May 2005

Document of the World Bank

Report No. 31651-HR

CroatiaCountry Financial Accountability Assessment

Operations Policy and Services UnitEurope and Central Asia Region

Report N

o. 31651-HR

Croatia

Country Financial A

ccountability Assessm

ent

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TABLE OF CONTENTS

PREFACE ........................................................................................................................... i EXECUTIVE SUMMARY ............................................................................................ I V

SUMMARY OF RECOMMENDATIONS AND TECHNICAL ASSISTANCE ACTION PLAN ............................................................................................................ XI11

CHAPTER 1 : COUNTRY. ECONOMIC AND ADMINISTRATIVE BACKGROUND ............................................................................................................... 1

CHAPTER 2: ASSESSMENT FRAMEWORK ............................................................ 4

CHAPTER 3: BUDGETING ........................................................................................... 8

I1 . FINDINGS .................................................................................................................. 11 I11 . SUMMARY OF FINDINGS AND ASSESSMENT OF FIDUCIARY RISK .............................. 19 IV . RECOMMENDATIONS .......................................................................................... 20

CHAPTER 4: TREASURY AND CASH MANAGEMENT ....................................... 21

I1 . FINDINGS ................................................................................................................... 23 I11 . SUMMARY OF FINDINGS AND ASSESSMENT OF FIDUCIARY RISK .............................. 30 IV . RECOMMENDATIONS ................................................................................................ 31

CHAPTER 5: ACCOUNTING AND FINANCIAL REPORTING ........................... 33 1 . BACKGROUND AND ASSESSMENT FRAMEWORK ......................................................... 33 I1 . FINDINGS ................................................................................................................... 36 111 . SUMMARY OF FINDINGS AND ASSESSMENT OF FIDUCIARY RISK .............................. 42 IV . RECOMMENDATIONS ................................................................................................ 43

CHAPTER 6: INTERNAL CONTROL AND INTERNAL AUDIT .......................... 44 1 . BACKGROUND AND ASSESSMENT FRAMEWORK ......................................................... 44 I1 . FINDINGS ................................................................................................................... 47

IV . RECOMMENDATIONS ................................................................................................ 56

CHAPTER 7 : EXTERNAL AUDIT AND LEGISLATIVE OVERSIGHT .............. 57

1 . BACKGROUND AND ASSESSMENT FRAMEWORK ......................................................... 57 I1 . FINDINGS ................................................................................................................... 60 111 . SUMMARY OF FINDINGS AND ASSESSMENT OF FIDUCIARY RISK .............................. 67 IV . RECOMMENDATIONS ................................................................................................ 67

CHAPTER 8: LOCAL AND REGIONAL SELF-GOVERNMENT UNITS ............ 69 I . BACKGROUND AND ASSESSMENT FRAMEWORK .......................................................... 69 I1 . FINDINGS ................................................................................................................... 70 111 . SUMMARY OF FINDINGS AND ASSESSMENT OF FIDUCIARY RISK .............................. 73 IV RECOMMENDATIONS 73

1 . BACKGROUND AND ASSESSMENT FRAMEWORK ........................................................... 8

1 . BACKGROUND AND ASSESSMENT FRAMEWORK ......................................................... 21

111 . SUMMARY OF FINDINGS AND ASSESSMENT OF FIDUCIARY R I S K S ............................ 55

. ................................................................................................

CHAPTER 9: CAPACITY DEVELOPMENT ............................................................ 74 I . RECENT TA ACTIVITIES IN THE FIELD OF PFM ............................................................ 74 11 . ASSESSMENT OF TA ABSORPTION CAPACITY. IMPACT AND COORDINATION ............... 75 111 . GENERAL ASSESSMENT OF PFM CAPACITY DEVELOPMENT NEEDS ........................... 76 IV . RECOMMENDATIONS ................................................................................................ 78

ANNEXES

ANNEX I: KEY PERSONS INTERVIEWED (IN ALPHABETICAL ORDER) .... 79 ANNEX I1 . FIDUCIARY RISK INDICATORS AND INTERPRETATION ........... 83 ANNEX I11 . OVERALL ASSESSMENT OF FIDUCIARY RISK ............................ 92

LIST OF TABLES

TABLE 1 . STANDARDS AND CODES PROMOTING FINANCIAL ACCOUNTABILITY ................... 4 TABLE 2 . FIDUCIARY RISK INDICATORS ............................................................................... 5 TABLE 3 . REVISED BUDGET PREPARATION CYCLE ............................................................ 13 TABLE 4 . STATE BUDGET REVENUE AND EXPENDITURE OUTTURNS 2001 -2003 ............... 16 TABLE 5 . VARlATION BETWEEN BUDGETED EXPENDITURE AND OUTTURN PER FUNCTION OF

GOVERNMENT ..................................................................................................... 17 TABLE 6 . ANNUAL FINANCIAL STATEMENTS .................................................................... 37 TABLE 7 . CARDS 2003 EXTERNAL AUDIT TWINNING PROJECT ACTIVITIES ..................... 63

LIST OF BOXES

BOX 1 . PRINCIPLE OF SOUND FINANCIAL MANAGEMENT ..................................................... 5 Box 2 . THE TREASURY LEDGER SYSTEM .......................................................................... 22 BOX 3 . TRANSACTION SYSTEM PROCESS ........................................................................... 27 Box 4 . INTERNATIONAL STANDARDS FOR THE PROFESSIONAL PRACTICE OF INTERNAL

AUDITING .............................................................................................................. 46

SECTION ................................................................................................................. 53 BOX 6 . FIFTEEN STEPS TO ESTABLISHING AN INTERNAL AUDIT U N I T ................................ 55

BOX 5 . A W E A K INTERNAL CONTROL FRAMEWORK IN THE PUBLIC DEBT MANAGEMENT

BOX 7 . OVERVIEW OF THE NTOSAI AUDITING STANDARDS ........................................... 58 BOX 8 . TASKS AND RESPONSIBILITIES OF TOWNS, MUNICIPALITIES AND COUNTIES .......... 70 Box 9 . EDIS ACCREDITATION CRITERIA . ANNEX TO COUNCIL REGULATION (EC.

EURATOM) No . 1266/1999 .................................................................................... 77

Croatia CFAA: Preface i

PREFACE

This report was prepared following missions to Croatia in December 2003 and March 2004 by a World Bank Task Team that consisted o f Andy Macdonald (Consultant, Former Comptroller General and Chief Information Officer for the Government o f Canada); Matthew Andrews, (Public Sector Management Specialist, ECSPE); and Johannes Stenbak Madsen, (Task Team Leader, Financial Management Specialist, ECSPS).

The C F A A team would l i ke to emphasize that the accuracy o f this report’s findings and recommendations depended largely on the feedback from their Croatian counterparts, including State Secretary o f the Ministry o f Finance (MOF), Martina DaliC; Assistant Ministers to the MOF Amali ja IkSiC, Josip KuliSiC, Ivan NovaCiC and N iko RaiC; as well as Assistant Auditors General L id i ja Pernar, Ljerka Lindsbauer and Hrvoje KordiC.

The C F A A i s based on discussions with public officials and an analysis o f data gathered during the missions. The Parliament (the Sabor), the Government and the State Audit Office fully supported the C F A A missions and engaged in dialogue with the Bank team. Particularly important was the input o f &me PrtenjaCa, who as Head o f the Sabor’s Budget Committee, provided essential insight to the processes relating to the extemal and parliamentary oversight o f the Government.

Objectives and Scope of the CFAA

The C F A A i s a diagnostic tool designed to enhance the World Bank’s knowledge o f public financial management (PFM) and accountability arrangements in client countries. I t supports both (a) the World Bank’s fiduciary responsibilities by identifying the strengths and weaknesses o f P F M arrangements so that the potential r isks to the use o f Bank funds can be assessed and managed; and (b) the World Bank’s development objectives by facilitating a common understanding by the borrower, the World Bank, and development partners that leads to the design and implementation o f capacity-building programs to improve the country’s PFM. CFAAs are not audits; they are not intended to be and they do not provide assurance on the specific uses to which World Bank funds have been or may be applied.

The overall objective o f the C F A A i s to provide relevant information to the World Bank and the government on the public sector financial accountability arrangements in Croatia and to joint ly develop a program for reforms and capacity building to improve transparency and accountability for the use o f public funds. To the extent that analytical work was already available, the C F A A has updated and deepened the knowledge in areas where more specific, detailed proposals are needed. Specific objectives o f the C F A A include: (i) to update knowledge o f primary public financial accountability institutions, and; (ii) to identify the most significant fiduciary r i sks and related capacity issues that require the Croatian government’s attention.

Croafia CFAA; Preface i i

Priority areas o f Attention

W h i l e covering all key issues o f the CFAA guidelines o f M a y 2003, the C F A A explicitly identifies the international standards, codes and laws that constitute the assessment framework for this report. With a view to the specific requirements o f the EU, and subsequently the Croatian administration’s preparedness for EU membership, the EC financial regulation’ constitutes an important part o f the assessment framework for the priority areas listed below.

The following broad topics are addressed in the CFAA:

Budgeting;

Treasury and cash management;

Accounting and financial reporting;

Internal control and internal audit;

External audit and legislative oversight;

Financial accountability arrangements for sub-national government;

Capacity development.

Benchmarking and Assessment o f Fiduciary Risk

W h i l e covering the main issues o f the World Bank’s internal M a y 2003 C F A A guidelines, the report also benchmarks the Croatian PFM system against the intemational standards, codes and laws that constitute the assessment framework (see Chapter on CFAA Assessment Framework, p. 5). Given the relevance o f EU requirements to Croatia the EC financial regulation constitutes an important part o f this framework.

As well as benchmarking against the standards, codes and international regulations, the CFAA also presents a nonnative rating o f fiduciary risk for each component reviewed; i t i s based on a four-step scale, including low, moderate, significant and high2. For each o f the components the fiduciary risk i s rated using a set o f indicators l isted in Annex 11. The annex also presents an interpretation o f the indicators and an objective justification for the rating given for the individual P F M components. The methodology for fiduciary risk indicators and interpretations in Annex I1 was developed by World Bank staff and PEFA3 Secretariat staff, working wi th their PEFA partners, as performance indicators for PFM, as part o f an effort to strengthen approaches to PFM reform. PEFA is a partnership program o f the World Bank, the European Commission, the UK Department for Intemational Development, the Swiss State Secretariat for Economic Affairs, the French Ministry o f Foreign Affairs, the Norwegian Ministry o f Foreign Affairs and the Intemational Monetary Fund (IMF). The PFM performance indicators and interpretations

1 Council regulation No. 160.512002 on the financial regulation applicable to the general budget o f the European Communities. * The fiduciary risk i s the risk o f funds not being spent for the purpose(s) for which they were appropriated. ’ Stands for Public Expenditure and Financial Accountabil ity.

have recently been used in assessments o f financial accountability arrangements in a number o f other countries in Europe and elsewhere, including in relatively advanced and middle-income economies similar to Croatia.

Whereas the fiduciary risk ratings can be used for the purpose o f comparison or benchmarking, they do not provide quantitative information about the probabilities o f funds not being spent for the intended purposes.

For an overall risk rating and a summary o f the fiduciary risk assessment, please see Annex I11 titled Overall Assessment o f Fiduciary Risk. The detailed interpretation o f the individual r isk indicators i s offered in Annex 11.

Acknowledgements

The team acknowledges the extensive cooperation and assistance from the staff o f various institutions that contributed to the CFAA, including officials and staff o f the Government, State agencies and multilateral organizations. In addition, gratef i l thanks go to Country Director, Anand Seth; to Country Manager, Indira KonjhodiiC; and to Operations Advisor, Albert Martinez, for taking a great interest and engaging in the work with the C F A A team. Further, the team would l i ke to thank John Hegarty (Manager, Financial Management, ECSPS); Pascale Kervyn de Lettenhove (ECSPS); Ranjan Ganguli (ECSPS), Sanja MadiareviC-Sujster (Senior Country Economist, ECSPE); Srebrenka Gudan (Consultant, ECSPE); Ljiljana Tarade (Assistant, ECCUS); the PAL team leader Satu Kahkonen (ECSPE); and peer reviewers Ritva Heikkinen (European Commission, EC Delegation Zagreb); Brian Olden (IMF, Fiscal Affairs department); Stephen MacLeod (OECD, SIGMA) and Simon Bradbury (World Bank, LOA), who offered much appreciated comments and inputs; and to Roula Balkash (Assistant, ECSPS); Susan Middaugh (Consultant, ECSPS) and Sioban Farey (Consultant, ECSPS) who assisted with the formatting and editing o f this report.

Croatia CFAA: Executive Summaw iv

EXECUTIVE SUMMARY

General

As a candidate country to the European Union (EU), Croatia currently focuses much o f i t s modernization efforts on meeting the requirements o f the acquis communautai~e~. These include meeting the requirements related to Public Financial Management (PFM). In the EU accession context this primarily concerns Chapter 28 on financial control’ and the issues captured under the European Commission’s concept, Public Internal Financial Control (PIFC).

In this context, the relevance o f the Country Financial Accountability Assessment (CFAA) i s evident. I t assesses the legal framework, institutional capacity and practices for the core financial control processes such as budgeting, treasury and cash management, accounting, financial reporting, internal control, internal audit, external audit and parliamentary oversight. In this CFAA, topics related to financial accountability arrangements for sub-national governments and P F M capacity development provide for a more complete analysis o f the P F M arrangements and fiduciary risks. The basic approach o f the C F A A has been to compare the PFM practices in Croatia with those promoted by relevant international standards also including a specific set o f indicators o f fiduciary risk.6

Having assessed the preceding aspects o f PFM in Croatia, this report concludes that the overallFduciary risk is ~igniJicant.~

Most o f the weaknesses in the P F M arrangements revolve around inefficiencies and weaknesses in the existing financial accounting and management systems. The Croatian Treasury within the Ministry o f Finance (MOF) relies on a SAP8 payment and financial accounting system to process and record revenues and expenditures to and from a Treasury Single Account (TSA) held at the Croatian National Bank. Whereas the S A P system can process and record al l payments made from the TSA, the Treasury has to rely on separate reports from Budget Users (BUS) for reconciliation and commitment accounting purposes. Although the most significant ones have now been integrated, several Extra-budgetary Funds and Agencies (EBFs) do not manage their finances via the

A French term which refers t o the entire complex o f European Community legislation that affects Member States o f the European Union. ’ The European Council (o f EU Heads o f State and Governments) in Copenhagen in June 1993 decided that accession to the EU would require: (i) that the candidate country has achieved stabil ity o f institutions guaranteeing democracy, the rule o f law, human rights and respect for and protection o f minorities; (ii) the existence o f a functioning market economy as w e l l as the capacity to cope with competitive pressures and market forces within the Union; (iii) the abi l i ty to take o n the obligations o f membership, including adherence to the aims o f political, economic and monetary union. Since then, the requirement under (iii) has been evaluated in 29 separate pol icy areas o r “chapters.” Chapter 28 relates to financial control arrangements in the government administration.

The standards are listed in Chapter 2. Fiduciary risk indicators are listed in Table 2 o f that chapter. ’ The fiduciary risk for the individual components o f P F M as we l l as the overall f iduciary risk o f the P F M system is measured o n a scale f rom low, moderate, significant t o high. See Annex I11 for Overall Assessment Fiduciary Risk and Annex I1 for a detailed interpretation o f the specific risk indicators applied.

6

Trademark for a h igh capacity computerized payment and accounting system.

TSA. There are a multitude o f financial accounting and management systems among BUS and EBFs, which are not interfaced with the S A P system. The S A P system i s under- utilized and the further rollout and development o f the system i s currently stalled by ineffective management. The Government’s decision to implement modified accrual- based accounting rules from the fiscal year 2002 was taken without due consideration of the state o f the current system infrastructure. Consequently, the annual financial reporting from BUS and the compilation and presentation o f the Government’s consolidated financial statements for the fiscal year 2002, were significantly delayed and contained unreliable data. This was further complicated by the adoption o f an overly ambitious statutory reporting calendar for BUS.

The internal control framework’ o f the Government administration has several weaknesses and i s not supported by a general system o f internal audit, though this i s a statutory requirement o f the organic Budget Act. Although the absence o f internal audit means that an important assurance function for the efficient and effective functioning o f systems i s missing, the Government’s external auditor, the State Audit Office, does provide a basic external assurance function vis-&vis Parliament (the Sabor). This report identif ies shortcomings in the SAO’s legal framework and practices that could jeopardize i t s independence and thereby limit i t s effectiveness. At the local level the problems in the P F M arrangements identified at the national level also prevail. With respect to capacity development, the number o f staff in key P F M functions, such as financial control, accounting and auditing, are inadequate and training capacities are lacking. Finally, the leadership role o f the Ministry o f Finance in reforming P F M i s severely undermined by a lack o f intra-ministerial coordination, management and administrative capacity in general.

A specific and very serious deficiency identified in this report i s the lack o f a sound internal control framework in the Ministry o f Finance’s Public Debt Management Section. The problems identified include a lack o f appropriate segregation o f duties, understaffing and a management with a history o f ignoring technical advice, including advice from i t s auditors. These findings are corroborated by reports from the external auditor, the World Bank and IMF assessments. Considering the large sums o f money involved, the CFAA recommends that the Croatian Government take action urgently to rectify the situation. See Box 5 in Chapter 6 for details.

This report offers a number o f recommendations to address the identified shortcomings and to mitigate the associated r isks. The following recommendations should be given the highest priority: (i) the Minister o f Finance should assign an Assistant Min is ter to develop and implement a strategic vision for the future evolution and rationalization of the Government’s financial systems; (ii) the M O F should commission an independent systems audit o f the S A P system; and (iii) the M O F should establish an inter-ministerial steering committee led by the State Secretary to oversee the development o f the S A P system. The Government has started taking a number o f actions in this field, including the undertaking o f a study o f existing financial management information systems and the drafting o f a financial management information system development strategy.

As defined by COS0 - the Committee o f Sponsoring Organizations o f the Treadway Commission.

Croatia CFAA: €xecutive Summaw vi

In addition to the above, a number o f recommendations should and could be implemented almost immediately. These include: (i) the M O F already completed and issued the Rulebook o n internal audit as referred to the organic Budget Act (BA)"; (ii) the MOF initiating the legislative changes needed to establish intemal audit in the most significant EBFs; (iii) BUS and M O F appointing financial controllers as required by the BA, and; (iv) the State Audit Office initiating the proposed legislative changes to the Act on State Audit .

For all aspects o f Public Financial Management, this report points out specific challenges that Croatia i s facing in i t s endeavor to meet the benchmarks represented by the acquis communautaive and the requirements for Public h t e m a l Financial Control (PIFC).

A more detailed assessment o f specific elements o f PFM, recommendations on how to modernize PFM in l ine with relevant international standards and the importance o f mitigating fiduciary r isks are summarized below:

Budgeting

The lack of budget comprehensiveness poses a fiduciary risk. Although the organic Budget Act o f 2003 included the regulation o f key aspects o f the EBF's (Extra-budgetary Funds and Agencies) budget preparation and financial management, EBFs remain excluded from certain provisions o f that Act, including provisions requiring intemal audit .

The current process for preparing and revising the budget appears to promote budget realism, but it does not provide for strategic budgeting or for the effective monitoring o f allocations. The budget classification includes administrative, economic, functional and programmatic classifications but the budget as i t i s presented to Parliament offers l i t t le information or direction about policies and strategies. The frequent budget revisions in the course o f the year could also undermine the strategies and policies that might be reflected in the budget. Stil l , the variations between budget figures and actual outturns at the functional level o f the budget are generally small. The Ministry o f Finance, which has very limited policy analysis capacity, does not analyze budget proposals to assess their strategic content. W h i l e the strong performance o f budgets in achieving targets thus suggests low fiduciary risk, there i s a moderate r isk that the budget wil l fai l to ensure efficient and effective resource allocations.

Budget users are given clear guidance for the preparation o f budget submissions and generally adhere to the budget calendar. The budget does not as yet provide the type o f information required to show key expenditure types or pol icy development. The program and medium-term budgeting innovations are tenuous, dependent on significant capacity building and cultural change in the Ministry o f Finance and in the l ine ministries. Furthermore, this kind o f budgetary approach requires a more active role o f the Parliamentary oversight committee. Whereas parliamentary scrutiny covers aggregates and detailed estimates o f expenditure and revenue, Parliament (the Sabor) appears to have accepted a limited oversight role and weak administrative capacity. There i s a risk

By the t i m e o f the r e p o r t release, the MOF issued the R u l e b o o k in A u g u s t 2004. 10

Croatia CFAA: Executive Summarv vii

that the budget wi l l continue to fail to reflect a strategic, medium-term policy agenda and to facilitate transparency.

Considering the different indicators, the C F A A finds the fiduciary risk associated with budgeting to b e moderate. The CFAA recommends that the MOF:

0 Integrate al l EBFs into the State budget and the Treasury Single Accounts system or alternatively make them subject to the similar budgeting, control and audit arrangements.

Build on i t s recent work in the Bureau o f Macroeconomic Forecasting to further strengthen the forecasting function in the Ministry o f Finance in order to ensure full transparency and timely production o f forecasts, and enhanced usefulness to Budget Users (BUS).

Strengthen the Medium Term Expenditure Framework, based o n a program classification and multi-year forecast.

Develop further the analytical capacity in the budget process by training budget analysts in the Ministry o f Finance and l ine ministries.

Strengthen the role o f the Parliamentary Budget Committee by focusing i t s mandate on budget analysis and improving i t s technical support.

0

0

0

0

Treasury and Cash Management

There i s a multiplicity o f financial management systems that are uncoordinated and un- regulated. In addition, the strategic advantages o f relying more on the main service provider FINA,” for the continued development the SAP system and other financial systems among BUS, have not been considered. The future development o f the Treasury’s S A P system and i t s relationship to a large number o f independent, uncoordinated financial accounting systems in budget entities has not been defined. This report suggests that components missing from the Treasury S A P system have increased the r isk o f budget over-expenditures. The absence o f a multi-period commitment control module and the lack o f any development activity to implement i t i s a serious shortcoming. Moreover, the cash management module’s partial implementation increases the r i s k o f inefficient cash management and potential estimation errors in the budget releases to budget entit ies that result in expenditure arrears. The most recent available data suggests that Government arrears constitute six percent o f the Government’s consolidated budget. This indicates that there i s a significant risk that Government payments are not made on time.

The implementation and development o f the Treasury’s S A P system has not had the strong management direction and support that such projects require. There i s no senior M O F manager o f the system who can establish clear requirements and deadlines, and drive the project team to succeed. Nor i s there evidence o f strong involvement by those MOF units that are the logical users o f the system; and l i ne ministry staff are also conspicuously absent. This situation guarantees that the requisite systems changes will not occur in the timeframe that i s necessary; projects o f lower priori ty or questionable

” The Financial Agency, Croatian abbreviation.

Croatia CFAA: Executive Summary viii

value may be implemented at significant cost and limited benefit. A clear review of the entire project by an independent, outside expert, i s warranted.

The existence of some 3,200 budget user bank accounts in private banks poses a fiduciary risk to the average HRK 500 mi l l ion cash balances on deposit. In addition to being an example o f poor cash management, this situation increases the fiduciary risk.

In summary, the risk resulting from the Treasury and cash management systems i s rated as significant .

The C F A A recommends that the MOF:

0 Assign to an Assistant Minister the responsibility for the formulation and implementation o f a strategic vision for the future evolution and rationalization o f a l l o f the financial systems in the Government o f Croatia. To ensure management ownership of the S A P systems, the same Assistant Minister should be responsible for the M O F System Improvement Section;

0 Commission an independent systems audit o f the S A P system by an intemationally recognized extemal auditor or management consultancy with extensive financial and IT experience. The audit should investigate, among others, means to increase SAP’S functionality for both the M O F and the BUS;

Establish a Steering Committee, chaired by the State Secretary with senior representation from al l affected M O F sectors, BUS, ministries and FINA, to oversee the development o f SAP. This body could also assist in the development and implementation of the strategic vision for the evolution o f the Government’s financial systems;

Implement the Treasury Single Account (TSA) by closing al l entity private bank accounts and consolidating them into the TSA.

Immediately implement the S A P module to process multi-period commitments.

0

0

0

Accounting and Financial Reporting

A significant improvement was made as the MOF, for the f i rst time, presented a set o f consolidated financial statements for the execution o f the state budget 2002. The recording and processing of transactions was, however, not prompt and it prevented a timely aggregation at the l ine ministry and MOF level. For the same reason, the consolidated financial statements for the state budget were not prepared within the statutory deadline, which seemed ambitious when compared to the deadlines set out in the EC financial regulation. Consequently, the SAO’s audit o f the consolidated financial statements for the fiscal year 2002 was partly based on draft statements. One o f the reasons for the delays in reporting appear to have been the change o f accounting rules, involving an ambitious acceleration o f the time-line for the BUS’ compilation o f their financial statements. The changes also involved an equally ambitious move from cash to modified accrual-based accounting principles. This move was only partially successful. Furthermore, the change does not affect the accounting entries for expenditures at the Treasury, which continues to be done on a cash basis. Due to the set-up o f the Treasury’s

Croatia CFAA: €xecutive Summarv ix

S A P system i t cannot generate a complete electronic audit trail for al l types o f transactions. In conclusion, accounting data related to the execution o f the expenditure budget 2002 were most likely not reliable. Adding to the fiduciary risk i s the existence o f a multitude o f accounting systems, which are often outdated and do not meet current standards for security and data protection. Based on the preceding, the fiduciary r i s k associated with accounting and financial reporting i s considered significant.

Based on the above the CFAA recommends M O F should:

0 Take action to ensure that the statutory rulebooks’2 and appropriate guidelines and training opportunities be offered to al l accountants and other staff o f Budget and Finance Units o f all BUS in order to ensure an effective implementation o f the new accounting rules.

Reinforce the State Accounting and Financial Reporting Section, in order to be able to provide more support to BUS in the application o f the new accounting rules, including the statutory formats and deadlines for financial reporting.

Extend the statutory deadlines for delivery o f the annual financial statements and initiate the necessary amendments o f the Budget Act and the Ordinance on Financial reporting and Budgetary accounting (OFB).

Prioritize the recruitment o f accountants and other accounting staff given the profundity o f the current reform the Government should make and the importance o f increasing capacity.

0 Consider a strategy to effectively support a modemization o f the state administration’s accounting system, which should be based on a detailed review and due consideration o f different possible solutions.

