Framework For Effective Local Government Finance World Bank

Framework For Effective Local Government Finance World Bank – Public Sector Management Thematic Group Michael Schaeffer March 2005

The ‘Quick Start’ Framework • Components of Effective Local Government • • • Finance A Shift in the Nature of Local Government Budgeting The Capital Budget The Role of Financial Reporting and Accounting The Treasury System Sequencing of Management Reforms 2

Essential Components: • Control Structure Derived From Legislative • • Framework A Standardized Chart of Accounts / Accounting System An Effective Treasury and Cash Management System Internal / External Reporting Effective [Timely] Budget and Reporting System 3

An Effective Financial Management System 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 Chart of Accounts Accounting Systems Transparent/ Accountable (External / Internal Audits) 4

Shift in the Nature of Local Government Budgeting “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 5

Framing Local Government Policy Budgets are Fundamental for Meeting Three Important Policy Objectives: 1. Aggregate Fiscal Discipline; 2. Allocation of Resources [Consistent with Strategic Policy and Priorities]; And, 3. Efficiency and Effectiveness 6

Local Government Budgets: In Theory and Practice Good Budget Practices Comprehensive Disciplined Legitimate Flexible Predictable Contestable: Subject to review and evaluation Honest Information must be accurate and timely. Transparent: Information about budget practices must be accessible and communicated to a wider audience. Accountable: Decision makers must be held responsible for the exercise of authority provided to them. Source: Public Expenditure Management Handbook (1998) World Bank Poor Budget Practices Unrealistic Planning and budgeting Short-term budgeting with no medium or long-term implications Numerous budget revisions throughout the year Government spends as cash becomes available not according to preset priorities Deferred budgeting: Arrears build-up as expenditures are pushed into subsequent years. Distorted priorities. Informal management: Extralegal behavior dictates how government operates with respect to hiring and procurement etc. , Corruption: Lack of enforcement of formal rules breeds illegal behavior (corruption). Source: A. Shick (1998) A Contemporary Approach to Public Expenditure Management. World Bank Institute. 7

Effective Financial Management and Budgeting • Set of Activities Where Intentions of Local Government • • • Managers and Politicians Becomes Operational One Mechanism to Determine Local Government Performance is Audit Performance Based Local Government Unit [LGU] Financial Management Necessitates a Change in Local Government Financial Management and Organization Must Produce Information in an Integrated Manner – Budgeting, Accounting, Cash (Treasury) and Debt Management Must be Linked 8

Working Within Proper Legal Environment • Detailed Rules with Respect to Local Government • • • Budgeting, Accounting, Cash And Debt Management Internal / External Audit Responsibilities Should be Designated Role of Any Oversight Agency Should be Defined Jurisdictions, Level of Autonomy, and the Components of Local Government Financial Management Systems Should be Spelled Out 9

Perspective on Budgeting • Establish Clear Operating Procedures Between • • • Management Sections of Each Implementing Department Limit Programmatic Classifications to Only What is Necessary for Effective Decision-making Simplify and Limit Account Classifications Match Budget Authority with Operating Level Codify Budget Procedures in a Manual Develop Performance Measurements that Can Be Used to Measure Efficiency / Effectiveness 10

Budget Formulation and Adoption • Local Government Budget Should include the Following: – Program Elements Should Be Limited / Meaningful – Present Multi-Year Data to Include Prior, Current and Forecast – Include all Units that Require Government Resources in the Budget Formulation Process 11

Revenue Mobilization and Forecasting: • Two Principles: 1. 2. • • • Own-source Revenues Should Be Sufficient to Enable LGUs to Finance all Locally Provided Services From Own Resources To Extent Possible, LGU Revenues Should Be Collected at the Local Government Level Most Basic Forecast – Use Revenues From Current Year Increased By a Growth Factor Better to Use Information on Forecasted Tax Bases and Planned Rates to Explicitly Calculate What is Legally Collectible Should Use Information on Tax Compliance Levels to Determine Likely LGU Revenues 12

Expenditure Forecast and Control • LGU Budgets Should Be Examined For • • • Conservative Characteristics Appropriations Should Be Fixed at Levels Determined By Best Estimates of Available Work, Services, and Price Levels For the Year Local Population [and, Legislature] Have Right to Know LGU Policy Objectives and Targets Informing General Public Increases Transparency, Accountability, and Allows For a General Consensus to Be Reached 13

