Report No. 26927-BA Bosnia and Herzegovina Country Financial Accountability Assessment June 10, 2003 Operations Policy and Services Unit Europe and Central Asia Region Document of the World Bank CURRENCYEQUIVALENTS Unit of currency= Convertible Mark (KM) FISCAL YEAR FY02 ACRONYMNSAND ABBREVIATIONS AAA Association of Accountants and Auditors JAFIS Associationfor Public Finance AFU Anti-FraudUnit KM ConvertibleMark (KonvertnbilnaMarka) AG Auditor General LAC1 Loan Administration ChangeInitiative BAC Business Environment Adjustment Credit LRRP Legal and RegulatoryReform Program BENAP Business Environment Adjustment Program MBS Mutual Service Bureaux (WB> MIFI Municipal Infrastructure Finance and BiH Bosnia and Herzegovina Implementation CAFAO Customs and Fiscal AssistanceOffice MFTER Ministry of Foreign Trade and Economic CBBH Central Bank of Bosnia and Herzegovina Relations coso Committee of Sponsoring Organizations MOF Ministry of Finance (Integrated Framework for Internal Control) MOT Ministry of Treasury CPE ContinuingProfessionalEducation OECD Organization for Economic Cooperation and CPAR Country Procurement Assessment Report Development CPPR Country PortfolioPerformanceReview OHR Ofice of the High Representative in Bosnia DPA Dayton Peace Agreement and Herzegovina EAF Entity Armed Forces OSCE Organization for the Stabilityand Cooperation EBPAC Enterprise & Bank PrivatizationAdjustment in Europe Credit (WB) PAC Public Accounts Committee ESI European StabilityInitiative PB Payment Bureau EC European Commission PEIR Public Expenditure and Institutional Review EP ElektroPrivredna PFSAC Public FinanceStructuralAdjustmentCredit EU EuropeanUnion PIC Peace ImplementationCouncil EUBAS EuropeanUnion Banking Advisory Services PlU ProjectImplementationUnit FARAH Financial Accounting, Reporting and PMR ProjectManagementReport AuditingHandbook (WB) PSARP Private SectorAccountingReformProject FBA FederationBanking Agency PSC Public SectorCommittee FBiH Federationof Bosnia and Herzegovina RS Republic of Srpska FIAS Foreign InvestmentAdvisory Service RSBA Republic of SrpskaBanking Agency FMIS FinancialManagement Information System SAI Supreme Audit Institution FMS FinancialManagement Specialist SAO Supreme Audit Office GAO US General Accounting Office SEED South Eastern Europe Enterprise Development GDP Gross Domestic Product Facilitv GFS General FinanceStatistics SEEPAD South Eastern European Partnership on IAA Instituteof Accountantsand Auditors Accountancy Development IAG International Advisory Group SFOR North Atlantic Treaty Organization (NATO) IAS International Accounting Standards StabilizationForce IAPC International AuditingPracticesCommittee SFRY SocialistFederal Republic of Yugoslavia IASC International Accounting Standards SNAO SwedishNational Audit Office Committee SOE State-OwnedEnterprise IC International Community SPA1 StabilityPact Anti-CorruptionInitiative ICG International Crisis Group SRO Self-RegulatoryOrganization IFAC International Federationof Accountants TGL TreasuryGeneral Ledger IF1 International FinancingInstitution TI Transparency International INTOSAI International Organizationof SupremeAudit TSA TreasurySingleAccount Institutions TTA Treasury Transit Account IOSCO International Organization of Securities UNDP United NationsDevelopmentProgram Commissions USAID United States Agency for International ISA International Standardson Auditing Development Regional Vice-president: Shigeo Katsu, ECAVP Country Director: Orsalia Kalantzopoulos, ECCU4 Sector Director: Alain Colliou, ECSPS Sector Manager: John Hegarty, ECSPS Task Team Leader: Roberto Tarallo, LCOAA Bosniaand Herzeuovina: Countnl Financial AccountabilitvAssessment i TABLEOFCONTENTS TABLE OF CONTENTS ............................................................................................................... i PREFACE ...................................... !............................................................................................. IV EXECUTIVE SUMMARY ......................................................................................................... V I ITHECONTEXT . ...................................................... ................................................................. 1 Recent History: Pre- andPost-Conflict ................................................................................... 1 GoverniqgStructures 1 The Entities: FederationofBiHand the RS................................................................................ State-level Institutions ................................................................................................................. ................................................................................................................ 2 LegalFramework ...................................................................................................................... 2 PoliticalPower Structures ........................................................................................................ 3 InternationalCommunityRole................................................................................................ 4 5 EconomicGovernanceIssues ................................................................................................... 6 Public Sector................................................................................................................................ 7 Conflict of Interest....................................................................................................................... Corruption ................................................................................................................................. 7 Anti-Corruption Efforts............................................................................................................... 9 9 I1PUBLIC SECTOR: BUDGETMANAGEMENT, MONITORING AND . EVALUATION, AND OVERSIGHT ........................................................................................ 11 11 BudgetFramework andPlanning.......................................................................................... Strengtheningthe Role of State-levelInstitutions................................................................ 13 Legal Framework ...................................................................................................................... 13 Planning..................................................................................................................................... 14 Budget Policy Coherence and DecisionMaking....................................................................... 15 Budget Coverage ....................................................................................................................... 16 Extra-budgetary Funds.............................................................................................................. 18 BudgetPreparation................................................................................................................. 17 Off-budget Resources................................................................................................................ 19 RevenueManagement............................................................................................................. 20 BudgetExecution..................................................................................................................... 19 Public Sector AccountingandReporting.............................................................................. 21 Budget Classifications and Chart of Accounts .......................................................................... 21 Accounting and Reporting Systems .......................................................................................... 23 Accounting Standards................................................................................................................ 22 Automation of Accounting: Treasury GeneralLedgers...................................................... 24 Debt Reporting........................................................................................................................ BudgetMonitoring andEvaluation....................................................................................... 25 26 ParliamentaryOversight ........................................................................................................ 27 I11PUBLICSECTOR: FINANCIAL CONTROLSAND AUDITING . ................................. 29 Weakness of Audit Functions ................................................................................................. 29 Institutional Basis...................................................................................................................... 29 29 Financial Controls................................................................................................................... Cultural Basis ............................................................................................................................ InternalAuditing..................................................................................................................... 31 32 ExternalAudit ......................................................................................................................... 33 I V PAYMENT SYSTEM, TREASURYAND FINANCIAL SECTOR . ................................. 38 The Payment System............................................................................................................... 38 Bosnia and Herzeaovina: Country Financial Accountability Assessment 11 Payment Bureaux Legacy.......................................................................................................... 38 New Payment System................................................................................................................ 39 Transformation o f the Payment Bureaux .................................................................................. 40 Transition to a Treasury System............................................................................................ 41 Payment Bureaux Role inBudget Execution ............................................................................ 41 Transitory Arrangements for the Treasury System ................................................................... 42 Steps Remainingto EstablishTreasury Systems.................................................................. 43 Treasury System Design............................................................................................................ 43 Establishingthe Treasury Single Account ................................................................................ 45 46 Financial Sector ....................................................................................................................... Treatment of Extra-budgetary Funds under the Treasury System............................................. 47 Central Bank o f Bosnia and Herzegovina ................................................................................. 48 Banlung Supervision: the Banking Agencies ............................................................................ 50 Need to Enforce Compliance..................................................................................................... 51 Need to Retrain Bankers............................................................................................................ 51 V FIDUCIARY CONSIDERATIONS . ...................................................................................... 53 Accountability for Use of ExternalAssistance Funds.......................................................... World Bank-financedProjects: the 2000 Country Portfolio PerformanceReview..........54 56 Institutional CapacityBuildingandRequiredFiduciary Safeguards................................ 57 V I PRIVATE SECTORACCOUNTING AND AUDITING . .................................................. 60 60 Needfor Unified Standards,RegulationandLicensing....................................................... Background.............................................................................................................................. 61 Accounting andAuditing Standards..................................................................................... 62 Regulationof Audit Profession............................................................................................... 64 SimplifiedFinancial Reporting.............................................................................................. 64 Regulatory and Standards-settingBodies............................................................................. 66 Federation o f Bosnia and Herzegovina ..................................................................................... 66 Republic o f Srpska .................................................................................................................... 67 ProfessionalAssociations........................................................................................................ 67 Licensing................................................................................................................................... 68 Federation of Bosnia and Herzegovina ..................................................................................... 68 Republika Srpska....................................................................................................................... 69 Developingthe Profession....................................................................................................... 69 Capacity Building...................................................................................................................... 70 Improved Chart o f Accounts ..................................................................................................... 70 UnifiedProfessionalCertification.......................................................................................... 71 ANNEX 1-MEETINGSCHEDULE ........................................................................................ 72 ANNEX 2 -BIBLIOGRAPHY AND REFERENCES ............................................................. 74 ANNEX 3 - FINANCIALMANAGEMENT AT ENTITY, CANTONAL AND MUNICIPAL LEVELS ............................................................................................................... 76 Budget Framework.................................................................................................................... 78 Budget Preparation.................................................................................................................... 78 Revenues Collection and Management..................................................................................... 78 Treasury..................................................................................................................................... 79 Budget Allocation...................................................................................................................... 79 Financial Reporting................................................................................................................... 79 Intemal Audit ............................................................................................................................ 80 Extemal Audit ........................................................................................................................... 80 Budget Framework.................................................................................................................... 80 Budget Preparation .................................................................................................................... 80 Revenue Allocation ................................................................................................................... 81 Financial Reporting System ...................................................................................................... 81 Auditing..................................................................................................................................... 82 Budget Framework.................................................................................................................... 82 BudgetPreparation.................................................................................................................... 82 Revenue Allocation ................................................................................................................... 82 Financial Accounting and Reporting System............................................................................ 83 Auditing..................................................................................................................................... 83 ANNEX 4 -POLITICAL STRUCTUREOF BIH ................................................................... 84 ANNEX 5 MAP- .......................................................................................................................... 85 BOXES Box 1.The Yugoslav legacy............................................................................................................ 6 Box 2.Public FinancialManagement inEastern Europe socialist-type governments ..................30 Box 3.BiH Supreme Audit Institutions (SAI): Legal Provisions inneed o f strengthening..........36 Box 4.Evolution of Payment Bureax inother former SFRY countries ........................................ 38 Box 5.Teethingproblems experienced with the introduction o f the new payment system ..........40 Box 6.Banking agencies ............................................................................................................... 50 Box 7.PIU-managedprojects: main financial management issues outlined inthe CPPR ............56 Box 8. Training and Technical Assistance from USAID .............................................................. 63 Bosnia and Herzeaovina: Country Financial Accounfabiiitv Assessment iv PREFACE This report was prepared on the basis o f the findings o f a World Bank mission to Bosnia and Herzegovina from February 19 to March 9, 2001, by a Task Team comprised o f Roberto Tarallo, Team Leader and Siew Chai Ting, Resident Sr. Financial Management Specialist. The task was part o f a larger World Bank mission, comprising the Task Team for the Country Procurement Assessment Report (CPAR), led by Shaun Moss, Team Leader; and the Task Team for the Public Expenditure and Institutional Review (PEIR), led by Sebnem Akkaya, Team Leader. The CFAA's and CPAR's main findings and recommendations were incorporated into the BiH Public Expenditure and Institutional Review (PEIR), publishedas World Bank Report No. 24297. Relevant PEIR findings are also incorporatedinto this CFAA, which reflects developments through early 2002. The report is based on the results o f interviews with public and private institutions, at the State, Federation, and Republic o f Srpska levels, as well as on detailed analysis o f the laws, documents and other information collected. On the part o f the government and private sector institutions, the counterparts to the assessment lent their full and proactive support to the CFAA mission and engaged with the Bank's team in a comprehensive dialogue about the issues identified by the assessment. The Bank is grateful to the Governments o f Bosnia and Herzegovina for this cooperation. The list o f counterparts met is providedinAnnex 1and documents reviewed inAnnex 2. Purposeof the Report A CFAA considers the strength o f the financial accountability framework in both the public and private sectors. The aim i s to assess whether the existing framework, as designed and as practiced, i s sufficient to ensure proper use o f funds, both the country's own resources as well as those provided by the Bank and other institutions. One o f the CFAA's main purposes i s to assist the Bank in assessing the risks which the financial accountability framework poses for the implementation o f Bank programs and the use o f Bank funds, and to propose suitable measures to manage these risks. It also supports dialogue with the borrower country and development partners on financial accountability matters, and assists in the design o f programs to build financial management capacity. The CFAA involves a diagnostic exercise covering the financial management systems o f both public and private sectors o f a country. It i s 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 o f financial management systems, a diagnosis o f problems and advice on their resolution, and an indication o f the level of financial accountability risk inthe country concerned. Each CFAA i s expected to cover a minimum core content-areas that must be covered in all CFAAs. Although financial accountability encompasses a wide range o f activities in the private and public sectors o f an economy, for the purpose o fthe CFAA, the following are considered to be core: Bosnia and Herzeaovina: CFAA - Preface V Budgeting Public Sector Accounting and FinancialReporting Public Sector Internal Controls System Public Sector Auditing Legislative Scrutiny o f the Public Sector Financial Management Private Sector FinancialAccounting and Auditing Practices Inthe context of a country's overall governance environment, the executive arm of the government has an obligation to the public for safekeeping and proper use o f public resources entrusted by its constituents, and to provide a credible 1egaVregulatory framework to promote good financial governance inbothprivate and public sectors o fthe economy. The institutional and legal/regulatory regime that seeks to provide this assurance constitutes the public financial accountability framework in a country. In the context o f the private sector, the accounting and auditing regulatory framework and associated enforcement mechanisms should provide reasonable assurance to interested parties that financial operations are conducted properly and that investments are managed with due care and are protectedfrom the risk o f fraud andmisuse. The Bank's interest in the CFAA primarily lies in providing inputs for managing 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. It is therefore necessary for a country to develop a proper financial accountability framework, in design as well as inpractice. The CFAA, therefore, needs not only to focus on the existing systemic weaknesses giving rise to fiduciary risks, but also to present advice on developmentalneeds. Acknowledgements The mission members wish to acknowledge the extensive cooperation and assistance received from officials and staff o f the public organizations, state agencies and private sector institutions interviewed. Mr. Simon Gray, Lead Country Officer for Bosnia and Herzegovina, offered invaluable assistance and information in advance o f the mission. Mmes.Jasmina Hadzic and Julija Maric, Team Assistants inthe Bank's Sarajevo Office, provided support with logistic arrangements for the mission and, together with Ms.h i l a Kuka, Program Assistant, ECSPS, with report preparation. Messrs. John Hegarty, ECA Regional Financial Management Adviser, and David Shand, FM Advisor and Peer Reviewer, offered invaluable comments and provided other important inputs to the task. Ms. Suzanne Snell, Consultant, and Gilma Unda, Program Assistant, LCOAA, assisted with the editingand formatting o fthe report. Bosnia and Herzeqovina: CFAA - Execufive Summarv vi EXECUTIVESUMMARY BACKGROUND This Country Financial Accountability Assessment (CFAA) was prepared on the basis o f the findings o f a World Bank mission to Bosnia and Herzegovina in 2001, and reflects developments through early 2002. The CFAA was a constituent element o f the Public Expenditure and Institutional Review (PEIR) publishedinJune 2002 on the basis o f work carried out in 2001-2002, and the key findings o f the CFAA on the public expenditure policy and institutional framework form a significant part o f the PEIR section dealing with financial management in the government sector. While some o f the diagnosis presented inthis CFAA may have been overtaken by events since early 2002, most o f its recommendations remain valid and the report provides a sound analytical framework for ongoing reforms in the field o f public expenditure management. The CFAA also serves as a reference for stakeholders, external and domestic alike, with an interest in issues o f financial accountability. COUNTRYCONTEXT Following four years o f civil war, the December 1995 Dayton Peace Agreement (DPA) established Bosnia and Herzegovina (BiH) as a country o f two Entitiesand a central State government. Each o f the two Entities, the Federation o f Bosnia and Herzegovina (FBiH) and Republic o f Srpska (RS), enjoys a high level o f autonomy. While the State government has responsibility for foreign affairs, trade, monetary policy and a few other key areas, nearly all political control and fiscal management in BiH resides within the Entities. The DPA also established the Office o f the High Representative (OHR). The High Representative, a senior foreign diplomat, is charged with monitoring the implementation o f the civilian part o f the Peace Accords on behalf o f the International Community (IC) and is the de facto executive power. Since December 1997, the HighRepresentative has been able to impose decisions in case o f disagreement and to dismiss officials who obstruct the Dayton Accords or engage in corrupt behaviors. Important decisions related to the implementation o f the DPA or other aspects o f the country's stewardship are often reached only after pressure fiom the international community (IC). The country i s in transition not only to a market and a post-war economy, but also to a peculiar (and still fragile) conception o f statehood. Public administration in BiH combines pre-war, wartime and post-war institutions, often exercising overlapping administrative authority. The administrative organs operating within a complex governmental structure, the international strategy focus i s on building the institutional base o f BiH's democracy and fiscal management, using international influence to protect key institutions duringtheir vulnerable early phase, andbringthem to a point where they can sustain themselves after international support i s withdrawn. At the same time, the way to Europebeingthe creation o f a single free economic space in BIH, harmonization and creation o f common institutions are crucial. Statehood needs to be reinforced and specific areas need to be strengthened inthe two Entities inview o f the Bosnia and Herzeaovina: CFAA - Executive Summarv vii requirements for EU accession. The CFAA recommends support o f the shift o f key institutions and processes from the Entities to the State as advocated by the IC. Such a shift would empower State institutions with stable and predictable budgetary resources and ensure harmonized fiscal management and oversight. At the same time, to mitigate concerns about over-centralization, effective governance should be promoted at the cantonal and municipal levels, where financial accountability i s also weak. PUBLIC FINANCIALMANAGEMENT Bosnia and Herzegovina (BiH) has made significant strides in developing key elements of its public expenditure management (PEM) systems over the last seven years. At present, the system operates within an improved legal and institutional framework inter alia for budget management (both Entities have adopted organic Budget Laws, complemented by Annual Budget Laws, Laws on Budget Execution and Laws on Implementation o fBudget), foreign debt management and external audit. Beginning in 1999, both Entities and selected cantons in the Federation began creating the necessary conditions for improving the linkages between their macro-fiscal planning and budgeting within a simplified version o f a medium term expenditure framework (MTEF). In2000, the Supreme Audit Institutions began operatingboth at the State level and in each Entity, gradually improving the transparency o f the operation o f the budgetary institutions. The closure o f the Payment Bureaux (PB) inJanuary 2001 marked the beginning o f movement toward a Treasury system, with each Entity having its computerized Treasury system inplace as o f January 2002, albeit partially covering State and sub-Entitylevel budgettransactions. Considering that these reforms have been implemented against a backdrop o f a dual process o f nation building and economic transformation in a war-torn economy, they become all the more impressive.Nevertheless, these very challenges have often become a factor in slowing down the realization o f full benefits of reforms because they translated into both weak implementation and enforcement capacity in BiH's fragmented govemance framework. The most obvious evidence o f these capacity limitations are widespread public payment arrears, large off-budget public sector activities, and poor outcomes inresource allocations and quality o fpublic services. In the period ahead, much remains to be developed and aggressively implemented, if BiH's public expenditure management and financial accountability systems are to help authorities move toward fiscal sustainability in a self-governed fiscal management framework. In particular, in the specific area o f public financial management, proper institutional and governance arrangements would enable the authorities to introduce a system o f checks and balances for more disciplined, transparent and accountable fiscal management - through effective monitoring, evaluation, audit and legislative oversight o f finances and performance o fbudget programs and activities. Bosnia and Herzeqovina. CFAA - Execufive Summarv 1111 BUDGETPLANNING, MANAGEMENT AND OVERSIGHT In BiH, fiscal management is conducted separately in 14 political structures, each of which has independent executive and legislative powers. This makes achieving consensus and policy coherence more challenging, not only because o f the numerous, often ethnically based checks and balances that the system embodies (especially at the State and Federation levels), but also because o f weak centers o f government, with limited capacity in promoting binding and sustainable budget decisions and policy outcomes across BiH. To foster harmonization, the CFAA recommends that the proposed revisions to the Organic Budget Laws include provisions for specifying: timing and modalities o f consultations and information exchange between central and local levels within each government; introduction o f systematic bottom-up reporting; and consolidation o f the fiscal data at the center (Le. State; Republika Srpska and Federation central governments). At the same time, the CFAA recommends that the linkage between the macro-fiscal framework and the budget be strengthenedby providing for medium-term forecasts and a statement on the budget's main policy objectives inthe Organic Budget Laws. The Entity governments (and over time the State) should assume a principle role in defining the overall macro-fiscal parameters that will guide preparation of sub-Entity (and over time, sub-national) budgets. The requirements for the justification o f budget proposals from Budget Institutions (BIs) also need to be strengthened, both by improving the specificity o f the required information and by broadening the economic and functional categories on which information i s requested. The CFAA recommends that governments consistently follow the Budget Framework Paper developed in consultation with the World Bank (WB) for the preparation o ftheir annual budgets. Bothbudgetplanningand executionpresent disfmctionalities, mainly due to: the absence o f a comprehensive resource framework (implying fragmented resource management, with particularly poor attention to consolidating externally financed expenditures and off- budget domestic resources, such as privatization receipts and off-budget earmarked resources); and the disconnect between legal and regulatory framework, on the one hand, and concrete decision-making and management practices, on the other (for instance in managing extra-budgetary funds, mainly Social Security Funds, comprising one-third o f consolidated on-budget revenues in both Entities). In addition, there i s an extreme separation o f the recurrent expenditure side o f the budget (mostly financed by domestic revenues and donations) and its investment and capital expenditure part, exclusively financed by foreign resources. Budget execution weaknesses are compounded by inadequate internal controls, insufficient reporting and public disclosure, as well as a lack o f comprehensive monitoring and evaluation, and legislative oversight. Expanded budget coverage, and integration o f extra- and off- budget resources into the overall resource framework, i s essential to the preparation o f realistic and effective budgets in BiH. The CFAA recommends that: reporting on the extra-budgetary funds (EBFs)be improved by enforcing the requirements o fthe Organic Budget Law for better scrutiny; budgetary support that each EBF receives during a fiscal year be systematically defined based on sound financial planning and reporting by the EBFs; and EBFs be Bosnia and Herzeuovina: CFAA- ExecutiveSummaw ix subject to the same annual auditing requirements as those o f other fiscal accounts, Likewise, off-budget fiscal resources need to be incorporated into the budgets by all levels o f governments. These resources could still be directed to their original use, but they must be included in the budget submissions and subject to the same budget controls as other public fiscal resources. In the area of accounting, the CFAA endorses the full adoption o f Treasury General Ledgers (TGLs) and the accounting systems they support, which would centralize the cash rationing system within the Treasury. Placing the final payment decision at Treasury eliminates breaches o f legality and possible arbitrariness in payment selection by spending units, and ensures adequate control over the consistency o f the nature, type and amount o f the expenditure with budget allocations. The CFAA explicitly supports integrating the databases used for recording debt and repayment into the new TGL system. To allow for optimization o f cash management and tracking o f arrears - until computerized Treasury General Ledgers (TGLs), systematically applying commitment accounting, will be fully operationalized - the CFAA recommends the enforcement of commitment recording at all level o f governments The implementation of the Project/Grant Accounting module o f the new accounting systems i s particularly relevant and recommended by the CFAA: with opportune and minimal adaptations, this module offers the prospect o f being able to use BiH's own accounting and reporting system to support World Bank and donor-assisted project execution; and ensure that these resources are fully accounted for. Interms of financial reporting, the CFAA recommends that timely, relevant reporting on budget execution be prepared by the governments and presented to the legislature for discussion. In particular, the Ministry o f Finance o f each sub-Entity government should prepare periodic budget execution reports (on at least a quarterly basis) and reports on EBFactivities, with a content designed to allow analysis of important fiscal parameters. Finally, at present, the non-existence or ineffectiveness o f the PACs perpetuates the vacuum o f legislative scrutiny over the executive. The CFAA stresses the importance of creating strong budget oversight finctions at all level o f governments, and o f separating it fiom other legislative functions, while ensuring that effective coordination and collaboration i s established betweenPACs and Supreme Audit Institutions. FINANCIALCONTROLSAND AUDITING The financial accountability framework in BiH is permeated by the weakness o f the control environment in which public finance management have historically taken place. Sound audit functions have started to develop, following on the greater emphasis placed on them by the World Bank, donors and other development partners under their programs inBiH.Independent, external audits ofgovernment accounts beguninlate2000, with the setup o f the Supreme Audit Institutions (SAIs). However, with the exception o f a few cantons that have developed the relevant legislation and started implementation, modem intemal audit functions are still lacking at all tiers o fBiHadministrative structures. Bosnia and Herzeaovina: CFAA- Executive Summaw x The Entities' work on internal auditing must be brought up to comparable speed with that o f the external auditing achievements. The establishment o f a sound control environment is, in fact, key to the improvement o f financial accountability in BiH. The first and most effective line o f defense against corruption and misconduct is the establishment of adequate management controls within the executive, such as budgetary controls and internal auditing, as well as monitoring and evaluation systems. Inthe period ahead, the full-scale implementation o f the TGL systems and their expansion to the sub-Entitylevel within a Treasury framework that will avoid institutionalizing fragmentation in fiscal management will go a long ways towards improving overall financial controls and accountability inBiH. The main vehicle for the establishment o f a strong control environment is institutionalized intemal controls and intemal auditing within public sector institutions- a radical change in the BiH context. The CFAA recommends that modern internal audit functions be introduced within government institutions, in a way that pilots the evolution of the existingMOF InspectionUnits towards an internal auditing department model. The CFAA recommends adoption o f a legislative and organizational framework for a sound internal audit systemboth at the Entity and State level, buildingon the extemal assistance provided to date. Each Entity and canton M O F should develop a time-bound implementation timetable for adopting this framework by developed at working across the various governmental institutions, and gradually expanding it to municipalities and other public institutions. The establishment o f proper internal audit functions can, in fact, only be seen as a medium-termprocess and can be achieved only through a gradual approach, startingthe process with the M O F at the level o f the Entities and then gradually expanding to cantons, municipalities and other public institutions. Initially, the setup o f a small, centralized, independent, and highly professional internal audit department within the MOFs would be more cost-effective and efficient than the establishment o f internal auditing departments in the various ministries and agencies although, in the longer term, this shouldbethe objective. A few cantons (including Sarajevo, Tuzla and Bihac) have already introduced internal audit functions in connection with the technical assistance and capacity building support provided by the World Bank PFSAC 11. The Tuzla legislation, based on a model developed in collaboration with the WB, could form a model for use throughout other cantons in the Federation as well as for the development o f internal auditing o f the Federationand Republika Srpska central governments. The extemal audit function was introduced inlate 2000, with the operationalization o f the SupremeAudit Institutions (SAI) ineach Entity and at the State level, with co-ordination arrangements and a uniform legislative framework (which, however, needs further alignment and strengthening). The