CHAPTER 12 FINANCIAL REPORTING

CHAPTER 12 FINANCIAL REPORTING A. General Principles 1. Objectives of reporting 1 The essential purpose of a financial reporting system is to demonstrate how the government has managed its financial resources revenues and expenditures, assets and liabilities. Ideally, therefore, it should answer the following questions: Budgetary integrity. Have resources been used in conformity with legal authorisations and mandatory requirements? What is the portion/part of appropriations not committed (i.e. not used)? What are the expenditures committed but not yet paid? Operating performance. How much do programmes cost? How were they financed? What was achieved? What are the liabilities arising from their execution? How has the government managed its assets? Stewardship. Did the government s financial position improve or deteriorate? What provision has been made for the future? Systems and control. Are there systems to ensure effective compliance with budgetary and financial regulations, proper management of assets and adequate performance? Reports are an important instrument for planning and policy formulation. For this purpose, they should provide information on ongoing programmes and the main objectives of government ministries and agencies. Reports can also be used as a source of information for parliament and the general public. They give an organisation the opportunity to present a statement of its achievements, and to provide information for a wide variety of purposes. Reporting must take into account the needs of different groups of users including: (i) the council of ministers, ministries, agencies, and programme managers; (ii) the legislature; and (iii) outside the government, individual citizens, the media, corporations, universities, NGOs and other interest groups, investors and creditors, IFIs and the financial markets. According to surveys carried out in several countries, 2 many groups of users need comprehensive and timely information on the budget. The executive branch of government needs periodic information about the status of budgetary resources to ensure efficient budget implementation and to assess the comparative costs of different programmes. Citizens and the legislature need information on the costs and performance of programmes that affect them and their constituents. The financial markets use information on the

318 Managing Public Expenditure - A Reference Book for Transition Countries government s finances in order to assess the credit worthiness of a country and to make judgements about the value of its debt and the appropriate level of interest rates and exchange rates. 2. Principles of reporting Reports prepared by the government for internal and external use are governed by the following principles: Completeness. The information, in the aggregate, should cover all aspects of the government s financial relationships. Legitimacy. The form and contents of financial reports should be appropriate for the intended users and comply with accepted standards. User friendliness. Reports should be easy to understand by well-informed and interested users, and should permit information to be captured quickly and communicated easily. They should include explanations and interpretations for legislators and citizens who are not familiar with budgetary concepts and methodological issues. Financial statements can be difficult for non-accountants; where possible, charts and illustrations should be used to improve readability. Reliability. The information presented in the reports should be verifiable and free of bias. Reliability does not imply precision or certainty. For some items, a properly explained estimate provides more meaningful information than no estimate at all (for example, tax expenditures, fiscal risks or superannuation liabilities). Relevance. Information is provided in response to an explicitly recognised need. The traditional function of year-end reports is to allow the legislature to verify budget execution. The broader objectives of financial reporting require that reports take into account the different needs of the various users. A frequent criticism of government financial reports is that they are both overloaded with information and difficult to interpret. Consistency. Consistency in the methodology, scope and coverage of financial reports is required not only internally, but also over time. Once an accounting or reporting method is adopted, it should be used for all similar transactions unless there is good cause to change it. If methods or the coverage of reports have altered, or if the financial reporting entity has changed, the effect of the change should be shown in the reports. Timeliness. The passage of time usually diminishes the usefulness of information. A timely estimate may then be more useful than precise information that takes longer to produce. However, the value of timeliness should not preclude statistical compilation and data checking even after the preliminary reports have been published. Comparability. Financial reporting should help users make relevant comparisons among similar reporting units, such as comparisons of the costs of specific functions or activities. Usefulness. Reports on the operations of specific ministries or agencies, to be useful both inside and outside the organisation, should contribute to an understanding of the current and future activities of the agency, its sources and uses of funds, the financial management of these funds, and its assets and liabilities.

