Documentof The World Bank FOROFFICIAL USEONLY ReportNo: 42314-AZ PROJECT APPRAISAL DOCUMENT ON A PROPOSED CREDIT INTHE AMOUNT OF SDR7.0 MILLION (US$ 11.O MILLION EQUIVALENT) TO THE AZERBAIJAN REPUBLIC FOR A CORPORATE AND PUBLIC SECTOR ACCOUNTABILITY PROJECT February 29,2008 OperationsPolicy and Services Financial Management Unit Europe and Central Asia Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EQUIVALENTS (Exchange Rate EffectiveJanuary 31,2008) Currency Unit = New Manat (AZN) 0.80AZN = US$1 US$1.5905 = SDR 1 FISCAL YEAR January 1 - December31 ABBREVIATIONS AND ACRONYMS ACCA Association of CharteredCertified Accountants ACPATER Azerbaijan Center for Professional Accounting and Audit Training, Education and Research BEEP Business Environmental EnterprisePerception Survey CAPSAP Corporate and Public Sector Accountability Project CFAA Country Financial Accountability Assessment CIPA CertifiedInternational Professional Accountant CIPFA Chartered Institute of Public Finance Accountants CoA Chamber of Accounts (Supreme Audit Institution) CoAA Chamber of Auditors of Azerbaijan CPAR Country Procurement Assessment Report CPD Continuous Professional Development CPS Country Partnership Strategy DPL Development Policy Lending EBRD European Bank for Reconstruction and Development ECCAA Eurasian Council for CertifiedAccountants and Auditors EITI Extractive Industry Transparency Initiative EU EuropeanUnion F M Financial Management FMC Financial Management Control FMS Financial Management Specialist FSU Former Soviet Union GDP Gross Domestic Product GRECO Group of States Against Corruption IAASB International Auditing and Assurance Standards Board IDA International Development Association IDF Institutional Development Fund IES International Education Standards IFAC International Federation of Accountants IFRS International Financial Reporting Standards IMF International Monetary Fund IPSAS International Public Sector Accounting Standards IRR Internal Rate of Return FOROFFICIAL USE ONLY ISA International Standardson Auditing MOE MinistryofEducation MOED Ministry ofEconomic Development MOF Ministry ofFinance NASBO NationalAccounting Standards for Budgetary Organizations NASCO NationalAccounting Standards for Commercial Organizations PHRD Policy andHumanResourcesDevelopment (Grant) PEFA Public Expenditure and Financial Accountability PIE Public Interest Entity PIFC Public Internal Financial Control PMU Project ManagementUnit PRSC Poverty Reduction Support Credit PSC Project SteeringCommittee PV PresentValue R E O 1 Requestfor Expression of Interest ROSC Report on Observanceof Standards and Codes SECO State Secretariat for Economic Affairs (Switzerland) SMO Statementsof MembershipObligation SOCAR State Oil Company of Azerbaijan Republic SOEs State-OwnedEnterprises SOFAZ State Oil Fund of the Azerbaijan Republic SPPRED State Program on Poverty Reduction and Economic Development SWAP Sector Wide Approach TIMS Treasury InformationManagement System USAID UnitedStates Agency for International Development VAT Value Added Tax Vice President: Shigeo Katsu Country Director: D-MDowsett-Coirolo, ECCU3 Country Manager: Gregory T. Jedrzejczak Acting Sector Manager: Siew Chai Ting Task Team Leader: IdaNjeri Muhoho Co-Task Team Leader: John Hegarty This document has a restricted distribution and may be used by recipients only in the performance o f their official duties. Its contents may not be otherwise disclosed without World Bank authorization. FOR OFFICIAL USE ONLY AZERBAIJAN CORPORATE AND PUBLIC SECTOR ACCOUNTABILITY PROJECT CONTENTS Page I STRATEGICCONTEXTANDRATIONALE . .................................................................. 1 A. Country and sector issues.................................................................................................... 1 B . Rationale for Bank involvement.......................................................................................... 2 C . Higher level objectives to which the project contributes .................................................... 3 I1. PROJECT DESCRIPTION .............................................................................................. 3 A . Lendinginstrument.............................................................................................................. 3 B . Project development objective and key indicators .............................................................. 3 C . Project components.............................................................................................................. 4 D . Lessonslearned and reflected inthe project design ............................................................ 6 E . Alternatives consideredand reasons for rejection............................................................... 7 I11. IMPLEMENTATION ....................................................................................................... 8 A. Partnershiparrangements.................................................................................................... 8 B. Institutional and implementation arrangements .................................................................. 8 C . Monitoringand evaluation of outcomeshesults.................................................................. 8 D . Sustainability ...................................................................................................................... -9 E . Critical risks andpossible controversial aspects ................................................................. 9 F. Credit conditions and covenants........................................................................................ 12 I V . APPRAISAL SUMMARY .............................................................................................. 12 A . Economic and financial analyses ....................................................................................... 12 B .Technical ........................................................................................................................... 14 C. Fiduciary............................................................................................................................ 15 D . Social ................................................................................................................................. 15 E. Environment ...................................................................................................................... 16 F. Safeguardpolicies.............................................................................................................. . . 16 G. Policy Exceptions andReadiness..................................................................................... -16 Annex 1: Country and Sector or ProgramBackground .......................................................... 17 Annex 2: Major RelatedProjectsFinancedby the Bankand/or otherAgencies ..................22 Annex 3: Results Frameworkand Monitoring ......................................................................... 23 Annex 4: DetailedProjectDescription ...................................................................................... 31 Annex 5: ProjectCosts ................................................................................................................ 41 Annex 6: ImplementationArrangements .................................................................................. 42 Annex 7: FinancialManagementand DisbursementArrangements ..................................... 44 Annex 8: ProcurementArrangements ....................................................................................... 52 Annex 9: Economic and FinancialAnalysis .............................................................................. 63 Annex 10: SafeguardPolicyIssues ............................................................................................. 72 Annex 11:ProjectPreparationand Supervision ...................................................................... 73 Annex 12: Documents in the ProjectFile .................................................................................. 74 Annex 13: Statement of Loansand Credits ............................................................................... 75 Annex 14: Country at a Glance .................................................................................................. 77 Annex 15: Map ............................................................................................................................. 79 AZERBAIJAN CORPORATE AND PUBLIC SECTOR ACCOUNTABILITY PROJECT PROJECT APPRAISAL DOCUMENT EUROPE AND CENTRAL ASIA ECSPS Date: January 28,2008 Team Leader: IdaN.Muhoho Country Director: D-MDowsett-Coirolo Sectors: General finance sector (5OY0);General Acting Sector Manager: Siew Chai Ting public administration sector (50%) Themes: Standards and financial reporting (P);Corporate governance (P);Public expenditure, financial management and procurement (P) Project ID: PO99924 Environmental screening category: Not Required Lending Instrument: Specific Investment Loan [ 3 Loan [XI Credit [ 3 Grant [ ] Guarantee [ 3 Other: For Loans/Credits/Others: Credit Total Bank financing (US$m.): 11.OO equivalent Grants Borrower: RepublicofAzerbaijan Azerbaijan ResponsibleAgency: MinistryofFinance S. Vurgun Str., 83 Azerbaijan Tel: 994 12 493 81 03 Cumulative1 0.8 I 2.40 I 5.40 I 8.60 I 11.00 I Project implementation period: Start September 25,2008 End: June 29,2012 Expected effectiveness date: September 25,2008 Expected closing date: December 31,20 12 Does the project depart from the CAS incontent or other significant respects? ReJ PAD C.1 [ ]Yes [XINO Does the project requireany exceptions from Bankpolicies? ReJ PAD G.4 [ ]Yes [XINO Have these beenapproved by Bank management? [[ ]Yes [XINO ]Yes [ IN0 I s approval for any policy exception sought from the Board? Doesthe project include any critical risks rated "substantial" or "high"? Ref: PAD E.3 [XIYes [ ]No Does the project meet the Regional criteria for readiness for implementation? [X ]Yes [ 3 Re$ PAD G.4 No Projectdevelopmentobjective Re$ PAD B.2, TechnicalAnnex 3 The main Project Development Objective is to strengthenaccountability and transparency in financial reporting for the public and corporate sectors inline with international best practices. The key beneficiaries are the Public Interest Entitiesincluding State-OwnedEnterprises, the Chamber of Accounts (the country's supreme audit institution), the Chamber of Auditors (the country's auditing services regulator and standard-setter), the Ministry of Finance, and accounting and auditing professionals and stakeholders inAzerbaijan. Projectdescription ReJ PAD C.2, TechnicalAnnex 4 Component 1- Corporate Sector Component. This component would support the corporate sector (including state-owned enterprises) in implementing appropriate accounting standards; ensure the sustainability and transparency of these interventions through the establishment of appropriate legal and institutional frameworks; and strengthen the statutory audit function. The MoF has decided that direct financial support with the transition to IFRS would be provided under the project to three Public Interest Entities (state-owned enterprises), namely Baku Metropolitan (urban transport company), Azerkimya (chemical company) and AZERSU (water company). Their selection was based on the capacity and financial means of the PIEs to implement IFRS successfully. The implementation of IFRS by an additional six PIEs that have been identified would also be monitored and supported under the project, but by means of technical assistance inthe form of advisory services rather than through direct financial transfers. This component would support establishment of appropriate legal and institutional frameworks and capacity for translation, adoption and enforcement of IFRS and NASCO. Improving the statutory framework and building capacity to regulate and oversee the audit function including the translation of International Standards on Auditing (ISA) would also be supported under this component. Component2 -Public Sector Accountability. This component aims to enhance public sector accountability through: (i)the implementation of the Government's public sector accounting reform strategy, being the strategy currently being drafted to implement that part of the 2004 Accounting Law that requires budget organizations and off-budget state funds to prepare financial statements in accordance with National Accounting Standards for Budget Organizations (NASBOs) which in turn are based on International Public Sector Accounting Standards (IPSAS). This will: (i)enhance both accountability to stockholders and information for management of budget organizations and off-budget state funds; (ii) strengthening the public sector internal financial control (PIFC) framework by insisting that managers are responsible for establishing and maintaining sound internal control frameworks for their organizations paving the way and setting up modern internal audit units in budget organizations that can provide management with assurance that the processes for which they are accountable are operating in a manner which will minimize the probability of the occurrence of fiaud, error or inefficient and uneconomic practices; and (iii)strengthening the capacity o f the country's Supreme Audit Institution, the Chamber of Accounts (CoA), to increase transparency and accountability in managing public resources. Component3 Strengtheningaccounting,auditingandfinancialmanagementcapacity - This component will build long-term capacity inaccounting, auditing and financial management. Itwill includethe creation of anAzerbaijan Center for Professional Accounting, Auditing Training Education and Research(ACPATER) which will be subordinate to the Ministry of Finance, and have broad responsibility for strengtheningAzerbaijan accounting, auditing and financial managementcapacity, includingthe implementation of this component. Other activities will include: establishing education standards requiredof university courses and professional qualifications as well as qualifications and experience requiredof public sector financial managementprofessionals; assistinginstitutions to develop the capacity to deliver the education to satisfy these standards; monitoringthe quality of university education; awarding professional qualifications; maintaining an Azeri-language lexiconof accounting terminology; providing official translations of international standards; and developing methodological guidelines and other relevant materials for academics, professionals andpractitioners.. Component4 -ProjectManagement. The project will provide support to the Government to implementthe project, and will include support for overall project management,technical assistance on contract administration and supervision, procurement and financial management; monitoringand evaluation ofproject impacts, and annual financial audit of project accounts. Which safeguardpolicies are triggered, if any? Re$ PAD F.4, Technical Annex 10 None Significant, non-standard conditions, if any, for: Re$ PAD F.3 Credit effectiveness: -- Adoption o f Project Operational Manual by the Ministry o f Finance Establishment o f the Project Steering Committee, to be maintained untilthe completion - o f the Project under terms of reference satisfactory to the Association The Co-Financing Agreement has been executed and delivered and all conditions precedent to the effectiveness or to the right o f the Recipient to make withdrawals under it (other thanthe effectiveness o fthe Agreement) hasbeen fulfilled.- I. STRATEGICCONTEXTANDRATIONALE A. Countryand sector issues. 1. Although the Republic of Azerbaijan was among the world's leading oil producers inthe late 19th century, during the period when the country became part of the former Soviet Union (1920 - 1991) exploitation of its oil resources was not a high priority and economic policies left both little to show for Azerbaijan's oil wealth and much of its population in poverty. Since independence in 1991,oil and gas discoveries have given Azerbaijan new means of combating poverty and developing into a diversified, sustainable, middle-income country in the coming years. 2. The Government's challenge today is to build on the opportunities provided by the oil revenue to stimulate a sustainable and diversified market economy. Over the past few years, and with the support of foreign investors and the international development community, Azerbaijan has been putting in place both the infrastructure needed to realize rapid growth in oil and gas exports, and a credible framework to manage the increase in resource flows in an effective and transparent manner. A cornerstoneof Azerbaijan's governance framework inthe managementof oil revenues i s the State Oil Fundof Azerbaijan, establishedin 1999 as the mechanism to ensure transparency in terms of accounting for the country's oil revenues and foster intergenerational equality of benefit from its oil wealth. The most difficult challenge the Government faces is to avoid the path followed by some natural resource-rich countries in which citizens derive little benefit from the influx of oil revenues, by implementing a policy agenda that leads to improved incomes and equity for current and future generations, while maintaining macroeconomic and financial stability. Diversification of the non-oil economy requires improvements in the supply of utilities, better infrastructure services (especially transportation), continued investment in humancapital, a supportive business environment, strengthened public sector management, and expansionof the financial sector. 3. InAzerbaijan, critical among the "cross-sectoral" issues to be addressed is the relatively weak legal and institutional framework for accounting and auditing, and limited experience with international best practices of accounting, auditing and financial management. Aside from the banking sector, the inherited Soviet-style accounting system still reflects more the needs of central planning than of a modern market-driven economy. 4. The proposed Corporate and Public Sector Accountability Project (CAPSAP) is an important component of the World Bank Group's Country Partnership Strategy (CPS) for 2007 to 2010, which was discussed by the Board on December 7,2006. Inparticular, the first pillar of the CPS aims at: (i)improving the quality and transparency of public sector governance by maintaining a stable macroeconomic framework that makes prudent use of oil revenues; (ii) improving public expenditure planning and management; (iii)strengthening financial management and procurement systems; (iv) establishing proper public sector and corporate governance, accounting and auditing frameworks; and (v) creating an administrative and regulatory environment conducive to growth. CAPSAP will focus on improving the capacity, transparency, and accountability of state institutions and public interest entities leading to better public and corporate financial management and improved governance. CAPSAP will support implementation of the Accounting Law enacted inNovember 2004, which mandatestransition to 1 International Financial Reporting Standards (IFRS) for Public Interest Entities, defined as commercial entities deemed by the Government of Azerbaijan to have a public interest in their operations, National Accounting Standards for Commercial Organizations (NASCO) for non- Public Interest Entities, and International Public Sector Accounting Standards (IPSAS) for budget organizations. This law represented a major step forward in addressingtransparency and accountability in the corporate and public sectors, and its development was supported by IDA under accounting and auditing Report on the Observance of Standards and Codes (ROSC) technical assistance. Moving forward, the Law on Audit Services, Law on Internal Audit and Law on Public Financial Reporting will also require strengthening, in line with the new Accounting Law. The quality of higher education in accounting and auditing i s constrained by ad hoc curriculum development and a general lack of continuing education for accountancy professionals. The increased use of the Azeri language poses further challenges, because of the absence of textbooks and other teaching materials. B. Rationalefor Bankinvolvement 5. The project interventions are anchored in the Government's reform agenda that aims to align the Azeri accounting and auditing arrangements with international practices bringing them closer to the needs of a market economy. These changes include developing a supportive and appropriate legislative and institutional environment, reforming accounting standards and strengtheningthe accounting and auditing profession. 6. The analysis and recommendations of country diagnostic studies covering both the corporate and public sectors carried out by the Bank -- including the Country Financial Accountability Assessment (CFAA in2003) and the 2006 ROSC -- point to the needfor reforms to build capable and accountable state and public interest institutions to manage public resources and improve accountability and transparency in financial reporting. The Bank is well placed to offer institutional capacity building support and technical assistance to state oversight institutions and selected state-owned enterprises, and to strengthening accounting and auditing profession in the country, sharing its extensive experience elsewhere in the ECA region, including in the EU- accessioncountries. 7. The proposed project will benefit from a strong foundation of intensive and fruitful Government-Bank dialogue on financial management and regulatory issues and from a country assistance program which includesintensive engagement inAzerbaijan's most critical economic sectors, such as electricity, transportation, water, sewerage and sanitation, among others. Hence the Bank is well positionedto: (i) the Government designa framework for implementing the help Accounting and Auditing Laws; and (ii)assist the country's large SOEs and other public and private sector entities to implement these laws. At the technical level, the Bank has been engaged in corporate and public sector reforms in Azerbaijan through two separate operations: (i) IBTA-2projectaddressedcapacitybuildingofthecountry's supremeauditinstitution,the the Chamber of Accounts; and (ii) IDF Grant assisted the Government inaccounting and auditing an reforms, including institutional capacity building for implementation of accounting and auditing legislative reforms, review of existing laws and regulations for harmonization with the new Accounting Law, and analysis of technical assistance required to strengthen capacity of the Chamber of Auditors, the country's auditing services regulator and standard-setter. Some of the 2 key recommendations and action plans from these two operations will be implemented through CAPSAP (see Annex 4). The IDA-financed Financial Services Technical Assistance Project supported the Ministry of Finance and the National Bank o f Azerbaijan in implementing the Government strategy on introducing international accounting standards to the bankingsector. C. Higher level objectives to which the project contributes 8. The Country Partnership Strategy for 2007 to 2010 outlines four higher-level objectives: improved public sector management and prevention o f corruption; sustainable and balanced growth o f the non-oil economy; quality of and access to social services; and improved environmental management. The proposed project directly contributes to the first of these objectives through: (i) strengthened financial management; and (ii) corporate governance, proper accounting and auditing, and will indirectly support the other three objectives through its impact on key public institutions and private actors. 9. Transparency and accountability in financial reporting are essential for enhancing the management o f public funds. Each o f the project components has been defined on the basis of the results o f a number o f studies which have assessed: (i) value added in introducing IPSAS the inAzerbaijan by comparing the country's public sector accounting framework with international best practices; (ii)the quality o f the country's public internal financial control, by reference to the EU PIFC model; (iii)the assistance required by PIEs in the transition from national accounting standards to IFRS; and (iv) the measures required to achieve international standards inhigher-leveleducation, including inuniversities andprofessionalinstitutions. 