Report No. 31651-HR Croatia Country Financial Accountability Assessment May 2005 Operations Policy and Services Unit Europe and Central Asia Region Document of the World Bank TABLEOF CONTENTS PREFACE ........................................................................................................................... i EXECUTIVESUMMARY ............................................................................................ IV SUMMARY OFRECOMMENDATIONSAND TECHNICAL ASSISTANCE ACTION PLAN ............................................................................................................ XI11 CHAPTER 1:COUNTRY. ECONOMICAND ADMINISTRATIVE BACKGROUND ............................................................................................................... 1 CHAPTER 2: ASSESSMENT FRAMEWORK ............................................................ 4 CHAPTER3: BUDGETING ........................................................................................... 8 1.BACKGROUND ASSESSMENTFRAMEWORK AND ........................................................... 8 I1.FINDINGS.................................................................................................................. 11 I11. SUMMARY OFFINDINGSAND ASSESSMENTFIDUCIARY RISK.............................. OF 19 IV. RECOMMENDATIONS .......................................................................................... 20 CHAPTER4: TREASURY AND CASHMANAGEMENT ....................................... 21 1.BACKGROUND ASSESSMENTFRAMEWORK AND ......................................................... 21 I1.FINDINGS................................................................................................................... 23 I11.SUMMARY OFFINDINGS AND ASSESSMENT OF FIDUCIARY RISK .............................. 30 IV.RECOMMENDATIONS ................................................................................................ 31 CHAPTER5: ACCOUNTINGAND FINANCIALREPORTING ........................... 33 1.BACKGROUND ASSESSMENTFRAMEWORK AND ......................................................... 33 I1.FINDINGS................................................................................................................... 36 111.SUMMARYOFFINDINGSANDASSESSMENTFIDUCIARY RISK.............................. OF 42 IV.RECOMMENDATIONS ................................................................................................ 43 CHAPTER6: INTERNALCONTROLAND INTERNALAUDIT .......................... 44 1.BACKGROUND ASSESSMENTFRAMEWORK AND ......................................................... 44 I1.FINDINGS ................................................................................................................... 47 111.SUMMARY OFFINDINGSAND ASSESSMENTFIDUCIARY RISKS ............................ OF 55 IV.RECOMMENDATIONS ................................................................................................ 56 CHAPTER 7:EXTERNAL AUDIT AND LEGISLATIVE OVERSIGHT ..............57 1.BACKGROUND ASSESSMENTFRAMEWORK AND ......................................................... 57 I1.FINDINGS ................................................................................................................... 60 111.SUMMARY OFFINDINGSAND ASSESSMENTFIDUCIARY RISK.............................. OF 67 IV.RECOMMENDATIONS ................................................................................................ 67 CHAPTER 8: LOCAL AND REGIONAL SELF-GOVERNMENTUNITS ............69 I.BACKGROUND ASSESSMENT AND FRAMEWORK .......................................................... 69 I1.FINDINGS ................................................................................................................... 70 111.SUMMARY OFFINDINGSAND ASSESSMENTFIDUCIARY RISK .............................. OF 73 IV.RECOMMENDATIONS ................................................................................................ 73 CHAPTER 9: CAPACITY DEVELOPMENT ............................................................ 74 I.RECENTTAACTIVITIESINTHEFIELDOFPFM............................................................ 74 11.ASSESSMENTTA ABSORPTIONCAPACITY. IMPACTAND COORDINATION...............75 OF 111. GENERALASSESSMENT OFPFMCAPACITY DEVELOPMENTNEEDS........................... 76 IV.RECOMMENDATIONS ................................................................................................ 78 ANNEXES ANNEX I:KEY PERSONSINTERVIEWED (INALPHABETICAL ORDER) ....79 ANNEX I1 FIDUCIARY RISKINDICATORS AND INTERPRETATION ANNEX I11 OVERALL ASSESSMENT OF FIDUCIARY RISK .. ...........83 ............................ 92 LIST OF TABLES ...................4 TABLE2.FIDUCIARYRISK INDICATORS............................................................................... TABLE1.STANDARDSAND CODESPROMOTING FINANCIALACCOUNTABILITY 5 TABLE3.REVISEDBUDGET PREPARATIONCYCLE............................................................ 13 TABLE4.STATE BUDGET REVENUEAND EXPENDITURE OUTTURNS 2001-2003 ...............16 TABLE5.VARlATION BETWEENBUDGETEDEXPENDITUREAND OUTTURNPERFUNCTIONOF TABLE6.GOVERNMENT ..................................................................................................... 17 ANNUALFINANCIALSTATEMENTS .................................................................... 37 TABLE7.CARDS 2003 EXTERNAL AUDIT TWINNING PROJECT ACTIVITIES..................... 63 LISTOF BOXES BOX 1.PRINCIPLEOF SOUND FINANCIALMANAGEMENT ..................................................... 5 Box2.THETREASURY LEDGER SYSTEM.......................................................................... 22 BOX3.TRANSACTIONSYSTEMPROCESS ........................................................................... 27 Box4. INTERNATIONAL OFINTERNALSTANDARDS FOR THE PROFESSIONALPRACTICE BOX 5 A WEAK INTERNALCONTROLFRAMEWORKTHE PUBLIC DEBT .AUDITING .............................................................................................................. 46 IN MANAGEMENT SECTION ................................................................................................................. 53 BOX 6 FIFTEENSTEPS TO ESTABLISHING INTERNAL AUDITUNIT 55 BOX 7 OVERVIEW OF THE NTOSAIAUDITINGSTANDARDS .. AN ................................ ........................................... 58 BOX 8.TASKS AND RESPONSIBILITIESOF TOWNS, MUNICIPALITIES COUNTIES .......... 70 AND Box9.EDISACCREDITATION CRITERIA .ANNEXTO COUNCILREGULATION (EC. EURATOM) . 1266/1999.................................................................................... No 77 Croatia CFAA: Preface i PREFACE This report was prepared following missions to Croatia in December 2003 and March 2004 by a World Bank Task Team that consisted o f Andy Macdonald (Consultant, Former Comptroller General and Chief Information Officer for the Government o f Canada); Matthew Andrews, (Public Sector Management Specialist, ECSPE); and Johannes Stenbak Madsen, (Task Team Leader, Financial Management Specialist, ECSPS). The CFAA team would like to emphasize that the accuracy o f this report's findings and recommendations depended largely on the feedback from their Croatian counterparts, including State Secretary o f the Ministry o f Finance (MOF), Martina DaliC; Assistant Ministers to the MOF Amalija IkSiC, Josip KuliSiC, Ivan NovaCiC and Niko RaiC; as well as Assistant Auditors General Lidija Pernar, Ljerka Lindsbauer and Hrvoje KordiC. The CFAA is based on discussions with public officials and an analysis o f data gathered during the missions. The Parliament (the Sabor), the Government and the State Audit Office fully supported the CFAA missions and engaged in dialogue with the Bank team. Particularly important was the input o f &me PrtenjaCa, who as Head o f the Sabor's Budget Committee, provided essential insightto the processesrelating to the extemal and parliamentary oversight o fthe Government. Objectives and Scope of the CFAA The CFAA i s a diagnostic tool designed to enhance the World Bank's knowledge o f public financial management (PFM) and accountability arrangements in client countries. It supports both (a) the World Bank's fiduciary responsibilities by identifying the strengths and weaknesses o f PFM arrangements so that the potential risks to the use o f Bank funds can be assessed and managed; and (b) the World Bank's development objectives by facilitating a common understanding by the borrower, the World Bank, and development partners that leads to the design and implementation o f capacity-building programs to improve the country's PFM. CFAAs are not audits; they are not intendedto be and they do not provide assurance on the specific uses to which World Bank funds have been or may be applied. The overall objective o f the CFAA is to provide relevant information to the World Bank and the government on the public sector financial accountability arrangements in Croatia and to jointly develop a program for reforms and capacity building to improve transparency and accountability for the use o f public funds. To the extent that analytical work was already available, the CFAA has updated and deepened the knowledge in areas where more specific, detailed proposals are needed. Specific objectives o f the CFAA include: (i) to update knowledge o f primary public financial accountability institutions, and; (ii) to identify the most significant fiduciary risks and related capacity issues that require the Croatian government's attention. Croafia CFAA; Preface ii Priority areas ofAttention While covering all key issues o f the CFAA guidelines o f May 2003, the CFAA explicitly identifies the international standards, codes and laws that constitute the assessment framework for this report. With a view to the specific requirements o f the EU, and subsequently the Croatian administration's preparedness for EU membership, the EC financial regulation' constitutes an important part o f the assessment framework for the priority areas listedbelow. The following broadtopics are addressedinthe CFAA: Budgeting; Treasury and cash management; Accounting and financial reporting; Internal control and internal audit; External audit and legislative oversight; Financial accountability arrangements for sub-national government; Capacity development. BenchmarkingandAssessment of FiduciaryRisk While covering the main issues o f the World Bank's internal May 2003 CFAA guidelines, the report also benchmarks the Croatian PFM system against the intemational standards, codes and laws that constitute the assessment framework (see Chapter on CFAA Assessment Framework, p. 5). Giventhe relevance o f EUrequirements to Croatia the EC financial regulation constitutes an important part o f this framework. As well as benchmarking against the standards, codes and international regulations, the CFAA also presents a nonnative rating o f fiduciary risk for each component reviewed; it i s based on a four-step scale, including low, moderate, significant and high2.For each o f the components the fiduciary risk i s ratedusing a set o f indicators listed inAnnex 11.The annex also presents an interpretation o f the indicators and an objective justification for the rating given for the individual PFM components. The methodology for fiduciary risk indicators and interpretations inAnnex I1was developed by World Bank staff and PEFA3 Secretariat staff, working with their PEFA partners, as performance indicators for PFM, as part o f an effort to strengthen approaches to PFM reform. PEFA is a partnership program o f the World Bank, the European Commission, the UK Department for Intemational Development, the Swiss State Secretariat for Economic Affairs, the French Ministry o f Foreign Affairs, the Norwegian Ministry o f Foreign Affairs and the Intemational Monetary Fund (IMF). The PFM performance indicators and interpretations 1Council regulationNo. 160.512002on the financial regulationapplicable to the general budget of the *European Communities. 'The fiduciary risk is the risk o f funds not being spent for the purpose(s) for which they were appropriated. Stands for Public Expenditure and Financial Accountability. have recently been used in assessments o f financial accountability arrangements in a number o f other countries inEurope and elsewhere, including inrelatively advanced and middle-income economies similar to Croatia. Whereas the fiduciary risk ratings can be used for the purpose o f comparison or benchmarking, they do not provide quantitative information about the probabilities o f funds not being spent for the intendedpurposes. For an overall risk rating and a summary o f the fiduciary risk assessment, please see Annex I11titled Overall Assessment o f Fiduciary Risk. The detailed interpretation o f the individual risk indicators i s offered inAnnex 11. Acknowledgements The team acknowledges the extensive cooperation and assistance from the staff o f various institutions that contributed to the CFAA, including officials and staff o f the Government, State agencies and multilateral organizations. Inaddition, gratefil thanks go to Country Director, Anand Seth; to Country Manager, Indira KonjhodiiC; and to Operations Advisor, Albert Martinez, for taking a great interest and engaging inthe work with the CFAA team. Further, the team would like to thank John Hegarty (Manager, Financial Management, ECSPS); Pascale Kervyn de Lettenhove (ECSPS); Ranjan Ganguli (ECSPS), Sanja MadiareviC-Sujster (Senior Country Economist, ECSPE); Srebrenka Gudan (Consultant, ECSPE); Ljiljana Tarade (Assistant, ECCUS); the PAL team leader Satu Kahkonen (ECSPE); and peer reviewers Ritva Heikkinen (European Commission, EC Delegation Zagreb); Brian Olden (IMF, Fiscal Affairs department); Stephen MacLeod (OECD, SIGMA) and Simon Bradbury (World Bank, LOA), who offered much appreciated comments and inputs; and to Roula Balkash (Assistant, ECSPS); Susan Middaugh (Consultant, ECSPS) and Sioban Farey (Consultant, ECSPS) who assistedwith the formatting and editing o f this report. Croatia CFAA: Executive Summaw iv EXECUTIVE SUMMARY General As a candidate country to the European Union (EU), Croatia currently focuses much of its modernization efforts on meeting the requirements o f the acquis communautai~e~. These include meeting the requirementsrelated to Public Financial Management (PFM). Inthe EUaccession context this primarily concerns Chapter 28 on financial control' and the issues captured under the European Commission's concept, Public Internal Financial Control (PIFC). In this context, the relevance o f the Country Financial Accountability Assessment (CFAA) i s evident. It assesses the legal framework, institutional capacity and practices for the core financial control processes such as budgeting, treasury and cash management, accounting, financial reporting, internal control, internal audit, external audit and parliamentary oversight. In this CFAA, topics related to financial accountability arrangements for sub-national governments and PFM capacity development provide for a more complete analysis o f the PFM arrangements and fiduciary risks. The basic approach o f the CFAA has been to compare the PFMpractices in Croatia with those promoted by relevant international standards also including a specific set o f indicators o f fiduciary risk.6 Having assessed the preceding aspects o f PFM in Croatia, this report concludes that the overallFduciary risk is ~igniJicant.~ Most o f the weaknesses in the P F M arrangements revolve around inefficiencies and weaknesses in the existing financial accounting and management systems. The Croatian Treasury within the Ministry o f Finance (MOF) relies on a SAP8 payment and financial accounting system to process and record revenues and expenditures to and from a Treasury Single Account (TSA) held at the Croatian National Bank. Whereas the SAP system can process and record all paymentsmade from the TSA, the Treasury has to rely on separate reports from Budget Users (BUS) for reconciliation and commitment accounting purposes. Although the most significant ones have now been integrated, several Extra-budgetary Funds and Agencies (EBFs) do not manage their finances via the A Frenchterm which refers to the entire complex o f European Community legislation that affects Member States o f the EuropeanUnion. 'The European Council (of EUHeads o f State and Governments) inCopenhagen inJune 1993 decided that accession to the EUwould require: (i) that the candidate country has achieved stability o f institutions guaranteeing democracy, the rule o f law, human rights and respect for and protectiono f minorities; (ii) the existence o f a functioning market economy as well as the capacity to cope with competitive pressures and market forces within the Union; (iii) the ability to take on the obligations o f membership, including adherence to the aims o fpolitical, economic and monetary union. Since then, the requirement under (iii) has been evaluated in29 separate policy areas or "chapters." Chapter 28 relates to financial control arrangements in the government administration. 6 'The The standards are listed inChapter 2. Fiduciary risk indicators are listed inTable 2 o f that chapter. fiduciary risk for the individual components o f P F M as well as the overall fiduciary risk o f the P F M system is measured on a scale from low, moderate, significant to high. See Annex I11for Overall Assessment Fiduciary Risk and Annex I1for a detailed interpretation o f the specific risk indicators applied. Trademark for a high capacity computerized payment and accounting system. TSA. There are a multitudeo f financial accounting and management systems among BUS and EBFs, which are not interfaced with the SAP system. The S A P system i s under- utilized and the further rollout and development o f the system i s currently stalled by ineffective management. The Government's decision to implement modified accrual- based accounting rules from the fiscal year 2002 was taken without due consideration of the state o f the current system infrastructure. Consequently, the annual financial reporting from BUSand the compilation and presentation o f the Government's consolidated financial statements for the fiscal year 2002, were significantly delayed and contained unreliable data. This was further complicated by the adoption o f an overly ambitious statutory reporting calendar for BUS. The internal control framework' o f the Government administration has several weaknesses and i s not supported by a general system o f internal audit, though this i s a statutory requirement o f the organic Budget Act. Although the absence o f internal audit means that an important assurance function for the efficient and effective functioning o f systems i s missing, the Government's external auditor, the State Audit Office, does provide a basic external assurance function vis-&vis Parliament (the Sabor). This report identifies shortcomings inthe SAO's legal framework and practices that couldjeopardize i t s independence and thereby limit its effectiveness. At the local level the problems inthe PFM arrangements identified at the national level also prevail. With respect to capacity development, the number o f staff in key PFM functions, such as financial control, accounting and auditing, are inadequate and training capacities are lacking. Finally, the leadership role o f the Ministryo f Finance inreforming PFM i s severely underminedby a lack o f intra-ministerial coordination, management and administrative capacity in general. A specific and very serious deficiency identified in this report is the lack o f a sound internal control framework in the Ministry o f Finance's Public Debt Management Section. The problems identified include a lack o f appropriate segregation o f duties, understaffing and a management with a history o f ignoring technical advice, including advice from its auditors. These findings are corroborated by reports from the external auditor, the World Bank and IMF assessments. Considering the large sums o f money involved, the CFAA recommends that the Croatian Government take action urgently to rectify the situation. See Box 5 inChapter 6 for details. This report offers a number o f recommendations to address the identified shortcomings and to mitigate the associated risks. The following recommendations should be given the highest priority: (i) Minister o f Finance should assign an Assistant Minister to the develop and implement a strategic vision for the future evolution and rationalization of the Government's financial systems; (ii) the MOF should commission an independent systems audit o f the SAP system; and (iii) the M O F should establish an inter-ministerial steering committee led by the State Secretary to oversee the development o f the SAP system. The Government has started taking a number o f actions in this field, including the undertaking o f a study o f existing financial management information systems and the drafting o f a financial management information system development strategy. As definedby COS0 the Committee of Sponsoring Organizations of the Treadway Commission. - Croatia CFAA: xecutive Summaw vi Inadditionto the above, anumberofrecommendations should and couldbeimplemented almost immediately. These include: (i)the MOF already completed and issued the Rulebook on internal audit as referred to the organic Budget Act (BA)"; (ii) MOF the initiating the legislative changes neededto establish intemal audit inthe most significant EBFs; (iii) and MOF appointing financial controllers as required by the BA, and; BUS (iv) the State Audit Office initiating the proposed legislative changes to the Act on State Audit. For all aspects o f Public Financial Management, this report points out specific challenges that Croatia is facing in its endeavor to meet the benchmarks represented by the acquis communautaive and the requirements for Public htemal Financial Control (PIFC). A more detailed assessment o f specific elements o f PFM, recommendations on how to modernize PFM in line with relevant international standards and the importance o f mitigating fiduciary risks are summarized below: Budgeting The lack of budget comprehensiveness poses a fiduciary risk. Although the organic Budget Act o f 2003 included the regulation o f key aspects o f the EBF's (Extra-budgetary Funds and Agencies) budget preparation and financial management, EBFs remain excluded from certain provisions o f that Act, including provisions requiring intemal audit. The current process for preparing and revising the budget appears to promote budget realism, but it does not provide for strategic budgeting or for the effective monitoring o f allocations. The budget classification includes administrative, economic, functional and programmatic classifications but the budget as it i s presented to Parliament offers little information or direction about policies and strategies. The frequent budget revisions in the course o f the year could also undermine the strategies and policies that might be reflected inthe budget. Still, the variations between budget figures and actual outturns at the functional level o fthe budget are generally small. The Ministryo f Finance, which has very limited policy analysis capacity, does not analyze budget proposals to assess their strategic content. While the strong performance o f budgets in achieving targets thus suggests low fiduciary risk, there is a moderate risk that the budget will fail to ensure efficient and effective resource allocations. Budget users are given clear guidance for the preparation o f budget submissions and generally adhere to the budget calendar. The budget does not as yet provide the type o f information required to show key expenditure types or policy development. The program and medium-termbudgeting innovations are tenuous, dependent on significant capacity building and cultural change in the Ministry o f Finance and in the line ministries. Furthermore, this kind o f budgetary approach requires a more active role o f the Parliamentary oversight committee. Whereas parliamentary scrutiny covers aggregates and detailed estimates o f expenditure and revenue, Parliament (the Sabor) appears to have accepted a limited oversight role and weak administrative capacity. There i s a risk 10By the time of the report release, the MOF issued the Rulebook inAugust 2004. Croatia CFAA: Executive Summarv vii that the budget will continue to fail to reflect a strategic, medium-termpolicy agenda and to facilitate transparency. Considering the different indicators, the CFAA finds the fiduciary risk associated with budgetingto be moderate. The CFAA recommends that the MOF: 0 Integrate all EBFs into the State budget and the Treasury Single Accounts system or alternatively make them subject to the similar budgeting, control and audit arrangements. 0 Build on its recent work inthe Bureau o f Macroeconomic Forecasting to further strengthen the forecasting function in the Ministry o f Finance in order to ensure full transparency and timely production o f forecasts, and enhanced usefulness to Budget Users (BUS). 0 Strengthen the Medium Term Expenditure Framework, based on a program classification and multi-year forecast. 0 Develop further the analytical capacity in the budget process by training budget analysts inthe Ministryo fFinance and line ministries. 0 Strengthen the role o f the Parliamentary Budget Committee by focusing its mandate on budget analysis and improving its technical support. Treasury and Cash Management There i s a multiplicity o f financial management systems that are uncoordinated and un- regulated. In addition, the strategic advantages o f relying more on the main service provider FINA," for the continued development the SAP system and other financial systems among BUS,have not been considered. The future development o f the Treasury's SAP system and its relationship to a large number o f independent, uncoordinated financial accounting systems inbudget entities has not been defined. This report suggests that components missing from the Treasury SAP system have increased the risk ofbudget over-expenditures. The absence o f a multi-period commitment control module and the lack o f any development activity to implement it i s a serious shortcoming. Moreover, the cash management module's partial implementation increases the risk o f inefficient cash management and potential estimation errors in the budget releases to budget entities that result in expenditure arrears. The most recent available data suggests that Government arrears constitute six percent o f the Government's consolidated budget. This indicates that there i s a significant risk that Government payments are not made on time. The implementation and development o f the Treasury's SAP system has not had the strong management direction and support that such projects require. There is no senior M O F manager o f the system who can establish clear requirements and deadlines, and drive the project team to succeed. Nor is there evidence o f strong involvement by those MOF units that are the logical users o f the system; and line ministry staff are also conspicuously absent. This situation guarantees that the requisite systems changes will not occur in the timeframe that i s necessary; projects o f lower priority or questionable "TheFinancialAgency, Croatianabbreviation. Croatia CFAA: Executive Summary viii value may be implementedat significant cost and limitedbenefit. A clear review of the entire project by an independent, outside expert, i s warranted. The existence of some 3,200 budgetuser bank accounts inprivate banks poses a fiduciary risk to the average HRK 500 million cash balances on deposit. In addition to being an example o fpoor cash management, this situation increasesthe fiduciary risk. Insummary, the risk resulting from the Treasury and cash management systems is rated as significant . The CFAA recommends that the MOF: 0 Assign to an Assistant Minister the responsibility for the formulation and implementationo f a strategic vision for the future evolution and rationalization o f all o f the financial systems inthe Government o f Croatia. To ensure management ownership of the SAP systems, the same Assistant Minister should be responsible for the M O F System Improvement Section; 0 Commission an independent systems audit o f the SAP system by an intemationally recognized extemal auditor or management consultancy with extensive financial and IT experience. The audit should investigate, among others, means to increase SAP'S functionality for both the M O F and the BUS; 0 Establish a Steering Committee, chaired by the State Secretary with senior representation from all affected M O F sectors, BUS,ministries and FINA, to oversee the development o f SAP. This body could also assist in the development and implementation of the strategic vision for the evolution o f the Government's financial systems; 0 Implement the Treasury Single Account (TSA) by closing all entity private bank accounts and consolidatingthem into the TSA. 0 Immediately implementthe SAP module to process multi-period commitments. AccountingandFinancialReporting A significant improvement was made as the MOF, for the first time, presented a set o f consolidated financial statements for the execution o f the state budget 2002. The recording and processing of transactions was, however, not prompt and it prevented a timely aggregation at the line ministry and MOF level. For the same reason, the consolidated financial statements for the state budget were not prepared within the statutory deadline, which seemed ambitious when compared to the deadlines set out in the EC financial regulation. Consequently, the SAO's audit o f the consolidated financial statements for the fiscal year 2002 was partly based on draft statements. One o f the reasons for the delays in reporting appear to have been the change o f accounting rules, involving an ambitious acceleration o f the time-line for the BUS'compilation o f their financial statements. The changes also involved an equally ambitious move from cash to modified accrual-based accounting principles. This move was only partially successful. Furthermore, the change does not affect the accounting entries for expenditures at the Treasury, which continues to be done on a cash basis. Dueto the set-up o f the Treasury's Croatia CFAA: xecutive Summarv ix SAP system it cannot generate a complete electronic audit trail for all types o f transactions. In conclusion, accounting data related to the execution o f the expenditure budget 2002 were most likely not reliable. Addingto the fiduciary risk is the existence o f a multitude o f accounting systems, which are often outdated and do not meet current standards for security and data protection. Based on the preceding, the fiduciary risk associated with accounting and financial reporting i s considered significant. Based on the above the CFAA recommends M O F should: 0 Take action to ensure that the statutory rulebooks'2 and appropriate guidelines and training opportunities be offered to all accountants and other staff o f Budget and Finance Units o f all BUSin order to ensure an effective implementation o f the new accountingrules. 0 Reinforce the State Accounting and Financial Reporting Section, in order to be able to provide more support to BUSin the application o f the new accounting rules, including the statutory formats and deadlines for financial reporting. 0 Extendthe statutory deadlines for delivery o f the annual financial statements and initiate the necessary amendments o f the Budget Act and the Ordinance on Financial reporting andBudgetary accounting (OFB). 0 Prioritize the recruitment o f accountants and other accounting staff given the profundity o f the current reform the Government should make and the importance o f increasing capacity. 0 Consider a strategy to effectively support a modemization o f the state administration's accounting system, which should be based on a detailed review and due consideration o f differentpossible solutions. InternalControlandInternalAudit Whereas a number of Rulebooks and regulations provide the regulatory framework for procedures and physical controls, a proper segregation o f duties, appropriate staffing, exemplary management behavior and other key components in a sound internal control framework often do not exist. The Public Debt Management Section o f the M O F offers one such an example. Also, there are numerous examples o f Rulebooks mentioned in laws, which have not yet been issued. The Budget Users' financial controllers requiredby the Budget Act (BA) have typically not yet been recruited or assigned to the task. The current control environment is not robust enough to mitigate the risk o f official corruption and conflicts o f interest. The introduction o f intemal audit via the BA i s a positive development. The CARDS project in support o f establishing intemal audit units (IAUs) is well conceived and has a realistic and robust plan for a progressive implementation across the Government. It must be strongly supported because it offers the best path to conformance with Chapter 28 o f the acquis communautaire and a PIFC- compliant intemal control and audit system. The CFAA offers practical guidance for BUS,who wants to establish such a unit.Weighingthe different fiduciary risk indicators, l2As requiredby the Organic BudgetAct. Croatia CFAA: Executive Summaw X the CFAA finds the risk associated with the internal control framework, including internal audit to be significant. The CFAA recommends that: 0 The M O F eliminate the identified weaknesses in the internal control framework of the Public Debt Management Section o f the MOF, given considerable risks and the large sums involved. 