Croatia Country Financial Accountability...

Croatia Country Financial Accountability Assessment

May 12, 2005 Operations Policy and Services Europe and Central Asia Region

Document of the World Bank

CURRENCY EQUIVALENT 1 HRK = 0.17450 US$ (MAY 12, 2005)

FISCAL YEAR JANUARY 1 – DECEMBER 31

ABBREVIATIONS AND ACRONYMS

ASA Act on State Audit BA (Organic) Budget Act BFU Budget and Finance Unit BU Budget User CAAT Computer Assisted Auditing Techniques CARDS Community Assistance for Reconstruction,

Development and Stability CAS Country Assistance Strategy CFAA Country Financial Accountability Assessment CIA Certified Internal Auditor CNB Croatian National Bank COA Chart of Accounts COM Council of Ministers COSO Committee of the Sponsoring Organization of the

Treadway Commission CPAR Country Procurement Assessment Report CRU Control and Revision Unit EBF Extra-Budgetary Funds EC European Communities ECA Europe and Central Asia Region ECSPE Europe and Central Asia Region, Poverty

Reduction/Economic Management Department, World Bank

ECSPS Europe and Central Asia, Operations and Policy Services, World Bank

EDIS Extended Decentralized Implementation Systems ESA European System of Accounts ESW Economic and Sector Work EUG European Implementing Guidelines for the

INTOSAI Auditing Standards FINA Financial Agency FMS Financial Management Specialist FY Fiscal/Financial Year GDP Gross Domestic Product GSF Government Financial Statistics GSFM GFS Manual HABOR Croatian Agency for Bank Reconstruction and

Development HBU Head of a Budget User HRK Croatian Kuna IAS International Accounting Standards IASB International Accounting Standards Board IAU Internal Audit Unit IBRD International Bank for Reconstruction and

Development IFAC International Federation of Accountants IIA Institute of Internal Auditors IMF International Monetary Fund INTOSAI International Organization of Supreme Audit

Institutions

INTOSAIAS INTOSAI Auditing Standards IPSAS International Public Sector Accounting Standards ISA International Standards on Auditing ISPA Instrument for Structural Policies for Accession ISPPIA International Standards for the Professional

Practice of Internal Auditing LCSPE Latin America & Caribbean Region, Sector Unit

for Economic Policy, World Bank MOF Ministry of Finance MP Member of Parliament MTEF Medium Term Expenditure Framework MTSA Regulation on Methods in Managing the Treasury

Single Account etc (OG No.97/1995) OECD Organization for Economic Cooperation and

Development OFB Ordinance on Financial Reporting and Budgetary

Accounting OPCFM Operations Policy & Country Services, Financial

Management, World Bank PAL Programmatic Adjustment Loans PDMS Public Debt Management Section PEFA Public Expenditure and Financial Accountability PEIR Public Expenditure and Institutions Review PFM Public Financial Management PIFC Public Internal Financial Control ROSC Reports on the Observance of Standards and

Codes SAA Stability and Association Agreement SAF State Accounting and Financial Reporting SAP Trademark of financial accounting and

management information system SAI Supreme Audit Institution SAO State Audit Office SAPARD Special Accession Program for Agriculture and

Rural Development SIGMA Support for Improvement in Governance and

Management in Central and Eastern Europe SNA System of National Accounts SOE Socially or State-Owned Enterprise TA Technical Assistance TSA Treasury Single Account TRM Treasury Reference Model USAID United States Agency for International

Development

Regional Vice-President: Shigeo Katsu, ECA Vice-Presidency Country Director: Anand Seth, ECCU5

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

Task Team Leader: Johannes Stenbaek Madsen, ECSPS, Financial Management

TABLE OF CONTENTS

PREFACE...........................................................................................................................I

EXECUTIVE SUMMARY ............................................................................................ IV

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

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

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

CHAPTER 3: BUDGETING ........................................................................................... 8 I. BACKGROUND AND ASSESSMENT FRAMEWORK ........................................................... 8 II . FINDINGS .................................................................................................................. 11 III. SUMMARY OF FINDINGS AND ASSESSMENT OF FIDUCIARY RISK.............................. 20 IV. RECOMMENDATIONS.......................................................................................... 21

CHAPTER 4: TREASURY AND CASH MANAGEMENT....................................... 22 I. BACKGROUND AND ASSESSMENT FRAMEWORK ......................................................... 22 II. FINDINGS................................................................................................................... 24 III. SUMMARY OF FINDINGS AND ASSESSMENT OF FIDUCIARY RISK.............................. 31 IV. RECOMMENDATIONS................................................................................................ 32

CHAPTER 5: ACCOUNTING AND FINANCIAL REPORTING ........................... 34 I. BACKGROUND AND ASSESSMENT FRAMEWORK ......................................................... 34 II. FINDINGS................................................................................................................... 36 III. SUMMARY OF FINDINGS AND ASSESSMENT OF FIDUCIARY RISK.............................. 43 IV. RECOMMENDATIONS................................................................................................ 43

CHAPTER 6: INTERNAL CONTROL AND INTERNAL AUDIT.......................... 45 I. BACKGROUND AND ASSESSMENT FRAMEWORK ......................................................... 45 II. FINDINGS................................................................................................................... 48 III. SUMMARY OF FINDINGS AND ASSESSMENT OF FIDUCIARY RISKS ............................ 56 IV. RECOMMENDATIONS................................................................................................ 57

CHAPTER 7: EXTERNAL AUDIT AND LEGISLATIVE OVERSIGHT .............. 58 I. BACKGROUND AND ASSESSMENT FRAMEWORK ......................................................... 58 II. FINDINGS................................................................................................................... 61 III. SUMMARY OF FINDINGS AND ASSESSMENT OF FIDUCIARY RISK.............................. 68 IV. RECOMMENDATIONS................................................................................................ 68

CHAPTER 8: LOCAL AND REGIONAL SELF-GOVERNMENT UNITS............ 70 I. BACKGROUND AND ASSESSMENT FRAMEWORK.......................................................... 70 II. FINDINGS................................................................................................................... 71 III. SUMMARY OF FINDINGS AND ASSESSMENT OF FIDUCIARY RISK.............................. 74 IV. RECOMMENDATIONS................................................................................................ 74

CHAPTER 9: CAPACITY DEVELOPMENT ............................................................ 75

I. RECENT TA ACTIVITIES IN THE FIELD OF PFM............................................................ 75 II. ASSESSMENT OF TA ABSORPTION CAPACITY, IMPACT AND COORDINATION .............. 76 III. GENERAL ASSESSMENT OF PFM CAPACITY DEVELOPMENT NEEDS........................... 77 IV. RECOMMENDATIONS................................................................................................ 79

ANNEX I: KEY PERSONS INTERVIEWED (IN ALPHABETICAL ORDER) .... 80

ANNEX II. FIDUCIARY RISK INDICATORS AND INTERPRETATION........... 84

ANNEX III. OVERALL ASSESSMENT OF FIDUCIARY RISK ............................ 92

LIST OF TABLES AND BOXES

TABLE 1. STANDARDS AND CODES PROMOTING FINANCIAL ACCOUNTABILITY................... 4 BOX 1: PRINCIPLE OF SOUND FINANCIAL MANAGEMENT .................................................... 5 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 . VARIATION BETWEEN BUDGETED EXPENDITURE AND OUTTURN PER FUNCTION OF

GOVERNMENT ............................................................................................................ 18 BOX 2. THE TREASURY LEDGER SYSTEM.......................................................................... 23 BOX 3. TRANSACTION SYSTEM PROCESS ........................................................................... 28 TABLE 6. ANNUAL FINANCIAL STATEMENTS .................................................................... 38 BOX 4. INTERNATIONAL STANDARDS FOR THE PROFESSIONAL PRACTICE OF INTERNAL

AUDITING .................................................................................................................. 47 BOX 5. A WEAK INTERNAL CONTROL FRAMEWORK IN THE PUBLIC DEBT MANAGEMENT

SECTION..................................................................................................................... 54 BOX 6 . FIFTEEN STEPS TO ESTABLISHING AN INTERNAL AUDIT UNIT............................... 56 BOX 7. OVERVIEW OF THE INTOSAI AUDITING STANDARDS ........................................... 59 TABLE 7. CARDS 2003 EXTERNAL AUDIT TWINNING PROJECT ACTIVITIES..................... 63 BOX 8. TASKS AND RESPONSIBILITIES OF TOWNS, MUNICIPALITIES AND COUNTIES .......... 71 BOX 9. EDIS ACCREDITATION CRITERIA. ANNEX TO COUNCIL REGULATION (EC,

EURATOM) NO. 1266/1999 ........................................................................................ 78

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PREFACE

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

The CFAA team would like to emphasize that the accuracy of this report’s findings and recommendations depended largely on the feedback from their Croatian counterparts, including State Secretary of the Ministry of Finance (MOF), Martina Dalić; Assistant Ministers to the MOF Amalija Ikšić, Josip Kulišić, Ivan Novačić and Niko Raič; as well as Assistant Auditors General Lidija Pernar, Ljerka Lindsbauer and Hrvoje Kordić.

The CFAA is based on discussions with public officials and an analysis of data gathered during the missions. The Parliament (the Sabor), the Government and the State Audit Office fully supported the CFAA missions and engaged in dialogue with the Bank team. Particularly important was the input of Šime Prtenjača, who as Head of the Sabor’s Budget Committee, provided essential insight to the processes relating to the external and parliamentary oversight of the Government.

Objectives and Scope of the CFAA

The CFAA is a diagnostic tool designed to enhance the World Bank’s knowledge of public financial management (PFM) and accountability arrangements in client countries. It supports both (a) the World Bank’s fiduciary responsibilities by identifying the strengths and weaknesses of PFM arrangements so that the potential risks to the use of 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 of 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 of the CFAA is to provide relevant information to the World Bank and the government on the public sector financial accountability arrangements in Croatia and to jointly develop a program for reforms and capacity building to improve transparency and accountability for the use of public funds. To the extent that analytical work was already available, the CFAA has updated and deepened the knowledge in areas where more specific, detailed proposals are needed. Specific objectives of the CFAA include: (i) to update knowledge of primary public financial accountability institutions, and; (ii) to identify the most significant fiduciary risks and related capacity issues that require the Croatian government’s attention.

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Priority areas of Attention

While covering all key issues of the CFAA guidelines of May 2003, the CFAA explicitly identifies the international standards, codes and laws that constitute the assessment framework for this report. With a view to the specific requirements of the EU, and subsequently the Croatian administration’s preparedness for EU membership, the EC financial regulation1 constitutes an important part of 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 of Fiduciary Risk

While covering the main issues of the World Bank’s internal May 2003 CFAA guidelines, the report also benchmarks the Croatian PFM system against the international standards, codes and laws that constitute the assessment framework (see Chapter on CFAA Assessment Framework, p. 5). Given the relevance of EU requirements to Croatia the EC financial regulation constitutes an important part of this framework.

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

1 Council regulation No. 1605/2002 on the financial regulation applicable to the general budget of the European Communities. 2 The fiduciary risk is the risk of funds not being spent for the purpose(s) for which they were appropriated. 3 Stands for Public Expenditure and Financial Accountability.

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have recently been used in assessments of financial accountability arrangements in a number of 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 of comparison or benchmarking, they do not provide quantitative information about the probabilities of funds not being spent for the intended purposes.

For an overall risk rating and a summary of the fiduciary risk assessment, please see Annex III titled Overall Assessment of Fiduciary Risk. The detailed interpretation of the individual risk indicators is offered in Annex II.

Acknowledgements

The team acknowledges the extensive cooperation and assistance from the staff of various institutions that contributed to the CFAA, including officials and staff of the Government, State agencies and multilateral organizations. In addition, grateful thanks go to Country Director, Anand Seth; to Country Manager, Indira Konjhodžić; and to Operations Advisor, Albert Martinez, for taking a great interest and engaging in the work with the CFAA team. Further, the team would like to thank John Hegarty (Manager, Financial Management, ECSPS); Pascale Kervyn de Lettenhove (ECSPS); Ranjan Ganguli (ECSPS), Sanja Madžarević-Šujster (Senior Country Economist, ECSPE); Srebrenka Gudan (Consultant, ECSPE); Ljiljana Tarade (Assistant, ECCU5); 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 of this report.

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EXECUTIVE SUMMARY

General

As a candidate country to the European Union (EU), Croatia currently focuses much of its modernization efforts on meeting the requirements of the acquis communautaire4. These include meeting the requirements related to Public Financial Management (PFM). In the EU accession context this primarily concerns Chapter 28 on financial control5 and the issues captured under the European Commission’s concept, Public Internal Financial Control (PIFC).

In this context, the relevance of the Country Financial Accountability Assessment (CFAA) is evident. It 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 PFM capacity development provide for a more complete analysis of the PFM arrangements and fiduciary risks. The basic approach of the CFAA has been to compare the PFM practices in Croatia with those promoted by relevant international standards also including a specific set of indicators of fiduciary risk.6

Having assessed the preceding aspects of PFM in Croatia, this report concludes that the overall fiduciary risk is significant.7

Most of the weaknesses in the PFM arrangements revolve around inefficiencies and weaknesses in the existing financial accounting and management systems. The Croatian Treasury within the Ministry of 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 SAP system can process and record all 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

4 A French term which refers to the entire complex of European Community legislation that affects Member States of the European Union. 5 The European Council (of EU Heads of State and Governments) in Copenhagen in June 1993 decided that accession to the EU would require: (i) that the candidate country has achieved stability of institutions guaranteeing democracy, the rule of law, human rights and respect for and protection of minorities; (ii) the existence of a functioning market economy as well as the capacity to cope with competitive pressures and market forces within the Union; (iii) the ability to take on the obligations of membership, including adherence to the aims of political, economic and monetary union. Since then, the requirement under (iii) has been evaluated in 29 separate policy areas or “chapters.” Chapter 28 relates to financial control arrangements in the government administration. 6 The standards are listed in Chapter 2. Fiduciary risk indicators are listed in Table 2 of that chapter. 7 The fiduciary risk for the individual components of PFM as well as the overall fiduciary risk of the PFM system is measured on a scale from low, moderate, significant to high. See Annex III for Overall Assessment Fiduciary Risk and Annex II for a detailed interpretation of the specific risk indicators applied. 8 Trademark for a high capacity computerized payment and accounting system.

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TSA. There are a multitude of financial accounting and management systems among BUs and EBFs, which are not interfaced with the SAP system. The SAP system is under-utilized and the further rollout and development of the system is 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 of the current system infrastructure. Consequently, the annual financial reporting from BUs and the compilation and presentation of 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 of an overly ambitious statutory reporting calendar for BUs.

The internal control framework9 of the Government administration has several weaknesses and is not supported by a general system of internal audit, though this is a statutory requirement of the organic Budget Act. Although the absence of internal audit means that an important assurance function for the efficient and effective functioning of systems is missing, the Government’s external auditor, the State Audit Office, does provide a basic external assurance function vis-à-vis Parliament (the Sabor). This report identifies shortcomings in the SAO’s legal framework and practices that could jeopardize its independence and thereby limit its effectiveness. At the local level the problems in the PFM arrangements identified at the national level also prevail. With respect to capacity development, the number of staff in key PFM functions, such as financial control, accounting and auditing, are inadequate and training capacities are lacking. Finally, the leadership role of the Ministry of Finance in reforming PFM is severely undermined by a lack of intra-ministerial coordination, management and administrative capacity in general.

A specific and very serious deficiency identified in this report is the lack of a sound internal control framework in the Ministry of Finance’s Public Debt Management Section. The problems identified include a lack of appropriate segregation of duties, understaffing and a management with a history of ignoring technical advice, including advice from its auditors. These findings are corroborated by reports from the external auditor, the World Bank and IMF assessments. Considering the large sums of 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 of recommendations to address the identified shortcomings and to mitigate the associated risks. The following recommendations should be given the highest priority: (i) the Minister of Finance should assign an Assistant Minister to develop and implement a strategic vision for the future evolution and rationalization of the Government’s financial systems; (ii) the MOF should commission an independent systems audit of the SAP system; and (iii) the MOF should establish an inter-ministerial steering committee led by the State Secretary to oversee the development of the SAP system. The Government has started taking a number of actions in this field, including the undertaking of a study of existing financial management information systems and the drafting of a financial management information system development strategy.

9 As defined by COSO – the Committee of Sponsoring Organizations of the Treadway Commission.

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In addition to the above, a number of recommendations should and could be implemented almost immediately. These include: (i) the MOF already completed and issued the Rulebook on internal audit as referred to the organic Budget Act (BA)10; (ii) the MOF initiating the legislative changes needed to establish internal audit in the most significant EBFs; (iii) BUs and MOF 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 of Public Financial Management, this report points out specific challenges that Croatia is facing in its endeavor to meet the benchmarks represented by the acquis communautaire and the requirements for Public Internal Financial Control (PIFC).

A more detailed assessment of specific elements of PFM, recommendations on how to modernize PFM in line with relevant international standards and the importance of mitigating fiduciary risks are summarized below:

Budgeting

The lack of budget comprehensiveness poses a fiduciary risk. Although the organic Budget Act of 2003 included the regulation of key aspects of the EBF’s (Extra-budgetary Funds and Agencies) budget preparation and financial management, EBFs remain excluded from certain provisions of that Act, including provisions requiring internal 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 of allocations. The budget classification includes administrative, economic, functional and programmatic classifications but the budget as it is presented to Parliament offers little information or direction about policies and strategies. The frequent budget revisions in the course of the year could also undermine the strategies and policies that might be reflected in the budget. Still, the variations between budget figures and actual outturns at the functional level of the budget are generally small. The Ministry of Finance, which has very limited policy analysis capacity, does not analyze budget proposals to assess their strategic content. While the strong performance of budgets in achieving targets thus suggests low fiduciary risk, there is a moderate risk that the budget will fail to ensure efficient and effective resource allocations.

Budget users are given clear guidance for the preparation of budget submissions and generally adhere to the budget calendar. The budget does not as yet provide the type of information required to show key expenditure types or policy development. The program and medium-term budgeting innovations are tenuous, dependent on significant capacity building and cultural change in the Ministry of Finance and in the line ministries. Furthermore, this kind of budgetary approach requires a more active role of the Parliamentary oversight committee. Whereas parliamentary scrutiny covers aggregates and detailed estimates of expenditure and revenue, Parliament (the Sabor) appears to 10 By the time of the report release, the MOF issued the Rulebook in August 2004.

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have accepted a limited oversight role and weak administrative capacity. There is a risk that the budget will continue to fail to reflect a strategic, medium-term policy agenda and to facilitate transparency.

Considering the different indicators, the CFAA finds the fiduciary risk associated with budgeting to be moderate. The CFAA recommends that the MOF:

• Integrate all 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 its recent work in the Bureau of Macroeconomic Forecasting to further strengthen the forecasting function in the Ministry of Finance in order to ensure full transparency and timely production of forecasts, and enhanced usefulness to Budget Users (BUs).

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

• Develop further the analytical capacity in the budget process by training budget analysts in the Ministry of Finance and line ministries.

• Strengthen the role of the Parliamentary Budget Committee by focusing its mandate on budget analysis and improving its technical support.

Treasury and Cash Management

There is a multiplicity of financial management systems that are uncoordinated and un-regulated. In addition, the strategic advantages of relying more on the main service provider FINA,11 for the continued development the SAP system and other financial systems among BUs, have not been considered. The future development of the Treasury’s SAP system and its relationship to a large number of independent, uncoordinated financial accounting systems in budget entities has not been defined. This report suggests that components missing from the Treasury SAP system have increased the risk of budget over-expenditures. The absence of a multi-period commitment control module and the lack of any development activity to implement it is a serious shortcoming. Moreover, the cash management module’s partial implementation increases the risk of inefficient cash management and potential estimation errors in the budget releases to budget entities that result in expenditure arrears. The most recent available data suggests that Government arrears constitute six percent of the Government’s consolidated budget. This indicates that there is a significant risk that Government payments are not made on time.

The implementation and development of the Treasury’s SAP system has not had the strong management direction and support that such projects require. There is no senior MOF manager of the system who can establish clear requirements and deadlines, and drive the project team to succeed. Nor is there evidence of strong involvement by those MOF units that are the logical users of the system; and line ministry staff are also

11 The Financial Agency, Croatian abbreviation.

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conspicuously absent. This situation guarantees that the requisite systems changes will not occur in the timeframe that is necessary; projects of lower priority or questionable value may be implemented at significant cost and limited benefit. A clear review of the entire project by an independent, outside expert, is warranted.

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

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

The CFAA recommends that the MOF:

• Assign to an Assistant Minister the responsibility for the formulation and implementation of a strategic vision for the future evolution and rationalization of all of the financial systems in the Government of Croatia. To ensure management ownership of the SAP systems, the same Assistant Minister should be responsible for the MOF System Improvement Section;

• Commission an independent systems audit of the SAP system by an

internationally recognized external 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 MOF and the BUs;

• Establish a Steering Committee, chaired by the State Secretary with senior representation from all affected MOF sectors, BUs, ministries and FINA, to oversee the development of SAP. This body could also assist in the development and implementation of the strategic vision for the evolution of the Government’s financial systems;

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

• Immediately implement the SAP module to process multi-period commitments.