11. PROJECT DESCRIPTION A, Lendinginstrument 10. A Specific Investment Credit will finance US$11 million o f the estimated total project cost o f US$24 million. The balance of US$13 million will be provided by Government counterpart finding o f US$S.O million; and a Japan Policy and Human Resource Development (PHRD) Co-financing Grant of US$3 million which will support embedding IFRS in PIEs. A Swiss Government/SECO Grant is expected of about US$2 million to finance the strengthening o f public sector accountability. B. Project development objectiveand key indicators 11. The Project Development Objective i s to strengthen accountability and transparency in financial reporting for public and corporate sectors in line with international best practices. The key beneficiaries are the Public Interest Entities including State-Owned Enterprises, the Chamber o f Accounts (the country's supreme audit institution), the Chamber o f Auditors (in its role as the country's auditing services regulator and standard-setter, subject to whatever rebalancing o f responsibilities between the Ministryo f Finance and the Chamber of Auditors may take place as part o f the enhancements introduced when improving the statutory framework), the Ministry of Finance, and accounting and auditing professionals and stakeholders inAzerbaijan. 3 12. The PIEs have outdated financial management systems. A shift to modern accounting and financial management systems would enable management to achieve transparency and accountability in financial reporting, improve decision-making, realize cost saving from improved systems, and minimize business corruption. Azerbaijan will benefit from higher tax collection from improved and efficient enterprises as a result of the introduction of IFRS and National Accounting Standards for Budgetary Organizations (NASBO) that are in line with IPSAS and promote transparency and accountability in financial reporting in both corporate and public sectors. Inaddition, and with more accountable budgetary institutions should also helpto reduce perceived country risks and contribute to lowering costs associated with sovereign borrowing. 13. The monitoring and evaluation framework of the project is presented in Annex 3. The key performance indicators for the project include: a. number of PIEs publishing annual audited IFRS financial statements within the statutory deadlines; b. number of staff inChamber of Auditors trained innewmethodology to inspect audit firms; c. number ofNASBOs issued based on IPSAS; d. Comprehensiveness,relevanceand understandingof internal control rules andprocedures and coverage andquality ofthe internal audit function; e. number of accreditedtraining programs (incl. undergraduate, graduate and vocational training programs); C. Projectcomponents 14. The CAPSAP comprisesthe following four components: Component 1 - Corporate Sector Accountability (estimated total cost US4.74 million, of which IDA US$1.19million, GOAUS$0.55 million, and PHRD Co-FinancingGrant US$3 million). 15. This component would support the corporate sector (including state-ownedenterprises) in implementing appropriate accounting standards; ensure the sustainability and transparency of these interventions through the establishment of appropriate legal and institutional frameworks; and improve statutory framework and building capacity to regulate and oversee the audit function. The MoF has decided that direct financial support with the transition to IFRSwould be provided under the project to three Public Interest Entities (state-owned enterprises), namely Baku Metropolitan (urban transport company), Azerkimya (chemical company) and AZERSU (water company). Their selection was based on the capacity and financial means of the PIEs to implement IFRS successfully. The implementation of IFRS by an additional six PIEs that have been identified would also be monitored and supported under the project, but by means of technical assistance inthe form of advisory services rather than through direct financial transfers. This component would support establishment of appropriate legal and institutional frameworks 4 and capacity for translation, adoption and enforcement of IFRS and NASCO. Improving the statutory framework and building capacity to regulate and oversee the audit function, including the translation of International Standards on Auditing (ISA), would also be supportedunder this component. Component2 - Public Sector Accountability (estimatedtotal cost U$3.81million, of which IDA US$1.21million,GOAUS%0.60million, and SECO US$2.0 million). 16. This component aims to enhance public sector accountability through: the implementation of the Government's public sector accounting reform strategy, the strategy currently being drafted to implement the part of the 2004 Accounting Law that requires budget organizations and off-budget state funds to prepare financial statements in accordance with NationalAccounting Standards for Budget Organizations (NASBOs) which, inturn, are basedon International Public Sector Accounting Standards (IPSAS). This will: (i)enhance both accountability to stockholders and information for management of budget organizations and off- budget state funds; (ii) strengthen the public sector internal financial control (PIFC) framework by insisting that managers are responsible for establishing and maintaining sound internal control frameworks for their organizations, paving the way for setting up modern internal audit units in budget organizations that can provide management with assurance that the processes for which they are accountable are operating in a manner which will minimize the probability o f the occurrence of fraud, error or inefficient and uneconomic practices; and (iii)strengthen the capacity o f the country's SupremeAudit Institution, the Chamber of Accounts (CoA), to increase transparency and accountability inmanaging public resources. Component 3 - Strengthening accounting, auditing and financial management capacity (estimated total cost US$11.71million, of which IDA US$8.03 million and GOAUS$3.68 million). 17. This component will build long-term capacity in accounting, auditing and financial management. It will include the creation of an Azerbaijan Center for Professional Accounting and Audit Training Education and Research (ACPATER) which will be subordinate to the Ministry of Finance, and have broad responsibility for strengthening Azerbaijan accounting, auditing and financial management capacity, including the implementation o f this component. Other activities will include: establishing education standards required of university courses and professional qualifications as well as qualifications and experience required of public sector financial management professionals; assisting institutions to develop the capacity to deliver the education to satisfy these standards; monitoring the quality of university education; awarding professional qualifications; maintaining an Azeri-language lexicon of accounting and auditing terminology; providing official translations of international standards; and developing methodological guidelines and other relevant materials for academics, professionals and practitioners. 5 Component 4 - Project Management (estimated total cost US$0.84 million, of which IDA US$0.57millionand GOAUS$0.27million). 18. This component will provide support to the Government to implement the project, and will include support for overall project management, and technical assistance in such areas as contract administration and supervision, procurement and financial management, monitoring and evaluation o f project impacts, and annual financial audit o f project financial statements and accounts. 19. The balance o f US$2.9 million is the 18 percent Value Added Tax. Bank financed projects approved after January 1,2008 are subject to VAT at the current rate o f 18 percent. The Government contribution will separately cover these VAT related costs. D. Lessonslearnedand reflectedin the project design 20. This is the first Bank project in this sector in Azerbaijan. However, the conceptual approach and design o f the project draw on World Bank experience with implementing similar projects in other regions, as well as from extensive diagnostic work in other ECA countries which have addressed similar challenges. CAPSAP draws on relevant international standards and regulatory models with respect to the design o f the interventions which it supports, reinforced by close coordination with the EU and other development partners, at the design and implementationphases o f the operation. 21. With respect to corporate sector accountability, while IFRS meets the recognized international best practice benchmark, the transition process can be costly, and therefore within the project, the adoption o f these standards will be promoted primarily among PIES, where this cost can be justified in terms o f the public interest benefits. For non-public-interest-entities, a simplified financial reporting procedure (NASCO) should suffice and will take into account the limited capacity of such entities. Improved financial reporting is also essential in the public sector, as a means o f enhancing accountability and transparency, economy, efficiency, and effectiveness with which public resources are managed. IPSAS - which draw heavily on IFRS, modified to take account o f the specificities o f the government sector - are the recognized international benchmarks inthis area. 22. The successful adoption o f international accounting standards by both public and corporate entities does not suffice for transformative and sustainable change in transparency and governance. These initiatives must be supplemented by institutional and legal changes to support a transparent environment for updated accounting processes. For the corporate sector, this means that the adoption of IFRS should go beyond financial statement transformation to the proper "embedding" o f IFRS within an enterprise, whereby: (i) enterprise develops its own the capacity to prepare IFRS financial statements with no, or very limited, assistance from the external auditors; (ii)the accounting systems are upgraded to capture the full range o f data required to support IFRS compliance; and (iii) the adoption o f new recognition and measurement approaches to the production of decision-useful information extends to that produced for internal management purposes. This has significant implications in terms o f upgrading IT systems, 6 putting in place new procedures and controls, and overhauling internal management and performance reporting, the only method of achieving the full benefits of the switch to IFRS. This i s the approach adopted in CAPSAP. 23. Similarly, the proper management of public resources requires an appropriate governing control framework, based on internationally recognized best practices. Given the successful experience of other transition economies, especially those in the process of EU accession, the model chosen as the benchmark for assessing the current status of public internal financial control inAzerbaijan, as part of project preparation, was the EU's PIFC model. Lessons learned elsewhere can easily be transferred and, once work under the project to develop a strategy to strengthenpublic internal financial control is completed, the European Commission has indicated its willingness to consider positively any request from Government to support implementation, using financial resources available under the European Neighborhood Policy Instrument for Azerbaijan. Inaddition, the external audit is one of the pillars of the public sector accountability framework, and the approach adopted to strengthen the Supreme Audit Institution (SAI) draws extensively on other SA1 strengthening initiatives in other CIS countries, which share a similar constitutional and administrative tradition, and which have undergone similar governance reforms. 24. For improvements in accountability on both the corporate and public sectors to succeed, legal, regulatory, institutional, and procedural changes are necessary but not sufficient in themselves. Reflecting the scale and scope of the changes required to move from the inherited Soviet system to one which i s responsive to the current needs of Azerbaijan (drawing on the experience of countries which have already undergone a similar change), a major renewal and upgrading of the associated human capital is essential. This affects not only new entrants to the labor market, but also existing accountants and auditors whose skill sets must be fundamentally rebalanced. Azerbaijan suffers from a severe shortage, inboth qualitative and quantitative terms, of accounting and auditing skills, and this shortage is becoming steadily more acute as the economy grows and transforms. CAPSAP therefore places great emphasis on human capacity development, by means of putting in place sustainable institutional capacity to train and retrain. Mechanisms to facilitate the gradual "importation" of international best practices are also supported. E. Alternatives considered and reasons for rejection 25. Investment Credit versus Development Policy Lending. In principle, support to the Government could be provided through policy-based lending. However, due to weak institutional capacity and the current level of success of Government reform efforts inthe sector, an investment lending operation with targeted capacity building activities is deemed more appropriate. 7 111. IMPLEMENTATION A. Partnershiparrangements 26. A Japanese PHRD Grant for project preparation and a Co-financing Grant for project implementation have been made available in support of CAPSAP. SECO is funding a Bank- managed Public Expenditure and Financial Accountability (PEFA) assessment which will provide baseline indicators for the public sector component of the project. In addition, SECO will finance institutional capacity building of the Chamber of Accounts during project implementation. The project design draws on prior analytical and technical assistance work funded by USAID. The EuropeanCommission funded prior work inthe field of corporate sector financial reporting, and has indicated its willingness to consider positively any request from Government to fund the implementation of the strategy to strengthen public internal financial control, once completed. Close and regular donor coordination is an essential element of project design and implementation. See Annex 2 for more detail on major related projects financed by the Bank or other donors. B. Institutionalandimplementationarrangements 27. The project will be implemented by the Ministry of Finance through a Project Management Unit (PMU)'. The key staff of the PMU has been selected competitively. The director will provide overall coordination for project implementation and direction, reporting to the Deputy Minister of Finance. Other key members of the PMU include a procurement specialist, a financial management specialist, a monitoring and evaluation specialist, a twinning advisor (international), and other technical experts as required. The PMU will have the overall responsibility for project financial management, disbursements, auditing arrangements, procurement, monitoring and evaluation. It is envisaged that the PMU could eventually be absorbed into the ACPATER for sustainability of the project activities. 28. Project Steering committee (PSC). A PSC will be established by official Government decision, and will include high-level representatives from key project beneficiaries -Ministry of Finance, Ministry of Education, Ministry of Economic Development, Chamber of Accounts, Chamber of Auditors, and the PMU Director. The Deputy Minister of Finance will chair the PSC. The role of the PSC will be to make decisions on key legal and regulatory issues affecting project implementation, and to approve annual work plans and budgets. An international expert will be hired and financed from the Project to advise the Ministry of Finance, the PSC and the PMU. Establishment of the PSC is a condition of Effectiveness. See Annex 6 for detailed implementation arrangements. C. Monitoringand evaluationof outcomes/results 29. Monitoring and evaluation (M&E) of the project activities will be the responsibility of the PMU with periodic consultation with donors and facilitation of stakeholder participation. The PMU, with the support of a technical advisor, will prepare proposals for a monitoring and evaluation system to be used throughout project implementation. The M&E system will identify ' PMUestablishedunder MinisterialDecree No. 1-75 datedJuly 30,2007 8 results indicators and potential sources of data on outputs and outcomes. The PMU Monitoring and Evaluation Specialist will be responsible for the collection and consolidation of information required to track progress against the monitoring plan described in the Results Framework (Annex 3). Hehhe will be responsible for refinement and development of baseline data and the review of progress made inmeeting intermediate level results and indicators. The indicators will help measureprogress in addressing some of the institutional weaknesses of the sector described inSection 1(A) ofthe PAD on country and sector issues. 30. Comprehensive quarterly and annual evaluations of progress on project implementation will be conducted and coordinated with key beneficiaries and other key donors, using agreed project indicators. A mid-termreview of the project will also be carried out at the end o f the second year of project implementation. See Annex 3 on results framework and monitoring. Public dissemination of the project results would be carried out through the Ministry of Finance website (see Part I1(B) of the PAD). D. Sustainability 31. The Government is highly committed to making the needed reforms in accounting and auditing, in line with international standards, with related capacity building and institutional strengthening. The enactment of the Accounting Law (June 2004) and related Presidential Decree No. 192 dated February 2005 clearly shows Borrower commitment to transition to international accounting standards and best practices conducive to transparency in accounting and financial reporting for both budgetary organizations and public interest entities. Inaddition, the Government is strongly committed to addressingthe pressingneedto increasethe availability of trained accountants. Harmonization and coordination with other development partners on approachesto governance work and consistent messages on key issues relating to accounting and auditing reforms inthe country are central to ensuring sustainability and development impact. E. Critical risksand possiblecontroversial aspects 32. The implementation of the project poses various technical, capacity and coordination- related challenges for the Government. The main risks of the proposed operation and mitigation measures to address such risks are summarized below. 9 E E: E: E: E 2 v) E E E: E 3 3 E E e E E cw 0 3 U 0 U P F Y 8 1 F. Credit conditionsand covenants 33. Board Conditions: None 34. Effectiveness Conditions: - Approval of Project Operational Manual - Establishment of the Project Steering Committee, to be maintained untilthe completion of the Project under terms of reference satisfactory to the Association. - Execution of the PHRD Co-financing grant agreement. IV. APPRAISAL SUMMARY A. FinancialAnalysis FinancialAnalysis and Cost-Effectiveness 35. The financial and cost effectiveness analysis (Annex 9) suggests that the following arguments support the implementation of the proposedoperation: 36. Good corporate governance and accountability reduce the cost of borrowingfor the private sector. Better corporate governance and accountability of the Government units will enable foreign banks and rating agencies to increasethe credit rating of Azeri companies, and are likely to result in lower risk premiums. Our estimate i s that the immediate financial gain due to lower risk premiumwill not be very significant. 37. Significant cost savings result from modern management information systems for PIES.At present, many PIEs have an outdated and/or inadequate management information system. The project will assist the PIEs to make a swift and smooth institutional transition to modern information, accounting and reporting systems. Annex 9 presents the data sources and analysis framework. It is estimated that the present value of the future cost savings due to better informationand accounting systems i s equal to US$32.28 million. The financial costs paidby the beneficiaries of the CAPSAP are only US$4.94 million, which impliesthat the net present value of the perceived direct financial savings by the participating PIEs is at least US$27.34 million. 38. Cost-Effectiveness of Component 3: Strengthening Accounting, Auditing and FM Capacity. The base cost estimate of training one personto the CAP/ACCA Level 1 is US$2,000 per year in the ECA region. These skills, which can be acquired at training centers in Kazakhstan, Russia or Ukraine, require travel costs (US$400-800/person/trip), lodging and logistical expenses (US$800-2,000/person/trip), over and above the US$2,000 base training cost per person. Under CAPSAP, the CAP/ACCA Level 1 would be undertaken in Azerbaijan; alternative to training the cadre under the CAPSAP project is to continue the practice of sending people abroad. The direct financial savings over the next five years of conducting training in Azerbaijan are estimatedto be US$5.4 million, inpresent value terms, discounted by 12 percent. Annex 9 indicates that even on a cost-effectiveness basis, CAPSAP's training costs are the lowest-cost alternative. However, this is also a long-run investment in human capital, with a 12 significant payback as international experience suggests. However, the value of this strategic investment i s difficult to capture inmonetary terms. FiscalImpact 39. The potential fiscal impact of the project can be estimated by looking at the additional tax collection by the Government as a result of the project, which is often a natural by-product of an effectively implemented accountability and transparency reform. (See Annex 9 for discussion and assumptions used.) If we assume that the current overall tax compliance rate is as good as 70 percent, then it means that there is a potential for further tax collection, and each additional point of compliance is worth US$21.6 million. It is not unreasonable to expect the tax administration will be able to capture 1-3 additional compliance points because of the CAPSAP project. Ifwe assume that the compliance rate increases only by one point, and the additional tax collection over the next five years i s fixed at US$21.6 million in constant 2007 prices, then the present value of this additional revenue for the Government is US$78.0 million, discounted by 12percent inreal terms. 40. Azeri legislation stipulates that VAT of 18 percent will be levied on goods and services purchased by the IDA credit; the VAT will be paid out of counterpart funding by the Government. For the purpose of the financial analysis, the VAT i s included in the project costs and will show an additional US$2.9 million inflow into the Treasury over 2008-2012. The presentvalue of the inflows to the treasury, discounted by 12 percent inreal terms, is equivalent to US$2.2 million. At the same time, the Government budget will be increased by an additional US2.9 million between 2008 and 2012. As such, the net likely impact of the VAT on the Treasury's operations i s expectedto be nileach year. StakeholderImpact Assessment 41. The team also undertook a stakeholder impact assessment inregard to allocation of direct financial impacts identified in the financial analysis. The table below presents the summary expected impact on stakeholders. The expenditures of the government include the financing o f the CAPSAP project, and benefits that are counted towards the government are additional tax collection and costs savings in education and training. The net present value of government cashflows is US$67.3 million. Table 2: StakeholderImpacts,constant 2007 prices(US$ million) Year PV 2008 2009 2010 2011 2012 Government CAPSAPcashflowgross ofVAT I/ -18.3 -6.1 -8.0 -4.7 -3.0 -2.2 Cost Savings in EducatiodTraining 5.4 1.8 2.8 1.4 0.7 0.4 FiscalImpact 78.0 21.6 21.6 21.6 21.6 21.6 VAT collected 2.2 0.7 1.o 0.6 0.4 0.3 Sub-total 67.3 18.0 17.4 18.9 19.7 20.0 13 B. Technical 42. The project will support the implementation of the Accounting Law by embedding IFRS inthe PIESandpublic sector accounting standards, consistentwith IPSAS inthe public sector. It will assist inthe strengtheningof statutory audit inthe country through enhancement of the legal framework governing auditing in Azerbaijan, and through the development of a transparent system of auditing and building of the institutional capacity building including structure of the Chamber of Auditors, the country's auditing services regulator and standard-setter in the corporate sector. The project will support implementation of the Government's accounting reform strategy including development of a public sector accounting policy-making, standard- setting and enforcement capacity within the Ministry of Finance. The current public internal financial control framework does not clearly stipulate that managers are responsible for establishing and maintaining sound internal control frameworks in their organizations. Rather, various decrees, regulations and instructions prescribe various controls that must be implemented, and these tend to be implemented, but not in a coherent and consistent manner. The Government has commissioned a comparison of the Azerbaijan framework for public sector internal control with good practice and relevant international standards. The project will assist the Government to finalize the PIFC Policy Paper which will be drafted to address the weaknesses identified by this gap analysis. The European Commission has indicated its willingness to consider positively any request from Government to support implementation, using financial resources available under the European Neighborhood Policy Instrument for Azerbaijan. Strengthening of the external audit for the public sector will be supported through implementation of a three-year Strategic Development Plan (2008-2010) of the Chamber o f Accounts (CoA), including enhancing legislative framework, enforcement mechanism and methodology on external audit. In addition capacity of the CoA will be strengthened through provision of computer equipment, as well as an on-line connection to the Treasury Information Management System (TIMS), developing and implementing a training program, twinning and pilot audits with an experienced peer SAI, and providing for independent audit of the CoA. Strengthening accounting, auditing and financial management capacity inboththe corporate and the public sector will be supportedby creation of an ACPATER, whichwill be subordinateto the Ministry ofFinance. 