0 The M O F issue all statutory Rulebooks and the necessary detailed guidelines that concern internal control as a matter o f priority. MOF and other BUSmust subsequently take steps to develop appropriate written procedures for financial processes. 0 The M O F establish an internal audit function by proposing changes in laws affecting all EBFs, and key entities receiving or managing public funds, with the inclusion o f FINA. 0 The BUSshould hire an individual or assign an existing staff member as soon as possible, to perform the role o f Financial Controller in accordance with the provisions o fthe BA. This should be a person other than the Chief Accountant. 0 The MOF provide a strong champion for change for the new internal control and audit system, and should develop and promulgate its draft PIFC policy with a vision o f its internal control system and a strategic vision o f its internal control system that i s consistent with the Budget Act and the ongoing EU funded technical assistanceactivities. ExternalAudit andParliamentaryOversight The Act on State Audit provides a broad mandate for those public funds and institutions that it i s required to audit as well as the audit standards and methods it can apply. However, the act has shortcomings that should be addressed by the State Audit Office (SAO) and Parliament (the Sabor) as a matter o fpriority. One shortcoming i s that the S A 0 is not formally required to provide a statement o f assurance on the execution o f the state budget. The SA0 i s however required to report to the Sabor annually on the audits performed and it does offers an opinion based on audits of the full set o f Government financial statements. Due to the nature o f its legal mandate and the methods applied this however does not constitute a formal statement of assurance on the Government consolidated financial statements or the execution o fthe state budget. The SAO's legal framework does not guarantee its financial independence from the government, which currently makes it subject to the MOF's budget supervision. Whereas the Act on State Audit (ASA) explicitly provides a mandate for it, the SA0 still has not piloted any audits o f economy, efficiency or effectiveness. The SAO's reports are perceived to be authoritative and the Sabor acts on audit recommendations. There are indications that the Sabor considers the SAO's reports rather narrow in focus and scope. The combined fiduciary risk associated with external auditing and Parliamentary oversight i s considered moderate. Croatia CFAA: Executive Summaw xi The CFAA recommends: 0 The ASA be amended to ensure that the SA0 budget is presented directly to Parliament without prior adjustments by the MOF. The MOF's right to exercise budget supervision over the SA0 should subsequently stop, while the annual financial statement o f the SA0 be made subject to an independent external audit appointedby Parliament. 0 The ASA be amended so that the SA0 will be formally required to submit a statement o f assurance on the execution o f the State Budget as to whether the Government's consolidated financial statements gives a true and fair view o f its financial position and the sources and uses o f funds. In doing so, the S A 0 should seek to apply the International Standards on Auditing (ISA) and develop its competencies accordingly. 0 The ASA should be amended to allow the SA0 to audit all EU funds. The SA0 should consider positively the challenge o f auditing and becoming a certifying body for future EUfundedprograms inCroatia. 0 SA0 take concrete initiatives to pilot audits of economy, efficiency and effectiveness (performance or value-for-money audits) in line with the recommendations o f the 1999 CFAA, the 2002 SIGMA peer review and the World Bank's Public Expenditure and InstitutionReview2002. 0 The SA0 and the Sabor shouldjointly consider the establishment o f a specialized Public Accounts Committee, for example, as a sub-committee o f the Budget Committee. Sub-nationalGovernment On the whole, the budgeting practices o f sub-national governments are sound. They provide reasonable assurance that the budget reflects the priorities o f local and regional interests and political parties. These practices also effectively prevent over-borrowing at the sub-national level and the generation o f contingent liabilities at the state level. That being said, the existence of a great number of bank accounts owned by local government increases the risk o f public funds following channels outside the formal processes set out in the BA. The ongoing process o f decentralization, combined with recent changes in accounting rules have caused problems in the reliability o f financial reporting to the MOF, The S A 0 provides external audit arrangements with appropriate frequency and provides a safeguard against the misuse o f funds. The SAO's resources are, however, spread thinly at the sub-national level. Generally speaking, the transparency o f the PFM system seems greater at the sub-national level than at the state level. More direct lines o f accountability between the citizen and the elected representative should reinforce this. Based on the concrete concerns related to cash management, the reliability o f financial reporting and internal control, the fiduciary risk associated with the PFM and financial accountability arrangements for sub-national governments i s ratedsignificant. Croatia CFAA: Executive Summaw xii The CFAA recommends the following: 0 The M O F should issue all the statutory rulebooks and guidelines on internal audit and accounting referred to in the Budget Act, which also applies to sub-national government. Furthermore, it should offer appropriate training for their effective application. Local and regional administrations should prepare to implement the intentions o fthe new act, including steps to establish Internal Audit Units. 0 The practice of engaging and educating citizens in local budget expenditures, as done in the town o f Varazdin, i s a best practice in ensuring transparency and accountability. The concrete practice o f public campaigns (for example, via the distribution o f flyers) to inform citizens about the use and sources o f the local budget should be expanded to other sub-national government administrations. CapacityDevelopment The number and capability o f staff in newly established and specialized PFM functions are inadequate; financial controllers and internal auditors are one such example. In addition, staff responsible for bookkeeping, accounting and financial reporting do not know how to undertake the changes to the accounting regimerequiredby the BudgetAct. A similar situation exists for the Ordinance on Financial Reporting and Budgetary Accounting (OFB) for Budget Users. These professional groups are essential to the PFM; and the Croatian govemment needs to address this problem, which can also have an impact on the administration's ability to develop implementing agencies for EU pre- accession and structural funds. The CFAA recommends that M O F should: 0 Designate a responsible senior management position at the Director level (minimum) to oversee the development o fthe comprehensive training strategy, in consultation with the donor community, planned and current training providers andthe professional associations o f accounting and auditing inCroatia. - m 4 .Ei M .g c1 x Y .I L .I .a s80 5 e! CHAPTER 1:COUNTRY, ECONOMIC AND ADMINISTRATIVE BACKGROUND EconomicBackground 1. Currently, Croatia's economy i s characterized by a slowdown. The industrial output growth rate has recovered slightly following a period o f stagnation; it has generally low growth rates, low inflation and highunemployment. Inthe fourth quarter o f 2003, industrial production reached a 5.6 percent annual growth rate. Inthe same period the Consolidated General Government deficit reached HRK 3.5 billion or approximately 1.8 percent o f GDP. Inthe last quarter o f 2003, public debt was 55.5 percent o f GDP". The growth in Croatia's public debt has become an issue o f concem. The repayment costs, including interests have been steadily increasing from HRK 2.4 billion in 1999, to an estimated HRK 4.5 billion in 2003, or close to 5 percent o f total expenditure o f the general govemment16. 2. Croatia's relationship to the EU i s defined via the Stabilization and Association Agreement (SAA). The process o f approaching the EUincluded the initiation o f reforms in all areas of the acquis communautaire, including those linked to financial control (Chapter 28). Following the European Commission's positive communication o f April 20, 2004, conceming Croatia's application for EUmembership, Croatia formally became a candidate country to the European Union (EU). 3. Inits opinion of April 2004, the European Commission stated that Croatia could be considered a functioning market economy. The Commission also noted however, that the working o f market mechanisms still was in need o f some improvement. Among the issues emphasized by the Commission was the fact that enterprise restructuring and privatization has been slower than expected and that certain large state and formerly socially-owned enterprises continues to play a significant role inthe economy. Also, the need for reforms o f the fiscal and social security systems as well as the public administration were said to be in-complete. The Commission also stressed that fiscal consolidation neededto be vigorously pursued. AdministrativeBackground 4. The Croatian budgetary system has undergone several reform or reform attempts during the last three to four years. This has included a change o f accounting principles; the first consolidation o f the government's accounts; the addition o f budget classifications; the initiation o f program budgeting; the introduction o f a Treasury Single Account and a computerized Treasury system. In fact, the development o f a treasury system had already started by 1995. At the same time, the administrative capacity o f the key institutions for budgetary control has been called into question. It has been argued that the amounts allocated for professional improvement o f budget professionals o f Parliament, Government (Council o f Ministers) and Ministry o f Finance are insufficient. This argument is being supported by the fact that even when the budgets for the three institutions have steadily increased over the last three FYs, the budgets for professional l5World Bank data. l6Newsletter of the Institute of Public Finance, No. 12, December 2003 training have not or they continued to be financed at a very modest level". To judge from the current debate among professionals in Croatia, it seems evident that the Public Financial Management system i s under some stress, which i s bound to influence the regularity and effectiveness o f services inkey administrative bodies such as the Ministry o fFinance. 5. Stress on the administration also appears to be generated from deficiencies inthe framework for the civil service in general. The Law on Civil Servants and Support Staff o f 2001 provides a legal basis for the status o f civil servants. The Law does not make any distinction between state officials (political appointees; they are covered by a separate legislation) and civil servants, thereby leaving unresolved issues such as status, role and obligations o f political personnel inthe civil service, tenure o f political appointees within the civil service, modalities for the conversion o f the status o f political appointees to that o f civil servants. The current number o f administrative rulebooks and inconsistencies between them create the conditions for a multitude o f civil service management standards. The Law suffers fiom further deficiencies, especially with regard to a system of promotions, mobility, separation from service and disciplinary measures. The rules goveming recruitment and selection o f candidates could also be improved. A point o f discussion is whether the salaries o f civil servants are too low to attract adequate numbers o f young and educated professionals to work in the state administration, especially as they have to have the same or higher education than those working inother sectors. There i s no central training institution for civil servants, or a Government training program. However, following the adoption o f the Law on the Organization and Scope o f the Ministries and State Administrative Organizations o f December 22, 2003 and a Decree on the Intemal Structure o f the Central State Office for Administration adopted in January 2004, a Civil Service Training Center for training and education o f state employees has been created. Also, a new draft Civil Service Law has recently been prepared with assistance fiom the EU's CARDS 2001 program. If approved in Parliament, the law will bring Croatian legislation into line with EC standards. 6. The backbone of public financial management inthe former Yugoslavia was the Social Accounting Service, which was the sole institution responsible for executing financial transactions within the Yugoslav territory. In 1993, the Service on Croatian territory was transformed into the Institute for Payment Transactions (ZAP), which gradually improved the technological and organizational aspects o f its business, while maintaining its monopoly on a number o f basic banking services. Although a monopoly, it gained a reputation of efficiency in its operations, which included processing o f some 500,000 transactions in real time on a daily basis. With the government's reform o f the transactions system, certain ZAP services were discontinued to allow the development o f a competitive market for financial services in Croatia. Continuing its operation under the name FINA (Financial Agency) the institution today plays a major role both incollecting state revenues, handling cash and providing system support and maintenance for the Treasury. In this respect FINA i s a unique institution. With its 179 branches, sub- branches and offices it plays a key role inPublic Financial Management inCroatia. "NewsletteroftheInstituteofPublicFinance,No. 11andNo.13,December2003 Croatia CFAA: Country, Economic and Administrative Backsround 3 Relationship to the CAS, lending program and policy dialog with country authorities 7. Since Croatia joined the World Bank in 1993, the Bank has provided financial support, technical assistance, policy advice and analytical services to Croatia. These activities formed the basis o f the Country Assistance Strategy (CAS), which was developed in close cooperation with the Croatian government. The current CAS covers a three-year period o f 1999-2003; a new CAS i s in preparation. The CFAA has advised in the drafting o f the CAS. 8. As o f December 2003, the World Bank's active portfolio at the end of 2003 consisted o f 11 projects; these projects represented loans to the amounts o f US$ 448 million; and o f that, US$122million has been disbursed so far. In addition, five projects representing an indicative total loan amount o f US$232 million are in preparation. Finally, the Croatian government i s discussing a large Programmatic Adjustment Loan (PAL). Whereas specific amounts have not yet been agreed to, the loan i s likely to be around $150 million. The World Bank will be supporting the implementation o f a broad set o f Government policies over a three-year period. One o f the policy areas covered by the P A L i s public expenditure management. The exact topics are still to be determined and the CFAA will advise on the choice o f focus areas. 9. Whereas lending initially focused on investment in infrastructure reconstruction after the war, more recently, the World Bank's assistance has expanded to include the health, agriculture and forestry sectors, enterprise and financial sector reform, capital market development, as well as judicial and pension system reform. In determining the specific policy areas to be covered by the PAL, the World Bank is working closely together with the European Commission to make sure the P A L addresses priorities relevant for EUaccession. CHAPTER2: ASSESSMENT FRAMEWORK 10. In order to conduct quality CFAAs in all of the Bank's borrower countries, guidelines and questionnaires were developed to help Bank staff assess financial accountability arrangements. The CFAA structure broadly follows these guidelines. Since the administrations o f borrower countries often seek benchmarks against which to measure their systems, this report will refer to the internationally accepted standards. See table 1 for an overview o f the standards and codes. Table I.Standards and CodesPromoting Financial Accountability Organization I Standards & Codes cos0 Framework for internal control EU European System o f Accounts 1995 (ESA 95) Council Regulation No. 160512002 on the Financial Regulations applicable to the General Budget o f the European Communities (EC Financial Regulations) EUImplementing Guidelines for the INTOSAIAuditing Standards (EUG) IASB International Accounting Standards (IAS) International Financial Reporting Standards (IFRS) IFAC International Public Sector Accounting Standards (IPSAS) International Standards o n Auditing(ISA) IIA II International Standards for the Professional Practice o f Internal Auditing - (ISPPIA) IMF Code o f GoodPractices onFiscal Transparency I Government Financial Statistics (GFS 2001) INTOSAI INTOSAI Auditing Standards (INTOSAI AS) OECD Best Practices for Budget Transparency World Bank III Treasury Reference Model 11. In the context of EU expansion, candidate countries are obliged to adopt the acquis communautaire, including provisions related to financial control o f EU funds, as found in the accession negotiations o f "Chapter 28." This chapter concerns public internal financial control. A recently adopted EU regulation, No. 1605/2002--referred to here as the EC Financial Regulation--alongwith the corresponding implementation o f EC regulations, No. 234212002 and No. 2343/2002, which concern the financial regulation o f the EC general budget, represents an important development in what the EU considers good practices for public sector governance and financial accountability. When applied to the EC budget, this regulation has direct legal effect in managing EU-funded programs implemented in and by its member states. While it is not legally binding for member states to manage their own budgets, it i s an important benchmark o f what to expect from current candidates and future member states. Also, due to its legal status for member states, the benchmark will be a useful reference for the long term. 12. The EC Financial Regulation offers a framework for govemance and financial management that defines basic concepts as well as the roles/responsibilities o f the various actors in a system promoting what the EU calls "sound financial management." This framework describes the responsibilities o f the authorizing officer, accounting officer and internal auditor. It also sets out principles for sound budgeting and budget execution and for dischargingthe consolidated accounts. Croatia CFAA: Assessment Framework 5 13. The EU text uses the term "management board" to describe "the main intemal body responsible for taking decisions on financial and budgetary matters, irrespective o f the name given to it in the constituent instrument o f the Community body" (Article 2, paragraph 2, Regulation No. 2343/2002). The CFAA uses it interchangeably with "senior management" and "management group." The EU principle o f "sound financial management" i s defined inBox 1. Box 1:_Principle of Sound Financial Management _ _ _ ~ ~ _ _ _ ___ - __ - - - ~ ~ Article 25 I 1 Budget appropriations shall be used in accordance with the principle o f sound financial management, that i s to say, inaccordance with the prmciples of economy, efficiency and effectiveness. __ ~ Official Journal of the European Communities,L 357/81, December 31, 2002 (Commission Regulation No 2343/2002) FiduciaryRisk 14. According to Article 111, Section 5 o f the Il3RD's Articles o f Agreement - General Provisions Relating to Loans and Guarantees, fiduciary risk relates to the possibility o f Bank loans or guarantees not being used exclusively for the purposes for which they were granted. The CFAA addresses a part o f the fiduciary risk by assessing whether the systems inplace support the use o f Bank proceeds for their intendedpurpose. However, it does not constitute an actual audit o f the use o f the proceeds, nor the economy, efficiency and effectiveness o f this use. 15. The specific indicators used to assess the fiduciary risk for each PFM component and CFAA chapter are listedintable 2 below. "able2. Fiduciary Risk Indicators CFAA Chapter PFMcomponent Riskindicators" Chapter 3 Budgeting 1.Aggregate fiscal deficit compared to originalbudget. 2. Composition o f expenditure out-turn compared to original approved budget. 3. Extent to which budget reports include all significant expenditures on central government activities, including those funded by donors. _____ 4. Adequacy o f information o n fiscal projections, budget and outtums provided inbudget documentation. 5. Administrative, economic, functional and programmatic classification o f the budget. 6. Extent o f multi-year perspective in fiscal planning, expenditure policy-making and budgeting 7. Orderliness andparticipation inthe annual budget process. See Annex I1for elaboration and interpretation of risk indicators. Croafia CFAA: Assessment Framework 6 ICFAA Chapter PFMcomponent Riskindicators" 8. Legislative scrutiny of the annual budget law. Chapter 4 Treasury and cash 9. Single Treasury Account. management 10. Stock o f expenditure arrears. 11. Effectiveness o f cash flow planning, management and monitoring. 12. Procedures inoperation for the management and recording o f debt and guarantees. 13 Extent to which spending ministries and agencies are able to pian and commit expenditures inaccordance with originalirevised budgets. Chapter 5 Accounting & I 14. Comnuterized accounting svstems I financial reporting 15. Audit trail documentation 16. Timeliness and regularity o f data reconciliation. r 17. Timeliness, quality and dissemination o f in-year budget reports. 18. Timeliness and quality o f audited financial statements submitted to the legislature Chapter 6 Internal control & 19. Corruptionperception (Ranking inTransparency internal audit International Index) 20. Written procedures 21.Effectiveness o f internal controls 22. The effectiveness o f internal audit Chapter 7 Extemal audit & 23. The scope and nature o f external audit. legislative oversight 24. Follow UP o f audit reports by the executive or audited entity. 25. Legislative scrutiny o f external audit reports Chapter 8 Sub-National The above as applied to sub-national govemment Government 16. Each o f the above categories involves both control risks and inherent risks. The former are where systems or components o f control (whether ex ante or ex post) do not function adequately; they include reporting systems that do not provide accurate and/or timely information. The latter are based on environmental factors in the country or organization, which may reflect current attitudes towards fiscal discipline or corruption, disregarding the existence o f intemal controls. 17. The risk associated with the individual components o f the PFM system and the overall fiduciary risk i s ratedbetween high, significant, moderate or low. Annex I1shows the interpretation used to distinguish between the individual ratings. The fiduciary risk within an individual PFM component, such as Budgeting, is calculated as a simple average o f the rating o f each indicator presented in Table 2 above. The ratings for the individual PFM components are summarized at the end o f each chapter summary o f this report. The overall risk rating for the entire PFM system i s also calculated as a simple average while giving equal weight to the individual PFM components. This information can be found inAnnex 111. 18. It should be emphasized, that whereas the fiduciary risk ratings can be used for the purpose of comparison or benchmarking they do not provide quantitative information about the probabilities o f funds not beingspent for the intendedpurposes. Croatia CFAA: Assessment Framework 7 Fiduciary Risk Indicatorsand BenchmarkingAgainst Standards 19. Whereas a rating o f the fiduciary risk i s used to summarize and prioritize the findings in different areas of PFM, the report basically provides for a comparison between Croatian and good intemational practice in the field o f PFM as these are expressed in intemational standards for financial management. This includes a benchmarking against relevant provisions o f the Financial Regulation o f the European Communities in the field o f budgeting, accounting and auditing, as well as against internationally recognized standards for accounting and auditing. 20. Croatia's ranking in the Transparency Intemational Conuption Perception Index 2003 as 59 out o f 133 co~ntries'~,s used as a fiduciary risk indicator under the heading i "internal control". The CFAA i s not intended to cover issues pertaining to official corruption, nor i s it intendedto assess the specific methods used indetecting corruption. l 9See Annex I1 for interpretation. CHAPTER3: BUDGETING I.BackgroundandAssessmentFramework Background 21. Inthe late 1990s,the functioning o fthe state budget systembegan to bematter of concern for the Croatian government. The budget was not comprehensive; and the public finance sector consisted o f a significant number o f extra-budgetary funds and agencies (EBFs) and a great number o f state enterprises with poor financial reporting. Furthermore, while expenditures were specified at a high level o f detail in the annual budgetpresented to the Sabor, it lacked a strategic policy drivendirection and a matching budgetclassification. 22. The 2002 Public Expenditure and Institutional Review (PEIR)" noted that the Government hadmade some progress since its independence; it had passed a new organic Budget Act (BA) and implemented a multi-year investment program. The PEIR noted that the major components o f the budget process are in the hands o f the BUS,including policy and planning and that the role o f the Ministry o f Finance i s weak. The Ministry of Finance did not set standards for the decentralized budget development taking place in the spending entities; it plays a limited role in coordinating government-wide financial issues. The M O F also failed to provide a basic analysis o f the budgetary impact o f policy issues, a common and vital role that typically facilitates effective budget negotiations and Cabinet decision-making. 23. Weaknesses like these are largely responsible for the lack o f discipline in the budget formulation process (for example, BUScommonly developed highly inflated proposals), the lack o f strategic orientation in the budget, and the lack o f realism in budgetdocuments. 24. The PEIR identified four areas for the Government to focus its public expenditure and financial management reforms: strengthening the central entities responsible for budgeting, treasury and intemal control; developing standardized accounts, budgets and PFM procedures; improving internal control and audit; bringing all revenues and expenditures (including EBFs) on-budget to improve transparency and resource allocation efficiency. 25. Infocusingonnecessaryreforms inthe budgetformulation process, the PEIRalso addressed problems in developing the macroeconomic framework for the budget, budget analysis and preparation cycle. Key recommendations to deal with weaknesses in these areas included: (1) fostering improved budget forecasts through collecting and analyzing economic forecasts from a number o f leading private and public sector agencies to determine median parameters; (2) amending the budget law to provide greater transparency to economic estimates underlying the budget; (3) establishing an explicit multi-year framework to support improved budget decision-making; (4) improving ''WorldBank,Improving Fiscal Sustainability and Enhancing Effectiveness in Croatia - A Public Expenditure and Institutional Review, March 2002. sectoral analysis in the budget and the budget analysis capacity o f the Ministry o f Finance; (5) establishing the Budget Office in Law; (6) improving the strategic orientation o f budgets through the introduction o f a program classification; (7) getting line ministries to formulate their budgets prior to receipt o f the MOF call letter; and (8) requiringthat the Council o f Ministers budget for the full cost o f mandatory programs -- unless specific legislation to alter the program to meet a lower budget i s prepared and submittedwith the annual budget. 26. More recently, in the 2004 Overview o f Foreign Technical Assistance (hereafter referred to as the Donors' Report),*l the World Bank, EU, USAID, U S Treasury and the IMF jointly identified a number o f technical assistance-supported reforms for the new govemment. These reforms resonate with the PEIR proposals. They include strengthening macroeconomic forecasting and medium-term fiscal planning, creating linkages to the annual budget plan, clearly defining budget preparation responsibilities and facilitating provision o f a budget manual, capturing commitments in the General Ledger accounting systemand improving budgetmonitoring. Assessment Framework 27. It is generally agreed that management o fpublic expenditures should be aimed at ensuring: 0 Aggregatefiscal discipline, to achieve macroeconomic stability; 0 Allocative efficiency, which involves prioritizing programs according to Government policies and selecting the most cost-effective programs and projects; 0 Efficiency and effectiveness in deliveringpublic services. To achieve these goals, the budgetprocess should adhere to basic principles and appropriate methods developed. 28. EC Budgetary Principles. To meet the above objectives, budget managers inEU member state administrations must observe the budgetaryprinciples laid down inthe EC financial regulations, when managing EU funds. A summary o f the principles i s listed below:22 0 Unity and accuracy (comprehensiveness). Because the budget forecasts and authorizes revenues and expenditures, all o f these mustbe included. 0 Universality. This principle i s based on two rules: "non-assignment," which states that budget revenues may not be allocated to particular items o f expenditure, and the gross aspect, which states that all revenues and expenditures must be entered in full, without adjustments against each other (no netting). The 2'Overview of Foreign Technical Assistance Provided to the MOF,letter to Secretary of State, Ministry of Finance, 13 January 2004. 22The provisions relevant for budget preparation and presentation are presentedinthe Commission Regulation (EC, Euratom) Nos. 234212002 and 2343120002 of 23 December 2002. See also http:1ieurot,a.eu,int1conmdbudgetibudget/indexen.htm Croatia CFAA: Budsetin0 10 principles aim to ensure aggregate fiscal discipline and efficient allocation o f resources, which require that all expenditure programs be reviewedtogether. 0 Annuality. Appropriations must be authorized for the fiscal year; rules for carrying over funds from one year to the next are specified. For multi-year operations, the EC financial regulation distinguishbetween payments authorized for the fiscal year and legal commitments authorized to cover multi-year operations. 0 Equilibrium Cfiscal discipline). Budget revenues and payment appropriations must be balanced. The budget o f EU member states is bound by fiscal rules defined inthe Maastricht and Amsterdamtreaties. 0 Specification. Each appropriation must have a purpose and be assigned to a specific objective to prevent any confusion between appropriations at the authorization and the execution stage; this ensures the budget i s unambiguous and executed according to the decisions o f the budgetary authority. Rules for making exceptions, such as transfers betweenappropriation accounts, mustbe specified. 0 Sound financial management. This involves economy, efficiency and effectiveness in conducting activities and delivering public services. Specific, measurable, achievable, relevant, and timely objectives must be stated for all sectors covered by the budget and for monitoring and evaluation (M&E) of performance indicators. 0 Transparency. This ensures the objectives will be correctly formulated and pursued. 29. In 1998, the IMF developed a Code of Good Practices on Fiscal Transparency that stressed (a) clear fiscal roles and responsibilities; (b) public availability o f information; (c) open processes o f budget preparation, execution, and reporting; and (d) independent reviews and assurance o f the integrity o f fiscal forecasts, information and accounts. 