Accounting and Financial Reporting

A significant improvement was made as the MOF, for the first time, presented a set of consolidated financial statements for the execution of the state budget 2002. The recording and processing of transactions was, however, not prompt and it prevented a timely aggregation at the line 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 of the consolidated financial statements for the fiscal year 2002 was partly based on draft statements. One of the reasons for the delays in reporting appear to have been the change of accounting rules, involving an ambitious acceleration of the time-line for the BUs’ compilation of their

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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 of the Treasury’s SAP system it cannot generate a complete electronic audit trail for all types of transactions. In conclusion, accounting data related to the execution of the expenditure budget 2002 were most likely not reliable. Adding to the fiduciary risk is the existence of a multitude of accounting systems, which are often outdated and do not meet current standards for security and data protection. Based on the preceding, the fiduciary risk associated with accounting and financial reporting is considered significant.

Based on the above the CFAA recommends MOF should:

• Take action to ensure that the statutory rulebooks12 and appropriate guidelines and training opportunities be offered to all accountants and other staff of Budget and Finance Units of all BUs in order to ensure an effective implementation of 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 of the new accounting rules, including the statutory formats and deadlines for financial reporting.

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

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

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

Internal Control and Internal Audit

Whereas a number of Rulebooks and regulations provide the regulatory framework for procedures and physical controls, a proper segregation of 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 of the MOF offers one such an example. Also, there are numerous examples of 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 is not robust enough to mitigate the risk of official corruption and conflicts of interest. The introduction of internal audit via the BA is a positive development. The CARDS project in support of establishing internal audit units (IAUs) is well conceived and has a realistic and robust plan for a progressive implementation across the Government. It must be strongly supported because it offers

12 As required by the Organic Budget Act.

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the best path to conformance with Chapter 28 of the acquis communautaire and a PIFC-compliant internal control and audit system. The CFAA offers practical guidance for BUs, who wants to establish such a unit. Weighing the different fiduciary risk indicators, the CFAA finds the risk associated with the internal control framework, including internal audit to be significant.

The CFAA recommends that:

• The MOF eliminate the identified weaknesses in the internal control framework of the Public Debt Management Section of the MOF, given considerable risks and the large sums involved.

• The MOF issue all statutory Rulebooks and the necessary detailed guidelines that concern internal control as a matter of priority. MOF and other BUs must subsequently take steps to develop appropriate written procedures for financial processes.

• The MOF establish an internal audit function by proposing changes in laws affecting all EBFs, and key entities receiving or managing public funds, with the inclusion of FINA.

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

• The MOF provide a strong champion for change for the new internal control and audit system, and should develop and promulgate its draft PIFC policy with a vision of its internal control system and a strategic vision of its internal control system that is consistent with the Budget Act and the ongoing EU funded technical assistance activities.

External Audit and Parliamentary Oversight

The Act on State Audit provides a broad mandate for those public funds and institutions that it is 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 Sabor) as a matter of priority.

One shortcoming is that the SAO is not formally required to provide a statement of assurance on the execution of the state budget. The SAO is 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 of Government financial statements. Due to the nature of its legal mandate and the methods applied this however does not constitute a formal statement of assurance on the Government consolidated financial statements or the execution of the state budget.

The SAO’s legal framework does not guarantee its financial independence from the government, which currently makes it subject to the MOF’s budget supervision. Whereas the Act on State Audit (ASA) explicitly provides a mandate for it, the SAO still has not piloted any audits of economy, efficiency or effectiveness. The SAO’s reports are

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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 is considered moderate.

The CFAA recommends:

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

• The ASA be amended so that the SAO will be formally required to submit a statement of assurance on the execution of the State Budget as to whether the Government’s consolidated financial statements gives a true and fair view of its financial position and the sources and uses of funds. In doing so, the SAO should seek to apply the International Standards on Auditing (ISA) and develop its competencies accordingly.

• The ASA should be amended to allow the SAO to audit all EU funds. The SAO should consider positively the challenge of auditing and becoming a certifying body for future EU funded programs in Croatia.

• SAO take concrete initiatives to pilot audits of economy, efficiency and effectiveness (performance or value-for-money audits) in line with the recommendations of the 1999 CFAA, the 2002 SIGMA peer review and the World Bank’s Public Expenditure and Institution Review 2002.

• The SAO and the Sabor should jointly consider the establishment of a specialized Public Accounts Committee, for example, as a sub-committee of the Budget Committee.

Sub-national Government

On the whole, the budgeting practices of sub-national governments are sound. They provide reasonable assurance that the budget reflects the priorities of local and regional interests and political parties. These practices also effectively prevent over-borrowing at the sub-national level and the generation of 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 of public funds following channels outside the formal processes set out in the BA. The ongoing process of decentralization, combined with recent changes in accounting rules have caused problems in the reliability of financial reporting to the MOF, The SAO provides external audit arrangements with appropriate frequency and provides a safeguard against the misuse of funds. The SAO’s resources are, however, spread thinly at the sub-national level. Generally speaking, the transparency of the PFM system seems greater at the sub-national level than at the state level. More direct lines of accountability between the citizen and the elected representative should reinforce this. Based on the concrete concerns related to cash management, the reliability of financial

Croatia CFAA: Executive Summary xii

reporting and internal control, the fiduciary risk associated with the PFM and financial accountability arrangements for sub-national governments is rated significant.

The CFAA recommends the following:

• The MOF 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, it should offer appropriate training for their effective application. Local and regional administrations should prepare to implement the intentions of 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 of Varazdin, is a best practice in ensuring transparency and accountability. The concrete practice of public campaigns (for example, via the distribution of flyers) to inform citizens about the use and sources of the local budget should be expanded to other sub-national government administrations.

Capacity Development

The number and capability of 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 government 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 CFAA recommends that MOF should:

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

Croatia CFAA: Summary of Recommendations and Technical Assistance Action Plan xiii

SUMMARY OF RECOMMENDATIONS AND TECHNICAL ASSISTANCE ACTION PLAN

TA Timing13Summary of Recommendations Proposed Development Activities Responsibility

BUDGETING (MODERATE RISK)

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

2. Strengthen the forecasting function in the Ministry of Finance.

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

4. Develop further the analytical capacity in the budget process by training budget analysts in the Ministry of Finance and line ministries.

5. Strengthen the role of the Parliamentary Budget Committee by focusing its mandate on budget analysis and improving its technical support.

Assistance to develop program budgeting and the comprehensive budget manual (3) can be provided from the on-going US treasury project and the WB IDF Grant for Strengthening Budget Manamagent. Assistance the implementation of other recommendations may also be provided from the USAID Fiscal Reform Project and the European Union’s CARDS 2005 program. It should however be noted that the USAID fiscal reform project comes to an end in September 2004. For more accurate references to these projects, see Chapter 9.

Parliament

(Sabor) Council of Ministers (COM)

Ministry of Finance (MOF)

Short Term

(1)-(3) Medium

Term (4)-(5)

13 Short term = < 1year; Medium term = 2-4 years; Long term = > 4 years.

Croatia CFAA: Summary of Recommendations and Technical Assistance Action Plan xiv

Summary of Recommendations Proposed Development Activities Responsibility TA Timing

TREASURY & CASH MANAGEMENT (SIGNIFICANT RISK)

1. The MOF should assign to an Assistant Minister the responsibility for the formulation and implementation of a strategic vision for the future evolution and rationalization of all of the financial systems in the Government of Croatia and to be responsible for the MOF System Improvement Section.

2. The MOF should initiate an independent systems audit of the SAP system by an internationally recognized external auditor or management consultancy with extensive financial and IT experience.

3. The MOF should establish a Steering Committee, chaired by the State Secretary with senior representation from all affected MOF sectors, line ministries and FINA, to oversee the development of SAP and assist in the development and implementation of the strategic vision for the evolution of the Government’s financial systems.

4. The MOF should implement the Treasury Single Account by closing all entity private bank accounts and consolidating them into the TSA.

5. The MOF should immediately implement the SAP module to process multi-period commitments.

(1), (3), (4) and (5) to be initiated immediately by the MOF. FINA with the support of MOF could initiate implementation of recommendation (6). Funding for (2) may be available from the EU, but could be advised by World Bank specialist. For more accurate project references, see Chapter 9.

Government/COM

MOF

Short Term

(All)

Croatia CFAA: Summary of Recommendations and Technical Assistance Action Plan xv


ACCOUNTING & FINANCIAL REPORTING (SIGNIFICANT RISK) 1. The MOF should take action to ensure that all statutory rulebooks and other appropriate guidelines and training opportunities be offered to the staff of all Budget Users’ (BUs) Budget and Finance Units (BFUs). 2. The State Accounting and Financial Reporting Section of the MOF should be reinforced in order to be able to provide more support to BUs in the application of the new accounting rules. 3. The MOF should extend the statutory deadlines of delivery of the annual financial statements and initiate the necessary amendments of the Budget Act and the Ordinance on Financial and Budgetary Accounting (OFB). 4. The current reform the Government should make the recruitment of accountants and other accounting staff a matter of priority. 5. The MOF should consider a strategy to effectively support a modernization of the state administration’s accounting systems, which should be based on a detailed review and due consideration of different possible solutions.

Besides the more immediate action that the Government needs to adopt, recommendation (1) could be implemented with the assistance from the CARDS 2002 Public Debt Management project and the joint World Bank-IMF program on Central Government Management and debt Market. Technical assistance not currently available. Additional budgetary resources will be required.

MOF

Short Term

(1) Medium

Term (2)+(3)

Croatia CFAA: Summary of Recommendations and Technical Assistance Action Plan xvi


INTERNAL CONTROL & INTERNAL AUDIT (SIGNIFICANT RISK) 1. The Government should take immediate action to eliminate the weaknesses in the internal control framework of the Public Debt Management Section of the MOF. 2. The MOF should issue all statutory Rulebooks and other necessary guidelines relating to internal audit and internal control. 3. The MOF and other BUs should take steps to develop appropriate, detailed written procedures for financial processes. 4. Propose changes in law to require an internal audit function to be established in all EBFs and any other entities that receives or manages public funds, including FINA. 5. Budget Users should hire individuals or assign responsibilities to existing staff in order to establish a Financial Controller in accordance with the provisions of the Budget Act. 6. The MOF should provide a strong champion of change for the new internal control and audit system, and should develop and promulgate its draft PIFC policy paper with a strategic vision of its internal control system and a risk-assessment based approach to management, that is consistent with the Budget Act and the ongoing EU funded technical assistance activities.

Most of the issues are addressed under the CARDS 2002 internal audit and PIFC project. In terms of follow-up, the European Commission has indicated that it has only programmed the roll out of internal audit to lower levels of government in connection with CARDS 2004, whereas the CARDS 2002 project focuses on the central level of the government administration. A PIFC Development Strategy was adopted by the Government and the MOF in September 2004. The Rulebook on internal audit was issued in August 2004.

MOF

CARDS project on PIFC and internal audit

Short Term

(1)-(3)

Medium Term (4)

Croatia CFAA: Summary of Recommendations and Technical Assistance Action Plan xvii


EXTERNAL AUDIT & PARLIAMENTARY OVERSIGHT (MODERATE RISK) 1. The ASA should be amended to ensure that the SAO budget is presented directly to Parliament without prior adjustments by the MOF; the annual financial statement of the SAO should be subject to an independent external audit appointed by Parliament.

2. The ASA should be amended so that the SAO will be formally required to produce a positive statement of assurance on the execution of the State Budget while seeking to apply ISA.

3. The ASA should be amended to allow the SAO to audit all EU funds and SAO should consider positively the challenge of auditing future EU funded programs in Croatia.

4. In line with the recommendations of the 1999 CFAA, the 2002 SIGMA peer review and the 2002 PEIR, it is recommended that the SAO take concrete initiatives to pilot audits of economy, efficiency and effectiveness (performance or value-for-money audits).

5. The SAO and the Sabor should jointly consider the establishment of a specialized Public Accounts Committee, for example as a sub-committee to the Budget Committee.

The necessary technical assistance could be provided from the CARDS 2003 twinning project. For accurate reference see Chapter 9.

SAO Sabor

Short Term

(1), (4)

Medium term

(2), (3), (5)

Croatia CFAA: Summary of Recommendations and Technical Assistance Action Plan xviii


SUB-NATIONAL GOVERNMENT (SIGNIFICANT RISK) 1. As at the state level, the MOF should issue all the statutory14 rulebooks and guidelines on internal audit and accounting referred to in the BA; the MOF should also offer appropriate training for their effective application. In addition, local and regional administrations should prepare to implement the BA new intentions, including steps to establish IAUs.

2. The practice of engaging and educating citizens in local budget expenditures, as done in the town of Varazdin, should be expanded to other sub-national government administrations.

Implementation of (1) could be supported by the EU’s CARDS 2004 program.

MOF

Short Term

14 As required by the organic Budget Act.

Croatia CFAA: Summary of Recommendations and Technical Assistance Action Plan xix


CAPACITY DEVELOPMENT 1. Designate a responsible senior management position at Director level (minimum) to oversee the development of a comprehensive training strategy, in consultation with the donor community, planned and current training providers and the professional associations of accounting and auditing in Croatia.

Technical Assistance may be needed, but significant budgetary resource must be mobilized.

COM MOF

Donors

Medium

Term (All)

Croatia CFAA: Country and Economic Background 1

CHAPTER 1: COUNTRY, ECONOMIC AND ADMINISTRATIVE BACKGROUND

Economic Background 1. Currently, Croatia’s economy is characterized by a slowdown. The industrial output growth rate has recovered slightly following a period of stagnation; it has generally low growth rates, low inflation and high unemployment. In the fourth quarter of 2003, industrial production reached a 5.6 percent annual growth rate. In the same period the Consolidated General Government deficit reached HRK 3.5 billion or approximately 1.8 percent of GDP. In the last quarter of 2003, public debt was 55.5 percent of GDP15. The growth in Croatia’s public debt has become an issue of concern. The repayment costs, including interests have been steadily increasing from HRK 2.4 billion in 1999, to an estimated HRK 4.5 billion in 2003, or close to 5 percent of total expenditure of the general government16.

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

3. In its opinion of April 2004, the European Commission stated that Croatia could be considered a functioning market economy. The Commission also noted however, that the working of market mechanisms still was in need of 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 of 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 of accounting principles; the first consolidation of the government’s accounts; the addition of budget classifications; the initiation of program budgeting; the introduction of a Treasury Single Account and a computerized Treasury system. In fact, the development of a treasury system had already started by 1995. At the same time, the administrative capacity of the key institutions for budgetary control has been called into question. It has been argued that the amounts allocated for professional improvement of budget professionals of Parliament, Government (Council of Ministers) and Ministry of Finance are insufficient. This argument is 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

15 World Bank data. 16 Newsletter of the Institute of Public Finance, No. 12, December 2003


training have not or they continued to be financed at a very modest level17. To judge from the current debate among professionals in Croatia, it seems evident that the Public Financial Management system is under some stress, which is bound to influence the regularity and effectiveness of services in key administrative bodies such as the Ministry of Finance.

5. Stress on the administration also appears to be generated from deficiencies in the framework for the civil service in general. The Law on Civil Servants and Support Staff of 2001 provides a legal basis for the status of civil servants. The Law does not make any distinction between state officials (political appointees; they are covered by a separate legislation) and civil servants, thereby leaving unresolved issues such as status, role and obligations of political personnel in the civil service, tenure of political appointees within the civil service, modalities for the conversion of the status of political appointees to that of civil servants. The current number of administrative rulebooks and inconsistencies between them create the conditions for a multitude of civil service management standards. The Law suffers from further deficiencies, especially with regard to a system of promotions, mobility, separation from service and disciplinary measures. The rules governing recruitment and selection of candidates could also be improved. A point of discussion is whether the salaries of civil servants are too low to attract adequate numbers of 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 is no central training institution for civil servants, or a Government training program. However, following the adoption of the Law on the Organization and Scope of the Ministries and State Administrative Organizations of December 22, 2003 and a Decree on the Internal Structure of the Central State Office for Administration adopted in January 2004, a Civil Service Training Center for training and education of state employees has been created. Also, a new draft Civil Service Law has recently been prepared with assistance from the EU’s CARDS 2001 program. If approved in Parliament, the law will 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 of its business, while maintaining its monopoly on a number of basic banking services. Although a monopoly, it gained a reputation of efficiency in its operations, which included processing of some 500,000 transactions in real time on a daily basis. With the government’s reform of the transactions system, certain ZAP services were discontinued to allow the development of a competitive market for financial services in Croatia. Continuing its 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 is a unique institution. With its 179 branches, sub-branches and offices it plays a key role in Public Financial Management in Croatia.

17 Newsletter of the Institute of Public Finance, No. 11 and No. 13, December 2003


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 of the Country Assistance Strategy (CAS), which was developed in close cooperation with the Croatian government. The current CAS covers a three-year period of 1999-2003; a new CAS is in preparation. The CFAA has advised in the drafting of the CAS.

8. As of December 2003, the World Bank’s active portfolio at the end of 2003 consisted of 11 projects; these projects represented loans to the amounts of US$ 448 million; and of that, US$122million has been disbursed so far. In addition, five projects representing an indicative total loan amount of US$232 million are in preparation. Finally, the Croatian government is discussing a large Programmatic Adjustment Loan (PAL). Whereas specific amounts have not yet been agreed to, the loan is likely to be around $150 million. The World Bank will be supporting the implementation of a broad set of Government policies over a three-year period. One of the policy areas covered by the PAL is public expenditure management. The exact topics are still to be determined and the CFAA will advise on the choice of 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 policy areas to be covered by the PAL, the World Bank is working closely together with the European Commission to make sure the PAL addresses priorities relevant for EU accession.

Croatia CFAA: Budgeting 4

CHAPTER 2: ASSESSMENT FRAMEWORK

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

Table 1. Standards and Codes Promoting Financial Accountability Organization Standards & Codes COSO • Framework for internal control EU

• European System of Accounts 1995 (ESA 95) • Council Regulation No. 1605/2002 on the Financial Regulations applicable

to the General Budget of the European Communities (EC Financial Regulations)

• EU Implementing Guidelines for the INTOSAI Auditing Standards (EUG) IASB • International Accounting Standards (IAS)

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

• International Standards on Auditing (ISA) IIA • International Standards for the Professional Practice of Internal Auditing

(ISPPIA) IMF • Code of Good Practices on Fiscal Transparency

• Government Financial Statistics (GFS 2001) INTOSAI • INTOSAI Auditing Standards (INTOSAI AS) OECD • Best Practices for Budget Transparency World Bank • Treasury Reference Model

11. In the context of EU expansion, candidate countries are obliged to adopt the acquis communautaire, including provisions related to financial control of EU funds, as found in the accession negotiations of “Chapter 28.” This chapter concerns public internal financial control. A recently adopted EU regulation, No. 1605/2002--referred to here as the EC Financial Regulation--along with the corresponding implementation of EC regulations, No. 2342/2002 and No. 2343/2002, which concern the financial regulation of 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 EC budget, this regulation has direct legal effect in managing EU-funded programs implemented in and by its member states. While it is not legally binding for member states to manage their own budgets, it is an important benchmark of what to expect from current candidates and future member states. Also, due to its legal status for member states, the benchmark will be a useful reference for the long term.

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


13. The EU text uses the term “management board” to describe “the main internal body responsible for taking decisions on financial and budgetary matters, irrespective of the name given to it in the constituent instrument of the Community body” (Article 2, paragraph 2, Regulation No. 2343/2002). The CFAA uses it interchangeably with “senior management” and “management group.” The EU principle of “sound financial management” is defined in Box 1.

Box 1: Principle of Sound Financial Management

Article 25

Budget appropriations shall be used in accordance with the principle of sound financial management, that is to say, in accordance with the principles of economy, efficiency and effectiveness.

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

Fiduciary Risk

14. According to Article III, Section 5 of the IBRD’s Articles of Agreement – General Provisions Relating to Loans and Guarantees, fiduciary risk relates to the possibility of Bank loans or guarantees not being used exclusively for the purposes for which they were granted. The CFAA addresses a part of the fiduciary risk by assessing whether the systems in place support the use of Bank proceeds for their intended purpose. However, it does not constitute an actual audit of the use of the proceeds, nor the economy, efficiency and effectiveness of this use.

15. The specific indicators used to assess the fiduciary risk for each PFM component and CFAA chapter are listed in table 2 below.

Table 2. Fiduciary Risk Indicators CFAA Chapter PFM component Risk indicators18

1. Aggregate fiscal deficit compared to original budget. Chapter 3 Budgeting

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

3. Extent to which budget reports include all significant expenditures on central government activities, including those funded by donors.

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

18 See Annex II for elaboration and interpretation of risk indicators.


Risk indicators18CFAA Chapter PFM component

8. Legislative scrutiny of the annual budget law. 9. Single Treasury Account. 10. Stock of expenditure arrears. 11. Effectiveness of cash flow planning, management and monitoring.

Chapter 4 Treasury and cash management

12. Procedures in operation for the management and recording of debt and guarantees. 13 Extent to which spending ministries and agencies are able to plan and commit expenditures in accordance with original/revised budgets. 14. Computerized accounting systems 15. Audit trail documentation 16. Timeliness and regularity of data reconciliation.

