Report No. 28941-GE Georgia Country Financial Accountability Assessment September 26, 2003 Operations Policy and Services Unit Europe and Central Asia Region Document of the World Bank TABLE OF CONTENTS TABLE OF CONTENTS ........................................................................................................................... i A PREFACE B EXECUTIVESUMMARY ...III I 1 I1 BUDGETFORMULATIONAND EXECUTION ....COUNTRYBACKGROUND............................................................................................................. ..................................................................................................................................... -...... .......................................................................................................... i ........................................................................... 5 1. LEGAL BASIS...................................................................................................................................... 5 (a) The 2003 Budget SystemsLaw ............................................................................................ 5 (b) 6 (c) Discussion Scope of the Budget............................................................................................................... ............................................................................................................................. 7 (d) Recommendations ................................................................................................................. 7 2. SUB-NATIONAL (a) Current Arrangements ........................................................................................................... GOVERNMENTS ........................................................................................................ 88 (b) Discussion............................................................................................................................. 9 (c) Recommendations ............................................................................................................... 10 3. PUBLIC ....................................................................................................................... 10 Discussion........................................................................................................................... Current Arrangements ......................................................................................................... ENTERPRISES (a) 10 (b) 12 (c) Recommendations ............................................................................................................... 14 4. BUDGET 14 14 Budget Preparation Cycle.................................................................................................... Current Arrangements ......................................................................................................... REALISM............................................................................................................................ (a) (b) 16 (c) Discussion........................................................................................................................... Classification....................................................................................................................... 17 (d) 17 (e) Recommendations ............................................................................................................... 17 5. BUDGET 18 (a) Current Arrangements ......................................................................................................... EXECUTIONPROCESS ......................................................................................................... 18 (b) Arrears ................................................................................................................................. 19 (c) Recommendations ............................................................................................................... 20 6. TREASURY Legislativebase................................................................................................................... OPERATIONS ................................................................................................................. 20 (a) 20 (b) Recommendations ............................................................................................................... Progress............................................................................................................................... 21 (c) 21 I11 .ACCOUNTING& REPORTING ........................................................................................... .-....23 (a) Accounting .......................................................................................................................... 23 (b) Reporting............................................................................................................................. 24 (c) Discussion ........................................................................................................................... 24 (d) Recommendations ............................................................................................................... 25 IV INTERNALCONTROLS . .............................................................................................................. 26 (a) Internal Control Framework ................................................................................................ 26 (b) 31 (c) Recommendations ............................................................................................................... Combating Corruptionthrough Improved Internal Controls................................................ 33 V . INTERNAL AUDIT ......................................................................................................................... 34 (a) Legislative Basis.................................................................................................................. 34 (b) Recommendations ............................................................................................................... Discussion........................................................................................................................... 35 (c) 37 VI EXTERNALAUDIT . ................................................................................................................. -....38 (a) Discussion........................................................................................................................... LegislativeBasis.................................................................................................................. 38 (b) 38 40 VI1 LEGISLATIVE SCRUTINYAND PUBLICACCOUNTABILITY .(c) Recommendations ............................................................................................................... ......................................... 42 (a) Legislativebase................................................................................................................... 42 (b) Discussion ........................................................................................................................... 42 43 VI11 FIDUCIARY CONSIDERATIONSINBANK-FINANCEDPROJECTS .(c) Recommendations ............................................................................................................... .............................. 44 (a) Investment Projects ............................................................................................................. 44 (b) Flow of funds arrangements for adjustment operations ....................................................... 46 (c) Auditingarrangements.................................................... :................................................... 47 (d) Recommendations ............................................................................................................... Procurement issues.............................................................................................................. 47 (e) 48 I X CAPACITY DEVELOPMENT . .................................................................................................. -....49 (a) Capacity BuildingProgram ................................................................................................. 49 (b) Recommendations ............................................................................................................... 51 X APPENDICES . .................................................................................................................................. 52 (a) Summary of Recommendations........................................................................................... 52 (b) List of Key Counterparts ..................................................................................................... 59 (c) Recent Government Anti-Corruption Initiatives.................................................................. 61 (d) 2001Dividends: Top 22 Public Enterprises (Million GEL) ............................................... 62 LISTOF FIGURES Figure 1: Key Macroeconomic Variables................................................................................................ 1 Figure 2: Compositionof 2003 Budget................................................................................................... 2 Figure 3: Total Lendingas of January 1, 2003 ........................................................................................ 3 Figure4: 2001 Dividend Payout (%) for Top 22 Public Enterprises by Profit...................................... 12 Figure 5: Actual Expenditure vs. Original Central Government Budget .............................................. 15 Figure 6: Actual 2002 Revenuesvs.Budget (inmillionGEL) .............................................................. 15 Figure7: Estimated Budgetary Expenditure Arrears............................................................................. 19 Figure8: ................................................................................ 23 Figure 10: Parliamentary LegislativeProposal for StateFinancial Control ............................................ Figure9: Components of an Internal Control System ........................................................................... International Standardsand Application 27 29 Figure 12: ProposedInspector General Laws.......................................................................................... Figure 11: Compliance of Financial Control Framework with PIFCS Requirements ............................. 32 Figure 13: Steps to Establishing an Internal Audit Function inthe Government of Georgia ..................35 Figure 14: ProposedCapacity Development Programfor Finance and Audit Staff................................ 36 50 Georqia: Country Financial Accountability Assessment i A. PREFACE This Country Financial Accountability Assessment (CFAA) report was prepared on the basis of the findings o f a World Bank mission to Georgia by a core team in May 2002, following an earlier scoping mission in February. The team was led by Roberto Tarallo, and included Philip Jackson, Principal Auditor, UK National Audit Office, and Sophie Devnosadze, Portfolio Analyst, World Bank Tbilisi Office. The task was part o f a larger World Bank mission, comprising the Task Team of Rocio Castro and Bernard Meyer on the Public Expenditure Review and a private sector Audit Firm Capacity assessment team comprising Cliff Isaak, Ekaterina Arsenyeva, and Faith Miller. They were assisted by Peter Nicholas, Lead Country Officer, and Tevfik Yaprak, Country Manager. Due to staff changes, the report was not completed, and in February 2003, an update team composed o f Andy Macdonald, Consultant, Ekaterina Arsenyeva, and Sophie Devnosadze completed the fieldwork necessary to update the original report. The teams would like to thank the Government o f Georgia for their cooperation and support to the two CFAA project teams. Their patience with the second team as they covered areas previously discussed in detail with the first team was remarkable. Many individuals contributed their time and effort to meet with the teams and respond to their questions. A list o f all people interviewed inpresented inAppendix B. OBJECTIVESAND SCOPE OFTHE CFAA A CFAA is a diagnostic exercise, designed to facilitate a common understanding by the borrower, the Bank and their development partners o f the country's financial accountability framework. Its objective i s to determine ifthe design and implementation o f the public financial management framework will ensure proper use o f the country's own resources and those provided by the Bank and other donors. The CFAA assesses the fiduciary risks in the financial accountability framework for the Government's management and execution o f its budgets and for the implementation of Bank programs and the use o f Bank funds. It then makes recommendations designed to mitigate these risks. The CFAA also supports a dialogue with the borrower country anddevelopment partners on financial accountability matters, and assists inthe design o fprograms to build financial management capacity. The CFAA is not an audit, and it does not provide assurance that all funds are being used for intended purposes. However, it provides a well-informed and objective assessment o f the strengths and weaknesses of financial management systems, a diagnosis o f problems and advice on their resolution, and an indication o f the level o f financial accountability risk in the country concerned. Each CFAA i s expected to cover specified core content. Although financial accountability encompasses a wide range o f activities in the private and public sectors o f an economy, for the purpose o f CFAA, the following are the core contents o f the CFAA: Budgeting Formulation and Execution'; Public Sector Accounting and Financial Reporting; Public Sector Internal Control ' This particular area was hlly covered ina 2002 PER and its results are summarized inthis CFAA for completeness. Other similar areas are identified throughout the report. Georoia: Country Financial Accounfabiiifv Assessment ii System; Public Sector Auditing; Legislative Scrutiny o f Public Sector Financial Management; and Private Sector Financial Accounting and Auditing Practices. The executive arm o f the Government has the obligation to ensure the safekeeping and proper use o f public resources entrusted by its constituents. It must also provide a credible legal/regulatory framework that promotes sound financial governance inboth private and public sectors o f the economy. This institutional and legal/regulatory regime constitutes the public financial accountability framework. This framework should provide reasonable assurance to interested parties that financial operations are conducted properly, and that investments are managedwith due care andprotectionfrom fraud andmisuse. The Bank's interest in the CFAA lies principally in the management o f fiduciary risks. The Bank's fiduciary responsibilities to its shareholders and the borrowing government's fiduciary responsibilities to its citizens are closely related. Ifthe borrowing government meets its fiduciary responsibilities to the citizens, the Bank's fiduciary responsibilities are automatically met. The CFAA focuses on identifying existing systemic weaknesses that contribute to fiduciary risks and presents advice on how these risks can be mitigated. ACKNOWLEDGMENT The mission members wish to acknowledge the extensive cooperation and assistance received from officials and staff o f the public organizations, state agencies, and other institutions interviewed. David Shand, Financial Management Adviser; Parminder Brar, Financial Management Adviser; Rocio Castro, Senior Country Economist; Pierre Messali, Financial Management Specialist; and Tevfik Yaprak, Country Manager for Georgia, have offered invaluable comments andprovided other important inputsto the report. Georqia CFAA: Executive Summarv iii B. EXECUTIVE SUMMARY A number o f in-depth studies were conducted between the time o f the preparation o f the first draft CFAA report inMay 2002 and the final mission inFebruary 2003. These included a PER, CPAR and an IMF Report on the Observance o f Standards and Codes (ROSC) mission. Each of these missions identifieda number o f serious weaknesses and made recommendations to address them. Some of these weaknesses had been identified inthe CFAA report and others represented new findings. These new findings and their associated recommendations have been reflected in the final CFAA report, sometimes by explicit inclusion, other times byreference. As a result, this final report has a strong emphasis on the internal control framework and fiduciary risks and presents specific short- and medium-term recommendations to mitigate them. In conducting its mission, the team noted that the availability and reliability o f financial information beyond routine budget utilization data is severely limited, precluding analysis in a number o f areas. Improving the quality o f reliable, complete and accurate financial information i s essential for sound management decision-making. This report makes four priority and an additional twenty-one recommendations. They are designed to strengthen the legal foundation for internal financial control, construct a modem internal control framework, and develop the human capacity to administer them successfully. Internal controls must be the priority o f the Government if it is to reduce its fiduciary risk. Recommendations are summarized inAppendix A. This summary deals only with the four most critical areas o f risk for the Government o f Georgia that should constitute areas o f immediate priority for Government action. Priority I:Implement a Sound Legal Foundationfor Effective Financial Controls The Government should adopt the EU's Public Internal Financial Control System framework as the basis for its financial control framework and then establish an appropriate legislative foundation to support its implementation. This would enable a more compatible dialogue with the EU on future financial issues. At present, there is a plethora o f contradictory, incomplete, actual or proposed legislation relating to various aspects o f internal control that must be rationalized. The Minister o f Finance and his staff must work with the various parties that have proposed new or amended legislation to build a consensus on the way ahead, rationalize the proposed laws where necessary, and achieve a modem, effective legislative foundation for internal control. This i s an area o f high fiduciary risk, as internal controls are critical to the safe andeffective management ofthe resources o fthe Government. There i s general recognition by the Government that Georgia's environment has a highdegree of corruption, which requires strong internal controls. Without them, the entire budget of the Government i s at significant risk. Current financial controls are functioning sufficiently well to regulate basic budget spending of the central government and to provide budget utilization reports, but not much more. The Minister o f Finance must lead these reforms. Georqia CFAA: Executive Summary iv Priority 2 -Build the Internal Audit Function Internal audit is a basic building block in intemal controls, and i s in the front line in the fight against corruption. With the exception o f a nascent intemal audit unit in the MOF's Inspector General Directorate and small budget control units ina handful o f entities, internal audit does not exist. This i s a serious shortcoming, as without internal audit, management has no source of independent information on how well their internal controls are working and where they are faulty, and the only feedback they receive is compliance audit information from the external auditor. Internal audit information on the state o f financial controls should be routinely available to all budget entities. Because internal audit provides management with important information on the functioning o f its intemal controls over, inter alia, all the financial resources of the Government, the lack o f an effectively functioning internal audit system constitutes a high fiduciary risk. The Minister o f Finance must champion the development o f the intemal audit function. This begins with the development of the legal foundation mentioned above, but it also requires the commitment o f ministerial and management attention and financial resources. An appropriate implementation strategy is required; the CFAA report recommends starting with strengthening the internal audit component o f the Inspector General function in MOF and fully integrating it into MOF operations with an appropriately strong mandate. This will require vigorous management support to consolidate all audit and investigative functions in M O F and all o f its agencies, including the revenue agencies. Additional resources should be allocated for training the inspector general staff on international standards and best practices in auditing and investigations. The M O F should seek the necessary donor technical assistance for this training. At the request o f MOF or the accountable minister, the MOF internal audit unit could conduct investigations and internal audits o f other entities. This could continue until each o f the ministries has independent and competent internal auditors to monitor their own internal management controls. In addition, MOF must begin to establish its role as the policy maker for internal audit, developing intemal audit policies, procedures and manuals-based on international auditing standards-for use by auditors across government. This would be done in close collaboration with the Chamber o f Control. M O F should also serve as the leader and champion for internal audit. Priority 3 -Strengthen the External Audit Function The Chamber o fControl is another critical element inthe control over fraud and corruption. This i s especially so given the absence o f an effective internal audit capacity. It i s important that its effectiveness be strengthened and that its mandate is adjusted to one that is more appropriate for a Supreme Audit Institution. A number o f key changes in legislation are requiredto restore the COC's mandate so that it i s aligned with that of an external auditor under INTOSAI standards. At present, COC performs certain oversight and directive functions over internal audit that