / budget and funds allocations (e.g. due to purchase orders, or other payments). The system will have facilities to check availability o f appropriation, commitment and funds allocation prior to approving a payment.

Print or transmit electronic consolidated payment instructions to be acted upon by the banking system.

Record revenue and other receipts against appropriate account heads.

If required, print checks against payment instructions and or make arrangements for the electronic transfer o f payment information to an external paying entity (e.g. a Bank).

Azerbaijan CFAA: Public Sector Accountins, lnternal Controls and ReDorfins 13

0 Consolidate data from regional treasury offices, as necessary. The system will have good report writing facilitates and enable easy retrieval and reporting on data in the system data bases, in a variety o f formats. The system would be able to produce the commonly required accounting and management reports.

0 The system would have facilities to restrict access only to duly authorized staff.

28. The architecture proposed for the TIMS system by the Government under advice from the resident IMF advisor envisages a centralized system running at the central Treasury office in Baku. The 85 regional treasuries distributed through out the country would connect to this system in an online mode to process transactions. Such an architecture has the advantage that i t eliminates the need to synchronize system data bases that would be necessary in a distributed system and would reduce system maintenance costs and efforts since the application software would only be operating at the Central site. This strategy i s dependent upon a high speed and reliable telecommunications network; such a network will, according to the Ministry o f Communications, be established within the next two or three years, and indeed is already available for approximately 50% o f the 85 cities in which the regional treasuries operate.

29. The recently approved Bank-financed IBTA2 project will assist in the implementation o f TIMS by financing: technical assistance, computer equipment, software and training to assist the authorities to design, develop, test and implement processes, procedures and systems, related regulations and training programs for budget execution and treasury operations. The TIMS system wil l f i rst be implemented at a set o f pi lot sites and then replicated across the country. More technical details in respect o f financing to be provided by I B T A 2 may be found in the relevant project documentation.

Extra-budgetary Operations and Funds, Including the Oil Fund

30. are subject to standard Treasury accounting, internal control and reporting requirements.

Extra-budgetary operations o f ministries and BOs pass through the Treasury and

3 1. The Parliament adopted the Law "On the Social Protection Fund" o n November 15, 2001, which provided for the specialized social funds - Social Protection Fund, Disabled Person's Fund and Employment Fund - to be merged. Similarly, according to the Law on Budget 2002, eleven extra-budgetary funds (0.8 bln Manats) out o f 85 are to be included directly with the revenues and expenditure parts o f the Budget 2002. In 2003 the other extra-budgetary funds and operations o f budget agencies wil l be included to the state budget. At that point the O i l Fund and the Social Protection Fund will be the only remaining extra-budgetary funds. Bo th the Law on Budget 2002 and the L a w "On the Social Protection Fund" were made effective on January 1,2002.

32. The o i l windfall has been handled well to date, with the Government avoiding oil- fueled spending sprees, rapid external debt accumulation, or excessive real appreciation o f the exchange rate. To improve management o f natural resource revenues, the State Oil Fund was established by Presidential Decree on December 29, 1999. The Fund was set up as an extra-budgetary institution accountable to the President and became effective at the beginning o f 2001. Preparation o f the Oil Fund budget and the Government budget i s

Azerbaijan CFAA: Public Sector Accounfina, lnternal Controls and Reporting 14

done in tandem within overall macroeconomic and fiscal aggregates agreed with the IMF, and the consolidated budget presented to Parliament. Sources o f Oi l Fund revenues include bonuses and revenues from sale o f crude o i l and gas, and earnings from related activities. In i t ia l ly the Oil Fund’s assets amounted to US$270 mil l ion. These assets increased to US$499 and US$690 mi l l ion at end-2001 and end-2002 respectively.

33. The Oil Fund’s non-operational expenditures are: (i) strictly l imi ted to funding projects within the consolidated Government budget, which correspond to strategic priorities as outlined in the PRSP, MTEF, and PIP; (ii) channeled through the Treasury; (iii) consistent with the overall fiscal policy, which aims at continued macroeconomic stability and growing the national wealth, including the value o f human, physical and natural resources; (iv) subject to high standards with regard to accountability and transparency to ensure aggregate fiscal restraints and good governance essential for fiscal discipline and avoiding the danger o f hurriedly and ill-conceived expenditure projects; (v) not only to be based on the availability o f resources, but also to take into account institutional capacity to spend these efficiently today, as compared to saving them for future generations; (vi) subject to a proper assessment o f r isk and uncertainty, especially with regard to volatile o i l prices; and (vii) not to be made for investing in commercial activities where the private sector is typically more efficient. In this way, the O i l Fund will help to strengthen fiscal discipline by providing a measure o f insulation for i t s assets from political spending pressures. Adherence to the Oil Fund regulations and disclosure rules i s a structural performance criterion o f the ongoing IMF’s PRGF program.

34. Given the current low-income status o f Azerbaijan and the pressing need to reduce poverty, some o f the Oil Fund’s funds, consistent with sustainable development, wil l be allocated for additional expenditure for lifting bottlenecks that prevent growth and especially affect the poor. Direct poverty reducing measures are warranted to alleviate the plight o f the poorest, and among them the one million Internally Displaced Persons (IDPs) and refugees o f the Nagorno-Karabakh conflict. Thus, the f i rs t allocation by the O i l Fund was for housing projects for IDPs in the amount o f US$36 m i l l i on which was followed by a second allocation of US$40 million. Other alternatives for spending out o f the O i l Fund are investment in human capital and rehabilitation o f infrastructure, especially in rural areas.

35. A Supervisory Board for the O i l Fund was appointed in December 2001 and implements general oversight over the composition o f the Oil Fund’s assets and compliance to the expenditure rules. I t represents a structure o f a very formal nature, as ultimate supervision and decision-making prerogative rests only with the President. The first meeting o f the Supervisory Board was held in July 2002, was inaugurated by the President and elected the Prime Minister to the position o f Chairman. Members o f the Board are also appointed by the President and comprise ten members including key governmental officials (such as the prime minister, key economic ministers and advisers, and the Chairman o f the Board of the National Bank) as we l l as academia. Members o f the Supervisory Board meet at least once every quarter, but any member o f the Supervisory Board or the Executive Director can call for an ad-hoc meetings, when necessary. The preparation o f the Oil Fund’s budget and investment pol icy are carried out in consultation and coordination with the MOF and endorsed by the Supervisory Board prior to approval by the President. In November 2002, the Oil Fund’s 2003 budget was

Azerbaijan CFAA: Public Secfor Accountinq, lnfernal Controls and Reoodinq 15

discussed and endorsed. O i l Fund expenditures (other than administrative expenses) wil l be part o f the approved and published Consolidated Budget, MTEF and, for investment projects, o f the PIP, which al l wil l be submitted to the Parliament according to the new BSL.

36. In the init ial stage, the Oil Fund aims to build up i t s capital. Prudential asset management guidelines have been developed to ensure that the assets are managed in a professional way, and in an open and competitive tender internationally recognized f i r m s are hired to manage the assets. The intention o f the Oil Fund’s disbursement rules is to allow the Fund to make a contribution to current consumption and to domestic capital investment o n a sustainable basis. The adopted Regulations provide that the Oil Fund budget be prepared at the same level o f detail and classification as the state budget. Furthermore, the expenditure o f the Oil Fund will be consistent with the approved annual state budget and (except for i t s own administrative expenses) wil l be executed through the Treasury, subject to standard accounting, procurement and other rules. In line with i t s Regulations, the Oil Fund i s audited annually by an intemationally recognized auditor, and makes public both the audited financial statements as well as an annual report and budget. Unaudited quarterly financial information o n the revenues and assets o f the O i l Fund is released to the general public and mass media as well as on other occasions if deemed necessary. Finally, quarterly published budget execution reports include information o n Oil Fund expenditures.