WB supported the establishment o f Supreme Audit Institutions (SAIs) in the two Entities and the State as a key element o f the Public Finance Sector Adjustment Credit (PFSAC 11). Since their establishment, supported by donor assistance, all three SAIs undertook an audit o f the public administration institutions, including a significant number o f sub-Entity governments. At present, the Bosnia and Helzeaovina: CFAA - Executive Summarv xi SAW work is necessarily focused primarily on compliance audits, though they aim to develop the necessary skills to perform financial (or attestation) audits. One o f the most urgent priorities for the State and the Entity governments in the near term i s the strict enforcement o f existing rules and regulations on public sector accounting and financial reporting, as well as ensuring SAIs' full access to auditable accounting records and other necessary financial information. The CFAA also assigns high priority to the need to institutionalize working relations and collaboration both between SAIs and respective Parliamentary Public Accounts Committees (PACs) and between SAIs and bodies in charge o f governmental internal audit functions. The CFAA recommends consideration o f the need for creating a legal basis for permanent legislative oversight over the SAIs, through the establishment o f dedicated Parliamentary Audit Committees. The CFAA recommends preparationo f a needs assessment and mobilization of firther external technical assistance to facilitate expansion o f audit activities to cover all mandatedareas. The CFAA also strongly recommends that SA1activities be given adequate financing that i s tied to the annual work plan. Ensuring adequate funding and mobilization o f the necessary external technical assistance for the SAIs should be an unconditional priority of the State and the Entity authorities if the SAIs are to rapidly assume the full range o f activities assigned to them, all o f which are critical for effectively strengthening public sector financial accountability. PAYMENTSYSTEM Treasury The new payment system in BiHbegan to function on January 5,2001, and on the same date, payment transactions through the Payment Bureaux stopped. The Central Bank of BiH (CBBH) took over the clearing and settlement functions. In the Federation, the Treasury function i s to be performed by the M O F and taxes collected by the Tax Administration; responsibility for the two main statistic surveys has been transferred to the Federal Office o f Statistics. Similar procedures have been adopted inthe RS. The interim, transitory arrangements for revenue collection and payment transactions were in place for all governments through 2001. While these arrangements have since been superceded by the newly established computerized TGLs at the Entity levels, the transitional arrangements continue to operate at the State and sub-Entity levels. As a result o f the slow pace o f implementation o fthe Treasury Single Account (TSA), the only transactions that the Federation and RS governments currently control are those relating to the collection o f revenues at the central government level, and the authorization of expenditures from the Treasury-MOF main accounts to the budget institutions. Municipal government budget execution in both Entities i s outside the control o f the central (cantonal for the Federation) governments and the reporting lines are unclear and very weak. The lack o f clear organizational arrangements i s compounded by serious capacity issues. Treasury departments lack financial planning capability to improve cash management and Bosnia and Heneuovina: CFAA- Executive Summary xii financial planning, required to ensure smooth budget execution and tracking o f arrears. There is generalized lack o f understanding and appreciation o f the role o f the Treasury: its role being confined to payment administration, while cash management functions are not yet inplace. The CFAA would encourage BiH governments, at all levels, to demonstrate stronger commitment in pushing ahead the full implementation o f the new Treasury system by way o f removing the remaining obstacles faced in establishing the Single Treasury Account. In particular, the CFAA recommends that the State Treasury and sub-Entity MOFs concentrate their efforts on establishing a proper control environment over disbursements, introducing standardized ex-ante and ex-post intemal controls to ensure that the transitory system incorporates adequate checks and balances. An immediate measure recommended by the CFAA is to eliminate the use o f individual budget institutions accounts (i.e. imprest accounts) and to ensure the establishment o f adequate cash management functions, and the use o f Treasury Single Account. FinancialSector The banking system is weak and presents serious problems. Domestic private banks are illiquid, undercapitalized, exposed to non-performing loans, and poorly managed. Slow progress has been made in the privatization o f state-owned banks, which remain a drag on the vitality o f the banking system. Even privately owned banks that have no dubious issues from the pre-war period are faced with asset and solvency problems resulting from insider relationships and related party transactions. Notwithstanding the excessive number o f credit institutions, giventhe existing economic poential and the modest credit potential, the Federation banking sector has recently registered substantial improvements and can be, in general, regarded as sounder than that o f the Republika Srpska, where the situation could progressively worsen, inthe absence o f appropriate regulatory actions. The CFAA recommends that the regulatory and supervisory functions o f Banking Agencies be enhanced, and that sanctions be enforced on banks in both entities that are not in compliance with regulations. The obligation for an audit o f annual financial statements o f banks has proven the most critical area o f non-compliance. At the same time, the verification o f fit and proper ownership and management o f banks in both Entities should include potential conflict o f interest (ownership by related persons or parties holding key management positions). FINANCIALMANAGEMENT FIDUCIARYCONSIDERATIONS Without donor funds, the post-war reconstruction o f BiH would not have been possible. In the adjustment phase required by the public finance stabilization process, donor financial assistance and significant budgetary support will remain indispensable over the short to mediumterm. The International Community is generally active in diagnosing weaknesses and problems affecting proper accountability for uses o f funds, and in implementing actions to ensure concrete application o f opportune fiduciary safeguards. However, in order to ensure effective coordination and lasting results, the CFAA recommends that sound financial Bosnia and Herzeaovina: CFAA-Executive Summarv xiii management for foreign assistance be given a higher priority on the Peace Implementation Council's agenda, to be dealt with on a comprehensive basis and notjust interms ofadhoc, disconnected initiatives as is presentlyoftenthe case. Based on the analysis o f the existing financial management systems and procedures, the capacity o f its institutional and human resources, and the threat o f corruption, the CFAA finds that the environment for project implementation inBiHi s highrisk and requires the continued application o f appropriate mitigation strategies to minimize fiduciary risks and maintain them at acceptable levels. The CFAA has the four main recommendations to increase accountability for the use o f external funds: (i) reorganize the aid management function in each Entity in order to ensure direct information flow to the MOFs, with eventual transfer o f foreign-financed project databases to the Treasuries; (ii)define core project-specific information that Project Implementation Units (PIUs) will be required to report and synchronize information collection from donors with the budget cycle; (iii)initiate a process for inclusion o f projects financed by external credits as capital expenditure in the relevant line ministrybudgets; and (iv) establish a requirement for estimating future recurrent cost implications o f ongoing and new investmentprojects. The existence o f PIUs as independent organizations within the public sector could represent another factor limiting the role o f line ministries in policy formulation and implementation o f their programs. Therefore, while the CFAA considers it appropriate to maintain the current ring-fencing arrangements inproject implementation, it reiterates the BiH 2000 Country Portfolio Performance Review (CPPR) recommendations to: (i) consolidate PIUs and (ii)refrain from creating new PIUs for future projects, unless justified by exceptional reasons. The medium- to long-term goal would be to implement opportune capacity building initiatives which, inturn, would allow all projects to migrate into the responsible ministriedagencies andbe mainstreamed once fiduciary risk has been reduced. At the same time, the CFAA recommends that report-based disbursement should not be introduced inthe BiHportfolio at this stage because o f significant risks relating to project financial management, PIUcapacity, the banking system, and general governance issues. N o concerns were raised, by the CFAA mission, as to the front-end accountability aspects o f the flow o f funds receivedunder adjustment-type operations. PRIVATE SECTOR ACCOUNTINGAND AUDITING The governments o f Bosnia and Herzegovina have committed to making the transition to a market economy, and the Entities are actively reforming the national accounting and auditing methodology, supported in these efforts by independent professional organizations. However, the country needs an appropriate, unified national regulatory regime for accounting and auditing that brings into alignment the different Federation and RS regimes, before serious differences begin to emerge. The objective should be the development o f a State-level, unified approach to accounting and auditing disciplines, as well as to the regulation o fthe accountancy and auditing profession. Bosnia and Herzegovina: CFAA - Executive Summarv xiv The CFAA finds that the successful establishment o f a State-level institutional set up for the regulation o f the audit profession i s a key element for creating a sustainable environment for continued reform. The CFAA recommends that existing independent professional organizations work together towards the establishment o f a single State-level regulatory body that would also qualify for full membership in IFAC.N o application for IFAC membership should be submitted until the State-level regulatory body i s established, fully finctioning and empowered. Likewise, the development o f a single accounting professional certification program for BiH through a State-level Self-Regulatory Organization (SRO) - representing, and composed o f members o f the professional organizations in both Entities - provides the best chance for sustainable and uninterruptedprivate sector accounting reform, laying the foundations for successful participation in regional and world markets. However, no official mandate exists at present with the State to require Entity associations to cooperate informing such ajoint venture. The CFAA strongly recommends that the formation of a unified accounting and auditing profession at the State level be mandated, to represent andlead accountingreform for bothEntities. As to accounting, at the present time, there are no formal requirements imposed by law. The informal arrangements existing in practice, within business entities, are basic bookkeeping , financial reporting for tax compliance, and intemal (unofficial) reporting. Managers o f enterprises show no ownership for the preparation o f general purpose financial statements, which are o f little use to outside investors. Few accountants understand (or are capable o f applying) the Entities' standards in the preparation o f financial statements. As a result, non-compliance with the standards i s observable in areas such as consolidated accounts, interpretation o f accounting policies, asset valuation, and depreciation. Rather than rigid application o f intemational standards, what i s required at this point in time are practical tools, such as a more useful chart o f accounts, and extensive retraining o f accountants and auditors. Most small to medium-sized enterprises, in fact, do not (and cannot) have the appropriate infrastructure or expertise to prepare sophisticated financial statements complying with International Accounting Standards (IAS), or their local adaptation; moreover, they have no need to do so. The CFAA strongly recommends the establishment o f a more appropriate, two-tier system, articulated in distinct requirements for small and medium- sized enterprises on the one hand, and large enterprises on the other. A reasonable way to proceed i s to maintain tax accounting for all enterprises, supplemented by binding, pure IAS for the very small number o f companies that wish to use them or that the CFAA believes should be obliged to use them (all companies listed on the stock market, banks, insurance companies, utilities, privatized enterprises, cross-border and multinational enterprises, PIF and mutual finds). For small and medium-sized businesses, which are currently the majority in BiH, accounting and reporting requirements could be limited to compliance with tax accounting. Based on the experiences o f other continental-Europe countries, the remedy for widespread non-compliance with intemational accounting and auditing standards recommended by the CFAA i s the establishment o f an appropriate link between Bosnia and Herzegovina: CFAA -Executive Summarv xv accounting standards and tax reporting through the creation o f an adequate chart of accounts for private sector use. Standards alone are not implementable. Accountants also need methodological instructions on how to implement IAS-based standards in private sector work, and this requires an IAS-compatible chart o f accounts. Such a chart of accounts would support IAS financial statements and, at the same time, would form the basis for tax reporting and tracking the data needed to reconcile the financial and tax accounting models. Finally, there i s a need for an appropriate program o f capacity development to support both the implementation o f a unified regulatory regime and the enhancement o f the skills o f 8,000 practicing accountants and auditors. The CFAA finds that there i s a need to re- certify the practitioners who accessed the accountancy and auditing profession prior to the establishment o f the new curricula, in accordance with acceptable international benchmarks. I. CONTEXT THE RecentHistory:Pre- andPost-Conflict 1. Bosnia and Herzegovina (BiH) i s one o f the smaller European countries, situated inthe Balkan peninsula (South-Eastern Europe), with a population of about 3.7 million (1999 estimate), that i s composed o f three major ethnic and religious groups: Bosniacs, Serbs, and Croats, with other small minority ethnic groups. 2. BiHis one o f five republics born out o f the disintegration o f the former Socialist Federal Republic o f Yugoslavia (SFRY). The other four are Slovenia, Croatia, Former Yugoslav Republic (FYR) o f Macedonia, and the Federal Republic o f Yugoslavia (FRY), composed o f Serbia and Montenegro (see IBRDMap 30689 at back o f report). At the end o f February 1992, following the independence o f three o f these (Slovenia, FYR o f Macedonia, and Croatia), BiH held a Referendum o f Independence. Over 65 percent of its citizens declared BiH an independent, sovereign country within its historically established borders. On April 7, 1992, BiH was internationally recognized as an independent country and became a member o f the UnitedNations. 3. A civil war that lasted from April 1992 to December 1995 saw all ethnic groups fighting among themselves for the control o f territories. The war ended with the signing of the Dayton Peace Agreement (DPA), which avoided the disintegration o f BiH by establishing the State o f Bosnia and Herzegovina (the central authority) and two Entities, each with a high level o f autonomy. The two entities are the Federation o f Bosnia and Herzegovina (the Federation) and the Republic o f Srpska (RS). This multi-tiered governance structure was further expanded in March 2000, when the Brcko territory was declared an Autonomous District. 4. The Agreement also established the Office o f the High Representative (OHR). The High Representative, a senior foreign diplomat, i s charged with monitoring the implementation o f the civilian part o f the Peace Agreement on behalf o f the International Community (IC), and coordinating the activities o f international organizations operating inBiH. The HighRepresentative is advised by the Peace Implementation Council (PIC), which includes all signatories to the Dayton Agreement. GoverningStructures 5. The very first lens neededto analyze the framework o f financial accountability in Bosnia and Herzegovina i s to understand its unique and complex governance structure (the chart in Annex 4 displays the structure o f BiH's governments). A single sovereign state with a highly decentralized administrative structure, BiH is intransition not only to a market and a post-war economy, but also to a peculiar, and still fragile, conception of statehood. BiH: CFAA- The Confexf 2 State-level Institutions 6. Under the Basic Principles agreed in Geneva and New York in September 1995 and confirmed at Dayton, Ohio (USA) on November 21, 1995, the State i s delegated responsibility for monetary policy; external affairs, including foreign trade and customs policy and international debt; immigration, refugee and asylum policy; and inter-Entity criminal enforcement and regulation o f inter-entity transportation. The State is entitledto pass all necessary legislation controlling these aspects o f the law. The Entities are then required by the Constitution to enact regulations that do not contradict State legislation. The following institutions exist at the State level: Parliamentary Assembly, Presidency, Council o f Ministers, Constitutional Court, and Central Bank. Legislative power at the State level is vested in a bicameral parliament, the 42-member House o f Representatives and the 15-member House o f Peoples. Two-thirds o f members o f the House of Representatives are elected from the Federation and one-third from the Republic of Srpska. The House o f Peoples consists o f five Bosnians and five Croatian delegates nominated by the Federation House o f Peoples and five Serbian delegates nominated by the RSNationalParliament. 7. The Presidency o fBiH(Head o f State) consists o f a rotating collective presidency o f three elected members, one from each constituent people: Bosniac and Croat from the territory o f the Federation o f Bosnia and Herzegovina; and Serb from the territory o f Republic o f Srpska. Each member o f the presidency serves as chairman for eight months. The Presidency collectively nominates the Chairman o f the Council o f Ministers, who takes office upon the approval o f the House o f Representatives. The Chairman i s the Prime Minister, who establishes his government by appointing six state-level Ministers and their deputies. Two-thirds o f all ministers at most may be appointed from the Federation. Deputy ministers must belong to a different ethnic group from that o f the minister.The five appointedministers and their deputies are also approved by the House o fRepresentatives. The six ministers constitute the State Council o f Ministers. 8. The highest judicial authority is the Constitutional Court o f BiH. It consists of nine members: four members nominated by the House o f Representatives from the Federation; two members elected by the RS; the other three members are nominated by the President o fthe EuropeanCourt for HumanRights, inagreement with the Presidency. TheEntities: Federation of BiH and the RS 9. Interms of administrative divisions, Bosnia and Herzegovina is made up of two Entities-the Federation o f Bosnia and Herzegovina (the Federation) and the Republic of Srpska (RS)-plus the self-administering Brcko District (see IBRD Map 30689, at end of report). The District o f Brcko, whose status was not resolved by the Dayton Peace Agreement, has been administered directly under the State o f Bosnia and Herzegovina since March 8, 2000. The Federation is administratively subdivided into ten cantons. According to the DPA, all power not vested in the State (Central Government) i s conferred upon the Entities which, in consideration o f the current, limited scope o f State powers, are endowed with broad capabilities. The decentralized institutional and administrative structure o f the Federation also leaves significant political independence to the cantons. BiH: CFAA - The Context 3 10. The Entities may be seen as two semi-autonomous states joined together in a loose federation. * They are expressly assigned responsibility for all governmental functions and powers that do not fall under the purview o f the State. They are the sole revenue-raising bodies and have broad control over the courts, police, ordinary legislation, education and, for the RS, local governments. With respect to the military, the State Constitution recognizes that each o f the ethnic groups inBiHhas command over its own armed forces which, at present, do not answer to a central authority.2 11. The Federation is headed by a premier and has a bicameral system (House o f Representatives and House o f the Peoples). The Federation government consists o f 13 ministries, based in Sarajevo and Mostar. Its sub-national governmental administrative structure consists o f cantons and, within the cantons, local governments (municipalities). Each canton and each municipality has its own elected assemblies and governments, which are empowered locally to implement various policies and regulations. 12. The Republic o f Srpska is a unitary Entity headed by a premier, with a single assembly (National Parliament) and a directly elected president. Its government consists of 19 ministries based in Banja Luka. The sub-units o f RS governmental administration are its municipalities. Legal Framework 13. There are three constitutions in force inBosnia and Herzegovina, one each for the State, the RS, and the Federation. The 1995 State Constitution i s laid out in Annex 4 o f the DPA and governs the relations between the two Entities within the state. The constitutions o f the Federation, which came into force in 1994, and o f the Republic o f Srpska, which entered into effect in 1992, were subsequently amended to bringthem into compliance with the 1995 BiH State Constitution. The Republic o f Srpska Constitution established the RS government and set forth the powers o f the respective bodies within the RS. The Federation Constitution instituted the Federation government. The Federation consists o f a federal government, ten cantonal governments (some Muslim- dominated, some Croat-dominated, and some mixed), as well as municipal governments. The cantons are granted all powers not expressly reserved for the Federation. 14. This setup, shown inthe chart o f Annex 4 o f this report, results in a fragmented and significantly weakened legal framework. The legal systems o f the Entities have, in fact, a high degree o f independence; greater cooperation between the Entities in adopting and implementing uniform, consistent laws and regulations i s slowly surfacing. In particular, delegating authority to the Entities for the implementation o f legislation in "Given the capacity of the Entities to veto legislation passed by the Central Govemment, the structure of the govemment in BiHis better understood as two semi-autonomousstatesjoined together in a loose federation". Foreign Investment Advisory Service,Bosnia and Herzegovina: Administrative Barriers to Investment, January 2001 I The Dayton Agreement was a territorial and political compromise that ended the war in BiH. It did not require the dismantling of the wartime regime: armies, police and other security services remainedin place. Significant progress has been, however, recently achieved toward forging a Common Defense Policy for BiH. This is the first step in the directionof establishinga State-leveldefense identity which will help fulfill an essential condition for BiH to become part of the Euro-Atlanticstructuresand enhance stability in SouthEast Europe. BiH: CFAA - The Context 4 compliance with the BiH Constitution has proven problematic. Although the Entities are obliged to pass laws that conform to State legislation, inpractice, the Entities have often used this structural autonomy to create a default veto power over any unpopular legislation by delaying the adoption o f Entity-level laws that comply with BiHState laws. The Entities may also elect not to implement BiH laws by invoking a clause in the BiH Constitution that allows them to decline implementation o f legislation that contravenes their national interest. The language o f this clause is so broad as to allow the Entities to opt out o f legislation at will, thereby giving each Entitythe status o f a de facto country. 15. The consequences o f such decentralized administrative structure are clearly observable inthe area o f public sector financial management where the introduction o f a comprehensive framework to ensure and promote transparency and accountability in public finance management, and to provide legislative and enforcement bodies with the necessary information to exercise oversight over the executive regarding the management of public finances, i s still in progress. Broadening and deepening these reforms is only the first step: the implementation and enforcement o f a sounder system o f checks and balances - in the political realm as well as in financial and economic management - should aim at the creation o f a climate o f collaboration among the various factions in the achievement o f the common good, helpingto restore public confidence, avoiding the risk of gridlock and the repeated imposition o f solutions by external authorities. Political Power Structures 16. The political field in Bosnia and Herzegovina is still affected by significant difficulties typical o f a post-war environment. A basic feature o f the situation in BiH prior to the October 2000 elections was the dominant role played by ethnically based political parties in the central govemment and entity legislatures, executive and administrative positions, whose political activity aimed largely at promoting or safeguarding the interests o f the groups they represented. Differences in the political agenda o f the major parties made it difficult to reach consensus in the legislative bodies of the State, the Entities, and even the Presidency, with serious implications for the passage, implementation, and enforcement o f legislation. 17. Although technically the three nationalist parties are no longer inpower since the October 2000 elections and the new governments are operating under the aegis o f the Alliance for Change, differences in political agenda are likely to continue. The new governments have expressed their commitment to reform, by way o f introducing more cohesive governance processes; concrete evidence o f change i s slowly surfacing. 18. This extreme polarization has implications in terms o f public confidence in officials and politicians, which i s generally low: public debate i s perceived as confrontational and decision-making i s driven by special interests, such as ethnic solidarity. On the positive side, more moderate politicians are gradually emerging, having an appeal that crosses ethnic boundaries and convincingly advocating policies that address common rather than sectarian concerns. 19. With such a low base o f confidence, it is understandable that a worsening economic climate, widespread poverty, and unemployment have stimulated a more openly critical approach to officials, even within their own ethnic groups. Public BiH: CFAA - The Context 5 institutions' modest achievements in fighting illegal economic activity and corruption, profiteering, and patronage are perceived by a significant percentage o f the public as a serious problems, and as endemic in political life.3 In both the Federation and the RS, allegations o f corruption o f public officials were made inboth parliament and the media, and several cases have beenbrought before the courts. InternationalCommunityRole 20. Given the challenge of achieving consensus between the major political blocks, important decisions related to the implementation o f the DPA or other aspects o f the country's stewardship (even with regard to issues o f vital public interest, such as meeting the conditions for closer cooperation with the EU and membership in international bodies) are often reached only after pressure from the international community (IC) or by decision o f the High Representative. Since December 1997, the High Representative has been able to impose decisions and to dismiss officials who obstruct the Dayton Agreement andor engage in corrupt behaviors. Between December 1997 and November 2000, OHR intervened on over 160 occasions to impose or repeal a government or parliamentary appointment, decision, or law at the State or Entity level. In total, 63 appointments have been rescinded. 21. The degree o f political and institutional stability in BiH is consequently still closely related to the presence of the international community. However, it could be argued that its willingness to overrule the constitutional process i s inhibiting the development o f democracy and ownership o f the peace and statehood creation process. Therefore, the strategy o f the IC i s re-focusing on buildingthe institutional base o f BiH's democracy, promoting strong and independent executive institutions, subject to parliament scrutiny through the rule o f law. The challenge i s to find ways to use international influence to protect key institutions during their vulnerable early phase, and bring them to a point where they can sustain themselves after intemational support is withdrawn. For example, the Central Bank i s being administeredby an intemational chair duringatransitional phase. 22. Also, finding the right balance o f integration and decentralization among the Entities, the cantons, and the municipalities in the exercise o f government in BiHs is of crucial importance, fostering the move from fragmentation to harmonization. Source: UNDP, "Early Waming Systemin BiH-Public Opinion Survey," PrismResearch(May 2000). Box 1. The Yugoslav legacy The combination o fwar inthe context o ftransitionand ethnic conflicts have clearly compounded and exacerbated the economic governance models inherited by Bosnia and Herzegovina. BiHwas born out o f the disintegration o f the Socialist Federal Republic of Yugoslavia (SFRY), whose economic system had collapsed into hyperinflation and recession by the end o f the 1980s. The Yugoslav system was far more market-oriented than those o f other Eastern European state-run economies. Unlike the system prevailing in the Warsaw Pact countries, in fact, the Yugoslav system did not rely on central planning and its enterprises were run by both managers and their employees who were fiee to make their own price, extemal trade and investment decisions. Banks were not an instrument for central planning but were owned by enterprises and managed in a decentralized manner. The SFRY was spared the worst features o f central planning, particularly administrative price- setting, and State control over trade flows. Although the trade regime fiamework was comparable to that o f market economies for decades, a number o f distortionary policies shielded selected inefficient sectors/enterprises fiom competition (agrokombinats and poorly performing industrial sector enterprises), leading to higher costs for domestic producers, which were, in tum, partially offset by a system o f direct subsidies. The so-called self-management or social-ownership system, with its two-tier banking system and free pricing mechanism for most consumer goods, allowed degrees o f competition beyond those existing in the Warsaw Pact countries and generally avoided the typical shortages o f consumer goods characteristic of those economies. Consequently, in comparison with other state-run economies, the SFRY presented a relatively developed private sector and a higher share o f services in its overall economic structure. However, the model underlyingthe structure o f social ownership presented unclear governance arrangements: ownership rights belonged to "the society" (i.e. to no clearly identified owners) while day-to-day management was in practice entrusted to boards o fAssociated Labor (a combination o f employees and managers). Economic Governance Issues 23. BiHis still the second poorest country inEurope (only Albania has a lower GDP per capita). To date, international aid flows have provided a lifeline of support, but they cannot continue indefinitely. Though some progress has been made, insufficient private investment and the failure to create a truly single economic space has produced serious problems o f poverty and material hardship inlarge sectors of the p ~ p u l a t i o n . ~ Quoting from the UNDP's Human DevelopmentReport for 2000, "in 1998, 58 percent of the population in the Federation and 64 percent in the Republic of Srpska were impoverished. In October 1998 in the Federation, the consumer basket of basic needs for a family of four cost KM447 per month. Those with an income amountingto less than two thirds of that basket are consideredimpoverished.This appliedto about 60 percent of the population, among them a high proportion (about one quarter) of employed people. The average net salary was KM352 per month. Only the average net income of those employed by financial institutions and in public administration (KM 527 and 475 respectively)covered the entire cost of the consumer basket... in mid 2000, average net wages were KM 418 in the Federationand KM289 inthe RS; a very low level ifwe take into account the fact that shops sell most goods at prices not muchbelowthose in Westem Europe." Public Sector 24. Public administration in BiH combines pre-war, wartime and post-war institutions, often exercising overlapping administrative authority. The administrative organs operate within a complex governmental structure. Resources in public administration are generally scarce and the supply o f experienced and qualified civil servants is limited. 25. Accountability, as well as economy, efficiency and effectiveness o f public finance management are seriously undermined by insufficient coordination (in the sense o f insufficient inter-Entity and inter-governmental communication, poor participatory mechanisms and inadequacy o f functional and reporting lines in government functions) and weak governance (in terms of disconnect between the stated rules o f the game and actual behaviors, including conflict of interest). These conditions lead to non-systematic, poor budget management processes, compounded by inadequate financial management systems (accounting and reporting), and insufficient internal control and auditing mechanisms, including enforcement and oversight from the legislature. Harmonizing public policy and fiscal management (i.e. the achievement o f the common good) and politics (i.e. the achievement o f special interests) i s the priority in BiH, and the most critical challenge. In such a context, measures to bring accountability into public sector finances are also measures inthe fight against poverty. 26. The post-war reconstruction o f BiHwould not have been possible without donor funds: BiH is the country that has received the most international assistance per capita since World War 11.Since inthe adjustment phase requiredby the ongoing public finance stabilization process, revenue shortfalls are likely, significant budgetary support will remain indispensable over the short to medium term. In this respect, the Steering Board o f the Peace Implementation Council recognized the importance o f independent international audits and investigations as instruments to supervise the reform process (PIC Steering Board Communique o f February 1,2001). Corruption 27. Corruption i s widely regarded as being a major problem in BiH. An Anti- corruption Diagnostic Survey conductedby the Bank at the request o f the Government o f BiH in 2000 found that corruption is regarded as "widespread" by 60 percent of the general public, 54 percent o f public officials, and 52 percent o f entrepreneurs. In particular, twenty-two percent o f respondents thought that corruption would lead foreign investors not to invest inBiH, while 10 percent thought it would retard the development o f the private sector. 28. The survey results highlight the fact that the politicization o f public sector administration in BiH i s facilitating corruption. Selective results o f the survey - conducted across a wide range o f public officials, private sector leaders, and the general public - which are presented below, clearly call for reform o fpublic administration: 0 57 to 80 percent o f surveyed public officials believe that bribing for promotions and transfers exists; BiH: CFAA - The Context 8 54 to 79 percent o frespondents believe that bribing for hiringexists; 60 to 80 percent o f respondents believe that bribing for easy assignments exists; approximately one-third o f respondents indicated that those who do not participate inbribery are ostracized, victimized or forced to leave; the perceived incidence o f bribery was much lower in institutions with clear, written personnel guidelines; perceptions o f bribery are higher in institutions where personnel policy i s influencedbypolitical connections, affiliations, or pressure; corrupt practices are felt to behigher at senior levels; 60 to 90 percent o f respondents think that colleagues runbusinesses on the side; and 67 percent believe that corruption influences regulatoryAega1decisions. ther studies on the subject support the conclusion that corruption is widespread and that it presents a significant barrier to both foreign direct investments and local private sector economic activity. One such study, by the Intemational Crisis Group (ICG) concluded that: "corruption i s the most common complaint heard from businessmen. The most common form o f corruption revolves around the various inspectors and minor government officials.. .Those inpower use their influence to award lucrative contracts to cronies and family member^.',^ 30. Endemic and pervasive corruption, as observed in BiH, is a threat to economic govemance. It contributes to low public morale, creates mistrust and disaffection towards public institutions, and wastes public resources. In order to overcome the institutional causes o f corruption, what i s required i s a shift to an institutional order that disperses political and economic power through a network o f institutions, operating within the rule o f the law and promoting responsible governance as well as enlarged, consensual ownership. 