30. To achieve clear roles and responsibilities, laws must be created that cover budgetary and extra-budgetary activities and fiscal management tasks must be assigned. Further,budget documents and fiscal reports mustbe available to the public; these should cover all the Government and local level budgetary and extra-budgetary activities. 31. The principle of opennessrequires the following be presented with the budget: (a) a fiscal and economic outlook paper, including a statement o f fiscal policy objectives and priorities, and the macroeconomic forecasts on which the budget i s based; (b) a statement o f contingent liabilities and tax expenditures; (c) the overall balance, data on previous budget execution, and analytical tables derived from budget estimates. Budget data, as well as extra-budgetary data, should be reported on a gross basis with expenditures classified by economic, functional and administrative category. 32. To assure the budget's integrity, detailed information on revenue/expenditure forecasts should be available for independentscrutiny. Croatia CFAA: Budsetinu 11 33. Medium-Term Expenditure Framework. A medium-term macro-economic framework is a basic requirement for fiscal transparency. In addition, the IMF Fiscal Transparency (FT) manual identifies as a best practice the preparation o f medium-term budget (or expenditure) frameworks (MTEFs).Ifthe processes are disciplined, an MTEF provides a clear statement o f the effects o f current policies and a mechanism for planning, controlling and monitoring the introduction o fnew and changed policies. 34. Most OECD countries have introduced instruments to create multi-year budget perspectives. However, such budgets vary from country to country. They can be either "extended MTEFs," where each activity i s listed separately and aimed at promoting and monitoring operational perfonnance or those that cover broad expenditure programs and focus on inter-sectoral resource allocations. The former has the advantage o f addressing all objectives o f public expenditure management, but its implementation requires robust reporting and accountability systems and highly disciplined processes. 35. However in sophisticated expenditure programming process, key MTEF characteristics involve: 0 Well-defined fiscal policy objectives; 0 Integratedmedium-termmacroeconomic and fiscal forecasts; 0 Estimates o f expenditures and receipts o f ministries in relation to sector policy priorities; 0 The MTEF is rolled over each year; the first out-year expenditure estimates become the basis for budgetnegotiations for the following year; 0 The MTEF and budget are prepared under hardbudgetconstraints. 36. TheFduciary risk associated with budgeting will be assessed as the risk that: (i) the budget i s not implementedas passed; (ii) are not spent for the purposes set out funds inthe budget; (iii) significant government activities are not covered by the budget23. 11. Findings Legal Framework 37. The original 1993 budget law was revised by the Government as an organic Budget Act (BA) in May 2003. This Act now governs the budget process. The BA includes a number o f budget reforms recommended in previous donor studies, including such items as: (i)the creation o f a Treasury function within the M O F and the consolidation o f the largest EBFs into the Treasury Single Account; (ii) inclusion o f the 23The specific indicators used are: (i) variation between aggregate budget expenditure out-turn and the The original budget; (ii) The variation between the composition o fbudget expenditure out-turn and the composition inthe original budget; (iii) Budget reports do not include all significant expenditures on government activities, including those funded by donors; (iv) Aggregate fiscal performance and position o f the parastatal and sub-national government sectors are not included inthe consolidated government reporting; (v) The budget is not classified on an administrative, economic and functional or programmatic basis; (vi) Key fiscal information i s not published, i s non accessible andor not user-friendly; (vii) The legislature does not scrutinize and debate the annual budget. See Table 2 inChapter 2 for overview. Croafia CFAA: Budsetina 12 all off-budget revenues and donor aid inthe budget revenues; (iii) creation o f a multi-year budget to be approved by Parliament; (iv) a requirement that all proposed laws contain financial estimates on their impact over the three-year planning horizon and that they have the approval o f the Minister o f Finance; (v) a five-category budget classification by organization, economic, functional, location and program; (vi) a revised budget calendar; and (vii) multi-year expenditure commitments. 38. The provisions of the BA apply to state budget institutions, local and regional self-govemed entities. In addition, the BA states that "particular" provisions shall also regulate the budgetary relationship to Extra-budgetary Funds (EBFs). This obviously implies that certain provisions, including certain provisions related to the budget approval24 and those requiring the establishment o f intemal audit, do not apply. The applicability and enforceability o f certain key provisions o f the BA i s therefore not clear whenit come to EBFs. 39. The BA defines the roles and responsibilities o f Budget Users (BUS),Extra- budgetary funds (EBFs)~~, Heads o f the Budget Users, Chief Accountants (CA) and Heads o f Budget & Finance Units (BFUs), and financial controllers. It states that the MOF shall issue implementing regulations and "Rulebooks" to regulate accounting, financial reporting, control and audit. More than a year after the BA's implementation, most o f these regulations and rulebooks still have not been issued. The BA requires budget users to establish internal audit units. 40. The BA seeks to introduce a working two-stage budget process in Croatia in which the Ministry o f Finance and Government play a meaningful top-down role. They set macroeconomic and policy parameters for developing the budget; spending entities develop disciplined, strategic budgets within them. Tracing the revised budget preparation cycle intable 3 shows important features inthe Act. 24Art. 24 (5) & (6) states: "The financialplano fthe extra-budgetary user [EBF] shallbe passed by its responsible body inaccordance with the procedure describedby special law, by other regulation, or by the foundation charter o f the extra-budgetary user.[..] The financial plan referred to in [..I Article shall be this passedprior to the passage o f the state budget, and Sabor shall approve the financial plan along with the state budget." 25The Budget Act states: "EBF is an extra budgetary user, legal person founded o n the basis o f law, which legal personi s financed from the earmarked contributions and other revenues" (Art. 3 (16)). Deadline Action Action/Approval April 1 Macroeconomic Forecast &budget GuidelinesPrepared Minister ofFinance April 10 Three-year macroforecast and Guidelines Approved Government April 20 ProposedBudget Ceilings for Ministries Minister ofFinance May 15 IIIIBudget Circular, ceilings and macroparameters IIIIGovernment May 31 Budget instructionsissuedto BUS,local governments andEBFs Ministero fFinance June 30 BUSsubmitbudgetsto responsibleMinistry BUS Determined Ministry submits budgets to MOF Ministry by budget circular Oct. 15 Draft State Budgetand ConsolidatedState Budgetto Minister ofFinance Governmentz6 Nov. 15 Draft State BudgetandConsolidatedState Budgetto Sabor 1 I Government ~ Dec. 31 State Budgetand ConsolidatedState Budget Approved Sabor ~ January 1 Budget Implementation BUS,Local governments, EBFs 41. Between April 1 and May 15 during the first four steps in the new budget preparation cycle, the Ministry o f Finance develops a macroeconomic forecast on which the budgetary parameters will be based. This forecast becomes a three-year projection with budget guidelines requiring Government approval. The macroeconomic parameters are translated into specific Ministerial budget ceilings; the guidelines and ceilings are passed through the Government for approval before being incorporated into a budget circular. The latter sets the rules for Ministries in developing budgetary submissions; it provides the base rule for facilitating affordability (the ceilings) and resource allocation efficiency (the tie to macroeconomic and Government policy). 42. Ministries have a significant period o f time to develop their budgets in the new preparation cycle. It i s important to note that the BA requires them to submit a variety o f new forms with their budget requests, outlining details such as their strategic direction, their programs and activities, as well as the traditional information on proposed spending by economic item.When this information is submittedto the Ministryo fFinance, the aim i s that proposals will be disciplined (within ceilings) and with sufficient detail to facilitate focused and efficient negotiations-and ultimately budget allocations that are realistic and strategic. 26 The State Budgetcomprises only the central institution, such as ministries, whereas the Consolidated State Budget also includesEBFs and local government. 43. The BA also expands the lengtho f time the Sabor has to discuss and analyze the draft budget and to enhance accountability inthe preparationprocess. InstitutionalFrameworkand Capacity 44. The Budget Preparation Section o f the M O F is responsible for preparing the budget. In recent years, it has suffered significantly in terms o f numbers and qualifications o f staff. Capacity i s particularly lacking inthe Budget Analysis Unit within the Ministry o f Finance. This unit has the poorly defined but vital role o f analyzing the fiscal impact o f legislative and policy adjustments. Because o f capacity limitations and also because o f an implicit focus on compliance with the rules of budget preparation rather than preparation quality and analysis, the efficiency and effectiveness o f public expenditureprograms are insufficiently reviewedwhen the budget is prepared. 45. The MOF's Bureau o f Macroeconomic Forecasting i s responsible for conducting macro-economic analyses and for preparing economic and fiscal projections. The capacity and competence o f this unit's staff have been put into question in recent years, though the current management appear to have a clear vision for the Bureau's future development. There was little dialog between this unit and private sector forecasting bodies. There was also a lack o f effective checks and balances for minimizing incentives for optimistic revenue forecasts. As part o f its new vision, however, the Bureau has recently reopened channels for dialog with other entities and has begunto institute checks and balances in the forecasting process. It has also restarted producing integrated macroeconomic and fiscal projections for a three year period. The quality and effect o f these adjustments have still to be verified, but it i s hoped that these steps will foster future improvements and improvedbudgetquality. 46. Questions have been raised about the suitability o f the existing organizational structure and capacity o f the MOF; the questions stemmed from the reforms introduced by the 2003 BA. Particularly lacking was capacity in IT; this is vital for introducing the SAP modules intrinsic to an ongoing program budgeting reform. The policy focus o f a program-type approach to budgetingalso underlinedthe lack o fpolicy analysis within the MinistryofFinance. The budgetingunitsinthe line ministries exhibit a similar weakness. Practice 47. Budget unity, comprehensiveness and universality. While the Government has made progress in addressing issues o f scope, some concerns remain. EBFs and agencies still constitute a significant portion o f the Consolidated General Government Budget 48. The two most significant EBFs, the Health InsuranceFundand the Pension Fund, are now integrated into the budget and manages the transactions via the TSA and the SAP system. Other EBFs at the national level still operate outside o f the budget and the TSA; they include Roads, Highways, Privatization Agencg7 and the Bank Rehabilitation Agency. Some o f these take the form o f Funds; others are public enterprises (and another i s the Croatian Bank for Reconstruction and Development). Many o f them receive large subsidies from the state budget; some public enterprises providing utilities at the local 27 Inprocessofbeingmergedwith the Office for StateProperty management. Croatia CFAA: Budaetinq 15 levels also receive subsidiesS2* All these EBFs are included in the Consolidated General Government Budget to provide a complete picture o f the Government's financial operations in any given fiscal year. However, because their operations are off-budget, their allocations do not come out o f a competitive process with other budget agencies, but for example, are determinedby a separate law (for instance, for Health Insurance). 49. EBFs operating outside the Treasury Single Account (TSA) pose a fiduciary risk to public funds. First, because the consolidated state budget i s formulated without recognition o f all expenditures, there is a risk that the budget will not reflect actual expenditure requirements and hence that allocations will not be efficient. Second, because the budget i s formulated without recognition o f all revenues, there i s a risk that the budget will not reflect all revenue availability. These risks materialize in problems with fund reliability and the need for budget revisions after Parliamentary approval; they undermine the value o f the formulated process (and hence the formulation process) and complicate budgetary accountability and approval processes. A hrther fiduciary risk i s that, the EBFs that are not integrated into the common budget system are not subject to the same oversight andmanagement requirements as for BUS. 50. The progress made to date instrengthening the accountability arrangements o f the major EBFs (the Health Insurance Fund and the Pension Fund) has not been reflected in the other EBFs mentioned above. While included in the consolidated state budget, these EBFs are not subject to the same rigorous controls ofbudget entities, despite significant expenditures o f public revenues. The planned merger o f HFP, the privatization fund, into the Office for State Property Management i s a good step in the direction o f inclusion o f all spending entities into the State budget. 51. Annuality. In accordance with the BA, budget forecasts cover multiple years. Practically, the Government has prepared the 2005 budget to act as the foundation for a three year budget framework, starting with 2005-2007 period. Budget allocations as voted on by Parliament, however, cover only one year. There i s no practical or legal link between the budget forecasts for outer years and future allocations (there is no rollover mechanism in place, for example). Spending entities still do not develop budgets that actually mirror medium-termprograms and strategies, and the Government still needs to develop a mechanism that connects outer year forecasts to future year budget allocation processes. 52. The budget calendar o f the BA (see Table 3 above) and the annual budget implementation act provides appropriate guidance for the budget preparation process, which i s generally respected by BUS 53. Equilibrium. The aggregate fiscal balance is a "bottom line" measure o f budget performance. If the balance deviates from the budgeted balance, this indicates that the public financial management systemi s not delivering effective fiscal discipline. Intable 4 below the variations between the aggregate budgeted total revenues and total expenditures and their outtums as well as the balances for the last three fiscal years: 28F o r example, the Highway agency expenditures o f 5.6 billion HRK generated a deficit o f 3.5 billion in 2003. Table 4. State Budget Revenue and Expenditure Outturns 2001-200329 Source: World Bank, StateAudit Office and Ministry of Finance 54. A comparison of budgeted and actual revenue provides an overall indication o f the realism of the budget and subsequently the quality o f forecasting and revenue administration. As it can be seen from Table 4, during the last three years domestic revenue out-tums inCroatia have been routinely above or around forecast figures. 55. Table 4 shows that the expenditure budgets were fairly realistic. The table also shows that while the realism has varied from a large deficit o f over HRK 4.3 billion in 2001 to 80 percent o fthe target in2002 to 114 percent in2003. 56. Specification, sound financial management and transparency. Apart from ensuring realistic budget proposals, the budget process facilitates the development o f allocations that have a high likelihood o f being implemented in an efficient and effective manner. These allocations should also be transparent and open to scrutiny. 57. The Croatian budget classification consists o f both an economic, functional and programmatic dimensions. 58. Current revisions to the budget are commonplace in Croatia. In its report on Audits Performed in 2002, the SA0 reported that during the year some 14 reallocations of budgetary resources were made. Out o f these, eight were approved by the MOF and in the remaining six cases the Govemment approved the reallocations. The S A 0 found that reallocations approved by the Govemment were made in the amount o f HRK 160.1 million was not permitted under the provisions of the Budget Execution Act for 2002. The total reallocations for 2002 amounting to HRK 240.7 million irregular reallocations constituted the major part o f reallocations in 2002. The total reallocations constituted 0.3 percent o f total expenditure in 2002. Whereas this does not present a significant proportion o f the budget, the Govemment's practice o f approving reallocations that violates basic appropriation law clearly undermines financial accountability. One way o f establishing the extent o f current budget reallocations (at vote or functional level) is the degree to which budget appropriations match out-tums. Intable 5 below, the budget and outtums for the last three fiscal years i s shown per function o f government: 29This differs from Consolidated General Government inthat it s doesn't include certain government sub- sectors such as social security. 30Including grants. All 2003 actual figures are un-audited. 3'Includes lending and repayment costs. All 2003 actual figures are un-audited. 32The budget deficits of Consolidated General Government were inthe same period (measured on a cash basis): HRK 11.8 billion (2001); HRK 7.9 billion (2002); HRK 9.8 billion (2003). cultural and 1 religious affairs 11; 1,088 1,081 and services 955 955 100 969 945 98 Fuel and energy affairs and services 18 8 44 9 8 89 7 Agriculture, forestry, fishing affairs and services 1,655 1,642 99 1,922 1,848 96 3,204 2,321 72 Mining, manufacturing, const. affairs and services 544 466 86 489 413 84 749 657 88 Transport and communicational affairs and services 3,461 3,113 90 1,527 1,277 84 1,939 1,789 92 Other economic affairs and 932 832 89 995 830 83 1,354 1,507 111 services Expendituresnot classified by major group 3,914 3,946 101 4,993 4,585 92 5,547 5,082 92 Total Expenditure34/ 48,849 56,723 94 73,255 71,992 94 77,919 79,113 97 Average iource: World Bank, Ministry ofFinance, State Audit Office 33Based on rounded numbers. 34To reconcile with data intable 5, please notice that the totals do not include lendingand repayment costs which inactual outturns were: HRK 1,089 millionin2001; HRK 1,377 million in2002; and HRK 1,333 millionin2003. Croatia CFAA: Buduetinu 18 59. On average, Croatia performs well against this measure; out-tums were some 6 percent less than appropriations in 2001 and 2002, and 3 percent less in 2003, respectively. In key expenditure areas, however, some concems do arise that suggest: expenditures may not be sufficiently specific to ensure that policy priorities are met; financial management systems are not sound or transparent enough to ensure spending efficiency and effectiveness. Selected areas o f concem include (See table 5): Health Affairs and Services where budget out-tums were 43 percent lower than allocations in 2001 and Spending on Fuel and Energy Affairs and Service, which was between 10 percent (2003) and 60 percent (2001) lower than allocations. General public services were modestly but seemingly permanent over-budgeted with outtum being 6-10 percent over budget during the period. Educational Affairs and Services budgets modestly but repeatedly under-budgetedwith out-turns at 2-7 percent under budget inthe period. 60. Apart from raising questions about realism, these statistics also question whether the budgets developed are specific enough to make their policy orientation clear. Budgets are typically developed according to economic and functional classification schemes in Croatia. To improve the output and outcome orientation, a program classification was added informally in 2001 and formally introduced through the BA in 2003. Budget expenditures are specified and adopted by the Sabor at a high level o f detail in the economic classification. Whereas it i s a positive characteristic that could facilitate transparency and assist Parliamentarians in making budgetary votes, evidence suggests that a review o f a detailed economic classification has drawbacks. Parliamentarians, especially inthe Budget Committee charged with analyzing the budget draft, have limited technical support and the highly detailed budget can overwhelm them. The detailed economic classification shown in the annual budget document to the Sabor, also fails to provide specificity about the purpose o f expenditures; it facilitates control but not strategic management. Indeed, the move towards a more outcome and results focused budget process, promoted via program budgeting,is potentially underminedby a budget document which continues to be formally presented and adopted in a highly detailed economic classification. 61. The basic idea behindprogram budgeting is that each appropriation must have a purpose and be assigned to a specific objective to prevent any confusion between appropriations at the authorization and the execution stage. The reform intends to orient expenditures towards programs and activities and those responsible for implementation. The idea i s to reorient the budget from a process focus to a service focus, whereby all expenditure allocations are clearly specified and managers have incentives to manage in strategic, efficient and accountable ways. This kind o f management vision and accountability for spending on objectives clashes with a detailed control o f individual items in the economic classification. Apart from this potential clash, success in program budgetingreform also hinges on the exiting administrative capacity. The reform requires additional training o f professionals in the Ministry o f Finance and in the Budget and Finance Units (BFUs) o f spending units. The main dilemmas relate to the definition o f programs and sub-programs and the specification o f expenditures accordingly. The reform i s also highly dependent on government's developing clear policy priorities and communicating these priorities to spending units to facilitate linkages between expenditures and policies in these entities. The lack o f specificity inpolicies and o f clear Croatia CFAA: Budsefinq 19 thinking which links government activities to policies undermines any technical initiatives to improve specificity. 62. Medium Term Expenditure Framework (MTEF).The govemment operates with a three-year fiscal framework. A further development o f the framework into a comprehensive MTEF has been under way for number o f years and i s also part o f the dialog between the World Bank and the Croatian government in connection with the Programmatic Adjustment Loan (PAL) currently being negotiated. 63. There i s currently not sufficient administrative capacity inthe Ministry o f Finance and line ministries to develop and implement a comprehensive MTEF. Also, the detail in the economic classification currently used for budget preparation complicates a move towards a MTEF focused on programs. This would also require that the role o f the medium-termfiscal forecasts be clarified -for example, determining the way inwhich outer year estimates are expected to be translated into current budgets. The CFAA also finds that the Ministry o f Finance and line ministries are short o f analysts to cost new legislative and policy proposals and communicate their benefits and develop spending programs to facilitate multi-year policy plans. 111. Summarv of Findingsand Assessment of FiduciarvRisk 64. The lack o f budget comprehensiveness poses a fiduciary risk. Whereas the organic Budget Act o f 2003 included the regulation o f key aspects o f the (Extra- budgetary Funds) EBF's budget preparation and financial management, EBFs remain excluded from certain provisions o f that Act, including provisions requiring internal audit. 65. The current process for preparing and revising the budget appear to promote budget realism, but it does not provide for strategic budgeting or for the effective monitoring o f allocations. The budget classification includes administrative, economic, functional and programmatic classifications, but the budget as it is presented to Parliament offers little information or direction about policies and strategies. The frequent budget revisions in the course o f the year furthermore undermine the strategies and policies that might be reflected in the budget. The Ministry o f Finance, which has very limited policy analysis capacity, does not analyze budget proposals to assess their strategic content. While the strong performance o f budgets in achieving targets thus suggests low fiduciary risk, there i s a moderate risk that the budget will fail to ensure efficient and effective resource allocations. 66. Budget users are given clear guidance for the preparation of the budget submissions and generally adhere to the budget calendar. The budget does not as yet provide the type o f information required to show key expenditure types or policy development. The program and medium-term budgeting innovations are tenuous, dependent on significant capacity building and cultural change inthe Ministry o f Finance and in the line ministries. Furthermore, this kind o f budgetary approach requires a more active role o f the Parliamentary oversight committee. Whereas parliamentary scrutiny covers aggregates and detailed estimates o f expenditure and revenue, Parliament appears to have accepted to have a limited oversight role and weak administrative capacity. There Croatia CFAA: Budaefina 20 is a risk that the budget will continue to fail to reflect a strategic, medium-termpolicy agenda and to facilitate transparency. 67. Considering the different indicators, the CFAA finds the fiduciary risk associated with budgetingto be moderate. IV. Recommendations 68. The CFAA recommends first that the M O F take action to either fully integrate all existing EBFs into the state budget and Treasury Single Account system, or alternatively make them subject to similar budgeting, accounting, financial reporting and auditing requirements as all BUS,while keeping for example its own banking arrangements. For both scenarios, the BA and other relevant laws and regulations should be amended accordingly. 69. The CFAA also recommends strengthening the macroeconomic forecasting function in the Ministry o f Finance. Historically, the forecasting model has been non- transparent; forecast quality has been questionable, not open to verification, and not produced according to a timetable stipulated in legislation. The lack o f adherence to a timetable has limited the ability o f line ministries to develop budget proposals on time. Recent M O F reforms in this area are intended to address some o f these problems. For example, the MOF now opens its projections to external verification, which enables comparisonwith forecasts developed inthe private sector. 70. The CFAA also recommends taking necessary steps to move towards a Medium Term Expenditure Framework, based on a program classification and multi-year forecast. This requires assessingthe functionality o fthe program budgeting module inSAP against other alternatives, buildingstrategic budgeting capacity inthe Ministry o f Finance and in the line ministries, and considering the detail at which economic classification is required to minimize clashes with the new reform. It also requires clarifying the role o f medium- term fiscal forecasts in the budget process- for example, determining the way inwhich outer year estimates are expected to be translated into current budgets. 71. The CFAA also recommends developing an analytical capacity in the budget process by training budget analysts in the Ministry o f Finance and line ministries. These analysts should be able to cost new legislative and policy proposals and communicate their benefits and intime should also be able to develop spendingprograms to facilitate multi-year policy plans. Also, the CFAA recommends that a budget manualbe developed and formally issued to advance and support multi-year budgeting and an effective functioning o fprogram budgeting. 72. Finally, the CFAA recommends strengthening the role o f the Parliamentary Budget Committee by focusing its mandate on budget analysis and improving its technical support. Croatia CFAA: Treasurv and cash manaqement 21 CHAPTER 4: TREASURY CASHMANAGEMENT AND I.BackgroundandAssessmentFramework Background 73. The MOF have expended considerable effort in establishing and improving the Government's treasury function. While good progress has been made in the basic functions, a number o f areas still need attention. The PEIR recommended that the M O F immediately institute commitment controls by establishing a process o f MOF review o f all contracts prior to ~ignature.~'The Donors' 2003 report to the also observed that commitments were not captured in SAP; it also noted that MOF's cash management activities could be further strengthenedby providing oversight and control o f the daily available cash fund movements on State treasury accounts, by reducing the number o f budgetary user bank accounts outside o f the TSA; by providing a rolling financial plan to aid in liquidity forecasting and by planning an improved short term management o fborrowing and investments. Assessment Framework 74. Treasury Systems. No internationally accepted standards or codes exist for managing cash and treasury systems. However, it i s generally agreed that an effective cashplanning and management system should 37: 0 Recognize the time value and opportunity cost o f cash; 0 Enable line ministries to plan expenditures effectively; 0 Anticipate macroeconomic developments while accommodating significant economic changes and minimizing the adverse effects on budget execution; 0 Respondto the cash needs o f line ministries; 0 Becomprehensive, covering all inflows o f cashresources; 0 Plan for liquidating short- and long-tenn cash liabilities. 75. Best practices for accounting and financial controls, issues closely related to cash management, are reflected in international standards and codes, separately reviewed in this report. 76. To minimize borrowing costs and maximize interest-bearing deposits, cash balances are most efficiently centralized in a "treasury single account" (TSA). A TSA i s either a single account or a set o f linked accounts through which the Government executes all payments. Inpractice, various methods exist to centralize cash flows. Under centralized systems, requests for payment and invoices justifying them are sent to the j5The MOF now receives a manual monthly report o f commitments made for the following month. Commitments beyondthe next month are not reported. j6Overview of Foreign TechnicalAssistance Provided to theMinister of Finance, Zagreb, 14 Jan 2004. j7E.g. inBarry H.Potter and Jack Diamond. Guidelines for Public Expenditure Management, IMF, 1999. Croatia CFAA: Treasuw and cash manaaement 22 Treasury, w h i c h approves them before making payments. Under decentralized treasury systems, B U ' s can administer bank accounts, but the Treasury must authorize them; these are zero-balance accounts, with money transferred to them (from specific approved payments). Or banks accept the payment orders sent by line agencies up to a certain limit defined by the treasury. 