October 19, 2004

Document of the World BankR

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1345-U

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zbekistan

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Report No. 31345-UZ

UzbekistanCountry Financial Accountability Assessment

Operations Policy and ServicesEurope and Central Asia Region

TABLE OF CONTENTS

PREFACE ............................................................................................................................................................... i

EXECUTIVE SUMMARY .................................................................................................................................. iv

I . COUNTRY 'BACKGROUND .......................................................................................................................... 1

GOVERNING STRUCTURES ....................................................................................... ......................... 1 ECONOMIC BACKGROUND AND PROSPECTS ...................... .......... ...... 1 RELATIONSHIP OF THE CFAA. LESDING PROGRAM AND P LOGUE IES 2

I1 . PUBLIC SECTOR BUDGET MANAGEMENT ..................................................... 4

INTRODUCTION .................................................................................................................................................... 4 PRINCIPLES AND RISKS ........................................................................................................................................ 4 THE SCOPE OF THE BUDGET ................................................................................................................................. 5 THE BUDGET PREPARATION PROCESS ................................................................................................................... 6 TRANSPARENCY AND ACCOUNTABILITY ASPECTS OF THE BUDGET PROCESS ......................................................... 6 BUDGET EXECUTIOS AND CASH MANAGEMENT ISSUES . RECENT AND PROPOSE MAIN RECOMMENDAT

Short term (within ......................................................................................................................... 9

I11 . EXTRA BUDGETARY FUNDS ....................................................................................... 11 Medium term (one to three years) ............................................................................................................... 10

INTRODUCTION . ..................................

Budget and cash management issues Governance issues

MAE RECOMMENDAT Short term (within Medium term (one ............................................................................................................... 14

I V . PUBLIC SECTOR ACCOUNTING AND FISCAL REPORTING ....... 16

INTRODUCTION .................................................................................................................................................. 16 Budget Reporting ........................................................................................................................................ 18

MAIN R E C O M ~ E N D A T I O ~ S ................................................................................................................................ 19 Short term (within one year) ....................................................................................................................... 19 Medium term (one to three years) . 19 Long term (over three years) 19

V . SELECTED REVENUE ADMINISTRATION ISSUES .................................. 21

INTRODUCTION .................................................................................................................................................. 21 ORGANIZATIONAL STRUCTURE OF TAX ADMrrl'lSTRATION ................................................................................. 22 ACCOUNTING, REPORTING AND CONTROL OF REVENUES ................................................................................... 23 MAIN RECOMMENDATIONS ................................................................................................................................ 24

Short term (within one year) ....................................................................................................................... 24 Medium term (one to three years) .............................................................................................................. 24

V I . INTERNAL CONTROLS AND INTERNAL AUDIT ..................................... 25

INTRODUCTION ... ...... 25 CURRENT SYSTEMS OF INTERh'AL CONTROL IN UZBEKISTAN 26 TOWARDS AN IMPROVED REGIME OF INT ................................... 26 b K K l V T I O N A L ARRANGEMENTS FOR FIN OF THE CONTROL AND 27

Introduction ................................................................................................................................................. 27 The Control and Revision Unit of the M in i s t y ofFinance (CRU) .............................................................. 28 Towards a modern internal audit function .................................................................................................. 29

M A I N RECOMMENDATIONS ............................................................................................................................... 30 Short term (within one year) ....................................................................................................................... 30 Medium(one to three years) ........................................................... ....... ................................ 30

Long term (over three years) ....................................................................................................................... 31

VI1 . EXTERNAL AUDIT ............................................................................................................... 32

INTRODUCTIOS PROGRESS ON T MAIN RECOMM ...................... ............................................................................................ 33

Medium term (one to three years) ............................................................................................................... 34 Long term (over three years) ....................................................................................................................... 34

VI11 . PUBLIC ENTERPRISES .................................................................................................. 35

INTRODUCTION

GOVERNANCE OF PUBLIC ENTERPRISES MAIN RECOMMENDATIONS .................. .......................................

Long term (over three years) ....................................................................................................................... 38 I X . FINANCIAL MANAGEMENT ARRANGEMENTS IN BANK- FUNDED PROJECTS ........................................................................................................................ 40

I~TRODUCTION .................................................................................................................................................. 40 FINANCIAL MANAGEMENT ARRANGEMENTS ..................................................................................................... 40

Institutional arrangements 40 Financial Management 41

TOWARDS MAPSTREAMIN INANCIAL MANAGEMENT 42 ANNEX I: Development Action Matr ix ............................................................................................................ 43

ANNEX I1 - International Standards and Codes .............................................................................................. 50

ANNEX 111: L i s t o f Extra-Budgetary Funds .................................................................................................. 51

ANNEX IV : Overview Of Governance Arrangements - Major Extra Budgetary Funds ............................ 53

TABLES

Table 1: World Bank Lending to Uzbekistan ($ Millions) ............................................................................... 2 Table 2: Extra-budgetary fund spending 1999-2004 (Billion Soums) ............................................................ 12 Table 3: Revenues o f the State Budget o f Uzbekistan (Mil l ion soums) .......................................................... 22 Table 4: Standards and Codes Promoting Financial Accountability ............................................................. 50

BOXES

Box 1: Budget Management . Institutional Issues . Key Messages from the World Bank Public

Box 2: Improving Financial management of Extra-budgetary funds ............................................................. 14 Box 3: Key weaknesses o f the government accounting system and their impact on reporting and decision making 17 Box 4: Proposed development o f government accounting standards ..................................................... 18 Box 5: Institutional Arrangements fo r Tax Policy and Administration in Uzbekistan ................................. 23 Box 6: The Control and Revision Unit (CRU) of STC ..................................................................................... 24 Box 7 : Three main features of a modern internal control systems ................................................................. 25 Box 8: Important reforms to improve public sector internal controls ............................................................ 27 Box 9: The Control and Revision Unit of the Ministry of Finance (CRU) ..................................................... 29

Expenditure Review, 2004 (PER) ......................................................................................................................... 5

PREFACE

This report was prepared after missions to Uzbekistan in 2003 and 2004 by a Task Team comprising Andrew Mackie (Task Team Leader, ECSPS), John Ogallo (Senior Financial Management Specialist, ECSPS), Andy Macdonald (Public Sector Consultant) and Nurmukhammad Yusupov (Consultant).

This report i s based on the results o f interviews and discussions with various public sector institutions as well as an analysis o f data gathered during the mission including copies o f relevant legislation, instructions and reports. Many Government counterparts lent their support to the CFAA Mission and engaged in the dialogue. The Bank i s grateful for this cooperation.

Objectives of the CFAA

The overall objectives o f the Uzbekistan CFAA are to (i) help the government strengthen i t s public sector financial accountability arrangements; (ii) identify and document the most significant fiduciary r i sks ' in the Government public financial management systems (PFM); (iii) document the existing program o f reforms and capacity building to improve transparency and accountability aspects o f the PFM, making additional recommendations for capacity building, if necessary.

This i s the f i rst CFAA prepared by the Bank in Uzbekistan. I t s timing i s particularly relevant in the context o f a period drastic fiscal adjustment and an increased focus on the efficiency and effectiveness o f public spending. Changes to the constitution and budgetary reforms are being undertaken by the Government, with support from the donor community. The public financial management framework in Uzbekistan i s s t i l l evolving, and improvements are required in many o f i t s components. The CFAA provides an analysis o f current issues, focusing on practical, realistic and sequenced improvements in the country's P F M systems, taking into account the considerable capacity constraints in Uzbekistan. In this sense the C F A A i s primarily a forward looking assessment rather than a diagnostic o f existing problems, which have already been extensively documented in previous reports.

Since borrower countries often look for benchmarks against which their systems can be measured, this report contains clear references to those internationally accepted standards and codes which inform the most essential financial management tasks, such as budgeting, accounting, internal control, internal audit and extemal audit. In l o w capacity countries such as Uzbekistan many o f these standards should be seen as longer te rm goals which have be used to frame legislative reform and capacity building initiatives, rather than benchmarks for the assessment o f current P F M systems. A preliminary l i s t o f international standards and codes i s contained in Annex I1 to this Report as a reference document.

Experience from other countries has shown that, to be successful, reforms to the institutions and mechanisms o f financial accountability should not been seen as an end in themselves but rather as part o f broader economic, political, and fiscal reforms within government. Therefore, one o f the other objectives o f the Uzbekistan C F A A has been to explain the rationale for reform in a way which encourages broad dissemination beyond technical

' The fiduciary risk i s the r i s k o f funds not being spent for the purposes for which they have been appropriated.

.. Uzbekisfan: Counfw Financial AccountabUity Assessment 11

financial specialists within the Government. The CFAA complements two other pieces o f Bank diagnostic work; the Country Procurement Assessment Report (CPAR) wh ich was completed in 2003 and a Public Expenditure Review (PER) wh ich i s being prepared in parallel with the CFAA.

Approach

The core content o f the CFAA i s l isted below. Where possible the CFAA documents rather than duplicates analytical work camed out by the Bank and the rest o f the donor community. Where a particular i t em i s being addressed by another initiative, that donor i s identified.

Public sector budgeting [IMF, WB, USAID, U S Treasury, EU TACIS ] - - -

scope o f the budget (including the treatment o f extra-budgetary funds); transparency and accountability aspects o f the budget process; budget execution and cash management.

Selected revenue issues [CFAA]

Public enterprises [AsDB]

Public sector accounting and reporting [IMF, WB PFMP, CFAA]

Internal controls and internal audit [CFAA]

External audit and parliamentary oversight [CFAA]

- monitor ing and oversight - governance, f inancial reporting and audit

Arrangements for managing the proceeds o f Bank lending [CFAA]

During the scoping mission it was recognized that the CFAA Team w o u l d b e able to conduct a desk review o f m u c h o f the budget function and place reliance o n previous diagnostic w o r k and work ing closely with W o r l d Bank staf f conducting the Public Expenditure Review (PER) and the Public Financial Management Reform Project (PFMR). Beyond the consolidated state budget the government o f Uzbekistan carries out significant amounts o f resource redistribution through extra-budgetary accounts and funds, lending policies and publ ic guarantees. Given the orientation o f the CFAA and the overall materiality o f the amounts involved, the Team focused considerable attention o n the scope o f the budget entity, accountability and transparency aspects o f extra-budgetary funds and publ ic enterprises.

Accounting, internal controls/internal audit and external audit are specific areas wh ich have not received much attention in previous diagnostic reviews and have therefore been analyzed in support o f the Government’s treasury and constitutional reforms.

Public procurement has been covered extensively in the March 2003 Country Procurement Assessment Report (CPAR). In summary, the report noted that the legislative framework, institutions and enforcement regime fo r publ ic procurement are under developed. Overall the C P A R gave the procurement environment a high-risk rating. The k e y findings o f direct relevance to the CFAA are (i) that bo th internal and external controls over procurement are inadequate; (ii) procurement-related corruption i s a threat to publ ic expenditure and; (iii) the private sector has l i t t le fa i th in the fairness o f publ ic tenders. The CPAR also recommended that internal and external audit controls over procurement should b e strengthened.

... Uzbekistan: Country Financial Accountabilifv Assessmenf 111

The assistance provided by donors supports Government’s efforts to establish modern financial institutions and develop staff s k i l l s and capabilities to enable it to manage i t s own affairs. The CFAA identifies those init iatives already underway, assesses the Government’s progress in each area and comments o n their fu ture plans. Where additional actions are recommended these are presented in a Development Act ion M a t r i x (see Annex I), which ident i fy a series o f proposals highlight (i) legislative reforms, (ii) institutional arrangements, (iii) human resource and capacity building and (iv) suggested timing (short, medium or long term) o f implementation o f the proposed action.

Acknowledgements

The C F A A team wishes to acknowledge the extensive and grateful cooperation and assistance received f rom staff in the various institutions who contributed to the CFAA, including officials and staff o f the Government, state agencies and enterprises, and bi-lateral and multi lateral organizations. Grateful thanks also go to the Bank’s Public Expenditure Review and Public Financial Reform Project task team, particularly Ritu Anand and Roland Clarke. In addition Mar t i n Raiser (Uzbekistan Country Manager) and Bakht ior Abdullaev (Uzbekistan Country Officer) provided invaluable in-country assistance and information. John Hegarty (Manager, Financial Management, ECA), Pascale de K e r v y n Lettenhove (ECSPS) and peer reviewers, D im i ta r Radev (IMF), Roland Clarke (ECSPE) and Hisham Ahmed W a l y (MCACS) offered m u c h appreciated comments and inputs.

Uzbekistan: CFAA Executive Summaw iv

EXECUTIVE SUMMARY

Introduction

Since declaring i t s independence in August 1991 Uzbekistan has taken a markedly different course f rom most Commonwealth o f Independent States (CIS) countries by fol lowing a gradual transition to a market economy and adopting a development strategy aimed at accelerated industrialization. Wh i le taking in i t ia l steps to the transition to a market-based economy, the State has retained the levers o f control over the reform process and an extensive ro le in the economy.

In the past f ive years Uzbekistan has faced a drastic fiscal adjustment fo l lowing a decline in budget revenues. The aggregate level o f government spending has come down, extra- budgetary funds have been reduced and streamlined somewhat, and redistribution through quasi-fiscal operations has decreased. General government expenditures, including those financed by government guaranteed borrowing, have come d o w n by over 11 percentage points o f GDP since 1998.

The out look i s for publ ic resources to become scarcer as the reforms progress further. It i s v i ta l that the Government focus o n the effectiveness o f publ ic spending and min imize and inefficiencies. There are a number o f elements o n which the Government could build improvements to the framework o f publ ic accountability. A new Constitution has been passed and a bi-cameral parliamentary system began operations in January 2005. M a j o r reforms to the health and education sector have begun. Elements o f the budget process are already being addressed through the development o f revised budget preparation procedures and the introduction o f a treasury system.

These reforms require fundamental changes to the institutions o f government and to the attitudes o f public servants. Pol icy mak ing functions o f spending ministries need to be developed and accountability f o r po l i cy and spending decisions needs to b e clarified. Management in budgetary institutions needs new tools and institutions to establish, maintain and be held accountable for the internal control environment.