Budget Execution and Expenditure Control • Key Elements For Consideration in The Financial Management of Budget Implementation: – Provide Guidelines For Re-programming Budget Line Items – Re-programming Requiring Higher Level Approval Should Only Be For Shifts Between Major Line Items – Establish Clear Procedures for Committing Funds – Establish Clear Procedures for Distributing Allotted Budget Authority on a Quarterly [Monthly] Basis – Quarterly Budget Allocations Must Be Made in Conjunction With Aggressive Cash Management 14

Factors Influencing Escalating Expenditures • Soft Budget Constraints • Fragmented Approaches to Budgeting • Creating Future Expenditure Commitments By Under provisioning • Lack of Transparency • Systematic Errors in Budget Forecasting 15

The Capital Budget • Concerned With Creation of Long-Term Assets • Organized Along Multi-Year (5 -Year) Capital • • Investment Plan Financing of Investments Often Requires a Different [More Complex] Set of Capacities Officials Also Need Skills to Procure Construction Services in a Cost-Effective, Open Manner 16

Structure of Capital Budget • Inventory of Capital Assets • Multi-Year Capital Investment Plan (CIP) • Financing Plan 17

Structure of a Capital Budget Revenue (Receipts) Expenditures I. Taxes and Property Earmarked for Capital Projects I. Acquisition of Existing Assets 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 Domestic Accounts Maintained by the Government External Repayment of Loans III. Capital Transfers to Other Levels of Government Transfers to Public Sector Enterprises IV. Depreciation Allowances IV. Repayment of Loans V. Sale of Property VI. Capital Grants Source: A. Premchand (2000) “Capital Budgets: Theory and Practice. ” 18

Determining Capital Expenditure Resource Allocation • Used in the Production [Supply] of Goods and Services [Productivity Criteria] • Life Extends Beyond a Fiscal Year • Not Intended For Resale in the Ordinary Course of Operations 19

Number of Capital Projects that LGU Can Finance, Depends On: • Level of Recurring Future Operating Expenditures • Cost Recovery Elements • Availability of Cost Sharing By Different Tiers of Government [or PPP] • Debt Structures and Instruments 20

Capital Budget Issues Functional Area Issues I. Project and Investment Appraisal 1. Need to apply uniform and consistent guidelines • Analysis techniques in many countries are qualitatively deficient. • Analysis studies may lend themselves to manipulation and often become studies designed to support decisions already undertaken. II. Funding Arrangements 1. Centralized Borrowing Centralized borrowing may lead to resource fungibility and the 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. Medium Term Rolling Plans 2. Contingent Liability and Associated Risk Management Should be Part of the Budget Decision Making Process 3. Risk Assessment IV. Budget Implementation 1. Release of Funds 2. Underfunding 3. Payment 1. Possibility of Contributing to Budgetary Rigidity 2. Most Local (State) Budget Systems Have no Mechanism For this Purpose. Some Countries Have Initiated Efforts to Pass Legislation and Associated Regulations. 3. Changes in Interest, Inflation (and, Exchange Rates) Pose Serious Implications for the Financing of Self-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. 1. Capital Projects Have Their Own Seasonality of Expenditure Flows. Each Project May Have Its Own Distinctive Requirements. Funding, Budgetary 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) 21

Role of Accounting and Financial Reporting • Accounting is Systematic Gathering of Financial Transactions • Compiling and Reporting of Transactions in a Meaningful and Systematic Manner 22

Unified Chart of Accounts • Represents Basic Structure of Municipal Financial Accounting • Must Include all Categories of Assets, Liabilities, Revenue and Expenditures, And Equity Accounts • Provides a Logical Structure For Classifying Transactions 23

Accounting Treatments: • Cash: – Simplest of All Accounting Procedures – Records How Much is Received – Records How Much is Paid Out – Records How Much is in the Bank – Simplest to Implement – However, May not Provide for Adequate Controls on LGU Transactions 24

Cash Accounting: Not Recommended By GAAP • Cash Received as Loan Illustrated as Revenue on Operating Statement not • • as Liability on Balance Sheet To Correct: Most Cash Accounting Systems Recognize not only Cash, But Other Assets and Liabilities Arising Through Prior Cash Transactions. Does Not Alter Fact that Outstanding Obligations In the Form of Contract or Purchase Orders are Not Immediately Reflected In Accounting Records records. Available Balance May Be Overstated Can Lead to Unwise LGU Expenditures and Potential Overspending LGUs Operating on A Cash Basis May Ignore Obligations to Vendors For Services Received [But Not Yet Paid] This Type of Action Creates A Floating Debt Outside the Normal Financial Management System Cash Basis Accounting 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. 25