Chapter 5 Accounting & financial reporting

17. Timeliness, quality and dissemination of in-year budget reports. 18. Timeliness and quality of audited financial statements submitted to the legislature 19. Corruption perception (Ranking in Transparency International Index) 20. Written procedures

Chapter 6 Internal control & internal audit

21. Effectiveness of internal controls 22. The effectiveness of internal audit 23. The scope and nature of external audit. 24. Follow up of audit reports by the executive or audited entity.

Chapter 7 External audit & legislative oversight

25. Legislative scrutiny of external audit reports Chapter 8 Sub-National

Government The above as applied to sub-national government

16. Each of the above categories involves both control risks and inherent risks. The former are where systems or components of 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 of internal controls.

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

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


Fiduciary Risk Indicators and Benchmarking Against Standards

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

20. Croatia’s ranking in the Transparency International Corruption Perception Index 2003 as 59 out of 133 countries19, is used as a fiduciary risk indicator under the heading “internal control”. The CFAA is not intended to cover issues pertaining to official corruption, nor is it intended to assess the specific methods used in detecting corruption.

19 See Annex II for interpretation.


CHAPTER 3: BUDGETING

I. Background and Assessment Framework

Background

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

22. The 2002 Public Expenditure and Institutional Review (PEIR)20 noted that the Government had made some progress since its independence; it had passed a new organic Budget Act (BA) and implemented a multi-year investment program. The PEIR noted that the major components of the budget process are in the hands of the BUs, including policy and planning and that the role of the Ministry of Finance is weak. The Ministry of Finance did not set standards for the decentralized budget development taking place in the spending entities; it plays a limited role in coordinating government-wide financial issues. The MOF also failed to provide a basic analysis of the budgetary impact of policy issues, a common and vital role that typically facilitates effective budget negotiations and Cabinet decision-making.

23. Weaknesses like these are largely responsible for the lack of discipline in the budget formulation process (for example, BUs commonly developed highly inflated proposals), the lack of strategic orientation in the budget, and the lack of realism in budget documents.

24. The PEIR identified four areas for the Government to focus its public expenditure and financial management reforms: strengthening the central entities responsible for budgeting, treasury and internal control; developing standardized accounts, budgets and PFM procedures; improving internal control and audit; bringing all 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. Key recommendations to deal with weaknesses in these areas included: (1) fostering improved budget forecasts through collecting and analyzing economic forecasts from a number of 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

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

26. More recently, in the 2004 Overview of Foreign Technical Assistance (hereafter referred to as the Donors’ Report),21 the World Bank, EU, USAID, US Treasury and the IMF jointly identified a number of technical assistance-supported reforms for the new government. 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 of a budget manual, capturing commitments in the General Ledger accounting system and improving budget monitoring.

Assessment Framework

27. It is generally agreed that management of public expenditures should be aimed at ensuring:

• Aggregate fiscal discipline, to achieve macroeconomic stability;

• Allocative efficiency, which involves prioritizing programs according to Government policies and selecting the most cost-effective programs and projects;

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

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 of the principles is listed below:22

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

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

21 Overview of Foreign Technical Assistance Provided to the MOF, letter to Secretary of State, Ministry of Finance, 13 January 2004. 22 The provisions relevant for budget preparation and presentation are presented in the Commission Regulation (EC, Euratom) Nos. 2342/2002 and 2343/20002 of 23 December 2002. See also http://europa.eu.int/comm/budget/budget/index_en.htm

http://europa.eu.int/comm/budget/budget/index_en.htm


principles aim to ensure aggregate fiscal discipline and efficient allocation of resources, which require that all expenditure programs be reviewed together.

• Annuality. Appropriations must be authorized for the fiscal year; rules 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 (fiscal discipline). Budget revenues and payment appropriations must be balanced. The budget of EU member states is bound by fiscal rules 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 is unambiguous and executed according to the decisions of the budgetary authority. Rules for making exceptions, such as transfers between appropriation accounts, must be specified.

• 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 will be correctly formulated and pursued.

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 of information; (c) open processes of budget preparation, execution, and reporting; and (d) independent reviews and assurance of the integrity of 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 all the Government and local level budgetary and extra-budgetary activities.

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

32. To assure the budget’s integrity, detailed information on revenue/expenditure forecasts should be available for independent scrutiny.


33. Medium-Term Expenditure Framework. A medium-term macro-economic framework is a basic requirement for fiscal transparency. In addition, the IMF Fiscal Transparency (FT) manual identifies as a best practice the preparation of medium-term budget (or expenditure) frameworks (MTEFs). If the processes are disciplined, an MTEF provides a clear statement of the effects of current policies and a mechanism for planning, controlling and monitoring the introduction of 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 is listed separately and aimed at promoting and monitoring operational performance or those that cover broad expenditure programs and focus on inter-sectoral resource allocations. The former has the advantage of addressing all objectives of public expenditure management, but its implementation requires robust reporting and accountability systems and highly disciplined processes.

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

• Well-defined fiscal policy objectives; • Integrated medium-term macroeconomic and fiscal forecasts; • Estimates of expenditures and receipts of ministries in relation to sector policy

priorities; • The MTEF is 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.

36. The fiduciary risk associated with budgeting will be assessed as the risk that: (i) the budget is 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.

II . Findings

Legal Framework

37. The original 1993 budget law was revised by the Government as an organic Budget Act (BA) in May 2003. This Act now governs the budget process. The BA includes a number of budget reforms recommended in previous donor studies, including such items as: (i) the creation of a Treasury function within the MOF and the consolidation of the largest EBFs into the Treasury Single Account; (ii) the inclusion of all off-budget revenues and donor aid in the budget revenues; (iii) creation of a multi-year budget to be approved by Parliament; (iv) a requirement that all proposed laws contain

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 of budget expenditure out-turn and the composition in the original budget; (iii) Budget reports do not include all significant expenditures on government activities, including those funded by donors; (iv) Aggregate fiscal performance and position of the parastatal and sub-national government sectors are not included in the consolidated government reporting; (v) The budget is not classified on an administrative, economic and functional or programmatic basis; (vi) Key fiscal information is not published, is non accessible and/or not user-friendly; (vii) The legislature does not scrutinize and debate the annual budget. See Table 2 in Chapter 2 for overview.


financial estimates on their impact over the three-year planning horizon and that they have the approval of the Minister of 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 of the BA apply to state budget institutions, local and regional self-governed 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 of internal audit, do not apply. The applicability and enforceability of certain key provisions of the BA is therefore not clear when it come to EBFs.

39. The BA defines the roles and responsibilities of Budget Users (BUs), Extra-budgetary funds (EBFs)25, Heads of the Budget Users, Chief Accountants (CA) and Heads of Budget & Finance Units (BFUs), and financial controllers. It 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 of these regulations and rulebooks still 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 of Finance and Government play a meaningful top-down role. They set macroeconomic and policy 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 plan of the extra-budgetary user [EBF] shall be passed by its responsible body in accordance with the procedure described by special law, by other regulation, or by the foundation charter of the extra-budgetary user.[..] The financial plan referred to in [..] this Article shall be passed prior to the passage of the state budget, and Sabor shall approve the financial plan along with the state budget.” 25 The Budget Act states: “EBF is an extra budgetary user, legal person founded on the basis of law, which legal person is financed from the earmarked contributions and other revenues” (Art. 3 (16)).


Table 3. Revised Budget Preparation Cycle

Deadline Action Action/Approval

April 1 Macroeconomic Forecast & budget Guidelines Prepared Minister of Finance

April 10 Three-year macro forecast and Guidelines Approved Government

April 20 Proposed Budget Ceilings for Ministries Minister of Finance

May 15 Budget Circular, ceilings and macro parameters Government

May 31 Budget instructions issued to BUs, local governments and EBFs Minister of Finance

June 30 BUs submit budgets to responsible Ministry BUs

Determined by budget circular

Ministry submits budgets to MOF Ministry

Oct. 15 Draft State Budget and Consolidated State Budget to Government26

Minister of Finance

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

Dec. 31 State Budget and Consolidated State Budget Approved Sabor

January 1 Budget Implementation BUs, Local governments, EBFs

41. Between April 1 and May 15 during the first four steps in the new budget preparation cycle, the Ministry of Finance develops a macroeconomic forecast on which the budgetary parameters will 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 Ministries in developing budgetary submissions; it provides the base rule for facilitating affordability (the ceilings) and resource allocation efficiency (the tie to macroeconomic and Government policy).

42. Ministries have a significant period of time to develop their budgets in the new preparation cycle. It is important to note that the BA requires them to submit a variety of 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. When this information is submitted to the Ministry of Finance, the aim is 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. The BA also expands the length of time the Sabor has to discuss and analyze the draft budget and to enhance accountability in the preparation process.

Institutional Framework and Capacity

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

45. The MOF’s Bureau of Macroeconomic Forecasting is responsible for conducting macro-economic analyses and for preparing economic and fiscal projections. The capacity and competence of 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 little dialog between this unit and private sector forecasting bodies. There was also a lack of effective checks and balances for minimizing incentives for optimistic revenue forecasts. As part of its 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. It has also restarted producing integrated macroeconomic and fiscal projections for a three year period. The quality and effect of these adjustments have still to be verified, but it is hoped that these steps will foster future improvements and improved budget quality.

46. Questions have been raised about the suitability of the existing organizational structure and capacity of the MOF; the questions stemmed from the reforms introduced by the 2003 BA. Particularly lacking was capacity in IT; this is vital for introducing the SAP modules intrinsic to an ongoing program budgeting reform. The policy focus of a program-type approach to budgeting also underlined the lack of policy analysis within the Ministry of Finance. The budgeting units in the line ministries exhibit a similar weakness.

Practice

47. Budget unity, comprehensiveness and universality. While the Government has made progress in addressing issues of scope, some concerns remain. EBFs and agencies still constitute a significant portion of 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 SAP system. Other EBFs at the national level still operate outside of the budget and the TSA; they include Roads, Highways, Privatization Agency27 and the Bank Rehabilitation Agency. Some of these take the form of Funds; others are public enterprises (and another is the Croatian Bank for Reconstruction and Development). Many of them receive large subsidies from the state budget; some public enterprises providing utilities at the local levels also receive subsidies.28 All these EBFs are included in the Consolidated General Government Budget to provide a complete picture of the Government’s financial operations in any given fiscal year. However, because their operations are off-budget, their allocations do not come out of 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 is formulated without recognition of all expenditures, there is a risk that the budget will not reflect actual expenditure requirements and hence that allocations will not be efficient. Second, because the budget is formulated without recognition of all revenues, there is a risk that the budget will not reflect all revenue availability. These risks materialize in problems with fund reliability and the need for budget revisions after Parliamentary approval; they undermine the value of the formulated process (and hence the formulation process) and complicate budgetary accountability and approval processes. A further fiduciary risk is 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 of the major EBFs (the Health Insurance Fund and the Pension Fund) has not been reflected in the other EBFs mentioned above. While included in the consolidated state budget, these EBFs are not subject to the same rigorous controls of budget entities, despite significant expenditures of public revenues. The planned merger of HFP, the privatization fund, into the Office for State Property Management is a good step in the direction of inclusion of all spending entities into the State budget.

51. 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 is no practical or legal link between the budget forecasts for outer years and future allocations (there is no rollover mechanism in place, for example). Spending entities still do not develop budgets that actually mirror medium-term programs and strategies, and the Government still needs to develop a mechanism that connects outer year forecasts to future year budget allocation processes.

27 In process of being merged with the Office for State Property management. 28 For example, the Highway agency expenditures of 5.6 billion HRK generated a deficit of 3.5 billion in 2003.


52. The budget calendar of the BA (see Table 3 above) and the annual budget implementation act provides appropriate guidance for the budget preparation process, which is generally respected by BUs

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

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

In mill. HRK Budget2001

Actual 2001

Actual/Budget

%

Budget 2002

Actual 2002

Actual/Budget

%

Budget 2003

Actual 2003

Actual/Budget

% Total revenues30 49,679 53,503 108 70,218 69,869 99 77,784 78,260 101 Total expenditure31 49,679 57,813 116 74,614 73,370 98 79,702 80,447 101 Balances32 0 -4,309 -4,396 -3,500 80 -1,918 -2,187 114

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

54. A comparison of budgeted and actual revenue provides an overall indication of the realism of the budget and subsequently the quality of forecasting and revenue administration. As it can be seen from Table 4, during the last three years domestic revenue out-turns 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 of over HRK 4.3 billion in 2001 to 80 percent of 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 of allocations that have a high likelihood of being implemented in an efficient and effective manner. These allocations should also be transparent and open to scrutiny.

57. The Croatian budget classification consists of both an economic, functional and programmatic dimensions.

58. Current revisions to the budget are commonplace in Croatia. In its report on Audits Performed in 2002, the SAO reported that during the year some 14 reallocations of budgetary resources were made. Out of these, eight were approved by the MOF and in the remaining six cases the Government approved the reallocations. The SAO found that reallocations approved by the Government were made in the amount of HRK 160.1 million was not permitted under the provisions of the Budget Execution Act for 2002. The total reallocations for 2002 amounting to HRK 240.7 million irregular reallocations constituted the major part of reallocations in 2002. The total reallocations constituted 0.3 29 This differs from Consolidated General Government in that it s doesn’t include certain government sub-sectors such as social security. 30 Including grants. All 2003 actual figures are un-audited. 31 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 billion (2001); HRK 7.9 billion (2002); HRK 9.8 billion (2003).


percent of total expenditure in 2002. Whereas this does not present a significant proportion of the budget, the Government’s practice of approving reallocations that violates basic appropriation law clearly undermines financial accountability. One way of establishing the extent of current budget reallocations (at vote or functional level) is the degree to which budget appropriations match out-turns. In table 5 below, the budget and outturns for the last three fiscal years is shown per function of government:


Table 5 . Variation between budgeted expenditure and outturn per function of government

Mill. HRK Budget 2001

Actual 2001

B./A., %33

Budget 2002

Actual 2002

B./A., % Budget 2003

Actual 2003

B./A., %

General public services

3,161 2,978 94 3,193 2,901 91 3,834 3,455 90

Defense affairs and services

4,268 4,339 102 4,355 4,353 100 3,989 4,089 103

Public order and safety affairs

4,784 4,761 100 4,761 4,748 100 5,133 5,176 101

Education affairs and services

6,138 6,581 107 6,060 6,176 102 6,691 6,807 102

Health affairs and services

474 270 57 10,751 10,704 100 11,371 11,609 102

Soc. security and welfare affairs and services

16,796 25,153 150 32,248 32,171 100 31,637 33,390 106

Housing and community amenity affairs & services

1,747 1,677 96 982 1,033 105 2,276 2,141 94

Recreational cultural and religious affairs and services

955 955 100 969 945 98 1,088 1,085 100

Fuel and energy affairs and services

18 8 44 9 8 89 7 7 100

Agriculture, forestry, fishing affairs and services

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

Mining, manufacturing, const. affairs and services

544 466 86 489 413 84 749 657 88

Transport and communicational affairs and services

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

Other economic affairs and services

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

Expenditures not classified by major group

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

Total Expenditure34/ Average variation

48,849 56,723 94

73,255 71,992 94

77,919 79,113 97

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

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 million in 2001; HRK 1,377 million in 2002; and HRK 1,333 million in 2003.


59. On average, Croatia performs well against this measure; out-turns were some 6 percent less than appropriations in 2001 and 2002, and 3 percent less in 2003, respectively. In key expenditure areas, however, some concerns do arise that suggest: expenditures may not be sufficiently specific to ensure that policy priorities are met; financial management systems are not sound or transparent enough to ensure spending efficiency and effectiveness. Selected areas of concern include (See table 5): Health Affairs and Services where budget out-turns 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 outturn 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 policy 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 of detail in the economic classification. Whereas it is a positive characteristic that could facilitate transparency and assist Parliamentarians in making budgetary votes, evidence suggests that a review of a detailed economic classification has drawbacks. Parliamentarians, especially in the Budget Committee charged with analyzing the budget draft, have limited 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 of expenditures; it facilitates control but not strategic management. Indeed, the move towards a more outcome and results focused budget process, promoted via program budgeting, is 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 is 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 is to reorient the budget from a process focus to a service focus, whereby all expenditure allocations are clearly specified and managers have incentives to manage in strategic, efficient and accountable ways. This kind of management vision and accountability for spending on objectives clashes with a detailed control of individual items in the economic classification. Apart from this potential clash, success in program budgeting reform also hinges on the exiting administrative capacity. The reform requires additional training of professionals in the Ministry of Finance and in the Budget and Finance Units (BFUs) of spending units. The main dilemmas relate to the definition of programs and sub-programs and the specification of expenditures accordingly. The reform is also highly dependent on government’s developing clear policy priorities and communicating these priorities to spending units to facilitate linkages between expenditures and policies in these entities. The lack of specificity in policies and of clear


thinking which links government activities to policies undermines any technical initiatives to improve specificity.

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

63. There is currently not sufficient administrative capacity in the Ministry of Finance and line 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 of 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 CFAA also finds that the Ministry of Finance and line ministries are short of analysts to cost new legislative and policy proposals and communicate their benefits and develop spending programs to facilitate multi-year policy plans. III. Summary of Findings and Assessment of Fiduciary Risk

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

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

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


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

67. Considering the different indicators, the CFAA finds the fiduciary risk associated with budgeting to be moderate.

IV. Recommendations

68. The CFAA recommends first that the MOF take action to either fully integrate all 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 all BUs, while keeping for example its own banking arrangements. For both scenarios, the BA and other relevant laws and regulations should be amended accordingly.

69. The CFAA also recommends strengthening the macroeconomic forecasting function in the Ministry of 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 of adherence to a timetable has limited the ability of line ministries to develop budget proposals on time. Recent MOF reforms in this area are intended to address some of these problems. For example, the MOF now opens its projections to external verification, which enables comparison with forecasts developed in the private sector.

70. The CFAA 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 of the program budgeting module in SAP against other alternatives, building strategic budgeting capacity in the Ministry of Finance and in the line ministries, and considering the detail at which economic classification is required to minimize clashes with the new reform. It also requires clarifying the role of 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 of Finance and line ministries. These analysts should be able to cost new legislative and policy proposals and communicate their benefits and in time should also be able to develop spending programs to facilitate multi-year policy plans. Also, the CFAA recommends that a budget manual be developed and formally issued to advance and support multi-year budgeting and an effective functioning of program budgeting.

72. Finally, the CFAA recommends strengthening the role of the Parliamentary Budget Committee by focusing its mandate on budget analysis and improving its technical support.

Croatia CFAA: Treasury and cash management 22

CHAPTER 4: TREASURY AND CASH MANAGEMENT


Background

73. The MOF have expended considerable effort in establishing and improving the Government’s treasury function. While good progress has been made in the basic functions, a number of areas still need attention. The PEIR recommended that the MOF immediately institute commitment controls by establishing a process of MOF review of all contracts prior to signature.35 36 The Donors’ 2003 report to the Government also observed that commitments were not captured in SAP; it also noted that MOF’s cash management activities could be further strengthened by providing oversight and control of the daily available cash fund movements on State treasury accounts, by reducing the number of budgetary user bank accounts outside of the TSA; by providing a rolling financial plan to aid in liquidity forecasting and by planning an improved short term management of borrowing and investments.


74. Treasury Systems. No internationally accepted standards or codes exist for managing cash and treasury systems. However, it is generally agreed that an effective cash planning and management system should 37:

• Recognize the time value and opportunity cost of cash;

• Enable line 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 of line ministries;

• Be comprehensive, covering all inflows of cash resources;

• Plan for liquidating short- and long-term cash liabilities.

75. 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 is either a single account or a set of 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 35 The MOF now receives a manual monthly report of commitments made for the following month. Commitments beyond the next month are not reported.36 Overview of Foreign Technical Assistance Provided to the Minister of Finance, Zagreb, 14 Jan 2004. 37 E.g. in Barry H. Potter and Jack Diamond. Guidelines for Public Expenditure Management, IMF, 1999.


Treasury, which approves them before making payments. Under decentralized treasury systems, BU’s can administer bank accounts, but the Treasury must authorize them; these are zero-balance accounts, with money transferred to them (from specific approved payments). Or banks accept the payment orders sent by line agencies up to a certain limit defined by the treasury.

77. Treasury information systems are commonly established to control spending, efficiently implement the budget and minimize the cost of Government borrowing. Such systems should be able to provide for secure execution of payments, which includes recording the required preliminary checks and commitments, validations and authorizations. The Treasury Reference Model (TRM) developed by the World Bank and the IMF provides an outline for what a treasury system should deliver (see Box 2).

Box 2. The Treasury Ledger System.

A Treasury Ledger System includes a set of summary control accounts [the ledger] that maintain budget authority and actual spending, and handle all posting and reports generated from this database. Such a system can create transactions and authority (appropriations, apportionments and allocations), record all 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 and/or arrange for the electronic transfer of

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

Record transactions

- Record initial 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) initial 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

- Print consolidated payment instructions for action by the banking system; - Consolidate data from all ministries and regional offices as necessary; - Facilitate/support easy retrieval of data in system databases in various formats; - Produce good reports, such as commonly required accounting and management reports.