State-owned Enterprises

37. As discussed earlier, the non-oil sector remains constrained by slow progress with financial discipline and efficient management in public utilities that together are estimated to generate a quasi-fiscal deficit which averaged approximately 14 percent o f GDP in the period 1998-2001. To support and enable the design and implementation o f the programs o f reform and privatization in the utility and o i l sectors, the Government is aware o f the need to have access to and provide prospective investors with appropriate financial and operational information. In this regard, the ongoing MOF-led reform o f A z e r i accounting standards (see discussion further on in this CFAA) i s a key tool of government.

38. The Government has also recently instructed SOCAR, Azerenergy, Azerigaz and A R W C to deliver and also share with the Government, NBA, IMF and World Bank: (i) monthly accounts receivable statements arranged by user groups; (ii) monthly statements o f non-technical losses; (iii) monthly statements of historic and projected cash flows; (iv) annual financial statements prepared in accordance with International Accounting Standards (IAS’) as well as an audit opinion thereon from a reputable intemationally- recognized auditor having performed the audit in accordance with International Standards on Auditing (ISA); and (iv) a plan to upgrade their financial management arrangements, including the design and implementation of appropriate accounting procedures and internal controls, to enable the production of reliable, relevant, accurate and timely

For the purposes o f this report, the term “IAS” encompasses the standards endorsed by the International Accounting Standards Board (IASB), including those designated “International Financial Reporting Standards” (IFRS)

Azerbaijan CFAA: Public Sector Accounfinu, lntemal Controls and Reportinu 16

financial and management accounting information. Additionally, the Government wil l begin a review o f the adequacy o f electricity, gas and water tariffs.

39. I t i s anticipated that, in the context of the prospective EU-TACIS project to assist in the introduction, development and application o f international financial reporting standards in the non-banking sector (see discussion later), support will be given to selected state-owned enterprises to help them effectively adopt and implement the new standards .

Azerbaijan CFAA: Public Sector Audifinu 17

4. PUBLIC SECTOR AUDITING

External auditing

40. The Constitution invests Parliament with the power to establish the Chamber of Accounts, the Supreme Audit Institution (SAI) o f the Azerbaijan Republic. The Internal Regulations (Charter) o f the Parliament confirms that the Chamber o f Accounts i s “a permanent budget control organ” reporting to Parliament and that the key senior positions o f the Chamber o f Accounts (the Chairman, the Deputy Chairman and seven Auditors) are to be elected to their positions by Parliament. After some confusion following the creation o f the Chamber o f Auditors in 1994 (see section below on private sector auditing), the L a w on the Chamber o f Accounts (1999) was passed establishing the Chamber o f Accounts

41. Fol lowing a review o f the Law on the Chamber o f Accounts by the IMF as wel l as a review o f the draft Internal Regulations o f the Chamber o f Accounts by the Bank, amendments to the Law on the Chamber o f Accounts have been enacted and Parliament has approved the Internal Regulations (Charter) of the Chamber o f Accounts. Together with the enactment o f the new Budget Systems Law, the Chamber o f Accounts is now invested with the necessary authority and r ights to enable it to audit and make public the results o f i t s audits o f a l l public sector bodies and organizations, including al l budgetary and extra-budgetary organizations and funds. I t was agreed that further revisions to the Law on the Chamber o f Accounts as well as the Internal Regulations (Charter) would be made in due course based upon practical experience o f their implementation.

42. The Chairman and the Deputy o f the Chamber o f Accounts were appointed by Parliament in June 2001 and five Auditors have since also been elected. Resources for the full staffing and proper functioning o f the Chamber were allocated in the 2002 budget. During 2002, and in conjunction with the Bank-financed Second Institution- Building Technical Assistance credit (BTA2), the Chamber intends to: (i) complete the appointment o f a l l seven Auditors; (ii) develop a revised organizational structure; (iii) formulate staff grades with appropriate j ob descriptions and recruitment criteria; (iv) equip the Chamber with appropriate numbers and types o f computers and software; and (v) prepare the Chamber’s 2003 work plan and present the related 2003 financial plan to Parliament. These matters are explicit pre-conditions for release o f the SAC-I1 second tranche.

43. In view o f the recent formation o f the Chamber o f Accounts as wel l as the comparatively limited experience o f i t s key senior post-holders in matters o f auditing, there i s a considerable amount o f capacity-building to be done. The objective o f the T A financed under B T A 2 is to advise the Chamber o f Accounts to maintain an appropriate legislative framework and develop an appropriate professional and institutional capacity in order that it may have a positive impact on the Azerbaijan public sector financial management. More specifically, the TA will:

0 Assist the Chamber o f Accounts to review, on an ongoing basis, the appropriateness of, and compliance with, the legal framework relating to the

Azerbaijan CFAA: Public Sector Audifina 18

Chamber o f Accounts, and provide advice on i t s internal organizational structure and human resource arrangements.

0 Provide the Chamber o f Accounts with the necessary working tools and practices including international Standards and Practices (INTOSAI), IT systems and office equipment, and procedures for developing the necessary work program and budgets.

Provide the Chamber o f Accounts with training, including formal training by Consultants in accounting and auditing, training provided by SAIs, INTOSAI, EUROSAI, Association o f Certified Chartered Accountants (ACCA).

0 Help the Government to arrange study tours and fellowships and support the qualification o f staff in professional accounting and auditing examinations such as those administered by the ACCA. The TA will also provide on-the j o b training to the staff o f the Chamber o f Accounts.

0 Provide advice and help to develop and implement an information strategy for the Chamber o f Accounts, including the manner by which the Chamber o f Accounts wil l communicate i t s objectives and results to the public.

0 Secure representation o f the Chamber o f Accounts in the appropriate international forum, including INTOSAI and its regional associations, EUROSAI and ASOSAI. I t wil l also help to organize and advise o n the participation o f the Chamber o f Accounts at appropriate international SA1 conferences, symposiums, seminars and working parties.

44. The Chamber o f Accounts i s planning to submit to Parliament reports on budget execution and other reports for the six-month period ending June 30, 2002. I t will take some time before the Chamber i s fully functioning, but it i s planning to audit at least one ministry and one state owned enterprise in the course o f 2002.

Internal auditing

45. Presidential Decree No. 462, On Compliance o f Rules in Controlling the Industry, Service and Finance-Credit Activities, o f June 17, 1996 sought to reduce the number o f dual, parallel and unwarranted inspections which were fe l t to be negatively impacting the development o f the market economy. However, i t was fel t that the measures introduced by the Decree did not go far enough and thus Presidential Decree No. 69, On Improvement o f Public Control System and Addressing the Art i f ic ial Obstacles in the Development o f Ownership, o f January 7, 1999 was also enacted. The latter decree abolished al l intemal inspectiodcontrol departments o f ministries, committees and other central executive power bodies, except for: the M a i n Department o f Public Finance Control (MDPFC) in the M O F in respect o f public finances; the Ministry o f Taxes in respect o f matters within i t s jurisdiction; and the National Bank o f Azerbaijan (NBA) in respect o f i t s role as banking supervisor. The Government took this action as part o f its strategy to reduce obstacles for private sector development; i t was felt that these departments unduly harassed the Budget Organizations (BOs) and companies under their jurisdiction leading to both widespread inefficiencies and corruption.

Azerbaijan CFAA: Public Sector Auditins 19

46. Thus, and although some o f the internal audit departments abolished by the 1999 decree may have been reformed into renamed departments that closely resembled their former incarnations, no ministry, committee nor other central executive power bodies has a proper internal audit function in the normal sense o f the term- being an appraisal activity established within an entity performing a service to the entity including, amongst other things, examining, evaluating and monitoring the adequacy and effectiveness o f the accounting and internal control systems. N o r are there any plans to introduce internal audit in any o f the ministries whilst at the same time addressing the earlier concerns of harassment, inefficiencies and corruption. As the MDPFC comprises only 4 technical officers and 50 inspectors, the effectiveness o f this department i s very constrained.

