2nd ARC Report - Strengthening The Financial

The 2nd ARC Report on Strengthening the Financial System presents key insights and recommendations aimed at fortifying and improving the financial mechanisms within the administrative framework.

Table of Contents

PUBLIC FINANCE MANAGEMENT – CONCEPTS AND CORE PRINCIPLES

Public Finance Management (PFM) is concerned with the comprehensive administration of resource mobilization and expenditure management within government. Similar to how financial management is a crucial aspect of organizational management, PFM plays an essential role in the governance process. It encompasses resource mobilization, program prioritization, the budgetary process, efficient resource management, and the implementation of controls. The increasing aspirations of the public place additional demands on financial resources, with an emphasis on value for money, making effective PFM increasingly vital.
Traditionally, financial management in developing countries focused on central agencies, such as the Ministry/Department of Finance, controlling spending agencies through continuous review, input specification, and document verification. This approach, rooted in history, still persists, albeit to a decreasing extent.
Reforms in financial management have targeted areas like taxation, using the government budget for economic development through enhanced budget classification systems, and accounting system improvements. Cost-benefit analysis techniques have also been employed. The 1970s emphasized fiscal deficit containment, while the 1980s saw the emergence of a management approach incorporating corporate financial management principles within an accountability framework. Despite these efforts, the financial management systems in developing countries have been slow to adapt to changing requirements, often following a segmented reform approach.
Public Finance Management encompasses various components such as taxation, resource mobilization, debt and cash management, the budgetary process, accounting systems, information systems, and internal and external audit. Reforming the public finance system necessitates several measures, including the critical improvement of revenue collection. A well-run country relies on proper revenue generation, and taxes play a role in establishing the authority of the government.
In a globalized world, external forces increasingly influence tax policy, with governments’ decisions revolving more around the efficiency of tax collection and the expansiveness of the tax net than the tax rate itself. Consequently, revenue services need proper resourcing and motivation to enhance tax collection efficiency. Efficient management of debt and cash is crucial, necessitating the establishment of sound principles for deficit funding, seeking efficiencies, and introducing effective risk management procedures. Proper administration of the government’s borrowing program can reduce funding costs. Effective planning and resource allocation are paramount, urging governments to develop and institutionalize planning processes at all levels. The budgeting process should prioritize transparency and inclusivity, emphasizing outputs over mere expenditures and inputs, supported by robust accounting and reporting procedures. Adequate resourcing for the office of the accountant-general is essential. Effective oversight and monitoring play a pivotal role in sound governance and PFM reform. A well-functioning PFM system should incorporate clear rules on transparency and reporting, along with enforceable sanctions for failures. Oversight mechanisms should include internal controls within the national treasury and external oversight by entities like independent parliamentary committees, a public ombudsman, a free media, civil society, and an independent auditor-general.

