More Stringent Assessment of PFM Consultants

[petagny]

I've just been involved in an offer for some work for Belgian Co-operation. As part of the bid, prospective consultants had to provide answers to the following questions:

Question 1. (max 3 pages)

a. What is the rationale behind the use of a cash basis of accounting in many countries over many years? Or the other way around: why is accrual accounting moving into public sector accounting at a much slower pace than in the private sector? Discuss.
b. Why are some countries still on a cash basis for budgeting, but on a accrual basis for accounting?

Question 2 (max 3 pages)

What are the main evolutions in the field of internal control and audit in the public sector?

Question 3 (max 3 pages)

What are the key differences between the French and English system in the field of budget execution? What are the strengths and weaknesses of both systems (budget execution)?


Are any other donors going down this route?

[Napodano]

Never seen such a thing 

The questions are straigh-forward, but one would feel quite annoyed to be put throught this test.

I would rather go for a phone conversation, exchanging views on the assignment.

BTW, petagny

would you post your answers to this topic, once and if you reply them? My take in a flash would be:

Q1. cash basis accounting in developing countries is linked to the capacity level of public servants and the difficulty to valuate public assets

Q2. central harmonization unit in MoF

Q3. the French system is strong central control mainly on inputs (often ex-ante), English system goes through the setting of ministry ceilings and  ex-post monitoring and evaluation. I believe that this difference is now a thing of the past as the 'English' system is now prevailing.

Any other PFMBoarder to go through the questions? It would be fun to compare our views.

[petagny]

OK. The bids were opened today, so I can share my responses. I wouldn't say mine are model answers - working against a time constraint etc. - but this is how I responded to Question 1 (I'll post the answers to the other two questions separately):

Question 1:
a. What is the rationale behind the use of a cash basis of accounting in many countries
over many years? Or the other way around: why is accrual accounting moving into
public sector accounting at a much slower pace than in the private sector? Discuss.
b. Why are some countries still on a cash basis for budgeting, but on an accrual basis for
accounting ?

Answer 1.a

While the theoretical advantages of accrual accounting have been widely advertised and the approach has the support of many international organisations (IMF, IFAC, etc.), the cash basis for accounting still remains widely used. This relates to the apparent simplicity of cash accounting and the substantial organisational, human resource and financial requirements of introducing full accrual accounting.

In reality, countries are situated along a spectrum from full-cash accounting, through modified cash accounting (where some commitments with cash implications outside the financial year in question are covered) and modified accrual accounting (where assets are written off as soon as acquired), to full-accrual accounting, with rather fewer at the accruals end.
Under a cash-based system, transactions and events are only recognised when cash is paid or received. The financial statements generated cover cash receipts, cash disbursements and opening and closing cash balances. The accounts are therefore relatively easy for legislators and the public to understand. However, they suffer from the disadvantage of not representing a full picture of the financial position of the public sector, including changes in assets and liabilities, and not being an accurate basis for assessing the full cost of public service delivery. Correcting for this disadvantage, accrual accounting, which mimics the approach used in the private sector, recognises transactions and events with financial implications when they actually occur and not when cash is paid or received. Thus expenses incurred will reflect the actual consumption of goods and services, even if these are not paid for in the financial year. Non-cash expenses such as use of capital assets are also accounted for, as should be long-term future expenditure commitments, e.g., pension obligations to public sector employees. The financial statements generated through accrual accounting will therefore cover revenues, expenses (including depreciation of capital assets), assets (both financial and non-financial), and liabilities. A balance sheet for the government is therefore generated showing net assets, just as for a private sector enterprise. Accrual accounts should also be supported by cash-flow statements, a fact that is sometimes forgotten.

By accounting for all the resources that an entity controls and for the deployment of those resources, accrual accounting improves overall budgetary accountability and transparency. By taking account of the full financial implications of medium to long-term expenditure commitments that go beyond conventional debt, accrual accounting can aid macro-fiscal management and, as a basis for more accurately estimating the cost of public services, accrual accounting can assist in assessing and improving the efficiency and effectiveness of public expenditure. Accrual accounts can also serve as a basis for assessing alternative service delivery options, including contracting out, and improve asset management.
While the theoretical advantages of accrual accounting seem evident, its introduction can be onerous particularly for countries with poorly developed PFM systems, where there may be other more important priorities. Even for those countries with more advanced PFM systems, the gains from introducing accrual accounting may not always be seen as large enough to outweigh the significant efforts involved.

Financial information requirements for accrual accounting are substantial and by necessity require a sophisticated IT-based accounting system. Countries that are not yet able to report accurately, comprehensively and in a timely fashion on a cash-basis, should probably not therefore be considering moving to accruals, before having reached this level. The human resource capacities required for accrual accounting are likewise substantially greater than for cash-based accounts, which for the most part can be put together by staff without specialised accountancy skills. This is certainly not the case for accrual accounts. Perhaps the most onerous part of accrual-based accounting is setting up and maintaining up-to-date and accurate asset registers that identify all government assets, and keep track of and value them. Many countries are a long way from being able to do this, hence the prevalence of modified accrual accounting.