31. Progress can only be made by changing the way politics relates to economic management and business, both in the public and the private sector. Only the achievement o f political stability and the establishment o f proper governance mechanisms will allow deepening economic reform and sound management o f public finances, creating the conditions for self-sustaining, market-driven economic growth, to avoid an economic crisis as BiH makes the transition from a donor-dependent economy, This will be only possible if functional and democratically accountable common institutions can be fostered and supported by transparent, effective decisional and management processes, including a sound financial basis, based on the rule o f law. "Why Will No-one Invest in Bosnia and Herzegovina? An Overview of Impediments to Investment and Self- Sustaining Economic Growth inthe Post-Dayton Era," IntemationalCrisis Group, April 21, 1999. Conflict of Interest 32. In a country where confidence in government institutions is crucial to the processes o f economic stabilization and democracy and to attracting foreign investment required for economic recovery, it i s important that high standards are seen to apply to the exercise and holding o f public, government and political office. The extent o f discretion available to public officials, the accumulation o f institutional and administrative functions, and the participation o f public officials in businesses that they are in a position to favor are all factors which give rise to powerful vested interests, leading to a high degree o f institutional inertia and opportunities for corruption. Criteria should be introduced to reduce the current high level o f conflict o f interest on the part o f public officials. Technical competence, personal integrity, and public statements o f personal income and wealth and o f business holdings or directorships should be required of those seeking to hold public office. 33. Personal accountability i s a particular issue for government officials and chairs o f public sector agencies. Hence the importance o f a law on conflict o f interest, defining a clear demarcation between the political sphere and the electoral mandate as it refers to economic and public finance management. The required improvements would need to be preceded by the introduction o f substantial changes, including civil service reform, and involve actions such as ministerial restructuring and consolidation (to strengthen analytical capacity, policy coordination and working links); creation o f a strong cadres o f public officials below deputy minister level (which would, over time, result intechnically sound directorates, less subject to patronage); and introducing career paths based on competition and transparent merit criteria (linking measurable results in programs implementation with performance evaluation). Anti-Corruption Efforts 34. Given its position as the chief civilian peace implementation agency inBiH, and its responsibilities overseeing the implementation o f the civilian aspects o f the Dayton Peace Agreement on behalf o f the international community and for coordinating the activities o f the civilian organizations operating in BiH, the Office o f the High Representative (OHR) has historically taken the lead in anti-corruption initiatives. In February 1999, OHR developed the first Anti-Corruption Strategy for BiH, which combined the investigation and prosecution o f individual fraud, corruption and economic crime cases by OHR's Anti-Fraud Department (AFD) with a systemic anti-corruption strategy built on the four "pillars" o f (i) eliminating opportunities for corruption, (ii) transparency and reporting, (iii) control and penalties, and (iv) education and public awareness.6 35. While the OHR has done much good work infighting corruption inBiH, not all o f its recommendations have been implemented. More recently, the State government and the Entities havetaken a more proactive role inanti-conuption with wide participationby "Comprehensive Anti-Corruption Strategy for Bosnia and Herzegovina," February 15, 1999, available at www.ohr.intlohr-deptlafdlac-cor-strat/default.asp?content~id=5240 BiH: CFAA - The Confexf 10 civil society and have promulgated, in February 2002, their own Action Plan for Combating CorruptionY7which foresees an ambitious set o f reforms, including a comprehensive action plan for determiningthe priorities in fighting corruption. Important elements o f the necessary public administration reforms will be included in this anti- corruption plan. The Anti-corruption Action Plan also foresees the adoption o f laws such as a Law on Preventing Money Laundering, Law on State ServicelPublic AdministratiodPreventing Corruption, Law on Conflict o f Interest, and a Law on Responsibility o f Legal Persons for Criminal Offenses, as well as reinforcing the currently weak institutional arrangements to fight corruption by establishing an Office for Combating Corruption and Organized Crime. 36. The CFAA conclusions are that the fight againstcorruption must be aimedat overcoming institutional causes of corruption. It is the view of the CFAA that the measure of success in anti-corruption efforts is the actual implementation of the strategies and legal framework to produce impact-in economic terms, the reduction o f administrative barriers, and in political terms, greater transparency and less state capture. At the same time, participation and scrutiny from the public and civil society should be increased, for instance, through the introduction o f consultation requirements and timely dissemination o f public finance data: information empowering civil society, preventingabuses and decreasing the possibilities for corruption. '"Action Plan for Combating Corruption" February, 2002 published by Ministry of Foreign Trade and Economic Relations, Council o f Ministers o f BiH; Ministry of Justice, Govemment of the Federation; Ministry of Justice, Govemment of RS available at www.prsp.infolenglishiindex2.htm 6iH: CFAA-Public SecforBudqet Manaaement,Moniforina and Evaluafion,and oversiqht 11 11.PUBLIC SECTOR: BUDGET MANAGEMENT,MONITORING AND EVALUATION, AND OVERSIGHT 37. The Dayton Peace Agreement put in place a highly decentralized fiscal system, articulated in State, Entity and Cantonal budgets. Although the State i s the obligator for all external debt, it has no revenue-raising authority. In the Federation, the cantons receive over half o f general government revenues and undertake basic government services such as education and health. The RS, due to its centralized government structure, has a unified budget system. 38. Bosnia and Herzegovina has made significant strides in developing key elements o f its public expenditure management (PEM) systems over the last seven years. At present, the system operates within an improved legal and institutional framework inter alia for budget management (both Entities have adopted organic Budget Laws, complemented by Annual Budget Laws, Laws on Budget Execution and Laws on Implementation o f Budget), foreign debt management and external audit. Beginning in 1999, both Entities and selected cantons in the Federation began creating necessary conditions for improving the linkages between their macro-fiscal planning and budgeting within a simplified version o f a mediumterm expenditure framework (MTEF). In2000, the Supreme Audit Institutions began operating both at the State level and ineach Entity, gradually improving the transparency o f the operation o f the budgetary institutions. The closure o f the Payment Bureaux (PB) in January 2001 marked the beginning of movement toward a Treasury system, with each Entityhaving its computerized Treasury system in place as o f January 2002, albeit covering only State and Entity level budget transactions at the initial phase. 39. Considering that these reforms have been implemented against a backdrop o f a dual process o f nation buildingand economic transformation ina war-tom economy, they become all the more impressive. Nevertheless, these very challenges have often become a factor in slowing down the realization o f full benefits o f reforms because they translated into both weak implementation and enforcement capacity in BiH's fragmented governance framework. The most obvious evidence o f these capacity limitations are widespread public payment arrears, large off-budget public sector activities, and poor outcomes in resource allocations and quality o f public services. In the period ahead, much remains to be developed and aggressively implemented, if BiH's public expenditure management and financial accountability systems are to help authorities move toward fiscal sustainability in a self-governed fiscal management framework. In particular, in the specific area of public financial management, proper institutional and governance arrangements could enable the authorities to introduce a system o f checks and balances for more transparent and accountable fiscal management, through effective monitoring, evaluation, audit and legislative oversight o f finances and performance o f budgetprograms and activities. Strengthening the Role of State-level Institutions 40. The Peace Implementation Council has repeatedly called for the strengthening of the State institutions inBiH, inview o ftheir cohesive potential, and for the identification BiH: CFAA - Public Sector Budget Management, Monitoring and Evaluation, and oversiaht 12 I and establishment o f adequate and realistic sources o f budgetary support for these institutions. At present, the bulk o f the State's budgetary needs are met by contributions from both Entities, and to a minor extent by administrative and consular fees. The process of securing adequate resources has been contentious, because issues relating to State competencies are repeatedly disputed. Furthermore, given the difficult budget situation in both Entities, the State needs to be granted a greater degree o f budgetary autonomy, and this means being able to generate an increasingshare o f its fiscal requirements from non- Entity sources. A greater degree of self-financing would also increase accountability in State ministries, which currently appear to enjoy excessive discretion in spending funds that they do not raise. 41. Since the establishment o f the State Treasury, the OHR, the IMF, and the WB have been assisting the authorities in formulating realistic State budgets that are consistent with the financial capability o f its financiers. The goal i s to create an effective, modern budget system with appropriate checks and balances to ensure full accountability and transparency. At the same time, a number o f existing (the State Border Service and the Refugee Return Program) and new critical institutions (the State Court system, for example) are inadequately funded or not funded at all. Although progress has beenmade, a proper system o f financial planning has yet to be developed and decisions will soon have to be made on possible independent sources o frevenues. 42. The CFAA recommends support of the shift of key institutionsandprocesses from the Entities to the State as advocatedby the InternationalCommunity.With the support of BiH's new government,this shift couldpossiblybe accelerated.Such a shift would empower State institutions with stable and predictable budgetary resources and ensure fiscal discipline and oversight o f public finance management. At the same time, inorder to mitigate concems about over-centralization, effective govemance should be promoted at the cantonal and municipal levels, where financial accountability i s also weak. The need to promote governance at local government levels is based on the recognition that statehood needs to be reinforced and specific areas are to be strengthenedin the two Entitiesinview of the requirementsfor EUaccession.' 43. The way to Europeis the creationof a single free economic space inBIHand, to that end, harmonization and creation of common institutions are crucial. At present, many political and administrative barriers stand in the way. The solution could be to concentrate regulatory and oversight powers at the State level, while maintainingthe current decentralizationof budget management.Inorder to achieve this, the two Entities must generate sustainable sources o f financing, particularly inview of a future reduction inconcessional finance. This i s also relevant in terms of resolving issues relating to the representation o f BiH within intemational organizations and institutions. For instance, BiHi s entitled to a seat when it will become a member o f the Intemational Organization for Securities Commission (IOSCO); the problem i s to ensure equal membership of the two Entities' securities and exchange commissions. BiH: CFAA - Public Sector Budaet Manaqement,Moniforinq and Evaluation, and oversiqhf 13 BudgetFrameworkandPlanning 44. Both budget planning and execution present disfunctionalities mainly due to the absence o f a comprehensive resource framework and the disconnect between legal and regulatory arrangements, on the one hand, and concrete decision-making and management practices, on the other. There is an extreme separation o f the recurrent expenditure side o f the budget (mostly financed by domestic revenues and donations) and its investment and capital expenditure part, exclusively financed by foreign resources. There is fragmented resource management, including management o f extra-budgetary funds (EBFs), poor attention to consolidating externally financed expenditures and off- budget domestic resources (such as privatization receipts and off-budget earmarked resources). The total amount o f resources that remain unaccounted for in the resource framework, be it at the Entity or sub-Entity level, is extremely large-equivalent to over 45 percent o f total Federation resources and over 35 percent o f total RS resources in 2000. The integration o f these resources into the overall resource framework is essential to the preparation o f realistic and effective budgets in BiH. Finally, there are inadequate internal controls on budget management, insufficient reporting and public disclosure, as well as a lack o f comprehensive monitoring and evaluation, and legislative oversight. Legal Framework 45. The existing legal framework for budget management in both Entities involves key elements for budget formulation and fiscal discipline. They provide for MOFs to present a report on the macro-fiscal policies in the beginning o f the budget formulation process and include provisions for maintaining fiscal balance in all instances during the formulation, approval and execution o f the budget. They also provide for comprehensive coverage o f the budget, including extra-budgetary funds. Equally important i s the full enforcement o f the existing legislative framework, especially those provisions concerning the coverage o f the budget and the financial planning and reporting, which are the least observed at present. 46. However, as the BiH moves toward a more advanced phase in its economic recovery and transition process, a number o f issues need to be addressed to improve the effectiveness o f the legal framework, especially concerning the strategic focus and coverage o f the budget, and coordination both between and within BiH's government tiers. The CFAA recommends that the proposed revisions to the Organic Budget Laws include provisions (i) for specifying how, when and on what issues consultation and informationexchange will be conductedbetween central and local levels within each government; (ii) for systematic bottom-upreporting; and (iii)for consolidationof the fiscal data at the center (Le. State; RS and Federation central governments). 47. Similarly, there i s a need for a greater reliance on by-laws, implementing regulations, and operational guidelines, both in order to more adequately define the principle budgetary laws - which are in place now - and for providing a more flexible operational framework that can respond more quickly to a changing environment. The recent adoption o f sub-entity borrowing guidelines in each Entity constitutes a good example for such a process. In the future, aid management, roles and responsibilities BiH: CFAA - Public Secfor Budaet Manaaemenf, Monitorinns and Evaluafion, and oversiaht 14 regarding consolidation o f fiscal accounts, and multi-year budget plans could be considered good candidates for further definition through by-laws and implementing regulations. The CFAA recommends that the linkage between the macro-fiscal framework andthe budgetbe strengthenedby providingfor medium-termforecasts and a statementon the budget's mainpolicyobjectivesin the OrganicBudgetLaws. The Entity governments (and over time the State) should assume a principle role in defining the overall macro-fiscal parameters that will guide preparation o f sub-Entity (and over time, subnational) budgets. The requirementsfor the justificationof budget proposalsfromBudgetInstitutionsalso needto be strengthened,bothby improving the specificity of the required information and by broadening the economic categorieson which informationis requested. Planning 48. If the budget is to become an effective policy tool, then the budget planning process should include the following key elements: (i) a macro-fiscal framework that defines the available resource envelope in a given period; (ii) the economic and sector policy framework that defines the objectives, priorities, and outcomes for key sectors and the economy as a whole, and; (iii) budget expenditure allocations that translate policy priorities into the expenditure decisions that meet those priorities most cost-effectively. If properly carried out, the budget planningprocess could be a very powerful instrument in facilitating the consensus needed both for policy tradeoffs called for by hard budget constraints and for concomitant expenditure decisions at the highest levels o f the government and legislature. 49. Despite considerable progress to date, BiH's present budget planning process falls short o f meetingthese requirements. There are four areas o f weaknesses: (i) absence o f a comprehensive resource framework for the budget; (ii) weak enabling framework for sound budget planning; (iii) weak capacity for budget and sector policy planning in the MOFs and line ministries; and (iv) fragmentation in policy formulation and decision making. 50. Key elements o f the budget planning process remain weak or are intheir infancy across BiH, in particular, an adequate budget formulation timetable and systems for facilitating the analysis, planning, review, and monitoring o f the budget programs,. The budget preparation timetable is the same across all governments, with the process being carried out during June-November o f the current budget year. However, he adoption o f the budgets usually experiences delays, though they are gradually getting shorter. Based on the time requiredfor preparation and adoption o f the budgets over the last few years, the timetable for the preparation o f the budgets appears unrealistically short and does not allow for appropriate consultation and coordinated budget preparation across BiH's multi-tiered governments. Delays are partly attributable to the often difficult process o f preparing realistic budgets4.e. consistent with the macro-fiscal programs agreed with the F I s . Delays are also attributable to the difficulty of gaining legislative approval, especially in the Federation, largely due to the lack o f prior consultations and coordination with the various players inboth Entities. The CFAA recommendsthat the relevant legislation be amended to extend the timetable for the preparation of the BiH: CFAA - Public Sector Budqet Management, Moniforina and Evaluation, and oversiqhf 15 annualbudget to a full calendar year, beginningwith the preparationof the multi- year budgetplanningprocess. 51. Intermsofstrengthening capacities for budgetplanning, andadjustingthe roleof MOFs to the changing needs o f the budget process, both Entities have made efforts to establish capacities for macro-fiscal management and, to a lesser extent, for policy and programming in line ministries in the context o f initial medium-term expenditure framework (MTEF) phase. A macro-fiscal department was established inthe M O F within each Entity, in 2000 for the Federation and in 2001 for RS. Nevertheless, these departmentsremain understaffedand lack the expertise to effectively undertakeanalytical functions. Moreover, the present fragmented fiscal management and reporting lines do not provide adequate fiscal data for a reasonably comprehensive fiscal analysis and monitoring work to be carried out. If the State and the Entities are to take a more prominent role indeveloping macro-fiscal programs inBiHand to improve predictability of their respective overall resource framework-hence, performance o f their budgets- then capacity building in fiscal management will need to be made one o f the priority tasks in the medium term. Intime, this will improve MOF's ability to assume a greater role in guiding the process o f strategic fiscal policy choices and monitoring, informing role inthe budgetmanagement process. 52. The CFAA recommends, in the short run, that BiH continue to use international technical assistance (particularly, on-the-job training) to develop analytical capacity, with the objective to extensivelypractice the new skills. Policy programming units need to be established in a few key line ministries in the near term and gradually expand this to other sectors. The MOFs need to improve economic forecasting ability by collecting direct information and economic forecasts from prominent public and private sector agencies and by closer coordination with key public sector institutions (such as tax and customs administrations, key line ministries, Central Bank, and EBFs). Budget Policy Coherence and Decision Making 53. Fiscal management framework i s a key factor in effective and coherent budget policy and decision making, since it defines the way executive and legislative powers are exercised and decisions are taken with regard to economic policies and resource allocations. InBiH, fiscal management i s conducted separately in 14 political structures, each o f which has independent executive and legislative powers. This makes achieving consensus and policy coherence more challenging, not only because o f the numerous, heterogeneous checks and balances that the system embodies (especially at the State and Federationlevels), but also because o f weak centers o f government, with limitedcapacity inpromotingbindingand sustainable budgetdecisions andpolicyoutcomes acrossBiH. 54. The institutional fragmentation and weakness at the center present challenges to budget policy formulation in two main dimensions. Fragmentation creates a favorable environment for policy paralysis as a result o f numerous players involved in policy formulation, and numerous veto points that can block the development and implementation o f coherent policies. The weak center creates a favorable environment for policy asymmetry, as demonstrated in the formulation and implementation o f BiH: CFAA -Public Sector Budset Manasement, Monitorins and Evaluation, and oversight 16 incompatible policies by different levels o f governments. Policy asymmetry i s more pronounced at the Federation level, giventhe need for coordination with the ten cantons, but it is also present at the State level with regardto policy coordination betweenthe two Entities. There i s much scope to improve coordination even within RS. 55. Addressing these challenges requires a two-pronged strategy. First, it requires establishing formal policy harmonization and coordination channels between the State and the Entities, between the Federation and its cantons, and within the cantons themselves.Inturn, an effective consultation process would require facilitating tools, such as a consolidated fiscal framework, joint sector strategy plans, and implementation outcome reviews. Second, it requires effective organizational arrangements, operating rules, and high-quality support that will improve policy formulation and review capacity at the center o f government. While meeting these requirements i s a long-term process, which will partly be driven by the country's evolving political structure, there are measures that are within the reach o f the authorities in the near term, especially ineach Entity. Budget Coverage 56. BiH fiscal aggregates are poorly definedand budgets are not all-inclusive for all levels o f government. Specifically, budgets do not include (i) revenues and sources o f all funds (grants, donations received by foreign governments, IDA-assisted projects and other donor financed projects; only budgetary support is currently included) nor (ii) all expenditures and other uses o f funds (for instance large off-budget items, including military sector and transfers to SOEs). Significant extra-budgetary funds, such as pensions, unemployment, health insurance, and social spending items such as child protection are shielded from general budget scrutiny; and, at the same time, there i s little oversight and control over management o f extra-budgetary funds). T o ensure completeness and integrityin the whole budgetingexercise, the CFAA recommends that the gaps be filled, introducing at minimum: an explicit consideration o f arrears; foreign financial assistance (grants, IDA investment credits, etc); budgetary organizations self-generated (off-budget) revenues; all transfers among public sector institutions at large, including autonomous legal entities enjoying budget financing (e.g. quantification of foregone revenues from SOEs and corresponding cost o f goods and services provided by SOEs. 57. In its December 2000 Letter of Intent to the IMF, the Government of BiH announced that the financial plans o f extra-budgetary funds and the use o f privatization proceeds were to require approval by the respective parliaments. Also, the reduction in off-budget expenditures were to be quantified on the basis o f audits carried out in both Entities by external auditors, and military revenues and expenditureswere to be brought on budgetstarting in2002. The CFAA recommendsthat provisionsbe made to ensure that extra-budgetaryfunds (startingwith the larger ones, such as Pension Funds)be subject to external audit, possibly under the umbrella o f the Auditor General, to reinforce role and visibility o f the SupremeAudit Institutions. BiH: CFAA- Public Sector Budqef Manaqemenf, Monitorinq and Evaluafion, and oversiqhf 17 BudgetPreparation 58. The budget preparation process is very unsystematic and varies across Entity, cantonal, and municipal governments and between Entities. A detailed description of budget processes i s presented as Annex 3 to this report, along with details about accounting and reporting and intemal and external audit functions. The annex provides information for the two Entities, one canton (Sarajevo), and two municipalities (Central Sarajevo inthe Federation and Banja Luka inthe RS). 59. There i s still clear disconnect, at all levels o f governments, between the formulation o f the budgets and their management, both in terms o f accurate estimates o f revenue flows and their actual mobilization, or spending. Even withinthe executive, there i s insufficient coordination between the Prime Minister's office, the MOF, and the newly formed Treasuries to support the development o f annual budgets.Annual laws on budget implementations have been approved several months after the commencement o f the new fiscal year. The annual budgeting process is not yet conceived within the framework of an overall medium-term planning strategy formulation - for example, in the RS there i s an adviser to the Prime Minister for strategic planning, but the adviser's interactions with the MOF Budget Department are still limited. 60. The CFAA recommends that policy priorities be clearly linked to a fiscal plan, within the overall macroeconomic constraints. The budget cycle and the legislative program calendar should be harmonized and the development o f legislative programs should be explicitly linked to a medium-long term plan and to the annual budget. Currently the fiscal implications and economic impact o f passing new laws i s not considered in the forecasting exercise. For example, in the RS the 2001 legislative program (136 laws) was not costed out, and was prepared without consultation with the MOF. Linkages between budget planning and execution should be strengthened, and periodic progress reports should be submittedby the MOF to governments, and from the cabinet to the parliament,to allow for better monitoring and evaluation. 61. Budget formulation is characterized by a top-down approach, observable inboth Entities, which contributes to the budget allocatiodactual spending gaps. The negative effects o f the top-down approach are most acute at the ministerial and cantonal levels. Priorities are, in fact, not based on objective needs but on subjectivity. The Entities have made some efforts to initiate the process o f linking policy with budgetary resources allocation during the budget formulation stage by introducing the medium-tenn expenditure framework elaborated in concert with the WB (including pilot cantons) and have tried to consolidate foreign aid financing into the budget framework. 62. Although MTEFs are regarded as a useful exercise from the budget officials' point o f view, their consideration in the budget discussion at the higher decision-making level, such as the Cabinet o f Ministers and the Parliament, has been very limited. While the authorities have committed to continue the process o f medium-term planning (especially in the RS where commitment seems to be clearer), the approach for institutionalizing them to render them relevant for the annual budget formulation process would needto be revised. 6iH:CFAA -Public Sector Budaet Manaaement, Monitorina and valuation, and oversiuht 18 63. To strengthen ownership and governance o fthe budget process, the link should be made between policy-making and strategic planning, which would then feed into the annual budgeting exercise. Placing greater emphasis on a bottom-up, consultative approach would introduce inclusiveness measures which would, in turn, improve fiscal discipline and make results more predictable. A Budget Framework Paper was prepared as part o fthe Second Public Finance Structural Adjustment Credit (PFSAC-2), the budget management reform component o f which aimed to develop a comprehensive, medium- term budgetary strategy that i s expected to contribute to a more efficient budget planning in the Entities and in the cantons. The CFAA recommends that governments consistentlyfollow the BudgetFrameworkPaper developedin consultationwith the WorldBankfor the preparationof annualbudgets. 64. At the municipal level, the Municipal Infrastructure Finance and Implementation (MIFI) program and Municipal Governance Program were introduced by the OSCE in 1998 to help a pilot group of municipal administrators develop participatory, transparent decision-making structures. The program provided municipalities with tools and mechanisms for better budget planning (including separation o f operational and capital budgets starting with the 2000 planning cycle) as well as management o f fiscal resources and financial operations (including greater internal budgetary control over the work o f the administration). Extra-budgetav Funds 65. Social Security Funds are the major extra-budgetary funds (EBFs) in BiH, comprising one-third o f consolidated on-budget revenues in both Entities. They are administered off-budget and at central level in RS, and at both Federal and cantonal levels in the Federation, with cantons playing a larger role on balance. EBFs are all under-fundedand receivebudgetary transfers o f varying amounts, though transfers are o f a systematic nature only inRS. Although the Entities' Organic Budget Laws require that EBFs present their financial plan for approval to the Ministry o f Finance before the budgetis submittedto the Parliament, and that their financial plan should subsequently be presented to the Parliament along with the annual budget law, in practice, these requirements are not being enforced. The financial troubles o f the EBFsplay a role inthis outcome, delaying institutionalization o f much needed transparent and sound financial planning and reporting rules for EBFs. The lack o f such rules further complicates administration o f the EBFs by exposing them to rather ad-hoc crisis management all the time. 66. Given their nature, the EBFs do not lend themselves to integration into the budgetary framework. Nonetheless, the CFAA recommendsthat: (i) reportingon the EBFs be greatly improved by enforcing the requirements of the Organic Budget Law for better scrutiny; (ii) budgetary support that each EBF receives during a fiscal year be systematically defined based on sound financial planning and reporting by the EBFs; and (iii) EBFs be subject to the same annual auditing requirementsas those of other fiscal accounts. BiH: CFAA - Public Sector Budqef Management Monitorinq and Evaluation, and oversiqht 19 Off-budget Resources 67. As in the case o f EBFs, the Entities' Organic Budget Laws include provisions defining, in general, which resources should be considered as fiscal resources and, hence, incorporated into the budget, notwithstanding their final use. Nevertheless, these provisions have not been systematically enforced regarding some off-budget resources, including privatization receipts and earmarked fees and rental income, mainly at sub- Entity level, for discretionary financing o f local activities. While it is possible to obtain information on the privatization receipts, it i s difficult to understand local off-budget resources, which are not included in the fiscal accounts and some o f which are not reported at all. 68. The bulk o f privatization activities are carried out by the twelve privatization agencies, one for each Entity and canton. These agencies channel privatization receipts across public administrative units as dictated by the Privatization Law. Receipts are allocated to final users, and, in general, their use has been treated as off-budget spending by the final beneficiaries. However, proper privatization accounting would requires all these transactions to be recorded under the budget o f their final beneficiary-more specifically, they should be recorded as a financing item and their use to be included as an spending item o f the final user. The practice, in BiH, has been ad-hoc; with some agencies-such as the Federation Pension Fund- recording its revenues from privatization and their respective use, and most (cantonal governments) keeping the spending financed with these funds completely outside the budget. In the Federation, some privatization receipts, equivalent to some 35 percent o f total cash privatization receipts, accrued directly to sellers. The CFAA recommends that the rule be set to incorporateprivatizationreceiptsintothe budget of their finalbeneficiary. 69. Ifbudgets are to provide a unified measure of public fiscal activity, off-budget fiscal resources need to be incorporated into the budgetsby all levels o f governments The CFAA recommendsthat an inventory of off-budget resources be prepared, with a view to their rationalization (so that cost o f collection and administration will be reduced) and incorporation into the budgets.These resources could still be directed to their original use, but they should be included in the budget submissions, and subject to the same budget controls as other public fiscal resources. BudgetExecution 70. Weak fiscal discipline in budget execution creates a vacuum that allows informal arrangements for the reallocation of budget funds to flourish. At the Entity level (especially in the Federation), there i s great discretion in operating budget cuts. Clear priorities to make such cuts are therefore needed that protect sensitive items. Currency board rules and fiscal discipline monitored by the IMF and the WB (in order to prevent BiH's different levels o f government from contracting domestic debt) keep the deficit within levels compatible with available sources o f foreign financing. These conditions have resulted in a cash-rationing system, where funding gaps are dealt with by accumulating arrears (particularly inwages and welfare benefits). 71. The proper dynamics and articulation o f budget revenues and expenditure is altered by diffused netting-out practices (or "compensation"), based on forgiveness o f 5iH: CFAA - Public Secfor Budaef Manaaement, Monitorinu and Evaluafion, and oversiaht 20 taxation in exchange for goods and services provided by State-Owned Enterprises (SOEs). Compensation happens at all public administration levels, especially in transactions with public utilities. There i s no quantification o f foregone revenues or services provided by SOEs but not paid for. Because they do not generate actual monetary flows, the offset revenues and expenses are not fully accounted for, and the underlyingtransactions often remainundisclosed. 72. The key problem with the practice o f compensation is that it protects scarce public resources fiom competition for their best use, and subverts transparency and completeness inreporting. At the same time, credit lines or guarantees extended to SOEs do not follow proper authorization mechanisms and are not published in the media. For instance, there have been cases, within the previous RS government, o f non-transparent decisions - such as extension of soft loans in the form o f working capital to SOEs - authorized by Cabinet o f Ministers but not published in the Official Gazette. In past years, this resulted inillegitimate and uncontrolled issuance o f guarantees (both from the budgets and through state-owned banks), representing hiddendebt creation in the form of contingent liabilities for which the ultimate guarantors are the governments-and the amounts o f which are unknown. 73. Budget execution reports are untimelyand incomplete. Separate Entity- and State- level budget reports are prepared only at midyear, and no consolidated budgets are prepared inthe Federation, or for the country as a whole (central government plus Entity governments). This situation undermines any possible predictability o f spending units' financial position and inhibits any kind o f audit trail on authorized reallocation o f funds during the fiscal year. Governments appear to decide expenditures without reference to the planned budget, and there is no link between expenditure to revenue collection. The most critical issue, therefore, i s the extent, timeliness and reliability o f financial information about government operations, including budget allocations, performance targets o f public agencies and their actual performance, public procurement and contracting. The CFAA recommends that timely, relevant reporting on budget execution be prepared by the governments and presented to the legislature for discussion on a monthly or quarterly basis. Timely, accurate reportingwould help to identify financing gaps and make budget revisions more predictable and transparent. 74. In the Republika Srspka, a positive development in that direction is the presentation (starting inJune 2001) o f a report o f the government on the execution o f the quarterly budget to the National Assembly. The acceptance o f the report determined a series o f measures which the government was expected to undertake for improving budget execution outcomes, including a request to strengthen the executive's internal controls and intemal auditing functions. RevenueManagement 75. Given the sense o f urgency o f structural reforms, further cuts inbudget spending and restructuring away from recurrent spending are likely to continue. However, the focus should be as much on increasing revenues as on a reduction o f public expenditure, 6iH: CFAA - Public Sector Budset Manauement, Monitorina and Evaluation, and oversiqht 21 since no recourse to domestic borrowing is allowed, while external borrowing is on concessional terms only. 76. The taxation scheme in place allows numerous tax shelters and exemptions. A complex tax-payment system i s in place (involving enormous paperwork and multiple accounts) with negative repercussions on voluntary compliance. There i s excessive fragmentation o f types o f taxes, especially indirect taxes such as sales tax, and this creates incentives for evasion and further discourages tax compliance. Significant smuggling o f excisable goods (alcohol, cigarettes, coffee) means tax evasion on a grand scale, diverting resources from the public budget. The impact on the resource envelope underminesthe self-sustainability o f government programs. 