will, over time, become unnecessary as internal controls are implemented and mature in all Government entities. The external audit function constitutes a low risk for the Government; it i s included as a priority because o f its critical role in discharging the fhctions normally performed by intemal audit and in supporting the development o f internal audit capacity within Government. Georgia CFAA: Executive Summary v The SA0 must move quickly to comply fully with all INTOSAI standards for conducting its audits. Additional donor assistance for training will be necessary. The Office must continue its training in attest and specialized audits to enable it to fully discharge all the functions o f a modem supreme audit institution. The Law on the Chamber o f Control should be amended to remove the provision enabling its retention o f special revenues (30 percent o f fines levied). This represents a potential conflict of interest that could threaten the public's perception o f the independence o f the COC and induces undesirable revenue-seeking behavior intheir conducting o f audits. Priority 4 Build Staff Capacitiesin Financial Management and Auditing - The Government's present capacity to implement these recommendations is seriously impaired by a lack o f trained staff resources. Skilled financial managers, project managers, accountants andauditors are inshort supply. This issue will require a longer-term effort to train existingstaff and establish programs to develop students with the required financial management skills and knowledge o f relevant internationalpublic sector accounting and auditing standards. The Government must develop a human resource strategy for building this capacity. A set of possible components o f such a strategy i s detailed in the report. Extensive donor assistance and creative new approaches are necessary for implementingthe required training. Without trained and competent staff in the key areas o f financial management and control and internal/external audit, there can be no effective controls operating within the Government. The present lack o f skills constitutes a highrisk for the Government. Summay Fiduciay Risk Assessment The CFAA assessed each component o f the public expenditure management framework throughout the report and analyzed the fiduciary risks in the system o f internal controls. The individual assessments took account o f the level and magnitude o f risk presented in each component. The CFAA team adopted the European Union's Public Internal Financial Control Systems (PIFCS) model o f internal control as the basis for its analysis o f the Government's internal control framework. While the Government is taking action to improve its systems of financial management, significant and serious weaknesses remain in many parts o f its expenditure management system. Based on this analysis, the overall fiduciary risk o f the Government's public expenditure management framework i s rated as HIGH. The high fiduciary risk rating is based on the following assessments: e Public enterprises: While progress i s being made in bringing into the budget preparation process the extra-budgetary funds and special revenues, EBFs remain outside o fthe Treasury spending controls and public enterprises remain outside o f the Government reporting entity. These enterprises do not provide the Government with timely and accurate financial statements o f their financial position and results o f operations; nor does the Government exercise appropriate oversight over their operations. Public enterprises represent a potentially high risk to the Government because o f their potential for large actual and contingent ` liabilities. Georqia CFAA: Executive Summaw vi Local governments: The large amount o f the budget spent by local governments, coupled with the inadequate legal and operating framework for budget planning and execution by local governments, represents a moderate-high fiduciary risk. Budgeting: The absence o f a medium-term expenditure framework2 and related budget ceilings, large variances in budget/actual revenues, EBFs operating outside o f Treasury spending controls and arrears at approximately 3 percent o f GDP indicate that significant work continues to be required to make improvements to the budgeting process. This is a moderate/high risk for the Government. Accounting and Reporting: The Government does not follow the International Public Sector Accounting Standards (IPSAS) cash-based accounting standards for its budget entities, and the law does not require strict adherence to it. Because reliable and consistent financial information i s a cornerstone o f financial management and control, this is rated as a moderate fiduciary risk. Internal Controls: Ifthe EU's internal control system model and criteria were applied to the Government, their current controls would indicate a high level o f fiduciary risk. The organizational values o f the civil service are not conducive to effective internal control. The existing legislative base does not address a number o f key control requirements; internal audit has not been implemented and financial management systems and staff financial skills are weak. A major program for financial capacity development is essential. While the Government partially satisfies the criteria for an effective external audit function, with regard to its basic ex ante and ex post controls over spending and creation o f an anti-corruption program, the weak state o f internal controls constitutes a highrisk for the Government. The 2004 Budget is to some extent based on the preliminary forecasts o f the main medium term macroeconomic and fiscal parameters for 2004-2006. More robust linkages are required inhture fiscal years. Georqia CFAA: Countrv Backaround 1 I.COUNTRYBACKGROUND 1. The Republic o f Georgia i s located inthe southwestem Caucasus region o f westem Asia. Georgia was part o f the Russian Empire from the early nineteenth century to 1918, an independentrepublic from 1918 to 1920, and a part o f the Soviet Union from 1922 to 1991. It declared its independence from the Soviet Union in 1991. Georgia has two autonomous regions, Adjara and Abkhazia, and the semi-autonomous region o f South Ossetia. The country i s still in political and economic transition. The Constitution established a presidential, parliamentary democracy with a unicameral Parliament. While there is not a constitutionally-required prime minister, elements ofhis responsibilitiesarepresently fulfilled by a stateminister. 2. Followingthe break-up of the Soviet Union and untilthe mid-l990s, Georgia's economy suffered a dramatic collapse. There was a significant drop in real GDP, accompanied by hyperinflation, sharp currency depreciation, and rapidly depleting foreign exchange reserves3. These difficult initial conditions, the result o f the collapse o f trade and transport links with the Soviet Union, were followed by sharp negativebusiness conditions as suppliers movedto market pricing. The resulting large fiscal deficits were financed mainly by seigniorage, which further exacerbated inflationary pressures. Post-independence military conflicts with Ossetian and Abkhazian secessionist groups also contributed to destabilizing further the country's weak macroeconomic position. 3. Georgia shares the challenges o f other former Soviet republics inmaking the transition to a market-based economy. The Baku-Suspa oil pipeline that transports oil from Azerbaijan across Georgia to the Black Sea coast generates transit revenues, and there i s increasing oil and gas exploration activity. 4. The structural reforms that began in the mid-1990s helped to restore economic growth and bring inflation under control. However, after a significant economic recovery in 1996-97, real GDP growth slowed from 10.6 percent in 1997 to 1.9 percent in 2000. Since then, it has resumed its steady growth, registering 5.4 percent in2002. Inflation has been slowly creeping up over the last three years, starting from 4.1 percent in 2000, to 4.7 percent in 2001, and 5.4 percent in 2002, albeit well below the levels previously experienced. Revenue growth has been steady, although tempered somewhat by delays in revenue transfers from the semi-autonomous region of Adjara. Figure 1provides the key macroeconomic statistics. Figure 1: Key MacroeconomicVariables Source: World Bank, Georgia Public Expenditure Review, November 2002, and IMF (2002 data). This is a similar situation to other former Soviet countries as they begantheir transitions to a market-based economy. GeoraiaCFAA: Countrv Backuround 2 5. Social outcomes, especially in the health sector, have deteriorated sharply over the past decade. Infant and maternal mortality have increased substantially, and the number o f new cases of communicable diseases has risen. In education, where outcome indicators are not available, there are signs that quality is rapidly declining. Moreover, the poor have suffered disproportionately from inadequate access to social services and from crippling basic infrastr~cture.~ 6. Georgia's growth and poverty reduction efforts depend on the sound management o f scarce public resources. While substantial fiscal adjustment has taken place under Georgia's stabilization program, primarily relying on expenditure cuts5, fiscal sustainability is yet to be established. Public expenditures in maintenance and rehabilitation o f basic infrastructure are negligible and those in the social sectors are among the lowest in the region. In addition, an increasing share o f fiscal revenue is being devoted to service Georgia's large external debt. Other problems, such as excessive civil service staff levels and public physical facilities, low pay and poor training for civil servants, a lack o f clear government spending priorities and pervasive corruption inall levels, all combine to work against the effective use o f scarce public resources.6 7. General government expenditures are divided into three categories: central government, state (extra-budgetary) funds, and local government. The central government and state funds comprise the state budget. State funds include the pension and road funds, which are financed by payroll and excise taxes respectively and pensions are supplemented by central transfers. Figure 2 shows that inthe 2003 budget, central government budget units accounted for 56 percent o fthe total budget, EBFs 17 percent, and local governments 27 percent. The total EBF budget i s estimated at 355.7 million GEL, o f which the central government provides 79 million GEL, and with 276.7 million from EBF's own generated sources. Transfers to local governments are a combination o f shared revenues, revenues wholly for the use o f the local governments (personal and corporate income taxes), and locally-determined fees and charges. Figure2: Compositionof 2003 Budget I OCentral EBFs ILocal 1 - ~~ 'ibid. World Bank, GeorgiaPublic Expenditure Review,November 2002, p. 2. This was initially achievedthrough a dramatic reduction ingeneralGovernmentexpendituresin 1995, accountingfor 20 percentof GDP. This involved elimination of a number of subsidies and significant downsizing of the public sector ibid, p. 2. 8. Government revenues continue to be well below their potential. The PER noted that major problems remain in tax policy (large numbers o f specific exemptions that benefit a small number o f participants) and implementation (especially in collections enforcement), as well as strong institutional resistance to the changes in culture that accompany such reforms. It i s estimated that 2001 actual tax revenues were 45 percent below their potential, or 850 million GEL. Frequent exemptions occurring throughout the year and underperforming revenue collections have contributed to unreliable and overly optimistic revenue forecasts in the budget. As the year progresses and revenues fall short o f forecasts, budgetary expenditures are adjusted downwards and cash releases are restricted. This adversely affects the credibility of the entire budget process and exacerbates resource allocation restrictions, as explained in the Budget Formulation and Execution Section (Section 11). WorldBank Lending to Georgia 9. Since Bank Group lending commenced in 1994, Georgia has been the largest IDA borrower among the CIS countries. Its loans total about $705 million for 31operations, of which $280million (about 40 percent) comes from five adjustment operations (see Figure 3). 4995 1996 1997 1998 1999 2000 2001 2002 Total Committed 103.1 90.8 174.6 26.2 114.9 47.6 92.6 55.4 705.2 Disbursed 86.0 76.4 64.3 52.9 78.8 18.1 63.1 61.3 500.9 10. The first loans approved were an Institution Building Credit to provide technical assistance and training to strengthen public institutions, and a Municipal Infrastructure Development Credit aimed at protecting essential existing infrastructure from further decay and renovating urgentlyneeded economic and social services7. Adjustment lending included a 1995 Rehabilitation Credit to provide budgetary support for implementation o f Georgia's economic reform program, a Structural Adjustment Credit (SAC) in 1996, SAC I1in 1997, SAC I11in 1999, and an energy SECAC (approved in 1999). 11. Investment lending to Georgia has included support to almost every sector: energy, rehabilitation o f municipal infrastructure and decentralization, and the social sector. Operations have included a health credit and establishment o f a Social Investment Fund. Lending has also supported private sector development and improved efficiency o f the enterprise sector, including private sector farming and agro-processing, environmental protection, and management o f the coastal zone on the Black Sea. A Structural Reform Support Project provided technical assistance and investment in the areas o f hospital restructuring, privatization and financial sector strengthening, public sector management, and social sector sustainability. This was followed by a Judicial Reform Project to assist in the development o f an independent and professional judiciary. InMay andJune 2001, the Board further approved a number o f other important credits to revitalize the country's existing infrastructure. Including heating and energy saving measures for schools and hospitals, urban transport; water supply; waste water; solid waste collection and disposal GeorqiaCFAA: COUiIfW Backqround 4 12. Currently the Bank has a large and diverse portfolio in Georgia. It comprises 17 IDA credits totaling US $284 million (of which about 70 percent i s yet to be disbursed) and three Global Environmental Facility grants amounting to U S $12.5 million, which are under implementation. The current portfolio continues to be very broad, covering almost every sector-education, health, social protection, energy, roads, water and sanitation, agriculture, agricultural research and extension, irrigation and drainage, forestry, environment, biodiversity, enterprise development, municipal development, judicial reform, and cultural heritage. Georqia CFAA: Buduet Formulation and Execution 5 11. BUDGETFORMULATIONAND EXECUTION 1. LEGAL BASIS 13. Chapter 6 o f the Constitution i s dedicated to state finances and control. It covers, inter alia, Government's and Parliament's budgetary roles and procedures, as well as the responsibilities o f the Chamber o f Control to exercise financial and economic oversight of state revenues and expenditure. It also requires the COC to report to Parliament on the Government's execution of the budget. 14. The revised 2003 Budget System Law (BSL) regulates the preparation, approval, execution, reporting, and control o f the budget. It also details the budgetary relations and responsibilities o f the central authorities, local authorities, and special funds. It assigns to the Minister o f Finance primary responsibility for the budget process and for the formulation of regulations on budgetary and treasury activities, including the organization and management of state budget execution and the coordination of accounting controls. Ex ante and ex post spending controls are assigned to the Treasury, and its responsibilities exercised on behalf o f the Minister o f Finance are detailed. The Minister also has responsibility for issuingdirections on accounting procedures and reporting requirements for all spending agencies, for borrowing and debt transactions executed on behalf o f the Government, and for the form and content o f the final report on the budget and its submission to Parliament. The Budget System law also accords the COC a role inthe approval o f the classification o f accounts. 15. The responsibilities o f individual ministers for budget formulation and execution are also specified in the Budget Systems Law. They include ensuring that the budget requests are comprehensive, meet the content requirements established by the Minister o f Finance, and respect the spending ceiling established in the budget circular. The ministers also have an obligation to ensure that their spending conforms to the purposes and uses o f their budget approved by Parliament, and can exercise their authority to reallocate funds within their total appropriation, inaccordance with rules established by the Ministerof Finance. (a) The2003 Budget SystemsLaw 16. Parliament approved in May 2003 a new budget systems law that, in its final form, contains many, but not all, o fthe draft proposals to change the law made inJanuary 2003. 0 While it confers on the Minister o f Finance the power to establish regulations on budget and Treasury activities and to coordinate `the budget process, it does not refer to his responsibility to make any other changes necessary to improve the effectiveness o fthe Budget Law. 0 It requires the budget to include as receipts the revenues o f all extra-budgetary funds (state special funds). However, on the expenditure side, state special funds revenues continue to be earmarked to finance specific expenditures and measures and they do not require prior approval o f the Minister o f Finance to make expenditures or incur commitments. Inaddition, they are not obligated to use the TSA, a serious shortcoming. It eliminated the legislative requirements for "protected items" (salaries, pensions, social allowances, debt obligations, and other categories specified in the annual budget law), allocations that had guaranteedpriority inspending. Treasury retains responsibility for accounting for all receipts and payments o f the state budget (central budget and state special funds) and maintains them in a TSA, but only controls the expenditures o f the central budget entities. State special funds are therefore free to spend without Treasury oversight and may open bank accounts outside o f the TSA. The MOF is responsible for issuing o f accounting and reporting directions that are consistent with the basic principles o f International Standards and that apply to all spending agencies, state special funds and local authorities. The minister is also responsible for formulating jointly with the Chamber o f Control, the methodology for internal audits. Internal audit units are subordinate to the head o fthe spending agency, state special fundor local authority. Special revenues arising from fees, fines and penalties and other revenues collected and earmarked for the ministries' own use now form part o f Government receipts and are no longerpermitted to beretainedby the ministries. There have been recommendations that the budget system law should be an organic budget law, to preclude being overridden by future ordinary legislation.8 MOF officials advised that given the current political climate inParliament, with the upcoming elections in the autumn o f 2003, this year would not be the most propitious time to attempt to get the requisite two-thirds majority to make it an organic law. MOF did, however, support the concept. (b) Scope of theBudget 18. The budget entity includes the central government', state special funds, the autonomous republics o f Abkhazia and Adjara, and local governments. There are 87 first line and approximately 1800 second line budget entities. Two remaining extra-budgetary funds (the United State Social Security Fundand the Road Fund) are submittedto Parliament and passed at the same time as the annual budget, but remain outside o f the MOF processes for budget execution. There are approximately 400 active public enterprises that are not included in the Government's reporting entity". These are controlled by the Ministry o f Economy or by the local government administrations. The Government owns at least 5 1percent o f their outstanding shares and it i s likely that many o f these public enterprises would meet the control criteria necessary for their inclusion inthe reporting entity. Finally, there is an unknown number of joint public enterprises o f which the Government is a minority shareholder. While they would not be expected to fall within the scope o f the reporting entity, their financial implications for the Government's financial position shouldbe disclosed. 19. Inthe 2002 budget, Parliament approved special revenues amounting to 111.2 million GEL; however, the true amount is at present difficult to know with certainty. These are generally fee-for-service revenues, and Tax and Customs agencies, the Interior and Foreign Affairs ministries, MOF andthe COC collect most o f these revenues. Line ministries are responsible for * COC has advised that this would require a constitutional amendment. Comprising the executive, legislative andjudicial branches. IoInfact, there are some 1400public enterprises currently inexistence, a large number o fwhich are inactive. Georqia CFAA:Budset Formulation and Execufioion 7 reporting these data to MOF, but there are no measures or legal basis by which to ensure that the amounts reported are accurate and complete. The proposed legislative amendments to the Budget Systems Law would have given the Minister o f Finance increased authority to require the reporting o f all such budget-related information by budget entities; these provisions didnot make it into the law passedby Parliament. (c) Discussion 20. The inclusion o f special revenues and the EBFs in the receipts o f the state consolidated fund will strengthen financial controls over revenues. However, the exempting o f all EBFs from the expenditure controls of the Treasury leaves a significant gap in the overall framework o f internal financial controls that must be addressed. Not all state special funds are identical in scope or function, and the Government should carefklly review its policies on these EBFs to ensure that they are fully consolidated to the maximum possible extent. While there may be sound internal control and transparency reasons to do so, there are broader policy issues that should be considered as well. Given that these special revenues were used to provide for supporting ministry operations, which in many cases included salary supplements, the Government will have to formulate and implement an appropriate salary strategy that avoids the imposition o f significant salary penalties on its civil servants. Reductions in already low salaries could be an invitation to increased fraud and corruption within the civil service community. 