Framework for Effective Local

Quick Start:

Government Finance

March 2005

Authored by: Michael Schaeffer This report was made possible through support provided by the World Bank’s Public Sector and Expenditure Management Thematic Group. The opinions expressed herein are solely those of the author(s) and do not necessarily reflect the views of the World Bank.

Acronyms and Abbreviations

A/P Accounts Payable B/S Balance Sheet CIP Capital Investment Plan FA Fixed Assets FASB Financial Accounting Standards Board FY Fiscal Year GAAP Generally Accepted Accounting Principles GASB Government Accounting Standards Board IMF International Monetary Fund I/S Income Statement IAS International Accounting Standards O&M Operations and Maintenance US$ United States Dollar (Unit of Currency) WB World Bank

2 Abstract...... 5 1 Introduction...... 6 2 Essential Components of Effective Local Government Finance...... 7 3 A Shift in the Nature of Local Government Budgeting...... 8 3.1 Framing Local Government Policy...... 9 3.2 Effective Financial Management and Budgeting...... 11 3.3 Significance of Financial Management...... 12 3.4 Working Within a Proper Legal Environment...... 13 3.5 Perspective on Budgeting...... 14 3.5.a Budget Formulation and Adoption...... 15 3.5.b Budget Execution and Expenditure Control...... 18 3.5.c Factors Influencing Escalating Expenditures...... 19 3.5.d Ineffective Budget Spending...... 21 4 The Capital Budget...... 21 4.1.a Rationale for Capital Budgets...... 21 4.1.b Structure of the Capital Budget...... 22 4.1.c Determining Capital Expenditures Resource Allocation?...... 23 4.1.d Implications for Recurring Expenditures...... 24 4.1.e Integrating Investment Projects into the Budget...... 25 4.1.f Implementing the Capital Budget...... 25 4.1.g Capital Budget Issues...... 26 5 Role of Accounting and Financial Reporting...... 28 5.1 Unified Chart of Accounts...... 28 5.2 Why are Strong Local Government Accounting Systems Important?....29 5.3 Cash versus Accrual Accounting...... 29 5.3.a Cash Accounting...... 29 5.3.b Accrual Accounting...... 30 5.3.c Modified Accrual Accounting...... 32 5.4 Deciding on an Accounting System...... 32 5.5 Financial Reporting...... 33 5.6 Appropriations Control...... 33 5.7 Auditing...... 34 5.7.a Auditing and the Local Government...... 34 5.7.b Shortcomings in Local Government Audits...... 35 5.7.c Prerequisites for Effective Auditing...... 35 6 The Treasury System...... 36 6.1 General Responsibilities of the Treasury...... 36 6.2 Overview of Local Government Cash Management Operations...... 37 6.3 Cash Management...... 37

3 6.3.a Controlling Cash Flows...... 38 6.3.b The Cash Management Cycle...... 39 6.3.c Single Bank Accounts...... 39 6.3.d Cash Collections...... 40 6.4 Linking Budget Implementation and Cash Plans...... 40 6.5 Financial Health and Stability...... 41 6.6 Managing a Crisis...... 41 7 Sequencing of Financial Management Reforms...... 41 8 Conclusions...... 44 Bibliography...... 45

4 1 Abstract

Enhancing local government management capacity is a central element to the success of any decentralization strategy. Effective and efficient local government budgeting and financial management is the cornerstone of any effective decentralization strategy. The task of improving local government financial management systems is enormous.

The past decade has seen dramatic shifts, in theory and practice, in the area of local government finance and public sector management and reform. The innovative ideas of local government public sector financial management have reshaped thinking about public policy (and, financial management) in both developed and transitional countries. The restructuring of public services in order to enhance their efficiency with the introduction of private market discipline, and increased competition, into what was heretofore the realm of public administration has prompted the need for more discipline in local government public administration and promoted more open, accountable, and citizen focused performance oriented budgets.

The central theme of this note is that broad technical requirements of accounting, auditing, and budgeting are similar for all countries. However, a core underpinning structure can be specified to meet these requirements. This ‘quick start’ note provides a framework for central elements of local government budgeting and financial management practices and is organized into three primary sections including: i.) Essential Components of Effective Local Government Finance; ii.) The Treasury System; and, iii.) A Shift in the Nature of Local Government Budgeting.

5 2 Introduction

The movement toward decentralization has brought increased attention to the need to enhance capacity at local government levels in order to manage local government resources in a transparent, effective and efficient manner. Good local level public sector management is imperative if decentralization is to be successful. Decentralization of public sector resources and service delivery is however not without controversy.

In many countries, political forces exist that may oppose increasing the authority and responsibility at local government levels often cite a lack of capacity at the local level to manage resources properly. The preponderance of international evidence and experience illustrate that decentralization can provide more effective and relevant services and increase public sector accountability. However, unless local municipal governments are provided with the capacity to manage their increased responsibilities and financial resources, decentralization could in fact lead to less transparency and less effective and efficient local government management.

Citizens are generally closer to local governments and their operations and can provide inputs on how local government resources can be used to address the local community’s issues. As a result, local governments have the potential to be among the most transparent and accountable levels of government. However, in the absence of strong and transparent management systems, corruption, inefficiency, and ineffective local government management is a very likely possibility.

Enhancing local government management capacity is a key to the success of any decentralization strategy. Effective and efficient local government budgeting and financial management is the cornerstone of any effective decentralization strategy. The task of improving local government financial management systems is enormous. The legal framework varies across countries. Local governments vary in size, financial and economic resources. As a result, there is no singular financial management system that can be applied across the board to all local governments and countries. What is similar across countries and local governments is the conceptual framework of modern budgeting and financial management. The application of these budgeting and financial management practices may however vary across countries.1 This ‘quick start’ note provides a framework for central elements of local government budgeting and financial management practices and is organized into five primary sections including: i.) Essential Components of Effective Local Government Finance; ii.) A Shift in the Nature of Local Government Budgeting; iii.) The Capital Budget; iv.) The Role of Financial Reporting and Accounting; and, v.) The Treasury System.

1 For a more detailed discussion with respect to municipal finances and expenditure management please see Michael Schaeffer 2005 “Framework for Municipal Finance and Expenditure Management.”

6 3 Essential Components of Effective Local Government2 Finance

The central theme of this and the following chapters is that broad technical requirements of accounting, auditing, and budgeting are similar for all countries. However, a core underpinning structure can be specified to meet these requirements. In effect, a core system for effective local government finance as outlined in Box 1 below includes:

. A control structure that governs the use of government funds and are derived from legislative framework.3

. A standardized chart of account, an accounting system (that consists of modules for accounts payable, account receivables, and the general ledger) and enables consistent recording for expenditure control, costing and economic (financial) analysis.

. An effective treasury and cash management system that links local government budgets to effective cash collections and disbursements. And,

. Reporting requirements that include internal and external reporting for government policy makers and managers and the local community.

. An effective, timely budget and reporting system.

2 The term ‘local government’ used throughout this paper denotes the units of government that provide direct services to citizens at the lower intermediate and lowest levels. In a number of countries (i.e. Italy with its city-states) local governments were autonomous long before the country in its present form was constituted. On the other hand, transition (developing) countries started with strong central governments and the nature of local governance is usually not well rooted (or in some cases well-defined). 3 See World Bank 1998 “Public Expenditure Management Handbook” Pg. 61

7 Box 1 Components of an Effective Financial Management System Community Driven Performance Measurements Community Ownership

Budget Policies Formulation and Execution Community (Participation) Driven

Effective Treasury and Cash Management Systems Standardized Transparent/ Accountable Chart of Accounts (External / Internal Audits) Accounting Systems

4 A Shift in the Nature of Local Government Budgeting

The following sections will discuss how local government financial systems can be improved through the development of a standardized chart of account, effective accounting, and auditing procedures, and by paying careful attention to the development of more effective treasury and cash management operations. Reforms in the area of local budget efforts represent a substantial departure from the past. In the area of local budgeting, the focus has shifted from due process approaches of conventional budgeting to a wider agenda of local government public expenditure management.4

The new local government budgeting approach recognizes the failure of local government budgets to address the relationship between control and performance and the incentives for performance in the full range of formal (and, informal) budgeting, decision making, local government administrative management and citizen participation. The local government budgeting process has shifted to such an extent that it now highlights the complex web of institutions, actors, and community participants involved in the budget process, and links local government expenditures with measurable results in terms of outputs and outcomes.

4 ODI Briefing Paper May 2004.

8 Box 2 A Shift in the Nature of the Budgeting Process

“Conventional Budgeting:” Budget Process Rules Inputs Compliance Hierarchal/Centralized Control

“New Public Expenditure Management:” Budget Policies/Institutions Incentives Outputs/Outcomes Performance Orientation Decentralized Responsibilities Transparency and Accountability

Source: ODI Briefing Paper May 2004. M. Schaeffer, “Framework for Effective Local Government Finance and Expenditure Management.” 2005

4.1 Framing Local Government Policy

Throughout the world, local governments are engaged in processes for determining how to raise, allocate and spend public resources according to the needs of the local community. The manner in which public resources are used is a fundamental determinant of the effectiveness of public policy objectives. The annual budget is a key policy document that establishes a local government’s intentions for raising revenues and using resources for the year.

What is a local government budget? Wildavsky (1975) and Pradham and Campos (1996) define a budget as the following:

9 . A record of the past.

. A plan (or statement) of the future.