0

0

0

Internal Control and Internal Audit

Whereas a number of Rulebooks and regulations provide the regulatory framework for procedures and physical controls, a proper segregation o f duties, appropriate staffing, exemplary management behavior and other key components in a sound internal control framework often do not exist. The Public Debt Management Section o f the M O F offers one such an example. Also, there are numerous examples o f Rulebooks mentioned in laws, which have not yet been issued. The Budget Users’ financial controllers required by the Budget Act (BA) have typically not yet been recruited or assigned to the task. The current control environment i s not robust enough to mitigate the risk o f official corruption and conflicts o f interest. The introduction o f intemal audit v ia the BA i s a positive development. The CARDS project in support o f establishing intemal audit units (IAUs) i s well conceived and has a realistic and robust plan for a progressive implementation across the Government. I t must be strongly supported because i t offers the best path to conformance with Chapter 28 o f the acquis communautaire and a PIFC- compliant intemal control and audit system. The C F A A offers practical guidance for BUS, who wants to establish such a unit. Weighing the different fiduciary risk indicators,

l2 As required by the Organic Budget Act.

Croatia CFAA: Executive Summaw X

the C F A A finds the risk associated with the internal control framework, including internal audit to be significant.

The C F A A recommends that:

0 The M O F eliminate the identified weaknesses in the internal control framework of the Public Debt Management Section o f the MOF, given considerable risks and the large sums involved.

The M O F issue al l statutory Rulebooks and the necessary detailed guidelines that concern internal control as a matter o f priority. MOF and other BUS must subsequently take steps to develop appropriate written procedures for financial processes.

The M O F establish an internal audit function by proposing changes in laws affecting al l EBFs, and key entities receiving or managing public funds, with the inclusion o f FINA.

The BUS should hire an individual or assign an existing staff member as soon as possible, to perform the role o f Financial Controller in accordance with the provisions o f the BA. This should be a person other than the Chief Accountant.

The M O F provide a strong champion for change for the new internal control and audit system, and should develop and promulgate i t s draft PIFC pol icy with a vision o f i t s internal control system and a strategic vision o f i t s internal control system that i s consistent with the Budget Act and the ongoing EU funded technical assistance activities.

0

0

0

0

External Audit and Parliamentary Oversight

The Act on State Audit provides a broad mandate for those public funds and institutions that i t i s required to audit as well as the audit standards and methods i t can apply. However, the act has shortcomings that should be addressed by the State Audit Off ice (SAO) and Parliament (the Sabor) as a matter o f priority.

One shortcoming i s that the S A 0 i s not formally required to provide a statement o f assurance on the execution o f the state budget. The SA0 i s however required to report to the Sabor annually on the audits performed and it does offers an opinion based on audits of the full set o f Government financial statements. Due to the nature o f i t s legal mandate and the methods applied this however does not constitute a formal statement o f assurance on the Government consolidated financial statements or the execution o f the state budget.

The SAO’s legal framework does not guarantee its financial independence from the government, which currently makes i t subject to the MOF’s budget supervision. Whereas the Act on State Audit (ASA) explicitly provides a mandate for it, the SA0 s t i l l has not piloted any audits o f economy, efficiency or effectiveness. The SAO’s reports are perceived to be authoritative and the Sabor acts on audit recommendations. There are indications that the Sabor considers the SAO’s reports rather narrow in focus and scope. The combined fiduciary risk associated with external auditing and Parliamentary oversight i s considered moderate.

Croatia CFAA: Executive Summaw xi

The C F A A recommends:

0 The ASA be amended to ensure that the SA0 budget i s presented directly to Parliament without prior adjustments by the MOF. The MOF’s right to exercise budget supervision over the SA0 should subsequently stop, while the annual financial statement o f the SA0 be made subject to an independent external audit appointed by Parliament.

The ASA be amended so that the SA0 will be formally required to submit a statement o f assurance on the execution o f the State Budget as to whether the Government’s consolidated financial statements gives a true and fair view o f its financial position and the sources and uses o f funds. In doing so, the S A 0 should seek to apply the International Standards on Auditing (ISA) and develop i t s competencies accordingly.

The ASA should be amended to allow the SA0 to audit al l EU funds. The SA0 should consider positively the challenge o f auditing and becoming a certifying body for future EU funded programs in Croatia.

0 SA0 take concrete initiatives to pi lot audits o f economy, efficiency and effectiveness (performance or value-for-money audits) in l ine with the recommendations o f the 1999 CFAA, the 2002 SIGMA peer review and the World Bank’s Public Expenditure and Institution Review 2002.

The SA0 and the Sabor should jo int ly consider the establishment o f a specialized Public Accounts Committee, for example, as a sub-committee o f the Budget Committee.

0

0

0

Sub-national Government

On the whole, the budgeting practices o f sub-national governments are sound. They provide reasonable assurance that the budget reflects the priorities o f local and regional interests and political parties. These practices also effectively prevent over-borrowing at the sub-national level and the generation o f contingent liabilities at the state level. That being said, the existence of a great number of bank accounts owned by local government increases the risk o f public funds fol lowing channels outside the formal processes set out in the BA. The ongoing process o f decentralization, combined with recent changes in accounting rules have caused problems in the reliability o f financial reporting to the MOF, The S A 0 provides external audit arrangements with appropriate frequency and provides a safeguard against the misuse o f funds. The SAO’s resources are, however, spread thinly at the sub-national level. Generally speaking, the transparency o f the PFM system seems greater at the sub-national level than at the state level. M o r e direct lines o f accountability between the citizen and the elected representative should reinforce this. Based on the concrete concerns related to cash management, the rel iabi l i ty o f financial reporting and internal control, the fiduciary r isk associated with the PFM and financial accountability arrangements for sub-national governments i s rated significant.

Croatia CFAA: Executive Summaw xii

The C F A A recommends the following:

0 The M O F should issue all the statutory rulebooks and guidelines on internal audit and accounting referred to in the Budget Act, which also applies to sub-national government. Furthermore, i t should offer appropriate training for their effective application. Local and regional administrations should prepare to implement the intentions o f the new act, including steps to establish Internal Audit Units.

The practice of engaging and educating citizens in local budget expenditures, as done in the town o f Varazdin, i s a best practice in ensuring transparency and accountability. The concrete practice o f public campaigns (for example, via the distribution o f flyers) to inform citizens about the use and sources o f the local budget should be expanded to other sub-national government administrations.

0

Capacity Development

The number and capability o f staff in newly established and specialized PFM functions are inadequate; financial controllers and internal auditors are one such example. In addition, staff responsible for bookkeeping, accounting and financial reporting do not know how to undertake the changes to the accounting regime required by the Budget Act. A similar situation exists for the Ordinance on Financial Reporting and Budgetary Accounting (OFB) for Budget Users. These professional groups are essential to the PFM; and the Croatian govemment needs to address this problem, which can also have an impact on the administration’s ability to develop implementing agencies for EU pre- accession and structural funds.

The C F A A recommends that M O F should:

0 Designate a responsible senior management position at the Director level (minimum) to oversee the development o f the comprehensive training strategy, in consultation with the donor community, planned and current training providers and the professional associations o f accounting and auditing in Croatia.

m - M

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0

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8

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CHAPTER 1 : COUNTRY, ECONOMIC AND ADMINISTRATIVE BACKGROUND

Economic Background

1. Currently, Croatia’s economy i s characterized by a slowdown. The industrial output growth rate has recovered slightly following a period o f stagnation; i t has generally l o w growth rates, low inflation and high unemployment. In the fourth quarter o f 2003, industrial production reached a 5.6 percent annual growth rate. In the same period the Consolidated General Government deficit reached HRK 3.5 bi l l ion or approximately 1.8 percent o f GDP. In the last quarter o f 2003, public debt was 55.5 percent o f GDP”. The growth in Croatia’s public debt has become an issue o f concem. The repayment costs, including interests have been steadily increasing from HRK 2.4 b i l l ion in 1999, to an estimated HRK 4.5 bi l l ion in 2003, or close to 5 percent o f total expenditure o f the general govemment16.

2. Croatia’s relationship to the EU i s defined via the Stabilization and Association Agreement (SAA). The process o f approaching the EU included the initiation o f reforms in al l areas o f the acquis communautaire, including those linked to financial control (Chapter 28). Following the European Commission’s positive communication o f April 20, 2004, conceming Croatia’s application for EU membership, Croatia formally became a candidate country to the European Union (EU).

3. In i t s opinion o f April 2004, the European Commission stated that Croatia could be considered a functioning market economy. The Commission also noted however, that the working o f market mechanisms s t i l l was in need o f some improvement. Among the issues emphasized by the Commission was the fact that enterprise restructuring and privatization has been slower than expected and that certain large state and formerly socially-owned enterprises continues to play a significant role in the economy. Also, the need for reforms o f the fiscal and social security systems as well as the public administration were said to be in-complete. The Commission also stressed that fiscal consolidation needed to be vigorously pursued.

Administrative Background

4. The Croatian budgetary system has undergone several reform or reform attempts during the last three to four years. This has included a change o f accounting principles; the first consolidation o f the government’s accounts; the addition o f budget classifications; the initiation o f program budgeting; the introduction o f a Treasury Single Account and a computerized Treasury system. In fact, the development o f a treasury system had already started by 1995. At the same time, the administrative capacity o f the key institutions for budgetary control has been called into question. It has been argued that the amounts allocated for professional improvement o f budget professionals o f Parliament, Government (Council o f Ministers) and Ministry o f Finance are insufficient. This argument i s being supported by the fact that even when the budgets for the three institutions have steadily increased over the last three FYs, the budgets for professional

l5 World Bank data. l6 Newsletter o f the Institute o f Public Finance, No. 12, December 2003

training have not or they continued to be financed at a very modest level”. To judge from the current debate among professionals in Croatia, i t seems evident that the Public Financial Management system i s under some stress, which i s bound to influence the regularity and effectiveness o f services in key administrative bodies such as the Ministry o f Finance.

5. Stress on the administration also appears to be generated from deficiencies in the framework for the c iv i l service in general. The Law on Civ i l Servants and Support Staff o f 2001 provides a legal basis for the status o f c iv i l servants. The Law does not make any distinction between state officials (political appointees; they are covered by a separate legislation) and c iv i l servants, thereby leaving unresolved issues such as status, role and obligations o f political personnel in the c iv i l service, tenure o f political appointees within the civ i l service, modalities for the conversion o f the status o f political appointees to that o f c iv i l servants. The current number o f administrative rulebooks and inconsistencies between them create the conditions for a multitude o f c iv i l service management standards. The Law suffers f i om further deficiencies, especially with regard to a system of promotions, mobility, separation from service and disciplinary measures. The rules goveming recruitment and selection o f candidates could also be improved. A point o f discussion is whether the salaries o f c iv i l servants are too l ow to attract adequate numbers o f young and educated professionals to work in the state administration, especially as they have to have the same or higher education than those working in other sectors. There i s no central training institution for c iv i l servants, or a Government training program. However, following the adoption o f the Law on the Organization and Scope o f the Ministr ies and State Administrative Organizations o f December 22, 2003 and a Decree on the Intemal Structure o f the Central State Office for Administration adopted in January 2004, a C iv i l Service Training Center for training and education o f state employees has been created. Also, a new draft C iv i l Service Law has recently been prepared with assistance f i om the EU’s CARDS 2001 program. I f approved in Parliament, the law wil l bring Croatian legislation into line with EC standards.

6. The backbone of public financial management in the former Yugoslavia was the Social Accounting Service, which was the sole institution responsible for executing financial transactions within the Yugoslav territory. In 1993, the Service on Croatian territory was transformed into the Institute for Payment Transactions (ZAP), which gradually improved the technological and organizational aspects o f i t s business, while maintaining i t s monopoly o n a number o f basic banking services. Although a monopoly, i t gained a reputation of efficiency in i t s operations, which included processing o f some 500,000 transactions in real time on a daily basis. With the government’s reform o f the transactions system, certain ZAP services were discontinued to allow the development o f a competitive market for financial services in Croatia. Continuing i t s operation under the name FINA (Financial Agency) the institution today plays a major role both in collecting state revenues, handling cash and providing system support and maintenance for the Treasury. In this respect FINA i s a unique institution. With i t s 179 branches, sub- branches and offices it plays a key role in Public Financial Management in Croatia.

” Newsletter o f the Inst i tute o f Pub l ic Finance, No. 11 and No. 13, December 2003

Croatia CFAA: Country, Economic and Administrative Backsround 3

Relationship to the CAS, lending program and policy dialog with country authorities

7. Since Croatia joined the World Bank in 1993, the Bank has provided financial support, technical assistance, policy advice and analytical services to Croatia. These activities formed the basis o f the Country Assistance Strategy (CAS), which was developed in close cooperation with the Croatian government. The current CAS covers a three-year period o f 1999-2003; a new CAS i s in preparation. The C F A A has advised in the drafting o f the CAS.

8. As o f December 2003, the World Bank’s active portfolio at the end o f 2003 consisted o f 11 projects; these projects represented loans to the amounts o f US$ 448 million; and o f that, US$122million has been disbursed so far. In addition, five projects representing an indicative total loan amount o f US$232 mi l l ion are in preparation. Finally, the Croatian government i s discussing a large Programmatic Adjustment Loan (PAL). Whereas specific amounts have not yet been agreed to, the loan i s likely to be around $150 million. The World Bank wil l be supporting the implementation o f a broad set o f Government policies over a three-year period. One o f the pol icy areas covered by the P A L i s public expenditure management. The exact topics are st i l l to be determined and the C F A A wil l advise on the choice o f focus areas.

9. Whereas lending initially focused on investment in infrastructure reconstruction after the war, more recently, the World Bank’s assistance has expanded to include the health, agriculture and forestry sectors, enterprise and financial sector reform, capital market development, as well as judicial and pension system reform. In determining the specific pol icy areas to be covered by the PAL, the World Bank i s working closely together with the European Commission to make sure the P A L addresses priorities relevant for EU accession.

CHAPTER 2: ASSESSMENT FRAMEWORK

cos0 EU

IASB

IFAC

10. In order to conduct quality CFAAs in all o f the Bank’s borrower countries, guidelines and questionnaires were developed to help Bank staff assess financial accountability arrangements. The C F A A structure broadly follows these guidelines. Since the administrations o f borrower countries often seek benchmarks against which to measure their systems, this report wi l l refer to the internationally accepted standards. See table 1 for an overview o f the standards and codes.

Framework for internal control European System o f Accounts 1995 (ESA 95) Council Regulation No. 160512002 o n the Financial Regulations applicable to the General Budget o f the European Communities (EC Financial Regulations) EU Implementing Guidelines for the I N T O S A I Auditing Standards (EUG)

International Financial Reporting Standards (IFRS) International Public Sector Accounting Standards (IPSAS)

International Accounting Standards (IAS)

Table I. Standards and Codes Promoting Financial Accountability Organization I Standards & Codes

IMF

- (ISPPIA) Code o f Good Practices on Fiscal Transparency

I I

International Standards o n Auditing (ISA) International Standards for the Professional Practice o f Internal Auditing I IA

I Government Financial Statistics (GFS 2001) INTOSAI I I N T O S A I Audit ing Standards ( INTOSAI AS) OECD I Best Practices for Budget Transparency World Bank I Treasury Reference M o d e l

11. In the context o f EU expansion, candidate countries are obliged to adopt the acquis communautaire, including provisions related to financial control o f EU funds, as found in the accession negotiations o f “Chapter 28.” This chapter concerns public internal financial control. A recently adopted EU regulation, No. 1605/2002--referred to here as the E C Financial Regulation--along with the corresponding implementation o f EC regulations, No. 234212002 and No. 2343/2002, which concern the financial regulation o f the EC general budget, represents an important development in what the EU considers good practices for public sector governance and financial accountability. When applied to the E C budget, this regulation has direct legal effect in managing EU-funded programs implemented in and by i t s member states. W h i l e i t i s not legally binding for member states to manage their own budgets, i t i s an important benchmark o f what to expect from current candidates and future member states. Also, due to i t s legal status for member states, the benchmark wi l l be a useful reference for the long term.

12. The EC Financial Regulation offers a framework for govemance and financial management that defines basic concepts as well as the roles/responsibilities o f the various actors in a system promoting what the EU calls “sound financial management.” This framework describes the responsibilities o f the authorizing officer, accounting officer and internal auditor. I t also sets out principles for sound budgeting and budget execution and for discharging the consolidated accounts.

Croatia CFAA: Assessment Framework 5

PFM component

13. The EU text uses the term “management board” to describe “the ma in intemal body responsible for taking decisions o n financial and budgetary matters, irrespective o f the name g iven to it in the constituent instrument o f the Community body” (Article 2, paragraph 2, Regulation No. 2343/2002). The C F A A uses i t interchangeably with “senior management” and “management group.” The EU principle o f “sound financial management” i s defined in B o x 1.

Risk indicators”

~

Box 1: Principle of Sound Financial Management ~ _ _ _ _ ~ ~ _ _ _ ___ - __ - - -

Article 25

Budget appropriations shall be used in accordance with the principle o f sound financial management, that i s to say, in accordance with the prmciples o f economy, efficiency and effectiveness.

I

1

~ __ Official Journal of the European Communities, L 357/81, December 31, 2002 (Commission Regulation No 2343/2002)

Budgeting

Fiduciary Risk

1. Aggregate fiscal deficit compared to original budget.

14. According to Art icle 111, Section 5 o f the I l3RD’s Articles o f Agreement - General Provisions Relating to Loans and Guarantees, f iduciary r i sk relates to the possibi l i ty o f Bank loans or guarantees not being used exclusively for the purposes for wh ich they were granted. The CFAA addresses a part o f the fiduciary risk by assessing whether the systems in place support the use o f Bank proceeds for their intended purpose. However, i t does not constitute an actual audit o f the use o f the proceeds, nor the economy, efficiency and effectiveness o f this use.

15. and CFAA chapter are l isted in table 2 below.

The specific indicators used to assess the fiduciary risk for each PFM component

”able 2. Fiduciary Risk Indicators CFAA Chapter

Chapter 3

2. Composition o f expenditure out-turn compared to original approved budget.

3. Extent to which budget reports include a l l significant expenditures o n central government activities, including those funded by donors.

_____

4. Adequacy o f information o n fiscal projections, budget and outtums provided in budget documentation. 5. Administrative, economic, functional and programmatic classification o f the budget. 6. Extent o f multi-year perspective in fiscal planning, expenditure pol icy-making and budgeting 7. Orderliness and participation in the annual budget process.

See Annex I1 for elaboration and interpretation o f risk indicators.

Croafia CFAA: Assessment Framework 6

PFM component

Treasury and cash management

CFAA Chapter I Risk indicators"

8. Legislative scrutiny o f the annual budget law. 9. Single Treasury Account. 10. Stock o f expenditure arrears. 1 1. Effectiveness o f cash f l ow planning, management and monitoring. 12. Procedures in operation for the management and recording o f debt and guarantees. 13 Extent to which spending ministries and agencies are able to pian and commit expenditures in accordance with originalirevised budgets.

Chapter 4

Internal control & internal audit

Extemal audit & legislative oversight

Sub-National Government

Chapter 5

reports. 18. Timeliness and quality o f audited financial statements submitted to the legislature 19. Corruption perception (Ranking in Transparency International Index) 20. Writ ten procedures 2 1. Effectiveness o f internal controls 22. The effectiveness o f internal audit 23. The scope and nature o f external audit. 24. Fol low UP o f audit reports by the executive or audited entity. 25. Legislative scrutiny o f external audit reports The above as applied to sub-national govemment

Chapter 6 r Chapter 7

Chapter 8

Accounting & financial reporting

I 14. Comnuterized accounting svstems I 15. Audit trail documentation 16. Timeliness and regularity o f data reconciliation. 17. Timeliness, quality and dissemination o f in-year budget

16. Each o f the above categories involves both control r isks and inherent risks. The former are where systems or components o f control (whether ex ante or ex post) do not function adequately; they include reporting systems that do not provide accurate and/or timely information. The latter are based on environmental factors in the country or organization, which may reflect current attitudes towards fiscal discipline or corruption, disregarding the existence o f intemal controls.

17. The r isk associated with the individual components o f the PFM system and the overall fiduciary risk i s rated between high, significant, moderate or low. Annex I1 shows the interpretation used to distinguish between the individual ratings. The fiduciary risk within an individual P F M component, such as Budgeting, i s calculated as a simple average o f the rating o f each indicator presented in Table 2 above. The ratings for the individual P F M components are summarized at the end o f each chapter summary o f this report. The overall risk rating for the entire PFM system i s also calculated as a simple average while giving equal weight to the individual P F M components. This information can be found in Annex 111.

18. I t should be emphasized, that whereas the fiduciary risk ratings can be used for the purpose o f comparison or benchmarking they do not provide quantitative information about the probabilities o f funds not being spent for the intended purposes.

Croatia CFAA: Assessment Framework 7

Fiduciary Risk Indicators and Benchmarking Against Standards

19. Whereas a rating o f the fiduciary risk i s used to summarize and prioritize the findings in different areas o f PFM, the report basically provides for a comparison between Croatian and good intemational practice in the field o f P F M as these are expressed in intemational standards for financial management. This includes a benchmarking against relevant provisions o f the Financial Regulation o f the European Communities in the field o f budgeting, accounting and auditing, as well as against internationally recognized standards for accounting and auditing.

20. Croatia’s ranking in the Transparency Intemational Conuption Perception Index 2003 as 59 out o f 133 co~ntr ies’~, i s used as a fiduciary risk indicator under the heading “internal control”. The CFAA i s not intended to cover issues pertaining to official corruption, nor i s i t intended to assess the specific methods used in detecting corruption.

l 9 See Annex I1 for interpretation.

CHAPTER 3: BUDGETING

I. Background and Assessment Framework

Background

21. In the late 1990s, the functioning o f the state budget system began to be matter o f concern for the Croatian government. The budget was not comprehensive; and the public finance sector consisted o f a significant number o f extra-budgetary funds and agencies (EBFs) and a great number o f state enterprises with poor financial reporting. Furthermore, while expenditures were specified at a high level o f detail in the annual budget presented to the Sabor, i t lacked a strategic policy driven direction and a matching budget classification.

22. The 2002 Public Expenditure and Institutional Review (PEIR)” noted that the Government had made some progress since i t s independence; i t had passed a new organic Budget Act (BA) and implemented a multi-year investment program. The PEIR noted that the major components o f the budget process are in the hands o f the BUS, including pol icy and planning and that the role o f the Ministry o f Finance i s weak. The Ministry o f Finance did not set standards for the decentralized budget development taking place in the spending entities; i t plays a l imited role in coordinating government-wide financial issues. The M O F also failed to provide a basic analysis o f the budgetary impact o f pol icy issues, a common and vital role that typically facilitates effective budget negotiations and Cabinet decision-making.

23. Weaknesses l i ke these are largely responsible for the lack o f discipline in the budget formulation process (for example, BUS commonly developed highly inflated proposals), the lack o f strategic orientation in the budget, and the lack o f realism in budget documents.

24. The PEIR identified four areas for the Government to focus i t s public expenditure and financial management reforms: strengthening the central entities responsible for budgeting, treasury and intemal control; developing standardized accounts, budgets and P F M procedures; improving internal control and audit; bringing al l revenues and expenditures (including EBFs) on-budget to improve transparency and resource allocation efficiency.

25. In focusing on necessary reforms in the budget formulation process, the PEIR also addressed problems in developing the macroeconomic framework for the budget, budget analysis and preparation cycle. K e y recommendations to deal with weaknesses in these areas included: (1) fostering improved budget forecasts through collecting and analyzing economic forecasts from a number o f leading private and public sector agencies to determine median parameters; (2) amending the budget law to provide greater transparency to economic estimates underlying the budget; (3) establishing an explicit multi-year framework to support improved budget decision-making; (4) improving

’’ World Bank, Improving Fiscal Sustainability and Enhancing Effectiveness in Croatia - A Public Expenditure and Institutional Review, March 2002.

sectoral analysis in the budget and the budget analysis capacity o f the Ministry o f Finance; (5) establishing the Budget Office in Law; (6) improving the strategic orientation o f budgets through the introduction o f a program classification; (7) getting l ine ministries to formulate their budgets prior to receipt o f the MOF call letter; and ( 8 ) requiring that the Council o f Ministers budget for the full cost o f mandatory programs -- unless specific legislation to alter the program to meet a lower budget i s prepared and submitted with the annual budget.

26. More recently, in the 2004 Overview o f Foreign Technical Assistance (hereafter referred to as the Donors’ Report),*l the World Bank, EU, USAID, U S Treasury and the IMF joint ly identified a number o f technical assistance-supported reforms for the new govemment. These reforms resonate with the PEIR proposals. They include strengthening macroeconomic forecasting and medium-term fiscal planning, creating linkages to the annual budget plan, clearly defining budget preparation responsibilities and facilitating provision o f a budget manual, capturing commitments in the General Ledger accounting system and improving budget monitoring.

Assessment Framework

27. ensuring:

I t i s generally agreed that management o f public expenditures should be aimed at

0

0 Allocative efficiency, which involves prioritizing programs according to

Aggregate fiscal discipline, to achieve macroeconomic stability;

Government policies and selecting the most cost-effective programs and projects;

Efficiency and effectiveness in deliveringpublic services. To achieve these goals, the budget process should adhere to basic principles and appropriate methods developed.

0

28. EC Budgetary Principles. To meet the above objectives, budget managers in EU member state administrations must observe the budgetary principles laid down in the EC financial regulations, when managing EU funds. A summary o f the principles i s l isted below:22

0 Unity and accuracy (comprehensiveness). Because the budget forecasts and authorizes revenues and expenditures, all o f these must be included.

Universality. This principle i s based on two rules: “non-assignment,” which states that budget revenues may not be allocated to particular items o f expenditure, and the gross aspect, which states that al l revenues and expenditures must be entered in full, without adjustments against each other (no netting). The

0

2’ Overview of Foreign Technical Assistance Provided to the MOF, letter to Secretary o f State, Ministry o f Finance, 13 January 2004. 22 The provisions relevant for budget preparation and presentation are presented in the Commission Regulation (EC, Euratom) Nos. 234212002 and 2343120002 o f 23 December 2002. See also http:1ieurot,a.eu,int1conmdbudgetibudget/index en.htm

Croatia CFAA: Budsetin0 10

principles aim to ensure aggregate fiscal discipline and efficient allocation o f resources, which require that al l expenditure programs be reviewed together.

Appropriations must be authorized for the fiscal year; ru les for carrying over funds from one year to the next are specified. For multi-year operations, the EC financial regulation distinguish between payments authorized for the fiscal year and legal commitments authorized to cover multi-year operations.

Equilibrium Cfiscal discipline). Budget revenues and payment appropriations must b e balanced. The budget o f EU member states i s bound by fiscal ru les defined in the Maastricht and Amsterdam treaties.

Specification. Each appropriation must have a purpose and be assigned to a specific objective to prevent any confusion between appropriations at the authorization and the execution stage; this ensures the budget i s unambiguous and executed according to the decisions o f the budgetary authority. Rules for making exceptions, such as transfers between appropriation accounts, must be specified.

0 Sound financial management. This involves economy, efficiency and effectiveness in conducting activities and delivering public services. Specific, measurable, achievable, relevant, and timely objectives must be stated for all sectors covered by the budget and for monitoring and evaluation (M&E) of performance indicators.

Transparency. This ensures the objectives wil l be correctly formulated and pursued.