21. The recently passed amendments were designed to strengthen the role o f the MOF inthe budgetaryprocesses. However, there are shortcomings inthe proposed changes. First, the Budget Systems Law is not an organic budget law, and therefore can be overridden by any other law passed subsequently. This means that a future state budget law could alter the provisions o f the Budget Systems Law in a significant fashion that could seriously erode internal controls on the budgeting process. Second, the continued exemption o f the state special funds, with their significant expenditure responsibilities, from normal Treasury spending oversight and control constitutes a highfiduciary risk to the Government. The revised law did not add significant new authorities to the Minister o f Finance in the area o f ministerial .and EBF reporting, and.it is difficult to see how the Treasury will be able to provide its regular accounting and reporting on the payments made by the state special funds. Given that the law exempts them from all aspects o f Treasury ex ante and ex post controls. (d) Recommendations 22. From a financial control perspective, the current scope restrictions in the budgeting systemand its need for further development constitute a highfiduciary risk for the Government. 23. The CFAA recommends that the Government make the budget law an organic law at the earliest feasible opportunity, and that it move to include all state special funds within the full control environment provided for the central budget entities. 24. The CFAA recommends that the Government take into account the impact o fthe removal o f earmarked special revenues in ministries in the budgets o f entities and that it develop a compensation strategy to ensure that these entities will provide appropriate salary compensation for staff and motivation for them to continue to collect the revenues. 2. SUB-NATIONAL GOVERNMENTS" (a) Current Arrangements 25. Georgia operates under a decentralized fiscal administration provided in the Constitution and in an organic law on local governance and self-govemance. Local governance relates to the rayons, and self-govemance refers to the local governments o f cities, towns, and villages. There are two semi-autonomous regions (Abkhazia and Adjara), ten administrative regions with governors appointed by the President, 56 districts (rayons) with a directly elected council and a legal budget, and 1031 self-governing units (cities, towns, and villages), with the responsibility for local service delivery. The team met with officials from the municipality o f Tbilisi to understand their budget formulation and execution processes, and their relationship with the national government and the rayon. 26. The responsibilities between different levels o f Government are not clearly defined, and inter-governmental fiscal relations do not have a sound legal base. While a law on local government exists, its implementation is dependent on three other laws on transfer o f assets to local governments, local government revenues, and transfers to local governments from central government budget12. Thus at present, while the districts have an elected council and control over their own budgets, inpractice the central government controls the district budget execution. It does so by exercising arbitrary control over transfers in the absence o f legislative criteria that could prescribe the amounts to be transferred. As a result, district governments must negotiate budgets with the central government, and local governments with the district governments on an annual basis as part o f the budget approval process. This confers an excessive degree of discretion to the district governments in their determination o f individual local budgets (for which they do not share accountability) from their district budgets. 27. According to the legislation, local governments enjoy a great deal o f autonomy in preparing and executing their own budgets. The central government's involvement i s primarily the direct cash transfers it makes to the districts through the system o f local trea~uries'~.The rest of their funding comes from a mix o f taxes and fees, some o f which are split with the central govemment, such as income and profit taxes. A fixed percentage o f these shared revenues from the central budget i s set by Parliament for a three-year period. For the years 2002-2004, 85 percent of income and profit taxes are credited to the local administrations, and the remaining 15 percent goes to the central budget. Other taxes are retained fully by local government, such as land tax, property tax, tax on economic activities, ecological/pollution tax, hotel tax, gambling tax, and the advertisement tax. 28. One o f the revenue problems faced by the local authorities relates to the tax collection performance by the central government tax authorities. The problem i s two-fold: local tax revenues are not budgeted properly, inpart due to uncertain compliance levels o f taxpayers and taxes are collected by central government agents paid out of the rayon budgets, and who therefore assign priority focus on those taxes that remain with the central budget. Even shared I'World Bank, GeorgiaPublic ExpenditureReview, November 2002, Chapter4 is the source for muchof this section. l2The team was advised inAugust 2003 that the govemment is now draftingall three laws ona prioritybasis. The Tbilisi budgetdoes not normallyreceivetransfers from central budget. Georqia CFAA: Budget Formulation and Execufion 9 revenues may be credited to the central government account initially, and then redistributed to the rayons at a later date. This makes for difficult cash management in the local government budgets. 29. In practice, the current system o f revenue assignment denies local governments any meaningful revenue autonomy. There are no revenue accounts in Treasury for local government revenues. The transfers are made to the accounts o f the rayons, which do not have any direct accountability for the execution o f the budgets that they control, and local governments must then negotiate with them to get a share that does not necessarily reflect the contents o f their budget request, but what they could gain fro their bargainingpower. Other issues include: 0 The central government releases allocated shared taxes and central transfers according to its cash management needs, at the expense o fthe local governments. 0 The central government transfers lower-than-budgeted revenues and accumulates arrears, thereby transferring its cash management problems to the local level. 0 The central government specifies service levels for locally-provided services but does not permit local authorities discretion to set fees, local taxes, and tariffs according to local conditions. 0 There is exclusive reliance on a revenue allocation methodology for the main shared taxes that can result ininequitable distribution o f resource^'^. 0 Local governments lack the capacity to properly formulate, negotiate, and manage their budgets and maintain effective intemal management controls over their spending. (b) Discussion 30. The EU PIFCS criteria for internal controls require a sound legislative framework for intemal financial control for all budget entities including, where appropriate, local governments. Sound budget processes are also critical for the effective planning and utilization o f local government financial resources that reflect local priorities. The legislative framework governing local government financing and budgeting is not inplace. Given their limited capacity for budget planning and execution and maintaining intemal controls, there i s a potential risk to the central government from large arrears and direct or contingent liabilities. This could have a major adverse budgetary impact on the central budget, should a serious financial problem occur. For these reasons, the team has assessedthese fiduciary risks to the Government as moderate-high. 31. The local government budget execution system is flawed and must be revised. The budget environment creates the potential for misallocated resources, duplication or under- provision o f public services, under-funding o f delegated functions, and accumulation o f arrears. The Public Expenditure Review dealt with the issues in detail, and its recommendations will not be repeated inthis report. l4This distribution is only to the rayon level; individual local self-governments must then negotiate with the rayon inorder to get their share o fcentral transfers. This has the potential to further erode the equitable distribution o f transfers relative to source o f collection. 32. Intemal budgetary controls are difficult to maintain. The unreliable budget revenues do not permit the setting o f rational priorities for local government expenditures and result in an inefficient resource utilization process. In addition, the incentives to live within a budget are eliminated when budget revenues are clearly insufficient for the knownrequirements. 33. The current system o f revenue sharing i s untenable and must be addressed on a priority basis. The Government needs to create a resource-sharing framework that enables the local governments to adequately meet their responsibilities under the subsidiarity principle and to exercise appropriate management controls over services provided to their citizenry. This framework must thenbe translated into law to provide a reasonable degree o fbudgetary certainty to local governments inthe conduct o f their budget planningand execution activities. (e) Recommendations 34. The magnitude o f spending by local governments, incomplete legislative base goveming the preparation and execution o f their budgets, high variability o f central government cash releases to local governments throughout the year, and generally poor state o f financial management goveming the relations between the central and local governments distort the budget preparation and execution processes and pose a moderate-high fiduciary risk for the Government. 35. The CFAA recommends that the Government ensure that the legal framework necessary for the establishment o f effective local government operations and administration provides an appropriate basis for their financial management authority and accountability in revenue generation, budget formulation, and budgetexecution. 3. PUBLICENTERPRISES (a) Current Arrangements 36. There was significant activity in the privatization o f public enterprises in the past. However, a large number still remain outside o f the Government entity, operating in a non- transparent manner. A public enterprise i s one in which state ownership equals or exceeds 51 percent. Activities o f public enterprises are regulated by the Law on Entrepreneurs", the same law that governs privately-owned enterprises. Public enterprises were supervised by two governmental bodies: the Ministry o f State Property Management (MOSP), which provided management oversight and administered restructuring and related activities; and the MOF's Department o f Financial Management of the State Property and Non-tax Revenue (DFMSP), which monitors their financial performance and dividend revenues to the budget. In early 2003, the Ministry o f State Property was abolished and its responsibilities transferred to the Ministryof Economy, Industry and Trade. Currently, state property managementI6 and the privatization processes are carried out by the Ministry o f Economy, Industry and Trade (MOE). Normal ongoing shareholder responsibilities for public enterprises have been transferred to the Enterprise Management Agency, a separate public legal entity controlled by MOE. Many unresolved issues 15DatedOctober 28, 1994, and amended 14times, the latest inJuly 2002. l6Excluding state owned shares and assets heldby the Enterprise Management Agency, a separate public legal entity. regarding present and future arrangements for public asset management remain.Audits o f these state-owned enterprises are carried out by the Chamber o f Control. Its audits are restricted to enterprises established under public law; those created under private law are subject to an independent audit, in an identical manner to any other private sector enterprise, in accordance with the Law on Audit Activitie~'~.This law is currently under revision, and the team was advised that it will make mandatory the use o f international standards for auditing. 37. The total number o f public enterprises is not precisely known. In the past, individual ministries and local administrations were able to create public enterprises in an uncontrolled fashion. The DFMSP advised the team that approximately 1,400 state-owned enterprises remain in Georgia: 950 were established by the regional divisions of the MOE and owned by local administrations; and 450 are currently under the ownership and supervision o f the MOE. The separation o f ownership o f the public enterprises between the central and local governments remains an outstanding issue that significantly affects their accountability mechanisms. The regional offices provide only minimal supervision over the enterprises within their jurisdiction. The team was advised that many o f these public enterprises are inactive and do not currently conduct any economic activities. Financial data for public enterprises are incomplete and highly suspect; makingmajor decisions based on these data without due diligence is risky. 38. The MOSP was engaged in the continued rationalization o f the number o f public enterprises by applying four different strategies. These included forcing insolvent entities into bankruptcy through the courts, liquidation through the sale o f their assets, consolidation andor restructuring to eliminate losses, and privatization (performed by the Ministry o f the Economy). Previously, many entities were kept alive by their ministries using state subsidies; this is no longer the case. In addition, the MOSP was developing a register o f all public enterprises, in cooperation with the State Department o f Statistics, to allow for better oversight and control, 39. Financial information relating to public enterprises is incomplete and o f questionable reliability. There i s no reliable consolidated database on the financial performance o f public enterprises. The MOSP had 60 regional offices, operating in a decentralized manner. The regional offices collected basic management and financial information about public enterprises that were located within their zone of responsibility, and sent the data to headquarters. These data were not consistent; there was no proper accounting consolidation o f these data, no computer-based financial information systems, and no reliable database for the public enterprises in headquarters or in the regions. In short, the available information was of questionable reliability and would require validation for management decision-making purposes. 40. The DFMSP has three subdivisions that deal with public enterprises. They are responsible for dividend monitoring, restructuring o f enterprises, and the registration o f other non-tax revenues. Their activities are presently very passive-the recording o f dividends, loans, and repayments-rather than proactive monitoring, questioning, and follow up on management activities that respond to COC, MOF or donor recommendations. 41. There is no well-defined framework to direct MOF activities with respect to public enterprises. It participates in setting the financial management, accounting and dividendpolicies for the enterprises. The financial data that it uses are provided by MOE (MOSP) and are of l7 Law onAudit Activities # 623, February 7, 1995. Georuia CFAA: Budaet Formulation and Execution 12 questionable reliability. DFMSP also produces and monitors lists o f bankrupt enterprises and enterprises under restructuring and/or liquidation. However, the decision to initiate court proceedings against such enterprises rests with the MOE, not MOF. It appears that there is little cooperation between the two ministries when it comes to the management o f public enterprises on behalf of the budget. There have been no visible improvements since the recent reorganizationand merger o fthe MOSP into the M O E 42. There is apparently little rationale for the current dividend practices. Currently, a committee o f MOF and MOE determines the appropriate level o f dividends. The team was advised that the present profit allocation is to be a 70/30 split between retained eamings and dividends. This has not been the case in the past. Using the only data available, and acknowledging their unknown reliability, the team analyzed the financial performance and dividend policies o f a selected group o fpublic enterprises. Figure 4 and Appendix Drefer. Figure4: 2001 DividendPayout(%)for Top 22 PublicEnterprisesby Profit 1 1-10 11-20 21-30 31-40 41-50 51-60 61-70 71-80 81-90 91-100 Payout (in percent) 43. Dividend arrears in 2001 totaled 8.5 million GEL. Of that amount, four entities: JSC Elektrogaatsema, Engurhesi Ltd., JSC Sakrusengro, and JSC Georgian Gas International Corporation accounted for 7 million GEL (82 percent) o f the total. The team was advised that collection powers o f MOF are limited, and because dividend arrears are non-tax revenues, they cannot utilize the collection services o fthe income tax or customs agencies to enforce payment". Improved legal powers are required to ensure that outstanding arrears are collected. The team believes that dividend rates should be tailored by the joint MOENOF committee to reflect the unique circumstances of eachpublic enterprise and the Government's revenue requirements. (b) Discussion 44. There i s an implicit categorization o f these public enterprises into three or more groupings: major, significant enterprises that deserve management attention; insignificant entities that should be wound up or otherwise eliminated; and the remainder. It i s important that the However, as majorityshareholders, the Governmentcould instructthe MOE to direct the entity to pay the outstandingdividendsto the Government's account. This apparentlyhas notbeendone. Georuia CFAA: Budaet Formulation and Execution 13 Government develop an explicit governance framework that protects its interests with regard to the significant public enterprises. This framework would consider both the Government's and the public's interest, the latter o f which is best served by a highly transparent and accountable governance process with regular public reporting. 45. There is no effective management oversight and financial control being exercised over public enterprises. Joint accountability between two ministries results in opaque and uncertain accountability for the operations of these public enterprises. Essential information to support an appropriate management oversight function is lacking. The Government does not have timely and accurate financial information to support the development o f a proper dividend policy; nor does it have accurate information on public entity assets and liabilities. No one i s performing a proper financial consolidation of these enterprises that would include, for example, audited financial statements for all financial data and the elimination o f inter-company transactions. In . effect, there are no meaningful financial statements available to support proper analysis o f the enterprises. Information that currently exists is inunconsolidated, preliminary, unaudited lists of financial variables. 46. The IMF required the Government to engage external, private sector auditing firms to audit three o f the largest public enterprises. These entities are the State Railways, Poti Port, and the Madneuli MiningCompany. The Govemment has now completed the tender process and the winners have been selected. This represents an excellent first step towards establishing a more effective management control regime over its majority-owned enterprises. Because public enterprises operate in a non-transparent manner, there has been no effective management oversight by the Government, creating the potential for fraud or corruption inthe conduct o ftheir business affairs. The audit conclusions and recommendations will undoubtedly provide sound advice for improvements in governance for all public enterprises. The Government should plan similar audits by external audit firms for all o f its major public enterprises over a five-year cycle. 47. The Government could benefit from assigning to a single ministry the 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 of the central government on 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. The team was advised that there has been no improvement in the information flows relating to public enterprises since the move to M O E occurred. 48. There may be a similar fiduciary risk arising from joint public enterprises in which the Government is a minority shareholder. The CFAA team did not explore this issue in depth; however, given the lack o f attention to those entities in which the state i s the majority shareholder, it i s likely that even less attention is directed to minority shareholdings. The issue for the state is should any o f these entities fail, the associated liabilities" may accrue to the state budget by virtue that it i s the only identifiable shareholder still solvent, and, as a part owner, there could be political pressure for the Government "to do something". l 9Whereas previously these liabilities would be both actual and contingent, there is a risk that a number of the contingent liabilities would become actual liabilities. Georgia CFAA: Budget Formulation and Execution 14 (e) Recommendations 49. This sector has been highly active in the past, and rationalizatiordprivatization activities continue. Given the government funds involved and the known liabilities in the remaining enterprises, this constitutes a moderate fiduciary risk for the Government. 