. A mechanism for allocating resources.

. An instrument for improving efficiency.

. A means for securing economic growth.

. An engine of income distribution.

. A precedent.

. The result of political bargaining.

. The most operational expression of (local) policies in the public sector.

Wildavsky (1975) and Pradhan and Campos (1996) point out that budgets are fundamental for meeting three important policy objectives.

1. Aggregate fiscal discipline.5

2. Allocation of resources consistent with strategic policy and priorities.6 And,

3. Efficiency and effectiveness.7

In essence, the budget process forces public policy choices to be made and tradeoffs to be identified. A financial and budgeting environment characterized by a general lack of transparency and accountability reduces the budgeting process to nothing more than wish lists which may or may not be fulfilled or may be financed through means which may put the local government’s fiscal stability at risk.

The complexity of the environment in which local government budgets are formulated and implemented often results in a high degree of uncertainty about actual budget outcomes. Sometimes financial shocks, political turmoil, or natural disasters can adversely impact the performance outcomes of local government budgets by shifting

5 Decisions regarding total revenues, expenditures and other financing arrangements shape the form of local government intervention in the local economy. In order to avoid accommodating all spending demands, it may be necessary to establish aggregate spending ceilings before any decisions on individual line-item components can be decided. 6 Local government expenditures should be based on the strategic priorities established by the local community and ingrained in the local budget. Spending decisions should be based on whether the expenditure can achieve an effective outcome. 7 Local governments should utilize budgetary decisions towards maximizing tangible outputs and outcomes.

10 priorities and stimulating ad-hoc measures which undermine the predictability and significance of the budget as a local government policy statement. Box 3 reflects upon the theory and practice of local government budgets, and presents a brief list of good and poor local government budgeting principles.

Box 3 Local Government Budgets: In Theory and Practice

Good Budget Practices Poor Budget Practices

Comprehensive Unrealistic Planning and budgeting Disciplined Short-term budgeting with no medium or long- Legitimate term implications Flexible Numerous budget revisions throughout the year Predictable Government spends as cash becomes available Contestable: Subject to review and not according to preset priorities evaluation Deferred budgeting: Arrears build-up as Honest expenditures are pushed into subsequent years. Information must be accurate and Distorted priorities. timely. Informal management: Extralegal behavior Transparent: Information about dictates how government operates with respect budget practices must be accessible to hiring and procurement etc., and communicated to a wider Corruption: Lack of enforcement of formal audience. rules breeds illegal behavior (corruption). Accountable: Decision makers must be held responsible for the exercise of authority provided to them. Source: A. Shick (1998) A Contemporary Approach to Public Expenditure Management. World Bank Institute.

Source: Public Expenditure Management Handbook (1998) World Bank

4.2 Effective Financial Management and Budgeting

Financial management and budgeting refers to the set of activities by which the intentions of local government managers and politicians become operational. Traditionally, control over funds was sufficient for managing local government operational activities. Emphasis was placed on compliance with financial regulations and not effective public sector service delivery or performance. The only mechanism for gauging local government performance was to conduct an audit. However, conducting audits is no longer sufficient for ensuring effective local government service delivery and ensuring public sector transparency and accountability.

11 Performance based local government financial management necessitates a change in the approach to local government financial management and organization. Modern budgeting and financial management seeks to develop financial information that not only assures control of local government financial resources, but also is useful for local government decision makers in executing programs. To effectively manage, and explain to the local voters the effectiveness and need for local government programs, means producing financial information in an integrated manner. As a result the core functions of a local government financial management system – budgeting, accounting, cash (treasury), and debt management – must be integrated so that transactions that affect various individual components are entered only once and their effect is simultaneously registered in all the affected subsystems.

Increasingly, national governments are improving and modernizing their financial management systems. Unfortunately, many of these changes have yet to find their way down to local government levels.8 In India for example, there are new laws and regulations which require local governments to engage in accrual based financial accounting. Yet, many Indian local governments are ill-equipped to introduce these required changes. Budgeting, accounting and cash management remain the core element of financial management systems at the local government level. This section presents the significance of financial management, the legal environment, and the budgeting process.

4.3 Significance of Financial Management

Raising revenue through taxation and then spending tax revenues for public goods forms the basis for the existence of all (local, national and, central) governments. In this respect, no government can last or be effective without public financial management. The significance of public sector financial management is explicitly and implicitly implied at various levels of government. For example, public financial management is:

. The area where taxpayers (local constituency) focus most of their attention and where most regulations have been instituted. Finance and accounting laws and regulations are among the earliest and most thorough part of most subnational state and local government statutes.

. The area with the most numerous professional standards issued by various organizations such as for example the Governmental Accounting Standards Board (GASB). Though many of these standards may appear as recommended practices rather than obligatory regulations, governments are under increasing pressure from the general public to adopt recommendations which increase transparency, accountability and better service delivery and performance.

8 Change has been relatively slow in coming to some countries. Some countries continue to have two distinct charts of accounts: one for budgeting purposes and one for accounting. Often times, these two types of chart of accounts are maintained due to historical legacy legal requirements. As a general rule, there should be one chart of accounts detailing the personnel, utilities rent etc., accompanied by a budget classification system that identifies income and expense by source, program, project and operational unit.

12 . The first among local and state government departments to employ new technology. In India it is the financial management and accounting sectors that have adopted computerization before any other departments. In most countries, local and statement governments have invested in some form of integrated accounting systems needed to improve financial management capacity.

. Revenue mobilization and improving the efficiency of public expenditures: Providing local governments with their own sources of revenues not only increases accountability but reduces the pressure on the national budget, thereby allowing more effective macroeconomic management policies and the pursuit of national priorities. Many countries in transition face a scarcity of resources. Therefore, increasing the efficiency of public expenditures must be a fundamental priority of government policy. An effective decentralized system has the potential of significantly increasing the efficiency of public expenditures. But this goal can only be achieved with a well-designed system that balances autonomy and accountability at the local level.

Why is local government public financial management so important? The government sector increasingly places more emphasis on planning, control and efficient and effective public service delivery. Increasingly, local government management decisions are being made in a more coordinated manner under the umbrella of strategic plans or city development strategies with local government financial managers playing a more significant role in the financial control process.

4.4 Working Within a Proper Legal Environment

In most countries, local governments exist within two legal frameworks. The overarching framework is dictated by the national government. In addition, a second legal framework is established by the local political structure. In many cases the legal underpinning of local governments are defined by a ‘Local Government’ and ‘Local Budget Laws’. To be most effective, the legal foundation of an effective local government financial management system must be codified. The legal environment must ensure that any financial management system meets constitutional requirements, identifies the relevant oversight and standard-setting agencies, and allows for specific regulations and guidelines to be developed by relevant agencies.

The proper legal and financial management framework dealing with local governments should include:

. Detailed rules with respect to local government budgeting, accounting, cash and debt management.9

. The responsibility for internal and external audit should be designated by referencing other relevant legislation.

9 Any legal and financial framework should clearly establish a role for national oversight and regulatory agencies such as the Auditor Generals Office (e.g., India).

13 . The role(s) of any oversight agencies and their respective responsibilities should be clearly defined and delineated.

. The basic jurisdictions, level of autonomy, and the core components of local government financial management systems should be clearly spelled out.

The legal framework established at the national level generally establishes the accounting and audit standards for local governments, the taxing authority, and defines the roles that other relevant agencies play in ensuring effective local government financial management and service delivery.

4.5 Perspective on Budgeting

Budgets represent the core element of any integrated local government financial system. Local governments plan, implement and evaluate local government policies through the budget. Although accounting plays a central role in recording and developing local government financial information, budgeting determines the kind of information that is needed and the classification system of revenue and expenditure accounts.10

Local government budgets should also provide a fundamental internal management control mechanism over the expenditure of government funds. In other words, the control of local government expenditures should include a responsibility for effective and efficient use of government funds. Using a broader definition of budgetary control is the need to assign responsibility for implementing the budget. The assignment of responsibility should be reflected in the selection of implementing units and in how the financial data from these units should be rolled up into larger units (e.g., departments or categories).

Many local government financial systems centralize the formulation, execution and the control of many aspects of the local budget. This often results in a dislocation between what is supposed to happen and what actually transpires at the operational level. This kind of budgetary dislocation has significant ramifications throughout the budget cycle. Budgets may not be based on operational realities. How can local government operational managers be held accountable for budget performance? In terms of execution and evaluation, when budget and accounting systems are not integrated, accounting information regarding budget implementation can be less than reliable.

When designing an integrated budget and effective local government financial framework, it is necessary to:

. Establish clear operating procedures between the financial management sections of each implementing department and the local government budget office.

10 The classification of revenue and expenditure accounts should be defined within International Accounting Standards (IAS) and / or Generally Accepted Accounting Principles (GAAP).

14 . Limit programmatic classifications to only what is necessary for effective decision making. In addition, simplify and limit account classifications.11

. Match budget authority with operating level.

. Codify budget procedures in a manual. Abrupt changes in budget procedures should be avoided.

. Develop performance measurements that can be used to measure efficiency and effectiveness. Performance measurements should also be developed to measure the progress of the local government towards long-term goals.12

Budget Formulation and Adoption

Budget formulation (and, adoption) is the translation of local government polices and programs into their financial implications. The financial plan is the benchmark against which local government performance will be measured. The budget formulation process lays the framework against which the implementation of activities and programs delineated in the budget will be measured. The budget’s usefulness as a means of local government policy is determined largely by the degree to which it accurately integrates local government policy with operational realities.