This Report has been prepared with the overriding goal o f helping the government in their efforts towards strengthening control and accountability and supporting greater efficiency o f publ ic spending. The Report examines a l l areas o f publ ic sector accountability, including accountability and transparency aspects o f the budget, accounting and external financial reporting, revenue management, the internal control environment, internal and external audit and governance o f publ ic enterprises. The goal has been to present a fonvard-looking analysis o f current issues, focusing o n practical, realistic and sequenced improvements in the Country’s publ ic financial management systems. The recommendations have taken into account the considerable capacity constraints in Uzbekistan and the l imi ted history o f re form in an environment marked by severe deficiencies in transparency and accountability.

Ultimately, technical improvements in financial management will on l y be successful if they are supported by overarching institutional, economic and pol i t ical reforms. Good financial management practices underlie government’s accountability to i t s citizens through a transparent, efficient and effective use o f publ ic funds:

Uzbekistan CFAA: Executive Summary V

The k e y analysis and recommendations for establishing a sound financial accountability framework are described in the fo l lowing paragraphs:

Public sector budget management

Budget management processes in Uzbekistan create considerable r i s k s to the Government. The f i rst r i s k i s a po l i cy risk; it i s the risk that policies passed by Parliament are not implemented through the budget. The second risk, a budget and financial management risk, i s the possibil i ty that funds are no t spent according to their intended use. This risk i s compounded by a large share (about 25 percent) o f off-budget resources not subject to budget scrutiny.

I n Uzbekistan, the policy risk is signiJicant owing to process and institutional breakdowns between policies and budgeting. The greatest challenge in the re fo rm o f Uzbekistan’s publ ic finances i s to make the transition f rom institutions inherited f rom the centrally planned economy, to ones in wh ich po l i cy mak ing i s l inked to budgeting. M u c h o f the reform process requires fundamental changes, largely outside and beyond the Ministry o f Finance. First, the Government should clarify the l ong term role o f the publ ic sector in the economy, with a v iew to accelerating the transition towards a market-based economy supported by transparent and accountable publ ic institutions. Whi le economic and sector policies are developed, institutions should b e established at the center o f government to coordinate strategic po l i cy choices. Spending ministries should be reorganized along functional lines and include under them many o f the state institutions which deal directly with the MOF. N e w budgeting processes and the establishment o f the Treasury, will o f course require w o r k within the MOF. However, until n o w budget reform has largely been centered around technical developments within the MOF. One o f the m a i n tasks for the MOF i s to make the case to the Government and publ ic institutions for the need for reforms and the l ong term benefits that will ensue.

There is also a high risk that funds may not be used for their intended purposes, as the budget lacks comprehensiveness and limited budget information prohibits meaninaful budget scrutiny. The present budget i s no t comprehensive, and the budget process i s fragmented. Extra-budgetary funds account fo r one quarter of state budget expenditure and are not subject t o the same scrutiny as the budget. In addition, the formulat ion o f investment budget i s a separate process; there i s n o mechanism for consideration o f the impact o f future recurrent costs in evaluating new investments, nor i s there a mechanism for debt recording o f externally financed investments.

The C F A A recommends that n o n e w extra-budgetary funds b e created and that existing funds should be subject to the same rules for budget preparation, rev iew and audit as the budget. In addition, the process fo r recurrent and investment budget preparation should be merged with due consideration o f recurrent costs and debt impact in later years.

The transparency o f budget documentation also needs to b e significantly improved. The present budget classification i s rudimentary and insufficient to analyze the development o f po l i cy or serve as a basis to h o l d spending units accountable through budget execution. Transparency and accountabil ity w o u l d be enhanced by the publ icat ion o f budget documentation wh ich includes the budget, macroeconomic forecasts and an explanation o f the ma in budgetary measures.

In Uzbekistan, the present budget execution arrangements are inef f ic ient and non-transparent; exposing the government to the risk (a) that payments are n o t made in accordance with the

Uzbekisfan CFAA: Executive Summary vi

budget, (b) that payments are not made on a timely basis and distort the implementation o f government activities and (c) that finance officials have insufficient information to make the most effective and efficient use o f cash. Disbursement takes place through numerous government bank accounts held in commercial banks. This makes budget implementation difficult to monitor and liquidity impossible to manage. Numerous extra-budgetary accounts fbrther weaken liquidity management, budget execution monitoring and control. These problems are recognized by M O F who has begun work on the introduction o f a treasury system wi th the support o f the IMF and Wor ld Bank. The establishment o f the Treasury requires a major institutional reorganization o f MOF and considerable capacity building in the finance function across al l areas o f government.

Public sector accounting

Uzbekistan’s public sector accounting traditions were inherited from the Soviet Union; where budget reporting was merely a financial reflection o f detailed production plans. Developing a modem accounting system and financial reporting system will protect and manage public money and discharge accountability. The government has a large number o f bookkeepers who are familiar wi th double entry, accrual based accounting but who are reliant on manual systems and will need training on modem financial accounting and reporting. As part o f the treasury reforms the Government has developed a well thought-out development plan for the phased introduction o f accounting reforms based on International Public Sector Accounting Standards (IPSAS). The Report recommends that training on public sector accounting begins immediately and cautions against ambitions running ahead o f available capacity. Specifically, accruals accounting should remain a long term goal once the government has successfully implemented and reported in compliance with the cash basis o f accounting.

Revenue administration issues

As regards the revenue collection agencies the Report notes the Government’s investment in management information systems and efforts to improve the quality o f reporting between collection agencies and MOF. However, the Government s t i l l faces a major challenge o f enforcing tax pol icy without stifling the development o f legitimate economic activity. The complexities o f the current tax policy may discourage compliance. The CFAA also echoes previous reports in recommending that the commercial banking sector stops acting as a de- facto tax enforcement agency. The Report also recommends that the Government pass a proposed amendment to the Tax Code restricting access to taxpayers’ banking information.

Internal control and internal audit

In common wi th other transition economies in the region concepts o f internal control and internal audit are not well understood. The present fragmented execution system (discussed above) results in a loss o f budgetary control which can be addressed, in part through the reform o f treasury systems. Long t e r m reforms to institutions which monitor and control the budgetary process are also required. The present approach o f the Control and Revision Unit o f MOF (CRU) focuses on top-down controls over compliance which do nothing to support managers in budgetary institutions establish, maintain and be held accountable for the internal control environment. The Report proposes a phased approach to reform which builds capacity in tandem with the on-going treasury reforms and prepares C R U for a long te rm role as a modem internal audit department within Government.

Uzbekistan CFAA: Executive Summary vii

External audit

Effective external audit provides an independent assessment that the overall objectives set by Parliament and government have been reflected in the budget, scrutinizes the overall quality o f public expenditure, and management o f public assets and liabilities. To date l imited progress has been made on the development o f an independent public sector external audit function in Uzbekistan. The constitutional and budgetary reforms present an opportunity to develop such an institution. A small Chamber o f Accounts (COA) has been created within the President’s Office and could be developed into an external audit function. The Report proposes a four point development plan: (1) establishing a legislative base for the audit function; (2) increasing the transparency and disclosure o f i t s work; (3) providing additional resources to the COA; and (4) enlisting the support o f the international community to assist in i t s development. A long term goal for the C O A should be to provide a professional opinion on the government annual budget report based on international accounting standards.

Public enterprises

Uzbekistan s t i l l has a large number o f public enterprises. Due to ill-defined l ines o f authority there i s l i t t le external and internal discipline on corporate performance, and litt le separation between government and business. The Report recommends reforms to the regulatory framework; separating pol icy and regulatory activities where conflicts o f interest arise and privatizing commercial operations so they do not have access to state powers. The transparency o f financial information should be improved by a phased introduction o f publicly available financial reports prepared and audited in accordance with international standards o f accounting and auditing.

Capacity building

The capacity o f the Government to absorb and implement an ambitious series o f public sector financial management reforms wil l be a challenging long te rm exercise. Financial management training i s needed in a l l public sector institutions but the needs are particularly acute in the regions and in budgetary institutions. Many finance officers have had no formal training since the 1980’s and there i s a lack o f computers and basic guidelines to assist staff. Many o f the international developments in budgeting, accounting and auditing are completely new to technical finance specialists. They need broad exposure to the latest techniques which should also be introduced into academic programs. A high level o f literacy and numeracy, an adaptable population, and well-developed educational institutions offer obvious opportunities for improvement.

Development Action Matrix

The assistance provided by donors supports the Government’s efforts to establish modem financial institutions and to develop staff sk i l l s and capabilities to enable it to manage i t s own affairs. The CFAA identifies those initiatives already underway, assesses the Government’s progress in each area and comments on their future plans. Where additional actions are recommended these are presented in a Development Action Matr ix (see Annex I), which identifies a series o f proposals highlighting, if applicable (i) legislative reforms, (ii) institutional arrangements, (iii) human resource and capacity building and (iv) suggested timing (short, medium or long term) o f implementation o f the proposed reform.

Uzbekisfan CFAA: Execufive Summaw viii

*Underpinning a genuine reform process i s the improvement in transparency o f Government’s management o f publ ic resources. At this juncture, the Government could demonstrate i t s commitment to greater transparency with the fo l lowing measures (included in the Matr ix) which do not requir ing external assistance.

1. Budget preparation should b e made more transparent with the publication o f the budget, together with documentation o n i t s assumptions and ma in lines o f po l icy

2. In the area o f extra-budgetary fund management, at a minimum n o new extra- budgetary fund should be created; and existing funds should be incorporated into the Budget where possible. In addition, the Government should amend Decree 414 to limit extra-budgetary funds to the payments o f pa id services and not a l low budget surpluses.

3. Revenue management needs to be made more transparent: the Government should implement the proposed amendment to the Tax Code to restrict access o f the tax authorities to the banking informat ion o f taxpayers.

4. The Government should enhance transparency in publ ic enterprise management by selecting two publ ic enterprises for p i lo t audits o f their 2004 financial statements according to international standards. The results o f these audits should be published.

At the same time the Government should also start exploring possible external support for medium-term reforms particularly in the areas o f internal and external audit.

* Reforms in financial management and accountability do no t happen in a vacuum. Such reforms are unl ikely to succeed unless overall pol i t ical conditions and commitment i s fueling them. In addition to pol i t ical commitment, the management o f the transition has to be thought through. Finally, linkages between publ ic financial management and overall public sector reforms have to be understood and addressed.

Uzbekistan: CFAA Countrv Backaround 7

I. COUNTRY BACKGROUND

Governing Structures

1. An independent Uzbekistan was created in 1991. O f the 15 countries which emerged f rom the breakup o f the Soviet Union, i t i s the third largest in terms o f population (25.2 mil l ion) and the fourth largest in terms o f land mass (447,000 square kilometers). Islam Karimov has been the country’s President since independence.

2. Following a referendum, the Constitution has been amended to permit the creation o f a bicameral parliamentary system that began operations in January 2005, replacing the present unicameral system. This wil l consist o f an elected upper house (Senate) and an elected lower house (Legislative Chamber). A number o f powers previously exercised by the President have been transferred to the Senate, including the appointment o f the Prime Minister. The President has stated that the full time representatives o f the lower house will focus principally on legislative issues while the Senate wil l provide for territorial representation. Under the revised Constitution the President’s term o f office was also extended from 5 to 7 years.

Economic background and prospects

3. W h i l e taking init ial steps to the transition to a market-based economy, the State has retained an extensive role in the economy. The state continues to be involved in a wide range o f off-budget economic activities managing whole sectors o f the economy such as cotton production. Instances such as when the authorities require enterprises to perform work without payment, for example by providing employees for cotton picking or paying for urban beautification projects, point to a much larger influence o f the state than i s indicated by the quantifiable fiscal and quasifiscal operations. If control over the economy through parastatal industrial associations and state-owned commercial banks, centralized planning o f production and distribution, and heavy regulatory burden are added, the reach o f the state i s greater s t i l l . Progress in privatizing large f i rms in the banking, mining and utility sectors such as telecommunications, energy, and transport has been slow. T h e slow transition o f the Uzbek economy resulted in high levels o f Government revenues and expenditures for public and publicly guaranteed investment and extra-budgetary funds, which reached 60 percent o f GDP in the mid-1990s. In the past five years there has been a drastic fiscal adjustment following a decline in budget revenues. Between 1998 and 2003 consolidated budget expenditures, including extra-budgetary funds and net lending were slashed by 10 percentage points o f GDP. The aggregate level o f government spending also saw similar dramatic declines during the period.

4. Throughout the late 1990’s the Government imposed strict currency controls and Government continued to set prices and quantities in major sectors (agnculture, mining and energy) o f the Uzbek economy. This enabled the Government to avoid the output slump experienced in other transition economies but it also resulted in below average growth in the post-transition period. As a result merchandize exports fel l 32 percent between 1997 and 2001, and another 14 percent in 2002 alone.2 Per capita net FDI i s now the lowest in the CIS,

’ World Bank, Uzbekistan Country Brief, 2003 p. 1.

and the GDP per capita o f $2360 i s third lowes t3 Fol lowing a series o f exchange rate devaluations the gap between of f ic ia l and parallel market rates, which stood at over 400 percent in early 2000, has been vir tual ly eliminated, and in October 2003 the authorities announced the introduction o f convertibil i ty.

Item

Commitments Disbursements

5. External developments have been favorable for Uzbekistan since late 2002. Prices o f i t s ma in export commodities - cotton and gold - rose sharply, contributing to the growth o f exports o f goods and services by 27 percent in value terms and boosting foreign exchange reserves by over 0.4 bn. soums. As a result, a l l o f Uzbekistan’s external debt ratios improved and were below their values in 2000 when external borrowing was tightened. The w o r l d market prices, however, are volatile. The k e y factors for improvement o f Uzbekistan’s creditworthiness are, in addition to continued the tight borrowing policies o f recent years, an improved environment fo r economic growth, diversif ication and a further sustained increase o f exports. This will b e hard to achieve without a reorientation f rom the current inward- oriented strategy based o n the dominant role o f the state to a more open, market-oriented development strategy.