Source: Treasury Reference Model, World Bank 2001, p. 16

78. Cash Management. Specific indicators of cash management performance include such factors as the ability of the Government to accurately forecast and monitor their revenues throughout the year. Because the revenue forecast drives the entire expenditure


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 is disruption of the budget execution process and the potential for misallocations of resources. Therefore, sub-indicators of 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 of expenditure arrears.

79. The fiduciary risk associated with cash management will be assessed as the risk 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 of government activities.

II. Findings

Legal Framework

80. The legal framework for the Treasury system includes the 2003 Budget Act (BA); the Treasury General Ledger System and Methods of Managing the Single Treasury Account located in the Central Bank of Croatia (Official Gazette No.97/1995); Internal Organization of the Ministry of Finance (26 Jul 2001); Instructions on the Execution of the State Budget from the Single Treasury Account; and other supporting regulations relating to budget execution, control and reporting.38


81. The Ministry of Finance. The Treasury function in Croatia is composed of five distinct administrative sections:39

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

• The State Budget Execution Section is responsible for performing all tasks related to the execution of 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 all obligations of the state, issues securities on the domestic and external markets, and manages all aspects of the public debt portfolio – sources, terms and conditions of payment, interest rates- and advises on the issuance of government guarantees.

38 See Chapter 6 on internal control and internal audit for more details. 39 Regulation on the Internal Organization of the Ministry of Finance, July 2001, articles 6, 7.


• The Systems Improvement Section is responsible for the planning, development and operation of 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 of budget expenditure.

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

83. For the government, FINA:

• Settles all payment and revenue transactions that involve the Government of Croatia

• Maintains and operates a number of registers of clients of government services, including the Central Registry of Insurees, registry of 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 all other public revenues accruing to the state.

• Processes supplier payments approved by the Treasury SAP system, depositing funds in the accounts of suppliers or individuals throughout the country

• Participates with the government in its pension reform initiatives that involve payments; ministry pilots (Defense, Interior) to develop interfaces between their ministry financial systems and the Treasury SAP system

84. FINA-specific support to the Treasury’s SAP financial transaction and accounting system includes:

• IT Support through outsourced operation of the SAP 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 of the entire system on a 24/7 basis, • Technical support to accommodate the IT systems changes required by the

passage of the new Budget Act; • Transaction data processing and data backup for all work in all treasury offices; • Service level agreements to establish the levels of service to be provided and

penalties for non-performance; • Daily update of all financial data cleared in the FINA system, update and maintain

changes in the accounts registers and communicate these automatically to the SAP system;

• Manually enter all rejected transactions returned by private banks for whatever reason.


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

86. FINA is not required to comply with the Budget Act’s requirement to establish a modern internal audit function. Given that it undertakes a wide variety of services, outsourced by MOF and other entities that are operating within the budget, it would be important for the Government to require that FINA establish an internal audit unit. Major external clients of 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 of the following modules:

• Budget preparation is under implementation and was used for the preparation of 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 is considered by World Bank and IMF experts to be a work in progress.

• Cash management module exists, but it is 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 of the MOF is lacking.

88. For 2004, a number of additions to the SAP system are planned:

• A strategic enterprise management module is under development. The first 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 of all components of the consolidated government entity is under development;

• Program budgeting capabilities are under development;

• A management portal for MOF initially and all ministries in the future, is also under construction.

89. However, key parts of a basic treasury system are still missing. The commitment control module has never been activated. As a result, manual commitment reporting on a monthly basis is required from all budget entities. There is also a multi-year commitment capacity within the SAP system that could readily accommodate capital project


commitments and other multi-year future obligations. Moreover, the lack of a management decision on the selection of a replacement of 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 of 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 of whether the current SPRINT system or the SAP module is more appropriate.

Practice

90. The Treasury Single Account System. A Treasury Single Account (TSA) system is in the process of being implemented. It now accounts for all state domestic revenues – taxes, duties and other levies, EBF charges and own-generated revenues, using information that is captured and coded by FINA. On the expenditure side, the SAP system currently deals with payroll (through two transit accounts, for deposit in the bank accounts of individual civil servants), supplier payments and capital expenditure payments. Both are deposited into the appropriate vendor accounts on file with the system. Most EBFs are not formally required to use the TSA in the Croatian National Bank, and a number of them41 employ accounts in the Postal Bank that is also wholly owned by the Government and uses FINA for its transaction processing.

91. In order to make payments via the TSA, BUs first submit standardized financial plans to the MOF 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 of these plans the MOF sets monthly ceilings for all BUs and enter the corresponding budget allocations into the SAP 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 is a large number of bank accounts held by BUs in private banks. The vast majority of 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 of HRK 500 million was on deposit in these accounts. This represents a significant cash management inefficiency. The consolidation of these accounts into the TSA should be a priority.

40 An existing system, SPRINT, has become obsolete; its original supplier no longer supports it. 41 E.g. The Employment Fund, the Health Insurance Fund regional offices expenditures; Croatian Waters self-generated fees..


Box 3. Transaction System Process

1. Provided a Budget User (BU) first records a fully coded commitment into its own financial system, based on a purchase order approved by an appropriate authority within the entity.

2. Provided that the commitment is for expenditure within the next month, it is reviewed by the budget execution division for compliance with the appropriation purpose and amount and then recorded in the SAP system.42 Next the purchase order is approved by an authorizing authority within the BU in question and sent to the supplier.

3. When the goods are delivered and confirmed, a request for payment is entered into the entity’s financial system and separately into the SAP system.

4. The budget execution section checks the request in the SAP system against the available cash in the entity’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.

5. FINA records the transaction and provides copies of the transaction records to the MOF and the BU’s Budget & Finance Unit; the data is then keyed into their own financial system to reflect the transaction. FINA also captures all domestic revenues and provide records to MOF and SAP.

6. Monthly, the BUs send the MOF a statement of outstanding commitments that are expected to be settled in the following month. Commitments extending beyond this period are not disclosed. SAP does not accommodate commitments beyond the next month.

93. Additionally, the government has foreign exchange accounts to cover the governments’ operations. A proportion of the Government’s debt-servicing transactions are handled by three private banks. One of 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 of receiving foreign loan funds are made. The extent of other bank accounts operating in other countries is not known, nor is it controlled.

94. Transaction Processing. The budget entity follows a complex process to make expenditures. Typically it 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 SAP, identical data has to be entered several times. It is common that for example a ministry has separate financial systems for different types of appropriations. This could include a system for pay-roll, one or capital expenditure, one for current expenditure and so fourth. This increases the likelihood of errors, requires regular reconciliations and represents an inefficient use of financial staff resources and introduces significant delays into the financial system.

95. The SAP system was designed to meet MOF’s needs, with little or no regard for the requirements of the budget entities. It imposes a heavy workload on the line 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 of each other and the SAP system. This has led to widespread duplication of functions and overlapping data entry requirements. This situation is a 42 BUs at lower level (e.g. social centers or schools) who do not have access to SAP terminals submit payment requests to the BUs at the central level (typically a ministry).


reflection of the “bottom up” growth of individual entities’ financial management systems, a common occurrence in all large entities as they begin to integrate their financial management information. While the financial management information system solutions of individual BUs are not formally decided by the MOF, there is an opportunity now for MOF to begin a process of rationalization of its financial systems in use across the Government.

97. In common with many other major IT projects, the SAP project is technology-driven. There is 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 of management, then implement new SAP services to respond to them. This supply-push approach is guaranteed to yield inefficient results; a demand-pull approach is required where the users of the system are heavily involved in, and committed to, improvements in the functionality and the efficiency of the SAP and related systems.

98. Within the MOF, no one at a senior level have been taking responsibilities for SAP’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 SAP. The SAP 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 of all of the financial systems in the Government of Croatia by:

• Performing an inventory of all financial management systems in the budget entities, EBFs and agencies and detailing their functionality;

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

• Submitting recommendations to the Minister of Finance and then to the Government for approval;

• Implementing the rationalization strategy in cooperation with the budget entities.

99. The MOF state that:

• The responsibility for the SAP system development is encompassed by the function of the Chief State Treasurer, who is simultaneous the project manager;

• A document entitled “Uniform IT System Development Strategy for Public Financial Management in the Republic of Croatia” has been prepared and will be forwarded to the Government for approval;

The MOF state that the latter document clearly indicates the guidelines pertaining to rationalization and further development of the public finance system in the Republic of Croatia.


100. In a positive development, under the agreed World Bank supported PAL program the Government has agreed to assess the functionality and overlap of financial systems (including SAP) in ministries and budget entities, and develop a strategy to rationalize and integrate financial systems.

101. The CFAA concludes that the governance structure of the SAP system does not work. This could for instance be revitalized by the creation of a new steering committee, chaired by the State Secretary for Finance, whose members include Assistant Ministers from all key areas of MOF, senior level representatives from selected line ministries and the CEO of FINA. The role of this committee should be to:

• Establish development priorities for the SAP system and arrange for funding of its improvements;

• Establish sub-committees of all users of the SAP system and of the key ministry financial systems to ensure that their future evolution is consistent with the overall strategy for government financial systems. The chairs of each sub-committee would also participate in the steering committee.

102. The MOF state that the SAP development project is managed by a Project Supervisory Board, headed by the State Secretary of the MOF, while its members are an Assistant Minister of Finance, the Secretary of the MOF and the Deputy State Secretary from the Central Development Strategy Office. The MOF further state that assistant ministers from other ministries who manage IT processes for financial functions in their ministries will also participate in the Project Supervisory Board’s work.

103. Seeds of cooperation between SAP and budget entity financial systems are in place. There is a pilot project involving the MOF and the Ministries of Defense and the Interior to examine the development of an interface between their internal financial systems and SAP. This would enable the automated transfer of relevant data between the ministry and the MOF, thereby eliminating the manual reporting and the re-entry of data in MOF. The results of this pilot should be used as input in the strategic vision initiative referred to above.

104. The MOF have informed the World Bank that it also has initiated a pilot project to link the Ministry of Science, Education and Sports and the Ministry of Health and Social Welfare to the State Treasury System.

105. Cash Management. Budget execution is closely monitored and controlled at a highly disaggregated level of economic classification by the MOF Budget Execution Division. All budget entities prepare an annual and monthly forecast of expenditures that are manually submitted to the MOF and recorded in the SAP budget system. Two weeks before the end of a given month, the cash management unit provides monthly limits to the budget entities, based on their cash flow analysis of the government’s cash position. The budget entities then revise their monthly financial plans and send them back manually to MOF. Then they are entered into the SAP budget system. This forms the basis for the monthly execution by the budget entity. A measure for the system’s efficiency is the total of arrears, which in 2003 constituted 6 percent of the consolidated state budget.


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

• Preparation of an annual and monthly forecast of revenues. In close cooperation with all MOF agencies and revenues collection entities, the cash management unit developed a revenue forecast model, based on historical revenues data beginning in 1998;

• Forecast of annual and monthly budget cash inflows and outflows and calculation of the monthly net cash surplus/requirements. It uses the forecasting model and the monthly budget execution estimates provided by budget entities to MOF for recording in SAP. 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 is currently not the case;

• Weekly updates of the forecast cash position, based on the TSA, cash and foreign exchange balances of the MOF and budget users in budget units, banks and the revenues from the revenue forecast model, comparison of the total revenue inflows to the estimated cash outflows from SAP;

• 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 SAP;

• 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 its activities to encompass the cash activities of all BUs and EBFs, to reduce the number of bank accounts operating outside of the TSA, to implement a rolling cash forecasting financial plan and to improve decision-making processes for short-term borrowing and investing. The CFAA endorses these recommendations; they are repeated here for reasons of completeness.

III. Summary of Findings and Assessment of Fiduciary Risk

108. There is a need to rationalize the future development of financial systems in budget entities. Multiple financial systems operating independently in individual budget entities increase the risk of budget execution errors. Because these systems are not coordinated with SAP, extensive data re-entry is 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 SAP system in line ministries, there is a natural tendency to assign duties that should be separated for reasons of financial control to a single individual who has been trained in the SAP system.

109. The components missing from the SAP system have increased the risk of budget over-expenditures. The absence of a multi-period commitment control module and the lack of any development activity to implement it is a serious shortcoming. Moreover, the


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

110. Successful IT projects depend on strong management direction and support. That has been lacking in the Treasury system. No senior MOF 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 is there evidence of strong involvement by those MOF units who are the logical users of the system; line ministry staff have also been conspicuously absent so far. There is the need for a vision of the future evolution of the financial systems in the government that, when endorsed by the government, would serve as the blueprint for future evolution of SAP and the individual financial systems in budget entities. In a positive development, the Government has recently agreed under the World Bank supported PAL program to take steps that will form the basis for the development of such a vision.

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

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

IV. Recommendations

113. The CFAA recommends that the MOF:

• assign to an Assistant Minister responsibility for the formulation and implementation of a strategic vision for the future evolution and rationalization of all of the financial systems in the Government of Croatia.

• ensure management ownership of the SAP systems by assigning responsibility for its development and operation to the same Assistant Minister identified above. This Assistant Minister should have assigned management responsibility for the MOF System Improvement Section;

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

• establish a Steering Committee, chaired by the State Secretary with senior representation from all affected MOF sectors, line ministries and FINA, to oversee the development of SAP and assist in the development and


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

• 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 SAP system to process multi-period commitments;

Croatia CFAA: Accounting and financial reporting 34

CHAPTER 5: ACCOUNTING AND FINANCIAL REPORTING


Background

114. For the FY 2002, the MOF for the first time prepared a set of consolidated financial statements for the execution of the state budget. At the same time, the formal introduction of modified accrual-based accounting principles began with reissuing of the Ordinance on Financial Reporting in Budgetary Accounting (Official Gazette OG No. 92/92 with amendments No. 3/03 and No. 12/03, hereafter the OFB). Subsequently, the June 2003 amendment of the BA required the modified accrual basis for accounting and the reporting of all BUs and EBFs.

115. As for a number of other PFM-related activities, the continued development of the Treasury system is key to accounting and financial reporting. To some extent, the lack of progress in developing the Treasury’s SAP system is also delaying the modernization and simplification of accounting and financial reporting.

116. Both the MOF and the SAO have reviewed the transition from cash to modified accruals. A competent group of accounting specialists in the MOF has prepared a report on this issue titled, “Errors made in financial statements;” the SAO has reported on similar issues in its 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. The Donors’ Report identifies a number of problems related to accounting and financial reporting and offer ideas to their solution. The problems identified include43:

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

• SAP not set up to adequately capture the commitments data; • Too many accounting and statistical methodologies used; • EBFs do not use the Chart of Accounts (COA); • The COA is GFS2001 compatible, while reports are produced using GFS1986; • EU requires the use of ESA95; • Accounting reports are not generated automatically; • Collection of data not all in electronic form; • Accounting is done on the basis of modified cash rather than modified accruals.

Assessment Framework 43 The problems listed below are quoted from the before mentioned report, “Overview of Foreign Technical Assistance Provided to the MOF”, included in a letter to State Secretary, Ministry of Finance, January 13, 2004. The MOF has informed the World Bank that they do not agree with the conclusions in the third and ninth bullet points (“Too many accounting and statistical methodologies used” and “Accounting is done on the basis of modified cash rather than modified accruals”).


118. Whereas the System of 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 of 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 economic/budget criteria for joining the Euro-zone set forth in the Maastricht Treaty). This type of balance combines all central government departments, social security funds and local governments into a single General Government account. Because of the ESA 95's definition of “deficit”, the balance does not take into account-estimated expenditures (allocations for depreciation and provisions). Rather, it focuses on 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 of the balance, which offers some flexibility in applying the standard.

119. The International Financial Reporting Standards (IFRS),44 issued by the International Accounting Standards Board (IASB), are the recognized standards for private sector accounting worldwide. Meanwhile, an increasing number of governments are applying the International Public Sector Accounting Standards (IPSAS) created by the Federation of Accountants (IFAC). According to IPSAS 1, a complete set of financial statements from a government entity should include the following: (a) a statement of financial position; (b) a statement of financial performance; (c) a statement of changes in net assets/equity; (d) a statement of cash flow and (e) accounting policies and notes to the financial statements. The equivalent terms for (a)-(c) in IAS 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 EC Financial Regulation. Providing a benchmark for public sector financial reporting and a legal requirement when it come to managing EU’s own funds, this regulation will serve as the basic assessment framework in this chapter. The accounting provisions of the EC financial regulation, which broadly reflects the principles of the IPSAS,46 can be summarized as follows:47

• The annual accounts of an [EC] administrative body shall consist of both financial statements and a report on budget implementation, where the first reflects the financial position and financial performance of 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; (d) comparability of information; (e) materiality; (f) no-netting48; (g) presenting

44 The International Accounting Standards (IAS) were integrated into the new IFRS. 45 To date, 20 IPSAS have been issued. IPSAS 1 concerns the “Presentation of Financial Statements.” 46 Although the IPSAS terminology is not used, it reflects the terminology of the IAS, now IFRS. 47 Summarizes the key issues addressed in articles 76-90 of Commission Regulation No. (EC, Euratom) No. 2343/2002. Terms are used as in the regulation. 48 That receivables and debt may not offset one another.


reality over appearance ; (h) accruals,49 and consist of a “balance sheet,” “economic out-turn account,” “cash-flow table,” “statement on changes in capital” and an annex that discusses and supplements the information (notes);

• Budget implementation reports should consist of budget out-turn accounts on revenues and expenditures and an annex with comments and supplementary information. An institution’s accounting officer should submit its 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 it 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;

• The central accounting authority (in the EC 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 the final accounts to the Commission’s Accounting Officer (the central accounting authority, for example, MOF) and to the Court of Auditors (the supreme audit institution) by July 1. The Court of Auditors should, in turn, publish them by October 31 of the year following the financial year.

121. The structure of the chapter follows from the above overview of the accounting and financial reporting provisions of the EC financial regulation.

122. Fiduciary Risk. The fiduciary risk associated with accounting and financial reporting will be assessed as the risk that financial reporting is unreliable or not timely; the fiduciary risk will have the following indicators: (i) Absence of prompt recording and processing of transactions, allowing timely aggregation at line ministry and Ministry of Finance level; (ii) Absence of 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 of audited financial statements to the legislature is not timely. For overview of the fiduciary risk indicators used in the CFAA, please see table 2 in Chapter 2.

II. Findings

Legal Framework

49 Commission Regulation (EC, Euratom) No. 2342/2002, Articles 187-195. These principles reflect the principles for presentation of financial statements laid down in IPSAS 1. The introduction of accrual-based accounting principles to the public sector is not a legal requirement for EU Membership. Nevertheless, when it comes to the management of funds from the European Union's budget, the application of accrual-based accounting principles is a legal requirement indeed. This requirement appears separately in the relevant EC regulations for specific funds (e.g. Cohesion or Structural Funds). It is also a general principle of the EC Financial Regulations and its implementing regulations. The GFS2001, ESA95, IPSAS and IFRS share an important commonality; they promote and provide guidance on the use of accrual-based accounting principles.


123. The legal framework for accounting and financial reporting for BUs and EBFs includes the BA, the OFB, Regulation No. 97/95 on the Main Treasury Ledger System and Methods of Managing the Single Treasury Account and the Book of Rules on Budgetary Accounting and Chart of Accounts (COA) with the COA attached (OG No. 119/01 and 74/02).

124. The BA sets out the basic principles of accounting and the requirements for financial reporting. In accordance with BA articles 115 and 121, it is 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 of Accountants, while at the same time it is explicitly stated that accounting shall be based on modified accrual-based accounting principles. A set of IPSASs has been developed on a full accruals basis, and there is 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 point50. Still, considering the specificity of the provisions of the BA relevant guidance is provided. Specifically it is stated that BUs shall adjust the value of non-financial fixed assets using a producers price indexation, while taking historical cost as the point of departure (Art. 121 (2) and (3)).

125. The BA establishes that BUs shall prepare financial statements on a monthly, quarterly, semi-annual and annual basis. It 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 of Finance (Art. 123 (1)). Finally, the BA charges the MOF with preparing the consolidated financial statements of the Republic of Croatia budget accounts and to submit it to the Government or the executive of the local executive body. Up until the passing of 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 of the financial statements. It also includes the Government Chart of Accounts and elaborates on its application. The COA is based on the economic classification of GFS 2001.


127. The MOF's State Accounting and Financial reporting (SAF) Section has responsibility for implementing the Government’s accounting policies and for consolidating the government’s accounts. The staff of the SAF Section are generally very competent. Five out of the nine positions budgeted for are filled. Considering the importance of the area and the profound reforms of 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 expertise of the accounting staff generally seems sufficient in BFUs, the staff are often few in numbers. This complicates further a fundamental change of accounting rules requiring time off for training and it makes it difficult to secure an appropriate segregation of duties among bookkeeping, accounting and treasury functions. 50 It is envisaged that some entities in the process of moving from cash accounting to full accrual accounting may wish to adopt the requirements of particular accrual-based IPSASs during this process.


128. Whereas all ministries, other central BUs and the major EBFs have direct access to the Treasury SAP system51, subordinate institutions depend on their own systems for financial reporting.