A local government budget focused on improving financial management should include the following elements:

. Program elements should be limited and meaningful. The number of program elements should not be dissected into a large number of minor subcategories.

. Present multi-year data to include prior, current and projected (or forecast) financial data.

. Include all units that require government resources in the budget formulation process. At the same time, develop and codify budget instructions for these units.

In principal, each budget is unique and should be prepared in ignorance of past budgets. This generally does not happen because former budgets contain information on the preferences of voters and tradeoffs previously achieved. In addition, past budgets also contain commitments that cannot be changed from one year to the next. There is some danger in using existing budgets as a template for preparing new budgets. For example, expenditures that were once useful may have now lost their relevance. To

11 Too much detail may contribute to concealing the big picture. In addition, creating a system that has too much detail may overtax local government information and personnel systems. 12 See Michael Schaeffer 2000 “Municipal Budgeting Toolkit.” Performance indicators should be a mix of physical and financial indicators. However, under no circumstances should these indicators be overly complex or cumbersome.

15 avoid this, each area of budget expenditure should be subject to in-depth analysis and review on a rotating basis.13

4.5.1 Local Government Revenue Mobilization and Forecasting

Two basic principles of assigning revenues to subnational governments are generally suggested:

1. Own-source revenues should ideally be sufficient to enable (or at partially enable) subnational governments to finance from their own resources all local provided services primarily benefiting local residents.

2. To the extent possible, subnational revenues should be collected only from local residents.

Bird (2000) illustrates that this approach should be based on three basic principles: i.) More attention should be paid to matching expenditure and revenue needs at different levels of government; ii.) More effort should be made to ensure that all governments bear significant responsibility at the margin for financing the expenditures for which they are politically responsible; and, iii.) Subnational taxes should not unduly distort the allocation of resources. The bottom line is that unless subnational governments have a significant degree of freedom to alter the level and composition of their revenues, neither local budget autonomy or subnational government accountability are meaningful concepts.

Revenue autonomy at the subnational level or the ability to increase revenues (by changing rates or bases, or by introducing new taxes) has for many countries been slowly introduced. However tax autonomy at the subnational level remains relatively low. Traditionally, a number of taxes are assigned as ‘own revenues’, but this is often a misnomer because the structure of the tax is determined by the central government. In some countries, limited revenue autonomy has been granted often in the form of some choice rates for small taxes such as nuisance taxes or even some user charges.

Perhaps a significant factor contributing to the continued fragility of fiscal balance are the weak efforts made by many local governments in improving tax and non- tax revenues corresponding to increases in expenditure plans and commitments. The revenue base for many local governments in most countries continues to be weak. Every local government unit should prepare basic forecasts of the expected amount of revenue (income). The most basic forecast is to use revenues from the current year increased by a growth factor. However, this type of forecasting technique can hide many useful facts. For example, deterioration in tax compliance can be masked by an increase in the tax base. It is thus preferable to forecast potential revenues using information on forecasted bases and planned rates to explicitly calculate what is legally collectible and then to use information on tax compliance levels to determine likely local government revenues.

13 Some local government units have incorporated sunset clause provisions into various programs stipulating that a program will end unless it is explicitly renewed after a given time interval.

16 Revenues from intergovernmental transfers may be more difficult to forecast since the formula used to calculate them may not be readily transparent or the data used to calculate the transfer may not be readily available to the local government. Ideally, a forecast will be provided by the national (or, state) government.

4.5.2 Expenditure Forecast and Control

Local government finances are somewhat disadvantaged, compared to national government or even private business finances. Unlike national governments that control money and credit, local municipal governments cannot easily inflate tax yields. In addition, unlike private business, local municipal governments cannot discontinue activities whose costs become unattractive. Because of these factors, local municipal government budgets should be examined for their conservative characteristics. The budget pressures likely to be revealed may, in general, tend to unbalance the budget, rather than produce surpluses. In forecasting local municipal government operating budgets, realistic questions concern what can go wrong and what has to be done within the budget framework to prevent anything from going wrong.

There are a number of ways in which a local municipal government budget can be strengthened. Foremost is the conservative estimation of both revenues and expenditures. This means that in estimating revenues, real best estimates are used without straining to raise revenue estimates to avoid tax increases or having to consider appropriation cuts. Similarly, appropriations should be fixed at levels determined by the best estimates of available work, services, and price levels for the year. Budgets predicated on inflated revenue estimates and shaved appropriations may be only narrowly balanced under the best of conditions and are readily unbalanced by external pressures.

The local legislature and the population have a right to know the government policy objectives and targets. Informing the general public and legislature not only increases transparency and accountability, but also allows for a general consensus to be reached within civil society. Developing a policy consensus around the financial forecast may take additional time, but it will be an invaluable foundation for the implementation of the local government’s policy and financial programs.

Local governments should closely monitor and control budget expenditures to minimize the potential of expenditure overruns (revenue shortfalls). Leaving budget overruns unchecked over the course of a fiscal year can greatly exacerbate their negative effects. Since local governments have slightly more control over expenditures than revenues, they should closely control and monitor outlays.

Budget Execution and Expenditure Control

One of the biggest problems with respect to local government budgeting and financial management is the lack of current financial information at the operational level as operations are being carried out. The financial element of budget feedback is provided

17 by the local government accounting systems. This information is often untimely, unreliable and in some cases, simply irrelevant. When information is available, it often does not reach the appropriate decision maker at the operational level.

Local government budget execution entails designing internal managerial controls over budget compliance. In addition to considering the capacity of local government officials to administer these budget controls, local government officials must also take into consideration the cost and benefits of implementing an extensive budgetary control system. In some cases, the whole control system can break down because the controls have been set to unrealistic levels that may sound good, but in practice may paralyze execution or be largely meaningless.14 For example, setting levels for individual transactions above which the approval of a higher authority is required generally helps to maintain oversight without losing control.

Delegating approval authority does not mean giving up expenditure or budget oversight responsibility. One technique used to exercise oversight is called ‘exception reporting’. Exception reporting draws comparisons between actual and expected expenditures, or between current expenditures and those of a prior comparable period (or, against some other preset standard). A variance is calculated between what is forecast (or expected) and what actually happened. Exceptions are noted for additional inquiry or analysis. An exception to what is expected does not necessarily imply that there is a problem. It just means that the reason for the exception should be investigated more thoroughly.

Another analytical technique for maintaining oversight without specifically approving each individual transaction is to compare financial results between comparable operating units. For example, hospitals of similar size should have approximately the same cost structure. If one hospital is spending significantly more than the other, that difference should be investigated.

Some key elements for consideration in the financial management of budget implementation include:

. Providing guidelines for reprogramming budget line items.

. Reprogramming requiring higher level approval should be only for shifts between major line items.

. Establish clear procedures for committing funds for goods and services, accruing expenses and making payments. These procedures should be designed to discourage unrecorded outstanding liabilities. And,

. Establish clear procedures for distributing allotted budget authority on a quarterly or monthly basis. Distributions should be based on disbursement plans developed

14 Failure to delegate approval authority to appropriate levels or persons can result in persons approving transactions who have no basis on which to judge appropriateness.

18 by operating units in cooperation with cash management and local government policy makers.

. Allocating funds to operating departments or sectors on a quarterly basis during the budget year can help municipal finance managers control expenditures15. It also enables the detection of budget overspending in a timely manner and prevents any fiscal gap from widening to the point where it becomes difficult to close. Quarterly allocations of funds also can foster more accurate operating department planning and more prudent use of quarterly budget projections in the planning phase.

. Quarterly budget allocations must be made in conjunction with an aggressive cash flow management program and should be based on the analysis of monthly reports measuring actual expenditures against budget forecast.16

. Expenditure control and cash flow management must be integrated through the use of at least monthly reports which can the following non-exclusive information list: i) actual expenditures; ii) budgeted expenditures; iii) comparison of expenditures as a percent (%) of the budget; and, iv) unpaid expenditures. Comparing budgeted to actual expenditures on an at least a monthly and quarterly basis helps managers take prompt actions to curb overspending.

Factors Influencing Escalating Expenditures

A number of factors generally can be considered for the escalation of local (and, State) government expenditures and can broadly be classified as:

. Soft budget constraint;

. Fragmented approaches to budgeting;

. Creating future expenditure commitments by under provisioning;

. Lack of transparency; and,

. Systematic errors in budget forecasting.

A soft budget constraint has been the bane of many local budgetary processes. For example, supplemental budgetary appropriations have been the rule in countries like Georgia rather than the exception. A hard budget constraint, such as those faced by individuals and private enterprises could discipline the decision-making units of local governments. A hard budget constraint not only implies that revenues and expenditures

15 Quarterly budget allocation is one method only for controlling (monitoring) expenditures. This method does present problems with respect to the execution of the capital budget. 16 Cash budget information can be in real time while the budget account usual implies that the data can be presented in the following month.

19 come into balance but as Rodden and Litvack (2000) state, a hard budget constraint must also be defined wherein local governments are unable to shift liabilities (i.e., arrears, borrowings, etc.,) to higher levels of government. Only a hard budget constraint can generate more effective expenditure management and budgetary efficiency.