1992- 1997 1998 1999 2000 2001 2002 2003 Total 1996

247 5 127 55 29 76 60 599 100 7 15 23 26 36 44 17 268

Relationship of the CFAA, lending program and policy dialogue with the Country’s authorities

6. The FY02-04 Country Assistance Strategy (CAS) included the completion o f the CFAA as a core non-lending activity o f the Bank during the period. With an overarching goal o f improving living standards and alleviating poverty in Uzbekistan the C A S recognizes the importance o f developing Uzbekistan’s publ ic sector institutions and systems o f governance especially in the areas o f transparency and accountability. A new C A S for FY05-07 i s currently being prepared. Subject t o the outcome o f the 2005-07 C A S discussions several new operations could enter the port fo l io in FY05, including the Public Financial Management Reform (PFMR) Project, which supports the important reforms to budget processes discussed in this Report.

7. Since Uzbekistan jo ined the W o r l d Bank and the IDA in 1992 it has been supported with a modest program o f lending, technical assistance and pol icy advice in support o f i t s reforms. The pr imary areas o f attention have been: reforms in public po l i cy to increase transparency, l iberalization o f trade and fiscal reforms; private sector development to he lp alleviate poverty through j o b and wealth creation; human capital investment; and i r r igat ion and drainage investments to improve productivity. A summary o f Bank lending i s shown below:

Ibid; GDP per capita refers to 2000.

Uzbekistan CFAA: Countw Backqround 3

8. The l imi ted lending program has been complemented by non-lending activities centered around selected fiduciary economic and sector studies. The Bank completed the Country Procurement Assessment Report (CPAR) in 2003 and a Public Expenditure Review (PER) has been prepared in parallel with the C F A A .

9. The Bank’s lending act iv i ty has been focused o n investment projects. Fiduciary safeguards and financial management in the Uzbekistan port fo l io are arranged outside the national institutions o f accountability using stand-alone project implementation units. Budget support operations are not envisaged in the next C A S cycle.

Uzbekistan CFAA: Public Sector Budget Manaqemeni 4

11. PUBLIC SECTOR BUDGET MANAGEMENT

Introduction

10. The focus o f CFAA i s o n budgetary issues wh ich impact o n public sector financial accountability. The Report analyzes both the comprehensiveness and transparency o f the budget process. Later sections o f the report analyze accountability and transparency issues arising f rom extra-budgetary funds and public enterprises.

11. This Report does not provide a detailed examination o f institutional reforms required to reform the budgetary process; nor does it review the allocation o f resources against government priorities. These issues are the domain o f the Public Expenditure Review (the k e y institutional issues arising f rom the PER analysis are summarized in B o x 1 below). The problems inherent within the present system o f budget management have been documented in previous report^.^ The ma in focus o f this chapter i s t o explain the rationale for the development o f a treasury system and provide a deeper understanding o f the challenges posed by this far-reaching init iative.

Principles and Risks

12. Public sector budgeting poses two types o f risk to sound financial management. Firstly there i s the pol icy risk related to the government fail ing to implement the budget passed by the Parliament. As discussed above, these issues are pr imar i ly dealt with in the context o f the PER. Second, there i s the financial management risk that budgetary fimds are not spent for the purposes set out in the budget. This risk i s compounded when significant government activities operating outside the budget are not subject t o normal budget scrutiny and procedures. These issues are discussed below.

13. The budget execution arrangements have an important impact on the management o f the government’s liquidity position and cash requirements. A failure to manage liquidity ef f ic ient ly creates r i sks (1) that payments are n o t made in accordance with the budget, (2) that payments are no t made o n a t imely basis and distort the implementation o f government activities and (3) that finance officials have insufficient information to make the most effective and efficient use o f cash.

14. budgeting should be reviewed:

T o understand the scope o f these risks, the fo l lowing dimension and principles o f

The scope of the budget: i s the budget comprehensive enough to a l low effective pol icy and resources linkages, review and trade-offs? Similarly, are the resources outside the budget subject t o the same policy, review, financial reporting and accountability requirements?

The budget preparation process: I s data o n budget preparation and implementation available, timely, reliable and presented in a w a y that allows the Government to assess implementation o f publ ic policies? I s the budget preparation process conducive to fiscal sustainability and responsibility, and does i t link policies and resources?

See for example the Uzbekistan: Government Financial Management, A Diagnostic Report, World Bank, ECSPE, June 2000 and Uzbekistan: Budget and Treasury Reforms, IMF Fiscal Affairs Dept, March 2003.

0 Budget presentation: I s the budget presentation transparent and clear enough to assess whether i t reflects the Government po l icy priorities, and i s the use o f the funds clearly spelled out?

Availability and quality of budget information: i s the budget available outside the Executive to a l low for open rev iew o f the Government’s proposed use o f funds?

The scope of the budget

15. In Uzbekistan, the budget excludes a significant portion of public funds. As a result, it does not a l low effective po l i cy and resources linkages, rev iew and trade-offs and does not present a comprehensive v iew o f the government sector.

16. Extra-budgetary funds (EBFs) are a large part of total State expenditure. EBFs account for approximately one quarter o f total State budget expenditures; and include four major fimds’ and additional smaller EBFs (accounting for less than 10 percent o f total EBF expenditure). M a n y o f the smaller EBFs are designed to provide incentives to budget entities engaged in revenue production. The state budget does n o t cover a l l government agencies and previous studies have recommended that the government bring a l l controlled entities in to a consolidated reporting entity. In doing so EBFs wou ld b e consolidated in to the budget and more accurately reflects central budget activities. Because o f their overall materiality the issue o f extra-budgetary accounts i s discussed in greater depth in the next section o f the CFAA.

Box 1: Budget Management - Institutional Issues - Key Messages from the World Bank Public Expenditure Review, 2004 (PER) Uzbekistan has begun major reforms to the health and education sector. Budget preparation and execution weaknesses are being addressed through the development o f revised budget preparation procedures and the introduction o f a Treasury system. These changes are part o f a l ong term process requiring a fundamental change in institutions across govemment. Pol icy mak ing functions o f spending ministries need to b e developed; accountability for po l i cy and spending decisions need t o be clarified.

In the l ong term much o f the reform o f public finances wi l l require changes outside the Min is t ry o f Finance. Institutions should be established at the center o f govemment to coordinate strategic po l i cy choices. Spending ministries should be reorganized along functional l ines and include many o f the state institutions wh ich currently deal directly with M O F . Until n o w budget re fo rm has largely been centered around technical developments w i th in the MOF. One o f the main tasks for the MOF i s to make the case to the Govemment and public institutions for the need for reforms and the long term benefits that will ensue.

Amongst the key short term recommendations o f the PER are proposals which wou ld make the presentation o f the budget more transparent and enable the Oliy Maj l i s to evaluate the effectiveness o f the allocation o f resources. In the medium to long term the PER proposes structural changes t o MOF; creating a modem organization equipped to perform the development o f macro-economic po l i cy and sustainable expenditure. The PER also recommends the creation o f high level committee o f the Cabinet o f Ministers (COM) responsible for overseeing the budget process and presenting strategic choices to the COM.

Source- Public Expenditure Review, 2004

’ Road Fund, Pension Fund, Employment Fund and State Property Fund.

Uzbekistan CFAA: Public Sector Budqet Management 6

The budget preparation process

17. Pol icy development takes place centrally in the apparatus o f the Cabinet o f Ministers and the Presidential Administration. Strategic decisions take place outside the budgetary process, wh ich means that funding for new initiatives m a y be lacking or the budget will b e allocated in an ad hoc manner by MOF. Until recently there was n o in i t ia l resource envelope specified in cal l ing for budget requests. For the f i rst t ime in the 2005 budget process expenditure ceilings were set for sectors. This i s an important step forward in the budget process. However the process o f setting ceilings will require further development and formalization. In particular i t i s important that C O M approves budget ceilings for institutions and not just functions, and the process o f setting ceilings should be codi f ied in the Budget Systems L a w (BSL) o r in regulations issued by the MOF based o n the BSL . Budget requests are based upon standard cost norms and historic allocations. Notwithstanding the improvements, the present budget preparation process i s not conducive to fiscal sustainability, nor does it link policies to resources.

18. There i s no integrated evaluation o f investment and current spending in each sector. The lead agency fo r the investment budget i s no t the MOF but by the MOE wh ich i s responsible for the PIP.6Although MOF officials are involved in this process and a l l projects are formal ly subject t o a process o f appraisal, they are no t evaluated together with other publ ic resources being assigned to a particular sector, within a budgetary envelope for the sector. In addition a number o f basic decisions in the PIP are taken outside the formal budget process (for example, a p r i o r i decisions o n the numbers o f schools and hospitals to be constructed). There i s also n o mechanism for the consideration o f the impact o f recurrent cost implications (beyond the next budget year) o f new investments.

19. Separation of PIP and external financing promotes the view that such resources are additional o r free. Since a significant proportion o f the PIP i s financed f rom external borrowing, the existence o f the PIP in i t s present f o rm promotes the v iew that foreign financing i s in some sense “free” money apart f rom the budget. Al though the appraisal o f PIP projects does include an assessment o f the abi l i ty t o repay the loans these are no t taken into account as part o f the budgetary envelope available for spending by institutions.

Transparency and accountability aspects of the budget process

20. Budget documentation i s not transparent and clear enough to assess whether it reflects the Government policy priorities, and the use o f the funds i s not clearly spelled out. In addition, the budget process does no t lend i tse l f open review o f the Government’s proposed use o f funds.

21. Budget presentation suffers f r o m the fragmented budget (discussed above) and a classification which does not meet international standards. The overview tables o n spending are insufficient to analyze the development o f pol icy. Greater transparency could be achieved through presenting the budget by organizational and economic classification, with comparative data for the previous year and forecasts for the next two years.

The PIP covers both General Government investment (centralized investments) as w e l l as that carried out by publ ic enterprises financed f rom their o w n resources and direct foreign investment (decentralized investments).

Uzbekistan CFAA: Public Sector Budget Manaqement 7

22. The budget classification used for structuring the information does not allow clear accountability for the use o f resources. The functional classification i s a m i x of functional elements and economic categories, and the economic classification i s limited to four categories, as noted above. Recently considerable work has been carried out in the MOF, with the assistance o f the IMF and U S Treasury to develop functional, economic, organizational and program classifications, consistent with the standard GFS 200 1 classifications o f the IMF. This classification identifies the structural unit, the budget beneficiary and the main activity for which budget funding wil l be used. If this classification i s used for the presentation and execution o f the budget, i t would allow for clear accountability in the use o f resources by institutions, and provide the Oliy Majl is and C O M with a means to evaluate the budget in a coherent manner. I t i s expected that the GFS 2001 classification will be implemented for the 2006 budget and, in addition a programmatic budget classification will be implemented in 2007.

23. The Oliy Majlis approve a budget based on broad functional classification. Parliamentarians are provided with an aggregated overview o f proposed government budgetary expenditures and revenues and the tax and fee levels that will be required to meet the revenue budget targets. W h i l e additional information i s available on request, the format and the highly aggregated level o f the information makes i t dif f icult for an individual parliamentarian to formulate an informed opinion. The broad budget parameters are also disclosed, for the f i rs t time this year, on the M O F website. What are missing are the detailed disclosures o f the individual budgets o f the f i r s t l ine budget entities and their sub-entities that compose the main budget variables.

24. The detailed budget i s prepared aper approval by the Oliy Majlis. Once the budget i s approved in parliament a second budget process begins. Since the budget approved by the legislature does not assign resources to institutions and economic categories, i t i s only following the approval o f the budgets that the negotiations and allocation o f budgets o f institutions at the central leve l takes place by the MOF. A similar process also then takes place at the Oblast level for local institutions. On the revenue side the revenue forecasts are broken down by type o f tax and locality to reflect revenue raising plans which become obligatory for the local governments.

25. Transparency and accountability would be enhanced by the publication of Budget documentation. Publication i s standard international practice in virtually al l countries in the world. The decision o f the Government to begin publishing the details o f budget execution for 2003 i s very welcome and institutionalization o f this practice would be an important step forward in transparency. In particular this would include the budget, the macroeconomic forecasts underlying i t and an explanation o f the main budgetary measures.

Budget execution and cash management issues

26. Fragmented organizational arrangements for the budget make implementation difficult to monitor. Budget execution takes place through the Central Bank o f Uzbekistan (CBU) and commercial banks on the basis o f a monthly cash release system. There i s no distinction between the authority to spend and the release o f funds. Cash i s . disbursed into thousands o f individual bank accounts o f budget institutions. The C B U estimates that there are 120,000 Government bank accounts.

Uzbekisfan CFAA: Public Sector Budqef Manaqement a

27. The present budget execution arrangements expose the Government to important risks (1) that payments are not made in accordance with the budget, (2) that payments are not made o n a t imely basis and distort the implementation o f government activities and (3) that finance officials have insufficient information to make the most effective and efficient use o f cash. These r isks are recognized by the Government and are being addressed through the development o f the treasury system.

28. There i s uncertainty in the availability and timing of funds. In principle, budget funds are released to spending agencies o n the basis o f month ly expenditure plans. Al though funds released over the whole year are in accordance with the approved budget, to keep cash under control these releases are not automatic and are pr ior i t ized by the MOF or the Oblast Finance Department. The timing o f availabil ity o f funds i s determined in part by the availabil ity o f revenue (dependent o n seasonal o r local fluctuations) at the relevant level o f decision-making (MOF, oblast o r rayon). The need for priorit ization7 in release o f cash makes control o f execution a source o f pol i t ical and economic power, and subject to lobby ing and rent-seeking'. The resulting uncertainty as to the timing o f the release o f funds generates incentives to cash hoarding and the accumulation o f id le balances by budget organizations. Cash management i s further complicated by the rat ioning o f cash by the CBU to the banking system. Even when funds are made available through the banking system to the bank accounts o f BIs, these are unable to make payments in cash to f inal recipients. As a result arrears o f several months have occurred in wage and pension payments in some areas.

29. Extra budgetary accounts in the banking system further weaken liquidity management and fiscal control. Spending agencies use extra-budgetary accounts (established under decree 414) to manage their o w n resources. Wh i le such arrangements facilitate cost recovery, the high number o f extra-budgetary bank accounts maintained by budget institutions creates further loopholes in the fiscal control system.