Financial Reporting 319 A distinction between special purpose reports, prepared to meet specific needs, and general-purpose financial reports, prepared for a wider audience, can help to define the presentation and the mode of dissemination of the reports. For example, reports needed to monitor budget implementation are specialpurpose reports, designed mainly for use within the government, while financial statements should be considered as general-purpose reports. However, the distinction is partly subjective and depends on the country context. Many governments have special reporting requirements, e.g. environmental reporting (resulting from environmental audits) or retirement fund reporting (for pension policy), and the like. This type of reporting is becoming more frequent as governments face the need to respond to pressures from various interest groups. B. Main Reports 1. Budget execution reports a. Managing budget implementation For managing budget execution the following reports are needed: Daily flash reports on cash flows. These reports should distinguish inflows and outflows, but it is better for cash flow forecasting to have a breakdown of expenditure and revenue by broad economic categories (at least weekly). Monthly reports on budget execution based on the budget classification system. These reports specify: Initial appropriations. Revision of appropriations and supplementary appropriations. Amounts apportioned. Commitments, expenditures at the verification stage, and payments. b. Appropriation accounts An annual appropriation report (or budget enforcement report) must be submitted to the supreme audit institution (SAI) and the legislature. The production of such a report should be laid down in the organic budget law. The report should be forwarded to the SAI for audit purposes no later than two months after the end of the budget period. At the same time, the information should be released for public consumption. In addition to the annual appropriation report, the government should produce a statement of emergency procedures incurred during the year and the financial reports listed below. 2. Financial reporting Regardless of the accounting system and the quality of the accounts and financial records, certain minimum reporting standards should be met in any country.

320 Managing Public Expenditure - A Reference Book for Transition Countries a. Minimum financial reporting requirements The objective should be to produce the following reports, and to keep appropriate accounting books or ancillary registers: 1. Government consolidated operations table. The government should publish an analytical report on its consolidated financial operations. This report should consist of three tables showing the financial operations for (i) central government; (ii) local governments; and (iii) general government. Financial information on extra-budgetary funds (EBFs) should be consolidated into the accounts of the relevant level of government. In the GFS, the preferred treatment of social security funds is to classify them as a part of the level of government at which they operate. An alternative treatment is to present their financial information in a fourth table. This report should be prepared in accordance with GFS standards. However, it is not expected that every country will adopt immediately a full accrual accounting system, as suggested in GFS 2000. Nevertheless, the presentation of the government operations table and the economic classification of transactions should be prepared in accordance with the GFS 2000 standards, whatever the basis of accounting. Ideally, this information should be prepared both on an accrual basis (or modified accrual basis) and a cash basis. The report should cover at least two fiscal years to allow comparisons to be made. The information included in the government operations table should be derived from the government accounts. When additional accounting elements are introduced in the consolidated table, a double-entry procedure should be followed (e.g. both revenues and expenditures of an EBF should be included into the accounts). All tables or memorandum items required for comparison with the annual budget report and other reports (e.g. local government budget execution and funds management reports) should be annexed to this report. 2. Statement on stocks and flows of domestic arrears. This report distinguishes between arrears to the private sector, arrears to subnational government entities, and arrears to the non-government public sector. 3. Summary report on the execution of the government expenditure programme. This report covers expenditure from the budget and funds by broad function and programme (if any). It should distinguish between current and capital expenditures, show previous years for comparison, and give estimates for the following year if the country prepares multi-year estimates. The report should cover at least two fiscal years to allow the user to make comparisons. It should include a narrative statement on government expenditure policy. 4. Report on medium-term external debt. This report should include the following statements: Debt outstanding and disbursed (DOD) for medium-term external public debt, classified into the following categories: DOD without arrears, with interest arrears, and with principal arrears. Directly contracted debt and guarantees. Broad categories of creditors (e.g. IFIs and commercial creditors).

Financial Reporting 321 Broad categories of beneficiaries of guarantees (e.g. industrial and agricultural enterprises owned by the state). Debt instruments (loans and other obligations). Projections of public debt servicing costs for the next five to ten years, distinguishing: Directly contracted debt, and guaranteed debt, by broad category of creditor. Projections on both an accrual basis and a cash basis for partly rescheduled debt. New borrowings. Debt rescheduling over the period. 5. Report on short-term borrowing. The format of this report depends on the level of development of the financial markets in the country. Depending on the composition of its debt and the organisational arrangements within the country, the report can be consolidated with the report on medium-term debt (item 4) or prepared separately. 6. Report on grants. This report should show donor pledges, disbursements and estimated receipts (see discussion below). 7. Report on lending and on-lending. This report shows loans contracted, interest and principal repayments over the period, and the stock and flows of arrears by major category of beneficiary. It should include a narrative on any problems met in collecting payments from debtors, and an assessment of future risks. 8. Statement of forward commitments. In order to meet its obligations of accountability to the legislature, this report should show forward (multi-year) commitments and the projected payment schedule by function or programme and by line ministry or agency. 9. Statement of cash flows. Like a normal commercial bank monthly statement, this statement shows flows of cash revenues and cash payments, and opening and closing cash balances. It covers all government cash and bank accounts, and is normally produced directly from government accounts. 10. Statement of tax expenditures. This report provides estimates of tax expenditures by sector/function and the type of concession or subsidy provided. 11. Statement of other liabilities and other contingent liabilities. If possible, in addition to the debt reports, a statement should be prepared to show other liabilities and contingencies, such as pension liabilities and insurance contingencies. 12. Statements of physical assets and investments for selected sectors/programmes. For the infrastructure sector, it can be useful to produce statements showing the most significant assets, capital investment on an accrual basis (i.e. the increase in physical assets, which can be very different from expenditures disbursed), and the costs of maintenance, including deferred maintenance. This statement can be included in the report on investment expenditures mentioned below.