50. The Government does not know the extent o fits actual or contingent liabilities associated with its public enterprises, which could be large. The lack o f an effective govemance structure for the public enterprises, coupled with an absence o f timely and accurate financial information2' provided to the two oversight ministries, who themselves do not communicate essential information effectively to each other, represents a moderate-high fiduciary risk to the Government. 51. The CFAA recommends that the Government establish a public enterprise govemance framework in law and policy that establishes management oversight and financial controls appropriate to their status as state-controlled entities. This framework would recognize the audit responsibilities o f the Chamber o f Control established in law. The Government should apply this framework to significant public enterprises, in order to achieve a high degree o f transparency, with regularpublic reportingon the individual financial results o feach significant entity. 52. The Government should require an external audit by private sector international auditing firms of all significant public enterprises over a five-year cycle and make the results o f these audits public. 4. BUDGETREALISM (a) Current Arrangements 53. The PER examined the factors affecting the extent to which a budget realistically forecasts the actual financial performance o f the Government in that fiscal year. In a well- functioning budget process, expenditures reflect the Government's current priorities, and there should be a low variance between initial budget forecast and actual budget spending for any fiscal year. Instances o f large variations adversely affect the budget's credibility with line ministries, which must prepare their budgets and attempt to live within the approved budget levels. However, inGeorgia: 0 The priorities o f the Government are not reflected inthe budget because there is no clear set of priorities to guide the budget formulation process. 0 The resources available to fimd new initiatives are generally over-estimated and as this becomes apparent throughout the year, fundingi s reduced to maintain ongoing programs. 0 Budget execution procedures permit priorities to be easily changed during the fiscal year in unintendedand unforeseenways. *' The team has serious doubts that what financial information that does exist is not accounted for according to intemational accounting standards promulgated by IFAC. 54. Budget revisions in themselves are not necessarily a problem, to the extent that they are the result o f unforeseen and significant expenditureitems that arise in-year and occasion changes in priorities. However, a history o f large variances is indicative of a more serious problem in budget credibility. The data for 2000 and 2001 revealed that while the Government was making progress, the total variance o f 18 percent was still significant. The deviations were more pronouncedacross the functional categories. For example, subsidies and current transfers were 8 percent over budget, expenditures on wageshalaries and food were both at and above 100 percent o f budget, while office expenditures were executed at 40 percent, and utilities were at 19 percent o fbudget (Figure 5 refers). Figure5: ActualExpenditurevs. OriginalCentralGovernmentBudget(in millionGEL ) Item 2000 2001 2002 Original Budget 1074.2 853.8 995.7 Actual Expenditures 681.4 698.7 962.7 %Original Budget 63% 82% 97% Source: PER Table 3.1 for 2000 and 2001; MOFpreliminary data for 2002. 55. The Government appears to have the problem under control in 2002. Using M O F preliminary data, the budget execution percentage rose to 97 percent. This appears to be a very highutilization rate, one that will require confirmation when the final budget report for 2002 is tabled inParliament and the COC report confirms the data. At that time, the variance distribution across functional categories may bereplicated. 56. The revenue data for 2002 continued the trend o f significant shortfalls in actual revenues versus forecasts, indicating a GEL 116.8 million (12.5 percent) shortfall in actual revenues (GEL 817.6 million) against a budget o f GEL 934.4 million. While GEL 46.2 million o f the shortfall i s due to the non-remittance o f revenues from Adjara, identified in the PER, the remainder is a combination of shortfalls in tax revenues and grants. Figure 6 refers. This demonstrates that the Government i s still not able to manage its revenues according to planned, which inpart explains the continued high levels of arrears to suppliers21, and erodes the credibility of the budget numbers. Figure6: Actual2002 Revenuesvs. Budget(in millionGEL) Budget Actual Variance from VarianceDue TO Budget Adjara Other Total Revenues& Grants 934.8 818.0 116.8 46.2 70.6 Revenues 856.7 795.4 61.3 46.2 70.6 I Tax Revenues I 773.9 I 722.6I 51.3 I 46.2 I 10.1I I Grants I 78.1 1 22.6I 55.5 I 0 1 55.5I Source: Ministry of Finance 21Arrears are analyzed inthe section on budget execution. Georgia CFAA: Budget formulation and Execution 16 (b) Budget Preparation Cycle 57. Budget preparation consists o f two stages-the submission of the main aggregate fiscal parameters to Parliament, and the communication o f the budget law along with the detailed line items. The PER analyzed the existing cycle and concluded that it was too compressed, with insufficient time for the ministries to perform their work and take into account the key factors necessary for an effective budget process. At that time, budget preparation began inMarch of the budget year with the preparation o f aggregate budget parameters, submitted by June 1 for parliamentary approval. The new law has made a number o f changes: 0 The Minister o f Finance begins work on the Medium Term Economic Framework, Medium Term Fiscal Forecasts and Basic Directions for Budget and Tax Policy on March 1, coordinating the work with the NBG, Ministry o fthe Economy, Trade and Industry and other ministries identifiedbypresidential decree. 0 The Basic Directions for Budget and Tax Policy are submitted by the President to the economic committees o f Parliament by May 1. It i s based on the two medium term documents and outlines the Government's fiscal situation and strategies for the current, budgetand following years. 0 The Finance and Budget Committee, after consulting with other parliamentary committees, sends its conclusions to the President by June 1' 58. The MOF establishes the individual ministry ceilings. Line ministries are required to negotiate with the MOF and to submit their budget request by August 15. This is considerably more time than the previous four weeks allocated under the previous budget law. The intent is to enable greater input by ministries and to increase their sense o f ownership o f the final budget. The consolidated budget is submitted to the President by September 15 and to Parliament by end-September, with approval before the beginningo fthe fiscal year on January 1. .59. M O F continues in its efforts to transfer greater responsibility for budget preparation to line ministries. In the 2003 budget process, line ministries received clear ceilings by which they could begin to prepare their 2003 budgets. M O F advised that the initial attempt was only partially successful; a number o f ministries chose not to respect these ceilings inthis first year of use. Line ministries have also been given responsibility for intra-envelope allocations, rather than having to do so through MOF. MOF believes that, over time, the quality o f budget preparation will improve as a result o f these changes. Though the budget sent to Parliament is still heavily detailed by line item, MOF has begun the process o f dialoguing with Parliament about the structure o fthe budgetsubmission. 60. The team discussed the recent changes to the budget cycle with a large line ministry (Education). They expressed strong support for the allocation o f more time to ministries to prepare their budgets in line with the ceilings provided and to negotiate with MOF. Previously, there were no discussions and budgets were simply imposed on the ministry. Now there is the sense within the ministrythat they can have a more active dialogue with MOF as they construct their annual budget. The ministry staff conceded that it will take a number o f years for the process to be completely implemented, but noted that the planned and actual changes being implemented would encourage more realistic budgets that would have a significantly higher degree o f budget ownership by the individual ministries. The ministry concluded by expressing strong support for the existing and proposed budget preparation improvement initiatives. (c) Classification 61. An IMFROSC team recently completed a fiscal transparency review in Georgia22.While the report is at a preliminary stage and its main conclusions are subject to review, its observations on classification are non-controversial and consistent with the findings of the original CFAA report. The budget classification generally meets the GFS definition and is improving. The current budget classification system provides for a detailed classification based on functions, programs, projects, responsibility centers, and objects o f expenditure. However, the presentation o f budget revenues, expenditures, and financing is not exactly according to the GFS methodology and financing shows only loans received. The economic classification also has minor differences with the GFS at a few lower classification levels. MOF advised the team that targeted programs will be disclosed at two levels o f economic object, with the third reserved for ministryuse. (d) Discussion 62. The PER concluded that it is not the public expenditure level, but their efficient management, that matters the most at this stage in Georgia's transition. Notably, the establishment o f a predictable fiscal framework i s a prerequisite for improved expenditure management. Both central agencies and local governments work with extremely short planning horizons, and the lack o f predictability and other weaknesses in budget management mean that agencies have neither incentives nor the necessary information base for the fundamental restructuringrequiredto bringpublic expendituresinline with sector objectives. 63. Improvements have already been made in public sector resource management. They include the incorporation into budget preparation and approval procedures the extra-budgetary funds and the establishment o f a Treasury, entrusted with the responsibility of managing the execution o f the central budget. The centralizationinthe Treasury o f cash management functions o f the state budget-funded organizations is a preliminary step to ensure that all necessary information and reports on budget execution may be produced in an orderly and timely manner. MOF has an Accounting Methodology Department charged with the development o f a uniform chart o f account, accounting policies and procedures, and reporting formats for budget organizations. The Government has begunimplementing commitment accounting. (e) Recommendations 64. This area constitutes a moderate fiduciary risk to the Government. The basic .framework i s in place, but many improvements must be made to develop a more realistic budget and ease the budget execution problems associated with frequent adjustments and cash controls. The CFAA fully endorses the prior recommendations o f the PER in the area o f budget formulation and execution. Specifically, the Government l2 IMFpreliminary draft report, January 2003. 23 The Govemment is already addressing a number o f these. Georgia CFAA: Budget Formulafionand Execution 18 0 Develop a medium-termbudgetthat links to a future MTEF and reflects its priorities 0 Enforce hard budget ceilings for ministries as specified in the new budget systems law and continue its support for a more bottom-up process o fbudget development that builds ministry ownership o f the budget 0 Establish budget incentives to encourage ministries to rationalize their programs and reallocate resources according to their priorities 0 Now that the law no longer requires protected items, phase out their use over the medium term as an integral part of its move towards resourcingthat better reflects policy priorities. 5. BUDGETEXECUTION PROCESS (a) Current Arrangements 65. Once the budget is approved, MOF prepares a quarterly allocation plan to guide the execution o f the budget. The monthly cash releases to ministries or authorizations to spend are based on the quarterly allocations, and spending units make commitments and issue payment orders for the purchases of goods and services. Currently, while releases are intended to mirror the quarterly plan, revenue shortfalls have forced MOF to delay or miss fulfilling the cash release agreements inthe quarterly plan. The release delays and shortfalls have had their greatest impact on supplier goods and services and investment spending, as the existing budget law requires that the releases for protected categories o f spending have priority. There are also some categories that lack protected status but are honored on a consistent basis to fulfill MOF commitments. 66. The new budget systems law no longer requires protected items. In the short term, this will have virtually no impact on the distribution o f budget spending, due to the nature o f the expenditure categories presently protected. Inthe future, as the Government i s able to introduce more results-based budgeting for ministries, there may be an opportunity to reallocate incrementalresources to new budget initiatives that would not be currently protected. This would require a level o f revenues that exceeds those expenditures that the Government feels must be met on an ongoing basis. Were this to occur, then MOF could reward ministries that undertake major restructuring o f their programs to increase their efficiency, by enabling them to retain the freed up resources for allocation elsewhere within the program. 67. MOF has indicated that with the inclusion o f special revenues in the state budget and their appropriation by Parliament, the use o f such revenues will be gradually phased out in the mediumterm. Currently, the use of special revenues to supplement salaries andoperatingcosts is widespread. Examples include a 3 percent levy on revenues collected by MOF revenue agencies, a 30 percent charge against fines and penalties levied by the Chamber o f Control as a result of its audits, levies against visa andpassport revenues, etc. 68. The Government requires a strategy that addresses all issues surrounding the elimination o f earmarking o f special revenues in the budgeting process. While phasing out o f special revenues i s a laudable objective, in terms o f resource allocative efficiency and reduction in opportunities for fraud, the Government will have to face a number o f issues: 0 Many special revenues are earmarked within a specific legislative base that will have to be amended; this requires a well-planned process to identify all such instances and then propose the appropriate amendments. 0 There will be strong resistance from those agencies most affected by this proposed initiative. It will be critical for the Government to have inplace a strategy to address the overall issue of inadequate public sector compensation in a way that does not contribute to increased corruption. Failure to do so would increase the already highrisk o f fraud and corruption in agencies collecting revenues. 0 The Government requires a strategy to address how to maintain an appropriate level of commitment within ministries to continue to collect government revenues in the absence of direct financial benefits currently afforded by the special revenues. One option would be for M O F to allocate additional resources through the budget formulation process to those agencies that met or exceeded their budget revenues targets inthe previous year. (b) Arrears 69. The PER noted that budgetary expenditure arrears are symptomatic o f an ineffective budget system. The inability o fthe Treasury system to fully capture commitments has meant that the estimates o f arrears by category and in total have been variable and imprecise and may understate the true levels24. Based on a combination o f IMF and World Bank data, the team estimated a December 31, 2002 stock o f GEL 374 million, with an estimate o f GEL 315 million for the end o f 2003, or 3.3 percent o f GDP25.Figure 7 provides the latest estimated expenditure arrears for the period 1998-2003. It demonstrates that the stock o f budgetary arrears continues to be highandthat the underlying budgetaryproblems creating these arrears still exist. Figure7: EstimatedBudgetaryExpenditureArrears 1998 - 2002 (GEL Million) Year Stock Change 1998 140.1 1999 236.0 -95.9 2000 320.0 -84.0 2001 404.0 -12.7 2002 374.2 29.8 Source: CFAA team estimates, based on IMF and World Bank data 70. At over 3 percent o f GDP, wage, pension, and supplier arrears still constitute a major challenge to the Government's budget execution process-onethat must be better managed. Large arrears to suppliers impose significant costs to the Government. They adversely affect the prices paid for services, as suppliers build into their prices the economic costs o f long delays in payments. These are additional costs that the Government can illafford. Wage arrears have the 24MOF advisedthat Treasury is only able to capture the commitments ofthe Budget entities 25Based on an assumed repayment of GEL 50 million. Georgia CFAA: Budget Formuiafion and Execution 20 potential to increase rent-seeking behavior by affected public officials and pension arrears can create political pressures on the Government. None o fthese are desirable outcomes. 71. It is not clear that the MOF has a full accounting o f all o f its arrears, which could potentially include, in addition to supplier payments, debt-related interest and repayments and statutory payments from budgetary and extra-budgetary programs such as pensions and social programs. The IMF has requested a study to establish the stock o f all arrears, to be completed in 2003, in part occasioned by their ROSC observation that the Government has systematically under-budgeted liabilities inorder to meet fiscal targets. 72. The implementation o f commitment accounting and controls will assist in the identification and tracking o f expenditure arrears. More realistic revenue forecasting can increase the predictability o f budget entity cash flows in the near term. The persistent revenue shortfalls from budgeted levels force deviations from the planned cash allocations to budget units, which create arrears in the non-protected expenditures. Finally, the under-reporting o f liabilities in order to conform to IMF fiscal requirements distorts the financial position o f the Government andprecludes effective budgetmanagement. (c) Recommendations 73. The Government has made progress in legislative reforms to include EBF in the budget preparation and approval processes, include EBF receipts intotal Government receipts, eliminate the earmarking o f special revenues, and remove legislatively prescribed protected items. There will be little, if any, impact inthe short term. More worrisome are the exemption o f EBFs from MOF Treasury expenditure controls and continued high levels o f arrears. These arrears are due in part to budget revenue shortfalls and the resulting cash release strategies used by MOF, complicatedby the lack o f commitment accounting and control. At present, the budget execution process constitutes a moderate level o f fiduciary risk to the Government. 74. The CFAA recommends that the Government ensure that all its debt-related, statutory and supplier expenditure arrears are fully identified, recorded and employed in the budget formulation and executionprocess, and report them in a schedule attached to its regular monthly and annual financial statements. 6. TREASURY OPERATIONS (a) Legislative base 75. Authority for Treasury operations i s derived from a number o f sources. The Budget Systems Law established its basic functions and scope, which are the exercise o f ex ante and ex post controls over spending by ministries and other budget organizations; the monthly cash release to budget organizations as part o f its cash management activities; the management o f the State Consolidated Fund in the National Bank o f Georgia; and the maintenance o f full and accurate records over all aspects o fTreasury's operations. Sub-legislative instrumentshave given additional authority for operational activities. The draft budget planexpands the Treasury role to include as revenues all state receipts and special revenues, and confirms Treasury responsibility Georqia CFAA: Budqet Formulation and Execution 21 for full and accurate accounting for all receipts and payments o f the state budget. InApril 2003, the Treasury was scheduled to assume revenue responsibilityfrom the central bank26. (b) Progress 76. The Government is making progress in establishing an effective Treasury Department within MOF. The IMFROSC observed that the implementation o f the Treasury Single Account (TSA) will not be completed until 2004, a date confirmed by Treasury, and recommended that the Government accord a higher priority to accelerating its implementation. 77. The Treasury has implementedthe commitment registry for all expenditures, using a new economic object to classify them. The treasury codes and the 137 zero balance revenue transit accounts for central government, personal and corporate income tax, pensions, customs duties, VAT, and all other revenues sources have been set up, and the central bank assigned district codes for all commercial banks and regional tax and customs units. In all but three regions2' Budget entities will all have accounts maintained by the appropriate regional offices of the National Bank. The Treasury will have to close over 12,000 budget revenue transit accounts, a significant effort in its own right. Implementation o f commitment accounting began in October 2002 with 30 spending units that accounted for 70 percent o f spending, and extended it to all units inJanuary 2003. 78. The system is to be supported by a regional IT network to capture and record commitment data electronically under a new Chart o f Accounts. At the time o f the mission, the hardware to support the system had not yet been delivered for the April start o f the parallel runs. The project had experienced prior delays due to illness o f the Treasury advisor and procurement processes. This has been resolvedand the system i s now beingimplemented. 