Report No. 31345-UZ Uzbekistan Country Financial Accountability Assessment October 19, 2004 Operations Policy and Services Europe and Central Asia Region Document of the World Bank TABLE CONTENTS OF PREFACE ............................................................................................................................................................... i EXECUTIVE SUMMARY .................................................................................................................................. iv I COUNTRY'BACKGROUND . .......................................................................................................................... 1 GOVERNINGSTRUCTURES....................................................................................... ......................... 1 ECONOMICBACKGROUNDAND PROSPECTS...................... .......... ...... 1 RELATIONSHIP OF THE CFAA. LESDING PROGRAMAND P IES 2 I1 PUBLIC SECTORBUDGET MANAGEMENT..................................................... . LOGUE 4 INTRODUCTION .................................................................................................................................................... 4 PRINCIPLESAND RISKS ........................................................................................................................................ 4 THESCOPE OF THE BUDGET ................................................................................................................................. 5 THEBUDGET PREPARATIONPROCESS................................................................................................................... 6 TRANSPARENCY ACCOUNTABILITY ASPECTS OFTHE BUDGET PROCESS......................................................... AND 6 BUDGET EXECUTIOSAND CASH MANAGEMENT ISSUES . RECENT AND PROPOSE MAINRECOMMENDAT Short term (within ......................................................................................................................... 9 I11 EXTRA BUDGETARY FUNDS....................................................................................... .Medium term (one to threeyears) ............................................................................................................... 10 11 INTRODUCTION . .................................. Budget and cash management issues Governance issues MAERECOMMENDAT Short term (within I V PUBLIC SECTORACCOUNTING AND FISCAL REPORTING.......16 .Medium term (one ............................................................................................................... 14 INTRODUCTION .................................................................................................................................................. 16 Budget Reporting ........................................................................................................................................ 18 MAINRECOM~ENDATIO~S ................................................................................................................................ 19 Short term (within oneyear) ....................................................................................................................... 19 Medium term (one to threeyears) . 19 Long term (over three years) 19 V SELECTED REVENUE ADMINISTRATION ISSUES.................................. . 21 INTRODUCTION .................................................................................................................................................. 21 ORGANIZATIONAL STRUCTURE OF TAX ADMrrl'lSTRATION ................................................................................. 22 ACCOUNTING, REPORTINGAND CONTROL OF REVENUES ................................................................................... 23 MAINRECOMMENDATIONS ................................................................................................................................ 24 Short term (within oneyear) ....................................................................................................................... 24 V I INTERNAL CONTROLS AND INTERNAL AUDIT..................................... . Medium term (one to three years) .............................................................................................................. 24 25 INTRODUCTION ... ...... 25 CURRENT SYSTEMSOF INTERh'AL CONTROL INUZBEKISTAN 26 TOWARDS IMPROVED REGIMEOF INT AN ................................... 26 bKKlVTIONAL ARRANGEMENTS FOR FIN OF THE CONTROL AND 27 Introduction................................................................................................................................................. 27 The Control and Revision Unit of the Ministy ofFinance (CRU).............................................................. 28 Towards a modern internal auditfunction .................................................................................................. 29 M A I NRECOMMENDATIONS ............................................................................................................................... 30 Short term (within oneyear) ....................................................................................................................... 30 Medium(one to three years) ........................................................... ....... ................................ 30 31 VI1 EXTERNAL AUDIT............................................................................................................... . Long term (over three years) ....................................................................................................................... 32 INTRODUCTIOS PROGRESS ON T MAINRECOMM ...................... ............................................................................................ 33 Medium term (one to threeyears) ............................................................................................................... 34 VI11 PUBLIC ENTERPRISES.................................................................................................. Long term (over three years) ....................................................................................................................... . 34 35 INTRODUCTION GOVERNANCE PUBLIC ENTERPRISES OF MAINRECOMMENDATIONS.................. ....................................... Long term (over threeyears) ....................................................................................................................... 38 I X FINANCIAL MANAGEMENTARRANGEMENTS INBANK- . FUNDEDPROJECTS........................................................................................................................ 40 I~TRODUCTION .................................................................................................................................................. 40 FINANCIALMANAGEMENT ARRANGEMENTS ..................................................................................................... 40 Institutional arrangements 40 Financial Management 41 TOWARDS MAPSTREAMIN INANCIAL MANAGEMENT 42 ANNEX I: Development Action Matrix ............................................................................................................ 43 ANNEX I1 - International Standards and Codes .............................................................................................. 50 ANNEX 111:List o f Extra-Budgetary Funds .................................................................................................. 51 ANNEX IV: Overview Of Governance Arrangements - Major Extra Budgetary Funds ............................ 53 TABLES Table 1: World Bank Lending to Uzbekistan ($ Millions) ............................................................................... 2 Table 2: Extra-budgetary fund spending 1999-2004 (Billion Soums) ............................................................ 12 Table 3: Revenues of the State Budget of Uzbekistan(Million soums) 22 Table 4: Standards and Codes Promoting Financial Accountability ............................................................. .......................................................... 50 BOXES Box 1:Budget Management . InstitutionalIssues. Messagesfrom the World Bank Public Expenditure Review, 2004 (PER) ......................................................................................................................... Key 5 Box 2: Improving Financial management of Extra-budgetary funds ............................................................. 14 Box 3: Key weaknesses of the government accounting system and their impact on reporting and decision making 17 Box 4: Proposed development of government accounting standards ..................................................... 18 Box 5: InstitutionalArrangements for Tax Policy and Administration in Uzbekistan 23 Box 6: The Control and Revision Unit (CRU) of STC ..................................................................................... ................................. 24 Box 7: Three main features of a modern internal control systems ................................................................. 25 Box 8: Important reforms to improve public sector internal controls ............................................................ 27 Box 9: The Control and Revision Unit of the Ministry of Finance (CRU) ..................................................... 29 PREFACE This report was prepared after missions to Uzbekistan in 2003 and 2004 by a Task Team comprising Andrew Mackie (Task Team Leader, ECSPS), John Ogallo (Senior Financial Management Specialist, ECSPS), Andy Macdonald (Public Sector Consultant) and Nurmukhammad Yusupov (Consultant). This report is based on the results o f interviews and discussions with various public sector institutions as well as an analysis o f data gathered during the mission including copies o f relevant legislation, instructions and reports. Many Government counterparts lent their support to the CFAA Mission and engaged in the dialogue. The Bank i s grateful for this cooperation. Objectives of the CFAA The overall objectives o f the Uzbekistan CFAA are to (i) the government strengthen its help public sector financial accountability arrangements; (ii)identify and document the most significant fiduciary risks' in the Government public financial management systems (PFM); (iii)document the existingprogram o f reforms and capacity buildingto improve transparency and accountability aspects o f the PFM, making additional recommendations for capacity building,ifnecessary. This is the first CFAA preparedby the Bank inUzbekistan. Its timing is particularly relevant in the context of a period drastic fiscal adjustment and an increased focus on the efficiency and effectiveness o f public spending. Changes to the constitution and budgetary reforms are being undertaken by the Government, with support from the donor community. The public financial management framework in Uzbekistan i s still evolving, and improvements are required in many o f its components. The CFAA provides an analysis o f current issues, focusing on practical, realistic and sequenced improvements in the country's PFM systems, taking into account the considerable capacity constraints in Uzbekistan. In this sense the CFAA i s primarily a forward looking assessment rather than a diagnostic o f existing problems, which have already been extensively documented inprevious reports. Since borrower countries often look for benchmarks against which their systems can be measured, this report contains clear references to those internationally accepted standards and codes which inform the most essential financial management tasks, such as budgeting, accounting, internal control, internal audit and extemal audit. Inlow capacity countries such as Uzbekistan many o f these standards should be seen as longer term goals which have be used to frame legislative reform and capacity buildinginitiatives, rather than benchmarks for the assessment o f current PFM systems. A preliminary list o f international standards and codes i s contained inAnnex I1to this Report as a reference document. Experience from other countries has shown that, to be successful, reforms to the institutions and mechanisms o f financial accountability should not been seen as an end inthemselves but rather as part o f broader economic, political, and fiscal reforms within government. Therefore, one o f the other objectives o f the Uzbekistan CFAA has been to explain the rationale for reform in a way which encourages broad dissemination beyond technical ' The fiduciary riski s the risk of funds not beingspent for the purposes for which they havebeen appropriated. .. Uzbekisfan: Counfw Financial AccountabUity Assessment 11 financial specialists within the Government. The CFAA complements two other pieces o f Bank diagnostic work; the Country Procurement Assessment Report (CPAR) which was completed in 2003 and a Public Expenditure Review (PER) which i s being prepared in parallel with the CFAA. Approach The core content o f the CFAA i s listed below. Where possible the CFAA documents rather than duplicates analytical work camed out by the Bank and the rest o f the donor community. Where a particular item i s being addressed by another initiative, that donor i s identified. Public sector budgeting [IMF, WB, USAID, U S Treasury, EUTACIS] - scope o f the budget (including the treatment o f extra-budgetary funds); - transparency and accountability aspects o f the budget process; - budget execution and cash management. Selected revenue issues [CFAA] Public sector accounting and reporting [IMF, WB PFMP, CFAA] Internal controls and internal audit [CFAA] External audit and parliamentary oversight [CFAA] Public enterprises [AsDB] -- monitoring and oversight governance, financial reporting and audit Arrangements for managing the proceeds o f Bank lending [CFAA] Duringthe scoping mission it was recognized that the CFAA Team would be able to conduct a desk review o f much o f the budget function and place reliance on previous diagnostic work and working closely with World Bank staff conducting the Public Expenditure Review (PER) and the Public Financial Management Reform Project (PFMR). Beyond the consolidated state budget the government o f Uzbekistan carries out significant amounts o f resource redistribution through extra-budgetary accounts and funds, lending policies and public guarantees. Given the orientation o f the CFAA and the overall materiality o f the amounts involved, the Team focused considerable attention on the scope o f the budget entity, accountability and transparency aspects o f extra-budgetary funds and public enterprises. Accounting, internal controls/internal audit and external audit are specific areas which have not received much attention in previous diagnostic reviews and have therefore been analyzed insupport o fthe Government's treasury and constitutional reforms. Public procurement has been covered extensively in the March 2003 Country Procurement Assessment Report (CPAR). In summary, the report noted that the legislative framework, institutions and enforcement regime for public procurement are under developed. Overall the CPAR gave the procurement environment a high-risk rating. The key findings o f direct relevance to the CFAA are (i) that both internal and external controls over procurement are inadequate; (ii) procurement-related corruption i s a threat to public expenditure and; (iii) the private sector has little faith in the fairness o f public tenders. The CPAR also recommended that internal and external audit controls over procurement should be strengthened. ... Uzbekistan: Country Financial Accountabilifv Assessmenf 111 The assistance provided by donors supports Government's efforts to establish modern financial institutions and develop staff skills and capabilities to enable it to manage its own affairs. The CFAA identifies those initiatives already underway, assesses the Government's progress in each area and comments on their future plans. Where additional actions are recommended these are presented in a Development Action Matrix (see Annex I), which identify a series o f proposals highlight (i) legislative reforms, (ii) institutional arrangements, (iii) resourceandcapacitybuildingand(iv)suggestedtiming(short, mediumorlong human term) o f implementation o f the proposed action. Acknowledgements The C F A A team wishes to acknowledge the extensive and grateful cooperation and assistance received from staff in the various institutions who contributed to the CFAA, including officials and staff o f the Government, state agencies and enterprises, and bi-lateral and multilateral organizations. Grateful thanks also go to the Bank's Public Expenditure Review and Public Financial Reform Project task team, particularly Ritu Anand and Roland Clarke. In addition Martin Raiser (Uzbekistan Country Manager) and Bakhtior Abdullaev (Uzbekistan Country Officer) provided invaluable in-country assistance and information. John Hegarty (Manager, Financial Management, ECA), Pascale de Kervyn Lettenhove (ECSPS) and peer reviewers, Dimitar Radev (IMF), Roland Clarke (ECSPE) and Hisham Ahmed Waly (MCACS) offered much appreciated comments and inputs. Uzbekistan: CFAA Executive Summaw iv EXECUTIVESUMMARY Introduction Since declaring its independence in August 1991 Uzbekistan has taken a markedly different course from most Commonwealth o f Independent States (CIS) countries by following a gradual transition to a market economy and adopting a development strategy aimed at accelerated industrialization. While taking initial steps to the transition to a market-based economy, the State has retained the levers o f control over the reform process and an extensive role inthe economy. Inthe past five years Uzbekistan has faced a drastic fiscal adjustment following a decline in budget revenues. The aggregate level o f government spending has come down, extra- budgetary funds have been reduced and streamlined somewhat, and redistribution through quasi-fiscal operations has decreased. General government expenditures, including those financed by government guaranteed borrowing, have come down by over 11 percentage points o f GDP since 1998. The outlook i s for public resources to become scarcer as the reforms progress further. It i s vital that the Government focus o n the effectiveness o f public spending and minimize and inefficiencies. There are a number o f elements on which the Government could build improvements to the framework o f public accountability. A new Constitution has been passed and a bi-cameral parliamentary system began operations in January 2005. Major reforms to the health and education sector have begun. Elements o f the budget process are already being addressed through the development o f revised budget preparation procedures and the introduction o f a treasury system. These reforms require fundamental changes to the institutions o f government and to the attitudes o f public servants. Policy making functions o f spending ministries need to be developed and accountability for policy and spending decisions needs to be clarified. Management in budgetary institutions needs new tools and institutions to establish, maintain and be held accountable for the internal control environment. This Report has been prepared with the overriding goal of helping the government in their efforts towards strengthening control and accountability and supporting greater efficiency o f public spending. The Report examines all areas o f public sector accountability, including accountability and