77. Treasury information systems are commonly established to control spending, efficiently implement the budget and minimize the cost of Government borrowing. Such systems should b e able to provide for secure execution o f payments, which includes recording the required preliminary checks and commitments, validations and authorizations. The Treasury Reference Model (TRM) developed by the World Bank and the IMFprovides an outline for what a treasury system should deliver (see Box 2). Box 2. The Treasury Ledger System. A Treasury Ledger Systemincludes a set o f summary control accounts [the ledger] that ~ maintainbudget authority and actual spending, andhandle all posting and reports generated ~ from this database. Such a system can create transactions and authority (appropriations, ~ apportionments and allocations), record all transaction details, and consolidate and disseminate ~ information. Some examples include: Createauthorityandtransactions ~ ~ - Distributeappropriation and commitment authorizations to spendingministries; ~ ' Distribute allocations to spending ministries; ~ -- Print checks against payments instructions andor arrange for the electronic transfer of ~ ~ payment information to an external paying entity (e.g. a bank), ifrequired. Recordtransactions I - - Record initial budgets, as approved by the legislature; Record expenditures against commitments and allocations (e.g. due to purchase orders or other payments); - Recordrevenues and other receipts against appropriate accounts; - Capture and maintain records throughout the year on: (a) initial and revised budgets; (b) budget transfers for a typical Budget User (BU); (c) commitments incurred by BUS against approved limits and appropriations; and (d) funding allocations against appropriations and subsequent changes. Consolidateanddisseminatetransactioninformationand reports -- Consolidate data from all ministries and regional offices as necessary; Facilitatehpport easy retneval of data insystem databases invanous formats; - Produce good reports, such as commonly required accounting and management reports. ~ 78. Cash Management. Specific indicators o f cash management performance include such factors as the ability o f the Government to accurately forecast and monitor their revenues throughout the year. Because the revenue forecast drives the entire expenditure Croatia CFAA: Treasurv and cash manauement 23 planning process, overly optimistic revenue forecasts can result in shortfalls that can only be managed by spending freezes or cash rationing. This situation results in expenditure arrears; budget entities are unable to meet their commitments under the original budget cash release plans or enter into new commitments under the original plan. The net effect i s disruption o f the budget execution process and the potential for misallocations o f resources. Therefore, sub-indicators o f cash management performance include actual to budget revenue comparisons, shortfalls inmonthly and quarterly expenditures relative to approved plans, the extent of cash rationing and the level and growth o f expenditure arrears. 79. The fiduciary risk associated with cash management will be assessed as the risk that: (i) payments are not made inaccordance with the purposes and specific activities set out in the budget; (ii)delayed payments distort the effective implementation o f government activities. 11.Findings LegalFramework 80. The legal framework for the Treasury system includes the 2003 Budget Act (BA); the Treasury General Ledger System and Methods o f Managing the Single Treasury Account located in the Central Bank o f Croatia (Official Gazette No.97/1995); Internal Organization o f the Ministry of Finance (26 Jul 2001); Instructions on the Execution o f the State Budget from the Single Treasury Account; and other supporting regulations relatingto budget execution, control andrep~rting.~' InstitutionalFramework and Capacity 81. The Ministry of Finance. The Treasury function in Croatia i s composed o f five distinct administrative sections:39 0 The Budget Preparation Section is responsible for the budget preparation o f central government entities, local and regional self-governments and EBFs, the preparation of monthly, quarterly and annual plans for execution o f the budget, capital planning activities and related activities. 0 The State Budget Execution Section i s responsible for perfonning all tasks related to the execution o f the State budget, including budget preparation and utilization reports, the Kuna payment system, cash management and foreign exchange transactions. 0 The Public Debt Management Section registers all obligations o f the state, issues securities on the domestic and external markets, and manages all aspects o f the public debt portfolio - sources, terms and conditions o f payment, interest rates- and advises on the issuance o f government guarantees. 38 See Chapter 6 on internal control and internal audit for more details. 39 Regulation on the Intemal Organization of the Ministry o f Finance, July 2001, articles 6, 7, Croatia CFAA: Treasurv and cash manaaement 24 The Systems Improvement Section is responsible for the planning, development and operation o f the Treasury information systems, staff training and interactions with the payment services provider, FINA. The Budgetary Supervision Section exercises supervisory control over the state budget entities to ensure the legality and appropriateness o fbudget expenditure. 82. FINA.An important component inthe Treasury systemis performedby FINA. It i s a state-owned financial agency that has evolved from its ZAP roots to become a major player in the banking system of Croatia (it operates the payment and settlement system for the banking sector) and a critical partner for the Government across a wide range o f functions it performs on a contractual basis. 83. For the government, FINA: 0 Settles all payment and revenue transactions that involve the Government o f Croatia 0 Maintains and operates a number o f registers o f clients o f government services, including the Central Registry o f Insurees, registry o f legal entities and natural persons and the financial statement register (that includes monthly, quarterly and annual reports) 0 Processes mandatory social payment remittances, taxes and local government taxes and all other public revenues accruing to the state. 0 Processes supplier payments approved by the Treasury SAP system, depositing funds inthe accounts o fsuppliersor individuals throughout the country 0 Participates with the government in its pension reform initiatives that involve payments; ministry pilots (Defense, Interior) to develop interfaces between their ministryfinancial systems andthe Treasury SAP system 84. FINA-specific support to the Treasury's SAP financial transaction and accounting systemincludes: I T Support through outsourced operation o f the SAP system, including housing and maintaining the hardware, software, local and wide area networks in Zagreb and inthe regional Treasury units inthe ministries across the country; Technical and operational support o f the entire system on a 24/7 basis, Technical support to accommodate the IT systems changes required by the passageo f the new Budget Act; Transaction data processing and data backup for all work in all treasury offices; Service level agreements to establish the levels o f service to be provided and penalties for non-performance; Croatia CFAA: Treasuw and cash manaqement 25 0 Daily updateo f all financial data cleared inthe FINA system, update and maintain changes in the accounts registers and communicate these automatically to the S A P system; 0 Manually enter all rejected transactions returned by private banks for whatever reason. 85. While FINA does not have the capacity to do SAP software development, it could develop the capacity should the government contract for it to be provided as part o f future outsourcing services. 86. FINA is not requiredto comply with the BudgetAct's requirement to establish a modem internal audit function. Given that it undertakes a wide variety o f services, outsourced by M O F and other entities that are operating within the budget, it would be important for the Govemment to require that FINA establish an internal audit unit.Major external clients o f FINA should also be represented on an internal audit review committee within FINA. See also recommendation in Chapter 6 on internal control and internal audit. 87. TheSAPSystem consists o fthe following modules: 0 Budget preparation is under implementation and was used for the preparation o f the budget for 2003; 0 Budget execution is also running in MOF, supporting the general ledger, and recording information about payments from the Treasury Single Account in the CroatianNational Bank; 0 Debt management module exists but has not been implemented. The module has however not yet been tested and i s considered by World Bank and IMF experts to be awork inprogress. 0 Cash management module exists, but it i s currently unable to function partly because the debt management module implementation has halted and partly because forecasts from several other systems are unreliable. Also, the necessary coordination and cooperation between the various departments o f the M O F i s lacking. 88. For 2004, a numbero f additions to the SAP system are planned: 0 A strategic enterprise management module is under development. The first phase, which pertains to budgetplanning has now been established; 0 A budget data warehouse module has been established, while a warehouse ledger for all revenues and expenditures and financial statements o f all components o f the consolidated government entity is under development; 0 Program budgetingcapabilities are under development; 0 A management portal for MOF initially and all ministries in the future, is also under construction. 89. However, key parts o f a basic treasury system are still missing. The commitment control module has never been activated. As a result, manual commitment reporting on a monthly basis i s required from all budget entities. There i s also a multi-year commitment capacity within the SAP system that could readily accommodate capital project commitments and other multi-year future obligations. Moreover, the lack o f a management decision on the selection o f a replacement o f the debt management system has resulted in an impaired cash management function that does not fully meet the needs of the cash management unit. 40 A mission of World Bank and IMF experts recommended that a review be undertaken to assess what would be the most suitable way forward for debt management. USAID has done an independent assessment o f whether the current SPRINT system or the SAP module i s more appropriate. Practice 90. The Treasury Single Account System.A Treasury Single Account (TSA) system i s in the process o f being implemented. It now accounts for all state domestic revenues - taxes, duties and other levies, EBF charges and own-generated revenues, using information that i s captured and coded by FINA. On the expenditure side, the SAP system currently deals with payroll (through two transit accounts, for deposit inthe bank accounts o f individual civil servants), supplier payments and capital expenditure payments. Both are deposited into the appropriate vendor accounts on file with the system. Most EBFs are not formally required to use the TSA in the Croatian National Bank, and a number o f them4' employ accounts in the Postal Bank that i s also wholly- owned by the Government and uses FINA for its transaction processing. 91. Inorder to make payments via the TSA, BUSfirst submit standardized financial plansto the MOF based on the appropriations approved bythe Sabor. The financial plans cover the entire year and are broken into 12 monthly plans. On the basis o f these plans the M O F sets monthly ceilings for all BUSand enter the correspondingbudget allocations into the SAP system. Once the ceilings are set, the BUScan enter commitment requests against the relevant allocations to make payments. Whereas the ceilings were originally meant to be a hard budget constraints, the BUSfrequently request the Treasury to make reallocations however means that this does not work inpractice. 92. Large BUSuse transit accounts, while other BUSpass their payments directly to the vendor accounts from the TSA. However, there i s a large number o f bank accounts held by BUSin private banks. The vast majority o f these 3,200 accounts are in the government owned Postal Bank. Originally intended only for small local incidental payments, they are widely used as operating accounts. In2002 it was estimated that an average o f HRK 500 million was on deposit inthese accounts. This represents significant cash management inefficiency. The consolidation o f these accounts into the TSA should be a priority. ~ 40 An existing system, SPRINT, has become obsolete; its original supplier no longer supports it. 41 E.g. The Employment Fund,the Health Insurance Fundregional offices expenditures; Croatian Waters self-generated fees.. Croatia CFAA: Jreasurv and cash manaaement 27 Box 3. Transaction System Process 1. Provided a Budget User (BU) first records a fully coded commitment into its own financial system, based on a purchase order approvedby an appropriate authority within the entity. 2. Provided that the commitment is for expenditure within the next month, it i s reviewedby the budget execution division for compliance with the appropriation purpose and amount and then recorded inthe SAP ~ystem.~'Next the purchase order i s approved by an authorizing authority within the BUinquestion and sent to the supplier. 3 . When the goods are delivered and confirmed, a request for payment is entered into the entity's financial system and separately into the SAP system. 4. The budget execution section checks the request inthe SAP systemagainst the available cash in the entity's monthly cash plan. Ifsufficient resources are inthe account, SAP issues a payment request to FINA, which works as the transactionprocessing agency for government payments. 5. FINA records the transaction andprovides copies o fthe transactionrecords to the MOF and the BU's Budget & Finance Unit; the data is then keyed into their own financial systemto reflect the transaction. FINA also captures all domestic revenues and provide records to MOF and SAP. 6. Monthly, the BUSsend the M O F a statement o f outstanding commitments that are expected to be settled inthe following month. Commitments extending beyond this period are not disclosed. SAP does not accommodate commitments beyond the next month. 93. Additionally, the government has foreign exchange accounts to cover the governments' operations. A proportion o f the Government's debt-servicing transactions are handled by three private banks. One o f these banks acts as the government's agent in the London and Paris Club debt management operations. The government also holds a foreign exchange account in the Croatian National Bank, through which both repayment transactions and transactions o f receiving foreign loan funds are made. The extent o f other bank accounts operating inother countries i s not known, nor i s it controlled. 94. Transaction Processing. The budget entity follows a complex process to make expenditures. Typically it involves at least one additional financial system in the ministry/agency and multiple data entry activities, as shown in Box 3. This process has internal control and efficiency problems. Because there are no electronic interfaces betweenthe entities financial systems and SAP, identical data has to be entered several times. It i s common that for example a ministry has separate financial systems for different types o f appropriations. This could include a system for pay-roll, one or capital expenditure, one for current expenditure and so fourth. This increases the likelihood o f errors, requires regular reconciliations and represents an inefficient use o f financial staff resources and introduces significant delays into the financial system. 95. The SAP system was designed to meet MOF's needs, with little or no regard for the requirements o f the budget entities. It imposes a heavy workload on the line ministries and agencies, without any support for their normal budgetary requirements. Moreover, existing transactions authorizations remain paper-based; the BFUs do not benefit from automation that could redesign the financial submission and approval processes and reduce the existing paper flow. 96. The team observed many different financial systems in the budget entities, each operating independently o f each other and the SAP system. This has led to widespread duplication o f functions and overlapping data entry requirements. This situation is a - ~~ 42BUSat lower level (e.g. social centers or schools) who do not have access to SAP terminals submit payment requests to the BUSat the central level (typically a ministry). Croatia CFAA: Jreasurv and cash management 28 reflection o f the "bottom up" growth o f individual entities' financial management systems, a common occurrence in all large entities as they begin to integrate their financial management information. While the financial management information system solutions o f individual BUSare not formally decided by the MOF, there i s an opportunity now for MOF to begin a process o f rationalization o f its financial systems in use across the Government. 97. In common with many other major IT projects, the SAP project is technology- driven. There is no strong user group demanding future improvements to the SAP system and its interactions with the budget entities. Rather, the technical project team attempts to anticipate the future needs o f management, then implement new SAP services to respond to them. This supply-pushapproach i s guaranteed to yield inefficient results; a demand- pull approach is required where the users of the system are heavily involved in, and committed to, improvements in the functionality and the efficiency o f the SAP and related systems. 98. Within the MOF, no one at a senior level have been taking responsibilities for SAP'S further development. A senior executive at the Assistant Minister level must be assigned the responsibility for SAP development and for rationalizing the many ministry systems that interact with SAP. The SAP organizational unit should report directly to this individual. The Assistant Minister would be assigned the responsibility to develop a strategic vision for the future evolution and rationalization o f all o f the financial systems inthe Government o fCroatiaby: 0 Performing an inventory o f all financial management systems in the budget entities, EBFs and agencies and detailing their functionality; 0 Developing a set o f options for the rationalization and future evolution o f the financial systems inthe Government o f Croatia and costs o f each option; 0 Submitting recommendations to the Minister o f Finance and then to the Government for approval; 0 Implementingthe rationalizationstrategy incooperation with the budget entities. 99. The M O F state that: 0 The responsibility for the SAP system development i s encompassed by the function o fthe Chief State Treasurer, who i s simultaneous the project manager; 0 A document entitled "Unifonn IT System Development Strategy for Public Financial Management in the Republic o f Croatia" has been prepared and will be forwarded to the Govemment for approval; The MOF state that the latter document clearly indicates the guidelines pertaining to rationalization and further development o f the public finance system in the Republic of Croatia. Croatia CFAA: Treasurv and cash manaaemenf 29 100. Inapositive development, under the agreed World Bank supported PALprogram the Government has agreed to assess the functionality and overlap o f financial systems (including S A P ) in ministries and budget entities, and develop a strategy to rationalize and integrate financial systems. 101. The CFAA concludes that the governance structure o f the SAP system does not work. This could for instance be revitalized by the creation o f a new steering committee, chaired by the State Secretary for Finance, whose members include Assistant Ministers from all key areas o f MOF, senior level representatives from selected line ministries and the CEO o f FINA. The role o fthis committee should be to: 0 Establish development priorities for the SAP system and arrange for funding o f its improvements; 0 Establish sub-committees o f all users o f the SAP system and o f the key ministry financial systems to ensure that their future evolution i s consistent with the overall strategy for government financial systems. The chairs o f each sub-committee would also participate inthe steering committee. 102. The MOF state that the SAP development project is managed by a Project Supervisory Board, headed by the State Secretary o f the MOF, while its members are an Assistant Minister o f Finance, the Secretary o f the MOF and the Deputy State Secretary from the Central Development Strategy Office. The MOF further state that assistant ministers fi-om other ministries who manage IT processes for financial functions in their ministries will also participate inthe Project Supervisory Board's work. 103. Seeds o f cooperation between SAP and budget entity financial systems are in place. There is a pilot project involving the MOF and the Ministries o f Defense and the Interior to examine the development o f an interface between their internal financial systems and SAP. This would enable the automated transfer o f relevant data between the ministry and the MOF, thereby eliminating the manual reporting and the re-entry o f data inMOF. The results o f this pilot shouldbe used as input inthe strategic vision initiative referred to above. 104. The MOF have informed the World Bank that it also has initiated a pilot project to link the Ministry o f Science, Education and Sports and the Ministry o f Health and Social Welfare to the State Treasury System. 105. Cash Management. Budget execution is closely monitored and controlled at a highly disaggregated level o f economic classification by the MOF Budget Execution Division. All budget entities prepare an annual and monthly forecast o f expenditures that are manually submitted to the MOF and recorded in the SAP budget system. Two weeks before the end of a given month, the cash management unit provides monthly limitsto the budget entities, based on their cash flow analysis o f the government's cash position. The budget entities then revise their monthly financial plans and send them back manually to MOF. Then they are entered into the SAP budget system. This forms the basis for the monthly executionby the budget entity. A measure for the system's efficiency i s the total o f arrears, which in2003 constituted 6 percent o f the consolidated state budget. Croatia CFAA: Treasuw and cash manaqement 30 106. In 2001, the cash management unit was established in the Budget Execution division o f the MOF with a staff o f five; technical support comes from the IMF. The unit performs several keytasks: 0 Preparation o f an annual and monthly forecast o f revenues. In close cooperation with all MOF agencies and revenues collection entities, the cash management unit developed a revenue forecast model, based on historical revenues data beginning in1998; 0 Forecast o f annual and monthly budget cash inflows and outflows and calculation o f the monthly net cash surplus/requirements. It uses the forecasting model and the monthly budget execution estimates provided by budget entities to MOF for recording in SAP. Whereas it should also accommodate the Public Debt Management sector's financial plans for debt principal and interest disbursements and estimated payments on government guarantees, this i s currently not the case; 0 Weekly updates of the forecast cash position, based on the TSA, cash and foreign exchange balances of the M O F and budget users in budget units, banks and the revenues from the revenue forecast model, comparison of the total revenue inflows to the estimated cash outflows from SAP; 0 Making recommendations for short-term financing or investment decisions for the government, based on the forecast net cashpositions; 0 Providing maximum monthly cash allocation limits to each budget user through SAP; 0 Analyzing actual cash results from budget execution to refine the revenue forecasting model and related cash management techniques. 107. The Donors' Report recommended that the cash management group should seek to extend its activities to encompass the cash activities o f all BUSand EBFs, to reduce the number o f bank accounts operating outside o f the TSA, to implement a rolling cash forecasting financial plan and to improve decision-making processes for short-term borrowing and investing.The CFAA endorses these recommendations; they are repeated here for reasons o f completeness. 111.SummaryofFindingsandAssessment of FiduciaryRisk 108. There is a need to rationalize the future development o f financial systems in budget entities. Multiple financial systems operating independently in individual budget entities increase the risk o f budget execution errors. Because these systems are not coordinated with SAP, extensive data re-entry i s necessary. To avoid increases in the error rate in transaction processing frequent reconciliations are required. As well, due to the small number of skilled staff operating the SAP system in line ministries, there i s a natural tendency to assign duties that should be separated for reasons o f financial control to a single individual who has beentrained inthe SAP system. 109. The components missing from the SAP system have increased the risk o f budget over-expenditures. The absence of a multi-period commitment control module and the lack o f any development activity to implement it i s a serious shortcoming. Moreover, the Croatia CFAA: Treasurv and cash manaaemenf 31 cash management module's partial implementation increases the risk o f inefficient cash management and potential estimation errors in the budget releases to budget entities. These may result in expenditure arrears. 110. Successful I T projects depend on strong management direction and support. That has been lacking in the Treasury system. N o senior M O F manager is responsible for the system's development. Nor has any senior manager established clear requirements and deadlines to drive the project team to succeed. Nor i s there evidence o f strong involvement by those MOF units who are the logical users o f the system; line ministry staff have also been conspicuously absent so far. There i s the need for a vision o f the future evolution of the financial systems in the government that, when endorsed by the government, would serve as the blueprint for future evolution o f SAP and the individual financial systems in budget entities. In a positive development, the Government has recently agreed under the World Bank supported P A L program to take steps that will form the basis for the development o f such a vision. 111. The existence of some 3,200 budgetary entity bank accounts in private banks poses a fiduciary risk to the average HRK 500 million cash balances on deposit. In addition to being poor cash management, this situation increases the fiduciary risk associated with the system; it does not contribute to effective financial controls. A similar problem may exist in the case o f foreign bank accounts that support external borrowing activities; the team was unable to assess the situation in sufficient detail to reach a conclusion. 112. Insummary, the riskresultingfrom the Treasury andcashmanagement systems is rated as significant. IV. Recommendations 113. The CFAA recommends that the MOF: e assign to an Assistant Minister responsibility for the formulation and implementation o f a strategic vision for the future evolution and rationalization o f all o fthe financial systems inthe Government o f Croatia. e ensure management ownership o f the SAP systems by assigning responsibility for its development and operation to the same Assistant Minister identified above. This Assistant Minister should have assigned management responsibility for the MOF SystemImprovement Section; e commission an independent systems audit o f the SAP system by an external, private sector auditor with extensive financial and IT experience. The auditor should investigate, among others, means to increase SAP'S functionality for both the MOF and the budget entities; e establish a Steering Committee, chaired by the State Secretary with senior representation from all affected MOF sectors, line ministries and FINA, to oversee the development o f SAP and assist in the development and Croatia CFAA: Treasuw and cash manaqement 32 implementation o f the strategic vision for the evolution o f the Government's financial systems; 0 implement the Treasury Single Account by closing all entity private bank accounts and consolidating them into the TSA; and implement the module in the MOF SAP system to process multi-period commitments; Croatia CFAA: Accountinq and financial reportinq 33 CHAPTER5: ACCOUNTING AND FINANCIAL REPORTING I.BackgroundandAssessmentFramework Background 114. For the FY 2002, the MOF for the first time prepared a set o f consolidated financial statements for the execution o f the state budget. At the same time, the formal introduction o f modified accrual-based accounting principles began with reissuing of the Ordinance on Financial Reporting in Budgetary Accounting (Official Gazette OG No. 92/92 with amendments No. 3/03 and No. 12/03, hereafter the OFB). Subsequently, the June 2003 amendment o f the BA requiredthe modified accrual basis for accounting and the reporting o f all BUSand EBFs. 115. As for a number ofother PFM-related activities, the continued development ofthe Treasury system i s key to accounting and financial reporting. To some extent, the lack o f progress indeveloping the Treasury's SAP system i s also delaying the modernization and simplification o f accounting and financial reporting. 116. Both the M O F and the SA0 have reviewed the transition from cash to modified accruals. A competent group of accounting specialists in the MOF has prepareda report on this issue titled, "Errors made in financial statements;'' the SA0 has reported on similar issues in its Report on Performed Audits for 2002. The MOF has also done a comparative review of the IPSAS, GFS and the Croatian state budget accounting system and generally seem well informed about current developments related to public sector accounting standards. 117. The Donors' Report identifies a number o f problems related to accounting and financial reporting and offer ideas to their solution. The problems identifiedinclude43: Timely monthly [budget] execution reports are not available for unconsolidated government; SAP not set up to adequately capture the commitments data; Too many accounting and statistical methodologies used; EBFsdo not use the Chart o fAccounts (COA); The COA is GFS2001 compatible, while reports are produced using GFS1986; EUrequires the use ofESA95; Accounting reports are not generated automatically; Collection o f data not all inelectronic form; Accounting i s done on the basis o f modified cash rather than modified accruals. 43The problems listed below are quoted from the before mentionedreport, "Overview o f Foreign Technical Assistance Providedto the MOF", included ina letter to State Secretary, Ministry o f Finance, January 13, 2004. The MOF has informed the World Bank that they do not agree with the conclusions inthe thirdand ninthbulletpoints ("Too many accounting andstatistical methodologies used" and "Accounting is done on the basis o f modified cash rather than modified accruals"). Croatia CFAA: Accounfing and financial reporting 34 Assessment Framework 118. Whereas the System o f National Accounts (SNA) and the IMF's Government Financial Statistics (GFS) are the most common references for economic and budget classifications, statistics, and accounting techniques, EU-accession countries are asked to apply the European System o fAccounts (ESA) 95. Like GFS 2001, this system adopts an accrual financial reporting framework that can be used to calculate the "Maastricht" budget balance (the economichudget criteria for joining the Euro-zone set forth in the Maastricht Treaty). This type o f balance combines all central government departments, social security funds and local governments into a single General Government account. Because o f the ESA 95's definition o f "deficit", the balance does not take into account- estimated expenditures (allocations for depreciation and provisions). Rather, it focuses on specific circumstances and the EU's own data needs. Some differences exist between the ESA 95 and the other two schemes (SNA 95 and GFS 2001). Generally, the ESA 95 concepts are more specific and precise than the SNA's. Also, GFS 2001 provides several definitions o f the balance, which offers some flexibility inapplying the standard. 119. The International Financial Reporting Standards (IFRS),44 issued by the Intemational Accounting Standards Board (IASB), are the recognized standards for private sector accounting worldwide. Meanwhile, an increasing number o f governments are applying the International Public Sector Accounting Standards (IPSAS) created by the Federation o f Accountants (IFAC). According to IPSAS 1, a complete set o f financial statements from a government entity should include the following: (a) a statement o f financial position; (b) a statement o f financial performance; (c) a statement o f changes in net assetdequity; (d) a statement o f cash flow and (e) accounting policies and notes to the financial statements. The equivalent terms for (a)-(c) in IAS 1 are: "balance sheet," "income statement" and "equity." 