43. As part of the project, technical assistancewill be provided to strengthenthe institutional framework andto build capacity for the implementation of the project, which would allow use of country systems within the life of the project. This will include capacity building of the Chamber o f Accounts (the country's supreme audit institution), the Chamber of Auditors (in its role as the country's auditing services regulator and standard-setter, subject to whatever rebalancing of responsibilities between the Ministry of Finance and the Chamber of Auditors may take place as part of the enhancements introduced when improving the statutory framework), and the Ministry of Finance that is responsible for the implementation of the Project. In addition, the project will support strengthening public internal financial control systems. It is envisaged that the PMU will be incorporated into the ACPATER inthe course of project implementation for sustainability of the project. 14 C. Fiduciary (a) Financial Management 44. A financial management review of the PMU's systems and arrangements for project implementation was carried out during project preparation. Such systems include project accounting, financial reporting, disbursement and auditing arrangements. Although the PMU key staff has experience in their area of expertise, they lack experience in implementing Bank- financed projects. However, the Bank provided the PMU staff with training in financial management and disbursements, with additional training to be provided during project implementation. The Project accounting system requires strengthening to meet Bank requirements on financial reporting, and systems controls policies and procedures for Project implementation documented in the Project Operational Manual (POM). The project financial management arrangementswere assessed in October 2007 and reviewed again in February 2008 and they were found to be acceptable to the Bank. The overall financial management risk is rated as "moderate". Detailed financial management assessment, includingan agreed action plan i s outlined inAnnex 7 of the PAD. Approval of the POM is a Condition of Effectiveness. (b) Procurement 45. At the country level, a comprehensive analysis of the public procurement system in Azerbaijan was carried out during the 2003 Country Procurement Assessment Review (CPAR). This CPAR concludes that, although certain progress had been made and procurement reform has beenhighlighted as a priority in Azerbaijan in the preceding two-three years, there was still significant progress to be made. In 2001, Azerbaijan adopted a Public Procurement Law (PPL) based extensively on UNCITRAL model, but with selected provisions which differed from the Bank's Guidelines, and recent findings have shown that these differences have caused problems in Bank-financed operations. This PPL deficiency was remedied in 2005 when a Presidential Decree was issued. The CPAR also identified practices involving misapplication of the provisions of the PPL, and consequently the CPAR concluded that Azerbaijan should be rated as a high-risk country in respect of the public procurement system. Individual projects have taken these risks into account and designed arrangements which result in the lowering of procurement risks after mitigation, as is the case with CAPSAP. The PMUstaff incharge ofprocurement will be the procurement officer supported by the PMU Director. As the procurement capacity of the PMU is low, these PMU staff will attend procurement training in ILO Turin and also that provided regionally by the Bank. D. Social 46. Most of the financing under the CAPSAP will go to assisting selected public and corporate sector entities in the implementation of international accounting standards, to assist in the implementation of an appropriate legal and institutional framework to support the sustainability of these investments, and to develop human capital for the accounting sector. As such, the project is expected to have a positive social impact in that it will achieve greater transparency in the public and corporate sector through greater oversight and enforcement processes. In addition, the investments in the accounting education will mean a competitive 15 accounting sector in Azerbaijan that can positively assist the younger generation intraining and job placement, as well as older workers inretraining for the needs of a market economy. Indeed, this social benefit is a high priority for the Government of Azerbaijan, and they aim to finance nearly US$5 million for this component. E. Environment 47. Since the project is not expectedto make any investments in infrastructure, the expected environmental impact is negligible. F. Safeguardpolicies 48. The project raises no safeguards issues. SafeguardPoliciesTriggered by the Project Yes No Environmental Assessment (OP/BP 4.01) [I [X 1 Natural Habitats (OP/BP 4.04) [I [X 1 Pest Management(OP 4.09) [I [XI Physical Cultural Resources (OP/BP 4.1 1) [I Involuntary Resettlement (OP/BP 4.12) [I E[XI XI Indigenous Peoples(OP/BP 4.10) [I [X 1 [X 1 Forests(OP/BP 4.36) [I Safety of Dams (OP/BP 4.37) [I [XI Projects inDisputedAreas (OP/BP 7.60)* [I [X 1 Projects on International Waterways (OP/BP 7.50) [I [ XI G. Policy Exceptionsand Readiness 49. There are no exceptions required from Bankpolicies. 50. Procurementpackages for the four project components will be preparedand ready for issuanceto potential bidders shortly after Credit effectiveness. 'Bysupportingtheproposedproject,theBankdoesnotintendtoprejudicethefinaldeterminationof theparties'claimson the disputed areas 16 Annex 1: Country and Sector or ProgramBackground AZERBAIJAN: CORPORATE AND PUBLIC SECTOR ACCOUNTABILITY PROJECT Country Context 1. The challenge faced by Government is to build on the opportunities provided by the increase in oil revenue to stimulate a sustainable and diversifiedmarket economy. Azerbaijan's national income will be rising substantially over the next several years, as new oil production comes on stream and international oil prices remain high. A significant part of this income will be leaving the country, however, in the form of repatriation of capital and profits by foreign investors. Moreover, the revenue boom is expected to be relatively short-lived, peaking in about 2010 and declining steadily thereafter. ImprovingGovernance 2. Progress has beenmade insome important areas of governance, particularly inincreasing the transparency of oil revenue management. The establishment of SOFAZ and compliance with the EITI reporting requirement have resultedin an upsurge of activity of a coalition of some 90 nongovernmental organizations (NGOs) monitoringoil revenues and has expanded opportunities for civil society to engage indialogue with the Government. Corporate governance and financial accountability of state-ownedenterprises remain major issues, however, weakening overall fiscal discipline. 3. With respect to corruption, despite some improvement in 2005, Azerbaijan consistently ranks near the bottom of Transparency International's Corruption Perceptions Index rankings, and weak governance is widely perceived as an obstacle to doing business. Azerbaijan is ranked 99 in `Doing Business 2007' (out of 175 countries), and four areas that need urgent attention according to the report are: tax administration; customs; licensing regime; and corruption. The BarMEBRD Business Environment Enterprise Perceptions Survey (BEEPS) in 2005 also indicates that weak governance is widely perceived as an obstacle to doing business, and that corruption infact has increased since BEEPS 2002. 4. The Government is committed to increasing transparency and reducing corruption and has undertaken several initiatives to combat corruption: passing new anticorruption legislation, strengthening anticorruption institutions, and creating an anticorruption office in the Prosecutor General's Office and an anticorruption department in the Ministry of Interior. The Group of States against Corruption (GRECO) under the Council of Europe publishedits Evaluation Report on Azerbaijan in June 2006 commending the progress made in adopting new legislation. In addition, the Doing Business 2008 report reflected slight improvements over previous years, ranking Azerbaijan 96 out of 175 countries. These reforms will need continued Government commitment to sustainreform incombating corruption. Accounting and Auditing in Azerbaijan 5. The inherited `Soviet-based style accounting system' caters to the needs of central planning, providing financial, tax and statistical information to relevant ministries and 17 government agencies. It emphasizes standardization and uniformity so that informationcould be compared across sectors and industries. Azerbaijan's accounting and auditing reforms in both the corporate and public sectors lag behindthose of other FSUcountries, despite amendmentsto existing laws and regulations that govern accounting and auditing in the country, such as adoption of a new Law on Accounting, and amendment to the Tax Law, the Civil Code, the Banking Law, and the Enterprises Law. Azerbaijan has made some progress in developing an accounting infrastructure suitable to the needs of a market economy in the last few years. However, there are significant shortcomings inthe legal and regulatory framework that currently support accounting and auditing. Aligning the Statutory and Institutional Frameworkwith International Standards 6. The present legal framework governing auditing in Azerbaijan is outdated; this framework does not constitute a foundation that would enable the current auditing profession to provide meaningful assurance on publicly available financial information. In response, the Government of Azerbaijan has drafted a Law on Auditing Services. The proposed Law on Auditing Services should cover such critical areas as: (i) regulation of the profession; (ii)rights and responsibilities of auditors; (iii) audit quality assurance; and (iv) liability and disciplinary provisions. Significant enhancements to the Chamber of Auditors' structure, oversight and due process are needed to improve its success and legitimacy. The Chamber, the country's auditing services regulator and standard-setter should only retain its right to regulate the statutory audit profession if it successfully addresses the above critical issues. In addition, the Law should specify the auditing standards to be used in Azerbaijan, adopting in full the International Standards on Auditing (ISA). Development of a transparent system conducive to the improved quality of audit work would also require amendmentsto harmonize and regulate current auditing practices. Transparent procedures for the appointment, selection and dismissal of auditors should be clearly definedto establish the objectivity and independence of auditors. The fees for statutory audits and other services provided by auditors should be disclosed, thus ensuring furthertransparency ofauditors' work. 7. The adoption of the new Accounting Law created a legal basis for large-scale, comprehensive accounting reform by mandating IFRS for PIES, and NASBOs consistent with IPSAS for budgetary organizations. The Law also sets the foundation for the development of NASCOs, based on IFRS for medium-sized enterprises. Although the Law on Accounting aims for full compliance with international standards and good practices, it offers very little guidance on transition to NASBOs. No NASBOs have been drafted that are in line with the IPSAS, and there is low capacity to embedNASBOs inbudgetary organizations. 8. IFRS constitute the recognized international best practice benchmark. Their use, however, should be confined to those public interest entities where the significant costs of compliance can be justified in terms of the public interest benefits. Non-public-interest-entities should be subject to a simplified financial reporting regime, which takes account of the lesser capacity of such entities. Although there are benefits which can accrue to enterprises through the voluntary adoption of high quality financial reporting standards, the credibility of any financial reporting regime is dependent on incorporating it within a robust legal and regulatory regime, with proper arrangements for monitoring enforcement and oversight, tailored to the degree of 18 public interest at stake. The features underpinthe new Accounting Law (on which the Bank had earlier advised), the successful implementation o f which will be supported by CAPSAP. 9. The successful adoption o f IFRS by public interest entities requires going further than a simple transformation o f financial statements prepared under different national accounting standards, whereby a limited number o f adjustments are made to address the key recognition, measurement, and disclosure differences between such national standards and IFRS. Firstly, such "transformations" are typically performed by an enterprise's auditors, which lessen the degree o f enterprise ownership for the transformed financial statements, at the same time as significantly impairing the independence o f the auditors who thereby form an opinion based on a review o f their own work. Secondly, full compliance with IFRS typically requires the use o f underlying accounting data which i s often overlooked by accounting systems designed with the needs o f less demanding national standards in mind. Thirdly, the full benefits o f IFRS are not confined to the preparation o f higher quality financial statements for external users. The utility o f IFRS is maximized when corresponding changes are made inthe internal financial information generated to support management decision-making, so that the enhanced decision usefulness o f IFRS- compliant information passes down to internal reporting. As a consequence o f these three factors, the adoption of IFRS should go beyond financial statement transformation to the proper "embedding" o f IFRS within an enterprise, whereby the enterprise develops its own capacity to prepare IFRS financial statements with limitedor no assistance from the external auditors; where the accounting systems are upgraded to capture the full range o f data requiredto support IFRS compliance; and where the adoption o f new recognition and measurement approaches to the production o f decision-useful information extends to that produced for internal management purposes. This has significant implications in terms o f upgrading IT systems, putting in place new procedures and controls, and overhauling internal management and performance reporting, but only by doing this will the full benefits of the switch to IFRS be achieved. This is the approach adopted in CAPSAP. 10. The successful enhancement o f financial reporting practices in the corporate sector cannot be attained through reliance on voluntary action and market forces alone, given the agency problems, information asymmetries and free-rider difficulties associated with rebalancing a primary mechanism for accountability by enterprise management to external stakeholders. The state has an essential role to play in terms o f facilitating the "importation" o f international standards into the domestic regulatory regime, developing simplified standards for smaller entities, and ensuring that relevant standards are complied with through robust enforcement mechanisms. For this reason, CAPSAP supports the development o f the necessary capacity at the MinistryofFinance. 11. An important mechanism for enhancing the credibility o f financial information reported by enterprises to external stakeholders, and for providing assurance on financial statements, is the independent external audit function. For this to operate effectively, voluntary action and market mechanisms alone are not sufficient, nor i s a system based only on self-regulation by the audit profession itself. An appropriate legal and institutional framework i s needed to specify the roles and responsibilities o f auditors, to determine the standards (both technical and ethical) which should apply to the conduct o f audits, to fix licensing requirements and the conditions for 19 access to such licenses, and to provide for adequate, independent quality assurance and external oversight of the work of auditors. CAPSAP supports the facilitation of these goals. 12. Improved financial reporting i s also essential in the public sector, to enhance accountability and transparency, and to improve the economy, efficiency, and effectiveness with which public resources are managed. IPSAS - which draw heavily on IFRS, modified for the government sector -are the recognized international benchmark inthis area. However, given the needto balance the capacity of countries to comply with the standards against the benefits which accrue from their use, IPSAS provide a wide range of accounting treatments options, which can be applied whilst still complying with IPSAS. Specifically, the range of treatments varies from purely cash-based accounting to full-accrual financial reporting. For each country, it is important to choose the right point along this cash-accruals spectrum, bearing in mind both the capacity of budget units to apply the relevant standards and the ability of financial statement users to process the information provided for decision-making purposes. Accordingly, the design of CAPSAP is based on a benchmarking of current Azerbaijani practices against IPSAS, an assessment of the current capacity of both preparers and users, and a considered evaluation of the cash-accruals balance which is most appropriate for Azerbaijan at this time, whilst still leaving open the possibility for further evolution over time as the country context changes. The project also foresees the development, within the Ministry of Finance, of the capacity to manage this processon anongoing basis, within arobust legal framework. 13. Similarly, the proper management of public resources requires an appropriate governing control framework, based on internationally recognized best practices. Given the successful experience of other transition economies, especially those which have completed, or are still engaged in, the process of EU accession, the model chosen as the benchmark for assessing the current status of public internal financial control in Azerbaijan, as part of project preparation, was the EU's PIFC model. Lessons learned elsewhere can easily be transferred and, once work under the project to develop a strategy to strengthen public internal financial control is completed, the European Commission has indicated its willingness to consider positively any request from Government to support implementation, using financial resources available under the EuropeanNeighborhood Policy Instrument for Azerbaijan. 14. For improvements in accountability in both the corporate and public sectors to succeed, legal, regulatory, institutional, and procedural changes are necessary but not sufficient. Reflecting the scale and scope of the changes requiredto move from the inheritedSoviet system to one which i s responsive to the current needs of Azerbaijan (drawing on the experience of countries which have undergone a similar change), a major renewal and upgrading of the associated human capital is essential. This affects both new entrants to the labor market, and existing accountants and auditors whose skill sets must be fundamentally rebalanced. Azerbaijan suffers from a severe shortage, in both qualitative and quantitative terms, of accounting and auditing skills, and this skills' shortage is becoming steadily more acute as the economy grows andtransforms. 15. CAPSAP therefore places great emphasis on human capacity development, not through a single training event, but by establishing a sustainable institutional capacity to train and retrain accountants and auditors. Mechanisms to facilitate the "importation" of international best 20 practices over time are also supported, as well as the implementation o f accounting reforms introduced by the Law on Accounting. The proposed project aims to improve governance, transparency and accountability by: (i)strengthening both public sector and corporate sector systems and controls; (ii)public sector and corporate sector financial reporting standards and practices; and (iii)increasing the number o f qualified accounting and auditing professionals to work inthe public and corporate sectors. See Annex 4 on `Detailed Project Description'. 16. The Letter of Development Policy issued under the Poverty Reduction Support Credit set out a reform program for balanced economic growth and poverty reduction and confirmed the Government o f Azerbaijan's intention to seek financial assistance to "improve governance and increase the efficiency and effectiveness o f management o f public resources". The related reforms are the focal point o f the Corporate and Public Sector Accountability Project. 21 Annex 2: Major RelatedProjectsFinancedby the Bankand/or other Agencies AZERBAIJAN: CORPORATE AND PUBLIC SECTORACCOUNTABILITY PROJECT The following projects supportedby the Bank and other donors inaccounting and auditing sector inAzerbaijan, include: 1. IDA/BankandIFC projectsand operations Project Name Amount Financier IP/DO Sector Issue (US$ Million) Ratings IBTA-2 IDA IP - s Public Administration DO-S Poverty 20.0 IDA D O - S Public Administration Reduction Support Credit Second 60.0 IDA IP - s Public Administration Structural D O - S Central Government Adjustment Administration Credit Utility and Infrastructure Sectors IDF Grant on ,340 WBTF I P - s General Finance e Accounting and D O - S Auditing ROSC on .095 WB Accounting and Auditin Investment IFC TA Facility InvestmentClimate Climate 2. Other Donorfunded project Project Name Amount Financier IP/DO Sector Issue Ratings TACIS I& I1 EUTACIS General Finance - development ofNASCOs - taxtraining Treasury Management USAID/WB Public Administration InformationSystem (TMIS) General Finance Corporate Governance SECO General Finance Azerbaijan Bank Training EUTACIS General Finance Center (ABTC) Modernization of Taxation EUTACIS General Finance System Public Investment and Policv USAID Public Administration 22 Annex 3: ResultsFrameworkandMonitoring AZERBAIJAN: CORPORATEAND PUBLIC SECTOR ACCOUNTABILITY PROJECT ResultsFramework PDO The mainProject Development Transparency inthe corporate IR1-YR2:Assess the Objective is to strengthen and public sectors increased nstitutionaland legal accountabilityandtransparency through publishingannual Invironment; identify best infinancialreportingfor the financialstatements accordingto bracticeandtrainingneeds public and corporate sectors in internationalstandards. linewith internationalbest practices, andto support Accountabilitywithin Ministry of institutionalstrengtheningto Financeand Chamber of IR3:Mid-termevaluationof sustainreforms. Accounts to enforce PIFC irojectresultsto assess progress established nthe accountingand auditing eformagenda in bothcorporate UpdatedLegislativeFramework .ndpublic sectors. for accountingand auditing standards established. Accountingand auditing profession strengthenedthrough !R5: Determine additionalneeds the establishmentoftrainingand or sustainabilityofreforms certificationprogramsand hroughreviewofprojectresults educationstandards in linewith .ndrelevant reviews internationalstandards. 