N S U T I C T I N S U B. Theoretical issues: Budget definition and budgeting principles. Brainstorming

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1 P U B L I C I N S T I T U T I O N S A C C O I U N T I N G UNIT 2 THE BUDGETING PROCESS IN PUBLIC SECTOR Theoretical issues: Budget definition and budgeting principles Budget is a plan for the accomplishment of programs related to objectives and goals within a definite time period, including an estimate of resources required, together with an estimate of resources available, usually compared with one or more past periods and showing future requirements. Government budgeting is the allocation and use of resources, and associated decisions about how the resources used will be acquired, by that part of the public sector which is financed primarily by compulsory charges such as taxes. The government budget is therefore a financial plan which covers those public sector agencies such as ministries and the social security system which are primarily taxfinanced. Brainstorming Think about the following issues and you will find out what are the budgeting principles - Is there any ante connection between expenditures and revenues? - How many government budgets should I prepare at country level? - Which currency should I use? - How often should I prepare a budget? - Is it secret or do I have access to consult it if I want to? Universality principle Unitary principle Unitary currency Annuality principle Publicity principle Budgetary specialization principle budget classification (it will be detailed afterwards) Funds authorizing officers = managers of public institutions with legal statute 3 ranks: primary, secondary and tertiary 1

2 Stages of the annual budget process Reading... and matching Read the following text related to budgeting process. After matching the stages of annual budget process to their description arrange them in the proper order. HOW TO CREATE A STATE BUDGET * Issue guidelines to all state agencies before they prepare their funding requests for the next fiscal year. The state's budget office prepares and issues these. Guidelines usually include financial information, such as projected revenues, expenditure targets, and inflation rates. The information will usually include guidance on the governor's policy priorities. Collect, review, and analyze all agency budget requests. The budget office may also analyze financial and demographic data to determine the need for agency programs. The review process may include meetings or formal hearings between the budget office and state agencies. Consolidate all agency requests into a proposed state budget. Once a budget proposal is complete, the state budget office submits it to the governor with recommendations. The governor, with the help of his or her staff, finalizes the budget proposal. Submit the proposed budget to the state legislature for approval. In most states, the governor does this, usually when delivering a "state of the state" speech. During this speech, usually given annually, the governor provides an overview of the budget and stresses his or her policy priorities. Consider the budget for approval. This is the work of the state legislature. The legislative stage of the budget process usually begins with legislative committee hearings. Typically, each chamber of the legislature (usually known as the House of Representatives and the Senate) approves its own version of the state budget, which means a House-Senate conference committee must resolve differences between the two versions. Once this is done, the Legislature adopts the budget before the beginning of the fiscal year. Stages ( )Budget execution (3) ( ) Budget preparation and enactment (2) ( ) Accounting, Auditing and Reporting (4) ( ) Aggregate fiscal policy formulation (1) Description This stage refers to the determination of the government s overarching objectives for the budget deficit, debt and other relevant fiscal aggregates, which should then be translated into decisions about the desired levels of aggregate revenue and expenditure. (1) This stage covers the preparation of accounting records of government spending and revenue, their auditing by both internal and external auditors, and the provision of reports on budget execution to government agencies, ministers, parliament and the public. (4) This stage refers to the carrying out of the expenditure plan developed in the budget including the entering of contracts and expenditure of funds. (3) In this stage of the budget process the government decides how much funding it will provide to which agencies and for which purposes. This is given formal expression in the budget law and budget regulations, which are enacted by the legislature and the highest executive organs of government (i.e. the president or cabinet of ministers). (2) * Hall, S., How to create a state budget, available at 2

3 Summary box Budgeting objectives Reading... and True or False? Read the following text related to budget planning and decided which of the following statements is True (T) or False (F). ( ) If budgeting does not keep debt to sustainable limits, financial markets can potentially lose confidence in the security of lending to government. (T) ( ) Deficits and debt must get out of control because this is important for economic confidence and stability. (F) ( ) Funds should be allocated to the sectors and programs which are less effective in meeting social need. (F) ( ) Funds are moved away from sectors and programs where spending is low priority. (T) ( ) Government services should be delivered efficiently and, have to be designed and managed so as to maximize their effectiveness. (T) Considering the above statements what do you think that the key objectives of budgeting are? Sound macrofiscal outcomes Appropriate prioritization of expenditure Service effectiveness and efficiency 3