Practice

129. Annual Financial Statements. Whereas the BA does not distinguish between financial statements and budget execution reports, it 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 of the year” (Article 122). The formats for the annual financial statements as well as the current financial statements from the all BUs and EBFs are regulated via the OFB, which consists of forms to be used. As it is specified in the annual circular letter from the MOF to all 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 of assets and liabilities; (iv) statement on own revenues and expenses earned; and, (v) Notes. The deadlines for the submission of the statements from the various subordinate BUs to the higher level BUs and eventually to the MOF and the Sabor are set out in table 6 below:

Table 6. Annual Financial Statements

Report By Financial Reports Required Date Due Submitted to

Central BUs and agencies52 in a Ministry

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

January 31 Ministry; SAO Local Office; Regional FINA office

Agencies that are also a ministry

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

January 31 Ministry of Finance; SAO Local Office; Regional FINA office

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

February 28 Ministry of Finance ; Regional FINA office

BUs of Local and Regional Self-governments

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

January 31 Unit of local and regional self-government; SAO Local Office; Regional FINA office

51 There are some 55 direct users of the SAP system, which is serviced and maintained by FINA. 52 As defined in the BA: “[Agencies] are budget users established as institutions by law and regulations by virtue of law and financed from the budget”. Agencies are referred to as “institutions” in the available translation of the BA.


Local and Regional Self-Governments

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

January 31 Ministry of Finance ; SAO Local Office; Regional FINA office

Local and regional Self-Governments

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

February 28 Ministry of Finance; Regional FINA office

130. A consolidated financial statement for the State Budget and the Consolidated State Budget of the Republic of Croatia was prepared for the first time for the fiscal year 2002. The State Accounting and Financial Reporting (SAF) Section performs all of the necessary consolidations to produce the consolidated financial statements. They receive statements from Ministries and other BUs in accordance with the schedule in table 6 above.

131. Consolidated financial statements covering 53 local governments out of a total of 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 of total local and regional government spending. The SAF Section endeavors to have all local and regional self-governed units submit their statements according to the preceding schedule.

132. In preparation of the Government's liability reports, an estimate is also made of the likely guarantees by the government for the debt of State Owned Enterprises (SOEs). The Section on Economic Affairs has performed this function, using explicit risk assessment criteria. The SAO audits these assessments on a case-by-case basis. These funds go into a government Guarantee Reserve account.54 The MOF displays on its web site an excellent overview of 10 of its major SOEs and three EBFs55 operating outside of the TSA. The MOF advised that this number has increased to 23 SOEs. Unfortunately, the web-site did not give access to the financial statements that it appeared to give access to when the CFAA team tested it.

133. In its audit of the consolidated financial statement of the state accounts, the SAO noticed that it 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 flow statement on June 3, 2003. The statutory date for delivery of the statements is

53 As part of an agreement with the IMF. 54 The 2004 budget contains a provision for approximately HRK 500 Million for this reserve. 55 The Bank for Reconstruction and Development, the Deposit Insurance and Bank Rehabilitation Agency and the Croatian Privatization Fund.


January 31. The SAO 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 of assets and liabilities; the Statement on liabilities; and Notes were not submitted at all. The SAO also notes that the deadline for the delivery of financial statements for the State Budget and BUs had been shortened one month compared to the year before. In conclusion, the SAO states that the timeline of thirty days to deliver the statutory financial statements is too short, in particular for the most material BUs. A comparison between the deadlines in table 6 with those of the EC financial regulation, supports the SAO’s conclusion.

134. Accounting Principles. As the MOF 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 full accrual accounting and abide by international standards. To do so, a number of changes will need to occur in the treasury's general ledger, including the capture of non-financial assets and liabilities. Unfortunately, the required development of the SAP system is not happening, partially because the SAF Section has no effective channels of communications to the SAP project team.

135. As also noted in the Donors’ Report, the EU is requiring from its Member States to apply ESA95 on the national accounts. In its Opinion on the Application of Croatia for membership of the European Union, the European Commission stated that the National accounts and GNP/GNI figures were produced “using definitions and accounting rules of 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 CFAA did not obtain any information that indicated that the MOF has initiated work in this field. Based on the feedback received, is seems likely that the SAF Section is awaiting the outcome of work initiated by IFAC’s Public Sector Board to harmonize and approximate IPSAS, GFS and ESA.

136. The SAF Section seem well aware of developments in public sector accounting and reporting for the purpose of maintaining their accounting policies and standards. Quality control consists of 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 its communities by distributing a circular that identifies common problems and errors, then explains how to avoid them. Due to the limited number of staff its “enforcement” capacity is however very limited.

137. Evaluating the application of the new modified accrual-based accounting principles in 2002 and first quarter of 2003, the MOF found that many BUs did not follow the MOF's specifications set forth in the OFB and the Book of Rules on Budgetary Accounting. The MOF also found that a great number of financial statements came in after the statutory deadline; that meant the MOF had less time to consolidate the Government’s accounts. Shortcomings were attributed to decentralization, for example, schools and social centers as well 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 MOF found many coding errors in the accounts of decentralized institutions, including many in the Health sector.56

138. The MOF stresses that most BUs and local units are disciplined and they compile their statements and hand them in within the statutory deadline. The statement is general and does not pertain to a particular period or fiscal year.

139. In its Report on Audits Performed in 2002, the SAO 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 of balance sheets; valuation of assets and liabilities posed a great challenge for the BUs. The SAO also noted that the OFB had been changed twice in the course of 2003; modifications that further complicated the exercise of changing accounting principles.

140. The application of modified accrual-based accounting principles is a statutory requirement. Still, the accounting for expenditure via the Treasury SAP system is cash based as it records payments made from the TSA. Also, the findings of the SAO and the MOF indicate that accounting at the level of individual BUs is generally not done in accordance with the new provisions of the BA and the OFB, and often continues to be done on a cash basis. The MOF have informed the World Bank that the essence of the application of the modified accrual-based accounting principle in the Croatian government administration is the recognition of expenditure based on the accrual principles and revenues based on the cash principle. The details for these principles are laid down in the Book of 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 of the end of 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 of the end of the month. The latter report is the basis for measuring arrears.

142. The general ledger does not provide complete and timely information on the total public debt, liabilities and receivables of the state. It does not provide a basis for monitoring liabilities and receivables, which is why the system cannot produce the data needed to generate a balance sheet. The SAP system cannot generate the information needed to identify an individual contract entered into by the MOF or the size of the legal commitment it has accepted by signing the contract.

56 Report titled: “Errors made in financial statements”, Ministry of Finance, 2003. 57 Modified accruals is described in Article 20 of the Book of Rules on Budgetary Accounting and the COA as:

• 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 of non-financial assets are not considered expenses or revenues, • Current assets used for daily activities are considered expenses at the moment of purchase, • Inventories are recorded in the balance sheet, • Donations of non-financial assets are not classified as revenues or expenses.


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 of revenue and the accounts to which they are credited. Upon request of 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 on a real-time basis. The MOF delivers weekly reports on the realization of own revenues to ministries and other BUs. Commitments for expenditures and outlays are recorded in SAP by the MOF on the basis of reports received from ministries and other BUs in accordance with the Chart of Accounts.

144. Accounting data on revenues provided directly by FINA are perceived to be reliable. Based on the findings of the SAO as well as observation made by MOF staff and advisers, the CFAA must however conclude that accounting data concerning expenditure and outlays generally are not. Also, reconciliation of accounting data is typically only done at the level of ministries and other central BUs. This is another factor weakening the reliability of accounting data.

145. Accounting Systems. Each BU has two and often three or four financial accounting systems. As the SAP system is only available to the BUs which hold one of the 55 SAP terminals, most BUs cannot rely on SAP for current financial reporting. Furthermore, the SAP system only provides detail at the 5th level of the economic classification58, which is not enough for the type of reports that BUs typically need. For instance, it is not possible to identify all vendors at that level of the classification system. It is therefore not possible to generate a complete audit trail that enables the tracking of accounting entries backwards and forwards in the system. Often the accounting systems are customized for different types of 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 of interfaces not only means a lot of double work for the accounts and systems operators, it also adds to the complexity of consolidation exercises and increases the risk of errors.

146. Although all BUs reviewed had to some degree computerized the accounting function, some were still relying on spread sheets or outdated accounting software which do not meet modern 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.

147. Chart of Accounts. In accordance with art. 117 of the BA, the MOF has issued a Book of Rules with a Chart of Accounts (COA) and the OFB. The MOF has also published an Instruction on the Economic and Functional Classification of Expenditure and Revenues. The Instruction’s classification is one of the dimensions of the COA. The latter provides a framework and background for the accounting records of the budget and BUs activities. The COA is relatively new (from 2002) and as shown in the SAO’s audit

58 The Budget is adopted by the Sabor at the 4th level of classification.


of the fiscal year 2002 as well as the MOF’s later evaluation (2003), the COA was until recently still not applied correctly. Also, a number of 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. The MOF state that the COA (like the accounting policies and methodologies) is prescribed and all entities within the general State must apply it, and do apply it.

149. Financial Statements to External Audit. In 2003, delays occurred in the submission of financial statements to the MOF 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 its Report on the Audits Performed in the preceding fiscal year no later than 5 month after the completion of financial statements of the government. The SAO has so far been able to meet this deadline.


150. The MOF, for the first time, presented a consolidated financial statement for the state budget which is a significant improvement. As the CFAA finds, the recording and processing of transactions was, however, not prompt which prevented a timely aggregation at the line ministry and MOF 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 of the accounts for the fiscal year 2002 was partly based on draft consolidated financial statements. One of the reasons for the delays in reporting was the change of in accounting rules, involving an ambitious acceleration of the time-line for the BUs’ compilation of 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 CFAA 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 of the Treasury’s SAP system it cannot generate a complete electronic audit trail. The CFAA concludes that accounting data related to the execution of the expenditure budget is not reliable. Adding to the fiduciary risk is the existence of a multitude of accounting systems, which are often outdated and do not meet current standards for security and data protection. Based on the preceding, the fiduciary risk associated with accounting and financial reporting is considered significant.

IV. Recommendations

152. Based on the above findings the CFAA would like to make the following recommendations:

• The MOF 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 of Budget and Finance Units (BFUs) to ensure an effective implementation of the new accounting rules.


• The SAF Section of the MOF should be reinforced in order to be able to provide more support to BUs in the application of the new accounting rules, including the statutory formats and deadlines for financial reporting.

• The MOF should extend the statutory deadlines of delivery of annual the financial statements and initiate the necessary amendments of the BA and the OFB.

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

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

Croatia CFAA: Internal Control and Internal Audit 45

CHAPTER 6: INTERNAL CONTROL AND INTERNAL AUDIT


Background

153. The current development of an internal 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 concerned with the development of Public Internal Financial Control (PIFC); another related to internal audit specifically. The project is “hosted” by the MOF but the end beneficiaries are in principle all BUs. The project started in 2003 around the same time that the Sabor passed the new BA, which made the establishment of IAU in all BUs a statutory requirement.

154. In September 2004, the Government and the MOF adopted a “PIFC Development Strategy for Croatia”, which sets out the framework for the future development of the Government financial control system, in line with the requirements under EU negotiation Chapter 28.


155. Internal Control Framework. INTOSAI defines internal control as the process by which an organization governs its activities to effectively and efficiently accomplish its mission.59 Within the COSO60 framework, internal control is defined as a process, introduced by a board of directors, management and other personnel, to provide reasonable assurances that objectives will be achieved. Such controls consist of five interrelated components:

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

• Risk Assessment: Risk assessment involves the identification of the key risks faced by the organization. Major risks 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 illegal acts.

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

59 The Internal Control Standards Committee of INTOSAI, “Internal Control: Providing a Foundation for Accountability in Government”, 2001, p. 5. 60 The Committee of the Sponsoring Organizations of the Securities and Exchange Commission: http://www.coso.org

http://www.coso.org/


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 of information between management and staff in both directions is essential for internal 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: Internal audit is a critical element in the management control system. It provides feedback to management on the performance of its controls and what should be done to strengthen them. The SAO can also exercise this monitoring function, but it is outside the internal control framework.

156. Internal audit is an integral yet distinct part of internal control. It is defined by the Institute of Internal Auditors (IIA) as: “an independent, objective assurance and consulting activity designed to add value and improve an organization’s operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control and governance processes.” The IIA specifies International Standards for the Professional Practice of Internal Auditing (ISPPIA).

157. In Chapter 28 of the acquis communautaire, the European Commission has promoted its internal control model, Public Internal Financial Control (PIFC). PIFC covers all of the components identified in the COSO framework. PIFC has two components - financial management and control (FMC) and internal audit (IA). The FMC, which consists of all actions other than internal audit, aims to supervise all aspects of financial management - administrative, managerial and budgetary – to enable proper control over public finances. Another part of Chapter 28 deals with the protection of 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.61

158. There are many possible consequences of weak internal 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 fail to meet its objectives through misallocation of resources. The presence of any significant deficiency in these factors could result in a loss of public confidence in the Government.

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

61 Office de la Lutte Anti-Fraude.


practice advisories offer detailed guidance and practical interpretations of the standards. See Box 4.62

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

1000 Purpose, authority and responsibility 1100 Independence and objectivity 1200 Proficiency and due professional care 1300 Quality assurance and improvement The Performance Standards 2000 Managing the IA activity 2100 Nature of work 2200 Engagement planning 2300 Performing the engagement 2400 Communicating results 2500 Monitoring progress 2600 Management’s acceptance of risks

Implementing standards apply the attribute/performance standards to specific types of engagements (for example, a compliance audit, fraud investigation, control self-assessment, and others).

Source: The Institute of Internal Auditors: http://www.theiia.org

160. One important source of internal control requirements is based on Chapter 28 of the aquis communautaire. For countries seeking to become candidates for EU accession, the harmonization of their financial controls with those of the EU is a natural step in the accession process. More specific details on internal controls are in the EC’s Financial Regulations.63 This regulation lists several internal control responsibilities for various positions in the budgetary control process, including the authorizing officer, accounting officers, and imprest administrators, internal and external auditors. For example, the responsibilities of the authorizing officer include:

• establishing the organizational structure and the internal management and control systems and procedures suited to the performance of his/her 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 of sound financial management have been applied. (Art. 39 (3))

• requiring that the authorizing officer report to the management board on the performance of his/her duties in the form of an annual activity report. This report contains the results of operations and progress in achieving objectives, identifies operational risks, the use of resources and the functioning of internal control systems. (Art. 40 (1)).

62 As the CFAA review is not exhaustive, it should not be considered a formal review of the internal audit system’s compliance with ISPPIA. 63 Council (EC, Euratom) regulation No. 1605/2002 and the implementing regulations, Commission regulations No. 2342/2002 and No. 2343/2002.

http://www.theiia.org/


161. The regulation also describes the position and duties of the internal auditor in a manner that is generally consistent with the IIA ISPPIA standards.

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

II. Findings

Legal Framework

163. The internal control framework derives from a variety of laws. The most basic act is the 2003 organic Budget Act (BA), which provides the legal requirement for internal audit in the public sector. Other regulations, such as the Regulation on the internal organization of MOF (Official Gazette (OG), No. 70/2001) and the Principles of the Internal Organization of 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 Main Treasury Book System and Methods of 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 Internal Control Office and the Instructions on Implementation of 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 of rulebooks, which provide details on specific elements of 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 is 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 civil service conduct. They include the Act on the Structure and Scope of Ministries (2000), Act on Civil Servants and Civil Service Employees (2001), State Administration System Act (1993, amended in 1999), and the Regulation on the Principles of Internal Organization of the State Administration Bodies (2001). No formal Code of Ethics or Conduct for civil servant exists. The issue of conflicts of interest is not explicitly addressed in the legislation.

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


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

167. The BA defines the Financial Controller as the person responsible for the lawful execution of the Budget head’s orders in a manner that conforms to the financial regulations (Art. 113).

168. The BA’s Chief Accountant duties are those of the Controller of Payments as specified in the MTSA. He/she is 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. The functions of the chief accountant and financial controller require that separate individuals discharge these functions.64

170. The BA identifies the budget inspection function (Budget Supervision Office) as that which supervises65 the lawfulness, timeliness and purpose of the use of budgetary funds. It charges the MOF to supervise all budget entities, EBFs and local and regional self-governments. The Budget Supervision Office performs this function.

171. Each BU is also required to have an internal audit function that is independent, objective and which examines instances of non-compliance and makes recommendations for their elimination. Moreover, internal audit is 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. The BA sets penalties for non-compliance with the BA provisions in section XII of the act.

Institutional Framework & Capacity

173. Internal control framework. Within MOF, the Treasury and the Directorate for Internal Audit and Control are responsible for the status of PIFC vis-à-vis the European Commission. The Budget Supervision Office manages the use of budgetary resources (revenues, expenditures and procurements) in the local and regional self-government units. The CFAA team found BFUs in all entities visited; the key staff’s knowledge of their existing budgetary processes was sound. The BA’s assignment of management responsibilities was also reflected in the practical set-up of 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 of any overall unifying vision of internal control. Many parties in MOF perform “hard” 66 internal financial controls; they include budget preparation, budget execution 64 Many budget entities have not designated a financial controller, as required by PIFC. 65 This is the traditional control and revision unit (CRU) function that characterized the majority of the transition countries audit functions in the first decade after they assumed independence. 66 It is common in the framework of the “COSO” model to distinguish between “hard” and “soft” controls; soft refers to informal controls and hard refers to the more traditional, formal controls.


sectors, the internal control directorate and the Budget Supervision Office. The COSO concept of the internal 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 of parties within the MOF who exercise these controls do not effectively communicate with each other. The net effect is a highly complex set of internal controls adding no value to the operations.

175. There is also a Government Office for Internal Control and a number of internal control, or inspection units, in line ministries mandated to conduct administrative inspections. This is a legacy of 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 Internal Financial Control (PIFC) Development Strategy for Croatia adopted by the Croatian Government and the MOF in September 2004, the Ordinance on the Croatian Government’s Internal Control Office shall align the name of the Office and description of operations under its authority with the basic postulates of the PIFC

176. Internal Audit. At present there are five Internal Audit Units (IAU) in the state administration. The unit which is in the MOF has a staff of six. The six staff are referred to as inspectors and none of them are trained in the application of modern internal audit methodology. While the BA requires the establishment of modern internal audit functions in all BUs, line ministries and other BUs do not understand what the role should be of IAUs or how it differs from the current budget supervision and other inspection functions. For this reason, the ongoing CARDS project team has focused on components to support internal audit development: the IAU in the MOF 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 of rules and guidelines for modern internal audit, specific training for internal auditors on new techniques of modern internal audit and an overall strategy for a phased implementation of IA throughout the budget entities, EBFs and local and regional self-governments. This undertaking could also contribute to a rationalization of 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 of 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 of modern internal audit.67 The team is also in the process of establishing an internal auditor training program that would offer the graduates a form of certification and would permit them to take IIA equivalent exams which are required for the internationally recognized certified internal auditor designation. The target is 120 trained auditors during the life of phase I of the CARDS project (40 trained by the project staff, 80 by local trainers who have been part of the project). The MOF and the Government should offer strong support to the work of the CARDS project team and champion the modifications to the control framework across all the organizations of government. 67 Two of the six instruction modules are on internal audit. The CFAA team was advised that the Government planned to graduate 100 civil servants from the program in two phases. The program is partially financed by the World Bank


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

Practice

179. Control Environment. The control environment consists of hard as well as soft controls applied by senior management to ensure that an organization and its staff are competent and professional. It includes values communicated explicitly through formal policies and communiqués, and implicitly through the behavior models set by senior management. It 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 of internal control to be underdeveloped. There is no Code of Ethics for the Civil service as a whole, but a Law on Civil Service (OG No. 27/01), which regulates the employment of civil servants, including rights and responsibilities. A Code of Ethics for Internal Auditors will also be included in the Rulebook on Internal Audit, which was in draft at the time of the CFAA mission. Management in BUs generally did not appear to be supportive of the new internal control approach promoted by the concept of PIFC. There were no visible, management champions of the changes necessary to implement it; it was stealthy instead of an open, transparent communication of the needs and the plans to meet these requirements. The team encountered instances of inappropriate delegation of functions that violated the separation of duties control principle68 and a lack of timely, comprehensive documentation on the key financial processes operating in line ministries and in MOF. In some cases, key elements of the control environment (for example, internal audit units) were not required for EBFs, although this is 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 of a modern internal audit across the Government.

182. As also reported in the European Commissions’ Opinion on Croatia’s Application for Membership of the European Union, International reports and surveys indicate that corruption in Croatia continues to be a problem that affects various aspects of society, including public offices. In the Transparency International Corruption Perception Index 2003 Croatia was ranked at the same level as Colombia, El Salvador and Slovakia69 and lower than countries such as Belarus and Bulgaria. The inherent risk of official corruption work to undermines the control environment.