transparency aspects o f the budget, accounting and external financial reporting, revenue management, the internal control environment, internal and external audit and governance o f public enterprises. The goal has been to present a fonvard-looking analysis o f current issues, focusing o n practical, realistic and sequenced improvements in the Country's public financial management systems. The recommendations have taken into account the considerable capacity constraints in Uzbekistan and the limited history o f reform inan environment markedby severe deficiencies intransparency and accountability. Ultimately, technical improvements in financial management will only be successful if they are supported by overarching institutional, economic and political reforms. Good financial management practices underlie government's accountability to its citizens through a transparent, efficient and effective use o f public funds: Uzbekistan CFAA: Executive Summary V The key analysis and recommendations for establishing a sound financial accountability framework are described inthe following paragraphs: Public sector budget management Budget management processes in Uzbekistan create considerable risks to the Government. The first risk i s a policy risk; it i s the risk that policies passed by Parliament are not implemented through the budget. The second risk, a budget and financial management risk, i s the possibility that funds are not spent according to their intended use. This risk i s compounded by a large share (about 25 percent) o f off-budget resources not subject to budget scrutiny. In Uzbekistan, the policy risk is signiJicant owing to process and institutional breakdowns between policies and budgeting. The greatest challenge in the reform o f Uzbekistan's public finances i s to make the transition from institutions inherited from the centrally planned economy, to ones in which policy making i s linked to budgeting. M u c h o f the reform process requires fundamental changes, largely outside and beyond the Ministry o f Finance. First, the Government should clarify the long term role o f the public sector in the economy, with a view to accelerating the transition towards a market-based economy supported by transparent and accountable public institutions. While economic and sector policies are developed, institutions should be established at the center o f government to coordinate strategic policy choices. Spending ministries should be reorganized along functional lines and include under them many o f the state institutions which deal directly with the MOF. N e w budgeting processes and the establishment o f the Treasury, will o f course require work within the MOF. However, until now budget reform has largely been centered around technical developments within the MOF. One o f the main tasks for the MOF is to make the case to the Government and public institutions for the need for reforms and the long term benefits that will ensue. There is also a high risk that funds may not be used for their intended purposes, as the budget lacks comprehensiveness and limited budget information prohibits meaninaful budget scrutiny. The present budget is not comprehensive, and the budget process i s fragmented. Extra-budgetary funds account for one quarter of state budget expenditure and are not subject to the same scrutiny as the budget. In addition, the formulation o f investment budget i s a separate process; there i s no mechanism for consideration o f the impact o f future recurrent costs in evaluating new investments, nor i s there a mechanism for debt recording o f externally financed investments. The C F A A recommends that no new extra-budgetary funds be created and that existing funds should be subject to the same rules for budget preparation, review and audit as the budget. In addition, the process for recurrent and investment budget preparation should be merged with due consideration o f recurrent costs and debt impact in later years. The transparency o f budget documentation also needs to be significantly improved. The present budget classification i s rudimentary and insufficient to analyze the development o f policy or serve as a basis to hold spending units accountable through budget execution. Transparency and accountability would be enhanced by the publication o f budget documentation which includes the budget, macroeconomic forecasts and an explanation o f the main budgetary measures. InUzbekistan, the presentbudget execution arrangements are inefficient and non-transparent; exposing the government to the risk (a) that payments are not made in accordance with the Uzbekisfan CFAA: Executive Summary vi budget, (b) that payments are not made on a timely basis and distort the implementation o f government activities and (c) that finance officials have insufficient information to make the most effective and efficient use o f cash. Disbursement takes place through numerous government bank accounts held in commercial banks. This makes budget implementation difficult to monitor and liquidity impossible to manage. Numerous extra-budgetary accounts fbrther weaken liquidity management, budget execution monitoring and control. These problems are recognized by MOF who has begun work on the introduction o f a treasury system with the support o f the IMF and World Bank. The establishment o f the Treasury requires a major institutional reorganization o f MOF and considerable capacity building in the finance function across all areas o f government. Public sector accounting Uzbekistan's public sector accounting traditions were inherited from the Soviet Union; where budget reporting was merely a financial reflection o f detailed production plans. Developing a modem accounting system and financial reporting system will protect and manage public money and discharge accountability. The government has a large number o f bookkeepers who are familiar with double entry, accrual based accountingbut who are reliant on manual systems and will need training on modem financial accounting and reporting. As part o f the treasury reforms the Government has developed a well thought-out development plan for the phased introduction o f accounting reforms based on International Public Sector Accounting Standards (IPSAS). The Report recommends that training on public sector accounting begins immediately and cautions against ambitions running ahead o f available capacity. Specifically, accruals accounting should remain a long term goal once the government has successfully implementedand reported in compliance with the cash basis o f accounting. Revenue administration issues As regards the revenue collection agencies the Report notes the Government's investmentin management information systems and efforts to improve the quality o f reporting between collection agencies and MOF. However, the Government still faces a major challenge o f enforcing tax policy without stifling the development o f legitimate economic activity. The complexities o f the current tax policy may discourage compliance. The CFAA also echoes previous reports in recommending that the commercial banking sector stops acting as a de- facto tax enforcement agency. The Report also recommends that the Government pass a proposed amendment to the Tax Code restricting access to taxpayers' banking information. Internal control and internal audit In common with other transition economies in the region concepts of internal control and internal audit are not well understood. The present fragmented execution system (discussed above) results in a loss o f budgetary control which can be addressed, in part through the reform o f treasury systems. Long term reforms to institutions which monitor and control the budgetary process are also required.The present approach o f the Control and Revision Unit o f MOF (CRU) focuses on top-down controls over compliance which do nothing to support managers in budgetary institutions establish, maintain and be held accountable for the internal control environment. The Report proposes a phased approachto reform which builds capacity intandem with the on-going treasury reforms and prepares CRU for a long term role as a modem internal audit department within Government. Uzbekistan CFAA: Executive Summary vii External audit Effective external audit provides an independent assessment that the overall objectives set by Parliament and government have been reflected in the budget, scrutinizes the overall quality o f public expenditure, and management o f public assets and liabilities. To date limited progress has been made on the development o f an independent public sector external audit function in Uzbekistan. The constitutional and budgetary reforms present an opportunity to develop such an institution. A small Chamber o f Accounts (COA) has been created within the President's Office and could be developed into an external audit function. The Report proposes a four point development plan: (1) establishing a legislative base for the audit function; (2) increasing the transparency and disclosure o f its work; (3) providing additional resources to the COA; and (4) enlisting the support o f the international community to assist in its development. A long term goal for the COA should be to provide a professional opinion on the government annual budget report based on international accounting standards. Public enterprises Uzbekistan still has a large number o f public enterprises. Due to ill-defined lines o f authority there i s little external and internal discipline on corporate performance, and little separation between government and business. The Report recommends reforms to the regulatory framework; separating policy and regulatory activities where conflicts o f interest arise and privatizing commercial operations so they do not have access to state powers. The transparency o f financial information should be improved by a phased introduction o f publicly available financial reports prepared and audited in accordance with international standards o f accounting and auditing. Capacity building The capacity o f the Government to absorb and implementan ambitious series o fpublic sector financial management reforms will be a challenging long term exercise. Financial management training i s needed in all public sector institutions but the needs are particularly acute in the regions and in budgetary institutions. Many finance officers have had no formal training since the 1980's and there i s a lack o f computers and basic guidelines to assist staff. Many o f the international developments inbudgeting, accounting and auditing are completely new to technical finance specialists. They needbroad exposure to the latest techniques which should also be introduced into academic programs. A highlevel o f literacy and numeracy, an adaptable population, and well-developed educational institutions offer obvious opportunities for improvement. DevelopmentAction Matrix The assistance provided by donors supports the Government's efforts to establish modem financial institutions and to develop staff skills and capabilities to enable it to manage its own affairs. The CFAA identifies those initiatives already underway, assesses the Government's progress in each area and comments on their future plans. Where additional actions are recommended these are presented in a Development Action Matrix (see Annex I), which identifies a series o f proposals highlighting, if applicable (i)legislative reforms, (ii) institutional arrangements, (iii)human resource and capacity building and (iv) suggested timing(short, mediumor long term) o fimplementation ofthe proposedreform. Uzbekisfan CFAA: Execufive Summaw viii *Underpinning a genuine reform process i s the improvement in transparency o f Government's management o f public resources. At this juncture, the Government could demonstrate its commitment to greater transparency with the following measures (included in the Matrix) which do not requiring external assistance. 1. Budget preparation should be made more transparent with the publication o f the budget, together with documentation on its assumptions and main lines o f policy 2. In the area o f extra-budgetary fund management, at a minimum no new extra- budgetary fund should be created; and existing funds should be incorporated into the Budget where possible. In addition, the Government should amend Decree 414 to limit extra-budgetary funds to the payments o f paid services and not allow budget surpluses. 3. Revenue management needs to be made more transparent: the Government should implement the proposed amendment to the Tax Code to restrict access o f the tax authorities to the banking information o f taxpayers. 4. The Government should enhance transparency in public enterprise management by selecting two public enterprises for pilot audits o f their 2004 financial statements according to international standards. The results o f these audits should be published. At the same time the Government should also start exploring possible external support for medium-term reforms particularly inthe areas o f internal and external audit. * Reforms in financial management and accountability do not happen in a vacuum. Such reforms are unlikely to succeed unless overall political conditions and commitment i s fueling them. In addition to political commitment, the management o f the transition has to be thought through. Finally, linkages between public financial management and overall public sector reforms have to be understood and addressed. Uzbekistan: CFAA Countrv Backaround 7 I.COUNTRYBACKGROUND Governing Structures 1. An independent Uzbekistan was created in 1991. Of the 15 countries which emerged from the breakup o f the Soviet Union, it is the third largest in terms o f population (25.2 million) and the fourth largest interms o f land mass (447,000 square kilometers). Islam Karimov has been the country's President since independence. 2. Following a referendum, the Constitution has been amended to permit the creation o f a bicameral parliamentary system that began operations in January 2005, replacing the present unicameral system. This will consist o f an elected upper house (Senate) and an elected lower house (Legislative Chamber). A number o f powers previously exercised by the President have been transferred to the Senate, including the appointment o f the Prime Minister.The President has stated that the full time representatives of the lower house will focus principally on legislative issues while the Senate will provide for territorial representation. Under the revised Constitution the President's term o f office was also extended from 5 to 7 years. Economic background andprospects 3. While taking initial steps to the transition to a market-based economy, the State has retained an extensive role in the economy. The state continues to be involvedin a wide range o f off-budget economic activities managing whole sectors o f the economy such as cotton production. Instances such as when the authorities require enterprises to perform work without payment, for example by providing employees for cotton picking or paying for urban beautification projects, point to a much larger influence o f the state than i s indicated by the quantifiable fiscal and quasifiscal operations. If control over the economy through parastatal industrial associations and state-owned commercial banks, centralized planning o f production and distribution, and heavy regulatory burden are added, the reach o f the state i s greater still. Progress in privatizing large firms in the banking, mining and utility sectors such as telecommunications, energy, and transport has been slow. The slow transition o f the Uzbek economy resulted in high levels o f Government revenues and expenditures for public and publicly guaranteed investment and extra-budgetary funds, which reached 60 percent o f GDP inthe mid-1990s. Inthe past five years there has been a drastic fiscal adjustment following a decline in budget revenues. Between 1998 and 2003 consolidated budget expenditures, including extra-budgetary funds and net lending were slashed by 10 percentage points o f GDP. The aggregate level o f government spending also saw similar dramatic declines during the period. 4. Throughout the late 1990's the Government imposed strict currency controls and Government continued to set prices and quantities in major sectors (agnculture, mining and energy) o f the Uzbek economy. This enabled the Government to avoid the output slump experienced in other transition economies but it also resulted inbelow average growth in the post-transition period. As a result merchandize exports fell 32 percent between 1997 and 2001, and another 14 percent in 2002 alone.2Per capita net FDIi s now the lowest inthe CIS, 'WorldBank, Uzbekistan Country Brief, 2003 p. 1. and the GDP per capita o f $2360 i s third lowest3 Following a series o f exchange rate devaluations the gap between official and parallel market rates, which stood at over 400 percent in early 2000, has been virtually eliminated, and in October 2003 the authorities announced the introduction o f convertibility. 5. External developments have been favorable for Uzbekistan since late 2002. Prices o f its main export commodities - cotton and gold- rose sharply, contributing to the growth o f exports o f goods and services by 27 percent in value terms and boosting foreign exchange reserves by over 0.4 bn. soums. As a result, all o f Uzbekistan's external debt ratios improved and were below their values in 2000 when external borrowing was tightened. The world market prices, however, are volatile. The key factors for improvement o f Uzbekistan's creditworthiness are, in addition to continued the tight borrowing policies o f recent years, an improved environment for economic growth, diversification and a further sustained increase o f exports. This will be hard to achieve without a reorientation from the current inward- oriented strategy based o n the dominant role o f the state to a more open, market-oriented development strategy. Relationship of the CFAA, lendingprogram andpolicy dialogue with the Country's authorities 6. The FY02-04 Country Assistance Strategy (CAS) included the completion o f the CFAA as a core non-lending activity o f the Bank duringthe period. With an overarching goal o f improving living standards and alleviating poverty in Uzbekistan the CAS recognizes the importance o f developing Uzbekistan's public sector institutions and systems o f governance especially in the areas o f transparency and accountability. A new CAS for FY05-07 i s currently being prepared. Subject to the outcome o f the 2005-07 CAS discussions several new operations could enter the portfolio in FY05, including the Public Financial Management Reform (PFMR) Project, which supports the important reforms to budget processes discussed in this Report. 