47. This CFAA recommends that a strategy should be developed for a properly functioning public sector intemal audit function. The lessons o f the previous incarnations o f internal auditing departments which were believed to harass their subjects leading to widespread inefficiencies and corruption should be analyzed and used to mitigate their recurrence. The government has agreed to consider this issue. The following bullet- points outline one possible approach:

0 An Internal Audit Department should be created, headed by a Chief Government Internal Auditor (CGIA), reporting to the Prime Minister or Minister o f Finance, and which would have the fol lowing responsibilities: (a) standard-setting - to develop public sector internal audit standards and enforce their implementation; (b) recruitment - to develop recruitment pol icy including entry and promotion criteria and recruit internal audit staff for a l l internal audit positions across the govemment; (c) training - to develop and deliver structured training programs including continuous education programs; (d) quality assurance - to develop quality assurance mechanisms to ensure high quality internal audit work; and (e) internal audit work - to carry out internal audit work upon the request o f a line ministry, for example in circumstances where the l ine ministry lacks appropriate capacity.

0 Each l ine ministry would be responsible for and held accountable for maintaining an adequate internal control framework within their ministries. Each line ministry should establish an internal audit department, headed by a director and reporting directly to the line minister as well as, if circumstances warrant, to an audit committee in the line ministry. Each line ministry’s internal audit department will be responsible for conducting internal audit activities within the l ine ministry and submitting internal audit reports to the line minister and audit committee.

0 Each line minister should prepare an annual assurance letter addressed to the Prime Minister or Minister o f Finance confirming that an effective internal control framework has been maintained within the ministry and describing key issues as well as any remedial action plans to address material weaknesses. This would reinforce the accountability o f the l ine minister to maintain an effective internal control framework in the ministry and strengthen the decentralized internal audit structure. The Prime Minister or Minister o f Finance should annually prepare a summary table o f al l l i ne ministers’ assurance letters and

Azerbaijan CFAA: Public Sector Auditing 20

present i t to the Council o f Ministers for discussion. This would enhance the govemment’s awareness o f the state o f its financial management framework.

Azerbaijan CFAA: Leuislafive Scrutiny of Public Sector Financial Manauemenf 21

5. LEGISLATIVE SCRUTINY OF PUBLIC SECTOR FINANCIAL MANAGEMENT

48. The legislative scrutiny o f the public sector finances i s currently in a state o f significant change. A s discussed earlier, a new Budget Systems Law (BSL) has been approved by Parliament and has been enacted and became effective o n January 1, 2003. Until recently (prior to the enactment o f the new BSL), the following documents were submitted to the Parliament together with the draft State Budget:

a

a

a

a

a

e

a

a

49.

report on performance o f the state budget in the current year;

draft L a w on the state budget for the next fiscal year;

concept o f economic and social development with forecast indices for next fiscal year;

earmarked budget funds;

main directions in budget and tax policy;

combined financial balances o f Azerbaijan Republic;

draft laws on extra-budgetary funds; and

revenue and expenditure estimates o f state budget as per budget classification for the next fiscal.

The information was not considered comprehensive enough to generate a meaningful debate in the Parliament for informed decisions o n the government’s budget proposals. The information provided was highly aggregated and was not based on full classification details. In addition: information on extra-budgetary operations was not provided; there were no explanatory notes in support o f the budget proposals; information on government debt and guarantees was not provided; and investment expenditure was shown as a one-line item. All o f these issues appear now to have been addressed by the new BSL and thus the effectiveness and impact o f these changes remain to be evaluated with respect to the State Budget for 2004, the f i rs t year for which these new budgeting provisions wil l be implemented. However, i t s t i l l appears that Parliament i s only able to approve or reject the budget in its entirety with no possibility o f raising a line-item veto or similar and, on a related theme, Parliament has very l i t t le control over appropriations. Thus government i s able to reallocate between economic heads and organizations and between sub-sections o f the functional heads, thereby diluting the discipline among budget users to formulate reasonable budget proposals and function strictly within their appropriations. Only in circumstances where actual revenues in any quarter are less than 20% o f budgeted revenues for that quarter or where actual revenues in the first ha l f o f the year are less than 30% o f budgeted revenues for that ha l f year does the B S L provide for a debate on the issue in Parliament. Thus i t i s difficult to impose hard budget constraints on the budget users as they have the option to approach the appropriate authorities to get increased allocations.

Azerbaijan CFAA: Leqislative Scrufinv of Public Sector Financial Manaqement 22

50. In terms o f reporting on budget execution, the new B S L specifically provides for regular monthly, quarterly and annual reporting based on functional and economic classifications and these are to be shared with Parliament and the media o n a quarterly basis together with other financial indicators and narrative reports. The annual report on budget execution i s shared with Parliament by M a y 15 for approval. Again, as the present B S L became effective only on January 1, 2003, the effectiveness and impact of these changes remain to be evaluated. Also, i t i s expected that the quality o f reporting to Parliament will improve significantly after the Treasury Information Management Systems (TIMS) described earlier in this report has been fully implemented.

51. The Parliamentary Commission recently formed by the merger o f the two Parliamentary Permanent Commissions on Economic Policy and Budget Issues established in accordance with the L a w o n Permanent Commissions o f Parliament (1 998) is charged inter alia with: (i) reviewing draft laws on the state budget, banking activity, accounting, local taxes, and local budget issues amongst others; (ii) considering the candidates nominated by the President o f Azerbaijan to take positions o n the Board o f the National Bank o f Azerbaijan (NBA); (iii) considering the candidates nominated to the positions o f Chairman, Deputy Chairman and seven Auditors o f the Chamber o f Accounts, the Azerbaijan supreme audit institution; (iv) considering issues raised in respect o f the state budget as raised by other permanent commissions o f Parliament; and (v) considering the candidates nominated to the positions o f Chairman and Deputy Chairman o f the Chamber o f Auditors, the organization both charged with standard- setting and regulation o f the private sector auditing profession and also able to perform audits o f both private and public sectors (see discussion o f private sector auditing later in this CFAA).

52. Permanent commissions o f Parliament are empowered to request any information and representatives from central and local executive, juridical bodies, local self- governments (municipalities), state-owned and private enterprises, departments and other organizations. All such requests must be complied with within ten days unless they contain government, military or commercial secrets and an explanation o f the reasons are presented to the Chairman o f Parliament.

Azerbaijan CFAA: Local Government Institutions' Financial Manaaement 23

6. LOCAL GOVERNMENT INSTITUTIONS' FINANCIAL MANAGEMENT

53. Azerbaijan is organized according to a two-tier administrative system (central government and sub-national govemments comprising rayons, cities and municipalities, and one autonomous regioddistrict). Local executive power i s assigned to governors, who are appointed by the President. The Constitution defines the roles o f local government institutions (LGIs) which, among others, impose taxes and approve their own budgets.

54. A clear division o f responsibilities between different levels o f government i s s t i l l emerging. Azerbaijan i s in the process o f establishing municipal govemments. However, the new and proposed laws do not define their responsibilities or sources o f revenue clearly. The Draft Law on Municipal Property defines what property (e.g., primary and secondary schools) wil l become municipal property, and the municipalities will have the responsibility for maintaining and managing these properties. The L a w on Financial Principles o f Municipalities (1 999) states that budgeted expenditures may include other items such as local social protection, socioeconomic development, or environmental protection. This law also defines local budget revenues which include 17 taxable activities that will provide revenues for the municipalities and will be collected locally as well as subventions from the state budget. However, the specific criteria for determining the size o f the transfers from the state budget are not provided and thus municipalities receive ad hoc transfers from the state budget and there i s no systematic process in place for fiscal transfers from central govemment. In addition, although the law says certain criteria will be taken into account, i t also states, in effect, that a deficit shall be covered by subsidies received from the State budget. Finally, municipalities are given the right to short- or long-term credit from domestic financial institutions, but the law also states that the State government wil l bear no responsibility for covering the obligations of municipalities to credit institutions.