In general, decentralized decision-making and a bottom-up approach to budgeting have a number of positive associated benefits in the context of planning, programming and implementation of programs and projects. Fragmented approaches to budget development invariably lead to over-estimation and over-spending of budget spending envelopes. This is because various local government spending agencies take into account the full benefits associated from various spending programs, but consider only the costs which falls directly on them. Thus policy makers in a decentralized budgetary process may systematically over-estimate the net marginal benefit of increased public spending. In contrast, where there is a degree of centralized budget formulation at the local government level a more comprehensive view of revenues and expenditures can be developed.

Another problem that may occur in the local government budgetary process is the committed expenditure which is the result of under-provisioning in earlier periods. Often one comes into a situation where a project requiring massive resources for its completion is included in the budget with a modest budget provision. This will lead to commitments in the following periods as well as cost escalation due to inordinate delays. One of the primary reasons for low capital productivity in many developing countries and high incremental capital output ratios in the public sector is a result of this kind of budget under provisioning.

In many countries, local government budgeting is shrouded in secrecy and may suffer from lack of transparency. As a result, the perceived benefits of spending are often over-estimated by various interested parties. On the other hand, the spending requirements are usually underestimated. Clever budget formulators often employ subtle techniques like the strategic use of budget projections: overstatement of effects of budgetary changes and the strategic use of multi-year budgeting to increase the opacity of the budget.

As a result, the tendency to systematically underestimate the growth of local government growth of public expenditure is inbuilt into various local government budget processes. As a general rule, any revised local government budget is always significantly higher then the initial budget estimates. In addition, more often then not, the final budget figures are still higher than the revised estimates. Almost invariably, one year’s budget estimate is related to the revised estimates of the preceding year or the actual expenditure of the previous year(s). This type of comparison invariably gives the impression that the growth in expenditure is significantly lower than the real growth.

20 Ineffective Budget Spending

One of the major impediments in many local government budgeting processes is that spending follows budget cycles over riding all other considerations. A general ‘Rule of Lapse’ implied in the annual budget implies that unless expenditure is incurred before the financial year end, the money will lapse. This results in some potential waste in the local government budget and expenditure management system. The budget cycle introduces serious distortions in spending which are usually bunched towards the end of the budget time-frame.

5 The Capital Budget

Local government capital budgets have multiple objectives, including serving as windows on the net worth of public bodies and as vehicles of development.17 The capital budget is largely concerned with the creation of long-term assets. Governments commonly establish a uniform and organized multi-year (5-year) capital investment plan (CIP) to outline the public facilities, infrastructure, and land purchases that the jurisdiction intends to implement during a multi-year period given the availability of funds.18

Financing of government investments requires a different (and often more complex) set of capacities and means of financing than general service provision and maintenance. The investment process requires the capacity to prepare medium and long- range local development plans (often in conjunction with national and/or regional development plans), to prepare and design credible investment projects (appropriately sized for local needs, full estimate of costs, including additional operating costs which result from investment implementation), and to develop a feasible financing plan, which usually combines local inputs, conditional and/or matching transfers. In addition, officials need the skills to procure construction services and inputs in a cost-effective and open manner, to oversee appropriate implementation of the project and to ensure proper maintenance and servicing of the new infrastructure or buildings that have been completed.

Rationale for Capital Budgets

What is the general rational for establishing a capital budget? From the point of view of financing, governments established capital budgets to explore alternatives to taxation. Public sector capital budget development arose principally because it enabled governments to engage in borrowing resources that had a greater potential to bring about a better distribution of government services among taxpayers and beneficiaries.19 Public

17 See A. Premchand (2000) “Capital Budgets: Theory and Practice” Page 2. 18 Discussion of the capital investment planning process, capital budgeting, and project prioritization is presented in Schaeffer ‘Framework for Effective Local Government Finance and Expenditure Management’ 2005.. 19 Ibid Page 5

21 sector borrowing for capital asset formation effectively contributes to a better distribution between consumption and investment.

Investment projects tend to be uneven in the years that they occur. Projects require significant amount of resources during the conception and development phase, but have fairly long life cycles. This contributes to uneven resource mobilization measures to match the level of investment expenditures. In effect, while capital expenditures tend to be lumpy reflecting the nature of the projects to be financed, when properly organized and financed, investment projects have the potential of establishing a smooth revenue profile. From an accounting perspective, capital budgets (and local government balance sheets) should have depreciation and capital charges reflecting the life of the asset over its life span rather than the fiscal year in which the expenditure is incurred on its acquisition or completion.20

Structure of the Capital Budget21

The structure of the capital budget and planning process is usually a multi-step process, including:

. Inventory of Capital Assets;

. Multi-Year Capital Investment Plan (CIP); And,

. Financing Plan

A central element of the capital budget and the multi-year capital investment plan is the financial analysis aimed at minimizing the financial effect of investment project(s) on the local budget, while maximizing the impact or returns of the project in addressing the community’s needs. The capital budget process is not only a management tool for guiding the expenditure of public resources over an extended period of time, but also represents a commitment by the local government to provide its community with the desired and required level of service. The structure of the capital budget that has generally evolved over the years can be illustrated in the manner presented in Table 1. A capital budget has an extensive portfolio. For example, even though property taxes are paid from current income, they are considered to be levies on capital and as such are included in capital receipts. Surpluses from current budget are another source of receipt.

20 Ibid Page 5. 21 See Michael Schaeffer (2000) “Municipal Budgeting Toolkit” Page 25.

22 Table 1 Structure of a Capital Budget Revenue (Receipts) Expenditures I. Taxes and Property Earmarked for I. Acquisition of Existing Assets Capital Projects . Plant, Property, Equipment . Financial II. Surpluses from the Current Account II. Acquisition of New Assets . Plant, Property, Equipment . Financial (Other than capital transfers) III. Proceeds from Borrowing III. Capital Transfers . Domestic . Transfers to Other Levels of . Accounts Maintained by the Government Government . Transfers to Public Sector . External Enterprises . Repayment of Loans IV. Depreciation Allowances IV. Repayment of Loans V. Sale of Property VI. Capital Grants Source: A. Premchand (2000) “Capital Budgets: Theory and Practice.”

Depreciation allowances represent a contra or balancing entry to the capital budget in that these allowances where are charged to the current account are treated as capital receipts.22 Charging depreciation allowances has a short-term impact of contributing to a reduced budgetary surplus (or potentially to increase the deficit). However, this has to be tempered with the recognition that depreciation allowances are not maintained on a cash basis and serve more as book entry features of government accounting.

Determining Capital Expenditures Resource Allocation?

Capital expenditures are simply defined as outlays incurred on the acquisition, creation of an asset or a transfer leading to the creation or acquisition of an asset. Capital expenditures are included in the capital budget so long as they meet three basic criteria:23

1. They are used in the production or supply of goods and services (productivity criterion);

2. Their life extends beyond a fiscal year (longevity criterion); and,

3. They are not intended for resale in the ordinary course of operations.

22 For a more thorough discussion on asset valuation, depreciation, and amortization, please see Annex A: Establishing a Fixed Asset Methodology; Annex B: Revaluation of Fixed Assets; and Annex C: An Overview of Fixed Asset Valuation and Depreciation. 23 A. Premchand (2000) “Capital Budgets: Theory and Practice.” Pg 8

23 In addition, there are two kinds of capital investment projects that economists generally distinguish between that are included in the capital budget:

. Self-financing projects refer to those projects that have the potential to service future interest payments.

. Self-liquidating projects refer to those projects that have the potential to service both interest and principal repayment.

A key element in capital investment planning is the determination of resources to be allocated. In financial planning, the local government must investigate the financing options and the fiscal feasibility of funding the various project requests. The most critical stage of the capital investment program consists of conducting detailed financial analysis of the local government’s capacity and ability to undertake the investment program. In order to arrive at capital investment spending decisions, techniques ranging from discounted cash flows to sophisticated economic, financial, institutional and environmental analysis are applied. The application of these techniques has been facilitated by the fact that capital projects are generally financed by institutional lenders who insist on the completion of detailed studies as fundamental steps leading to the financing of projects.

The number of public improvements that a local government can finance generally depends on the following non-exclusive list: 24

. The level of recurring future operating expenditures;

. The cost recovery elements for individual projects and the potential for the public investment to be revenue generating;

. The availability of cost sharing by different tiers of government (or public private partnerships); and,

. Debt structures and instruments (debt-carrying capacity).

Implications for Recurring Expenditures

A detailed analysis of increased investment spending on current and future operating expenditures is a cornerstone in the development of the capital budget. Even without any additional capital spending, recurrent operating expenditures may be accelerating quickly such that it may be inappropriate to engage in additional capital spending until expenditures are brought under control. In addition, all current account transfers including a separate identification of costs to be transferred to the current operating budget including project design costs, future operation and maintenance

24 For a more detailed discussion of capital budgeting process see Michael Schaeffer “Municipal Budgeting Toolkit” 2000.

24 spending, and all financing charges must be integrated into the future recurrent expenditure account.

For each operating agency responsible for the operation and maintenance (O&M) of the capital infrastructure, the necessity of additional current and future expenditures to maintain the new capital facilities should be identified so that the impact on the department (and, jurisdiction) budget can be identified. The eventual impact on the recurrent expenditure budget may significantly influence the decision whether to move forward on certain capital investment projects or not. One of the most common and substantial failures of capital planning and budgeting has been the failure to provide for O&M, with the result that newly built capital facilities are allowed to deteriorate, or in extreme cases, go unutilized because the operating agency refuses to absorb the budgetary burden of operations. No project should be approved unless O&M costs have been estimated and the line agency responsible for operations has confirmed that it both accepts the cost estimates and is willing to assume O&M obligations.