Recent and proposed reforms

30. Many o f the weaknesses highlighted above are being addressed through the introduction o f a treasury system and work on the budget preparation process. The MOF has begun w o r k o n a m o d e m treasury system with the support o f the IMF and the Bank's Public Finance Reform project. A U S Treasury Advisor i s assisting the Ministry o f Finance with improv ing i t s budget preparation procedures including revising the budget classifications (introducing an organizational classification), strengthening the legal framework o f the budgetary process and improv ing the format and the content o f budget submissions prepared by l ine ministries.

31. A modern treasury system offers a number of potential benefits which can address the limitations of the current system and will assist in the implementation of budget plans and the management of public resources. Firstly, the creation o f a single treasury account and dai ly cash reports will enable the government to manage cash, f inancial assets and short term investments efficiently. The result wil l b e a reduction in the cost o f i d le

Pr ior i ty i s given to wages, pensions and utility payments. ' The problem i s exacerbated by unclear lines o f accountabil ity o f the local finance departments wh ich report t o bo th the MOF and the Oblast authorities.

Uzbekistan CFAA: Public Sector Buduet Manauement 9

balances and an increase in cash predictabil ity which can be made available to spending units. Second improved reporting through a modern Government Financial Management Informat ion System (GFMIS) provides better analytical information to moni tor the budget execution process at a l l levels o f government. Reporting o f expenditures provide reliable and timely assurance that publ ic resources have been used in conformity with the legal authorizations and mandatory requi remenkg Off ic ia ls can monitor the proport ion o f appropriations not committed and expenses committed but unpaid. Finally, systems and procedures improve the management o f domestic and foreign debt through regular recording and reporting o f loans including their associated disbursement and repayment schedules.

32. The establishment of the Treasury entails a major institutional reorganization for MOF. Under the draft proposals the Treasury will be established as a unit o f the MOF, headed by a Deputy Minister, and i t wil l comprise a Central Treasury (CT) located in the head office o f the MOF and a network o f local treasury branches (LTBs) throughout Uzbekistan. Under the new arrangements the LTBs wou ld be directly subordinate to the CT and not to local Govemments.

33. The treasury reforms will require considerable capacity building. The capacity o f the Government to absorb and implement an ambitious series o f publ ic sector financial management reforms will be a challenging and on-going exercise. Finance training i s needed in a l l publ ic sector institutions but i s particularly acute in the regions and in budgetary institutions. M a n y finance officers have had n o formal training since the 1980’s and there i s a lack o f computers and basic guidelines to assist staff.

34. MOF have identif ied 21,000 new and existing staff sub-divided in to (i) treasury staff, (ii) finance officers in MOF, oblast and rayon level finance offices and (iii) finance and accounting officers in budgetary units (predominantly in the health and education sectors). MOF propose to set up a training faci l i ty in the Treasury building to accommodate classrooms. The MOF will develop in i t ia l trainers for trainers program and develop training materials and modules based o n the skill and competences required o f finance officers.

Main Recommendations

35. conclusions drawn in the PER and are repeated in CFAA for continuity o f reporting.

The recommendations included in this section are consistent with the analysis and

Short term (within one vear)

36. Adopt fully the outline budget process developed for the 2005 budget.

i) selection o f projects. ii) classification i s presented to the COM and Oliy M a j l i s in that form.

PIP should be prepared in close collaboration with the Ministry o f Finance in the

The budget i s formulated around the organizational and programmatic

37. policy, should be published.

The budget, together with documentation on its assumptions and main lines of

Discussed in greater detail in Section I V

Medium term (one to three vears)

38. required are:

The Budget System Law should be amended. The principal amendments

i> i i) cash. This i s essential for the introduction o f the Treasury.

To require the enactment o f the budget by the Oliy Maj l is . To define appropriations as an authority to spend separate f rom the release o f

39. Multi-year PIP process should be reinstated and coordinated by MOF. The choice o f projects within the general government sphere should b e coordinated by the MOF as part o f an annual and med ium term budget process. The MOE should b e responsible for developing methodology for project appraisal and quality control o f proposed projects. The MOF should maintain a database o f ongoing projects showing their impact o n future recurrent costs, wh ich should b e integrated into a wider med ium term budget perspective.

40. Transparent operational rules and procedures should be developed for the Treasury control of budget execution. The rules should a l l ow the Treasury to ver i fy the legality o f payments, but give i t n o authority to priorit ize payments except by rules that are published by the MOF. The rules for managing budget execution should al low different levels o f control o f expenditure, and be consistent with sectoral reforms.

Uzbekistan CFAA: Extra Budsetaw Funds 11

111. EXTRA BUDGETARY FUNDS

Introduction

41. Extra-budgetary funds pose three types o f risk to sound financial management. Firstly there i s the policy risk that through poor government oversight and operational management extra-budgetary funds fai l to meet overall policy objectives. Second, there i s the performance risk, where use o f the funds for their intended purposes cannot be ascertained due to poor oversight and management. Finally, there i s the financial risk. I t has two sub-components:

e Fiscal risk: the fund may overspend i ts general budget allocation through weak

Cash management risk: by holding separate extra-budgetary funds the Government

commitment controls or unauthorized borrowing;

may have to either borrow funds when idle balances remain in the fund bank accounts or reduce cash allocations to other programs to accommodate the increased demands o f the extra-budgetary fund.

0

42. The second and third r isks (performance and financial r isks) are the most relevant to the C F A A diagnostic. These r i s k s occur because extra-budgetary accounts are off-budget and often operate outside the general budget formulation, execution, and reporting system. Simply including the fund balance sheet in the annual Government budget documentation would not be sufficient as they would s t i l l not be subject to normal budget scrutiny and procedures.

Extra-Budgetary Funds in Uzbekistan

43. The overall amounts o f spending o f extra-budgetary funds in Uzbekistan are highly material, accounting for approximately one quarter o f total State budget expenditures. Table 1 provides details o f the spending on the four major funds and over 20 smaller funds (accounting for less than 10 percent o f total extra-budgetary expenditure and presented in aggregated form).

44. The smaller funds" have been established principally to provide incentives to budget entities engaged in revenue production. These revenues can then be spent on staff bonuses, benefits, and other spending related to the entity. Revenues include the tax and customs commissions (20 percent o f penalties collected), State Property Commission (1 percent o f privatization revenues, MOF (10 percent o f C R U recoveries to the state budget)".

45. In addition spending agencies use extra-budgetary accounts (established under decree 414) to manage to provide greater flexibility in the budget execution process. I t creates provisions which allow budget entities to transfer unused budgetary funds into an extra-budgetary account, known as a development fund. The number o f these funds i s roughly equal to the number o f budget entities, approximately 13,000. These development accounts are off-budget and non-lapsing at year-end, and are not subject to normal budget

lo A l is t o f a l l extra- budgetary funds i s included in Annex IV.

Resolution in 2003. The Resolution also provides fo r estimates o f extra-budgetary funds t o b e registered with the Ministry o f Finance and i s taken into account in the budget formulation process.

The allocation o f fees and penalties to extra-budgetary funds o f the ministries were reduced by COM

execution controls. In 2003, total expenditures f rom these accounts were estimated at 10 percent o f budgetary expenditures. These development accounts are maintained in commercial banks.

Road Fund

Table 2: Extra-budgetary fund spending 1999-2004 (Billion Soums)

Actual Actual Actual Actual Forecast Budget 32.0 51.7 72.4 123.1 140.3 152.0

I Fund I 1999 1 2000 I 2001 I 2002 1 2003 I 2004 I

EBFFercent o f State Budget incl. EBFs

24.4% 24.5% 25.7% 25.8% 24.7%* 28.0%*

Source: Ministry of Finance. n/a - not available; * = excluding other EBFs.

Impact of extra-budgetary funds

Budget and cash management issues

46. Extra-budgetary funding further fragments the budgetary process and creates significant policy risks. The smaller funds have been created with their o w n sources o f income, and cover recurrent expenditures such as maintenance, repairs o r subsidies in different sectors, wh ich are the items being squeezed under the current budgeting process. The creation o f extra-budgetary funds for these purposes i s a substitute fo r an effective budget process and reflects an inabi l i ty to priorit ize. If an overriding need for maintenance, staff incentives or any other expenditure i s recognized this should be provided for through the normal budget process.

47. N o new extra-budgetary funds should be created. The creation o f extra- budgetary funds i s a symptom o f failures o f the budget process to allocate sufficient funds fo r activities such a maintenance and capital purchases. These funds are often created as a result o f pol i t ical lobbying o r ad hoc pr ior i ty setting at a higher level. In the case o f the smaller funds these account for a subset o f expenditure within sectors wh ich should b e more proper ly be considered under normal budgetary processes. F o r this reason the government should p lan to wind these funds up in the medium term. I t i s recognized that the Government i s mak ing efforts to reduce the number o f extra-budgetary funds, but the recent creation o f a new ear- marked fund for basic education i s a cause for concern, because o f the w a y in wh ich these funds circumvent the normal budgetary processes.

48. Controlling of extra-budgetary funds could be linked to greater flexibility in spending. Since many o f the smaller funds were introduced to give more f lex ib i l i ty t o spending institutions, their abol i t ion has to b e l i nked with measures which give institutions

Uzbekistan CFAA: : Extra Budqetary Funds 13

more f lex ib i l i ty in spending. This could be achieved by reducing the level o f detail in the expenditure tables and al lowing greater scope for virement wi thout reference to the Ministry o f Finance.

49. Extra-budgetary funds in the banking system weaken fiscal control and expose government to fiscal risks. Whi le development accounts facilitate cost recovery, the high number o f extra-budgetary bank accounts maintained by Budget Institutions creates loopholes in the fiscal control system. The existence o f separate bank accounts also increases financing costs and fiscal r i sks i f funds are able to borrow.

Governance issues

50. The CFAA conducted a review o f the four major funds financial management processes and controls (see Annex 111). F r o m this analysis i t appears that extra-budgetary funds are not as stringently monitored and controlled as other budget entities. For example wh i l e budgets are tabled in Parliament with the state budget there i s n o legal requirement fo r extra-budgetary funds’ annual reports to b e made public. The present procedures lack transparency and create an uncertain and inconsistent control and accountability environment.

51. The Government should establish common budgetary, audit, control and reporting procedures which can be scrutinized, questioned and approved by the MOF, COM and Oliy Maj l is (see Box 2). To mitigate the performance risk, extra-budgetary funds should b e consolidated in the state budget and operate the same processes o f preparation, execution, report ing and control as the rest o f the budget.

52. The governance arrangements for the Road Fund should be reviewed in the light of recent institutional changes. The m a i n supplier t o the Road Fund i s Uzavtoyol, the state construction company f i o m wh ich the Fund was recently separated. Uzavtoyal i s represented o n the Management Counci l o f the Road Fund and as such has a significant role in determining the Fund expenditures priorities, a clear conf l ic t o f interest. The Government could strengthen the contract-like relationship between the Road Fund and suppliers through an independent Management Counci l wh ich specifies the resources provided and the performance expectations o f the Fund. Governance could b e improved st i l l further if budget formulation and the determination o f the priorit ies in the Road Fund were to become the responsibility o f the appropriate sector ministry (Ministry o f Transport and Communications).

Uzbekistan CFAA: : Extra Budqetarv Funds 14

Box 2: Improving Financial management of Extra-budgetary funds In terms o f financial management and control, extra-budgetary funds l i e between the degree o f oversight and control exercised by the Govemment over i t s budgetary entities and i t s public enterprises. Because they are important elements o f the delivery o f social services provided to citizens, increased transparency in the budget would provide important information t o those most directly affected by the funds’ operation.

To minimize the risks outlined at the start o f this section (particularly performance and financial r isks) governments should minimize extra-budgetary funds. However, there are a number o f intermediate steps that a govemment can take to minimize risk whi le rationalizing their uti l ization over time. These include having extra- budgetary funds:

Included in annual budget documents on the same information base as the general budget (with

Subjected to the same M O F and Parliamentary scrutiny as on-budget spending;

Meet common requirements for accounting, intemal audit and control, and reporting;

Record and report accounts on the same time frame and frequency as general budget and financial reports;

Follow general principles o f transparency in reporting and operation (e.g. regular reporting within

Clear oversight authority; even if an EBF is established with an independent Supervisory Council, clear

supplementary reporting as appropriate to the particular fund);

Government and to Parliament, compliance w i th procurement, and contracting rules);

oversight responsibility should b e given to a l ine ministry for sectoral po l i cy issues and to MOF for matters relating to financial accountability;

Subject to independent annual extemal audit.

M a i n recommendations

Short term (within one year)

53. N o new extra-budgetary funds should be created. The existing smaller funds should be reviewed and where possible, re-integrated into the budget, with funding being made through standard budget allocations. At the same time the Government should build flexibility into virement procedures without recourse to MOF.

Medium term (one to three vears)

54. Extra-budgetary funds should be subject to the same rules as the rest of the budget. All EBFs should be put under the aegis o f a relevant sectoral ministry and they should be subject to the same r u l e s for budget preparation, review and control. In particular choices on expenditure within the fund should be subject to questioning from the MOF and the C O M as well as the Oliy Majlis.

55. Extra-budgetary funds should be limited to the payments for paid services and not allow budget surpluses. Extra-budgetary accounts should be limited to paid services or the collection o f other specific fees. The practice o f transferring surplus funds to extra- budgetary accounts (414 development accounts) undermines fiscal control and provides perverse incentives. If specific allocations are required for bonuses and staff incentives, these should be provided by budget allocations for these purposes. The issue o f f lexibil i ty should also be dealt with by reducing the level o f control o f the Ministry o f Finance on the expenditure tables for budget execution.

Uzbekistan CFAA: : Extra Budqetarv Funds 15

I n the medium term extra-budgetary funds should be included in the treasury system for the purposes of managing cash. However this objective will be achieved only to the extent that the Treasury performs the budget execution h n c t i o n and extra-budgetary accounts are fully ring fenced within the Treasury. In such a control environment hnds wou ld be released once the authorizations have been made in accordance with clearly defined procedures. Handled correctly this reform wou ld improve financial management without inappropriate l imitations being placed o n operational managementI2.