79. MOF advised that 13 revenue accounting unit staff have been selected and trained by central bank experts, and that the unit i s now functioning. A six-person cash management unit i s planned, but there has been no staffing taken as o f the mission date. The effectiveness of the planned cash management operation will be contingent on the implementation o f the TSA and the supporting IT systems. Treasury advised that the TSA and all supporting systems will be fully implementedbythe end o f2004. (c) Recommendations 80. The pace of development o f the Treasury function and the transfer o f functions from the National Bank o f Georgia to the Treasury is o f concern to all donors. To the extent that functions will not be transferred until the Treasury is capable o f performing the necessary operations, the level o f fiduciary risk due to the actual transfer i s low, as the central bank could continue to operate as before untilsuch time as the Treasury is prepared. 81. The ROSC identified the lack of a TSA and the need for a single treasury general ledger. Greater priority mustbe assigned to these areas. 26Inaccordance with PresidentialDecreeNo. 557, dated December 31,2002. 27 Inthese regions, the NBGdoes not have a regional office andbudget entities are servedbycommercial banks, 82. The CFAA recommends that the Government accelerate its implementation of the Treasury Single Account and the initial revenue accounting phase, including the elimination of the existing revenue transit accounts. Georgia CFAA: Accountins and Reporting 23 111. ACCOUNTING & REPORTING (a) Accounting 83. There i s a variety of international standards that apply to different types o f entities within Georgia. Given the Government's commitment to follow international standards, it is useful to identifythe different international standards and their areas of application. Figure 8 provides this analysis. Figure8: InternationalStandardsandApplication ~~ StandardsBody Standard Applies To InternationalAccounting InternationalAccounting All entities established underprivate Standards Committee Standards (US) sector laws, including public (IASC) enterprises, agencies IFAC Public Sector InternationalPublic Sector All public sector entities subject to Committee Accounting Standards public sector laws, includingbudget (IPSAS) entities, special funds, PIUs Institute o f Internal International Standards for All internalauditors inpublic and Auditors (IIA) Auditing(ISA) private sector International Various pronouncements All Supreme Audit Organizations Organizationo f doing external audits o f Supreme Audit Governments Institutions (INTOSAI) 84. For the Government, the relevant international standards are the IPSAS cash-based accounting and reporting standards for all public sector entities and the IIA ISA for its internal auditors. The IPSAS standard applies to all budget entities, EBFs, and PIUs that are established underpublic law2*.For the public sector, the MOF is the state regulatory body inaccounting and reporting. It i s responsible for establishing accounting norms and rules for the Legal Entities of Public Law, issuing instructions and methodologies and implementing them in practice. The BudgetSystems Law governs the accounting and reporting o fGovernment financial activities. 85. The M O F Accounting Methodology Department i s charged with the development of a uniform chart o f accounts, accounting policies and procedures, and reporting formats for budget entities, state special funds and local authorities. The accounting system is the key for financial information to support state financial administration; this information is highly dependent on the reliability of the financial information received from spending ministries and other entities. At present, the budgetary entities employ mixed accounting, whereby revenues are recorded on a cash basis, and expenditures and recorded on an accrual basis29. The classification o f local 28Public entities established under private law and private sector entities are subject to the I A S accounting requirements. 29Source: IMFROSC. This is based on the USSR InstructionNo. 61 (1987). Georgia CFAA: Accounting and Reporting 24 Government expenditures does not comply with the GFS requirements, making functional analyses more difficult. (b) Reporting 86. Previous studies by the IMF (ROSC) and the World Bank (PER) have extensively analyzed the financial reports currently beingprepared by the Government o f Georgia. These are summarized inthe following paragraphs. 87. The budget documents now cover most o f central government fiscal activities. There is a summary table comparing the current and proposed budgets by various categories o f expenditure to provide a variance analysis o f the different components o f revenue and expenditure. These are complemented by detailed monthly budget execution reports on central government entities, as well as aggregated fiscal reports. There i s also information disclosed regularly duringthe year on gross public debt and external and domestic financing. The Government also reports monthly on external debt for foreign loans and Government-guaranteed loans. Final budget note disclosure includes a statement of contingent liabilities o f the Government3', loan guarantees with a concessional element of at least 35 percent, and defense aid in-kindfrom international entities. 88. Additional areas for improvement include the need to address the budgeted revenues collected by the semi-autonomous region o f Ajara3', which have not been remittedto the central government and are therefore not included in the reported revenues o f the central government. Disclosure in the local governments' monthly reports is at an aggregated level for revenues, expenditures, and financing, and omits classifications. Grants-in-kind or foreign loans to public enterprises may not be fully reported; these depend on MOF being informed o f all such arrangements. Finally, the Government does not disclose any financial performance information innotes to its final statementsrelatingto the financialperformanceofitspublic enterprises. (c) Discussion 89. The Government has adopted a pure cash basis o f accounting to govern its financial activities. However, it does not, in law, adhere to the P S A S standards, stating only that it i s "consistent with basic principles o f international accounting standards". The law on Budget Systems specifies that all budget entities are to use the cash basis o f accounting for the recording and reporting o f their transactions. This has not been the practice in a number o f the extra- budgetary funds, which have been criticized by the SA1 for using accrual accounting for their expenditures and cash accounting for revenues. The team saw no evidence that the accounting office i s playing an active role in enforcement o f the cash-based accounting policy.32Given that these international standards continually evolve, maintaining compliance with international standards will be an ongoing task for the MOF, requiringcommitted resources. 90. The IFAC Public Sector Committee has recently released its cash-based IPSAS on Financial Reporting under the Cash Basis o f Accounting. Given the uncertain state o f the 30The ROSCnoted that significant contingent liabilities are found in the public enterprise sector, particularly energy sector accounts receivable that require offsetting subsidies. 31Ajara contains two o f the four main entry points in Georgia for customs clearing. 32MOF Treasury advised that they have requested an IMFexpert to assist inthe preparationof the relevant legislation to introduce international accounting standards (Letter dated August 4, 2003). Georqia CFAA: Accounting and Repodina 25 Government's compliance with the IPSAS cash basis o f accounting, MOF should review its monthly and annual statements for compliance with the new reporting standard. This i s the standard against which the Chamber o f Control must express audit opinion as to whether the accounts present a true and fair picture o f the financial operations o f the central govemment. In addition, compliance with IPSAS would satisfy one element o f the EU's PIFCS internal control criteria. 91. There is a timing problem with the Government's annual external fiscal statements. The Constitution requires that the consolidated annual accounts o f the state budget be tabled within three months after the end o f the fiscal year. The Law on the Chamber o f Control requires that it report to Parliament on the reports on the state budget implementation no later than two weeks after submission o f the Government reports by the President. This precludes an effective attest audit by the Chamber o f Control before the report is tabled. Subsequent audits o f the individual submissions detect errors, some sufficiently material as to require re-statement andre-submission to MOF. Given that the auditor's report i s an integral part o f any financial statement, this is a significant shortcoming. (d) Recommendations 92. Significant gaps between international public sector accounting standards and current practices inGeorgia make this a medium-level fiduciary risk, as these international standards are the core o fthe internal control framework. 93. The CFAA recommends that the Government revise the Budget Systems Law to require M O F to issue accounting and reporting instructions that are fully compliant with the IFAC International Public Sector Accounting Standards for cash-based accounting and reporting, not just "consistent with basic principles o f international standards". 94. The CFAA recommends that the MOF review on a continuing basis its compliance with the new IPSAS cash-based accounting and reporting standard and make the changes necessary to ensure that its monthly and final budget execution financial statements conform as well. 95. The CFAA recommends that the Budget Systems Law shouldbe amended to give the COC additional time (30 -45 days, to be determined after consultationwith Parliament) to prepare and submit to Parliament its audit opinion on the Government's consolidatedannual report on budget execution. Georgia CFAA: Internal Controls 26 IV. INTERNAL CONTROLS (a) Interna1 Control Framework 96. There is a common model for internal management control in Government that is based on international standards o f internal control and audit. This represents a departure from the past practice in Georgia, and indeed in all countries that were part o f the former Soviet Union, in which internal control and internal audit were synonymous33.The long-term difficulty with this internal control model was that it did not explicitly assign to management responsibility for establishing and maintaining internal controls and did nothing to encourage management to accept its responsibility for internal controls. Rather, that responsibility defaulted to MOF financial control agents. 97. Modem internal management control is quite different from the present Georgian model. It begins with the recognition that it is a management responsibility to maintain an effective internal control regime. It recognizes that it is the internal auditor's job to provide independent and objective advice to management on the effectiveness o f its controls, and to make recommendations as to how to improve the existing internal controls. Responsibility for the establishment o f the management control framework rests with management, not the auditor. 98. While there are a number o f different sources for internal control their essential components are similar. This CFAA has used the EU's Public Internal Financial Control Systems model, since it is used by the EU as a basis for its negotiations with all accession and pre- accession countries. The PIFCS model figures prominently in the EU's assessment of Government internal controls before the Government receives significant amounts o f EU pre- accession funding. 99. .Internal control is defined as the organization, policies, and procedures that.help ensure that Government programs achieve their intended results. In addition, the programs should reflect the organizations' stated objectives, be protected from fraud, waste and mismanagement, and utilize reliable and timely information in management decision-making. Sound internal control requires a strong control environment and a coherent framework o f control policies, procedures, and systems. Figure 9 shows the key components o f an internal control system. 33This was so becausethere was, bydefinition, no audit function that was external to Government. Since the Government controlled everything, there was no need for an external function when the MOF control office providedfinancial controls. Inthe transition period, the need for increased democratic accountability and transparency resulted in the establishment o f external audit bodies. The control offices strongly resistedattempts to eliminate them, and inmany transition countries there remains a substantial level o f overlap and duplication of functions that is politically and institutionally difficult to remove (comment from Richard Allen, World Bank). 34These include the definitions provided by SIGMA, INTOSAI, and the EUPIFCS model for the public sector. Private sector models that do not materially differ from those for the public sector include the 1991Committee of Sponsoring Organizations for the Treadway Commission(COSO), the American Sarbanes-Oxley Act o f 2002, and a large number o f definitions providedby national standards-setting professional accounting bodies. Georqia CFAA: lnternal Controls 27 Figure 9: Components of an Internal Control System A Sound Control Environment: This includes the soft aspects o f an organization-ethical values, professional and personal integnty that promote respect for the stewardship, and efficient and effective utilization o f public funds. These are reinforced by a management leadership and operating style that promote these values throughout the organization and require the sound delegation o f responsibility, authority and accountability for performance, and competent staff. Risk Assessment: The identification o f the key risks faced by the organization. Major risks may include: a lack o f management integrity and weak organizational values; inappropriate delegation o f authority and responsibility; insufficient staff training; inadequate management oversight; and inadequate policies and processes to monitor and control illegal acts. Control Policies and Processes: Cost-effective controls are designed to mitigate identified risks. These include: clearly-defined work responsibilities; separation o f duties in processes that involve funds; well- documented work processes with at least one ex ante approval for each financial process; ex post controls exercised by management and/or Treasury; strictly enforced limits on budget entities spending according to the budget authorizations; and supporting systems. Information and Communication: A timely, regular flow o f information between management and staff in both directions is essential to effective controls. This is usually assisted by information systems that communicate to management the results of operations, deficiencies, and issues requiring management attention. Inthe other direction, management directives are communicated to staff so that they are able to fully perform their work. Monitoring: Internal Audit i s a critical component in any control system. It i s the "eyes and ears" of management in the control of the organization-an independent feedback loop to management on the performance o f the entire control system and with recommendations for improvement. Monitoring also involves an external party, the external auditor (State Audit Office, Auditor General, or equivalent) and may include other special evaluations as required. 100. The external auditor i s not part o f the Government's internal control framework, yet he plays an important role in it. H e audits the elements of internal control, including the internal auditor function, independently o f the Government, and reports to Parliament on the results of his investigations. Results of internal audits are routinely available to the external auditor under enabling legislation. The external auditor reinforces internal control systems, monitors and reports on instances in which management fails to respond appropriately to internal audit recommendations. 101. The consequences o f weak internal controls may b e many. Expenditures may b e made for purposes not approved by Parliament, or in amounts exceeding authorized levels. Funds may not b e used with due regard for efficiency and effectiveness. Fraud or corruption m a y divert public funds for personal or private gain and the organization may fail to meet its objectives through misallocation of resources. The presence of any significant deficiency in these factors could result in a loss inpublic confidence inthe Government3'. 102. Internal controls may not always b e effective. Management must b e aware o f certain risks involved inthe operation of their systems o f internal control, such as: 35In1979,the Auditor GeneralofCanadacreated apoliticalcrisis when hereportedthat the internal financial controls within the Government of Canadawere so weak that the Government was "close to losing control of the public purse." Georaia CFAA: lnternal Confrois 28 Collusion between a number o f key individuals in a process to subvert the controls and falsify the normal documentation; Dishonest senior management can subvert the controls because the internal control system is designed to help management control the organization; they do not control the top managers. The independent external auditor reporting to Parliament plays a key role in such circumstances; Flawed control systems may fail to detect control deficiencies. This may occur because of a system design that was adapted from another entity and that is unsuitable for the organization or other shortcuts to a properly designed system; Poor implementation due to insufficient stafftraining, workloads that exceed staff capacity to deliver and encourage shortcuts to cumbersome procedures; Inadequate management action on reported control failures will guarantee a control breakdown. Timely and visible management action to address identified control deficiencies is essential to maintaining control; the staff quickly learns whether management i s performing its part inthe overall system o f controls and conducts themselves accordingly. 103. The EUhas identified three pillars for an effective PIFCS system. These include a strong system o f financial management and controls; a robust and functionally independent internal audit function in the Government; and strong financial and internal audit policy functions, operated by MOF, which has responsibility to oversee the operations o f the internal financial control systems across Government. These three pillars form the basis for EU assessments of a Government's systems o f internal control. Such a system requires: Systematic specification o f financial management and control ina comprehensive set of laws and regulations, supplemented by MOF-issued standards and guidelines Strong financial management systems, including budget planning and execution; a strong .MOF with clear responsibility for all aspects o f financial management and control; well- trained budget managers and financial staff in budget entities; and clear accountabilities between all participants inthe system o f financial management and control Internationally compliant standards covering financial accounting and reporting, internal audit, and a MOFwith the mandate andpower to enforce these standards. Effective ex ante and ex post controls inplace inall financial processes o f the Government Effective internal audit function Mechanism to fight fraud and corruption Strong external audit and parliamentary oversight. 104. The CFAA will employ these criteria in order to assess the Government o f Georgia's internal control framework. 105. The existing laws governing internal controls are weak. Those that exist contain a number o f provisions that do not comply with the PIFCS requirements, and planned legislation from Parliament exhibits other instances o fnon-compliance. 106. For example, the Minister of Finance does not have sufficient authority over intemal audit; PIFCS requires that he have clearly specified legislative responsibility for establishing and maintaining the internal financial control framework, including intemal audit. The Minister of Finance must have legislative authority to prepare appropriate sub-legislative instruments relating to intemal financial controls and propose them for approval of the Government, as well as the ability to develop policies, standards and guidelines for use by internal auditors throughout the Government. H e also requires legal authority to ensure their effective implementation and monitor compliance. Significant strengthening of the legal base for internal controls andthe role of the Minister o f Finance will be necessary to meet the EU PIFCS requirements. The existing requirements on the new budget systems l a w that the Minister of Finance consult with, and obtain the approval of, the Chamber of Control for internal audit methodology should be extended to all proposals affecting the internal financial control framework. This is standard practice inthe development and implementation of modem intemal financial controls. 107. Both the Georgian Govemment and Parliament are presently considering a number o f proposed laws that treat various aspects of the financial control framework. They conflict with each other, with existing legislation, and with the PIFCS internal financial control model. Of particular concern is a draft Law on State Financial Control (Figure lo),which i s a draft proposal to establish an internal financial control framework inthe Govemment of Georgia. Figure 10: Parliamentary Legislative Proposalfor State Financial Control To fillthe gap ininternal control legislation, the Budgetary Committee o f Parliament is developinga Law on State Financial Control. Basically, it is a law on internal control and internal audit. This draft law covers the central government, state special funds and local governments, as well as public legal entities established to privatize state property. The draft law defines some o f the key features o f a Government financial control system as: 1. The state financial control system that comprises the mandatory audit o f all public institutions, the implementation o f internal financial control, and the Chamber o f Control audit o fpublic institutions, and other control agents. 