Repair and replacement investment, in contrast, often is designed to generate operating savings by installing new facilities that are less costly to maintain or by substituting one-time repairs for annual maintenance. Such savings to the annual operating budget should also be included at the time of project preparation. The O&M costs or saving associated with a project not only need to be recognized in calculating the consequences of the investment budget for the recurrent budget, but should be a factor in project selection.

Integrating Investment Projects into the Budget

It is essential to ensure that the capital investment projects and their recurrent budgets are integrated within an overall spending envelope both in the annual budget and in any proposed budget expenditure framework. The annual process of determining the aggregate spending level for local governments should include both investment outlays and the proposed recurrent budget. Any new investment spending proposals should be finalized at the same time as the recurrent budget. Any new investment spending proposals during the fiscal year should be considered within the parameters of the proposed medium term expenditure budget.

Implementing the Capital Budget

In the final implementation stage, final development and adoption of the capital budget occurs. The multi-year capital investment plan should include the following components:

. All relevant project/investment cost details including construction and financing costs (and, any other costs attributed to project development);

25 . The annual capital cost disbursement schedule including direct construction payments but all principal/interest repayment for debt financing25; and,

. All current account transfers including a separate identification of costs to be transferred to the current operating budget including: project design costs; future operation and maintenance spending; and all fees and interest charges required for successful project development.26

At this final stage of development, the completed capital budget should have the full cost implications for all proposed projects; the annual capital costs (or annual financial value) of all proposed investment projects; and, the current budget implications of each project. For the local legislative body and constituency, the capital budget is an important management tools in that it:

. Allows the local jurisdiction and constituency to be better informed on the need for short- and long-term capital expenditures; and,

. Allows the local jurisdiction and constituency to consider and make more informed recommendations with respect to future capital spending.

The normal procedure for the implementation of the investment plan is that the jurisdiction adopts the capital budget, incorporating it as a separate feature of the total annual municipal budget. The remaining years of the program are accepted by resolution, subject to annual revision and authorization. It is essential that when the local government adopts a multi-year capital spending project/program, that the expenditure accrues as a future liability. In other words, this capital spending should be accounted for on the municipal balance sheet as expenditures committed for future years.

Capital Budget Issues

A number of salient issues arise with respect to the capital budget and capital expenditure process and are presented in Table 2. Capital budget issues include underfunding of projects and year-end unspent amount. For example,

. Underfunding: Even with effective budget financial management and planning, many local governments may be confronted with revenue shortfalls during the fiscal year. A typical reaction on the part of local government financial planners may include underfunding various projects and programs. However,

25 An alternative to incorporating debt service (interest plus principal) into the multi-year capital budget is to include only a summary line item for total project amortization rather than a case-by-case amortization or debt service schedule. 26 The decision to include all fees and interest charges as a transfer to the re-current budget or as a capital expenditure depends on the accounting approach pursued. In many consolidated financial statements’ interest and principal are considered as capital costs. Alternatively, many jurisdictions consider interest as a recurrent cost and principal as capital expenditure. There is no rule-of-thumb as to which is the preeminent approach. Preference, however, is generally expressed for carrying interest into the (re) current operating budget rather than as a capital expenditure. The rational for this is that principal represents the actual investment cost whereas interest and associated fees represent the costs associated with a particular method of financing.

26 underfunding may not be the most prudent choice. Near-term underfunding of projects may contribute to future cost escalations and may pose formidable problems for eventual project related cost recovery.27

. Year-End Unspent Funds: Unspent funds generally represent leakages in the local government financial control system. Some countries allow for carryover into the next year. However, other countries do not allow for carry-over thereby contributing to a rash of unwise year-end spending. Year-end unspent funds contribute to the differences between budgetary intent and outcome.

Table 2 Capital Budget Issues Functional Area Issues I. Project and Investment Appraisal Analysis techniques in many countries are qualitatively deficient. Analysis studies may lend themselves to manipulation 1. Need to apply uniform and and often become studies designed to support decisions already consistent guidelines undertaken. II. Funding Arrangements Centralized borrowing may lead to resource fungibility and the 2. Centralized Borrowing loss of project identity. In the case of India (State and Local Governments) it may be difficult to measure loan performance effectiveness III. Budget Formulation 1. Possibility of Contributing to Budgetary Rigidity 1. Medium Term Rolling Plans 2. Most Local (State) Budget Systems Have no 2. Contingent Liability and Mechanism For this Purpose. Some Countries Have Associated Risk Management Initiated Efforts to Pass Legislation and Associated Should be Part of the Budget Regulations. 3. Changes in Interest, Inflation (and, Exchange Rates) Decision Making Process Pose Serious Implications for the Financing of Self- 3. Risk Assessment Financing and Self-Liquidating Projects. In Many Cases, These Costs Are Borne by the General Budget. In Order to Understand the Risks, These Transactions need to be More Transparent. IV. Budget Implementation 1. Capital Projects Have Their Own Seasonality of 1. Release of Funds Expenditure Flows. Each Project May Have Its Own 2. Underfunding Distinctive Requirements. Funding, Budgetary 3. Payment Authority, and Cash Management Must be Synchronized in Conformity with Project Requirements and Implementation Schedule. 2. Projects are in Many Cases Underfunded. Even the Amounts Estimated in the Budget May not be Released in a Timely Manner. 3. Project Payments are Generally Decentralized. There may be delays in payments. Arrears in Payments are Common and Reveal A Failure of Cash (Expenditure) Management System.

Source: A. Premchand (2000) Capital Budgets: Theory and Practice, and Schaeffer et al Croatia: Investment Packaging Manual (2004)

27 To minimize such difficulties techniques such as critical path method and project evaluation and review techniques are used.

27 6 Role of Accounting and Financial Reporting

Accounting is the systematic gathering of financial transactions and the compiling and reporting of these transactions in a meaningful and consistent manner so that local government decision-makers can measure progress towards goals established in the budget; estimate resources required to accomplish these objectives; and, to effectively allocate resources across competing goals and objectives. In principal, accounting should be relatively straight forward-document the cash coming in, and record the cash going out. However, accounting is in fact a complex system of financial interactions that must be properly designed in order to function well and to provide decision makers with effective management reporting information. This section provides a basic overview of some necessary features of an effective local government accounting system, such as a Chart of Account. In addition, basic principals of cash, modified accrual and accrual accounting are reviewed.

6.1 Unified Chart of Accounts

Accounting detail is important, but the sheer volume of transactions that may occur at the local government level means that information regarding individual transactions must be collected and systematically classified. The chart of accounts represents the basic structure of municipal financial accounting and must include all categories of assets, liabilities, revenue and expenditures, and equity accounts of the local government. A well-designed chart of accounts provides a logical structure for classifying financial transactions so that financial data can be viewed from a number of perspectives.28

Many local governments suffer from antiquated chart of accounts that are often prescribed by national authorities. The design of an appropriate chart of account requires a clear understanding of how local governments operate, who uses the information, and what are the needs of the users. In general, a single uniform chart of accounts accompanied by budget classifiers is necessary for a truly integrated accounting, budgeting and local government financial management and accounting system.

To facilitate consolidation and inter-regional comparisons, a central government will provide a standard chart of accounts29 that all local level budgeting units must adhere. However, as the backbone of local government finance, the chart of accounts is often ill-defined. In Croatia, for example, the Ministry of Finance does not prescribe the classification of the budget by cost type or by function. Instead, expenditures are classified only according to administrative categories (i.e. budgetary beneficiaries and purposes) and no classification of expenditures in terms of programs, sub-programs, or

28 The Chart of Accounts must be designed in a collaborative manner between the budget and accounting departments. 29 A Chart of Accounts is a listing of all accounts in the general ledger, each account accompanied by a specific reference number. To establish a chart of account, one needs to define the various accounts to be used by the local government. Each account should have a number to identify it. For small local self- governments three (3) digit level account numbers may suffice as an account identifier. With more digits, new accounts may be added while maintaining the logical order.

28 categories or activities is provided.30 Obviously, in the case of Croatia, the system makes only the most rudimentary analysis of the budget impossible.

6.2 Why are Strong Local Government Accounting Systems Important?

National and subnational governments are increasingly competing for international financial resources (capital). Strong accounting and public expenditure management systems provide a competitive advantage for subnational governments that install and effectively utilize these systems. Without a strong accounting system based on International Accounting Standards (IAS) or Generally Accepted Accounting Principles (GAAP), information provided to private sector institutions (investors) will not be timely, relevant, complete, or comparable.

6.3 Cash versus Accrual Accounting

One of the most fundamental decisions in designing an accounting system is the basis on which the transactions will be recorded. Several accounting methods are recognized by the International Federation of Accountants: cash, modified cash, modified accrual, and accrual. Basic elements of cash and accrual and modified accrual accounting are described in the sections below.31

Cash Accounting32

The simplest of all accounting procedures is to record cash transactions: how much is received; how much is paid out; and, how much is on hand at the bank. In effect, revenues and transfers are not recorded in accounts until cash is received, and expenditures (or expenses in proprietary funds) and transfers out are recorded only when cash is disbursed. The benefit of cash basis accounting is that it is relatively simple to implement, but where there exists a strong parallel encumbrance system, cash basis accounting fails to adequately control local government transactions.