4 Estimating expences Identify primary program objectives and assessing the financial resources the city will need to pay for those programs. Obtain information from each city department. Those involved in the budget planning process must agree on common financial goals, but there are likely to be many revisions of those goals before a final budget is adopted. Determine the cost of services that the city is required by law to provide, ranking those needs in order of priority. Examine the previous year's spending for each department when projecting costs for the next fiscal year. Budgets are based in part on how much money was spent for programs and services in the past. However, those planning the budget must also keep in mind what the city can afford. Take into account that personnel costs account for a large percentage of a city's budget. Salaries and benefits paid to municipal employees are among the budget components that officials review when looking for ways to trim costs. Even when layoffs are avoided, a hiring freeze may be implemented as a cost-savings option. Request a list of the city's fixed municipal assets. Instruct each department to conduct an inventory and assess the condition of its assets. This will budget planners determine when maintenance or upgrades are needed for streets, sidewalks, bridges, drainage systems, curbs or utilities and water. Set timelines for receiving and reviewing information. Address questions or concerns about budget specifics throughout the process. Talk to the city's financial advisers and make changes to proposal as needed. Estimate how much money the city needs to provide optional services that residents want. Although most budget requests are considered to be an investment in the city's future, it may be necessary to make tough choices when establishing priorities for funding public safety, education, infrastructure, parks, transportation and the arts. Depending on the funding available, some project requests may be delayed HOW TO PLAN A CITY BUDGET * Calculating revenues Calculate the city's expected income from taxes and other sources. Although taxes generally account for more than half of a city's operating revenue, consider how much income the city will receive from fees, fines and other charges. User feels include such things as water and sewer services, garbage collection, parking meters, transit fares, and licensing fees. While each city's dependence on these revenues varies, in many cases, they account for a minor percentage of the annual operating revenue. Many budget planners take into account how much revenue has been earned from these sources in the past. Consider how much funding the city expects from state and federal government grants to provide special services. The federal government allocates money to grant programs that local governments receive directly or through the state to help fund such community programs as public health, child development, housing, and economic development Some city governments rely on investment income and loans to finance programs and services. Estimate how much income the city will raise through taxes. Since taxes are used to pay for such essential public services as police and fire departments, a tax increase may be necessary. However, if budget planners project a budget surplus, the money can be used to pay down debt or saved for a fiscal year when revenues fall short of projections. Educate citizens on key points of the budget and offer them opportunities to participate in the budget planning process. Encourage them to speak about proposed spending at public meetings. Officials can use a public forum to discuss the major economic issues affecting the city, including changing trends in the national economy. Community leaders can provide information and facts about the city's schools, job opportunities, community services and public programs. * Keefer, A., How to plan a city budget available at 4

5 Effectiveness and efficiency keywords leading to performance Key questions and matching Think about an HIV/AIDS prevention campaign which aims to reduce such infections. How it should be consider if it succeeds in reducing the rate of new HIV/AIDS infections? How it should be consider if it succeeds it at the lowest possible cost? Effectiveness Efficiency refers to the extent to which a service delivers the benefits which it is supposed to deliver to society (1) is about minimizing waste in the production of government services (2) is about the extent to which programs achieve their intended outcomes (1) refers to delivery of services at the lowest possible cost, without sacrificing quality (2) Case study * China to Build Beijing-Shanghai High Speed Railway Your client is The Ministry of Railways (MOR) of China. The ministry is responsible for the development of the rail network and rail infrastructure in mainland China, passenger services, and regulation of the rail industry. The ministry is also in charge of the operations of China Railways which manages 16 railway bureaus and 2 railway group companies in China. Recently, the Chinese MOR is considering investing a large amount of money to build a high speed railway between Beijing and Shanghai, the two largest cities and the two most important economic zones in China. Additional information: 1. Comparison of regular railway and high-speed railway The regular railway line distance between Beijing and Shanghai is about 1,320 kilometers or 820 miles. Due to low speed and frequent stops, it takes about 12 hours to travel between Beijing and Shanghai by regular railway. The proposed Beijing Shanghai high-speed railway will be of similar line distance, and will be parallel to the conventional railway. Designed for a maximum speed of 450 kilometer per hour, the high-speed train will take only 3 hours to travel between Beijing and Shanghai. 2. Population The population of Beijing is 19.5 million as of The population of Shanghai is 23 million as of Capital requirement of the project Fixed costs: USD $2.5 billion, this includes the costs of railway infrastructure, railway stations, high-speed trains, and license of technology. Variable costs (operational): USD $50,000 per high-speed train per day Requirements You have been hired by the ministry to advise them on this major project. Should they go ahead with the investment? What issues must be considered before making a go / no-go decision? * Management Consulting Case Interviews, available at 5