23 IntermediateOutcomes Use of Intermediate Outcome Monitoring Component 1: PIEspublishreliable and - # of PIESpublishing annual Assesses PIEs' ability to understandableannualfinancial auditedIFRSfinancial statements comply with Accounting statements. within the statutory deadlines. Law. Credible corporatesector accounting- # of IFRSfinancial statements Low levelsmay indicate andauditingregulatory function. reviewedby MOF for compliance reluctanceofMoFto -with IFRS. supervise and/orChamber of # of oversightvisits performedby Auditors to be supervised. MoF of Chamber of Auditors. Credible corporatesector statutory - # of staff in Chamber of Auditors Low levelsmay indicate audit profession. trained in new methodologyto reluctanceof Chamber of - inspectaudit firms. Auditors to reformand # o f inspectionsperformedby supervise its members. Chamber ofAuditors in accordance with new inspection -methodology. % of licensedauditors complying with CPDrequirements. Component 2: Public sector budget organizations - # ofNASBOs issuedbasedon Low levelsmay indicate poor producehighquality financial IPSAS. NASBOformulation process statements. - # ofbudget organizations as well as poor or absence of publishingannualNASBO implementationguidelines financial statements within the and/or poortrainingand/or insufficientresourcesfor - statutory deadlines. # ofbudgetorganizations' implementation. financial statements reviewedby MOF for compliancewith NASBOs. 24 IntermediateOutcomes IntermediateOutcome Use of Intermediate Indicators Outcome Monitoring Functional and transparentpublic - Scope and nature of external audit Indicates success of sector externalaudit and internal (correspondsto PEFA indicator implementation of Chamber financial control functions. - PI-26(i)). ofAccounts strategic plan, Timeliness of submissionof particularly regarding external audit reportsto upgrading the Chamber's HR legislature(correspondsto PEFA andtraining functions. - indicator PL26(ii)). Comprehensiveness, relevance Low levels may indicate poor and understandingof internal coordination and issues control rules and procedures. relating to operation and (correspondsto PEFA indicator functioning of the harmonization units - PI-2O(ii)). Coverage and quality of the responsiblefor leading PIFC internal audit function ref0rm... (correspondsto PEFA indicator P1-21(i)). Component3: Sustainable financial management - # of accreditedtraining programs Would assess success and human capacity. (incl. undergraduate, graduate and impact of ACPATER. - vocational training programs). # of accreditededucational facilities offeringtraining --programs. # of accreditedtrainers. # of students successfully passing the various training programs. 25 C .d 2 2 0 VI N 3N 0 C 3 8 N - 3 0 H N 3 c BE 3 2 a r0 4 0 hl 0 r 4 2 2 - s0 00 VI 3 00 g 0 0 - VI 2 rn 0 0 - 0 rn g 0 0 0 0 0 z"s z"8 28 z"c e, e, e, z" z"c LL 55 3 0 0 0 0 2 3 *0 0 0 I- 0 rn O 0 0 E! 0 0 0 V 8 V 8 V 8 o m *5 *5 O M O M ** 5 5 ;; 2 2 z 3 z 3 3 3 z z % 2 2 2 % % E! 0 0 0 0 - 8 v) V S e v ) 3 0 3 0 0 0 0 cl d d m m 0 m 0 0 0 0 N N N N 0 0 0 0 Annex 4: DetailedProjectDescription AZERBAIJAN: CORPORATE AND PUBLIC SECTOR ACCOUNTABILITY PROJECT 1. The project will comprise of four components: (1) Corporate sector accountability; (2) Public sector accountability; (3) Strengthening accounting, auditing and financial managementcapacity; and (4) Project Management. Component 1: CorporateSector Accountability(Estimatedcost US$4.74million) 2. Component 1 has three sub-components: (1.1) Assist Public Interest Entities (PIEs) in embedding IFRS, in compliance with the Accounting Law; (1.2) Establishing appropriate legal and institutional frameworks and capacity for translation, adoption and enforcement of IFRS and NASCO; and (1.3) improve statutory framework and building capacity to regulate and oversee the audit function. 3. Sub-component 1.1Assisting the PIEs in embedding IFRS. The need for this component is highlighted in the recent Accounting and Auditing (A&A) ROSC report. The PIEs are commercial entities deemed by the Government of Azerbaijan to be those entities inwhich there i s a public interest intheir operations. 20 entities were approvedby a resolution of the Cabinet of Ministers No. 140 dated July 18 2005. These comprise Azerenergi, Baku Electrical Network Azerbaijan, Azercell, State Oil Company of Azerbaijan Republic (SOCAR), Heydar Aliev Baku Oil Refinery (SOCAR subsidiary), Azerneftyag Oil Refinery (SOCAR subsidiary), Oil Pipelines Department of SOCAR, Marketing and Operational Department of SOCAR, Azneft Production Union (SOCAR subsidiary), Azeraijan State Railways (ADDY), Baku Metropoliteni, Azerbaijan Airlines State Concern, National Aviation Company of the Azerbaijan Airlines State Concern, Caspian State Shipping Company, Azerigas, Azerigasnegi Production Union, Azerzu, Aztelecom, Azkimya, Etilen-Polietilen Plant of Azkimya. All except Baku Electrical Network are 100 percent state-ownedjoint stock companies. SOCAR represents 6 o f the companies, Azkimya represents 2, Azerigas represents 2 and the Airlines State Concern 2, so there are 12 distinct PIE groups. 4. Some of the PIE groups, notably the state oil company, SOCAR, and Azercell have the ability and resources to achieve the above process without major assistance. Seven other PIE groups are considered to have the financial resources required, but may needtechnical advice to support them inthe process. Three PIEs (Azersu, Azkimya, and Baku Metropoliteni) do not have the resources or the capacity to effect a successful transition to IFRS without financial and technical assistance. The World Bank has teams currently working with three of the PIEs (Azerzu, Azerenergi and ADDY) and the teams working with Azerzu and ADDY have prepared Terms of Reference (TORS)for projects assistingthe companies intransitioning to IFRS. Such assistance would typically include the following tasks: - Developing an appropriate accounting and financial management system which properly and promptly records all relevant transactions in such a way that local, 31 regional, and fully consolidated national financial statements can be prepared to meet IFRS. This new system of accounting will provide a basis for the production of credible internal management accounting data which will help managers administer the company more effectively and provide a sound base for tariff adjustments and provide external financial reports which comply with IFRS. The system should provide the required statistical and financial information for the Government (where the PIE is state-owned) and should be designed with strong internal control mechanismsthat will allow, where possible, easy confirmation of information submitted by regional outposts to an external source of information; the system must be designed to encourage an honest and factual submission of information (even if showing poor results), rather than informationthat i s inline with expectations, regardless of reality. - The development of a computerized system using currently available commercial software but where appropriate equivalent manual systems should be considered (for example in regions with few transactions and unreliable power supplies). The system should be standardized across all regional reporting units with facilities for the consolidation of information at regional and national levels. This suggests that a wide area network would be appropriate with all system controls based in headquarters but other solutions may be appropriate for some PIES.However, all software and hardware must be capable of being supported locally. - Development of an appropriate revised chart of accounts, a detailed manual of procedures and appropriate backup procedures. Training inthe system should be provided so that there should be a fully trained cadre of staff capable of operating the system at the completion ofthe assignment. 5. The following detailed tasks are likely to be undertakenina number of stages; --- - Review of current systems and procedures Development of a Strategy, Timescale and Detailed Budget for implementation Detailed SystemDesign including Revenue Generation (Billing and Collection) PurchaseLedger Payroll Nominal ledger (Expenditure Analysis) Asset Registers Balance Sheet Consolidation from utility to ultimate holding company Management reporting Internal control function External financial reporting - --- Assessment of available software options Selection andprocurement of software Selection andprocurement of computer hardware Design o f manual procedures to integrate with computerized systems where appropriate 32 Installation of system Preparationof detailed operation manual Staff training Handover of system The typical expected timescale of such a project would be between 18 months 2 - years from initial planning and appointment of external consultants (ifappropriate) to the completion of system installation, completion of documentation and staff training. 7. Based on studies carried out during project preparation, it is estimated that the support required to underpin the embedding IFRS in the three PIEs requiring most assistance will be approximately $800,000 to $900,000 for each entity, while a further $500,000 is needed for in-kindadvisory support to other PIEs. Total costs are therefore estimated at $3,060,000, with the bulk of the financing being provided by a Japanese PHRD co-financing grant. A further US$0.5 million i s allocated to accounting system reform ineach of the World Bank's projects supporting ADDY, Azerzu and Azerenerj. 8. Sub-component 1.2 Establishing appropriate legal and institutional frameworks - and capacity for translation, adoption and enforcement of IFRS and NASCO. The need for this is highlighted in the recent A&A ROSC report. This component involves working closely with the Ministry of Finance to establish the necessary and appropriate framework and capacity for translation, adoption and enforcement of the accounting standards applicable under the Law on Accounting, (which is IFRS for PIEs and NASCOs for all other commercial entities). The MoF is overseeing the translation of IFRS into Azerbaijani and developing NASCOs based on IFRS (with support from an EU-funded project). During the CAPSAP project, the Law on Accounting requirements will become effective, and the Ministry of Finance will have to assume primary responsibility for enforcing the requirements of the Law. 9. Currently, the MoF does not have sufficient capacity, experience or expertise to effectively monitor and enforce the requirements of the Law on Accounting. This component will provide the Ministrywith technical assistance and support in completing the translation of IFRS, developing and adopting NASCOs and developing an effective and efficient monitoring and enforcement capacity for the implementation of the two sets of accounting standardsrequiredunder the Law on Accounting. 10. Sub-component 1.3, Improving the statutory framework and building capacity to regulate and oversee the audit function. The need for this component is highlighted in the recentA&A ROSC report. 11. There are two parts to the strengthening of the audit function: (i) working with the MoF to improve the statutory framework for audit, using international best practice as a benchmark; and (ii)working with the Chamber of Auditors (CoAA), the organization nominated in Azeri Law as the regulator of auditors, to assist them in meeting the requirements of the reformed audit law and their obligations as members of the International Federation of Accountants (IFAC) as set out in IFAC's Statements of Membership Obligations (SMOs). The SMOs represent international best practice for organizations of accountants and auditors. As part of the enhancements introduced when 33 improving the statutory framework, some rebalancing of responsibilities between the MoF andthe Chamber of Auditors (CoAA) may take place. 12. The CAPSAP project will work with policy makers to enhance the statutory framework for audit and to amend the Law on Auditing Services to make it compliant with international bestpractice inthe following areas: Audit objectives and subjects of audit -- Audit objectives and subjects of audit --- The Chamber of Auditors' mandateand responsibilities The Chamber of Auditors' structure and accountability Accreditation and registration of auditors and audit firms Rights and responsibilities of auditors In addition, the project will work with policymakers so that the statutory framework would be amended to incorporate the following requirements: - Procedures ruling auditor appointment, selection, dismissal and resignation process - should be clearly defined. The statutory audit fees and other services for non-audit services provided by the auditor should be disclosed. 13. An action plan for the assistance to the CoAA is set out ina study preparedunder an IDF grant by CGA Canada, `Institutional Capacity Building for the Implementation of Accounting and Auditing Reforms in the Republic of Azerbaijan - Action Plan for the Reform of the Chamber of Auditors. This action plan was designed to implement the recommendations of the A&A ROSC and developed with the active participation and agreement of the CoAA and the MoF. The main purpose of the action plan, as set out in the executive summary of the report, is to `propose initiatives that would strengthenthe Chamber of Auditors so that it can fulfill its role effectively in the context of the implementation of the new accounting law and the move to international standards of accounting and audit'. The proposals to reform and strengthenthe CoAA are centered on five areas (Statutory Framework; Code of Ethics, Monitoring and Enforcement; Certification and Licensing; Continuing Professional Development, Audit Standards) and the reforms fall into three categories (Documentation and Due Process; Capacity Building; Infrastructure). 14. The final area relating to audit standards (including the translation of International Standards on Auditing) may interact or overlap with the actions envisagedunder the third component of CAPSAP, establishing the competencies of the ACPATER. The timetable for the action plan runs to the end of 2009, but is dependent on the starting date o f the reforms, which should commence inJanuary 2008. 15. The action plan includes a detailed budget and timetable, the total cost of which i s US$600,000 which will be provided under the project, split equally betweenIDA and the Government. 34 Component2: PublicSector Accountability(Estimatedcost of US$3.81million). Sub-component 2.1-Public sector accounting reform. 16. The role of an accounting system during the time of Soviet central planning was to provide economic and statistical data and informationrelevant to the needs of the fiscal and other state authorities. These systems did not, however, satisfy the needs of a market economy, nor did they cater to the application of modern management techniques. In recognition of this, in 2004, the Government of Azerbaijan enacted a new Law on Accounting which requires: (i)Public Interest Entities (PIEs) to prepare financial statements in accordance with IFRS; (ii)other commercial organizations to prepare financial statements in accordance with NASCOs, which, in turn, are based on IFRS (except for smaller enterprises, which are obliged only to follow simplified requirements, but which may use NASCOs); and (iii)municipalities, budget organizations and off- budget state funds (Le. the State Oil Fund and the Social Security Fund) to prepare financial statements in accordance with National Accounting Standards for Budget Organizations (NASBOs) which in turn are based on International Public Sector Accounting Standards (IPSAS). While boththe implementation of IFRSs inPIEs and the development of NASCOs for commercial organizations have begun and are showing promising results, the picture is less positive inrespect of the NASBOs. No NASBO has been or is currently being developed despite the requirement in the Law on Accounting that municipalities, budget organizations and off-budget state prepare financial statements inaccordancewithNASBOsfrom January 1,2009. 17. A report comparing the Azeri public sector accounting framework with IPSAS confirms that the Azeri framework is based on a modified accrual basis of accounting distinguishing between current expenditures and capital expenditures. However, the mixture of elements of cash and accrual accounting clearly compromises the quality of financial reporting. The current accounting practices have significant gaps in the recognition o f assets and liabilities as well as in the recognition of expenses and revenues. Items such as financial instruments or construction contracts are less transparent than fixed assets. Other line items, such as provisions and off-balance sheet items are completely missing. The report finds that the shortcomings of the presentpublic sector financial reporting framework go beyond the basis of accounting and includes the presentation of financial statements as well as recognition and measurement issues. In addition, although line budget organizations prepare financial statements, consolidated financial statements are not prepared for the Government as a whole. The report concludes that implementation of full accrual NASBOs would lead to a comprehensive recognition of all assets, liabilities, expenses and revenues of the reporting entity. This would enhance both accountability to the constituencies and informationfor management of Budget Organizations. 18. Building on this report, the Government is currently inthe process of preparing a public sector accounting reform strategy. CAPSAP will finance the implementation of this strategy which is likely to propose: (i)in conjunction with components 2.2 and 3, educating senior public management through awareness workshops and training courses to enable them to better understand the benefits of and principles underlying good 35 financial managementboth interms of the quality of informationnecessary for decision- making and monitoring as well as interms of fiduciary risk management. This will help to create the demand for public sector accounting reform that i s essential for successful implementation of the reform; (ii)a phased introduction of NASBOs based on IPSAS that takes into account public sector institutions' financial resource constraints, human capital constraints and the current capacities of accounting and financial management information systems; (iii) amendments to the legal framework, particularly at the level of secondary legislation, as well as other implementing regulations; (iv) public sector accounting policy-making, standard-setting and enforcement institutions either within, or overseen by, the MoF; (v) strengthening systems for the production of consolidated government financial statements prepared in accordance with NASBOs; and (vi) in conjunction with Component 3, delivery of training to public sector management, accountants and auditors. Sub-component 2.2. - External audit and Internal Financial Control 19. With the assistance of the former Bank-financed Poverty Reduction Support Credit (PRSC) and Second Institution Building Project (IBTA2), the Government financed the capacity strengthening of Chamber of Accounts (CoA), the country's Supreme Audit Institution, in order to increase transparency and accountability in managing public resources. The CoA is currently formulating a Strategic Development Plan for the next phase of its capacity-building, the implementation of which will be financed by CAPSAP. This will likely include: enhancing legislative framework, enforcement mechanism and methodology on external audit; providing computer equipment and an on-line connection to the Treasury Information Management System (TIMS); developing and implementing a training program; twinning and pilot audits with an experiencedpeer SAI; and providing for the independentaudit of the CoA. 20. The Azerbaijan public sector internal financial control framework does not clearly establish that managers are responsible for establishing and maintaining sound internal control frameworks for their organizations. Rather, various decrees, regulations and instructions prescribe various controls to be implemented and these are usually implemented as prescribed. However, there is great scope for internal control improvement. A Public Internal Financial Control (PIFC) Gap Analysis completed recently noted that " internal regulations of budget organizations are outdated, do not reflect the business processes, do not specify duties, responsibilities, accountability, monitoring, reporting tasks especially in terms of management of public funds and delivering public services". 21. In 1999, in an attempt to reduce the negative impact of duplicative control and audit investigations, the President issued a decree which abolished all public sector internal inspectiodcontrol departments with the exception o f the Main Department of Public Finance Control (MDPFC) in the MoF in respect of public finances; the Ministry of Taxes inrespect of matters withinitsjurisdiction, and the National Bank of Azerbaijan (NBA) in respect of its role as banking supervisor. Thus, at present, only a few budget organizations have Internal Control Departments and no budget organization has a proper internal audit function to provide assurance to management that the processes for which they are accountable are operating ina manner which will minimize the probability o f the occurrenceof fraud, error or inefficient anduneconomic practices. 36 22. Guidedby the experiences of the new member states of the European Union and the EuropeanCommission, the Government has commissioned the PIFC Gap Analysis, to do a comparison of the Azeri framework for public sector internal control with good practice and relevant international standards, and is now formulating a discussion paper for a policy and action plan to strengthen the public sector internal control framework (Le. a PIFC Policy Paper). CAPSAP will finance the completion of the Government's PIFC Policy Paper which is likely to proposethe following: (i)theestablishmentofappropriate legal andinstitutional frameworks. Thismay include establishing a single PIFC Central Harmonization Unit (CHU) or two separate CHUs one for Financial Management Control (FMC) and another for - Internal Audit (IA). It may also include establishing harmonized Financial Directorates in income and spending centers as well as harmonized functionally independentdecentralized internal audit units; (ii)the assignment of responsibility for advising on and taking initiatives in regulating PIFC through the issuance of appropriate regulations, standards and guidelines; (iii)thedevelopmentofamoderninternalauditfunctionto coverallministriesand other major budgetary income and spendingentities; (iv) in conjunction with Component 3, establish sustainable training facilities for all those involved in the Azeri PIFC framework including managers, financial officers and internal auditors; and (v) appropriate linkages between audit and assurance functions, particularly internal audit and the external auditor, and the establishment of appropriate relations between PIFC bodies and other government bodies responsible for investigating andprosecuting financial fraud and related criminal activities. 23. CAPSAP will finance the completion of the Government's PIFC Policy Paper. The European Commission has indicated its willingness to consider positively any request from Government to support implementation, using financial resources available under the EuropeanNeighborhoodPolicy Instrumentfor Azerbaijan. Component 3: Strengthening accounting, auditing and financial management capacity(Estimatedcost US$11.71million). 24. This component provides the underpinnings for the success of the other two components of CAPSAP by supporting the human capacity development that is required to strengthen both corporate and public sector accounting and auditing. The recent corporate sector A&A ROSC indicates that there is a strong needto improve the capacity of the accounting and audit professions to enable them to enhance the quality of financial statements and statutory audits, and promote public trust. The genuine understanding and adoption of these new accounting and auditing requirements is dependent on adequate education and training for preparers, auditors, and regulators. Although there will be an ongoing need for training inthe requirementsof Azerbaijani tax reporting, there must be a greater focus on general purpose financial reporting. The report continues by making a number of recommendationsto address capacity issues, including: (i) encouraging "chief 37 accountants" and other preparers of financial statements in Azerbaijani companies to improve their understanding and application of accrual accounting and IFRS; (ii) assisting vocational and academic education institutions with the development of an IFRS-and ISA-compliant syllabus andtraining materials, and enhancingthe relationships between the accounting profession and universities; (iii)strengthening the professional qualification requirements for all individuals who wish to obtain the right to conduct statutory audits in Azerbaijan, drawing upon International Education Standards; and (iv) articulating and enforcing Continuous Professional Development (CPD) requirements. In respect of the public sector, there is a recognized need to better enhance the skills of public sector accountants, and financial and other managers in order to realize the benefits of accounting reform, strengthen public internal financial control systems, and enhance external audit. 