77. The introduction o f Treasury Single Accounts (TSA) will simplify and systematize collection and improve revenue trackability. The introduction o f VAT (proposed for 2003) will standardize and unify the revenue stream and allow better controls. So far, the work of the EU-financed Customs and Fiscal Assistance Office (CAFAO) has improved tax collection and enforcement and restructured the tax system, and its next goal i s to reduce tax rates while simultaneously broadening the base for collection. Payment system reforms are also expected to improve revenue collection (see chapter IV below). PublicSectorAccountingandReporting Budget Classijkations and Chart of Accounts 78. Improving systems o f accounting and expenditure controls in the execution o f budgetary transactions has been an important reform element, supported through extensive external technical assistance in BiH. A comprehensive budget classification, reflecting Government Finance Statistics (GFS) conventions, was developed in the Federation starting in 1998, with technical assistance from the U.S. Treasury Department. The budget classification structures, the chart of accounts, and the reporting formats are duly explained in a Rule Book issued in 1999. The State budget currently uses a traditional, administrative classification structure; however, it is envisaged that the State will switch to a new classification structure based on the one adopted in the Federation (i.e. a simplified subset o f the structures developed for the entities and cantons). In the RS, a new chart o f accounts, based on the GFS economic and functional classifications, was introduced in 2000, But the budget for 2001 was prepared in accordance with the old classifications and converted after its approval by the Parliament. 79. Nevertheless, actual implementation o f these new systems to date has remained limitedand asymmetric. Budget management continues to be based mainly on economic and administrative categories for planning, execution and monitoring purposes. Only a few o f the simpler elements o f the new chart o f accounts and classifications are being used at the Federal government level, Sarajevo Canton, and Central Sarajevo municipality. As discussed in chapter IV, the introduction o f the new Treasury General Ledgers (TGLs) in each Entity, albeit only at the higher levels so far, has been the first tangible step towards changing this practice, since TGLs embody the new chart of accounts, and the State i s also to beginusing the new chart o f accounts, compatible with those inthe Entities. BiH: CFAA- Public Secfor Budaet Manaaement Monitorha and Evaluation, and oversiaht 22 80. The full adoption o f the chart o f accounts will improve the transparency and accountability inthe execution and reporting o f the budgetary transactions. Nevertheless, its elements are too detailed to be useful for budget policy management purposes. For budget use, the accounting elements need to be consolidated into a structured budget classification, preferably one using GFS-compatible functional and economic categories. The new chart o f accounts allows for such consolidation, since the codification is compatible with the GFS classification. The CFAA recommends the generalized applicationof GFS concepts and classificationsat all level of governments,to ensure consistency of approach, consolidation, and meaningful analyses of the variances. Application o f GFS will not only help significantly improve policy analysis, but it will also allow close monitoring o f actual implementation o f policy priorities-both are critical, inter alia, for effectiveness o f fiscal management and for the Poverty Reduction Strategy. Accounting Standards 81. InbothEntities, accountingstandards are issuedbythe respective standard-setting bodies (see chapter VI o f this report). There is a fairly clear and detailed framework for financial reporting o f public institutions based on International Accounting Standards (IAS), as discussed inSectionVI. The Rule Book indicates which IAS standards apply to the public sector and which do not, and states how each relevant standard applies, with a brief description o f its content and how it has been incorporated in the Rule Book. However, existing accounting practices do not actually follow the applicable accounting policies and procedures, and are not well documented. This partly reflects the weak capacity within public sector institutions and the absence o f enforcement powers o f the standard-setting bodies, which lack authority, means, and resources to ensure that mandatory accounting standards are correctly implemented or to sanction cases o f non- compliance. 82. The poor application o f existing standards is also partly explained by the unnecessarily complex IAS on which the Entity Accounting Standards are based. Given the current capacity o f BiH's public institutions, these standards are clearly too demanding. Therefore, it i s the view of the CFAA that it might be more appropriate to phaseinthe implementationofIAS standardsbasedon real needs. 83. More generally, IAS - which were written to promote consistency and comparability in financial reporting across different countries - may be the right solution for enterprise accounting, while International Public Sector Accounting Standards (IPSAS) are more appropriate for governments and other users in public sector organizations. IPSAS are issued by the Public Sector Committee (PSC) of the International Federation o f Accountants (IFAC). which has developed a standard setting out the requirements for the presentation o f the primary financial statement under the cash basis o f accounting, as well as the statement's structure and minimum content requirements. The CFAA considers the IFAC-PSC Financial Reporting Under the Cash Basis of Accounting standard more directly applicableto current practicein BiH. Accounting and ReportingSystems 84. Despite the adoption o f a subset o f N S by bothEntities, which would inprinciple require a shift to accrual accounting, pure cash bookkeeping has continued, and is most likely to stay inplace at the sub-Entity level inthe near-term, prior to the introduction o f the TGL at the sub-Entity level. Cash bookkeeping i s supplemented by a rudimentary commitment tracking system, not integrated with the overall accounting system. Under this system, locally developed software packages were customized, in both Entities, to take into account the new budget classifications and to provide basic routines to compile classified reports, but many accounting functions remain semi-manual and paper-based. The software apparently allows recording o f purchase commitments at invoice stage, and their linkage when payment becomes due recording o f commitments and monitoring their liquidation - being based on reports received by the MOF from the line ministries and performed as a parallel activity to conventionalbookkeeping. 85. As a preliminary measure, the CFAA recommends the enforcement of commitment recording at all level of governments. In the period ahead, fully computerized TGLs - which will be systematically applying commitment accounting - would allow optimization o f cash management and tracking o f arrears, a major break with the past, especially with regard to arrears tracking. Over the medium term, a switch to a modified accrual accounting system could be c~nsidered.~ Modified accrual accounting would help public sector institutions to better understand their financial position and would support decision-making. However, the shifi from cash to accrual accounting i s well beyond BiH's current capabilities. 86. Consolidated budget execution reports for the country as a whole (central government plus Entity governments), and for the whole Federation are not prepared. Separate Entity- and State-level budget execution reports for the previous fiscal year are available only at midyear. The CFAA recommends that timely, at all level of governments, relevant reporting on budget executionbe preparedand presentedto the legislature for discussion. This would be facilitated by the preparation o f regular interim reports on budget execution which, at present, are not customary. At present, reports are incomplete and late and therefore do not provide useful or relevant information for decision-making or budget management purposes (e.g. analysis o f trends)." Timely, accurate reporting would help to identify financing gaps and make budget revisions more transparent and disciplined. The CFAA recommends that the MOFs of each sub-Entity government prepare periodic monthly reports on budget execution reports, includingEBF activities, on at least a quarterly basis, with a the content designedto allow analysisof importantfiscal parameters. Under the modified accrual basis, revenues (similarly to receipts under the cash basis system) are recognizedonly when cash is received, while expenses and related liabilities (as differentiated from payments under the cash basis system) are recorded when incurred, irrespective of the time of cash disbursements. The modified accrual basis can sometimesbe a more prudent, conservativeapproachto financial statements presentationandit is generallyfollowed in cases where revenues cannot be measured until they are actually received (e.g. taxes, fines and fees), or where the timing and amounts to be collectedon accountsreceivablemay be highly uncertain. 10The OHR engaged, in February2001, an internationalaudit team (in the RS working under the authority ofthe SAI), to carry out a special review of flow of funds in the Federation(including six Cantons) and the RS central govements. The reports,publishedinJune 2001, confirm infull, with abundant supportingevidence, the CFAA's findings. BiH: CFAA - Pubic Sector Suduet Manaqement Monitorinq and Evaluafion, and oversiqhi 24 Automation of Accounting: Treasury GeneralLedgers 87. Progress in establishing Treasury systems at the State and Entity levels has paved the way for a computerized Treasury General Ledger (TGL) system, established through extensive extemal technical assistance from U S A l D and the U S Treasury Department. The TGL system became operational in both Entities in January 2002; the State government is also introducing it. The TGL system records all budget transactions at the Federation and central RS level, and generatesfinancial reports. 88. The full exploitation o f the new Treasury General Ledger functionalities i s expected to strengthen the ability to manage budgets by capturing financial information at the point where/when financial transactions are initiated; improve the quality and extent o f management information to decision-makers, providing easy access to that information; and allow preparation o f consolidated financial information. The main ledgers would be: Accounts Payable and Disbursements, Purchasing (Goods and Services), and Accounts Receivable and Cash Receipts. The envisaged accounting routines would introduce internal controls that are nonexistent at present: journal vouchers would be accompanied by approvals and referenced to budget information (available budget balances); daily, monthly and yearly reconciliation would be performed. Other books, to be gradually implemented, would include Human Resources andPayroll, FixedAssets, and Inventory. 89. The full-scale implementation o f TGLs would also help both Entities to draw up financial information for properly accounting for the existence, ownership and value o f their assets and liabilities. Currently, accounting books do not reflect, off-budget public liabilities, difficult-to-quantify contingent liabilities (for instance, guarantees issued by all levels o f govements), or economic transactions with various counterparts within the public sector at large (especially implicit subsidies to public enterprises and utilities, publicly-owned banks, and other quasi-governmental organizations). 90. The TGLs, and the accounting systems which they support, allow for the automation o f functions now performed manually. The system would be maintained through computerized data collection, either via on-line (dial-up or direct connection) or PC file-transfers, based on a cluster o f workstations attached to servers. It would be interfaced with extemal information systems, receiving inputs from the Revenue Collection System and feeding data into the Cash Payment/Transfer System. The system would generate reports, documents and on-line queries, and would accommodate database tools as well as spreadsheet and word-processing applications. Different servers would be utilized within the Treasury, with workstations locally attached to the central system. Main sectoral ministries and agencies would have stand-alone workstations for direct connection whereas, for small ministries and budgetary institutions, information would be transferred via PC file-transfers o fpaper documents. 91. The TGL accounting system is built upon GFS budget classifications designedto ease financial reporting and allow comparability o f budget and actual data for variance analysis. The systems have commitment accounting capabilities Cpurchaseorders) and are geared at introducing accounts payable and receivable. The cash book would be used to record receipts and disbursements, allowing for more efficient cash management. BiH: CFAA - Public Sector Budget ManaQement, MoniforinQ and Evaluation, and oversiqht 25 geared at introducing accounts payable and receivable. The cash book would be used to record receipts and disbursements, allowing for more efficient cash management. Standard security and integrity controls, including audit trail are embedded inthe system, which i s designed to work with different accounting bases (cash, modified accrual and full accrual). 92. Enhanced budget control i s another important feature o f the new accounting systems. Instead o f a monthly allocation o f cash to spending units, there would be a monthly allocation o f budget funds within the TGL. The system would calculate available budget funds on the basis o f budget allocations, deducting purchase commitments and payments to date. For purchase of goods and services, the new system requires recording o f purchases within the TGL so that budget funds could be reserved for payments o f those purchases. To that extent, approved purchase orders would be recordedwithin the TGL. 93. Currently, spending units are making payment decisions based on the available cash. Under the new system, ministries would continue to process all documents related to a payment, but the Treasury would make payment decisions based on available cash. Spending units could initiate purchases based on the available budget allocation, but the system would only issue a payment order ifif found sufficient hnds were available in the system; otherwise, it would reject the purchase. The use o f a new form (Payment Release) would be required as an input into the new system and would contain all relevant payment information, including amounts due to the vendor, payment due dates, and outstandingpayments. 94. The CFAA endorses the proposed approach, according to which the cash rationingsystem would be centralizedwithin the Treasury,which would also retain the final payment decision, diminishing the possibility for breaches of legality and arbitrariness inpayment selection by spendingunits, and ensuring adequate control over the consistency o f the nature, type and amount o fthe expenditure with budget allocations. 95. O f particular interest i s the Project/Grant Accounting module o f the new accounting systems. Its implementationi s particularlyrelevant, and recommended by the CFAA, With opportune and minimal adaptations, this module offers the prospectof beingable to use BiH'sown accountingand reportingsystem to support World Bankanddonor-assistedprojectexecution. DebtReporting 96. The integration o f sovereign debt management within the overall government accounting systems is another step that will need to be taken in the near term. Responsibility for Federation debt operations has been transferred to the Treasury as part o f the government's program to modernize Treasury functions, and expanded resources (staffing and equipment) are being organized. The introduction o f the new TGL-based financial management system is, in fact, propitious for changes to the procedures for accounting and disclosure o f debts in the Entities. However, the existing databases presently used for recording debt amounts and repayments (including debt service) are not interfaced with the new system. This necessary link was discusses by the CFAA 6iH: CFAA - Public Sector Budget Manaaement Monitoring and Evaluation, and oversight 26 mission with U SAID consultants and it will, hopefully, be taken into consideration during continuing implementation o f TGL systems. 97. Presently debt service i s managed using a single-entry, partial tracking database that is, not linked to an accounting system and thus cannot record liabilities. In fact, at present, Federation Treasury reporting o f debt i s not in agreement with debt information maintained by the debt units within the MOF o f the State and MOF of the Federation. Accounting procedures have not been developed to separate funding for budgetary support from investment fund guarantees. The Treasury does not assess loan risks for purposes o f recording and reporting contingent liabilities. For instance, the Federation budget document does not disclose information on outstanding loans and loan guarantees, nor does it disclose a consolidated picture o f debt for the Federation by including debt o f the cantons and municipalities. 98. Sovereign foreign debt that is administered through the State appears to be under adequate accounting control (State Law on External Debt o f 1997).Procedures do exist to ensure timely payment and there are indications that they are carefully adhered to. However, the separation o fborrowing, debt financing and fiscal authority implies the risk that, if one Entity defaults, the ability o f both the State and the other Entity to borrow would be compromised. The main risk relating to the external debt is, therefore, not its level, but the reliance o f debt service payments on transfers from the Entities to the State budget. The resolution o f observed settling delays in these transfers would imply an automatic transfer from the Entities' budget; but this would in turn imply an integrated budget management system that, at present, i s not in place. The CFAA explicitly supports integratingthe databasesused for recordingdebt and repayment into the new TGL system, inlinewith the recommendationsformulated above. BudgetMonitoringandEvaluation 99. Despite progress, budget monitoring in BiH i s currently limited to monitoring fiscal aggregates and ensuring, broadly, that fiscal discipline i s being maintained. Monitoring takes place in different forms during the course o f budget implementation, startingwith the monitoring of expenditure limits at the time the monthly allocations are issued from the Treasury Departments inMOFs at the Entity level, and from the cantonal budget departments in MOFs in the Federation. MOFs also try to monitor fiscal aggregates during the year through the quarterly data that i s being reported from the Budget Institutions (BIs). A particular emphasis has been given to monitoring tax and customs revenue performance, an effort that i s very effectively assisted by EC's Customs and Fiscal Assistance Office (CAFAO), providing opportunities for a broader monitoring across each Entity.However, there is no monitoring o f consolidated fiscal aggregates for the Entities and for BiH as a whole, except for the monitoring provided by the International Financing Institutions (IFIs). Particularly absent i s any monitoring o f municipal fiscal aggregates. 100. While monitoring fiscal performance is essential and should be rigorously advanced, more attention will also need to be paid to monitoring and analysis o f other dimensions o f budget management in BiH, such as budget policies and programs. For instance, very little i s being done, either during the year or after the budget is closed, to 6iH: CFAA- Public Sector Budcref Management, Monitoring and Evaluation, and oversight 27 examine how budget allocations are being spent, whether they are used for the purposes intended, and whether they are achieving the intendedresults. Expanding the monitoring function to include these performance dimensions o f budget management requires, in turn, a well-functioning evaluation system, which allows managers to (i) determine how their resources are being used and whether spendingon budget programs is contributing to the achievement o f the original plan objectives; and (ii) assess ongoing programs and policies and take corrective action as necessary.'' The evaluation o f budget programs and activities with regard to their outcomes should, in fact, feed into the next budget cycle deliberations, and also allow the introduction o f a system o f incentives linkedto spending units' performance. 101. These budget evaluation functions are not yet adequately developed in BiH, and form no significant part o f the process. Planning o f budget programs is mainly incremental, and the budget submission process does not require budget proposals, including domestic investment proposals, to be accompanied by cost-effectiveness or cost-benefit analysis. Evaluation tools, such as client surveys, for intemal use o f the executive or for extemal publication, are also largely absent at present. Effective and broad monitoring and evaluation o f this sort requires good quality fiscal data and regular and systematic reporting from authorized departments; as noted earlier, establishing computerized Treasuries would constitute a major step toward improving the completeness o f the information base as well as timeliness and relevance o f reporting on fiscal aggregates and implementation o fbudget programs, though as yet only at the Entity level. The CFAA recommends the initiation of design of basic output measurement in order to expand budget evaluation coverage to outcomes of key budget policies and programs, and integration of output measurement into the annual budget process. ParliamentaryOversight 102. Establishing an enabling environment for proper parliamentary budget oversight i s another priority inBiH. Parliamentary Public Accounts Committees (PAC) constitute a mechanism for administering the accountability o f the executive to the legislature. In BiH, this mechanism has not yet been broadly established or sufficiently empowered to function. Neither Entity has established a Public Accounts Committee. In the Republika Srpska, the oversight prerogative remains with the Foreign Trade and Economic Relations Committee o f the Parliament which, however, has not exercised it. At the State level, the Public Accounts Committee (PAC) i s required to provide the government with its opinion before the annual budget i s presented to the Assembly for discussion. However, the Committee i s not working due to lack o f proper structure, resources (staff, adequate office space, equipment), and a clear mandate. The non-existence or I Evaluationcantakeplaceex-ante, duringtheimplementationor ex-post, after thebudgethasbeenclosed.During the budget preparation process the Budget Department, central agencies and budget institutions evaluate their policies and programs, in order to determine their performance and whether they should continue in the next budget year, be expanded or suspended and replaced with more efficient programs. During the course o f implementation, evaluation enables that corrective actions are taken as needed for non-performing programs to restructure them and ensure better outcomes. Ex-post evaluations are often used to improve the design o f future programs and contribute to the strategic policy decisions. BiH: CFAA - Public Sector Budaet Manaaement, Monitorins and Evaluation, and oversiaht 28 ineffectiveness of the PACs perpetuates the vacuum of legislative scrutiny over the executive. The CFAA stresses the importance of creating strong budget oversight functions at all level of governments and of separating it from other legislative functions,while ensuringthat effective coordinationand collaborationis established betweenPACs and SupremeAudit Institutions. BiH: CFAA - Public Sector Financial Controls and Auditing 29 111.PUBLIC SECTOR: FINANCIAL CONTROLS AND AUDITING Weakness of Audit Functions 103. The financial accountability framework in BiH i s permeated by the weakness o f the control environment in which public finance management take place. Sound audit functions have started to develop, following on the greater emphasis placed on them by the World Bank, donors and other development partners under their programs in BiH. Independent, external audits o f government accounts begun in late 2000, with the setup o f the Supreme Audit Institutions (SAIs). 104. However, with the exception o f a few cantons that have developed the relevant legislation and started implementation, modem intemal audit functions are still lacking at all tiers o f BiH administrative structures. Institutional Basis 105. The war destroyed the pre-existing goveming structure, and the absence o f the external audit function inthe legacy o f a socialist system meant that BiH Supreme Audit Institutions had to be created ex-novo. At present, an inherited surrogate o f audit functions i s still exercised by the MOF Inspection Units in both Entities and by the Financial Police, particularly active in investigating financial frauds. However, existing Inspection Units within the Entities' MOFs are not equipped to cope with the need to ensure sufficient checks and balances in the system or to prevent abuses. With the development o f the Treasury, the part o f financial controls relating to accounting and reporting is becoming automated and could eventually be routinely performed off-site by a unitwithin the Treasury. 106. Currently each o f the Entity's MOFs has an Inspection Unit in charge o f control activities, mainly consisting o f documentary reviews and physical check o f assets and inventories, carried out through on-site inspections o f all budgetary institutions. However, these units have inadequate mandate, are insufficiently staffed, poorly equipped, and inadequately trained to carry out their duties efficiently and effectively. The orientation o fwork places emphasis on individual cases and not on the establishment o f a comprehensive internal control framework and effective intemal auditing, where management i s responsible for ensuring the operation o f appropriate controls for the ministqdagency. Nor i s there adequate coordination between internal audit and the newly established external audit functions carried out by the Supreme Audit Institutions. As a result, auditing and related inspection activities are fragmented and either overlap or fail to have adequate coverage. CulturalBasis 107. The lack o f capacity and proper orientation is compounded by the lack o f a "control consciousness'' within governments. In the absence o f such consciousness, controls can in fact easily be overridden by individuals, if a proper control environment and sufficient safeguard mechanisms are not inplace (e.g. adequate segregation o f duties, periodic inventory, independent reconciliation). Even when such mechanisms are in place, they may be overridden by collusion. A significant overall shift in attitude towards control must therefore take place before any internal control system will b e effective. Box 2. Public FinancialManagement inEastern Europe socialist-type governments External audit functions, documenting the financial accountability o f the executive to the legislature, were unknown in Eastern Europe socialist countries. Rather than a forum for negotiation among pluralistic points o f view brought together through a democratic electoral process, parliaments in such governments were rubber-stamping organs for deliberations taken within the political apparatus o f the ruling party. Likewise, the absence o f adequate checks and balances within the executive can be explained by a prevailing bureaucratic "control" mentality, aimed primarily at assessing the formalism o f administrative and economic functions, rather than their substance, and resulting infragmented, overlapping and unsystematic controls. The same approach affected the conduct o f accounting in centralized economies, where it was conceived as a statistical exercise, rather than a tool supporting management's decision-malung processes; nor did financial reporting serve the purpose o f providing information to thirdparties. Infact, insuch a context, the notion of accountabilityofpublic officials to stakeholders at large (the electorate, the taxpayers, employees, creditors, media, the public) did not exist, because it served no purpose. In the specific context of SFRY (and, subsequently, in BiH), the Payment Bureaux were, until their dismantlement, the key element o f the internal controls system for boththe public sector and the socially-owned sector, and were the institutions traditionally in charge o f the administration and quasi-audit functions o f budgetary transactions (or of any other transaction involving financial flows). Under this system, MOF internal control functions were limited to basic, documentary controls over accounting and reporting o f spending units, and custodial-type oversight. In other words, they were control activities falling somewhat between financial controls and internal audit, but these functions were not conducted systematically or as part of any overall managerial control within an organization, and rather focused on investigations relating to uncover abuses o f public officials in the use o f property and economic resources, rather than prevent and/or minimize their occurrence. ~~ 108. The establishment o f a sound control environment i s k e y to the improvement o f financial accountability in BiH. The first and most effective line of defense against corruption and misconduct, therefore, i s the establishment o f adequate management controls within the executive, such as budgetary controls and internal auditing, as w e l l as monitoring and evaluation systems. The Special Audits (basically, a Review Engagement) undertaken in b o t h the Federation and the RS and published in M a y 2001, provide ample evidence, through the examination of individual financial transactions leading to the identification o f systematic problems, of the current lack o f mechanisms that would protect public expenditure from corruption andincompetence. l2 results The of l2 February2001,theHighRepresentativeappointedaSpecialAuditortoconductanauditoftheFederationbudget. In A similar audit of the Republic of Srpska budget was conducted by an OSCE audit team in cooperationwith the RS Supreme Audit Institution. Although this is a limited scope review - not involving audit assurance - of the Entities' budgets and o f some cantonal budgets, it gives a good picture of the status of public finance management in BiH. According to thejoint OHWOSCE press release on occasionof the reports' publication, "The reportsclearly show that BiH: CFAA - Public Sector Financial Controls and Audifinq 31 the Special Audits confirm that, during the period o f transition from Payment Bureaux quasi-audit functions to a full-fhctioning Treasury system and the implementation o f intemal and extemal audit functions being currently implemented, the existing internal controls practices are inadequate to protect public assets against losses from fraud and negligence. FinancialControls 109. Until their closure in January 2001, the Payment Bureaux performed quasi- financial control and reporting functions on the budget transactions. The transitory Treasury arrangements that were put inplace after their closure (discussed inchapter IV) have provided only a very weak system o f controls concerning expenditure management. While this situation changed in January 2002 with the establishment o f computerized TGLs at the Federal Government level inthe Federation and central government level in RS, weak systems o f financial controls are still present inthe sub-Entitygovemments and for extra-budgetary funds (EBFs) in all governments. This i s particular risky for Federation finances, where cantons and municipalities account for over 45 percent o f general government spending. 110. Although financial controls do formally exist within the State and Entity MOFs, they are easy to circumvent, because decisions to release funds inline ministries are often communicated informally; decisions are carried out that violate statutes (for instance involving payments for which no delegated authorizations exist); there i s little or no follow-up to ensure that funds have been spent as intended; accounting records and supporting documentation are incomplete and do not allow for an appropriate audit trail; and existing procurement methods are inappropriate or not properly enforced. 111. Such basic internal control functions are embedded in the new Treasury system. The Treasuries, holding exclusive authority for transfer o f funds, will substantially improve budget execution control and cash management functions. In particular, the establishment o f the Treasury Single Account (TSA) will provide the necessary integrity o f the overall flow o f funds. Furthermore, the introduction o f ex-ante controls over the legality o f expenditure types and amounts (based on the budget appropriations approved by the parliament and recorded inthe Treasury General Ledger) will contribute to a more orderly and disciplined management o f public finances. Among others, these controls will make it possible to perform selective checks on spending units or budgetary items that show significant and unexpected deviations from norms or desired patterns, contributing to the overall budget management monitoring and evaluation and allowing to take corrective actions as necessary. 112. At the Entitylevel, the new computerized TGL system is expected to bringmore transparency and better management o f budget expenditures because it provides a full the current operation o f govemments in BiH is not only wasteful and a fundamental source of corruption but i s also a hindrance to BiH's economic development and to its prospects for European integration." BiH: CFAA- Public Secfor Financial Controls and Audifins 32 range o f automated and systematic controls, including (i)ex-ante controls on the legitimacy o f the expenditures; (ii) posting o f every transaction according to a newly adopted chart o f accounts; (iii) automatic generation o f periodic, comprehensive reports and information on budget execution; (iv) and systematic reconciliation with the banks o f the BIs' account balances. Inthe period ahead, the full-scale implementation o f the TGL systems and their expansion to the sub-Entitylevel within a Treasury framework that will avoid institutionalizing fragmentation in fiscal management (see Section lV of this report) will go a long ways towards improving overall financial controls and accountability inBiH. InternalAuditing 113. The CFAA recognizes that the main vehicle for the establishment of a strong control environment i s institutionalized internal controls and internal auditing within public sector institutions-a radical change in the BiH context. Independent internal auditing functions should verify compliance with legal and regulatory aspects, along with adequacy of organizational structures and operational functions. The Entity Organic BudgetLaws provide the Ministers of Financewith the required legal authority by giving them responsibility for the accounting and supervision of revenues and expenditures. The same applies to the cantonal Ministers of Finance in the Federation.The goal is to designthe implementation o f a strong control framework, in a way that would allow audit functions to graduate from investigations conducted at the single transaction level to a system audit approach. The Integrated Framework for Intemal Control published by the Committee o f Sponsoring Organizations (COSO) can provide guidance in this critical area. The CFAA recommends that modern internal audit functions be introduced within government institutions, in a way that pilots the evolution of the existing MOF Inspection Units towards an internal auditing department model. To this end, the control structure, systems and practices o f budget institutions will need to be constantly tested and monitored by govemments' internal audit functions, through independent checks and balances that would, in tum, produce reliable results for external auditors. 114. The establishment o f proper intemal audit functions should be seen as a medium- term process and can be achieved only through a gradual approach, starting the process with the MOF at the level o f the Entities and then gradually expanding to cantons, municipalities and other public institutions. This would imply the setup o f a small, centralized, independent (from the various departments and agencies, i.e. solely answerable to the Minister), and highlyprofessional intemal audit department within the MOFs, working across the various governmental institutions. Initially, this would be more cost-effective and efficient than the establishment o f internal auditing departments in the various ministries and agencies although, in the longer term, this should be the objective. 115. Under the World Bank Second Public Finance Structural Adjustment Credit (PFSAC II), an Intemal Audit Model has been developed and presented to the budget inspection staff through comprehensive training seminars held by the World Bank inboth Entities. The modelenvisages that Intemal Audit Units should initiallybe responsible for compliance audit to improve the control and management o f budgetary revenues and BiH: CFAA - Public Sector Financial Controls and Auditina 33 expenditures. A few cantons (including Sarajevo, Tuzla and Bihac) have already introduced internal audit functions with PFSAC I1 technical assistance and capacity building support. In particular, the Tuzla canton was the first to develop internal audit legislation, which was adopted by its parliament in2000. This legislation provides for an independent internal audit function within the canton, reporting to the Audit Committee of the Tuzla canton parliament. Ifimplemented properly, the legislation will significantly improve the transparency o f government financial operations inthe Tuzla canton. 