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

68 Even in MOF, the Assistant Minister responsible for internal audit has temporary responsibility for budget execution. This role violates the principle that auditors have no other operational responsibilities within an organization. 69 All ranked number 59 which in accordance with the interpretation in Annex II equal Significant fiduciary risk, together with all other countries ranked between 46-88.


level civil 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 is no practice of risk assessments being an integral part of management. Whereas the legal base is clear, the objectives of government organizations are often nonexistent and strategies often missing. Consequently, planning is 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 of 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 of accounting information and job-descriptions that ensure appropriate segregation of duties typically are not. The treasury system provides centralized control of all budgetary expenditures through the TSA and a centralized computer system (SAP) for the General ledger in MOF. Its controls cover budgetary preparation, execution and accounting. The Treasury defines cash allotments for treasuries in support of the budget execution by budget entities and it 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 funds, and local and regional self-governments. Controls are performed pursuant to a ratified control plan, which is adopted by the Chief State Treasurer on the proposal of the chief executive of the budgetary control organizational unit at the beginning of the fiscal year. The plan is drafted on the basis of irregularities observed in the preceding year (assessments of inspectors, proposals and suggestions from the Preparation Sector and the Budget Execution Sector, and the State Audit Office). During preparation of the plan, the following are considered:

• whether there is 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 of control inspections conducted in individual entities during the preceding period,

• petitions from citizens, institutions and trade unions,

• the available number of inspectors.

187. According to the description provided by the MOF, the budgetary control is conducted for the current fiscal year, and only exceptionally, if circumstances require, does it do so for the preceding period. In this respect it differs from the State Audit Office (SAO). Another essential difference in approaches between the Budget Supervision Office and the SAO or the Croatian Government’s Internal Control Office is the fact that budgetary control inspectors compile reports of their completed inspections and directly file motions for initiation of misdemeanor proceedings against the relevant body, or


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

188. If irregularities that do not bear the traits of misdemeanors or crimes are detected by the Budgetary Supervision Office, measures are stipulated for the elimination of 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 of failure to pay these revenues into the budget were incorporated into the appropriate legislation, while the return of unused or improperly used budgetary funds has been ordered. Additionally, the need to re-examine subordinate legislation pertaining to decentralized functions of 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 still to be recruited.

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


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

Serious weaknesses were identified in the control framework of the Public Debt Management Section (PDMS) of the Ministry of Finance. The Assistant Minister and Head of the Section is the key player in all aspects of its operations, negotiating the borrowings, approving principal and interest repayments and other key tasks. Conventional internal controls would require clear segregation of duties, comprehensive written procedures and job-descriptions as a safeguard against irregularities in the financial processes.

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

In its Report on the Audits Performed on the fiscal year 2002, the State Audit Office (SAO) reported that out of a planned number of 18 positions in the PDMS only eight had been filled. The SAO concluded that the number was insufficient and had a negative impact on the quality of the task execution. It also pointed to frequent changes in staff having an equally negative impact. The SAO drew attention to bookkeeping irregularities in the PDMS’s records on its trading with bonds and the fact that in some cases bookkeeping data were entered into the system with up to a year’s delay. It was evident from the report that earlier years’ recommendations for more prompt recording of transactions had not been properly responded to by the management of the PDMS.

Interviews conducted by the CFAA team revealed that an inspection undertaken in 2003 by the newly created internal audit unit of the MOF had made a number of recommendations to which the management of the PDMS was not responsive. The CFAA team was not able to obtain a copy of the report in question.

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

Resident advisers of the IMF and SIGMA experts who had reviewed the PDMS expressed concerns about the lack of controls, inappropriate filing practices, existence of off-shore accounts and the key person risks inherent in the organization of the PDMS.

The PDMS currently manages a debt portfolio of over HRK 80 billion, generating interest payments in the amount of some HRK 4 billion per year (2003 rounded budget estimates).


191. Information and Communication. There are many different financial management information systems in use in line ministries, the MOF, EBFs and local and regional self-governments. The SAP system in the MOF serves primarily serves the MOF and the central BUs and EBFs70 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 SAP system; these entries require frequent reconciliation between control data from different systems.

192. This process is inefficient, error-prone and contributes to non-separation of duties. A limited number of staff (often one) is trained on the SAP system; the staff have to perform all of the data entries, including authorizations. Duplication of data entries in multiple separate financial systems represents a major potential for introducing errors; it also requires regular reconciliation.

193. Monitoring. These elements are vital to internal 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 of advice on how well its internal control systems are operating. This is the key role of internal audit, which is now being implemented on a phased-in basis across all budget entities. The only feedback management receives is comments from the SAO. The SAO uncovers these comments in the course of its compliance and regularity audits, a practice which is highly undesirable.

194. Internal Audit. Internal audit in Croatia is undeveloped. At the time of the CFAA appraisal mission in March 2004, there were no active internal audit units in any of the ministries or agencies visited except the MOF; all had budget supervision or internal control functions performing the type of inspections specified in the BA.71 In the line ministries and EBFs visited, there was no understanding of the exact role and function of modern internal audit, despite the BA’s clear requirements and its 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 line ministries and other central BUs, have been selected for training. The MOF committed to training six staff in the first phase of internal audit training; these staff will become the core of a modern internal 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 of IAUs, all BUs need advice to establish such units. It appeared to the CFAA team that the PIFC and internal audit project had largely been confined to the MOF, though recently more ministries and other BUs have been involved. In Box 6 below, the CFAA offer some practical advice or “fifteen steps to establishing an IAU”, which could be used by BUs who are now in the process of establishing an IAU:

70 The BUs and major EBFs that have SAP terminals – regional treasuries. 71 MOF has six staff employed in the budget inspection function for MOF, all line ministries and EBFs.


Box 6 . Fifteen Steps to Establishing an Internal Audit Unit

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

1. Review the literature on internal audit, starting with the definition of internal audit. 2. Interview senior management 3. Initiate the development of 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 of basic internal control issues with the external auditor 6. Develop a list of all auditable entities and operations 7. Map (e.g. with flow-charts) the major processes within the organization 8. Develop a Charter (terms of reference) for the Unit 9. Develop a risk and audit needs assessment for your organization 10. Build the budget for the unit 11. Develop a one-year and a three-year audit plan (medium term perspective could vary depending on the type of operations)

12. Hire staff and develop a training plan for staff 13. Ensure that management notifies other departments in your organization about the function, responsibilities and the added value of your unit 14. Work actively with management to develop appropriate reporting and working relationships 15. Develop a methodology for following up on and ensuring effective implementation of audit recommendations

III. Summary of Findings and Assessment of Fiduciary Risks

196. Whereas a number of Rulebooks and regulations provide the regulatory framework for procedures and physical controls, detailed written procedures and job-descriptions ensuring an appropriate segregation of duties are typically not in place. The Public Debt Management Section of the MOF offers such an example. Also, there are numerous examples of 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 of official corruption and potential conflicts of interests to some extent undermines the control environment. The introduction of internal audit via the BA is a positive development. At the time of the CFAA appraisal mission there were no other internal audit units being established, other than the one in the MOF. By the time of the report dissemination there are five being established. The CFAA offer some practical guidance for BUs who want to establish such units. This is well conceived and has a

http://www.theiia.org/


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

IV. Recommendations

197. The CFAA team makes the following recommendations:

• Due to the significant risk and the large sums involved, the Government should take immediate action to eliminate the weaknesses in the internal control framework of the Public Debt Management Section of the MOF.

• The MOF must also as a matter of priority issue all statutory Rulebooks and other necessary guidelines relating to internal audit and internal control. MOF and other BUs must subsequently take steps to develop appropriate written procedures for financial processes.

• The MOF should propose changes in law to require an internal audit function to be established in all EBFs and any other entities in receipt of public funds outside of the budget.

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

• The MOF should provide a strong champion of change for the new internal control and audit system, including providing support to establish internal audit units in all major BUs in accordance with the provisions of the BA.

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

Croatia CFAA: External Audit and Legislative Oversight 58

CHAPTER 7: EXTERNAL AUDIT AND LEGISLATIVE OVERSIGHT


External Audit

198. The SAO states its mission is to audit all government operations and to improve the legality, efficiency and effectiveness of all legal entities and other legal entities regulated by the State Audit Act. The latter has responsibility for the management of public property. In addition, the SAO emphasizes its role in promoting public accountability.

199. The 1999 World Bank CFAA recommended that the SAO broaden its audits to cover aspects of economy, efficiency and effectiveness and not just address compliance with rules and regulations. Furthermore, the 1999 CFAA recommended that additional staff should receive training in internationally- accepted auditing standards. At that time, the CFAA also recommended that the SAO 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 of the SAO. Material recommendations included: strengthening the SAO's legal mandate to reinforce its independence72 and to align its audit resources with its statutory responsibilities; revising its 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 of the auditees; extending its audit activities to performance.

201. In the Commission’s Opinion on Croatia’s application to EU membership of 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 its Opinion on Croatia’s Application for Membership of the European Union.

202. The 2002 World Bank PEIR reviewed the SAO’s operations. It recommended that the SAO should continue to focus on compliance and financial audits in the short term. Over the long term, the Bank recommended that the SAO conduct performance audits and cite deviations from the current law and examples of non-compliance.

203. As a result of the peer review and a previously conducted self-assessment, the SAO adopted a five-year Strategic Development Plan (SDP) in May 2003 and began its implementation. Based on the SDP, CARDS 2003 has financed a EUR 1.6 million twinning project which is to begin in 2004 and to run over a period of 30 months.

204. The assessment framework used for external audit will be the INTOSAI AS. It covers Basic Postulates, General Standards, Field Standards and Reporting Standards.73

72 This is a common situation among transition countries’ SAO mandates. 73 This CFAA does not cover every aspect of the INTOSAI AS. it is not a formal review of the SAO’s application of the standards. Nor does it constitute a formal World Bank review of the SAO’s suitability as an external auditor of Bank projects. The complete text of the Standards are available at the following web-site: http://www.intosai.org/2_CodEth_AudStand2001_E.pdf

http://www.intosai.org/2_CodEth_AudStand2001_E.pdf


Box 7 provides an overview of the INTOSAI AS, which will provide the headlines in the structure for this chapter:

Box 7. Overview of the INTOSAI Auditing Standards

Basic Principles in Government Auditing • Promotion of public accountability • Legal basis for access • Conflicts of interest

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

Field Standards in Government Auditing • Planning • Supervision and review • Study and evaluation of Internal Control • Compliance With Applicable Laws and Regulations • Audit Evidence • Analysis of Financial Statements

Reporting Standards in Government Auditing • Fairness, accuracy and timeliness • Statements of assurance

Source: INTOSAI: http://www.intosai.org

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 of them are in widespread use among EU and candidate countries.

Parliamentary Oversight

206. The internal rules of the Sabor created the committee on budget and finance, which consists of nine members and a staff of four. The committee's function is to review all budget bills. The Sabor cannot pass a bill until the budget committee has rendered its opinion. The SAO does not advise the Budget committee while it is formulating the budget.

207. Parliament's discussion of budget policy, its review and approval of proposed budgets and its review of the execution of the approved budget are cornerstones of a democracy. The 2002 PEIR concluded that the Sabor should become more active in the budgeting process and insist on accountability. To support the committee and the Sabor

http://www.intosai.org/


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

• Several professionals be added to the budget committee staff;

• The Government make budget submissions more user friendly;

• Parliament trains its Members in the budget process and the rules that go with it.

208. No internationally recognized standards exist for Parliamentary oversight of budget implementation. However, SIGMA/OECD produced a practice advisory74, which presents various issues related to Parliamentary purview and its interaction with SAIs.75 The report describes the structure of Parliamentary committees that address SAI reports, procedures/practices for SAI and Parliamentary interactions, and a system for ensuring effective Parliamentary follow-up on SAI 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 of Ministers) should grant discharge [give formal approval or certification] to the senior management of the BUs after the external auditor examines the financial statements and annual report. This formal approval includes the auditor’s attestation (the “statement of assurance” or declaration d'assurance (most often referred to as the “DAS”) about “the reliability and the legality and regularity of the underlying transactions.”76

Fiduciary Risks

210. The fiduciary risk associated with external audit and parliamentary oversight is the risk that: • The SAI’s independence, including its financial independence, is not assured; • The SAI’s audit mandate does not cover all relevant public funds; • The SAI does not have a mandate to undertake all types of audits listed in the

INTOSAI AS; • The SAI does not demonstrate it has followed proper audit guidance according to

international standards; • The SAI 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.

74 SIGMA Papers: No. 33. “Relations between Supreme Audit Institutions and Parliamentary Committees”, OECD, December 2002: http://www.oecd.org/pdf/M00038000/M00038767.pdf75 76 Commission Regulation (EC, Euratom) No. 2343/2002 of 23 December, Title VIII, Art. 91-95

http://www.oecd.org/pdf/M00038000/M00038767.pdf


II. Findings

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

212. The ASA provides the SAO with a broad mandate to audit all financial statements and financial transactions of 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 of Croatia or local and regional self-government units own a majority stake (Art. 1). The ASA does not explicitly offer a mandate to audit grants or other incomes or loans from foreign sources.

213. The ASA defines the SAO's audit activities in a way that ensures the right to undertake all types of 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 of system efficiency and effectiveness. The ASA's audit mandate is unique in that it defines the audit of 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 SAO must make public the applied auditing standards in the Croatian language (Art. 4.2). In addition, the professional Code of Ethics for Certified State Auditors must comply with the INTOSAI Code of Ethics (Art. 8.5 (2)). The ASA also contains provisions to prevent the SAO’s auditors from working with conflicts of interest.

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

Institutional Framework and Capacity 216. The State Audit Office is a young institution, established in 1993 and managed by an AG. The Parliament (the Sabor) appoints the AG. The Office has a staff of 301 people, 226 of whom are certified state auditors. They operate in Zagreb and in 20 regional offices across Croatia. The regional offices vary in size from five to 17 staff


members. A Deputy AG and seven Assistant AGs all work out of the SAO’s central office in Zagreb. The central office has eight departments77.

Practice – The INTOSAI AS Basic Postulates 217. Promotion of Public Accountability. In the first part of the INTOSAI AS, the Basic Postulates says the SAI should comply with, and require, promote and facilitate public accountability in the management of public resources. That means applying accounting standards and internal controls; it also means transparency, accessibility to data, and a fair presentation of information. The postulates are assumptions the SAI agrees to when joining INTOSAI. The SAO has undertaken self-assessments against the INTOSAI AS. As previously described, the ASA contains explicit references to the INTOSAI AS and the INTOSAI Code of Ethics.

218. Legal Basis for Access. As previously stated, the ASA gives the SAO a mandate to audit all bodies of State Government and its legal entities. The SAO may also audit local government bodies and legal entities. However, it does not have a legal mandate to audit EU and other foreign grants.

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

Practice – The INTOSAI AS General Standards 220. Independence. The ASA established the SAO as the principal State auditor, legally independent of the executive and subordinate to the Sabor. The AG's appointment to an eight year term seems appropriate to ensure independence of his/her office.

221. The SAO's budget comes about in the same way as any BU. Like for the BUs’, it is 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 SAO must establish an IAU that is in accordance with the provisions of the June 2003 BA. However, the IAU is not yet operational. The SAO is 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 SAO has the capacity to assume its tasks, it must carefully apply auditing standards. It must also recruit/sustain the appropriate number of

77 Department for the audit of state budget and BUs (staff=9); Department for the audit of budget and local and regional self-government (9); Department for the audit of fund institutes and financial institutions (7); Department for the audit of legal entities fully or partially financed from the state budget (8); Department for the audit of transformation and privatization (32); Department of legal affairs and relations with other subjects (8); Department of IT and human resources management (9); Department for accountancy and general affairs (16).


staff with the education/experience to meet their responsibilities. Also, it must: (a) produce and issue detailed audit guidance to its 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 SAO 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 of post-graduate work experience, and passed a state vocational exam and one for certified state auditors. The SAO issues and updates an Audit Manual, which contains procedures and established practices. The goal is to ensure supervision and review of audit assignments.

225. Applying Standards. As stated previously, the application of INTOSAI AS and the INTOSAI Code of Ethics is 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 AS defined audits, including performance audits,that the SAO does not do. Furthermore, when the SAO refers to an attestation audit, it is not the same type of audit referred to in the INTOSAI AS, the EUG and the ISA, but merely an audit of financial statements which is concluded with a certificate using (four) standard opinions.

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

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

228. As mentioned previously, CARDS 2003 will finance a EUR 1.6 million twinning project to be launched in 2004. The planned project activities appear in table 7 below.

Table 7. CARDS 2003 External Audit Twinning Project Activities


Project Activity No.

1 Strengthening of institutional independence 2 Changes and amendments of the State Audit Act 3 Definition of various types of audits and establishment of audit procedures 4 Pilot audits for financial audits 5 Pilot audits for performance audit 6 Pilot audits for information systems 7 Pilot audits of EU funds 8 Creation of the report on the result of pilot audits performed 9 Creation of working procedures

10 Application of international auditing standards 11 Application of methods of statistical sampling 12 Development of quality control and quality assurance in the audit process 13 Review of structure of the Annual Report 14 Research of results of audit activities 15 Research, preparation and presentation of the public relations strategy 16 Reexamination of organizational structure of the Office with a view to introducing new

functions and changing exiting ones 17 Review of information system of the Office 18 Development of the IT strategy with implementation plan 19 Development of internal supervision of the State Audit Office 20 Development of internal communication 21 Seminar on team work and team management 22 Research, application and presentation of personnel strategy 23 Qualification structure of personnel 24 Development of the program of personnel training 25 Forming the strategy of international relations 26 Forming the communications strategy

Source: CARDS Twinning Project Fiche, EC delegation to the Republic of Croatia, Zagreb 2003

229. Clearly, these activities show the scope of the project is ambitious. In the medium term, these activities are capable of addressing all the SAO’s developing needs. Consequently, the twinning project could most likely address the CFAA's recommendations.

230. Audit Guidance. The SAO has developed an Audit Manual with detailed technical guidelines and procedures to carry out the standards it is to uphold. The Manual and other technical guidelines have regular updates. The CFAA was unable to obtain a copy of the Manual and the Guideline for a detailed review.

231. Staff Composition and Adequacy. The SAO management finds the current number and composition of staff appropriate. Should the SAO develop a financial audit that is consistent with the ISA or expand its performance audit capability, the size and breakdown of the staff may require a review. The staff is most familiar with compliance and the regularity of legality audits. The SIGMA peer review concluded that the size of the staff was inadequate to satisfy the SAO’s annual statutory audits of local and regional self-government and all privatizations. SIGMA estimated in 2002 that up to 50 percent of the SAO’s resources were spent on privatization audits. Another indication that the


SAO's resources are spread too thin is the volume of work it initiates or reviews. See next paragraph for details.

232. Monitoring Efficiency and Effectiveness. Whereas the SAO has procedures and mechanisms to evaluate the efficiency and effectiveness of individual auditors, it does not systematically monitor the efficiency and effectiveness of its operations. The CFAA finds that the scope of audit services provided to be quite narrow and that a more holistic interpretation of the SAO’s mandate and role is desirable to keep government accountable.

233. In its Report on Audits Performed in 2002, it reports to have audited a total of 44 financial statements, 611 subjects and that in addition to that it received 11,327 financial reports during that same period. Out of 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 of the audits performed.

Practice – The INTOSAI AS Field Standards 234. Planning. Audit planning is an integral part of SAO’s work. Planning is implicit in the ASA, internal guidelines and the SAO Audit Manual. Detailed guidelines for developing an audit plan appear in the SAO Audit Manual under the title: “The Process of designing the Annual Audit Program of the State Audit Office.” The guideline also explains how to organize the planning process.

235. The ASA gives the Sabor the option of 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 SAO addresses quality assurance in all phases of the individual audit assignment. According to SAO management, supervision of audit teams includes an evaluation of:

• The audit team’s understanding of the audit plan; • Compliance with auditing standards and institutional practices; • Compliance with each phase of the audit plan; • Completeness of audit documentation and relevant facts to support conclusions in

its findings, and; • Audit goals or objectives.

Evaluations consist of audit team leader performance reviews and overall supervision by superiors in the course of an audit assignment. In addition, ex post reviews entail feedback from auditees, evaluations of work by a parliamentary committee and members of Parliament, self-assessments by management and staff and external peer reviews, including bilateral exchanges. Generally speaking, documentation of quality assurance procedures is in the form of a sign off 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 SAO usually does not rely on the work of internal audit or internal administrative control units. Assessments of internal control and accounting systems are not an integral part of 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 of these separate reviews influence the scope of substantive testing by the SAO but only to the extent that specific transactions already checked by an internal controller or auditor and found satisfactory by the SAO will not be selected for substantive testing again. All other transactions are subject to substantive testing.

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

239. Audit of Government Annual Accounts. As required by the ASA, within five months of the expiration of the statutory deadline for submission of financial statements of BUs, the SAO submits an annual report to the Sabor on the audits it has carried out as well as its own activities. The report is a summary of findings in connection with audits of BUs’ financial statements. The executive summary does not constitute a statement of assurance, but concludes whether the errors and irregularities detected significantly affect the financial statement of individual institutions. Out of 44 audit opinions on financial statements issued in 2002, the SAO gave three “negative” (qualified) opinions, and four so-called “unconditional“ audit opinions. The remaining opinions were conditional. The SAO does not conclude on the realism or regularity of the execution of 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 is 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 & Disclosure.78 The assertions refer to items on the balance sheet/financial position as well as the income statement/the statement of financial performance. Because the SAO auditors are not required to systematically scrutinize these assertions, certain relevant evidence may be overlooked in some cases.