25. The government is currently formulating a strategy for the development of institutional framework, standards and syllabi for corporate and public sector accounting, auditing and financial management education, to be financed by CAPSAP. It is anticipated that the strategy will confirm the need for an Azerbaijan Center for Professional Accounting and Audit Training Education and Research (ACPATER), which will be subordinateto the MoF. It i s also anticipated that the strategy will propose the following activities that CAPSAP will finance: (a) Senior public management will attend awareness workshops and training courses to enable them better to understandthe benefits of and principles underlying good financial management, both in terms of the quality of information necessary for decision-making and monitoring as well as interms of fiduciary risk management. This will help to create demand for both public sector accounting reform as well as for the strengthening of public internal financial control systems. (b) Standards will be established for accounting and auditing qualifications and professional designations including syllabi, examinations and experience criteria. By reference primarily to International Education Standards for Professional Accountants (IESs) as approved and issued by the Education Committee of the International Federation of Accountants (IFAC), education standards will be established for formal professional accounting qualifications that will be associated with specific grades within specific streams of public sector financial management specialists',and various private sector accounting professionals2. In conjunction with this activity, relevant civil service rules and regulations will recognize that promotionto these grades or entry into these streams is conditional upon having the requiredprofessional qualification3. The remuneration of public 1For example: bookkeepers may be requiredto have a basic "Accounting Technician" qualification; accountants may be requiredto hold a professional "Certificate" accountancy qualification; Chief Accountants may be requiredto hold a higher-level professional "Diploma" accountancy qualification; Heads o f Finance Departments may be requiredto hold a comprehensive "Final Test o f Professional Competence"; and internal auditors may be requiredto hold both a high level general professional qualification as well as a specialized professional qualification in internal auditing. For example: professional bookkeepers and accountants; tax advisers; insolvency practitioners; and auditors. There will needto be a period oftransition during which incumbent staffholding the specific grades within the identifiedprofessional streams are afforded the opportunity to obtain the necessaryprofessional qualifications. Staff failing to make satisfactory progress towards obtain the necessary professional 38 sector staff within these streams should recognize the value of their qualifications. University accountancy degree programs will be modernized; official recognition and continued public financing of university accountancy degree programs will be conditional uponthe programs satisfying the education standards. Institutions will be assisted in developing the capacity to deliver accounting qualifications and university accountancy degree programs. A significant effort will be requiredto establish the capacity to deliver the education to satisfy these standards. Universities and other institutions delivering professional accountancy training will need to be re-tooled and re-skilled. Accordingly, the following approach will be followed: (i)detailed syllabi for the various professional qualifications will be established based on existing internationally recognized professional accountancy qualifications4; (ii)course materials will be translated into Azeri; (iii) Azerbaijan-specific course materials will be devised inaccordance with recognized international norms5; (iv) a core group of two or three tutors per subject will be identified from within the Azerbaijan accountancy education sector6 and will be trained by international consultants to deliver the course materials in Azerbaijan; (v) a first cohort comprising lecturers from universities and other institutions delivering professional accountancy training7will be taught by the core group of tutors to deliver the training in their institutions. Financial assistance, in the form o f part-payment or subsidies of the costs of professional qualifications in accounting and auditing will be provided to successive colleagues of public and private sector accountants to encourage the re-tooling program. Providers of accounting and auditing education and qualifications (e.g. universities, professional bodies and audit supervisory bodies) will be licensed and monitored. Professional and ethical standards for accountants andauditors will be established Independent oversight of audit supervisory bodies and professional accounting bodies. qualifications will be re-assignedto a more suitable position or to a more suitable professional stream. Staffwith only a few years of employment remaining untiltheir retirement will be assessedby other means for their suitability for their position and, ifdeemed suitable, "grandfathered" without the requirementto study for and obtain the requiredprofessionalqualification. Examplesof such qualifications may include: the International Certificate and Diploma in Public Sector Accounting and Audit administeredby the CharteredInstitute of Public Finance Accountants (CIPFA); the various professional qualifications administeredby the Association of CharteredCertifiedAccountants JACCA); and the Certified International ProfessionalAccountant (CIPA) program administeredby the EurasianCouncil for Certified Accountants and Auditors (ECCAA) and developed as part of the USAID EnterpriseDevelopmentProiect in Central Asia. Examplesof Azerbaijan-specific courses are law and taxation. A commitment will be required from the chosentutors to deliver the training to a specific number of students as part of a centrally-administeredprogram for a fixed fee also to be determinedcentrally. 7 It is expectedthat universities and other institutions delivering professional accountancytraining will apply to deliver the entire course and therefore will present a team of lecturers to be trained as part of the first cohort. A commitment will be required from the universities or other institutions to deliver the entire course to a specific number of students as part of a centrally-administered program for a fixed fee also to be determinedcentrally. Grantsmay be awardedto universities and other institutions to enable them to upgradetheir accountancyeducation facilities. 39 (g) Development of accounting terminology, methodological guidelines and other relevant materials for academics professionals and practitioners. (h) Establishment of an international advisory panel of experts in accounting and auditing Component4: ProjectManagement(Estimatedcosts US$0.84 million). 26. A PMU has been established within the Ministry of Finance with the overall responsibility for all aspects of project management and implementation, including procurement and contracting, financial management (accounting, reporting, disbursements, auditing arrangements), and monitoring and evaluation of project activities. Inaddition, a PSC comprising key beneficiaries and line ministries to oversee regulatory reforms and review/approval of work plans and budget will be established prior to project effectiveness. Both the PMU (headed by director and reporting to deputy minister), andthe PSC (chaired by deputy minister) will report to the Minister of Finance. For sustainability of the project, the PMU will be strengthenedduring the implementation ofthe project to facilitate incorporating the PMU into the ACPATER at project closing. 40 Annex 5: ProjectCosts AZERBAIJAN: CORPORATE AND PUBLIC SECTOR ACCOUNTABILITY PROJECT Foreign Local Total %of Total Project Cost By Component andor Activity us us us Base Cost $million $million $million A. Corporate Sector Accountability -- - - - 3.81 0.76 4.57 23 EmbeddingIFRSinPIESandNAS inNon-PIES 2.57 0.49 3.06 Framework & Institutional Framework for 0.33 0.07 0.40 Translation, Adoption & Enforcementof IFRS - & NASCO Improving Statutory Frameworkand Building 0.91 0.20 1.11 Capacity to Regulateand Oversee the Audit Function B. Public SectorAccountability -- - 3.34 - 0.30 - 3.64 19 Develop Public Sector Accounting Standards 1.38 0.30 1.68 ExternalAudit and InternalFinancialControl 1.96 1.96 C. Strengtheningaccounting, auditingand financial - - 5.96 4.62 10.58 54 managementcapacity - EstablishACPATER - DevelopiUpgrade 1.71 0.37 2.08 Accounting & Auditing Skills 4.25 4.25 8.50 D. Project Management --- Operation - - - 0.60 0.16 0.76 4 Consultant Services and Staff Costs 0.45 0.12 0.57 and Maintenance(incl. equipment) 0.08 0.02 0.10 Audit of Project FinancialStatements 0.07 0.02 0.09 Total Baseline Cost 13.71 5.84 19.55 100 PhysicalContingencies Price Contingencies 0.61 0.94 1.55 Value Added Tax (VAT) ' 1.68 1.22 2.90 Total Project Costs 16.00 8.00 24.00 Financine Plan (US%million) (including contingencies) Component/ActiviW IDA Credit PHRD GOA SECO Total Grant A: Corporate Sector Accountability 1.19 3.O 0.55 4.74 B: Public Sector Accountability 1.21 0.60 2.00 3.81 C: Strengthening accounting, auditing 8.03 3.68 11.71 and financial managementcapacity D: ProjectManagement 0.57 0.27 0.84 E: Value Added Tax (VAT) 2.90 2.90 Total FinancingRequiredand 11.0 3.0 8.0 2.0 24.0 Available Grants exemptedfrom VAT 41 Annex 6: ImplementationArrangements AZERBAIJAN: CORPORATEAND PUBLIC SECTORACCOUNTABILITY PROJECT 1. The project will be implemented by the MoF through the PMU'. The key staff o f the P MU, including director, financial management specialist, procurement specialist and translator, has been selected competitively. The current P M U team selected for the implementation o f PHRD grant will need to be strengthenedfor CAPSAP before the proposed project will become effective. The P M U director heads the P M U and reports directly to the deputy minister o f finance. Other key members o f the PMU, such as monitoring and evaluation specialist, twinning advisor (international), and other technical experts will be recruited before the start of project implementation. The PMU will have the overall responsibility on fiduciary aspects o f the project, including: -- Project planningand budgeting Financial management -project accounting, financial reporting, Credit/Grant/Government counterpart funds disbursement - Auditingarrangements - - Procurement and contracting Monitoring and evaluation o f all Project activities and indicators for Project - implementation. Review and approve Consultants' reports (withina month after the reports' - submission) Coordination with Project beneficiaries, line ministries, the SteeringCommittee, the World Bank and other donors. 2. It is envisaged that the PMU could eventually be absorbed into ACPATER to ensure the project's sustainability. 3. Project Steering Committee. The PSC will be established by official Government decision, and headed by Deputy Minister o f Finance. Members o f the PSC will include high- level representatives from key project beneficiaries -Ministry o f Finance, Ministry o f Education, Ministry of Economic Development, Chamber of Accounts, Chamber of Auditors, the PMU Director, and an international advisor hiredto advise Ministry o f Finance, the P M U and the PSC. The role o f the PSC will be to make decisions on key legal and regulatory issues affecting project implementation, and to approve annual work plans and budgets. 4. Inparticular, the PSC willberesponsible for: - - Review and approve the project's annual work plans and budgets Review and approve new education standards for accounting and auditing, as well as the - unified Azerbaijani language lexicon for accounting and auditing terminology Review implementation o f IFRS and IPSAS standards by relevant agencies and entities inaccordance withthenew Law on Accounting IEstablished under Ministerial Decree No. 1-75 dated July 30, 2007 42 - Facilitate proposed amendments and changes to the legislation framework addressed - within the Project Issue quarterly press releasesfor public on Project's progress 5. Readiness for implementation. While the Government lacks the specific capacity to implement reforms in accounting, auditing and financial management, they have shown strong commitment to the project and its objectives. The Government recognizes the need for such a project to address the critical needfor accountants inthe private sector, for more appropriate and rigorous accounting standards for the public sector and for the long-term training of accounting and auditing professionals. The project will build on the existing capacity inthe country and will leverage the enthusiasm of the Government and of the private sector to drive the reform for long- term sustainability. 43 Annex 7: FinancialManagementand DisbursementArrangements AZERBAIJAN: CORPORATE AND PUBLIC SECTORACCOUNTABILITY PROJECT Executive Summary. 1. The PMU established at the MoF will be responsible for overall project implementation. The PMU will consult with Accounting Methodology Department of the MoF, its main government counterpart, on the implementation of the project's technical aspects. The project financial managementand procurement responsibilities will rest solely with the PMU. 2. As of the date ofthis report, the MoF does not have overdue audit. 3. The PMU was established in July 2007 to implement a PHRD grant that was signed for the preparation of CAPSAP. The PMU staff consists of a Director, who reports directly to the Deputy Minister of Finance, and three staff - a Finance Management Specialist, a Procurement Specialist, and a Translator/Administrator. The PMU Director resigned at the end of December 2007 and Financial Management Specialist has been acting as PMU Director since then. The current PMU staff capacity i s weak and will need to be strengthened before project becomes effective. 4. The project financial management arrangements were assessed in October 2007 and reviewed again inFebruary 2008 and they were found to be acceptableto the Bank. 5. The overall financial management risk for the project is rated as "substantial" before mitigation measures. With adequate mitigationmeasures that were agreed on with the PMU, the financial managementresidual risk is rated "moderate". Country Issues 6. The Country Partnership Strategy (CPS)for 2007 to 2010 addresses issues of transparency in public sector governance, especially in the challenge to maintain a stable macroeconomic framework that makes prudent use of oil revenues. The report recommends several measuresto improve public sector governance that include: (i)improving public expenditure planning and management; (ii)strengthening financial management and procurement systems; (iii) establishing proper public sector and corporate governance, accounting and auditing frameworks; and (iv) creating an administrative and regulatory environment conducive to growth. CAPSAP directly addresses these suggestions for improved governance at the country and sector levelthrough institutional and capacity building inaccounting and auditing sectors. 7. A Country Financial Accountability Assessment (CFAA)for Azerbaijan was carried out in 2003 with the objective of identifying strengths and weaknesses of the country's financial accountability arrangements and the risk that these may pose to the use of Bank funds. The report identified weaknesses and made recommendations to strengthen public and corporate sector accounting, auditing, governance and financial accountability frameworks. 44 8. A Country Procurement Assessment (CPAR) carried out in 2002 reviewed the current two- stage control by the Ministry of Finance following budget allocation. The contract-by-contract control compares the prices of bids to some "average market price" and rejectedto the extent that the successful bid price exceeds the hypothetical market price. The CPAR recommended that this control should beabandonedas it leads to widespread inefficiencies and corruption. 9. The Accounting Law enacted in November 2004 mandates PIES including SOEs, the application of IFRS in preparation of their financial statements. The Law focuses on changing the role and significance of accounting and financial reporting in Azerbaijan, aligning it with good international practices, and thus promoting transparency and accountability in financial reporting. Risk Analysis 10. The overall financial management risk for the project is substantial before mitigation measures, but is reduced to moderate after mitigation measures agreed on and incorporated into the project design. The table below summarizes the financial management assessment and risk ratings of this project together with risk mitigation measures: Risk Risk Financial Rating Rating Mgmt before Risk Mitigation MeasuresIncorporated into after Assessment Mitigation Project Design mitigation Measures measures I.InherentRisk Country H Legaland regulatoryreformsconduciveto H level increasedaccountabilityand efficiencyaddressed inthe PRSC and inthe proposedCorporate& Public Sector Accountabilityproject Entity Althoughthe projectwill be implementedby the Level PMU, the involvementofMoF staff inproject implementationis critical for project success. The current level of cooperationbetweenthem is weak. The PSC that will have membersfrom MOF top officials will assist PMU inestablishing areliable working relationshipbetweenPMUandthe MOF departments. . 'roject The PMUstaff does nothave previous experience devel.No inBankfinanced projectimplementation.Specific irevious trainingsfor all PMU staffwill be developedto :xperience trainthem inbank proceduresandpolicies.The nBank PMUwill be strengthenedby recruitingadditional )perations staff h e r a l l H S Zontrol Risk 3udgeting S Budgetingprocesswill be in accordancewith local M legislationrequirements.The current budgeting process is too bureaucratic.PMU staff will needto cooperate with the MoF relevant department in order to meet internaldeadlines. PSC will assist PMU in submittingnecessary inputs to the MOF for the project budget. iccounting I S PMU was maintainingaccountingrecords for the M 45 PHRDgrant inexcelbasedspreadsheets. A 1C systemhas beenselectedand is beinginstalledfor the mainproject accountingrecordkeepingand reporting. Internal H Internalproceduresdocumentedinthe POM. S Controls FundsFlow S DesignatedAccounts (DAs) will be openedby the M PMUfor IDA, PHRD and SECO funds. Traditional disbursementmethod, SOE and Direct payments,will be usedto disburse IDA funds. Local Treasury systemwill be usedfor counterpart funding. Moderatedelays anticipated inreleasing budgetaryallocations for project implementation. Financial S Accounting system will have capacity to generate M Reporting necessaryreports.PMUFMS will be responsible for on time submissionofreports. Auditing S The projectwill be auditedby audit firm M acceptableto the Bank... Overall S Overall risk is Substantial before mitigation M measures and moderate after mitigation Imeasures agreed. Strengths 11. The PMU reports directly to Deputy Minister o f Finance and the PMU staff will have direct access to top MoF officials for day to day operational decision making. In addition, the P M U i s now implementing a PHRD grant that was allocated for CAPSAP project preparation and by the time the CAPSAP i s declared effective, the P M U will have obtained experience in Bank fiduciary procedures andpolicies. Weaknessesand Action Plan 12. The PMU staff does not have previous experience in implementing Bank or other IF1 financed projects. In addition, the P M U maintains accounting records in excel based spreadsheets. A 1C Accounting system has been selected and i s currently being installed for project accounting to replace the excel based system. Training will be provided to the P M U staff on financial management and disbursements during project implementation. A Project Operational Manual (POM) has been prepared documenting internal policies and procedures for project implementation. Adoption o fthe P O M i s a condition o f effectiveness. Significant Weaknesses Action Responsibility Completion Date I Remarks The levelof PMUstaff is PMUkey staff (director, financial PMUandthe Throughout project not appropriatefor proper management specialist and MOF implementation level of segregationof procurementspecialist) will be duties among staff;and maintaineduntil completion of the further trainingofthe project. Further training will be PMUstaff is requiredin providedthroughout project financial managementand implementation. disbursements.,, 46 Implementing entity 13. Project Management Unit, The project will be implemented by the MoF through the PMU. The PMU will be responsible for the following functions: (i) planning and budgeting; (ii) procurement; (iii)financial management including project accounting and financial reporting, disbursement and auditing arrangements; and (iv) monitoring and evaluation. The Project Director i s responsible for ensuring on a daily basis that the project i s progressing according to plan and that the PMU is fulfilling its tasks. The Project Director will report directly to the Deputy Minister of Finance, and will also be a member of the PSC, and is responsible for providing the final signature approving project reports, evaluations and disbursements according to the rules established in the Project Operational Manual. Other key members of the PMU include, procurement specialist, financial specialist, monitoring and evaluation specialist, twinning advisor (international), and other technical experts as required. Once the capacity of the PMU has been established, it is envisaged that it could eventually become absorbed by ACPATER 14. Project Steering Committee The PSC will be establishedby official Government decision (conditions of effectiveness), and will include the high level representatives of the Ministry o f Finance, Ministry of Education, Ministry of Economic Development, Chamber of Accounts, Chamber of Auditors, and the Project Director. The Chairman of the PSC- the Deputy Minister of Finance- will be officially appointed by Government. An international expert will be hired and financed from the Project to advise the MoF Accounting Policy Unit, the PSC andthe PMU. The role of the PSC will be to plan and direct the overall activities of the project through the Project Director, to make decision on key issues of project implementation, and to approve annual work plans and budgets. Budgeting 15. The project budgets will need to be part of the annual budget of the MoF. The PMU Financial Management Specialist, underthe supervision of PMU Director, will be responsible for preparing a draft project budget split by quarterly expenditures, components and sources of finance. The draft project budget will need to be agreed with Accounting Methodology and other relevant departments of the MoF before it is finally sent for consolidation to the department of the MoF responsiblefor annual budget formulation ofthe Ministry. 16. Since the process of budget formulation is long and bureaucratic in Azerbaijan, the PSC will assist PMU infinalizing the project budget and including it into the MoF's annual budget in atimely fashion. 17. The substantial risk associated with budgeting is reduced to moderate after mitigation measures incorporated into project design. 47 Accounting system Accounting software: 18. The PMU will have an independent accounting software for accounting and record keeping o f the project. The current accounting system o f the MoF is unreliable for the needs o f the project. Inaddition, the MoF officials are reluctant to grant access to their accounting system because of confidentiality issues. 19. The P M U will be responsible for the project accounting. The structure of the Chart o f Accounts will conform closely to the project cost tables, capturing financial data under appropriate components, including sources and uses o f funds in sufficient detail to satisfy reporting requirements. The 1C accounting software has been selected for project accounting and financial reporting, customized to reflect project needs, and designed to provide periodic, accurate and reliable financial information required by all interested parties including the Bank and Government ministriesand agencies. Staffing: 20. The Financial Management Specialist of the P M U is responsible for FM aspects o f the PHRD grant. The current P M U structure with a few additional staff i s expected to be in place for CAPSAP as well. The FMS has a broad experience in teaching accounting at the Baku Economic University with limited experience in accounting practice. His good communication skills will be required to deal with relevant MoF departments and other organizations that are beneficiaries o f the project. However, in order to set up an appropriate segregation o f duties among PMU staff the recruitment o f project accountant/cashier will be required. The project accountant/cashier will be responsible for maintaining accounting records inthe system and FMS will be responsible for regular reconciliations and overall supervision o f the financial operations of the PMU. The P M U staff will be supported by short-term international consultants as needed. Accountingpolicies andprocedures: 21. The implementing agency will maintain appropriate financial records and reports in accordance with existing government financial regulations and standards acceptable to IDA. The P O M has a special FM section where all essential accounting policies and procedures will be outlined. 