116. Gradually, internal auditing could be broadened to include the operational efficiency o f non-financial systems and, eventually, the overall effectiveness with which the whole range o f services are delivered, particularly in key line ministries. To achieve this, the Entities' work on internal auditing must be brought up to speed inorder to match achievements in external auditing. The Tuzla legislation, and the regulations made under it, could form a model for use throughout other cantons inthe Federation, as well as for the development o f internal auditing of the Federation and Republika Srpska central governments. The CFAA recommends adoption of a legislative and organizational framework for a sound internal audit system both at the Entity and State level, buildingon the externalassistance providedto date. 117. Under such a reform, an MOF internal audit department would progressively take over: (i) compliance audits (verifying concrete adherence to rules and regulation); (ii) IT and information systems audits (testing system's functionalities and integrity); and (iii) organizational and procedural audits (assessing the robustness and adequacy o f managerial and operational processes). Attestation audits (certification o f financial statements) would be the exclusive prerogative o f external audits, carried out by the Supreme Audit Institutions. To move in that direction, the existing Inspections Units would need to be reorganized (with implications for MOF's organizational structure) and staff training and systems upgrades would also be required. Technical assistance will therefore be needed to build the necessary skills and develop the requiredmethodology. The CFAA recommends that a time-bound implementationtimetable for adopting this framework by developed at each Entity and canton MOF, working across the various governmentalinstitutions,and gradually expandingit to municipalitiesand other publicinstitutions. ExternalAudit 118. The external audit function was introduced in late 2000, with the operationalization o f the Supreme Audit Institutions (SAI). The most critical aspect in designing an external audit system in BiH was to determine a feasible organizational structure that would enable several layers o f largely autonomous governments to undertake sound audit functions within their jurisdictions, while at the same time ensuring consistency o f standards, methodology and quality across all levels o f government. To achieve this, S A I s have been established in each Entity and at the State level, with co-ordination arrangements under the State SAI, and a uniform legislative framework. The objective was to effectively address chronic weaknesses in financial transparency and accountability o f public administration in BiH. Although SAIs are still at their infancy, their operation to date has already verified how critical the external audit BiH: CFAA - Public Sector Financial Confrols and Audifins 34 function i s to the transparency and reliability o f public sector financial management systems, as well as to the credibility o f government financial statements inBiH. 119. The State Auditor General (AG) i s appointed by the Presidency, acting solely in accordance with the advice o f both Houses o f the Parliamentary Assembly o f BiH. There are two DeputyAuditors General, nominatedby following the same procedure, who must be appointed from different ethnic groups than that o f the AG. The AG and the Deputies may be dismissed only if the parliament passes a motion asking for their removal on the grounds o f misbehavior, or if the quality o f audit work fails to meet the standards determined by the law, as certified by the Independent Quality Review (IQR)- see Box 3 below. 120. By law, a Coordination Board of the Supreme Audit Institutions was created to function as the technical body o f all three SAIs. The Coordination Board consists o f a Committee and a Secretariat. The three AGs and their deputies are members o f the Coordination Committee, which is chaired by the Auditor General o f the State Audit Office. The main functions o f the Committee are to establish audit standards (to be consistently applied by the three SAIs); to ensure consistent audit quality; to assign responsibilities for joint audit activities; and to determine representation in international bodies. The members o f the Coordination Board meet according to a fixed schedule on at least a quarterly basis. InApril 2001, the Board adopted the International Organization o f SupremeAudit Institutions (INTOSAI) Code o fEthics for public sector auditors. 121. According to the law that established the SAIs, the audit standards issued by the INTOSAI are to be applied by the three SAIs with regards to the fundamental aspects o f the audit work (audit organization, documentation, reporting, and quality assurance). In addition, the SAIs are empowered to carry out ad hoc (special) audits at the request o f the corresponding parliament or at the legitimate request o f a governmental organization. The BM's SAIswere recognizedby andhave gained amembershipinthe INTOSAIin2001. 122. The legislative framework unambiguously assigns ex-post, external audit functions to the three SAIs. The mandate o f the SAIs i s very broad, encompassing the verification o f all public revenues and expenditures (i.e. their proper collection, legality and safeguard), the proper custody o f assets; and the annual audit o f accounts o f ministries, courts and government bodies, municipalities, public funds and other public institutions. The mandate also extends to enterprises, companies or organizations partially or wholly owned, controlled or funded by the budget or other funds controlled or guaranteed by the parliament and/or the municipalities; as well as organizations or activities receiving government fimds, loan or grants from the central government budgetsand/or municipalities. 123. The WB supported the establishment o f Supreme Audit Institutions (SAIs) inthe two Entities and the State as a key element o f the Public Finance Sector Adjustment Credit (PFSAC 11). Since their establishment, all three SAIs have invested substantial efforts incapacity building, with the assistance o f the Swedish International Development Agency (SIDA), which operated as institutional advisor to the SAIs during their start up phase. The SAIs simultaneously undertook an audit o f the public administration institutions, including a significant number o f sub-Entity governments. Duringthis initial BiH: CFAA- Public Sector Financial Controls and Auditing 35 phase, poor accounting and financial reporting in the public sector remained a major obstacle to the proper and timely audit o f government finances-several budget beneficiaries and institutions were unable to provide the SAIs with their financial reports. In order to ensure a smooth functioning of the SAIs prerogatives, the CFAA recognizes that one of the most urgent priorities for the State and the Entity governments is the strict enforcement of existing rules and regulations on public sector accounting and financial reporting, as well as ensuring SAIs' full access to auditable accounting records and other necessary financial information. 124. At present, the SAW work is necessarily focused primarily on compliance audits, though they aim to develop the necessary skills to perform financial, or certification, audits, as required by their mandates. To this effect, the activity with the highest value- added for the SAIs i s the preparation o f good management reports, an important building block for a new and stronger control environment. It is also an activity that requires further significant skill enhancement in all three SAIs, through continued external technical assistance. The CFAA recommends preparation of a needs assessment and mobilization of further external technical assistance to facilitate expansion of audit activities to cover all mandated areas. 125. Looking forward, beyond the continued need for capacity building in the SAIs, there are number o f issues which will need to be addressed by the State and the Entity governments in order to create strong enabling environment for the SAIs. First and foremost, there i s an immediate need to increase awareness, within public sector and broadly in BiH, about the role and mandate o f the SAIs. Similarly, the CFAA assigns high priority to the need to institutionalize working relations and collaboration both between SAIs and respective Parliamentary Public Accounts Committees (PAC)- as the latter i s established in time-and between SAIs and bodies in charge of governmental internal audit functions. The appreciation o f the linkage and complementarities o f sound government internal auditing functions and external audit activities is particularly important insustaining a smoothly functioning audit function that avoids duplication o f efforts. Inaddition, the CFAA recommends that consideration be given to the need for creating a legal basis for permanent legislative oversight over the SAIs, through the establishment of dedicated Parliamentary Audit Committees. At the same time, clear mechanisms and procedures should be established regulating the resolution of conflicts between auditors and auditees-currently the only requirementis that disagreement be simply recordedinthe audit report. 126. Inthe near term, there is also a need to reconsider several provisions ofthe audit legislation, which either diverged from the original uniform legal framework or were inadequately specified during the process o f final adoption o f the State and Entity Laws on Supreme Audit. These provisions concern appointment and removal provisions, control over work program (especially the obligation to carry out all requested ad hoc or `special' audits), and the specific mandate o f the Federation for cantonal and municipal audits (see box). Revisions to these provisions are necessary, not only for improving the strength o f SAIs at all levels, but also for restoring the uniformity in the legislative framework. 6iH: CFAA -Public Sector Financial Confrols and Auditin0 36 Provision CFAARecommendation Federation SAI ~~ Appointment. The AG and the Deputy Auditor It is advisable that govemment involvement in the General are appointed by the President of the appointment process be eliminated.Both the AG and Federation in accordance with the advice of the Deputy AG are appointed for a fixed, non- 1 govemment, with prior approval fromthe Parliament. renewableterm of five years. Removal. Both the AG and the Deputy AG may be This provision leaves wide discretionfor the dismissal -7I removed from office if both Houses pass a motion not considered adequate to ensure the AG's 1 of the AG on non-technicalgrounds and, therefore, is , asking for their removal should they "for any reason, be unableto performthe duties o f office" (Article 6). independence in the exercise of his mandate. Its I elimination is necessary to remove opportunity for ~ improperly influencingthe AG to be removed. Independent Quality Review. The AG and the Although this provision goes in the right direction (in Deputy AG may be also removed from office if the the attempt to establish means and clear procedures quality of the audit work fails to meet the standards allowing for the legislative oversight over the SAI), determined in the law, which must be certified by the the fact that the appointment of the IQR is an option, Independent Quality Reviewer (IQR) who may be andnot aprescribedparliamentaryfunction, leavesthe appointed under the modalities specified by the law matter open to arbitrary action (or inaction). The (Article 27). The IQR must be an intemationally independent quality review must be a mandated recognized organizationwith expertiseinassessingthe function. work of SAIs. Legislative Oversight. The current law directs the The latter is a provision, which compromises SA1to submit its reports on the audit of the financial legislative oversight. It should be eliminated to accounts of the Budget Users in the Federation to the establish an exclusivereportinglines to the legislature. President and Parliament and to the responsible All Audit Office reports should be discussed with the ministers. Ministries and their views should be recorded, but Parliament Cantonalandmunicipal audits are the responsibilityof The mandate of the SA1 over extemal audits o f RS SAI Appointment. The AG and the Deputy AG are It is advisable that govemment involvement in the appointedby the parliamenton the recommendationof appointment processbe eliminated. the govemment. Job Plan Approval. Currentlythe Job Plan Rules are Job Plan Rules approval needs to be changed to AG- also approvedby the govemment. approval only for preventing job plans from being I I IIIIIItCUuy puuIILS C I V I L C I1U1111S. Legislative Oversight. The SA1reports, and is solely The AG reports brought before the Parliament but accountable,to the Parliament. they simply recorded in the SAI-Bulletin. It will be ! ucLcsaaiy tu iiavc LIICIII ~~UIISIICU 111 LIICuiiiudi Gazette and made available for purchase from the SAL BiH: CFAA - Public Sector Financial Controis and Auditin0 37 ~ Removal and Independent Quality Review.The AG As in the Federation, the ambiguity in the dismissal 1 ceases his functions when he submits a written process needsto be eliminated. ~ the position; (iii) if the parliament passes a motion removing him from office on the basis of severe adverse criticism in the Independent Quality Work Program. The Law obliges the SA1to carry out This provision obstructs the SAIs work and therefore all requested special audits, notwithstanding the needs to be replaced by a provision allowing the SAIs , approved work program and priorities of the SAIs to assess and determinethe needfor special audits. during a year SAL State SAI Job Plan Approval. Currently the Job Plan Rules are As in the case of RS, there is need for providing for a ~ also approvedby the government joint determinationby the AG and the Deputies of the Rules of Service, which would not be limited by public service norms (currently agreed between the -Legislative .. ,. uversignr. in terms . . , 1-AG.and the Council of Ministers o f BiH). .. . T . .. 01 reporting lines, me 1 . .. I . . .. .. . 1 . 1 AG is requiredto "submit the report to the Presidency who shall cause it to be laid before Parliament" (Art. administrationbody andneeds to be removed 14). The AG is therefore accountable to both the presidency and the parliament; however, the AG may be required not to disclose information in a public report, in cases where the Chief Legal Office has issued an act statingthe sensitivity of the information to be disclosed(Article 28). Work Program. The Law oblige the SA1to carry out all requested special audits, notwithstanding the approved work program and priorities o f the SAIs during ayear SAI. 128. An equally important step towards strengthening the SAIs inthe near term, which i s strongly recommended by the CFAA, is anchoring the institutional mandate o f SAIs to the State and Entity Constitutions, as originally planned. This is a standard norm in countries with established traditions o f public sector external audit. The CFAA also strongly recommends that SA1 activities be given adequate financing that i s tied to the annual work plan. So far, despite the strength o f the legislative provisions to ensure adequate and regular financing for the SAIs, in practice, financing arrangements have required difficult negotiations and the allocated budget has fallen short o f meeting additional staff and capital expenditure needs (for premises and IT hardware) to adequately equip the SAIs' regional offices. Ensuringadequate funding and mobilization o f the necessary external technical assistance for the SAIs should be seen as a priority of the State and the Entity authorities if the SAIs are to rapidly assume the full range o f activities assigned to them, all o f which are critical for effectively strengthening public financial accountability. 6iH:CFAA - Pavmenf Svsfem, Treasuw and FinancialSector 38 IV.PAYMENT SYSTEM, TREASURY AND FINANCIAL SECTOR The PaymentSystem 129. The Payment Bureaux (PB), created in the SFRY during the 1950s to manage socially-owned resources through full control o f the financial sector, had a monopoly over providing payment services. However, their activities went well beyond providing payments for both private and public sector transactions. The PB basically managed all financial transfers (also collecting and distributingtaxes and custom revenues), provided Treasury and accounting services to both the public and the private sector, and were the primary source o f statistical data for the country. Their monopoly over execution o f payment transactions provided the backbone for their power and control over the numerous functions they performed. 130. As an institution, the PB made a valuable contribution in a centrally planned economic environment. Their monopoly over all payment transactions, however, precluded banks from providing transactions services for their customers and hence inhibitedbanks from developing customer relationships. This, in tum, preventedbanks from offering banking services that are considered normal in a free market environment. As a consequence, the financial services sector was severely constrained and the financial intermediationprocess was retarded. 131. Policies and procedures o f the PB also created negative incentives for the development and day-to-day activities o f business in general. At the same time, given their prerogatives, in the specific BiH context the PB were crucial for political control over most large enterprises and were used as a source o f cash by the dominant nationalist parties. The Payment Bureaux' ultimate control over the allocation and distribution o f productive and financial resources represented a major obstacle to the development o f sound financial intermediation in the context o f a market economy, and one o f the main deterrents to potential foreign investors. Their non-transparent practices (including lack of external audits) were, in fact, largely perceived as the primary channel for diversion of funds within the system. Box 4. Evolution of Payment Bureax in other former SFRY countries The national states emerging from the breakup o f the SFRY have adopted different approaches in dealing with the transformation and elimination o f the Payment Bureaux. Slovenia decided to separate the PB into a number o f more or less independent bodies that perform specific tasks. The ZAP is still in operation in Croatia, although with different responsibilities. In Serbia and Montenegro, PB functions have been absorbed, respectively, by the National Bank of Yugoslavia and the Central Bank o f Montenegro. In Macedonia, the MOF also dismantled the PB, in the transition to a Treasury-Public Revenue Office. Payment Bureaux Legacy 132. Originally a single system run from Belgrade under the SFRY, the former Office o f Social Bookkeeping (Sluzba Drustvenog Knjigovodstva, or SDK), was split into three parallel Payment Bureaux that were functioning in BiHmore or less independently from BiH: CFAA - Pavment Svstem, Treasurv and Financial Sector 39 each other: the Bosniac ZPP, the Croat ZAP and the Serb SPP. This ethnic division, the lack o f transparency inPB operations, and their perceived links with nationalist political parties (and party funding) were the main reasons why the international community felt the PB had to be eliminated. 133. In addition to being a lucrative source of revenue through fees, PB also had at their disposal abroadrange of regulatorytools for controlling private business, including the allocation o f premises, licensing and inspection regimes, import/export licenses and tax assessment. The application of these tools created barriers to market entry and ensured that political connections were required for commercial success.l3 New Payment System 134. Preparations for the introduction o f the new payment system began following the 1998 Madrid conference o f the Peace Implementation Council (PIC), which called for the elimination o f the Payment Bureaux (PB). In December 1998, the PIC called for the transfer o f the functions o f the PB to more relevant institutions and their elimination by December 31, 2000. At the beginning o f 1999, the International Advisory Group on Payment Bureaux Transformation (IAGPB) was established, chaired by U SAID. Other members o f IAGare the WB, IMF, EU, CAFAO, OHR and U S Treasury. 135. An independentfinancial verification o fPayment Bureaux was conductedin2000 under IAGPB's auspices by three local audit firms, with the support o f advisors from the Financial Sector Regulatory Practice o f Barents Group. The objectives o f the verification were: (i) to confirm whether the significant assets and liabilities shown on the books of the PB existed; and (ii) determine, to the extent possible, the legal ownership o f assets to and liabilities. The key findings of the report were that while the majority o f assets and liabilities o f the PB were accounted for, overall the PB operated in a non-transparent manner, maintaining a complex accounting system that allowed them to conceal or obscure underlyingtransactions, particularly inthe clearing o f accounts. 136. The new payment system inBiHbeganto function on January 5, 2001, preceded by a testing period with a small number o fbanks. Onthe same date, payment transactions through the Payment Bureaux stopped. The Central Bank o f BiH took over the clearing l3 A February 1999 USAID study found that the "non-transparency and credit-creation capabilities of the Payment Bureaux give those controlling these institutions a tremendous amount of potential power." (Payments Bureaux in Bosnia and Herzegovina: Obstacles to Development and a Strategy for Orderly Transformations," Sarajevo, February 15, 1999). A 1999 International Crisis Group (ICG) Balkans Report powerfully depicted the Payment Bureaux' abnormalities. "These organizations are inefficient, charge high fees, engage in corrupt practices, lack transparency, and increase dramatically the cost o f doing business. They promote the fundamental subversion o f private property rights. They hold huge money surpluses which can and have been diverted to the use o f political parties (who are better organized than government to take advantage of them). They drive much o f the economy underground and drain working capital from business and the commercial banking sector.. In essence, the Payment Bureaux act as brake on . the BiH economy. Under the current system, banks are not allowed to conduct payment transactions. Neither are they able to mediate consumer cash deposits. Only the Payment Bureaux may do this. At the end o f each day, all businesses and banks are required to deposit their day's receipts at the PB. This robs banks o f their primary source of cash deposits, reducingthe amount of working capital available to the economy. It also dramatically lowers banking income, causing many banks to hover on the brink o f insolvency." (Why Will No One Invest in Bosnia and Herzegovina?) ICG No. 64,21 April 1999) BiH: CFAA - Pavment Svstem, Treasurv and Financial Sector 40 and settlement functions. In the Federation, the Treasury function i s to be performed by the MOF and taxes collected by the Tax Administration; responsibility for the two main statistic surveys has been transferred to the Federal Office o f Statistics. Similar procedures have beenadopted inthe RS. Box 5. Teethingproblemsexperiencedwith the introductionof the new payment system The introduction o f the new payment system has not gone without some teething problems, primarily because o f the profound transformations involved, including cultural ones, and because of BiH's weak and underdeveloped banking sector and generally dysfunctional economic environment. Coordination o f the various operations that were once the monopoly o f a single institution took some time. Most o f the commercial banks that obtained licenses to conduct internalpayment transactions had no experience inthis field and this caused significant delays in payment operations as well as in the inflow o f public revenues. Problems created by the lack o f experience were compounded by the banks' chronic liquidity problems, implying that funds received were not processed immediately. Furthermore, in terms o f capacity, not all banks could handle the increase in payment orders that needed to be processed, causing further delays in transfers. Banks adjusted relatively quickly to the new situation and are now able to handle the payment transactions fairly rapidly and efficiently. Another initial problem was the suitability o f the information systems. The information flow from commercial banks to public institutions receiving funds was insufficient. For instance, a bank would at the end o f each business day be able to inform the Tax Administration o f how much revenue was collected, but could not specify the type o f tax or the taxpayer's name. It also seemed not to be exactly clear to all parties how the information i s supposed to be communicated to different public organizations (for instance, whether the Tax Administration or the banks are responsible to provide information to the Insurance Funds).As a result, Entitybodies incharge o f collection (such as Tax and Customs Administrations) were experiencing difficulties in re- establishing dual-check capabilities (their own data reconciled with bank statements). Other initial problems stemmed from taxpayer non-compliance. Payment orders were incorrectly filled in.The PBs used to perform calculations on taxes and social contributions and redirect them to the appropriate accounts. In the new system, employers have more responsibility for these payments but regularly failed to fill inthe payment orders correctly. This was partly due to a lack o f awareness. Also, some o f the recipients o f the revenues (Health or Pension Insurance Funds, municipalities, cantons, etc.) neglected to open a depositary bank account in time. As a consequence, large amounts o f money were floating around in the banking system without it being clear to which account they neededto be directed. To solve this problem, changes were made inpayment orders and a public awareness campaign was developed, resulting in better compliance and a smooth operation o f the new system. Transformation of the Payment Bureaux 137. While initial teething problems had mostly cleared up by June 2001 (see box 5), the elimination o f the last remnants o f the Payment Bureaux remains a continuing issue. Although the functions traditionally performed by the PB have been transferred to BiH; CFAA - Pavment Svsfem. Treasury and Financial Secfor 41 State/Entity Treasuries, the clearing-house within the CBBH, the Tax and Customs Administrations, and the Statistical Agencies, the PB themselves have not yet disappeared. Partly due to a reluctance to dismiss the PB staff (who are among the best paid and supposedly best-trained public employees), the ZAP, ZPP and SPP have established so-called Mutual Service Bureaux (MSB) from the remains o f the PB. It i s planned that these MSBs will perform activities for commercial banks on a contractual basis and that they will be privatized; however, it i s doubtful whether the managerial skills are available to turn these MSBs into viable organizations. Therefore, the CFAA recommends that MSB operations be discontinued and that the focus be on the establishmentof a full-fledgedTreasury system. Transitionto a Treasury System 138. The shutdown o f the Payment Bureaux, along with the need to ensure greater transparency and accountability in public financial management, constituted the foundation for the establishment o f a full-fledged Treasury system in BiH. The beginnings o f preparatory work for the establishment o f the Treasury systems in BiH dates back to 1999, when the IMF and the WB started working with the Entities to develop a conceptual design for such system and to outline the steps for its implementation. Payment Bureaux Role in Budget Execution 139. Until their closure in January 2001, the Payments Bureaux (PB) and MOFs carried out limitedbudget execution functions, in both Entities and the State. After the budget was approved by Parliament, the MOF's Budget Department prepared monthly allocation plans for budget institutions, which were sent to the PB for execution. The PB authorized payments against this limit, simply performing a banking service for the budget against a fairly highfee. A transaction slip was sent to the Budget Institutions (BI) and the M O F for every transaction that occurred. The PBs also sent banking statements to the MOF and BIs regularly, as they did for any other client using their services. 140. The process involved some rudimentary financial planning and cash management that were carried out by the BIs and the MOFs. Nevertheless, although the MOF prepared monthly allocation plans, spending authorizations were, in practice, given for much shorter periods, such as a week, based on the revenues that were coming into the governments' accounts. This practice occurred mainly because of cash limitations and the need to limit expenditure arrears, which were rather common feature o f the budget execution. 141. All in all, the system was inadequate for supporting sound budget execution. While the MOFs monitored total allocations from the budget, they did not monitor actual spending, since there was no single account that consolidated govemment resources, although the information could have been found inthe PB accounts. Prioritization and the predictability of funds for carrying out budget activities were weak due to frequent changes in allocation plans from week to week and month to month throughout the year. As a result, the budget ended up authorizing mostly non-discretionary payments such as wages and especially veteran benefits. Moreover, the lack o f sufficient information and 6iH: CFAA - Pavment Svstem, Treasury and Financial Sector 42 delays inthe reporting o fbudget accounts made it impossible to discover any inefficiency or abuse and take preventive action. Transitory Arrangementsfor the Treasury System 142. The closure o f the PBs required the establishment o f several systems to replace the functions that PBs used to perform, including transitory arrangements for budget execution functions at all government levels, which were in place for all governments through 2001. While these arrangements have since been superceded by the newly established computerized TGLs at the Entity levels, the transitional arrangements will continue to operate at the State and sub-Entity levels. These arrangements focus almost entirely on the revenue side o f the budget with little attention to expenditures. Under these systems, banking arrangements for budget execution were taken over by the commercial banks. Two main accounts were established, a Depository Account (DA), where collected revenues are consolidated, and a Transaction Account (TA), from whence budget allocations are paid out, were established inselected banks inthe name o f the MOFs at each government. The budget institutions (Bis) were, on the other hand, instructed to open individual accounts anywhere in the commercial banking system, which posed serious risks for the effective and transparent use o f budgetary resources. Monthly budget allocations are transferred from the MOFs Treasury Account to the BIs accounts, which i s the last point ina transaction that can be traced by the MOF. From this point on, any spending authorized from BIs cannot be traced by the MOF, unless it is recorded and reported from the BIitself. 143. The interim, transitory arrangements aimed to secure the non-interruption of revenue collection and payment transactions. However, there is limited audit trail to trace back movements o f funds from depository banks, Treasury accounts and budgetary accounts. The lack o f clear organizational arrangements i s compounded by serious capacity issues. Treasury departments lack financial planning capability to improve cash management and financial planning, required to ensure smooth budget execution and tracking o f arrears. There i s generalized lack o f understanding and appreciation o f the role o f the Treasury: its role is still confined to payment administration, and cash management functions are not yet inplace. 144. State and sub-Entity governments, lacking automated TGLs, are still exposed to the risk o f concealment o f records or omission o f transactions from accounts. The CFAA recommendsthat the State Treasury and sub-EntityMOFs concentratetheir effortson establishinga proper controlenvironment over disbursements,introducing standardized ex-ante and ex-post internal controls to ensure that the transitory system incorporates adequate checks and balances. An immediate measure recommendedby the CFAA is to eliminate the use of individual budget institutions accounts (i.e. imprest accounts) and to ensure the establishment of adequate cash management functions and the use of Treasury Single Account. The CFAA further recommends that the State and sub-Entity Treasury systems be designed with a view to ensure uniformity in standards for accounting and reportingand to facilitate consolidated fiscal managementand monitoring. Steps Remainingto EstablishTreasury Systems 145. Substantial progress has been made in establishing both the legal and institutional frameworks for the development o f Treasury systems at the State and the Entity levels. The RS has adopted a sound Treasury Law. A Treasury Law was also adopted for the State. The Federation also undertook a significant revision o f its regulation. BothEntities have established a Treasury Department in their MOFs within the last two years. The State has created the Ministry o f Treasury, which includes all budget and debt management functions. This i s regarded as an important measure to strengthen the financial basis o f the State institutions. 146. These developments have paved the way for the operationalization of a computerized Treasury General Ledger (TGL) system in each Entity in January 2002 in the two Entities (Federation and RS), with the State soon to follow. These TGL systems record all budget transactions and generate financial reports. They are able to monitor budget institutions' spending limits and conformity with budget allocations, and record transactions automatically according to a new and improved chart o f accounts. If implemented properly, they will significantly increase transparency and accountability in the execution o f the budget. They will also provide timely and accurate information to be used inthe budget planning and decision-making processes. 147. However, no formal decision has been taken regarding: (i) the final design o f the system in either Entity, including extension o f the Treasury system to sub-Entity level; (ii)the treatment of extra-budgetary funds under the Treasury system; or (iii)the introduction o f the most critical feature underlying the Treasury system, the Treasury Single Account (TSA). Treasury SystemDesign 148. The design o f a broader Treasury systemneeds to take into account the Entities' unique governing structures, while helping to develop integrated fiscal monitoring systems and unified standards for accounting and reporting. In this endeavor, while design o f the broader Treasury system in the RS can follow a more classical model o f a unitary entity with a relatively centralized budget, the design o f the system in the Federationrequires special attention to its 10 fiscally autonomous cantons. 149. Options in addressing these special design challenges are being discussed by the authorities and donors. Two options are worth noting, which are also emphasized in the joint IMF and the World Bank Treasury study.I4One envisages the creation o f a unified service for payment and accounting o f government transactions (PAO), with offices in each canton, and independent management o f the Treasury Accounts at each level o f government. Under this system, each canton has full authority for its budget preparation and execution. Cantonal treasuries remain responsible for allocating resources, authorizing spending and managing their TGL, while payment processing and day-to-day l4For details, see A strategy for the Development of Entity Treasury Systems, Joint World Bank-IMF Report, November 2000. BiH: CFAA - Pavment Svstem, Treasurv and FinancialSector 44 posting o f the transactions into the TGL i s done by the PAOs. The alternative to this system i s the establishment o f 11 independent Treasuries-ne each in the Federation and the cantons. While the experience with the newly established TGL systems will contribute information for the final design decision, the final system design ought to be able to offer the following benefits o f a P A 0 network: a Enhancing much needed inter-government cooperation inthe Federation, thereby fostering symmetric professional excellence in Treasury management in all regions; a Ensuring that standardized government financial regulations and Treasury procedures conforming to international norms o f efficiency, transparence and accountability are applied at all levels o f government; a Enabling the use o f commonly shared computing and data communication resources; a Enabling the use o f uniform accounting and reporting format across the Federation; a Eliminating the use o f imprest account^'^ and ensuring adequate cash management through the use o f TSAs; a Allowing for the use o fprofessionally qualified and specially trained staff inTGL accounting, I T and other required disciplines; a Ensuring economies o f scale and elimination o f redundancies and duplications in daily transaction management routines. 150. The newly established computerized treasuries continue to rely on individual budget institutions (BI) accounts-so called imprest accounts-placed inthe commercial banks, for part o ftheir cash transactions. Inorder to limit the problems that use o f imprest accounts creates, both Entities have made considerable progress in limiting cash transactions prior to the launch o f the new system-they both reported less than 15 percent o f cash transactions in early 2002. In the Federation, the MOF has prepared a new computerized payroll system under which all employees will be paid through bank accounts. The payroll system i s treated as an accounting subsystem using a transit account specifically for wages, which also ensures that the commitment and payment phases are correctly accounted inthe computerized TGL. 151. The remaining cash transactions would, however, all need to be placed under Treasury control. InRS this will be achieved through the branch Treasury offices. Inthe Federation however, the Treasury will only be present in Sarajevo and Mostar, and an interim solution o f a limited number o f imprest accounts (where replenishment i s strictly connected to justification) may be needed for a small number o f local units o f Federal government operating in other cantons. At the State level, the only institutions that are l5Imprest Accounts are accounts outside the TSA system that work as a non-zero deposit account. They are constantly replenished through budget allocations in order to allow access to cash resources to remote budget users located far from the Treasury office. BiH: CFAA - Pavment Svstem, Treasw and Financial Sector 45 located outside Sarajevo and might require a similar arrangement are the institutions of State Border Services. The need for individual BI accounts will be eliminated if the PAOs are to be added into the system inthe period ahead. Establishing the Treasury Single Account 152. The ability to record and report the cash position o f the governments as a whole at each phase o f the budget execution process, and at any point intime, require establishing Treasury Single Accounts. Intheir cash-short environment, the BiH governments should ensure that they efficiently use all idle cash balances and improve the management o f arrears. Therefore, establishment of TSAs (to be held at the Central Bank o f BiH) i s critical for fully realizing the benefits o f the computerized TGLs. Efforts are currently under way inboth Entities and the State to establish a TSA system that operates through Treasury Transit Accounts (TTA) heldincommercial banks. 