6 Budgeting approaches Reading... and discussion LINE-ITEM BUDGETING / PERFORMANCE BUDGETING * A traditional approach to budgeting and the one that is most likely present in some portion of every government s budget today is line-item or object-of expenditure budgeting. A simplistic approach to budgeting line-items is called incremental budgeting. In essence, an incremental budgeting is derived from the current s year budget by adding amounts expected to be required by line items. Examples include salary and wage increases, increases in the cost of supply and equipment, decreases that would result from shrinkage in the scale of operations forced by pressures such as spending limitations mandated by the electorate and cuts in capital equipment purchases. Incremental budgeting focuses largely on controlling resource inputs and typically uses the line-item budget format in which the focus is on departmental expenditures for specific purposes or objects, such as personnel, supplies, equipment and travel. The weakness of the incremental approach is that focuses on government operations in terms of money spent in the prior year rather than what was accomplished by spending. In the 1970s, an approach to wed the legally required budget process to a rational process of allocating resources among alternative uses was introduces - zero-based budgeting (ZBB). As the name indicates, the basic concept of ZBB is that the very existence of each activity as well as the amounts of resources requested to be allocated to each activity must be justified each year, which is a move toward program budgeting. The ZBB approach has several advantages: it is easy to understand, uses easily available line-item data and involves staff form the government that is going to incur in the cost. Typically, staff prepares three types of budgets one representing basic service needs, another reflecting the cost of delivering services at the current level and a third that captures the cost of the extending services to meet new demand. It is hard to argue with the basic premise of annually re-evaluating the value that a program or department adds to total government operations. However, ZBB is not widely used because it is time-intensive and managers become skeptical of the approach when marginally successful programs continue to be funded to come degree. The evolution of the concept of a budget from an estimate of proposed expenditures and the proposed means of financing them to an operating plan was a natural accomplishment to the development of the concept of professional management. In public administration, as in business administration, the concept of professionalism demanded the administrators or managers attempt to put the scarce resources of qualified personnel and money to the best possible users. The legal requirement that administrators of governments submit appropriation requests to the legislative bodies in budget format provided a basis for adapting required budgetary estimates of proposed expenditures to broader management use. The legislative appropriation process has traditionally required administrators to justify budgets requests. A logical justification of proposed expenditures is to relate the proposed expenditures of each governmental subdivision during the budget period. The type of budgeting in witch input of resources is related to output of services is sometimes known as performance budgeting. * Wilson, E.R., Reck, J.L. and Kattelus, S.C. (2010), Accounting for governmental and non-profit entities, McGraw Hill/Irwin, pp