0 Annuality.

0

0

0

29. In 1998, the IMF developed a Code of Good Practices on Fiscal Transparency that stressed (a) clear fiscal roles and responsibilities; (b) public availability o f information; (c) open processes o f budget preparation, execution, and reporting; and (d) independent reviews and assurance o f the integrity o f fiscal forecasts, information and accounts.

30. To achieve clear roles and responsibilities, laws must be created that cover budgetary and extra-budgetary activities and fiscal management tasks must be assigned. Further, budget documents and fiscal reports must be available to the public; these should cover al l the Government and local level budgetary and extra-budgetary activities.

3 1. The principle of openness requires the fol lowing be presented with the budget: (a) a fiscal and economic outlook paper, including a statement o f fiscal pol icy objectives and priorities, and the macroeconomic forecasts on which the budget i s based; (b) a statement o f contingent liabilities and tax expenditures; (c) the overall balance, data o n previous budget execution, and analytical tables derived from budget estimates. Budget data, as well as extra-budgetary data, should be reported o n a gross basis with expenditures classified by economic, functional and administrative category.

32. forecasts should be available for independent scrutiny.

To assure the budget’s integrity, detailed information on revenue/expenditure

Croatia CFAA: Budsetinu 11

33. Medium-Term Expenditure Framework. A medium-term macro-economic framework i s a basic requirement for fiscal transparency. In addition, the IMF Fiscal Transparency (FT) manual identifies as a best practice the preparation o f medium-term budget (or expenditure) frameworks (MTEFs). I f the processes are disciplined, an MTEF provides a clear statement o f the effects o f current policies and a mechanism for planning, controlling and monitoring the introduction o f new and changed policies.

34. Most OECD countries have introduced instruments to create multi-year budget perspectives. However, such budgets vary from country to country. They can be either “extended MTEFs,” where each activity i s listed separately and aimed at promoting and monitoring operational perfonnance or those that cover broad expenditure programs and focus on inter-sectoral resource allocations. The former has the advantage o f addressing al l objectives o f public expenditure management, but i t s implementation requires robust reporting and accountability systems and highly disciplined processes.

35. However in sophisticated expenditure programming process, key MTEF characteristics involve :

0 Well-defined fiscal policy objectives;

0

0

Integrated medium-term macroeconomic and fiscal forecasts;

Estimates o f expenditures and receipts o f ministries in relation to sector pol icy priorities;

The MTEF i s rolled over each year; the first out-year expenditure estimates become the basis for budget negotiations for the following year;

The MTEF and budget are prepared under hard budget constraints.

0

0

36. TheFduciary r isk associated with budgeting wil l be assessed as the risk that: (i) the budget i s not implemented as passed; (ii) funds are not spent for the purposes set out in the budget; (iii) significant government activities are not covered by the budget23.

11. Findings

Legal Framework

37. The original 1993 budget law was revised by the Government as an organic Budget Act (BA) in M a y 2003. This Ac t now governs the budget process. The BA includes a number o f budget reforms recommended in previous donor studies, including such items as: (i) the creation o f a Treasury function within the M O F and the consolidation o f the largest EBFs into the Treasury Single Account; (ii) the inclusion o f

23 The specific indicators used are: (i) The variation between aggregate budget expenditure out-turn and the original budget; (ii) The variation between the composition o f budget expenditure out-turn and the composition in the original budget; (iii) Budget reports do not include a l l significant expenditures o n government activities, including those funded by donors; (iv) Aggregate fiscal performance and position o f the parastatal and sub-national government sectors are not included in the consolidated government reporting; (v) The budget i s not classified o n an administrative, economic and functional or programmatic basis; (vi) Key fiscal information i s not published, i s n o n accessible andor not user-friendly; (vii) The legislature does not scrutinize and debate the annual budget. See Table 2 in Chapter 2 for overview.

Croafia CFAA: Budsetina 12

al l off-budget revenues and donor aid in the budget revenues; (iii) creation o f a multi-year budget to be approved by Parliament; (iv) a requirement that al l proposed laws contain financial estimates on their impact over the three-year planning horizon and that they have the approval o f the Minister o f Finance; (v) a five-category budget classification by organization, economic, functional, location and program; (vi) a revised budget calendar; and (vii) multi-year expenditure commitments.

38. The provisions o f the BA apply to state budget institutions, local and regional self-govemed entities. In addition, the BA states that “particular” provisions shall also regulate the budgetary relationship to Extra-budgetary Funds (EBFs). This obviously implies that certain provisions, including certain provisions related to the budget approval24 and those requiring the establishment o f intemal audit, do not apply. The applicability and enforceability o f certain key provisions o f the BA i s therefore not clear when it come to EBFs.

39. The BA defines the roles and responsibilities o f Budget Users (BUS), Extra- budgetary funds (EBFs)~~, Heads o f the Budget Users, Chief Accountants (CA) and Heads o f Budget & Finance Units (BFUs), and financial controllers. I t states that the MOF shall issue implementing regulations and “Rulebooks” to regulate accounting, financial reporting, control and audit. More than a year after the BA’s implementation, most o f these regulations and rulebooks s t i l l have not been issued. The BA requires budget users to establish internal audit units.

40. The BA seeks to introduce a working two-stage budget process in Croatia in which the Ministry o f Finance and Government play a meaningful top-down role. They set macroeconomic and pol icy parameters for developing the budget; spending entities develop disciplined, strategic budgets within them. Tracing the revised budget preparation cycle in table 3 shows important features in the Act.

24 Art. 24 (5) & (6) states: “The financial p lan o f the extra-budgetary user [EBF] shall be passed by i t s responsible body in accordance with the procedure described by special law, by other regulation, o r by the foundation charter o f the extra-budgetary user.[..] The financial plan referred to in [..I this Art icle shall be passed pr ior to the passage o f the state budget, and Sabor shall approve the financial p lan along with the state budget.” 25 The Budget Act states: “EBF i s an extra budgetary user, legal person founded o n the basis o f law, which legal person i s financed f rom the earmarked contributions and other revenues” (Art. 3 (16)).

Deadline

April 1 I Macroeconomic Forecast &budget Guidelines Prepared I Minister o f Finance

Action Action/Approval

April 10 I Three-year macro forecast and Guidelines Approved I Government

May 3 1

June 30

Determined by budget circular

April 20 I Proposed Budget Ceilings for Min is t r ies I Minister o f Finance

Budget instructions issued to BUS, local governments and EBFs

BUS submit budgets to responsible Ministry

Ministry submits budgets to MOF

Minister o f Finance

BUS

Ministry

May 15 I Budget Circular, ceilings and macro parameters I Government

Oct. 15 Draft State Budget and Consolidated State Budget to Governmentz6

January 1

Minister o f Finance

Budget Implementation

Nov. 15 ~ Draft State Budget and Consolidated State Budget to Sabor 1 Government

Dec. 3 1 ~ State Budget and Consolidated State Budget Approved I Sabor

BUS, Local governments, EBFs

41. Between April 1 and M a y 15 during the first four steps in the new budget preparation cycle, the Ministry o f Finance develops a macroeconomic forecast on which the budgetary parameters wi l l be based. This forecast becomes a three-year projection with budget guidelines requiring Government approval. The macroeconomic parameters are translated into specific Ministerial budget ceilings; the guidelines and ceilings are passed through the Government for approval before being incorporated into a budget circular. The latter sets the rules for Min is t r ies in developing budgetary submissions; it provides the base r u l e for facilitating affordability (the ceilings) and resource allocation efficiency (the t ie to macroeconomic and Government policy).

42. Ministries have a significant period o f time to develop their budgets in the new preparation cycle. I t i s important to note that the BA requires them to submit a variety o f new forms with their budget requests, outlining details such as their strategic direction, their programs and activities, as well as the traditional information on proposed spending by economic item. W h e n this information i s submitted to the Ministry o f Finance, the aim i s that proposals will be disciplined (within ceilings) and with sufficient detail to facilitate focused and efficient negotiations-and ultimately budget allocations that are realistic and strategic.

26 The State Budget comprises only the central institution, such as ministries, whereas the Consolidated State Budget also includes EBFs and local government.

43. draft budget and to enhance accountability in the preparation process.

The BA also expands the length o f time the Sabor has to discuss and analyze the

Institutional Framework and Capacity

44. The Budget Preparation Section o f the M O F i s responsible for preparing the budget. In recent years, i t has suffered significantly in terms o f numbers and qualifications o f staff. Capacity i s particularly lacking in the Budget Analysis Unit within the Ministry o f Finance. This unit has the poorly defined but vital role o f analyzing the fiscal impact o f legislative and pol icy adjustments. Because o f capacity limitations and also because o f an implicit focus on compliance with the rules o f budget preparation rather than preparation quality and analysis, the efficiency and effectiveness o f public expenditure programs are insufficiently reviewed when the budget i s prepared.

45. The MOF’s Bureau o f Macroeconomic Forecasting i s responsible for conducting macro-economic analyses and for preparing economic and fiscal projections. The capacity and competence o f this unit’s staff have been put into question in recent years, though the current management appear to have a clear vision for the Bureau’s future development. There was l i t t le dialog between this unit and private sector forecasting bodies. There was also a lack o f effective checks and balances for minimizing incentives for optimistic revenue forecasts. As part o f i t s new vision, however, the Bureau has recently reopened channels for dialog with other entities and has begun to institute checks and balances in the forecasting process. I t has also restarted producing integrated macroeconomic and fiscal projections for a three year period. The quality and effect o f these adjustments have s t i l l to be verified, but it i s hoped that these steps wil l foster future improvements and improved budget quality.

46. Questions have been raised about the suitability o f the existing organizational structure and capacity o f the MOF; the questions stemmed from the reforms introduced by the 2003 BA. Particularly lacking was capacity in IT; this i s vital for introducing the S A P modules intrinsic to an ongoing program budgeting reform. The pol icy focus o f a program-type approach to budgeting also underlined the lack o f pol icy analysis within the Ministry o f Finance. The budgeting units in the l ine ministries exhibit a similar weakness.

Practice

47. Budget unity, comprehensiveness and universality. While the Government has made progress in addressing issues o f scope, some concerns remain. EBFs and agencies s t i l l constitute a significant portion o f the Consolidated General Government Budget

48. The two most significant EBFs, the Health Insurance Fund and the Pension Fund, are now integrated into the budget and manages the transactions via the TSA and the S A P system. Other EBFs at the national level st i l l operate outside o f the budget and the TSA; they include Roads, Highways, Privatization Agencg7 and the Bank Rehabilitation Agency. Some o f these take the form o f Funds; others are public enterprises (and another i s the Croatian Bank for Reconstruction and Development). Many o f them receive large subsidies from the state budget; some public enterprises providing ut i l i t ies at the local

27 In process of being merged with the Office for State Property management.

Croatia CFAA: Budaetinq 15

levels also receive subsidiesS2* All these EBFs are included in the Consolidated General Government Budget to provide a complete picture o f the Government’s financial operations in any given fiscal year. However, because their operations are off-budget, their allocations do not come out o f a competitive process with other budget agencies, but for example, are determined by a separate law (for instance, for Health Insurance).

49. EBFs operating outside the Treasury Single Account (TSA) pose a fiduciary risk to public funds. First, because the consolidated state budget i s formulated without recognition o f all expenditures, there is a risk that the budget wil l not reflect actual expenditure requirements and hence that allocations wil l not be efficient. Second, because the budget i s formulated without recognition o f al l revenues, there i s a risk that the budget wi l l not reflect al l revenue availability. These r isks materialize in problems with fund reliability and the need for budget revisions after Parliamentary approval; they undermine the value o f the formulated process (and hence the formulation process) and complicate budgetary accountability and approval processes. A hr ther fiduciary risk i s that, the EBFs that are not integrated into the common budget system are not subject to the same oversight and management requirements as for BUS.

50. The progress made to date in strengthening the accountability arrangements o f the major EBFs (the Health Insurance Fund and the Pension Fund) has not been reflected in the other EBFs mentioned above. W h i l e included in the consolidated state budget, these EBFs are not subject to the same rigorous controls o f budget entities, despite significant expenditures o f public revenues. The planned merger o f HFP, the privatization fund, into the Office for State Property Management i s a good step in the direction o f inclusion o f al l spending entities into the State budget.

5 1. Annuality. In accordance with the BA, budget forecasts cover multiple years. Practically, the Government has prepared the 2005 budget to act as the foundation for a three year budget framework, starting with 2005-2007 period. Budget allocations as voted on by Parliament, however, cover only one year. There i s no practical or legal link between the budget forecasts for outer years and future allocations (there i s no rollover mechanism in place, for example). Spending entities s t i l l do not develop budgets that actually mirror medium-term programs and strategies, and the Government st i l l needs to develop a mechanism that connects outer year forecasts to future year budget allocation processes.

52. The budget calendar o f the BA (see Table 3 above) and the annual budget implementation act provides appropriate guidance for the budget preparation process, which i s generally respected by BUS

53. Equilibrium. The aggregate fiscal balance i s a “bottom line” measure o f budget performance. If the balance deviates from the budgeted balance, this indicates that the public financial management system i s not delivering effective fiscal discipline. In table 4 below the variations between the aggregate budgeted total revenues and total expenditures and their outtums as well as the balances for the last three fiscal years:

28 F o r example, the H i g h w a y agency expenditures o f 5.6 b i l l i o n HRK generated a de f ic i t o f 3.5 b i l l i o n in 2003.

Table 4. State Budget Revenue and Expenditure Outturns 2001-200329

Source: World Bank, State Audit Office and Ministry of Finance

54. A comparison o f budgeted and actual revenue provides an overall indication o f the realism of the budget and subsequently the quality o f forecasting and revenue administration. As i t can be seen from Table 4, during the last three years domestic revenue out-tums in Croatia have been routinely above or around forecast figures.

55. Table 4 shows that the expenditure budgets were fairly realistic. The table also shows that while the realism has varied from a large deficit o f over HRK 4.3 bi l l ion in 2001 to 80 percent o f the target in 2002 to 114 percent in 2003.

56. Specification, sound financial management and transparency. Apart from ensuring realistic budget proposals, the budget process facilitates the development o f allocations that have a high likelihood o f being implemented in an efficient and effective manner. These allocations should also be transparent and open to scrutiny.

57. programmatic dimensions.

The Croatian budget classification consists o f both an economic, functional and

58. Current revisions to the budget are commonplace in Croatia. In i t s report on Audits Performed in 2002, the SA0 reported that during the year some 14 reallocations of budgetary resources were made. Out o f these, eight were approved by the MOF and in the remaining six cases the Govemment approved the reallocations. The S A 0 found that reallocations approved by the Govemment were made in the amount o f HRK 160.1 mi l l ion was not permitted under the provisions o f the Budget Execution Act for 2002. The total reallocations for 2002 amounting to HRK 240.7 mi l l ion irregular reallocations constituted the major part o f reallocations in 2002. The total reallocations constituted 0.3 percent o f total expenditure in 2002. Whereas this does not present a significant proportion o f the budget, the Govemment 's practice o f approving reallocations that violates basic appropriation law clearly undermines financial accountability. One way o f establishing the extent o f current budget reallocations (at vote or functional level) is the degree to which budget appropriations match out-tums. In table 5 below, the budget and outtums for the last three fiscal years i s shown per function o f government:

29 This differs f rom Consolidated General Government in that i t s doesn't include certain government sub- sectors such as social security. 30 Including grants. All 2003 actual figures are un-audited. 3' Includes lending and repayment costs. All 2003 actual figures are un-audited. 32 The budget deficits of Consolidated General Government were in the same period (measured on a cash basis): HRK 11.8 b i l l i on (2001); HRK 7.9 bi l l ion (2002); HRK 9.8 b i l l i o n (2003).

cultural and

and services Fuel and energy affairs and services Agriculture, forestry, fishing affairs and services Mining, manufacturing, const. affairs and services Transport and communicational affairs and services Other economic affairs and services Expenditures not classified by major group Total Expenditure34/ Average

iource: World Bank,

religious affairs

33 Based on rounded numbers. 34 To reconcile with data in table 5, please notice that the totals do not include lending and repayment costs which in actual outturns were: HRK 1,089 m i l l i on in 2001; HRK 1,377 m i l l i on in 2002; and HRK 1,333 m i l l i on in 2003.

1,088 1,081 1 11; 955 955 100 969 945 98

18 8 44 9 8 89 7

1,655 1,642 99 1,922 1,848 96 3,204 2,321 72

466 86 489 413 84 749 657 88 544

3,461 3,113 90 1,527 1,277 84 1,939 1,789 92

932 832 89 995 830 83 1,354 1,507 111

3,914 3,946 101 4,993 4,585 92 5,547 5,082 92

48,849 56,723 94 73,255 71,992 94 77,919 79,113 97

Ministry ofFinance, State Audit Office

Croatia CFAA: Buduetinu 18

59. On average, Croatia performs wel l against this measure; out-tums were some 6 percent less than appropriations in 2001 and 2002, and 3 percent less in 2003, respectively. In key expenditure areas, however, some concems do arise that suggest: expenditures may not be sufficiently specific to ensure that pol icy priorities are met; financial management systems are not sound or transparent enough to ensure spending efficiency and effectiveness. Selected areas o f concem include (See table 5): Health Affairs and Services where budget out-tums were 43 percent lower than allocations in 2001 and Spending on Fuel and Energy Affairs and Service, which was between 10 percent (2003) and 60 percent (2001) lower than allocations. General public services were modestly but seemingly permanent over-budgeted with outtum being 6- 10 percent over budget during the period. Educational Affairs and Services budgets modestly but repeatedly under-budgeted with out-turns at 2-7 percent under budget in the period.

60. Apart from raising questions about realism, these statistics also question whether the budgets developed are specific enough to make their pol icy orientation clear. Budgets are typically developed according to economic and functional classification schemes in Croatia. To improve the output and outcome orientation, a program classification was added informally in 2001 and formally introduced through the BA in 2003. Budget expenditures are specified and adopted by the Sabor at a high level o f detail in the economic classification. Whereas i t i s a positive characteristic that could facilitate transparency and assist Parliamentarians in making budgetary votes, evidence suggests that a review o f a detailed economic classification has drawbacks. Parliamentarians, especially in the Budget Committee charged with analyzing the budget draft, have l imited technical support and the highly detailed budget can overwhelm them. The detailed economic classification shown in the annual budget document to the Sabor, also fails to provide specificity about the purpose o f expenditures; i t facilitates control but not strategic management. Indeed, the move towards a more outcome and results focused budget process, promoted via program budgeting, i s potentially undermined by a budget document which continues to be formally presented and adopted in a highly detailed economic classification.

61. The basic idea behind program budgeting i s that each appropriation must have a purpose and be assigned to a specific objective to prevent any confusion between appropriations at the authorization and the execution stage. The reform intends to orient expenditures towards programs and activities and those responsible for implementation. The idea i s to reorient the budget from a process focus to a service focus, whereby a l l expenditure allocations are clearly specified and managers have incentives to manage in strategic, efficient and accountable ways. This kind o f management vision and accountability for spending on objectives clashes with a detailed control o f individual items in the economic classification. Apart from this potential clash, success in program budgeting reform also hinges o n the exiting administrative capacity. The reform requires additional training o f professionals in the Ministry o f Finance and in the Budget and Finance Units (BFUs) o f spending units. The main dilemmas relate to the definition o f programs and sub-programs and the specification o f expenditures accordingly. The reform i s also highly dependent on government’s developing clear pol icy priorities and communicating these priorities to spending units to facilitate linkages between expenditures and policies in these entities. The lack o f specificity in policies and o f clear

Croatia CFAA: Budsefinq 19

thinking which l i n k s government activities to policies undermines any technical initiatives to improve specificity.

62. Medium Term Expenditure Framework (MTEF). The govemment operates with a three-year fiscal framework. A further development o f the framework into a comprehensive M T E F has been under way for number o f years and i s also part o f the dialog between the World Bank and the Croatian government in connection with the Programmatic Adjustment Loan (PAL) currently being negotiated.

63. There i s currently not sufficient administrative capacity in the Ministry o f Finance and l ine ministries to develop and implement a comprehensive MTEF. Also, the detail in the economic classification currently used for budget preparation complicates a move towards a MTEF focused on programs. This would also require that the role o f the medium-term fiscal forecasts be clarified - for example, determining the way in which outer year estimates are expected to be translated into current budgets. The C F A A also finds that the Ministry o f Finance and l ine ministries are short o f analysts to cost new legislative and pol icy proposals and communicate their benefits and develop spending programs to facilitate multi-year policy plans.

111. Summarv of Findings and Assessment of Fiduciarv Risk

64. The lack o f budget comprehensiveness poses a fiduciary risk. Whereas the organic Budget Act o f 2003 included the regulation o f key aspects o f the (Extra- budgetary Funds) EBF’s budget preparation and financial management, EBFs remain excluded from certain provisions o f that Act, including provisions requiring internal audit.

65. The current process for preparing and revising the budget appear to promote budget realism, but i t does not provide for strategic budgeting or for the effective monitoring o f allocations. The budget classification includes administrative, economic, functional and programmatic classifications, but the budget as it i s presented to Parliament offers l i t t le information or direction about policies and strategies. The frequent budget revisions in the course o f the year furthermore undermine the strategies and policies that might be reflected in the budget. The Ministry o f Finance, which has very limited policy analysis capacity, does not analyze budget proposals to assess their strategic content. Whi le the strong performance o f budgets in achieving targets thus suggests low fiduciary risk, there i s a moderate risk that the budget will fa i l to ensure efficient and effective resource allocations.

66. Budget users are given clear guidance for the preparation o f the budget submissions and generally adhere to the budget calendar. The budget does not as yet provide the type o f information required to show key expenditure types or pol icy development. The program and medium-term budgeting innovations are tenuous, dependent on significant capacity building and cultural change in the Ministry o f Finance and in the l i ne ministries. Furthermore, this kind o f budgetary approach requires a more active role o f the Parliamentary oversight committee. Whereas parliamentary scrutiny covers aggregates and detailed estimates o f expenditure and revenue, Parliament appears to have accepted to have a limited oversight role and weak administrative capacity. There

Croatia CFAA: Budaefina 20

is a risk that the budget wi l l continue to fail to reflect a strategic, medium-term policy agenda and to facilitate transparency.

67. with budgeting to be moderate.

Considering the different indicators, the C F A A finds the fiduciary r i s k associated

IV. Recommendations

68. The CFAA recommends f i rst that the M O F take action to either fully integrate al l existing EBFs into the state budget and Treasury Single Account system, or alternatively make them subject to similar budgeting, accounting, financial reporting and auditing requirements as al l BUS, while keeping for example i t s own banking arrangements. For both scenarios, the BA and other relevant laws and regulations should be amended accordingly.

69. The C F A A also recommends strengthening the macroeconomic forecasting function in the Ministry o f Finance. Historically, the forecasting model has been non- transparent; forecast quality has been questionable, not open to verification, and not produced according to a timetable stipulated in legislation. The lack o f adherence to a timetable has limited the ability o f l ine ministries to develop budget proposals on time. Recent M O F reforms in this area are intended to address some o f these problems. For example, the MOF now opens i t s projections to external verification, which enables comparison with forecasts developed in the private sector.

70. The C F A A also recommends taking necessary steps to move towards a Medium Term Expenditure Framework, based on a program classification and multi-year forecast. This requires assessing the functionality o f the program budgeting module in S A P against other alternatives, building strategic budgeting capacity in the Ministry o f Finance and in the l ine ministries, and considering the detail at which economic classification is required to minimize clashes with the new reform. I t also requires clarifying the role o f medium- term fiscal forecasts in the budget process- for example, determining the way in which outer year estimates are expected to be translated into current budgets.

71. The CFAA also recommends developing an analytical capacity in the budget process by training budget analysts in the Ministry o f Finance and l ine ministries. These analysts should be able to cost new legislative and pol icy proposals and communicate their benefits and in time should also be able to develop spending programs to facilitate multi-year policy plans. Also, the C F A A recommends that a budget manual be developed and formally issued to advance and support multi-year budgeting and an effective functioning o f program budgeting.

72. Finally, the C F A A recommends strengthening the role o f the Parliamentary Budget Committee by focusing i t s mandate o n budget analysis and improving its technical support.

Croatia CFAA: Treasurv and cash manaqement 21

CHAPTER 4: TREASURY AND CASH MANAGEMENT

I. Background and Assessment Framework

Background

73. The M O F have expended considerable effort in establishing and improving the Government’s treasury function. W h i l e good progress has been made in the basic functions, a number o f areas still need attention. The PEIR recommended that the M O F immediately institute commitment controls by establishing a process o f MOF review o f al l contracts prior to ~ignature.~’ The Donors’ 2003 report to the also observed that commitments were not captured in S A P ; i t also noted that MOF’s cash management activities could be further strengthened by providing oversight and control o f the daily available cash fund movements on State treasury accounts, by reducing the number o f budgetary user bank accounts outside o f the TSA; by providing a rol l ing financial plan to aid in liquidity forecasting and by planning an improved short te rm management o f borrowing and investments.

Assessment Framework

74. Treasury Systems. N o internationally accepted standards or codes exist for managing cash and treasury systems. However, it i s generally agreed that an effective cash planning and management system should 37:

0

0

0

0

0

0

75.

Recognize the time value and opportunity cost o f cash;

Enable l ine ministries to plan expenditures effectively;

Anticipate macroeconomic developments while accommodating significant economic changes and minimizing the adverse effects on budget execution;

Respond to the cash needs o f line ministries;

Be comprehensive, covering al l inflows o f cash resources;

Plan for liquidating short- and long-tenn cash liabilities.

Best practices for accounting and financial controls, issues closely related to cash management, are reflected in international standards and codes, separately reviewed in this report.

76. To minimize borrowing costs and maximize interest-bearing deposits, cash balances are most efficiently centralized in a “treasury single account” (TSA). A TSA i s either a single account or a set o f linked accounts through which the Government executes all payments. In practice, various methods exist to centralize cash flows. Under centralized systems, requests for payment and invoices justifying them are sent to the

j5 The MOF n o w receives a manual monthly report o f commitments made for the fol lowing month. Commitments beyond the next month are not reported. j6 Overview of Foreign Technical Assistance Provided to the Minister of Finance, Zagreb, 14 Jan 2004. j7 E.g. in Barry H. Potter and Jack Diamond. Guidelines for Public Expenditure Management, IMF, 1999.

Croatia CFAA: Treasuw and cash manaaement 22

- - -

Consolidate data f rom al l ministries and regional offices as necessary; Faci l i tatehpport easy retneval o f data in system databases in vanous formats; Produce good reports, such as commonly required accounting and management reports.

~

Treasury, w h i c h approves them before mak ing payments. U n d e r decentralized treasury systems, B U ' s can administer bank accounts, but the Treasury m u s t authorize them; these are zero-balance accounts, with m o n e y transferred to them ( f r o m specific approved payments). Or banks accept the payment orders sent by l i ne agencies up to a certain limit def ined by t h e treasury.