2. The objectives o f financial control are to ensure the legitimacy, reasonability and efficient receipt and use o f public funds. 3. There are three components o f State Financial Control: the prevention o f financial violations; the assessment o f legitimacy, reasonability and efficiency o f the use o fpublic funds; and the financial administration (which i s essentially a process to issue an administrative order used against public institutions to redress an infraction). 4. The Ministerof Finance i s responsible for establishing the financial controls for the use o fpublic funds and the approval o fthe state financial standards (public expenditure documenting standard, financial accounting and reporting standards, financial control standards) and financial administration acts. 5. There are State Control Agents, including internal control agents (internal auditors), external control agents (Chamber o f Control external auditors), public sector auditors licensed by the Public Sector Auditors Boardto audit public institutions, and those control agents designatedby the two autonomous republics. 6. It would be mandatory to establish InternalFinancial Control Units(internal audit units) in Parliament and its agencies, governmental institutions, inpublic institution whose annual budgets exceed one million GEL, and inthe two autonomous republics o f Abkhazia and Adjara. 7. A mandatory annual audit is performedby the internal financial control unit or, inits absence, a public sector auditor o f a public institution's financial documents; it is the responsibility o fthe Head of the public institution to conduct the audit. 8. The results of all such audits are reported to the Head of the public institution and the Chamber o f Control. 9. The powers o fthe state financial control agents and the internal financial control units are similar to the existing powers o f the extemal auditors and the Chamber o f Control. 10. The Chamber o f Control would be given additional responsibilities to: train and qualify the Heads of internal audit units and public sector auditors; define the time limit, standards, andprocedures o f the annual audit o f the public institution's financial documents performed by IA departments; and establish the standards and procedures for internal financial control. 108. The State Financial Control Law proposed by the Parliamentary Budget Committee sets out, for the first time, a Government-wide public financial management framework, including the establishment o f internal audit department^^^ within all key state bodies. The State Financial Control Law has the potential to make a major contribution to strengthening internal control in the Government o f Georgia, but only ifsome serious flaws are corrected. 109. In its present form, the State Law on Financial Control does not meet the PIFCS requirements for a modem internal control system. It assigns responsibilities to COC that are inappropriate for an external audit institution and that should be the responsibility o fthe Minister of Finance37.It fails to recognize the role o fmanagement inthe maintenance and enforcement o f the internal financial control framework, and inappropriately assigns an ex ante control responsibility over spending to COC and the internal auditors, which i s clearly the responsibility o f the Government. 110. The Parliamentary Budget Committee should make a number o f amendments to have a clear, effective regime for internal financial control that complies with EU requirements. This . includes the transfer from'COCto the Minister of Finance responsibility for: 0 Approving the financial control and reporting policies and standards to be used by all public institutions, after consultation with, and the agreement of, the COC; 0 Establishing the policies, standards and procedures used by internal auditor, after consultation with, and the agreement of, the COC. Internal audit processes and procedures are a management responsibility, and the COC audit activities should focus more on auditing the effectiveness and comprehensiveness o fthese controls; 0 Eliminating COC oversight and direction over internal auditors3*; 0 Exercising COC supervision o f intemal auditors in terms o f the receipt and use o f public funds; 36These are called Internal FinancialControl Units inthe legislation. 37Who would be required to consult with, and obtain the approval of, the COC for all proposed changes that affect the internal financial control framework. 38Oversight inthe form o f an external audit o f an internal audit directorate would still be permitted. GeorqiaCFAA: lnternal Confrok 31 0 Training and licensing o f heads o f intemal audit-this is a role that MOF may wish to assign to COC, but it should not be a legislative requirement that the COC do so. 111. The legislation should permit the Government to progressively make these transfers as its intemal control capacity is developed. This would ensure that the intemal controls presently in place would not disappear through a single legislative amendment with a near-term proclamation date. MOF would be requiredto consult with COC on these transfers. (b) Combating Corruption through Improved Internal Controls 112. Effective internal controls are critical to fighting corruption and reducing fiduciary risk. JNTOSAI identified a number o f governmental functions as susceptible to corruption and therefore areas of potentially high fiduciary risk. These are presented below, with the available evidence3' on their applicability to Georgia. Extra-budgetary activities: The Government has made progress inbringingthe EBFs into the budget formulation and approval process. The EBFs should be brought under the MOF budget execution processes to ensure appropriate financial controls over their spending. In addition, public enterprises need significantly more attention from their Boards o f Directors and MOF to monitor and control their financial operations to ensure that there i s no fraud or corruption, and that cost-effective use is made o f the public resources invested in these entities. Recruitment of employees: The team did not examine this area in its study. However, the survey on indicated that in the past, a significant percentage o f a number of categories o f officials who are in positions to exercise discretional decision-making that affect directly ordinary citizens and enterprises were believed to have purchased their positions, a clear indication o f a market price for rent-seeking behavior. In particular, 48 percent o f customs officials and 38 percent o f tax inspectors were believed to have purchased their positions. This is particularly critical when the practice o frent sharing with superiors is taken into account. Awarding of Government procurement contractsfor capital expenditures, public works and supplier goods and services: Abuses o f the contracting process, in which considerable personal discretion can be exercised, remain a major problem. Despite guiding laws, procurement violations are commonplace, as reporting inthe June 2002 CPAR, and noted in the Bank's corruption report. There i s widespread ignorance o f the requirements o f the law and the processes to be followed, insufficient training to officials who must administer the processes in addition to their other duties. More than 50 percent o f the survey participants cited the necessity to make unofficial payments as a reason for not participating in Government procurement opportunities. Tax assessment and collections: The PER identified the revenue collection area (tax, custom inspectors) as a high fiduciary risk function with significant potential for fraudulent or corrupt activities. The Bank corruption study confirmed this. Tax inspectors were rated j 9World Bank, Corruption in Georgia -Survey Evidence, June 2000. Jointly undertakenby the WorldBankandthe Government of Georgia, basedon 1998 householdand businesssurvey data. 40 Governmentibid. Georaia CFAA: lnternal Controls 32 among the most corrupt (22 percent rated them as the worst) with households having to pay bribes an average o f 43 percent o f the time. The situation is no better for customs inspectors at border crossings; households reported that they had to pay bribes an average o f 60 percent o f the time. 113. Overall, Georgia ranks in the mid-range for corruption among all CIS countries. Low public sector salaries and low `levels o f accountability for their decisions adversely affect the performance o f its civil service. This is reinforced by a low probability o f being detected should corrupt activities be initiated, and there is widespread sharing o f illegal payments with superior officers. 114. The new Government has made a public commitment to fight corruption andhas initiated an aggressive program to combat it. In July 2000, it established an anti-corruption commission that will aid in its efforts to reduce the incidence o f corruption. It covers six major areas that include strengthening the financial management o f state resources and increasing the effectiveness o f the civil service. In addition, the Government has undertaken other initiatives, including the revisions to the Law on State Procurement in 2001 that strengthens the legal framework around the spendingo fpublic funds for procurement o f goods and services. InMarch 2001, a presidential decree established 17 specific action areas to implement the Government's anti-corruption campaign. These are detailed in Appendix C. In addition, the Government plans to implement other essential public expenditure reforms that directly support reducing corruption, including the creation o f an inspector general function within MOF, treasury commitment controls, and the bringingo f a number o f EBFs into the budget. 115. It is clear that there are serious problems with the Government's system of internal financial controls, and that strong action from the Government will be required over a protracted period to rectify this deeply embedded problem. Figure 11 provides a brief summary o f the extent to which the Government o f Georgia's internal financial control fi-amework meets the EU's PIFCS requirements. For completeness, this table anticipates data from successive chapters inorder to provide a comprehensive picture. Figure 11: Complianceof FinancialControlFrameworkwith PIFCSRequirements PIFCS Criterion Status Comments Organizationalvalues, ethics and NOT MET Corruption inthe civil service i s a pervasive practices support effective internal problem across many aspects of Government. contro1s Controls specifiedinlaw and NOT MET Partial andincomplete legislative foundation; regulations,complementedby MOF- existing laws contain non-PIFCS compliant issuedstandards andguidelines provisions, as do currently proposeddraft laws Strong financial systemswith clear NOT MET Budgetplanning and executionsystems are accountabilities for all participants, weak, staff lack essentialslulls to operate well-trained staff and a strongMOF within the control processes, andcentral with responsibilitiesfor financial Treasury controls are slow to develop. controls IntemationalAccounting, reporting NOT MET Legislation does not require the strict and auditingstandards are employed adherence to IPSAS accountingandreporting throughout the Government, enforced standards, nor to IIA International Standards by MOF for Auditing PIFCSCriterion Status Comments Effective ex ante andex post controls PARTIALLY Limitedcentralizedex antecontrols inplaceinall financial processes MEETS exercisedby Treasury; only COC performs ex post audits ofbudgetentities. Effective Internal Audit function NOTMET There isno effective internal audit function within the Government Mechanismsto fight fraud and PARTIALLY The Governmenthasbeguna number of corruption MEETS measures to combat corruption; these are medium-terminitiatives interms ofimpact Strongexternalaudit and - PARTIALLY COC is effective, but greater parliamentary parliamentaryoversight oversightofthe Government's implementationofthe COC recommendationsi sreauired. 116. Based on the above analysis, the team has rated the fiduciary risk o f the Government's internal control framework as high. (e) Recommendations 117. The current confused and incomplete state o f internal financial controls constitutes a serious fiduciary risk for the Government. 118. The CFAA recommends that the Government pass legislation giving specific and full authority and responsibility to the Minister o f Finance for the establishment and maintenance of the internal financial control framework that complies fully with stated international standards and the authority to implement it across the Government. The framework should be required to meet the EU's Public Internal Financial Control System requirements. The Minister o f Finance should be given the authority to develop sub-legislative instruments and propose them to the Government for consideration, as well as the ability to promulgate internal financial control standards and guidelines to be usedby all ministries andbudget entities.. The Minister o f Finance should be required to consult with, and obtain the agreement of, the COC on all significant proposals affecting the Government's internal financial control framework, including internal audit. 119. M O F should engage in early discussions with the Budget Committee of Parliament to ensure that their draft Law on State Financial Control gives appropriate recognition to the role o f management and separates the external auditor from activities that are the legitimate responsibility o fmanagement. 120. The CFAA recommends that the Finance & Budget Committee o f Parliament consider amending their draft legislationon State Financial Control to: 0 Establish a financial control regime that conforms with EU PIFCS standards for internal financial control, and which assigns to the Minister o f Finance responsibility for the Government's internal financial control system e Assign to the Minister o f Finance the responsibility for decisions relating to the hiring, firing, training to international standards, and certification o f heads o f internal audit units and their staff. Georgia CFAA: lnternal Audit 34 V. INTERNAL AUDIT (a) Legislative Basis 121. The existing legal basis for intemal audit i s weak and does not meet PIFCS requirements. The Budget Systems Law gives the Minister o f Finance a limited mandate, restricted to issuing methodology for internal auditors in budget entities. It also assigns responsibility for the procedures for internal audit to the head o f the spending agency, EBF or local authority, rather than the Minister o fFinance. The powers o f M O F inmatters relating to intemal audit and control need strengthening through additional enabling legislation. Part o f this can be achieved through the amendments to the Law on State Financial Control discussed previously; the remainder can be achieved by additional legislative changes to the Budget Systems Law or other more specific legislationrelatingto intemal control and audit. 122. The MOF has developed a draft law4' on an inspector general function for all ministries that includes an intemal audit and an investigation function. It would establish the Inspector General as functionally independentand unique ineach ministry. This is the same model as that employed in the U S Federal Government. Coincidentally, a similar draft law has been under development by the Ministry o f Justice42. A U S Treasury advisor to the M O F indicated that a comparison o fthe two laws revealed only one significant difference, discussed below. 123. The MOF's draft Inspector General Law specifies a two-pronged approach to maintaining internal control. An investigative arm would have the capacity to examine instances of suspected fraud and corruption and to conduct criminal investigations; an intemal audit group would review intemal financial control systems and procedures and advise management on the state of their intemal controls. Figure 12provides the draft Law's key features. This proposal has been circulated within Government and selected professional extemal bodies and has a number of supporters within the Government. Given the current state o f acceptance within M O F and in selected ministries, the team believes that it should be further explored by M O F as an effective way to fast-track the development o finternal audit across the Government line ministrie~.~~ 4'Technical assistance was provided to MOFby the Office o f Technical Assistance o f the U S Department o f the Treasury's Office o f Inspector General mission 42The team was advised that the Government has made a decision to adopt the Ministry o f Justice version, but the debate continues and parliament has not yet approved it. Hence both models are described inthis report. 43This would be inaddition to the necessary legislative requirements for internal control previously discussed. Figure 12: Proposed Inspector General Laws ~~ ~ The Law establishes, inter alia: 1. Independent and objective Offices o f Inspectors General inall ministriesto: Undertake audits and investigations relating to the ministryprograms and operations. Make recommendations to promote economy, efficiency and effectiveness inministry administrationand detect and prevent fraud and abuse. Identify and prosecute participants engaged infraudulent or corrupt activities. Inform the head o fthe ministry, the President, and Parliament about the problems and deficiencies identified within the ministry. 2. The inspectors general ineach ministry are appointedremovedby the President (MOF version) or bythe accountable minister (Justice version) and shall exercise independence inthe conduct o ftheir activities. 3. There will be Investigation and InternalAudit unitswithin each organization, each headed by an assistant inspector general. 4. Semi-annual reports shall be preparedby each inspector general on the results o f their investigations and shall be sent to the minister, who shall then transmit it to the President and Parliament within one month o freceipt. 5. The inspector general will have access rightssimilar to the COC; the power to subpoena information withheld; conduct criminal investigations inthe ministry. (b) Discussion 124. There is an urgent need for effective internal audit functions within Georgian Government institutions. There are few internal audit groups in ministries, and those that exist act more as accounting control units. 125. MOF has created an Inspector General's Office that will be responsible for conducting intemal audits and investigating illegality. It brought together the disparate audit and review groups within the ministry under one body to provide a coordinated audit and investigation function for the entire ministry. The function was originally located in the tax inspection area, but district tax collectors objected strongly to this oversight o f their activities, and it was relocated to MOF headquarters. Despite this organizational change, other unconsolidated audit and enforcement functions remain in the revenue agencies; the Monitoring Bureau and the Extraordinary Legion carry out investigations and monitor shipments to prevent smuggling, but neither have-a strong reputation for effective control. 126. The MOF Inspector General's Office has adequate resources, but its staff is not qualified to perform their jobs. Some limited auditor training has begun; much more i s required. There are 16 staff engaged in the investigation unit and 29 in the intemal audit area. However, it proved impossible for the function to hire qualified audit staff, and the result i s an operation that lacks the essential structures, policies and people for an effective intemal audit and investigation unit. In addition, MOF management has not taken action on those audit recommendations that the inspector general does make. GeorqiaCFAA: lnternal Audit 36 127. The newly-created inspector general function has been marginalized within MOF. Located in an office building far removed from the mainstream activities o f the ministry, the inspector general is expected to coordinate the activities o f all the Ministry o f Finance and agency groups that perform audit and investigation functions. Such coordination has not occurred, and there is negligible cooperation between the various groups. For example, the team was advised o f a recent move within customs to establish their own inspector general function, without any discussion with the central function. Senior M O F management has not resolved this conflict within its own ministry, indicating a lack o f management support. Senior level executive support is essential for this necessary, but manifestly unpopular, reform to be successfully implemented inMOF and across Government. The MOF management has very recently begunto use the audit component o f the Inspector General function for internal reviews o f the ministry administration, an excellent first step. 128. The lack o f a proper internal audit legislative framework and an identified role for M O F inits implementationdoes not meet the EUtest for effective internal audit. It also means that the expenditures o f the Government are at significant fiduciary risk 129. MOF management must give higherpriority to internal audit. The team recommends an initial focus on strengthening the Inspector General Department inMOF and perhaps one or two other ministries where there is a strong desire to see the function implemented. The MOF could then begin to ensure that internal audit units are established in other budget entities; this should be considered as a medium-term objective. 