Experience indicates that a carefully staged approach to implementing accrual accounting is likely to be more successful than ‘big-bang’ solutions. Such an approach would involve maintenance of cash-based accounts while preparations are under way and going live with a mixture of cash and accruals, until the latter are embedded and extended.

Question 1.b

Only a handful of advanced countries (e.g. the UK, New Zealand and Australia) have implemented budgeting on a full accruals basis (i.e., voting appropriations on an accruals basis) alongside full accrual accounting. Some countries (with accrual-based accounting) have adopted a selective approach to accrual budgeting (e.g., Denmark and Switzerland) and others considered it and then did not move forward to any significant extent (e.g., Canada). Accrual budgeting involves ex ante planning on an accruals basis and, as such, represents another step up in sophistication and complexity. Accrual budgeting should reinforces all the advantages of accrual accounting, and some commentators maintain that the full benefits are most unlikely to be achieved without it. Notwithstanding this, cash-based budgeting remains the norm in advanced countries, even if it runs alongside accruals-based accounting. For less advanced countries, if accrual accounting represents a significant challenge, then accrual budgeting represents an even bigger one and it would be very risky for most to move away from cash-based appropriations with the current PFM systems.

When implemented, accrual-based budgeting is usually introduced as part of a package of performance-oriented management and budgeting reforms that focus on improving the delivery of public services and the achievement of policy outcomes through decentralised decision-making and reduced central control over inputs. It therefore represents part of a major reform initiative demanding decisive political support to drive it forward, together with the necessary financial resources, systems development and upgrading of human resource capacities. The considerable level of commitment required to drive through such a reform is difficult to envisage in many countries, particularly as the benefits have sometimes proved difficult to pin down in countries that have gone down this route (e.g., UK and Australia).

The challenges in introducing accrual budgeting include developing appropriate accounting standards for the budget and deciding what assets to value and how to do this. These issues can be overcome in time, but the complexity of using accrual measures for planning and managing the use of public sector resources throws up other more deep-seated problems that are more difficult to overcome. One of these is that accrual-based measures of value can experience significant volatility because of abrupt changes in the valuation of assets or liabilities or changes in assumptions used to put a value on future payments, e.g., assumptions concerning the future path of interest rates, inflation and productivity growth. Management and oversight of non-cash expenses, like depreciation, can also pose significant challenges. Overall, accrual budgeting introduces increased technical complexity into budgeting that can make it less transparent and less understandable. There are also increased opportunities for manipulation, e.g., in calculating of depreciation or capitalisation of expenses. For these reasons and the significant requirements for upgrading systems and developing human capacities, many countries have shied away from introducing full accrual budgeting, although those operating accrual accounting systems often supplement budgetary documents with accrual accounting information.

[petagny]

Here's my answer to Question 2:

Question 2: What are the main evolutions in the field of internal control and audit in the public sector?

Answer: Traditionally in many PFM systems internal control has been based around centralised ex ante control and ex post inspection with a focus on following up third party complaints, investigating doubtful transactions, identifying non-compliance with rules and punishing those who commit errors. The emphasis has been on legality and regularity with little room for economy, efficiency and effectiveness criteria. More modern approaches to internal control emphasise transparency, accountability and value-for-money objectives, are more preventive in their approaches and examine broader systems rather than the symptoms of system failures.

Modern approaches to internal control and audit are based on the key concepts of managerial accountability and functionally independent decentralised internal audit. There is considerably less emphasis on investigative functions and punishment of individual irregularities. The aim is to prevent such irregularities by ensuring that adequate systems are in place to reduce the risk of corruption, fraud or error. Effective public internal control usually works in cooperation with external audit function and is itself subject to assessment by the Supreme Audit Institution.

The first level of control is seen as being at the level of the public sector manager with responsibility for using public monies. Such a manager should be responsible for establishing and maintaining adequate financial management and control systems to carry out the tasks of the budgetary cycle. He/she should be responsible for a risk assessment of these systems to identify the main risks. Budgetary entities should then have a functionally independent internal auditor reporting directly to the ministry’s top management (i.e., not part of the department of finance or equivalent) and with responsibility for objectively assessing the internal control systems put in place by managers. While internal audit reports to higher management, it should have independence concerning the approach to auditing. Its role is to independently evaluate the adequacy of internal control systems set up by managers and to identify any weaknesses and associated remedial measures. Thus internal auditing differs substantially from a traditional inspection function and from ‘pre-audit’ of transactions, i.e., pre-payment checks of payment vouchers. How well systems serve the core PFM criteria of economy, efficiency and effectiveness is stressed in any evaluation. Recommendations on improvements are made to managers who are ultimately responsible for adopting or rejecting these. Managers are also seen as being responsible for dealing with human or systematic errors arising from their systems, while the appropriate legal means should apply to cases of fraud. Thus in this new model the internal audit does not have any judicial authority.

A central body for harmonising approaches to internal audit across government is often seen as important. This body, often located within the finance ministry, has responsibility for developing and promoting internal control and audit approaches in accordance with international norms and for coordinating the introduction of legislation relating to managerial accountability and internal audit.