45 120. The EC Financial Regulation. The underlying principles for sound financial reporting in the public sector are reflected in the EU's 2002 adopted E C Financial Regulation. Providing a benchmark for public sector financial reporting and a legal requirement when it come to managing EU's own funds, this regulation will serve as the basic assessment framework in this chapter. The accounting provisions o f the EC financial regulation, which broadly reflects the principles o f the can be summarized as follows:47 The annual accounts o f an [EC] administrative body shall consist o f both jkancial statements and a report on budget implementation, where the first reflects the financial position and financial performance o f the reporting entity and the latter the cash revenues and expenditure processed duringthe period; Financial statements should draw on generally-accepted accounting principles, including: (a) a going concern; (b) prudence; (c) consistent accounting methods; 44 The International Accounting Standards (IAS) were integrated into the new IFRS. 45 T o date, 20 IPSAS have beenissued. IPSAS 1 concerns the "Presentation of Financial Statements." 46 Although the IPSAS terminology i s not used, it reflects the terminology of the IAS, now IFRS. 47 Summarizes the key issues addressed inarticles 76-90 o f CommissionRegulation No. (EC, Euratom) No. 234312002. Terms are used as inthe regulation. Croatia CFAA: Accountina and financial reporfins 35 (d) comparability o f information; (e) materiality; (f) n~-netting~~;presenting (g) reality over appearance ; (h) accruals,49 and consist o f a "balance sheet," "economic out-tum account," "cash-flow table," "statement on changes in capital" and an annex that discusses and supplements the information (notes); 0 Budget implementation reports should consist o f budget out-turn accounts on revenues and expenditures and an annex with comments and supplementary information. An institution's accounting officer should submit its provisional accounts to the [EC's] accounting officer no later than March 1. Then the EC's accounting officer consolidates the Commission's accounts; 0 A computerized accounting system must be inplace to organize an institution's budget and financial information. Once it is, figures may be entered, filed and registered. Moreover, the computer facilitates an audit trail that can track accounting data backwards and forwards inthe system; 0 The central accounting authority (in the EC context, the Commission's Accounting Officer) must adopt a harmonized chart of accounts that institutions can apply; 0 The director (the most senior manager) must submit thefinal accounts to the Commission's Accounting Officer (the central accounting authority, for example, MOF) and to the Court o f Auditors (the supreme audit institution) by July 1. The Court o f Auditors should, in tum, publish them by October 31 o f the year following the financial year. 121. The structure o f the chapter follows from the above overview o f the accounting and financial reportingprovisions o fthe EC financial regulation. 122. Fiduciary Risk. The fiduciary risk associated with accounting and financial reporting.wil1be assessed as the risk that financial reporting i s unreliable or not timely; the fiduciary riskwill have the following indicators: (i) Absence o fprompt recording and processing o f transactions, allowing timely aggregation at line ministry and Ministry o f Finance level; (ii) Absence o f prompt and regular data reconciliation; (iii) budget In-year execution reports, which reflect the budget classification, are not disseminated within the government in a timely manner; (iv) Presentation o f audited financial statements to the legislature i s not timely. For overview o f the fiduciary risk indicators used in the CFAA, please see table 2 inChapter 2. 48 That receivables and debt may not offset one another. 49Commission Regulation (EC, Euratom) No. 234212002, Articles 187-195. These principles reflect the principles for presentation o f financial statements laid down inIPSAS 1.The introductionof accrual-based accounting principles to the public sector is not a legal requirement for EUMembership. Nevertheless, when it comes to the management o f funds from the EuropeanUnion's budget, the application o f accrual- based accounting principles i s a legal requirement indeed. This requirement appears separately inthe relevant EC regulations for specific funds (e.g. Cohesion or Structural Funds). It i s also a general principle o f the EC Financial Regulations and its implementingregulations. The GFS2001, ESA95, IPSAS and IFRS share an important commonality; they promote andprovide guidance on the use of accrual- based accounting principles. 11. Findings Legal Framework 123. The legal framework for accounting and financial reporting for BUSand EBFs includes the BA, the OFB, Regulation No. 97/95 on the Main Treasury Ledger System and Methods o f Managing the Single Treasury Account and the Book o f Rules on Budgetary Accounting and Chart of Accounts (COA) with the COA attached (OG No. 119/01 and 74/02). 124. The BA sets out the basic principles o f accounting and the requirements for financial reporting. In accordance with BA articles 115 and 121, it i s required that accounting shall be based on "International Accounting Standards for the public sector", which appears to refer to the International Public Sector Accounting Standards (IPSASs) issued by the International Federation o f Accountants, while at the same time it is explicitly stated that accounting shall be based on modified accrual-based accounting principles. A set o f IPSASs has been developed on a full accruals basis, and there i s also a separate IPSAS which specifies the requirements for reporting on a full cash basis. However, there are no modified-accrual IPSASs, which implies that there could be some inconsistency inthe BA on this point5'. Still, considering the specificity o f the provisions o f the BA relevant guidance i s provided. Specifically it i s stated that BUSshall adjust the value o f non-financial fixed assets using a producers price indexation, while taking historical cost as the point o f departure (Art.121 (2) and (3)). 125. The BA establishes that BUSshall prepare financial statements on a monthly, quarterly, semi-annual and annual basis. It stipulates that ministries and other central BUS shall consolidate statements from those BUSthat report to them, and subsequently deliver these statements to the Ministry o f Finance (Art. 123 (1)). Finally, the BA charges the M O F with preparing the consolidated financial statements o f the Republic o f Croatia budget accounts and to submit it to the Government or the executive of the local executive body. Up until the passing o f the BA, the Government was not required to present a consolidated financial statement. 126. The OFB regulates in more detail the rules on accounting and presentation o f the financial statements. It also includes the Government Chart o f Accounts and elaborates on its application. The COA i s based on the economic classification o f GFS 2001. InstitutionalFramework and Capacity 127. The MOF's State Accounting and Financial reporting (SAF) Section has responsibility for implementing the Government's accounting policies and for consolidatingthe government's accounts. The staff o f the SAF Section are generally very competent. Five out o f the nine positions budgeted for are filled. Considering the importance o f the area and the profound reforms o f the system that are taking place, the unit seems understaffed. The responsibility for accounting and financial reporting for other BUSrests with the BUS'respective Budget & Finance Units (BFUs). Though the 50It is envisaged that some entities inthe process of movingfrom cash accounting to full accrual accounting may wish to adopt the requirements of particular accrual-based IPSASs during this process. Croatia CFAA: Accountinq and financial reportinq 37 expertise o f the accounting staff generally seems sufficient in BFUs, the staff are often few in numbers. This complicates further a fundamental change o f accounting rules requiring time off for training and it makes it difficult to secure an appropriate segregation o f duties among bookkeeping, accounting and treasury functions. 128. Whereas all ministries, other central BUSand the major EBFs have direct access to the Treasury SAP systemS1,subordinate institutions depend on their own systems for financial reporting. Practice 129. Annual Financial Statements. Whereas the BA does not distinguish between financial statements and budget execution reports, it does contain specific provisions concerning "semi-annual and annual financial statements on the budget execution" (Art. 124-128) as opposed to "financial statements" prepared for "periods in the course o f the year" (Article 122). The formats for the annual financial statements as well as the current financial statements fi-om the all BUSand EBFs are regulated via the OFB, which consists o f forms to be used. As it is specified in the annual circular letter from the M O F to all BUS,financial statements consist of: (i) a Balance sheet; (ii)a statement on revenues and expenditure; (iii)statement on the changes occurred to the value o f assets a and liabilities; (iv) statement on own revenues and expenses earned; and, (v) Notes. The deadlines for the submission o f the statements from the various subordinate BUSto the higher level BUSand eventually to the M O F and the Sabor are set out intable 6 below: Table 6. Annual Financial Statements ReportBy FinancialReportsRequired DateDue Submittedto Central BUSand Balance Sheet; Revenues and January 31 Ministry; agenciess2ina Expenditures; Receipts and SA0 Local Office; Ministry Outlays; Changes in assets and RegionalFINA office liabilities; own revenue and related expenditures; Notes Agencies that are also Balance Sheet; Revenues and January 31 Ministry o f Finance; a ministry Expenditures; Receipts and S A 0 Local Office; Outlays; Expenditures by Regional FINA office Function; Changes inassets and liabilities; own revenue and related expenditures; Notes Ministry CONSOLIDATED REPORTS February 28 Ministry o fFinance ; Balance Sheet; Revenues and Regional FINA office Expenditures; Receipts and Outlays; Expenditure by Function; Changes in assets and liabilities; own revenue and related expenditures; Notes "Therearesome55directusersoftheSAPsystem,whichisservicedandmaintainedbyFINA. 52As defined inthe BA: "[Agencies] are budget users establishedas institutions by law and regulations by virtue o f law and financed from the budget". Agencies are referred to as "institutions" inthe available translation o f the BA. Croafia CFAA: Accountina and financial reportinu 38 ReportBy FinancialReports Required DateDue Submitted to BUSo f Local and Balance Sheet; Revenues and January 31 Unitoflocal and Regional Self- Expenditures; Receipts and regional self- governments Outlays; Changes inassets and government; liabilities; Reports on Liabilities; S A 0 Local Office; Ownrevenue and related Regional FINA office expenditures; Notes Local and Regional Balance Sheet; Revenues and January 31 Ministryo fFinance ; Self-Governments Expenditures; Receipts and S A 0 Local Office; Outlays; Expenditures by Regional FINA office Function; Cash Flows; Changes inassets andliabilities; Liabilities; own revenue and related expenditures; Notes Local and regional CONSOLIDATED REPORTS February 28 Ministryo fFinance; Self-Governments Balance Sheet; Revenues and Regional FINA office Expenditures; receipts and outlays; Expenditures by Function; Receipts and Outlays; Changes inassets and liabilities; Liabilities; own revenue and related expenditures; Notes 130. A consolidated financial statement for the State Budget and the Consolidated State Budget o f the Republic o f Croatia was prepared for the first time for the fiscal year 2002. The State Accounting and Financial Reporting (SAF) Section performs all o f th.e necessary consolidations to produce the consolidated financial statements. They receive statements from Ministries and other BUSin accordance with the schedule in table 6 above. 131. Consolidated financial statements covering 53 local governments out o f a total o f 568 entities are also prepared.53The remaining local governments typically submit their financial statements to the MOF after the statutory due date and are therefore not included. The 53 local administrations account for more than 60 percent o f total local and regional government spending. The SAF Section endeavors to have all local and regional self-govemedunits submit their statements according to the preceding schedule. 132. Inpreparation of the Government's liability reports, an estimate is also made of the likely guarantees by the government for the debt o f State Owned Enterprises (SOEs). The Section on Economic Affairs has performed this function, using explicit risk assessment criteria. The SA0 audits these assessments on a case-by-case basis. These funds go into a government Guarantee Reserve account.54The MOF displays on its web site an excellent overview o f 10 o f its major SOEs and three EBFs~~ operating outside of the TSA. The M O F advised that this number has increased to 23 SOEs. Unfortunately, j3As part o f an agreement with the IMF. j4The 2004 budget contains a provision for approximately HRK 500 Million for this reserve. j5The Bank for Reconstruction and Development, the Deposit Insurance and Bank Rehabilitation Agency and the Croatian Privatization Fund. Croatia CFAA: Accountha and financial reportinq 39 the web-site did not give access to the financial statements that it appeared to give access to when the CFAA team tested it. 133. Inits audit ofthe consolidated financial statement ofthe state accounts, the SA0 noticed that it received only a draft Statement on revenues and expenditureinApril 2003 and the final Statement on revenues and expenditure, Receipts and outlays and the Cash flow statement on June 3, 2003. The statutory date for delivery o f the statements i s January 31. The SA0 further noted that the statements received were not reconciled with data in the ledger and with the factual situation, which was substantiated with examples in the report. Other statutory reports, including the consolidated Balance sheet; the Statement on the changes inthe value and size o f assets and liabilities; the Statement on liabilities; and Notes were not submitted at all. The SA0 also notes that the deadline for the delivery o f financial statements for the State Budget and BUShad been shortened one month compared to the year before. In conclusion, the S A 0 states that the timeline o f thirty days to deliver the statutory financial statements is too short, in particular for the most material BUS.A comparison between the deadlines in table 6 with those o f the EC financial regulation, supports the SAO's conclusion. 134. Accounting Principles. As the MOF formally adjusted to the modified accrual- based accounting principles it has aimed at positioning the Government's own accounting rules between the GFS2001 and the IPSAS requirements. A long-term objective is to move to fillaccrual accounting and abide by international standards. To do so, a number o f changes will need to occur in the treasury's general ledger, including the capture o f non-financial assets and liabilities. Unfortunately, the required development o f the SAP system is not happening, partially because the SAF Sectior, has no effective channels o f communications to the SAP project team. 135. As also noted inthe Donors' Report, the EUis requiring fkom its Member States to apply ESA95 on the national accounts. Inits Opinion on the Application o f Croatia for membership o f the European Union, the European Commission stated that the National accounts and GNP/GNIfigures were produced "using definitions and accounting rules o f the ESA95". As indicated in this chapter's section on assessment framework, the definitions and accounting rules used by ESA 95 and GFS2001 are to some extent similar. Still, adjustments are needed to be able to present the Croatian General Government in an ESA95 format. The CFAA did not obtain any information that indicated that the MOF has initiated work inthis field. Based on the feedback received, i s seems likely that the SAF Section i s awaiting the outcome o f work initiated by IFAC's Public Sector Board to harmonize and approximate PSAS, GFS and ESA. 136. The SAF Section seem well aware o f developments in public sector accounting and reporting for the purpose o f maintaining their accounting policies and standards. Quality control consists o f reviewing the budget entity's financial statements to ensure the appropriate accounting policies are inuse. The Section maintains regular contact with the budget entities in its communities by distributing a circular that identifies common problems and errors, then explains how to avoid them. Due to the limited number o f staff its "enforcement" capacity i s however very limited. Croatia CFAA: Accounfinq and financial reoon`inq 40 137. Evaluating the application o f the new modified accrual-based accounting principles in 2002 and first quarter o f 2003, the M O F found that many BUSdid not follow the MOF's specifications set forth inthe OFB and the Book o f Rules on Budgetary Accounting. The MOF also found that a great number o f financial statements came in after the statutory deadline; that meant the M O F had less time to consolidate the Government's accounts. Shortcomings were attributed to decentralization, for example, schools and social centers as well as local and regional sub-national governments. Accountants in the decentralized institutions were often unfamiliar with the organizational codes that applied to a regional or local administrative body, compared to a similar administrative body at the state level. In general, the M O F found many coding errors inthe accounts o f decentralized institutions, including many inthe Health sector.56 138. The MOF stresses that most BUSand local units are disciplined and they compile their statements and handthem inwithin the statutory deadline. The statement is general and does not pertain to a particular period or fiscal year. 139. In its Report on Audits Performed in 2002, the SA0 found that the move to modified accruals had caused major problems and irregularities inthe accounts. Usually the errors had to do with the preparation o f balance sheets; valuation o f assets and liabilities posed a great challenge for the BUS.The SA0 also noted that the OFB had been changed twice in the course o f 2003; modifications that further complicated the exercise o f changing accountingprinciples. 140. The application o f modified accrual-based accounting principles is a statutory requirement. Still, the accounting for expenditure via the Treasury SAP system i s cash based as it records payments made from the TSA. Also, the findings o f the SAO and the M O F indicate that accounting at the level o f individual BUSi s generally not done in accordance with the new provisions o f the BA and the OFB, and often continues to be done on a cash basis. The M O F have informed the World Bank that the essence o f the application o f the modified accrual-based accounting principle in the Croatian government administration i s the recognition o f expenditure based on the accrual principles and revenues based on the cash principle. The details for these principles are laid down inthe Book o f Rules on Budgetary Accounting and the COA57. 141. Subordinated BUS(for instance social centers) are required to prepare a monthly liability report within 10 days o f the end o f the month to the higher level BU (e.g. a ministry). Inturn, the central BU must submit a consolidated liabilities report to MOF and FINA within 15 days o f the end o f the month. The latter report i s the basis for measuring arrears. j6 Report titled: "Errors made infinancial statements", Ministryo f Finance, 2003. j7Modified accruals is described inArticle 20 o f the Book of Rules onBudgetary Accounting and the COA as: Depreciation of non-financial assets is not an expense, 0 Revenues are recognized when cash is received, Expensesare recognized when spending occurs, Changes invalue o f non-financial assets are not considered expenses or revenues, Current assets usedfor daily activities are considered expenses at the moment o fpurchase, Inventories are recorded inthe balance sheet, Donations of non-financial assets are not classified as revenues or expenses. 142. The general ledger does not provide complete and timely information on the total public debt, liabilities and receivables o f the state. It does not provide a basis for monitoring liabilities and receivables, which i s why the system cannot produce the data needed to generate a balance sheet. The SAP system cannot generate the information needed to identify an individual contract entered into by the MOF or the size o f the legal commitment it has accepted by signing the contract. 143. Budget Implementation Reports. Revenue and expenditure reports are submitted from the BUSto the MOF on a quarterly basis. Data provided from FINA is the basis for the revenue data for both the current and the annual budget implementation reports (i.e. financial statement on revenues and expenditure). FINA delivers reports to the MOF on the revenues collected on a daily basis. The reports are broken down to different types o f revenue and the accounts to which they are credited. Upon request of the MOF, FINA can also produce reports that identify the payer. FINA also sends weekly reports to BUS on the payments made for the institution from the TSA. FINA keeps data on a real-time basis. The MOF delivers weekly reports on the realization o f own revenues to ministries and other BUS.Commitments for expenditures and outlays are recorded in SAP by the MOF on the basis of reports received from ministries and other BUSin accordance with the Chart o fAccounts. 144. Accounting data on revenues provided directly by FINA are perceived to be reliable. Based on the findings o f the SA0 as well as observation made by MOF staff and advisers, the CFAA must however conclude that accounting data concerning expenditure and outlays generally are not. Also, reconciliation o f accounting data i s typically only done at the level o fministries and other central BUS.This i s another factor weakening the reliability o f accounting data. 145. Accounting Systems. Each BU has two and often three or four financial accounting systems. As the SAP system is only available to the BUSwhich hold one o f the 55 SAP terminals, most BUScannot rely on SAP for current financial reporting. Furthermore, the SAP system only provides detail at the 5th level of the economic cla~sification~~,which i s not enough for the type o f reports that BUStypically need. For instance, it i s not possible to identify all vendors at that level o f the classification system. It is therefore not possible to generate a complete audit trail that enables the tracking o f accounting entries backwards and forwards in the system. Often the accounting systems are customized for different types o f expenditures, for example, one to manage payroll, another for current expenditures and yet another for capital expenditures. The existence of many different systems combined with the lack o f interfaces not only means a lot o f double work for the accounts and systems operators, it also adds to the complexity o f consolidation exercises and increases the risk o f errors. 146. Although all BUSreviewed had to some degree computerized the accounting function, some were still relying on spread sheets or outdated accounting software which do not meet modem standards for security and data protection. Also, financial statements are still to a large extent submitted manually - via diskettes or on paper - rather than electronically or on-line. '*The Budget i s adopted by the Sabor at the 4" level o f classification. Croafia CFAA:Accountina and financial reoortinq 42 147. Chart ofAccounts. Inaccordance with art. 117 o f the BA, the MOF has issued a Book o f Rules with a Chart o f Accounts (COA) and the OFB. The M O F has also published an Instruction on the Economic and Functional Classification o f Expenditure and Revenues. The Instruction's classification i s one o f the dimensions o f the.COA. The latter provides a framework and background for the accounting records o f the budget and BUSactivities. The COA is relatively new (from 2002) and as shown inthe SAO's audit o f the fiscal year 2002 as well as the MOF's later evaluation (2003), the COA was until recently still not applied correctly. Also, a number o f EBFs are not required to apply the COA. This however does not go for the two most significant EBFs, the Health Insurance Fundand the Pensions Fund. 148. The M O F state that the COA (like the accounting policies and methodologies) is prescribed and all entities within the general State must apply it, and do apply it. 149. Financial Statements to External Audit. In 2003, delays occurred in the submission o f financial statements to the M O F and the SAO. As stated above, the statutory deadlines set by the legislation were generally not observed by BUS.In accordance with the Act on State Audit, the State Audit Office (SAO) has to submit its Report on the Audits Performed in the preceding fiscal year no later than 5 month after the completion o f financial statements o f the government. The S A 0 has so far been able to meet this deadline. 111. Summaryof FindingsandAssessment of FiduciarvRisk 150, The MOF, for the first time, presented a consolidated financial statement for the state budget which i s a significant improvement. As the CFAA finds, the recording and processing o f transactions was, however, not prompt which prevented a timely aggregation at the line ministry and M O F level. For the same reason, the consolidated financial statements for the state budget 2002 were not prepared within the statutory deadline, which seem to be unrealistic. Consequently, the SAO's audit o f the accounts for the fiscal year 2002 was partly based on draft consolidated financial statements. One o f the reasons for the delays inreporting was the change o f in accounting rules, involving an ambitious acceleration o f the time-line for the BUS'compilation o f their financial statements. The changes also involved an equally ambitious move from cash to modified accrual-based accounting principles. The move was only partially successful. Furthermore, the CFAA finds that the change does not affect the accounting entries for expendituresat the Treasury, which continues to be done on a cash basis. 151. The CFAA also found that due to the nature o f the Treasury's SAP system it cannot generate a complete electronic audit trail. The CFAA concludes that accounting data related to the execution of the expenditure budget i s not reliable. Adding to the fiduciary risk i s the existence o f a multitude o f accounting systems, which are often outdated and do not meet current standards for security and data protection. Based on the preceding, the fiduciary risk associated with accounting and financial reporting i s considered significant. IV. Recommendations 152. Based on the above findings the CFAA would like to make the following recommendations: 0 The M O F should take action to ensure that the statutory rulebooks and other appropriate guidelines are disseminated and training opportunities are offered to accountants and other staff o f Budget and Finance Units (BFUs) to ensure an effective implementation o fthe new accounting rules. 0 The SAF Section o f the MOF should be reinforced inorder to be able to provide more support to BUSinthe application o f the new accounting rules, including the statutory formats and deadlines for financial reporting. 0 The M O F should extend the statutory deadlines o f delivery o f annual the financial statements and initiate the necessary amendments o f the BA and the OFB. 0 Due to the importance o f the issue and the profundity of the current reform the Government should make the recruitment o f accountants and other accounting staff a matter o fhighimmediate priority. 0 The M O F need to consider a strategy to effectively support a modemization of the state administration's accounting system. Any such strategy should however be based on an in-deptreview o f the existing systems and consideration o f different alternatives to improve functionalities. CHAPTER 6: INTERNAL CONTROL AND INTERNAL AUDIT I.BackgroundandAssessmentFramework Background 153. The current development o f an intemal control framework and internal audit functions in the Croatian public sector basically evolves around an on-going EU project funded from CARDS 2002. The project has two components: one concemed with the development o f Public Internal Financial Control (PIFC); another related to intemal audit specifically. The project is "hosted" by the MOF but the endbeneficiaries are inprinciple all BUS.The project started in 2003 around the same time that the Sabor passed the new BA,which made the establishment o fIAUinall BUSa statutory requirement. 154. InSeptember 2004, the Government and the MOF adopted a "PIFC Development Strategy for Croatia", which sets out the framework for the future development o f the Government financial control system, inline with the requirements under EUnegotiation Chapter 28. Assessment Framework 155. Internal ControlFramework. INTOSAI defines intemal control as the process by which an organization govems its activities to effectively and efficiently accomplish its mission.59 Within the COS060 framework, internal control i s defined as a process, introduced by a board o f directors, management and other personnel, to provide reasonable assurances that objectives will be achieved. Such controls consist o f five interrelated components: 0 Control Environment: This includes the soft aspects o f an organization- the ethical values, professional and personal integrity that promote respect for the stewardship and effective and efficient use o f public resources. They are reinforced by a management leadership and operating style that promotes these values throughout the organization and requires the sound delegation o f responsibility, authority and accountability for performance by competent staff. 0 Risk Assessment: Risk assessment involves the identification o f the key risks faced by the organization. Major risks may include such control factors as: a lack of management integrity and weak organizational values; inappropriate delegation of authority and responsibility; insufficient staff training; inadequate management oversight; and inadequate policies and processes to monitor and control illegal acts. 0 Control Activities: Cost-effective controls are designed to mitigate risk. They include: well-defined job responsibilities; separation o f duties in processes handling funds; well-documented work processes with at least one ex ante 59The Intemal Control Standards Committee o fINTOSAI, "Internal Control: Providing a Foundation for Accountability inGovernment", 2001, p. 5. 6oThe Committeeof the SponsoringOrganizations of the Securities and ExchangeCommission: hm:iiwww.coso.org Croatia CFAA: lnternal Control and lnternal Audit 45 approval step for financial processes; ex post control exercised by both management and Treasury; strictly enforced budget spending limits and support financial information systems. 0 Information and Communication: A timely and regular flow o f information between management and staff inboth directions i s essential for intemal controls. Staff report information on operations to management; management, in turn, conveys information about the entity, new policies and practices and other information relating to the entity. 0 Monitoring: Intemal audit i s a critical element inthe management control system. It provides feedback to management on the performance o f its controls and what should be done to strengthen them. The S A 0 can also exercise this monitoring function, but it i s outside the intemal control framework. 156. Intemal audit is an integral yet distinct part o f intemal control. It i s defined by the Institute o f Intemal Auditors (IIA) as: "an independent, objective assurance and consulting activity designed to add value and improve an organization's operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness o f risk management, control and governance processes." The IIA specifies Intemational Standards for the Professional Practice o f Intemal Auditing (ISPPIA). 