7 Performance budgeting is a conceptual plan for relating resources inputs to the efficient production of outputs and historically focused on each organizational unit rather than programs. The use of performance budgeting in governments received significant impetus from work the first Hoover Commission did for federal government. Its report, presented to the Congress in 1949, led to the adoption in the federal government of budgets then known as cost-based budgets or cist budgets. The use of these designations suggests that a government desiring to use performance budgeting must have an accrual accounting system rather than a cash accounting system in order to routinely ascertain the costs of programs and activities. The recommendations of the second Hoover Commission led to the statutory requirement of both accrual accounting and cost-based budgeting for agencies of the executive branch of the federal government. Federal statutes also required the synchronization of budgetary and accounting classifications and the coordination of these with the organizational structure of the agencies. Entities that use performance budgeting consider it a financial management tool and not a subfield of accounting. Discussion Discuss upon budgeting approaches presented above. What are the benefits of each budgeting approach? Which one do you think that it s the most appropriate for public sector? Provide arguments for your answer. Exercise Read the following assertions related to the purposes of budgets and check ( ) those which are specific to public sector budgeting process: Budgets are used: 1. ( ) as a guide for the present and future 2. ( ) to guide for the allocations of limited resources 3. ( ) to plan, control and estimate the amount to be received and spent during specified period 4. ( ) as a means of accountability for the money earlier entrusted and the appropriations newly approved 5. ( ) to motivate managers towards the achievement of corporate goals 6. ( ) as a means of evaluating performance 7. ( ) to collect and distribute funds 8. ( ) to inform managers about the results and operations of their responsibility domains 9. ( ) as a standard of measurement for the purposes of controlling on-going economic endeavors 10. ( ) to highlight polices which are designed to promote economic growth, full employment and enhance the quality of life of the citizenry 7

8 Types of budgets and their features Take a look and analyze Take a look at the following operating and capital budget and try to identify their features. Then, fill in the gaps below. 8

9 . describes the programs and resources used to carry them out within a specified period of time. It contains the plan for revenues and expenditures for the period, usually referred to as a fiscal year. In governmental terms, the expenditure plan represents the authorized limit of expenditures for the operating unit. Most of it provide funds for such elements as staff, benefits, supplies and operating expenses as well as grants and disbursements. (Operating budget) contains the plans and resource allocations for capital acquisitions. They receive different treatment than operating funds because their use is often a more complex and longer term proposition than the one year operating funds. They often involve complex planning processes with considerable financial risk and cash outlay. Land and buildings are well known capital goods. Increasingly, information technology infrastructure is a part of the capital budgets. Determining what is and what is not treated as a capital item is a matter of policy within public sector organizations. (Capital Budget) Take another look and analyze Take a look at the following line-item budget, program budget and functional budget and Analyze them and discuss upon their structure and purpose. Comment upon possible advantages and disadvantages of each budget type. Fill in the gaps below... lays out all organizational programs or functional areas and determines how much resources to put into each program area based on the services and production outputs it creates. (Program budgeting).. makes it easy to verify when a single item exceeds the budget or comes in under budget. (Line item budget).. focuses on expenditures within a department to accomplish a process or to complete a company initiative. (Functional budget) 9

10 From traditional to performance budgeting Line-items / incremental budgets Involves picking last year s figures and adding a percentage (mainly based on trend of economic events, inflation and available funds) to arrive at current year s budget. Zero-based budget It is program budgeting that requires every item of expenditure to be justified as if the particular activity or program is taking off for the first time. Resources are not necessary allocated in accordance with the previous patterns. Each item of expenditure proposed has to be annually re-justified. This method seeks to avoid perpetuating obsolete expenditure items. Exercise Decide which of the following assertions refer to either line-item or zero-based budgeting and group them into advantages and disadvantages Line-item budgeting Zero-based budgeting Advantages Disadvantages Advantages Disadvantages 1. ( ) it is simple to understand and operate 2. ( ) it provides a better yardstick for the measurement of performance 3. ( ) it suits the country s level of development, where there is paucity of data 4. ( ) it is cheaper to produce 5. ( ) it is not so good for recurrent expenditure and it has not been successful in the public sector 6. ( ) it creates questioning attitude instead of assuming that current practice maximizes expected money value 7. ( ) it allows optimum allocation of resources by need and benefit accruing, rather than political or emotional considerations 8. ( ) it encourages the continuity of projects 9. ( ) bureaucrats often do not trust the approach and hence frustrate its effectiveness 10. ( ) it is most appropriate for profit-oriented projects 11. ( ) there is sometimes the problem of fixing the minimum level of expenditure when determining decision packages 12. ( ) it ensures that budget is translated in monetary language and relates to relevant activity operations 13. ( ) it may cause a major shift in resource allocation 14. ( ) it fails to clarify the cost of alternative methods of achieving programmed objectives 15. ( ) it provides a better yardstick for the measurement of performance 16. ( ) it results in continual growth budget totals related to inflation, as opposed to serious economic needs 17. ( ) allocations into heads and sub-heads facilitate the monitoring of performance 18. ( ) it focuses attention on the future rather than the past; old and new projects are therefore appraised on the same basis 19. ( ) it acts as a tool for change form which benefits are likely to accrue 10