130. MOF should make specific legislative provisions to strengthen the Minister o f Finance's role in establishing the framework for internal audit across the Government and to require that internal audits comply with IIA International Standards of Auditing and EU requirements. Its role ininternal audit is described inFigure 13. Figure 13: Steps to Establishingan InternalAudit Functioninthe Governmentof Georgia . The Government establishes a strong legislative base that places overall responsibility for internal audit with the Minister o f Finance and that requires internal audits to be carried out in all first line budget entities (thiscould be contracted out to another ministry or another Government entity ifcost- effective to do so). Minister o f Finance, through MOF, prepares and issues internal audit standards, guidelines, and . manuals that conform to IIA International Standards for Auditing to govern the planning, conduct, training, and reporting o f all Government internal auditors and their professional development. Minister o f Finance establishes an external review committee for the Government's intemal audit . function, composed o f experts in various domains from outside of the public sector to provide advice and assistance to the minister on the activities and future development o f the intemal audit function. MOF develops a program o f the qualification and certification o f internal auditors and ensures that training to intemational standards i s made available to all new and existing staff. MOF establishes an internal audit quality assurance process and reports annually and publicly on the overall conclusions o f intemal audits conducted across the system. I I Georqia CFAA: lnfernal Audit 37 (c) Recommendations 131. A strong internal audit system is a prerequisite for effective internal controls. The virtual absence o f any systematic legislative basis for internal audit constitutes a highfiduciary risk for the Government. 132. The CFAA recommends that the Government establish an effective internal audit unit within its existing inspector general function and develop aplanfor the implementationof internal audit function across the Government. As the Government's internal audit capacity develops, the Government should propose amendments to the legislation o f COC to remove its directions over internal audit. Georsia CFAA: External Audit 38 VI. EXTERNALAUDIT (a) Legislative Basis 133. The current law on the Chamber o f Control establishes the traditional objectives for a supreme audit institution. They include supervisingthe use and spending of state resources and other assets, protecting property and wealth, performing audits, and analyzing the legality, purposefulness and effectiveness o fthe use o f state material and monetary resources. There are a numberof provisions worth noting. Among them, the COC: 0 Evaluates the soundness o f revenues and expenditures in the draft state budget submitted to Parliament 0 Performs tax or customs audits o f individuals and enterprises 0 I s not required to adopt INTOSAI auditing standards; rather, it only "recognizes" the statute and mainprinciples o f other basic documents o f INTOSAIand EUROSAI" 0 Undertakes unscheduled audits at the request o f Parliament and the President 0 Coordinates the audit work o f other bodies to eliminate overlap and duplication 0 Establishes internal control standards, audit standards, and related regulations and manuals which are then binding for all entities 0 I s subject to review by a commission established under a decision o fParliament 0 Retains 30 percent o f all fines leviedas special revenues to be used by COC to strengthenits material and technical base. (b) Discussion 134. COC is an important component o f financial control o f public funds, particularly in an environment o f inefficiency and corruption. It has received technical assistance from donors that include USAID, GTZ, and EU TACIS for the adoption o f INTOSAI standards, and training of staff to implement the new standards for audit planning, execution and reporting. As this proceeds, it will enable COC to develop into an SA1that fully meets all INTOSAIrequirements. 135. COC has limited resources with which to conduct its annual audits. The legislative requirement for annual audits means that higher risk entities may not always get the audit attention they warrant. Rather than perform all audits themselves, COC could consider sub- contracting specific audit assignments to other qualified external auditors (e.g., registered private sector audit firms). The wording o f its existing legislation already allows the COC to "invite external experts and consultants.. . incarrying out the audits"44. While this wording permits sub- contracting, for greater certainty, the COC law could be amended to state COC can "retain quaEij?ed audit and other external experts and consultants to assist in, or perform, audits designated by the COG`" (proposed changes are in italics). Inaddition, the Budget Systems Law 44Law ofGeorgianChamber of Control, Article 49. would require revision to state COC ... i s responsible for causing the audits that support " Parliament's certification o f the final annual accounts." This would give COC the flexibility to perform those attest audits that it wishes to do itself and sub-contract other attest audits that must be performed to other external auditors. The COC advised the CFAA team that existing legislation already permits them to engage other qualified auditors and that further clarification inlaw is unnecessary. 136. The COC has been forced to assume part o f the role o f an internal auditor because of the lack of an effective internal audit function. As the internal audit function develops and matures, the COC expects to be able to withdraw from this role, and to rely, where appropriate, on the work of the internal auditors inthe conduct o ftheir external audits. 137. This "internal auditor" focus may be in part driven by the special revenues retained by COC, amounting to 30 percent o f all penalties levied. These funds are used for salary enhancements and other investments in the chamber help5. This represents a potential conflict of interest for COC, in that it could provide an incentive to find something wrong so that penalties can be levied and revenues generated for the COC. In addition, the 30 percent rule i s alleged to encourage COC to intervene when an internal audit o f any significance is initiated by the Government. COC has the right o f first audit for any budgetary entity. This means that, when COC initiates an audit, the internal audit ceases, regardless o f the fact that the latter may have been underway for some time. This enables COC to perform the audit, levy the penalties, and gain additional special revenues. The impact o f the budget systems law's inclusion o f special revenues inbudget receipts will have to be carefully managed. 138. The team was originally advised that no other audits may be carried out on the entity for one year after the completion o f the COC audit, regardless o f the circumstances. This appeared to exclude COC and other auditors (internal auditors, customs and tax auditors) from performing their responsibilities with respect to that entity. Discussions with the COC revealedthat there are no such prohibitions in law, and that other audits can be scheduled in the same year. The team believes that this should be specifically authorized in law, to eliminate any hrther misconceptions on the issue. 139. The COC maintains considerable documentation on errors and irregularities they discover. This is essential if the errorshrregularities are to be proven and penalties issued (30 percent o f which becomes COC income). Over time, the CFAA team believes that their focus will provide greater supporting analysis on the key elements o fthe entity's financial statement in support o f the audit opinion on the true andfair view o f these statements in accordance with evolving international standards. 140. Audit duplication occurs in the audit o f PIUSfor Bank-financed projects. At present, external auditors are engaged to conduct these audits, using audit criteria that include requirements o f the COC as specified by them. The COC continues to independently audit PIUS, noting that it i s the only auditor with a mandate to examine the effectiveness o f the projects. Under its risk-based audit approach, COC could rely more on the external auditor's work for its 45This i s identified as a temporary measure inthe L a w on the Chamber o f Control, ineffect until "the uniform procedure for promotion in the state bodies i s worked out". The 2003 Budget Systems Law has incorporated special revenues into budgetary receipts. detailed, budget-compliance testing and conventional audit opinions, and could assign more of its audit resources to assessingproject effectiveness. 141. Under a well-developed system o f internal controls, it would be unnecessary for the COC to have powers o f law enforcement. This is not a role for modem SAIs in a mature system of internal financial controls. The appropriate role for the COC would be to report its findings to management and Parliament, and make appropriate recommendations for management or other authorities to resolve the problem. The COC would, however, monitor the Government's implementation o f its recommendations on an ongoing basis and report its findings to Parliament inits annualreport. 142. However, taking into account the weak internal control process, it would be inadvisable to remove these enforcement powers at this time. The study has already recommended that the development of an internal control framework be a top priority o f the Government. Until such time as the internal control regime is established and its effectiveness proven, the COC should continue to exercise these enforcement powers. 143. There is only a limited external review of the activities of the Chamber o f Control. Parliament can strike a commission to conduct a review o f the COC's activities, but only two such reviews have been undertaken, in 1999 and 2003. There is no provision for a mandatory annual external audit. The team believes that it is important for the COC to undergo an annual extemal audit, just as every other budget entity, and as well recommends that the COC undergo a periodic a peer review, particularly inits current state o f de~elopment~~. 144. COC's present necessary involvement in some o f the functions o f internal audit means that the intemal control component o f the PIFCS requirements is not strictly met. However, in terms o fthe external auditor function, the COC fulfills the PIFCS criteria. (e) Recommendations 145. At present, SA1 is the only audit component within the Government's internal control framework. Its auditors are continuing to upgrade their skills to meet the requirements of the more complex audit procedures. The team believes that the COC's exercise o f external audit fbnction constitutes a low fiduciary risk for the Government. 146. The CFAA recommends that the Law on the Chamber o f Control and the Budget Systems Law should be amended to: 0 Give the COC additional time (30-45 days) to be determined after consultation with Parliament to prepare and submit to Parliament its opinion on the Government's consolidated annual report on budget execution. 0 Permit COC and other auditors to have access to documents from a budget entity from prior years where, intheir opinion, it is inthe public interest to do so. 46A peer review is a review o fa SA1undertakenby a team ofauditors from other SAIs and EC SIGMA experts. It provides a diagnostic to identify areas where improvements can be made. The report is an intemal document for the SAT management. Georqia CFAA: Exfernal Audit 41 0 Clarify that other audits can be undertaken by any auditor in an entity that has been audited bythe COC inthe sameperiod. 0 Require the COC to monitor the Government's implementation o f the material COC recommendations and to report them to Parliament inthe COC's annual report. 0 Require an annual external financial audit o f the COC by a parliamentary commission that can be created under existing legislation. 0 Eliminate the COC's 30 percent rule inrevenue collection, as part o f the general move away from earmarking resources to support specific ministry activities.47 147. The CFAA recommends that the COC request that SIGMA conduct a peer group review of its operations in the near future, and periodically thereafter, to measure its progress against earlier recommendations. 47As mentioned previously, this shouldbe done inconcert with a general government policy to address the compensation issues that arise as special revenues are eliminated. Georqia CFAA: Leqislative Scrufinv and Public Accountability 42 VII. LEGISLATIVE SCRUTINYAND PUBLICACCOUNTABILITY (a) Legislative base 148. Article 92 o f the Constitution assigns to Parliament the responsibility to enact the annual budget law submitted by the President, who is requiredunder Article 93 to submit the proposed budgetthree months before the start o f the next fiscal year. The budget is to be accompanied by a report on the execution o f the current budget. Article 97 requires the Chamber o f Control to report semi-annually on the execution o f the State budget by the Government, and annually on the results o f its audit activities. 149. Further details are prescribed inthe Law on State Budget System. It assigns to: The Parliamentary Committee on Budget and Finances the responsibility to consider the basic budget data and directions submitted by the President by May 1, and to report on its conclusions to the Presidentby June 1. Parliament and its various committees have the responsibility to review the draft annual budget law with attachments on: the fiscal statement and budget assumptions; statement o f revenues and expenditures by three levels o f economic and h c t i o n a l classification, including investment projects and donor-funded projects; and the budget surplus or deficit andits application or financing. The President the ability to propose amendments to the budget and Parliament to power to approve the amended budget law. Parliament the right to review the quarterly status o f the Government's budget andthe annual final accounts, and the conclusions o f the Chamber o f Control. Final accounts o f local budgets are treated similarly. (b) Discussion 150. Strong parliamentary oversight o f the Government's financial stewardship over public resources is another key component o f the PIFCS requirements. There i s active legislative oversight provided by Parliament on the financial budget proposals and actual performance of the Government. The Parliamentary Budget Committee actively monitors the formulation and execution o fthe Government's budgetduringthe year. Their comments and input are reflected in the final approved budget. The committee i s also very active in deliberating on new legislation (over 100 laws in recent years); it i s currently evaluating the new draft law on State Financial ControI. 151. The Budget Office o f the Parliament o f Georgia is supported by professional staff that assists it in analyzing the budget. It began in 1998 with USAID support, and presently has 24 staff members who analyze various reports from the Government and COC, initiate special studies and surveys on issues of importance, and disseminate their work widely in Government, Parliament and civil society. The staff views the COC audit reports as being satisfactory interms o f detailed compliance activities, but its level o f reporting could do more in identifying all o f the broader issues o f interest to all parliamentarians. They would prefer to see additional analysis Georsia CFAA:Leuislafive Scfutinv and Public Accountabilifv 43 and synthesis o f the audit findings into high-level conclusions that Parliament might be better able to understand and act on. 152. There is a reasonable degree o f public interest in the financial operations o f the Government. Spending arrears have affected significant numbers in civil society, and the issues surrounding the Government's budget proposals attract considerable media attention and public comment. 153. The legislature does not always follow up on the recommendations o f the external audit reports. Parliament can require the executive branch to respond to accusations and answer questions before the Parliament. The team was advised that when COC discloses significant problems in a ministry, Parliament often takes them into account when determining that ministry's budget allocation. 154. While the budget committee is active, the actual impact o f their activities on the accountability o f the Government is more difficult to determine. The current political environment appears not to encourage strengthening the accountability o f Government to Parliament, and any assessments o fParliament's oversight effectiveness must be made inlight of these underlying conditions. However, there is now a base on which further development can take place. 155. The overall impact of the COC's reports i s hard to gauge, as there are conflicting opinions. Certainly there i s good initial impact in that the interest o f Parliament, the official recipient o f the reports, i s high. The inevitable criticisms o f the Government attract much media coverage and comment. The committee recognizes that it i s the media's role to interpret the COC's report and the Government's final budgetreports. The Committee indicated that the print and television media have carried their messages to the public, and the head o f the Budget Office, a former parliamentarianhimself, i s widely quoted on important issues. (c) Recommendations 156. Parliamentary oversight i s present and increasing in its effectiveness. There i s clearly more to be accomplished, however, so the present fiduciary risks involved are low/moderate. 157. The CFAA recommends that the Parliament should assign to the COC the responsibility for monitoringthe Government's responsesto all its audit recommendations and for tracking their implementationuntilcompleted. This opinion should be addressedto Parliament and the public, as well as the Government. Georaia CFAA: Fiduciaw Considerations in Bank-Financed Projecfs 44 VIII. FIDUCIARY CONSIDERATIONS INBANK-FINANCED PROJECTS (a) Investment Projects 158. Reliance on Public Sector Financial Management Framework. From the foregoing analysis it can be seen that there have been improvements in the public financial accountability arrangements in Georgia. At the same time, the CFAA Report raises a number o f issues that require further reforms and capacity building efforts. Under these circumstances, it is inappropriate to place total reliance on the existing public sector financial management framework for the purposes of satisfying the Bank's fiduciary financial management arrangements. The CFAA recommends that during the project cycle, the Bank and counterparts need to take into consideration the inherent weaknesses in all aspects o f the system and build appropriate safeguards to minimize risks. 159. Implementing arrangements. The legal status o f PIUs is well-established in law. Bank- financed investment projects in Georgia are implemented by standard project implementation' coordination units (PIUs), staffed by individual local consultants employed on contract. All PWs operating in Georgia are established as legal entities o f the public law in accordance with the Civil Code, with the exception o f the Tbilisi Water Utility Development Bureau, which is registered as a LimitedLiability Company. 160. PIU financial staff requires more training. There is insufficient training on the World Bank financial management and disbursement procedures and on international public sector accounting standards. This can potentially adversely affect the quality o f the project financial management arrangements, increasing fiduciary risk. Inaddition, a pool o f well-trained financial management professionals could, in the future, be of considerable use to the Government as it seeks to establish an enhanced financial management control framework across the central government, State Special Funds and local administrations. 161. MOF should develop a standard framework for PIUS.This framework would include standardized job descriptions, staffing levels, compensation arrangements and hiringguidelines. These standards are a useful tool to ensure that the PIU staff, especially the financial management staff, have job descriptions that cover all essential tasks necessary for effective management and control. The Country Portfolio Performance Review, M O F and the Foreign Investment Advisory Council Secretariat agreed to draft standardized job descriptions by March 2001. As o f May 2003, they have not been completed. This has the potential to contribute to fiduciary risk across the entire portfolio, especially if the number o f projects increases significantly, as discussed below. 162. Disbursement arrangements. Disbursement controls over IDA funds continue to be tightly regulated. All investment projects use traditional disbursement methods based on the determination o f the eligibility o f individual expenditures. This is complicated by weaknesses in a number o f the PIU budgeting systems that result in unrealistic annual budgets, resulting in Georqia CFAA: Fiducian/ Considerationsin Bank-Financed Projects 45 increased fiduciary risks to the Bank for these h n d ~ .In'the future, as the financial management ~ capacities develop, funds could be advanced on the basis o f a program o f budgeted project activities, agreed by the Bank. The funds advanced would be reconciled, ex post, against evidence that the budgeted activities took place, together with supporting financial management reports on the use of project resources. These would be subject to annual audit, with active follow-up by the Bank on any audit findings. 163. Banking arrangements. The Georgian banking systemhas a number o fweaknesses, most importantly, instabilities in financial condition o f commercial banks. These are due to their insufficient capitalization and high credit risk because there are only a few borrowers who are engaged in economic activities that generate the hard currency required to repay the foreign- currency denominated loans. These borrowers bear the exchange rate risk and exchange rate volatility could compromise their ability to service these loans. Currently there are 25 Georgian commercial banks and two subsidiaries of foreign bank functioning in Georgia. Two foreign banks are Ziraat Bank, Turkey, which only serves Turkish businessmen in Georgia, and Caucasus Development Bank, which has a head office in Baku, Azerbaijan, and which also does not carry out any active operations in Georgia, functioning more like a representative office. Of the 25 Georgian banks, only about 12 banks are really active in their operations, and approximately 80 to 85 percent of total assets are concentrated in about 10banks. The National Bank o f Georgia i s actively working on consolidation o f the banking system in the country, particularly in respect to small non-active banks. It is expected that in two or three years, the number o f commercial banks will be reduced from 25 to approximately 10 to 12 banks, well capitalized and active inthe market. 