77. Treasury information systems are common ly established to contro l spending, e f f ic ient ly imp lemen t the budget and min im ize the cost o f Government borrowing. Such systems should b e able t o p rov ide for secure execution o f payments, w h i c h includes record ing t h e required p re l im ina ry checks and commitments, validations and authorizations. The Treasury Reference M o d e l (TRM) developed by the World B a n k and the IMF prov ides a n out l ine fo r what a treasury system should de l iver (see Box 2).

Box 2. The Treasury Ledger System.

~ A Treasury Ledger System includes a set o f summary control accounts [the ledger] that

~ f rom this database. Such a system can create transactions and authority (appropriations, maintain budget authority and actual spending, and handle al l posting and reports generated ~

apportionments and allocations), record al l transaction details, and consolidate and disseminate ~

information. Some examples include:

Create authority and transactions ~

~

~ - Distribute appropriation and commitment authorizations to spending ministries; ~ - Distribute allocations to spending ministries; ' ~ - Print checks against payments instructions andor arrange for the electronic transfer of ~

payment information to an external paying entity (e.g. a bank), i f required.

Record transactions I

- -

Record init ial budgets, as approved by the legislature; Record expenditures against commitments and allocations (e.g. due to purchase orders or other payments); Record revenues and other receipts against appropriate accounts; Capture and maintain records throughout the year on: (a) in i t ia l and revised budgets; (b) budget transfers for a typical Budget User (BU); (c) commitments incurred by BUS against approved limits and appropriations; and (d) funding allocations against appropriations and subsequent changes.

- -

Consolidate and disseminate transaction information and reports

78. Cash Management. Speci f ic indicators o f cash management performance inc lude such factors as the ab i l i t y o f the Government to accurately forecast and monitor the i r revenues throughout the year. Because the revenue forecast dr ives the entire expenditure

Croatia CFAA: Treasurv and cash manauement 23

planning process, overly optimistic revenue forecasts can result in shortfalls that can only be managed by spending freezes or cash rationing. This situation results in expenditure arrears; budget entities are unable to meet their commitments under the original budget cash release plans or enter into new commitments under the original plan. The net effect i s disruption o f the budget execution process and the potential for misallocations o f resources. Therefore, sub-indicators o f cash management performance include actual to budget revenue comparisons, shortfalls in monthly and quarterly expenditures relative to approved plans, the extent of cash rationing and the level and growth o f expenditure arrears.

79. The fiduciary r i s k associated with cash management wil l be assessed as the r i s k that: (i) payments are not made in accordance with the purposes and specific activities set out in the budget; (ii) delayed payments distort the effective implementation o f government activities.

11. Findings

Legal Framework

80. The legal framework for the Treasury system includes the 2003 Budget Act (BA); the Treasury General Ledger System and Methods o f Managing the Single Treasury Account located in the Central Bank o f Croatia (Official Gazette No.97/1995); Internal Organization o f the Ministry of Finance (26 Jul 2001); Instructions on the Execution o f the State Budget from the Single Treasury Account; and other supporting regulations relating to budget execution, control and rep~r t i ng .~ '

Institutional Framework and Capacity

8 1. distinct administrative sections:39

The Ministry of Finance. The Treasury function in Croatia i s composed o f five

0 The Budget Preparation Section i s responsible for the budget preparation o f central government entities, local and regional self-governments and EBFs, the preparation of monthly, quarterly and annual plans for execution o f the budget, capital planning activities and related activities.

The State Budget Execution Section i s responsible for perfonning al l tasks related to the execution o f the State budget, including budget preparation and utilization reports, the Kuna payment system, cash management and foreign exchange transactions.

The Public Debt Management Section registers al l obligations o f the state, issues securities on the domestic and external markets, and manages all aspects o f the public debt portfolio - sources, terms and conditions o f payment, interest rates- and advises on the issuance o f government guarantees.

0

0

See Chapter 6 on internal control and internal audit for more details. Regulation on the Intemal Organization o f the Ministry o f Finance, July 2001, articles 6, 7,

38

39

Croatia CFAA: Treasurv and cash manaaement 24

The Systems Improvement Section i s responsible for the planning, development and operation o f the Treasury information systems, staff training and interactions with the payment services provider, FINA.

The Budgetary Supervision Section exercises supervisory control over the state budget entities to ensure the legality and appropriateness o f budget expenditure.

82. FINA. An important component in the Treasury system i s performed by FINA. I t i s a state-owned financial agency that has evolved from i t s ZAP roots to become a major player in the banking system o f Croatia (it operates the payment and settlement system for the banking sector) and a critical partner for the Government across a wide range o f functions i t performs on a contractual basis.

83.

0

0

0

0

0

84.

For the government, FINA:

Settles al l payment and revenue transactions that involve the Government o f Croatia

Maintains and operates a number o f registers o f clients o f government services, including the Central Registry o f Insurees, registry o f legal entities and natural persons and the financial statement register (that includes monthly, quarterly and annual reports)

Processes mandatory social payment remittances, taxes and local government taxes and al l other public revenues accruing to the state.

Processes supplier payments approved by the Treasury S A P system, depositing funds in the accounts o f suppliers or individuals throughout the country

Participates with the government in i t s pension reform initiatives that involve payments; ministry pilots (Defense, Interior) to develop interfaces between their ministry financial systems and the Treasury S A P system

FINA-specific support to the Treasury’s S A P financial transaction and accounting system includes:

I T Support through outsourced operation o f the S A P system, including housing and maintaining the hardware, software, local and wide area networks in Zagreb and in the regional Treasury units in the ministries across the country;

Technical and operational support o f the entire system on a 24/7 basis,

Technical support to accommodate the IT systems changes required by the passage o f the new Budget Act;

Transaction data processing and data backup for al l work in al l treasury offices;

Service level agreements to establish the levels o f service to be provided and penalties for non-performance;

Croatia CFAA: Treasuw and cash manaqement 25

0 Dai ly update o f al l financial data cleared in the FINA system, update and maintain changes in the accounts registers and communicate these automatically to the S A P system;

Manually enter a l l rejected transactions returned by private banks for whatever reason.

0

85. While FINA does not have the capacity to do SAP software development, i t could develop the capacity should the government contract for i t to be provided as part o f future outsourcing services.

86. FINA i s not required to comply with the Budget Act’s requirement to establish a modem internal audit function. Given that it undertakes a wide variety o f services, outsourced by M O F and other entities that are operating within the budget, i t would be important for the Govemment to require that FINA establish an internal audit unit. Major external clients o f FINA should also be represented on an internal audit review committee within FINA. See also recommendation in Chapter 6 on internal control and internal audit.

87. The SAP System consists o f the following modules:

0 Budget preparation is under implementation and was used for the preparation o f the budget for 2003;

Budget execution is also running in MOF, supporting the general ledger, and recording information about payments from the Treasury Single Account in the Croatian National Bank;

Debt management module exists but has not been implemented. The module has however not yet been tested and i s considered by World Bank and IMF experts to be a work in progress.

Cash management module exists, but i t i s currently unable to function partly because the debt management module implementation has halted and partly because forecasts from several other systems are unreliable. Also, the necessary coordination and cooperation between the various departments o f the M O F i s lacking.

0

0

0

88. For 2004, a number o f additions to the S A P system are planned:

0 A strategic enterprise management module is under development. The f i rs t phase, which pertains to budget planning has now been established;

A budget data warehouse module has been established, while a warehouse ledger for all revenues and expenditures and financial statements o f al l components o f the consolidated government entity i s under development;

Program budgeting capabilities are under development;

0

0

0 A management portal for M O F initially and al l ministries in the future, i s also under construction.

89. However, key parts o f a basic treasury system are s t i l l missing. The commitment control module has never been activated. As a result, manual commitment reporting on a monthly basis i s required from al l budget entities. There i s also a multi-year commitment capacity within the S A P system that could readily accommodate capital project commitments and other multi-year future obligations. Moreover, the lack o f a management decision on the selection o f a replacement o f the debt management system has resulted in an impaired cash management function that does not fully meet the needs of the cash management unit. 40 A mission o f World Bank and IMF experts recommended that a review be undertaken to assess what would be the most suitable way forward for debt management. USAID has done an independent assessment o f whether the current SPRINT system or the S A P module i s more appropriate.

Practice

90. The Treasury Single Account System. A Treasury Single Account (TSA) system i s in the process o f being implemented. I t now accounts for al l state domestic revenues - taxes, duties and other levies, EBF charges and own-generated revenues, using information that i s captured and coded by FINA. On the expenditure side, the S A P system currently deals with payroll (through two transit accounts, for deposit in the bank accounts o f individual c iv i l servants), supplier payments and capital expenditure payments. Both are deposited into the appropriate vendor accounts on f i l e with the system. Most EBFs are not formally required to use the TSA in the Croatian National Bank, and a number o f them4' employ accounts in the Postal Bank that i s also wholly- owned by the Government and uses FINA for i t s transaction processing.

91. In order to make payments v ia the TSA, BUS f i rs t submit standardized financial plans to the M O F based on the appropriations approved by the Sabor. The financial plans cover the entire year and are broken into 12 monthly plans. On the basis o f these plans the M O F sets monthly ceilings for a l l BUS and enter the corresponding budget allocations into the S A P system. Once the ceilings are set, the BUS can enter commitment requests against the relevant allocations to make payments. Whereas the ceilings were originally meant to be a hard budget constraints, the BUS frequently request the Treasury to make reallocations however means that this does not work in practice.

92. Large BUS use transit accounts, while other BUS pass their payments directly to the vendor accounts from the TSA. However, there i s a large number o f bank accounts held by BUS in private banks. The vast majority o f these 3,200 accounts are in the government owned Postal Bank. Originally intended only for small local incidental payments, they are widely used as operating accounts. In 2002 it was estimated that an average o f HRK 500 mi l l ion was on deposit in these accounts. This represents significant cash management inefficiency. The consolidation o f these accounts into the TSA should be a priority. ~

An exist ing system, SPRINT, has become obsolete; i t s o r ig ina l suppl ier n o longer supports it. 40

41 E.g. The Employment Fund, the Hea l th Insurance Fund regional of f ices expenditures; Croat ian Waters self-generated fees..

Croatia CFAA: Jreasurv and cash manaaement 27

Box 3. Transaction System Process

1.

2.

Provided a Budget User (BU) first records a fully coded commitment into i t s o w n financial system, based on a purchase order approved by an appropriate authority within the entity. Provided that the commitment i s for expenditure within the next month, it i s reviewed by the budget execution division for compliance with the appropriation purpose and amount and then recorded in the SAP ~ y s t e m . ~ ’ Next the purchase order i s approved by an authorizing authority within the BU in question and sent to the supplier. When the goods are delivered and confirmed, a request for payment i s entered into the entity’s f inancial system and separately into the SAP system. The budget execution section checks the request in the SAP system against the available cash in the ent i t y ’s monthly cash plan. If sufficient resources are in the account, SAP issues a payment request to FINA, which works as the transaction processing agency for government payments. FINA records the transaction and provides copies o f the transaction records to the MOF and the BU ’s Budget & Finance Unit; the data i s then keyed in to their own financial system to reflect the transaction. FINA also captures a l l domestic revenues and provide records to MOF and SAP. Monthly, the BUS send the M O F a statement o f outstanding commitments that are expected to b e settled in the fol lowing month. Commitments extending beyond this period are not disclosed. SAP does not accommodate commitments beyond the next month.

3 .

4.

5.

6.

93. Additionally, the government has foreign exchange accounts to cover the governments’ operations. A proportion o f the Government’s debt-servicing transactions are handled by three private banks. One o f these banks acts as the government’s agent in the London and Paris Club debt management operations. The government also holds a foreign exchange account in the Croatian National Bank, through which both repayment transactions and transactions o f receiving foreign loan funds are made. The extent o f other bank accounts operating in other countries i s not known, nor i s i t controlled.

94. Transaction Processing. The budget entity follows a complex process to make expenditures. Typically i t involves at least one additional financial system in the ministry/agency and multiple data entry activities, as shown in Box 3. This process has internal control and efficiency problems. Because there are no electronic interfaces between the entities financial systems and S A P , identical data has to be entered several times. I t i s common that for example a ministry has separate financial systems for different types o f appropriations. This could include a system for pay-roll, one or capital expenditure, one for current expenditure and so fourth. This increases the likelihood o f errors, requires regular reconciliations and represents an inefficient use o f financial staff resources and introduces significant delays into the financial system.

95. The S A P system was designed to meet MOF’s needs, with l i t t le or no regard for the requirements o f the budget entities. I t imposes a heavy workload o n the l ine ministries and agencies, without any support for their normal budgetary requirements. Moreover, existing transactions authorizations remain paper-based; the BFUs do not benefit from automation that could redesign the financial submission and approval processes and reduce the existing paper flow.

96. The team observed many different financial systems in the budget entities, each operating independently o f each other and the S A P system. This has led to widespread duplication o f functions and overlapping data entry requirements. This situation is a - ~~

42 BUS at lower level (e.g. social centers or schools) who do n o t have access to SAP terminals submit payment requests to the BUS at the central level (typically a ministry).

Croatia CFAA: Jreasurv and cash management 28

reflection o f the “bottom up” growth o f individual entities’ financial management systems, a common occurrence in al l large entities as they begin to integrate their financial management information. W h i l e the financial management information system solutions o f individual BUS are not formally decided by the MOF, there i s an opportunity now for MOF to begin a process o f rationalization o f i t s financial systems in use across the Government.

97. In common with many other major IT projects, the S A P project is technology- driven. There i s no strong user group demanding future improvements to the SAP system and its interactions with the budget entities. Rather, the technical project team attempts to anticipate the future needs o f management, then implement new S A P services to respond to them. This supply-push approach i s guaranteed to yield inefficient results; a demand- pull approach is required where the users o f the system are heavily involved in, and committed to, improvements in the functionality and the efficiency o f the S A P and related systems.

98. Within the MOF, no one at a senior level have been taking responsibilities for S A P ’ S further development. A senior executive at the Assistant Minister level must be assigned the responsibility for SAP development and for rationalizing the many ministry systems that interact with S A P . The S A P organizational unit should report directly to this individual. The Assistant Minister would be assigned the responsibility to develop a strategic vision for the future evolution and rationalization o f al l o f the financial systems in the Government o f Croatia by:

0 Performing an inventory o f al l financial management systems in the budget entities, EBFs and agencies and detailing their functionality;

Developing a set o f options for the rationalization and future evolution o f the financial systems in the Government o f Croatia and costs o f each option;

0 Submitting recommendations to the Minister o f Finance and then to the Government for approval;

Implementing the rationalization strategy in cooperation with the budget entities.

0

0

99. The M O F state that:

0 The responsibility for the S A P system development i s encompassed by the function o f the Chief State Treasurer, who i s simultaneous the project manager;

0 A document entitled “Unifonn IT System Development Strategy for Public Financial Management in the Republic o f Croatia” has been prepared and wil l be forwarded to the Govemment for approval;

The M O F state that the latter document clearly indicates the guidelines pertaining to rationalization and further development o f the public finance system in the Republic of Croatia.

Croatia CFAA: Treasurv and cash manaaemenf 29

100. In a posit ive development, under the agreed Wor ld Bank supported PAL program the Government has agreed to assess the functionality and overlap o f financial systems (including S A P ) in ministries and budget entities, and develop a strategy to rationalize and integrate financial systems.

101. The CFAA concludes that the governance structure o f the S A P system does not work. This cou ld for instance be revitalized by the creation o f a new steering committee, chaired by the State Secretary for Finance, whose members include Assistant Ministers from a l l key areas o f MOF, senior level representatives f rom selected l ine ministries and the CEO o f FINA. The role o f this committee should be to:

0 Establish development priorities for the S A P system and arrange for funding o f i t s improvements;

Establish sub-committees o f a l l users o f the S A P system and o f the k e y min is t ry financial systems to ensure that their future evolution i s consistent with the overall strategy for government financial systems. The chairs o f each sub-committee wou ld also participate in the steering committee.

0

102. The MOF state that the S A P development project i s managed by a Project Supervisory Board, headed by the State Secretary o f the MOF, whi le i t s members are an Assistant Min is ter o f Finance, the Secretary o f the MOF and the Deputy State Secretary f rom the Central Development Strategy Office. The MOF further state that assistant ministers fi-om other ministries who manage IT processes for f inancial functions in their ministries wil l also participate in the Project Supervisory Board’s work.

103. Seeds o f cooperation between S A P and budget entity f inancial systems are in place. There i s a p i lo t project invo lv ing the MOF and the Ministr ies o f Defense and the Interior to examine the development o f an interface between their internal f inancial systems and S A P . This wou ld enable the automated transfer o f relevant data between the ministry and the MOF, thereby eliminating the manual reporting and the re-entry o f data in MOF. The results o f this p i lo t should be used as input in the strategic vision init iative referred to above.

104. The MOF have informed the Wor ld Bank that i t also has init iated a p i lo t project to link the Ministry o f Science, Education and Sports and the M in i s t r y o f Health and Social Welfare to the State Treasury System.

105. Cash Management. Budget execution i s closely monitored and controlled at a highly disaggregated level o f economic classification by the MOF Budget Execution Division. All budget entities prepare an annual and month ly forecast o f expenditures that are manually submitted to the MOF and recorded in the S A P budget system. T w o weeks before the end of a given month, the cash management unit provides month ly limits to the budget entities, based on their cash f l ow analysis o f the government’s cash position. The budget entities then revise their month ly financial plans and send them back manually to MOF. Then they are entered in to the S A P budget system. This forms the basis for the monthly execution by the budget entity. A measure for the system’s efficiency i s the total o f arrears, which in 2003 constituted 6 percent o f the consolidated state budget.

Croatia CFAA: Treasuw and cash manaqement 30

106. In 2001, the cash management unit was established in the Budget Execution division o f the M O F with a staff o f five; technical support comes from the IMF. The unit performs several key tasks:

0 Preparation o f an annual and monthly forecast o f revenues. In close cooperation with al l M O F agencies and revenues collection entities, the cash management unit developed a revenue forecast model, based on historical revenues data beginning in 1998;

Forecast o f annual and monthly budget cash inflows and outflows and calculation o f the monthly net cash surplus/requirements. I t uses the forecasting model and the monthly budget execution estimates provided by budget entities to MOF for recording in S A P . Whereas it should also accommodate the Public Debt Management sector’s financial plans for debt principal and interest disbursements and estimated payments on government guarantees, this i s currently not the case;

Weekly updates of the forecast cash position, based on the TSA, cash and foreign exchange balances of the M O F and budget users in budget units, banks and the revenues from the revenue forecast model, comparison of the total revenue inf lows to the estimated cash outflows from S A P ;

Making recommendations for short-term financing or investment decisions for the government, based on the forecast net cash positions;

Providing maximum monthly cash allocation limits to each budget user through S A P ;

Analyzing actual cash results from budget execution to refine the revenue forecasting model and related cash management techniques.

107. The Donors’ Report recommended that the cash management group should seek to extend i t s activities to encompass the cash activities o f a l l BUS and EBFs, to reduce the number o f bank accounts operating outside o f the TSA, to implement a rol l ing cash forecasting financial plan and to improve decision-making processes for short-term borrowing and investing. The C F A A endorses these recommendations; they are repeated here for reasons o f completeness.

0

0

0

0

0

111. Summary of Findings and Assessment o f Fiduciary Risk

108. There i s a need to rationalize the future development o f financial systems in budget entities. Multiple financial systems operating independently in individual budget entit ies increase the risk o f budget execution errors. Because these systems are not coordinated with S A P , extensive data re-entry i s necessary. To avoid increases in the error rate in transaction processing frequent reconciliations are required. As well, due to the small number of skilled staff operating the S A P system in l ine ministries, there i s a natural tendency to assign duties that should be separated for reasons o f financial control to a single individual who has been trained in the S A P system.

109. The components missing from the S A P system have increased the risk o f budget over-expenditures. The absence of a multi-period commitment control module and the lack o f any development activity to implement it i s a serious shortcoming. Moreover, the

Croatia CFAA: Treasurv and cash manaaemenf 31

cash management module’s partial implementation increases the risk o f inefficient cash management and potential estimation errors in the budget releases to budget entities. These may result in expenditure arrears.

110. Successful I T projects depend on strong management direction and support. That has been lacking in the Treasury system. N o senior M O F manager is responsible for the system’s development. Nor has any senior manager established clear requirements and deadlines to drive the project team to succeed. Nor i s there evidence o f strong involvement by those M O F units who are the logical users o f the system; l ine ministry staff have also been conspicuously absent so far. There i s the need for a vision o f the future evolution o f the financial systems in the government that, when endorsed by the government, would serve as the blueprint for future evolution o f SAP and the individual financial systems in budget entities. In a positive development, the Government has recently agreed under the World Bank supported P A L program to take steps that wil l form the basis for the development o f such a vision.

111. The existence o f some 3,200 budgetary entity bank accounts in private banks poses a fiduciary r i s k to the average HRK 500 mi l l ion cash balances on deposit. In addition to being poor cash management, this situation increases the fiduciary r i s k associated with the system; it does not contribute to effective financial controls. A similar problem may exist in the case o f foreign bank accounts that support external borrowing activities; the team was unable to assess the situation in sufficient detail to reach a conclusion.

1 12. rated as significant.

In summary, the risk resulting from the Treasury and cash management systems i s

IV. Recommendations

113.

e

e

e

e

The CFAA recommends that the MOF:

assign to an Assistant Minister responsibility for the formulation and implementation o f a strategic vision for the future evolution and rationalization o f al l o f the financial systems in the Government o f Croatia.

ensure management ownership o f the S A P systems by assigning responsibility for i t s development and operation to the same Assistant Minister identified above. This Assistant Minister should have assigned management responsibility for the M O F System Improvement Section;

commission an independent systems audit o f the S A P system by an external, private sector auditor with extensive financial and IT experience. The auditor should investigate, among others, means to increase S A P ’ S functionality for both the MOF and the budget entities;

establish a Steering Committee, chaired by the State Secretary with senior representation from al l affected MOF sectors, l ine ministries and FINA, to oversee the development o f S A P and assist in the development and

Croatia CFAA: Treasuw and cash manaqement 32

implementation o f the strategic vision for the evolution o f the Government’s financial systems;

0 implement the Treasury Single Account by closing all entity private bank accounts and consolidating them into the TSA; and implement the module in the MOF S A P system to process multi-period commitments;

Croatia CFAA: Accountinq and financial reportinq 33

CHAPTER 5: ACCOUNTING AND FINANCIAL REPORTING

I. Background and Assessment Framework

Background

114. For the FY 2002, the M O F for the f i rs t time prepared a set o f consolidated financial statements for the execution o f the state budget. At the same time, the formal introduction o f modified accrual-based accounting principles began with reissuing o f the Ordinance on Financial Reporting in Budgetary Accounting (Official Gazette O G No. 92/92 with amendments No. 3/03 and No. 12/03, hereafter the OFB). Subsequently, the June 2003 amendment o f the BA required the modified accrual basis for accounting and the reporting o f al l BUS and EBFs.

1 15. As for a number o f other PFM-related activities, the continued development o f the Treasury system i s key to accounting and financial reporting. To some extent, the lack o f progress in developing the Treasury’s S A P system i s also delaying the modernization and simplification o f accounting and financial reporting.

116. Both the M O F and the SA0 have reviewed the transition from cash to modified accruals. A competent group of accounting specialists in the M O F has prepared a report on this issue titled, “Errors made in financial statements;’’ the SA0 has reported on similar issues in i t s Report on Performed Audits for 2002. The MOF has also done a comparative review of the IPSAS, GFS and the Croatian state budget accounting system and generally seem well informed about current developments related to public sector accounting standards.

117. financial reporting and offer ideas to their solution. The problems identified include43 :

The Donors’ Report identifies a number o f problems related to accounting and

Timely monthly [budget] execution reports are not available for unconsolidated government;

S A P not set up to adequately capture the commitments data; Too many accounting and statistical methodologies used;

EBFs do not use the Chart o f Accounts (COA); The C O A i s GFS2001 compatible, while reports are produced using GFS1986;

EU requires the use o f ESA95;

Accounting reports are not generated automatically; Collection o f data not al l in electronic form;

Accounting i s done on the basis o f modified cash rather than modified accruals.

43 The problems listed below are quoted f rom the before mentioned report, “Overview o f Foreign Technical Assistance Provided to the MOF”, included in a letter t o State Secretary, Ministry o f Finance, January 13, 2004. The MOF has informed the Wor ld Bank that they do no t agree with the conclusions in the third and ninth bullet points (“Too many accounting and statistical methodologies used” and “Accounting i s done o n the basis o f modif ied cash rather than modif ied accruals”).

Croatia CFAA: Accounfing and financial reporting 34

Assessment Framework

118. Whereas the System o f National Accounts (SNA) and the IMF’s Government Financial Statistics (GFS) are the most common references for economic and budget classifications, statistics, and accounting techniques, EU-accession countries are asked to apply the European System o f Accounts (ESA) 95. Like GFS 2001, this system adopts an accrual financial reporting framework that can be used to calculate the “Maastricht” budget balance (the economichudget criteria for joining the Euro-zone set forth in the Maastricht Treaty). This type o f balance combines all central government departments, social security funds and local governments into a single General Government account. Because o f the ESA 95’s definition o f “deficit”, the balance does not take into account- estimated expenditures (allocations for depreciation and provisions). Rather, i t focuses o n specific circumstances and the EU’s own data needs. Some differences exist between the ESA 95 and the other two schemes (SNA 95 and GFS 2001). Generally, the ESA 95 concepts are more specific and precise than the SNA’s. Also, GFS 2001 provides several definitions o f the balance, which offers some flexibility in applying the standard.

119. The International Financial Reporting Standards (IFRS),44 issued by the Intemational Accounting Standards Board (IASB), are the recognized standards for private sector accounting worldwide. Meanwhile, an increasing number o f governments are applying the International Public Sector Accounting Standards (IPSAS) created by the Federation o f Accountants (IFAC). According to IPSAS 1, a complete set o f financial statements from a government entity should include the following: (a) a statement o f financial position; (b) a statement o f financial performance; (c) a statement o f changes in net assetdequity; (d) a statement o f cash f low and (e) accounting policies and notes to the financial statements. The equivalent terms for (a)-(c) in I A S 1 are: “balance sheet,” “income statement” and “equity.” 45

120. The EC Financial Regulation. The underlying principles for sound financial reporting in the public sector are reflected in the EU’s 2002 adopted E C Financial Regulation. Providing a benchmark for public sector financial reporting and a legal requirement when i t come to managing EU’s own funds, this regulation will serve as the basic assessment framework in this chapter. The accounting provisions o f the E C financial regulation, which broadly reflects the principles o f the can be summarized as follows:47

The annual accounts o f an [EC] administrative body shall consist o f both jkancial statements and a report on budget implementation, where the f i rs t reflects the financial position and financial performance o f the reporting entity and the latter the cash revenues and expenditure processed during the period;

Financial statements should draw on generally-accepted accounting principles, including: (a) a going concern; (b) prudence; (c) consistent accounting methods;

44 The International Accounting Standards (IAS) were integrated into the new IFRS. 45 T o date, 20 IPSAS have been issued. IPSAS 1 concerns the “Presentation o f Financial Statements.” 46 Although the IPSAS terminology i s no t used, it reflects the terminology o f the IAS , n o w IFRS. 47 Summarizes the key issues addressed in articles 76-90 o f Commission Regulation No. (EC, Euratom) No. 234312002. Terms are used as in the regulation.