153. As a result o f the slow pace of implementation o f the TSA, the only transactions that the Federation and RS governments currently control are those relating to the collection o f revenues at the central government level, and the authorization of expenditures from the Treasury-MOF main accounts to the budget institutions. Municipal government budget execution in both Entities is outside the control o f the central (cantonal for the Federation) governments and the reporting lines are unclear and very weak. As a result, there are no ex-post controls that the funds have been utilized by the spending units as authorized, no cash management functions to reduce the occurrence o f arrears, and no proper audit trail over movement o f funds at either central or local government level. The only evidence on how the money is being spent seems to be with the budget institutions themselves, which are required to send quarterly reports to the newly established Treasury offices (although these are not even reconciled with the bank statements). 154. The CFAA would encourageBiH governments, at all levels, to demonstrate stronger commitmentin pushingaheadthe full implementationof the new Treasury system by way of removing the remaining obstacles faced in establishingthe Single Treasury Account. The way in which the functioning o f the TSA would resolve these problems i s clearly demonstrated in the conceptual design o f the new public sector Financial Management Information System (FMIS), financed by USAID for the new Treasury system. The system envisaged i s based on a centralized Treasury system, with several branch Treasury offices operating sub-accounts o f the Treasury Single Account (TSA). All government accounts would be consolidatedinto a unified account. 155. The establishment o f the TSA would require the closing o f the accounts o f the budget institutions inthe commercial banks. The TSA would be maintainedinthe Central Bank and the accounts in the depository banks would operate like a transit account (all sub-accounts being part o f the same tree). A Transit Treasury Account (TTA) would be operated by each branch for daily receipt and payment operations. TTAs would operate as sub-accounts o f the STA, so that at any time funds can be withdrawn from them or deposited to them from the main STA account. Direct receipts could also come directly to the STAYfrom which payments could also be made for centralized payment hnctions, BiH: CFAA - Payment Svstem, Treasurvand financial Secfor 46 such as debt service. The TTAs in commercial banks would operate as zero balance accounts, since all balances would be swept at the end o fthe day to the TSA. 156. Inthe management of revenue operations, the local or branches of the Treasury would operate their TTA and perform reconciliation o f inflows with the local offices o f the Tax Administration. Commercial banks would, of course, continue to play a role in the tax receipt handling by the Treasury. Authorized banks would receive tax payments from taxpayers and remit the amounts collected at the end of the day, together with payment orders and all supporting documents, to the concerned Tax Administration office. The sharing o f revenues between the Entities and the municipalities could be handled either at the main Treasury department or at the Treasury local branch, as considered administratively appropriate. With respect to the management o f expenditure operations, the Treasury local branch i s envisaged as receiving payment claims/instructions from the relevant budget institutions and processing them on their behalf through payment orders on its TTA. Treatment of Extra-budgetary Funds under the Treasury System 157. The legal framework inboth Entities envisages that extra-budgetary funds (EBFs) will be included in the Treasury system. As previously noted, the EBFs have their own management systems, budget and accounting rules and undertake a large volume o f small-scale payments throughout each Entity. Inthe case o f the Health Fund, they also operate many subordinate medical facilities. Their inclusion in the Treasury system will necessarily involve a large increase inthe volume o f Treasury work. 158. The CFAA recommends that a phased approach to the inclusion of extra- budgetaryfunds in the Treasury be adopted.While eventual coverage of the EBFs in the Treasury system i s desirable, a phased approach to this end will smooth out the increase in the coverage o f the Treasury systems. It should be possible initially for the Treasury to handle the EBFs Treasury Single Accounts. The commingling o f such EBF and general budgetary resources, however, should be avoided, since inno way should the general budgets be automatically requiredto fund any EBF deficits. It may be possible to come to some agreement on short-term liquidity arrangements between the EBF-TSAs in the interests o f an efficient cash management, but the terms and conditions o f all such arrangements should be explicitly stated. As to the processing EBF transactions, it i s recommended that they remain outside the Treasury system at present and only when the Treasury system has demonstrated capacity to handle this workload, should there be any attempt to execute these operations through the Treasury system. 159. This stepwise approach implies that EBFs, though they are institutions o f general government, will remain excluded from immediate coverage in the Treasury system. Therefore, an adequate reporting system will need to be developed from the EBFs to the Entity treasuries, which will allow monitoring o f their activities and consolidation o f the general government accounts inboth Entities. Achieving the latter objective requires that a similar reporting system be also developed for the municipal governments, which will also remain outside the coverage o f the Entity treasuries, even when a cantonal Treasury systemhas beenput inplace. The CFAA recommendsthe introductionof a reporting system for EBFs and sub-Entity governments that will allow for full-fledged monitoring of their activities and consolidation of their accounts with the rest of generalgovernmentaccounts inbothEntities. FinancialSector 160. The elimination o f the Payment Bureaux is an important step in the direction o f establishing a modem, market-oriented private banking sector. Development o f the banking sector was, infact, precluded by the existence o f the PB that, having a monopoly on domestic payment transfers among legal and physical persons, had relegatedbanks to a minor role in the country's financial system. The development o f a robust banking system was also hindered by the prohibition o f bank fees on intermediation services. Furthermore, because o f entrenched cross-ownership arrangements, banks were acting as the financing arms o f the industrial conglomerates, extending soft loans and guarantees to non-creditworthy enterprises,I6 which resultedinnon-performing loans and huge losses. 161. As a result, BiH's banking system is weak and presents serious problems. Domestic private banks are illiquid, undercapitalized, exposed to non-performing loans, and poorly managed. Slow progress has been made in the privatization o f state-owned banks, which remain a drag on the vitality o f the banking system. The amended Banking Laws in both Entities now allow commercial banks to operate throughout the country, and this will require continued harmonization o f regulations between the two Entities and levelingoperational conditions. 162. There i s still an excessive number o f commercial banks in BiH, especially in the Federation, given the existing economic potential and the modest credit potential, which inturnare the result of a very low capital base due to significant economic and financial risks. In fact, state-owned banks cannot resolve their status or the problems they inherited fi-om the previous system (bad debts and low operational efficiency) without going through the privatization process. However, even banks that have no dubious issues from the pre-war period (meaning banks that started their operations during or after the war and which are mostly privately owned) are faced with numerous problems (poor assets quality, insolvency). These problems resulted fi-om insider relationships and related party transactions-extension o f loans, guarantees, letters o f credit or other commitments to individuals or companies related to the bank through ownership or direct and indirect control - pervasive across the whole system, involving both private and state-owned banks. 163, This network o f relations-based transactions created a situation o f unclear governance, compounded by poor management, where majority shareholders, but also members o f Management Boards and senior management o f banks, and their related entities (companies owned by them or with significant interests) were at the same time majority debtors to the bank. Bad loans or collaterals for loan repayment created problems and delays in collection or nonpayment in general, resulting in significant loan l6For example, a publicly owned bank inthe Federationhad extendedto apublicly owned utility company, guarantees that were greater than its equity capital (also its total off-balance sheet exposure amounted to four times its capital). Also, apublicly owned bank in the RShad an exposureto the publicly ownedrefinery company equal to about twice its equity capital, andto anotherpublic-ownedenergy company roughly equals to its capitalbase. BiH: CFAA - Pavment Svstem, Treasurvand Financial Sector 48 losses and problems in provisioning for their coverage and, in some cases, the effective bankruptcy o f banks. 164. Notwithstanding the excessive number o f credit institutions, the Federation banking sector has recently registered substantial improvements and can be, in general, regarded as sounder than that o f the Republika Srpska where, in the absence o f appropriate regulatory actions, the situation may even worsen. One recent development i s the polarization o f the BiH banking market (particularly in the Federation, which has recently attracted several foreign banks), with international players fighting for market share and growing by buildingup their branch networks and acquiring other banks. Also, although all banks continue to consider themselves as "universal banks" offering a full range o f services, they are in fact competing in a market which is still immature, in the sense that most customers are only interested instandard products such as loans, deposits, international trade transactions and, recently, payment services. As the international banks come into this market, differentiation will inevitably follow, with some banks specializing inmortgage or savings functions, for example. 165. Once the processes o f polarization and differentiation runtheir course inBiH, the likely result will be (i)a limited number o f subsidiaries (or branches) o f large international banks acting as investment bankers; (ii)a few large local banks; (iii) a number o f smaller banks, serving local markets or the needs o f specific market segments. At present, this process is more advanced in the Federation, where the entry o f foreign strategic investors has already taken place. In that respect, bank privatization in the RS, started only in 1999, has not been successful so far. The circumstance that some foreign banks plan to open branches in Banja Luka can be interpreted as a strategy that treats both Entities as a single economic market. 166. A Deposit Insurance Agency (DIA) is inplace inthe Federation, but none has yet been established in the RS. To date, only few banks in the Federation have been accredited to participate to the insurance scheme, and coverage i s limited (KM5,000 per customer per bank). Availability o f deposit insurance i s in the interest o f the general public, protecting the interests o f account holders, and it i s regarded as an important step contributing to the return o f confidence in the banking system. The issue, i s however, whether two Insurance Agencies can be viable inthis market. Central Bank of Bosnia and Herzegovina 167. The Central Bank o f Bosnia and Herzegovina (CBBH), with headquarters in Sarajevo and offices in Banja Luka and Mostar, is headed by an international governor, appointed for a six-year period. The Governing Board consists o f the governor and three other members. After the expiration o f the present Steering Committee's mandate in November 2003, the CBBH will be run by a Steering Committee appointed by the BiH Presidency for a six-year period, which will choose a governor from its members. The success o f the CBBH i s the result o f its low political profile and its ability to approach its mandate in a technical fashion. It is a highly regarded and trusted institution, both within BiH and abroad. The CBBH functions involve a modem payment and clearing system, with apositiveimpact on the economic and commercial system. BiH: CFAA - Pavment Svstem, Treasurvand Financial Secfor 49 168. The CBBH has a restricted mandate for the first six years o f its existence: it operates as a central bank under a currency board arrangement, requiring that the aggregate amount o f its monetary liabilities shall at no time exceed the equivalent o f its net foreign exchange reserves. The official national currency o f BiH i s the Convertible Marka (KM).The official exchange rate to German Mark (DEM) hadbeen definedby the Law on the Central Bank o f Bosnia and Herzegovina as 1KM : 1DEM. Opportune legal amendments to tie the KM to the Euro from January 1, 2002 have been introduced. The CBBH i s legally required to purchase and sell without restrictions, KM on demand for Euros within the territory o f BiH for the defined exchange rate. As a result o f these arrangements, the KMis the most stable currency inSouth Eastern Europe. 169. The CBBH, under the assistance provided by the European Union Banking Advisory Services (EUBAS) i s focusing on the further strengthening o f its operational ~apacity.'~ The CBBH prepares its financial statements in accordance with the Law on the Central Bank o f Bosnia and Herzegovina and the Law on Intemal Payments Operation. CBBH annual financial statements are auditedby international firms. "The EUBAS is an EC-funded project aimedat creating greater confidence inthe banking systemby supporting the development o f modern banking practices such as credit risk analysis, payments, foreign exchange and trade banking; and strengthening the key banking institutions, including the Central Bank, Bank Training Institute and the banks themselves. Box 6. Bankingagencies The Federation Banking Agency (FBA) was established in 1998 in accordance with the Law on the Federation o f BiH Banking Agency. The main tasks o f the FBA are the issuance o f licenses authorizing bank establishment and class o f activities, and the monitoring o f banks' performance. FBA performs bank supervision off-site (through periodic reports, data and other types of information on banks) as well as on-site examinations. The banking system i s regulated by a number o f laws and decisions (including: Decision on Minimum Standards for Intemal and External Audit in Banks; and Decision on Minimum Standards on the Extent, Format and Contents o f Program and Statements on Economy-Financial Audit o f Banks). The FBA prescribes the format and timeline o f banks' reporting for prudential supervision purposes as well as for general purpose financial reporting (balance sheet, income statement and cash flow statement). Examination o f banks through reports i s performed on the basis o f (i) monthly and quarterly balance sheets, including additional information on cash flows, loans, deposits and off-balance sheet items; (ii) quarterly information o f solvency o f banks, on capital and capital adequacy, assets classification, concentration o f risks, liquidity position, exposure to foreign exchange risk, which i s based on prescribed FBA reports; (iii)quarterly information on results o f banks' operations (income statement and cash flows statement); and annual audited financial statements. The RS Banking. Agency (RSBA) was established under the Law on Banlung Agency o f the Republika Srpska at the end o f 1998 with the basic goal o f improving and supporting a sound and stable banking system. The RSBA supervises the banking system as a whole, reviewing commercial banks' liquidity and solvency on both an individual and consolidated basis. The objective i s to detect-and ifpossible, prevent-exposure to credit and financial risks, as well as to provide for banks' compliance with legal and regulatory provisions. Inthis respect, the agency has been working, since its establishment, on preparation and issuance o f an overall legal and regulatory framework to support the RS banking system restructuring. The most important element o f such framework i s the Law on Banks (July 15, 1999), accompanied by a number of Decisions (regulatory acts) issued by the Managing Board inMarch and December 1999, defining in greater detail, the provisions framed by the law. Also, the Agency has issued a number of instructions for the application o f the Decisions. Banking Supewision: the BankingAgencies 170. Under BiH's present currency board arrangement, monetary policy is o f limited relevance and banking supervision i s the prerogative o f the two banking agencies in the two Entities (one each for the Federation and Republika Srpska - see box 6). Officials o f the two agencies, the Central Bank, and the Federation Deposit Insurance Agency meet monthly, the primary focus being on the harmonization o f banking supervision. By reason of the sensitivity o f the areas covered by their activities, the OHR has granted banking agencies' officials legal protection from prosecution inthe performance o f their legitimate functions. 171. International advisors (financed under a USAID project) have supported the preparation o f a legal and regulatory framework for the Banking Agencies. Besides issuing banking licenses and monitoring banks' performance (through banking regulations, prudential requirements, and regular supervision assessments), the Banking Agencies are empowered to prescribe the adoption o f sectoral standardized classifications (chart o f accounts), accounting policies, financial report types, schedules, and formats. Comprehensive guidelines on bookkeeping, as well as preparation o f statutory and general purpose financial statements, have beenissued bythe two agencies. 172. In the area of prudential supervision, the core principles expressed in the guidelines issued by the Basle Committee on Banking Supervision have been transformed into regulatory instruments and reporting obligations by banks. In order to overcome problems stemming fiom the banks' low capitalization, net capital requirements are being increased in stages, from KM 5 million to KM 10 million by end June 2001 in the Federation and end June 2002 in the RS. However, the majority o f commercial banks, especially inthe RS, are struggling to cope with the achievement, and maintenance, o fthe required ratios. Need to Enforce Compliance 173. The obligation for an audit o f annual financial statements o f banks has proven the most critical area o f non-compliance. In the Federation, annual audits, as well as the publication o f the audit report in a summarized form in one o f the Federation daily newspapers, are prescribed by the Law on Banks and FBA's decisions. Although audit o f year-end financial statements i s a legal obligation, many banks violated the law with respect to the audit o f 1998 financial year (the first under the new regulatory requirement), which resulted in the submission o f charges and initiation o f law-suits against both banks and their legal representatives (bank directors). The situation had improved by the 1999 financial year audit, when all banks were required to engage extemal auditors (with one exception) and submit audit reports to the FBA. After the completion o f the audit, however, ninebanks (out o f 36) had to change the annual reports they had previously filed with the FBA (which can be accepted as final only after revision andconfirmation as accurate by the external auditor). 174. The CFAA recommendsthat supervisory sanctions be enforcedon banks in both entities that are not in compliance with regulations. At the same time, the verification of fit and proper ownership and managementof banks in both Entities should includepotentialconflict of interest(for instance ownership by related persons or parties holding key management position). Regulatory and supervisory functions of BankingAgencies should be enhanced, and aimed at detecting related-party transactions (looking beyond direct ownership at second- and third-tier owners). This will require the introduction o f qualitative surveillance over the issuance o f guarantees and/or extensions o f loans under the 20 percent-40 percent thresholds in order to detect highly risky positions with single clients, created by cumulative borrowing through single instruments under the thresholds. Suchpositionsremain, at present, undetected. Need to Retrain Bankers 175. The biggest challenge i s the development o f professional banking specialists to manage banks and staff Banking Agencies. The current situation is, in fact, primarily the result o f poor management and administration. Few banks have adequately trained technical staff ,and members o f the management boards are often not sufficiently BiH; CFAA - Payment Svstem, Jreasurv and Financial Sector 52 competent, or independent enough, to perform their statutory mandate. The majority of banks have poorly developed intemal control systems and no internal audit functions. Slow implementation o fprescribed accounting policies and standards i s observable and a substantial amount o f training will be necessary to develop the necessary skills and knowledge basis. Doubts relating to the quality o f financial reporting (especially with respect to interim, unaudited accounting situations) undermine efficient banking supervision through regulated reports, and hamper the implementation o f early waming principles in the examination process. Inthe absence o f market inputs that would ideally drive the skills upgrading process, the CFAA recommends that stronger regulatory pressure and sanctions be directed at bank managers who are responsiblefor the developmentof the requiredcorporategovernanceandfinancialreportingculture. BiH: CFAA - Fiduciarv Considerations 53 V. FIDUCIARY CONSIDERATIONS 176. It is a primary objective o f the CFAA to assess the fiduciary risks involved in doing business (through lending and non-lending operations) with the country. Based on the analysis of the existing financial management systems and procedures, the capacity of its institutional and human resources, and the threat of corruption, the CFAA finds that the environment for project implementationin BiH is high risk, and requires the continued application of appropriate mitigation strategies to minimizefiduciary risksandmaintainthem at acceptablelevels. 177. From the outset, intemational financial assistance to BiH has been characterized by the need to act fast (e.g. disburse rapidly) through emergency projects focusing on infrastructure reconstruction and rehabilitation, in order to cope with the post-war reconstruction needs and the necessary jump-starting o f the economy. IFIs and donors were confronted with the complex, fragmented institutional and administrative structure o f a country emerging from civil war, and were required to strike a delicate balance between respecting ethnic prerogatives and promoting proper governance and accountability for the use o f funds. Especially inthe first phase o f international assistance to BiH, the use o f special fiduciary arrangements, such as higher financial thresholds for procurement than in other countries in the region, thus represented a pragmatic trade-off between aid effectiveness (measured in terms o f results promptness), and observance o f minimum fiduciary safeguards. For instance, two Procurement Monitoring and Auditing Units were set up to in Sarajevo and Banja Luka to carry out sample-based, in-process monitoring and ex-post audits o f procurement, in order to mitigate the heightened risks arising from the emergency nature o f the implementation arrangements, and the perceived highlevel o f corruption inthe country. 178. The lack, at all levels o f governments, o f adequate capacity to manage resources inan accountable and transparent fashion generated concrete risks for leakage andmisuse o f aid funds. This i s particularly the case with respect to grants from foreign governments, provided under bilateral cooperation and assistance agreements. There have reportedly been cases o f diversion o f grant proceeds through non-transparent flow o f funds through mechanisms exploiting horizontalhertical schemes o f indirect cross- ownership among recipient agencies, banks and political parties, as confirmed by the Special Audit Report by the Special Auditor in both the Federation and the RS. In this respect, the U S General Accounting Office (GAO) July 2000 report on Bosnia and Herzegovina highlighted that, although intemal controls over international aid appear adequate, there are no controls on most o f the grants and loans provided by the U S government indirect support o fthe Entities' budgets". l8 Quotingfrom the GAO report, "All of the assistance supplants the monies of the Entity governments; consequently, it frees up government funds for uses over which the intemational community has no control. Finally, while the international community provides assistance and funds, the Entity governments are losing hundreds of million of dollars in public revenues due to corruption, an irrational tax system, and widespread custom duties and tax evasion, accordingto USAID, the OHR, the CAFAO and the ICG." BiH: CFAA - Fiduciary Considerations 54 179. By contrast, second-generation Bank-funded projects have increasingly been associated with policy reform inkey financial accountability areas, resulting inincreased fiduciary comfort; as a result, the nature o f financial management contained in these projects has changed commensurately, and this poses new challenges for the involved implementing agencies. As part o f this shift, the nature o f the loan portfolio has moved away from infrastructure projects and now contains relatively more projects inareas such as health, labor market reform, and education. 180. As a result o f the increased awareness o f corruption, the International Community i s now generally much more active in diagnosing weaknesses and problems affecting proper accountability for uses o f h d s , and in implementing actions to ensure concrete application o f opportune fiduciary safeguards. However, in order to ensure effective coordination and lasting results, it is the CFAA's recommendation that sound financial managementfor foreign assistance be given a higher priority on the Peace ImplementationCouncil's agenda, to be dealt with on a comprehensive basis and not just interms o f ad hoc, disconnected initiatives as is presentlyoften the case. Measures to introduce accountability for foreign aid funds should move inparallel with, and reinforce, the development o f the Supreme Audit Institutions and the establishment o f adequate financial management capacity within BiHgovernments. Accountabilityfor Use ofExternalAssistance Funds 181. Resources received under external assistance programs represent an important element o f public expenditure in BiH, requiring that they be subject to the procedures o f planning, authorization, and accountability provided by the budget. Currently, only budgetary support financing i s thoroughly included inthe Entitybudgets.The majority o f external financing received as project assistance (foreign financing and bilateral direct donations) remain effectively outside the budgets and the governments' accounts, although both Entities have been making efforts to capture the "credit- financed" portions project assistance in their budgets, albeit in an annex form. The 2000 budgets for both Entities included spending both on domestically financed capital projects and aggregate information on externally financed projects (with RS being better able to expand the coverage o f external financing than the Federation due to availability o f adequate data). Coverage was expanded in the 2001-2002 budgets with the help o f deeper analysis that was carried out to update information on project commitments and expenditures. These efforts were assisted by the World Bank under the PFSAC 11, which envisaged initiation of a process toward a more comprehensive, multi-year budget planning process as one o f its key structural budgetary reform elements. 182. Nevertheless, despite significant efforts for their integration into the budget since 1999, progress to date remains limited. A number o f factors played a role in constraining the authorities' ability to achieve more tangible progress to date. The first factor i s the scattered management o f external project assistance through Project Implementation Units (PIUs) outside the governments' budgetingsystem. Although it is the intention o f both donors and BiH authorities to consolidate existing PIUs where possible and to incorporate future PIUs into the line ministries in order to build capacity, project management through PIUs was unavoidable inthe reconstruction effort, given the lack o f capacity and systems to handle large and wide-ranging efforts in the post-conflict era. In BiH: CFAA - Fiduciarv Considerations 55 many cases, there are now multiple PIUs within one sector or in one ministry, working for different donors. There i s very little communication among the PIUs and aid coordination units o f the government, and there are no systematic reporting lines to the government ministries. 183. The second factor is the management and coordination o f donor assistance through various State and the Entity aid coordination bodies outside the MOFs," which are the main repository o f information, yet have limited coordination with the donors, MOFs, and PIUs as well with each other. Despite improvements over the last three years, the coverage o f the database varies across the Entities, with no systematic reporting on investment planning and implementation. One o f the main reasons for this outcome is lack o f systematic flow o f disbursement information-both actual and planned-fiom the PKJs. And the third factor is a limited and irregular direct flow o f information fkom donors to the public aid-coordination bodies, relative to the extent o f donor involvement infinancing public investments. 184. The CFAA has the followingrecommendationsto increaseaccountabilityfor the use of externalfunds. Reorganize the aid management function in each Entity in order to ensure direct information flow to the M O F consistent with the budget process. The objective should be to eventually integrate the aid management function within the M O F structures, transferring the management o f foreign-financed project databases to the Treasuries. Define core project-specific information that PKJs will be required to report periodically to the MOF through the aid coordination bodies. Improve the consistency o f the existing structure o f project information with the budgetclassification structure. Systematize the timing o f information collection from donors to make it compatible with the timingo f the budget cycle. , Initiate a process for inclusion o f projects financed by external credits as capital expenditure in the relevant line ministry budgets. Where there is no clear ministerial responsibility for the project, the expenditure could be included under the budget o f the MOF. Expenditures that are extemally financed should be clearly identified, since they will be subject to different financial management procedures. l 9Aid coordination bodies include (i)at the State level, the Ministry o f Foreign Trade and Economic Relations and MinistryofTreasury at the State level, (ii) the Federation, the Office ofthe Reconstruction Co-ordination Committee in inthe Prime Minister's office, and (iii) RS, the Aid Co-ordination and Development Unit inthe Ministry ofForeign in Economic Relations. These bodies undertake various functions, including participation in project negotiations and preparation o f legal documents, follow-up o f project implementation, maintenance o f project databases, and involvement in formulation o f sector strategies and programming o f investment needs. Despite their broad range o f functions, in practice their role in investment planning and programming is limited due to lack o f capacity. However, they remain the main repository o f information on foreign-financed investments, which they receive on an ad hoc basis by requesting it fromdonors and PIUs. BiH: CFAA - Fiduciarv Considerations 56 0 Establish a requirement for estimating future recurrent cost implications o f ongoing and new investmentprojects. WorldBank-financedProjects:the 2000 CountryPortfolioPerformanceReview 185. The fourth Bosnia and Herzegovina Country Portfolio Performance Review (CPPR) reviewed overall financial management arrangements in the Bank portfolio o f active investment-type projects, in order to identify both country-generic and project- specific financial management issues requiring attention. Ten active projects were analyzed on the basis o f a review o f audit reports, including management letters and o f financial management supervision reports. The CPPR highlighted a number o f generic project management issues, both institutional and financial, and formulated recommendations for their resolution (see box below). Box 7. PIU-managedprojects:mainfinancial managementissuesoutlinedinthe CPPR .Consolidation o f PIUs and capacity building. There i s an excessive number o f PIUs in the Federation. For capacity building as well as for economical and efficiency reasons, there should be some consolidation o f PIUs according to the types o f projects and the needs o f the Federationgovernment. .Counterpart financing. Counterpart financing should be agreed during negotiation and these funds must be incorporated in the Entities' budgets as protected items during implementation. The governments must ensure that counterpart funding i s made available when the projects become effective. .Financing o f taxes. Different interpretations have led to differing financing arrangements and a lack o f standard practices, including for social and medical contributions by employee and employer, and different application o f policies on the financing o f taxes for both staff salaries and consultants. Based on the current position adopted by the Bank, including the introduction o f Standard Disbursement Percentages, the opportune strategies should be adopted by the borrower for uniform implementation inBiH. .Flow o f funds. There i s inadequate monitoring o f fund transfers between different bank accounts, especially to the local bank accounts. .Reconciliation. Procedures for performing reconciliation at closer intervals are not in place, Another issue affecting project performance i s that some o f the Special Account bank statements are sent to MFTER but are not forwarded to the PIUs in a timely and regular fashion. The MFTER should re-distribute the bank statements to the PIUs without delay; alternatively the banks should be requested by the MFTER to send copies o f the bank statements to PIUs directly. C r e d i t withdrawal procedures. Credit withdrawal procedures have become quite cumbersome and time-consuming, requiring specific approval and signature o f higher authorities in ministerial departments o f the State and the Entities, not all o f which are close to project execution. The same multiple signature system applies to payment orders and Special Account transactions,creating delays, since there i s usually no altemative signatory for the designated minister, and processing comes to a halt when the person is unavailable. Apart from not promoting accountability in personnel responsible for the day-to-day execution of projects, these arrangements affect the project's performance by creatingroutine delays inthe payment orders, in the transfer o f funds fkom Special Accounts to local project bank accounts, and in budgeting, cash forecasting, and other accounting processes. The solution i s to reduce the number o f signatures to two and to identify altemative signatories for the designated ministers. .Accounting; policies. The MFTER, in conjunction with the two Entities, should issue acceptable accounting policies on the following aspects o f project accounting: (i) ownership o f assets after project's closing date and PIU closure; and (ii) accounting for interest on local bank accounts. .Lack o f consolidated uroiect financial statements. Consolidated project financial statements are normally prepared by the auditors, based on the financial records maintained o f the reporting units.The MFTERshould assign appropriate staff to consolidate project financial statements, Altematively, the MFTERcould assign consolidationresponsibility to a specific PIU. 186. The CPPR pointed out the benefits of portfolio-wide arrangements, such as the use o f a single auditor for all WB-assisted projects, financed by Credit proceeds. The Ministry o f Foreign Trade and Economic Relations (MFTER) signed, in 1999, a three- year global contract (renewable annually) with a global audit firm hired from abroad. 187. However, the CPPR also highlightedthat insufficient action has been taken by the MFTER, line ministries in the two Entities, and PIUs to carry out recommendations contained in WE3 management's letters and in respect of the implementation of action plans to remedy the deficiencies addressed by the auditor. The CFAA recommendsthat additionaltrainingbe providedto PIUaccountantson the preparationof the annual financialstatementsand on carrying out the recommendedactions for dealingwith the reportedweaknesses. InstitutionalCapacityBuildingandRequiredFiduciarySafeguards 188. While PIUs have the virtue of ensuring smooth and efficient project management and of being more easily controllable by the WB, their existence (as independent organizations within the public sector) could represent another factor limiting the role of line ministries in policy formulation and implementation o f their programs. Therefore, while the CFAA considers it appropriate to maintain the current ring-fencing arrangements in project implementation, the CFAA reiterates the CPPR's recommendations(i) to consolidatePIUs and (ii)to refrain from creating new PIUs for futureprojects,unless there are exceptional reasons. 189. The medium- to long-term goal would be to implement opportune capacity building initiatives which, in turn, would allow to migrate and mainstream all projects into the responsible ministries/agencies. Such empowerment o f line ministries can only work in BiH once (i) govemment's financial management capacity (human resources as well as accounting and reporting systems) has risen to an adequate level; and (ii) suitable checks and balances are in place (internal controls as well as external auditing and oversight). The progressively enlarged coverage o f ministries and government agencies by the Supreme Audit Institutions, the effective operationalization o f Treasury functions, and the implementation o f the new financial management and information system, would all positively contribute to the realization o f these conditions; however, at present, none of these conditions obtains. An interimsolution, pendingthe development of sounder financialmanagement and suitabletechnicalskills within the public administration, i s to find the right balancebetweenring-fencingand sectoralministry ownership. 