The Government envisages that w i th in the framework o f the Public Finance Management Reform Project the I 2

Treasury wi l l perform the budget execution o f extra-budgetary funds and the development accounts o f budget agencies.

IV. PUBLIC SECTOR ACCOUNTING AND FISCAL REPORTING

Introduction

56. Under the Soviet central planning system accounting was an exercise in booking- keeping; budget reporting was merely a financial reflection o f detailed production plans. M o d e m government accounting and financial reporting protect and manage publ ic money and discharge accountability. Therefore good accounting practices support transparency in the use o f funds and help c lar i fy responsibilities in funds management. When governments engage in economic act iv i ty - be it buying or selling services or borrowing and lending money they are subject to economic accountability. When they l evy and are in receipt o f revenues they are subject to pol i t ical accountability.

57. Accounting reforms should no t been seen as an end in themselves but should be seen as tools for supporting the implementation o f broader economic, political, and fiscal reforms within government. Hav ing a broad v iew o f stakeholder requirements in the context o f a countries socio-economic development i s helpful in identifying priorit ies based o n the priorit ies in the national economy. For example, changes to accounting and budgetary systems in the Uni ted K i n g d o m wou ld have been more l imi ted without pressure to restructure health and social welfare systems and reduce overall levels o f t a ~ a t i o n . ' ~

58. Government accounting has three broad purposes w h i c h can be used to illustrate priorit ies in order to build full capacity into a government accounting system.14 The basic purpose o f government accounting i s t o safeguard publ ic money and prevent corruption. The intermediate purpose i s to facilitate budgeting and planning o f revenues, expenditures and debt management. At this stage officials go beyond score-keeping and use management and cost data to conduct government operations in a more economical, effective and efficient manner. Final ly the advanced purpose o f government accounting i s t o help government discharge i t s publ ic accountability. At this stage the emphasis o f accounting shif ts f rom bureaucratic control t o accountabil ity reporting to the public. I t i s no t enough for government officials to keep accurate books and records - they are open to the publ ic through transparent and comprehensible financial statements.

Current accounting arrangements

59. Government accounting in Uzbekistan i s based on the Soviet accounting system which uses many concepts o f modern accounting including accrual measurements and double entry bookkeeping. In addition Uzbekistan has a large number o f bookkeepers w h o are trained in these concepts and are prof ic ient in their application. However, there are significant capacity constraints wh ich hinder the development o f a modem system of accounting and financial reporting. The accounting systems used at a central and local government level are predominantly manual. There i s n o central management information system; significant reliance i s p laced o n banking records and computer spreadsheet packages.

l3 See for example - Hepworth, N., 2001 Government Budgeting and Accounting Reform in the United Kingdom. Government Budgeting and Accounting Reform Symposium, Beijing 2001. l4 See Chan, Public Money and Management - January 2003. Government Accounting: An Assessment of The0 y, Purposes and Standards.

60. All budget organizations prepare monthly, quarterly and annual reports on budget execution. Republican budget institutions submit their financial reports to higher level units, wh ich then consolidate and submit reports to the M O F . Regional ly financed budget institutions submit financial reports to higher finance departments where they are consolidated and submitted to regional finance departments. These are further consolidated and submitted to the MOF. Budget accounting i s prepared o n a cash basis, although some additional accruals informat ion i s provided in accordance with the stipulated order. Separate charts o f account are prepared for cash releases to l ine ministries and regional finance departments.

61. T h e f ramework of government accounting contains some weaknesses, l imit ing i t s use for the three purposes mentioned above. The MOF and regional and local government finance departments operate a cash-based chart o f accounts, wh i l e budget institutions use a quasi-accrual based accounting system wh ich does not meet international standards. The MOF cash accounts are inaccurate in that they do not report the f ina l disposition o f cash deposited in the bank accounts o f l i ne ministries/departments and finance departments o f regional and local governments. Current laws specify broad responsibilities o f a l l parties and the processes to be fol lowed in accounting and financial reporting. However, the regulations need updating to address fundamental weaknesses highlighted in previous reports” (See B o x 3 above).

Box 3: Key weaknesses of the government accounting system and their impact on reporting and decision making

Expenditure accounting in M O F i s based on the financing transferred to l ine ministries. T h i s corresponds neither t o accrued expenditures nor to the final disposition o f cash;

o f the verif ication stage o f transactions in the MOF accounting system and budgetary institutions. Payables information is provided by budgetary institutions through their parent organizations once every quarter. This i s inadequate, particularly in an environment o f frequent cash shortages;

MOF cannot systematically monitor and report on arrears because o f the timing gap between the recording

to expenses within a reporting period. T h i s distorts the report ing o f budget entities; MOF and regional finance departments do not fo l low consistently defined principles for matching revenues

expected to be called in during the year. There i s a need fo r more comprehensive information about the real level o f govemment’s liabilities, relating to both debts and other obligations;

The M O F does no t analyze and report contingent l iabil i t ies and guarantees, including those that are

threshold value for capitalization o f transactions pertaining t o f ixed assets i s either too l o w or non-existent; There i s inadequate recognition o f materiality in recording transactions and events. For example the

reporting presented t o Parliament. The annual execution report i s not subject to an independent audit t o legitimize the rel iabi l i ty o f financial

l5 See for example PDP, loc cit, Annex 9.

Uzbekistan CFAA: Public Sector Accountinina and Fiscal Reportinq 18

Budget Reuorting

Government accounting - the introduction of modern accounting andfinancial reporting system

62. The introduction of the Treasury permits prompt and relevant reporting. The establishment o f the Treasury with a single account processing a l l payments and receipts al lows for consolidated, consistent and t imely reporting o f central government, l ine ministries and local governments expenditures and revenues for decision making. This will enable po l i cy makers and institutions to respond in a t imely manner to changes in the fiscal environment. I t wou ld also enable regular reporting to the publ ic and parliament, thus enhancing accountability and transparency.

63. The proposed accounting and financial reporting reforms are ambitious but w e l l thought out. The phased development o f modem public sector accounting and financial reporting as an integral part o f the treasury reforms and based o n recognized international standards i s an approach which could promote greater accountability and transparency (see B o x 4). F e w countries in the w o r l d have adopted full-accruals accounting and this should be viewed as a l ong t e r m goal. The in i t ia l focus should be o n a w e l l f imct ioning treasury system with accurate reporting o f cash supplemented by accrual o n payables, receivables and financial assets and liabilities. The Government should ensure that technical reforms do not get ahead o f institutional reforms and implementation capacity.

Box 4: Proposed development of government accounting standards The govemment intends to gradually introduce govemment accounting standards using I F A C International Public Sector Accounting Standards (IPSAS)’ and in compliance w i th GFS 2001 recognition principles’. The plan proposes a move f rom cash to accruals fo l lowing the path outl ined below:-

* T h e f i rs t phase is to apply the Uzbekistan Government Sector Account ing Standard’ (UzGSAS) for Cash which complies with the IPSAS Cash Accounting Standard. During this phase the MOF intends t o introduce a budget classification and Chart o f Accounts compliant w i th GFS 2001 and intemational accounting standards.

In the second phase the govemment w i l l develop standards for accounting and reporting o f payables, receivables, financial assets and liabil i t ies (modiJied accrual accounting). These reforms w i l l fo l low the introduction o f the Treasury system and introduction o f the GFMIS (presently planned for 2007).

In the final phase full accrual accounting wi l l b e in implemented wh ich provides for accounting and reporting o f non-financial and contingent assets and liabil i t ies

64. Communicating the rationale benefits of the accounting and financial reporting reforms can begin immediately. Currently financial reporting in Uzbekistan has an audience which i s limited to technical f inancial specialists. The use o f f inancial reporting as a basic tool o f managerial decision mak ing and accountability within government should be an integral part o f the strategy o f communications and training carried out in parallel with the treasury reforms. The MOF, loca l finance departments and bookkeepers need basic training in the proposed publ ic sector accounting and financial reporting reforms. Later,

Uzbekistan CFAA: Public Sector Accounting and Fiscal Reporting 19

during implementation there will be a need for detailed training, the development o f manuals and user guides to assist finance staff in their work.

65. Independent audit o f t he annual budget execution repo r t will enhance credibi l i ty and fu r ther increase transparency. This should be a medium to long term goal once the government has introduced internationally recognized standards and enhanced the capacity o f the external audit function (see also section VI11 o f the CFAA).

66. Communicating the rat ionale benef i ts o f the accounting and financial repor t ing reforms can begin immediately. Currently financial reporting in Uzbekistan has an audience which i s l imited to technical financial specialists. The use o f financial reporting as a basic tool o f managerial decision making and accountability within government should be an integral part o f the strategy o f communications and training carried out in parallel with the treasury reforms. The MOF, local finance departments and bookkeepers need basic training in the proposed public sector accounting and financial reporting reforms. Later, during implementation there wil l be a need for detailed training, the development o f manuals and user guides to assist finance staff in their work.

67. Independent audit o f the annual budget execution repo r t will enhance credibi l i ty and further increase transparency. This should be a medium to long term goal once the government has introduced internationally recognized standards and enhanced the capacity o f the external audit function (see also section VI11 o f the CFAA).

Main recommendations

Short term (within one vear)

68. Government’s commitment to accounting re fo rm process outl ined above.

Treasury G F M I S User Requirement Document (URD) should conf i rm the

69. The government should train users and providers o f financial information on the benefits o f public sector accounting and financial reporting. This t ra in ing should be conducted as an in tegra l p a r t o f communicating the goals o f the treasury reforms.

Medium term (one to three vears)

70. Continue phased development o f accounting and reporting standards.

i) ii)

iii)

Cash elements o f the new accounting standards; Accrual elements o f the accounting standards added together with accounting policies; Replacement o f o ld quasi-accruals accounting instruction with instruction based on international standards

Long term (over three vears)

71. accounting standard i s implemented.

The annual budget execution repor t should be subject t o audi t once the cash

Uzbekistan CFAA: Public Secfor Accounf in~ and Fiscal Reportinq 20

72. Consider the development of full-accruals accounting based (i) o n evaluation o f the experience to date in Uzbekistan and (ii) experience o f accruals accounting in other economies in transition.

Uzbekisfan CFAA: Selected Revenue and Administration h u e s 21

V. SELECTED REVENUE ADMINISTRATION ISSUES

Introduction

73. Revenue administration arrangements have an important impact o n the management o f the government’s liquidity position and the availabil ity o f cash to carry out government po l icy decisions. Adequate financial management arrangements require comprehensive systems and institutional arrangements bo th to formulate tax and ta r i f f policies and processes to administer and collect tax and non-tax revenues. Account ing informat ion systems should provide bo th aggregated informat ion to enable the efficient management o f cash and disaggregated regional, sectoral and taxpayer informat ion to monitor and control tax compliance.

74. The focus o n this b r i e f section i s o n selected areas o f revenue collection wh ich impact o n the effectiveness o f fiscal and cash management. Especially the fo l lowing matters are discussed:

0 Institutional issues - the extent to wh ich the organization o f po l i cy and collection agencies assists in the efficient and effective management o f revenue and overall cash management;

collection;

management;

0 Prompt collection o f a l l revenues - n o unreasonable gap between date due and actual

Adequacy o f revenue monitor ing - as part o f overall budget monitor ing and cash 0

0 Auditing procedures for revenues.

75. Tax levels in Uzbekistan continue to b e relatively high at 25.7 percent o f GDP, compared to the average rate o f 22 percent in the CIS, although there i s a gradual downwards trend. The tax legislation i s very complex, and it i s frequently revised. A breakdown o f the tax revenues for the per iod 2002 and 2003, together with the 2004 budget i s shown in Table 2 below. The CFAA does no t cover issues o f tax po l i cy o r tax administration in great detail; these have been addressed in previous Bank reports16 f r o m wh ich this section has been drawn and updated.

See in particular:- Uzbekistan: Government Financial Management: A Diagnostic Report, World Bank, 16

ECSPE. June 2000.

Uzbekistan CFAA: Seiecfed Revenue and Adminisfration issues 22

2. Indirect Taxes VAT Excise Tax Customs Tax Unified customs payment from individuals Tax on use o f gasoline, diesel oil and gas for vehicles from

1,018,296 1,353,801 1,532,944 535,760 604,2 70 44 7,490

492,043 693,623 751.567 29,354 40,964 60,745 24,328 45, I 4 9 68, I52 25,081 38,304 48,210

individuals 3. Resource payments and property tax Property tax

139,258 222,264 260,100 34,254 71,435 74,317

individuals 3. Resource payments and property tax Property tax

139,258 222,264 260,100 34,254 71,435 74,317

Land tax Tax on use o f depths Tax on use o f water resources Environmental tax 4. Municipal improvement and social infrastructure

Organizational Structure of Tax Administration

3 7,798 51,428 76,167 18,306 29,807 43,295

6,434 8,777 12,146 42,465 60,s 18 54,176 39,666 40,708 45,734

76. The organizational structure of tax administration in Uzbekistan i s fragmented (a summary o f the institutional arrangements i s shown in Box 5). Like many other countries in the region, different departments are organized by function, type o f tax, and type o f taxpayers, with overlapping and often conflicting responsibilities. To improve the tax administration’s operating efficiency, a new structure might be created along functional l ines. This would include departments for key tasks such as returns filing and payment, collection enforcement, audit, appeals, and taxpayer services. Subsidiaries in large corporate groups, including large public enterprises report to local tax offices rather than being handled centrally in one tax office. Previous reports have suggested that, in order to improve efficiency and capture a l l revenue income, special offices could also be established to administer and control the largest taxpayers.