7. Since Uzbekistanjoined the World Bank and the IDA in 1992 it has been supported with a modest program o f lending, technical assistance and policy advice in support o f its reforms. The primary areas o f attention have been: reforms in public policy to increase transparency, liberalization o f trade and fiscal reforms; private sector development to help alleviate poverty through job and wealth creation; human capital investment; and irrigation and drainage investments to improve productivity. A summary o f Bank lending i s shown below: Item 1992- 1997 1998 1999 2000 2001 2002 2003 Total 1996 Commitments 247 5 127 55 29 76 60 599 Disbursements 100 7 15 23 26 36 44 17 268 Ibid; GDP per capitarefers to 2000. Uzbekistan CFAA: Countw Backqround 3 8. The limited lending program has been complemented by non-lending activities centered around selected fiduciary economic and sector studies. The Bank completed the Country Procurement Assessment Report (CPAR) in 2003 and a Public Expenditure Review (PER) has been prepared inparallel with the CFAA. 9. The Bank's lending activity has been focused on investment projects. Fiduciary safeguards and financial management in the Uzbekistan portfolio are arranged outside the national institutions o f accountability using stand-alone project implementation units. Budget support operations are not envisaged inthe next CAS cycle. Uzbekistan CFAA: Public Sector Budget Manaqemeni 4 11.PUBLIC SECTORBUDGETMANAGEMENT Introduction 10. The focus o f CFAA i s on budgetary issues which impact on public sector financial accountability. The Report analyzes both the comprehensiveness and transparency o f the budget process. Later sections o f the report analyze accountability and transparency issues arising from extra-budgetary funds and public enterprises. 11. This Report does not provide a detailed examination o f institutional reforms required to reform the budgetary process; nor does it review the allocation o f resources against government priorities. These issues are the domain o f the Public Expenditure Review (the key institutional issues arising from the PER analysis are summarized in Box 1 below). The problems inherent within the present system o f budget management have been documented inprevious report^.^ The main focus o f this chapter i s to explain the rationale for the development o f a treasury system and provide a deeper understanding o f the challenges posed by this far-reaching initiative. Principles and Risks 12. Public sector budgeting poses two types of risk to sound financial management. Firstly there is the policy risk related to the government failing to implement the budget passed by the Parliament. As discussed above, these issues are primarily dealt with inthe context o f the PER.Second, there is the financial management risk that budgetary fimds are not spent for the purposes set out in the budget. This risk i s compounded when significant government activities operating outside the budget are not subject to normal budget scrutiny and procedures. These issues are discussed below. 13. The budget execution arrangements have an important impact on the management of the government's liquidity position and cash requirements.A failure to manage liquidity efficiently creates risks (1) that payments are not made in accordance with the budget, (2) that payments are not made on a timely basis and distort the implementation o f government activities and (3) that finance officials have insufficient information to make the most effective and efficient use o f cash. 14. To understand the scope o f these risks, the following dimension and principles o f budgeting should be reviewed: The scope of the budget: i s the budget comprehensive enough to allow effective policy and resources linkages, review and trade-offs? Similarly, are the resources outside the budget subject to the same policy, review, financial reporting and accountability requirements? The budget preparation process: Is data o n budget preparation and implementation available, timely, reliable and presented in a way that allows the Government to assess implementation o fpublic policies? I s the budget preparationprocess conducive to fiscal sustainability and responsibility, and does it link policies and resources? See for example the Uzbekistan: Government Financial Management, A Diagnostic Report, World Bank, ECSPE, June 2000 and Uzbekistan: Budget and Treasury Reforms, IMF FiscalAffairs Dept, March2003. 0 Budget presentation: I s the budget presentation transparent and clear enough to assess whether it reflects the Government policy priorities, and i s the use o f the funds clearly spelled out? Availability and quality of budget information: i s the budget available outside the Executive to allow for open review o f the Government's proposed use o f funds? The scope of the budget 15. In Uzbekistan, the budget excludes a significant portion of public funds. As a result, it does not allow effective policy and resources linkages, review and trade-offs and does not present a comprehensive view o f the government sector. 16. Extra-budgetary funds (EBFs) are a large part of total State expenditure. EBFs account for approximately one quarter o f total State budget expenditures; and include four major fimds' and additional smaller EBFs (accounting for less than 10 percent o f total EBF expenditure). Many o f the smaller EBFs are designed to provide incentives to budget entities engaged in revenue production. The state budget does not cover all government agencies and previous studies have recommended that the government bring all controlled entities into a consolidated reporting entity. In doing so EBFs would be consolidated into the budget and more accurately reflects central budget activities. Because o f their overall materiality the issue o f extra-budgetary accounts i s discussed in greater depth in the next section o f the CFAA. Box 1: Budget Management - Institutional Issues - Key Messagesfrom the World Bank Public ExpenditureReview, 2004 (PER) Uzbekistan has begun major reforms to the health and education sector. Budget preparation and execution weaknesses are being addressed through the development o f revised budget preparation procedures and the introduction o f a Treasury system. These changes are part o f a long term process requiring a fundamental change in institutions across govemment. Policy making functions o f spending ministries need to be developed; accountability for policy and spending decisions need to be clarified. In the long term much o f the reform of public finances will require changes outside the Ministry o f Finance. Institutions should be established at the center o f govemment to coordinate strategic policy choices. Spending ministries should be reorganized along functional lines and include many o f the state institutions which currently deal directly with MOF. Until now budget reform has largely been centered around technical developments within the MOF. One o f the main tasks for the MOF is to make the case to the Govemment and public institutions for the need for reforms and the long term benefits that will ensue. Amongst the key short term recommendations o f the PER are proposals which would make the presentation o f the budget more transparent and enable the Oliy Majlis to evaluate the effectiveness o f the allocation o f resources. In the medium to long term the PER proposes structural changes to MOF; creating a modem organization equipped to perform the development o f macro-economic policy and sustainable expenditure. The PER also recommends the creation o f high level committee o f the Cabinet o f Ministers (COM) responsible for overseeing the budget process and presenting strategic choices to the COM. Source- Public Expenditure Review, 2004 'Road Fund, Pension Fund, Employment Fund and State Property Fund. Uzbekistan CFAA: Public Sector Budqet Management 6 The budgetpreparation process 17. Policy development takes place centrally in the apparatus o f the Cabinet o f Ministers and the Presidential Administration. Strategic decisions take place outside the budgetary process, which means that funding for new initiatives may be lacking or the budget will be allocated in an ad hoc manner by MOF. Until recently there was no initial resource envelope specified in calling for budget requests. For the first time in the 2005 budget process expenditure ceilings were set for sectors. This i s an important step forward in the budget process. However the process o f setting ceilings will require further development and formalization. Inparticular it i s important that C O M approves budget ceilings for institutions and not just functions, and the process o f setting ceilings should be codified in the Budget Systems L a w (BSL) or in regulations issued by the MOF based on the BSL. Budget requests are based upon standard cost norms and historic allocations. Notwithstanding the improvements, the present budget preparation process i s not conducive to fiscal sustainability, nor does it link policies to resources. 18. There is no integrated evaluation of investment and current spending in each sector. The lead agency for the investment budget i s not the MOF but by the MOE which i s responsible for the PIP.6Although MOF officials are involved in this process and all projects are formally subject to a process o f appraisal, they are not evaluated together with other public resources being assigned to a particular sector, within a budgetary envelope for the sector. Inaddition a number o f basic decisions inthe PIP are taken outside the formal budget process (for example, a priori decisions on the numbers o f schools and hospitals to be constructed). There i s also n o mechanism for the consideration o f the impact o f recurrent cost implications (beyond the next budget year) o f new investments. 19. Separation of PIP and external financing promotes the view that such resources are additional or free. Since a significant proportion o f the PIP i s financed from external borrowing, the existence o f the PIP in its present form promotes the view that foreign financing i s in some sense "free" money apart from the budget. Although the appraisal o f PIP projects does include an assessment o f the ability to repay the loans these are not taken into account as part o f the budgetary envelope available for spending by institutions. Transparency and accountability aspects of the budgetprocess 20. Budget documentation i s not transparent and clear enough to assess whether it reflects the Government policy priorities, and the use of the funds i s not clearly spelled out. In addition, the budget process does not lend itself open review o f the Government's proposed use o f funds. 21. Budget presentation suffers from the fragmented budget (discussed above) and a classification which does not meet international standards. The overview tables on spending are insufficient to analyze the development o f policy. Greater transparency could be achieved through presenting the budget by organizational and economic classification, with comparative data for the previous year and forecasts for the next two years. The PIP covers both General Government investment (centralized investments) as well as that carried out by public enterprises financed from their own resources and direct foreign investment (decentralized investments). Uzbekistan CFAA: Public Sector Budget Manaqement 7 22. The budget classification used for structuring the information does not allow clear accountability for the use of resources. The functional classification i s a mix of functional elements and economic categories, and the economic classification i s limited to four categories, as noted above. Recently considerable work has been carried out inthe MOF, with the assistance o f the IMF and U S Treasury to develop functional, economic, organizational and program classifications, consistent with the standard GFS 2001 classifications o f the IMF. This classification identifies the structural unit, the budget beneficiary and the main activity for which budget funding will be used. Ifthis classification i s used for the presentation and execution o f the budget, it would allow for clear accountability in the use o f resources by institutions, and provide the Oliy Majlis and C O M with a means to evaluate the budget in a coherent manner. It is expected that the GFS 2001 classification will be implemented for the 2006 budget and, in addition a programmatic budget classification will be implementedin 2007. 23. The Oliy Majlis approve a budget based on broad functional classification. Parliamentarians are provided with an aggregated overview o f proposed government budgetary expenditures and revenues and the tax and fee levels that will be requiredto meet the revenue budget targets. While additional information i s available on request, the format and the highly aggregated level o f the information makes it difficult for an individual parliamentarian to formulate an informed opinion. The broad budget parameters are also disclosed, for the first time this year, on the MOF website. What are missing are the detailed disclosures o f the individual budgets o f the first line budget entities and their sub-entities that compose the main budgetvariables. 24. The detailed budget is prepared aper approval by the Oliy Majlis. Once the budget is approved inparliament a second budgetprocess begins. Since the budget approved by the legislature does not assign resources to institutions and economic categories, it is only following the approval o f the budgets that the negotiations and allocation o f budgets o f institutions at the central level takes place by the MOF. A similar process also then takes place at the Oblast level for local institutions. On the revenue side the revenue forecasts are broken down by type o f tax and locality to reflect revenue raising plans which become obligatory for the local governments. 25. Transparency and accountability would be enhanced by the publication of Budget documentation. Publication i s standard international practice in virtually all countries in the world. The decision o f the Government to begin publishing the details o f budget execution for 2003 i s very welcome and institutionalization o f this practice would be an important step forward in transparency. In particular this would include the budget, the macroeconomic forecasts underlyingit and an explanation o f the mainbudgetary measures. Budget execution and cash management issues 26. Fragmented organizational arrangements for the budget make implementation difficult to monitor. Budget execution takes place through the Central Bank o f Uzbekistan (CBU) and commercial banks on the basis o f a monthly cash release system. There i s no distinction between the authority to spend and the release o f funds. Cash i s . disbursed into thousands o f individual bank accounts o f budget institutions. The C B U estimates that there are 120,000 Government bank accounts. Uzbekisfan CFAA: Public Sector Budqef Manaqement a 27. The present budget execution arrangements expose the Government to important risks (1) that payments are not made in accordance with the budget, (2) that payments are not made on a timely basis and distort the implementation o f government activities and (3) that finance officials have insufficient information to make the most effective and efficient use o f cash. These risks are recognized by the Government and are being addressed through the development o f the treasury system. 28. There is uncertaintyin the availability and timing of funds. Inprinciple, budget funds are released to spending agencies on the basis o f monthly expenditure plans. Although funds released over the whole year are in accordance with the approved budget, to keep cash under control these releases are not automatic and are prioritized by the MOF or the Oblast Finance Department. The timing o f availability o f funds i s determined in part by the availability o f revenue (dependent on seasonal or local fluctuations) at the relevant level o f decision-making (MOF, oblast or rayon). The need for prioritization7 in release o f cash makes control o f execution a source o f political and economic power, and subject to lobbying and rent-seeking'. The resulting uncertainty as to the timing o f the release o f funds generates incentives to cash hoarding and the accumulation o f idle balances by budget organizations. Cash management i s further complicated by the rationing o f cash by the CBU to the banking system. Even when funds are made available through the banking system to the bank accounts o f BIs, these are unable to make payments in cash to final recipients. As a result arrears o f several months have occurred in wage and pension payments in some areas. 29. Extra budgetary accounts in the banking system further weaken liquidity management and fiscal control. Spending agencies use extra-budgetary accounts (established under decree 414) to manage their own resources. While such arrangements facilitate cost recovery, the high number o f extra-budgetary bank accounts maintained by budget institutions creates further loopholes inthe fiscal control system. Recent andproposed reforms 30. Many of the weaknesses highlighted above are being addressed through the introductionof a treasury system and work on the budget preparation process. The MOF has begun work on a modem treasury system with the support of the IMF and the Bank's Public Finance Reform project. A U S Treasury Advisor i s assisting the Ministry o f Finance with improving its budget preparation procedures including revising the budget classifications (introducing an organizational classification), strengthening the legal framework o f the budgetary process and improving the format and the content o f budget submissions prepared by line ministries. 31. A modern treasury system offers a number of potential benefits which can address the limitations of the current system and will assist in the implementationof budget plans and the management of public resources. Firstly, the creation of a single treasury account and daily cash reports will enable the government to manage cash, financial assets and short term investments efficiently. The result will be a reduction inthe cost o f idle 'Priorityi s given to wages, pensions and utility payments. The problem i s exacerbated by unclear lines o f accountability o f the local finance departments which report to both the MOF and the Oblast authorities. Uzbekistan CFAA: Public Sector Buduet Manauement 9 balances and an increase in cash predictability which can be made available to spending units. Second improved reporting through a modern Government Financial Management Information System (GFMIS) provides better analytical information to monitor the budget execution process at all levels o f government. Reporting o f expenditures provide reliable and timely assurance that public resources have been used in conformity with the legal authorizations and mandatory requiremenkg Officials can monitor the proportion o f appropriations not committed and expenses committed but unpaid. Finally, systems and procedures improve the management o f domestic and foreign debt through regular recording and reporting o f loans including their associated disbursement and repayment schedules. 32. The establishment of the Treasury entails a major institutionalreorganization for MOF. Under the draft proposals the Treasury will be established as a unit o f the MOF, headed by a Deputy Minister, and it will comprise a Central Treasury (CT) located in the head office o f the MOF and a network o f local treasury branches (LTBs) throughout Uzbekistan. Under the new arrangements the LTBs would be directly subordinate to the CT and not to local Govemments. 33. The treasury reformswill require considerable capacity building.The capacity o f the Government to absorb and implement an ambitious series o f public sector financial management reforms will be a challenging and on-going exercise. Finance training i s needed in all public sector institutions but is particularly acute in the regions and in budgetary institutions. Many finance officers have had n o formal training since the 1980's and there i s a lack o f computers and basic guidelines to assist staff. 