This model of internal control and audit is captured in the dimensions of PEFA indicator PI-21, ‘Effectiveness of Internal Audit’, which emphasise the amount of time spent by internal audit on systemic issues, the distribution of internal audit reports and the action by management on internal audit findings. PI-21 is, however, often one of the indicators with the poorest scores because the model diverges so much from the traditional approach to internal control and audit, particularly in formerly centrally planned economies and countries that follow the ‘French’ system. Often, in these countries, attempts to convert inspection functions into modern internal audit have met with limited success because the approach is so different. The approach is also very much associated with the introduction of performance-oriented approaches to planning, management and budgeting, which are notoriously difficult to implement in PFM environments where some of the basic building blocks of a good PFM system are not yet in place.

[petagny]

Here's my answer to the third question:

Question 3: What are the key differences between the French and English system in the field of budget execution? What are the strengths and weaknesses of both systems (budget execution)?

Answer:

The key difference between the French and English systems in budget execution relates to the nature and extent of ex ante expenditure controls and the degree of decentralisation of decision-making.

Many former French colonies have budget execution processes that derive from a model formerly practiced by France, but now superseded in that country. However, since these countries share many common features it is useful to label this the ‘French’ model, although there are frequent variations in the details of the process between countries.

The ‘French’ system is characterised by separation of responsibilities for authorising expenditures and by centralised financial control (and corresponding dilution of financial management responsibilities in spending ministries). The Ministry of Finance dominates the budget execution process, with spending agencies having a rather limited role in authorising expenditure compared to the ‘English’ system. There are formal expenditure controls at each stage of the expenditure cycle (‘engagement’, ‘liquidation’, ‘ordonnancement’ and ‘paiement’), which are often implemented by officials of the Ministry of Finance in different capacities. Thus there is often an ex ante control (with visa) performed by a financial controller (an official belonging to the Ministry of Finance) before a spending ministry commits to an expenditure (‘engagement’). Similarly, the financial controller may be involved, with the spending ministry, in attesting that the goods or services have been received and verification of the amount to be paid (‘liquidation’), although this is not universal. The order to pay the invoice, although prepared by the spending ministry, is issued by the financial controller (‘ordonnancement’), with an accompanying visa control, and submitted to the public accountant in the Treasury for control of the regularity of the ‘ordonnancement’ and eventual payment (‘paiement’ stage). The latter step reflects separation of authorities between the person authorising the payment and the person making the payment, which is a feature of the ‘French’ system (even though the two parties are from different branches of the same organisation, the Ministry of Finance).

Although it is again something of a characterisation, the ‘English’ system entails greater delegation of responsibility for budget execution to spending ministries and does not include the same intensity of ex ante controls. The accounting officer in a spending ministry, usually the senior civil servant (permanent secretary) has extensive delegated powers once the finance ministry has issued quarterly or annual spending limits (‘warrants’) after adoption of the budget. These warrants confer legal authority to authorise spending from the agreed allocations and officials of the spending ministry have the right to initiate and authorise each step of the expenditure cycle from commitment to payment. The accounting officer must make sure that the warrants are not exceeded and that virements are appropriately authorised. He/she can delegate authority to officials of the ministry and is responsible for ensuring that they do not overspend. Missing from this system are a formal ex ante commitment control and authorisation of the payment order by an official external to the spending ministry. While a spending ministry can usually issue a payment order, the execution of the payment is more often centralised under an accountant general, but in some countries both payment authorisation and actual payment can be decentralised.

The ‘French’ system is commitment based, allowing spending ministries (subject to the controls described above) to commit expenditures up to monthly or quarterly limits issued by the finance ministry. One potential disadvantage of this is that there may be no check on cash availability to make the actual payment and arrears might be more likely to build up. At the end of the fiscal year, a period of time (generally two months) is allowed to process and record cash payment transactions relating to commitments made towards the end of the year but for which the goods or services had not been delivered by year-end. In the ‘English’ system, budget authorisations are cash-based and, in principle, no cash transaction relating to the previous year’s budget should take place at the beginning of a new financial year.

In general it can be said that the ‘French’ system can help foster better macro-fiscal control because of the centralised control over commitments. The ‘English’ system, because of its delegated authorities has potential advantages in supporting better resource allocation and greater efficiency in budget management. Under the ‘French’ system, centralisation can assist in faster and more comprehensive in-year reporting and annual accounts, whereas the ‘English’ system leaves room for delay and incomplete reporting.

The ‘French’ model is prone to a certain amount of duplication of functions and authorities that can lead to delays in budget execution. Some of this duplication is deliberate, to ensure that there is sufficient oversight to avoid waste and misappropriation, but in some countries it is taken too far and opens up increased opportunities for rent-seeking behaviour.

[Napodano]

petagny,

Many thanks for posting your answers.

They will be food for thoughts for many in the community.

[STONE]

Marvellous, thank you both.  Just been working in a "French heritage" system (as I prefer to call it) and the big issue for LMs was "confronter les difficultes dans la chaine de decaissement" - delightfully vague, I thought.

[Martin Johnson]

Just a quick word of thanks from me too to Simon (Groom) aka Petagny. A very good synopsis of the issues that will provide a nice reference for us all when we need it!