78 Elaboration of 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 liability exists at a given date; (b) Rights and obligations: an asset or a liability pertains to the entity at a given date; (c) Occurrence: a transaction or 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 or liability is recorded at an appropriate carrying value; (f) Measurement: a transaction or event is recorded at the proper amount; revenue or expense is allocated to the proper period; and (g) Presentation and disclosure: an item is disclosed, classified, and described in accordance with the applicable financial reporting framework.


The focus of the SAO’s collection of audit evidence is somewhat broader and less systematic.

241. Interviews conducted indicated that the auditors perceive their approach to be identical to 100 percent substantive testing. It is however clear that an ex post verification of each of the transactions and supporting documentation related to the 11,327 financial reports that the SAO receive during the year is possible with a staff number of 301.

242. Audit of Financial Statements. The audit of financial statements prepared in accordance with the BA and the OFB, is an essential part of 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 via the ISA, which includes preliminary systematic assessments of risk and materiality, accounting systems and internal control systems in the broadest sense of the word (not only referring to hard and physical controls). Concerning the SAO’s approach to audit and the collection of audit evidence, see the paragraph above.

Practice – The INTOSAI AS on Reporting 243. Fairness, Accuracy and Timeliness. The fairness and accuracy of SAO reports should derive from adherence to its own procedures and the right of the auditee to react to the SAO’s findings. Whereas procedures in general appear to be adhered to, the CFAA did not obtain information to verify the degree of 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 SAO provides formal opinions on the financial statements of individual Bus, using its own standards and working guidelines. A formal plan is in place prior to it; moreover SAO's auditors appear to follow it. However, assessments of risk and materiality are not in use to systematically select audit areas and transactions. Risk assessment is generally done on the basis of intuition and prior experience and according to statistical models. Audit opinions do not constitute positive statements of assurance concerning the true and fair nature of the financial statements. In its statutory report to the Sabor, the SAO provides an opinion based on various audit findings. This does however does not constitute a statement of assurance on the execution of the budget, as the exact coverage and relative materiality of the selected auditees is not quantified. Nor are the criteria for the selection of individual transactions and operations audited made explicit in the report.

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

Practice - Parliamentary Oversight


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

247. Practice of SAI-Parliamentary Interaction. The CFAA team learned that the Sabor's perception of the SAO's reports is that they are not very informative. Although the AG and the SAO are generally respected, the level of cooperation between the Sabor and the SAO is characterized as routine instead of dynamic. Members of Parliament consider the SAO's audits as narrow in scope.

248. System for Effective Implementation. All decisions of the Budget Committee become formal opinions of the Sabor. Follow-up on the recommendations of the Committee is rigorous. Neither the Sabor nor the Government has a system to continuously monitor the recommendations of the SAO and their implementation.


249. The Act on State Audit provides a broad mandate for those public funds and institutions that it is 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 Sabor) as a matter of priority. One shortcoming is that the SAO is not formally required to provide a statement of assurance on the execution of the state budget. The SAO is 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 of Government financial statements. Due to the nature of its legal mandate and the methods applied this however does not constitute a formal statement of assurance on the Government consolidated financial statements or the execution of the state budget. The SAO’s legal framework does not guarantee its financial independence from the government, which currently makes it subject to the MOF’s budget supervision. Whereas the Act on State Audit explicitly provides a mandate for it, the SAO still has not piloted any audits of 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 is considered moderate.

IV. Recommendations

250. The ASA should be amended to ensure that the SAO 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 external audit and the auditor appointed by Parliament. Subsequently, the MOF's budget supervision over the SAO should cease.

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


252. The ASA should be amended to allow the SAO to audit all EU funds. The SAO should consider positively the challenge of auditing and becoming certifying body for future EU funded programs in Croatia.

253. In line with the recommendations of the 1999 CFAA, the 2002 SIGMA peer review and the 2002 PEIR, the SAO should initiate pilot audits of economy, efficiency and effectiveness (performance or value-for-money audits).

254. The SAO and the Sabor should jointly consider the establishment of a specialized Public Accounts Committee, for example, as a sub-committee to the Budget Committee.

Croatia CFAA: Local and regional self-government units 70

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 fire protection. A second phase of decentralization is scheduled for 2004. The government was expected to recommend legislative initiatives to:

• Expand the authority of 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 of clients in the target population to be served, geographical or climate factors); these standards are pivotal in equalization grants.

• Modify the central government’s processes and procedures that interfere with local decision making.

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

257. As the Croatian Government did not consider taking any further steps towards decentralization and as the elections for a new government were approaching, it was decided in September 2003 to postpone the implementation of 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 of the program. The members of the Commission are state officials, state secretaries and assistant ministers. The chairman is State Secretary of Central State Administration Office.



259. In assessing the fiduciary risk associated with the PFM arrangements, the CFAA will use the same framework applied to the central Government.

II. Findings

Legal Framework

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

261. The financing of local and regional self-governed units is regulated under Act No. 117/1993; the Act and its amendments pertain to the Financing of Local and regional Self-government Units.

262. The City of Zagreb has a particular law, the City of Zagreb Charter (hereafter the City Charter) No. 20/2001, which among other things regulates budget preparations.

263. The BA regulates PFM arrangements for all three types of sub-national units. The City Charter and the BA apply to the City of Zagreb.


264. Sub-national self-government in Croatia has two tiers: 20 counties are at the regional level, 123 cities and 426 municipalities at the local level.

265. The activities and areas of public policy falling within the purview of counties, municipalities and cities appear in Box 8 blow.

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

Municipalities & Towns Counties

• Housing • Spatial and urban planning • Utilities • Social and child care • Primary health care • Elementary education • Culture and sports • Consumer protection • Environmental protection • Fire protection and civil service

• Education • Health • Spatial and urban planning • Economic development • Transport and traffic infrastructure • Planning and development of a network

of educational, health, social, and cultural institutions


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

267. Each self-governed unit consists of 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 of its competencies. By statute, the Assembly also establishes various administrative bodies of self-government. The Mayor represents and presides over the local/regional government.

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

Practice

269. On the whole, budget preparations for local and regional governments follow the procedures laid 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 first round of internal negotiations among administrative departments and budget entities, the BFU of the relevant unit prepares a draft budget proposal which is submitted to the local government by October 15 of 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 of the current year. The representative body is required to adopt the budget by the end of the year, while its application should be effective as of January 1 of the year to which the budget refers.

270. Different revenues are available to the regional/local government administrations. For a city like Zagreb, they include:

• Income and profit taxes – which are collected and distributed via the tax administration

• Administrative fees

• Automobile taxes

• Concessions

• Reconciliation funds – special purpose

• Sales of assets


271. Revenues are in a special account managed by FINA. FINA is also responsible for allocating the correct percentage of collected revenue to the State and regional accounts.

272. In terms of fiscal transparency, the town of Varazdin has developed a practice of using fliers to inform its citizens how the town spent the money in the current and capital budgets and what were the sources of revenue.

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

274. Monitoring of borrowing is guided via strict observation of 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 of Finance only allows long-term borrowing for investments financed from their own budget, with the prior approval of the Government. Total annual liability may not exceed 20 % of the realized income of a particular local or regional self-government unit in the year preceding the year of borrowing.

275. County, municipal and town administrations usually have computerized accounting systems. In most cases, depending on the type of expenditure, there are several systems. In the county of Zagreb, there are separate systems for salaries, current expenditures and the accumulation of 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 of the relevant local or regional self-government unit. Financial statements serve as basis for preparation of these documents on budget execution and they are submitted to the Ministry of Finance and State Audit Office.

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

278. Although the BA requires the establishment of 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 MOF is 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 of funds becomes a resource problem for the administration.

279. The SAO audits the financial statements of local and regional administrations annually. Audits usually occur in teams of two to four auditors; these auditors are usually on site at the local or regional administration for a period of 1-1½ months.


280. On the whole, the budgeting practices of sub-national governments appear to be sound. They appear to ensure that the budget reflects the priorities of local and regional interests and political parties. These practices also appear to effectively prevent over-lending at the sub-national level and the generation of contingent liabilities at the state level. That being said, the likely existence of a great number of bank accounts owned by local government increases the risk of public funds following channels outside the formal processes set out in the BA. The ongoing process of decentralization, combined with recent changes in accounting rules have caused problems in the reliability of financial reporting to the MOF. The SAO provides external audit arrangements with appropriate frequency and provides a safeguard against the misuse of funds. The SAO’s resources are however spread thin at the sub-national level. Generally speaking, the transparency of the PFM system appears to be greater at the sub-national level than at the state level. This is also reinforced by more direct lines of accountability between the citizen and the elected representative. Based on the concrete concerns related to cash management, the reliability of financial reporting and internal control, the fiduciary risk associated with the PFM and financial accountability arrangements for sub-national governments must be rated significant.

IV. Recommendations

281. The CFAA recommends the following:

• As at the state level, the MOF should issue all the statutory79 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 of the new BA, including steps to establish IAUs.

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

79 As required by the organic Budget Act.

Croatia CFAA: Capacity Development 75

CHAPTER 9: CAPACITY DEVELOPMENT

282. In this chapter, the CFAA will offer an overview of recent technical assistance (TA) activities in the field of Public Financial Management (PFM). It will assess the ability of beneficiary institutions to absorb the TA 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 of PFM has been a priority of the EU; considerable amounts of money have funded technical assistance in this field. During the period of 2002-2004, the CARDS budget of the European Communities allocated EUR 10.5 million to improve the PFM in Croatia.80 In addition, USAID, the US Treasury, SIGMA, the IMF and the World Bank have been and will continue to provide advice in developing PFM capacity.

284. Current or upcoming PFM development projects include:

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

• CARDS 2002: Development of Public Debt Management Capacity (EUR 1.5 million.)

• SIGMA81: 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 is partially based on recommendations from the peer review)

• CARDS 2003: Strengthening the External Oversight of Budget Execution (EUR 1.6 million.)

• US Treasury: Resident Advisor Program with the Ministry of 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)

80 European Commission Country Strategy Paper for Croatia 2002-2006, p. 66. 81 SIGMA stands for Support for Improvement in Governance and Management; it is a joint initiative of the OECD and the European Communities. Activities in Croatia are funded from a “framework” grant to the OECD from the European Communities’ Balkans program. Short or medium-term assistance for expertise and project management come from the SIGMA 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. It should also be mentioned that under the headline of “public finance” the EU also finances a great number of technical assistance projects related to the development of the customs administration.

II. Assessment of TA absorption capacity, impact and coordination

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

288. MOF should be responsible for consolidating recommendations from 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 of programs, cash management, debt management and accounting issues.

289. Progress on the internal audit changes does not depend on the development of a treasury system. For its part, the MOF has not been very effective in promoting the CARDS 2002 project on PIFC and internal audit. During the course of the March 2004 mission the CFAA team interviewed a number of the senior management and BFU managers in ministries and other BUs. While these managers were aware of the requirement to establish internal audit, they were unaware of the ongoing PIFC and the new requirements of modern internal audit and of the project by the MOF. By June 2004 the awareness of the CARDS 2002 project had improved significantly, for example with the help of a proactive information campaign initiated by the EC delegation and the project management team. Generally, intra-MOF and inter-ministerial coordination is a significant problem for effective PFM capacity development. The MOF’s efforts with the Treasury system are a case in point.

290. On the whole, donor coordination of TA to Croatia seems efficient. As an indicator, the ECCSP 2002-2006 contained summaries of other donors’ activities. A matrix referred to an overview of contributions from the seven most important donor organizations to particular sectors, policy areas and institutions.82 In the PFM area, frequent consultations occur among the World Bank, IMF, USAID, US Treasury, SIGMA and European Commission; similar consultations take place. Considering the scope of TA provided and the priority that EU accession occupies on the Government’s agenda, the EU will take on a leadership and coordinative role. The challenge will be to 82 In addition to the European Commission: United Nations Development Program, European Bank of Reconstruction and Development, European Investment Bank, IMF, USAID and the World Bank.


complete the initial assistance in capacity development and to build a sustaining training program that will be capable of educating all future civil servants and new hires in the fundamentals of public financial management, budgeting, internal control and internal audit.

III. General assessment of PFM capacity development needs

291. The number and capability of staff in newly established and specialized PFM functions are inadequate. There is a serious shortfall in trained young staff knowledgeable in the principles of modern 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 is true of the Ordinance change on Financial Reporting and Budgetary Accounting for BUs. These professional groups are essential to the effective operation of the public financial management system in the Government of Croatia.

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

293. There is an Institute of Public Finance (IPF), an NGO, which deals with economic research and analysis relative to Public Financial Management. While it publishes a newsletter to inform civil servants and other relevant parties about key public financial management issues, it lacks the capacity to provide systematic training. It restricts itself to providing information on academic events concerning public finance that take place abroad.

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

295. The future needs in terms of competent PFM 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 on the basis of an Extended Decentralized Implementation System (EDIS) are set out:


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 of procedure, clear institutional and personal responsibilities; (II) the principle of separation of powers must be respected so that there is no risk of conflict of interest in procurement and payment; (III) Adequate personnel 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 of effective internal controls including an independent audit function and an effective accounting and financial reporting system which meets internationally accepted audit standards; (II) a recent financial and operational audit showing effective and timely management of Community assistance or national measures of similar nature; (III) a reliable national financial control system over the implementing agency; (IV) procurement rules which are endorsed by the Commission as meeting requirements of Title IX of the Financial Regulation applicable to the general budget of the European Communities; (V) Commitment by the National Authorizing Officer to bear the full financial responsibility and liability for the funds.

296. The Government must develop an integrated strategy for the development of its financial management, budgeting, debt management and internal audit personnel, both now and in the future. It must be a combination of re-training of those existing staff who demonstrate the capacity to make the transition to the new accrual base of accounting, or the modern internal audit, and recruitment programs to attract those recent graduates who have acquired all or part of the skills required through their university training. It must also include provisions for the acquisition of international certification in auditing (IIA) or accounting (CIPFA, and others). Budgeting should include the elements of capital investment, costing of budget alternatives and budget analysis. The components of the program should build on the exiting or planned training infrastructure for Croatian civil servants, with extensions where required. These include the Government accounting center in Ljubljana83, the planned internal audit training facilities in Zagreb being created as part of the CARDS 2002 program,84 plus other ad hoc training opportunities offered by donors from time to time.

83 The Government plans to educate approximately 100 accounting staff in Ljubljana over the next 2 years, financed by a World Bank project 50 will be trained in Ljubljana, the remaining 50 in Zagreb in Croatian. 84 The CARDS program objective is to train 120 auditors in the new techniques of modern internal audit – 40 trained by project staff and 870 by trainers trained by the project.


IV. Recommendations

297. MOF should designate a responsible senior management position at the Director level (minimum)85 to oversee the development of the comprehensive training strategy, in consultation with the donor community, planned and current training providers and the professional associations of accounting and auditing in Croatia. The objectives should be to:

• 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 of the training modules delivered under this program;

• Provides a continuing education program for the professional in government to assist them in maintaining the currency of their professional skills and practices.

• The Minister of Finance should obtain COM approval for this program and then enlist donor support for those components that require funding beyond the current project timeframe.

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

Croatia CFAA: Annex 1: Key persons interviewed 80

ANNEX I: KEY PERSONS INTERVIEWED (IN ALPHABETICAL ORDER)

Family name Given name Title/ function/department Institution

ANDRICEVIC Lana Assistant Budget Advisor US Department of Treasury

BERGMAN Vjeceslav Director Institute of Health Insurance

BLAZEKOVIC Katica Director of IT Support to Treasury

FINA

BOGNER Marijanka Head of Finance Department for Social Protection

Ministry of Social Welfare

BOLTAR Verica Director Varazdin Branch of FINA

BOWEN Martin Chief of Party USAID Fiscal Reform

BRKIC Vesna Economist Ministry of Finance

BRKIC Karmen Consultant USAID Fiscal Reform

CHETCUTI Frederic Team Leader EU CARDS project

CIZMOVIC Zaklina Head of Division for Development, Analysis and Statistical Infrastructure

Central Bureau of Statistics

CUJZEK Nevenka Head of Budget and Finance Department

County of Varazdin

CULJAK Ruzica Head of Analysis and Plan Unit

Institute of Health Insurance

CURKOVIC Vesna Assistant Head of Finance Department

City of Zagreb

DURIC Mario IT Senior Advisor Ministry of Finance

FAULEND Michael Advisor Croatian National Bank

FUTAC Sujeiane SAP/R3 Operator – IT Support

Ministry of Health and Social Welfare

GILJEVIC Vera Head of Accounting Division Ministry of Defense

GOLIK Marijana Head of Finance and Accounting Unit

Institute of Health Insurance

GRABOVAC Branka Head of Accounting for Public Debt and Cash Management Section

Ministry of Finance

GREGIC Zeljko Head of Budget Section Ministry of Defense

GRZUNOV Zeljko Assistant Minister Ministry of Sea, Tourism, Transport and Development

HEIKKINEN Ritva Sector Manager European Commission



HRUP Nevenka Audit Manager State Audit Office

HUZANIC Bozica SAP/R3 Operator – IT Support


IKSIC Amalija Assistant Minister for Budget Execution and Internal Audit and Control

Ministry of Finance

IVANDIC Vladimira Head of Section Ministry of Finance

JAMBRAC Josip Deputy County Governor Zagreb County Office

KARACIC Mladenka Head of State Accounting and Financial Reporting Division

Ministry of Finance

KEZELE Jerka Head of Department for Economic Affairs, Finances and Public revenues

City of Varazdin

KNEZEVIC Marela SAP/Treasury System operator

Ministry of Sea, Tourism, Transport and Development

KOJIC Slavko Member of the City Council and Head of Finance Department

City of Zagreb

KOKORIC Zeljko Project Manager B4B, SAP development

KORDIC Hrvoje Assistant Auditor General State Audit Office

KOTAVEC Sonja SAP/R3 Operator – IT Support


KULISIC Josip Assistant Minister for International Financial Institutions

Ministry of Finance

LANDSMAN Maja Director Croatian National Bank

LAUSIN Veronika Assistant Director Institute of Health Insurance

LINDSBAUER Ljerka Assistant Auditor General State Audit Office

LJUBICIC Milka Audit Manager State Audit Office

LUCIC Zorica Assistant of Minster Ministry of Finance

MALENICA Slavica Head of Section for Budget Supervision

Ministry of Finance

MAMIC Stipe Assistant Minister for Finance Ministry for Science, Education and Sport

MARIN Ana Head of Finance and Budget Department

Zagreb County Office

MARKOVIC Ljiljana Internal Revision Unit Central Bureau of Statistics

MARUSIC Jadranka Director Croatian National Bank



MATIJEVIC Katja Assistant Minister for Economic Affairs in Health


MEDIC Zdenka Sector Director, IT Support to Treasury

FINA

MISKOVIC Sara Head of Finance and Planning Division

Ministry of Justice

NIKOLIC-MUDRINIC

Vlasta Assistant Director of Legal, Finance, Accountancy and Central Administration


NØRREGAARD John Resident Representative IMF

NOVACIC Ivan Assistant Minister for Economic Affairs

Ministry of Finance

O’CALLAGHAN Garry Fiscal Advisor, Consultant US Treasury

PAP Jasenka Assistant Director Institute of Health Insurance

PERKOVIC Dijana Senior Adviser for Analysis Ministry of Defense

PERNAR Lidija Assistant Auditor General State Audit Office

POLHERT Sanja Cashless Payment Operations Department

Croatian National Bank

PRTENJACA Sime Member of the Sabor, Chairman of the Finance and Central Budget Committee

Croatian Parliament, the Sabor

PRUGOVECKI Gordan Head of Department Croatian National Bank

RAIC Niko Assistant Minister for Budget Preparation

Ministry of Finance

ROGIC Branko Deputy Head of Personnel Ministry of Defense

RUTH James Bennett Resident Budget Advisor US Department of Treasury

SABADZIJA Vito Head of the J8 Budget and Finance Division

Croatian Armed Forces

SABATI Zvonimir County Governor County of Varazdin

SALOPEK Vjera Deputy Head of Finance Department

City of Zagreb

SANTINI Ivona Consultant USAID Fiscal Reform

SARIC Sandra Audit Manager State Audit Office

SKRBINA Zeljka Senior Officer Croatian National Bank

SMUK Zdrana Head of Budget Division Ministry of Defense

SOKOLIC Snjezana Senior Inspector for Financial Matters of the General

Ministry of Defense


Family name Given name Title/ function/department Institution Inspectorate

SOSTARIC Tanja Senior Advisor Ministry of Finance

STARESINCIC Dijana Head of the Development Section

Ministry of Finance

STEGIC Marin Audit Manager State Audit Office

STOLNIK Vladimir Deputy County Governor County of Varazdin

SVIGIR Mario Advisor to Minister Ministry of Finance

TKALCIC Maja Head of Accounting and Finance Division


TORTIC Vesna Head of the M-4 Office of Assistant Minster for Finance and Budget

Ministry of Defense

VINCETIC Ivan Member of County Council responsible for Budget and Finances

County of Varazdin

VUCETIC Ivan Director FINA

VULETIC ANTIC Bozo Audit Manager State Audit Office

Croatia CFAA: Annex 2: Fiduciary Risk Indicators and Interpretation 84

ANNEX II. FIDUCIARY RISK INDICATORS AND INTERPRETATION

Indicator Score Guidance

BUDGETING

1. Aggregate fiscal deficit compared to original approved budget.

S L. In no more than one out of the last three years has the actual deficit exceeded the budgeted deficit by an amount equivalent to more than 2% of total budgeted expenditure, and in that one year the excess was less than 5 % of total budgeted expenditure. M. In no more than one out of the last three years has the actual deficit exceeded the budgeted deficit by an amount equivalent to more than 5 % of total budgeted expenditure. S. In no more than two of the last three years has the actual deficit exceeded the budgeted deficit by more than an amount equivalent to 5% of total budgeted expenditure. H. Meets neither L, M or S.