34. MOF have identified 21,000 new and existing staff sub-divided into (i) treasury staff, (ii) finance officers inMOF, oblast and rayon level finance offices and (iii) and finance accounting officers in budgetary units (predominantly in the health and education sectors). MOF propose to set up a training facility in the Treasury building to accommodate classrooms. The MOF will develop initial trainers for trainers program and develop training materials and modules based on the skill and competences required o f finance officers. Main Recommendations 35. The recommendations included in this section are consistent with the analysis and conclusions drawn inthe PER and are repeated inCFAA for continuity o freporting. Short term (within one vear) 36. Adopt fully the outline budget processdeveloped for the 2005 budget. i) PIP should be preparedinclose collaboration with the Ministryo f Finance inthe selection o f projects. ii) The budget i s formulated around the organizational and programmatic classification i s presented to the COM and Oliy Majlis inthat form. 37. The budget, together with documentation on its assumptions and mainlines of policy, should be published. Discussed in greater detail in Section IV Medium term (one to three vears) 38. The Budget System Law should be amended. The principal amendments requiredare: i> To require the enactment o fthe budget by the Oliy Majlis. ii) To define appropriations as an authority to spend separate from the release o f cash. This i s essential for the introduction o f the Treasury. 39. Multi-year PIP process should be reinstated and coordinated by MOF. The choice o f projects within the general government sphere should be coordinated by the MOF as part o f an annual and medium term budget process. The MOE should be responsible for developing methodology for project appraisal and quality control o f proposed projects. The MOF should maintain a database o f ongoing projects showing their impact on future recurrent costs, which should be integrated into a wider medium term budget perspective. 40. Transparent operational rules and procedures should be developed for the Treasury control of budget execution. The rules should allow the Treasury to verify the legality o f payments, but give it no authority to prioritize payments except by rules that are published by the MOF. The rules for managing budget execution should allow different levels o f control o f expenditure, and be consistent with sectoral reforms. Uzbekistan CFAA: Extra Budsetaw Funds 11 111.EXTRABUDGETARYFUNDS Introduction 41. Extra-budgetary funds pose three types o f risk to sound financial management. Firstly there is the policy risk that through poor government oversight and operational management extra-budgetary funds fail to meet overall policy objectives. Second, there i s the performance risk, where use of the funds for their intended purposes cannot be ascertained due to poor oversight and management. Finally, there i s the financial risk. It has two sub-components: e Fiscal risk: the fund may overspend its general budget allocation through weak commitment controls or unauthorized borrowing; 0 Cash management risk: by holding separate extra-budgetary funds the Government may have to either borrow funds when idle balances remain in the fund bank accounts or reduce cash allocations to other programs to accommodate the increased demands o f the extra-budgetary fund. 42. The second and third risks (performance and financial risks) are the most relevant to the CFAA diagnostic. These risks occur because extra-budgetary accounts are off-budget and often operate outside the general budget formulation, execution, and reporting system. Simply including the fund balance sheet in the annual Government budget documentation would not be sufficient as they would still not be subject to normal budget scrutiny and procedures. Extra-Budgetary Funds in Uzbekistan 43. The overall amounts o f spending o f extra-budgetary funds inUzbekistan are highly material, accounting for approximately one quarter o f total State budget expenditures. Table 1 provides details o f the spending on the four major funds and over 20 smaller funds (accounting for less than 10 percent o f total extra-budgetary expenditure and presented in aggregated form). 44. The smaller funds" have been established principally to provide incentives to budget entities engaged in revenue production. These revenues can then be spent on staff bonuses, benefits, and other spending related to the entity. Revenues include the tax and customs commissions (20 percent o f penalties collected), State Property Commission (1 percent o fprivatization revenues, MOF (10 percent o f CRU recoveries to the state budget)". 45. In addition spending agencies use extra-budgetary accounts (established under decree 414) to manage to provide greater flexibility in the budget execution process. It creates provisions which allow budget entities to transfer unused budgetary funds into an extra-budgetary account, known as a development fund. The number o f these funds i s roughly equal to the number o f budget entities, approximately 13,000. These development accounts are off-budget and non-lapsing at year-end, and are not subject to normal budget loA list o f all extra- budgetary funds i s included inAnnex IV. The allocation o f fees and penalties to extra-budgetary funds o f the ministries were reduced by COM Resolution in 2003. The Resolution also provides for estimates o f extra-budgetary funds to be registered with the Ministryo f Finance and is taken into account inthe budget formulation process. execution controls. In 2003, total expenditures from these accounts were estimated at 10 percent o f budgetary expenditures. These development accounts are maintained in commercial banks. Table 2: Extra-budgetary fund spending 1999-2004 (Billion Soums) I Fund I 1999 1 2000 I 2001 I 2002 1 2003 I 2004 I Actual Actual Actual Actual Forecast Budget RoadFund 32.0 51.7 72.4 123.1 140.3 152.0 EBFFercent of 24.4% 24.5% 25.7% 25.8% 24.7%* 28.0%* State Budget incl.EBFs Source: Ministry of Finance. n/a -not available;*= excluding other EBFs. Impact of extra-budgetary funds Budget and cash management issues 46. Extra-budgetary funding further fragments the budgetary process and creates significant policy risks. The smaller funds have been created with their own sources o f income, and cover recurrent expenditures such as maintenance, repairs or subsidies in different sectors, which are the items being squeezed under the current budgeting process. The creation o f extra-budgetary funds for these purposes i s a substitute for an effective budget process and reflects an inability to prioritize. If an overriding need for maintenance, staff incentives or any other expenditure i s recognized this should be provided for through the normal budget process. 47. N o new extra-budgetary funds should be created. The creation o f extra- budgetary funds i s a symptom o f failures o f the budget process to allocate sufficient funds for activities such a maintenance and capital purchases. These funds are often created as a result o f political lobbying or ad hoc priority setting at a higher level. In the case o f the smaller funds these account for a subset o f expenditure within sectors which should be more properly be considered under normal budgetary processes. For this reason the government should plan to wind these funds up in the medium term. It i s recognized that the Government i s making efforts to reduce the number o f extra-budgetary funds, but the recent creation o f a new ear- marked fund for basic education i s a cause for concern, because o f the way in which these funds circumvent the normal budgetary processes. 48. Controlling of extra-budgetary funds could be linked to greater flexibility in spending. Since many o f the smaller funds were introduced to give more flexibility to spending institutions, their abolition has to be linked with measures which give institutions Uzbekistan CFAA: :Extra Budqetary Funds 13 more flexibility in spending. This could be achieved by reducing the level o f detail in the expenditure tables and allowing greater scope for virement without reference to the Ministry o f Finance. 49. Extra-budgetary funds in the banking system weaken fiscal control and expose government to fiscal risks. While development accounts facilitate cost recovery, the high number o f extra-budgetary bank accounts maintained by Budget Institutions creates loopholes in the fiscal control system. The existence o f separate bank accounts also increases financing costs and fiscal risks if funds are able to borrow. Governance issues 50. The CFAA conducted a review o f the four major funds financial management processes and controls (see Annex 111). From this analysis it appears that extra-budgetary funds are not as stringently monitored and controlled as other budget entities. For example while budgets are tabled in Parliament with the state budget there i s n o legal requirement for extra-budgetary funds' annual reports to be made public. The present procedures lack transparency and create an uncertain and inconsistent control and accountability environment. 51. The Government should establish common budgetary, audit, control and reporting procedures which can be scrutinized, questioned and approved by the MOF, COM and Oliy Majlis (see Box 2). To mitigate the performance risk, extra-budgetary funds should be consolidated in the state budget and operate the same processes o f preparation, execution, reporting and control as the rest o f the budget. 52. The governance arrangements for the Road Fund should be reviewed in the light of recent institutional changes. The main supplier to the Road Fundi s Uzavtoyol, the state construction company f i o m which the Fund was recently separated. Uzavtoyal i s represented on the Management Council o f the Road Fund and as such has a significant role indetermining the Fundexpenditures priorities, a clear conflict of interest. The Government could strengthen the contract-like relationship between the Road Fund and suppliers through an independent Management Council which specifies the resources provided and the performance expectations o f the Fund. Governance could be improved still further if budget formulation and the determination o f the priorities in the Road Fund were to become the responsibility o f the appropriate sectorministry (Ministry of Transport and Communications). Uzbekistan CFAA: :Extra Budqetarv Funds 14 Box 2: Improving Financial management of Extra-budgetary funds In terms o f financial management and control, extra-budgetary funds lie between the degree o f oversight and control exercised by the Govemment over its budgetary entities and its public enterprises. Because they are important elements o f the delivery o f social services provided to citizens, increased transparency in the budget would provide important information to those most directly affected by the funds' operation. To minimize the risks outlined at the start o f this section (particularly performance and financial risks) governments should minimize extra-budgetary funds. However, there are a number o f intermediate steps that a govemment can take to minimize risk while rationalizing their utilization over time. These include having extra- budgetary funds: Included in annual budget documents on the same information base as the general budget (with supplementary reporting as appropriate to the particular fund); Subjected to the same M O F and Parliamentary scrutiny as on-budget spending; Meet common requirements for accounting, intemal audit and control, and reporting; Record and report accounts on the same time frame and frequency as general budget and financial reports; Follow general principles o f transparency in reporting and operation (e.g. regular reporting within Government and to Parliament, compliance with procurement, and contractingrules); Clear oversight authority; even if an EBFis established with an independent Supervisory Council, clear oversight responsibility shouldbe given to a line ministryfor sectoral policy issues and to MOF for matters relating to financial accountability; Subject to independent annual extemal audit. Main recommendations Short term (within one year) 53. N o new extra-budgetary funds should be created. The existing smaller funds should be reviewed and where possible, re-integrated into the budget, with funding being made through standard budget allocations. At the same time the Government should build flexibility into virementprocedures without recourseto MOF. Medium term (one to three vears) 54. Extra-budgetary funds should be subject to the same rules as the rest of the budget. All EBFs should be put under the aegis o f a relevant sectoral ministry and they should be subject to the same rules for budget preparation, review and control. Inparticular choices on expenditure within the fund should be subject to questioning from the MOF and the COM as well as the Oliy Majlis. 55. Extra-budgetary funds should be limited to the payments for paid services and not allow budget surpluses. Extra-budgetary accounts should be limitedto paid services or the collection o f other specific fees. The practice o f transferring surplus funds to extra- budgetary accounts (414 development accounts) undermines fiscal control and provides perverse incentives. If specific allocations are required for bonuses and staff incentives, these should be provided by budget allocations for these purposes. The issue o f flexibility should also be dealt with by reducing the level o f control o f the Ministry o f Finance on the expenditure tables for budget execution. Uzbekistan CFAA: :Extra Budqetarv Funds 15 In the medium term extra-budgetaryfunds should be includedinthe treasury system for the purposesof managingcash. However this objective will be achieved only to the extent that the Treasury performs the budget execution hnction and extra-budgetary accounts are fully ring fenced within the Treasury. In such a control environment hnds would be released once the authorizations have been made in accordance with clearly defined procedures. Handled correctly this reform would improve financial management without inappropriate limitations beingplaced on operational managementI2. I2The Government envisages that within the framework o f the Public Finance Management Reform Project the Treasury will perform the budget execution o f extra-budgetary funds and the development accounts o f budget agencies. IV.PUBLIC SECTORACCOUNTINGAND FISCALREPORTING Introduction 56. Under the Soviet central planning system accounting was an exercise in booking- keeping; budget reporting was merely a financial reflection o f detailed production plans. Modem government accounting and financial reporting protect and manage public money and discharge accountability. Therefore good accounting practices support transparency in the use o f funds and help clarify responsibilities in funds management. When governments engage in economic activity - be it buying or selling services or borrowing and lending money they are subject to economic accountability. When they levy and are in receipt o f revenues they are subject to political accountability. 57. Accounting reforms should not been seen as an end in themselves but should be seen as tools for supporting the implementation o f broader economic, political, and fiscal reforms within government. Having a broad view o f stakeholder requirements in the context o f a countries socio-economic development i s helpful in identifying priorities based on the priorities in the national economy. For example, changes to accounting and budgetary systems inthe United Kingdom would have been more limited without pressure to restructure health and social welfare systems and reduce overall levels o f t a ~ a t i o n . ' ~ 58. Government accounting has three broad purposes which can be used to illustrate priorities in order to build full capacity into a government accounting system.14 The basic purpose o f government accounting i s to safeguard public money and prevent corruption. The intermediate purpose i s to facilitate budgeting and planning o f revenues, expenditures and debt management. At this stage officials go beyond score-keeping and use management and cost data to conduct government operations in a more economical, effective and efficient manner. Finally the advanced purpose o f government accounting i s to help government discharge its public accountability. At this stage the emphasis o f accounting shifts from bureaucratic control to accountability reporting to the public. It is not enough for government officials to keep accurate books and records - they are open to the public through transparent and comprehensible financial statements. Current accounting arrangements 59. Government accounting in Uzbekistan is based on the Soviet accounting system which uses many concepts of modern accounting including accrual measurements and double entry bookkeeping. Inaddition Uzbekistan has a large number o f bookkeepers who are trained in these concepts and are proficient in their application. However, there are significant capacity constraints which hinder the development o f a modem system of accounting and financial reporting. The accounting systems used at a central and local government level are predominantly manual. There i s no central management information system; significant reliance i s placed on banking records and computer spreadsheet packages. l3Seeforexample-Hepworth,N.,2001GovernmentBudgetingandAccountingReform inthe United Kingdom. GovernmentBudgetingandAccountingReformSymposium, Beijing2001. l4SeeChan,PublicMoneyandManagement-January2003. GovernmentAccounting: AnAssessment of The0y, Purposes and Standards. 60. All budget organizations prepare monthly, quarterly and annual reports on budget execution. Republican budget institutions submit their financial reports to higher level units, which then consolidate and submit reports to the MOF. Regionally financed budget institutions submit financial reports to higher finance departments where they are consolidated and submitted to regional finance departments. These are further consolidated and submitted to the MOF. Budget accounting i s prepared on a cash basis, although some additional accruals information i s provided in accordance with the stipulated order. Separate charts o f account are prepared for cash releases to line ministries and regional finance departments. 