Croatia CFAA: Accountina and financial reporfins 35

(d) comparability o f information; (e) materiality; (f) n~-netting~~; (g) presenting reality over appearance ; (h) accruals,49 and consist o f a “balance sheet,” “economic out-tum account,” “cash-flow table,” “statement on changes in capital” and an annex that discusses and supplements the information (notes);

Budget implementation reports should consist o f budget out-turn accounts on revenues and expenditures and an annex with comments and supplementary information. An institution’s accounting officer should submit i t s provisional accounts to the [EC’s] accounting officer no later than March 1. Then the EC’s accounting officer consolidates the Commission’s accounts;

A computerized accounting system must be in place to organize an institution’s budget and financial information. Once i t is, figures may be entered, filed and registered. Moreover, the computer facilitates an audit trail that can track accounting data backwards and forwards in the system;

0 The central accounting authority (in the E C context, the Commission’s Accounting Officer) must adopt a harmonized chart of accounts that institutions can apply;

The director (the most senior manager) must submit thefinal accounts to the Commission’s Accounting Officer (the central accounting authority, for example, MOF) and to the Court o f Auditors (the supreme audit institution) by July 1. The Court o f Auditors should, in tum, publish them by October 31 o f the year following the financial year.

0

0

0

121. and financial reporting provisions o f the EC financial regulation.

The structure o f the chapter follows from the above overview o f the accounting

122. Fiduciary Risk. The fiduciary risk associated with accounting and financial reporting.wil1 be assessed as the risk that financial reporting i s unreliable or not timely; the fiduciary risk will have the following indicators: (i) Absence o f prompt recording and processing o f transactions, allowing timely aggregation at l ine ministry and Ministry o f Finance level; (ii) Absence o f prompt and regular data reconciliation; (iii) In-year budget execution reports, which reflect the budget classification, are not disseminated within the government in a timely manner; (iv) Presentation o f audited financial statements to the legislature i s not timely. For overview o f the fiduciary r i s k indicators used in the CFAA, please see table 2 in Chapter 2.

48 That receivables and debt may not offset one another. 49 Commission Regulation (EC, Euratom) N o . 234212002, Articles 187-195. These principles reflect the principles for presentation o f financial statements l a id down in IPSAS 1. The introduction o f accrual-based accounting principles to the public sector i s not a legal requirement for EU Membership. Nevertheless, when it comes to the management o f funds f rom the European Union’s budget, the application o f accrual- based accounting principles i s a legal requirement indeed. This requirement appears separately in the relevant E C regulations for specific funds (e.g. Cohesion o r Structural Funds). I t i s also a general principle o f the EC Financial Regulations and i t s implementing regulations. The GFS2001, ESA95, IPSAS and IFRS share an important commonality; they promote and provide guidance on the use o f accrual- based accounting principles.

11. Findings

Legal Framework

123. The legal framework for accounting and financial reporting for BUS and EBFs includes the BA, the OFB, Regulation No. 97/95 on the M a i n Treasury Ledger System and Methods o f Managing the Single Treasury Account and the Book o f Rules o n Budgetary Accounting and Chart of Accounts (COA) with the C O A attached (OG No. 1 19/01 and 74/02).

124. The BA sets out the basic principles o f accounting and the requirements for financial reporting. In accordance with BA articles 115 and 121, it i s required that accounting shall be based on “International Accounting Standards for the public sector”, which appears to refer to the International Public Sector Accounting Standards (IPSASs) issued by the International Federation o f Accountants, while at the same time i t is explicitly stated that accounting shall be based o n modified accrual-based accounting principles. A set o f IPSASs has been developed on a full accruals basis, and there i s also a separate IPSAS which specifies the requirements for reporting on a full cash basis. However, there are no modified-accrual IPSASs, which implies that there could be some inconsistency in the BA on this point5’. Sti l l , considering the specificity o f the provisions o f the BA relevant guidance i s provided. Specifically it i s stated that BUS shall adjust the value o f non-financial fixed assets using a producers price indexation, while taking historical cost as the point o f departure (Art. 121 (2) and (3)).

125. The BA establishes that BUS shall prepare financial statements o n a monthly, quarterly, semi-annual and annual basis. I t stipulates that ministries and other central BUS shall consolidate statements from those BUS that report to them, and subsequently deliver these statements to the Ministry o f Finance (Art. 123 (1)). Finally, the BA charges the M O F with preparing the consolidated financial statements o f the Republic o f Croatia budget accounts and to submit i t to the Government or the executive o f the local executive body. Up until the passing o f the BA, the Government was not required to present a consolidated financial statement.

126. The OFB regulates in more detail the rules on accounting and presentation o f the financial statements. I t also includes the Government Chart o f Accounts and elaborates on i t s application. The C O A i s based on the economic classification o f GFS 2001.

Institutional Framework and Capacity

127. The MOF’s State Accounting and Financial reporting ( S A F ) Section has responsibility for implementing the Government’s accounting policies and for consolidating the government’s accounts. The staff o f the S A F Section are generally very competent. Five out o f the nine positions budgeted for are filled. Considering the importance o f the area and the profound reforms o f the system that are taking place, the unit seems understaffed. The responsibility for accounting and financial reporting for other BUS rests with the BUS’ respective Budget & Finance Units (BFUs). Though the

I t is envisaged that some entities in the process o f moving from cash accounting to full accrual 50

accounting may wish to adopt the requirements o f particular accrual-based IPSASs during this process.

Croatia CFAA: Accountinq and financial reportinq 37

Date Due January 3 1

January 3 1

expertise o f the accounting staff generally seems sufficient in BFUs, the staff are often few in numbers. This complicates further a fundamental change o f accounting rules requiring t ime o f f for training and it makes it difficult to secure an appropriate segregation o f duties among bookkeeping, accounting and treasury functions.

Submitted to Ministry; SA0 Loca l Office; Regional FINA office

Min is t ry o f Finance; S A 0 Loca l Office; Regional FINA office

128. Whereas all ministries, other central BUS and the major EBFs have direct access to the Treasury S A P systemS1, subordinate institutions depend on their own systems for financial reporting.

February 28

Practice

Ministry o f Finance ; Regional FINA office

129. Annual Financial Statements. Whereas the BA does not distinguish between financial statements and budget execution reports, i t does contain specific provisions concerning “semi-annual and annual financial statements on the budget execution” (Art. 124-128) as opposed to “financial statements” prepared for “periods in the course o f the year” (Article 122). The formats for the annual financial statements as well as the current financial statements fi-om the al l BUS and EBFs are regulated via the OFB, which consists o f forms to be used. As i t i s specified in the annual circular letter f rom the M O F to al l BUS, financial statements consist of: (i) a Balance sheet; (ii) a statement on revenues and expenditure; (iii) a statement on the changes occurred to the value o f assets and liabilities; (iv) statement on own revenues and expenses earned; and, (v) Notes. The deadlines for the submission o f the statements from the various subordinate BUS to the higher level BUS and eventually to the M O F and the Sabor are set out in table 6 below:

Table 6. Annual Financial Statements

Report By Central BUS and agenciess2 in a Ministry

Agencies that are also a ministry

Ministry

Financial Reports Required Balance Sheet; Revenues and Expenditures; Receipts and Outlays; Changes in assets and liabilities; own revenue and related expenditures; Notes

Balance Sheet; Revenues and Expenditures; Receipts and Outlays; Expenditures by Function; Changes in assets and liabilities; own revenue and related expenditures; Notes

CONSOLIDATED REPORTS Balance Sheet; Revenues and Expenditures; Receipts and Outlays; Expenditure by Function; Changes in assets and liabilities; own revenue and related expenditures; Notes

” There are some 55 direct users o f the SAP system, wh ich is serviced and maintained by FINA.

virtue o f l aw and financed f rom the budget”. Agencies are referred to as “institutions” in the available translation o f the BA.

As defined in the BA: “[Agencies] are budget users established as institutions by law and regulations by 52

Croafia CFAA: Accountina and financial reportinu 38

Report By BUS o f Loca l and Regional Self- governments

Local and Regional Self-Governments

Local and regional Self-Governments

Financial Reports Required

Balance Sheet; Revenues and Expenditures; Receipts and Outlays; Changes in assets and liabilities; Reports on Liabilities; Own revenue and related expenditures; Notes

Balance Sheet; Revenues and Expenditures; Receipts and Outlays; Expenditures by Function; Cash Flows; Changes in assets and liabilities; Liabilities; own revenue and related expenditures; Notes

CONSOLIDATED REPORTS Balance Sheet; Revenues and Expenditures; receipts and outlays; Expenditures by Function; Receipts and Outlays; Changes in assets and liabilities; Liabilities; own revenue and related expenditures; Notes

Date Due

January 3 1

January 3 1

February 28

Submitted to

Unit o f local and regional self- government; S A 0 Loca l Office; Regional FINA office

Ministry o f Finance ; S A 0 Local Office; Regional FINA office

Ministry o f Finance; Regional FINA office

130. A consolidated financial statement for the State Budget and the Consolidated State Budget o f the Republic o f Croatia was prepared for the f i rs t time for the fiscal year 2002. The State Accounting and Financial Reporting ( S A F ) Section performs al l o f th.e necessary consolidations to produce the consolidated financial statements. They receive statements from Ministr ies and other BUS in accordance with the schedule in table 6 above.

131. Consolidated financial statements covering 53 local governments out o f a total o f 568 entities are also prepared.53 The remaining local governments typically submit their financial statements to the MOF after the statutory due date and are therefore not included. The 53 local administrations account for more than 60 percent o f total local and regional government spending. The S A F Section endeavors to have a l l local and regional self-govemed units submit their statements according to the preceding schedule.

132. In preparation o f the Government's liability reports, an estimate i s also made o f the likely guarantees by the government for the debt o f State Owned Enterprises (SOEs). The Section on Economic Affairs has performed this function, using explicit risk assessment criteria. The SA0 audits these assessments on a case-by-case basis. These funds go into a government Guarantee Reserve account.54 The MOF displays on i t s web site an excellent overview o f 10 o f i t s major SOEs and three EBFs~~ operating outside of the TSA. The M O F advised that this number has increased to 23 SOEs. Unfortunately,

j3 As part o f an agreement with the IMF. j4 The 2004 budget contains a provision for approximately HRK 500 M i l l i o n for t h i s reserve. j5 The Bank for Reconstruction and Development, the Deposit Insurance and Bank Rehabil itation Agency and the Croatian Privatization Fund.

Croatia CFAA: Accountha and financial reportinq 39

the web-site did not give access to the financial statements that i t appeared to give access to when the CFAA team tested it.

133. In its audit o f the consolidated financial statement o f the state accounts, the SA0 noticed that i t received only a draft Statement on revenues and expenditure in April 2003 and the final Statement on revenues and expenditure, Receipts and outlays and the Cash f low statement on June 3, 2003. The statutory date for delivery o f the statements i s January 3 1. The SA0 further noted that the statements received were not reconciled with data in the ledger and with the factual situation, which was substantiated with examples in the report. Other statutory reports, including the consolidated Balance sheet; the Statement on the changes in the value and size o f assets and liabilities; the Statement on liabilities; and Notes were not submitted at all. The SA0 also notes that the deadline for the delivery o f financial statements for the State Budget and BUS had been shortened one month compared to the year before. In conclusion, the S A 0 states that the timeline o f thirty days to deliver the statutory financial statements i s too short, in particular for the most material BUS. A comparison between the deadlines in table 6 with those o f the E C financial regulation, supports the SAO’s conclusion.

134. Accounting Principles. As the M O F formally adjusted to the modified accrual- based accounting principles it has aimed at positioning the Government’s own accounting rules between the GFS2001 and the IPSAS requirements. A long-term objective is to move to fill accrual accounting and abide by international standards. To do so, a number o f changes will need to occur in the treasury’s general ledger, including the capture o f non-financial assets and liabilities. Unfortunately, the required development o f the S A P system i s not happening, partially because the S A F Sectior, has no effective channels o f communications to the S A P project team.

135. As also noted in the Donors’ Report, the EU i s requiring fkom i t s Member States to apply ESA95 on the national accounts. In i t s Opinion on the Application o f Croatia for membership o f the European Union, the European Commission stated that the National accounts and GNP/GNI figures were produced “using definitions and accounting rules o f the ESA95”. As indicated in this chapter’s section on assessment framework, the definitions and accounting rules used by ESA 95 and GFS2001 are to some extent similar. Still, adjustments are needed to be able to present the Croatian General Government in an ESA95 format. The C F A A did not obtain any information that indicated that the M O F has initiated work in this field. Based o n the feedback received, i s seems likely that the SAF Section i s awaiting the outcome o f work initiated by IFAC’s Public Sector Board to harmonize and approximate PSAS, GFS and ESA.

136. The S A F Section seem well aware o f developments in public sector accounting and reporting for the purpose o f maintaining their accounting policies and standards. Quality control consists o f reviewing the budget entity’s financial statements to ensure the appropriate accounting policies are in use. The Section maintains regular contact with the budget entities in i t s communities by distributing a circular that identifies common problems and errors, then explains how to avoid them. Due to the limited number o f staff i t s “enforcement” capacity i s however very limited.

Croatia CFAA: Accounfinq and financial reoon‘inq 40

137. Evaluating the application o f the new modified accrual-based accounting principles in 2002 and f i rst quarter o f 2003, the M O F found that many BUS did not fol low the MOF’s specifications set forth in the OFB and the Book o f Rules o n Budgetary Accounting. The MOF also found that a great number o f financial statements came in after the statutory deadline; that meant the M O F had less time to consolidate the Government’s accounts. Shortcomings were attributed to decentralization, for example, schools and social centers as wel l as local and regional sub-national governments. Accountants in the decentralized institutions were often unfamiliar with the organizational codes that applied to a regional or local administrative body, compared to a similar administrative body at the state level. In general, the M O F found many coding errors in the accounts o f decentralized institutions, including many in the Health sector.56

138. The M O F stresses that most BUS and local units are disciplined and they compile their statements and hand them in within the statutory deadline. The statement i s general and does not pertain to a particular period or fiscal year.

139. In i t s Report on Audits Performed in 2002, the S A 0 found that the move to modified accruals had caused major problems and irregularities in the accounts. Usually the errors had to do with the preparation o f balance sheets; valuation o f assets and liabilities posed a great challenge for the BUS. The SA0 also noted that the OFB had been changed twice in the course o f 2003; modifications that further complicated the exercise o f changing accounting principles.

140. The application o f modified accrual-based accounting principles is a statutory requirement. Sti l l , the accounting for expenditure v ia the Treasury S A P system i s cash based as it records payments made from the TSA. Also, the findings o f the SAO and the M O F indicate that accounting at the level o f individual BUS i s generally not done in accordance with the new provisions o f the BA and the OFB, and often continues to be done on a cash basis. The M O F have informed the World Bank that the essence o f the application o f the modified accrual-based accounting principle in the Croatian government administration i s the recognition o f expenditure based on the accrual principles and revenues based on the cash principle. The details for these principles are laid down in the Book o f Rules on Budgetary Accounting and the COA57.

141. Subordinated BUS (for instance social centers) are required to prepare a monthly liability report within 10 days o f the end o f the month to the higher level BU (e.g. a ministry). In turn, the central BU must submit a consolidated liabilities report to MOF and FINA within 15 days o f the end o f the month. The latter report i s the basis for measuring arrears.

j6 Report titled: “Errors made in financial statements”, Ministry o f Finance, 2003. j7 Modi f ied accruals i s described in Art icle 20 o f the Book of Rules on Budgetary Accounting and the COA as :

0

Depreciation of non-financial assets is not an expense, Revenues are recognized when cash is received, Expenses are recognized when spending occurs, Changes in value o f non-financial assets are not considered expenses or revenues, Current assets used for dai ly activities are considered expenses at the moment o f purchase, Inventories are recorded in the balance sheet, Donations o f non-financial assets are not classified as revenues or expenses.

142. The general ledger does not provide complete and timely information on the total public debt, liabilities and receivables o f the state. I t does not provide a basis for monitoring liabilities and receivables, which i s why the system cannot produce the data needed to generate a balance sheet. The S A P system cannot generate the information needed to identify an individual contract entered into by the M O F or the size o f the legal commitment i t has accepted by signing the contract.

143. Budget Implementation Reports. Revenue and expenditure reports are submitted from the BUS to the MOF on a quarterly basis. Data provided from FINA is the basis for the revenue data for both the current and the annual budget implementation reports (i.e. financial statement on revenues and expenditure). FINA delivers reports to the MOF on the revenues collected on a daily basis. The reports are broken down to different types o f revenue and the accounts to which they are credited. Upon request o f the MOF, FINA can also produce reports that identify the payer. FINA also sends weekly reports to BUS on the payments made for the institution from the TSA. FINA keeps data o n a real-time basis. The MOF delivers weekly reports on the realization o f own revenues to ministries and other BUS. Commitments for expenditures and outlays are recorded in S A P by the M O F on the basis of reports received from ministries and other BUS in accordance with the Chart o f Accounts.

144. Accounting data on revenues provided directly by FINA are perceived to be reliable. Based on the findings o f the SA0 as well as observation made by MOF staff and advisers, the C F A A must however conclude that accounting data concerning expenditure and outlays generally are not. Also, reconciliation o f accounting data i s typically only done at the level o f ministries and other central BUS. This i s another factor weakening the reliability o f accounting data.

145. Accounting Systems. Each BU has two and often three or four financial accounting systems. As the S A P system is only available to the BUS which hold one o f the 55 S A P terminals, most BUS cannot rely o n S A P for current financial reporting. Furthermore, the S A P system only provides detail at the 5th level o f the economic c la~s i f icat ion~~, which i s not enough for the type o f reports that BUS typically need. For instance, i t i s not possible to identify all vendors at that level o f the classification system. I t i s therefore not possible to generate a complete audit trail that enables the tracking o f accounting entries backwards and forwards in the system. Often the accounting systems are customized for different types o f expenditures, for example, one to manage payroll, another for current expenditures and yet another for capital expenditures. The existence of many different systems combined with the lack o f interfaces not only means a lot o f double work for the accounts and systems operators, i t also adds to the complexity o f consolidation exercises and increases the risk o f errors.

146. Although al l BUS reviewed had to some degree computerized the accounting function, some were s t i l l relying on spread sheets or outdated accounting software which do not meet modem standards for security and data protection. Also, financial statements are still to a large extent submitted manually - via diskettes or on paper - rather than electronically or on-line.

'* The Budget i s adopted by the Sabor at the 4" leve l o f classification.

Croafia CFAA: Accountina and financial reoortinq 42

147. Chart ofAccounts. In accordance with art. 117 o f the BA, the MOF has issued a Book o f Rules with a Chart o f Accounts (COA) and the OFB. The M O F has also published an Instruction on the Economic and Functional Classification o f Expenditure and Revenues. The Instruction’s classification i s one o f the dimensions o f the. COA. The latter provides a framework and background for the accounting records o f the budget and BUS activities. The C O A i s relatively new (from 2002) and as shown in the SAO’s audit o f the fiscal year 2002 as well as the MOF’s later evaluation (2003), the C O A was unt i l recently s t i l l not applied correctly. Also, a number o f EBFs are not required to apply the COA. This however does not go for the two most significant EBFs, the Health Insurance Fund and the Pensions Fund.

148. prescribed and al l entities within the general State must apply it, and do apply it.

The M O F state that the COA (like the accounting policies and methodologies) i s

149. Financial Statements to External Audit. In 2003, delays occurred in the submission o f financial statements to the M O F and the SAO. As stated above, the statutory deadlines set by the legislation were generally not observed by BUS. In accordance with the Act on State Audit, the State Audit Office (SAO) has to submit i t s Report o n the Audits Performed in the preceding fiscal year no later than 5 month after the completion o f financial statements o f the government. The S A 0 has so far been able to meet this deadline.

111. Summary o f Findings and Assessment o f Fiduciarv Risk

150, The MOF, for the f i rs t time, presented a consolidated financial statement for the state budget which i s a significant improvement. As the C F A A finds, the recording and processing o f transactions was, however, not prompt which prevented a timely aggregation at the l ine ministry and M O F level. For the same reason, the consolidated financial statements for the state budget 2002 were not prepared within the statutory deadline, which seem to be unrealistic. Consequently, the SAO’s audit o f the accounts for the fiscal year 2002 was partly based on draft consolidated financial statements. One o f the reasons for the delays in reporting was the change o f in accounting rules, involving an ambitious acceleration o f the time-line for the BUS’ compilation o f their financial statements. The changes also involved an equally ambitious move from cash to modified accrual-based accounting principles. The move was only partially successful. Furthermore, the C F A A finds that the change does not affect the accounting entries for expenditures at the Treasury, which continues to be done on a cash basis.

151. The CFAA also found that due to the nature o f the Treasury’s S A P system i t cannot generate a complete electronic audit trail. The C F A A concludes that accounting data related to the execution of the expenditure budget i s not reliable. Adding to the fiduciary risk i s the existence o f a multitude o f accounting systems, which are often outdated and do not meet current standards for security and data protection. Based on the preceding, the fiduciary r i s k associated with accounting and financial reporting i s considered significant.

IV. Recommendations

152. recommendations:

Based on the above findings the CFAA would l i ke to make the fol lowing

0 The M O F should take action to ensure that the statutory rulebooks and other appropriate guidelines are disseminated and training opportunities are offered to accountants and other staff o f Budget and Finance Units (BFUs) to ensure an effective implementation o f the new accounting rules.

The S A F Section o f the M O F should be reinforced in order to be able to provide more support to BUS in the application o f the new accounting rules, including the statutory formats and deadlines for financial reporting.

The M O F should extend the statutory deadlines o f delivery o f annual the financial statements and initiate the necessary amendments o f the BA and the OFB.

Due to the importance o f the issue and the profundity o f the current reform the Government should make the recruitment o f accountants and other accounting staff a matter o f high immediate priority.

The M O F need to consider a strategy to effectively support a modemization of the state administration’s accounting system. Any such strategy should however be based on an in-dept review o f the existing systems and consideration o f different alternatives to improve functionalities.

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CHAPTER 6: INTERNAL CONTROL AND INTERNAL AUDIT

I. Background and Assessment Framework

Background

153. The current development o f an intemal control framework and internal audit functions in the Croatian public sector basically evolves around an on-going EU project funded from CARDS 2002. The project has two components: one concemed with the development o f Public Internal Financial Control (PIFC); another related to intemal audit specifically. The project is “hosted” by the M O F but the end beneficiaries are in principle al l BUS. The project started in 2003 around the same time that the Sabor passed the new BA, which made the establishment o f IAU in all BUS a statutory requirement.

154. In September 2004, the Government and the M O F adopted a “PIFC Development Strategy for Croatia”, which sets out the framework for the future development o f the Government financial control system, in l ine with the requirements under EU negotiation Chapter 28.

Assessment Framework

155. Internal Control Framework. INTOSAI defines intemal control as the process by which an organization govems i t s activities to effectively and efficiently accomplish its mission.59 Within the COS060 framework, internal control i s defined as a process, introduced by a board o f directors, management and other personnel, to provide reasonable assurances that objectives wil l be achieved. Such controls consist o f five interrelated components :

0 Control Environment: This includes the soft aspects o f an organization- the ethical values, professional and personal integrity that promote respect for the stewardship and effective and efficient use o f public resources. They are reinforced by a management leadership and operating style that promotes these values throughout the organization and requires the sound delegation o f responsibility, authority and accountability for performance by competent staff.

Risk Assessment: Risk assessment involves the identification o f the key r isks faced by the organization. Major r i sks may include such control factors as: a lack of management integrity and weak organizational values; inappropriate delegation of authority and responsibility; insufficient staff training; inadequate management oversight; and inadequate policies and processes to monitor and control il legal acts.

Control Activities: Cost-effective controls are designed to mitigate risk. They include: well-defined job responsibilities; separation o f duties in processes handling funds; well-documented work processes with at least one ex ante

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59 The Intemal Control Standards Committee o f INTOSAI, “Internal Control: Providing a Foundation for Accountability in Government”, 2001, p. 5 . 6o The Committee o f the Sponsoring Organizations o f the Securities and Exchange Commission: hm:iiwww.coso.org

Croatia CFAA: lnternal Control and lnternal Audit 45

approval step for financial processes; ex post control exercised by both management and Treasury; strictly enforced budget spending limits and support financial information systems.

Information and Communication: A timely and regular flow o f information between management and staff in both directions i s essential for intemal controls. Staff report information on operations to management; management, in turn, conveys information about the entity, new policies and practices and other information relating to the entity.

Monitoring: Intemal audit i s a critical element in the management control system. I t provides feedback to management on the performance o f i t s controls and what should be done to strengthen them. The S A 0 can also exercise this monitoring function, but it i s outside the intemal control framework.

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156. Intemal audit is an integral yet distinct part o f intemal control. I t i s defined by the Institute o f Intemal Auditors (IIA) as: “an independent, objective assurance and consulting activity designed to add value and improve an organization’s operations. I t helps an organization accomplish i t s objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness o f r isk management, control and governance processes.” The IIA specifies Intemational Standards for the Professional Practice o f Intemal Auditing (ISPPIA).

157. In Chapter 28 o f the acquis communautaire, the European Commission has promoted i t s intemal control model, Public Internal Financial Control (PIFC). PIFC covers al l o f the components identified in the C O S 0 framework. PIFC has two components - financial management and control (FMC) and intemal audit (IA). The FMC, which consists o f al l actions other than internal audit, aims to supervise al l aspects of financial management - administrative, managerial and budgetary - to enable proper control over public finances. Another part o f Chapter 28 deals with the protection o f the EU’s financial interest, including measures to fight fraud and to coordinate fraud-fighting activities with the appropriate national and EU authorities, including EU’s fraud-fighting office, OLAF?

158. There are many possible consequences o f weak intemal controls. Expenditures may be made for purposes not approved by Parliament or in amounts exceeding authorized levels. Funds may not be used with due regard for efficiency and effectiveness. Fraud or corruption may divert public funds for personal or private gain and the organization may fai l to meet i t s objectives through misallocation o f resources. The presence o f any significant deficiency in these factors could result in a loss o f public confidence in the Govemment.