WEAKNESSES OF THE BUDGET SYSTEM

The World Bank, after analyzing budgetary processes in several countries, identified common shortcomings in government budgets, including poor planning, a lack of links between policy-making, planning, and budgeting, inadequate expenditure control, insufficient funding for operations and maintenance, a disparity between the formulated and executed budget, inadequate accounting systems, unreliability in the flow of budgeted funds to agencies and lower levels of government, poor management of external aid, ineffective cash management, inadequate reporting of financial performance, and poorly motivated staff.
These weaknesses often stem from a failure to address linkages between various budgeting functions. Several factors contribute to budget systems and processes that create a disabling environment for performance in the public sector, both by commission and omission. There is an almost exclusive focus on inputs, with performance judged primarily in terms of spending no more or less than appropriated in the budget. The input focus takes a short-term approach to budget decision-making, neglecting long-term costs (potential and real) and exhibiting biases in the choice of policy instruments due to the short-term horizon.
Game-playing by aligning bids with the appropriate fiscal policy box was a prevalent practice, especially considering the appropriateness of fiscal policy, particularly post-1973. This often led to budgeting in real terms, which, in the presence of significant inflation, resulted in arbitrary cuts during budget execution with subsequent adverse supplementary consequences, sometimes validated through appropriations.
There was a pronounced focus on distributing gains from fiscal drag across new spending proposals, with Cabinet and other central agencies extensively involved in micro-decision-making on various funding aspects for ongoing policy. Last-minute across-the-board cuts, including during budget execution, were common, contributing to weak decision-making and unpredictability in funding for existing government policies. This unpredictability was flagged to the center by central budget agencies vigilant to identify and reclaim “fortuitous savings.”
Strong incentives existed to spend the entire budget early in the year and as quickly as possible due to the fear of across-the-board cuts during execution and the fact that the current year’s spending served as the starting point for the annual budget negotiations. The existing policy itself, separate from its funding, underwent minimal scrutiny from year to year, highlighting the shortcomings of incremental budgeting.
Poor linkages between policy and resources were evident at different levels, including between the centre and line agencies, within line agencies, and between policy advising, regulation, service delivery, and funding within government departments. This lack of clarity in purpose and task resulted in inadequate information on the performance of policies, programs, and services, and their associated costs.
In general, there were few incentives to improve the performance of provided resources. The budgetary reforms in OECD member countries aimed to address these issues and introduced core principles to enhance financial management systems. These reforms emphasized that financial management is the responsibility of all government departments and agencies, not solely the Finance wing or Finance Ministry. Furthermore, financial management reforms were considered a means to achieve good governance, aligning with broader governance reforms focused on transparency, accountability, corruption elimination, and fiscal and environmental sustainability.
Medium-Term Plan/Budget Frameworks and Aligning Plan Budgets and Accounts: The objective of medium-term plan/budget frameworks is to bridge the temporal gap between the short-term focus of annual budgets and the medium-term goals of government schemes and programs. Even when medium-term frameworks, such as Five-Year plans, are in place, it is crucial to explicitly align annual budgets with these plans and the corresponding accounting mechanisms. This alignment ensures a clear connection between the medium-term developmental plan and the annual budgeting process.
Prudent Economic Assumptions: The economic assumptions forming the basis of the budget must be prudent and accurate to prevent budgetary estimates from going awry. Avoiding an overly optimistic outlook is imperative.
Top-Down Budgeting Techniques: A shift from the conventional bottom-up approach to budgeting is necessary, moving towards a top-down framework. Desired outcomes should guide the allocation of resources at the macro level, sector-wise, fostering a focus on outputs and outcomes over inputs and processes.
Transparency and Simplicity: Budget documents should be straightforward and easily understandable, readily available in the public domain. Operational procedures related to budget management and fund release should be uncomplicated. The development of suitable financial management information systems ensures all transactions are recorded and ultimately open to public scrutiny.
Relaxing Central Input Controls: Greater operational autonomy and flexibility for government agencies can be achieved by consolidating budget items and decentralizing administrative and financial powers.
Focus on Results: Shifting accountability in government from compliance with rules and procedures to the achievement of results is essential, particularly with the relaxation of central input controls. Emphasizing ‘value for money’ becomes crucial.
Adopting Modern Financial Management Practices: Utilizing modern financial management tools such as accrual accounting, information technology, and financial information systems is key to enhancing decision-making and accountability. However, careful consideration is required to create a conducive environment and develop adequate capacity before implementing new practices.
Budgeting to be Realistic: Ensuring that budget projections are reasonably accurate is crucial for maintaining the credibility of the budgetary exercise.

Weaknesses in the Budgetary System and Implementation

Unrealistic Budget Estimates: Frequently, the budgeted amounts are not realistic, leading to revisions and supplementary budget decisions due to inadequacies in preparing estimates. Conversely, significant unspent provisions are often observed at the end of the year.
Delay in Implementation of Projects: Thinly spread resources and token provisions in some cases result in prolonged delays in project execution.
Skewed Expenditure Pattern: The expenditure pattern is uneven, with a substantial portion spent in the last quarter of the financial year, especially in the final month.
Inadequate Adherence to the Multi-year Perspective and ‘Missing Line of Sight’ perspective often results in ad hoc deviations, distorting long-term plan objectives. Plan schemes become dispersed into line items in budget estimates, lacking subsequent consolidation in both the estimates and final accounts. The alignment between the plan, budgets, and figures often fails to reflect the actual expenditure made for the receipt of goods and services. Funds parked outside government accounts present an inaccurate financial position, indicating that the government’s financial status is not accurately known at any given point in time.
Ad hoc Project Announcements: Indiscriminate announcements of projects/schemes not included in the plan/budget are regularly made without proper consideration and detailing.