61. The framework of government accounting contains some weaknesses, limiting its use for the three purposes mentioned above. The MOF and regional and local government finance departments operate a cash-based chart o f accounts, while budget institutions use a quasi-accrual based accounting system which does not meet international standards. The MOF cash accounts are inaccurate in that they do not report the final disposition o f cash deposited in the bank accounts o f line ministries/departments and finance departments o f regional and local governments. Current laws specify broad responsibilities o f all parties and the processes to be followed in accounting and financial reporting. However, the regulations need updating to address fundamental weaknesses highlighted in previous reports" (See B o x 3 above). Box 3: Key weaknessesof thegovernment accounting system and their impact on reporting and decision making Expenditure accounting in M O F i s based on the financing transferred to line ministries. This corresponds neither to accrued expenditures nor to the final disposition o f cash; MOF cannot systematicallymonitor andreport on arrears because o f the timinggap between the recording o f the verification stage o f transactions in the MOF accounting system and budgetaryinstitutions. Payables information is provided by budgetary institutions through their parent organizations once every quarter. This is inadequate, particularly in an environment o f frequent cash shortages; MOF andregional finance departments do not follow consistently defined principles for matching revenues to expenses within a reporting period. This distorts the reporting o f budget entities; The M O F does not analyze and report contingent liabilities and guarantees, including those that are expected to be called in during the year. There i s a need for more comprehensive information about the real level o f govemment's liabilities, relating to both debts and other obligations; There i s inadequate recognition o f materiality inrecordingtransactions and events. For example the threshold value for capitalization o f transactions pertaining to fixed assets is either too low or non-existent; The annual execution report i s not subject to an independent audit to legitimize the reliability o f financial reporting presented to Parliament. l5Seefor examplePDP, loccit,Annex 9. Uzbekistan CFAA: Public Sector Accountinina and Fiscal Reportinq 18 Budget Reuorting Government accounting -the introduction of modern accounting andfinancial reporting system 62. The introduction of the Treasury permits prompt and relevant reporting. The establishment o f the Treasury with a single account processing all payments and receipts allows for consolidated, consistent and timely reporting o f central government, line ministries and local governments expenditures and revenues for decision making. This will enable policy makers and institutions to respond in a timely manner to changes in the fiscal environment. It would also enable regular reporting to the public and parliament, thus enhancing accountability and transparency. 63. The proposed accounting and financial reporting reforms are ambitious but well thought out. The phased development o f modem public sector accounting and financial reporting as an integral part o f the treasury reforms and based on recognized international standards i s an approach which could promote greater accountability and transparency (see B o x 4). Few countries in the world have adopted full-accruals accounting and this should be viewed as a long term goal. The initial focus should be on a well fimctioning treasury system with accurate reporting o f cash supplemented by accrual on payables, receivables and financial assets and liabilities. The Government should ensure that technical reforms do not get ahead o f institutional reforms and implementation capacity. Box 4: Proposed development of government accounting standards The govemment intendsto gradually introduce govemment accounting standards usingI F A C International Public Sector Accounting Standards (IPSAS)' and in compliance with GFS 2001 recognition principles'. The plan proposes a move from cash to accruals following the path outlined below:- * The first phase is to apply the Uzbekistan Government Sector Accounting Standard' (UzGSAS) for Cash which complies with the IPSAS Cash Accounting Standard. Duringthis phase the MOF intends to introduce a budget classification and Chart of Accounts compliant with GFS 2001 and intemational accounting standards. Inthe second phase the govemment will develop standards for accounting and reporting ofpayables, receivables, financial assets and liabilities (modiJied accrual accounting). These reforms will follow the introduction o f the Treasury system and introduction o f the GFMIS (presently planned for 2007). Inthe final phase full accrual accounting will be inimplementedwhich provides for accounting andreporting o f non-financial and contingent assets and liabilities 64. Communicating the rationale benefits of the accounting and financial reporting reforms can begin immediately. Currently financial reporting in Uzbekistan has an audience which i s limited to technical financial specialists. The use o f financial reporting as a basic tool o f managerial decision making and accountability within government should be an integral part o f the strategy o f communications and training carried out inparallel with the treasury reforms. The MOF, local finance departments and bookkeepers need basic training in the proposed public sector accounting and financial reporting reforms. Later, Uzbekistan CFAA: Public Sector Accounting and Fiscal Reporting 19 duringimplementation there will be a need for detailed training, the development of manuals and user guides to assist finance staff intheir work. 65. Independent audit of the annual budget execution report will enhance credibility and further increase transparency. This should be a medium to long term goal once the government has introduced internationally recognized standards and enhanced the capacity o f the external audit function (see also section VI11o f the CFAA). 66. Communicating the rationale benefits of the accounting and financial reporting reforms can begin immediately. Currently financial reporting in Uzbekistan has an audience which i s limited to technical financial specialists. The use o f financial reporting as a basic tool o f managerial decision making and accountability within government should be an integral part o f the strategy o f communications and training carried out inparallel with the treasury reforms. The MOF, local finance departments and bookkeepers need basic training in the proposed public sector accounting and financial reporting reforms. Later, during implementation there will be a need for detailed training, the development of manuals and user guides to assist finance staff intheir work. 67. Independent audit of the annual budget execution report will enhance credibility and further increase transparency. This should be a medium to long term goal once the government has introduced internationally recognized standards and enhanced the capacity o f the external audit function (see also section VI11o f the CFAA). Main recommendations Short term (within one vear) 68. Treasury GFMIS User Requirement Document (URD) should confirm the Government's commitment to accounting reform process outlined above. 69. The government should train users and providers o f financial information on the benefits o f public sector accounting and financial reporting. This training should be conducted as an integralpart of communicating the goals of the treasury reforms. Medium term (one to three vears) 70. Continue phased development o f accounting and reporting standards. i) Cash elements o f the new accounting standards; ii) Accrual elements o f the accounting standards added together with accounting policies; iii) Replacementofoldquasi-accrualsaccountinginstructionwithinstruction based on international standards Long term (over three vears) 71. The annual budget execution report should be subject to audit once the cash accounting standard i s implemented. Uzbekistan CFAA: Public Secfor Accounfin~and Fiscal Reportinq 20 72. Consider the development of full-accruals accounting based (i) evaluation o f on the experience to date in Uzbekistan and (ii)experience o f accruals accounting in other economies intransition. Uzbekisfan CFAA: Selected Revenue and Administration h u e s 21 V. SELECTEDREVENUEADMINISTRATIONISSUES Introduction 73. Revenue administration arrangements have an important impact on the management o f the government's liquidity position and the availability o f cash to carry out government policy decisions. Adequate financial management arrangements require comprehensive systems and institutional arrangements both to formulate tax and tariff policies and processes to administer and collect tax and non-tax revenues. Accounting information systems should provide both aggregated information to enable the efficient management o f cash and disaggregated regional, sectoral and taxpayer information to monitor and control tax compliance. 74. The focus on this brief section i s on selected areas o f revenue collection which impact o n the effectiveness o f fiscal and cash management. Especially the following matters are discussed: 0 Institutional issues - the extent to which the organization o f policy and collection agencies assists in the efficient and effective management o f revenue and overall cash management; 0 Prompt collection o f all revenues - no unreasonable gap between date due and actual collection; 0 Adequacy o f revenue monitoring - as part o f overall budget monitoring and cash management; 0 Auditingprocedures for revenues. 75. Tax levels in Uzbekistan continue to be relatively high at 25.7 percent o f GDP, compared to the average rate o f 22 percent in the CIS, although there i s a gradual downwards trend. The tax legislation i s very complex, and it i s frequently revised. A breakdown o f the tax revenues for the period 2002 and 2003, together with the 2004 budget i s shown inTable 2 below. The CFAA does not cover issues o f tax policy or tax administration in great detail; these have been addressed inprevious Bank reports16 from which this section has been drawn and updated. 16See in particular:- Uzbekistan: Government Financial Management: A Diagnostic Report, World Bank, ECSPE. June 2000. Uzbekistan CFAA: Seiecfed Revenue and Adminisfration issues 22 2. Indirect Taxes 1,018,296 1,353,801 1,532,944 VAT 447,490 535,760 604,270 ExciseTax 492,043 693,623 751.567 Customs Tax 29,354 40,964 60,745 Unified customs payment from individuals 24,328 45,I49 68,I52 Tax on use of gasoline, diesel oil and gas for vehicles from 25,081 38,304 48,210 individuals 3. Resource payments and property tax 139,258 222,264 260,100 Propertytax 34,254 71,435 74,317 Land tax 37,798 51,428 76,167 Tax on use of depths 18,306 29,807 43,295 Tax on use of water resources 6,434 8,777 12,146 Environmental tax 42,465 I I -54,176 - I-- , 60,s 18 --,- - - , .,.,6 4. Municipal improvement and social infrastructure 39,666 40,708 45,734 development tax 5. Other revenues 161,493 108,424 68,433 11. Revenues of special funds (Off-budget PensionFund, Republican RoadFundunder 637,000 830,206 936,387 the Ministry of Finance,Employment Encouragement State Fund, SpecialAccount of the State Property Committee) Total Revenues 2,501,111 3,172,347 3,557,68 7 Organizational Structure of TaxAdministration 76. The organizational structure of tax administration in Uzbekistan is fragmented (a summary of the institutional arrangements i s shown in Box 5). Like many other countries in the region, different departments are organized by function, type o f tax, and type o f taxpayers, with overlapping and often conflicting responsibilities. To improve the tax administration's operating efficiency, a new structure might be created along functional lines. This would include departments for key tasks such as returns filing and payment, collection enforcement, audit, appeals, and taxpayer services. Subsidiaries in large corporate groups, including large public enterprises report to local tax offices rather than beinghandled centrally in one tax office. Previous reports have suggested that, in order to improve efficiency and capture all revenue income, special offices could also be established to administer and control the largest taxpayers. Box 5: Institutional Arrangements for Tax Policy and Administration in Uzbekistan The tax code specifies that special rates on profit taxes, excise taxes, and local taxes are set by the Cabinet o f Ministers (COM). The tax policy department of the Ministry o f Finance (MOF) has primary responsibility for direct taxes and the majority o f indirect and property taxes. It defines the overall tax policy, determines tax rates, drafts tax legislation and submits proposals through the M O F to the COM. The Budget Department in M O F performs the revenue accounting and forecasting functions. It receives revenue receipt information from tax collection agencies and provides revenue forecasts for use by the Tax Policy Department. Tax collection i s the responsibility o f the State Tax Committee (STC) and the State Customs Committee (SCC), who are both subordinate to the COM. Approximately 85 percent o f the taxes are collected by the STC. These include receipts from profit tax, income tax, value added tax and excise tax. The SCC collects about 13 percent o f tax revenue, with the rest coming from other sources. The STC has offices in each Rayon and Oblast, while the SCC has 180 customs posts manned by 1,400 customs officers along the border and in major airports. The Chairman o f the STC, SCC and Minister o f Finance all report to the Deputy Prime Minister in the COM. T h e STC and M O F discuss issues o f mutual concern through a Council of Experts. The Council rarely meets, and that communications between either o f the two revenue agencies and the MOF must follow a chain o f command up through the respective Chairman o f the State Revenue or Customs Committee to the Deputy Prime Minister to the Minister of Finance, the appropriate M O F Deputy Minister and then to the official to whom the message i s to b e delivered. Accounting, reporting and control of revenues 77. Communication between the collection agencies and Ministry of Finance is improving. The collection agencies have developed a matrix o f management reports which are provided to the tax policy department o f the Ministry o f Finance. However the present information systems preclude the provision o f useful information which would enable more detailed analytical work on tax policy and processes. 78. Collection agencies are investing in information technology. To increase the timely information flow, the tax authorities have been investing in the development o f management information systems. STC has a unified collection system which links local, oblast and Headquarters through satellite. SCC i s investing $24-$27 million to develop and implement unified management information system throughout Uzbekistan. Legal entities have a unique tax identification number and all citizens over 18 years old also have a unique taxpayer identificationnumber.A step forward in the efficient use o f information technology i s the Presidential Decree allowing the use o f electronic signatures with effect from January 1, 2004.17 79. The complexities of tax policy may discourage compliance. In common with other transition economies Uzbekistan faces a major challenge in enforcing existing tax policy without stifling the development o f legitimate economic activity. One crude measure o f the acceptance o f the tax regime by taxpayers i s the amount o f tax collected through the courts or administrative enforcement orders. One estimate, provided by the Ministry o f Finance indicated that between 11 and 15 percent o f taxes are collected through these mechanisms. This creates both an administrative burdenon the tax administration system and creates a cash flow problem due to the gap between the due date and actual collection o f tax revenues. l7Law"On ElectronicDigital Signatures" - 11 Dec 2003 and Law "On E-Commerce'' - 12 Dec 2003. 80. The commercial banking system continues to act as a tax enforcement mechanism. While tax collection is a normal function o f commercial banks, tax enforcement i s not a recognized function and undermines confidence in the financial system. With the support o f a U S Treasury Advisor the Government has developed an amendment to the Tax Code which would restrict access o f the STC to banking information o f taxpayers. Under the draft legislation banks would have to respond (i) to an encashment order, signed by the Head o f the local STC or (ii) a tax demand issued by a Court. This i s an important piece o f to legislation which would contribute to building confidence inthe banking sector o f the Uzbek economy. 81. The efficiency and effectiveness of revenue enforcement mechanisms could be enhanced through further capacity building.The structural and enforcement arrangements carried out by the Control and Revision Unit of STC i s described in Box 6 below. The Committee has started some work on developing risk-based IT systems to identify high-risk taxpayers. The early pilots have been hampered by a lack o f automated data and the overall complexity o f the tax regime in Uzbekistan. The Committee would benefit from technical assistance to develop skills and audit tools relevant to their needs. Box 6: The Control and Revision Unit (CRU) of STC The Control and Revision Unit i s the main tax inspection unit within the STC. The main function o f C R U is to ensure that taxpayers comply with existing tax legislation. This work i s carried out mainly through on-site visits to taxpayers. The Unit has approximately 250 staff; 24 staff based at Headquarters in Tashkent; an average o f 8 staff in each oblast and 3 staff in each rayon. CRU conduct their inspections accordingto an annual audit plan which receives input from the rayons and oblast tax offices. Taxpayers receive on-site visit every two years although more frequent visits can be conducted o f they are included in the annual plan agreed with the Republican Coordination Committee (RCC). C R U also conducts ad-hoc inspections based on the COM resolutions, also coordinated through the Republican Coordination Committee. According to C R U 75 percent o f inspections result in penalties which arise (i)through late payment o f taxes or (ii)inaccurate financial statements which form the basis o f the tax assessment. Main recommendations Short term (within one year) 82. Implement the proposed amendment to the Tax Code which would restrict access by the State Tax Committeeto bankinginformationon taxpayers. Medium term (one to three vears) 83. Simplify the number of taxes and reduce the number of exemptions. The complexity o f the present code i s the core reason for poor tax compliance in Uzbekistan and stifles private sector activity. 84. Capacitybuildingprogramfor enforcement agencies. Developrisk-basedmodel to manage revenue enforcement. Identify IT requirements for auditing based on risk model and selected audit tools. Develop training program for managing risk and audit o f taxpayers based on other countries experience. VI. INTERNALCONTROLSAND INTERNALAUDIT Introduction 85. In many transition countries internal control and internal audit have traditionally been synonymous. Internal auditors are found in a control directorate, at the centre o f government (typically the MOF) and sometimes in spending ministryheadquarters. They are agents o f financial control, whose objective was to ensure that all transactions o f the entity were legitimate and in compliance with relevant rules and regulations. This i s performed through centralized, top-down control activities over budget organizations. 86. Top-down internal audit which focuses on compliance issues does not support managers in budgetary institutions in establishing, maintaining and being held accountable for the internal control environment. That responsibility defaults to the state financial control unitunderresponsibilities establishedinlaw or resolution. 87. There i s increasing international consensus on the approach to public sector internal control and audit.'