Land tax Tax on use o f depths Tax on use o f water resources

4. Municipal improvement and social infrastructure

3 7,798 51,428 76,167 18,306 29,807 43,295

6,434 8,777 12,146 - I - - , - - , - - - , - .,.,6

39,666 I 40,708 I 45,734 development tax 5. Other revenues 11. Revenues of special funds (Off-budget Pension Fund, Republican Road Fund under the Ministry o f Finance, Employment Encouragement State

161,493 108,424 68,433

637,000 830,206 936,387

Fund, Special Account of the State Property Committee) Total Revenues 2,501,111 3,172,347 3,557,68 7

Box 5: Institutional Arrangements for Tax Policy and Administration in Uzbekistan The tax code specifies that special rates on prof i t taxes, excise taxes, and local taxes are set by the Cabinet o f Ministers (COM). The tax po l i cy department of the Min is t ry o f Finance (MOF) has pr imary responsibility for direct taxes and the major i ty o f indirect and property taxes. I t defines the overall tax policy, determines tax rates, drafts tax legislation and submits proposals through the M O F to the C O M .

The Budget Department in M O F performs the revenue accounting and forecasting functions. It receives revenue receipt informat ion f rom tax collection agencies and provides revenue forecasts for use by the Tax Pol icy Department.

Tax collection i s the responsibility o f the State Tax Committee (STC) and the State Customs Committee (SCC), who are bo th subordinate to the COM. Approximately 85 percent o f the taxes are collected by the STC. These include receipts f rom pro f i t tax, income tax, value added tax and excise tax. The SCC collects about 13 percent o f tax revenue, with the rest coming f rom other sources. The STC has offices in each Rayon and Oblast, whi le the SCC has 180 customs posts manned by 1,400 customs officers along the border and in major airports.

The Chairman o f the STC, SCC and Minister o f Finance al l report to the Deputy Pr ime Minister in the COM. T h e STC and M O F discuss issues o f mutual concern through a Council o f Experts. The Counci l rarely meets, and that communications between either o f the t w o revenue agencies and the MOF must fo l low a chain o f command up through the respective Chairman o f the State Revenue or Customs Committee t o the Deputy Prime Minister to the Minister o f Finance, the appropriate M O F Deputy Minister and then to the of f ic ia l to whom the message i s t o b e delivered.

Accounting, reporting and control of revenues

77. Communication between the collection agencies and Min is t ry o f Finance i s improving. The collection agencies have developed a matrix o f management reports which are provided to the tax pol icy department o f the Ministry o f Finance. However the present information systems preclude the provision o f useful information which would enable more detailed analytical work on tax policy and processes.

78. Collection agencies are investing in information technology. To increase the timely information flow, the tax authorities have been investing in the development o f management information systems. STC has a unified collection system which links local, oblast and Headquarters through satellite. SCC i s investing $24-$27 mi l l ion to develop and implement unified management information system throughout Uzbekistan. Legal enti t ies have a unique tax identification number and al l citizens over 18 years o ld also have a unique taxpayer identification number. A step forward in the efficient use o f information technology i s the Presidential Decree allowing the use o f electronic signatures with effect from January 1, 2004.17

79. T h e complexities o f tax policy may discourage compliance. In common wi th other transition economies Uzbekistan faces a major challenge in enforcing existing tax policy without stifling the development o f legitimate economic activity. One crude measure o f the acceptance o f the tax regime by taxpayers i s the amount o f tax collected through the courts or administrative enforcement orders. One estimate, provided by the Ministry o f Finance indicated that between 11 and 15 percent o f taxes are collected through these mechanisms. This creates both an administrative burden on the tax administration system and creates a cash f low problem due to the gap between the due date and actual collection o f tax revenues.

l7 L a w “On Electronic Digi ta l Signatures” - 11 Dec 2003 and L a w “On E-Commerce’’ - 12 Dec 2003.

80. The commercial banking system continues to act as a tax enforcement mechanism. W h i l e tax collection i s a normal function o f commercial banks, tax enforcement i s no t a recognized function and undermines confidence in the financial system. With the support o f a U S Treasury Advisor the Government has developed an amendment to the Tax Code wh ich wou ld restrict access o f the STC to banking informat ion o f taxpayers. Under the draft legislation banks wou ld have to respond (i) to an encashment order, signed by the Head o f the loca l STC or (ii) to a tax demand issued by a Court. This i s an important piece o f legislation wh ich would contribute to building confidence in the banking sector o f the Uzbek economy.

81. The efficiency and effectiveness of revenue enforcement mechanisms could be enhanced through further capacity building. The structural and enforcement arrangements carried out by the Control and Revis ion Unit o f STC i s described in Box 6 below. The Committee has started some w o r k o n developing risk-based IT systems to identify high-risk taxpayers. The early pilots have been hampered by a lack o f automated data and the overall complexi ty o f the tax regime in Uzbekistan. The Committee w o u l d benefit f r om technical assistance to develop sk i l l s and audit tools relevant to their needs.

Box 6: The Control and Revision Unit (CRU) of STC The Control and Revision Unit i s the main tax inspection unit w i th in the STC. The main function o f C R U i s to ensure that taxpayers comply with existing tax legislation. This work i s carried out ma in ly through on-site visits t o taxpayers. The Unit has approximately 250 staff; 24 staff based at Headquarters in Tashkent; an average o f 8 staff in each oblast and 3 staff in each rayon.

CRU conduct their inspections according t o an annual audit plan wh ich receives input f rom the rayons and oblast tax offices. Taxpayers receive on-site visit every t w o years although more frequent visits can be conducted o f they are included in the annual p lan agreed with the Republican Coordination Committee (RCC). C R U also conducts ad-hoc inspections based on the COM resolutions, also coordinated through the Republican Coordination Committee.

According t o C R U 75 percent o f inspections result in penalties wh ich arise (i) through late payment o f taxes or (ii) inaccurate financial statements which fo rm the basis o f the tax assessment.

M a i n recommendations

Short term (within one year)

82. access by the State Tax Committee to banking information on taxpayers.

Implement the proposed amendment to the Tax Code which would restrict

Medium term (one to three vears)

83. Simplify the number of taxes and reduce the number of exemptions. The complexi ty o f the present code i s the core reason fo r poo r tax compliance in Uzbekistan and stifles private sector activity.

84. Capacity building program for enforcement agencies. Develop risk-based model t o manage revenue enforcement. Ident i fy IT requirements for auditing based o n r i s k model and selected audit tools. Develop training program fo r managing r i s k and audit o f taxpayers based o n other countries experience.

VI. INTERNAL CONTROLS AND INTERNAL AUDIT

Introduction

85. In many transition countries internal control and internal audit have traditionally been synonymous. Internal auditors are found in a control directorate, at the centre o f government (typically the MOF) and sometimes in spending ministry headquarters. They are agents o f financial control, whose objective was to ensure that al l transactions o f the entity were legitimate and in compliance with relevant ru les and regulations. This i s performed through centralized, top-down control activities over budget organizations.

86. Top-down internal audit which focuses on compliance issues does not support managers in budgetary institutions in establishing, maintaining and being held accountable for the internal control environment. That responsibility defaults to the state financial control unit under responsibilities established in law or resolution.

87. There i s increasing international consensus on the approach to public sector internal control and audit.’* Modem internal control frameworks begin with a proposition that it i s management’s responsibility to establish and maintain an adequate internal control regime (see Box 7 below). The role o f financial management i s facilitating the delivery o f services and in the effective utilization o f resources. To do so government agencies need internal control systems which encompass governance, and a strong and ethical internal management culture. The role o f the internal auditor to provide independent and objective advice to management on the effectiveness o f their controls and to make recommendations as to how the controls can be improved.

[ h r e e main features of a modern internal control systems 1. The identification of areas of risk, including:

Uneconomic and inefficient administration;

Fraud and corruption;

The establishment of internal control systems to address these risks; these m a y be based in law, policies

Misuse or waste o f f inancial human and technical resources; Failure to execute budget and other po l i cy decisions (o f a financial and non-financial nature) in compliance with rules;

T h e failure to maintain complete, accurate and t imely accounting records;

Failure to provide t imely and reliable financial management information.

2. or procedures. Financial controls are a significant component o f management controls.

3. The establishment of a modern intemal audit function to check the intemal control systems, to identify gaps and to recommend corrective action by management.

88. Moving to models o f control in l i ne with international norms will be a challenging yet important long te rm reform. Experience in other former Soviet countries has shown that extensive time and effort i s required to provide a basic understanding o f concepts such as

* * IFAC, INTOSAI and the I IA a l l provide guidance and intemational standards fo r intemal control and audit.

Uzbekistan CFAA: lnfernal Controls and lnternal Audit 26

internal control, oversight and auditing. As discussed elsewhere in the Report, the timing and sequencing o f the institutional framework o f internal control should b e related to broader economic, po l i t ica l and fiscal reforms. The next section o f the Report provides a general overview to the publ ic sector internal control environment and then explores the institutional arrangements for internal audit in Uzbekistan.

Current systems of internal control ita Uzbekistan

89. T h e present system of budget execution results in a loss of budgetary control. The absence o f a modem treasury with an appropriate scope and a classification and informat ion system t o provide t imely and accurate financial informat ion i s a crit ical control risk. As a result, there i s n o overall system o f cash management and cash appropriations are held in numerous government bank accounts over w h i c h there i s l i t t le direct control.

90. T h e fragmented control environment creates the possibility o f significant liabilities, both actual and contingent, in the Government’s extra-budgetary funds, public enterprises and joint ventures. Few, if any, enterprises have separate internal audit units and the governance and transparency o f government agencies need to be reformed. The present governance framework i s incapable o f adequately monitor ing and controll ing these entities.

91. Reforms which can address some o f the above weaknesses are being undertaken by the Government. These include the establishment o f the new treasury law, the new Treasury organization within MOF, a common classification system that i s GFS 200 1 compliant, the establishment o f a single treasury account, modi f ied payment processes and supporting reporting formats. The Government i s t o adopt a centralized treasury model. Oblast and Rayon treasury offices will b e centrally controlled by the MOF Treasury department and supported by the Financial Management Informat ion System (FMIS).

92. Roles and responsibilities should evolve and become clearly defined through the treasury r e f o r m process. MOF’s ro le should become more focused o n monitor ing and evaluation o f the budget and setting government w ide standards for financial management systems, including internal control and audit. In this environment budget entities should assume full accountability for the formulation and execution o f their planned budgets, including the maintenance o f a system o f internal control.

Towards an Improved Regime of Internal Control

93. improv ing the internal control environment within the publ ic sector (See b o x 8 below).

A number o f treasury reforms proposed by the Government have the potential o f

Box 8: Important reforms to improve public sector internal controls 0 Completion o f the unified Chart o f Accounts and i ts implementation for the 2005 budget;

Passage o f the Treasury L a w and i ts establishment as a separate unit wi th in the MOF in 2004;

Installation o f the FMIS to provide the Treasury with systems t o conduct i t s activities associated with

Develop reporting systems to enable M O F to monitor rather than conduct detailed controls over budget

0

0

the management and control o f the TSA (currently scheduled for completion in 2007);

e

execution.

94. The separation of duties i s a fundamental aspect o f financial control. The establishment o f a treasury responsible for payment processing duties separate from the origin o f the payment (budgetary institutions) i s o f fundamental importance. In order to maximize the benefit for financial control o f the establishment o f the treasury, i t s role in controlling the regular payment orders should be maximized. This i s especially relevant in that one o f the reasons for the establishment o f the treasury i s the weakness in control over budget execution exercised by commercial banks.

95. The Treasury should have responsibility for confirming that all the elements of a payment order are correct. This implies giving Treasury powers to obtain information from budgetary institutions, including the right to withhold payment in the event that irregular payment orders are suspected with good cause. This requires shifting institutional responsibility for ex-ante control from the Control and Revision Unit (CRU) o f M O F to the Treasury (see further discussion o f the role o f C R U below).

96. While developing new financial controls the reforms should be linked to measures which give budget institutions more flexibility in making spending decisions. In particular reducing the level o f control through expenditure tables. This should be achieved by reducing the level o f detail in the budget tables and allowing greater scope for virement without reference to the MOF.

97. In conclusion the medium term goal o f MOF should be able to progressively modernize the internal control environment within government through the new institutional arrangements. However, this i s a complex long-term reform which involves realigning institutional arrangements which convey power and prestige.

Institutional arrangements for financial control - the role of the Control and Revision Unit

Introduction

98. Presently, there i s no public sector internal audit function Uzbekistan. The institution charged with conducting internal financial control i s the Control and Revision Unit o f the Ministry o f Finance (CRU). Within the Former Soviet Un ion C R U was charged with ensuring compliance with delegated budget authority and associated laws and decrees. One o f the challenges in developing decentralized systems o f internal control in l ine with international norms i s to convert C R U into a modern internal audit function.

Uzbekistan CFAA: lnternal Controls and internal Audit 28

99. Af ter the introduction of the new Treasury function responsibility for ex-ante expenditure controls will shift f r o m CRU to the Treasury function. Treasury staff, assisted by the new FMIS , will be able to exercise the ex-ante expenditure approvals for commitments and payments. In the medium t e r m C R U will have to change i t s role and functions. In the longer term the Government wil l wish to address h o w to develop a decentralized internal audit h n c t i o n which i s supportive o f management in l ine ministries and budgetary organizations.

The Control and Revision Unit of the Ministry of Finance (CRU)

100. T h e scope of CRUS w o r k i s narrow when benchmarked against international standards o f internal audit. I t s focus i s principally o n the identif ication and quantification o f the misuse o f publ ic hnds and ensuring that they are returned to the budget (see box 9 below).” W h i l e this function i s important the medium to long-term goal should be to develop a modem decentralized internal audit function which i s supportive o f the treasury reforms.

101. T h e narrow scope o f the CRU’s present control activities i s reinforced by i t s own measurement o f performance. Whi le this task i s crucial, inspectors have l i t t le incentive to ident i fy broader issues such as weaknesses in internal controls or potential improvements in administrative efficiency. I f these issues were addressed, i t wou ld improve the long-term development o f budget organizations and could be used as an additional measure o f overall institutional performance.

102. Salaries and incentives within CRU should support the overall goals of the treasury reform. The Ministry o f Finance i s allowed to retain 10 percent o f funds returned to the budget through the activities o f CRU. These are placed in a Special Fund o f which 25 percent i s available for salary enhancements to MOF staff and 75 percent f o r capital projects within the Ministry. Base salaries for CRU staff are in l i ne with other publ ic servants; however C R U staff can earn up to two times their regular salary based o n results and overall performance. In the medium to l ong term incentives for CRU staf f should b e based on the pr imary and boarder objectives o f improv ing systems o f publ ic sector f inancial management rather than the maximizat ion o f receipts.

l9 According to its Management, in the last f iscal year (2003) CRU has, through on-site visits uncovered irregularities amounting t o 600 m i l l i on soums (0.2% o f the state budget) in unauthorized or excess expenditure, the major i ty o f which has been retumed to the budget.