157. In Chapter 28 of the acquis communautaire, the European Commission has promoted its intemal control model, Public Internal Financial Control (PIFC). PIFC covers all o f the components identified in the COS0 framework. PIFC has two components - financial management and control (FMC) and intemal audit (IA). The FMC, which consists o f all actions other than internal audit, aims to supervise all aspects of financial management - administrative, managerial and budgetary - to enable proper control over public finances. Another part o f Chapter 28 deals with the protection o f the EU's financial interest, including measures to fight fraud and to coordinate fraud-fighting activities with the appropriate national and EU authorities, including EU's fraud-fighting office, OLAF? 158. There are many possible consequences o f weak intemal controls. Expenditures may be made for purposes not approved by Parliament or in amounts exceeding authorized levels. Funds may not be used with due regard for efficiency and effectiveness. Fraud or corruption may divert public funds for personal or private gain and the organization may fail to meet its objectives through misallocation o f resources. The presence o f any significant deficiency inthese factors could result in a loss o f public confidence inthe Govemment. 159. Internal Audit. The IIA issues the Intemational Standards for the Professional Practice o f Intemal Auditing (ISPPIA). They include a Code o f Ethics, Glossary, Attribute Standards, Performance Standards and Implementing Standards. In addition, 61Office de la Lutte Anti-Fraude. Croatia CFAA: lnternal Control and lnternal Audit 46 practice advisories offer detailed guidance and practical interpretations o f the standards. See BOX 4.(j2 Box 4. International Standardsfor the Professional Practice of Internal Auditing The Attribute Standards 1000 Purpose, authority and responsibility 1100 Independence and objectivity 1200 Proficiency and due professional care 1300 Quality assurance and improvement The Performance Standards 2000 Managing the IA activity 2100Nature o f work 2200 Engagement planning 2300 Perfonning the engagement 2400 Communicatingresults 2500 Monitoring progress 2600 Management's acceptance of risks Implementing standards apply the attributeiperformance standards to specific types o f engagements (for example, a compliance audit, fraud investigation, control self-assessment, and others). Source; The Institute o f InternalAuditors: ht@://www.theiiaorx 160. One important source o f internal control requirements i s based on Chapter 28 o f the aquis communautaire. For countries seeking to become candidates for EU accession, the harmonization o f their financial controls with those o f the EUi s a natural step inthe accession process. More specific details on internal controls are in the EC's Financial regulation^.^^ This regulation lists several internal control responsibilities for various positions in the budgetary control process, including the authorizing officer, accounting officers, and imprest administrators, internal and extemal auditors. For example, the responsibilities o f the authorizing officer include: 0 establishing the organizational structure and the internal management and control systems and procedures suited to the performance o f hidher duties, including where appropriate ex post verifications. (Art. 38 (4)). 0 specific requirements for at least one ex ante verification for each operation to ascertain if the expenditures are in order, if they conform to the laws and if principles o f sound financial management have been applied. (Art. 39 (3)) 0 requiring that the authorizing officer report to the management board on the performance o f hisher duties inthe form o f an annual activity report. This report contains the results of operations andprogress inachieving objectives, identifies operational risks, the use o f resources and the functioning o f internal control systems. (Art.40 (1)). 62As the CFAA review is not exhaustive, it should not be considered a formal review o fthe internalaudit s stem's compliance with ISPPIA. 6'Council (EC, Euratom) regulationNo. 1605/2002 and the implementing regulations, Commission regulations No. 234212002 and No. 234312002. Croatia CFAA: Internal Control and lnternal Audit 47 161. The regulation also describes the position and duties o f the internal auditor in a manner that i s generally consistent with the IIA ISPPIA standards. 162. The external auditor is not part o f the Government's intemal control framework, yet this auditor plays an important role in it. The external auditor audits the elements o f intemal control, including the intemal auditor function, independently o f the Government, and reports to Parliament on the results o f his investigations. Results o f internal audits are routinely available to the external auditor under enabling legislation. The external auditor reinforces intemal control systems, monitors and reports on instances where management fails to respond appropriately to intemal audit recommendations. 11.Findings Legal Framework 163. The intemal control framework derives from a variety o f laws. The most basic act i s the 2003 organic Budget Act (BA), which provides the legal requirement for internal audit in the public sector. Other regulations, such as the Regulation on the internal organization o f M O F (Official Gazette (OG), No. 70/2001) and the Principles o f the Internal Organization o f the State Administration Bodies (OG No. 43/2001), provides a legal basis for the authorizing environment and the internal control framework ingeneral. Finally, regulations such as the Main Treasury Book System and Methods o f Managing the Treasury Single Account (MTSA) (OG No. 97/1995), the Ordinance on Budget Supervision and Internal Supervision (OG No. 92/1996), the Ordinance on the Croatian Government's Intemal Control Office and the Instructions on Implementation o fthe State Budget Execution from the TSA (OG No. 4/2001), regulate specific, physical control and inspection functions, which constitute an integral part on the traditional Croatian administrative control environment. 164. There are also a set o f rulebooks, which provide details on specific elements o f the financial processes. Examples include Treasury, budget accounting, budget supervision and internal audit rulebooks. These guidelines are not assembled in a single book, but are scattered throughout the MOF. Each functional unit i s responsible for its own rules in a highly uncoordinated manner. Together, these source documents provide the basis for a reasonable framework for financial controls. 165. Non-financial laws also prescribe internal controls and civil service conduct. They include the Act on the Structure and Scope o f Ministries (2000), Act on Civil Servants and Civil Service Employees (2001), State Administration System Act (1993, amended in 1999), and the Regulation on the Principles o f Internal Organization o f the State Administration Bodies (2001). N o formal Code o f Ethics or Conduct for civil servant exists. The issue o f conflicts o f interest i s not explicitly addressed inthe legislation. 166. The Accounting Officer's responsibilities, assigned to Heads o f the BFUs, include budget planning and execution, verification o f obligations assumed, issuing payment orders and collecting receipts, lawful execution o f the budget, delegation o f responsibilities to others in the BFU, the application o f intemal regulations to the procedures applied in the unit and reporting the results o f financial operations on a regular basis. 167. The BA defines the Financial Controller as the person responsible for the lawful execution o f the Budget head's orders in a manner that conforms to the financial regulations (Art.113). 168. The BA's Chief Accountant duties are those o f the Controller o f Payments as specified in the MTSA. He/she i s established as the person responsible for controlling payments and establishing that the payments are lawful and in accordance with the budgetand the financial schedule. 169. The functions o f the chief accountant and financial controller require that separate individuals discharge these functions.64 170. The BA identifies the budget inspection function (Budget Supervision Office) as that which supervises65the lawfulness, timeliness and purpose o f the use of budgetary funds. It charges the M O F to supervise all budget entities, EBFs and local and regional self-governments. The Budget SupervisionOffice performs this function. 171. Each BU i s also required to have an intemal audit function that is independent, objective and which examines instances o f non-compliance and makes recommendations for their elimination. Moreover, intemal audit i s also expected to make recommendations for improving their internal control, administrative and accounting systems that support the business operations associated with the budget; EBFs are exempt from this requirement. 172. The BA sets penalties for non-compliance with the BA provisions in section XI1 o f the act. Institutional Framework & Capacity 173. Internal controlframework. Within MOF, the Treasury and the Directorate for Intemal Audit and Control are responsible for the status o f PIFC vis-a-vis the European Commission. The Budget Supervision Office manages the use o f budgetary resources (revenues, expenditures and procurements) in the local and regional self-government units. The CFAA team found BFUs in all entities visited; the key staffs knowledge o f their existing budgetary processes was sound. The BA's assignment o f management responsibilities was also reflected inthe practical set-up o f the BU's reviewed. 174. The EU-sponsored CARDS 2002 project has a mandate to build capacity both for financial management controls and internal audit. Early on the project team noted the "hard" lack o f any overall unifying vision of internal control. Many parties in MOF perform 66 intemal financial controls; they include budget preparation, budget execution 64 Many budget entities have not designated a financial controller, as requiredby PIFC. 65 This is the traditional control and revision unit (CRU) function that characterized the majority o f the transition countries audit functions inthe first decade after they assumed independence. 66 Iti s common in the framework o f the "COSO" model to distinguish between "hard" and "soft" controls; soft refers to informal controls and hard refers to the more traditional. formal controls. sectors, the intemal control directorate and the Budget Supervision Office. The COS0 concept o f the intemal control framework however does not exist. As a result, a multitude of overlapping controls exist which emanate from laws, regulations, policies and rulebooks. A number o f parties within the M O F who exercise these controls do not effectively communicate with each other. The net effect i s a highly complex set o f intemal controls adding no value to the operations. 175. There i s also a Government Office for Internal Control and a number o f internal control, or inspection units, in line ministries mandated to conduct administrative inspections. This i s a legacy o f the control system in the socialist administration, where controls where focused on behavior, and primarily aimed at prosecuting and placing responsibilities on individuals. In accordance with the Public Intemal Financial Control (PIFC) Development Strategy for Croatia adopted by the Croatian Government and the M O F in September 2004, the Ordinance on the Croatian Government's Internal Control Office shall align the name o f the Office and description o f operations under its authority with the basic postulates o fthe PIFC 176. Internal Audit. At present there are five Internal Audit Units (IAU) in the state administration. The unit which i s inthe M O F has a staff o f six. The six staff are referred to as inspectors and none o f them are trained in the application o f modem internal audit methodology. While the BA requires the establishment o f modern internal audit functions in all BUS,line ministries and other BUSdo not understand what the role should be o f I A U s or how it differs from the current budget supervision and other inspection functions. For this reason, the ongoing CARDS project team has focused on components to support intemal audit development: the IAU in the M O F works as a small central harmonization unit to develop the policies and strategies necessary to implement effective internal audit in all budget entities; the sets o f rules and guidelines for modem internal audit, specific training for internal auditors on new techniques o f modem internal audit and an overall strategy for a phased implementation o f IA throughout the budget entities, EBFs and local and regional self-governments. This undertakingcould also contribute to a rationalization o f the different inspection and audit functions currently operatingwithin MOF. 177. Training is planned at two levels. The program for public accountants at the Center o f Excellence in Public Finance in Ljubljana, presently used by the Government can be extended to address the key management issues and approaches used in the EU's financial management control system and the role o f modem internal audit.67The team i s also in the process o f establishing an internal auditor training program that would offer the graduates a form o f certification and would permit them to take IIAequivalent exams which are required for the internationally recognized certified intemal auditor designation. The target i s 120 trained auditors during the life o f phase Io f the CARDS project (40 trained by the project staff, 80 by local trainers who have been part o f the project). The M O F and the Government should offer strong support to the work o f the CARDS project team and champion the modifications to the control framework across all the organizations o f government. 67Two of the six instructionmodules are on internal audit. The CFAA team was advised that the Government planned to graduate 100 civil servants from the program intwo phases. The program i s partially financed by the World Bank Croafia CFAA: lnfernal Control and lnfernal Audit 50 178. Because a number o f donors (EU, WB, IMF and USAID) are presently involved in projects related to the intemal control and audit systems, there is the potential for significant synergy intheir individual undertakings. Practice 179. Control Environment. The control environment consists o f hard as well as soft controls applied by senior management to ensure that an organization and its staff are competent and professional. It includes values communicated explicitly through formal policies and communiquks, and implicitly through the behavior models set by senior management. It also involves organizational structures and a system for delegating authority, as well as adherence to sound financial reporting and accounting practices. 180. The team found the conception o f internal control to be underdeveloped. There is no Code o f Ethics for the Civil service as a whole, but a Law on Civil Service (OG No. 27/01), which regulates the employment o f civil servants, including rights and responsibilities. A Code o f Ethics for Internal Auditors will also be included in the Rulebook on Internal Audit, which was in draft at the time o f the CFAA mission. Management inBUSgenerally did not appear to be supportive o f the new internal control approach promoted by the concept o f PIFC. There were no visible, management champions o f the changes necessary to implement it; it was stealthy instead o f an open, transparent communication o f the needs and the plans to meet these requirements. The team encountered instances of inappropriate delegation o f functions that violated the separation o f duties control principle6* and a lack o f timely, comprehensivc documentation on the key financial processes operating inline ministries and inMOF. In some cases, key elements o f the control environment (for example, internal audit units) were not requiredfor EBFs, although this i s where they could be most effective. 181. The highly centralized ex ante and ex post controls exercised by the MOF's Treasury and budget inspection units monitor budgetary compliance and ensure budgetary control. However, they do not support the development o f a modem intemal audit across the Government. 182. As also reported inthe EuropeanCommissions' Opinion on Croatia's Application for Membership o f the European Union, International reports and surveys indicate that corruption in Croatia continues to be a problem that affects various aspects o f society, including public offices. In the Transparency International Corruption Perception Index 2003 Croatia was ranked at the same level as Colombia, El Salvador and Slovakia6' and lower than countries such as Belarus and Bulgaria. The inherent risk o f official corruption work to underminesthe control environment. 183. The CFAA found that potential conflicts o f interest are a common phenomenon in the Croatian administration. Furthermore, it seemed almost generally accepted that a high `*EveninMOF, the Assistant Minister responsible for intemal audit has temporary responsibility for budget execution. This role violates the principle that auditors have no other operational responsibilities within an organization. `'Allranked number 59 which inaccordance with the interpretation inAnnex I1equal Significant fiduciary risk, together with all other countries rankedbetween 46-88. Croatia CFAA: lnternal Control and lnternal Audit 51 level civil servant can have both significant political and economic interests besides his official function that may or may not influence his or her decisions ina official capacity. 184. Risk Assessment. Currently, there i s no practice o f risk assessments being an integral part o f management. Whereas the legal base i s clear, the objectives o f government organizations are often nonexistent and strategies often missing. Consequently, planning i s typically routine and mechanical exercises; it does not provide for a proper link betweenpolicies and operational activities. 185. Control Activities. Such activities cover the procedures established for: (a) accounting, financial transactions, contracts and include setting authorization limits for claims and transactions; (b) reliability o f data processing and information reports and (c) ex post control activities such as internal audits. Legal requirements for institutional controls are inplace, whereas detailed written procedures for example, for reconciliation o f accounting information and job-descriptions that ensure appropriate segregation o f duties typically are not. The treasury system provides centralized control o f all budgetary expenditures through the TSA and a centralized computer system (SAP) for the General ledger in MOF. Its controls cover budgetary preparation, execution and accounting. The Treasury defines cash allotments for treasuries in support o f the budget execution by budget entities and it interfaces with the FINApayment system that the BUS. 186. The MOF's Budget Supervision Office exercise controls over spending in BUS, EBFs, legal and natural persons that receive budgetary finds, and local and regional self- governments. Controls are performedpursuant to a ratified control plan, which i s adopted by the Chief State Treasurer on the proposal o f the chief executive o f the budgetary control organizational unit at the beginning o f the fiscal year. The plan is drafted on the basis o f irregularities observed in the preceding year (assessments o f inspectors, proposals and suggestions from the Preparation Sector and the Budget Execution Sector, and the State Audit Office). Duringpreparation o f the plan, the following are considered: 0 whether there is knowledge that funds are not being used legally, for their stated purpose and intimely fashion, 0 activities considered economic policy priorities inthe coming period, 0 frequency o f control inspections conducted in individual entities during the precedingperiod, a petitions from citizens, institutions and trade unions, 0 the available number o f inspectors. 187. According to the description provided by the MOT;, the budgetary control is conducted for the current fiscal year, and only exceptionally, if circumstances require, does it do so for the precedingperiod. Inthis respect it differs from the State Audit Office (SAO). Another essential difference in approaches between the Budget Supervision Office and the SA0 or the Croatian Government's Internal Control Office i s the fact that budgetary control inspectors compile reports o f their completed inspections and directly file motions for initiation o f misdemeanor proceedings against the relevant body, or Croatia CFAA: lnternal Control and lnternal Audit 52 criminal charges, with the public prosecution, inasmuch as the budget supervision ascertains that acts were committedthat bear the traits o f misdemeanors or crimes. 188. Ifirregularities that do not bear the traits ofmisdemeanors or crimes are detected by the Budgetary Supervision Office, measures are stipulated for the elimination o f such irregularities. Through improved communication with the Preparation Sector and the Budget Execution Sector, and with mediation by the Chief State Treasurer, the proposals of this Unit pertaining to own revenue projections by BUSwere accepted, and penal provisions in case o f failure to pay these revenues into the budget were incorporated into the appropriate legislation, while the retum o f unused or improperly used budgetary funds has been ordered. Additionally, the need to re-examine subordinate legislation pertaining to decentralized functions o f local and regional self-governments has been indicated. 189. The CFAA found that the function in BUSas financial controller, which the BA requires, had in most cases not yet been assigned to an appropriate person, or the controller was still to be recruited. 190. InBox 5 the CFAA offers a grave example ofan organizational set-up inCroatia where the internal control framework puts public funds at risk, the Public Debt Management Section o fthe MOF: Croatia CFAA: Internal Control and lnfernal Audit 53 Box 5. A Weak Internal Control Framework in the Public Debt Management Section Serious weaknesses were identified in the control framework o f the Public Debt Management Section (PDMS) o f the Ministry o f Finance. The Assistant Minister and Head o f the Section i s the key player in all aspects o f its operations, negotiating the borrowings, approving principal and interest repayments and other key tasks. Conventional internal controls would require clear segregation o f duties, comprehensive written procedures and job-descriptions as a safeguard against irregularities in the financial processes. Whereas the Ministry o f Finance was unable to arrange for the CFAA mission to meet with the Assistant Minister and Head o f the PDMS, a meeting was set up with one o f the Section's accountants. The meeting confirmed that key processes in the Section are undertaken without clear reference to comprehensive writtenprocedures. Inits Report on the Audits Performed on the fiscal year 2002, the State Audit Office (SAO) reported that out o f a planned number o f 18 positions in the PDMS only eight had been filled. The S A 0 concluded that the number was insufficient and had a negative impact on the quality o f the task execution. It also pointed to frequent changes in staff having an equally negative impact. The S A 0 drew attention to bookkeeping irregularities in the PDMS's records on its trading with bonds and the fact that in some cases bookkeeping data were entered into the system with up to a year's delay. It was evident from the report that earlier years' recommendations for more prompt recording o f transactions hadnot beenproperly responded to by the management o f the PDMS. Interviews conducted by the CFAA team revealed that an inspection undertaken in 2003 by the newly created internal audit unit o f the MOF had made a, number o f recommendations to which the management o f the PDMS was not responsive. The CFAA team was not able to obtain a copy o f the report inquestion. The joint mission o f the World Bank and IMF in 2003 identified significant areas in need o f improvement in the PDMS. This included the segregation o f functions via the creation o f a middle office to analyze the risks and to prepare an appropriate risk strategy for use in debt management activities; the creation o f a separate back office to assume all responsibilities for the recording o f all records inthe debt system and for the preparation o f payment authorizations; and greater transparency in the debt management strategy by requiring government approval and tabling o f the strategy in Parliament. Resident advisers o f the IMF and SIGMA experts who had reviewed the PDMS expressed concems about the lack o f controls, inappropriate filing practices, existence o f off-shore accounts and the key personrisks inherent inthe organization o f the PDMS. The PDMS currently manages a debt portfolio o f over HRK 80 billion, generating interest payments in the amount o f some HRK4 billionper year (2003 roundedbudget estimates). 191. Information and Communication. There are many different financial management infohation systems in use in line ministries, the MOF, EBFs and local and regional self-governments. The SAP system inthe MOF serves primarily serves the M O F and the central BUSand EBFs7' and then only partially. Several years after the system was brought on line, cash management, debt management and commitment control modules have yet to be implemented.Individual ministries must duplicate data entry into their own systems and make separate entries into the SAP system; these entries require frequent reconciliation between control data from different systems. 192. This process is inefficient, error-prone and contributes to non-separation o fduties. A limited number of staff (often one) is trained on the SAP system; the staff have to perfom all o f the data entries, including authorizations. Duplication o f data entries in multiple separate financial systems represents a major potential for introducing errors; it also requires regular reconciliation. 193. Monitoring. These elements are vital to intemal controls. They require information systems that can identify and capture relevant, reliable, and up-to-date financial and operational data from internal and external sources. Further, managers need performance indicators to monitor operational/financial activities and risks, and to assess progress towards targets. At present, management have no independent source o f advice on how well its internal control systems are operating. This i s the key role of intemal audit, which i s now being implemented on a phased-in basis across all budget entities. The only feedback management receives i s comments from the SAO. The SA0 uncovers these comments inthe course o f its compliance and regularity audits, a practice which i s highly undesirable. 194. Internal Audit. Internal audit inCroatia i s undeveloped. At the time o f the CFAA appraisal mission in March 2004, there were no active intemal audit units in any of the ministries or agencies visited except the MOF; all had budget supervision or internal control functions performing the type o f inspections specified in the BA.71In the line ministries and EBFs visited, there was no understanding o f the exact role and fbnction o f modem internal audit, despite the BA's clear requirements and its description of their responsibilities. Several BUShave expressed interest in participating in the training provided under the CARDS 2002 project. So far 40 staff from line ministries and other central BUS,have been selected for training. The M O F committed to training six staff in the first phase o f intemal audit training; these staff will become the core o f a modem intemal audit unit. 195. Besides the fact that the detailed guidelines (the Rulebook referred to in the BA) that should beprovided by the MOF for the establishment and operation o f IAUs, all BUS need advice to establish such units. It appeared to the CFAA team that the PIFC and intemal audit project had largely been confined to the MOF, though recently more ministries and other BUShave been involved. In Box 6 below, the CFAA offer some practical advice or "fifteen steps to establishing an IAU", which could be used by BUS who are now inthe process o f establishing an IAU: ' OThe BUSand major EBFs that have SAP terminals - regional treasuries. "MOFhassix staffemployed inthebudgetinspectionfunctionforMOF,alllineministriesandEBFs. Box 6. Fifteen Steps to Establishing an Internal Audit Unit 1. Review the literature on internal audit, starting with the definition o f internal audit. 2. Interview senior management 3. Initiate the development o f an audit committee by preparing a draft charter for the committee 4. Review your organization's budget, policies and procedures 5. Discuss and reach a common understanding o fbasic internal control issues with the external auditor 6. Develop a list o f all auditable entities and operations 7. Map (e.g. with flow-charts) the major processes within the organization 8. Develop a Charter (terms of reference) for the Unit 9. Develop a riskand audit needs assessment for your organization 10. Buildthe budget for the unit 11.Develop a one-year and a three-year audit plan (mediumtermperspective could vary depending on the type o f operations) 12.Hire staff and develop a training plan for staff 13. Ensure that managementnotifies other departments inyour organization about the function, responsibilities and the added value o f your unit 14. Work actively with management to develop appropriate reporting and working relationships 15. Develop a methodology for following up on and ensuring effective implementation o f audit recommendations Adaptedfrom theIIA s advisory; "Establishing an internal audit shop":http://www.theiia.org 111. Summaryof FindingsandAssessment of FiduciaryRisks 196. Whereas a number o f Rulebooks and regulations provide the regulatory framework for procedures and physical controls, detailed written procedures and job- descriptions ensuring an appropriate segregation o f duties are typically not inplace. The Public Debt Management Section o f the M O F offers such an example. Also, there are numerous examples o f Rulebooks mentioned in laws, which have not yet been issued. The BU financial controllers required by the BA have typically not been recruited yet. The inherent risk o f official corruption and potential conflicts o f interests to some extent undermines the control environment. The introduction o f internal audit via the BA is a positive development. At the time o f the CFAA appraisal mission there were no other internal audit units being established, other than the one in the MOF. By the time o f the report dissemination there are five being established. The CFAA offer some practical guidance for BUSwho want to establish such units. This i s well conceived and has a Croatia CFAA: lnfernal Control and lnternal Audit 56 realistic and robust plan for progressive implementation across the Government. It must be strongly supported because it offers the best path to conformance with Chapter 28 of the acquis communautaire and a PIFC-compliant intemal control and audit system. For these reasons, the CFAA finds the fiduciary risk associated with the intemal control framework, including intemal audit significant. IV. Recommendations 197. The CFAA team makes the following recommendations: 0 Due to the significant risk and the large sums involved, the Government should take immediate action to eliminate the weaknesses in the intemal control framework o f the Public DebtManagement Section o f the MOF. 0 The M O F must also as a matter o fpriority issue all statutory Rulebooks and other necessary guidelinesrelating to intemal audit and intemal control. MOF and other BUSmust subsequently take steps to develop appropriate written procedures for financial processes. 0 The MOF should propose changes in law to require an intemal audit function to be established inall EBFs and any other entities inreceipt o fpublic funds outside o f the budget. 0 The BUSshould as soon as possible hire individuals or assign responsibilities to the role o f Financial Controller in accordance with the provisions o f the BA. This should be another person than the Chief Accountant. e The MOF should provide a strong champion o f change for the new intemal control and audit system, including providing support to establish intemal audit unitsinall major BUSinaccordance withthe provisions ofthe BA. 0 The MOF should develop and promulgate the draft PIFC policy paper to promote a sound internal control fkamework consistent with the EU PIFC system. The policy paper should clearly identify the major components and responsible entities, which establishes a coordinating framework for the MOF intemal control policy centers (treasury, budget preparation execution, foreign exchange, internal audit and others.) and which rationalizes the legislative provisions that no longer align with this vision. CHAPTER 7: EXTERNAL AUDIT AND LEGISLATIVE OVERSIGHT I.BackgroundandAssessmentFramework ExternalAudit 198. The S A 0 states its mission is to audit all government operations and to improve the legality, efficiency and effectiveness o f all legal entities and other legal entities regulated by the State Audit Act. The latter has responsibility for the management o f public property. In addition, the SA0 emphasizes its role in promoting public accountability. 