L L. The composition of expenditures is close to budget– an average of no more than 10 percent variance at administrative or functional level in at least two of the three years (excluding interest on debt), and no more than 10 percent variance on an economic basis in at least two of the last three years would indicate a composition close to budget. M. An average of no more than 15% variance at administrative or functional level in at least two of the three years (excluding interest on debt), and no more than 15% variance on an economic basis in at least two of the last three years. S. An average of no more than 20% variance at the administrative or functional level in at least two of the last three years (excluding interest on debt). H. An average of more than 20% variance at the administrative or functional level in at least two of the last three years (excluding interest on debt).


S L. The level of extra-budgetary activities of central government is not significant (below 1% of total spending). Alternatively, the level is somewhat higher (up to 10% of total spending) but fiscal reports include complete information on these expenditures. All major donor-funded expenditures on government activities are captured in annual budget documents. M. The level of extra-budgetary activities of central government is below 10% to total spending and some fiscal reports cover the majority of these expenditures; alternatively extra-budgetary activities may be as high as 15%, but fiscal reports provide complete information on these expenditures. The majority of donor-funded expenditures on government activities are captured in the annual budget documents. S. The level of extra-budgetary activities of central government is less than 10% of total spending, but fiscal reports provide limited or no information on these expenditures; alternatively, extra-budgetary activities are higher than 10% and the majority of these expenditures are reported. Some donor-funded expenditures on government activities are captured in annual budget documents.



H. The level of extra-budgetary activities of central government is more than 10% of total spending and fiscal reports provide limited or no information on these expenditures. Little or no donor-funded expenditures on government activities are captured in annual budget documents. Note: Overall the rating is considered significant.

4. Adequacy of information on fiscal projections, budget and out-turns provided in budget documentation

S L. Annual budget documentation includes complete information on debt and financial assets, some information on contingent liabilities, and comparable information on prior year out-turns and future year projections. M. Annual budget documentation includes information on the debt level and comparable information to the out-turn of the prior year. S. Annual budget documentation provides either information on the level of debt, or provides comparable information of the prior year. H. Annual budget documentation provides information on neither debt nor comparable information of the prior year.

5. Administrative, economic, functional and programmatic classification of the budget.

L The Budget and Budget expenditures are classified: L. On an administrative, economic, functional, programmatic basis. M. On an administrative, economic, and functional (to sub-functional level) or administrative, economic and programmatic basis S. On an administrative, economic and functional level (10 main COFOG functions) basis. H. On another basis.

6. Extent of multi-year perspective in fiscal planning, expenditure policy-making and budgeting.

M L. Multi-year aggregate fiscal forecasts and forward expenditure estimates (based on economic and sectoral breakdown) are prepared on a rolling annual basis, costed statements of national and major sector strategies exist, and there is a strong direction provided in the budget circular (or equivalent) regarding the multi-year forecasts to be adhered to in budget submissions. M. Multi-year aggregate fiscal forecasts and forward expenditure estimates (based on an economic breakdown) are prepared on a rolling annual basis, statements of national strategy and sectoral strategy exist, and the budget circular (or equivalent) makes a link between the annual and multi-year forecasts and the national strategy. S. Multi-year aggregate fiscal forecasts are updated annually but no forward estimates of expenditure other than at the aggregate level, a statement of national strategy exists, and there is reference to the multi-year fiscal forecasts in the budget circular (or equivalent). Alternatively, fiscal forecasts cover the budget year only but the budget circular makes clear reference to national strategy. H. The fiscal forecasts cover the budget year only. No linkage is made between the annual budget and national strategy in the budget circular.

7. Orderliness and participation in the

S L. Spending ministries are given clear guidance for the preparation of budget submissions, including indicative ceilings that are informed by specific agreement at the political level on the relative spending priorities across sectors. Ministries adhere to the



annual budget process.

budget calendar and are generally able to fulfill the requirements of the budget calendar, including ceilings and data submissions. Negotiations with ministry of finance are open and transparent; line ministries know their final allocation at the conclusion of such negotiations. M. Spending ministries are given clear guidance for the preparation of budget submissions, and indicative ceilings are informed by general guidance from the political level concerning relative spending priorities. Ministries adhere to the budget calendar and circular requirements in most cases. Negotiations between ministry of finance and line ministries are rather opaque, and there may be a delay in line ministries learning the outcome of negotiations. S. There are occasional delays in the budget calendar and budget submissions from line ministries may be incomplete or lack the detail requested by ministry of finance. The political level is involved in reviewing and approving the estimates only after they have been prepared by ministry of finance, thereby constraining their ability to make adjustments. Budget conferences between ministry of finance and line ministries are highly restricted, with final outcomes reflecting the will of ministry of finance. H. Although a budget calendar and budget instructions may exist, they are generally not adhered to. Budget submissions are often late and if indicative ceilings are given, they are normally exceeded by line ministries. The political leadership generally only gets involved prior to the budget being submitted to the legislature, at which time little opportunity for adjustment exists. Ministry of finance prepares the budget with little input from line ministries, and the latter may only learn of their budget allocations when the budget is submitted to the legislature.

8. Legislative scrutiny of the annual budget law.

M L. I. Legislative scrutiny is comprehensive, well-informed by summary and detailed information, and involves in-depth review by specialized committee. II. The budget is passed before the financial year commences. M. I. Legislative scrutiny covers aggregates and detailed estimates of expenditure and revenue, is informed by user-friendly information, and involves some review by specialized committees. II. The budget is generally passed before the financial year commences. S. I. Legislative scrutiny covers the details of expenditure and revenue, only budget estimates are provided, some procedures exist and are partially followed. II. The budget is generally passed within two months of the start of the financial year. H. I. Legislative scrutiny is extremely limited and procedures are generally not followed. II. The budget is not generally passed within two months of the start of the financial year.

TREASURY AND CASH MANAGEMENT

9. Single Treasury Account

M L. A single treasury account is in place, through which all payments from the state budget are made either directly or via sub-accounts in the central bank. All current expenditure accounts owned by state budget institutions are zero-balance and cleared daily. M. The Ministry of Finance does have a single treasury account with the central bank though a small proportion of state budget



funds are managed outside the single treasury account and its sub-accounts in the central bank. The are some idle balances in these accounts. S. Whereas the Ministry of Finance does have its main account in the central bank, a significant number of state budget institutions have their current expenditure accounts in other accounts outside the central bank. There are significant idle balances in the accounts of state budget institutions. H. The major part of state budget funds are managed outside the central bank account of the Ministry of Finance.

10. Stock of expenditure arrears; little accumulation of new arrears over past year.

S L. There are very few or no expenditure arrears. M. There is a stock of some expenditure arrears (up to 5% of total expenditure), the accumulation of new arrears is low and the net stock level declined in the last year. S. It is estimated that there is a significant stock of expenditure arrears (5%-10% of total expenditure), though the information available may be incomplete. The accumulation of new arrears slowed down in the last year. This score will also apply if the estimated expenditure arrears are between 10% and 15%, but there has been a significant reduction in the level in the last year, and the accumulation of new arrears has slowed down in the last year. H. It is estimated that the stock of expenditure arrears exceed 10% of total expenditures, and/or no information on arrears is available. The stock of arrears has not been reduced significantly, and/or the accumulation of new arrears is continuing at a significant rate. Note: Based on data for 1999 and 2000.

11. Effectiveness of cash flow planning, management and monitoring.

S L. There is daily calculation and consolidation of all the government’s cash balances. Forecasts of all cash inflows and outflows are prepared for the fiscal year and updated monthly, based on revenue forecasts and budget implementation and procurement plans. Borrowing is planned on the basis of cash flow forecasts. M. There is daily calculation and consolidation of government cash balances, though some transactions such as those from extra-budgetary funds may remain outside the cash planning and consolidation arrangements. Cash flow forecasts are prepared for the fiscal year and updated monthly. S. The calculation of most government cash balances takes place regularly, though some accounts are not included in the cash planning arrangements. The system used does not allow for daily consolidation of bank accounts. Cash flow forecasts are updated periodically. H. The calculation of cash balances takes place irregularly, or cash flow planning is not undertaken.

12. Procedures in operation for the management and recording of debt and

S L. Domestic and foreign debt records are maintained on a single computerized debt management system and produce comprehensive reports for government routinely. Debt sustainability analysis is undertaken regularly. The issue of government guarantees is made against transparent criteria and fiscal targets, and approved by the ministry of finance. M. Regular reports on domestic and foreign debt are recorded on computerized debt management systems, or, in cases where



guarantees.

debt levels are low, using spreadsheet records which have been demonstrated to be accurate and robust. These produce regular reports. Debt sustainability analysis is undertaken from time to time. All guarantees are approved by the ministry of finance, and a limit is placed on the total that may be issued. S. Spreadsheet or manual records are maintained on debt, and reports on debt stock and service are prepared periodically. Debt sustainability is undertaken only infrequently. Some guarantees may be issued without ministry of finance approval. H. Debt records are incomplete or inaccurate to a significant degree. Government guarantees are issued on an ad hoc basis in an opaque manner. Note: Overall the fiduciary risk is deemed to be significant.

13. Extent to which spending ministries and agencies are able to plan and commit expenditures in accordance with original/revised budgets.

S L. Spending ministries and agencies are able to commit expenditures (eg. sign contracts with contractors and suppliers) in an orderly manner throughout the year, broadly in accordance with cash flow forecasts (agreed with finance ministry) and with the budget. Adjustment to the allocations takes place only once during the year and is done in a predictable, transparent way. M. Spending ministries and agencies have reliable information about the resources available/to be provided for a given quarter, and adjustments to budget allocations are transparent and occur only a limited number of times each year. S. Spending ministries and agencies have reliable information about the resources available/to be provided for a given quarter or more, but adjustments are not undertaken in a systematic and transparent manner. Alternatively, spending ministries and agencies have reliable information about the resources available/ to be provided for a given month, and the variation in the non-salary resources available to individual line ministries on a month-to- month basis is limited. H. Spending ministries and agencies have information about resources available for a month or less, and there is significant variation in the non-salary resources available to individual line ministries on a month-to-month basis.

ACCOUNTING AND FINANCIAL REPORTING

14. Computerized accounting systems

M L. All or close to all budgetary organizations use modern computerized accounting systems. M. More than half of budgetary organizations use modern computerized accounting systems, whereas the rest typically rely on old (e.g. DOS based) accounting systems or spreadsheets. S. Less than half of budgetary organizations use modern computerized accounting systems, whereas the rest rely on old accounting systems, spreadsheet or manual records. H. Less than 10% of budgetary organizations use modern computerized accounting systems, whereas the rest rely on old accounting systems, spreadsheet or manual records.

15. Audit trail documentation

H L. All or close to all budgetary organizations have electronically and readily available audit trail documentation for all major types of revenues and expenditure. M. More than half of budgetary organizations have electronically and readily available audit trail documentation for the most significant types of revenues and expenditure. S. Less than half of budgetary organization have electronically and readily available audit trail documentation for the most significant types of revenues and expenditure. H. Less than 10% of budgetary organizations have electronically and readily available audit trail documentation for the most



significant types of revenues and expenditure. 16. Timeliness and regularity of data reconciliation.

S L. High quality bank reconciliation is undertaken at aggregated and detailed levels at least monthly, with very little backlog. Suspense accounts are routinely reconciled and cleared quarterly, and advances accounts are reconciled quarterly. Few suspense and advance accounts have old, brought-forward balances. M. High quality bank reconciliation is undertaken monthly for bank accounts through which revenues are collected and expenditures made, with no major backlog. There is no major backlog in the annual reconciliation of suspense and advances accounts, and in the annual clearing of the suspense account balances. There are old, brought-forward balances in some suspense and advances accounts. S. Bank reconciliation is undertaken quarterly for bank accounts through which revenues are collected and expenditures made, with no major backlog. Not all differences are explained. Reconciliation of suspense and advances accounts generally takes place annually, though there are a significant number of accounts with old, brought-forward balances. H. There is a major backlog in quarterly bank reconciliation, and in annual reconciliation of suspense and advances. Note: For expenditures reconciliation is generally only done at ministerial level. Revenues are collected by FINA which also provide reliable transactions data for reconciliation. Note: Overall the rating is considered significant

17. Timeliness, quality and dissemination of in-year budget reports.

S L. Budget reports, with classification that allows direct comparison to the budget and which incorporate expenditure, revenue and debt information, are disseminated within government within four weeks of month and quarter end. There are no material concerns about the quality of the information. M. Budget reports, with classification that allows comparison to the budget at some levels and which incorporate expenditure and revenue information, are disseminated within government within four weeks of quarter end. Where there is some information that is lacking this is recognized and adequately reflected in the reports, and there may be some limited concerns about accuracy, but these shortcomings do not fundamentally compromise the overall consistency and usefulness of the reports. S. Budget reports are prepared within six weeks of quarter end, but major gaps exist in the information and the manner of compilation allows for a significant level of inaccuracy. Dissemination to line ministries is limited. H. Budget reports are not prepared within six weeks of the quarter end. Note: Budget implementation reports are produced by budget users monthly but expenditure data is suspect.

18. Timeliness and quality of audited financial statements submitted to the legislature

S L. The complete set of financial statements, certified by the external auditor, are presented to the legislature within 12 months of the year end. The financial statements are presented in accordance with IPSASs, GFS or an acceptable national standard. M. A complete set of financial statements were presented to the legislature within 12 months of year end. The financial statements are presented in accordance with IPSASs, GFS or an acceptable national standard. S. Financial statements were presented to the legislature within 12 months of year end. The financial statements are presented in a consistent manner over time and there is some disclosure of accounting policies applied. H. Financial statements were not to the legislature within twelve months of year end. Note: The set of financial statements was submitted for the first time for fiscal year 2002. In was recevied within the following year but was incomplete and significant delayed compared to the ambitious statutory calendar. Overall fiduciary risk is considered significant.

CFAA: Annex 2: Fiduciary Risk Indicators and Interpretation 90


INTERNAL CONTROL AND INTERNAL AUDIT

19. Corruption perception86

S L. The country is ranked among the top 15% in the Transparency International Corruption Perception Index. M. The country is ranked among the top 33% in the Transparency International Corruption Perception Index. S. The country is ranked between the top 33% and 66% in the Transparency International Corruption Perception Index. H. The country is ranked in the bottom 33% of the Transparency International Corruption Perception Index.

20. Written procedures S L. All or close to all budgetary organizations apply a set of comprehensive written procedures for internal control, including internal audit. M. More than half of budgetary organizations apply a comprehensive set of written procedures for internal control, including internal audit. S. Between 10-50% of budgetary organizations apply a comprehensive set of written procedures for internal control, including internal audit. H. Less than 10% of budgetary organizations apply comprehensive written procedures for internal control, including internal audit.

21. Effectiveness of internal controls

S L. The internal control system is relevant, incorporates a comprehensive and generally cost effective set of controls which are widely understood, the rate at which rules are not complied with is very low (no more that 3% error rate in routine financial procedures, as demonstrated by audit), the controls are only rarely bypassed, and top management takes clear and full responsibility for the effective operation of the system. M. The internal control system has a comprehensive set of controls, which are generally understood and which audit indicates are complied with (no more than 5% error rate in routine financial procedures). Emergency procedures are utilized on occasion, but in a deliberate and controlled manner. S. The internal control system consists of a basic set of rules for the processing and recording of transactions, which are well understood by those directly involved in their application, and which audit indicates are observed in a significant majority of transactions. Emergency procedures are utilized in non-emergency situations from time to time. H. The core set of rules are not complied with on a routine and widespread basis due to direct breach of rules or routine use of emergency procedures.

22. The effectiveness of internal audit

H L. An effective internal audit (or systems monitoring) function is in operation. M. The internal audit (or systems monitoring) function is in operation, and provides regular reports to top management on systemic issues that are widely disseminated. Its mandate and access may not fully meet professional standards.

86 Ranking 1-20 is defined as Low fiduciary risk; Ranking 21-45 is defined as Moderate fiduciary risk; Rank 46-88 is defined as Significant fiduciary risk; Rank 88-133 is defined as High fiduciary risk.

Croatia

CFAA: Annex 2: Fiduciary Risk Indicators and Interpretation 91


S. The internal audit (or systems monitoring) function exists and undertakes some systems review. Reports are often not disseminated and little evidence is available of follow up action by management. H. There is little or no internal audit or systems monitoring.

EXTERNAL AUDIT AND PARLIAMENTARY OVERSIGHT

23. The scope and nature of external audit.

M L. The external audit is adequately empowered, covers all major entities in the public sector and the full range of financial audit, focuses on significant and systemic issues in its reports, and generally adheres to auditing standards. M. All central government expenditures and revenues are covered by the external audit. Audit work includes assessment of internal control systems, and reports identify systemic issues as well as irregular transactions. S. 80% or more of central government expenditures are covered by the external audit. The external auditor has authority to obtain information and reports identify significant issues. Audit work is predominantly transaction level testing. H. Less than 80% of central government expenditures are covered by external audit, and/or external audit has very weak authority and so is unable to obtain the basic information required. Note: Data on actual coverage is not available, but the fact that no audit opinion has ever been issued on the content of the government financial statements may point to significantly insufficient coverage.

24. Follow up of audit reports by the executive or audited entity.

M L. There is evidence of effective follow up being taken to audit findings, in a timely manner. M. There is a formal response to audit findings, provided in a timely manner, but the follow up is not taken systematically. S. There is a formal response to audit findings, though delayed. Little follow up takes place. H. These is little evidence of response or follow up taken to audit findings. Note: There is insufficient data on overall timeliness of response.

25. Legislative scrutiny of external audit reports.

M L. A committee examines the external audit reports and completes in-depth hearings on key findings within one year of the report’s issue and within two years of the end of the relevant period. Follow up actions are recommended to the executive, and are generally acted upon. M. A committee examines the external audit reports and completes hearings within 18 months of the report’s issue, and within three years of the end of the relevant period. Follow up actions are recommended to the executive, some of which are acted upon. S. A committee examines the external audit reports but this is not completed within 30 months of the report’s issue. Follow up actions may be recommended but are rarely acted upon. H. There has been no examination of the external audit reports within the last three years, or the examinations are for periods ended 5 years or earlier.

Croatia

Croatia CFAA: Annex 3: Overall Assessment of Fiduciary Risk 92

ANNEX III. OVERALL ASSESSMENT OF FIDUCIARY RISK

The fiduciary risk within an individual PFM area, such as Budgeting, is calculated as a simple average of the rating of each indicator presented in Annex II and in the table below. The overall risk rating for the entire PFM system is also calculated as a simple average of the ratings assigned to the individual PFM components. This is summarized in the table below.

It should be emphasized that whereas the fiduciary risk ratings can be used for the purpose of comparison and benchmarking it does provide quantitative information about the probabilities of funds not being spent for the intended purposes.

PFM component Risk indicators Indicator

Risk87PFM component risk

1. Aggregate fiscal deficit compared to original budget.

Significant


Low


Significant

4. Adequacy of information on fiscal projections, budget and outturns provided in budget documentation.

Significant

5. Administrative, economic, functional and programmatic classification of the budget.

Low

6. Extent of multi-year perspective in fiscal planning, expenditure policy-making and budgeting

Moderate

7. Orderliness and participation in the annual budget process.

Significant

Budgeting

8. Legislative scrutiny of the annual budget law.

Moderate

Moderate

9. Single Treasury Account. Moderate 10. Stock of expenditure arrears. Significant 11. Effectiveness of cash flow planning, management and monitoring.

Significant

Treasury & cash management

12. Procedures in operation for the management and recording of debt and guarantees.

Significant

Significant

87 For explanation and interpretation see Annex II

Croatia CFAA: Annex 3: Overall Assessment of Fiduciary Risk 93

PFM component Risk indicators Indicator Risk87

PFM component risk

13 Extent to which spending ministries and agencies are able to plan and commit expenditures in accordance with original/revised budgets.

Significant

14. Computerized accounting systems Moderate 15. Audit trail documentation High 16. Timeliness and regularity of data reconciliation.

Significant

17. Timeliness, quality and dissemination of in-year budget reports.

Significant

Accounting & financial reporting

18. Timeliness and quality of audited financial statements submitted to the legislature

Significant

Significant

19. Corruption perception index ranking Significant 20. Written procedures Significant

Significant

21. Effectiveness of internal controls Significant

Internal control & internal audit

22. The effectiveness of internal audit High

23. The scope and nature of external audit. Moderate 24. Follow up of audit reports by the executive or audited entity.

Moderate External audit & legislative oversight

25. Legislative scrutiny of external audit reports

Moderate

Moderate

The above as applied to sub-national government

Significant Significant88Sub-National Government Overall Assessment of Fiduciary Risk

Significant

88 As summarized in section III, Chapter 8.

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