The cash basis is not recommended by GAAP because it usually gives a misleading picture of municipal accounts. For example:

. Cash received as a loan would be illustrated as revenue on the operating statement but not as a liability on the balance sheet.33 To correct for this kind of transaction, most cash accounting systems recognize not only cash, but also other assets and liabilities arising through prior cash transactions. The accounting correction however, does not alter the fact that at any point in time, outstanding obligations,

30 See Hogye Mihaly and Charles Mc Ferren Local Government Budgeting: The CEE Experience in Michaly Hogye (Editor) (2002) “Local Government Budgeting.” Open Society Institute Budapest, Hungary Page 51 31 Regardless of the accounting system used (accrual or cash basis) it is essential that local government financial accounts be timely and accurate. 32 For a more detailed discussion Michael Schaeffer “Municipal Budgeting Toolkit” 2000. 33 Cash basis accounting has serious limitations because it does not adequately record liabilities, either to provide future services or in recognition of services or goods received for which the bill has not been paid.

29 in the form of contracts or purchase orders issued, are not reflected in the accounting records. Consequently, the available balance is overstated. This can lead to unwise local municipal expenditures and potential budget overspending.34

. Local governments operating strictly on a cash basis by way of example may ignore obligations to vendors for services and goods received but not yet paid. This type of action effectively creates a floating debt outside the normal financial management system.

. The treatment of costs that may have a multi-year benefit under a cash basis accounting system may also be somewhat questionable. For example, charging the full cost of an item against the budget in the first year of its use may overstate the expense in the first year, but understates the expense in subsequent years. This may lead to local government decision making that in the near-term may appear good, but in the long-term may be more costly.

. Cash basis accounting does not permit the preparation of a balance sheet illustrating the assets and liabilities of local governments. This inability to present a balance sheet implies that the net worth of the local government cannot be presented. The balance sheet is effectively the cornerstone of the capital budget.

Cash basis accounting is sometimes modified to include accruals that will be received or due in the period directly following the end of the reported fiscal period. Bills that are expected to be paid in the month following the fiscal year would be accrued as would receipts that were certain to be collected in the following month. However, longer term receivables, or commitments that might be received or paid out several months into the next fiscal year, would not be reflected in the financial accounts of the local government.

Accrual Accounting

To resolve this problem many of the problems associated with cash accounting, accrual accounting35 has been advocated at various government levels. In order to understand what is actually happening in local government accounts, there must also be records that relate revenues and expenditures not to the time in which the cash is received or the disbursement made, but to the period for whose benefit the transaction occurs. Financial recording according to the benefit period, instead of the period in which cash moves, is known as accruing (accrual accounting). Under an accrual system, revenues

34 All accounting systems must include such cash records, but cash journals and ledgers by themselves do not constitute accounting or budgeting systems. This is because cash records do not indicate the time period to which a given transaction relates. The cash from receipt of a prior year receivable cannot be distinguished from receipt of revenues due for the first time, nor can disbursement on an expenditure account incurred this year be distinguished from a liability held over unpaid from the prior year. 35 Accrual reporting recognizes expenses incurred during the year, even if the expenses were not paid for and links the annual financial statement directly with changes in assets and liabilities in the local government’s financial position.

30 are recorded when the charge is effective not when the cash is received36. Expenditures are recorded when the obligation is incurred, irrespective of when the disbursement is made.37

Accrued revenues are usually expended on the assumption that the cash owing will be received. In fact, there may be loses. Taxpayers may dispute the amount owed, and the terms of grants and other transfer payments may be changed after the local government has already budgeted and spent the money. Likewise, expenditures when originally recorded may be over or under the amounts finally determined to be due. Contingencies should be provided for by means of reserves (contingency) accounts against ultimate losses and unrecorded liabilities.38

Accrual accounting involves changing three existing financial features of current local government financial operations including:

. Shifting the recording basis from cash to commitment;

. Separation of financial activities into current and capital, with full depreciation allowances that permit the allocation of costs over the life of the asset rather than recording the expenses when they are incurred; And,

. Preparation of financial statements that are in conformity with International Accounting Standards (IAS) or Generally Accepted Accounting Principles (GAAP).

Preparation of financial statements according to IAS or GAAP implies that local governments must prepare a balance sheet, operating statement, statement of cash flows and a statement of commitments and contingent liabilities. These statements will enable the local government to understand its net worth and provide the basis for making future investment decisions.39

36 Obviously, there are relatively few revenues that can be accrued in the technical sense – property taxes, some franchise taxes, and fiscal aid. Revenues not susceptible to accrual are in practice booked as cash received. It is important that accurate distinction be made between current year, prior year, and future year transactions. 37 The accrual basis is applied somewhat differently in proprietary funds (full accrual) than in governmental funds (modified accrual) because expenses are being measured in proprietary funds while expenditures are the focus in government funds. In brief, an expense is an amount of resources used up during the accounting period. Specifically, an expenditure is an amount of cash spent, or to be spent during an accounting period. Since governmental funds do not account for capital and debt (they are accounted for in fixed asset and long term debt account groups), expenditures, not expenses are measured. In contrast to government funds, the concern in proprietary funds is with net income. Full accrual accounting is used to record revenues when earned and expenses when incurred. In other words, expenses are recorded when a liability is incurred regardless of when an actual payment is made. 38 There are two means of establishing reserve accounts. One is to establish these accounts at the beginning of the fiscal year, when the budget anticipations and appropriations are entered as controls for the budgetary accounts. The other is to establish or adjust reserves during, at the end, or after the close of the fiscal year. 39 Accrual accounting remains a distant goal for many national, state, and local governments.

31 Modified Accrual Accounting

In modified accrual accounting, most transactions are accrued in the period in which the benefit is received. Other transactions, especially revenue are recorded on a cash basis. As a general rule, in modified accrual accounting, expenses are accrued and income from taxes, fees and other sources are recorded only when collected (cash basis). The net effect of modified accrual accounting is to bring income in line with actual cash available to pay bills, while at the same time ensuring that the recording of expenses cannot be manipulated by delaying until the bill is paid.

6.4 Deciding on an Accounting System

Local government decisions with respect to designing an accounting system should be focused strictly on one goal – providing the best information that will allow local government decision makers (and, the public) to manage public resources under their control in an effective and efficient manner. Too much detailed information can be expensive to collect. However, too little detail can mask emerging problems. The amount of detail required should be matched at the operating level. Local government line managers require significant detail so that they can manage resources effectively and spot problems as they emerge (and, take corrective action).

The use of modified accrual or accrual accounting in addition to mandatory cash basis accounting is continuously being debated in many countries (i.e., India, Croatia etc.). Until accrual accounting systems become a legal requirement none of the scarce financial or human resources available at the local government level will be used to implement such a system. There are substantial limitations to cash basis accounting. However, do these limitations imply that local governments should completely abandon cash basis accounting and budgeting for modified accrual or full accrual accounting?

Many countries, prompted by international donors and advisors are rushing towards modified or full accrual accounting systems. Accounting requirements largely depend on the nature of various programs or agencies. A modified (or full) accrual accounting system may be needed for some agencies or local governments that deliver services or has commercial activities, while for other local governments or agencies a cash based system and budgetary accounting could be satisfactory.

It is important to remember that moving from cash based accounting system(s) to modified or accrual accounting systems requires changes in the organizational flow of local government institutions and a general increase in local government capacity. Often times, it is far more effective to improve the quality of cash basis budget and accounting procedures than to convert to newer more time consuming systems. The primary importance of any local government accounting system is that financial information is transparent and is produced in a timely manner. The only essential feature of any budgetary accounting system is that complete budgetary accounting (or appropriation accounting) is the common denominator of every accounting system. In other words, all accounting systems should track appropriations, supplementary estimates, and the uses of

32 appropriations (i.e. release of funds, commitments, expenditures at the verification stage, and payments). For many local governments in developing countries, it is more important to provide assistance in improving their cash basis accounting systems rather than transitioning them to modified accrual systems. For other local governments with more informational requirements, it is fully acceptable to utilize modified accrual accounting practices.40

6.5 Financial Reporting

Financial reporting is one of the most important outcomes of the accounting system. Financial reporting is the process of compiling and organizing financial information into meaningful (transparent) reports to appropriate decision makers. Internal and external financial reports should be issued on a timely basis.

What type of financial information should a local government issue? External reporting by local governments should include three basic financial statements including: balance sheet, income statement (or statement of operations) and cash flow statement. Few local governments are able to issue these statements on a timely manner. For many local governments, the single most important financial statement to issue is an income statement indicating all municipal revenues and expenditures. When conditions allow, many local governments may feel comfortable issuing a simple balance sheet including liquid assets and liabilities. It is also essential that local governments include simple budget reports in their normal reporting cycle so that local citizens can access and understand the financial condition of the local government.

Internal local government reports generally vary across countries. However, one of the most common reports compares actual revenues and expenses with budget revenues and expenses. These reports should be issued at the lowest level of government and subsequently rolled up to the department level and municipal government level. These types of reports generally serve the needs of local government department heads. For example, a department manager should be able to access data by program, and individual operating unit or cost category.

6.6 Appropriations Control

As a general theme in public financial management, reviewing (checking) and control refer to mechanisms employed by local governments to ensure public money is spent in the manner that has been assigned and in the amount specified. In recent decades, a new trend has been to increase the discretionary power of officials, especially front-line (department) managers to improve the efficiency and effectiveness of government programs. Financial reporting to taxpayers and other interested parties is a natural extension of the internal checking and control systems.