322 Managing Public Expenditure - A Reference Book for Transition Countries b. Financial statements under an accrual accounting system 3 Accrual accounting systems allow the preparation of statements that give a much more complete view of the financial situation of the government, and a consistent and comprehensive framework for preparing the reports mentioned in the previous section. An accrual accounting system commonly entails the preparation of a financial position statement, or balance sheet, which shows the government s assets, liabilities and net worth; a financial performance statement, or operating statement, which shows the revenues and expenses during the fiscal year; and a statement of increase or decrease in net worth, which explains movements in the opening and closing balances. The accrual-based statements are supplemented by a statement of cash flows. As noted earlier, GFS 2000 and SNA93 distinguish transaction flows from other economic flows. Thus, the analytical framework presented in GFS 2000 includes, inter alia, the following key statements (see also Figure 12.1): The Government Operations Table, which is a summary of the transactions of the general government in a given accounting period. The Statement of Other Economic Flows, which describes factors influencing the government s financial position other than transactions. The Balance Sheet, which records the stocks of assets, liabilities and net worth of the government at the beginning and end of each accounting period. The Statement of Sources and Uses of Cash, which should be supplemented by cash-accrual reconciliation items. Movements in the opening and closing balance sheets are explained by both the transaction flows included in the government operations table, and the factors included in the statement of other economic flows. Notes to the financial statements should provide as much detail as needed to interpret the statements correctly and also a statement of accounting policies. These statements should be complemented by the reports mentioned earlier for the fields they do not cover or do not cover in sufficient detail (e.g. commitments, contingencies, tax expenditures and details on debt and borrowing). c. Coverage of financial reports within the government 4 Financial reports should cover all government entities. Fund accounting poses a problem in many countries. These funds include both independent funds and special accounts managed by the ministry of finance or the treasury. When fund accounting is not consolidated line by line, the revenues and expenditures of the government are inflated by transactions between funds, which constitute instead a mere transfer within the government sector. Under accrual accounting, if the consolidation is not properly done, when revenues attributed to a fund are greater than its expenditure, the excess revenue is included as a liability on the government s books, while any excess or deficiency of expenditure appears as an asset (Ross and Kelly, 1997). When these funds, in the aggregate, have significant financial imbalances, the financial position of the government can be seriously distorted.

Financial Reporting 323 Figure 12.1. GFS ANALYTICAL FRAMEWORK Flows Government Operations Other economic Flows Revenue Expense Stocks Net Operating Stocks Balance Opening Closing Balance Sheet Balance Sheet Transactions Capital assets: Capital assets in capital assets Revaluation, losses Capital assets & other changes Transactions Financial assets: Financial assets + in financial assets + Revaluation, losses = Financial assets & other changes Transactions Liabilities Liabilities in liabilities Revaluation, losses Liabilities & other changes Change in net worth Change in net worth Net worth due to transactions due to other Net worth = Net Operating Balance economic flows Source: GFS 2000. Whether or not extra-budgetary funds are justified in a particular country, there is no reason to exempt them from the accounting and reporting obligations to which all other government entities are subject. All funds and accounts of all entities of the government must be consolidated. To make this consolidation possible, the chart of accounts of government entities and the economic and functional classification of their budgets must fit a common framework determined at the central level. Good financial reporting is required for accountability. However, the allocation of resources is made through the budget process, and implementing a sound financial reporting system for extra-budgetary funds does not affect the arguments for their retention or abolition. d. Non-government public entities While the scope of the budget is limited to the state government, as defined in Chapter 2, a broader scope should be considered for financial reporting. Entities controlled or owned by the government should produce regular financial reports. The accounts of entities carrying out commercial activities should be on a full accrual basis, and their financial statements should be those required under accrual accounting principles. These accounts should be consolidated by the government and published. Such information is needed by the public and for policymaking purposes, notably for an analysis of subsidies, financing capital expenditures of public enterprises, on-lending, etc.