164. Prior to the 2000 CPPR, the Bank, MOF, and the National Bank o f Georgia agreed that banks eligible to hold project accounts would require CAMEL 1 or CAMEL 2 ratings. These criteria were further extended by the World Bank in 2001 to include compliance with the requirements contained in OP 12.204', which include all o f the central bank's prudential regulations and the limits on the maximum aggregate authorized balances o f all Government funds related to the Bank projects or co-financed projects inabank to no more than 25 percent of the bank's total liabilities (excluding shareholders' funds) provided that this amount should not exceed 100 percent of the bank's shareholders' funds (total equity). Such criteria proved to be very efficient for the purposes o f risk monitoring with respect to the bank arrangements for WB- financed projects, and thus the CFAA concludes that they currently do not require any amendments and their application should be continued. 165. Only a limited number of banks (approximately seven to eight) are currently able to comply with the eligibility criteria. This results in a significant concentration o f accounts in a small number o f financial institutions, increasing the potential for greater fiduciary risk. This necessitates constant monitoring of these bank's aggregate balances on accounts to ensure that the limits set for their total liabilities and equity are not exceeded. Information about all accounts opened by the PIUS, balances on these accounts, CAMEL ratings o f the banks, and their liabilities and equity i s collected on a regular (at least quarterly) basis and compliance with the 48The Secretariat o f the Foreign Investment Advisory Council has already begun to monitor project completion against stated milestones inan effort to improve budget to actual performance. 49World Bank Operational Policy 12.20 regulates opening and operation of special accounts o f Bank financed andor co-financed projects. It also sets the required characteristics for a bank to hold a special account. Georaia CFAA: Fiduciarv Considerations in Bank-Financed Projecfs 46 World Bank policy i s checked. Accounts for Government counterpart funds are normally opened inthe same commercial bankswhere special accounts and/or transit accounts are maintained. 166. The World Bank Georgia Country Office staff, with support from headquarters, actively monitors the condition o f the banking system in Georgia, paying particular attention to financial performance o f selected banks and tendencies in their development. Additionally, twice or three times per year in-depthreviews are conducted by the Bank team. 167. Financial reporting. Financial reporting by PIUs meets Bank standards. All projects appraised by the World Bank after July 1, 1998, must now produce and submit quarterlyproject management reports (PMRs) to the Bank, or begin their production at a future date specified in their development credit agreements. All PIUs also submit quarterly reports to MOF on uses of funds in accordance with standard formats and monthly reports to the tax inspection. Relevant reports must also be submitted to the Secretariat o fthe Foreign Investment Advisory Council. (6) now of funds arrangementsfor adjustment operations 168. Under the credit arrangements for Structural Adjustment Credits (SACS), the borrower i s requiredto open and maintain a separate deposit account inits Central Bank". The loanproceeds have to be used for eligible purposes as defined inthe credit agreement. Typically, for example, the loanproceeds cannot be used to finance items imported from a non-member country or goods and services from the standard negative list. 169. InGeorgia, deposit accounts for adjustment operations are to be opened inthe name of the Treasury Department o f the Ministry o f Finance in the National Bank o f Georgia (NBG). Tranches are transferred initially to the foreign currency deposit accounts (USD, or any other currency depending on the currency o f the original transfer). These foreign currency funds are sold to the NBG and included in the country's foreign exchange reserves. The local currency counterpart funds supported by the sale into Georgian Lari at the rate o f the NBG valid on that date are deposited in the Central Budget Account (Treasury Single Account) #103. Account #lo3 is maintained in Georgian Lari. From account #103, funds are transferred to other (target) accounts. However, based on our review o f the actual flow o f funds for adjustment operations, it appears that M O F does not understand and comply with the proper flow o f fund arrangements, as stipulated in the Credit agreements for adjustment operations. They require separate bank accounts for the proceeds from the loans and/or grants. In2003, an audit o f the Dutch grant for the co-financing o f the third Structural Adjustment Credit" was carried out. The auditors issued a clean audit opinion on the special purpose Statement o f Grant Receipts and Disbursements. 170. The National Bank o f Georgia plays a key role in ensuring control over such adjustment proceeds. NBG engages a big-four international audit firm to conduct annual audits o f its financial statements, which are prepared applying the principles o f IAS. The audit report for 2002 was unqualified and there were no major issues identified. 171. An IMF Safeguard Assessment, conducted in January 2002, concluded that there has been some improvement in the NJ3G's financial reporting, internal audit and cash management 50See Bank Operational Directive 8.60 51Trust Fund# 050182 Georqia CFAA: Fiduciary Considerations in Bank-Financed Projects 47 . procedures, but significant weaknesses were identified in their internal control system. In response to IMF recommendations, the NBG advised the team that they have reorganized their functions to strengthen the controls and to fulfill a structural performance criterion under the current PRGF-supported arrangements. (c) Auditing arrangements 172. Auditing arrangements are satisfactory. All Bank-financed investment projects are subject to an annual financial audit by an independent private audit firm. While no reliance has beenplaced so far on COC to carry out external financial statement audits for Bank purposes, the COC is the only auditor who assesses the effectiveness o f individual projects. To ensure high quality of independent private audits, the Bank performs assessment o f audit firms operating in CIS countries. The first review o f audit firms operating in Georgia took place in M a y 2002 and the next one - in June 2003. As a result o f review, the Bank compiles a list o f audit firms qualified to participate in tenders for audits o f Bank-financed projects, which is updated regularly. 173. In 2001, five firms provided these services for 19 Bank projects. The Chamber of Control, and Tax Inspection conduct various audits and reviews according to their own audit cycles. In addition to meeting the Bank's fiduciary requirements, auditing the Bank funded projects provides the Government o f Georgia with the tool to exercise its internal management oversight responsibility; the COC conducts its independent external oversight o f the projects as part o f its statutory responsibilities. All the private auditor project audit reports are shared with MOF, COC, the FIAC Secretariat and the line ministry. Most o f projects have received clean audit reports for fiscal years 2000 and 2001, although a number o f internal control issues raised inthe management letters52require ongoingattention. (d) Procurement issues 174. Continuing procurement issues mean continued high fiduciary risks. A Country Procurement Assessment (CPAR), conducted in Georgia in June 2002, rated the fiduciary risk for Bank portfolio as high. It further noted that the weak procurement environment raises concerns about the value o f money and accountability for public funds, especially because practices vary widely from the formal rules and enforcement is weak. The increasing shift inthe World Bank's new lending to social sector projects, which involve thousands o f small-value contracts at the sub-national Government level that are generally not subject to prior review by Bank staff, and where capacity for implementation and monitoring i s generally weak, will mean a continuation o f the high risk rating in Bank-financed projects. On a more positive note, the CPAR noted that most PIUs were staffed with relatively well-paid local consultants and included at least one procurement specialist with a good knowledge o f the Bank's guidelines and procedures. Most projects provide for formal procurement training, and procurement plans are regularly updated. 52These include PIU-Bank reconciliation deficiencies; failure to performannual debtorlcreditor reconciliation and failure to follow applicable accrual accounting standards. Georuia CFAA: Fiduciarv Considerations in Bank-Financed Projects 48 (e) Recommendations 175. Due to the large amounts o f funds involved; the opportunities for corruption or fraud; weaknesses in the banking sector, most importantly, instabilities in financial condition of commercial banks holding accounts o f PIUs; insufficient level o f training provided so far to the PIU financial staff both in the World Bank procedures and in International Financial Reporting Standards; non-compliance with the flow o f funds in adjustment operations; and weak procurement environment, this area has beenrated as a moderate-high fiduciary risk. Thus, the CFAA provides the following recommendations: Additional training should be provided to the staff o f the relevant MOF unit and to the PlU staff in World Bank financial management, disbursement, and procurement procedures, and inInternationalFinancialReportingStandards. The Government should complete the development o fthe standard framework for PIUs. This framework would include standardized job descriptions, staffing levels, compensation arrangements and hiring guidelines. These standards are useful tools to ensure that the PIU staff, especially the financial management staff, havejob descriptions that cover all essential tasks necessary for effective management and control. The NBG should continue its work on consolidation o f the commercial banks, and on introduction o f regulatory mechanism following the best practices and recommendations provided by international banking community, most importantly in respect o f the minimum capital o f commercialbanks (five million Euros). In preparing future adjustment operations, fiduciary arrangements should be reviewed and reflected in credit agreements in more detail, particularly in respect o f ring-fencing o f the deposit account into which adjustment proceeds are paid and in respect o f arrangements for auditing o f the deposit account. The CFAA also recommends as part o f its due diligence that the Bank receive copies o f the audited financial statements and management letters o f the NBG. The CFAA also recommends that the NBGcomply fully with the proper flow o f funds. for all adjustment operations. IX.CAPACITY DEVELOPMENT (a) Capacity BuildingProgram 176. A well-developed internal control system requires skilled staff to operate the controls, and an environment that supports their effective operations. At present, the Government fails to meet this component o f the EU's PIFCS requirements. 177. While there is a general lack o f capacity across the Government, the CFAA analysis has focused on the need to develop improved financial management skills. The team noted a critical need for training o f staff from all the financial functions in all the entities that it visited duringits mission. This includes staff o f the central and line ministries, the external auditor and the Plus. There was continual reference made to the adoption o f international standards for accounting and auditing activities. The team strongly endorses this approach to improving the Government financial management capacities. However, there was little recognition o f the implications for professional development and training that are requiredto support their adoption. 178. M O F must assume the lead role in ensuring the provision o f adequate training o f the accounting and auditing staff within the Government. The success o f future MOF reforms to strengtheninternal controls and internal audit will be critically dependent on technical assistance to train large numbers o f civil servants in the modem international standards for accounting and auditing. The COC has indicated its readiness to assist with the training o f the internal auditors, usingtheir existing audit training capacities. 179. Without financial management and audit this training, the initiatives will not succeed. MOF should undertake discussions with donors to ensure that TA can be provided to support this major change. MOF must take the lead role in ensuringthe definition o f training needs and then arranging for their provision, usingthe COC, donors and other training resources as appropriate. 180. The capacity o f a government to absorb and implement an ambitious set o f management reforms must be taken into account when discussing feasible targets and deadlines. Training of existing and new staff in new or modified processes for budget formulation and execution, treasury functions, procurement, internal controls, internal auditing and financial management, all present challenges that will require technical assistance and innovative human resource solutions. A recruitment strategy that focuses on hiring new graduates in economics, accounting and law i s also required. The Government could undertake a capacity development program usingappropriate elements of the process outlined inFigure 14. It provides a range o f strategies that could be employed to increase the staff skill levels in financial management. In all cases, some form o f additional compensation will be necessary to encourage take-up o fthe training and the longer term retention o f skilled staff. Georgia CFAA Capacitv Developmenf 50 Figure 14: Proposed CapacityDevelopmentProgramfor FinanceandAudit Staff 0 Undertake an inventory o f all existing financial and internal audit positions and future requirements inall ministriesandbudget entities. 0 Identify key knowledge and experience requirements o f each job type, including such functions as financial and budget management specialists in ministries, budget analysts in MOF, Treasury financial specialists, internal auditors, etc. 0 Establish gaps between the requirements for the positions and the existing capacities, and formulate strategies to address the needs, according to priority needs. 0 Adopt strategies to address the developmental needs to be considered could include a combination ofthe following: a. In-house training courses providedby COC, MOF and external experts. b. Local universities, technical institutes and the national accounting body providing tailored courses to develop required financial management skills; these courses could be paid for directly by the Government, or by the students, with reimbursement by the Government on successful completion. C. Courses offered by individual donors inspecified locations outside o f the country. d. Center o fExcellence inLjubljana, Sloveniafor specific financial management training. e. Post-graduate scholarships for existing staff to study abroad, with a commitment to return to the civil service for a designated period o f time. f. Targeted university recruitment programs to increase the number of highly-qualified new graduates in the civil service; this would consist o f a program to provide the participants with exposure to the range o f financial management or audit functions over a period o f time, and opportunities for career advancement. g. Twinning with other countries with well-established financial management or audit functions and with a capacity to assist intraining o f Georgian financial specialists. h. Industry/Government exchanges to insert skilled financial managers into key senior-level financial positions inselected ministries for a given period o f time. e Provide incentives for existing financial staff to undertake the required skills upgrading, such as a five-year provisional certification to permit them to complete the required training, after which unqualifiedindividuals would be removed form the designatedpositions 181. There i s also a need to identify senior- and middle-level champions of change in the Government. These are the people who can articulate the vision o f the future o f financial management and control, support the efforts that are required to make the changes, and to communicate their enthusiasm to the affected staff. Given the magnitude and the range o f changes envisaged, such champions are essential for long-term success. The CFAA team did not encounter any such champions during its mission, although there i s the potential for some to emerge. This has not commanded significant management attention from MOF. Greater leadership and management attention are crucial to the success of this strategy. Georgia CFAA: Capacitv Development 51 (b) Recommendations 182. Competent and highly trained staff in financial management and auditing are essential to successful internal controls. The current state o f untrained staff poses a highfiduciary risk for the Government. 183. The CFAA recommends that the MOF adopt and implement a comprehensive capacity- building strategy that establishes the priorities for recruitment and training o f the .financial and audit staff in the Government and begin its implementation on a priority basis, in consultation with donors. Gm m n ob 3 E; 3 3 +4 3 N - 0 m '(u 00 3 3 m U F n" sm dm m In \o f I- H c 6 i- f m m 9 s 0 3 m 3 m 3 4 Y) E-c 3 5Lo ;e" Y OA u $ .I Y cd I m v) u> CI 3 3 3 z z U N c.l 00 m 3 e n" s M s M a i .- f 0 c, .-bE Q v) *3 z vi t- vi vi vi m t- t- 1 m 5; Y i Georgia CFAA: Appendix (bJiisf of Kev CmnferDads 59 (b) List of Key Counterparts Many people gave generously of their time to assist both of the CFAA teams inthe consultations associated with the fieldwork and subsequent reviews ofthe document. They included: I.MINISTRY FINANCE OF a Mr.Vasil Gigolashvili (Deputy Minister ofFinance) a Mr.LashaZhvania (Deputy Minister ofFinance) a Mr.Zurab Miminoshvili(Director ofBudgetDepartment) a Mr.LevanGrigalashvili (Head ofAccounting MethodologyDepartment) a Mr.IliaKalandadze 11. MINISTRY TAXREVENUES(CURRENTLYWITHINMOF) OF a Mr.Levan Chrdileli (Head ofTax Department, currently Deputy Minister ofFinance) a Mr.Zaza Kobulasvili (Deputy ChairmanofTax Department) 111. TREASURY a Mr.DavidRamishvili (Head ofTreasury) a Mr.GeorgeBakradze (DeputyHead) a Mr.B.K.Chaturvedi(IMFAdvisor) IV. PARLIAMENT a Mr.Zaza Sioridze(ChairmanofBudgetCommittee) a Mr.RomanGorsiridze(Head ofBudgetOffice) v. MINISTRY OF STATE PROPERTYMANAGEMENT a Mr.Otar Makharadze VI. CHAMBEROFCONTROL a Mrs.Tamar Bitchikashvili (Deputy) a Mr.RomanBokeria VII. TBILISI MUNICIPALITY a Mr.AmiranDzebisashvili a Mr.KobaBekauri VIII. AUDITING COUNCIL a Mr.Nodar Kebadze (Head) a Mr.ElgudjaApridonidze (Deputy) Ix. GEORGIANFEDERATION OF PROFESSIONALACCOUNTANTS AND AUDITORS 0 Mr.RevazDzadzamia(Chairman ofthe Board) 0 Lavrenti Chumburidze (Executive Director) x. ANTICORRUPTIONPOLICYCOORDINATINGCOUNCILOFGEORGIA 0 Mr.MirianGogiashvili(Currently Minister ofFinance) XI. MINISTRY EDUCATION OF 0 Mr.Vladimer Sanadze(DeputyMinister) 0 Kakha Khaindrava(Head o fBudget Department) mission 1 XII. STATE CHANCELLERY 0 Temur Basilia (Economic Advisor to the President) 0 MikheilAlkhanishvili 0 Kakha Baindurashvili (National Consultant at FIAC secretariat) XIII. OTHERPARTIES(INCLUDING DONOWBILATERAL AGENCIES) 0 Kakha Khimshishvili, DFIDmission 2 0 Jurgen Shilling, GTZ 0 Geoffrey Minott, Joseph Taggart and Lado Gogadze, USAID 0 Jonathan Dunn, IMF (c) RecentGovernmentAnti-Corruption Initiatives Strategies Developed inthe following areas: 1. Liberalizing o fthe business environment; 2. Strengthening financial management o f state resources; 3. Increasingthe effectiveness o fthe civil service; 4. More effective law enforcement bodies andthejudiciary; 5. Development o frepresentative democracy; and 6. Educating the next generation on individual responsibilities. Priority Action Areas: 1. Develop monitoringsystem for customs bodies; 2. Matchtax declarations and asset assessments; 3. Limit inspections o f private enterprises to tax inspectors, COC and Interior ministryandimprove transparency 4. Improve staff vehicle/ license allocationprocesses; 5. Budget execution reports include all entities receiving state financing; 6. Streamline license and permitprocesses; 7. Increase transparency o f Government for citizen enquiries; 8. Budget law amendments to control loans, classify expenditures and capture special revenues; 9. All payments should be made directly to Treasury; 10. Report on enterprises with rescheduled tax payments and increase process transparency; 11. Publishlist o ffrequently-asked questions for customs and tax issues; 12. Increase management o f foreign credits; 13. Move PE management responsibilities to Ministry for State Property Management; and 14.Establisha Code o f Ethics for civil servants. Georgia CFAA: Appendix (dJ2001 Dividends: Top 22 Public Enterprises 62 (d) 2001Dividends:Top 22 Public Enterprises53 (Million GEL) Dividends Dividend Name of Enterprise Net Profit due (percent) Paid Arrears "Marine Company" Ltd. 25,989,441 JSC "Intemational Oil Corporation" 18,000,000 4,000,000 22 4,000,000 "Electro dispatching 2000" Ltd. 7,017,923 1,403,585 20 - 1,403,585 JSC "Elektrogadatsem" 1 6,143,113 1 614,311 1 10 50,000 564,311 I 1 1 ~~ "Engurhesi" Ltd. (Enguri Hydro Power Plant) 5,659,000 1,131,800 2o - 1,131,800 JSC "Sakrusenergo" 5,000,000 2,500,000 50 - 2,500,000 "Georgian Railway" Ltd. 3,574,000 2,000,000 56 2,000,000 JSC "Cascade ofVartsikhehesi" I 1 I 1 1 1 (Vartsikhe Hydro Power Plant) 2,204,490 440,898 20 - 440,898 JSC GeorgianGas Intemational Corporation" 1,961,068 1,961,068 100 - 1,961,068 II II - II - II II -- III 1 - I Poti port 1,700,000 700,000 41 700,000 I III I "Georgian Air Navigation" Ltd. - 1,576,675 I I I I JSC "Cascase of Gumathesi" (Gumathesi Hydro 790,600 158,120 20 - 158,120 JSC "Lajanurhesi" (Lajanuri Hydro 1 1 1 I I Power Plant) 618,700 123,740 2o I - 123,740 1 I I 1 1 JSC "Tbilisi Airport" 537,205 100,000 19 100,000 "Tbilaviamsheni" Ltd(Airplane Construction 530,000 530,000 100 530,000 TOTALS 82,802,457 16,476,049 7,996,722 8,479,328 S3 Source: Ministry ofFinance MAP SECTION