Uzbekistan CFAA: lnfernal Confrols and lnfernal Audif 29

Box 9: The Control and Revision Unit of the Ministry of Finance (CRU)

Introduction and scope of work

The MOF Control and Revision Unit currently have 860 staff. There is 63 staff in Head Off ice with the remainder based in 14 regional departments, in the Republic o f Karakalpakstan, and the C i t y o f Tashkent. The regional offices are subordinated to the Head Off ice in Tashkent and operational departments broadly mirror i ts structure. The C R U performs three main functions:

At the start o f the budget calendar, C R U reviews the allocation o f budget resources through budget tables to budgetary institutions;

registered budget tables. T h i s function i s carried out p r imar i l y through site visits by C R U local staff; Ex-post audit o f individual budget entities to ensure that budgets are executed in accordance with the

conducted according to an annual p lan and involve a combination o f site visits at major spending units in the oblast. The audit team for these visits typically numbers 10-15 staff.

Ex-post audits o f the execution o f the oblast level budgets by C R U staff f rom head office. These audits are

Capacity issues

The average age o f CRU staff i s 35-40 and the major i ty has a degree in finance or economics. Management a im to recruit graduates who have experience in the budgetary systems o f Uzbekistan.

The CRU has made efforts to bu i ld a performance evaluation system to assess the outputs, quality and results o f their inspectors. Al though the Report did not have an opportunity to evaluate this system in depth, i t would appear to be quite rigorous; according to C R U management, 250 out o f 550 professional staff put through the evaluation process received unsatisfactory grades. The Team was advised that approximately 10-12 staff i s expelled each year fo r misconduct, and a further 40-50 are subject to administrative discipline wh ich results in fines andlor wamings.

C R U holds annual training courses which cover legislative changes and inspection methodology. Their staff has had few opportunities to leam modem audit methodologies and wou ld benefit f r om technical assistance in al l aspects o f modem internal audit.

Towards a modern internal audit function

103. Modern public sector internal audit functions as a service to management, providing it w i th assurance that its internal control systems are functioning effectively. The focus o f internal audit i s the set o f r i s k s which internal control systems are designed to mitigate, and i t follows well-developed internal audit principles and procedures.

104. The experience in developing modem internal audit functions in FSU has been disappointing. First, the agencies such as CRU are a source o f institutional power that finance ministries are often reluctant to relinquish for a more decentralized management model. Second, a C R U i s limited in the scope and effectiveness o f i t s control activities by insufficient human resources and a lack o f supporting information systems. Thirdly, basic concepts o f internal and external audit do not fit comfortably in existing governance frameworks; they need to evolve in parallel with other reforms. Finally, in common with the rest o f the public sector in Uzbekistan, the l o w level o f salaries makes it diff icult for the CRU to attract and retain staff with the expertise and sk i l l s necessary to develop a modem internal audit func tion.

Uzbekistan CFAA: lnfernal Controls and lnternal Audif 30

105. Uzbekistan needs to sequence changes to the internal audit function which take into account the limited institutional capacity to implement reforms. The recent IMF FAD Report2’ recommended a f i rst step towards establishing a modem internal audit system - the establishment o f an internal audit function in the new Treasury unit. A k e y role o f the internal audit department wou ld be to strengthen the role o f the Treasury, thereby strengthening the entire financial control system. This internal audit unit should operate according to international internal audit standards.21 I t could operate in a complementary manner to CRU, but there wou ld b e regulatory provisions to ensure roles and responsibilities were w e l l defined. During the selection o f staff into the Treasury internal audit department’s staf f transfers f rom CRU should b e particularly carefully managed to ensure that on ly adequately qualified, motivated and competent auditors are recruited into the Treasury.

106. In the medium to long term CRU’s role might evolve into a centralized internal audit unit. I t wou ld operate o n behal f o f a l l budget entities that do not have internal audit units and perform i t s audits in conformity with international intemal audit standards. Clear criteria must be developed to specify their roles and accountabilities. The creation o f the treasury system will affect the l ong term staffing requirements fo r intemal audit. In setting up the new Internal Audit Department i t wou ld be important to ensure that appropriate selection criteria are set for the competences required f rom professional internal audit staff.

M a i n Recommendations

Short term (within one year)

107. Endorse the recommendations o f previous studies that an internal audit team be created within the n e w Treasury directorate, using staff f rom the CRU that has the required abilities to become the internal auditors for a l l Treasury operations.

108. Develop and implement a long-term strategy to br ing i t s internal control framework into compliance w i th international standards. This should provide a roadmap to develop the necessary legislative and structural changes to accomplish it.

Medium (one to three years)

109. Audit Department (IAD) and; (2) t h e modified CRU within the MOF.

Develop a long term staffing plan applicable to; (1) the Treasury Internal

110. Treasury IAD.

Set minimum requirements for the competence and s k i l l requirements o f the

11 1. Solicit donor support for professional development programs and training to allow CRU and Treasury IAD staff gain familiarity wi th international aspects o f public sector accounting, internal control and auditing.

2o Tanberg,, Kohnert, Zohrab and Ramachandran, Uzbekistan: Budzet and Treasuw Reforms. March 2003, Fiscal Affairs Department, IMF. pp 45-47.

audit manual have been provided in the draft Public Financial Manazement Reform Proiect, PDP Report - September 2003, Annex 10.

Extensive guidance on the possible govemance arrangements, the role o f Treasury IAD and a sample intemal 21

Uzbekistan CFAA: lnternal Controls and Internal Audit 31

Long term (over three years)

112. function, in order to:

Include specific new o r amended legislation beyond that establishing the Treasury

assign authority and responsibility to the Minister o f Finance fo r the establishment o f an effective internal control and audit framework in the Government;

redefine the respective roles and responsibilities o f CRU and Treasury Internal Audit Department;

require the creation o f internal audit units in al l major budget entities;

authorize the creation o f a modem, standards-based internal audit unit within the MOF. MOF CRU should be converted in to a central internal audit unit, resident in MOF, performing audits across a l l budget entities that do no t have their o w n internal audit units.

vest authority with the Min is ter o f Finance to establish the qualifications, training, certification, audit and reporting standards, policies and guidelines that would apply to a l l internal auditors in the Government.

Uzbekistan: CFAA: Exfernal Audit 32

VII. EXTERNAL AUDIT

Introduction

1 13. Auditing, together with internal controls and monitor ing processes and mechanisms are part o f the essential checks and balances over the use o f publ ic resources in government. Ef fect ive external audit provides an independent assessment that the overall objectives set by Parliament and government are being met and gives assurance as to the overall quality o f publ ic expenditure and the management o f publ ic assets and liabilities. Without this assurance there i s a risk o f f lawed information, mismanaged resources and that po l i cy decisions are ignored by operating units.

114. The fundamental distinction between external and internal audit pertains to the degree o f independence o f the auditor in relation to the audited entity and to w h o m the audit report i s addressed. T o be effective and objective in their audit work the external auditors should be fully independent f r o m the audited entity and their audit reports should b e addressed to entities separate f rom the bodies being audited. The differentiation between internal and external audit should not preclude close cooperation between the t w o functions as they carry out their respective responsibilities.

1 15. Fundamental principles o f auditor independence cause diff iculties in the context o f the present institutional and constitutional arrangements in many CIS countries. This should no t preclude the short t o med ium term development o f an audit institution wh ich provides additional assurance to the COM, Parliament and publ ic over the use o f publ ic funds.

1 16. International standards issued by International Organization o f Supreme Audit Institutions (INTOSAI)22 provide guidance o n the legislative base for external auditors. These include audit independence, objectivity, standards to guide the conduct and reporting o f audits, training o f external auditors and quality control processes.

Progress on the development of a Supreme Audit Institution

117. T o date limited progress has been made on the development of an independent SAI. Previous diagnostic reports recommended the establishment o f an independent Supreme Audit Institution (SAI)..23 The Parliamentary Committee o n Budget, Banking and Financial Issues has also recognized the need for such a function to fulfill i t s budget oversight function.

118. In 2002 a Chamber o f Accounts (COA) was established within the President’s Office.24 The Chamber i s accountable both to the President and the Oliy Majlis, and i s to b e “an independent organ, independent and objective in its assessments”. Although the COA lacks a number o f the attributes o f an external audit function, i t could be developed in to one. The COA currently has n ine staf f and i s managed by a Col leg ium (Board) o f ministers that meets twice annually. Currently i t uses CRU and revenue inspectors f rom other entities to provide the resources required to perform i t s w o r k program. In September 2004, it has

22 For more information see INTOSAI website www.intosai.org See for example - Narayan and Reid; Financial Management and Governance Issues in the Republic of 23

Uzbekistan, Asian Development Bank, 2000. Presidential decree # UP 3093 (21 June 2002) as amended by Decree # 3157 (4 Nov 2002). 24

Uzbekistan CFAA: External Audit 33

acquired expanded office space in the new Senate building, as a f irst step towards increasing i t s staff. These audit reports are not published, no r are they tabled in Parliament.

119. A limited number of audits are being performed. The COA i s carrying out a l imi ted number o f compliance audits focusing o n the execution o f the state budget. The scope o f COAs w o r k program i s l imi ted by a lack o f staff. Consequently the annual audit coverage (percentage o f budget funds subject t o COA audit) i s extremely low.

M a i n Recommendations

Short term (within one vear)

120. The COA does no t meet the I N T O S A I criteria for independence, no r does i t fo l low international auditing standards in the course o f i t s audits. I t is, however; a nascent external audit function, and could become the foundation for the development o f an acceptable state audit organization. A short-term development p lan might cover the fo l lowing steps.

Step I - Establish the Legislative Base.

121. The COA should establish a legal basis for its activities. The COA should seek technical assistance f rom donors to provide international experts to assist in the preparation o f a draft law. The Government should ensure that the provisions in the draft l a w require that the Chamber o f Accounts report to the Budget and Finance committee o f the Oliy M a j l i ~ ~ ~ .

122. At this embryonic stage of its development, the dual reporting relationship to the President and Parliament may provide both the authority and protection for the COA as it conducts its work. D u a l report ing could be continued until the function has matured and i t s ro le i s established across Government. The long term goal should be for the COA to report directly to Parliament.

123. The new law on the Chamber of Accounts should be passed by the government and approved by the Parliament before the constitutional changes come in to effect in January 2005.

Step 2 -Increase transparency and disclosure of audit work.

124. Currently neither the annual audit program nor the audit reports of the COA are available to the Oliy Majlis o r the public. Internationally the requirements fo r the distribution o f audit reports are often specified in the laws establishing the SAI. SAIs i s usually required to submit a l l reports to Parliament and most have considerable discretion in the distribution o f their findings.

125. In many countries audit reports are available to the public unless restricted for reasons of national security. In a democracy the general publ ic has a legitimate interest in the results o f the audits o f publ ic entities and the use o f publ ic funds.

During the CFAA Mission there was considerable confusion regarding the reporting relationship between the C O A and the budget institutions set up within the bicameral Parliament (O l iy Ma j i l i s and Senate). This needs to b e clarif ied through the process o f drafting the legislative base for the COA.

25

Uzbekistan CFAA: Exfernal Audit 34

Step 3 -Resource Chamber of Accounts, recognizing limited capacity to absorb new concepts.

126. A qualified and eminent finance professional should be appointed as President of the COA. This appointment should be made under the same terms as the Constitution provides for the appointment o f other senior independent positions (e.g. President o f the Supreme Court).

127. The COA should conduct staff recruitment based on clearly defined s k i l l s and competences, many o f which are new to auditors in Uzbekistan. Staff should have the necessary education and experience to learn modem auditing techniques that conform to international auditing standards. The C O A should develop a capacity development program which recognizes that in the short term it will have limited capacity to absorb new concepts and techniques.

Step 4 - Enlist Support from the International Community.

128. The Chamber o f Accounts should build links and organize training events with other SAIs in developed countries so that they can learn from their experience. The Government should initiate discussions with the international donor community in order to arrange funding for peer support from SAIs that have already completed the transition to a modem external audit function.

Medium term (one to three vears)

129. Develop s k i l l s in financial attestation audits. As noted above the COAs current work i s focused on compliance auditing; reviews o f individual transactions after the fact, to ensure that appropriate authorizations and documentation are present. Modem ex-post financial audits are broader in nature and involve an attestation o f the financial accountability o f government entities, involving the examination o f financial records and the expression o f an overall opinion on the financial statements. These audits are new to the public sector and the C O A should develop these sk i l l s steadily over time with the support o f international expertise. Init ially the C O A should carry out a number o f p i lo t audits and closely monitor the process and the results o f this work.

130. Define and build reporting lines to Parliament. The C O M i s likely to influence the work program o f the C O A in Uzbekistan in the medium to long term; however this should not preclude the development o f reporting l ines to Parliament. For example the audit reports could be sent to the Budget and Finance Committee and management o f the C O A could appear before the Committee. Creating this relationship would increase the transparency and credibility o f the mandate o f the COA.

Long term (over three vears)

13 1. Conduct an audit o f the annual budget execution report. The C O A should plan to conduct an audit o f the annual budget execution report when the Government f i rst prepares financial reports based on internationally recognized public sector accounting standards (see also Section IV o f the Report.)

Uzbekistan CFAA: Public Enterwises 35

VIII. PUBLIC ENTERPRISES

Introduction

132. Public enterprises are not part o f the definition o f general government in Uzbekistan. However, they conduct transactions that can have significant fiscal implications fo r the Government. These include the payment o f dividends, the receipt o f budgetary subsidies to cover losses, debt interest payments or loan payments due, the receipt o f publ ic loans o r guarantees, and liabil i t ies that can be a source o f contingent l iab i l i ty for the Government.