324 Managing Public Expenditure - A Reference Book for Transition Countries Some countries have adopted the concept of the government financial reporting entity (see IFAC, 1991), i.e. the set of organisations, transactions, and activities for which the government is accountable and that are to be covered by government financial reports. Criteria for defining the boundaries of this broadly defined entity are financing, ownership and control. Control is the criterion that is more consistent with the objectives of financial reporting, since government should be accountable for the resources and entities it controls, regardless of the extent of government financing or ownership. However, application of this criterion requires a greater element of subjective judgement. Rules for identifying the government entities that must produce financial statements are established either via legislation (as in France and Italy) or through accounting principles, such as the notion of control and the existence of users for which the information will be useful (as in Australia and New Zealand). 3. Line ministries reports 5 In some countries, reports are prepared showing the activities of line ministries and government agencies, and giving important information for deciding the intersectoral allocation of resources. If they are available before the start of budget preparation (which is desirable), they can be useful in preparing the initial budget ceilings. In some countries, these reports are discussed in legislative committees and made public. Such reports might include some or all of the following elements: Major policy issues in the ministry or agency concerned. Goals and objectives of the ministry and policy measures undertaken or proposed to meet these objectives. Programmes, projects and activities of the ministry. Fiscal performance and financial statements. Estimated expenditures (current and capital) in future years. Performance indicators and targets. Other relevant information, e.g. loans, guarantees and tax expenditures in the sector concerned. 4. Reports on capital investment expenditure a. Information requirements The presentation of investment expenditures in a unified report or as an identifiable part of a line ministry s report is generally desirable. Reports on investment expenditures should show, by programme/ project: Actual expenditures at the verification stage (not only the cash payments) during the fiscal year. Actual expenditures in the previous fiscal year.

Financial Reporting 325 Estimated costs of ongoing programmes/projects for the next three or four years. In a small country, investment expenditures are presented by project. In a large country, the report should be presented by programme. However, ongoing projects of national importance and significant size should be identified. For each of these projects, the report should indicate: (i) annual projected costs over a period of three to four years; (ii) total costs; and (iii) the estimated expenditure required to complete the project after the three or four-year period. In addition, accrual-based information on the progress of projects is important, especially in the transport, communication and energy sectors and for other substantial public works projects, where payment schedules do not necessarily coincide with physical implementation. For large infrastructure projects, the increase in asset value can be presented, along with the indicators of physical progress. Performance indicators can be included, particularly in the social and agriculture sectors. b. Special issues related to externally financed projects In those countries that benefit from external aid, the report on capital investments should also cover the non-investment component of projects financed from external sources, so that the information can be used in discussions with donors. The investment and the current cost component of each project must therefore be separated. Information on financing presented in the government accounts is based on disbursements. No matter how efficient the system of data collection within the country, there is always a time lag between drawings from loans and verified expenditures, and the length of the time lag depends largely on the procedures of the lender. Because the difference between drawings and expenditures may be large, these data must be compared and explained. Information on drawings and expenditures made from special funds should also be included in the report. In principle, grants-in-kind should be reported at the time they are received. Discrepancies with information from donors should be identified and explained. In practice, however, many countries rely on donor information in order to estimate expenditures financed from grants-in-kind. This often leads to mixing cash-based information from some donors with commitments or pledges from other donors. Better monitoring of grants is generally needed. Except when special disbursement procedures have been established, this monitoring should be done at the project level, the only level at which expenditures financed by grants can be reliably estimated. Even then, data from donors must be collected and compared with the project data. As discussed in Chapter 10, sources and uses of EU funds should be properly accounted for, disclosed and monitored.

326 Managing Public Expenditure - A Reference Book for Transition Countries NOTES 1. Drawn from United States, OMB, Objectives of Federal Financial Reporting, Statement of Federal Financial Accounting Concepts, Numbers 1 and 2, 1993; Liekerman (1993a); and Premchand (1995). 2. For more details of these survey results, see Premchand (1995). 3. See IFAC (1991) and Premchand (1995). 4. The term government in this paragraph refers to any government authority which may be at the central or subnational level. 5. See Premchand (1995) and Liekerman (1993a).