How to Overcome These Weaknesses:

Realistic Assumptions: Ensure that assumptions made while formulating estimates are realistic. At the end of each year, identify reasons for the gap between ‘estimates’ and ‘actuals’ and make efforts to minimize them. These assumptions should also be subject to audit.
Top-Down Budgeting: Abandon the method of formulating the annual budget by collecting details from different organizations/units/agencies and fitting them into a predetermined aggregate amount. Adopt a ‘top-down’ method indicating aggregate expenditure limits for each organization/agency.
Detailed Consideration of Projects: Include projects and schemes in the budget only after detailed consideration. Strictly adhere to norms for formulating the budget to avoid making token provisions and spreading resources thinly over numerous projects/schemes.
Stop Ad-Hoc Announcements: Cease the practice of announcing projects and schemes ad-hoc in budgets, on National Days, or during visits of dignitaries to the States. Essential projects/schemes should be considered in annual plans or during mid-term appraisals.
Internal Control Systems: Establish a sound internal control framework, including internal audit, to ensure compliance with rules and regulations, reliability of financial data, and efficient government operations. Internal controls serve as the first line of defense against improprieties, safeguard government assets, counter fraud and error, maintain satisfactory accounting records, and ensure that budgetary objectives align with government policies.

‘reasonable assurances’ that if improprieties do occur, they will be made transparent and appropriately addressed.”

While internal audit is part of the internal control system, it has a distinct role as one of the tools for evaluating and improving internal processes. Internal audit in government also involves auditing based on financial propriety standards (similar to external audit) and, therefore, is obligated to report on cases of improprieties in financial operations. The current scope of internal audit includes:

The Internal Audit Unit operates directly under the Pr.CCAs/CCAS/CAs, with overall responsibility remaining with the concerned Financial Adviser and the Secretary of the Ministry/Department.

The Principal Accounts Office, the Pay and Accounts Offices, and the offices of the D.D.Os in Ministries/Departments, Indian Missions, and other Govt. of India offices abroad fall within the jurisdiction of internal audit. Additionally, internal audit is required for auditing the implementing agencies for various schemes and programs of the Ministry/Department.
Internal Audit examines the initial accounts maintained in the executive offices to determine the extent of adherence to rules and regulations, systems and procedures in accounting and financial matters. The scrutiny covers all accounting records, including those related to fund accounts, loans and advances, disposal of confiscated stores, review of the installation and operating efficiency of expensive equipment and machinery, and examination of records related to the physical verification of stores, equipment, tools, and plant.
The accounts of all grantee institutions or organizations are open to inspection by the sanctioning authority and audit, both by the Comptroller and Auditor General of India under the provision of CAG (DPC) Act 1971 and internal audit by the Principal Accounts Office of the Ministry or Department, whenever the institution or organization is called upon to do so.
Observations of the C&AG on the functioning of Internal Audit indicate serious deficiencies in the existing system, making it inadequate and ineffective. The internal audit guidelines are outdated, lacking manuals and prescribed standards. Under-resourcing and manpower shortages, including qualified professional staff, lead to internal audits not being conducted in many departments. Limited staff of internal audit is sometimes diverted for accounting and budgeting purposes. Response to audit reports by auditee units is lacking, leading to the persistence of identified deficiencies. Numerous Central and State schemes, programs, Public Sector Undertakings, and Autonomous Bodies are kept out of the purview of internal audit. At the supervisory level, there is no segregation of duties related to internal audit and other accounting functions. Internal audit reports are routine and largely fault-finding exercises with no positive recommendations. Internal audit is accorded extremely low priority, with limited resource allocation in terms of manpower and finances.

EXTERNAL AUDIT AND PARLIAMENTARY CONTROL

External audit plays a crucial role in providing assurance to the Parliament/Legislature that public funds have been expended for the intended purposes. It serves as a vital element in upholding public accountability, offering independent scrutiny to ensure executive accountability to the Parliament/Legislature, as well as to the wider community, including taxpayers, consumers, and beneficiaries.
This form of audit acts as a deterrent against careless decision-making and an irresponsible attitude towards public expenditure and project management. It is considered indispensable in instilling confidence among the public that taxpayer money is being used judiciously and achieving its intended outcomes. External audit is also expected to contribute to achieving full value for money by evaluating the economy, efficiency, and effectiveness in the utilization of public resources, encompassing service quality and performance measurement.
Moreover, external audit goes beyond mere retrospective analysis and reporting. It adds value by proactively looking ahead, identifying lessons to be learned, and disseminating best practices. This forward-looking approach contributes to continuous improvement and efficiency in government operations.