190. This could be achieved by (i) redefining the roles and functions o f the existing PIUs, transforming them into a sort o f service-provider for specific competencies, such as procurement or financial management, which are difficult to find inthe public sector; (ii) re-balancing the PIUS' staffing numbers in favor o f ministry officials as opposed to external consultants, in favor o f the former, in order to build sustainable capacity; and (iii) introducing adequate reporting lines from the PIUs to ministries' senior management, for accountability purposes and to allow better monitoring and evaluation. 191. At the same time, the CFAA recommends that report-based disbursement should not be introducedinthe BiHportfolioat this stagebecause o f significant risks relating to (i) financial management weaknesses and lack o f capacity inPIUs; (ii) project the shaky banking system; and (iii)general governance problems presently affecting Bosnia and Herzegovina. 192. As to adjustment operations, the fiduciary safeguard embedded in WB's legal documents i s the right to request an audit o f the Deposit Account in which Credit proceeds are received. In order to review the suitability o f the flow o f funds received under adjustment-type operations, the CFAA mission obtained information relating to tranche releases under the Second Public Finance Structural Adjustment Credit (PFSAC II), CentralBank, Treasury, andMOFsofbothFederationandRSZ0.The involving CFAA review confirmed that all transactions in the sample reviewed, relating to receipt o f funds from IDA as well as transfer o f funds to IDA for debt service, were *'Under the PFSAC 11, the process for the receipt o f funds from the International Development Association (IDA) by the CBBH, transfer of funds to the government accounts and associated accounting transactions is articulated as follows: (i)the Minister o f Treasury notifies the CBBH o f the availability o f funds; (ii)the CBBH receives a SWIFT message from its foreign bank correspondent, confirming that the amount has been received at the CBBH's bank account abroad; (iii)a letter from the Minister o f Treasury advises the Central Bank on the distribution o f funds to the various government accounts; (iv) the Federation M O F provides the CBBH with instructions for the transfer o f the Federation's apportionment into appropriate government bank accounts held with commercial banks; and (v) in a separate letter, the Minister o f Treasury instructs the CBBH to transfer funds to the BiH central government's main account for budgetary purposes. The process for transfer o f funds to IDA is as follows: (i) the Minister o f Treasury advises the Central Bank to open a new account called IDA Cash Account "A" in KM for the payments relating to the promissory note issued to IDA; (ii) the CBBH i s instructed to transfer funds from Ministry o f Treasury's account with CBBH (Deposit Account) to IDA Cash Account "A" for the first repayment o f the promissory note. BiH: CFAA - Fiduciary Considerations 59 carried out in accordance with the authorized instructions from the respective government offices and adequately reflected in the CBBH accounting records. No concerns were raised as to the front-end accountability aspects of adjustment lending. BiH: CFAA - Private Sector Accounfinu and Audifina 60 VI. PFUVATESECTOR ACCOUNTING AND AUDITING 193. Bosnia and Herzegovina needs an appropriate, unifiednational regulatory regime for accounting and auditing that brings into alignment the different Federation and RS regimes, before serious differences begin to emerge. The objective should be the development o f a State-level, unified approach to accounting and auditing disciplines, as well as to the regulationo fthe accountancy and auditing profession. 194. Inthe absence of compliance with formal requirements imposed by law, the informal arrangements existing in practice with business entities are: (i)basic bookkeeping; (ii) financial reporting for tax-compliance purposes (subject to tax audit by the authorities); and (iii) internal (unofficial) reporting for management purposes. Inthis context, managers o f enterprises show no ownership for the preparation o f general purpose financial statements and often rely on auditors merely to prepare annual financial statements (compromising their supposed independence). But because the auditors themselves are not familiar with the new Accounting and Auditing Standards, the statements they prepare are o f no use to third parties for decision-making purposes. In such circumstances, insisting on the application o f International Accounting Standards, without due consideration o f the local situation and capacity, and without introducing the opportune distinctions, would be unproductive. To break this vicious cycle, what i s requiredinsteadare practicaltools, such as a more usefulchart o f accounts, and extensive retraining o f accountants and auditors. Background 195. Under the systems and practices inherited from the SFRY, accounting was designed to discipline enterprises in reaching plan targets and to protect state property and resources against unauthorized use. Because o f the enterprise governance arrangements in place in the SFRY and the associated diffuse ownership structure, there was no need to assess operational or financial efficiency o f individual businesses. No general purpose financial statements were prepared or audited, nor was any financial and economic data published for third-party use. Ownership rights belonged to "the society" (i.e. no clearly identified owner), while day-to-day management was inpractice entrusted to a Board of Associated Labor made up o f employees and managers. Within the utilitieshdustrialhervices sector conglomerates and agriculture sector agrokombinats typical of the SFRY, there was intensive cross-subsidization within group structures, with loss-making enterprises subsidized by profit-making enterprises. The combination o f intricate corporate structures and o f technically complex lines o f business made this horizontal style o f management quite a challenging task; it also completely obscured the financial situation and economic value o f both specific product lines and o f the business as a whole. 196. The accounting methodology in use in the SFRY, although ostensibly utilizing Western concepts and tools, was primarily intended to report on the results o f claims exercised by the various productive factors (creditors, banks, labor) rather than to measure the financial and economic results o f operations for the purpose o f making rational business decisions that would include considerations o f competitiveness and BiH: CFAA - Private Secfor Accounting and Auditina 61 profitability. In fact, the underlying market drivers, and corresponding incentives, were not inplace. 197. Subsequent developments in the accounting system mainly focused on the Entities' tax accounting applications and on the concrete need to satisfy a range of reporting and regulatory requirements from different state and public agencies. Consequently, financial reporting systems and practices observed in BiH today are still inadequate to assess performance o f companies under market economy conditions and to satisfy the diversifiedneeds o f other users o f financial information, including government agencies, company managers and employees, shareholders, lenders, as well as current and potential investors. Needfor UnifiedStandards,RegulationandLicensing 198. At present, accounting and auditing regulations are fragmented and inconsistent. There are different accounting and auditing laws, one for each o f the two Entities, but there is no such law at the State level, and there i s no uniformity inthe legal provisions. There are differences in accounting standards between the two Entities and different institutional arrangements for testing, accreditation o f accountants and licensing of auditors. There are different professional profiles and lack o f mutual recognition o f the titles and professional licensing procedures in place in the two Entities (or cross- accreditation): a practitioner must be accredited or licensed in both Federation and Republic o f Srpska to carry out cross-entity work in the territory o f BiH. At the same time, enterprises registered inboth entities are requiredto maintain a double set o f books and are subject to double financial statements publication and auditing requirements. These different rules, regulations and requirements do not effectively support and are not conducive to business development, and the differences create a powerful disincentive to foreign investment. 199. Bosnia and Herzegovina needs to develop adequate private sector accounting and auditing, essential for efficient decision-making by users o f financial information. A number o f legal and regulatory instruments are in place, ranging from commercial and business legislation to regulations enacted for the accounting and auditing profession. However, most state enterprises do not comply with the legal provisions. There i s no well-defined institutional or regulatory infrastructure in BiH capable o f ensuring enforcement and supporting the development of professional accounting and auditing technical capacities. Financial managers, accountants and auditors need to be educated, tested, certified and qualified. There are currently certain standards, but they are inadequate to the achievement o f the desired level o f technical competence and professionalism. The overall system i s in need o f reform, and in particular, the profession's institutional setup. 200. BiH State, Federation and Republika Srpska govemments have committed to making the transition to a market economy and the Entities are actively reforming the national financial reporting and accounting methodology, supported in these efforts by independent professional organizations. The CFAA recommends that existing independentprofessionalorganizationswork together towards the establishment of a State-level body for the licensing of auditors, and a unified, self-regulatory organization (SRO) of practitioners for both accountants and auditors. 201. These developments are part o f the infrastructure and professional support needed to foster an enabling environment for private sector enterprises, both national and international. However, there is currently no intention to have State-level accounting and auditing regulations and professional organizations, which is needed to achieve closer integration with Europe. As for other areas o f the country financial accountability framework in BiH, there i s a real opportunity to pursue the economic reform agenda more vigorously, and the reform o f accounting and auditing i s an integral part o f this agenda. Accounting and Auditing Standards 202. In the Federation, the Law on Accounting and Reporting (adopted in 1995 with amendments in 1998) illustrates the commitment to meet internationally accepted standards in these fields. The Codex o f Principles, Chart o f Accounts, and Federation Accounting Standards require that these standards be based on International Accounting Standards Federation Accounting Standards are issued by the Standards Committee o f the Institute o f Accountants and Auditors (IAA). The Institute, established by the parliament o f the Federation following the adoption o f the 1995 Law on Auditing, i s authorized to issue, harmonize, present and enforce application o f Accounting and Auditing Standards inthe Federation. 203. The RS Law on Accounting came into force, with the latest amendments, on January 1, 2000., The law requires its Accounting and Auditing Standards to be fully in compliance with IAS and ISA. The RS Association o f Accountants and Auditors (AAA), which was established following the adoption o f the Accounting Law, is currently issuing guidelines for the interpretation o f the standards (through explanations and case studies), in order to assist accountants in becoming familiar with the new requirements and to enable them to correctly implement the standards. The AAA i s the only professional organization authorized by the RS Law on Accounting for standard-setting, examination and professional accreditationo fboth accountants and auditors. 204. Inthe Federation, 38 Accounting Standards had been issued by the end of 2001. Some o f these are "pure" IAS (Le. adopted as published). In the majority o f cases, however, the relevant standard has been modified and adapted, to a smaller or larger extent (although more in the phrasing and terminology used, involving few material changes). For the newest IAS, there i s no corresponding Accounting Standard as yet. The Issuance o f Accounting Standards is, in fact, a gradual process: 25 standards were passed in 1998;7 standards in 1999;and 6 in2000/2001. There is normally a time lag of 6 to 12 months between the issuance o f a new or revised I A S and the release o f its Federation equivalent (although it may take longer, as for IAS 39). Although all Accounting IASB publishes its Standards in a series of pronouncements called Intemational Financial Reporting Standards (IFRS). It has also adopted the body of Standards issued by the Board of the Intemational Accounting Standards Committee. Those pronouncementscontinue to be designated as Intemational Accounting Standards (IAS). BiH: CFAA - Privafe Sector Accounfins and Audifins 63 Standards are published in the Official Gazette, the process for their development and issuance usually involves little consultation with the profession at large (e.g. no public comments on exposure drafts are invited). 205. International Standards on Auditing (ISA) are adopted in the Federation as a whole, and as published. They are issued by the International Auditing Practices Committee (IAPC) of the International Federation o f Accountants (IFAC). The auditing standards have been translated by the IAA and published, in March 1999, in a book available for purchase by the public. A similar process would apply for maintaining alignment with new International Standards on Auditing and their revisions. Box 8. TrainingandTechnicalAssistance from USAID The USAID Legal and Regulatory Reform Project (LRRP), among other activities, provided assistance to BiHgovernments in reviewing existing local accounting and auditing standards and aligning them to international standards. The LRRP started in June 1997 and ended in February 2000. Its main objectives were to provide technical assistance to Bosnia and Herzegovinathrough the establishment o f an overall economic, legal and business environment conducive to private sector development,both domestic and foreign. The Project's strategy was to work closely with government officials throughout BiH, as well as with accounting and auditing practitioners, lawyers, academics and business people, to ensure (i) the appropriate identification o f key work priorities; and (ii) selection o f business, legal and the accounting subjects deemed by these experts as inneed o freview, revisions or re-drafting. Under the current Private Sector Accounting Reform Project (PSARP), USAID has carried over its active training program in both Federation and the RS, involving foreign experts and BiH nationals (based on the widely adopted train-the-trainer approach). In the Federation, there have been more than 3,000 attendees. Seminars fall into three groups: Accounting Cycles (with focus on internal controls), Management and Cost Accounting (business oriented), and Auditing (both financial and operational audits), and were concentrated inmajor business areas o f the Federation (Tuzla, Mostar, Gorazde, Sarajevo and Zenica), with increasing demand fi-om more remote locations. Financial management training activities started later in the RS, in cooperation with the AAA. The LRRP covered three main areas: commercial regulation; securities regulation; accounting and auditing. Accounting and Auditing activities addressed development o f standards; professional training, and establishment of a national professional association. The ultimate goal i s the establishment of a national professional Self-Regulatory Organization (SRO) that would represent BiH internationally. USAID also introduced a corporate governance project, under which it intends to consolidate all current privatization, securities commission, public information, and legal reform activities. 5iH; CFAA - Private Sector Accounting and Auditing 64 Regulationof Audit Profession 206. The immediate need in BiH is to create a friendly, enabling environment for private sector development that overcomes fragmentation and political instability, institutional divisions, and administrative barriers, and that creates confidence for foreign direct investments (which, at present, are among the lowest in the Balkans). On the institutional side, this requires the preparation of a State law on accounting and auditing, which would be the platform for the establishment o f the common accounting and auditing regulatory functions. It also requires self-regulation o f professional activities through the creation o f a single, unified SRO, at the State-level. This i s also one o f the modifications inBiHinstitutional arrangements that would be required by the Road Map for EUaccession. 207. Because o f the externalities generated by the results o f audit activities, a contract between the auditor and the auditee cannot adequately protect all those who rely on the auditor's report. Therefore, it i s in the public interest for governments to retain all functions relating to the regulation o f audit. The CFAA finds that the successful establishment of a State-level institutional for the regulation of auditing is a key element for creating a sustainable environment for continuedreform. Such a State- level regulatory body could be either a line ministry department or, ifresponsibility i s to be delegated by the authorities, a public entity o f the Institute/Council o f Auditors type. The required institution would carry out activities such as (i) technical standards issuing having legal force, and applicable to individuals and entities specified by the law (in consideration o f the prevailing legalistic approach in these matters and the traditions o f the country); and (ii) licensing o f auditors. All regulated activities would be subject to oversight fiom the delegating ministry. 208. Inconsideration ofthe Presidency's role as coordinator and representative ofBiH ininternational organizations, and the small size of the country and its economy, efforts should be concentrated on the creation o f a single State-level regulatory body that would also qualify for full membership in IFAC. Such efforts would be consistent with the international community's efforts to strengthen State-level institutions and broaden their maridate, as well with as the approach adopted for international recognition (membership) of BiH's Supreme Audit Institutions and Securities Commissions, respectively, within INTOSAI and IOSCO. No application for IFAC membership should be submitted until the State-level regulatory body i s established, fully functioning and empowered. In this respect,the CFAA mission recommendedto USAID officialsthat the Private Sector AccountingReform Project should not support the applicationsfor IFAC associate membershipsubmittedby existingRS andFederationSROs. SimplifiedFinancialReporting 209. The current reporting systeminBiHcomprises a single set o f requirements ("one size fits all"). But most small to medium-sized enterprises do not (and cannot) have the appropriate infiastructure or expertise to prepare sophisticated financial statements complying with I A S (or their local adaptation); moreover, they have no need to do so. Evenlarger organizations are still strugglingto cope with the new accounting standards. The CFAA strongly recommends the establishmentof a more appropriate, two-tier BiH: CFAA - Private Sector Accountins and Auditinq 65 system, articulated in distinct requirements for small and medium-sized enterprises on the one hand, and large enterprises on the other. 210. The CFAA recommends that the differentiation of business entities' reporting requirementsbe evaluated by the authorities, along the lines prevailing in most EU countries, based on the joint consideration of: (i)size (with due regard to assets, number o f employees, and turnover indicators); (ii) ownership structure, such as diffused ownership (hence the need for minority shareholders' rights in public companies); and (iii) the relative importance o f externalities generated by the specific business and/or economic sector in which they operate (social, environmental and/or o f strategic nature, such as natural monopolies). 211. Based on this proposal, a reasonable way to proceed i s to maintain tax accounting for all enterprises, supplementedby binding, pureIAS for the very small number of companies that wish to use them or that the CFAA believes should be obliged to use them. Inthis respect, the CFAA recommends that the new Accounting Standards and financial audits of annual accounts be mandatory for all listed companies (once a functioning stock exchange market i s in place) and for all banks, insurance companies (including branches o f foreign credit and insurance institutions), utilities and other regulated economic activities, privatized enterprises,22 cross- border and multinational enterprises that have established business in BiH, PIF and mutual funds. For small and medium-sized businesses (such as owner-managed or closely-held productive or retail businesses), which are currently the majority in BiH, accounting and reporting requirements could be limited to compliance with tax accounting, with no (or more limited) publication requirements and tax audits. 212. For medium-sized to large enterprises (not many, at present), modified financial reporting requirements based on simplified accounting could be introduced. In this respect, consistency could be achieved by way o f providing a nationally standardized chart o f accounts, applications guidance and model financial statements. Although falling considerably short o f full IAS, such a simplified financial reporting model could still satisfy the information needs o f specific stakeholders, such as lenders and creditors, and potential investors would prudently have recourse to the appropriate due diligence. However, the cost-benefit justification for this intermediate model, involving significant regulatory intervention (which, in any case, i s not in place at present) has yet to be formulated inthe current and foreseeable economic context o fBiH. 22For privatized enterprises, the issue i s to improve the disclosure requirements to overcome the issues arising fromthe preparation o f opening balances involving the valuation o f assets based on the following classification: passive (because destroyed by the war and/or lostkontested ownership); neutral (representing socially-owned assets on which the society/community, it.the employees, exercises a right, such as apartments); and active (purely reflecting the historical cost and not on an accurate valuation based on stocktaking procedures, and which considers elements such as obsolescence), the combination o f which resulted in the unrealistic assessment of the value o f assets o f privatized enterprises, for which the assets' book value is totally inconsistent with their fair or market value. 6iH:CFAA - Private Sector Accountina and Auditins 66 Regulatory and Standards-setting Bodies Federation of Bosnia and Herzegovina 213. In the Federation, the Institute of Accountants and Auditors (IAA) is a public body, created by the 1995 Law on Accounting and Reporting, and i s in effect part o f the MOF. The 1995 law constitutes the IAA General Act and can be amended only by the parliament. Based on the law, and the agreement reached with the MOF, the IAA is the Federation's accounting and auditing regulatory agency and the standards-setting body (through the Standards Committee). 214. The Regulatory Board (RB) o f the IAA i s the governing body o f the IAA. The preparatory work for the establishment o f the Regulatory Board was done by the I A A ' s Standards Committee, which i s composed by representatives from the IAA, JAFIS, the Federation Chamber o f Commerce, MOF, and university professors. The members o f the Regulatory Board are appointed by the parliament for a term o f four years and report to the MOF. Based on public advertisement, the RB appointed in 1997 (following government agreement about their nomination) an Executive Director and Deputy Executive Director o f the IAA for four-year terms. The Regulatory Board members include the Chairman, IAA Director and Deputy Director, government appointees from the MOF, universityprofessors and lawyers. It i s unclear how many Board members are licensed auditors and independent accountants, nor what i s their degree o f competence in accounting and auditing matters. 215. The IAA is financed from its own revenue, earned via consulting services, and not from the government budget. It currently employs around 50 staff, many o f whom are independent accountants and/or licensed auditors. The IAA performs the following main activities: (i) drafting and issuance o f accounting and auditing standards; (ii) organization and delivery o f courses and examinations for obtaining the title o f independent accountant and authorized auditor; and (iii) issuance o f auditor's licenses (work permits) and maintenance o f a register o f auditing enterprises. The IAA is, in fact, the only institution in the Federation to conduct the training and examination process for the title of Independent Accountant and Authorized Auditor. 216. A significant conflict ofinterest is involvedinhaving, on the one hand, regulatory functions (standard-setting and licensing) and, on the other, activities such as organizing testing, marking tests, training and other consulting activities, publishing, and so forth, all concentrated within the same institution. Given that the IAA is responsible for both education and examining/licensing, there may be a reluctance to fail too many candidates, since this might reflect badly on the quality o f education provided or create a situation where only those candidates who have paid for IAA courses pass the test. Regulatory functions should, therefore, be separated from professional services and other commercial activities. This separation would have implications, if regulatory activities were to be funded as part o f a government budget.Even ifthe IAA is expected to continue to cover its own costs (for instance via licensing fees), I A A ' s revenues and expenditures might form part o fthe budget, to ensure transparency and accountability. BiH: CFAA - Privafe SectorAccounfinp and Audifinq 67 Republic of Svpska 217. The RS AAA appears to combine the functions o f regulatory agency and Self- Regulatory Organization (SRO) inone institution, along the lines o f the Central European Chamber model. The Association i s performing the following activities, among others: adoption o f the Codex o fPrinciples and ProfessionalEthics o f Accountants and Auditors; organization and management o f the educational process and examination to obtain the professional titles defined by the law; performing validation o f foreign licenses for professional titles of all levels; keeping the register o f individuals that acquire professional titles. Professional Associations 218. The core functions o f a professional SRO are (i) represent the interests o f its to members, (ii) provide training to its members and other stakeholders in using new to standards, and (iii) foster proper professional ethics and monitor professional behavior. to The Association for Public Finance (JAFIS), with almost 500 members in 2001, is the most prominent organization established to function as professional association o f accountants and auditors in the Federation. There are at least other two organizations competing for SRO status recognition: the Association o f Auditors, and the Association of Accountants and Auditors (Federation AAA). Members consult with the JAFIS for professional advice (free of charge); the Association distributes a newsletter to its members, together with several audit programs tailored to meet local needs. JAFIS i s holding monthly roundtables with current issues on audit methodology, taxation and general development o f the profession. JAFIS participates in the Annual Symposium o f the RS Association o f Accountants and Auditors (AAA), a forum that i s crucial to establishing the foundations for cooperation between the two Entities' organizations, including harmonization o f requirements for professional certification and continuing education. 219. JAFIS from the Federation and AAA from the RS are jointly representing Bosnia and Herzegovina in the South Eastem European Partnership on Accountancy Development (SEEPAD), a regional forum established under the auspices of the EU Stability Pact, OECD, USAID and other international and multilateral organizations, including the WB. However, since most areas requiringprogress and harmonization are those underthe control o f the government (Le. delegated to the IAA), it i s not evident that JAFIS, a voluntary, private association, should be the representative of the Federation at SEEPAD or in discussions with the Republika Srpska. Therefore, it will be crucial to define the roles and division o f labor between the Federation IAA in its capacity as official regulatory agency, and the professional SROs. The possibility o f unifying the three existing associations (JAFIS, AA and Federation AAA) into a single association, which would be recommended to IAA for approval as the Federation's SRO, i s also under discussion. BiH: CFAA - Private Sector Accountin0 and Audifina 68 Licensing Federation of Bosnia and Herzegovina 220. In the Federation, the possession of the designation of Independent Accountant grants the right to sign the financial statements which are required by tax authorities. However, there are many accountants (more than 3,000, practically all practitioners from the old system) who were admitted to the professional designation prior to start o f the examination system (1999). In the absence o f an examination for the majority o f practitioners in the Federation, there can be little assurance as to the quality o f the accountancy profession as a whole. 221. Based on the information provided by IAA, there were around 4,000 independent accountants in 2001. It i s expected there will be a substantial increase in the number o f new members within the next few years. Educational requirements for applying to the Certificate Program for Independent Accountant are prescribedby the General Act o f the IAA and the qualification requirement set out inthe Law on Accounting and Reporting (degree from an economic faculty plus 145 hours o f professional training and final test). The success rate i s quite highby world standards (more than 80 percent). 222. The Certificate Program for Authorized Auditor started in spring 1999. Educationalrequirements for applying to the program include a degree from an economic faculty plus 240 hours o f professional training inI A S and ISA (with the participation, in the form o f lectures, o f staff from the USAID Legal and Regulatory Reform Project, LRRP).The first generation of Authorized Auditors completed the program in 2000. Based on the information provided by IAA, there are currently around 200 Authorized Auditors. It i s expected that this number will increase significantly (to 250-300), when the current crop o f students will have passed the examination and applied for licenses. At present, there i s no continuing professional education (CPE) requirement, but there are plans for its gradual introduction. The IAA prepared and published the Codex o f Principles and Professional Ethics for Auditors (same as IFAC's), a booklet which i s being distributedfree o f charge to independent accountants and authorized auditors. 223. Holding the designation Authorized Auditor grants the right to perform certification (financial audit) hnctions, which include the auditing o f opening balance sheets o f banks and enterprises for privatization purposes, and the audits o f banks and enterprises that are mandated by banking and commercial laws. However, the rigor o f the examination i s dubious (almost all candidates pass the test), as i s the quality assurance monitoring system for the work o f the auditors (peer reviews). For instance, in terms o f disciplinary measures, there i s no track record that licenses have been withdrawn for unprofessional behavior or poor quality o f audit work. Although it may be too early to expect this, there are not clear indications that the need for such measures i s understood by the IAA. 224. As for private audit firms, there were 12 registered inthe Federation in2001. It is expected that their number will increase significantly, as the newly licensed Authorized Auditors start their own professional practices. There are no international audit firms in the Federation as yet. The major global accountancy ,firms have established logistic offices and/or signed representation or association agreements with local firms. 5iH: CFAA - Private Sector Accountinq and Auditing 69 Republika Srpska 225. There are five levels o fprofessionalqualification: (i) Accountant; (ii) Independent Accountant; (iii) Chartered Accountant; (iv) Auditor; and (iv) Chartered Auditor. Titles are based on progressive levels o f education, training, professional experience and type o f clientele; however, the number o f different designations could pose a risk o f fragmentation, with no one cohort reaching critical mass. 226. Based on the information provided by the AAA, there are around 4,000 accountants at different levels (of which around 1,500 are certified accountants and auditors). It is expected that their number will significantly increase in future years. Qualification requirements include holding a university degree, professional education and testing; the duration o f professional education depends on professional title, and it i s between six months and one year. Requiredhours o f professional education are 80 hours for Accountants; 100 hours for Independent Accountants; 120 hours for Chartered Accountants;l40 hours for Auditor; and 160 hours for Chartered Auditors. A training program on accounting standards started in December 1999. No continuing professional education (CPE) i s requiredcurrently but there are plans for its introduction. Professional education, professional training and final examination for acquisition o f all professional titles are administrated by Educational Committee o f the AAA. As to private audit firms, there are several small auditing companies, and local member firms o f global accounting firm networks (it is the local firmwhich is licensed, not the network). Developingthe Profession 227. From the CFAA review o f audited financial statements o f large utilities, banks and enterprise inboth Entities, it i s clear that few accountants understand (or are capable o f applying) the Entities' Accounting and Auditing Standards in the preparation o f financial statements. For one thing, these standards are new to local practitioners. Also, the kind o f supporting environment that would justify the adoption o f accounting standards modeled on IAS (Le. meeting the information needs o f multinational businesses, international trade and capital markets) i s entirely absent inBiHat present As a result, non-compliance with the Standards i s observable in areas such as consolidated accounts (they are not prepared); interpretation o f accounting policies (no adjustments for deferred taxation); asset valuation (inflexible application o f historical cost); depreciation (management decisions and current practices relating to depreciation clearly override the relevant Accounting Standard through the application o f tax depreciation rates). 228. There i s therefore a need for an appropriate program o f capacity development to support both the implementation o f a unified regulatory regime and the enhancement o f the skills o f the (almost) 8,000 practicing accountants and auditors (a much smaller number i s licensed based on the new regulations). For the CFAA there is, therefore, the need to re-certify the practitioners who accessed the accounting and auditing profession prior to the establishment of the new curricula, in accordance with acceptable internationalbenchmarks. Capacity Building 229. The development o f adequate knowledge and skills, especially for auditors, will take time and cannot be achieved through training alone. Higher qualification requirements are needed for accountants and auditors, together with compulsory continuing professional education. The CFAA finds that greater emphasis is required on practical work, along with mentoringprograms by internationalfirms. For this reason, USAID's Private Sector Accounting Reform Project should focus on developing and implementing a unified curriculum and qualification framework for accountants and auditors, benchmarking educational programs to international best practice, providing hands-on training and practice, and professional ethics (with recourse to international resident advisers inboth Entities). 230. Inthe medium term (3-5 years), the objective should be the formation of a small group o f world-class local accountants and auditors capable o f working with I A S and ISA. In order to allow the old-guard accountants and auditors (those who are not being licensed under the new rules) to cope with the new economic environment, there should be some sort o f grandfathering arrangements, allowing existing practitioners to be qualified (based on compulsory retraining and continuing professional education requirements) and then recertifiedwithin a set period o f time. Those who do not recertify should have their license to practice withdrawn. 231. In the longer run, the development of the market (especially capital markets) would do the rest, attracting businesses and creating a greater demand for business- related infrastructure and services (e.g. localization o f international audit firms). However, for BiHthere i s a long ways to go inthe development o f these markets. Inthe shorter term, there i s no alternative but to import the necessary skills and expertise, through recourse to international accounting firms.23 Improved Chart of Accounts 232. International Accounting Standards (and the BiH local standards derived upon them) are largely recommendatory in nature, often allowing for different disclosure and reporting options. Being the standards principle-driven, their application therefore requires exercising professionaljudgment. This approach is revolutionary for the mental habits and concrete practice o f BiH's accountants, who were trained (under the SFRY) to apply stringent and detailed bookkeeping classifications based on a standardized chart o f accounts and to post accounting transactions on the basis o f detailed mechanical procedures (rather than according to their meaning in economic and financial terms). Their orientation has continued to follow their training: to comply with tax-driven accounting rules-a very different orientation from general purpose financial reporting, which i s aimed at satisfying the needs o f different users o f financial information as to the financial position and results o f operations o f the concerned business entity. 