* Modem internal control frameworks begin with a proposition that it i s management's responsibility to establish and maintain an adequate internal control regime (see Box 7 below). The role o f financial management i s facilitating the delivery o f services and in the effective utilization o f resources. To do so government agencies need internal control systems which encompass governance, and a strong and ethical internal management culture. The role o f the internal auditor to provide independent and objective advice to management on the effectiveness o f their controls and to make recommendations as to how the controls can be improved. [ h r e e mainfeatures of a modern internal control systems 1. The identification of areas of risk, including: Misuse or waste o f financial human and technical resources; Failure to execute budget and other policy decisions (of a financial and non-financial nature) in compliance with rules; Uneconomic and inefficient administration; T h e failure to maintain complete, accurate and timely accounting records; Fraud and corruption; Failure to provide timely and reliable financial management information. 2. The establishment of internal control systems to address these risks; these may be based in law, policies or procedures. Financial controls are a significant component o f management controls. 3. The establishment of a modern intemal auditfunction to check the intemal control systems, to identify gaps and to recommend corrective action by management. 88. Moving to models o f control in line with international norms will be a challenging yet important long term reform. Experience in other former Soviet countries has shown that extensive time and effort i s required to provide a basic understanding o f concepts such as ** IFAC, INTOSAIand the IIA all provide guidance and intemational standards for intemal control and audit. Uzbekistan CFAA: lnfernal Controls and lnternal Audit 26 internal control, oversight and auditing. As discussed elsewhere inthe Report, the timing and sequencing o f the institutional framework o f internal control should be related to broader economic, political and fiscal reforms. The next section o f the Report provides a general overview to the public sector internal control environment and then explores the institutional arrangements for internal audit in Uzbekistan. Current systems of internal control ita Uzbekistan 89. The present system of budget execution results in a loss of budgetary control. The absence o f a modem treasury with an appropriate scope and a classification and information system to provide timely and accurate financial information i s a critical control risk.As a result, there is no overall system o f cash management and cash appropriations are held innumerous government bank accounts over which there i s little direct control. 90. The fragmented control environment creates the possibility of significant liabilities, both actual and contingent, in the Government's extra-budgetary funds, public enterprises and joint ventures. Few, if any, enterprises have separate internal audit unitsand the governance and transparency o f government agencies needto be reformed. The present governance framework i s incapable o f adequately monitoring and controlling these entities. 91. Reforms which can address some of the above weaknesses are being undertaken by the Government. These include the establishment o f the new treasury law, the new Treasury organization within MOF, a common classification system that i s GFS 2001 compliant, the establishment o f a single treasury account, modified payment processes and supporting reporting formats. The Government i s to adopt a centralized treasury model. Oblast and Rayon treasury offices will be centrally controlled by the MOF Treasury department and supported by the Financial Management Information System (FMIS). 92. Roles and responsibilities should evolve and become clearly defined through the treasury reform process. MOF's role should become more focused on monitoring and evaluation o f the budget and setting government wide standards for financial management systems, including internal control and audit. In this environment budget entities should assume full accountability for the formulation and execution o f their planned budgets, includingthe maintenance o f a system o f internal control. Towards an Improved Regime of Internal Control 93. A number o f treasury reforms proposed by the Government have the potential o f improving the internal control environment within the public sector (See box 8 below). Box 8: Important reforms to improve public sector internal controls 0 Completion o f the unified Chart o f Accounts and its implementation for the 2005 budget; 0 Passage o f the Treasury Law and its establishment as a separate unit within the MOF in 2004; 0 Installation o f the FMIS to provide the Treasury with systems to conduct its activities associated with the management and control o f the TSA (currently scheduled for completion in 2007); e Develop reporting systems to enable M O F to monitor rather than conduct detailed controls over budget execution. 94. The separation of duties is a fundamental aspect of financial control. The establishment o f a treasury responsible for payment processing duties separate from the origin o f the payment (budgetary institutions) i s o f fundamental importance. In order to maximize the benefit for financial control o f the establishment o f the treasury, its role in controlling the regular payment orders should be maximized. This i s especially relevant in that one o f the reasons for the establishment o f the treasury i s the weakness in control over budget execution exercised by commercial banks. 95. The Treasury should have responsibilityfor confirmingthat all the elements of a payment order are correct. This implies giving Treasury powers to obtain information from budgetary institutions, including the right to withhold payment in the event that irregular payment orders are suspected with good cause. This requires shifting institutional responsibility for ex-ante control from the Control and Revision Unit (CRU) o f M O F to the Treasury (see further discussion o f the role o f CRUbelow). 96. While developing new financial controls the reforms should be linked to measures which give budget institutionsmore flexibility in making spending decisions. In particular reducing the level of control through expenditure tables. This should be achieved by reducing the level o f detail in the budget tables and allowing greater scope for virement without reference to the MOF. 97. In conclusion the medium term goal of MOF should be able to progressively modernize the internal control environment within government through the new institutional arrangements. However, this i s a complex long-term reform which involves realigning institutional arrangements which convey power and prestige. Institutional arrangementsfor financial control -the role of the Control and Revision Unit Introduction 98. Presently, there is no public sector internal audit function Uzbekistan. The institution chargedwith conducting internal financial control i s the Control and RevisionUnit o f the Ministry o f Finance (CRU). Within the Former Soviet Union C R U was charged with ensuring compliance with delegated budget authority and associated laws and decrees. One o f the challenges in developing decentralized systems o f internal control in line with international norms i s to convert CRU into a modern internal audit function. Uzbekistan CFAA: lnternal Controls and internal Audit 28 99. After the introduction of the new Treasury function responsibility for ex-ante expenditure controls will shift from CRU to the Treasury function. Treasury staff, assisted by the new FMIS, will be able to exercise the ex-ante expenditure approvals for commitments and payments. In the medium term C R U will have to change its role and functions. In the longer term the Government will wish to address how to develop a decentralized internal audit hnction which i s supportive o f management in line ministries and budgetary organizations. The Control and Revision Unit of the Ministry of Finance (CRU) 100. The scope of CRUSwork i s narrow when benchmarked against international standards of internal audit. Its focus i s principally on the identification and quantification o f the misuse o f public hnds and ensuring that they are returned to the budget (see box 9 below)." While this function i s important the medium to long-term goal should be to develop a modem decentralized internal audit function which i s supportive o f the treasury reforms. 101. The narrow scope of the CRU's present control activities is reinforced by its own measurement of performance. While this task i s crucial, inspectors have little incentive to identify broader issues such as weaknesses in internal controls or potential improvements in administrative efficiency. If these issues were addressed, it would improve the long-term development o f budget organizations and could be used as an additional measure o f overall institutional performance. 102. Salaries and incentives within CRU should support the overall goals of the treasury reform. The Ministry o f Finance i s allowed to retain 10 percent o f funds returned to the budget through the activities o f CRU. These are placed in a Special Fund o f which 25 percent i s available for salary enhancements to MOF staff and 75 percent for capital projects within the Ministry. Base salaries for CRU staff are in line with other public servants; however C R U staff can earn up to two times their regular salary based o n results and overall performance. In the medium to long term incentives for CRU staff should be based on the primary and boarder objectives o f improving systems o f public sector financial management rather than the maximization o freceipts. l9AccordingtoitsManagement, inthelastfiscalyear(2003) CRUhas,throughon-sitevisits uncovered irregularities amounting to 600 million soums (0.2% of the state budget) in unauthorized or excess expenditure, the majority o f which has been retumed to the budget. Uzbekistan CFAA: lnfernal Confrols and lnfernal Audif 29 Box 9: The Control and Revision Unit of the Ministry of Finance (CRU) Introduction and scope of work The MOF Control and Revision Unit currently have 860 staff. There is 63 staff in Head Office with the remainder based in 14 regional departments, in the Republic o f Karakalpakstan, and the City o f Tashkent. The regional offices are subordinated to the Head Office in Tashkent and operational departments broadly mirror its structure. The C R U performs three main functions: At the start o fthe budget calendar, CRU reviews the allocation o fbudget resources through budget tables to budgetary institutions; Ex-post audit o f individual budget entities to ensure that budgets are executed in accordance with the registered budget tables. This function i s carried out primarily through site visits by C R U local staff; Ex-post audits o f the execution o f the oblast level budgets by C R U staff from head office. These audits are conducted according to an annual plan and involve a combination o f site visits at major spending units in the oblast. The audit team for these visits typically numbers 10-15 staff. Capacity issues The average age o f CRU staff i s 35-40 and the majority has a degree in finance or economics. Management aim to recruit graduates who have experience in the budgetary systems o f Uzbekistan. The CRU has made efforts to build a performance evaluation system to assess the outputs, quality and results o f their inspectors. Although the Report did not have an opportunity to evaluate this system in depth, it would appear to be quite rigorous; according to C R U management, 250 out o f 550 professional staff put through the evaluation process received unsatisfactory grades. The Team was advised that approximately 10-12 staff i s expelled each year for misconduct, and a further 40-50 are subject to administrative discipline which results in fines andlor wamings. C R U holds annual training courses which cover legislative changes and inspection methodology. Their staff has had few opportunities to leam modem audit methodologies and would benefit from technical assistance in all aspects o f modem internal audit. Towards a modern internal audit function 103. Modern public sector internal audit functions as a service to management, providing it with assurance that its internal control systems are functioning effectively. The focus o f internal audit i s the set o f risks which internal control systems are designed to mitigate, and it follows well-developed internal audit principles and procedures. 104. The experience in developing modem internal audit functions in FSU has been disappointing. First, the agencies such as CRU are a source o f institutional power that finance ministries are often reluctant to relinquish for a more decentralized management model. Second, a CRU is limited in the scope and effectiveness o f its control activities by insufficient human resources and a lack o f supporting information systems. Thirdly, basic concepts o f internal and external audit do not fit comfortably in existing governance frameworks; they need to evolve inparallel with other reforms. Finally, in common with the rest o f the public sector in Uzbekistan, the low level o f salaries makes it difficult for the CRU to attract and retain staff with the expertise and skills necessary to develop a modem internal audit function. Uzbekistan CFAA: lnfernal Controls and lnternal Audif 30 105. Uzbekistan needs to sequence changes to the internal audit function which take into account the limited institutional capacity to implement reforms. The recent IMF FAD Report2' recommended a first step towards establishing a modem internal audit system - the establishment o f an internal audit function inthe new Treasury unit.A key role o f the internal audit department would be to strengthen the role o f the Treasury, thereby strengthening the entire financial control system. This internal audit unit should operate according to international internal audit standards.21 It could operate in a complementary manner to CRU, but there would be regulatory provisions to ensure roles and responsibilities were well defined. Duringthe selection o f staff into the Treasury internal audit department's staff transfers from CRU should be particularly carefully managed to ensure that only adequately qualified, motivated and competent auditors are recruited into the Treasury. 106. In the medium to long term CRU's role might evolve into a centralized internal audit unit. It would operate on behalf o f all budget entities that do not have internal audit units and perform its audits in conformity with international intemal audit standards. Clear criteria must be developed to specify their roles and accountabilities. The creation o f the treasury system will affect the long term staffing requirements for intemal audit. In setting up the new Internal Audit Department it would be important to ensure that appropriate selection criteria are set for the competences required from professional internal audit staff. Main Recommendations Short term (within one year) 107. Endorse the recommendations o f previous studies that an internal audit team be created within the new Treasury directorate, using staff from the CRU that has the required abilities to become the internal auditors for all Treasury operations. 108. Develop and implement a long-term strategy to bring its internal control framework into compliance with international standards. This should provide a roadmap to develop the necessary legislative and structural changes to accomplish it. Medium (one to three years) 109. Develop a long term staffing plan applicable to; (1) the Treasury Internal Audit Department (IAD) and; (2) the modified CRUwithin the MOF. 110. Set minimum requirements for the competence and s k i l l requirements of the Treasury IAD. 111. Solicit donor support for professional development programs and training to allow CRU and Treasury IAD staff gain familiarity with international aspects of public sector accounting, internal control and auditing. 2o Tanberg,, Kohnert, Zohrab and Ramachandran, Uzbekistan: Budzet and Treasuw Reforms. March 2003, Fiscal Affairs Department, IMF.pp 45-47. 21Extensive guidance on the possible govemance arrangements, the role of Treasury IAD and a sample intemal audit manual have been provided in the draft Public Financial Manazement Reform Proiect, PDP Report - September 2003, Annex 10. Uzbekistan CFAA: lnternal Controls and Internal Audit 31 Long term (over three years) 112. Include specific new or amended legislation beyond that establishing the Treasury function, in order to: assign authority and responsibility to the Minister o f Finance for the establishment o f an effective internal control and audit framework inthe Government; redefine the respective roles and responsibilities o f CRU and Treasury Internal Audit Department; require the creation o f internal audit units in all major budget entities; authorize the creation o f a modem, standards-based internal audit unit within the MOF. MOF CRU should be converted into a central internal audit unit, resident in MOF, performing audits across all budget entities that do not have their own internal audit units. vest authority with the Minister o f Finance to establish the qualifications, training, certification, audit and reporting standards, policies and guidelines that would apply to all internal auditors inthe Government. Uzbekistan: CFAA: Exfernal Audit 32 VII. EXTERNALAUDIT Introduction 113. Auditing, together with internal controls and monitoring processes and mechanisms are part o f the essential checks and balances over the use o f public resources in government. Effective external audit provides an independent assessment that the overall objectives set by Parliament and government are being met and gives assurance as to the overall quality o f public expenditure and the management o f public assets and liabilities. Without this assurance there i s a risk o f flawed information, mismanaged resources and that policy decisions are ignored by operating units. 114. The fundamental distinction between external and internal audit pertains to the degree o f independence o f the auditor inrelation to the audited entity and to whom the audit report i s addressed. To be effective and objective in their audit work the external auditors should be fully independent from the audited entity and their audit reports should be addressed to entities separate from the bodies being audited. The differentiation between internal and external audit should not preclude close cooperation between the two functions as they carry out their respective responsibilities. 115. Fundamental principles o f auditor independence cause difficulties in the context o f the present institutional and constitutional arrangements in many CIS countries. This should not preclude the short to medium term development o f an audit institution which provides additional assurance to the COM, Parliament and public over the use o f public funds. 116. International standards issued by International Organization o f Supreme Audit Institutions (INTOSAI)22 provide guidance on the legislative base for external auditors. These include audit independence, objectivity, standards to guide the conduct and reporting o f audits, training o f external auditors and quality control processes. Progress on the development of a SupremeAudit Institution 117. To date limitedprogress has beenmade on the development of an independent SAI. Previous diagnostic reports recommended the establishment o f an independent Supreme Audit Institution (SAI)..23 The Parliamentary Committee on Budget, Banking and Financial Issues has also recognized the need for such a function to fulfill its budget oversight function. 