22. Fixed assets purchased under the project will be handed over to the project beneficiaries immediately after acquisitions and they will be registered in the Fixed Assets Registers o f appropriate government units. 23. The substantial risk associated with accounting system is reduced to moderate after mitigation measures incorporated into project design. 48 InternalControlsandInternalAudit. 24. In an attempt to reduce the negative impact of the duplicative control and audit investigations performed, the President issued a decree in 1999which abolished all public sector internal inspectiodcontrol departments with the exception of the MoF, Ministry of Taxes and NBA. The MainDepartment of Public Finance Control (MDPFC) inthe MoF is responsible for the internal control function within the MoF. However, the scope of the audits conducted and methodologies applied are not consistent with recognized international standards. The MDPFC, therefore, will not be involved in the project implementation. The second component of CAPSAP will address the issue of internal audit function within the public organizations in the country. 25. Controls and procedures for project implementation, including flow of funds, contracting, authorizations; segregations of duties will be documented in the Operational Manual. An intensive supervision to be undertakenby the project team will ensure that PMU has maintained a reliable internal control framework for the project. 26 The project accounting records will need to be reconciled with WB and internal MOF records on a monthly basis. 27. The high risk associated with internal controls is reduced to substantial after mitigation measures incorporated into the project design. Financia1Reporting. 28. For project monitoring purposes, quarterly interim un-audited financial reports (IFRs) (previously called financial monitoring reports) will be required. The PMU and Bank project team agreed that the format of the IFRs should include: (a) Project Sources and Uses of Funds; (b) Uses of Funds by Project Activity; (c) Special Account/Local Bank Account Statements. These financial reports will be submitted to IDA within 45 days of the end of each quarter. The first quarterly IFRs will be submitted after the end of the first full quarter following the initial disbursement. Formats of the annual financial statements and the IFRs will be incorporated in the Project Operations Manual (POM). The accounting software to be usedby project team will have the capacity to prepare IFRs incorporating all components, sub-components and expenditure categories, as may be appropriate. 29. The substantial risk associated with financial reporting is reduced to moderate after mitigationmeasures incorporated into the project design. Disbursement and Funds Flow Arrangements. 30. The Country Financing Parameters for the Republic of Azerbaijan approved in December2004 will be applied to determine the level of IDA financing. These Parametersallow cost sharing of up to 100percent, no country-level limit on financing o f recurrent costs, and local and foreign costs may be financed in any proportions required for the project. No taxes and duties are judged to be unreasonable. The Credit can therefore finance all taxes and duties associated with project expenditures. Bank financed projects approved after January 1,2008 are 49 subject to VAT at the current rate o f 18 percent. The Government contribution will separately cover these VAT related costs. 31. Transaction Based Disbursement Methods. The Government of Azerbaijan has not accepted Report-based Credit disbursement method (disbursements on basis o f InterimFinancial Reports). Therefore, the IDA Credit funds under the CAPSAP will be provided on standard IDA Credit terms, to be disbursed through transaction-based disbursement methods that include: reimbursements with full documentation, reimbursements on basis o f Statements o f Expenditures for small expenditures with defined thresholds, payments against Special Commitments, direct payments to third parties, and payments through the Designated Account. 32. DesignatedAccounts. To facilitate project implementation, Designated Accounts for IDA Credit, PHRD Co-financing Grant and SECO funds respectively, will be opened ina commercial bank, on terms and conditions acceptable to IDA. The DesignatedAccounts will be replenishedregularly, at least every three months, and audited inconjunction with the annual audit o fthe project financial statements. The ceilings o f the respective Designated Accounts are US$l.O million for IDA and US$300,000 for the PHRD Grant. 33. Government Contribution. The Government counterpart funds of US$S.O million will be disbursed from budgetary allocations expended through the Treasury System to a Project Account opened for the Ministry o f Finance. The PMU, on behalf o f the MoF, will be responsible for the management o f the Project Account for financing Project expenditures. Either the Minister or the Deputy Minister of Finance will be the authorized official to sign payment orders to finance expenditures financed from the budgetfunds. 34. All disbursements would be made on the basis o f full documentation for (a) contracts for goods costing more than the equivalent o f US$l00,000 each; and (b) services under contracts o f more than the equivalent o f US$50,000 for each consulting firm and more than the equivalent o f US$25,000 each for individual consultants. Disbursements below these thresholds would be made according to certified Statement o f Expenditure (SOEs). This documentation would be retained by implementing agency for at least one year after receipt by the IDA o f the audit report for the year in which the last disbursement was made or for such a period required by local legislation. Disbursements for expenditures above the SOE thresholds would be made against presentation o f full documentation relating to those expenditures. Currently there i s no plan to move to periodic disbursements. 35. The substantial risk associated with funds flow i s reduced to moderate after mitigation measures incorporated into project design. Financial Audits. 36. The audit of the proposed Project financial statements will be conducted by independent auditors under terms o f reference acceptable to IDA, and in accordance with International Standards on Auditing (ISA). The annual audited financial statements will be submitted to the IDA within six months after end o f each calendar year, and also at the closing of the project. The first audit for the Project will be at the end o f the first year o f Project implementation. The contract for the audit awarded during the first year o f project implementation can be extended 50 fiom year-to-year with the same auditor, subject to satisfactory performance. Such contract will be procuredunder Least-Cost Selection procurement method. A sample audit TORwas discussed with the MoF during appraisal and agreed upon during negotiations. The cost o f the audit is eligible for financing from the proceeds o f the Credit. A financial covenantfor the annual audit of theprojectfinancial statements is included in the legal agreement. Table of Audit ReportsRequired Audit Report DueDate 1 Continuing EntityFinancial Statements N/A 2 Project Specific Financial Statements June 30 each year for (including Special Opinions, SOE, previous calendaryear DesignatedAccount, other) 3 Onerational audit N/A 37. The financial audit risk i s moderate and no mitigation measures are required. SupervisionPlan. 38. The Bank will conduct financial management supervision every six months to monitor progress o f project implementation. The financial management supervision would pay particular attention to: (i)credit disbursements and financial management arrangements; (ii) review o f the project's Interim Financial Reports and audited financial statements; and (iii)review o f implementation o f auditor's recommendations on strengthening systems and controls as outlined inthe Management Letters issued bythe auditors withthe annual Audit Reports. 51 Annex 8: ProcurementArrangements AZERBAIJAN: CORPORATE AND PUBLIC SECTOR ACCOUNTABILITY PROJECT A. General 1. Procurement for the proposed project will be carried out in accordance with the World Bank's "Guidelines:Procurement under IBRDLoans and IDA Credits" dated May 2004 revised October 2006; and "Guidelines: Selection and Employment of Consultants by World Bank Borrowers" dated May 2004 revised October 2006, and the provisions stipulated in the Credit Agreement. The various items under different expenditure categories are described in general below. For each contract to be financed by the Credit, the different procurement methods or consultant selection methods, the need for pre-qualification, estimated costs, prior review requirements, and time frame will be agreed between the Borrower and the Bank in the Procurement Plan. The Procurement Plan will be updated annually or as required to reflect the actual project implementation needs and improvements ininstitutional capacity. 2. The Project contracts not financed directly by the Bank would be procured inaccordance with national regulations, or co-financing institutions' procurement regulations. The projected procurement would initially be advertised in a General Procurement Notice (GPN), and Specific Procurement Notices (SPNs) to be issued thereafter as needed. The Borrower will publish a GPN, acceptable to the Bank, online inthe UnitedNations Development Business (UNDB) and in the Development Gateway's dgMarket. The individual SPNs for goods and request for expressionof interests (REoIs) for consulting services will be advertised in a national newspaper or on the Ministry of Finance (MoF) website following negotiations. The SPN for International Competitive Bidding Goods packages and REoIs for consultant's contracts above USD 200,000 equivalent would be advertised on-line in UNDBIdgMarket. The results of contract awards for goods and consulting services will be posted on the UNDB and in the Development Gateway's dgMarket as required under the Guidelines. The Project Management Unit, established in the MoF would follow the World Bank anti-corruption measures and would not engage services of firms and individuals debarred by the Bank. The listingof such debarred firms and individuals i s located at: httv://www.worldbank.orghtmvbar/vrocure/debarr.html 3. Procurementof Works: The Project will not finance any civil works contracts. 4. Procurement of Goods: Goods procured under this Project will include information technology (IT) systems, office equipment, etc. The procurement will be conducted using the Bank's StandardBidding Documents (SBDs) for all ICB. Contracts for goods will be grouped in bidpackages as muchas feasible. International Competitive Bidding (ICB): Goods packages estimated to cost US$lOO,OOO and above per contract would be procured through ICB. I T equipment and software would be procured as separate packages and using a single-stageprocurement procedure. Shopping: Goods packages estimated to cost less than US$lOO,OOO per contract may be procured through Shopping procedures on the basis of at least three quotations obtained. The 52 Project Management Unit (PMU) would solicit quotations from at least three (normally 5-6) suppliers from eligible source countries. In case of Shopping for procurement of IT equipment (hardware, software, etc.) the PMU will follow the procedures set forth in the Bank external website. When soliciting quotations, the PMU will include in the shortlist the authorized firms which are recommended in this web-site; in addition, other firms or local dealers may be added to the shortlist, upon checking their credentials with respective manufacturers. Direct Contracting: Where certain goods are available from one particular supplier or in case where compatibility with existing equipment requires that goods must be procured under Direct Contracting (single-source) and have obtained prior approval form the Bank (in accordance with paragraphs3.6 and 3.7 of the ProcurementGuidelines). 5. Procurement of non-consulting services: The project will not finance any non- consulting services contracts (or technical services contracts). 6. Selection of Consultants: Consulting services under this project would include technical assistance for developing an accounting and financial management system in line with IFRS requirements for PIES; assistance on developing a revised chart of accounts including a detailed manual of procedures; assistance on enhancing the framework for audit for Chamber of Auditors; technical assistance to the Government on implementation of its accounting reform strategy, and assistance to develop the Government's PIFC Policy Paper; assistance on implementation of CoA capacity building, etc. The project will also finance training services and study tours. Short lists of consultants for services estimated to cost less than US$lOO,OOO equivalent per contract may be composed entirely of national consultants in accordance with the provisions of paragraph 2.7 of the Consultant Guidelines. The applicable selection methods will be as follows: Consulting servicesto be provided by firms estimatedto cost US$lOO,OOO or more per contract will be procured through Quality and Cost Based Selection (QCBS) method; this method would be used also for smaller contract amounts which are of complex nature. Consulting services to cost less than US$lOO,OOO equivalent each may be procured through Consultants Qualzjkations (CQ) method. The consulting contract for project audit may be selected through Least Cost Selection (LCS) method. Fixed budget method (FB) may be used for simple assignments and when the respective contract budget is requiredto be fixed, as provided for under clause 3.5 of Consultants Guidelines. Individual consultants will be selected in accordance with Section V of the Consultants Guidelines. Single source (SS) method may be usedfor certain consulting assignments with prior approval of the Bank inaccordance with paras 3.9 through 3.13 of the Consultants Guidelines. 7. Training: Training will include study tours in connection with the activities included in the Project components and reflectedinthe Annual Training and StudyTour Plansthat would be prior-reviewed by the Bank. The Bank will clear the plans upfront, while changes and additions to the plans would be reviewed separately as they occur and would cover the list of participants, agenda for training events and estimated budget. Consultants required for preparation, facilitation or conducting training activities shall be selected under appropriate procedures for selection of the Consultants as described above. Selection of such consultants shall be included inthe ProcurementPlan. 53 Under Component 3, the Project will finance awareness workshops and training courses for (a) senior public management staff; (b) experienced staff on accountinghinance within the Azerbaijan accountancy education sector will be identified as tutors (i.e. by creating two-three tutors per core group/area o f expertise) who will be trained by international consultants (as training o f trainers) and will deliver course materials in Azerbaijan; (c) lecturers from universities and other Azeri institutions (in charge with delivering professional accountancy training) will be trained by the core groups o f tutors, so to enable them to deliver the training to their institutionshniversities. Given the above training/workshops could involve potential government staff or university professors (such as tutoduniversity lecturers described above), provisions under clause 1.11 o f Consultants Guidelines will be respected in this regard, such as: (i)civilservantscanbehiredcontractedasindividualconsultants orasmemberofateamwith financing under the Credit provided they are on leave o f absence without pay and they have not been working for any o f the governmentheneficiary agencies immediately prior to taking leave o f absence; (ii)as an exception to (i) above, university professorsheachers and academics from research institutes in Azerbaijan, with unique experience on the relevant area such as accounting/finance, may be hired, contracted and financed individually under the project on a case by case basis with Bank's prior approval. 8. OperatingCosts: The Project would finance necessary operating expenditures incurred by the PMUto cover office supplies, communication and other administrative cost for the PMU operation. B. Assessment of the agency's capacityto implementprocurement 9. The PMU, led by the Director, will be composed by a financial officer, a procurement officer, a monitoring and evaluation officer, twinning advisor (international) and other local short term experts as required. The first two positions (Financial and Procurement Officers) along with the Office ManagedTranslator were hired competitively under the PHRD Grant for CAPSAP preparation. The P M U Director will be also selected competitively to replace the position remaining vacant after the previous PMU Director resigned. The main responsibility o f the Procurement Officer will be to coordinate procurement under the project, ensuring procedural compliance and contract awards in accordance with the World Bank procurement procedures for all four Project components. 10. An assessment o f the capacity o f the PMU to implement procurement actions for the Project was carried out in September 2007. The assessment reviewed the organizational structure for implementing the Project and the interaction between the P M U and respective benefitingagencies (BAS)that will benefit from the Project. 11. The key issues and risksconcerning procurement for implementation o f the Project have beenidentified and include the following: (i). At the country level, a comprehensive analysis of the public procurement system in Azerbaijan was carried out during the Country Procurement Assessment review (CPAR) in 2002 and finalized on June 2003. This assessment included all relevant aspects o f procurement operations such as the legislative framework, the effectiveness o f regulatory institutions, strengths o f the enforcement regime, capacity o f its institutional and human 54 resources. The CPAR concludes that, although certain progress has been made and procurement reform has been highlighted as priority in Azerbaijan in the last two-three years, there i s still significant progress that could be made. In2001 Azerbaijan adopted a Public Procurement Law (PPL) based extensively on UNCITRAL model. However, there were significant areas where provisions o f the PPL vary from the Bank's Guidelines and recent findings have shown that the differences have caused problems in Bank-financed operations. This was mainly due to State Procurement Agency's requirements that National Procurement procedures should be followed. In particular this appeared to be caused by the fact that the PPL was silent concerning contracts financed by donors. This PPL deficiency was fixed on 2005 when a Presidential Decree was issued. Subsequent to the passing o f the PPL in 2001 there was a Presidential Decree signed in January 2002 comprising implementation mechanisms. Nevertheless, it i s still common to observe misapplication o f the provisions o f this Law which result in dubious practices and excessive political interference in contract award decision in Azerbaijan. This had a delaying effect on Bank-financed procurement where some PIU directors and procurement staff were unable to act effectively or make timely decisions due to constraints applied by the State Procurement Agency. Consequently, the CPAR concluded that Azerbaijan should be rated as high-risk country in respect o f public procurement system. A CPAR for Azerbaijan i s expected to be carried out inFY08. (ii).At the project level, the P M U lacks experience with the Bank's procurement; the Procurement Officer has some knowledge on Azeri procurement rules and procedures and the P M U Director had some knowledge on Bank's procedures (given her involvement in another Bank's project). The overall procurement risk is rated "high". 12. The following actions need to be taken in order to alleviate the risks for poor implementationo fprocurement under the project: (i), The procurement file containing up to date procurement documents (guidelines, manuals, templates o f procurement notices, standard bidding documents for procurement o f goods and works, standard request for proposal documents for consulting services, evaluation report formats, regional and simplifiedprocurement documents etc.) shall be prepared by the Bank and provided to PMU at the time of Project Launch Workshop. The PMU is recommended to visit the Bank's web-site frequently to ensure using the most updated procurement documents. The Project Launch Workshop will have a specific session on Procurement Training for the PMU staff and also for the evaluation committee members (who need to be identified before issuingthe first Request for Proposals (RFP); especially for the last ones a one day workshop session will be conducted by the Bank procurement staff on how to evaluate technical proposals and preparetechnical evaluationreports. (ii).The P M U will have a full-time procurement officer. The procurement expert and P M U Director will attend regional procurement trainingdseminars organized by the Bank on procurement (expected in April 2008) and also they will attend training on Bank's procurement procedures given by I L O inTurin. 55 (iii).A BankProcurementSpecialist willbeamember oftheprojectteamthroughoutthe project cycle. During project implementation, the Bank's Procurement Specialist should be involved inthe supervisionmissions. (iv). Inorder to avoid any confusion, a clear communication procedure betweenthe PMU and the BAS,and between the PMU and the World Bank project staff should be established. For example, all correspondence relating to procurement, disbursement, etc., should be routed to the Bank through the PMU. The useful role o f the P M U here will be to ensure the completeness and accuracy o f the information being exchanged with the World Bank team. This will also allow the PMU to keep track o f the procurement and other activities being undertaken on behalf o f BASand to take corrective measures in case o f delays. Furthermore, this will allow P M U to collect data on procurement, project management, etc., for project monitoring and evaluation and for preparing consolidated periodic project progress reports. (v). The PMU should be fully equipped with necessary office space and with computers, phone/fax machines, photocopiers, etc, inorder to function efficiently. C. ProcurementPlan 13. The Borrower developed a procurement plan for project implementation which provides the basis for the procurement methods. This plan was discussed during appraisal and will be agreed with the P M U and the MoF and the World Bank Project Team during Negotiations on February 15, 2008. The procurement plan will be available in the project's database and in the Bank's external website. The Procurement Plan will be updated in agreement with the World Bank's Project Team annually or as required to reflect the actual project implementation needs and improvements ininstitutional capacity. D. Frequencyof ProcurementSupervision 14. In addition to the prior review supervision to be carried out from Bank offices, the capacity assessment o f the PT has recommended at least annually procurement supervision missions visitingthe field to carry out post review o f procurement actions. E. Detailsof the ProcurementArrangementsInvolvingInternationalCompetition 15. Goods (i). List of contract packages to be procured following ICB, direct contracting and other methods: See Procurement Plan (below); and (ii). All ICB contracts estimated to cost above US$lOO,OOO equivalent per contract, first two shopping contracts and all direct contracting will be subject to prior review by the Bank. 56 16. ConsultingServices (i). List of consulting assignments with short-list of international and local firms ands individual consultants: See Procurement Plan (below) and; (ii). Consultancy services estimated to cost above US$50,000 per contract, single source selection of consultants (firms or individuals), and individual consultants' contracts estimated above US$25,000 each will be subject to prior review by the Bank. All TOR will be subject of Bank's prior review regardless the estimatedamount. (iii).Short lists composed entirely of national consultants: Short lists of consultants for services estimated to cost less than US$lOO,OOO equivalent per contract may be composed entirely of national consultants in accordance with the provisions of paragraph 2.7 of the Consultant Guidelines. 