159. Internal Audit. The IIA issues the Intemational Standards for the Professional Practice o f Intemal Auditing (ISPPIA). They include a Code o f Ethics, Glossary, Attribute Standards, Performance Standards and Implementing Standards. In addition,

61 Office de l a Lutte Anti-Fraude.

Croatia CFAA: lnternal Control and lnternal Audit 46

practice advisories offer detailed guidance and practical interpretations o f the standards. See BOX 4.(j2

Box 4. International Standards for the Professional Practice of Internal Auditing

T h e A t t r i b u t e Standards

1000 Purpose, authority and responsibility 1100 Independence and objectivity 1200 Proficiency and due professional care 1300 Quality assurance and improvement T h e Per formance Standards 2000 Managing the IA activity 2 100 Nature o f work 2200 Engagement planning 2300 Perfonning the engagement 2400 Communicating results 2500 Monitoring progress 2600 Management's acceptance o f r i sks

Imp lemen t ing standards apply the attributeiperformance standards to specific types o f engagements (for example, a compliance audit, fraud investigation, control self-assessment, and others).

Source; The Inst i tute o f Internal Auditors: ht@://www. thei iaorx

160. One important source o f internal control requirements i s based on Chapter 28 o f the aquis communautaire. For countries seeking to become candidates for EU accession, the harmonization o f their financial controls with those o f the EU i s a natural step in the accession process. More specific details on internal controls are in the EC's Financial regulation^.^^ This regulation l i s t s several internal control responsibilities for various positions in the budgetary control process, including the authorizing officer, accounting officers, and imprest administrators, internal and extemal auditors. For example, the responsibilities o f the authorizing officer include:

0 establishing the organizational structure and the internal management and control systems and procedures suited to the performance o f hidher duties, including where appropriate ex post verifications. (Art. 38 (4)).

specific requirements for at least one ex ante verification for each operation to ascertain if the expenditures are in order, if they conform to the laws and if principles o f sound financial management have been applied. (Art. 39 (3))

requiring that the authorizing officer report to the management board o n the performance o f h i she r duties in the form o f an annual activity report. This report contains the results o f operations and progress in achieving objectives, identifies operational risks, the use o f resources and the functioning o f internal control systems. (Art. 40 (1)).

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62 As the CFAA review i s not exhaustive, i t should not be considered a formal review o f the internal audit s stem's compliance with ISPPIA. 6'Council (EC, Euratom) regulation No. 1605/2002 and the implementing regulations, Commission regulations No. 234212002 and No. 234312002.

Croatia CFAA: Internal Control and lnternal Audit 47

161. manner that i s generally consistent with the IIA ISPPIA standards.

The regulation also describes the position and duties o f the internal auditor in a

162. The external auditor i s not part o f the Government’s intemal control framework, yet this auditor plays an important role in it . The external auditor audits the elements o f intemal control, including the intemal auditor function, independently o f the Government, and reports to Parliament on the results o f his investigations. Results o f internal audits are routinely available to the external auditor under enabling legislation. The external auditor reinforces intemal control systems, monitors and reports on instances where management fails to respond appropriately to intemal audit recommendations.

11. Findings

Legal Framework

163. The intemal control framework derives from a variety o f laws. The most basic act i s the 2003 organic Budget Act (BA), which provides the legal requirement for internal audit in the public sector. Other regulations, such as the Regulation o n the internal organization o f M O F (Official Gazette (OG), No. 70/2001) and the Principles o f the Internal Organization o f the State Administration Bodies (OG No. 43/2001), provides a legal basis for the authorizing environment and the internal control framework in general. Finally, regulations such as the M a i n Treasury Book System and Methods o f Managing the Treasury Single Account (MTSA) (OG No. 97/1995), the Ordinance on Budget Supervision and Internal Supervision (OG No. 92/1996), the Ordinance on the Croatian Government’s Intemal Control Office and the Instructions on Implementation o f the State Budget Execution from the TSA (OG No. 4/2001), regulate specific, physical control and inspection functions, which constitute an integral part on the traditional Croatian administrative control environment.

164. There are also a set o f rulebooks, which provide details on specific elements o f the financial processes. Examples include Treasury, budget accounting, budget supervision and internal audit rulebooks. These guidelines are not assembled in a single book, but are scattered throughout the MOF. Each functional unit i s responsible for its own rules in a highly uncoordinated manner. Together, these source documents provide the basis for a reasonable framework for financial controls.

165. Non-financial laws also prescribe internal controls and c iv i l service conduct. They include the Act on the Structure and Scope o f Min is t r ies (2000), Act on C iv i l Servants and C iv i l Service Employees (2001), State Administration System Act (1993, amended in 1999), and the Regulation on the Principles o f Internal Organization o f the State Administration Bodies (2001). N o formal Code o f Ethics or Conduct for c iv i l servant exists. The issue o f conflicts o f interest i s not explicitly addressed in the legislation.

166. The Accounting Officer’s responsibilities, assigned to Heads o f the BFUs, include budget planning and execution, verification o f obligations assumed, issuing payment orders and collecting receipts, lawful execution o f the budget, delegation o f responsibilities to others in the BFU, the application o f intemal regulations to the

procedures applied in the unit and reporting the results o f financial operations on a regular basis.

167. The BA defines the Financial Controller as the person responsible for the lawful execution o f the Budget head’s orders in a manner that conforms to the financial regulations (Art. 1 13).

168. The BA ’s Chief Accountant duties are those o f the Controller o f Payments as specified in the MTSA. He/she i s established as the person responsible for controlling payments and establishing that the payments are lawful and in accordance with the budget and the financial schedule.

169. individuals discharge these functions.64

The functions o f the chief accountant and financial controller require that separate

170. The BA identifies the budget inspection function (Budget Supervision Office) as that which supervises65 the lawfulness, timeliness and purpose o f the use o f budgetary funds. I t charges the M O F to supervise al l budget entities, EBFs and local and regional self-governments. The Budget Supervision Office performs this function.

171. Each BU i s also required to have an intemal audit function that is independent, objective and which examines instances o f non-compliance and makes recommendations for their elimination. Moreover, intemal audit i s also expected to make recommendations for improving their internal control, administrative and accounting systems that support the business operations associated with the budget; EBFs are exempt from this requirement.

172. o f the act.

The BA sets penalties for non-compliance with the BA provisions in section XI1

Institutional Framework & Capacity

173. Internal control framework. Within MOF, the Treasury and the Directorate for Intemal Audit and Control are responsible for the status o f PIFC vis-a-vis the European Commission. The Budget Supervision Office manages the use o f budgetary resources (revenues, expenditures and procurements) in the local and regional self-government units. The CFAA team found BFUs in al l entities visited; the key staf fs knowledge o f their existing budgetary processes was sound. The BA’s assignment o f management responsibilities was also reflected in the practical set-up o f the BU’s reviewed.

174. The EU-sponsored CARDS 2002 project has a mandate to build capacity both for financial management controls and internal audit. Early on the project team noted the lack o f any overall unifying vision of internal control. Many parties in MOF perform

intemal financial controls; they include budget preparation, budget execution “hard” 66

64 Many budget entities have not designated a financial controller, as required by PIFC. 65 This i s the traditional control and revision unit (CRU) function that characterized the majori ty o f the transition countries audit functions in the f i rst decade after they assumed independence. 66 I t i s common in the framework o f the “COSO” model t o distinguish between “hard” and “soft” controls; soft refers to informal controls and hard refers to the more traditional. formal controls.

sectors, the intemal control directorate and the Budget Supervision Office. The C O S 0 concept o f the intemal control framework however does not exist. As a result, a multitude of overlapping controls exist which emanate from laws, regulations, policies and rulebooks. A number o f parties within the M O F who exercise these controls do not effectively communicate with each other. The net effect i s a highly complex set o f intemal controls adding no value to the operations.

175. There i s also a Government Office for Internal Control and a number o f internal control, or inspection units, in l ine ministries mandated to conduct administrative inspections. This i s a legacy o f the control system in the socialist administration, where controls where focused on behavior, and primarily aimed at prosecuting and placing responsibilities on individuals. In accordance with the Public Intemal Financial Control (PIFC) Development Strategy for Croatia adopted by the Croatian Government and the M O F in September 2004, the Ordinance on the Croatian Government’s Internal Control Office shall align the name o f the Office and description o f operations under its authority with the basic postulates o f the PIFC

176. Internal Audit. At present there are five Internal Audit Units (IAU) in the state administration. The unit which i s in the M O F has a staff o f six. The six staff are referred to as inspectors and none o f them are trained in the application o f modem internal audit methodology. W h i l e the BA requires the establishment o f modern internal audit functions in al l BUS, l ine ministries and other BUS do not understand what the role should be o f I A U s or how i t differs from the current budget supervision and other inspection functions. For this reason, the ongoing CARDS project team has focused on components to support intemal audit development: the IAU in the M O F works as a small central harmonization unit to develop the policies and strategies necessary to implement effective internal audit in all budget entities; the sets o f rules and guidelines for modem internal audit, specific training for internal auditors on new techniques o f modem internal audit and an overall strategy for a phased implementation o f IA throughout the budget entities, EBFs and local and regional self-governments. This undertaking could also contribute to a rationalization o f the different inspection and audit functions currently operating within MOF.

177. Training is planned at two levels. The program for public accountants at the Center o f Excellence in Public Finance in Ljubljana, presently used by the Government can be extended to address the key management issues and approaches used in the EU’s financial management control system and the role o f modem internal audit.67 The team i s also in the process o f establishing an internal auditor training program that would offer the graduates a form o f certification and would permit them to take IIA equivalent exams which are required for the internationally recognized certified intemal auditor designation. The target i s 120 trained auditors during the l i f e o f phase I o f the CARDS project (40 trained by the project staff, 80 by local trainers who have been part o f the project). The M O F and the Government should offer strong support to the work o f the CARDS project team and champion the modifications to the control framework across al l the organizations o f government.

67 T w o of the six instruction modules are on internal audit. The CFAA team was advised that the Government planned to graduate 100 c i v i l servants f r o m the program in two phases. The program i s partially financed by the Wor ld Bank

Croafia CFAA: lnfernal Control and lnfernal Audit 50

178. Because a number o f donors (EU, WB, IMF and USAID) are presently involved in projects related to the intemal control and audit systems, there i s the potential for significant synergy in their individual undertakings.

Practice

179. Control Environment. The control environment consists o f hard as wel l as soft controls applied by senior management to ensure that an organization and i t s staff are competent and professional. I t includes values communicated explicitly through formal policies and communiquks, and implici t ly through the behavior models set by senior management. I t also involves organizational structures and a system for delegating authority, as well as adherence to sound financial reporting and accounting practices.

180. The team found the conception o f internal control to be underdeveloped. There is no Code o f Ethics for the C iv i l service as a whole, but a L a w on C iv i l Service (OG No. 27/01), which regulates the employment o f c iv i l servants, including r i gh ts and responsibilities. A Code o f Ethics for Internal Auditors wil l also be included in the Rulebook on Internal Audit, which was in draft at the time o f the C F A A mission. Management in BUS generally did not appear to be supportive o f the new internal control approach promoted by the concept o f PIFC. There were no visible, management champions o f the changes necessary to implement it; i t was stealthy instead o f an open, transparent communication o f the needs and the plans to meet these requirements. The team encountered instances of inappropriate delegation o f functions that violated the separation o f duties control principle6* and a lack o f timely, comprehensivc documentation on the key financial processes operating in l ine ministries and in MOF. In some cases, key elements o f the control environment (for example, internal audit units) were not required for EBFs, although this i s where they could be most effective.

181. The highly centralized ex ante and ex post controls exercised by the MOF’s Treasury and budget inspection units monitor budgetary compliance and ensure budgetary control. However, they do not support the development o f a modem intemal audit across the Government.

182. As also reported in the European Commissions’ Opinion on Croatia’s Application for Membership o f the European Union, International reports and surveys indicate that corruption in Croatia continues to be a problem that affects various aspects o f society, including public offices. In the Transparency International Corruption Perception Index 2003 Croatia was ranked at the same level as Colombia, El Salvador and Slovakia6’ and lower than countries such as Belarus and Bulgaria. The inherent risk o f off icial corruption work to undermines the control environment.

183. The CFAA found that potential conflicts o f interest are a common phenomenon in the Croatian administration. Furthermore, i t seemed almost generally accepted that a high

‘* Even in MOF, the Assistant Minister responsible for intemal audit has temporary responsibil i ty for budget execution. This role violates the principle that auditors have n o other operational responsibilities within an organization. ‘’ All ranked number 59 which in accordance with the interpretation in Annex I1 equal Significant f iduciary risk, together with a l l other countries ranked between 46-88.

Croatia CFAA: lnternal Control and lnternal Audit 51

level c iv i l servant can have both significant political and economic interests besides his official function that may or may not influence his or her decisions in a official capacity.

184. Risk Assessment. Currently, there i s no practice o f risk assessments being an integral part o f management. Whereas the legal base i s clear, the objectives o f government organizations are often nonexistent and strategies often missing. Consequently, planning i s typically routine and mechanical exercises; it does not provide for a proper link between policies and operational activities.

185. Control Activities. Such activities cover the procedures established for: (a) accounting, financial transactions, contracts and include setting authorization limits for claims and transactions; (b) reliability o f data processing and information reports and (c) ex post control activities such as internal audits. Legal requirements for institutional controls are in place, whereas detailed written procedures for example, for reconciliation o f accounting information and job-descriptions that ensure appropriate segregation o f duties typically are not. The treasury system provides centralized control o f a l l budgetary expenditures through the TSA and a centralized computer system ( S A P ) for the General ledger in MOF. I t s controls cover budgetary preparation, execution and accounting. The Treasury defines cash allotments for treasuries in support o f the budget execution by budget entities and i t interfaces with the FINA payment system that the BUS.

186. The MOF’s Budget Supervision Office exercise controls over spending in BUS, EBFs, legal and natural persons that receive budgetary finds, and local and regional self- governments. Controls are performed pursuant to a ratified control plan, which i s adopted by the Chief State Treasurer on the proposal o f the chief executive o f the budgetary control organizational unit at the beginning o f the fiscal year. The plan is drafted on the basis o f irregularities observed in the preceding year (assessments o f inspectors, proposals and suggestions from the Preparation Sector and the Budget Execution Sector, and the State Audit Office). During preparation o f the plan, the following are considered:

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187.

whether there i s knowledge that funds are not being used legally, for their stated purpose and in timely fashion,

activities considered economic policy priorities in the coming period,

frequency o f control inspections conducted in individual entities during the preceding period,

petitions from citizens, institutions and trade unions,

the available number o f inspectors.

According to the description provided by the MOT;, the budgetary control is conducted for the current fiscal year, and only exceptionally, if circumstances require, does i t do so for the preceding period. In this respect i t differs from the State Audit Office (SAO). Another essential difference in approaches between the Budget Supervision Office and the SA0 or the Croatian Government’s Internal Control Office i s the fact that budgetary control inspectors compile reports o f their completed inspections and directly f i l e motions for initiation o f misdemeanor proceedings against the relevant body, or

Croatia CFAA: lnternal Control and lnternal Audit 52

criminal charges, with the public prosecution, inasmuch as the budget supervision ascertains that acts were committed that bear the traits o f misdemeanors or crimes.

188. If irregularities that do not bear the traits o f misdemeanors or crimes are detected by the Budgetary Supervision Office, measures are stipulated for the elimination o f such irregularities. Through improved communication with the Preparation Sector and the Budget Execution Sector, and with mediation by the Chief State Treasurer, the proposals of this Unit pertaining to own revenue projections by BUS were accepted, and penal provisions in case o f failure to pay these revenues into the budget were incorporated into the appropriate legislation, while the retum o f unused or improperly used budgetary funds has been ordered. Additionally, the need to re-examine subordinate legislation pertaining to decentralized functions o f local and regional self-governments has been indicated.

189. The CFAA found that the function in BUS as financial controller, which the BA requires, had in most cases not yet been assigned to an appropriate person, or the controller was s t i l l to be recruited.

190. In Box 5 the C F A A offers a grave example o f an organizational set-up in Croatia where the internal control framework puts public funds at risk, the Public Debt Management Section o f the MOF:

Croatia CFAA: Internal Control and lnfernal Audit 53

Box 5. A Weak Internal Control Framework in the Public Debt Management Section

Serious weaknesses were identified in the control framework o f the Public Debt Management Section (PDMS) o f the Ministry o f Finance. The Assistant Minister and Head o f the Section i s the k e y player in al l aspects o f i t s operations, negotiating the borrowings, approving principal and interest repayments and other k e y tasks. Conventional internal controls would require clear segregation o f duties, comprehensive written procedures and job-descriptions as a safeguard against irregularities in the financial processes.

Whereas the Ministry o f Finance was unable to arrange for the CFAA mission to meet with the Assistant Minister and Head o f the PDMS, a meeting was set up with one o f the Section’s accountants. The meeting confirmed that key processes in the Section are undertaken without clear reference to comprehensive written procedures.

In i t s Report on the Audits Performed on the fiscal year 2002, the State Audit Off ice (SAO) reported that out o f a planned number o f 18 positions in the P D M S only eight had been fi l led. The S A 0 concluded that the number was insufficient and had a negative impact on the quali ty o f the task execution. It also pointed to frequent changes in staff having an equally negative impact. The S A 0 drew attention to bookkeeping irregularities in the PDMS’s records on i t s trading with bonds and the fact that in some cases bookkeeping data were entered into the system with up to a year’s delay. I t was evident f r o m the report that earlier years’ recommendations for more prompt recording o f transactions had not been properly responded to by the management o f the PDMS.

Interviews conducted by the CFAA team revealed that an inspection undertaken in 2003 by the newly created internal audit unit o f the MOF had made a, number o f recommendations t o which the management o f the P D M S was not responsive. The CFAA team was not able to obtain a copy o f the report in question.

The jo in t mission o f the Wor ld Bank and IMF in 2003 identified significant areas in need o f improvement in the PDMS. This included the segregation o f functions via the creation o f a middle office to analyze the risks and to prepare an appropriate risk strategy for use in debt management activities; the creation o f a separate back office to assume a l l responsibilities for the recording o f a l l records in the debt system and for the preparation o f payment authorizations; and greater transparency in the debt management strategy by requiring government approval and tabling o f the strategy in Parliament.

Resident advisers o f the IMF and S I G M A experts who had reviewed the P D M S expressed concems about the lack o f controls, inappropriate f i l ing practices, existence o f off-shore accounts and the key person r isks inherent in the organization o f the PDMS.

The P D M S currently manages a debt portfolio o f over HRK 80 bil l ion, generating interest payments in the amount o f some HRK 4 b i l l i on per year (2003 rounded budget estimates).

19 1. Information and Communication. There are many different financial management i n foha t ion systems in use in l ine ministries, the MOF, EBFs and local and regional self-governments. The S A P system in the M O F serves primarily serves the M O F and the central BUS and EBFs7’ and then only partially. Several years after the system was brought on line, cash management, debt management and commitment control modules have yet to be implemented. Individual ministries must duplicate data entry into their own systems and make separate entries into the S A P system; these entries require frequent reconciliation between control data from different systems.

192. This process i s inefficient, error-prone and contributes to non-separation o f duties. A limited number of staff (often one) i s trained on the S A P system; the staff have to p e r f o m al l o f the data entries, including authorizations. Duplication o f data entries in multiple separate financial systems represents a major potential for introducing errors; i t also requires regular reconciliation.

193. Monitoring. These elements are vital to intemal controls. They require information systems that can identify and capture relevant, reliable, and up-to-date financial and operational data from internal and external sources. Further, managers need performance indicators to monitor operational/financial activities and risks, and to assess progress towards targets. At present, management have no independent source o f advice on how well i t s internal control systems are operating. This i s the key role of intemal audit, which i s now being implemented on a phased-in basis across al l budget entities. The only feedback management receives i s comments f rom the SAO. The SA0 uncovers these comments in the course o f i t s compliance and regularity audits, a practice which i s highly undesirable.

194. Internal Audit. Internal audit in Croatia i s undeveloped. At the time o f the C F A A appraisal mission in March 2004, there were no active intemal audit units in any of the ministries or agencies visited except the MOF; al l had budget supervision or internal control functions performing the type o f inspections specified in the BA.71 In the l ine ministries and EBFs visited, there was no understanding o f the exact role and fbnction o f modem internal audit, despite the BA’s clear requirements and i t s description of their responsibilities. Several BUS have expressed interest in participating in the training provided under the CARDS 2002 project. So far 40 staff from l ine ministries and other central BUS, have been selected for training. The M O F committed to training six staff in the first phase o f intemal audit training; these staff will become the core o f a modem intemal audit unit.

195. Besides the fact that the detailed guidelines (the Rulebook referred to in the BA) that should be provided by the MOF for the establishment and operation o f IAUs, al l BUS need advice to establish such units. I t appeared to the C F A A team that the PIFC and intemal audit project had largely been confined to the MOF, though recently more ministries and other BUS have been involved. In Box 6 below, the C F A A offer some practical advice or “fifteen steps to establishing an IAU”, which could be used by BUS who are now in the process o f establishing an IAU:

’ O The BUS and major EBFs that have S A P terminals - regional treasuries. ” MOF has six staff employed in the budget inspection function for MOF, a l l l ine ministries and EBFs.

Box 6 . Fifteen Steps to Establishing an Internal Audit Unit

1. Review the literature o n internal audit, starting wi th the definit ion o f internal audit.

2. Interview senior management

3. Init iate the development o f an audit committee by preparing a draft charter for the committee

4. Review your organization’s budget, policies and procedures

5. Discuss and reach a common understanding o f basic internal control issues with the external auditor

6. Develop a l i s t o f a l l auditable entities and operations

7. M a p (e.g. with flow-charts) the major processes within the organization

8. Develop a Charter (terms o f reference) for the Unit

9. Develop a risk and audit needs assessment for your organization

10. Build the budget for the unit

1 1. Develop a one-year and a three-year audit plan (medium term perspective could vary depending o n the type o f operations)

12. Hi re staff and develop a training p lan for staff

13. Ensure that management notifies other departments in your organization about the function, responsibilities and the added value o f your unit

14. Work actively with management to develop appropriate reporting and working relationships

15. Develop a methodology for fol lowing up o n and ensuring effective implementation o f audit recommendations

Adapted from the I IA s advisory; “Establishing an internal audit shop ”: http://www.theiia.org

111. Summary of Findings and Assessment of Fiduciary Risks

196. Whereas a number o f Rulebooks and regulations provide the regulatory framework for procedures and physical controls, detailed written procedures and job- descriptions ensuring an appropriate segregation o f duties are typically not in place. The Public Debt Management Section o f the M O F offers such an example. Also, there are numerous examples o f Rulebooks mentioned in laws, which have not yet been issued. The BU financial controllers required by the BA have typically not been recruited yet. The inherent risk o f off icial corruption and potential conflicts o f interests to some extent undermines the control environment. The introduction o f internal audit via the BA i s a positive development. At the time o f the C F A A appraisal mission there were no other internal audit units being established, other than the one in the MOF. By the time o f the report dissemination there are five being established. The C F A A offer some practical guidance for BUS who want to establish such units. This i s well conceived and has a

Croatia CFAA: lnfernal Control and lnternal Audit 56

realistic and robust plan for progressive implementation across the Government. I t must be strongly supported because i t offers the best path to conformance with Chapter 28 of the acquis communautaire and a PIFC-compliant intemal control and audit system. For these reasons, the C F A A finds the fiduciary risk associated with the intemal control framework, including intemal audit significant.

IV. Recommendations

197. The CFAA team makes the following recommendations:

0 Due to the significant risk and the large sums involved, the Government should take immediate action to eliminate the weaknesses in the intemal control framework o f the Public Debt Management Section o f the MOF.

The M O F must also as a matter o f priority issue al l statutory Rulebooks and other necessary guidelines relating to intemal audit and intemal control. MOF and other BUS must subsequently take steps to develop appropriate written procedures for financial processes.

The M O F should propose changes in law to require an intemal audit function to be established in al l EBFs and any other entities in receipt o f public funds outside o f the budget.

The BUS should as soon as possible hire individuals or assign responsibilities to the role o f Financial Controller in accordance with the provisions o f the BA. This should be another person than the Chief Accountant.

The M O F should provide a strong champion o f change for the new intemal control and audit system, including providing support to establish intemal audit units in all major BUS in accordance with the provisions o f the BA.

The M O F should develop and promulgate the draft PIFC pol icy paper to promote a sound internal control fkamework consistent with the EU PIFC system. The pol icy paper should clearly identify the major components and responsible entities, which establishes a coordinating framework for the MOF intemal control pol icy centers (treasury, budget preparation execution, foreign exchange, internal audit and others.) and which rationalizes the legislative provisions that no longer align with this vision.

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CHAPTER 7: EXTERNAL AUDIT AND LEGISLATIVE OVERSIGHT

I. Background and Assessment Framework

External Audit

198. The S A 0 states i t s mission is to audit all government operations and to improve the legality, efficiency and effectiveness o f all legal entities and other legal entities regulated by the State Audit Act. The latter has responsibility for the management o f public property. In addition, the SA0 emphasizes i t s role in promoting public accountability.

199. The 1999 World Bank CFAA recommended that the S A 0 broaden i t s audits to cover aspects o f economy, efficiency and effectiveness and not just address compliance with rules and regulations. Furthermore, the 1999 C F A A recommended that additional staff should receive training in internationally- accepted auditing standards. At that time, the CFAA also recommended that the S A 0 should improve access to data, network with the Government’s IT systems, and improve efficiency in general.

200. In 2002, SIGMA conducted an in-depth peer review o f the SAO. Material recommendations included: strengthening the SAO’s legal mandate to reinforce i t s independence7* and to align i t s audit resources with i t s statutory responsibilities; revising i t s regularity audits to conform with INTOSAI Auditing Standards (AS) so that a formal audit opinion on an attest audit could be rendered on the financial statements o f the auditees; extending i t s audit activities to performance.

201. In the Commission’s Opinion on Croatia’s application to EU membership o f April 20, 2004, the European Commission spoke about the need to strengthen the SAO’s financial independence and to provide a legal mandate for auditing EU funds in i t s Opinion on Croatia’s Application for Membership o f the European Union.

202. The 2002 World Bank P E R reviewed the SAO’s operations. I t recommended that the SA0 should continue to focus on compliance and financial audits in the short term. Over the long term, the Bank recommended that the S A 0 conduct performance audits and cite deviations from the current law and examples o f non-compliance.

203. As a result o f the peer review and a previously conducted self-assessment, the SA0 adopted a five-year Strategic Development Plan (SDP) in M a y 2003 and began i t s implementation. Based on the SDP, CARDS 2003 has financed a EUR 1.6 mi l l ion twinning project which i s to begin in 2004 and to run over a period o f 30 months.