40 Full accrual accounting may be beyond the scope and informational requirements that many local governments need to successfully run their locality.

33 Appropriation controls are specific spending authorizations derived by consensus between the chief executive of the local government and the council. Many appropriation controls specify down to the line-item, leaving no room for managerial flexibility. However, there are other appropriation control specifications that provide line mangers with a substantial degree of independent discretion. Each community must decide where the appropriate spending authorization line should be drawn. The appropriations controls should be well-stipulated in the rules guiding local department spending.

6.7 Auditing

Financial reporting must faithfully represent the financial condition and debt position of local governments to be useful. Auditing is the systematic process of verifying the reliability of financial reports and the appropriateness of the underlying financial activities. By definition an audit is an examination of systems, procedures, programs and financial data. The end product of an audit is a report issued by an independent auditor describing how well a municipal government’s financial statements describe its financial conditions and the results of its operations.41

In general a government’s audit report should: i.) Analyze the financial position of the local (State) government, including trends, quality of receipts (revenues) and expenditures; ii.) Evaluate the performance of the government on various financial management and accounting issues; and, iii.) Include audit observations on aspects such as irregularities and non-observance of rules and regulations, unnecessary (or wasteful) expenditures, and inefficiency, delays and non-achievement of objectives with respect to budget implementation.

Auditing and the Local Government

With respect to the auditor, responsibility for the audit function of local governments can generally be found at three (3) different levels: i.) the local government; ii.) central audit office; and, iii.) external private auditing/accounting companies. Every country has some form of formal requirement for the establishment of an internal audit function at the local self-government level. However, Croatia, for example, qualifies this requirement by stating that, despite the requirement, “…there is no organized internal control. The basic reason is the lack of qualified staff.”42 In effect, the primary audit control for local governments remains very centralized.

What exactly is audited when a local government budget is audited? Is it just the financial statement of the local government (i.e., municipality, urban local body) that is

41 There are three principal types of audit: compliance audit; management audit; and, program audit. A compliance audit determines if the local government has acted according to the applicable federal, state and local laws, regulations policies and procedures. A management audit determines if the local government is performing in an economical and efficient manner, identifies problems, and makes recommendations for improvements. A program audit determines whether the intended result of a local government activity is being achieved. 42 See Hogye Mihaly and Charles Mc Ferren Local Government Budgeting: The CEE Experience in Michaly Hogye (Editor) (2002) “Local Government Budgeting.” Open Society Institute Budapest, Hungary Page 63

34 audited? Or, are the affiliated entities (i.e. the water utility etc.,) of the local government also audited? Oftentimes, what is audited at the local government level differs by locality or Country. For example, in some countries various off-budget units (i.e. water utility, solid waste management departments) are viewed as separate legal entities incorporated under the relevant commercial law. In this case, the audit function depends almost solely on the decision of the board of directors with no direct State (or, local self-government) involvement other than that of an ordinary shareholder participating in the board elections. Even if these off-balance sheet entities are incorporated under commercial law, they still can (and should) be viewed as part of the local government’s (or State’s) assets and therefore should be subject to outside audit by a government office.

Shortcomings in Local Government Audits

Several short-comings with respect to audit practices in developing countries generally emerge.

. The audit appears to be principally oriented towards reviewing transactions rather than performance or systems. Audit observations on individual transactions or programs are useful. However, it may be difficult for local (State) government officials to easily evaluate the nature or severity of the issues being highlighted based on these individual observations alone.

. In general, developing country audit practices do not focus on a systematic review of the effectiveness of the internal control system(s) and its various components within which individual transactions are recorded. And,

. In some cases an appropriate certification of the financial reports (annual accounts) is not provided. Further, in many cases, the audit report inadequately highlights distortions in the annual account.

Even when the audit report highlights some distortions in local government financial practices, there may be a general lack of responsiveness and actions undertaken to audit observations. Some of these shortcomings can be overcome by building local government and staff capacity, establishing uniform and transparent financial management and accounting (auditing) procedural norms, and standardizing local government financial information systems thereby enabling more effective internal (and external) auditing.

Prerequisites for Effective Auditing

The International Organization of Supreme Audit Institutions (INTOSAI) has developed standards for the audit of government organizations and operations. These standards should be adopted by all government audit organizations around the world. The most important standards are those dealing with the following:

35 . Independence: The independence of a government auditing agency is essential to ensure that its work will not be biased by a relationship it might have to the entity being audited.

. Professional Skills: Auditing is a profession that requires a wide range of technical skills. In most countries, the ability of these skills is evidenced by some sort of certification.

In many countries the independence of the Supreme Audit Authority (SAA) may not be genuine. The statutory basis for the SAS should be clear. The SAA should have its own budget and staff, and authority to determine the scope of the audits. Not only the organization itself, but individual auditors themselves must be independent with respect to audits. However, in many countries there is no ‘fire-wall’ between the auditor and the audited local governments. Where this occurs, local governments should be subject to the same standards as all other government entities, but that the audit function could be assigned to a skilled local accounting / auditor practitioner.

7 The Treasury System

Governments need to ensure both efficient implementation of their budgets and good management of their financial resources. Financial management within the government includes various activities, including: formulation of fiscal policy, budget preparation; budget execution; management of financial operations; accounting; and auditing and evaluation.

7.1 General Responsibilities of the Treasury

Within this broad financial management function, the treasury function is set to achieve these specific objectives mentioned above. In brief, the treasury function covers the following activities:43

. Cash management;

. Management of bank accounts;

. Financial planning and forecasting of cash flows;

. Public debt management;

. Administration of grants and transfers; and,

. Financial asset management.

43 This section is based partly on Teresa Ter-Minassian, Pedro P. Parente, and Pedro Martiniez Mendez, “Setting up a Treasury in Economies in Transition.” IMF, 1995.

36 To carry out these activities, organizational arrangements and distribution of responsibilities vary considerably across countries.

It is generally accepted that governments must have an agency responsible for its financial management. However, a review of international experiences shows that treasuries assume a variety of responsibilities within the gamut of functions encompassed by government financial management. In general, the primary mandate of a treasury is to assure the optimal financial management of government resources, by ensuring that spending agencies are provided, in a timely manner, with the resources needed for a smooth provision of public services, while minimizing the cost of government financing.

Treasuries may be established at the center or federal level of government, but in a number of (especially federal) countries, state or regional governments have their own treasuries, independent of the national treasury. The development of sound treasury systems, both at the central (or federal) as well as at the subnational level of government, is seen as an integral part of transparent and accountable good governance practices.

7.2 Overview of Local Government Cash Management Operations

The role of many local government cash management operations appear to be limited to issuance of monthly limits, commitment control, and cash payments for state agency budget expenditures. In general, cash management practices (triaging payments) deliver effective cash outflow control, but to some extent undermine budget policies, adversely affecting suppliers and service delivery, and often lead to arrears. Measures to establish, develop, and improve treasury operations are needed to better meet fiscal targets, support program service delivery, and gather better information for control and analysis. Through full implementation of a treasury, budget oversight will be improved to allow in-year management of spending, and budget classification should be enhanced to support transparency and the introduction of a performance orientation.

In brief, local government level budgeting and financial reporting systems generally face the following issues, including: i.) Lack of strategic vision in the budget preparation process; and, ii.) Inadequate reporting and budgeting of public service enterprises. There is generally sufficient access to comparative financial information. However, the use of this comparative data is somewhat limited. These abovementioned issues are linked. In the absence of a clear strategy for local government level service delivery, service performance criteria cannot be identified (without performance indicators). Hence, no measurable service goals and standards can be quantified.

7.3 Cash Management

What is cash management? Cash management has the following purposes including: i.) Controlling aggregate local government spending, ii.) Implementing the budget efficiently, iii) Minimizing the cost of borrowing; and iv.) Maximizing

37 opportunities (and, efficient utilization) of local government resources.44 Too often, cash management is viewed as simply the disbursement office for local governments rather than the office which is responsible for managing the flow of public sector resources.

It is essential that cash management activities support the overall fiscal policies of the local government as expressed in the budget and the operational plans of each executing unit. Efficient budget implementation requires that any claims on the government be paid. Oftentimes legal restrictions or the untimely payment of intergovernmental transfers, in many countries prohibit local cash management operations from engaging in similar activity.

The options available to cash managers vary depending on the legal framework in which the local government operates and its ability to generate its own resources. National governments can use short-term borrowings to smooth out their cash flow and long term borrowings to finance multi-year investment projects. However, these options may not be readily available to local governments. To achieve the goal of fluid cash flow management, local governments must be proactive in consolidating their cash resources and in planning for future required cash disbursements. A fundamental element underlying a good cash management system is the ability to develop effective cash flow projections based on anticipated expenditures and receipts.

Controlling Cash Flows

Cash flow management implies minimizing the interval time when cash is received and the time that it is available for financing expenditure programs. What does it mean to effectively minimize the interval time between cash inflow and outflow and thereby minimize the cost of idle cash? Most people are familiar with the interest (and, other costs) associated with borrowing money. There is considerably less familiarity associated with the cost of holding idle cash or failing to engage in liquidity matching (matching the timing of revenues with the timing of expenditures). In order to maximize interest returns, effective cash management stipulates that excess cash resources would be invested in overnight accounts.