Azerbaijan CFAA: Private Secfor Accountina and Auditina 24

7. PRIVATE SECTOR ACCOUNTING AND AUDITING

55 . A s discussed earlier, the Government has as one o f its objectives, the removal o f impediments to growth and employment in the non-oil sectors. The Government wants to structure i ts investment environment and privatization program, to maximize inf low o f foreign direct investment, and local j ob creation. During the past several years, the Government privatized most small businesses and a number o f larger enterprises through the first privatization program and the Government recently started to implement an ambitious second-phase o f the privatization program.

56. This section o f the C F A A i s intended to provide support to the Government in the development o f the Azerbaijan investment climate by reviewing the private sector financial accounting and auditing framework and comparing it with international best- practice. The review o f this framework i s divided along two main sectors: the enterprise and banking sectors.

Enterprise Sector

Accounting

57. The accounting framework o f the enterprise sector i s fairly undeveloped and remains essentially unchanged from the time o f the Soviet Union in the form o f a fixed chart o f accounts, fixed bookkeeping methodologies and procedures, as wel l as fixed format accounting books and records. Accounting standards were directed towards the calculation and collection o f taxes as wel l as the compilation o f statistics rather than for the purposes o f managing and evaluating businesses.

58. However, and since the collapse o f the Soviet Union, the development o f different guidance and standards on accounting has created confusion because o f differences of principle between the texts as well as omissions o f guidance on particular issues. There are at present various sources o f guidance in respect o f what may collectively called accounting (tax, statistical and financial) standards, the primary ones being: the Civil Code (1999); the Law O n Accounting (1995); and the Tax Code (2000). Other sources o f guidance include: the Joint Stock Companies Law (1994) and the Enterprises Law (1994). For the sake o f illustration, the table below presents some o f the differences and omissions between the main texts.

Azerbaijan CFAA: Private Sector Accounfinu and Audifina 25

Accounting issue

depreciation rates

Fixed assets not to be depreciated

Financial leases

I Inventory valuation

doubtful receivables

Frequency o f financial statements

Format o f financial statements

Preparation o f consolidated group financial statements

records

Civil Code

U s e depreciation according to l i fe o f asset (Art. 121.9.2)

First-in first-out (FIFO) or other ( ~ r t . 12 1.14)

Provide to the extent not recoverable ( ~ r t . 121.9.4)

Every business year (Art. 121.1)

Prescribed in detail (Art. 122)

Balance Sheet Appendix to provide information on legal entities o f which more than 25% o f zharter capital i s owned ( ~ r t . 124.4)

Law on Accounting

Use depreciation norms issued by the Cabinet o f Ministers (M. 27.2)

Land ( ~ r t . 27.2)

Confirms that they can be capitalized as a fixed asset ( ~ r t . 27.5)

Average, FIFO or Last-in first-out (LIFO) (k. 19.1)

Provide to the extent not recoverable and specific write-off after f ive years ( ~ r t . 22.5)

Every calendar year (AIT. 32)

Azeri only ( ~ r t . 13.2)

Tax Code

U s e depreciation norms specified in the Tax Code ( ~ r t . 114)

Land, fine art and other assets not subject to wear and tear (Art. 114.2)

Defines as a lease where discounted value o f lease payments exceeds 90% o f value o f asset (Art. 140)

Average or individual actual

Only specific provisions and then only if accounted for as worthless (Art. 111.2)

(Art. 139.4)

Every calendar year ( ~ r t . 129)

Any but to provide translation into Azeri if requested (Art. 71.3)

59. In order to reduce the administrative burden o f complying with the various accounting standards, enterprises generally attempt to find the most common acceptable accounting pol icy (e.g. producing financial statements every calendar year and in the format prescribed by the C i v i l Code) although this i s not always possible (e.g. fixed assets depreciation rates).

60. In accordance with the L a w On Accounting (1995), the setting and enforcement o f accounting standards is the remit o f the MOF. Accordingly, the MOF established an Accounting Methodology Department which currently comprises eight full- time staff. Somewhat in contradiction, the Presidential Decree o f December 26, 2001, On Implementation o f the Law On the State Budget for 2002, required the Cabinet o f Ministers to prepare “the draft State Program on Reforms in

FIAS: Findings and recommendations in respect of tax and accounting

Private sector representatives consider the new Tax Code as a major improvement. However, investors criticized some unclear provisions and inconsistencies that make the day- to-day compliance difjcult. For example, the section on deductibles leaves much space for interpretation, and the tax inspectors on the ground use this interpretative space to the disadvantage of the taxpayer, regardless of the law’s obvious intention.

Another concern in the tax system is the accounting standards. There are considerable costs involved to companies to maintain two accounting books, one in accordance with Azeri Accounting Standards ( A S ) and one in accordance with IAS. The accounts in accordance with A S are seen as virtually meaningless by many investors and IAS is often followed even ifthe company is based solely in the country.

I n the medium-term, it would be critical to strengthen Government’s ongoing eforts (in cooperation with the IMF) to harmonize tax legislation with connected legislation, such as the accounting legislation and to introduce international accounting standards (IAS). As an option, especially for foreign-ownedfirms, use of only IAS could be made available as soon as a cadre in the tax administration has been appropriately trained.

Source: FIAS Diagnostic Review of the Environment for FDI (May 2002)

Accounting and the draft Law o n Accounting and present [them] to the President” within one month o f the Decree. In the spirit o f compromise, the Accounting Methodology Department o f the MOF worked together with the Cabinet o f Ministers to devise a program and action plan for the reform o f Azeri accounting standards which established the following main objectives:

0 To prepare in a timely fashion, important amendments and modifications into law o f the Republic o f Azerbaijan o n “Accounting” and other legal and normative acts.

0 Within two years, to prepare and approve national accounting standards reflecting a major part o f international accounting standards.

0 To revise current accounting methodologies and practices.

0 Within two years, to prepare a simplified accounting system for small enterprises.

Azerbaijan CFAA: Private Sector Accountinu and Audifina 27

61. Whilst the program’s objectives are generally sound, program design and implementation could benefit f rom external assistance. More specifically, i t is not clear that the MOF’s Accounting Methodology Department i s familiar with any recognized international standards of accounting, including International Accounting Standards (IAS) as promulgated by the International Accounting Standards Board (IASB), or o f the potential issues associated with the introduction o f a significantly new accounting standard regime, particularly in terms o f training and capacity-building. I t is understood that MOF is considering re-establishing a defunct Council o f Accountants to act as a sounding board for the MOF as it develops the requested new accounting standards.

62. In addition, EU-TACIS has initiated a project to assist in the introduction, development and application o f international financial reporting standards in the non- banking sector. The technical assistance wil l include institutional support to the Ministry o f Finance in the planning, drafting and implementation o f new accounting standards based on I A S as we l l as the development o f a comprehensive training program and support to selected enterprises to help them effectively adopt and implement the new standards. I t is expected that the technical assistance wil l start in December 2002 for a period o f approximately 18 months.

63. technical assistance to be provided by EU-TACIS, this C F A A recommends:

In respect o f private sector enterprise accounting, and in conjunction with the

0 the re-establishment o f the Council o f Accountants moderated by the M O F to comprise representatives o f practicing auditors, accountants with experience of preparing financial statements, users o f financial statements and academia as well as organizations such as the National Bank o f Azerbaijan, State Statistical Institute and the Tax Inspectorate. To give the Council the responsibility for preparing and determining accounting standards to be set by the M O F in a transparent and open manner. (The status and operation o f International Accounting Standards Committee (IASC) and i ts International Accounting Standards Board (IASB) will provide useful benchmarks in this regard. In addition, as the Council goes forward with the development o f national accounting standards, i t may wish to make use o f the resources provided by the IASC as i t develops i t s accounting standards);

0 the development o f a plan to harmonize the various sources o f accounting guidance, particularly the C iv i l Code and the Accounting Law as well as the requirements o f the State Statistical Committee, with a view to devising a manner in which a single set o f accounting standards may be developed that satisfies all interested parties and which may be readily revised from time to time, after due process;

0 the removal o f that part o f the remit o f the MOF which empowers it to enforce accounting standards but rather relying on auditors’ conclusions and where such conclusions indicate non-compliance with accounting standards, due process be allowed to take place within the legal system by any aggrieved parties; and

Azerbaijan CFAA: Private Sector Accountina and Audifinq 28

0 the development o f training and capacity-building programs to support any revisions to the accounting standards or methodologies and thereby increase the chance o f their orderly and successful implementation.