Accrual Accounting • Relates Revenues and Expenditures Not to the Time in • Which the Cash is Received or Disbursement Made, But To the Period For Whose Benefit The Transaction Occurs Involves Shifting Existing Financial Features of Current LGU Financial Operations – – – Shifting the Recording Basis From Cash To Commitment Separation of Financial Activities into Current and Capital Include Full Depreciation Allowances that Permit Allocation of Costs over the Life of The Asset Rather Than Recording Expenses When they are Incurred – Preparation of Financial Statements in Conformity with International Accounting Standards (IAS) or Generally Accepted Accounting Principles (GAAP) 26

Modified Accrual • Most Transactions are Accrued in the Period in Which • • Benefit Received Other Transactions – Especially Revenue are Accrued on a Cash Basis General Rule: – Expenses are Accrued – Income From Taxes, Fees, and Other Sources are Recorded only When Collected (Cash Basis) • Net Effect: 1. Bring Income in Line With Actual Cash Available to Pay Bills 2. Ensuring the Recording of Expenses cannot be Manipulated by Delaying Until the Bill is Paid 27

Deciding On An Accounting System • Moving From Cash to Modified, Accrual Systems Requires Changes in the Organization Flow of Local Government Institutions and Increase in LGU Capacity • Primary Importance of LGU Accounting System is that Financial Information Should be Timely, Transparent and Complete 28

Universal Features of Accounting Systems • Common Denominator: – All Systems Should Track Appropriations – Supplementary Estimates – Use of Appropriations • Release of Funds • Commitments • Expenditures at Verification Stage • Payments • May be More Effective to Assist LGUs in Improving Cash Basis Accounting First – Rather than Shifting to Other Accounting Systems 29

Financial Reporting • Process of Compiling and Organizing Financial • Information Into Meaningful Reports Financial Reports Should [In General] Include: – Balance Sheet [Not with Cash] – {However Can Use Simple Balance Sheet Recording Assets / Liabilities} – Income Statement – Cash Flow Statement 30

Auditing • Audit Report Should: – Analyze the Financial Position of the Local Government • Include Trends • Quality of Receipts [Revenues] • Expenditure Analysis – Evaluate Performance of Government on Various Financial Management and Accounting Issues – Include Audit Observations 31

Auditing and Local Government • Audit Function of Local Government Found at Three Levels – The Local Government Itself (Internal) – Central [Supreme] Audit Office – External Private Auditing Companies 32

Shortcomings In LGU Audits • Audit Oriented Toward Reviewing Transactions Rather than Performance • Do Not Focus on Systematic Review of the Effectiveness of Internal Control Systems • In Some Cases, Appropriate Certification of Financial Reports [Annual Accounts] Not Provided 33

Treasury System • Treasury Function Covers the Following: – Cash Management – Management of Bank Accounts – Financial Planning and Cash Flow Forecasting – Public Debt Management – Administration of Grants and Transfers – Financial Asset Management 34

What is Cash Management? • Controls Aggregate Local Government Spending • Implements the Budget Efficiently • Minimizes the Cost of Borrowing • Maximizes Opportunities for Using Government Resources 35

Controlling Cash Flows • Minimizing the Interval Time When Cash is Received and • • the Time Available For Financing Expenditure Programs Excess Cash Resources Should Not Be Idle LGU Treasurer Should – Establish Written Procedures for Certifying Payments and Transferring Payment Requests to Cash Management – Continuously Update Cash Flow Projections – Develop Payment Schedules that Allow Individual Departments to Track Payment Requests – Establish Standards and Procedures to Assure that Expenditures are Paid Within a Stipulated Time Frame 36

Framework For LGU Financial Management Feeders: Local Government Information Systems HR & Payroll Benefits Travel Acquisition Property Management Inventory Revenue Grants Loans Insurance Others Core Financial Functions Funds Management General Ledger Management Cost Management Payment Management Receivable Management Reporting Data Mining and Mapping Service Delivery Chart of Account / Accounting Management Information and Decision Support Financial Information: Financial Statements Financial Reports Budgeting Budget and Performance Integration Human Capital Management Program Management Performance Measurement Resource Cost Accounting Life Cycle Management Planning and Decisions Support Strategic Planning Annual Performance Report Fee Setting Competitive Sourcing 37

Sequencing • Chart of Accounts • Accounting • Local Government Fiscal Discipline • Treasury and Budget Systems 38