199. The 1999 World Bank CFAA recommended that the S A 0 broaden its audits to cover aspects o f economy, efficiency and effectiveness and not just address compliance with rules and regulations. Furthermore, the 1999 CFAA recommended that additional staff should receive training in internationally- accepted auditing standards. At that time, the CFAA also recommended that the S A 0 should improve access to data, network with the Government's IT systems, and improve efficiency ingeneral. 200. In 2002, SIGMA conducted an in-depth peer review of the SAO. Material recommendations included: strengthening the SAO's legal mandate to reinforce its independence7* and to align its audit resources with its statutory responsibilities; revising its regularity audits to conform with INTOSAI Auditing Standards (AS) so that a formal audit opinion on an attest audit could be rendered on the financial statements o f the auditees; extending its audit activities to performance. 201. Inthe Commission's Opinion on Croatia's applicationto EUmembershipofApril 20, 2004, the European Commission spoke about the need to strengthen the SAO's financial independence and to provide a legal mandate for auditing EU funds in its Opinion on Croatia's Application for Membership o fthe European Union. 202. The 2002 World Bank P E R reviewed the SAO's operations. It recommendedthat the SA0 should continue to focus on compliance and financial audits in the short term. Over the long term, the Bank recommended that the S A 0 conduct performance audits and cite deviations from the current law and examples ofnon-compliance. 203. As a result of the peer review and a previously conducted self-assessment, the SA0 adopted a five-year Strategic Development Plan (SDP) in May 2003 and began its implementation. Based on the SDP, CARDS 2003 has financed a EUR 1.6 million twinningproject which i s to beginin2004 and to runover aperiod o f 30 months. 204. The assessment framework used for external audit will be the INTOSAI AS. It covers Basic Postulates, General Standards, Field Standards and Reporting standard^.'^ '*Thisi s a common situation among transition countries' SA0 mandates. 73 This CFAA does not cover every aspect o f the INTOSAIAS. it i s not a formal review o f the SAO's application o f the standards. Nor does it constitute a formal World Bank review o f the SAO's suitability as an external auditor o f Bank projects. The complete text o f the Standards are available at the following web- site: h~:llww.w.iiltosai.or~l2 CodEth AudStand200 1 E.pdf Croatia CFAA: External Audit and Leaislafive Oversiqht 5% Box 7 provides an overview o f the INTOSAI AS, which will provide the headlines inthe structure for this chapter: Box 7. Overview of the INTOSAI Auditing Standards Basic Principlesin Government Auditing Promotion o f public accountability Legal basis for access 0 Conflicts o f interest GeneralStandardsin GovernmentAuditing Independence Competence Applyingstandards Recruitment Training and development Audit guidance Staff composition and adequacy Monitoring efficiency and effectiveness FieldStandardsinGovernmentAuditing Planning Supervision andreview Study and evaluation o f Internal Control Compliance With Applicable Laws and Regulations Audit Evidence Analysis o f Financial Statements ReportingStandardsin GovernmentAuditing Fairness, accuracy and timeliness Statements o f assurance 'ource: INTOSAI: 205. When assessing a Supreme Audit Institution's (SAI's) work, other standards may be more appropriate. The latter includes the IFAC International Standards on Auditing (ISA), internationally recognized standards for auditing financial statements, and the European Implementing Guidelines for the INTOSAI Auditing Standards (EUG). All o f them are inwidespread use amongEUand candidate countries. Parliamentary Oversight 206. The internal rules o f the Sabor created the committee on budget and finance, which consists o f nine members and a staff of four. The committee's function is to review all budget bills. The Sabor cannot pass a bill until the budget committee has rendered its opinion. The S A 0 does not advise the Budget committee while it i s formulating the budget. 207. Parliament's discussion o f budget policy, its review and approval o f proposed budgets and its review o f the execution o f the approved budget are cornerstones o f a democracy. The 2002 PER concluded that the Sabor should become more active in the budgetingprocess and insist on accountability. To support the committee and the Sabov in analyzing the substantive policy issues associated with the budget, it recommended that: 0 Several professionals be added to the budget committee staff; 0 The Government make budgetsubmissions more user friendly; 0 Parliament trains its Members in the budget process and the rules that go with it. 208. No internationally recognized standards exist for Parliamentary oversight of budget implementation. However, SIGMNOECD produced a practice advisory74,which presents various issues related to Parliamentary purview and its interaction with SAIS.~~ The report describes the structure of Parliamentary committees that address SA1reports, procedures/practices for SA1and Parliamentary interactions, and a system for ensuring effective Parliamentary follow-up on SA1reports. 209. Finally, the EC Financial Regulations offers good practice guidelines for external auditors and their interaction with legislators. They stipulate that external auditors (for example, the EC's Court of Auditors) should scrutinize the BU's accounts. Furthermore, Parliament (the European Parliament as well as the Council o f Ministers) should grant discharge [give formal approval or certification] to the senior management o f the BUS after the external auditor examines the financial statements and annual report. This formal approval includes the auditor's attestation (the "statement o f assurance" or declaration d`assurance (most often referred to as the "DAS,,) about "the reliability and the legality and regularity o fthe underlying Fiduciary Risks 210. The fiduciary risk associated with external audit and parliamentary oversight is the risk that: 0 The SAI's independence, including its financial independence, is not assured; 0 The SAI's audit mandate does not cover all relevantpublic fimds; 0 The SA1does not have a mandate to undertake all types o f audits listed in the INTOSAIAS; 0 The SA1does not demonstrate it has followed proper audit guidance according to international standards; 0 The SA1does not provide authoritative and relevant reports; 0 The executive or the legislature does not act upon SAI's audit reports;; 0 The legislature does not scrutinize external audit reports. 74SIGMA Papers: No. 33. "Relations betweenSupremeAudit Institutions andParliamentaryCommittees", OECD, December2002: http://www.oecd.ora/pdf/MOOO38OOO/MOOO38767.pdf 75 76CommissionRegulation(EC, Euratom)No. 234312002 o f 23 December, Title VIII, Art. 91-95 11.Findings Legal Framework 211. The State Audit Office came into being in July 1993 as a result o f the Act of State Audit (ASA). The Act refers to the principles o f the INTOSAI AS. It sets up the S A 0 as an independent institution directly accountable to the Croatian Parliament; the Sabor appoints the Auditor General (AG) for an eight-year renewable term. The ASA does not specifically address the financial independence o f the SAO; but it does say the State Budget should fund the SAO. The implication i s that the MOF must exercise budget supervision over the SAO. The BA requires all BU's, including the SAO, to establish IAUs.The ASA does not require extemal audit arrangements for the SAO. 212. The ASA provides the SA0 with a broad mandate to audit all financial statements and financial transactions o f the government, local and regional self-governments, legal entities financed by the budget in whole or in part, the Croatian National Bank (CNB), public enterprises, companies and other legal entities inwhich the Republic o f Croatia or local and regional self-government units own a majority stake (Art. 1).The A S A does not explicitly offer a mandate to audit grants or other incomes or loans from foreign sources. 213. The ASA defines the SAO's audit activities in a way that ensures the right to undertake all types o f audits covered by the INTOSAI AS. These include compliance with laws, regulations and procedures, financial (attestation) audits, assessments of` internal control and accounting, and audits o f system efficiency and effectiveness. The ASA's audit mandate i s unique in that it defines the audit o f privatization and transformation, which is mandatory for the SAO. 214. The SAO's auditing methods and procedures (Art. 4.1) make explicit reference to the INTOSAI AS. Moreover, the S A 0 must make public the applied auditing standards in the Croatian language (Art. 4.2). In addition, the professional Code of Ethics for Certified State Auditors must comply with the INTOSAI Code o f Ethics (Art. 8.5 (2)). The ASA also contains provisions to prevent the SAO's auditors from working with conflicts o f interest. 215. The ASA requires the SA0 to submit to the Sabor "an annual report on the executed audits and its own activities." The due date i s no later than five months after the expiration o f the statutory deadline for submission o f the BU's financial statements (Articles 11.4 and 11.5). The ASA does not define the exact coverage and scope o f the audit activities for the SAO's annual report. Institutional Framework and Capacity 216. The State Audit Office i s a young institution, established in 1993 and managed by an AG. The Parliament (the Sabor) appoints the AG. The Office has a staff o f 301 people, 226 o f whom are certified state auditors. They operate in Zagreb and in 20 regional offices across Croatia. The regional offices vary in size from five to 17 staff members. A Deputy AG and seven Assistant AGs all work out o f the SAO's central office inZagreb. The central office has eight department^'^. Practice-The INTOSAIAS Basic Postulates 217. Promotion of Public Accountability. In the first part o f the INTOSAI AS, the Basic Postulates says the SA1 should comply with, and require, promote and facilitate public accountability in the management o f public resources. That means applyng accounting standards and internal controls; it also means transparency, accessibility to data, and a fair presentation o f information. The postulates are assumptions the SA1 agrees to when joining INTOSAI. The SA0 has undertaken self-assessments against the INTOSAI AS. As previously described, the ASA contains explicit references to the INTOSAIAS and the INTOSAICode o f Ethics. 218. Legal Basisfor Access. As previously stated, the ASA gives the S A 0 a mandate to audit all bodies o f State Government and its legal entities. The SA0 may also audit local government bodies and legal entities. However, it does not have a legal mandate to audit EUand other foreign grants. 219. Conflicts of Interest. INTOSAIrequires that SAIs avoid conflicts o f interest inits audits. Article 6 o f the ASA prohibits auditors from both auditing entities and activities to which they have a business, political or family affiliation. There are no reports o f any recent violations o fthese provisions by SA0 managers or staff. Practice-The INTOSAIAS GeneralStandards 220. Independence. The ASA established the S A 0 as the principal State auditor, legally independent of the executive and subordinate to the Sabor. The AG's appointment to an eight year term seems appropriate to ensure independence o f hisker office. 221. The SAO's budget comes about in the same way as any BU. Like for the BUS',it i s subject to the same ex ante reviews and controls; the MOF supervises the SAO's budgets.This arrangement jeopardizes the SAO's independence. 222. The S A 0 must establish an IAU that i s in accordance with the provisions o f the June 2003 BA. However, the IAUi s not yet operational. The SA0 i s not legally required to nor does it appoint an external auditor. The Sabor has the right to request specific audits from the SAO. But the accountability arrangements between the two bodies are not comprehensive. 223. Competence. To ensure the SA0 has the capacity to assume its tasks, it must carefully apply auditing standards. It must also recruit/sustain the appropriate number of 77 Department for the audit o f state budget and BUS(staff=9); Department for the audit o fbudget and local and regional self-government (9); Department for the audit o f fund institutes and financial institutions (7); Department for the audit o f legal entities fully or partially financed from the state budget (8); Department for the audit o f transformation and privatization (32); Department o f legal affairs and relations with other subjects (8); Department o f IT and humanresources management (9);Department for accountancy and general affairs (16). Croatia CFAA: External Audit and Leaislative Oversiqht 62 staff with the educatiodexperience to meet their responsibilities. Also, it must: (a) produce and issue detailed audit guidance to its auditors, and (b) create an organization and procedures for supervision and reviews; the latter includes quality assurance and controls. 224. In accordance with the ASA, the SA0 has established a program for "certified state auditors." To be certified, auditors must have an advanced universitydegree in law or economics, at least three years o f post-graduate work experience, and passed a state vocational exam and one for certified state auditors. The SA0 issues and updates an Audit Manual, which contains procedures and established practices. The goal is to ensure supervision and review o f audit assignments. 225. Applying Standards. As stated previously, the application o f INTOSAI AS and the INTOSAI Code o f Ethics is an ASA requirement.These standards and the European Implementingguidelines for the INTOSAIAS (EUG) are available to the SAO's auditors in Croatian. There are certain INTOSAI AS defined audits, including performance audits,that the SA0 does not do. Furthermore, when the S A 0 refers to an attestation audit, it i s not the same type o f audit referred to in the INTOSAI AS, the EUG and the ISA, but merely an audit of financial statements which is concluded with a certificate using (four) standard opinions. 226. Recruitment. Most o f the SAO's audit staff have an academic background in law or economics. Staff are hired as a result o f public vacancy announcements. Recruitments follow formal procedures; the key criteria are work experience and formal education. 227. Training & Development. The SA0 has established a training program. `The scope of the training however depends on the amount o f money set aside for training activities in the Government's budget. Training takes place on the job and individual training sessions. When appropriate, training events are also arranged incooperation with the Croatian Auditors' Association, universities and other Croatian institutions. The S A 0 also participates ininternational training and methodology-developing activities arranged by INTOSAI, SIGMA or bilaterally betweenSAIs. 228. As mentioned previously, CARDS 2003 will finance a EUR 1.6 million twinning project to be launched in2004. The plannedproject activities appear intable 7 below. Croatia CFAA: External Audit and Leqislative Oversiqht 63 Table 7. CARDS2003 External Audit TwinningProject Activities 20 Development of internal communication 21 Seminar onteamwork andteammanagement 22 Research,application andpresentationofpersonnelstrategy 23 Qualification structureof personnel 24 Developmentofthe programofpersonneltraining 25 Formingthe strategy of internationalrelations 26 Formingthe communications strategy 229. Clearly, these activities show the scope o f the project i s ambitious. Inthe medium term, these activities are capable o f addressing all the SAO's developing needs. Consequently, the twinning project could most likely address the CFAA's recommendations. 230. Audit Guidance. The SA0 has developed an Audit Manual with detailed technical guidelines and procedures to carry out the standards it i s to uphold. The Manual and other technical guidelines have regular updates. The CFAA was unable to obtain a copy o f the Manual and the Guidelinefor a detailed review. 231. Staff Composition and Adequacy. The S A 0 management finds the current number and composition of staff appropriate. Should the SA0 develop a financial audit that i s consistent with the ISA or expand its performance audit capability, the size and breakdown o f the staff may require a review. The staff i s most familiar with compliance and the regularity o f legality audits. The SIGMA peer review concluded that the size o f the staff was inadequate to satisfy the SAO's annual statutory audits o f local and regional self-government and all privatizations. SIGMA estimated in 2002 that up to 50 percent o f Croatia CFAA: External Audit and Leaislafive Oversiaht 64 the SAO's resources were spent on privatization audits. Another indication that the SAO's resources are spread too thin i s the volume o f work it initiates or reviews. See next paragraph for details. 232. Monitoring Efficiency and Effectiveness. Whereas the SA0 has procedures and mechanisms to evaluate the efficiency and effectiveness o f individual auditors, it does not systematically monitor the efficiency and effectiveness o f its operations. The CFAA finds that the scope of audit services provided to be quite narrow and that a more holistic interpretation o f the SAO's mandate and role i s desirable to keep government accountable. 233. Inits Report onAudits Performed in2002, it reports to have audited a total of44 financial statements, 611 subjects and that in addition to that it received 11,327 financial reports during that same period. Out o f the 611 audited subjects, 568 were local or regional self-governments. This Report does not provide data that can be used to assess the relative coverage and the comprehensiveness o fthe audits performed. Practice-The INTOSAIAS FieldStandards 234. Planning. Audit planning i s an integral part o f SAO's work. Planning i s implicit in the ASA, internal guidelines and the SA0 Audit Manual. Detailed guidelines for developing an audit plan appear inthe SA0 Audit Manual under the title: "The Process o f designing the Annual Audit Program o f the State Audit Office." The guideline also explains how to organize the planning process. 235. The ASA gives the Sabor the option o f requesting ad hoc audits and investigations falling outside the annual work program. The Sabor has only used this opportunity a few times during the last 10 years. In each case, they occurred after consultationwith the AG. 236. Supervision and Review. The SA0 addresses quality assurance in all phases o f the individual audit assignment. According to SA0 management, supervision o f audit teams includes an evaluation of: 0 The audit team's understandingo fthe audit plan; 0 Compliance with auditing standards and institutional practices; 0 Compliance with eachphase o f the audit plan; 0 Completeness of audit documentation and relevant facts to support conclusions in its findings, and; 0 Audit goals or objectives. Evaluations consist of audit team leader performance reviews and overall supervision by superiors in the course o f an audit assignment. In addition, ex post reviews entail feedback from auditees, evaluations o f work by a parliamentary committee and members o f Parliament, self-assessments by management and staff and external peer reviews, including bilateral exchanges. Generally speaking, documentation o f quality assurance procedures is in the form of a sign off by superiors on the work done by the auditor undertaking the assignment. 237. Reviewing Internal Controls. On the whole, the Government does not have advanced internal control systems or IAUs. Consequently, the SA0 usually does not rely on the work of internal audit or internal administrative control units. Assessments o f internal control and accounting systems are not an integral part o f the SAO's financial audits. They are separate exercises that only occur when internal control or internal audit units have produced reports on physical control, inspection or auditing activities. The findings o f these separate reviews influence the scope o f substantive testing by the S A 0 but only to the extent that specific transactions already checked by an internal controller or auditor and found satisfactory by the SA0 will not be selected for substantive testing again. All other transactions are subject to substantive testing. 238. Compliance Testing. The main objective o f the SAO's audits i s to validate accounting entries and the financial operation's compliance with relevant laws and regulations. That means comprehensive substantive testing o f individual transactions. 239. Audit of Government Annual Accounts. As required by the ASA, within five months o f the expiration o f the statutory deadline for submission o f financial statements o f BUS,the S A 0 submits an annual report to the Sabor on the audits it has carried out as well as its own activities. The report is a summary o f findings in connection with audits o f BUS'financial statements. The executive summary does not constitute a statement o f assurance, but concludes whether the errors and irregularities detected significantly affect the financial statement o f individual institutions. Out o f 44 audit opinions on financial statements issued in 2002, the SA0 gave three "negative" (qualified) opinions, and four so-called "unconditional" audit opinions. The remaining opinions were conditional. The SA0 does not conclude onthe realismor regularity ofthe execution o fthe statebudgetas such. For more details, look under INTOSAI reporting standards - Statements of Assurance later inthis report. 240. Collection of Audit Evidence. The SAO's auditing standards differ from the ISA in one important respect. The SAO's standards do not explicitly refer to evidence to support "financial statement assertions," as set forth in the ISA. This evidence is fundamental to the accounting and auditing profession. The assertions are categorized in the ISA as follows: Existence; Rights and Obligations; Occurrence; Completeness; Valuation; Measurement; Presentation & D i s c l o s ~ r eThe . ~ ~ assertions refer to items on the balance sheetlfinancial position as well as the income statementlthe statement o f financial performance. Because the SA0 auditors are not required to systematically 78 Elaboration o f ISA 500: Financial statement assertions are assertions by management, explicit or otherwise, that are embodied inthe financial statements. They can be categorized as follows: (a) Existence: an asset or a liability exists at a given date; (b) Rights and obligations: an asset or a liability pertains to the entity at a given date; (c) Occurrence: a transaction or event took place which pertains to the entity during the period; (d) Completeness: there are no unrecorded assets, liabilities, transactions or events, or undisclosed items; (e) Valuation: an asset or liability is recorded at an appropriate carrying value; (0 Measurement: a transaction or event is recorded at the proper amount; revenue or expense is allocated to the proper period; and (8) Presentation and disclosure: an item i s disclosed, classified, and described in accordance with the applicable financial reporting framework. Croafia CFAA: External Audit and Leqislafive Oversiqhf 66 scrutinize these assertions, certain relevant evidence may be overlooked in some cases. The focus o f the SAO's collection o f audit evidence is somewhat broader and less systematic. 241. Interviews conducted indicated that the auditors perceive their approach to be identical to 100 percent substantive testing. It i s however clear that an ex post verification o f each o f the transactions and supporting documentation related to the 11,327 financial reports that the SA0 receive during the year i s possible with a staff number o f 301. 242. Audit of Financial Statements. The audit o f financial statements prepared in accordance with the BA and the OFB, i s an essential part o f the SAO's work. It issues standardized audit opinions with phrases similar to those recommended in the INTOSAI AS and the EUG and do refer to these audits as attestation audits. The approach used in these audits however do not appear to be consistent with the approach promoted via the ISA, which includes preliminary systematic assessments o f risk and materiality, accounting systems and internal control systems in the broadest sense o f the word (not only referring to hard and physical controls). Concerning the SAO's approach to audit and the collection o f audit evidence, see the paragraph above. Practice-The INTOSAI AS on Reporting 243. Fairness, Accuracy and Timeliness. The fairness and accuracy o f SA0 reports should derive from adherence to its own procedures and the right o f the auditee to react to the SAO's findings. Whereas procedures in general appear to be adhered to, the CFAA did not obtain information to verify the degree o f fairness and accuracy as perceived by the auditee. Feedback from the Sabor seemed to indicate that reports are perceived to be timely andreliable. 244. Statements of Assurance. The SA0 provides formal opinions on the financial statements o f individual Bus, using its own standards and working guidelines. A formal plan i s in place prior to it; moreover SAO's auditors appear to follow it. However, assessments o f risk and materiality are not inuse to systematically select audit areas and transactions. Risk assessment i s generally done on the basis o f intuition and prior experience and according to statistical models. Audit opinions do not constitute positive statements o f assurance concerning the true and fair nature o f the financial statements. In its statutory report to the Sabor, the SA0 provides an opinion based on various audit findings. This does however does not constitute a statement o f assurance on the execution o f the budget, as the exact coverage and relative materiality o f the selected auditees i s not quantified. Nor are the criteria for the selection o f individual transactions and operations audited made explicit inthe report. 245. In interviews with individual auditors, the CFAA learned that some Computer Assisted Audit Techniques (CAATs) were in the offing. However, the Report on the Audits Performed in2002 didnot mention the CAATs. Croafia CFAA: External Audit and Leaislative Oversiaht 67 Practice- Parliamentary Oversight 246. Organization of Parliamentary Committees. The Subor does not have a special Committee to review the SAO's reports. The reports usually a topic o f discussion by a variety o f committees, depending on which sector area the audit related to. The most frequent committee interlocutor is the Budget Committee, which consists o f 13 Members o fthe Subor. The Committee has three permanent staff. 247. Practice of SAI-Parliamentary Interaction. The CFAA team leamed that the Subor's perception o f the SAO's reports i s that they are not very informative. Although the AG and the SA0 are generally respected, the level o f cooperation between the Subor and the SA0 i s characterized as routine instead o f dynamic. Members o f Parliament consider the SAO's audits as narrow inscope. 248. System for Effective Implementation. All decisions o f the Budget Committee become formal opinions o f the Subor. Follow-up on the recommendations o f the Committee is rigorous. Neither the Sabor nor the Government has a system to continuously monitor the recommendations o f the S A 0 and their implementation. 111. Summary of Findingsand Assessment of Fiduciarv Risk 249. The Act on State Audit provides a broad mandate for those public funds and institutions that it i s required to audit as well as the audit standards and methods it can apply. However, the act has shortcomings that should be addressed by the State Audit Office (SAO) and Parliament (the Subor) as a matter o f priority. One shortcoming i s that the SA0 is not formally requiredto provide a statement o f assurance on the execution o f the state budget. The SA0 i s however required to report to the Sabor annually on the audits performed and it does offers an opinion based on audits o f the full set o f Government financial statements. Due to the nature o f its legal mandate and the methods applied this however does not constitute a formal statement o f assurance on the Government consolidated financial statements or the execution o f the state budget. The SAO's legal framework does not guarantee its financial independence from the government, which currently makes it subject to the MOF's budget supervision. Whereas the Act on State Audit explicitly provides a mandate for it, the SA0 still has not piloted any audits o f economy, efficiency or effectiveness. The SAO's reports are perceived to be authoritative and the Sabor acts on audit recommendations. There are indications that the Sabor considers the SAO's reports rather narrow in focus and scope. The combined fiduciary risk associated with extemal auditing and Parliamentary oversight is considered moderate. IV. Recommendations 250. The ASA should be amended to ensure that the S A 0 budget go directly to Parliament without prior adjustments by the MOF. At the same time, the SAO's annual financial statement should be made subject to an independent extemal audit and the auditor appointed by Parliament. Subsequently, the MOF's budget supervision over the SA0 should cease. Croatia CFAA: External Audit and Leqislative Oversiqht 68 251. The ASA should be amended in to require the SA0 to submit a statement of assurance that the Government's consolidated financial statement gives a true and fair view o f the sources and use o f funds. The SA0 should use the ISA as amodel. 252. The ASA should be amended to allow the S A 0 to audit all EU funds. The SA0 should consider positively the challenge o f auditing and becoming certifying body for future EUfundedprograms inCroatia. 253. In line with the recommendations of the 1999 CFAA, the 2002 SIGMA peer review and the 2002 PEIR, the SA0 should initiate pilot audits o f economy, efficiency and effectiveness (performance or value-for-money audits). 254. The S A 0 and the Sabor shouldjointly consider the establishment o f a specialized Public Accounts Committee, for example, as a sub-committee to the Budget Committee. Croatia CFAA: Local and reqionai self-oovernment units 69 CHAPTER 8: LOCALAND REGIONAL SELF-GOVERNMENT UNITS I.BackgroundandAssessmentframework Background 255. A national decentralization process began in 2001; counties and municipalities assumed new responsibilities for elementary and secondary education, health, social services, care for the elderly and fire protection. A second phase o f decentralization is scheduled for 2004. The government was expected to recommend legislative initiatives to: 0 Expand the authority of local governments; 0 Provide local governments with adequaterevenues to fairly and efficiently deliver the services for which they are responsible; 0 Restate minimum financial standards, based on objective criteria (for example, number of clients in the target population to be served, geographical or climate factors); these standards are pivotal inequalization grants. 0 Modify the central government's processes and procedures that interfere with local decision making. 256. From 2000 a USAID project supported the preparation o f a framework for decentralizing certain functions from the state budget to the budget o f local and regional self-government units and assisted inthe preparation o f the fiscal decentralization model for such functions. In mid-2001, the Croatian Parliament adopted a number of amendments to the Law on Financing o f Local and Regional Self-government Units. Subsequently, the Government o f the Republic o f Croatia adopts annually relevant decisions on minimumfinancial standards and the Decree on Calculation o f State Budget Equalization for decentralized government functions according to an equalization formula. 257. As the Croatian Government did not consider taking any further steps towards decentralization and as the elections for a new government were approaching, it was decided in September 2003 to postpone the implementation o f a planned CARDS 2002 Fiscal Decentralization Project. Subsequently, further activities related to this project were suspended. 258. On December 8, 2004, Croatian Government adopted a Framework for a Decentralization Program for the period from 2004 - 2007 and established the Commission for Decentralization which would coordinate the implementation o f the program. The members o f the Commission are state officials, state secretaries and assistant ministers. The chairman i s State Secretary o f Central State Administration Office. Croatia CFAA: Local and reaional self-qovernment units 70 Assessment Framework 259. Inassessing the fiduciary risk associatedwith the PFM arrangements, the CFAA will use the same framework applied to the central Government. 