Auditing

64. In accordance with the C iv i l Code, the L a w o n Enterprises and the Law on Joint Stock Companies, a l l limited l iabi l i ty companies, a l l jo int stock companies, and other legal entities exceeding prescribed thresholds are required to have an annual audit by an independent auditor or audit firm. In addition, and according to Instruction No. 9 on Taxation o f Profits and Income o f Foreign Legal Entities, a l l foreign entities carrying out activities in the Azerbaijan Republic through permanent representations are also required to submit annual audited financial statements.

65. The auditor i s appointed and the audited financial statements are approved at a general meeting o f shareholders although, in the case o f l imited l iabi l i ty companies, any shareholder may request an audit at any time, and in the case o f jo int stock companies, shareholders with greater than ten percent o f the voting share capital may request an audit at any time.

66. other things:

Auditing i s governed by the Law on Audit Service (1994) which defines, amongst

0 an audit: “the independent inspection o f legibility and authenticity in accounting calculation policy, accounting and financial report o f economic subjects dealing with production and goods sells, rendering o f services and works to be performed”; and

0 an auditor and audit firm: a “legal person, obtaining the right to render audit services . . . under license o f the Chamber o f Auditors”

67. In accordance with the L a w on Audit Service, auditors are prohibited f rom auditing organizations in which they have a personal interest , if they are related to the any o f the management o f the organization, if they are the founders or owners o f the organization or if they have rendered services to the organization connected with their professional activity. Further, auditors are forbidden f i om carrying out activities other than auditing.

68. There remains a certain amount o f confusion as to the precise remit o f the Chamber o f Auditors because, by virtue o f its foundation document, the Provisions o f the Chamber o f Auditors (1995) that were approved by the Azerbaijan Parliament, i t has the dual roles o f (i) audit profession standard-setter and regulator; and (ii) an audit institution enabling it to perform audits o f both private and public sectors. In addition, both the Chairman o f the Chamber of Auditors as wel l as his deputy are appointed by the Parliament. As discussed earlier, the Chamber o f Accounts was recently formed as the Azerbaijan Supreme Audit Institution (SAI) thus going some way to address the confusion in respect o f the audit o f the state and public sector organizations. However, and despite confirmation from the Chamber o f Auditors that i t wil l no longer engage in the provision of audit services, there remains a great deal o f reluctance by audit

Azerbaijan CFAA: Pn’vafe Secfor Accounfinu and Audifinu 29

practitioners to cooperate with the Chamber o f Auditors because it i s viewed as a potential competitor rather than as a standard-setter and regulator and because the Chamber o f Auditors is not regarded as representative o f the audit profession but rather imposed by Parliament.

69. The Chamber o f Auditors has a cadre o f 65 staff and comprises a Board, an Examination Commission, three so-called Special Commissions (Audit Norms and Standards Development; Recurring Audit; and Audit Quality Control) and nine departments / divisions (Standards; Audit Analysis and Organization; Specialists Training and Education; Control; Finance; International Relations and Information; Act iv i ty Management; Internal Audit; and the publication, “Economy and Audit”). There are approximately 33 auditing companies, 42 independent auditors and 192 licensed auditors registered with the Chamber o f Auditors. Audit companies are required to have no less than three independent licensed auditors. The Chamber o f Auditors awards audit licenses if the candidate auditor: has completed a higher education in accounting, economics or law; has more than three years of professional accounting experience; and has taken and passed any o f the biannual exams that are set and marked by the Chamber o f Auditors. The Chamber o f Auditors requires licensed auditors to have a 40 hours per annum o f Continuing Professional Education (CPE) although these requirements appear only to deem the attendance at courses and seminars organized by the Chamber o f Auditors and the passing o f various exams at the conclusion o f these courses as acceptable CPE. At the end o f an auditor’s licensed period, and after due consideration o f the auditor’s CPE, the Chamber may renew the auditor’s license for a further period o f five years.

70. There are 26 national auditing standards as well as a code o f ethics which were developed and issued by the Chamber o f Auditors as part o f a program o f developing a complete set o f Azeri auditing standards based upon International Standards on Auditing (ISA) as promulgated by the International Federation o f Accountants (IFAC). A further 10 auditing standards are expected to be developed in the course o f 2002. These auditing standards are registered with the Ministry o f Justice as normative documents and have the force o f law. In addition to the 26 auditing standards issued by the Chamber o f Auditors, the C iv i l Code also specifies the form o f required audit attestation.

71. The Chamber o f Auditors i s charged with enforcement o f auditing standards and perfonns this role by requiring auditors and audit companies to maintain records listing the audits that have been performed as well as submitting themselves to quality assurance inspections performed by the Chamber o f Auditors. As discussed earlier, there remains a great deal o f reluctance by audit practitioners to cooperate with the Chamber o f Auditors because i t i s viewed as a competitor rather than as a regulator, and because some o f the information requested by the Chamber o f Auditors seems to exceed their remit e.g. details o f fees charged to each client.

72. Because o f the init ial envisaged role o f the Chamber o f Auditors as an SAI, the Chamber o f Auditors i s a member o f the International Organization o f SAIs (INTOSAI) as well as its European and Asian regional organizations, EUROSAI and ASOSAI. The Chamber o f Auditors i s a member o f the Institute o f Internal Auditors and also the Eurasia Federation o f Accountants and Auditors, however i t i s not a member o f IFAC.

Azerbaijan CFAA: Private Sector Accounfinq and Auditinq 30

73. In respect o f private sector enterprise auditing, this C F A A recommends:

0 that entities which are required to have an audit should be defined in a single document, preferably in the C i v i l Code, rather than as currently, in a variety o f documents.

0 an amendment to both the Provisions o f the Chamber o f Auditors (1995) and the L a w on Audit Service (1994): (i) to reflect the status o f the Chamber o f Accounts as the country's Supreme Audit Institution and substitute the parliamentary accountability o f the Chamber o f Auditors with self-regulation, including the election o f the senior positions in the Chamber o f Auditors; and (ii) to exclude the provision o f auditing services from the permitted scope o f activities o f the Chamber o f Auditors;

0 that in respect o f the obligation for licensed auditors to engage in Continuing Professional Education (CPE), the Chamber o f Auditors should recognize that certain training delivered by organizations other than the Chamber o f Auditors are also o f value and therefore should count as CPE, particularly in view o f the limited capacity o f the Chamber o f Auditors to deliver such courses;

0 that the International Standards on Auditing (ISA) as promulgated by the International Federation o f Accountants (IFAC) should be adopted in their entirety rather than the Chamber o f Auditors preparing national standards o n auditing. Any guidance on the audit o f matters specific to Azerbaijan could be addressed by means o f additional guidance. Additionally, the reference in the C iv i l Code to the format o f reporting should be removed and such matters le f t to the discretion o f the Chamber o f Auditors - in effect the I S A standards on reporting would take precedence; and

0 The Chamber o f Auditors should relinquish i t s membership o f the International Organization o f Supreme Audit Institutions (INTOSAI) as we l l as i t s European and Asian regional organizations, EUROSAI and ASOSAI, in favor o f the Chamber o f Accounts, the recently established Azer i Supreme Audit Institution. The Chamber o f Auditors should j o i n IFAC.