Type of Audit

The evolving role of audit in India has seen a shift from its pre-independence focus on tracking government expenditures and receipts to a more comprehensive assessment of results achieved through public funds. Performance Audit has emerged as a critical tool for evaluating the economy, efficiency, and effectiveness of government expenditures in the post-independence era, especially in the context of planning and development.

Strengths of External Audit in India:

The Comptroller and Auditor General (CAG) of India holds a high constitutional status, making the institution a vital pillar of democratic governance. The long-standing traditions of public audit in India uphold the CAG’s position as an essential instrument of financial control and accountability.
The Constitution of India ensures the independence and autonomy of public audit, providing a robust foundation for its effectiveness.
The terms ‘Audit’ and the scope of audit have not been rigidly defined in the Constitution or the CAG’s DPC Act, 1971, allowing flexibility in responding to changes, reforms, new initiatives, evolving government activities, international developments in the audit profession, and rising stakeholder expectations related to public accountability.
The CAG possesses the authority to define the scope and extent of audits, with access to relevant records and information. Additionally, the CAG inherently determines the content of Audit Reports, which are mandated to be presented in the Parliament/Legislature, subsequently becoming public documents. Well-documented Audit Manuals and guidelines guide auditors in their procedures.

Challenges in External Audit:

External audit by the CAG has significantly contributed to enhancing financial management in the country, evidenced by numerous Inspection Reports, Audit Reports presented to the Parliament/Legislature, and recoveries prompted by audit interventions. Audit Reports address critical issues like weak budgetary controls, revenue collection deficiencies, mismanagement of public resources, inappropriate accounting, poor returns on investments, fund diversions, system deficiencies, and instances of poor resource management.

Relationship Between Audit and Government/Government Agencies:

The independent watchdog role of external audit is occasionally perceived by government agencies and auditees solely as a fault-finding exercise, leading to a lack of cooperation and delayed responses to audit observations. To maximize audit impact, there is a need for better understanding and synergy between government agencies and audit, fostering accountability, timely oversight, and collaborative approaches. Auditors and auditees should adopt a more positive approach to encourage innovation, change, and reform, addressing concerns about perceived discouragement by the audit process. Auditors must carefully assess whether departments took adequate measures to identify risks and plan before implementing reforms/innovations, considering potential financial losses. Deepening interaction between audit and the executive at senior levels is essential for meaningful discussions on important issues, recommendations, and necessary actions emerging from audits, fostering a collaborative and informed approach.

While the independence of audit is crucial for objectivity, it should not lead to isolation. Coordination with the executive is imperative, and mechanisms for regular interaction must be established. A quarterly reporting system should be instituted, with the Secretary updating on pending inspection reports, and the Accountant General communicating significant points and system deficiencies to each Administrative Secretary. Quarterly meetings should address common interests and discuss audit observations and recommendations for improvement. Auditors should empathize with the constraints faced by auditees and appreciate their perspectives.

Concerns have arisen about the perceived negativity in public audit reporting. While audit plays a pivotal role in ensuring accountability, it does not mandate a solely fault-finding approach. To foster enhanced public accountability and improve audit impact, there is a need for better understanding and synergy between auditors and auditees.
Balanced reporting is crucial, with audit reports not solely focusing on criticism but also providing a fair assessment and acknowledgment of good performance. Increased interaction and coordination between the executive and audit, particularly at senior levels, are essential. Regular and meaningful meetings should discuss important issues, and conclusions should be drawn on the actions required based on audit recommendations. Additionally, quarterly communications from the Accountant General to Administrative Secretaries should highlight significant points and areas for improvement identified during audit inspections.

Practice Questions

What are the concepts and core principles of Public Finance Management?
What are the weaknesses of the budget system in India?
What are the key elements of the budgetary reforms?
What are the weaknesses in the budgetary system and its implementation? How to overcome these weaknesses?
“External audit has a very important role to play in financial management.” Discuss.
Examine the relationship between audit and government agencies.

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2nd ARC Report – Strengthening The Financial System