11 20. ( ) it fails to fund new programs of high priority on a sufficiently reasonable scale 21. ( ) important projects can continue to receive funds, owing to their viability 22. ( ) it allows past errors to be carried forward, thus being inefficient in its operations 23. ( ) detailed scrutiny is not contained in the budget, thus the budget preparation is not well researched 24. ( ) lack of and sometimes unreliable data may inhibit or undermine the usefulness of the approach in the less developed economic environment 25. ( ) it does not clearly spell out the relationship between capital and recurrent expenditure. The approach is based on organizational set-ups rather than programs 26. ( ) it involves the task of analyzing and ranking a lot of data and information, which might be complicated in case of lack of qualified and competent personnel Performance budgeting is a model that is linked directly with financial and organizational results. Metrics that show how expenditures achieve objectives and deliver results are some of the primary characteristics of performance budgeting. Organizations apply performance budgeting in different ways, depending on their sector, customer base or constituency and their overall objectives. For example, a governmental agency may use its budget to reduce waste, while a university may wish to increase its attendance rates. Performance budgeting features: - there is measurement of the goods and service to be delivered, - unit costs are developed - budget figures are developed based on the level of service as determined by multiplying the unit cost and level of service - expected outputs are reported within the budget. Question What would a performance budget for Ottawa Hospital look like? Think at possible outcomes such as: - number and types of operations, - waiting times for operations - cost per operations - overhead costs as a percentage of overall budget - changes in service levels. Exercise Decide which of the following assertions refer to either (a) traditional or (b) performancebased budgeting ( ) If a budget area does not meet a target, it is evaluated for cutting or elimination so the funds can be used elsewhere in a more productive budget area. ( ) A traditional budget tries to match up income with spending. ( ) It does not necessarily give importance to one spending or income category over another. ( ) This approach first tries to establish a balance so deficit spending is avoided. ( ) It puts a priority on keeping those spending categories that prove worthwhile according to some criteria, such as return on money spent. ( ) Additional efforts can be made to save for longer-term goals by either increasing the income side of the picture or cutting down aggregate spending even more. ( ) The standard used is typically predetermined, such as a measured increased in sales or more widgets produced year over year or a certain amount of caseload being resolved. 11

12 Summary box Review exercise Identify the type of budgets described by each of the following assertions... - It has the most common format, connecting and reporting information on inputs used to produce.. - It allocates money to major program areas or activities rather than to specific line items, by focusing on program goals and examining all alternatives that may achieve program goals.. - It is essentially a program budget with performance measurement methodology used to make budget decisions, where all activities are divided into major functions and each activity must yield an identifiable output, management, administration, and overhead costs being distributed among the various activities of the performance unit.. It organizes information into decision packages, i.e. incremental spending levels that reflect varying levels of effort and costs (at lest three packages: a base-level, meeting the program s minimum requirements; current-level funding and enhanced package to address unmet needs). Each package is ranked according to perceived need for it relying on subjective judgment of decision-makers in ranking packages.. It starts with current revenues and projects next year by adjusting for inflation, volume, efficiency, technology, etc. 12