Ban king Sector

Background

74. The Government and the NBA, in close cooperation with both the Bank and the IMF, adopted, in late 1999, a comprehensive strategy for systemic banking sector reform to foster a sound, efficient private banking system, which would support the needs o f a functioning market economy. The strategy (summarized in the Government's letter to the Bank dated April 20,200 1) was aimed at three broad areas:

0 a more effective approach to restructuring and divestiture o f the state-owned banks. Significant progress has been made in this areas in that three large banks have been liquidated and the largest remaining bank, the International Bank o f Azerbaijan (IBA), is now 45% privately-owned and it is anticipated that it will

Azerbaijan CFAA: Pfivafe Sector Accountins and Audifins 31

become a majority privately-owned bank by mid-2003 with the EBRD becoming the main shareholder;

0 a more systematic focus on problems in the private banking sector. Progress has also been made in this area particularly with respect to banking supervision and regulation. In addition, there has already been a consolidation in the banking sector and in view o f the rise in the minimum capital for banks from US$2.5 m i l l i on to US$ 5 mi l l ion effective 2005, further consolidation in the banking sector i s l ikely to take place; and

0 actions to identify more clearly and address weaknesses in the broad infrastructure supporting banking activity. Considerable progress has been made in this area as discussed in the following paragraphs.

75. The main elements o f this strategy from a C F A A perspective include: (a) enhancing the legal and regulatory framework, resources and capacity for bank supervision and regulation for which significant progress has already been made; and (b) strengthening o f the financial infrastructure (accounting, auditing, payments system) necessary for supporting a sound, efficient banking system. In addition, the authorities have revised the legal framework by: (i) enacting a new L a w on Banks; (ii) submitting to Parliament amendments to the Bankruptcy Law; and (iii) enacting the Law o n Payments system.

76. The banking sector in Azerbaijan serves as the backbone o f the country's financial system. Following independence, a two-tier banking sector was created in 1992 comprising the NBA and the commercial banks. The sector i s relatively small, with total assets o f about US$980 mi l l ion representing approximately 25 percent o f GDP. Until early in 2000, four state-owned banks, AIB, PIB, SVB and the International Bank o f Azerbaijan (IBA), dominated the market. The non-performing loans accounted for well over 90 percent o f portfolios o f AIB and PIB and, in spite o f consecutive recapitalizations, they continued to run operating losses. IBA currently accounts for about 75% o f and therefore s t i l l dominates the market, but its market penetration i s slowly being reduced. AIB, MIB and SVB have been liquidated and replaced by a new bank, BUS Bank, which was been from performing assets of the three banks. BUS Bank has only partial operating license and cannot lend however it i s thought to be in stable financial and profitable condition. The non-performing assets o f the three banks were placed in a non-banking credit agency established by the Ministry o f Finance. As a whole, the banking sector i s in a stable condition and has the fol lowing characteristics:

0 until early 2001, the payment and settlement systems were rudimentary, with interbank payments carried out primarily on a physical basis. The inefficiency o f the payments system did not provide the degree o f confidence required to support the development o f the financial sector and constitutes an additional cost o f financing for the private sector. A Real Time Gross Settlement system started operating in February 2001 and i s now fully operational. This system initially handled only large payments however, and with the assistance o f the FSTA, a bulk / small value (retail) payment system was installed in August 2002 and became fully operational in December 2002;

Azerbaijan CFAA: Private Sector Accounting and Auditing 32

0 the private commercial banking network consists o f about 40 banks, most o f which seem to satisfy prescribed capital adequacy ratios but are nonetheless small and play a l imited role (less than ten percent o f the total sector). In view o f the earlier discussed prospective increase o f the minimum capital for banks, further consolidation in the banking sector i s expected;

0 although the NBA and the Government intend to encourage the opening o f foreign banks, this presence i s currently limited;

0 with assistance from the IMF, banking supervision and banking regulation have been strengthened but more needs to be done, particularly to improve the clarity and transparency o f rules and strengthen enforcement. There has been major progress in terms o f strengthening the capacity o f the NBA particularly with respect to enforcement, however, and in view o f their dominance o f the sector, the IBA continues to represent a challenge to the authority o f the NBA;

0 an International Accounting Standards (1AS)-based chart o f accounts for banks was prepared and introduced in early 2000. This has now been followed by the introduction o f US-based national banking accounting standards. With the support o f the FSTA, technical assistance i s being provided directly to individual banks in order that they may meet full compliance by mid-2003. The NBA i s i tself fully compliant with U S - for further information o n the NBA, refer to section 8 below which addresses the fiduciary implications o f the country’s financial management framework on Bank-financed projects.

Accounting and Auditing

77. In accordance with the L a w o n Banks and Banking Act iv i ty (1996) and the Law on the National Bank o f Azerbaijan (1996), banks are granted licenses, regulated and supervised by the central bank, the National Bank o f Azerbaijan (NBA). The extent of such regulation and supervision includes the banking sector’s accounting and auditing arrangements which have developed at a comparatively more rapid pace than those o f the enterprise sector.

78. The NBA has devised a chart o f accounts, 14 accounting standards based upon International Accounting Standards (IAS), and financial reporting formats, a l l for the banking sector and al l o f which wil l be refined and supplemented in the near future. Some o f the banking accounting standards developed by the NBA could apply equally well to the non-banking sector (e.g. the accounting standards for fixed assets, small value assets and leases). I t i s understood that the NBA was obliged to develop these basic accounting standards in addition to the purely banking sector accounting standards / guidance because o f the absence o f an acceptable set o f basic national accounting standards and because the authority o f the NBA to establish national accounting standards does not extend beyond the banking sector, such authority resting with the MOF.

79. The Bank i s currently assisting the Government through the NBA in i ts reform of the banking sector with the Financial Sector Technical Assistance credit (FSTA).

Azerbaijan CFAA: Private Sector Accountina and Auditins 33

Outputs f rom the FSTA in respect o f the banking sector’s financial accountability framework include:

a

a

a

a

a

a

80.

Establishment o f A z e r i banking accounting standards compatible with IAS.

Passage o f the required laws and regulations to enable the administration o f the above accounting standards.

Financial reporting by commercial banks based on the standards prescribed by NBA.

Completion by NBA o f the manual o f procedures and guidelines for accounting practices.

Development and strengthening o f banking supervision on-site inspection procedures and guidelines. (USAID will provide fwther necessary technical assistance for this).

Review and revision o f the laws and supporting regulations to enhance NBA’s supervisory capacity.

In accordance with the L a w on Banks and Banking Activity, a bank’s annual audited financial statements are approved by the general meeting o f shareholders, however the auditor i s appointed by the Supervisory Council, the Board o f Directors and shareholders with greater than ten percent o f the voting share capital rather than by the general meeting o f shareholders.

8 1. All banks are required to have an annual audit by external auditors acceptable to the NBA. In 2001, the NBA judged that some audit firms had been performing sub- standard audits and therefore decided that henceforth only certain auditors would be considered acceptable to perform the audits o f banks, being, in general terms, auditors licensed by the Chamber o f Auditors with specific experience o f conducting banking audits as well as auditors who have successfully completed special course on banking audits. There are presently approximately 15 audit f i r m s considered acceptable to the NBA - the so-called Big-4 intemational audit f i rms, who perform 85% o f al l banking audits, and other local auditors.

82. The EU-TACIS continues to finance the Azerbaijan Banking Training Center (ABTC), an organization that offers several accounting and auditing training programs, including those on risk management, internal controls, accounting standards for banks and the audit o f banks. The NBA is supportive o f the A B T C and both organizations work together with the Chamber o f Auditors in respect o f banking auditing issues. Those auditors attending and passing the exams set at the end o f these courses are adjudged to be acceptable auditors for the purposes o f auditing commercial banks.

83. In respect o f the banking sector, and in conjunction with the technical assistance being provided by Bank in the Financial Sector Technical Assistance credit (FSTA), this C F A A recommends:

Azerbaijan CFAA: Private Sector Accounting and Auditinq 34

0 that the NBA should work together with the MOF [and the prospective Council o f Accountants] to coordinate the ongoing development o f banking accounting standards led by the NBA with the prospective development o f non-banking national accounting standards led by the MOF with a view to reconciling and eliminating differences between the core non-banking accounting standards. In the long run, there should be only one set o f core non-industry-specific accounting standards with additional guidance and standards to be developed when required for specific sectors, including the banking sector; and

0 that the NBA, working together with the Chamber o f Auditors, should establish clear criteria by which auditors are deemed acceptable or othenvise to conduct the audits o f banks and banking institutions. (It is understood that an initiative with a similar objective has recently started in the Ukraine and thus the NBA and Chamber o f Auditors may be able to benefit from the Ukraine experience).