57 Attachment to Annex 8 Corporate and Public Sector Accountability Project (CAPSAP) Procurement Plan IGENERAL Agreed date of procurementPlan Original: February 15,2008 Dateof GeneralProcurementNotice: estimatedApril 2008 11. Goods andWorks andnon-consultingservices. 1. PriorReviewThreshold:ProcurementDecisions subject to Prior Reviewby the Bank as stated inAppendix 1to the Guidelines for Procurement: Procurement Method Method Threshold Prior Review Threshold /Cornments 1. ICB for Goods > $100,000 All subject to prior review 2. ShoppingGoods <$100,000 First 2 subject ofprior review 3. Direct Contracting * All subject of prior review 2. Prequalification.Bidders shall be pre-qualified in accordance with the provisions of paragraphs 2.9 and 2.10 of the Guidelines: No Prequalification i s envisaged for contracts under the Project. 3. Proposed Procedures for CDD Components (as per paragraph. 3.17 of the Guidelines:No CDD is envisaged. 4. Any Other SpecialProcurementArrangements:None Detailedprocurement table is enclosed below: 1 3 6 7 a j Ref. Contract Number of Expected Expected Notes No. (Deacrlptlon) Contract by Bank Contract contract Method (Pllor I signature completion Post) Date date Component 1-Corporate Sector Accountability 1 IT infrastructurefor PIES multiple Prior Mar 2009 (hardware and software) 2 IT equipmentfor improving multiple Shopping Post Dec 2008 June 2009 statutory framework and building capacityto regulate and oversee audit function 58 Component 2 -Public Sector Accountability 1 Computer equipment (under 1 ICB (a) SECO external audit subcomponent) Mar2009 Sep 2009 Financed 2 Materialsfor training (under 1 Shopping Post SECO external audit sub-component) (a) Jun 2009 Sep 2009 Financed Component 3 - Strengthening of Accounting, Auditing and FM capacity 1 Office equipment and furniture for 2 ICB Prior Jun 2009 Dec 2009 establishingACPATER 2 Audio visual equipment for 2 Shopping Post Jun 2009 Dec 2009 ACPATER 3 Photocopy, fax, etc 2 Shopping Post Jun 2009 Dec 2009 Component 4 - Project Management 1 IT equipmentfor PMU(PCs, 1 shopping Post Aug 2008 Sep 2008 printers, copier) 111. Selectionof Consultants 1. Prior Review Threshold:Selection decisions subject to Prior Review by Bank as stated inAppendix 1to the Guidelines Selection andEmployment ofConsultants: Selection Method Method Threshold Prior Review Threshold I Comments 1. CompetitiveMethods (Firms) QCBS ~$100,000 All prior review 2. CompetitiveMethods (Firms) LCS Any amount First contract and all more than $50,000 3 Competitivemethods (Firms)FB Any amount All contracts more than $50,000 4. CompetitiveMethods (Firms) CQ <$ 100,000 First two contractsand all more than $50,000 prior review 5. Individual consultants(Individual) First two subiect of prior review and all more than $25,000 . 6. Single Source (Firms and individual)* All subject of prior review 7. TOR for consultingcontracts All methods/values All subject to prior review 2. Short list comprising entirely of national consultants: Short list of consultants for services, estimated to cost less than $100,000 equivalent per contract, may comprise entirely o f national consultants in accordance with the provisions of paragraph 2.7 o f the Consultant Guidelines. 59 3. ConsultingServices assignmentwith selectionmethods andtime schedule (a) List of consultingassignmentswith short-listof internationalfirms, etc. DescriptionofAssignment 1 Number Selection Expected Expected Notes of 1 Method I%:;I:Review 1 Contract 1contract 1 Contracts denature -Date comoletio 1 c1 I Component 1-Corporate Sector I Post) I I n ciate I Accountability 1 ConsultingServices for IFRS conversion, multiple QCBS Prior Oct2008 Sep2011 PHRD including training financed Oct2008 Sep2010 IDA/ 2 Expertise on valuation support (on fixed Governme assets, impairments,etc nt 3 Technical assistance to PIES 2 QCBS Prior Oct2008 Sep2011 PHRD financed 4 Consultingservices for IT infrastructure for 2 QCBS Prior Oct2008 Jun2009 PHRD embeddingIFRS financed IDA/ 5 Expertise on documentationand due process 1 QCBS Prior Mar 2009 Mar 2011 Governme for statutory audit function nt IDA/ 6 Improving Statutory framework and 1 QCBS/FB Prior Dec 2008 Dec 2010 Governem building capacity to regulate and oversee nt audit function IDA/ 7 Institutional Framework and capacity for 1 QCBS Prior Oct 2008 Oct 2010 Governme translation, adoptionand enforcementof nt IFRS andNASCO C2 Component 2 -Public Sector Accountability 1 Internationalexpert for review and revision 1 Individual Prior Jan 2009 Sep 2009 of legislativeframework 2 Local expert for review and revisionof 1 Individual Post Jan 2009 Sep 2009 legislativeframework 3 DevelopingGuidanceandtraining materials 1 QCBS Prior Jun 2009 Dec 2011 for accountingrefom 4 Individualconsultantson NASBOs(locals) multiple Individual PriorPost Sep 2008 Sep 2011 consistentwith IPSAS 1I 1 11 5 Consultingfirm for formulating NASBOs 1 QCBS Prior 11 Sep 2008 1I Sep 2011 1 1 consistentwith PSAS Senior international advisor to management 1 1 Individual Sep 2008 Dec 2011 1 1 relatedto external audit (c) Fyf::d 7 Senior auditing advisorsfor TA for audit 2 Individual Jan2009 Jun2009 SECO methodology (C) Financed 8 Local audit advisor for TA of Audit 1 Individual Jan 2009 Jun 2009 SECO methodology (C) Financed 9 Training advisor for TA for audit 1 Individual Mar2009 Mar2010 SECO 60 Imethodology 1 I I I (C) IFinanced 10 ITrainers (International) (c) 2 Individual Jun 2009 Jun 2010 SECO Financed 11 Senior SA1auditor (c) 1 Individual Sep 2009 Sep 2010 SECO Financed 12 Short-term Legislationadvisor for auditing 1 Individual Jan 2009 Sep 2009 SECO (c) Financed 13 Local Short-termLegislation advisor for 1 Individual Jan 2009 Sep 2009 SECO auditing (C) Financed 14 IShort-term budgetconsultant(international) I 1 IIndividual 1 ISep 2009 1Sep 2010 SECO Financed SECO Sep 2009 Sep 2010 Financed Jan 2009 Mar2010 SECO Financed Jan 2009 Mar2010 SECO Financed Mar2009 Mar 2010 SECO Financed SECO Mar 2009 Mar2010 Financed Annual SECO plan Financed Annual SECO Plan Financed Jan 2009 Mar2010 Jan 2009 Mar2010 Jan 2009 Mar2010 Jan 2009 Mar2010 Jan 2009 Dec 2011 8 4 year study ACCA - Annual Plan 9 5 year study - ACCNAudit qualifications Annual Plan C4 Component 4- Project Management (a) Individual See 61 Notes: (a) The PMUstaff (Director, procurement officer, financial officer and translator) are already selected competitively and contracted underthe PHRD grant for Project preparation; therefore, the respective contracts for these positions will be a continuation provided satisfactory performance is achieved by consultants. (b) The contract amount for PMU staff include also social benefit amount for eachposition. (c) All these contracts will be financed from SECO; since it i s expected that the SECO will appoint the Bank as administrator o f the SECO funds (through an administrative agreement), these contracts will be administered by the Bank (following all rules and procedures established in the Credit Agreement), and therefore the respective indicatedprocurement methods will apply to them. IV. Ex-Post review: 1. All other contracts for goods and consulting services below prior review thresholds are subject of Bank's selective ex-post review. Periodic ex-post review by the Bank will be undertaken during regular supervision missions. Procurement documents, such as bidding documents, bids, bid evaluationreports and correspondencerelatedto bids and contracts will be kept readily available for the Bank's ex-post review during supervision mission or at any other point of time. Bank's mission will review at least one out of every five contracts which are subject of ex-postreview. 2. Record Keeping: The PMU will maintain complete procurement files which will be reviewedby supervisionmissions.All procurementrelateddocumentsthat requiresprior review will be cleared by the Procurement Accredited Staff (PAS) and related technical staff. Procurement information will be recorded by the PMU and submitted to the bank as part of quarterly (IFRs) and annual progress reports. A simple management information system with a procurement module would be established to assist the PMU procurement officer to monitor procurementinformation. 62 Annex 9: Economicand FinancialAnalysis AZERBAIJAN: CORPORATE AND PUBLIC SECTOR ACCOUNTABILITY PROJECT Introductionand AnalyticalFramework 1. The Corporate and Public Sector Accountability Project in Azerbaijan i s a program that aims at improving accountability and transparency o f public and corporate institutions; there have been a number o f similar initiatives undertaken in other countries. The project targets both corporate and public sector entities, and includes support for the introduction and implementation o f legislation, design and support o f IFRS standards, assistance for introduction of IFRS-compliant management information and reporting systems at public interest enterprises, and has a training/education component. While review o f appraisal literature reveals that no universally accepted evaluation framework exists concerning the overall quantification and monetization o f the benefits o f such projects, and cost-benefit analysis i s rarely conducted, the team employs a dual approach o f (i)applying a variety o f techniques to assess the potential benefits o f the project components and (ii)attempting to evaluate the benefits of the project as a whole. 2. First, we look at the individual components of the project that lend themselves to the traditional cost-benefit or to cost-effectiveness assessment. Although those benefits o f the individual components do not represent the whole impact on the economy, they can be thought o f representing the minimumlevel o fproject impact that could be reasonably quantified. 3. Component 1: Corporate Sector Accountability. This component focuses on embedding the IFRS for PIEs and on establishing appropriate legal and institutional frameworks and capacity for translation, adoption and enforcement of IFRS and NASCO. The project will set up legal, institutional, and IT framework inthe targeted PIEs. The review of appraisal literature suggests that, perhaps, four streams o f benefits can be theoretically quantified. Note that these specific streams are only relevant for the selected PIEs and do not represent the impact on the whole economy. a. First, improved accountability, transparency, and corporate governance have proven to attract a premiumby investors.' Ina 2002 McKinsey survey, institutional investors said they would pay premiums to own well-governed companies, and the premiums averaged 30 percent in Eastern Europe and Africa, and 22 percent in Asia and Latin Americaq2However, the stock exchange market in Azerbaijan i s very small and only few banks and financial institutions are listed. b. Secondly, improved accountability, transparency, and corporate governance make banks and rating agencies see companies in a better light. This means lower borrowing costs for well-governed firmsq3This holds true to some degree inregard to the sovereign borrowing: with more transparent public sector units and more ' See P. Coombesand M.Watson (2002); "Recommendations on GoodCorporate Governance Practices in 'Vietnam" (2003); R.Newel1and G. Wilson (2002). McKinsey's GlobalInvestor OpinionSurvey, 2002. See "The IrresistibleCase for Corporate Governance", InternationalFinance Corporation, March 2006. 63 accountable budgetary institutions the country risk perceived by lenders i s likely to be lower. At present, Azerbaijan does not need significant external lending facilities because it has enough internal liquidity and oil revenues. c. Next, there i s a substantial body o f empirical evidence that improvement o f and cost reductions, both in public and private sector institution^.^ The significance accounting and management information systems leads to significant efficiency gains o f good management information, accounting and reporting system goes beyond institutional efficiency and cost reductions. The business value o f improved and well- informed decision-making is often intangible and difficult to measure.' d. Finally, the tax authorities are likely to have a better grip on the business transactions of the companies, which will decrease the level of tax evasion and raise the tax compliance rate to some degree. The additional tax collection represents a gain to the Government. 4. Component 2: Public Sector Accountability. This component targets three areas: developing and implementing public sector accounting standards, strengtheningthe Chamber o f Accounts (Azerbaijan's supreme audit institution), and development of a strategy to strengthen public sector internal financial control. A number o f research papers list the benefits o f improved public sector accountability, which include greater transparency, more budget efficiency, lower corruption, and many others.6 There i s no universally accepted method to quantify such benefits. Furthermore, information comparable to information on Azeri PIES is not readily available However, this i s a component that is integral to the whole project and it does not make sense to look at it separately from other activities. Component 4 on Project-Management falls inthe same category, and should not be separated from the project. 5. Component 3: Strengthening Accounting, Auditing and Financial Management Capacity. This component is focused on capacity buildingandprofessional education. Placing a monetary value on education has been controversial. Inthe context o f the Corporate and Public Sector Accountability Project in Azerbaijan, this i s a component that i s integral to the sustainability of the whole initiative. Azerbaijan has a very shallow pool o f qualified accountants and professors. The project provides a very efficient method o f building the professional cadre over the short period, when the large numbers o f additional qualified accountants will be demanded by both public and private sector institutions. The project is not only a cost-effective way o f meeting the increasing demand for qualified accounting and auditing staff, but also enables Azerbaijan to build its own training and education base for this important profession. 6. Overall impact o f CAPSAP. The overall impact of the project on the economy is expected to be larger than the net benefits accruing to individual stakeholders in the corporate and public sector. Azerbaijan has been taking steps to diversify its economy away from the oil sector. This transition will likely be assisted through the implementation o f the project, which i s expected to push both the private and public entities towards better governance, and improve the See J. S. Jordan (1989); M.A. Mahmood and G.J. Mann (2000); P. Bolsta (2006); G. Brim (2004). 5See M.Gibson, D. Amott, and I. Jagielska (2004); A. Brown (2005); K.E. Murphy and S. J. Simon (2002); K.E. Murphy and S. J. Simon (2001). See D. Watkinns 2006; N.Hepworth 2002; L.Goubert2006; S. Fumiki 2007; J. Libbey 2006. 64 business climate inthe country. The largest impact o f the project i s expected to be on the private sector side, in the development o f the non-oil sectors7There have been a number o f countries where similar transitions have taken or are still taking place. In order to quantify a macro- economic benefits o f the project, it i s useful to ask how much value added such reforms brought into the economy inother countries. FinancialAnalysis and Cost-Effectiveness 7. Good corporate governance and accountability reduce the cost of borrowing Better corporate governance and accountability o f the Government units will enable foreign banks and rating agencies to increase the credit rating o f Azeri companies, and are likely to result in lower risk premiums.Our estimate is that the immediate financial gain due to lower risk premium will not be very significant.' 8. Cost savings as a result of modern management information system At present, many PIEs have an outdated and/or inadequate management information system. The project will assist the PIEs to make a swift and smooth institutional transition to modern information, accounting and reporting systems. There have been a number of empirical studies that confirm that organizations realize significant direct and indirect financial gains from implementation o f such information, accounting and reporting systems.' The actual financial gain realized by an institution depends on the sector, specific accounting and managerial information flow design o f the new system, IT configuration and other factors, but it i s not uncommon to observe reports from the companies that have improved their accounting and management information systems about return on investment (ROI) ina range from 50 percent to 400 percent." However, we turn to rather a conservative method to estimate the benefits of the accounting and managerial information system under the CAPSAP. The draft o f an Ernst & Young's survey on implementation o f IFRS by PIEs in Azerbaijan indicates that the average implementation costs '"Country PartnershipStrategy FY07-10 for Republic ofAzerbaijan", World Bank and IFC, December 7,2006. The stock of foreignprivate debt acquiredinAzerbaijanin2006 was 3.7 percent of GDP, or US$US$713million (Source: World Bank). The share ofprivate sector debt is expectedto graduallyrise to a levelof 5.8 percent of GDP in2012. We can assumethat only 70 percentofthat amount would be responsive to arisk premiumreduction.Also, we can make an assumptionthat the correspondingpremiumreductionis equivalent to 20 basic points, or two-tenths of a percent.The stream o fthe reductioninthe cost ofborrowingamountsto a present value of at leastUS$US$6.6 million over the period2008-12, discountedby 12percent inreal terms. Year 2006 2007 2008 2009 2010 2011 2012 3.7 3.9 4.1 4.4 5.0 5.5 5.8 Private Debt ( percentGDP) percent percent percent percent percent percent percent Private Debt (US$US$million) 713.1 996.6 1,343.4 1,710.3 2,150.1 2,548.4 2,823.5 Incremental Debt (US%US%million) 283.6 630.3 997.2 1,437.0 1,835.3 2,110.4 70 Share of debt responsiveto risk ratings percent Responsivedebt 198.5 441.2 698.1 1,005.9 1,284.7 1,477.3 0.20 Risk premiumreduction percent Red&tion in cost of borrowing 0.88 1.40 2.01 2.57 2.95 PV @, 12 percent (2007-12) 6.6 USSmillion 9 For a comprehensivereview of appraisal methodologies, see Enrique Silva M.(2001). I OSee Thoughtware Worldwide (2005). 65 range from US$1.25 to 2.5 million per PIE." The survey also states that the costs of compliance withthe IFRSinthe absence ofthe comprehensiveprogram assistance, such as CAPSAP, will be 2-3 times more expensive than without the CAPSAP. Assuming that there are 9 participating PIEs, and the average implementation cost i s US$1.793 million, the total implementation cost is US$16.14 million. Ifwe go along with the survey result and assign the value of the future stream of cost savings as two times the costs of implementation, since the survey of PIEs by Ernst& Young reports that their transition to the IFRS with the existing management information systems will be at least twice as expensive as with the CAPSAP. Hence, we can say that the present value of the future cost savings must be equal to US$32.28 million. The financial costs paid by the beneficiaries of the CAPSAP are only US$4.94 million, which implies that the net present value of the perceived direct financial savings by the participating PIEs is at least US$27.34 million. 9. Cost-Effectiveness of Component 3: Strengthening Accounting, Auditing and FM Capacity. The capacity building activities and education program financed under this component can be compared to the other alternatives of preparing the necessary number of accountants and auditors in Azerbaijan. The overall demand for the profession at present is estimated at an absolute minimum of 10,000 people of CAP/ACCA Level 1.I2The labor market i s very tight and even private companies are not able to attract enough qualified personnel even at high wage rates. The presenttraining capacity for accounting and auditing skills is almost non- existent, eventhe CAPSAP will be able to train only 500-700 people a year.13 10. The base cost estimate of training one person to the CAP/ACCA Level 1 is US$2,000 per year. The alternative to training the cadre under the CAPSAP project is to continue the practice of sending the people abroad. The cost of training accountants abroad is very high. SOFAZ spends on the average of US$lOO,OOO on training of its internal team of only 5 accountants. The basic accounting skills, provided under CAP/ACCA Level 1, acquired at training centers in Kazakhstan, Russia or Kiev are not as expensive, but still require travel costs (400- 800US$/persodyear), lodging and logistical expenses (800-2,000 US$/person/year). If we assume that the average travel costs are US$600/person/yearYand lodging/logistical expenses are US$lY400/person/year,then the direct financial savings over the next five years will be worth US$5.4 million, inpresentvalue terms, discounted by 12 percent real. 11. Even on a cost-effectiveness basis, CAPSAP's training costs are the lowest-cost alternative. In addition, this project provides a unique opportunity to the country to establish a professional training base for the profession. This i s a long-run investment inhumancapital, with Ernst & Young (2007). Project appraisalteam estimates, based on the UK statistics of 280,000 accountants for atotal population of 60.6 million. Ifthe same proportion of 0.46 percent of the population is used for Azerbaijan with it population of 7.96 million, the resulting figure is 36,780 accountants. An alternative method is to use the labor force statistics of Azerbaijan, which suggeststhat there is about 1.2 million people inthe public sector, and 5 percent ofthese are in administration, and shouldbe equippedwith the basic accountant skills. The resulting figure is 60,000 accountants. Inthe analysis, avery conservativenumber of 10,000 people is taken, which is the lowest number ofaccountants neededin Azerbaijan under all possible circumstances. 13 This implies that there is aneedto plan for another project expandingthe educationand training capacity of Azerbaijan, since some ofthe positions inpublic and private sector may have to be staffed with unqualified personnel, andthat a large group of accountants may haveto be trained outside ofAzerbaijan. 66 a significant payback as international experience suggests. However, the value of this strategic investment is difficult to capture inmonetary terms. 12. Fiscal Impact. The additional tax collection by the Government is often a natural by- product of an effectively implemented accountability and transparency reform. We start with a proposition that the tax compliance rates even in the most developed countries are rarely above 90 per~ent.'~ In developing countries, this rate is typically lower by a degree and there is a significant room for further improvement. Any effort to raise the accounting and reporting standards i s likely to lower the tax avoidance and increase the compliance rate. The total tax collection from the nine biggest taxpayers was 30.7 percent of the total tax collection in Azerbaijan in 2004." The share of tax revenue in GDP was about 17.4 percent in 2004. The macro-economic projections by the World Bank indicate that the share of tax revenue in 2007 is expected to be 19.2 percent of GDP. Since the tax collection data for the nine biggest taxpayers in2007 is not available, an extrapolation ofthe 2004 share of 30 is applied onthe total expected tax collection inthe country of US$4,93 1 million. The resulting contribution of the nine biggest taxpayers to the 2007 tax collection i s equal to US$1,514 million. Ifwe assume that the current overall tax compliance rate is as good as 70percent, then it means that there is a potential for further tax collection, and each additional point of compliance is worth US$21.6 million.16It is not unreasonable to expect the tax administration will be able to capture 1-3 additional compliance points because of the CAPSAP project. If we assume that the compliance rate increases only by one point, and the additional tax collection over the next five years is fixed at US$21.6 million inconstant 2007 prices, then the presentvalue of this additional revenue for the Government is US$78.0rnillionydiscounted by 12 percent inreal terms. 13. Azeri legislation stipulates that VAT of 18 percent will be levied on goods and services purchased by the IDA credit; the VAT will be paid out of counterpart funding by the government. For the purpose of the financial analysis, the VAT is included in the project costs and will show an additional US$2.9 million inflow into the Treasury over 2008-2012. The present value of the inflows to the treasury, discounted by 12 percent in real terms, i s equivalent to US$2.2 million. At the same time, the Government budget will be increased an additional US$2.9 million the 2008-2012 period. As such, the net likely impact of the VAT on the Treasury's operations is expectedto be nileachyear 14. Concluding the financial section, we can now summarize the benefits that traditional financial analysis is able to capture. Table below presents quantifiable benefits and costs that accrue to the PIES,participating government budgetary units, and tax administration. The annual cashflows are also shown inpresentvalue terms, discounted by 12percent real. l4 In2001, the overall UStax compliance rate was about 86 percent, accordingto US.Department ofthe Treasury (2006). '' l5 Source: interviews with Government officials. Compliance rate is the ratio o f actual fiscal collections over the potential fiscal collection. The difference often arises due to tax evasion, under-reporting and tax-avoidance. Any increase intax compliance i s beneficial for the tax administration and public finances. 