11.Findings Legal Framework 260. The legal base for Local Self-government in Croatia i s Act No. 33/2001 on Local and Regional Self-Government (LRSG). The law defines three types o f sub-national geographical units: Counties, Municipalities andTowns. Counties are defined as "units o f regional self-government" and towns and municipalities as "units o f local self- governments." A town i s defined as a community with 10,000 or more residents or the placewhere the county seat i s located. 261. The financing o f local and regional self-govemed units is regulatedunder Act No. 117/1993; the Act and its amendments pertain to the Financing o f Local and regional Self-government Units. 262. The City o f Zagreb has a particular law, the City o f Zagreb Charter (hereafter the City Charter) No. 20/2001, which among other things regulates budgetpreparations. 263. The BA regulates PFM arrangements for all three types of sub-national units. The City Charter and the BA apply to the City o fZagreb. InstitutionalFrameworkandCapacity 264. Sub-national self-govemment in Croatia has two tiers: 20 counties are at the regional level, 123 cities and 426 municipalities at the local level. 265. The activities and areas of public policy falling within the purview o f counties, municipalities and cities appear inBox 8 blow. Box 8. Tasksand responsibilitiesof Towns,Municipalities and Counties Municipalities& Towns Counties 0 Housing Education 0 Spatial and urban planning 0 Health 0 Utilities Spatial and urbanplanning 0 Social and child care Economic development 0 Primary health care Transport and traffic infrastructure 0 Elementary education Planning and development o f a network 0 Culture and sports o f educational, health, social, and 0 Consumer protection cultural institutions 0 Environmentalprotection 0 Fireprotection and civil service Croatia CFAA: Local and regional self-aovernment units 71 266. In cities with more than 30,000 inhabitants, the administration may perform the tasks o f a regional, county authority, provided they can obtain the necessary financing to deliver services. 267. Each self-governed unit consists o f a directly elected Assembly or Council. Subsequently, these units elect a Mayor. Apart from electing and dismissingthe Mayor, the Assembly makes decisions and generally acts within the scope o f its competencies. By statute, the Assembly also establishes various administrative bodies of self- government. The Mayor represents and presides over the local/regional government. 268. Typically, the local/regional government administration consists o f a Budget & Finance Unit (BFU), which i s responsible for the preparation, control and accounting o f the budget. BFUs vary in size. The CFAA visited two county administrations (Zagreb and Varazdin) and two towdcity administrations (Zagreb and Varazdin) that appeared to be adequately staffed. Generally, BFU staff numbers were in a 1:10 ratio to the total number o f administrative staff. Although the two towns/counties represent two different geographical areas, they represent the richest regions o f Croatia. Therefore, staff resources here may not reflect the less prosperous parts o fthe country. Practice 269. On the whole, budget preparations for local and regional governments follow the procedures laid down in the BA. After receiving the macro-economic indicators and revenue estimate guidelines from the MOF, the BFUs ask each department to submit its budget proposal for the following fiscal year. This process starts in early summer. After the first round o f internal negotiations among administrative departments and budget entities, the BFUo f the relevant unit prepares a draft budget proposal which i s submitted to the local government by October 15 o f the current year. The local government unit then decides on the entire budgetproposal and submits it to the competent representative body (council, assembly) for consideration and adoption by November 15 o f the current year. The representative body i s requiredto adopt the budget by the end o f the year, while its application should be effective as o f January 1 o fthe year to which the budget refers. 270. Differentrevenues are available to the regional/local government administrations. For a city like Zagreb, they include: 0 Income and profit taxes - which are collected and distributed via the tax administration 0 Administrative fees 0 Automobile taxes 0 Concessions 0 Reconciliation funds - special purpose 0 Sales o f assets 271. Revenues are ina special account managed by FINA.FINA i s also responsible for allocating the correct percentage o f collected revenue to the State and regional accounts. Croatia CFAA: Local and reaional self-aovernment units 72 272. Interms of fiscal transparency, the town of Varazdin has developed a practice of using fliers to inform its citizens how the town spent the money inthe current and capital budgets and sources o frevenue. 273. Counties, municipalities and towns are only supposed to have one bank account; salaries also come out o f this account. Salaries are paid directly from the country account after the heads o f the individual administrative entity, the BFU and the administrative head or governor o f the municipality/county/town.As sub-national governments are legal units with budgetary authority, each unit can enter into contracts. It is therefore likely they could each have several bank accounts in the name o f the local authority they represent. The CFAA however could not obtain any statistics on this. 274. Monitoring of borrowing i s guided via strict observation o f the Budget Act and the Regulations on Borrowing Procedure for local and regional self-government units. Also issuing of guarantees to local and regional self-government units by the Minister o f Finance only allows long-term borrowing for investments financed from their own budget, with the prior approval of the Government. Total annual liabilitymay not exceed 20 % o f the realized income o f a particular local or regional self-government unit in the year precedingthe year o fborrowing. 275. County, municipal and town administrations usually have computerized accounting systems. In most cases, depending on the type o f expenditure, there are several systems. Inthe county o f Zagreb, there are separate systems for salaries, current expenditures and the accumulation o fbalance sheet data, such as assets and liabilities. 276. Semi-annual and Annual Reports on Budget Execution, which follows the budget classification prescribed for budget preparation, are adopted by a representative body o f the relevant local or regional self-government unit. Financial statements serve as basis for preparation o f these documents on budget execution and they are submitted to the Ministryo fFinance and StateAudit Office. 277. As reported by the MOF, the reliability of financial reporting is in question subsequentto decentralization and various changes inaccounting rules for BUS.Boththe MOF and the SA0 report that the BUSassociated with the central and sub-national governments had significant difficulties meeting the new deadlines for submission o f financial reports to the M O F and the SAO. Moreover, ingeneral, the BUSdid not use the forms provided by the M O F to submit their financial statements. This contributed to a delay in the MOF's consolidation o f financial statements for the central and general governments. 278. Although the BA requires the establishment o f an IAU, the administrations interviewedhad not as yet established such units. They referred to the fact that did not have the so-called Rulebooks that the M O F i s supposed to issue in accordance with BA's Article 137. Financing the additional staff necessary to establish an IAUhas to come out of an existing budget; as a result, the lack o f funds becomes a resource problem for the administration. Croatia CFAA: Local and reaional self-government units 73 279. The S A 0 audits the financial statements o f local and regional administrations annually. Audits usually occur inteams o f two to four auditors; these auditors are usually on site at the local or regional administration for a period o f 1-1% months. 111.Summary of FindingsandAssessment of FiduciaryRisk 280. On the whole, the budgetingpractices o f sub-national governments appear to be sound. They appear to ensure that the budget reflects the priorities o f local and regional interests and political parties. These practices also appear to effectively prevent over- lending at the sub-national level and the generation of contingent liabilities at the state level. That being said, the likely existence of a great number o f bank accounts owned by local government increases the risk o f public funds following channels outside the formal processes set out in the BA. The ongoing process o f decentralization, combined with recent changes in accounting rules have caused problems in the reliability o f financial reporting to the MOF. The SA0 provides external audit arrangements with appropriate frequency and provides a safeguard against the misuse o f funds. The SAO's resources are however spread thin at the sub-national level. Generally speaking, the transparency o f the PFM system appears to be greater at the sub-national level than at the state level. This i s also reinforced by more direct lines o f accountability between the citizen and the elected representative. Based on the concrete concerns related to cashmanagement, the reliability o f financial reporting and internal control, the fiduciary risk associated with the PFM and financial accountability arrangements for sub-national governments must be rated sigrzificant. IV. Recommendations 281. The CFAA recommends the following: 0 As at the state level, the MOF should issue all the statutory" rulebooks and guidelines on internal audit and accounting referred to in the BA and offer appropriate training for their effective application. But local and regional administrations should prepare to implement the intentions o f the new BA, including steps to establish MUS. 0 The practice o f engaging and educating citizens in local budget expenditures, as done in the town o f Varazdin, i s a best practice in ensuring transparency and accountability. The concrete practice o f public campaigns (for example, distribution of flyers) to inform citizens about the use and sources o f the local budget should be expanded to other sub-national government administrations. 79As requiredby the organic Budget Act. Croatia CFAA: Capacity Development 74 CHAPTER CAPACITYDEVELOPMENT 9: 282. In this chapter, the CFAA will offer an overview o f recent technical assistance (TA) activities in the field of Public Financial Management (PFM). It will assess the ability o f beneficiary institutions to absorb the T A effectively as well as the sustainability of the capacity development effort. I.RecentTAactivitiesinthefieldofPFM 283. Because EU accession was a clear political objective from the beginning, the Croatian Government has benefited and continues to benefit from the EU CARDS (Community Assistance for Reconstruction, Development and Stabilization) program. The development o f P F M has been a priority o f the EU; considerable amounts o f money have funded technical assistance in this field. During the period o f 2002-2004, the CARDS budget o f the European Communities allocated EUR 10.5 million to improve the PFM inCroatia.80Inaddition, USAID, the US Treasury, SIGMA, the IMF and the World Bank have been and will continue to provide advice indeveloping PFMcapacity. 284. Current or upcoming PFM development projects include: e CARDS 2002: Development o f Public Internal Financial Control (PIFC) and Internal Audit (EUR 1.5 million), accompanied by a program o f training and development inmodern internal audit e CARDS 2002: Development o f Public Debt Management Capacity (EUR 1.5 million.) e SIGMA": Peer Review and Strategic Development Plan for the State Audit Office (Peer review report published in July 2003. Budget figures were not available. The CARDS 2003 project below is partially based on recommendations from the peer review) e CARDS 2003: Strengthening the External Oversight o f Budget Execution (EUR 1.6 million.) e U S Treasury: Resident Advisor Program with the Ministry o f Finance (Continues through 2004. Budget figures were not available) e USAID: Fiscal Reform Program (Implemented by Bearing Point consultancy through 2004. Budget figures were not available) e CARDS 2004: Strengthening Public Internal Financial Control Structures (EUR 1.5 million) e The World Bank IDF Grant for Strengthening Budget Management (USD 368 thousands) European Commission Country Strategy Paper for Croatia 2002-2006, p. 66. SIGMA stands for Support for Improvement inGovernance and Management; it is ajoint initiative of the OECD and the European Communities. Activities inCroatia are hnded from a "framework" grant to the OECD from the European Communities' Balkans program. Short or medium-term assistance for expertise and project management come from the SIGMA secretariat located at OECD's headquarters. 285. In addition to these activities, the IMF has sponsored a resident advisor to assist the CNB; until recently, an advisor also assisted the MOF. The World Bank has provided ad hoc advice during missions. The IMF's and the World Bank's advice on debt management has been provided through a "Joint Program on Central Government Debt Management and debt Market". The program's most recent mission to Zagreb was in February 2004. 286. It should also be mentioned that under the headline o f "public finance" the EU also finances a great number o f technical assistance projects related to the development o f the customs administration. 11.Assessmentof TA absorption capacity, impact andcoordination 287. The reform o fthe Croatian PFM system depends on the continued development o f the SAP-based state treasury system. As concluded in previous chapters, the system has suffered from a lack o f senior MOF management commitment and ownership, as well as an absence o f a broader context for subsequent financial systems reforms across the government. 288. MOF should be responsible for consolidating recommendations from the various partners and related projects. Because this has not happened, the highquality TA advice to improve the treasury system has been ineffective. Outstanding areas for improvement include TA for budgeting o f programs, cash management, debt management and accounting issues. 289. Progress on the internal audit changes does not depend on the development o f a treasury system. For its part, the MOF has not been very effective in promoting the CARDS 2002 project on PIFC and internal audit. During the course o f the March 2004 mission the CFAA team interviewed a number o f the senior management and BFU managers in ministries and other BUS.While these managers were aware o f the requirement to establish internal audit, they were unaware o f the ongoing PIFC and the new requirementso f modem internal audit and o f the project by the MOF. By June 2004 the awareness o f the CARDS 2002 project had improved significantly, for example with the help o f a proactive information campaign initiated by the EC delegation and the project management team. Generally, intra-MOF and inter-ministerial coordination i s a significant problem for effective PFM capacity development. The MOF's efforts with the Treasury systemare a case inpoint. 290. On the whole, donor coordination o f TA to Croatia seems efficient. As an indicator, the ECCSP 2002-2006 contained summaries o f other donors' activities. A matrix referred to an overview o f contributions from the seven most important donor organizations to particular sectors, policy areas and institutions.82 In the PFM area, frequent consultations occur among the World Bank, IMF, USAID, U S Treasury, SIGMA and European Commission; similar consultations take place. Considering the scope o f TA provided and the priority that EU accession occupies on the Government's agenda, the EUwill take on a leadership and coordinative role. The challenge will be to 82Inaddition to the EuropeanCommission: UnitedNations Development Program, EuropeanBank of Reconstruction and Development, European Investment Bank, IMF,USAID and the World Bank. CroafiaCFAA: Capacity Development 76 complete the initial assistance in capacity development and to build a sustaining training program that will be capable o f educating all future civil servants and new hires in the fundamentals o f public financial management, budgeting, internal control and internal audit. 111. General assessmentof PFMcapacitydevelopmentneeds 291. The number and capability of staff in newly established and specialized PFM functions are inadequate. There i s a serious shortfall in trained young staff knowledgeable in the principles o f modem financial management, budgeting, internal financial control, debt management and internal auditing. Staff responsible for bookkeeping, accounting and financial reporting do not know how to manage the changes associated with the new modified accrual accounting regimes introduced in 2002; the same i s true of the Ordinance change on Financial Reporting and Budgetary Accounting for BUS.These professional groups are essential to the effective operation o f the public financial management system inthe Government o f Croatia. 292. A broader and more holistic view o f the training requirements o f the government i s required. For example, there are no university degrees in public administration or public finance -- only law and economics. Whereas auditing courses are part o f the undergraduate curriculum in the Zagreb Faculty o f Economics, there are no specialized audit degrees offered by Croatian universities that could lead ultimately to some form o f international certification. The Croatian Association o f Accountants offers some training inaccountingand auditing, includinginternal auditing. 293. There i s an Institute o f Public Finance (PF), an NGO, which deals with economic research and analysis relative to Public Financial Management. While it publishes a newsletter to inform civil servants and other relevant parties about key public financial management issues, it lacks the capacity to provide systematic training. It restricts itself to providing information on academic events concerning public finance that take place abroad. 294. The lack o f qualified staff in key PFM functions i s due in part to the perception that the public sector i s not attractive to someone with a skillthat i s also in demand inthe private sector. Second, the nature of the civil service systemallows recruiting on the basis of political instead o fprofessionalmerit. 295. The future needs interms of competent PFM staff and systems to manage EUpre- accession, cohesion and structural funds will be considerable. To illustrate this, in Box 9 below the minimum requirements for managing pre-accession funds on the basis o f an ExtendedDecentralizedImplementation System (EDIS) are set out: Croatia CFAA: Capacifv Development 77 Box 9. EDIS Accreditation Criteria. Annex to Council Regulation (EC,Euratom) No. 1266/1999 1.Minimumcriteria for assessingthe ability of 2. Minimum conditions for decentralizing management to implementingagencies in applicant countries to manage implementing agencies in applicant countries. aid. The following criteria shall be appliedby the Decentralization to applicant countries with ex post Commission in assessingwhich implementing agencies control by the Commission may be considered for an inpartner countries are able to manage aid on a implementing agency where the following conditions are decentralizedbasis: met: ( I )there should be awell-defined system for managing (I)demonstrationo f effective internal controls including the fundswithfull internal rules ofprocedure, clear an independent auditfunction and an effective institutional andpersonal responsibilities; accountingand financial reporting systemwhich meets internationally accepted audit standards; (11) the principle of separation ofpowers must be respected so that there i s no risk of conflict o f interest in (11) a recentfinancial and operational audit showing procurement and payment; effective and timely management of Community assistance or nationalmeasuresof similar nature; (111)Adequatepersonnel must be available and assigned to the task. They musthavesuitable auditing skills and (111)areliablenationalfinancial control system over the experience,language skills and be fully trained in implementingagency; implementing Communityprogrammes. (1V)procurementrules which are endorsedby the Commission as meeting requirementsof Title IX of the FinancialRegulation applicable to the general budgetof the EuropeanCommunities; ( V ) Commitment by the National Authorizing Officer to bear thefullfinancial responsibility and liability for the funds. 296. The Government must develop an integrated strategy for the development o f its financial management, budgeting, debt management and intemal audit personnel, both now and inthe future. It must be a combination o f re-training o f those existing staff who demonstrate the capacity to make the transition to the new accrual base o f accounting, or the modem internal audit, and recruitment programs to attract those recent graduates who have acquired all or part o f the skills required through their university training. It must also include provisions for the acquisition o f international certification in auditing (IIA) or accounting (CIPFA, and others). Budgeting should include the elements o f capital investment, costing of budget alternatives and budget analysis. The components of the program should build on the exiting or planned training infi-astructure for Croatian civil servants, with extensions where required. These include the Government accounting center inLjubljanag3,the planned internal audit training facilities inZagreb being created as part o f the CARDS 2002 program,g4plus other ad hoc training opportunities offered by donors from time to time. 83 The Government plans to educate approximately 100 accounting staff inLjubljana over the next 2 years, financed by a World Bank project 50 will be trained in Ljubljana, the remaining 50 inZagreb inCroatian. 84 The CARDSprogram objective is to train 120 auditors inthe new techniques o f modern internal audit - 40 trained by project staff and 870 by trainers trained by the project. Croatia CFAA: Capacity Develooment 78 IV. Recommendations 297. MOF should designate a responsible senior management position at the Director level (minim~m)'~ to oversee the development o f the comprehensive training strategy, in consultation with the donor community, planned and current training providers and the professional associations o f accounting and auditing in Croatia. The objectives should be to: a Provide training inthe skills requiredto perform the new functions in financial management, inbudgeting, debt management and inauditing; a Provide an opportunity for international professional certification through participation in a university program or a professional organization that provides some recognition o f the training modules delivered under this program; a Provides a continuing education program for the professional in government to assist them inmaintainingthe currency o f their professionalskills andpractices. a The Ministero f Finance should obtain C O M approval for this program and then enlist donor support for those components that require fimding beyond the current project timeframe. 85This would be a most suitable role for the Secretary General o fthe Ministryof Finance. Croatia CFAA: Annex I: Kev persons interviewed 79 ANNEX1:KEYPERSONSINTERVIEWED (INALPHABETICAL ORDER) Family name Given name Title/fun ctioddepartment Institution ANDRICEVIC Lana Assistant Budget Advisor U S Department o f Treasury BERGMAN Vjeceslav Director Institute o f Health Insurance BLAZEKOVIC Katica Director o f IT Support to FINA Treasury BOGNER Marijanka Head o f Finance Department Ministryof SocialWelfare for Social Protection BOLTAR Verica Director Varazdin Branch o f FINA BOWEN Martin Chief o f Party USAID Fiscal Reform BRKIC Vesna Economist MinistryofFinance BRKIC Karmen Consultant USAID Fiscal Reform CHETCUTI Frederic Team Leader EUCARDS project CIZMOVIC Zaklina Head o f Division for Central Bureau o f Statistics Development, Analysis and Statistical Infrastructure CUJZEK Nevenka Head o f Budget and Finance County o f Varazdin Department CULJAK Ruzica Head o f Analysis and Plan Institute o f Health Insurance Unit CURKOVIC Vesna Assistant Head o f Finance City o f Zagreb Department DURIC Mario IT Senior Advisor MinistryofFinance FAULEND Michael Advisor CroatianNational Bank FUTAC Sujeiane SAP/R3 Operator -IT Ministryo fHealthand support Social Welfare GILJEVIC Vera Head o f Accounting Division MinistryofDefense GOLIK Marijana Head o f Finance and Institute o f Health Insurance Accounting Unit GRABOVAC Branka Head o f Accounting for Public Ministryo fFinance Debt and Cash Management Section GREGIC Zeljko Head o f Budget Section MinistryofDefense GRZUNOV Zeljko Assistant Minister Ministryo f Sea, Tourism, Transport and Development HEIKKWEN Ritva Sector Manager EuropeanCommission Family name Given name Title/function/department Institution HRUP Nevenka Audit Manager State Audit Office HUZANIC Bozica SAP/R3 Operator - IT MinistryofHealthand support Social Welfare IKSIC Amalija Assistant Minister for Budget MinistryofFinance Executionand Internal Audit and Control IVANDIC Vladimira Head o f Section MinistryofFinance JAMBRAC Josip Deputy County Governor Zagreb County Office KARACIC Mladenka Head o f State Accounting and MinistryofFinance FinancialReporting Division KEZELE Jerka Head o f Department for City o f Varazdin Economic Affairs, Finances and Public revenues KNEZEVIC Marela SAP/Treasury System Ministryof Sea, Tourism, operator Transport and Development KOJIC Slavko Member o f the City Council City o f Zagreb and Heado fFinance Department KOKORIC Zeljko Project Manager B4B, SAP development KORDIC Hrvoje Assistant Auditor General State Audit Office KOTAVEC Sonja SAP/R3 Operator - IT Ministry ofHealthand support Social Welfare KULISIC Josip Assistant Minister for MinistryofFinance International Financial Institutions LANDSMAN Maja Director CroatianNational Bank LAUSIN Veronika Assistant Director Institute o f Health Insurance LINDSBAUER Ljerka Assistant Auditor General State Audit Office LJUBICIC Milka Audit Manager State Audit Office LUCIC Zorica Assistant o f Minster MinistryofFinance MALENICA Slavica Head o f Section for Budget MinistryofFinance Supervision M A M I C Stipe Assistant Minister for Finance Ministryfor Science, Educationand Sport MARIN Ana Head o f Finance and Budget Zagreb County Office Department MARKOVIC Ljiljana Internal Revision Unit Central Bureau o f Statistics MARUSIC Jadranka Director Croatian National Bank Family name Given name Title/function/department Institution MATIJEVIC Katja Assistant Minister for MinistryofHealthand Economic Affairs inHealth Social Welfare MEDIC Zdenka Sector Director, IT Support to FINA Treasury MISKOVIC Sara Head of Finance and Planning MinistryofJustice Division NIKOLIC- Vlasta Assistant Director o f Legal, Central Bureauof Statistics MUDRINIC Finance, Accountancy and Central Administration NBRREGAARD John Resident Representative IMF NOVACIC Ivan Assistant Minister for MinistryofFinance Economic Affairs O'CALLAGHAN Gany Fiscal Advisor, Consultant U S Treasury PAP Jasenka Assistant Director Institute o f HealthInsurance PERKOVIC Dijana Senior Adviser for Analysis MinistryofDefense PERNAR Lidija Assistant Auditor General State Audit Office POLHERT Sanja Cashless Payment Operations CroatianNational Bank Department PRTENJACA Sime Member o f the Sabor, CroatianParliament, the Chairman o f the Finance and Sabor Central Budget Committee PRUGOVECKI Gordan Head o f Department CroatianNational Bank RAIC Niko Assistant Minister for Budget Ministryo fFinance Preparation ROGIC Branko Deputy Head o f Personnel Ministryo fDefense RUTH James Bennett Resident Budget Advisor U S Department o f Treasury SABADZIJA Vito Head o f the J8 Budget and Croatian ArmedForces Finance Division SABATI Zvonimir County Governor County o fVarazdin SALOPEK Vjera DeputyHead o fFinance City o f Zagreb Department SANTINI Ivona Consultant USAID Fiscal Reform SARIC Sandra Audit Manager State Audit Office SKRBINA Zeljka Senior Officer CroatianNational Bank SMUK Zdrana Head o f Budget Division MinistryofDefense SOKOLIC Snjezana Senior Inspector for Financial MinistryofDefense Matters of the General Croatia CFAA: Annex I: Kev persons interviewed 82 Family name Given name Title/fun ctioddepartment Institution Inspectorate SOSTARIC Tanja Senior Advisor Ministry o f Finance STARESINCIC Dijana Head o f the Development Ministryo fFinance Section STEGIC Marin Audit Manager State Audit Office STOLNIK Vladimir Deputy County Governor County o f Varazdin SVIGIR Mario Advisor to Minister MinistryofFinance TKALCIC Maja Head o f Accounting and Central Bureau o f Statistics Finance Division TORTIC Vesna Head o f the M-4 Office o f MinistryofDefense Assistant Minster for Finance and Budget VINCETIC Ivan Member o f County Council County o f Varazdin responsible for Budget and Finances VUCETIC Ivan Director FINA VULETIC ANTIC Bozo Audit Manager State Audit Office v) a L z n cn n 8 - L Y 3m 0 E 3 m d 5 B Yv1 +m 8 2 Ee, e, E G c Pc E F .e i- *m E5 .e 0 i- E5 i- m -B a 0 a0 3.e .e * 3i- 3 m f Be,2 W 3 3 5 9 .e .3 cd m 2x x 3 f 3 f g a 5 5x 8x m 0 -g 3 .e m .e V g f; e, f; e, e, 3 e, e, > M C 5 E 3 m E! Ea, a?i F .3 8 i- .3 + a .% an 80 U E 9 E 3 2s cm .e e, E -3E i- E .3 2L ! B0 .z s&8 Gc ! 5cu B0 0 i- % 'Ss E8 e, > 8 .3 a, > F 3 .3 i$ 0 u 0 -3 m @8 eh x a 3 .3 i- m .3 8 .e N Y 9 m N Fx .3 9 8 i- Fi2 a83 Y a, e3 cu -3 8 0 e rc 10 s0 0 A v2 z6 in V &8 L Y U 0 s .3 Y 33 0 3 01 6e, ru 0 Y Y3C Ba, 4g m m . A Ga, P a, n 4 z 1 3 a2 L. 8nz E Croatia CFAA: Annex 111: Overall Assessment of Fiduciary Risk 92 ANNEX111.OVERALLASSESSMENT FIDUCIARYI S K OF R The fiduciary risk within an individual PFM area, such as Budgeting, is calculated as a simple average of the rating o f each indicator presented in Annex I1and in the table below. The overall risk rating for the entire PFM system i s also calculated as a simple average o f the ratings assigned to the individual PFM components. This i s summarized in the table below. It should be emphasized that whereas the fiduciary risk ratings can be used for the purpose o f comparison and benchmarking it does provide quantitative information about theprobabilities of funds not beingspent for the intendedpurposes. PFMcomponent Riskindicators Indicator PFM Risks7 component risk Budgeting 1.Aggregate fiscal deficit comparedto Significant original budget. 2. Composition of expenditure out-turn L o w compared to original approved budget. 3. Extent to which budget reports include all Significant I significant expenditures on central government activities, including those funded Moderate by donors. 4. Adequacy o f information on fiscal Significant projections, budget and outturns provided in budget documentation. 5. Administrative, economic, functional and L o w programmatic classification o f the budget. 6. Extent o f multi-year perspective infiscal Moderate planning, expenditure policy-making and budgeting 7. Orderliness and participation inthe annual Significant budget process. 8. Legislative scrutiny of the annual budget Moderate law. Treasury & cash 9. Single Treasury Account. Moderate management 10. Stock of expenditure arrears. Significant 11. Effectiveness o f cash flow planning, Significant management and monitoring. 12. Procedures inoperation for the Significant Significant management and recording o f debt and guarantees. 87For explanation and interpretation see Annex I1 Croafia CFAA: Annex 111: Overall Assessmenf of Fiduciaw Risk 93 PFMcomponent Riskindicators Indicator PFM Risks7 component risk 13 Extentto which spending ministries and Significant agencies are able to plan and commit expenditures inaccordance with originalirevised budgets. Accounting & 14. Computerized accounting systems Moderate financial reporting 15. Audit trail documentation High r 16. Timeliness and regularity o f data Significant reconciliation. 17. Timeliness, quality and dissemination o f 1Significant Significant in-year budget reports. 18. Timeliness and quality o f audited financial ISignificant statements submittedto the legislature Internal control & 19. Corruption perception index ranking Significant internal audit 20. Writtenprocedures Significant Significant 21. Effectiveness o f internal controls Significant 22. The effectiveness o f internal audit High External audit & 23. The scope and nature o f external audit. Moderate legislative oversight 24. Follow up o f audit reports by the Moderate Moderate executive or audited entity. 25. Legislative scrutiny o f external audit Moderate reports Sub-National The above as applied to sub-national Significant Significant" Government government Overall Assessment of Significant 88As summarized insection 111, Chapter 8.