204. The assessment framework used for external audit wil l be the INTOSAI AS. It covers Basic Postulates, General Standards, Field Standards and Reporting standard^.'^

’* This i s a common situation among transition countries’ SA0 mandates. 73 This CFAA does not cover every aspect o f the INTOSAI AS. it i s not a formal review o f the SAO’s application o f the standards. Nor does it constitute a formal Wor ld Bank review o f the SAO’s suitability as an external auditor o f Bank projects. The complete text o f the Standards are available at the fol lowing web- site: h~:l lww.w.ii l tosai.or~l2 CodEth AudStand200 1 E.pdf

Croatia CFAA: External Audit and Leaislafive Oversiqht 5%

Box 7 provides an overview o f the INTOSAI AS, which wil l provide the headlines in the structure for this chapter:

Box 7. Overview of the INTOSAI Auditing Standards

Basic Principles in Government Auditing Promotion o f public accountability Legal basis for access

0 Conflicts o f interest

General Standards in Government Auditing Independence Competence Applying standards Recruitment Training and development Audit guidance Staff composition and adequacy Moni tor ing efficiency and effectiveness

Field Standards in Government Auditing Planning Supervision and review

Audit Evidence Analysis o f Financial Statements

Study and evaluation o f Internal Control Compliance With Applicable Laws and Regulations

Reporting Standards in Government Auditing Fairness, accuracy and timeliness Statements o f assurance

'ource: INTOSAI:

205. When assessing a Supreme Audit Institution's (SAI's) work, other standards may be more appropriate. The latter includes the IFAC International Standards on Auditing (ISA), internationally recognized standards for auditing financial statements, and the European Implementing Guidelines for the INTOSAI Auditing Standards (EUG). All o f them are in widespread use among EU and candidate countries.

Parliamentary Oversight

206. The internal rules o f the Sabor created the committee on budget and finance, which consists o f nine members and a staff of four. The committee's function is to review al l budget bills. The Sabor cannot pass a bill until the budget committee has rendered its opinion. The S A 0 does not advise the Budget committee while i t i s formulating the budget.

207. Parliament's discussion o f budget policy, its review and approval o f proposed budgets and its review o f the execution o f the approved budget are cornerstones o f a democracy. The 2002 PER concluded that the Sabor should become more active in the budgeting process and ins is t on accountability. To support the committee and the Sabov

in analyzing the substantive policy issues associated with the budget, i t recommended that:

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Several professionals be added to the budget committee staff;

The Government make budget submissions more user friendly;

Parliament trains i t s Members in the budget process and the ru les that go with it.

208. N o internationally recognized standards exist for Parliamentary oversight of budget implementation. However, S IGMNOECD produced a practice advisory74, which presents various issues related to Parliamentary purview and i t s interaction with SA IS .~~ The report describes the structure of Parliamentary committees that address SA1 reports, procedures/practices for SA1 and Parliamentary interactions, and a system for ensuring effective Parliamentary follow-up on SA1 reports.

209. Finally, the EC Financial Regulations offers good practice guidelines for external auditors and their interaction with legislators. They stipulate that external auditors (for example, the EC’s Court of Auditors) should scrutinize the BU’s accounts. Furthermore, Parliament (the European Parliament as well as the Council o f Ministers) should grant discharge [give formal approval or certification] to the senior management o f the BUS after the external auditor examines the financial statements and annual report. This formal approval includes the auditor’s attestation (the “statement o f assurance” or declaration d‘assurance (most often referred to as the “DAS,,) about “the reliability and the legality and regularity o f the underlying

Fiduciary Risks

210. the risk that:

The fiduciary r i s k associated with external audit and parliamentary oversight i s

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The SAI’s independence, including i t s financial independence, is not assured;

The SAI’s audit mandate does not cover al l relevant public fimds;

The SA1 does not have a mandate to undertake al l types o f audits listed in the INTOSAI AS;

The SA1 does not demonstrate it has followed proper audit guidance according to international standards;

The SA1 does not provide authoritative and relevant reports;

The executive or the legislature does not act upon SAI’s audit reports;;

The legislature does not scrutinize external audit reports.

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SIGMA Papers: No. 33. “Relations between Supreme Audit Institutions and Parliamentary Committees”, 74

OECD, December 2002: http://www.oecd.ora/pdf/MOOO38OOO/MOOO38767.pdf

76 Commission Regulation (EC, Euratom) No. 234312002 o f 23 December, Title VIII, Art. 91-95 75

11. Findings

Legal Framework

211. The State Audit Office came into being in July 1993 as a result o f the Act of State Audit (ASA). The Act refers to the principles o f the INTOSAI AS. It sets up the S A 0 as an independent institution directly accountable to the Croatian Parliament; the Sabor appoints the Auditor General (AG) for an eight-year renewable term. The A S A does not specifically address the financial independence o f the SAO; but it does say the State Budget should fund the SAO. The implication i s that the MOF must exercise budget supervision over the SAO. The BA requires al l BU’s, including the SAO, to establish IAUs. The A S A does not require extemal audit arrangements for the SAO.

212. The A S A provides the SA0 with a broad mandate to audit al l financial statements and financial transactions o f the government, local and regional self-governments, legal entities financed by the budget in whole or in part, the Croatian National Bank (CNB), public enterprises, companies and other legal entities in which the Republic o f Croatia or local and regional self-government units own a majority stake (Art. 1). The A S A does not explicitly offer a mandate to audit grants or other incomes or loans from foreign sources.

213. The A S A defines the SAO’s audit activities in a way that ensures the right to undertake al l types o f audits covered by the INTOSAI AS. These include compliance with laws, regulations and procedures, financial (attestation) audits, assessments of‘ internal control and accounting, and audits o f system efficiency and effectiveness. The ASA’s audit mandate i s unique in that i t defines the audit o f privatization and transformation, which is mandatory for the SAO.

214. The SAO’s auditing methods and procedures (Art. 4.1) make explicit reference to the INTOSAI AS. Moreover, the S A 0 must make public the applied auditing standards in the Croatian language (Art. 4.2). In addition, the professional Code o f Ethics for Certified State Auditors must comply with the INTOSAI Code o f Ethics (Art. 8.5 (2)). The ASA also contains provisions to prevent the SAO’s auditors from working with conflicts o f interest.

215. The A S A requires the SA0 to submit to the Sabor “an annual report on the executed audits and i t s own activities.” The due date i s no later than five months after the expiration o f the statutory deadline for submission o f the BU’s financial statements (Articles 11.4 and 11.5). The ASA does not define the exact coverage and scope o f the audit activities for the SAO’s annual report.

Institutional Framework and Capacity

216. The State Audit Office i s a young institution, established in 1993 and managed by an AG. The Parliament (the Sabor) appoints the AG. The Office has a staff o f 301 people, 226 o f whom are certified state auditors. They operate in Zagreb and in 20 regional offices across Croatia. The regional offices vary in size f rom f ive to 17 staff

members. A Deputy AG and seven Assistant AGs all work out o f the SAO's central office in Zagreb. The central office has eight department^'^.

Practice - The INTOSAI AS Basic Postulates

217. Promotion of Public Accountability. In the f i rst part o f the I N T O S A I AS, the Basic Postulates says the SA1 should comply with, and require, promote and facilitate public accountability in the management o f public resources. That means applyng accounting standards and internal controls; i t also means transparency, accessibility to data, and a fair presentation o f information. The postulates are assumptions the SA1 agrees to when joining INTOSAI. The SA0 has undertaken self-assessments against the INTOSAI AS. As previously described, the ASA contains explicit references to the INTOSAI A S and the INTOSAI Code o f Ethics.

21 8. Legal Basis for Access. As previously stated, the ASA gives the S A 0 a mandate to audit al l bodies o f State Government and i t s legal entities. The SA0 may also audit local government bodies and legal entities. However, i t does not have a legal mandate to audit EU and other foreign grants.

2 19. Conflicts of Interest. INTOSAI requires that SAIs avoid conflicts o f interest in i t s audits. Article 6 o f the ASA prohibits auditors from both auditing entities and activities to which they have a business, political or family affiliation. There are no reports o f any recent violations o f these provisions by SA0 managers or staff.

Practice - The INTOSAI AS General Standards

220. Independence. The ASA established the S A 0 as the principal State auditor, legally independent o f the executive and subordinate to the Sabor. The AG's appointment to an eight year te rm seems appropriate to ensure independence o f h isker office.

221. The SAO's budget comes about in the same way as any BU. Like for the BUS', i t i s subject to the same ex ante reviews and controls; the MOF supervises the SAO's budgets. This arrangement jeopardizes the SAO's independence.

222. The S A 0 must establish an IAU that i s in accordance with the provisions o f the June 2003 BA. However, the IAU i s not yet operational. The SA0 i s not legally required to nor does it appoint an external auditor. The Sabor has the right to request specific audits from the SAO. But the accountability arrangements between the two bodies are not comprehensive.

223. Competence. To ensure the SA0 has the capacity to assume its tasks, i t must carefully apply auditing standards. I t must also recruit/sustain the appropriate number of

77 Department for the audit o f state budget and BUS (staff=9); Department for the audit o f budget and local and regional self-government (9); Department for the audit o f fund institutes and financial institutions (7) ; Department for the audit o f legal enti t ies fully or partially financed f r o m the state budget (8); Department for the audit o f transformation and privatization (32); Department o f legal affairs and relations with other subjects (8); Department o f IT and human resources management (9); Department for accountancy and general affairs (1 6).

Croatia CFAA: External Audit and Leaislative Oversiqht 62

staff with the educatiodexperience to meet their responsibilities. Also, i t must: (a) produce and issue detailed audit guidance to i t s auditors, and (b) create an organization and procedures for supervision and reviews; the latter includes quality assurance and controls.

224. In accordance with the ASA, the SA0 has established a program for “certified state auditors.” To be certified, auditors must have an advanced university degree in law or economics, at least three years o f post-graduate work experience, and passed a state vocational exam and one for certified state auditors. The SA0 issues and updates an Audit Manual, which contains procedures and established practices. The goal i s to ensure supervision and review o f audit assignments.

225. Applying Standards. As stated previously, the application o f INTOSAI A S and the INTOSAI Code o f Ethics i s an ASA requirement. These standards and the European Implementing guidelines for the INTOSAI AS (EUG) are available to the SAO’s auditors in Croatian. There are certain INTOSAI A S defined audits, including performance audits,that the SA0 does not do. Furthermore, when the S A 0 refers to an attestation audit, i t i s not the same type o f audit referred to in the INTOSAI AS, the EUG and the ISA, but merely an audit of financial statements which i s concluded with a certificate using (four) standard opinions.

226. Recruitment. Most o f the SAO’s audit staff have an academic background in law or economics. Staff are hired as a result o f public vacancy announcements. Recruitments follow formal procedures; the key criteria are work experience and formal education.

227. Training & Development. The SA0 has established a training program. ‘The scope of the training however depends on the amount o f money set aside for training activities in the Government’s budget. Training takes place on the j ob and individual training sessions. When appropriate, training events are also arranged in cooperation with the Croatian Auditors’ Association, universities and other Croatian institutions. The S A 0 also participates in international training and methodology-developing activities arranged by INTOSAI, SIGMA or bilaterally between SAIs.

228. project to be launched in 2004. The planned project activities appear in table 7 below.

As mentioned previously, CARDS 2003 wil l finance a EUR 1.6 mi l l ion twinning

Croatia CFAA: External Audit and Leqislative Oversiqht 63

20 21 22 23 24 25 26

Table 7. CARDS 2003 External Audit Twinning Project Activities

Development o f internal communication Seminar on team work and team management Research, application and presentation of personnel strategy Qualification structure of personnel Development o f the program of personnel training Forming the strategy o f international relations Forming the communications strategy

229. Clearly, these activities show the scope o f the project i s ambitious. In the medium term, these activities are capable o f addressing al l the SAO’s developing needs. Consequently, the twinning project could most likely address the CFAA’s recommendations.

230. Audit Guidance. The SA0 has developed an Audit Manual with detailed technical guidelines and procedures to carry out the standards i t i s to uphold. The Manual and other technical guidelines have regular updates. The C F A A was unable to obtain a copy o f the Manual and the Guideline for a detailed review.

231. Staff Composition and Adequacy. The S A 0 management finds the current number and composition o f staff appropriate. Should the S A 0 develop a financial audit that i s consistent with the ISA or expand i t s performance audit capability, the size and breakdown o f the staff may require a review. The staff i s most familiar with compliance and the regularity o f legality audits. The S I G M A peer review concluded that the size o f the staff was inadequate to satisfy the SAO’s annual statutory audits o f local and regional self-government and al l privatizations. SIGMA estimated in 2002 that up to 50 percent o f

Croatia CFAA: External Audit and Leaislafive Oversiaht 64

the SAO’s resources were spent on privatization audits. Another indication that the SAO’s resources are spread too thin i s the volume o f work it initiates or reviews. See next paragraph for details.

232. Monitoring Efficiency and Effectiveness. Whereas the SA0 has procedures and mechanisms to evaluate the efficiency and effectiveness o f individual auditors, i t does not systematically monitor the efficiency and effectiveness o f i t s operations. The C F A A finds that the scope of audit services provided to be quite narrow and that a more holistic interpretation o f the SAO’s mandate and role i s desirable to keep government accountable.

233. In i t s Report on Audits Performed in 2002, i t reports to have audited a total o f 44 financial statements, 61 1 subjects and that in addition to that it received 11,327 financial reports during that same period. Out o f the 611 audited subjects, 568 were local or regional self-governments. This Report does not provide data that can be used to assess the relative coverage and the comprehensiveness o f the audits performed.

Practice - The INTOSAI AS Field Standards

234. Planning. Audit planning i s an integral part o f SAO’s work. Planning i s implici t in the ASA, internal guidelines and the S A 0 Audit Manual. Detailed guidelines for developing an audit plan appear in the SA0 Audit Manual under the t i t le: “The Process o f designing the Annual Audit Program o f the State Audit Office.” The guideline also explains how to organize the planning process.

235. The ASA gives the Sabor the option o f requesting ad hoc audits and investigations falling outside the annual work program. The Sabor has only used this opportunity a few times during the last 10 years. In each case, they occurred after consultation with the AG.

236. Supervision and Review. The SA0 addresses quality assurance in al l phases o f the individual audit assignment. According to SA0 management, supervision o f audit teams includes an evaluation of:

0

0

0

0

0 Audit goals or objectives.

The audit team’s understanding o f the audit plan; Compliance with auditing standards and institutional practices; Compliance with each phase o f the audit plan; Completeness of audit documentation and relevant facts to support conclusions in i t s findings, and;

Evaluations consist of audit team leader performance reviews and overall supervision by superiors in the course o f an audit assignment. In addition, ex post reviews entail feedback from auditees, evaluations o f work by a parliamentary committee and members o f Parliament, self-assessments by management and staff and external peer reviews, including bilateral exchanges. Generally speaking, documentation o f quality assurance

procedures i s in the form of a s ign o f f by superiors on the work done by the auditor undertaking the assignment.

237. Reviewing Internal Controls. On the whole, the Government does not have advanced internal control systems or IAUs. Consequently, the SA0 usually does not rely on the work of internal audit or internal administrative control units. Assessments o f internal control and accounting systems are not an integral part o f the SAO’s financial audits. They are separate exercises that only occur when internal control or internal audit units have produced reports on physical control, inspection or auditing activities. The findings o f these separate reviews influence the scope o f substantive testing by the S A 0 but only to the extent that specific transactions already checked by an internal controller or auditor and found satisfactory by the SA0 will not be selected for substantive testing again. All other transactions are subject to substantive testing.

238. Compliance Testing. The main objective o f the SAO’s audits i s to validate accounting entries and the financial operation’s compliance with relevant laws and regulations. That means comprehensive substantive testing o f individual transactions.

239. Audit of Government Annual Accounts. As required by the ASA, within five months o f the expiration o f the statutory deadline for submission o f financial statements o f BUS, the S A 0 submits an annual report to the Sabor on the audits it has carried out as well as its own activities. The report i s a summary o f findings in connection with audits o f BUS’ financial statements. The executive summary does not constitute a statement o f assurance, but concludes whether the errors and irregularities detected significantly affect the financial statement o f individual institutions. Out o f 44 audit opinions on financial statements issued in 2002, the SA0 gave three “negative” (qualified) opinions, and four so-called “unconditional“ audit opinions. The remaining opinions were conditional. The SA0 does not conclude on the realism or regularity o f the execution o f the state budget as such. For more details, look under INTOSAI reporting standards - Statements of Assurance later in this report.

240. Collection of Audit Evidence. The SAO’s auditing standards differ from the ISA in one important respect. The SAO’s standards do not explicitly refer to evidence to support “financial statement assertions,” as set forth in the ISA. This evidence i s fundamental to the accounting and auditing profession. The assertions are categorized in the ISA as follows: Existence; Rights and Obligations; Occurrence; Completeness; Valuation; Measurement; Presentation & D i s c l o s ~ r e . ~ ~ The assertions refer to items on the balance sheetlfinancial position as well as the income statementlthe statement o f financial performance. Because the SA0 auditors are not required to systematically

78 Elaboration o f ISA 500: Financial statement assertions are assertions by management, explicit or otherwise, that are embodied in the financial statements. They can be categorized as follows: (a) Existence: an asset or a l iabi l i ty exists at a given date; (b) Rights and obligations: an asset or a l iabi l i ty pertains to the entity at a given date; (c) Occurrence: a transaction o r event took place which pertains to the entity during the period; (d) Completeness: there are no unrecorded assets, liabilities, transactions or events, or undisclosed items; (e) Valuation: an asset o r l iabi l i ty is recorded at an appropriate carrying value; (0 Measurement: a transaction or event is recorded at the proper amount; revenue or expense is allocated to the proper period; and (8) Presentation and disclosure: an i t em i s disclosed, classified, and described in accordance with the applicable financial reporting framework.

Croafia CFAA: External Audit and Leqislafive Oversiqhf 66

scrutinize these assertions, certain relevant evidence may be overlooked in some cases. The focus o f the SAO’s collection o f audit evidence i s somewhat broader and less systematic.

241. Interviews conducted indicated that the auditors perceive their approach to be identical to 100 percent substantive testing. I t i s however clear that an ex post verification o f each o f the transactions and supporting documentation related to the 1 1,327 financial reports that the SA0 receive during the year i s possible with a staff number o f 301.

242. Audit of Financial Statements. The audit o f financial statements prepared in accordance with the BA and the OFB, i s an essential part o f the SAO’s work. It issues standardized audit opinions with phrases similar to those recommended in the INTOSAI AS and the EUG and do refer to these audits as attestation audits. The approach used in these audits however do not appear to be consistent with the approach promoted v ia the ISA, which includes preliminary systematic assessments o f r i s k and materiality, accounting systems and internal control systems in the broadest sense o f the word (not only referring to hard and physical controls). Concerning the SAO’s approach to audit and the collection o f audit evidence, see the paragraph above.

Practice - The INTOSAI AS on Reporting

243. Fairness, Accuracy and Timeliness. The fairness and accuracy o f SA0 reports should derive from adherence to i t s own procedures and the right o f the auditee to react to the SAO’s findings. Whereas procedures in general appear to be adhered to, the C F A A did not obtain information to verify the degree o f fairness and accuracy as perceived by the auditee. Feedback from the Sabor seemed to indicate that reports are perceived to be timely and reliable.

244. Statements of Assurance. The SA0 provides formal opinions on the financial statements o f individual Bus, using i t s own standards and working guidelines. A formal plan i s in place prior to it; moreover SAO’s auditors appear to fol low it. However, assessments o f risk and materiality are not in use to systematically select audit areas and transactions. Risk assessment i s generally done on the basis o f intuit ion and prior experience and according to statistical models. Audit opinions do not constitute positive statements o f assurance concerning the true and fair nature o f the financial statements. In i t s statutory report to the Sabor, the SA0 provides an opinion based on various audit findings. This does however does not constitute a statement o f assurance o n the execution o f the budget, as the exact coverage and relative materiality o f the selected auditees i s not quantified. Nor are the criteria for the selection o f individual transactions and operations audited made explicit in the report.

245. In interviews with individual auditors, the C F A A learned that some Computer Assisted Audit Techniques (CAATs) were in the offing. However, the Report o n the Audits Performed in 2002 did not mention the CAATs.

Croafia CFAA: External Audit and Leaislative Oversiaht 67

Practice - Parliamentary Oversight

246. Organization of Parliamentary Committees. The Subor does not have a special Committee to review the SAO's reports. The reports usually a topic o f discussion by a variety o f committees, depending on which sector area the audit related to. The most frequent committee interlocutor i s the Budget Committee, which consists o f 13 Members o f the Subor. The Committee has three permanent staff.

247. Practice of SAI-Parliamentary Interaction. The C F A A team leamed that the Subor's perception o f the SAO's reports i s that they are not very informative. Although the AG and the SA0 are generally respected, the level o f cooperation between the Subor and the SA0 i s characterized as routine instead o f dynamic. Members o f Parliament consider the SAO's audits as narrow in scope.

248. System for Effective Implementation. All decisions o f the Budget Committee become formal opinions o f the Subor. Follow-up on the recommendations o f the Committee i s rigorous. Neither the Sabor nor the Government has a system to continuously monitor the recommendations o f the S A 0 and their implementation.

111. Summary o f Findings and Assessment o f Fiduciarv Risk

249. The Act on State Audit provides a broad mandate for those public funds and institutions that i t i s required to audit as well as the audit standards and methods it can apply. However, the act has shortcomings that should be addressed by the State Audit Office (SAO) and Parliament (the Subor) as a matter o f priority. One shortcoming i s that the SA0 i s not formally required to provide a statement o f assurance o n the execution o f the state budget. The SA0 i s however required to report to the Sabor annually on the audits performed and it does offers an opinion based o n audits o f the full set o f Government financial statements. Due to the nature o f i t s legal mandate and the methods applied this however does not constitute a formal statement o f assurance on the Government consolidated financial statements or the execution o f the state budget. The SAO's legal framework does not guarantee i t s financial independence from the government, which currently makes i t subject to the MOF's budget supervision. Whereas the Act on State Audit explicitly provides a mandate for it, the SA0 sti l l has not piloted any audits o f economy, efficiency or effectiveness. The SAO's reports are perceived to be authoritative and the Sabor acts on audit recommendations. There are indications that the Sabor considers the SAO's reports rather narrow in focus and scope. The combined fiduciary risk associated with extemal auditing and Parliamentary oversight i s considered moderate.

IV. Recommendations

250. The ASA should be amended to ensure that the S A 0 budget go directly to Parliament without prior adjustments by the MOF. At the same time, the SAO's annual financial statement should be made subject to an independent extemal audit and the auditor appointed by Parliament. Subsequently, the MOF's budget supervision over the SA0 should cease.

Croatia CFAA: External Audit and Leqislative Oversiqht 68

251. The A S A should be amended in to require the SA0 to submit a statement of assurance that the Government’s consolidated financial statement gives a true and fair view o f the sources and use o f funds. The SA0 should use the ISA as a model.

252. The ASA should be amended to allow the S A 0 to audit all EU funds. The SA0 should consider positively the challenge o f auditing and becoming certifying body for future EU funded programs in Croatia.

253. In l ine with the recommendations o f the 1999 CFAA, the 2002 S I G M A peer review and the 2002 PEIR, the SA0 should initiate pi lot audits o f economy, efficiency and effectiveness (performance or value-for-money audits).

254. Public Accounts Committee, for example, as a sub-committee to the Budget Committee.

The S A 0 and the Sabor should joint ly consider the establishment o f a specialized

Croatia CFAA: Local and reqionai self-oovernment units 69

CHAPTER 8: LOCAL AND REGIONAL SELF-GOVERNMENT UNITS

I. Background and Assessment framework

Background

255. A national decentralization process began in 2001 ; counties and municipalities assumed new responsibilities for elementary and secondary education, health, social services, care for the elderly and f i re protection. A second phase o f decentralization i s scheduled for 2004. The government was expected to recommend legislative initiatives to:

0

0

Expand the authority o f local governments;

Provide local governments with adequate revenues to fairly and efficiently deliver the services for which they are responsible;

Restate minimum financial standards, based on objective criteria (for example, number o f clients in the target population to be served, geographical or climate factors); these standards are pivotal in equalization grants.

Mod i f y the central government’s processes and procedures that interfere with local decision making.

256. From 2000 a USAID project supported the preparation o f a framework for decentralizing certain functions from the state budget to the budget o f local and regional self-government units and assisted in the preparation o f the fiscal decentralization model for such functions. In mid-2001, the Croatian Parliament adopted a number o f amendments to the Law on Financing o f Local and Regional Self-government Units. Subsequently, the Government o f the Republic o f Croatia adopts annually relevant decisions on minimum financial standards and the Decree on Calculation o f State Budget Equalization for decentralized government functions according to an equalization formula.

0

0

257. As the Croatian Government did not consider taking any further steps towards decentralization and as the elections for a new government were approaching, i t was decided in September 2003 to postpone the implementation o f a planned CARDS 2002 Fiscal Decentralization Project. Subsequently, further activities related to this project were suspended.

258. On December 8, 2004, Croatian Government adopted a Framework for a Decentralization Program for the period from 2004 - 2007 and established the Commission for Decentralization which would coordinate the implementation o f the program. The members o f the Commission are state officials, state secretaries and assistant ministers. The chairman i s State Secretary o f Central State Administration Office.

Croatia CFAA: Local and reaional self-qovernment units 70

Assessment Framework

259. wi l l use the same framework applied to the central Government.

In assessing the fiduciary risk associated with the PFM arrangements, the C F A A

11. Findings

Legal Framework

260. The legal base for Local Self-government in Croatia i s Act No. 33/2001 on Local and Regional Self-Government (LRSG). The law defines three types o f sub-national geographical units: Counties, Municipalities and Towns. Counties are defined as “units o f regional self-government” and towns and municipalities as “units o f local self- governments.” A town i s defined as a community with 10,000 or more residents or the place where the county seat i s located.

261. The financing o f local and regional self-govemed units i s regulated under Act No. 117/1993; the Act and its amendments pertain to the Financing o f Local and regional Self-government Units.

262. City Charter) No. 20/2001, which among other things regulates budget preparations.

The City o f Zagreb has a particular law, the City o f Zagreb Charter (hereafter the

263. City Charter and the BA apply to the City o f Zagreb.

The BA regulates PFM arrangements for al l three types o f sub-national units. The

Institutional Framework and Capacity

264. regional level, 123 cities and 426 municipalities at the local level.

Sub-national self-govemment in Croatia has two tiers: 20 counties are at the

265. municipalities and cities appear in Box 8 blow.

Box 8. Tasks and responsibilities of Towns, Municipalities and Counties

The activities and areas of public pol icy falling within the purview o f counties,

Municipalities & Towns

0 Housing 0 Spatial and urban planning 0 Utilities 0 Social and chi ld care 0 Primary health care 0 Elementary education 0 Culture and sports 0 Consumer protection 0 Environmental protection 0 Fire protection and c iv i l service

Counties

Education 0 Health

Spatial and urban planning Economic development Transport and traffic infrastructure Planning and development o f a network o f educational, health, social, and cultural institutions

Croatia CFAA: Local and regional self-aovernment units 71

266. In cities wi th more than 30,000 inhabitants, the administration may perform the tasks o f a regional, county authority, provided they can obtain the necessary financing to deliver services.