23 Asi s the case with the audit o f WB-assistedproject, for which the auditor i s contracted from abroad. BiH: CFAA - Private Sector Accounfinu and Auditinq 71 233. Based on the experiences o f other continental-Europe countries that have devised practical solutions to such a dichotomy (France, for example), the approach recommended by the CFAA is the establishment of an appropriate link between accounting standards and tax reporting through the creation of an adequate chart of accounts for private sector use. Standards alone are not implementable. Accountants also need methodological instructions on how to implement IAS-based standards in private sector work, and this requires an IAS-compatible chart o f accounts. Such a chart o f accounts would support I A S financial statements and, at the same time, would form the basis for tax reporting and tracking the data needed to reconcile the financial and tax accounting models (e.g. inareas such as depreciation). UnifiedProfessionalCertification 234. In parallel, the development of a single accounting professional certification program for BiH through a State-level SRO, representing, and composed o f members o f the professional organizations in both Entities, provides the best chance for sustainable and uninterruptedprivate sector accounting reform, laying the foundations for successhl participation in regional and world markets. However, no official mandate exists at present with the State to require Entity associations to cooperate in forming such a joint venture. The CFAA strongly recommends that the formation of a unified accounting and auditing profession at the State level be mandated, to represent and lead accounting reform for both Entities. 235. The preparatory phase would entail coordination and joint initiatives between each Entity's individual association, which would allow both entities considerable self- government. At the same time, the joint venture would be a formal recognition o f cooperation in essential areas, such as a joint training, testing and accreditation o f accountants, cross-membership, joint publications, and the like. The State-level SRO, in the form o f voluntary professional body (Association o f Accountants type), would be in charge o f laying down binding rules for members, testing and CPE, as well as other member service activities such as training andpublications. ANNEX 1-MEETINGSCHEDULE Date Time Meeting Venue Monday,February26, 2001 16:OO- 17:OO Meeting with Srecko Bogunovic, Special @ ETF Building Adviser to RS PrimeMinister I -- Monday,February26,2001 17:30 - Meeting with Jacques Buribond, US Treasury @ Hotel Adviser to RS MOF 27,2001 09:OO- 1O:OO Meeting with Ms. Branka Bodroza, Director of Address: Mladena Agencies, RS Securities and Exchange Stojanovica4 Commission Phone: 051 308 311 Tuesday, February27,200 1 10:15 - 11:15 Meeting with Mira Vucic, Head of Accounting Address: Vuka Karadzic Department at RS MOF 4 Phone: 051215 545 r- Tuesday, February27,2001 11:15- 12:45 Meeting with Ms. Gordana Prastalo, Debt Address: Vuka Karadzic ManagementDepartment of RS MOF 4 Tuesday, February27,2001 13:OO- 14:30 Meeting with Aleksandra Simic, Head of Vuka Karadzic BudgetDepartmentat RS MOF Tuesday, February27, 2001 Meeting with Ms. Gordana Balaban, Head of Address: Vuka Accounting Department of RS Min. of Karadzica4 Education Phone: 051 218 482 Tuesday, February27,2001 16:OO- 17:30 Meeting with Greg Taber - USAID Banking Address: Marije Bursac Adviser to RSBA 411 Phone: 051 216 676 Wednesday, February 28, 09:OO- 1O:OO Meeting with Slavica Injac, Director of RS Address: Marije Bursac 2001 BankingAgency 4 1 Phone: Wednesday, February 28, 10:30- 12:OO Meeting with RalphLaws, US Treasury Adviser Check with IrindStevo 2001 Ito RS MOF Wednesday, February 28, 15:OO- 16:OO Meeting with Milenko Vracar - RS Minister of Check with IrindStevo 2001 Finance Wednesday, February 28, 17:OO- 18:30 Meeting with the Boris Dejvia, Transparency @ World Bank 2001 IntemationalBiH Thursday, March 1,2001 09:OO- 10:30 Meeting with Mr. Vladislav Djurasovic, Address: Mitra President of the Associationof Accountants and Kovacevica 13a Auditors (RS) Thursday, March 1, 2001 10:30 - 11:45 Meeting with Mr. Drasko Popovic, Director of Address: Mladena the RS Directoratefor Public Revenues Stojanovica7 Phone: 051 305 092 Thursday, March 1, 2001 Meetingwith Mr.Rodic, DeputyDirector of the Address: Mladena RS Directoratefor Privatization Stojanovica4 Phone: 051 308 311 Thursday, March 1, 2001 14:30 - 15:30 Meetingwith the RS PrimeMinister Check with IrindStevo Friday,March2, 2001 08:30 - 1O:OO Meeting with Manfred Dauster - OHR Head of @ OHR Anti FraudUnit EmerikaBluma 1 5iH CFAA: Annex I - Meetins Schedule 73 Date Time Meeting Venue Friday, March2,2001 13:OO - 14:OO Meeting with Jane McNeil - Financial @ World Bank ManagementSpecialistfrom SEED ~~~~~ Friday, March 2,2001 16:OO- 17:OO I Meeting with USAID's Coorporate Govemance 1@ World Bank Team ~~ ~~ Monday, March 5,2001 11:00- 12:OO Meeting with Mr. Vjekoslav Tomljan - Address: Cemalusa9 Federation Securities and Exchange Phone: 665 897 Commission Monday, March 5,2001 13:OO - 14:30 Lunch with Simon Gray (Principal Country @ Bella Italia Officer for BiH) Tuesday, March 6,2001 09:OO- 10:15 Meeting with Prof. Jahic, Federation IAA Address: Mehmeda Director General Spahe 5 Phone: 668 225 Tuesday, March 6, 2001 10130- 11:45 Meetingwith the Director of the FederationTax Address: Podgaj 3 Administration Phone: 202 007 _ _ _ ~ ~ Tuesday, March 6, 2001 13:30- 14:45 Meeting with Mr. Allan Janssen, Head of Address: Bistrik 9 CAFAO Phone: 666 040 Tuesday, March6,2001 16:30- 17130 Wednesday,March 7,2001 1o:oo - 1l:oo Ministerfor Budget, FederationMOF Spahe 5 Phone: 217 908 ~ Wednesday, March 7,2001 12130- 14:OO Meeting with Mr. Filip Andric, Director of Address: Mula Mustafe FederationCustomsAdministration I Baseskije 6, 4`h floor Phone: 442 256 Wednesday, March 7,2001 14:30- 15:30 Meetingwith LenaAnderson, SNAO Adviser to @ World Bank SAIs Wednesday, March 7,2001 16:OO- 17:OO IIMeetingwith Bill Lawranceand Gary Scopes of @ World Bank USAID Thursday, March8, 2001 1O:OO- 11:30 Meeting with Mr. Mirsad Sirbubalo, in charge Address: Mehmeda of Accounting and Internal Auditing as well as Spahe 5 Treasury at the FederationMoF Phone: 206 308 ~~ Thursday, March 8,2001 15:OO - 16:OO I Meetingwith Mr.Bruno de Schaetzenof IMF I Address: M.Tita 25 Friday, March23,2001 39.00 - 10.30 Meeting with Mr. Hasib Gianica, Saraqjevo Sarajevo Canton CantonalFinanceMinister Building Thursday, May 10,2001 10.00- 11.OO Meeting with Mustafa Ramovic, Sarajevo Sarajevo Municipal Mayor Building Thursday, May 24,2001 15.00- 16.00 Meeting with Dragoljub Davidovic, Banja Luka Municipal Building Municipal Mayor Friday,May 25,2001 10.00- 11.OO Meeting with Ms Radmila Stojnic, Head of Municipal Building Finance for BanjaqLuka Municipal BiH CFAA: Annex 2 -Biblioumhv and References 74 ANNEX 2 -BIBLIOGRAPHY AND REFERENCES BiH Council of Ministers - MFTER: Entrepreneurial Society (Bosnia and Herzegovina Economic Development Strategy Global Framework 2000-2004), Sarajevo, May 2001. BiH,Government of: CompetitivenessReport. Bosnia and Herzegovina, Government of and The World Bank - The Establishment of . Supreme Audit Institutions. Policy Paper, July 1998 (International Management ConsultantsLtd-IMC). Bosnia and Herzegovina, Governmentof: Letter of Intentto the IMF, December4, 2000. EBRD Business Forum: Bosnia and Herzegovina-2000 Country InvestmentProfile. Economist Intelligence Unit Country Report: Bosnia andHerzegovina, February2001. European Commission's Program of Support for Economic Revitalization in BiH: Bosnia andHerzegovina andthe Roadto Europe, April 20,200 1. European Stability Initiative: ReshapingInternational Priorities in Bosnia and Herzegovina -PartOne:BosnianPowerStructures, 1999; andPartTwo: InternationalPower, 2000. Federation of BiHandU S Treasury Department:Rule Book on Financial Reporting andthe Annual Accounts of the Budgets in the Federation of Bosnia and Herzegovina, July 27, 1999. Federation of Bosnia and Herzegovina, Banking Agency of the: Information on The Banking System of the Federation of Bosnia and Herzegovina as of 9/30/2000, September 2000. Federation of Bosnia and Herzegovina, Federal Ministry of Finance: Budget Framework Paper 2001-03 (preparedwith assistance fromthe World Bank), July 2000. Foreign Investment Advisory Service (FIAS), a joint service of the International Finance Corporation and The World Bank: Bosnia and Herzegovina: Administrative Barriers to Investment,January 2001 - Draft. International Crisis Group (ICG) Balkans Report No. 110: No Early Exit: NATO's Continuing Challenge inBosnia, SarajevoiBrussels,22 May 2001. International Crisis Group (ICG) Balkans Report No. 64, 21 April 1999: Why Will No One Invest in Bosnia and Herzegovina? - An Overview of the Impediments to Investmentsand Self-sustaining Economic Growth inthe Post-Dayton Era. International Crisis Group (ICG) Balkans Report No. 84: Rule o f Law in Public Administration - Confusion and discrimination in a Post-CommunistBureaucracy, Sarajevo, 15 December 1999. OHR SpecialAuditor ,FBiH SpecialAudit Report ,May 2001. OHR: Economic Strategyfor the Year 2001. OSCE Audit Team incooperationwith the RS Supreme Audit Institution, RS SpecialAudit Report, May 2001. PIC SteeringBoard Communique, February 1, 2001. Republic of Sprska, Banking Agency of: Report on Conditions of Banking System of Republic of Sprska for First Halfofthe Year 2000, May 2000. Republic of Sprska, Ministry ofFinance: Budget Framework Paper 2001-03 (preparedwith assistance from the World Bank), July 2000. BiH CFAA: Annex 2 - Biblioaraohv and References The World Bank: M O P for the Second Public Finance Structural Adjustment Credit, June 1, 1999. Transparency International: Bosna IHercegovina- launch o f the Country Chapter inBanja Luka, February 23, 2001. UNDP: Early Warning System in BiH: Public Opinion Survey, May 2000 (Prism Research). UNDP: Early Warning System in Bosnia and Herzegovina - Base Line Report and Quarterly Report July-September 2000 UNDP: HumanDevelopment Report for 2000. United States General Accounting Office (GAO) Report to Congressional Requesters and Testimony Before the Committee on International Relations, House o f Representatives: Bosnia - Crime and Corruption Threaten Successful Implementationo f the DaytonPeace Agreement, July 2000. United States Institute o f Peace (USIP) Special Report: Bosnia's Next Five Years- Dayton and Beyond, November 3,2000. USAID Barents G r o u p W M G : Bosnia and Herzegovina - Strengthening Bank Supervision, February 2,2001 . USAID Public Sector Accounting Project : BiH: Financial Information and Management System - Goals and Requirements, M a y 8, 2000 and updates. USAID, "Payment Bureaux in FiH: Obstacles to Development and a Strategy for Orderly Transformation," February 15, 1999. USAID: Nations in Transit 1998 - Civil Society, Democracy and Markets in East Central Europe and the Newly Independent States (Freedom House). World Bank Group, FARAHand LAC1ImplementationHandbook. World Bank: Bosnia and Herzegovina - Public Expenditure Review (I and I1 volumes), November 26, 1997. World Bank: Bosnia and Herzegovina Fourth Country Portfolio Performance Review (CPPR), March27-April 6, 2001 Aide Memoire. World Bank: Country Assistance Strategy o f the World Bank Group for Bosnia and Herzegovina, June 14, 2000. World Bank: Croatia Beyond Stabilization, December 19, 1997. World Bank: Inter-Country Governance Score Cards for South East Europe Concept Paper, February 2001. BiH CFAA: Annex 3 -Financial Manaaement at Entifv, Cantonal and MuniciDal Levels 76 ANNEX 3 - FINANCIAL MANAGEMENT AT ENTITY, CANTONAL AND MUNICIPAL LEVELS Entity Level: Federationof Bosniaand Herzegovina 1. The FederationTreasury operates as a department within the MOF, organized around two main units, Accounting and Budget Execution. The government issued the decree for the establishment o f the Treasury Single Account (TSA), Treasury General Ledger and functions o f the Treasury in M a y 2000. To support the establishment o f the TSA, profound modifications o f the information system were required (supported by a USAID-assisted project). Considerable investment i s also required incapacity buildingand continuing training, for management and staff to become familiar with the functioning o f a modern treasury system. 2. The Treasury i s organized around five units: IT, Accounting Methodology, Budget Execution, Accounting/Reporting, and Internal Controls. Its role i s to administer expenditure in accordance with the qualitative/quantitative criteria set out inthe annual budget law. The treasury system will introduce greater discipline in budget management, since will release funds only according to the approved budget appropriations, and will ease controls on budget expenditure, since each budgetary entity will have its own account with the Treasury. Classes o fpayments that are currently outside the budget (for instance the salaries o f military personnel, tax and customs administration managers) are gradually being centralized and brought under the treasury system. 3. Until 1999 there was no computerized accounting system in the MOF, since accounting and reporting functions were performed by the ZPP (Payment Bureau). At present, accounts are kept on a cash basis using a locally developed, PC-based accounting software customized for M O F use. Each line ministry maintains its own accounting records, which are mostly paper- based. While the ministries do not use a standardized accounting system, they are required to prepare financial reports using a common format. This prevents the preparation o f consolidated financial reports at the Federation central government level and creates serious problems in terms o f integrity, completeness and overall reliability o f accounting data (including spending units' reconciliation with MOF data), and timeliness o f financial reporting, despite the official reporting timeline. 4. At present, the Federation Treasury is unable to quantify the level o f commitments entered by spending units, including level o f the arrears. Even under the new treasury system, no contract registration (or purchase order system) will be established; however, it will be possible to check ex-ante on the correspondence o f expenditure with the approved budget24.With the new system, ministrieswill make their own entries but all within the same system, which will be Web- based or, in any case, accessible through on-line connection (with the main server resident in the Federation MOF). 5. According to the Rule Book, the creation o f an internal audit unit in all Federation Ministries is envisaged, with a centralized group o f controllers within the MOF, ensuring independent reviews o f the work performed. Staff previously employed inZPP (Payment Bureau) will be hiredfor this purpose. 24 For example, if the absence o f specific provisions to purchase personal computers in the relevant ministry's annual appropriations, no expenditure for personal computers can be approved. 5iH CFAA:Annex 3-Financial Manaqement af Entity, Cantonal and Municipal Levels 77 EntityLevel: Republicof Sprska 6. The RS has a very centralized government and budget system. Budget preparation i s a mainly a top-down exercise; while ministries and other spending units are, in fact, required to prepare data for planning purposes, in practice these inputs are not used in the actual decision- malung process. The budget i s prepared at the Entity (central government) level. While it indicates the amounts available for transfers to the municipalities, it does not include local government budgets (or revenue collected by the municipalities). The problem with budget planning in the RS is that increased expenditure implied by the passage o f new laws i s not taken into considerationduringbudget preparation. 7. Accounting and internal audit functions are concentrated in the MOF. The Accounting Department i s a small unit. The chart o f accounts, from a public sector budget perspective, for 2000 has been harmonized with broad IMF economic classification categories, but still does not reflect functional classifications. The 2001 budget was reformatted in accordance with the required IMF and WB classification only after its approval, including foreign government grants and IDA credits. Off-balance sheet items (such as guarantees) are ignored. Their recognition would imply changes inthe Budget Law to modify the definition o f debt. Municipalities maintain their own accounting records (for budgetary items and extra-budgetary funds), and these are not consolidated at the Entity level. 8. Bookkeeping i s performed usinga locally developed software, the performance o f which i s not judged satisfactory by its users. The setup o f the new Treasury system will allow the introduction o f a new computerized accounting system; training activities in the use o f the new system have been carried out. Each ministry has an accountant linking up with the unit responsible for the accounting o f all budgetary organizations (including data entry). In all ministries, segregation of duties i s ensured by having a cashier handling cash. Expenditure- supporting documents are maintained in the various spending units, which provide for (manual) journalizing and submit a monthly report to the RSMOF, whose Accounting Department prepares monthly consolidations o f data coming from spending units. 9. However, especially for budgetary entities having under their purview more than one separate spending unit (for instance, individual schools within the Ministry o f Education), actual expenditure recording i s highly fragmented and unreliable, since sub-units (or dependant organizations) do not submit expenditure reports to the parent ministry.Inthe case o f schools this problem has been rectified, as o f June 2000: with the introduction o f the new budget classifications, schools are in fact now required to submit such reports. 10. The new treasury system will provide for more transparency in budget funds allocation. In the previous system, managed by the Payment Bureau, it was common for revenues to be moved around various accounts, malung it very difficult to quantify and correctly record them. The current system, lacking minimum elements o f financial controls, does not prevent irrational spending (salaries, utilities consumption, etc.) and possible abuses. Under the new system the MOF will be able to direct funds to their correct use, within the limits o f authorized expenditure. However, extra-budgetary funds will continue to operate outside the new treasury system. 11. A small Budget Inspection (Controllers) Unit within the MOF is charged with the responsibility for carrying out internal audit functions for the all RS's public sector entities. There a clear capacity problem: staffing o f the unit i s insufficient to cover all ministries, government agencies, and municipalities (including onsite inspections), and the few staff available lack the required technical competence. 6iH CFAA: Annex 3 - Financial Management af Entity, Cantonal and Municipal Levels 78 Canton Level in the Federation: Canton of Sarajevo Budget Framework 12. Cantonal budget preparation i s required to comply with the Federation L a w on Budget, passed by the Federation Parliament in 1998, and with annual Laws on Budget Implementation passed by the Federation Parliament and the Cantonal Parliament each year. For the first time, the 2001 annual budget was based on the medium-term Budget Framework Paper (covering the period 2001-2003), preparedby the Canton with IMF/World Bank support. Budget Preparation 13. A two-way approach is adopted, involving both bottom-up and top-down consultations and processes. The MOF issues instructions and guidelines to all budget beneficiaries for the preparation o f their budget requests. There are 300 budgetary entities and 14,000 employees in the Sarajevo Canton. The line ministries are responsible for the detailed budget prepared on the basis o f the instructions and guidelines issued each year. The MOF formulates the draft budget for submission to the Cantonal Parliament based on the budget requests as well as the revenue assessment. However, the budgets are not always based on sound revenue estimate^^^. 14. According to the law, the draft budget i s to be completed by November 30. Public discussion o f the draft includes review by an independent parliamentary budget committee (with members from all political parties), but the MOF i s not required to accept its comments. The budget mustbe finalized and adopted by December 3126. Revenues Collection and Management 15. Ninety-two percent o f revenues collected (wage taxes, sale taxes and profit taxes) are the result o f the Federation Laws. Only 8 percent o f the revenues collected are the result o f the Cantonal Laws. There i s currently a lack o f coordination between the Federation and Cantonal MOFs regardingthe policies and procedures for revenue collection. For example, the Federation Tax Administration i s responsible for collection o f 92 percent o f Sarajevo Canton's revenue but it reports only to the Federation MOF, so the Cantonal M O F has no input or influence on the effectiveness o f collection management. 16. The regulations specifying cantonal revenues are usually issued by the Federation Parliament. However, changes are fi-equently made to these regulations without consulting the cantonal authorities. Such amendments, especially those made in the middle o f the fiscal year, have usually significantly reduced the cantonal revenue stream2'. 25The total budgetrequest for 2001 was KM 614 million, while a realistic assessment o f revenue collection for 2001 would have led to a budget o f around KM400 million. 26 For instance, the 2001 budget was not presented to the Cantonal Parliament within the prescribed timeframe due to the time required to complete changes in the Federation Government. The Cantonal Government issued a temporary decision to extend the deadline. The budget was finally presented to the Cantonal Parliament on at the end o f March, 2001. 27 Some o f these changes were introduced with the intervention o f IMF and WB. For example in 2000, there were three major changes: (i) inApril 2000, the payer o f the sale tax law was changed from first to final buyer. For this change, there was adequately consultation with the cantons, who agreed to the change, as well as with the WB; (ii) inAugust, the wage tax was decreased from 15 percent to 10percent, but in this case, there was no consultation and no submission o f comments was allowed; (iii) September, the in Treawy 17. The Treasury started operations on January 8, 2001 with the introduction o f the new payment system. The Treasury i s organized as a department within the MOF, with staff and equipment coming from the former Payment Bureau (ZPP). The system i s functioning much better than anticipated, as there has been no delay in the inflow o f revenue, except for those held up during the initial months. Currently, the Treasury's functions are limited to managing the revenue stream and allocating money to spending units according to the approved budget. A different department in the ministry i s responsible for budget execution. However, there are plans to merge the budget execution department with the Treasury. Ifthis happens, the Treasury would be able to monitor revenue as well as expenditure. Budget Allocation 18. The main problem in budget allocation and expenditure i s that sector ministries and beneficiaries continue to enter into obligations or contracts according to what appears in the budget, without regard to the actual inflow o f revenues or receipt o f funds. The principle that actual expenditure should be based on revenues collected, in order to avoid creation o f arrears (especially inunpaid bills), has never been practicedpreviously, i s not clearly understood, and i s still not yet in place. The MOF has accepted this principle but i s still working out the correct procedure (how much to allocate to the ministries and how to control monthly expenditures). Pure cash accounting i s still inuse, and the use o f accrual accounting concepts (as provided for inthe Rule Book on Financial Reporting and the Annual Accounts o f the Budgets in the FBiH) is not fully understood. Financial Reporting 19. The line ministries are responsible for providing budget executionreports to the Cantonal MOF. To accomplish this, the line ministries are responsible for the collection and initial consolidation o f all reports from lower-level beneficiaries, based on the instructions contained in the Rule Book (issued by the FederationMOF). For instance, the Cantonal Ministryo f Education collects and consolidates budget reports fiom 132 schools and educational institutions and sends only the consolidated report to the Cantonal MOF, where financial reports from municipal governments are also received. The financial reporting cycle envisages quarterly, semi-annually and yearly submissions. 20. The accounting and budgeting systems use internally generated software that runs in all sector ministries and the MOF. However, not all budget beneficiaries have the accounting software installed (the MOF and other beneficiaries have no funds to buy software and hardware for all users). Since different beneficiaries use different systems (often non-computerized) for accounting and reporting, and the ministries and other beneficiaries do not have adequate numbers o f slulled staff to perform these functions, there are no unified reports, whatever the Rule Book may say. It i s therefore difficult to ensure the reliability and completeness o f current financial reports, as there are too many budgetary entities not complying with official systems and procedures. sale tax was reduced from 4 to 2 percent, and in this case as well, there was no consultation and no submission o f comments was allowed. The result was that collections dropped significantly below anticipated amounts. BiH CFAA: Annex 3 -Financial Manaaement at Enfifv, Cantonal and Municbal Levels 80 21. Each canton i s responsible for reporting to the Federation on budget execution in accordance with the Rule Book. As to the relation between Cantonal government and the municipal governments, according to the Law on Budget, the Canton i s responsible for receiving and consolidating the accounts o f all municipalities and towns and sending the resulting consolidated account to the Federation government. The actual use o f this information at the FederationMOF level is unclear. With the exception o f the Canton o f Sarajevo, most cantons are not able to prepare these consolidated municipal reports. Municipal governments and municipalities have their own problems with preparation o f reports. Their staff needs training to help them to understand the Rule Book and the reporting requirements. Internal Audit 22. A small InspectionUnit has been established within the Cantonal MOF. The department head i s the chief o f budgetary inspection. The inspectors perform control of expenditure in accordance with the Internal Rule Book and report to MOF senior management. Findings relating to ineligible expenditure would be brought to the attention o f the responsible spending unit with a request for rectification. However, in practice, most sector ministries do not respond to the requests or decisions by the MOF. There i s plan to create an internal audit unit reporting to the parliamentary Audit Committee which, when introduced, will ensure greater transparency and also create enforcement authority. External Audit 23. At present there is no external audit o f the consolidated and individual accounts o f Cantonal budgetary organizations. The FBiH Audit Office (the Federation Supreme Audit Institution, SAI) has requested selected information and data from cantons and municipalities but has not expressed any intention to audit their financial statements. It i s recommended that the law be amended to mandate SA1 certification audits o f all cantonal government accounts (including line ministries, other budget beneficiaries, and municipalities). Municipal Level inthe Federation: Sarajevo Central Municipality Budget Framework 24. Federation municipalities are required to comply with the Federation Law on Budget, passed by the Federation Parliament in 1998, and with annual Laws on Budget Implementation passed by the Federation Parliament and the Municipal Parliament each year. Based on the provision o f cantonal grants to municipalities and their quarterly reporting requirements to the canton, municipalities should, inprinciple, harmonize their budgetswith the cantonal budget. Budget Preparation 25. The Municipality Finance Department i s responsible for budget preparation. The budget i s usually adopted before the end o f the calendar year. The steps in the budget processes are as follows: (a) The Finance Department develops the budget fkamework (or guidelines) based on the proposed development priorities, goals and purposes expressed by the Municipal Council during June/July each year (however, there are often delays. This activity i s based on consultations with the local communities. (b) The budget framework (or guidelines) is then approved by the municipal's Prime Minister(PM); BiH CFAA: Annex 3 Financial Management at Entitv, Canfonal and Municipal Levels - 81 (c) Each unit (or department) prepares an initial draft budget (estimated revenues, expenses, projection and number o f employees for salary calculation). The Finance Department assists the unit/department in the preparation and also with consolidation, where multiple unitsare involved. The departmentalbudgets should harmonize with those o f the various budget beneficiaries outside the municipal govemment (non-profit organizations or NGOs, accounting for about one third o fthe overall budget). (d) The Finance Department discusses the consolidated initial draft budget with the PM, who evaluates it in light o f the budget framework and proposes the needed increases or decreases for draft budget completion. (e) The Municipal Council reviews and approves the revised budget. The council adopts the draft budget, which i s publicized in the bulletin, for information to all communities and other stakeholders, activating a further, final round o f consultations. This process usually takes a month. (0 After receiving, reviewing and incorporating the inputs from communities, the final budget i s prepared and submitted to the Municipal Council for adoption. 26. Interms of oversight, at the municipal level, there is no Budget or Finance Committee that reviews the budget proposal or checks the results of budget execution. RevenueAllocation 27. Inthe Federation, municipal revenues come from two main sources: a share of local taxes collected in the municipality by the canton, and grants from the canton. Municipalities also collect their own income from operations such as renting office space, and other minor sources (registry o fbirths, deaths, marriages). 28. The municipality receives 70 percent o f real estate sales taxes collected in the municipality, with the remaining 30 percent going to the canton. The municipality receives 30 percent o f property taxes and taxes on income from property collected in the municipality, with the remaining 70 percent going to the canton. The municipal authorities have no means to check that the shared revenues they receive from the canton are the amounts they are actually due. Nor do they have the means to leam the income available at the cantonal level for the basic municipal grants. Financial Reporting System 29. Municipalities are required to submit: (i) quarterly reports to the cantons prepared in accordance with the prescribed format; and (ii) half-yearly report to the PM, in accordance with the budget framework laws. There are no monthly or regular reports for the PM or other budget stakeholders. All expenditures or commitments must be approved by the PM. The municipality monitors expenses via control purchase orders or commitment recording by the PM. Individual departments must consult with the Finance Department for actual budget balances before seeking approval from the PM on new orders or commitments. N o budget execution reports are prepared for budget stakeholders. The PM can approve extra-budgetary expenses up to a set limit from the so-called "discretional" fund. The accounting system for budget reporting uses a locally generated software called JAPET, installed only inthe Finance Department. There i s no financial manual for municipal stafe they rely on the budget frameworks and regulations as their official guidelines. A financial manual should be prepared by the canton and adopted by all municipalities. The blueprint should come from the Federation, to allow harmonization o f policies and procedures and to ease consolidation at Entity level. BiH CFAA: Annex 3 - Financial Manaaement at Entity, Cantonal and MuniciDal Levels 82 Auditing 30. There are no internal audit units at the municipal level. However, in the case o f Sarajevo Municipality, the Sarajevo Canton's MOF performs control reviews twice a year. There i s no external audit o f the municipality's financial statements nor o f other budget beneficiaries. The Federation Audit Office requests selected financial information and data from municipal govemments; but it has not expressed the intention to perform a certification audit o f their accounts, due to its limited resources. It i s part o f the Audit Office mandate to audit municipalities' financial statements - however, to do this, it should be provided with adequate human and technical resources. MunicipalLevel inthe RS:BanjaLukaMunicipality Budget Framework 31, Municipalities inthe RS are required to comply with the RS Law on Budget, the Law on self-governing local governments (which covers distribution o f taxes on goods and services collected within the municipality's boundaries), and the annual Decision on Budget Implementation passed by MunicipalAssembly eachyear. Budget Preparation 32. The Finance Department is responsible for budget preparation. The budget i s usually adopted before the end of the calendar year. The Finance Department develops the budget framework or guidelines based on the proposed priorities, goals and purposes o f the municipal government. The key criteria include (i) budget proposals from the budget holder (top-down) and from users o f their financing needs (bottom-up), (ii) realistic income expectations based on likely revenue collections by the finance department (top-down). As a result, the overall budget i s likely to be based on the prior year's budget (historical expenditure or revenues) plus variable increments (under 10 percent), which are different every year. The Finance Department discusses the consolidated initial draft budget with the mayor, who evaluates the budget for increases or decreases. The completed draft budget i s then submitted for the Municipal Assembly's review and approval. At present, there i s no budget oversight (or finance) committee within the Assembly that reviews draft budgets or checks on budget execution; however, the Assembly could appoint a commission The approved budgets are finally disbursed in 12 monthly installments, subject to cash flow availability. RevenueAllocation 33. Inthe RS, municipal revenues come from three sources. About two-thirds originate from the municipalities' share o f local taxes and duties collected in the municipalities, nearly a third from locally collected land use taxes, rental income from offices, billboards and garages, and registry fees, and a small amount from income earned by municipal services (including water and waste collection). 34. The municipalities receive 30 percent of taxes and dues (including sale taxes, inheritance taxes, taxes on overseas income, taxes on agnculture sector, and municipal residential taxes) collected in the municipality (35 percent for the Banja Luka City), with the remaining 70 percent going to the central government. From the municipalities' share, funds are mainly earmarked for municipal programs such as the municipal assembly, the mayor's office, municipal staff salaries, and programs and activities within the Department for Economic and Social Activities (materials for schools, kindergartens, center for social works, cultural & sport, scientific activities, and so forth). The remaining part i s earmarked to operate services, including water supply, road 6iH CFAA: Annex 3 -Financial Manauement at Enfifv. Cantonal and Municipal Levels 83 maintenance, solid waste collection, and car registration, which also eam income for their operations. Financial Accounting and Reporting System 35. There i s a financial manual in the municipality, complemented by the annual budget frameworks and regulations as the guidelines. Once a year, the municipality submits reports (including a financial position) to the Ministry o f Local Governments. Although the Municipal Assembly meets at least once a month, its members receive detailed financial reports only twice a year, Budget execution reports are, in fact, sent to the Assembly every six months and contain detailed financial reports prepared, on a cash basis, by the Finance Department, including actual revenues and costs vs. budgeted figures. No formal monthly or regular financial reports are prepared for the mayor or Assembly. Duringthe interim months, the Finance Department Head indicates to the Assembly whether the budget i s within the approved framework. 36. All funds and commitments must be used according to the approved annual budget and planned activities. Municipalities monitor their expenses through a system o f disbursements implying monthly cash releases. Individual departments must consult with the Finance Department for the budget balances before contracting new activities during the year. The Finance Department Head monitors cash inflows and outflows on a daily basis, based on manual reports prepared by his staff. If the inflow i s reduced, the cash disbursements are reduced accordingly. The accounting and budgeting reporting systems are assisted by locally generated software. The Banja Luka municipality i s planning to implement a new computerized integrated management information system under a project expected to start soon. Auditing 37. There i s no intemal audit unit inBanja Luka municipality. According to the mayor, there are plans to establish an internal control unit within the municipality which will report to the mayor and assembly. The Ministry o f Local Government i s also responsible for the performance o f the municipal governments. Furthermore, the RSMOF and financial police are supposed to perform control reviews. The financial audit unit o f the MOF reviews the operation o f the municipality at least once a year and produces a written report for the municipality and the MOF. 38. At present, no external audits of municipal financial statements are performed. The Supreme Audit Office (the Republic o f Sprska's Supreme Audit Institution, SAI) has requested selected information and data from municipal. However, due to its limited resources, it has not expressed any intention to perform certification audits o f municipalities' accounts, although this i s within its mandate. RS's SA1should be provided with adequate human and technical resources to audit the annual financial statements o f the municipalities. B 4 3 II n J U U t :--7 1