Corporate Governance and Financial Accountability

84. The core elements o f Azeri corporate governance are established in the C iv i l Code (1999), the Joint Stock Companies L a w (1994), the Enterprises L a w (1994), and the Law o n Banks and Banking Act iv i ty (1996). Using the principles o f corporate governance as established by the Organization for Economic Co-operation and Development (OECD) as a benchmark, the financial accountability aspects o f the country’s corporate governance framework are summarized below.

Quality offinancial information

85. Refer to earlier sections on private enterprise and banking sector accounting.

Audits and auditors

86. Refer to earlier sections o n private enterprise and banking sector auditing.

Financial Control

87. In accordance with the Law on Joint Stock Companies (1994), every jo int stock company i s obliged to establish, in addition to a management (Board) and a supervisory council, a financial auditing commission. The financial auditing commission, having been elected by the general meeting o f shareholders i s established in order to control (check) and audit the economical and financial activity o f the company. The financial auditing commission submits an annual report at the general meeting o f shareholders based o n the annual financial statements and without such a report from the financial auditing commission, i t i s not possible for the general meeting o f the shareholders to approve the annual financial statements. The financial-auditing commission also audits the financial and economic activity o f the company in the fol lowing cases:

0 on completion o f the economic year;

0 on demand from the general meeting o f the shareholders;

Azerbaijan CFAA: Private Sector Accountino and Auditino 35

0 o n demand from the shareholders who own one tenth o f vote;

0 o n demand from the supervisory council and management;

0 in other cases specified by the articles o f association.

88. In accordance with the L a w o n Banks and Banking Activities (1996), every bank i s obliged to establish, in addition to a management (Board) and a supervisory council, a financial auditing commission. The financial auditing commission, having been elected by the general meeting o f shareholders i s established in order to ensure compliance with banking legislation, normative acts o f the National Bank and the foundation documents o f the bank and also to control the bank’s accounting. The financial auditing commission executes audits according to the plan i t adopts and by the demand o f the Supervisory Council, the board and shareholders representing over 10%of votes, and in other cases, specified by the foundation documents. As is the case for jo int stock companies, the general meeting cannot approve the annual financial statements without a report from the financial auditing commission. Resolutions o f the financial auditing commission are adopted with a simple majority o f votes although abstentions are prohibited. The general meeting may remunerate the financial auditing commission and in such cases awards are to be granted only from the net prof i t o f the bank. In accordance with an instruction issued by the NBA, al l commercial banks are required to establish an internal audit function reporting directly to the Board as wel l as the financial auditing committee.

89. governance framework, this C F A A recommends:that:

In respect o f the financial accountability aspects o f the country’s corporate

0 the Law on Joint Stock Companies (1994) as well as the Law on Banks and Banking Activities (1996) should clarify the roles and resources available to the financial auditing commission. As currently formulated, the financial auditing commission appears to have the dual roles o f audit committee and internal auditor and i t i s not clearly remunerated for its performance o f either. The role o f a finance committee normally includes a consideration o f the reports and recommendations o f the organization’s internal and external auditors, both of which are financed by the organization directly. An internal auditor i s an appraisal activity established within an entity as a service to the entity and i t s hnctions include, amongst other things, examining, evaluating and monitoring the adequacy and effectiveness o f the accounting and internal control systems, Thus i t i s an internal auditor who audits an entity from within and an audit committee that analyzes the results o f both the internal and external auditor and presents these results to the Board as well as the general meeting o f shareholders. The remuneration o f the audit committee is normally decided upon by a remuneration committee although a vote on the matter by the general assembly could be reasonable alternative, and should not in any event, be contingent upon the profitability o f the organization.

Azerbaijan CFAA: Fiduciarv Considerations in ResDect of Bank-Financed Projects 36

8. FIDUCIARY CONSIDERATIONS IN RESPECT OF BANK-FINANCED PROJECTS

Reliance on Public Sector Financial Management Framework

90. In view o f the foregoing analysis o f the country’s public sector financial management framework it is clear that there is a need for substantial strengthening in the areas o f budgeting, treasury management, financial reporting, internal auditing and external auditing. Most o f these needs have already been recognized and there are already plans and operations underway to address them (refer to summary matrix at front o f this document). At present however, there are sufficient concerns about the operation and integrity o f the country’s public sector financial management framework that it would be inappropriate to place a blanket reliance o n the framework for the purposes o f satisfying the Bank’s fiduciary financial management requirements. Reliance on any particular aspect o f the country’s financial management fiamework for the purposes o f satisfying the Bank’s financial management requirements would need to be established on a case-by-case basis by reference to the specific financial management arrangements o f the institutions involved. This i s not to say that the Bank’s current approach of routinely “ring-fencing” Bank-financed projects and supporting the establishment o f so- called project implementation units is appropriate, but rather in view o f the ongoing and significant assistance being given to the government o f Azerbaijan in the strengthening o f its public sector financial management framework, Bank teams should n o w be strongly encouraged to explore the possibilities o f relying o n parts o f that framework for the purposes o f satisfying the Bank’s fiduciary financial management requirements. The recent appointment by the Bank o f a Financial Management Analyst in its Baku office should help to address and coordinate this issue.

Project Financial Management

91. This section o f the C F A A does not constitute a detailed assessment o f the financial management arrangements in place at the projects financed by the Bank. More specifically, the C F A A did not seek to and does not confirm the appropriateness o f the projects’ financial management arrangements and therefore does not substitute for normal supervision o f the portfolio’s financial management arrangements. Rather, this section o f the C F A A identifies and addresses certain generic project financial management issues across the portfolio o f Bank-financed projects in Azerbaijan.

Issues raised by the Country Portfolio Performance Review

92. A recent Country Portfolio Performance Review (CPPR) with representatives o f the Bank, government and project implementing units raised the fol lowing issues which have a bearing on the financial management arrangements o f Bank-financed projects:

0 the need for the Bank to perform a detailed evaluation o f audit firms and confirm their acceptability before the Bank wil l be able to issue no-objections to the use o f these audit f i r m s for the audits o f Bank-financed projects;

0 the need to ensure that copies o f audit reports are made available o n a timely basis to the responsible l ine Ministry;

Azerbaijan CFAA: Fiduciarv Considerations in ResDecf of Bank-Financed Projects 37

0 the need to avoid requiring that project implementing units produce multiple financial reports containing similar financial information in many different formats;

0 to ensure that government counterpart funds are provided on a timely basis;

0 the need for project implementing units to apply on a project-by-project basis to the Cabinet o f Ministers for exemptions from withholding taxes and customs duties o n imported goods;

0 the need to develop standard j o b descriptions for key staff in project implementing agencies; and

0 the need to move away from creating standalone project implementing units but rather strengthen the responsible line Ministry.

Project financial management systems

93. A br ie f review o f the financial management arrangements at the various project implementing units showed that a variety o f as well as similar project financial management systems have been established and are being managed without significant regard to building upon or leaming lessons from existing project implementing units in terms o f technical know-how, systems design and implementation, and ongoing issues such as taxation and import licenses. For example, although some software i s being used consistently in a few projects, one project’s software i s now out-of-date, one project maintains parallel accounting systems for Azeri and World Bank reporting purposes, and one project developed i t s own software. This diversity o f approaches to project financial management has resulted in a significant amount o f total financial management-related project expenditures, most notably software and consultants’ time and costs. I t was also noted that there i s little, if any, integration with responsible l ine ministries and their financial management systems.

94. This C F A A recommends that in order to minimize the risks and costs associated with the development and management o f multiple financial management systems at the many project implementing units implementing Bank-supported project, a centrally coordinated group to oversee such matters should be established, perhaps in the Foreign Economic Relations Department o f the Ministry o f Finance. This unit should also be charged with the responsibility to form a strategy better to integrate project financial management arrangements with those o f responsible l ine ministries.