118. In 2002 a Chamber of Accounts (COA) was established within the President's Office.24The Chamber is accountable both to the President and the Oliy Majlis, and is to be "an independent organ, independent and objective in its assessments". Although the COA lacks a number o f the attributes o f an external audit function, it could be developed into one. The COA currently has nine staff and i s managed by a Collegium (Board) o f ministers that meets twice annually. Currently it uses CRU and revenue inspectors from other entities to provide the resources required to perform its work program. In September 2004, it has 22 For more information see INTOSAIwebsite www.intosai.org 23 See for example - Narayan and Reid; Financial Management and Governance Issues in the Republic of Uzbekistan, Asian DevelopmentBank, 2000. 24Presidentialdecree# UP 3093 (21 June 2002) as amendedby Decree # 3157 (4 Nov 2002). Uzbekistan CFAA: External Audit 33 acquired expanded office space in the new Senate building, as a first step towards increasing its staff. These audit reports are not published, nor are they tabled in Parliament. 119. A limited number of audits are being performed. The COA is carrying out a limited number o f compliance audits focusing on the execution o f the state budget. The scope o f COAs work program i s limited by a lack o f staff. Consequently the annual audit coverage (percentage o fbudget funds subject to COA audit) i s extremely low. Main Recommendations Short term (within one vear) 120. The COA does not meet the I N T O S A I criteria for independence, nor does it follow international auditing standards in the course o f its audits. It is, however; a nascent external audit function, and could become the foundation for the development o f an acceptable state audit organization. A short-term development plan might cover the following steps. Step I - Establish the Legislative Base. 121. The COA should establish a legal basis for its activities.The COA should seek technical assistance from donors to provide international experts to assist in the preparation o f a draft law. The Government should ensure that the provisions inthe draft law require that the Chamber o f Accounts report to the Budget and Finance committee o f the Oliy M a j l i ~ ~ ~ . 122. At this embryonic stage of its development, the dual reporting relationship to the President and Parliament may provide both the authority and protection for the COA as it conducts its work. Dual reporting could be continued until the function has matured and its role i s established across Government. The long term goal should be for the COA to report directly to Parliament. 123. The new law on the Chamber of Accounts should be passedby the government and approved by the Parliament before the constitutional changes come into effect in January 2005. Step 2 -Increase transparency and disclosure of audit work. 124. Currently neither the annual audit programnor the audit reportsof the COA are available to the Oliy Majlis or the public. Internationally the requirements for the distribution o f audit reports are often specified in the laws establishing the SAI. SAIs i s usually required to submit all reports to Parliament and most have considerable discretion in the distribution o f their findings. 125. In many countries audit reports are available to the public unless restricted for reasons of nationalsecurity. Ina democracy the general public has a legitimate interest inthe resultso fthe audits o fpublic entities andthe use o fpublic funds. 25Duringthe CFAA Mission there was considerable confusionregarding the reporting relationship betweenthe C O A and the budget institutions set up within the bicameral Parliament (Oliy Majilis and Senate). This needs to be clarified through the process o f drafting the legislative base for the COA. Uzbekistan CFAA: Exfernal Audit 34 Step 3 -Resource Chamber of Accounts, recognizing limited capacity to absorb new concepts. 126. A qualifiedand eminentfinanceprofessionalshould be appointedas President of the COA. This appointment should be made under the same terms as the Constitution provides for the appointment o f other senior independent positions (e.g. President o f the Supreme Court). 127. The COA should conduct staff recruitmentbased on clearly definedskills and competences, many of which are new to auditors in Uzbekistan. Staff should have the necessary education and experience to learn modem auditing techniques that conform to international auditing standards. The COA should develop a capacity development program which recognizes that in the short term it will have limited capacity to absorb new concepts and techniques. Step 4 - Enlist Supportfrom the International Community. 128. The Chamber o f Accounts should build links and organize training events with other SAIs in developed countries so that they can learn from their experience. The Government should initiate discussions with the international donor community in order to arrange funding for peer support from SAIs that have already completed the transition to a modem external audit function. Medium term (one to three vears) 129. Develop skills in financial attestation audits. As noted above the COAs current work i s focused on compliance auditing; reviews o f individual transactions after the fact, to ensure that appropriate authorizations and documentation are present. Modem ex-post financial audits are broader in nature and involve an attestation o f the financial accountability o f government entities, involving the examination o f financial records and the expression o f an overall opinion on the financial statements. These audits are new to the public sector and the COA should develop these skills steadily over time with the support of international expertise. Initially the COA should carry out a number o f pilot audits and closely monitor the process and the results o f this work. 130. Define and build reportinglines to Parliament. The COM is likely to influence the work program of the COA in Uzbekistan in the medium to long term; however this should not preclude the development o f reporting lines to Parliament. For example the audit reports could be sent to the Budget and Finance Committee and management o f the COA could appear before the Committee. Creating this relationship would increase the transparency and credibility o f the mandate o f the COA. Long term (over three vears) 131. Conduct an audit of the annual budget execution report. The COA should plan to conduct an audit o f the annual budget execution report when the Government first prepares financial reports based on internationally recognized public sector accounting standards (see also Section IV o f the Report.) Uzbekistan CFAA: Public Enterwises 35 VIII. PUBLICENTERPRISES Introduction 132. Public enterprises are not part of the definition of general government in Uzbekistan. However, they conduct transactions that can have significant fiscal implications for the Government. These include the payment o f dividends, the receipt o f budgetary subsidies to cover losses, debt interest payments or loan payments due, the receipt o f public loans or guarantees, and liabilities that can be a source o f contingent liability for the Government. 133. Building a framework for oversight and monitoring the activities of public enterprises i s an important element of a country's framework of financial accountability. The key elements are: (1) improving systems o f corporate governance, financial reporting and auditing in enterprises; (2) developing the monitoring and oversight functions within Government, and (3) increasing the availability and transparency o f information to Parliament and public. Framework of oversightfor public enterprises in Uzbekistan 134. Uzbekistan has a large and complex web of corporate structures and institutions. In Uzbekistan the executive branch o f Government consists o f ministries, state committees and agencies. At the sub-executive level, there are agencies, which consist o f former sector ministries that have been partially privatized and allowed to operate on a quasi- commercial basis. The executive has substantial ownership interests in public enterprises, as there has been little privatization o f large enterprises. The country does not have an overarching state corporation's law and many o f the state enterprises are regulated by Presidential Decrees and have Charters and Resolutions approved by the COM. The governance arrangements for the use o f state powers are only partially defined, as the constitution does not formally specify the powers o f executive bodies and ministries, state committees, and associations; and they can all issue directives that have the force o f law. 135. Information on the exact number of state owned enterprises i s difficult to obtain. In addition to the public enterprises, there are also approximately 8000 enterprises without corporate form, an inheritance o f the country's Soviet past. Examples include hospitals, clinics, kindergartens, and other public service entities. The difficulty in compiling a complete inventory i s compounded by the definition o f what constitutes a public enterprise. The Government restricts this category to those that are 100 percent owned by the State. Any dilution o f this ownership by entities other than the State Property Committee places them in the Joint Stock Company (JSC) category, even if the shareholder i s another state entity. In reality the majority o f these JSCs remain under state control.26 136. Oversight and monitoring of public enterprises i s fragmented. The State Property Committee (SPC) i s responsible for (1) the implementation o f the privatization strategy o f the Government; (2) governance and public enterprises and the management o f 26Under Intemational Financial Reporting Standards effective state control would apply in any case where the Government owns more than 50% o f shares; this percentage can be significantly less ifthe state exercises significant control over the appointment o f key management staff or determines the finance and operating policies o f the entity. Uzbekistan CFAA: Public Enterprises 36 state property in company's where state ownership i s less than 100percent. The SPC's role in governance includes the regulation o f production and prices o f outputs in a number o f economic sectors, establishing the required authorized capital for Joint Stock Companies, and establishing limits o f outside ownership in the joint stock entities. Oversight o f public enterprises (i.e. 100percent owned by the state) i s the role o f the responsible ministry and the COM. 137. State representation on the Supervisory Board varies according to the percentage ownership of the capital of the entity. Inthose cases where the State ownership exceeds 50 percent, the Government appoints the Chairman o f the Board. Where the state holds less than 50 percent, a state trustee i s appointed from one o f a number o f professional management companies that provide trustees on a fee for service basis. The Trustee submits a report annually to the SPC describing the activities o f the trustee for the period. It does not contain the detailed financial statements, but does provide some financial information on revenues, expenses less salaries, accounts payable and accounts receivable. There i s no balance sheet report. The MOF monitors the dividend policy (and revenues into the budget) through the Government's board trustee. Governance of Public Enterprises 138. Due to ill-defined lines o f authority, there i s little external and internal discipline on corporate performance, and little effective separation between government and business. There are two broad categories o f factors that determine the performance o f the modem corporation: the internal incentive arrangements between owners and managers, and the external factors that discipline and monitor the behavior o f managers and ultimately the firm's p e r f ~ r m a n c eUnder the current corporate framework inUzbekistan, there i s a lack o f . ~ ~ clarity on the role o f directors, relative to shareholders and managers. Conflicts o f interest arise as many shareholders and directors o f JSCs are also public sector officials who have policy and regulatory responsibilities (See Case Studies for two o f the largest public enterprises below). 139. The government could benefit from a single ministrybeing given responsibility for the financial monitoring o f public entity or enterprise operations. This ministry would be responsible for, among other things, developing specific dividend and investment policies to maximize the benefits to the state, engaging external auditors, participating actively on behalf o f the central government in the supervisory Boards o f public entities or enterprises and preparing the required consolidated financial reports, and including them in notes to the government's financial statements. 2'This issue i s discussed in detail in Harry G.Broadman, Competition, Corporate Governance and Regulation in CentralAsia: Uzbekistan s Structural Reform Challenges, World Bank, May 2000 Uzbekistan CFAA: Public Enterprises 37 Case Study - Governance and FinancialManagementin Major PublicEnterprises Uzbekenergo was createdby Presidential Decreein 2001 from the former sector ministry for the generationand distribution of electrical energy.Although 100percentstate-owned,it was established as a Joint StockCompany (JSC) becausea number of entities itcontrols are JSCs. Its revenues come from electricity generationand distribution to regional electricitycompanies inUzbekistan.It does notreceivesubsidies from the State. Managementstructure, corporate governance and staffing. The main governing body is the Company's Councilchaired by a deputyprime minister, and including heads of elevenministries,agencies and two major public enterpriseclients (Uzneftgaz, Uzhimprom). There is also a SupervisoryCouncil whose primary focus is on strategicdevelopment and monitoring economicperformance. Its capital investmentprogramis reviewed and approved by the government (Ministry o f Economy and Agency for Foreign & ExternalEconomicRelations). The organizationalstructure and staffing levelswere establishedby COM Resolution;however managementcan make changes within the overall limits of the establishedstaff units.The ManagementBoard comprises ofsevenmembers; the Chairmanand six deputies, recommendedby the Council and approved by the COM. Accounting, reportingand internalcontrol structures. Internalcontrol is providedby the management structurewhich ensurescompliance with company's procedures.There is no intemd audit function, althougha unit similar to CRU performs the control function. Accounting is conducted according to the NationalAccounting Standards VAS) and consolidated accountsin accordancewith FRS. Uzbekenergoprepares annual audited financial statements,butthere is no requirement that they be tabled in Parliamentor published.The financial statements are preparedinaccordance with NAS and summary financial statements are presentedto shareholders. Copies are sent to the MOF, the Stde StatisticsCommittee andthe responsible sectorministry. All public enterprises preparemonthlytax reports to the State Tax Commission(STC) andother revenue agents. Audit arrangements. The SupervisoryBoard appointsthe extemal auditors. Two audit firms currentlyaudit the company. An intemationalfirm conductsan audit o f the consolidatedentityusinginternational auditing standards2*and a local audit firm performs audits inaccordancewith NationalAccounting Standards for tax purposes as requiredby law. The CFAA mission was unable to obtain copies o f the audit reports.The companyundergoes inspection every two years by the STC, as well as regular inspectionsby the Oil, Gas and EnergySupervision Agency and the MOF Control & RevisionUnit. Uzkommunhizmat(communalutility) was created as a part ofthe communal utility sector reforms that beganin 1993.These reforms beganby the privatizationof apartment blocksby the Ministry o f Housing and Utilities. In 1995,that ministry was transformed into the Ministryof CommunalUtilities. Subsequently,a PresidentialDecreeconverted the Ministry of CommunalUtilities into UzkommunhizmatPublic Enterprise.Itbothregulates and managesthe gas supply and inter-regional water distribution system. It also finances three research institutes. Becausethe governmenthas asingle-price policy for the provision of gas and water, it manages inter-regionalcross-subsidies.The state subsidiesthe company's services to permitit to break even on an annualbasis. Managementstructure, corporate governanceand staffing.Uzkommunhizmat is a public holding agency that is 100 percent ownedby the state. Itreports to the COM throughits Supxvisory Boardwhich is chairedby a deputy primeminister. There is 25,000 staff distributedthroughout Uzbekistanthat provides andmaintainits gas, water andnew capital investment 1operations. There is a Collegium(Board) approvedby the COM, consisting offive members-includingthe General Director,his deputiesand other managerialstaff ~ Accounting, reporting and internalcontrolstructures Accounting isconductedaccording to NAS. No audit is required o f the Agency's financial statements. Consolidatedfinancial statementson the activities ofthe Agency are submitted to the MoF, MoE, among other interestedagencies. The Agency has the right to receive and review financial statements from subsidiary companies under it. The wholesde and retailgas tariffs chargedby the Agency are set by MOF and approvedinthe annual budget by the Oliy Majlis. The Agency is subjectto the usualinspectionregime by the STC, the SCC and other revenue agents. There is no intemd audit function, but there is a control inspectorateresponsibleforbill collection and identification of unauthorizedconsumers inthe gas pipelinenetwork There are alsoregionalinspectoratescreatedwithin the regionalgas supply companiesto carry out the aforementionedtasks. The financialstatements are not requiredto be published, nor are they tabled inParliament.Copies are sent to the MOF, the Stae Committee of the Republic of Uzbekistanon Statistics and the MOE. 140. Supervisory Boards should be more independent for public enterprises. These could consist o f representatives from major clients, public interest groups and MOF. Board members would have greater accountability for the conduct o f the entity's operations. Budgets and financial statements should be reviewed and approved by the Supervisory Board ** The ISA-based audits are conducted because they are requiredby IFIs that have financed development activities of the company. on a regular basis, and the Board should review the auditor's report on the final statements for the year at the same time as the financial statements 141. Financial information relating to public enterprises i s incomplete and of questionable reliability. There i s no consolidated database on the financial performance o f public enterprises. Financial statements are not published or systematically analyzed in Government. As a result there i s a lack o f information on the magnitude or the extent o f their operations and their financial performance. The financial risk posed by public enterprises i s therefore not fully known by Government as it does not have timely and accurate financial information on the results o f public enterprises' operations (revenues and expenditures) or on its financial condition (assets and liabilities, contingencies). 