267. Each self-governed unit consists o f a directly elected Assembly or Council. Subsequently, these units elect a Mayor. Apart from electing and dismissing the Mayor, the Assembly makes decisions and generally acts within the scope o f i t s competencies. By statute, the Assembly also establishes various administrative bodies o f self- government. The Mayor represents and presides over the local/regional government.

268. Typically, the local/regional government administration consists o f a Budget & Finance Unit (BFU), which i s responsible for the preparation, control and accounting o f the budget. BFUs vary in size. The CFAA visited two county administrations (Zagreb and Varazdin) and two towdci ty administrations (Zagreb and Varazdin) that appeared to be adequately staffed. Generally, BFU staff numbers were in a 1 : 10 ratio to the total number o f administrative staff. Although the two towns/counties represent two different geographical areas, they represent the richest regions o f Croatia. Therefore, staff resources here may not reflect the less prosperous parts o f the country.

Practice

269. On the whole, budget preparations for local and regional governments fol low the procedures la id down in the BA. After receiving the macro-economic indicators and revenue estimate guidelines from the MOF, the BFUs ask each department to submit its budget proposal for the following fiscal year. This process starts in early summer. After the f i rs t round o f internal negotiations among administrative departments and budget entities, the BFU o f the relevant unit prepares a draft budget proposal which i s submitted to the local government by October 15 o f the current year. The local government unit then decides on the entire budget proposal and submits it to the competent representative body (council, assembly) for consideration and adoption by November 15 o f the current year. The representative body i s required to adopt the budget by the end o f the year, while i t s application should be effective as o f January 1 o f the year to which the budget refers.

270. For a city l i ke Zagreb, they include:

Different revenues are available to the regional/local government administrations.

0 Income and profi t taxes - which are collected and distributed via the tax administration

0 Administrative fees

0 Automobile taxes

0 Concessions

0

0 Sales o f assets

Reconciliation funds - special purpose

271. allocating the correct percentage o f collected revenue to the State and regional accounts.

Revenues are in a special account managed by FINA. FINA i s also responsible for

Croatia CFAA: Local and reaional self-aovernment units 72

272. In te rms o f fiscal transparency, the town o f Varazdin has developed a practice o f using fliers to inform i t s citizens how the town spent the money in the current and capital budgets and sources o f revenue.

273. Counties, municipalities and towns are only supposed to have one bank account; salaries also come out o f this account. Salaries are paid directly from the country account after the heads o f the individual administrative entity, the BFU and the administrative head or governor o f the municipality/county/town. As sub-national governments are legal units with budgetary authority, each unit can enter into contracts. It i s therefore likely they could each have several bank accounts in the name o f the local authority they represent. The CFAA however could not obtain any statistics on this.

274. Monitoring of borrowing i s guided via strict observation o f the Budget Act and the Regulations on Borrowing Procedure for local and regional self-government units. Also issuing of guarantees to local and regional self-government units by the Minister o f Finance only allows long-term borrowing for investments financed f rom their own budget, with the prior approval o f the Government. Total annual l iabi l i ty may not exceed 20 % o f the realized income o f a particular local or regional self-government unit in the year preceding the year o f borrowing.

275. County, municipal and town administrations usually have computerized accounting systems. In most cases, depending on the type o f expenditure, there are several systems. In the county o f Zagreb, there are separate systems for salaries, current expenditures and the accumulation o f balance sheet data, such as assets and liabilities.

276. Semi-annual and Annual Reports on Budget Execution, which follows the budget classification prescribed for budget preparation, are adopted by a representative body o f the relevant local or regional self-government unit. Financial statements serve as basis for preparation o f these documents on budget execution and they are submitted to the Ministry o f Finance and State Audit Office.

277. As reported by the MOF, the reliability o f financial reporting i s in question subsequent to decentralization and various changes in accounting rules for BUS. Bo th the M O F and the SA0 report that the BUS associated with the central and sub-national governments had significant difficulties meeting the new deadlines for submission o f financial reports to the M O F and the SAO. Moreover, in general, the BUS did not use the forms provided by the M O F to submit their financial statements. This contributed to a delay in the MOF’s consolidation o f financial statements for the central and general governments.

278. Although the BA requires the establishment o f an IAU, the administrations interviewed had not as yet established such units. They referred to the fact that did not have the so-called Rulebooks that the M O F i s supposed to issue in accordance with BA’s Article 137. Financing the additional staff necessary to establish an IAU has to come out of an existing budget; as a result, the lack o f funds becomes a resource problem for the administration.

Croatia CFAA: Local and reaional self-government units 73

279. The S A 0 audits the financial statements o f local and regional administrations annually. Audits usually occur in teams o f two to four auditors; these auditors are usually on site at the local or regional administration for a period o f 1-1 % months.

111. Summary of Findings and Assessment of Fiduciary Risk

280. On the whole, the budgeting practices o f sub-national governments appear to be sound. They appear to ensure that the budget reflects the priorities o f local and regional interests and political parties. These practices also appear to effectively prevent over- lending at the sub-national level and the generation o f contingent liabilities at the state level. That being said, the l ikely existence of a great number o f bank accounts owned by local government increases the risk o f public funds following channels outside the formal processes set out in the BA. The ongoing process o f decentralization, combined with recent changes in accounting rules have caused problems in the reliability o f financial reporting to the MOF. The SA0 provides external audit arrangements with appropriate frequency and provides a safeguard against the misuse o f funds. The SAO’s resources are however spread thin at the sub-national level. Generally speaking, the transparency o f the P F M system appears to be greater at the sub-national level than at the state level. This i s also reinforced by more direct lines o f accountability between the citizen and the elected representative. Based on the concrete concerns related to cash management, the reliability o f financial reporting and internal control, the fiduciary risk associated with the PFM and financial accountability arrangements for sub-national governments must be rated sigrzifican t.

IV. Recommendations

28 1. The C F A A recommends the following:

0 As at the state level, the M O F should issue al l the statutory” rulebooks and guidelines on internal audit and accounting referred to in the BA and offer appropriate training for their effective application. But local and regional administrations should prepare to implement the intentions o f the new BA, including steps to establish MUS.

The practice o f engaging and educating citizens in local budget expenditures, as done in the town o f Varazdin, i s a best practice in ensuring transparency and accountability. The concrete practice o f public campaigns (for example, distribution of flyers) to inform citizens about the use and sources o f the local budget should be expanded to other sub-national government administrations.

0

79 As required by the organic Budget Act.

Croatia CFAA: Capacity Development 74

CHAPTER 9: CAPACITY DEVELOPMENT

282. In this chapter, the CFAA wil l offer an overview o f recent technical assistance (TA) activities in the field o f Public Financial Management (PFM). I t wi l l assess the ability o f beneficiary institutions to absorb the T A effectively as well as the sustainability of the capacity development effort.

I. Recent TA activities in the field of PFM

283. Because EU accession was a clear political objective from the beginning, the Croatian Government has benefited and continues to benefit from the EU CARDS (Community Assistance for Reconstruction, Development and Stabilization) program. The development o f P F M has been a priority o f the EU; considerable amounts o f money have funded technical assistance in this field. During the period o f 2002-2004, the CARDS budget o f the European Communities allocated EUR 10.5 mi l l ion to improve the P F M in Croatia.80 In addition, USAID, the U S Treasury, SIGMA, the IMF and the Wor ld Bank have been and wil l continue to provide advice in developing PFM capacity.

284.

e

e

e

e

e

e

e

e

Current or upcoming P F M development projects include:

CARDS 2002: Development o f Public Internal Financial Control (PIFC) and Internal Audit (EUR 1.5 million), accompanied by a program o f training and development in modern internal audit

CARDS 2002: Development o f Public Debt Management Capacity (EUR 1.5 million.)

SIGMA": Peer Review and Strategic Development Plan for the State Audit Office (Peer review report published in July 2003. Budget figures were not available. The CARDS 2003 project below i s partially based on recommendations from the peer review)

CARDS 2003: Strengthening the External Oversight o f Budget Execution (EUR 1.6 million.)

U S Treasury: Resident Advisor Program with the Ministry o f Finance (Continues through 2004. Budget figures were not available)

USAID: Fiscal Reform Program (Implemented by Bearing Point consultancy through 2004. Budget figures were not available)

CARDS 2004: Strengthening Public Internal Financial Control Structures (EUR 1.5 million)

The World Bank IDF Grant for Strengthening Budget Management (USD 368 thousands)

European Commission Country Strategy Paper for Croatia 2002-2006, p. 66. S I G M A stands for Support for Improvement in Governance and Management; i t i s a j o in t init iative of the

OECD and the European Communities. Activit ies in Croatia are h n d e d f r o m a "framework" grant to the OECD f rom the European Communities' Balkans program. Short o r medium-term assistance for expertise and project management come f rom the S I G M A secretariat located at OECD's headquarters.

285. In addition to these activities, the IMF has sponsored a resident advisor to assist the CNB; until recently, an advisor also assisted the MOF. The World Bank has provided ad hoc advice during missions. The IMF’s and the World Bank’s advice on debt management has been provided through a “Joint Program on Central Government Debt Management and debt Market”. The program’s most recent mission to Zagreb was in February 2004.

286. I t should also be mentioned that under the headline o f “public finance” the EU also finances a great number o f technical assistance projects related to the development o f the customs administration.

11. Assessment of TA absorption capacity, impact and coordination

287. The reform o f the Croatian P F M system depends on the continued development o f the SAP-based state treasury system. As concluded in previous chapters, the system has suffered from a lack o f senior M O F management commitment and ownership, as well as an absence o f a broader context for subsequent financial systems reforms across the government.

288. MOF should be responsible for consolidating recommendations f rom the various partners and related projects. Because this has not happened, the high quality TA advice to improve the treasury system has been ineffective. Outstanding areas for improvement include TA for budgeting o f programs, cash management, debt management and accounting issues.

289. Progress on the internal audit changes does not depend on the development o f a treasury system. For i t s part, the MOF has not been very effective in promoting the CARDS 2002 project on PIFC and internal audit. During the course o f the March 2004 mission the C F A A team interviewed a number o f the senior management and BFU managers in ministries and other BUS. W h i l e these managers were aware o f the requirement to establish internal audit, they were unaware o f the ongoing PIFC and the new requirements o f modem internal audit and o f the project by the MOF. By June 2004 the awareness o f the CARDS 2002 project had improved significantly, for example with the help o f a proactive information campaign initiated by the E C delegation and the project management team. Generally, intra-MOF and inter-ministerial coordination i s a significant problem for effective P F M capacity development. The MOF’s efforts with the Treasury system are a case in point.

290. On the whole, donor coordination o f TA to Croatia seems efficient. As an indicator, the ECCSP 2002-2006 contained summaries o f other donors’ activities. A matrix referred to an overview o f contributions from the seven most important donor organizations to particular sectors, pol icy areas and institutions.82 In the PFM area, frequent consultations occur among the Wor ld Bank, IMF, USAID, U S Treasury, SIGMA and European Commission; similar consultations take place. Considering the scope o f TA provided and the priority that EU accession occupies o n the Government’s agenda, the EU will take on a leadership and coordinative role. The challenge wil l be to

82 In addition to the European Commission: Uni ted Nations Development Program, European Bank o f Reconstruction and Development, European Investment Bank, IMF, U S A I D and the W o r l d Bank.

Croafia CFAA: Capacity Development 76

complete the init ial assistance in capacity development and to build a sustaining training program that wil l be capable o f educating all future civ i l servants and new hires in the fundamentals o f public financial management, budgeting, internal control and internal audit.

111. General assessment o f PFM capacity development needs

291. The number and capability of staff in newly established and specialized P F M functions are inadequate. There i s a serious shortfall in trained young staff knowledgeable in the principles o f modem financial management, budgeting, internal financial control, debt management and internal auditing. Staff responsible for bookkeeping, accounting and financial reporting do not know how to manage the changes associated with the new modified accrual accounting regimes introduced in 2002; the same i s true of the Ordinance change on Financial Reporting and Budgetary Accounting for BUS. These professional groups are essential to the effective operation o f the public financial management system in the Government o f Croatia.

292. A broader and more holistic view o f the training requirements o f the government i s required. For example, there are no university degrees in public administration or public finance -- only law and economics. Whereas auditing courses are part o f the undergraduate curriculum in the Zagreb Faculty o f Economics, there are no specialized audit degrees offered by Croatian universities that could lead ultimately to some form o f international certification. The Croatian Association o f Accountants offers some training in accounting and auditing, including internal auditing.

293. There i s an Institute o f Public Finance (PF), an NGO, which deals with economic research and analysis relative to Public Financial Management. Whi le i t publishes a newsletter to inform c iv i l servants and other relevant parties about key public financial management issues, i t lacks the capacity to provide systematic training. I t restricts i t se l f to providing information on academic events concerning public finance that take place abroad.

294. The lack o f qualified staff in key PFM functions i s due in part to the perception that the public sector i s not attractive to someone with a skill that i s also in demand in the private sector. Second, the nature of the c iv i l service system allows recruiting on the basis of political instead o f professional merit.

295. The future needs in terms of competent P F M staff and systems to manage EU pre- accession, cohesion and structural funds will be considerable. To illustrate this, in Box 9 below the minimum requirements for managing pre-accession funds o n the basis o f an Extended Decentralized Implementation System (EDIS) are set out:

Croatia CFAA: Capacifv Development 77

Box 9. EDIS Accreditation Criteria. Annex to Council Regulation (EC, Euratom) No. 1266/1999

1. Minimum criteria for assessing the ability of implementing agencies in applicant countries to manage aid. The following criteria shall be applied by the Commission in assessing which implementing agencies in partner countries are able to manage aid on a decentralized basis:

( I ) there should be a well-defined system for managing the funds with full internal rules ofprocedure, clear institutional andpersonal responsibilities;

(11) the principle o f separation ofpowers must be respected so that there i s no risk o f conflict o f interest in procurement and payment;

(111) Adequatepersonnel must be available and assigned to the task. They must have suitable auditing skills and experience, language skills and be fully trained in implementing Community programmes.

2. Minimum conditions for decentralizing management to implementing agencies in applicant countries. Decentralization to applicant countries with ex post control by the Commission may be considered for an implementing agency where the following conditions are met:

( I ) demonstration o f effective internal controls including an independent audit function and an effective accounting and financial reporting system which meets internationally accepted audit standards;

(11) a recentfinancial and operational audit showing effective and timely management o f Community assistance or national measures o f similar nature;

(111) a reliable nationalfinancial control system over the implementing agency;

(1V)procurement rules which are endorsed by the Commission as meeting requirements o f Title I X o f the Financial Regulation applicable to the general budget o f the European Communities;

( V ) Commitment by the National Authorizing Officer to bear the fullfinancial responsibility and liability for the funds.

296. The Government must develop an integrated strategy for the development o f i t s financial management, budgeting, debt management and intemal audit personnel, both now and in the future. It must be a combination o f re-training o f those existing staff who demonstrate the capacity to make the transition to the new accrual base o f accounting, or the modem internal audit, and recruitment programs to attract those recent graduates who have acquired al l or part o f the ski l ls required through their university training. I t must also include provisions for the acquisition o f international certification in auditing (IIA) or accounting (CIPFA, and others). Budgeting should include the elements o f capital investment, costing o f budget alternatives and budget analysis. The components o f the program should build on the exiting or planned training infi-astructure for Croatian c iv i l servants, with extensions where required. These include the Government accounting center in Ljubljanag3, the planned internal audit training facilities in Zagreb being created as part o f the CARDS 2002 program,g4 plus other ad hoc training opportunities offered by donors from time to time.

83 The Government plans to educate approximately 100 accounting staff in Ljubl jana over the next 2 years, financed by a Wor ld Bank project 50 wil l be trained in Ljubljana, the remaining 50 in Zagreb in Croatian. 84 The CARDS program objective i s t o train 120 auditors in the new techniques o f modern internal audit - 40 trained by project staff and 870 by trainers trained by the project.

Croatia CFAA: Capacity Develooment 78

IV. Recommendations

297. MOF should designate a responsible senior management position at the Director level (minim~m)'~ to oversee the development o f the comprehensive training strategy, in consultation with the donor community, planned and current training providers and the professional associations o f accounting and auditing in Croatia. The objectives should be to:

a

a

a

a

Provide training in the skills required to perform the new functions in financial management, in budgeting, debt management and in auditing;

Provide an opportunity for international professional certification through participation in a university program or a professional organization that provides some recognition o f the training modules delivered under this program;

Provides a continuing education program for the professional in government to assist them in maintaining the currency o f their professional sk i l l s and practices.

The Minister o f Finance should obtain C O M approval for this program and then enlist donor support for those components that require fimding beyond the current project timeframe.

85 This would be a most suitable role for the Secretary General o f the Ministry of Finance.

Croatia CFAA: Annex I: Kev persons interviewed 79

ANNEX 1: KEY PERSONS INTERVIEWED (IN ALPHABETICAL ORDER)

Family name

ANDRICEVIC

BERGMAN

B L A Z E K O V I C

BOGNER

BOLTAR

BOWEN

B R K I C

B R K I C

CHETCUTI

C IZMOVIC

CUJZEK

CULJAK

CURKOVIC

D U R I C

FAULEND

F U T A C

GILJEVIC

GOLIK

GRABOVAC

GREGIC

GRZUNOV

HEIKKWEN

Given name

Lana

Vjeceslav

Katica

Marijanka

Verica

Mart in

Vesna

Karmen

Frederic

Zaklina

Nevenka

Ruzica

Vesna

Mar io

Michael

Sujeiane

Vera

Marijana

Branka

Zeljko

Zeljko

Ri tva

Title/ fun ctioddepartmen t

Assistant Budget Advisor

Director

Director o f IT Support to Treasury

Head o f Finance Department for Social Protection

Director

Chief o f Party

Economist

Consultant

Team Leader

Head o f Division for Development, Analysis and Statistical Infrastructure

Head o f Budget and Finance Department

Head o f Analysis and Plan Unit

Assistant Head o f Finance Department

IT Senior Advisor

Advisor

SAP/R3 Operator - IT

Head o f Accounting Div is ion

Head o f Finance and Accounting Unit

Head o f Accounting for Public Debt and Cash Management Section

Head o f Budget Section

Assistant Minister

support

Sector Manager

Institution

U S Department o f Treasury

Institute o f Health Insurance

FINA

Ministry o f Social Welfare

Varazdin Branch o f FINA

U S A I D Fiscal Reform

Ministry o f Finance

U S A I D Fiscal Reform

EU CARDS project

Central Bureau o f Statistics

County o f Varazdin

Institute o f Health Insurance

City o f Zagreb

Ministry o f Finance

Croatian National Bank

Ministry o f Health and Social Welfare

Ministry o f Defense

Institute o f Health Insurance

Ministry o f Finance

Ministry o f Defense

Ministry o f Sea, Tourism, Transport and Development

European Commission

Family name Given name Title/ function/department Institution

State Audit Office HRUP

H U Z A N I C

Nevenka

Bozica

Audit Manager

SAP/R3 Operator - IT

Assistant Minister for Budget Execution and Internal Audit and Control

Head o f Section

Deputy County Governor

Head o f State Accounting and Financial Reporting Div is ion

Head o f Department for Economic Affairs, Finances and Public revenues

SAP/Treasury System operator

Member o f the Ci ty Council and Head o f Finance Department

Project Manager

Assistant Auditor General

S A P / R 3 Operator - IT

Assistant Minister for International Financial Institutions

Director

Assistant Director

Assistant Auditor General

Audit Manager

Assistant o f Minster

Head o f Section for Budget Supervision

Assistant Minister for Finance

support

support

Ministry o f Health and Social Welfare

Ministry o f Finance IKS IC Amalija

I V A N D I C

J A M B R A C

KARACIC

Vladimira

Josip

Mladenka

Ministry o f Finance

Zagreb County Off ice

Ministry o f Finance

KEZELE Jerka C i t y o f Varazdin

KNEZEVIC Marela Ministry o f Sea, Tourism, Transport and Development

City o f Zagreb KOJIC Slavko

K O K O R I C

K O R D I C

K O T A V E C

Zeljko

Hrvoj e

Sonja

B4B, S A P development

State Audit Office

Ministry o f Health and Social Welfare

Ministry o f Finance K U L I S I C Josip

L A N D S M A N

L A U S I N

LINDSBAUER

LJUBICIC

L U C I C

M A L E N I C A

Ma ja

Veronika

Lj erka

M i l k a

Zorica

Slavica

Croatian National Bank

Institute o f Health Insurance

State Audit Office

State Audit Office

Ministry o f Finance

Ministry o f Finance

Stipe M A M I C Ministry for Science, Education and Sport

Zagreb County Office MARIN Head o f Finance and Budget Department

Internal Revision Unit

Director

Ana

M A R K O V I C

MARUSIC

Lj i l jana

Jadranka

Central Bureau o f Statistics

Croatian National Bank

Family name

M A T I J E V I C

M E D I C

M I S K O V I C

NIKOLIC- MUDRINIC

NBRREGAARD

N O V A C I C

O ’ C A L L A G H A N

PAP

PERKOVIC

PERNAR

POLHERT

PRTENJACA

PRUGOVECKI

R A I C

ROGIC

RUTH

SABADZIJA

S A B A T I

SALOPEK

SANTINI

SARIC

SKRBINA

S M U K

SOKOLIC

Given name

Katj a

Zdenka

Sara

Vlasta

John

Ivan

Gany Jasenka

Dijana

L id i ja

Sanja

Sime

Gordan

N i k o

Branko

James Bennett

V i to

Zvonimir

Vjera

Ivona

Sandra

Zelj k a

Zdrana

Snjezana

Title/ function/department

Assistant Minister for Economic Affairs in Health

Sector Director, IT Support to Treasury

Head o f Finance and Planning Division

Assistant Director o f Legal, Finance, Accountancy and Central Administration

Resident Representative

Assistant Minister for Economic Affairs

Fiscal Advisor, Consultant

Assistant Director

Senior Adviser for Analysis

Assistant Auditor General

Cashless Payment Operations Department

Member o f the Sabor, Chairman o f the Finance and Central Budget Committee

Head o f Department

Assistant Minister for Budget Preparation

Deputy Head o f Personnel

Resident Budget Advisor

Head o f the J8 Budget and Finance Divis ion

County Governor

Deputy Head o f Finance Department

Consultant

Audit Manager

Senior Officer

Head o f Budget Div is ion

Senior Inspector for Financial Matters o f the General

Institution

Ministry o f Health and Social Welfare

FINA

Ministry o f Justice

Central Bureau o f Statistics

IMF

Ministry o f Finance

U S Treasury

Institute o f Health Insurance

Ministry o f Defense

State Audit Office

Croatian National Bank

Croatian Parliament, the Sabor

Croatian National Bank

Ministry o f Finance

Ministry o f Defense

U S Department o f Treasury

Croatian Armed Forces

County o f Varazdin

Ci ty o f Zagreb

U S A I D Fiscal Reform

State Audit Office

Croatian National Bank

Ministry o f Defense

Ministry o f Defense

Croatia CFAA: Annex I: Kev persons interviewed 82

Family name

SOSTARIC

STARESINCIC

STEGIC

STOLNIK

SVIGIR

T K A L C I C

TORTIC

VINCETIC

VUCETIC

VULETIC A N T I C

Given name

Tanj a

Dijana

Mar in

Vladimir

Mar io

Maja

Vesna

Ivan

Ivan

Bozo

Title/ fun ctioddepartm ent

Inspectorate

Senior Advisor

Head o f the Development Section

Audit Manager

Deputy County Governor

Advisor to Minister

Head o f Accounting and Finance Divis ion

Head o f the M - 4 Office o f Assistant Minster for Finance and Budget

Member o f County Council responsible for Budget and Finances

Director

Audit Manager

Institution

Ministry o f Finance

Ministry o f Finance

State Audit Office

County o f Varazdin

Ministry o f Finance

Central Bureau o f Statistics

Ministry o f Defense

County o f Varazdin

FINA State Audit Off ice

v)

a L

n 8 -

L 0 Y m 3 E 3

z n cn

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+ m

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c E P F 0 m .e i-

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x 2

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g f;

3

5

x m V

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0 u m h e

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9

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x i-

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cu 0 8 10

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i-

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3

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9

a,

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v2

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3

e,

ru 0

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Y C 3 B g a,

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G a,

P a,

z

a2 L.

8 n z E

Croatia CFAA: Annex 111: Overall Assessment of Fiduciary Risk 92

1. Aggregate fiscal deficit compared to original budget.

ANNEX 111. OVERALL ASSESSMENT OF FIDUCIARY R I S K

Significant

The fiduciary risk within an individual P F M area, such as Budgeting, i s calculated as a simple average o f the rating o f each indicator presented in Annex I1 and in the table below. The overall risk rating for the entire P F M system i s also calculated as a simple average o f the ratings assigned to the individual P F M components. This i s summarized in the table below.

2. Composition o f expenditure out-turn compared to original approved budget.

I t should be emphasized that whereas the fiduciary risk ratings can be used for the purpose o f comparison and benchmarking i t does provide quantitative information about the probabilities o f funds not being spent for the intended purposes.

L o w

PFM component

I

Budgeting

3. Extent t o which budget reports include a l l significant expenditures o n central government activities, including those funded by donors.

4. Adequacy o f information o n fiscal projections, budget and outturns provided in budget documentation. 5 . Administrative, economic, functional and programmatic classification o f the budget. 6. Extent o f multi-year perspective in fiscal planning, expenditure policy-making and budgeting 7. Orderliness and participation in the annual budget process. 8. Legislative scrutiny o f the annual budget law.

Significant

Significant

L o w

Moderate

Significant

Moderate

Treasury & cash management

9. Single Treasury Account. 10. Stock o f expenditure arrears. 1 1. Effectiveness o f cash f l ow planning, management and monitoring. 12. Procedures in operation for the management and recording o f debt and guarantees.

Risk indicators

Moderate Significant Significant

Significant

Indicator Risks7

PFM component risk

Moderate

Significant

87 For explanation and interpretation see Annex I1

Croafia CFAA: Annex 111: Overall Assessmenf of Fiduciaw Risk 93

Risk indicators

13 Extent to which spending ministries and agencies are able to p lan and commit expenditures in accordance with originalirevised budgets. 14. Computerized accounting systems 15. Audit trail documentation 16. Timeliness and regularity o f data

PFM component Indicator PFM Risks7 component

risk

Significant

Moderate High Significant

Accounting & financial reporting

reconciliation. 17. Timeliness, quality and dissemination o f 1 Significant

Internal control & internal audit r External audit &

Significant

legislative oversight

statements submitted to the legislature 19. Corruption perception index ranking 20. Written procedures 21. Effectiveness o f internal controls 22. The effectiveness o f internal audit 23. The scope and nature o f external audit. 24. Fol low up o f audit reports by the

Sub-National Government

Significant Significant Significant Significant High Moderate Moderate Moderate

Overall Assessment of

executive or audited entity. 25. Legislative scrutiny o f external audit reports The above as applied to sub-national government

Moderate

Significant Significant"

in-year budget reports. 18. Timeliness and quality o f audited financial I Significant

Significant

88 As summarized in section 111, Chapter 8.