13 Stages of the annual budget process Most, but not all, governments prepare and issue their annual financial budgets as public documents, or otherwise make them publicly available. There are two main stages in the budgetary process which may be conducted on a cash or accrual basis at each of the levels of government (local, state and national): 1. Preparation stage - initial budgets are developed and submitted to the legislative bodies for consideration. Spending authority is granted by legislative bodies based on the political priorities and fiscal policies of government. These budgets reflect the financial characteristics of the government s plans for the forthcoming period and are used to analyze the potential consequences of those plans on the economy. 2. Execution stage - adherence to the fiscal policies is accomplished during this stage Exercise Arrange in appropriate order the following main steps in budget preparation and enactment: ( ) The formulation of budget funding decisions into legal authorizations ( control totals ) which can be appropriated by the parliament or promulgated by the executive government (4) ( ) The estimates of spending requirements particularly associated with ongoing commitments such as the government wage bill, capital projects underway, and expenditure obligations on mandatory items such as pensions and other social security payments (2) ( ) The determination of expenditure priorities (1) ( ) The formulation of current and capital budgets, which require different budget preparation methods but which should at the same time be linked (3) Rebus Fill in the following rebus with budget execution stages. Arrange them in a proper order. a) ( ) each payment is entered into the accounting system and its relevant characteristics recorded. In a well-developed system, the accounting system will also record the commitments stage. (Accounting stage) (6) b) ( ) based on the parliamentary budget appropriations, the finance ministry communicates to ministries their expenditure entitlements. The nature of these authorizations differs internationally. In some countries, authorizations are made on a month-by-month basis that is, each month ministries are told how much money they will have to spend in the coming month. (Authorization stage) (1) c) ( ) ensuring that the service or goods previously contracted for have been delivered, and meet the specifications of the contract. (Verification stage) (3) d) ( ) the payment is actually made.(payment stage) (5) e) ( ) the accounts are audited firstly by internal auditors (within the spending ministry concerned) and subsequently by external auditors (the auditor-general or audit court). (Auditing stage) (7) f) ( ) a commitment is a contract or some other obligation to make a future payment. (Commitment stage) (2) g) ( ) in the light of verification, approval for the payment to be made is given by an official independent of the persons who initiated the commitment. (Payment authorization stage) (4) 13

14 b A U T f H a A C C O U N T I N G O O R d M e I g P A Y M E N T A U T H O R I Z A T I O N A I U A Y T D T M M I c V E R I F I C A T I O N E E T O N N I N T T N G Summary box More information at: for Budget preparation for Budget execution 14

15 Budget classification and its principles Budget classification determines the manner in which the budget is classified and presented, thus having a direct impact on the transparency and coherence of the budget. It provides a normative framework for both policy decision making and accountability. Exercise Check ( ) the correct answers for the following question: Why do you think that classifying expenditures and revenues correctly is important for?... policy formulation and performance analysis recording into accounts allocating resources efficiently among sectors ensuring compliance with the budgetary resources approved by the legislature preparing financial statements auditing annual account day-to-day administration of the budget ensuring their transparency The primary aim of budget classification should be to ensure that the budget complies with the main principles of sound budget management. Question What are these main principles? Fill in the gaps with an appropriate answer. - principle it requires that the budget cover all government entities and institutions undertaking government operations, present a consolidated and complete view of these operations. (comprehensiveness) - principle it requires that the budget include all revenues and expenditures of all government entities undertaking government operations. This principle is important to ensure that the budget is effective in constraining total and sectoral government expenditure, and in promoting greater efficiency in the allocation of resources. (unity) - principle it requires consistency between different components of the budget. In particular, current expenditure needed for the operations and maintenance of past investment projects be fully reflected in the budget. Moreover, this principle implies that there should not be a dual budget system in which responsibilities among ministries, institutions, or entities in preparing and executing current and capital (or development) spending are fragmented. (internal consistency) A sound system of budget classification should at a minimum comprise a classification of revenues into various categories, and an administrative, economic and functional classifications of expenditures. Classification of Revenues Classification of Expenditures 15

16 - taxes - social contributions - grants - other revenues - administrative - economic - functional Example Illustrative budget classification scheme for expenditures Exercise Take a look at the illustrative example above and try to match each expenditure type with the appropriate definition. 1) The administrative classification 2) The economic classification 3) The functional classification a) categorizes expenditure according to the purposes and objectives for which they are intended. (3) b) identifies the entity that is responsible for managing the public funds concerned such as the ministry of education and health or, at a lower level, schools and hospitals. (1) c) identifies the type of expenditure incurred for example, salaries, goods and services, transfers and interest payments, or capital spending. (2) More information at: 16