67 IncrementalFinancialCashFlows,constant2007 prices(US$ million) Year I PV I 2008 2009 2010 2011 2012 I COSTS CAPSAP cashflow gross of VAT 1/ -18.3 -6.1 -8.0 -4.1 -3.0 -2.2 Additional PIEs costs -4.9 -1.6 -2.5 -1.3 -0.6 -0.3 Total Costs -23.3 -7.7 -10.6 -6.0 -3.6 -2.5 BENEFITS PV Cost Savingsdue to MIS 27.3 Cost Savingsin Educatioflraining 5.4 1.8 2.8 1.4 0.7 0.4 Fiscal Impact 78.0 21.6 21.6 21.6 21.6 21.6 VAT collected 2.2 0.7 1.o 0.6 0.4 0.3 TOTAL BENEFITS 112.9 24.1 25.4 23.6 22.7 22.2 PV Net FinancialImpact @. 12% (2007-12) 89.7 Stakeholder Impact Assessment 15. The next step i s to conduct a stakeholder impact assessment in regard to allocation o f direct financial impacts identified inthe financial analysis. Table below presents the summary o f stakeholder impacts. The expenditures o f the government include the financing o f CAPSAP project, and benefits that are counted towards the government are additional tax collection and costs savings in education and training. The net present value o f government cashflows i s US67.3million. StakeholderImpacts,constant2007 prices(US$ million) Year PV 2008 2009 2010 2011 2012 Government 63.2 16.8 15.7 17.8 18.9 19.5 CAPSAP cashflow 11 -19.0 -6.1 -7.7 -4.9 -3.5 -2.9 Cost Savings in EducatiodTraining 2.3 0.8 1.2 0.6 0.3 0.2 Fiscal Impact 77.9 21.6 21.6 21.6 21.6 21.6 V A T Collected 2.0 0.6 0.6 0.6 0.6 0.6 Corporate and Private Sector 21 86.1 13.1 14.7 17.1 19.5 18.9 Additional PIEs costs -4.9 -1.6 -2.5 -1.3 -0.6 -0.3 Fiscal Impact -77.9 -21.6 -21.6 -21.6 -21.6 -21.6 PV Cost Savings due to MIS 27.39 Reduction in business corruption 141.5 36.3 38.9 40.0 41.7 40.8 16. The second stakeholder group is represented by the PIEs but also includes the corporate and public sector in general. The financial costs imposed by the project are the additional financing costs o f the CAPSAP by the PIEs, and additional taxes paid to the government. The benefits are the cost savings due to improved management information system, and resources released due to reduction in business corruption. The net present value o f direct financial impact on the corporate and private sector, including the PIEs, i s a net cost o f US$55.6 million. 68 EconomicAnalysis 17. Inconducting the economic analysis of the project, we posit that proper accounting and reporting systems for both public and private sector entities are necessary, and there is no alternative to replacing such systems in an open developing economy. Rationally behaving private sector agents will begin implementing such systems if not for increasing the efficiency and competitiveness of the business, then for attracting foreign partners and credit. A clear confirmation of this argument i s seen in the banking sector in Azerbaijan, where the transformation from the old Soviet-style accounting and reporting standards towards a full IFRS system has been taking place just in the recent years, mainly driven by the demands of foreign banks and agencies. Now, it's time for the largest corporate and public sector entities to comply with international standards. Ultimately, the rest of economy will adjust and modernize. There i s a linkage betweenthe programs that increase the transparency, accountability, good governance and economic performance. The question is how strong this linkage is. 18. We carried out a quick assessment of 31 projects undertaken by the World Bank in 27 countries in the area of improving accountability, transparency and governance over the period 1999-2006. While this assessment i s done on a small sample of available observations, the results allow us to assess the value of improved accountability, transparency and governance reforms inmonetary terms." The results show that the average real growth rate of economy after the reform was 0.07 percent per year higher that the average real growth rate of economy inthe absence of the reform.lgThe way to interpret this result is to look at it as an annual opportunity cost of not having a decent system institutional and legal framework in place. Reforms in the transparency and accountability affect all sectors of an economy. While the sample of the 27 countries does not include other such resource-rich country as Azerbaijan, it is clear that both oil and non-oil sectors of Azerbaijan will be affected by the project. The CAPSAP project accelerates the pace of reforms in Azerbaijan and results in savings of economic resources. In , order to obtain an indicative measure of the possible benefits of the CAPSAP to the Azeri economy, venture to use the informationfrom the aforementioned review o f the 31projects; this undertaking should be interpreted with caution, as the sample of countries on which the aforementioned estimate was based, depended on availability of information, and not on random sampling or on sampling of resource rich countries. However, the approach taken towards the estimation of the project benefits is rather conservative; assuming that only the non-oil sector of Azerbaijan economy will enjoy the resource savings. 19. Table below presents the economic evaluation framework. The expectedvalue of GDP is expected to be around US$25,628 million in 2007, according to the macro-economic estimates by the World Bank. The projected growth rates over 2008-14 are taken from the same source. The projected GDP without the reform is based on the growth rates that are 0.07 percent lower than these inthe forecast are. The opportunity cost is the value of resources saved inthe non-oil sectors of the economy due to the implementation of the CAPSAP. The possible resource The List of projects is available. This topic deservesthe scrutiny of a full-fledged research study. There is a clear relationship betweenthe accountability, transparencyand governance reforms and economic growth, and it would be interesting to establish the exact natureand strengthofthis linkage, especially indeveloping countries. The historical data on real growth rates for the sample countries was sourced from the World Development Indicators database (2006) andthe IMFCountry Data (2007). 69 savings inthe oil sector are not included as benefits. Note that because we base our assumptions on other developing countries, and the resulting figure i s quite conservative because it does not imply "perfect" accountability, transparency and governance but rather means that Azerbaijan will have an improvement in these areas to the degree that other developing countries experienced it due to such reforms. Note that only first seven years o f benefits are included inthe model, while the system will be inuse for a longer period. The P V o f incremental GDP over the same period i s US$64.0 million. 20. The economic costs include the CAPSAP costs and additional costs by PIEs'~OThe present value o f CAPSAP total costs over 2008-12 amounts to US$18.3 million, including the applicable taxes. Taxes and VAT are not economic costs, and when these are removed, the net of tax project costs add to a PV o f US$16.1, discounted at 12 percent in real terms. The present value o f additional PIE costs i s US$4.9 million. Based on these assumptions, the net present value o f the project i s US$43.0 million, and the benefit-cost ratio is 3.0 times. The IRR can not be estimated because the project has "irregular" cash profile.21 IncrementalEconomicResourceFlow, constant 2007 prices(US$ million) Year 2007 2008 2009 2010 2011 2012 2013 2014 Projected GDP, USD million 25,628 30,738 34,308 36,253 37,013 37,699 38,724 39,774 Oil and Gas Sector 13,311 15,265 15,677 14,606 12,160 10,550 9,376 8,135 Non-Oil Sector 12,317 15,474 18,631 21,648 24,853 27,148 29,348 31,639 Growth Rate, Real Oil and Gas Sector 14.7% 2.7% -6.8% -16.7% -13.2% -11.1% -13.2% Non-Oil Sector 25.6% 20.4% 16.2% 14.8% 9.2% 8.1% 7.8% Projected GDP (without reform), USD million 30,730 34,297 36,240 36,998 37,681 38,705 39,753 Oil and Gas Sector 15,265 15,677 14,606 12,160 10,550 9,376 8,135 Non-Oil Sector 15,465 18,620 21,635 24,838 27,131 29,329 31,619 Opportunity Cost, USD million 8.6 10.8 13.0 15.2 17.4 19.0 20.5 ProjectBenefits, USDmillion 8.6 10.8 13.0 15.2 17.4 19.0 20.5 CAPSAP cashflow, USDmillion -5.4 -7.0 -4.1 -2.6 -1.9 0.0 0.0 Additional PIEScosts, USD million -1.6 -2.5 -1.3 -0.6 -0.3 0.0 0.0 Net resource Flow, USD million 1.7 1.2 7.6 11.9 15.2 19.0 20.5 NPV @ 12% (2007-12) 43.0 USD million Benefit-Cost Ratio 3.0 times 21. Note that the financial gains measured in the preceding section are not additional to the overall economic impact. Secondly, the expected economic resource flow i s based on conservative assumptions, and the ultimate impact o f improved accountability, transparency and better governance is likely to have a profound effect on the dynamics o f economic development inAzerbaijan. ' OThe CAPSAP offers only US$l.793 million per eachof the nine PIEs. Ernst & Young (2007) suggests that the maximumcosts are likely to be about US$2.5million per PIE.The difference of US$0.707millionper PIE is to be financedby the beneficiaries. The cashflow profile of additionalcosts by PIEs presentedinthe table corresponds to the CAPSAProllout. "FordiscussionoflimitationsofIRRcriterion,seeG.P.Jenkins(2005). 70 Sensitivity Analysis 22. A number of risk factors were listed inSection 5, which include, but not limitedto: weak commitment to reform due to political resistance to institutional reform; lack o f coordination among the M O F and the project beneficiaries; limited institutional capabilities o f M O F to implement a large scale project and other. Interms o f economic impact, most of these and other factors are likely to be translated into a lower reform response by the private sector, and lower contribution to the transformation and diversification o f the economy. A range o f possible values o f the change in the real growth rate i s presented in table below. Under all circumstances, the minimum contribution of the CAPSAP project to the economy is positive and the project is justified. Sensitivity Test: Response of Economy to Reform Change in Growth Rate NPV (US$million) Benefit-Cost Ratio (times) 0.03 percent 6.4 1.3 0.05 percent 24.7 2.2 0.07 percent 43.0 3.0 0.10 percent 70.4 4.3 23. A specific risk factor to which this project and other similar programs are exposed is the delay time. The start o f CAPSAP implementation i s scheduled for 2008 but if the project i s delayed, the economy will be penalized in terms o f the opportunity costs. Table below summarizes the cost o f project delay in present value terms. This i s a very conservative estimate o fthe opportunity cost that will be imposed on the economy ifCAPSAP i s postponed. Delay (years) NPV (US$ million) PV Cost of Delay (US$million) 0 43.0 1 29.8 13.1 2 14.6 28.4 Project Sustainability 24. The sustainability o f the project i s largely dependent on the Government commitment to implement the IFRS standards and its ability to enforce the accountability and transparency. There are all signs that the MOF and PIESare very serious about the reform. Another mitigation factor i s that the legislation and accounting/reporting standards established as a part o f the reform will make the corporate entities and private sector firms to demand more volume and quality o f accounting and auditing services, which in turn will ensure that the continuous training and educational component o f the project i s sustainable. Experience o f countries that undertook such reforms confirms that this mechanism works in practice. A good indicator o f project sustainability i s the experience o f the banking sector in Azerbaijan, which began the application o f IFRS even in the absence o f the regulatory and legislative framework, without any external assistance. While the transformation o f the sector i s still ongoing, it i s clear that the modern accounting and reporting standards are demanded and sustainable inthe long run. 71 Annex 10: SafeguardPolicyIssues AZERBAIJAN: CORPORATEAND PUBLIC SECTORACCOUNTABILITY PROJECT The project raises no safeguards issues. 72 Annex 11:ProjectPreparationand Supervision AZERBAIJAN: CORPORATE AND PUBLIC SECTOR ACCOUNTABILITY PROJECT Planned Actual PCN review 711712006 Initial PID to PIC 101712006 Initial ISDS to PIC 1011Ol2006 Appraisal 1Ol2007 1211Ol2007 Negotiations 02/14/2008 02/14/2008 Board/RVP approval 0312712008 Planned date of effectiveness 0912512008 Planned date of mid-term review 0613012010 Planned closingdate 12/31/2012 Key institutions responsible for preparation ofthe project: - Ministryof Finance through a Project Management Unit Bank staff and consultantswho worked on the project included: Name Title Unit IdaNjeriMuhoho Task Team LeaderISr. Financial ECSPS Management Specialist John Hegarty Co-Task Team Leadermead -Center for ECSPS Financial ReportingReform Ranjan Kumar Ganguli Financial Management Consultant ECSPS ChristianE. Petersen Lead Economist ECSSD Christos Kostopoulos Sr. Economist ECSPE Jonathan George Hooper Sr. Financial Management Specialist ECSPS Junko Funahashi Sr. Counsel LEGEM Hannah Koilpillai Sr. Finance Officer LOAFC Arben Maho Procurement Analyst ECSPS Norpulat Daniyarov Financial Management Specialist ECSPS Anna O'Donnell Consultant ECSPS Agil Guluzade Financial Management Consultant ECSPS Aida Mammadova Financial Management Consultant ECSPS Yagut Ertenlice Program Assistant ECCAZ Una Raymond Team Assistant ECSPS Bank funds expendedto date on project preparation: 1. Bank resources: $442,550 2. Trust funds: $182,776 3. Total: $625,326 Estimated Approval and Supervision Costs: 1, Estimated Cost to Approval: $95,372 2. Estimated Annual Supervision Cost: $100,000 73 Annex 12: Documents inthe ProjectFile AZERBAIJAN: CORPORATE AND PUBLIC SECTOR ACCOUNTABILITY PROJECT Bank Assessments 1. Accounting and Auditing Report on Observanceof Standards and Codes (ROSC) 2. Country Financial Accountability Assessment (CFAA) 3. Country Procurement Assessment Report (CPAR) 4. Financial Management Assessment Report 5. Economic and Financial Analysis Sources of Reference Other Bank Documents 1. Detailed Project Description 2. Detailed Project Cost Estimates 3. ProcurementPlan for the first 18 months of Project preparation Consultants' Reports for Project Preparation 1. Report on the Enhancementof Public Sector Financial Reporting (REPF), April 2007 2. Public Expenditure and Financial Accountability Assessment (PEFA), January 2008 3. Institutional Strengthening of the Chamber of Auditors of Azerbaijan, February 2008 4. Expert advice to Public Interest Entities(PIES)inthe implementation of International Financial Reporting Standards (IFRS), February 2008 5. Development of a strategy to adopt and implementNationalAccounting Standardsfor Budget Organizations (NASBOs) based on International Public Sector Accounting Standards (IPSAS), February 2008 6. Development of a Public Internal Financial Control (PIFC) Gap Analysis, February 2008 7. Strategic Development Plan for the Chamber of Accounts, February 2008 8. Development of the Institutional Framework, Standards and Syllabi for Accounting Education and Training inthe Corporate and Public Sectors, February 2008 9. Twinning arrangementsto the Accounting Policy Office o f the Ministry of Finance, February 2008 74 Annex 13: Statementof Loansand Credits AZERBAIJAN: CORPORATE AND PUBLIC SECTOR ACCOUNTABILITY PROJECT Difference between expected and actual Original Amount in US$Millions disbursements Project ID FY Purpose IBRD IDA SF GEF Cancel. Undisb. Orig. Frm.Rev'd PO90887 2006 ADCP-I1 0.00 29.20 0.00 0.00 0.00 29.78 0.00 0.00 PO94220 2006 HealthSector Reform Project 0.00 50.00 0.00 0.00 0.00 50.66 0.04 0.00 PO94488 2006 Highway 2 200.00 0.00 0.00 0.00 0.00 199.50 2.00 0.00 PO99201 2006 JUDICIAL MOD 0.00 21.60 0.00 0.00 0.00 21.74 0.00 0.00 PO89751 2005 IDP ECONDEVT SUPPORT 0.00 11.50 0.00 0.00 0.00 9.73 3.18 2.79 PO83341 2005 POWERTRANSMISSION 48.00 0.00 0.00 0.00 0.00 47.67 4.17 0.00 PO66199 2005 RURAL ENVIRONMENT 0.00 8.00 0.00 0.00 0.00 7.94 0.80 0.00 PO81616 2005 FIN SERVS DEVT 0.00 12.25 0.00 0.00 0.00 12.02 0.92 0.00 PO77031 2005 RURAL ENVIRONMENT (GEF) 0.00 0.00 0.00 5.00 0.00 5.00 0.58 0.00 PO49892 2004 PENSION& SOC ASST 0.00 10.00 0.00 0.00 0.00 7.88 5.29 -0.57 PO76234 2004 RURAL INVSMT (AZRIP) 0.00 15.00 0.00 0.00 0.00 12.33 1.52 0.00 PO70989 2003 ED SECT DEV (APL # 1) 0.00 18.00 0.00 0.00 0.00 11.80 7.31 0.00 PO08286 2003 IRRIGDIST SYS & MGMT IMPROVMT 0.00 35.00 0.00 0.00 0.00 35.51 8.06 0.00 PO66100 2002 AVIAN FLU(formerly IBTA 2) 0.00 9.45 0.00 0.00 0.00 5.80 1.10 0.00 PO40716 2001 HIGHWAY 0.00 40.00 0.00 0.00 0.00 13.43 7.22 -3.42 PO08284 2000 IRRIG/DRAINAGE REHAB 0.00 42.00 0.00 0.00 0.00 11.89 3.51 -2.06 PO58969 1999 CULT HERITAGE PRSV 0.00 7.50 0.00 0.00 0.00 1.16 0.79 0.85 Total: 248.00 309.50 0.00 5.00 0.00 483.84 46.49 - 2.41 AZERBAIJAN STATEMENTOF IFC's Held and Disbursed Portfolio InMillions o fUSDollars Cornrnitted Disbursed IFC IFC FY Approval Company Loan Equity Quasi Partic. Loan Equity Quasi Partic. Azerigazbank 3.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 2003 Azerigazbank 0.90 0.00 0.00 0.00 0.90 0.00 0.00 0.00 2006 Azerigazbank 0.00 2.30 0.00 0.00 0.00 0.00 0.00 0.00 1999 BakuHotel 1.46 0.00 0.00 0.00 1.46 0.00 0.00 0.00 2002 MFB Azerbaijan 0.00 1.60 0.00 0.00 0.00 1.60 0.00 0.00 2006 MFB Azerbaijan 3.00 0.00 0.00 0.00 3.00 0.00 0.00 0.00 2003 Rabitabank 0.90 0.00 0.00 0.00 0.90 0.00 0.00 0.00 UniBank 5.00 0.00 0.00 0.00 2.39 0.00 0.00 0.00 Total portfolio: 14.26 3.90 0.00 0.00 8.65 1.60 0.00 0.00 75 Approvals PendingCommitment FY Approval Company Loan EQuiW Quasi Partic 2001 Azer JV Increase 0.00 0.00 0.00 0.00 Total pendingcommitment: 0.00 0.00 0.00 0.00 76 Annex 14: Country at a Glance AZERBAIJAN: CORPORATEAND PUBLIC SECTOR ACCOUNTABILITY PROJECT Europe 8 Lower- POVERTYand SOCIAL Central mlddle- AzerbalJan Asia income 2006 Population, mid-year (millions) 6.5 460 2,276 1 GNI per capita (Atlas method, US$) 1,650 4,796 2,037 Lifeexpectancy GNI (Atlas method, US$ billions) T 15.7 2,206 4,635 Average annual growth, 2000-06 Population (%) 0.9 0.0 0.9 Laborforce (%) 2.5 0.5 1.4 GNI Gross per primary Moat recant estimate (latest year available, 200006) capita enrollment Poverty (% ofpopulationbelownationalpoverty line) 50 Urban population(% of totalpopulation) 52 64 47 Lifeexpectancy at birth (yean) 72 69 71 Infant mortality (per 1,000live births) 74 26 31 Child malnutrition(% of children under 5) 7 5 13 Access to improvedwater source Access to an improvedwater source (% ofpopulation) 77 92 61 Literacy (% ofpopulation age 15+) 97 69 - Gross primary enrollment (% of school-age population) 96 102 113 Azerbaijan Male 97 103 117 Lower-middle-income gmup Female 95 100 114 KEY ECONOMIC RATIOSand LONG-TERMTRENDS 1986 1996 2005 2000 GDP (US$ billions) 3.2 13.2 20.1 Gross capitalformationlGDP 29.0 42.0 37.7 Exports Of goods and ServiceslGDP 29,5 62.9 72.5 Trade Gross domestic savingslGDP 3.0 52.0 60.8 Gross nationalsavings/GDP 3.1 40.9 47.9 Current account balancelGDP -25.9 -10.0 -3.2 Interest paymentslGDP 0.1 0.2 Total debVGDP 13.8 14.2 Total debt service/exports 1.o 5.2 Present value of debVGDP 11.5 Present value of debVexports 33.5 Indebtedness 1986-96 1996-06 2005 2006 2006-10 (average annualgrowth) - GDP -15.7 12.2 26.4 34.5 19.5 Azerbafjan GDP per capita -16.6 11.2 25.2 33.1 16.6 Lower-middle-incomearoua Exports of goods and services .. 16.9 46.5 45.5 30.9 STRUCTURE of the ECONOMY 1986 1996 2005 2006 (% of GDP) Growth of capital and GDP (Oh) 1 I Agriculture 100T ,. 27.5 10.0 8.6 Industry .. 39.1 62.3 67.0 Manufacturing .. 11.6 7.8 Services .. 33.4 27.7 24.5 1 03 02 03 04 05 06 Householdfinal consumption expenditure 85.0 36.3 30.3 General gov't final consumption expenditure .... 12.0 11.6 9,0 imports of goods and services .. 55.5 52.9 49,5 -GCF *GDP 1986-96 1996-06 2005 2006 (average annualgrowth) Growth of exports and imports (Oh) Agriculture 6.9 7.5 6.0 60T industry 14.1 43.4 31.5 Manufacturing 3.9 4.6 Services ........ 9.3 10.6 11.2 Householdfinal consumption expenditure ., 12.4 11.6 8.9 General gov't final consumption expenditure 3.4 0.4 3.9 Gross capital formation 26.6 11.2 16.7 importsof goods and services ...... 18.2 10.9 37.7 Note: 2006 data are preliminalyestimates. This table was producedfrom the DevelopmentEconomics LDB database. The diamondsshow four key indicatorsin the country (in bold) comparedwith its income-group average.If data are missing,the diamond will be incomplete. 77 PRICESand GOVERNMENTFINANCE 1988 1996 2005 2006 Domestic prices Inflation (X) (W change) 2o T Consumer prices 19.9 9.5 ImplicitGDP deflator .... 26.4 16.1 5.3 Government finance (56 of GDP, indudes cumnt grants) Current revenue 87.876.5 102.228.6 87.719.4 01 02 03 M 05 0 Current budget balance -8,378.2 18:498.7 19:691.0 Overallsurplusideficit ......-13,904.0 769 3 5,192.2 -GDP deflator -.O-CPI TRADE 1966 1996 2005 2006 (US$ millions) Export and import levels(US$ mill.) Total exports (fob) 789 3,697 5,067 6,030T Crude oil 3,117 4,449 Petroleumproducts 402 Manufactures 286 580 618 Total imports (cif) 1,339 3,194 3,548 Food 382 Fueland energy 213 1,168 1,181 I Capitalgoods 226 Export price index (2000-100) 71 103 103 W 01 02 03 04 05 import price index (2000=100) 115 103 106 CI ~xportr rn Imports Terms of trade (2000=100) 62 99 97 BALANCE of PAYMENTS 1986 1996 2005 2006 (US$ millions) ICurrent account balance to GDP (Oh) 1 Exports of goods and services 938 4,215 5,619 0 Importsof goods and services 1,765 5,003 5,237 Resource balance -827 -788 382 -10 Net income -62 -706 -1,156 Net current transfers 67 173 136 -20 Current account balance -823 -1,321 -638 -30 Financingitems (net) 771 1,569 1,430 Changes in net reserves 52 -248 -791 -40 Memo: Reserves includinggold (US$ millions) 899 1,028 Conversionrate (DEC, locai/US$) 0.9 0 9 0.9 EXTERNAL DEBT and RESOURCEFLOWS 1986 1996 2005 2006 (US$ millions) Total debt outstandingand disbursed 438 1,881 iBRD 0 0 5 IDA 64 501 583 0:186 Total debt service 10 237 IBRD 0 0 1 IDA 0 6 8 Compositionof net resourceflows Officialgrants 43 93 Officialcreditors 47 70 Privatecreditors 0 9 Foreigndirect investment(net inflows) 627 1,680 Portfolioequity (net inflows) World Bank program Commitments 20 92 0 A . IBRD E Bilateral - Disbursements 36 48 65 B .IDA D .Other multilateral F .Private Principalrepayments 0 2 4 Net flows 36 46 62 Interest payments 0 4 6 Net transfers 35 41 56 Note: This table was produced from the Development EconomicsLDB database. 9/26/07 78 Map section 45°E 46°E 47°E 48°E 49°E To RUSSIAN Makhachkala GEORGIA Balaken G FEDERATION To To BALAKEN Zagatala r e Tbilisi Tbilisi a ZAGATALA ter KHACHMAZ C GUSAR a Gusar Khachmaz Gakh u AZERBAIJAN To GAKH c Vanadzor AGSTAFA a s Guba Devechi GAZAKH u To Sheki s GUBA Vanadzor Agstafa SHEKI M DEVECHI TOVUZ Oghuz o Gazakh u Siyazan 41°N 41°N Tovuz Kura Mingechevir n SIYAZAN L SAMUKH Reservoir OGHUZ Gabala t e a s i s SHEMKIR n Khizi e Shemkir GABALA s r Nabiagaly MINGECHEVIR Ismailli SHAMAKHY C Mingechevir ISMAILLI KHIZI To a Ganja Agdash SUMGAYIT Vanadzor u GANJA Yevlach Goychay Shamakhy Caspian Sea c Gedabay Geranboy a Sumgayit Khanlar AGDASH YEVLACH GOYCHAY Akhsu Maraza GEDABAY su KHANLAR Udjar GERANBOY AKHSU Khyrdalan s Dashkesan Barda GOBUSTAN UDJAR Lake DASHKESAN M Tartar ar Kyurdamir ABSHERON BAKU BAKU ARMENIA BARDA K Sevan TTARTAR AR AR ZARDAB u Zardab KYURDAMIR r To a HAGIKABUL Sevan AGDZHEBEDI Kelbadzhar AGDAM L Kura SABIRABAD Gazi-Mammad 40°N To Agdzhebedi o 40°N Yerevan KELBADZHAR o u n t a i n s Sabirabad KHODZHALY Agdam w IMISHLI l Ali Bayramli Khodzhaly a n Saatly This map was produced by the Map Design Unit of The World Bank. Imishli d ALI BAYRAMLI The boundaries, colors, denominations and any other information LACHIN Khodzhaveno BEILAGAN SAATLY shown on this map do not imply, on the part of The World Bank TURKEY Shusha SALYAN AN Group, any judgment on the legal status of any territory, or any SADARAKSadarak SHUSHA VENO Beilagan Araz endorsement or acceptance of such boundaries. Lachin Fizuli 50°E 51°E Sharur KHODZHA FIZULI BILASUVAR Salyan SHARUR SHAKHBUZ Bilasuvar Araz Gubadly BABEKShakhbuz Dzebrail Neftchala AZERBAIJAN GUBADLY DZEBRAIL NEFTCHALA JALILABAD NAKHCHIVAN Jalilabad DZHULFA Babek Zangilan Masally 39°N ORDUBAD ZANGILAN To Dzhulfa 39°N RAYON CAPITALS Salmas MASALLY Ordubad Lenkaran CAPITAL OF AUTONOMOUS REPUBLIC Yardymly YARDYMLY NATIONAL CAPITAL ISLAMIC REPUBLIC Lerik LowlLENKORAN LERIK Lenkoran RIVERS To and To Tabriz OF IRAN Tabriz MAIN ROADS 0 10 20 30 40 50 Kilometers SEPTEMBER ASTARA RAILROADS To Astara IBRD Tabriz 0 10 20 30 40 50 Miles RAYON BOUNDARIES 33365 2004 INTERNATIONAL BOUNDARIES To 45°E 46°E 47°E 48°E Rasht 49°E