142. Most public enterprises follow the national accounting standards (NAS) and are required to have audits but these do not comply with international standards. Although NASs are said to be based on International Financial Reporting Standards (IFRS), according to practitioners there are significant differences, for example in the areas o f fixed asset valuation and disclosure requirements that undermine transparency o f financial reporting. Public enterprises are required to have annual audits o f their financial statements. However, these audits are usually conducted primarily for tax purposes and do not comply with international standards. Main recommendations Medium term (one to three years) 143. Reform of the regulatory framework. Reforms should be introduced to separate policy and'regulatory activities where conflicts o f interests arise, and privatize commercial operations so they do not have access to state powers. A legal framework should be created for the management and operations o f state owned enterprises, with clear provisions for financial accountability and governance and well established governance structures. 144. There should be requirement to use International Financial Reporting Standards29for accounting and reporting of the results of the enterprise's activities in their financial statements. Adoption o f International Financial Reporting Standards could be on a phased approach, based o n the size and nature o f the enterprises. 145. The Government should encourage the use of independent external auditors to conduct the annual audit of IFRS financial statements of the enterprise, using International Standards of Auditing (ISA). The Government could conduct select two public enterprises for pilot audits o f their 2004 financial statements by an external, private sector international auditing firms using ISA. The audited financial statements should be published. Long term (over three years) 146. Increase transparency of financial information. Priority should be given for annual audited financial statements o f public enterprises and joint stock companies to be available to the COM, other shareholders and to the Oliy Majlis. These audited financial 29The Govemment should adopt a full translation of IntemationalFinancialReportingStandards which couldbe appliedto public interest enterprises;which would includethe major public enterprises. Uzbekistan CFAA:Public Enterorises 39 statements should be submitted to the responsible government minister,who would then table them inParliament within a specified period o f time. 147. Establishment of sector ministries to conduct policy. The Government should consider devoting to sector ministries in infrastructure sectors, such as energy, the responsibility o f defining that set policy and providing advice to the COM on the regulatory framework within those sectors. The Government could investigate ways o f strengthening the governance arrangements for government owned agencies to increase the level o f transparency and accountability o f their operations so that policies are implemented in the way envisaged by the COM. Uzbekistan CFAA: Financial Manaaement Arransements in Bank Funded Projects 40 IX.FINANCIALMANAGEMENTARRANGEMENTS INBANK- FUNDEDPROJECTS Introduction 148. This section reviews the financial management arrangements, in respect of World Bank (the Bank) requirementsfor IBRD/IDA-financedprojects. The present portfolio Specifically, it: (a) assesses the general quality o f the financial management arrangements for the Bank- financed portfolio; (b) highlightsthe key issues which affect the overall quality o f financial management inthe Bank portfolio; and (c) recommends measures to improve financial management arrangements in hture Bank operations. 149. The UzbekistanBank portfolio currently consists of ten operations (eight IBRD Loans and two IDA Credits). One loan, closed on December 31, 2003, i s being extended retroactively, while one loan due to close in June 2004, was extended for a limited period. Subject to the outcome o f on-going discussions between the Bank and the Government two new operations may enter the portfolio in FY05. There are also two project preparation activities financed by one PPF Advance and two PHRD Grants. Financial Management Arrangements Institutional arrangements 150. All World Bank-financedprojects in Uzbekistan have been managed by stand alone project implementing units (PIUs). This mitigates against the risks associated with weaknesses in government systems, but does little to develop long term public sector financial management capacity in government ministries and agencies. 151. Availability of skilled staff remains a challenge. The core fiduciary staff in each PIU includes an accountant and a procurement officer. Recruiting skilled accounting professionals, for projects i s difficult; PIUs often hire staff with an economics or bookkeeping background that then undergo training in project financial management. There are a small number o f experienced project accountants that tend to rotate amongst the PIUs. Inaddition PIU staff earns considerably more than government employees. These disparities create resentmentwith counterparts inthe line ministries. 152. PIUs install project financial management systems which are not integrated into the government accounting, reporting and audit systems. They maintain separate audit book-keeping systems and project financial statements are audited annually by private audit firms. These are subject to periodic reviews by World Bank staff to determine their eligibility to audit Bank-financed projects. Uzbekistan CFAA: Financial Manauement Arranqements in Bank-Funded Projects 41 153. Financial management arrangements for new projects are assessed to meet Bank's own fiduciary requirements. The practice i s to have acceptable financial management arrangements (i.e. project accounting, financial reporting, internal control, and auditing and financial management staff) early in the project cycle (prior to presentingto the project to the Bank's Board). This avoids disbursement delays during project implementation. These Bank requirementshave generally been met inUzbekistan. Financial Management Supervision 154. Bank staff conducts risk-based financial management supervision to ensure that financial management arrangements remain effective throughout project implementation. This supervision takes place once or twice a year depending on the assessed level o f fiduciary risk. 155. Project financial management systems have generally been satisfactory however some weaknesses have been noted inbudgeting, financial reporting and internal control inthe Uzbekistan portfolio. 156. Only a .few qualified project audit reports - timeliness remains an issue: A desk review o f the audit reports for FY 2002 indicates that the most projects received an unqualified audit opinion. Only two o f the audit reports contained qualified audit opinion. However, compliance with audit covenants was low. Out o f eleven projects with audit reports due by June 30, 2003, only six had submittedtheir audit reports on time. One project had its audit requirement waived due to delays in implementation, while four projects (about 36 percent o f the portfolio) had overdue audits, including one audit report that did not meet Bank requirements. 157. The following issues have been identified from bank supervision and audit reports received: 158. Budgeting: i s usually limited to procurement plans and counterpart funds; it i s not consolidated to show the overall position o f the project. Budget figures used for quarterly Project Management Reports (PMRs) have been, lifted from the Project Appraisal Documents (PAD) with little reference to the realities o fproject implementation. 159. Internal control: weak organizational structures result in inadequate segregation o f responsibilities for executing accounting transactions and reporting on project activities. This has given rise to cases o f inaccuracies, errors and incomplete records. None o f the PIUs have an internal audit function. Weaknesses in the internal control systems are not detected on a timely basis and often only highlighted in the auditor's annual management letter. Visits to PIUs by the MOF Control and Revision Unit are generally for inspection purposes to establish non-compliance with tax and other government regulations, not for internal control audits. 160. Non-compliance with Bank requirements: On occasion Bank funds have been commingled with other funds and not separately maintained as required. There have also been instances o f inadequate accounting for counterpart resources. Due to a lack o f counterpart funds, the Bank funds have been often used to pre-finance ineligible expenditures that should have beenpaid out o f counterpart funds. Uzbekistan CFAA: Financial Manaqement Arranqemenfs in Bank-Funded Projects 42 161. External Audit: Uzbekistan i s still to develop an independent Supreme Audit Institution which the Bank could rely on for auditing Bank-funds. Currently external audits o f Bank-financed projects are performed by independent private sector auditors who are selected in accordance with procurement guidelines and terms o f reference approved by the Bank. 162. Most local firms lack either the technical capacity or the requisite experience to carry out audits of Bank-financed projects. The Bank carries out periodic on-site assessments o f audit firms to determine their eligibility to audit Bank-financed project^.^' Other than two o f the international audit firms, only one local firm was considered conditionally eligible to carry out project audits.31The majority o f Bank-financed projects are audited by international audit firms based inAlmaty, Kazakhstan or Tashkent. TowardsMainstreaming Project Financial Management 163. Stand-alone project implementation units have been a necessary short-term, risk- mitigating strategy. Generally fiduciary arrangements for Bank projects hnction well in Uzbekistan. However, establishing fiduciary safeguards and financial management arrangements outside the national institutions o f accountability does nothing to contribute to the development o f sustainable financial management capacities inpublic institutions. 164. The Government's current efforts in public finance reforms will strengthen public sector financial management arrangements. Work discussed elsewhere in this Report should strengthen accounting and reporting, increase transparency and accountability, create a modem treasury function and institutions o f control, audit and supervision. As the government demonstrates progress in addressing its internal control weaknesses the Bank could envisage placing gradual reliance on elements o f the Government's financial management systems, reviewed o n a case-by-case basis. 165. Moving towards reliance on national institutions and public financial management systems will require a phased approach based on demonstrable progress towards strengthening these institutions and systems. In the medium term the Government should work towards integrating the PIP and external financing into the budgetary process.32The Ministry o f Economy should be responsible for developing a methodology for project appraisal and quality control o f proposed projects, which would include financial management arrangements. 30The last review for Uzbekistan was carried out in M a y 2003. 31Conditional eligibility means the audit firm does not meet all the requirements fo; full eligibility; and may only participate in tenders for audit of Bank-financed projects in their countries o f domicile. 32This is discussed in more detail in the PER. Y " 8 r: d . d z rc 0 m W LL 8 . . d z Q 2 d z . . d Q . d Q z z 2 z 5 e, 0 Y Y b" W 2 9 W t- 00 p u . . z d d 2 c 9 z . .d z d z k l c M E c 0 L v) 8z 8r: m . Q . Q 2 z . . Q Q Q 2 z 2 L 2 0 N N N M E 0 E u 84- 8I . zdi z . . d z d z i z . < z . d z 0 M .-Ea - 0 U EE d8 c? m r- N N N N L d 3 M E . . c m zd 4 z . 4 z 00 0 2 d cl m ANNEX I1-INTERNATIONAL STANDARDS AND CODES For the purpose o f conducting quality CFAAs in all o f the Bank's borrower countries, guidelinesand questionnaires have been developed to assist the Bank's staff in the process o f assessing the financial accountability arrangements. The structure o f the CFAA follows from these guidelines. Since the administrations o f the borrower countries are often looking for benchmarks against which their systems can be measured, this report contains clear references to those internationally accepted standards and codes that employed to develop the CFAA guidelines. Inthe case o f many poor/low capacity countries these standards and codes should be seen as long term goals rather than benchmarks which can be used in the assessment o f current systems. One way o f facilitating financial accountability i s to promote the application o f standards and codes for the practice o f the most essential financial management tasks, such as budgeting, accounting, internal control, internal audit and external audit. The internationally accepted standards and codes used in the CFAA report includes those promoted by the Council o f Europe, World Bank, IMF, the Organization o f Economic Cooperation and Development (OECD), the Committee o f the Sponsoring Organizations o f the Treadway Commission (COSO), the International Accounting Standards Board (IASB), the International Federation o f Accountants (IFAC), the Institute o f Internal Auditors (IIA), and the International Organization o f Supreme Audit Institutions (INTOSAI). An overview o f the standards and codes referred to inthis CFAA i s presented intable 1. Table 4: Standards and Codes PromotingFinancialAccountability I Organization 1Standards & Codes I I cos0 1 Framework for Intemal Control I IASB InternationalAccounting Standards (IAS) 0 Intemational Financial Reporting Standards (IFRS) IFAC 0 Intemational Public SectorAccounting Standards (IPSAS) Intemational Standards on Auditing (ISA) IIA 0 Standards for the ProfessionalPracticeof IntemalAuditing (SPPIA) IMF Code of GoodPracticeson Fiscal Transparency GovernmentFinancial Statistics (GFS 2001) System ofNational Accounts 93 (SNA 93) INTOSAI INTOSAIAuditing Standards (INTOSAI AS) OECD 0 Best Practicesfor Budget Transparency 0 System ofNational Accounts 93 (SNA93) OECDPrinciples of Corporate Governance World Bank I TreasuryReference Model Systembf National Accounts 93 (SNA 93) .-F * .-E: em -8 'S +- m x 5e, 4. v) 6 v) .-* F 0 0 s Er, ... ... 0 0 m W W cn .52. . 0vi 2i vi 0 00 Q vi 0 0 W u) OI 7 W 3 -gw i $ 5 .I z0 Y e, W e, 2 8 Bb B n B 8 5V 0 B u u3 -0 - 14 f Ym 6 zmE W .- E,2 l2> z" r- w m 0 * 6 b 0 -06!i .I Y e, Y H m .C w.- 0 YE .-E, i B UF 'S+ a E .-0 c Y b 3c 5* * 6 *6 - E E 0 0 W c W B 6> hbekistan CFAA Annex IV Ovenliew of Governance Arranaements-Major Extra Budqefaw Funds 52 ANNEX IV: OVERVIEW OFGOVERNANCE ARRANGEMENTSMAJOR - EXTRA BUDGETARYFUNDS jItem Road Fund Pension Fund EmploymentFund State Property Fund Legal Basis Law on the Road C O M Decree # 459 Law on Employment :OM Decree # 481 Fund#I20 (27Dec96); 5 Jan 1998 120 Oct 97) (2 Feb 1996) Resolution 498 (23 2oM Resolution #36: C O M Decree Dec 2000) :22 Aug 98) #334 (5Jun93); Resolution 444 (15 ZoM Resolution #51: Resolution 361 N o v 2000) 14 N o v 03) (21 August 2003) Revenues Percentage - 31.6 YOo f Gross - 0.9 % o f Gross Privatization charges on all Revenues From Revenues from receipts from the entities and Economic entities Economic entities sale o f public vehicle collected by State collected by State Tax Enterprises. p ~ r c h a s e r s ~ ~ . Tax Commission as Commission as part o f 5% o f revenues go part o f the Unified the Unified Social In2003 55.8 Billion to a Contingency Social Payment, - Charge; soums were Fund, unexpended 2.5% o f salary from generated. funds carryover at and year end -employees 0.7% gross revenues o f products (goods and services sold). Expenditures Construction and Pensions and social Unemployment Revenues are reconstruction, benefits and allowances, training allocated as equipment for compensatory cash programs and - to road construction payments for labor marketjob fOII0WS:- 40% & maintenance. communal services. creation measures the State Budget. Work performed targeted for high 30% - Allocated to by Uzavtoyol, a poverty areas. the appropriate Public Enterprise Monthly surplus regional construction distributedto other administration company entities with shortfall. (Council o f Ministers o f Karakalpakstan, khakeems' offices o f oblasts, City o f Tashkent ) for infrastructure development and social projects 5% - stays at SPC for maintenance and administrative expenses, privatization programs, etc. 34 1.5% gross revenue for economic entities, 2.5% for transport companies; 1% gross income for Wholesale trades, 1.5% for banks and insurance companies; 6% o f car and 20% o f busltruck purchase value; transit fees for all vehicles entering or leaving Uzbekistan. Uzbekistan CFAA: Annex IV: Overview of Governance Arrangements -Major Extra-Budgetaw Funds 53 Item Road Fund PensionFund Employment Fund State Property Fund commercial banks commercial bank for make all payments for collect and remit all Oblasts and Employment Fund RF fees another for all Rayons collect remittances from employers -Organization Staffin 45 in Tashkent 8 in Tashkent 3 in Tashkent 10inTashkent HQ Regional - Staffin Contracts with Approximately 700 Approximately 400 in About 30 (=2 in each Regional Uzavoyol for all inOblasts and Oblasts and Rayons oblast, RK and Offices construction and Rayons Tashkent city) maintenance Boardof Management No, the MLSP has No, the MLSP has Special Supervisory Directors Council of 21 overall overall accountability Board plus State person from accountability for the for the management o f Trustees in each Ministries, RF and management o f the the Fund. Public Enterprise key clients Fund. Budget Based on Fund Pension Fund Employment Fund Prepared by GKI ,if Preparation forecasts o f each prepares and submits prepares their budget n o financial client sub group to M L S P for dependence on the approval budget, MOF plays n o role. Budget Review Management STC reviews STC reviews revenue Special Supervisory and Approval Council revenue forecasts; forecast; Board approves budget MLSP approves and MLSP approves and and sends to MOF sends to MOF send to M O F Budget Execution o f the MOF C R U conducts M O F C R U conducts M O F CRU conducts Execution Road Fundbudget annual inspection. annual inspection. annual inspection. Monitoring performed by Periodic audit by and Control Road Fundunder Chamber o f Accounts. the Ministry o f Finance. ExternalBoard N o non-public N o t applicable Not applicable N o t applicable Members entity board members Approve Minister o f Minister o f Labor Minister o f Labor and Special Supervisory Budget and Finance as Chair and Social Protection Social Protection Board AnnualReport o f the Management Council External No legal Private Sector N o audit requirement Chamber o f Accounts Auditor for requirement for Auditor conducts periodic AnnualReport external audit. audits. Annual No. Summary o f Yes, by Minister o f Yes, by Minister o f Yes, by Minister o f Financial major issues and Finance as part o f Finance as part o f the Finance as part o f the ReportTabled challenges facing the Budget Budget Execution Budget Execution in Parliament RF. Execution Report Report Report Annual Report No. No. No. Annual report Made Public Not required Not required Not required published in the newspapers