Audit arrangements

95. At the time o f the CFAA, the borrower was substantially in compliance with al l audit covenants o f Bank-financed projects. This C F A A recommends that audit f i r m s currently performing the audits o f Bank-financed projects as well as any others expressing an interest in performing such audits, should be reviewed in the very near future by a team o f Bank financial management specialists o n the basis o f both information provided by the auditors as well as on-site and in detail to confirm these auditors’ acceptability to the Bank.

Azerbaijan CFAA: Fiduciary Considerations in Rewect of Bank-Financed Projects 38

Considerations of Corruption

96. Government intervention in the private sector i s considered extensive, and in many cases regulations either are not clear or their enforcement i s not transparent. There are also cases o f unequal treatment o f public and private sector enterprises, and foreign and domestic enterprises. Furthermore, regulations and licensing are a source o f rent seeking by public sector employees. Despite a Presidential decree in 1999 against intrusive inspections by police and prosecutors, this behavior persists. A L a w on Police and a L a w on Prosecutors were passed in 1999, but they are not sufficient to protect businesses from unwarranted investigations.

FIAS: Findings and recommendations in respect of corruption

26.8percent of the 555firms surveyed cited corruption as a critical problem.

In a limited survey of 20potential investors in Azerbaijan, investors consistently cited institutional corruption and unfair competition stemming from government interference in business activities as the main factors that led to their decision not to invest or to end operations.

Potential foreign investors clearly perceive the business government interaction much more negatively than existing investors probably due in part to the fact that prominent multinational corporations must guard against the legal liability and reputational risk of operating in an environment where illegal rent seeking exists. This signzjkantly increases the importance of sending the right policy signals to international investors, particularly in terms of combating illegal rent extraction and ensuring a level playing f ield for competition.

A key needs in the business environment includes: (9 addressing illegal rent extraction problems, which give rise to conflict of interest, an un-level playing field, and high reputational cost; and (ii) improving the legal framework for investors and enforcing existing laws consistently and even handedly.

Investors note tax administration and customs as areas where they face particular difficulties and harassment

Licensing requires particular attention. The net of special licenses is so tight that almost every business needs a license to operate. While the amended Decree of I997 lists about 80 special licenses, many of these special licenses require multiple certificates or permissions that add up to over 300 licenses/permission/certijkates.

Investors, both potential and existing, identify governance and corruption problems as a challenge for their business operations in the country. According to the FIAS Investment Climate and Administrative Cost survey, corruption ranks third in intensity of the problem after financing and interest rates. About 27percent offirms raised corruption as a moderate to serious obstacle to their businesses. Some other surveys indicate that the problem is more critical. Fo r example, the widely published 2001 rating by Transparency International places Azerbaijan 84 out of 91 countries surveyed. The FIAS survey ofpotential investors also ranks corruption in the list of top concerns.

The main forms ofproblems investors report include conflict of interest, state capture whereby certain interest groups may have power to influence rules and decision making by government oflcials, and lower level administrative corruption. This poses increased costs for doing business in the country and in some cases prohibitive costs in terms of reputational risks. Rent extraction practices act as taxes on investors by increasing their costs of doing business. Results of the Survey show that f irms on average pay 7.9% of their annual revenues for informal payments. Additionally, conflict of interest and state capture restricts market entry, which is detrimental to improving the productivity and competitiveness of Azerbaijan 's industries

Source: FIAS Diagnostic Review of the Environment for FDI (May 2002)

97. The Government i s aware o f the perception o f corruption and i s seeking Bank Group support for improving the investment climate in the non-oil sectors. A diagnostic review o f the investment climate was conducted by the Foreign Investment Advisory

Azerbaijan CFAA: Fiduciaw Considerations in Respect of Bank-Financed Proiects 39

Service (FIAS), a jo int service o f the International Finance Corporation and The World Bank. The diagnostic study completed in May2002 includes a review o f the legal and institutional framework for investment, comparing it with the situation in competitor countries, evaluating impediments and making concrete recommendations. The diagnostic includes a business environment and costs survey o f 555 foreign and domestic firms, to help identifying major problem areas, provide a basis for a future administrative barriers study and serve as a tool to measure progress (benchmark) in the future. Based on the results o f the FIAS survey and supported by SAC-11, the Government intends to agree o n a set o f pol icy actions to improve the business climate for both foreign and domestic investment and business creation.

98. Notwithstanding the findings o f the FIAS survey, i t should be noted that there has been a considerable improvement in the business environment in Azerbaijan. The EBRD’s Transition Report 2002 indicates that there has been a significant decrease in the level o f bribes as a proportion o f revenues paid by firms (1999: 3.7%; 2002: 2.7%) as wel l as in the number o f f i r m s paying bribes frequently (1999: 59%; 2002: 27%). The EBRD report also noted a significant decline in the amount o f time that management spends dealing with public officials (1999: 5.5%; 2002: 2.5%) and Azerbaijan now ranks third best in the Europe and Central Asia region on this particular measure. In addition, there i s currently a draft Law on Anti-corruption before the Parliament which was approved during its f i rs t reading on December 29, 2001. This i s a relatively extensive text making i t unlawful for government officials to abuse their positions by accepting financial inducements (comprehensively defined in the draft) and imposing, in addition to reimbursement o f the diverted funds to the Government, a series o f administrative measures from reprimands and demotions to dismissal. A working group has been established in the President’s Office to combat corruption although the draft Law envisages enforcement o f the Law by the Azerbaijan Republic Public Service Administration Council.

Azerbaijan CFAA: Next Sfeo 40

9. NEXTSTEPS

99. A matrix summarizing ongoing financial management initiatives and C F A A recommendations immediately follows the executive summary. The C F A A is intended to act as a unifying tool to bring the Government, the Bank and the donors around the table with a v iew to design a medium term reform program, prioritizing the actions to be taken, and assign hnding and support responsibilities. In M a y 2003, the Cabinet approved the recommendations contained in this CFAA.

100. In respect o f donor coordination: (i) the Asian Development Bank (AsDB) i s completing a Diagnostic Study o f Accounting and Auditing (DSAA) for Azerbaijan; (ii) as discussed earlier, the U S A I D i s supporting the implementation o f the new Treasury Information Management Systems (TIMS); (iii) the IMF continues to advise o n Treasury matters; and (iv) also as discussed earlier, EU-TACIS has initiated a project to assist in the introduction, development and application o f international financial reporting standards in the non-banking sector.

Azerbaijan CFAA: Affacbment I ; CFAA Team 41

ATTACHMENT 1: CFAA TEAM

Bank

Roberto Tarallo, Task Team Leader, LCR Manager, Financial Management Ranj an Ganguli, Financial Management Consultant Andrew Mackie, Peer Reviewer, Div is ion Chief, LOAGl Mozammal Hoque, Peer Reviewer, Sr. Financial Management Specialist, OPCFM Amitabha Mukherjee, Peer Reviewer, Sr. Public Sector Management Specialist, EASPR Joel Hellman, Peer Reviewer, Lead Specialist, ECSPE

Azerbaijan C F M C P A R Counterpart Team

Mr. Ogtay Hagverdiyev, Economic and Fiscal Pol icy Department, Cabinet o f Ministers Mr. Shahin Sadikhov, Deputy Director, Economic Policy and Forecasting Department,

Mr. Seyfaddin Talibov, Deputy Head, State Treasury Operations Department, Ministry o f

Mr. Nazim Husseynov, Chamber o f Accounts Mr. Vagi f Husseynov, Chamber o f Accounts Mr. Imran Mehdiyev, Director, State Procurement Agency Mr. Vagif Nasirof, Head, State Procurement Agency

Ministry o f Economic Development

Finance

Azerbaijan CFAA: Attachment 2 : Mao of Azerbaiian 42

ATTACHMENT 2: MAP OF AZERBAIJAN