While there is a real economic and financial cost to holding idle cash, there is an even greater cost to local governments to not having sufficient resources on hand to pay expenses in a timely manner. These costs can take several forms, including:

. The interest costs of borrowing funds to meet required payments. And,

. Borrowing from vendors by delaying payments may have hidden costs.

Although borrowing from vendors by delaying payments may appear to be interest free, they actually may carry very high costs. The vendor may refuse to do and further business with the local government. The vendor may charge a premium price in

44 Teresa Ter-Minassian, Pedro P. Parente, and Pedro Martiniez Mendez, “Setting up a Treasury in Economies in Transition.” IMF, 1995.

38 the future in order to cover the cost of capital tied up in receivables to the local government.

The Cash Management Cycle

The cash management cycle begins with budget preparation when resource inflows and outflows are scrutinized according to local government priorities. Regardless of the accounting basis (e.g., cash, accrual) the cash management function begins with the preparation of a cash flow projection based on the approved budget.

Cash flow projections should be developed using a bottom-up approach based on inputs from the various operating departments as to the timing of the cash resources needed to execute various programs at their approved funding levels. Arbitrarily dividing the annual budget into equal tranches (e.g., monthly, quarterly) can result in some departments of government being cash starved at critical points in their service year and others having an excess of spending authority. Front loading of cash requirements can be avoided by allowing individual departments to make quarterly adjustments to their proposed cash flow so long as the total amount does not exceed the funding levels submitted in the approved budget.45

Local government treasurers can ensure more effective cash management by:

. Establishing written procedures for certifying payments and transferring payment requests to cash management.

. Continuously updating cash flow projections.

. Developing payment schedules that allow individual departments to track their payment requests. And,

. Establishing standards and procedures to assure that expenditures are paid within the stipulated time frame and the all government obligations are paid when due.

Single Bank Accounts

On element of cash management that is central to effective local government cash management ability is the use of a single local government bank account. A single bank account allows the cash resources of the local government to be managed as a whole.46 When a local government single bank account is opened, subaccounts are generally opened for various departments or projects depending on need.47 For many local governments, subaccounts may not be necessary because of there relatively small size. In

45 More frequent adjustments can be made. However, it is advisable that any cash management (and, adjustment) rules be clearly stipulated. 46 A single bank account with several subaccounts is a fundamental prerequisite for effective local government cash management. 47 In deciding whether a subaccount should be opened, the cost of managing the subaccount should be weighed against the benefits of segregating expenditures by department of project.

39 larger local governments with a larger number of departments or autonomous units, subaccounts may be necessary. Using a single account means that cash will not lie idle in one unit’s account while another unit in the same local government cannot pay its bills. In addition, transaction costs associated with shifting funds from one subaccount to the other are eliminated.

Cash Collections

The manner by which local governments engage in cash collections varies depending on the condition available to the local government. Underlying an effective cash management philosophy is the principal to move funds as quickly as possible to incorporate them into a single account. For larger local governments one avenue is to use a commercial bank network to collect funds.

By virtue of the banking sector infrastructure, commercial banks are often able to collect revenues more efficiently than local government tax offices. Designated banks serve as collection points for the periodic deposit of taxes and other revenue (e.g., fees and charges) from the public. Collections are then transferred via the central clearing function from the bank’s account to the local government. In effect, the local taxing authority is left with the task of just focusing on tracking taxpayers.48

7.4 Linking Budget Implementation and Cash Plans

The local government budget provides the cash management function with the community’s spending plan for the year. The budget is the starting point from which the cash management function begins to develop cash flow projections for the fiscal year. These cash flow projections must be continuously updated and revised as the budget year unfolds.

Cash flow projections cannot be undertaken in isolation of the local government’s operating units nor should be done arbitrarily by simply dividing expenses into equal tranches. Instead, cash flow projections should be based on (bottom-up) inputs from the various expenditure agencies as to the expected timing of their cash needs.49 Cash flow planning must be undertaken in advance of the budget year and must be communicated to the various spending agencies in advance in order to ensure effective budget implementation. In addition, reducing uncertainty with respect to the local government’s debt repayment program can in many cases be rewarded with lower borrowing charges.

48 Other techniques are used in some countries. For example, the postal system is often used to pay and receive funds. In other countries, a common collection point for local government taxes and fees include supermarkets (Panama). 49 For this actual experience from the previous fiscal years can be used. But this may not be sufficient. Each operating unit head should also develop forward looking forecasts of projected cash flow requirements.

40 7.5 Financial Health and Stability50

In order to maintain good budget and effective cash management practices, the local government finance department should take primary responsibility for protecting various departments from the vagaries of the government’s cash position, and ensuring that liquidity constraints do not prevent departments from spending their budgets. In order to more effectively manage, some governments have moved to a system of semi- annual or quarterly allocations (releases) to departments. Other measures to institutionalize good financial and cash management include adopting structured cash planning processes, ensuring the availability of timely and reliable information on cash position, and better monitoring and reporting.

7.6 Managing a Crisis

This section introduces several measures to institutionalize good cash management practices and to effectively management government fiscal stress. These measures include:

. To manage fiscal stress, the government should use budget expenditure cuts rather than engage in cash rationing. Cuts in expenditure and cash rationing are both painful, but expenditure budget cuts are less ad hoc and provide for more predictability than cash rationing.

. Forecast expenditure cash needs over the year, as well as cash availability. Use these to prepare (rolling) quarterly cash forecasts. And,

. Identify measures to handle cash liquidity problems and timing mismatches of revenue and expenditure streams. Ensure that there is a structured payment system that matches inflows and outflows.

8 Sequencing of Financial Management Reforms

There is increasing demand and expectation that local government financial management systems produce meaningful financial data to evaluate program plans, budgets, and performance as well as to support a broad array of local government management decisions. This can only be realized in an integrated local government financial system framework that recognizes the full scope and dimension of local governments, including:

. The necessary information and data;

. The applications and services that deliver the information and data;

50 Improving debt and investment management are also vital areas for improving financial health and stability.

41 . The technology that supports those applications and services; and,

. An understanding of the functions, and the reporting requirements of local governments.

The vision for local government financial management, budgeting and accounting systems is a single integrated financial infrastructure with standardized applications and services that are supported and enabled by integrated local government financial management data and information. Best practice local government financial management systems must ensure accountability and control of resources, and produce accurate consistent, timely and useful financial and program information to measure performance and inform decision makers. Figure 1 illustrates the local government financial management and accounting process and information flow.

42 Figure 1: Framework for Local Government Financial Management

Management Information and Decision Support Feeders: Local Service Feeders: Local Financial Government Delivery Information: InformationGovernment Core Financial Functions Financial SystemsInformation Funds Management Statements HRSystems & Payroll General Ledger Management Financial Reports BenefitsHR & Payroll Benefits Cost Management Budgeting Travel Payment Management AcquisitionTravel Budget and PropertyAcquisition Receivable Management Performance ManagementProperty Reporting Integration InventoryManagement Human Capital RevenueInventory Management GrantsRevenue LoansGrants Program InsuranceLoans Management OthersInsurance Chart of Performance Others AccountChart of / Measurement Resource Cost Data Mining and Mapping AccountingAccount / Data Mining and Mapping Accounting Accounting Life Cycle Management

Planning and Decisions Support Strategic Planning Annual Performance Report Fee Setting Competitive Sourcing

The framework for local government financial management is relatively complex. Where does one start the process for effective local government financial reform? What is an appropriate sequence of steps?

1. Chart of Accounts The chart of accounts represents the basic structure of municipal financial accounting and financial transactions. It is essential to have a well-designed chart of accounts that provides a logical structure for classifying

43 financial transactions so that financial data can be viewed from a number of perspectives.

2. Accounting is fundamental to the stewardship of the local government funds. The purpose of account is to record financial events and ensure accountability as required by law. Accounting data must also provide the basis for program performance measurement. Accounting data must be linked to performance measurements through assignment of costs to departments, programs, projects or activities.

3. Local Government Fiscal Discipline If you can’t count the money, you can’t allocate it, and if you can’t allocate it, you can’t manage it.51 Local government fiscal discipline comes as a primary step, prior to resource allocation and general operational efficiency, in those local governments with weak revenue forecasts and cash management systems.

Treasury and Budget Systems are inextricably linked. In effect, none of the expenditure control and cash management objectives should be pursued in isolation of the other. Improvements in one or another area can and should go forward as and when circumstances permit. A coherent multi-year vision of the entire local government financial reform process is needed to establish effective local government financial management operations and to prevent progress in any one area from so getting out of line as to compromise progress in any other area. Any local government reform process should be viewed in light of its impact on the entire financial management system.52

9 Conclusions

Many differences across countries in the process of local government budgeting are the result of the varying structural relationships existing among the different levels of government. In addition, budget systems include a wide range of supporting services including accounting, budget examination, reporting and evaluation, and effective treasury management systems and operations. If any of these components are not adequate, the local government financial management and budgeting system is unlikely to perform well.

51 Salvatore Schiavo-Campo and Daniel Tommasi (1999) “Managing Government Expenditure” Page.5. 52 Schiavo-Campo and Tommasi (1999) state that with respect to sequencing of public expenditure management reforms in general that it is essential to design and implement improvements that do not jeopardize improvements in sectoral allocation and resource allocation that must eventually follow; and, have a clear ex-ante sense of how far to push improvements in expenditure and cash control before it becomes timely and necessary to address strategic allocation and management issues.

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