133. Building a framework for oversight and monitoring the activities o f public enterprises i s an important element of a country’s f ramework o f financial accountability. The key elements are: (1) improving systems o f corporate governance, f inancial reporting and auditing in enterprises; (2) developing the monitor ing and oversight functions within Government, and (3) increasing the availabil ity and transparency o f informat ion to Parliament and public.

Framework of oversight for public enterprises in Uzbekistan

134. Uzbekistan has a large and complex web of corporate structures and institutions. In Uzbekistan the executive branch o f Government consists o f ministries, state committees and agencies. At the sub-executive level, there are agencies, wh ich consist o f former sector ministries that have been part ia l ly privatized and al lowed to operate o n a quasi- commercial basis. The executive has substantial ownership interests in publ ic enterprises, as there has been l i t t le privatization o f large enterprises. The country does n o t have an overarching state corporation’s l a w and many o f the state enterprises are regulated by Presidential Decrees and have Charters and Resolutions approved by the COM. The governance arrangements for the use o f state powers are on ly part ia l ly defined, as the constitution does not formal ly specify the powers o f executive bodies and ministries, state committees, and associations; and they can a l l issue directives that have the force o f law.

135. Information on the exact number o f state owned enterprises i s difficult to obtain. In addition to the publ ic enterprises, there are also approximately 8000 enterprises wi thout corporate form, an inheritance o f the country’s Soviet past. Examples include hospitals, clinics, kindergartens, and other publ ic service entities. The d i f f icu l ty in compi l ing a complete inventory i s compounded by the def in i t ion o f what constitutes a publ ic enterprise. The Government restricts this category to those that are 100 percent owned by the State. Any di lut ion o f this ownership by entities other than the State Property Commit tee places them in the Joint Stock Company (JSC) category, even if the shareholder i s another state entity. In real i ty the major i ty o f these JSCs remain under state control.26

136. The State Property Committee (SPC) i s responsible fo r (1) the implementation o f the privatization strategy o f the Government; (2) governance and publ ic enterprises and the management o f

Oversight and monitoring o f public enterprises i s fragmented.

26 Under Intemational Financial Reporting Standards effective state control wou ld apply in any case where the Government owns more than 50% o f shares; this percentage can be significantly less if the state exercises significant control over the appointment o f key management staff or determines the finance and operating policies o f the entity.

Uzbekistan CFAA: Public Enterprises 36

state property in company’s where state ownership i s less than 100 percent. The SPC’s role in governance includes the regulation o f production and prices o f outputs in a number o f economic sectors, establishing the required authorized capital for Joint Stock Companies, and establishing limits o f outside ownership in the jo in t stock entities. Oversight o f publ ic enterprises (i.e. 100 percent owned by the state) i s the role o f the responsible ministry and the COM.

137. State representation on the Supervisory Board varies according to the percentage ownership of the capital o f the entity. In those cases where the State ownership exceeds 50 percent, the Government appoints the Chairman o f the Board. Where the state holds less than 50 percent, a state trustee i s appointed f rom one o f a number o f professional management companies that provide trustees o n a fee for service basis. The Trustee submits a report annually to the SPC describing the activities o f the trustee for the period. I t does not contain the detailed financial statements, but does provide some financial information o n revenues, expenses less salaries, accounts payable and accounts receivable. There i s n o balance sheet report. The MOF monitors the dividend pol icy (and revenues into the budget) through the Government’s board trustee.

Governance of Public Enterprises

138. Due to i l l-defined lines o f authority, there i s l i t t le external and internal discipline o n corporate performance, and l i t t le effective separation between government and business. There are two broad categories o f factors that determine the performance o f the modem corporation: the internal incentive arrangements between owners and managers, and the external factors that discipline and monitor the behavior o f managers and ul t imately the f i r m ’ s p e r f ~ r m a n c e . ~ ~ Under the current corporate framework in Uzbekistan, there i s a lack o f clarity o n the role o f directors, relative to shareholders and managers. Conflicts o f interest arise as many shareholders and directors o f JSCs are also publ ic sector officials who have po l i cy and regulatory responsibilities (See Case Studies for two o f the largest publ ic enterprises below).

139. The government could benefit f r om a single ministry being given responsibil i ty for the financial monitor ing o f publ ic entity or enterprise operations. This ministry wou ld be responsible for, among other things, developing specific d iv idend and investment policies to maximize the benefits t o the state, engaging external auditors, participating actively o n behal f o f the central government in the supervisory Boards o f publ ic entities o r enterprises and preparing the required consolidated financial reports, and including them in notes to the government’s financial statements.

2’ T h i s issue i s discussed in detail in Harry G. Broadman, Competition, Corporate Governance and Regulation in Central Asia: Uzbekistan s Structural Reform Challenges, World Bank, May 2000

Uzbekistan CFAA: Public Enterprises 37

Case Study - Governance and Financial Management in Major Public Enterprises

Uzbekenergo was created by Presidential Decree in 2001 from the former sector ministry for the generation and distribution of electrical energy. Although 100 percent state-owned, i t was established as a Joint Stock Company (JSC) because a number o f entities i t controls are JSCs. Its revenues come from electricity generation and distribution to regional electricity companies in Uzbekistan. I t does not receive subsidies from the State.

Management structure, corporate governance and staffing. The main governing body i s the Company’s Council chaired by a deputy prime minister, and including heads o f elevenministries, agencies and two major public enterprise clients (Uzneftgaz, Uzhimprom). There i s also a Supervisory Council whose primary focus i s on strategic development and monitoring economic performance. Its capital investment program i s reviewed and approved by the government (Ministry o f Economy and Agency for Foreign & External Economic Relations). The organizational structure and staffing levels were established by COM Resolution; however management can make changes within the overall limits o f the established staff units. The Management Board comprises of seven members; the Chairman and six deputies, recommended by the Council and approved by the COM.

Accounting, reporting and internal control structures. Internal control i s provided by the management structure which ensures compliance with company’s procedures. There i s no intemd audit function, although a unit s imi lar to CRU performs the control function. Accounting i s conducted according to the National Accounting Standards VAS) and consolidated accounts in accordance with FRS. Uzbekenergo prepares annual audited financial statements, but there i s no requirement that they be tabled in Parliament or published. The financial statements are prepared in accordance with NAS and summary financial statements are presented to shareholders. Copies are sent to the MOF, the Stde Statistics Committee and the responsible sector ministry. Al l public enterprises prepare monthly tax reports to the State Tax Commission (STC) and other revenue agents.

Audit arrangements. T h e Supervisory Board appoints the extemal auditors. Two audit f i rms currently audit the company. An intemational firm conducts an audit o f the consolidated entity using international auditing standards2* and a local audit firm performs audits in accordance with National Accounting Standards for tax purposes as required by law. The CFAA mission was unable to obtain copies o f the audit reports. The company undergoes inspection every two years by the STC, as well as regular inspections by the Oil, Gas and Energy Supervision Agency and the MOF Control & Revision Unit.

Uzkommunhizmat (communal utility) was created as a part o f the communal utility sector reforms that began in 1993. These reforms began by the privatization of apartment blocks by the Ministry o f Housing and Utilities. In 1995, that ministry was transformed into the Ministry of Communal Utilities. Subsequently, a Presidential Decree converted the Ministry of Communal Utilities into Uzkommunhizmat Public Enterprise. I t both regulates and manages the gas supply and inter-regional water distribution system. I t also finances three research institutes. Because the government has a single-price policy for the provision o f gas and water, it manages inter-regional cross-subsidies. The state subsidies the company’s services to permit i t to break even on an annual basis.

Management structure, corporate governance and staffing. Uzkommunhizmat i s a public holding agency that i s 100 percent owned by the state. I t reports to the COM through its Supxvisory Board which i s chaired by a deputy prime minister. There i s 25,000 staff distributed throughout Uzbekistan that provides and maintain its gas, water and new capital investment

1 operations. There i s a Collegium (Board) approved by the COM, consisting of five members - including the General ~ Director, his deputies and other managerial staff

Accounting, reporting and internal control structures Accounting i s conducted according to NAS. No audit is required o f the Agency’s financial statements. Consolidated financial statements on the activities of the Agency are submitted to the MoF, MoE, among other interested agencies. The Agency has the right to receive and review financial statements from subsidiary companies under it. The wholesde and retail gas tariffs charged by the Agency are set by MOF and approved in the annual budget by the Oliy Majl is. The Agency i s subject to the usual inspection regime by the STC, the SCC and other revenue agents. There i s no intemd audit function, but there i s a control inspectorate responsible forbill collection and identification of unauthorized consumers in the gas pipeline network There are also regional inspectorates created within the regional gas supply companies to carry out the aforementioned tasks. The financial statements are not required to be published, nor are they tabled in Parliament. Copies are sent to the MOF, the Stae Committee of the Republic o f Uzbekistan on Statistics and the MOE.

140. Supervisory Boards should be more independent for public enterprises. These could consist o f representatives from major clients, public interest groups and MOF. Board members would have greater accountability for the conduct o f the entity’s operations. Budgets and financial statements should be reviewed and approved by the Supervisory Board

** The ISA-based audits are conducted because they are required by IFIs that have financed development activities o f the company.

o n a regular basis, and the Board should review the auditor’s report o n the f inal statements for the year at the same t ime as the financial statements

14 1. Financial information relating to public enterprises i s incomplete and of questionable reliability. There i s n o consolidated database o n the financial performance o f publ ic enterprises. Financial statements are not published or systematically analyzed in Government. As a result there i s a lack o f information o n the magnitude or the extent o f their operations and their financial performance. The financial risk posed by publ ic enterprises i s therefore not fully known by Government as it does no t have t imely and accurate financial informat ion o n the results o f publ ic enterprises’ operations (revenues and expenditures) or o n i t s f inancial condition (assets and liabilities, contingencies).

142. Most public enterprises follow the national accounting standards (NAS) and are required to have audits but these do not comply with international standards. Al though N A S s are said to b e based o n International Financial Reporting Standards (IFRS), according to practitioners there are significant differences, for example in the areas o f f ixed asset valuation and disclosure requirements that undermine transparency o f financial reporting. Public enterprises are required to have annual audits o f their f inancial statements. However, these audits are usually conducted pr imar i ly for tax purposes and do no t comply with international standards.

Main recommendations

Medium term (one to three years)

143. Reform of the regulatory framework. Reforms should b e introduced to separate po l i cy and’ regulatory activities where conflicts o f interests arise, and privatize commercial operations so they do not have access to state powers. A legal f ramework should b e created fo r the management and operations o f state owned enterprises, with clear provisions for f inancial accountability and governance and w e l l established governance structures.

144. There should be requirement to use International Financial Reporting Standards29 for accounting and reporting of the results of the enterprise’s activities in their financial statements. Adopt ion o f International Financial Report ing Standards could b e o n a phased approach, based o n the size and nature o f the enterprises.

145. The Government should encourage the use of independent external auditors to conduct the annual audit of I F R S financial statements of the enterprise, using International Standards of Auditing (ISA). The Government could conduct select two publ ic enterprises for p i lo t audits o f their 2004 financial statements by an external, private sector international auditing f i r m s us ing I S A . The audited financial statements should be published.

Long term (over three years)

146. Increase transparency of financial information. Pr ior i ty should b e given for annual audited financial statements o f publ ic enterprises and j o i n t stock companies to b e available to the COM, other shareholders and to the Oliy Maj l is . These audited financial

The Govemment should adopt a full translation o f Intemational Financial Reporting Standards which could be 29

applied to public interest enterprises; which would include the major public enterprises.

Uzbekistan CFAA: Public Enterorises 39

statements should b e submitted to the responsible government minister, w h o w o u l d then table them in Parliament within a specified per iod o f time.

147. Establishment of sector ministries to conduct policy. The Government should consider devoting to sector ministries in infrastructure sectors, such as energy, the responsibility o f def in ing that set po l i cy and providing advice to the COM o n the regulatory framework within those sectors. The Government could investigate ways o f strengthening the governance arrangements for government owned agencies to increase the level o f transparency and accountability o f their operations so that policies are implemented in the way envisaged by the COM.

Uzbekistan CFAA: Financial Manaaement Arransements in Bank Funded Projects 40

IX. FINANCIAL MANAGEMENT ARRANGEMENTS IN BANK- FUNDED PROJECTS

Introduction

148. Bank (the Bank) requirements for IBRD/IDA-financed projects. The present portfolio

This section reviews the financial management arrangements, in respect o f Wor ld

Specifically, i t :

(a) assesses the general quality o f the financial management arrangements for the Bank- financed portfolio;

(b) highlights the key issues which affect the overall quality o f financial management in the Bank portfolio; and

(c) recommends measures to improve financial management arrangements in hture Bank operations.

149. The Uzbekistan Bank portfolio currently consists of ten operations (eight IBRD Loans and two IDA Credits). One loan, closed on December 3 1, 2003, i s being extended retroactively, while one loan due to close in June 2004, was extended for a limited period. Subject to the outcome o f on-going discussions between the Bank and the Government two new operations may enter the portfolio in FY05. There are also two project preparation activities financed by one PPF Advance and two PHRD Grants.

Financial Management Arrangements

Institutional arrangements

150. All World Bank-financed projects in Uzbekistan have been managed by stand alone project implementing units (PIUs). This mitigates against the r isks associated with weaknesses in government systems, but does l i t t le to develop long t e r m public sector financial management capacity in government ministries and agencies.

151. Availability of skilled staff remains a challenge. The core fiduciary staff in each P I U includes an accountant and a procurement officer. Recruiting skilled accounting professionals, for projects i s difficult; PIUs often hire staff with an economics or bookkeeping background that then undergo training in project financial management. There are a small number o f experienced project accountants that tend to rotate amongst the PIUs. In addition P I U staff earns considerably more than government employees. These disparities create resentment with counterparts in the l ine ministries.

152. PIUs install project financial management systems which are not integrated into the government accounting, reporting and audit systems. They maintain separate audit book-keeping systems and project financial statements are audited annually by private audit f i r m s . These are subject to periodic reviews by Wor ld Bank staff to determine their eligibility to audit Bank-financed projects.

Uzbekistan CFAA: Financial Manauement Arranqements in Bank-Funded Projects 41

153. Financial management arrangements for new projects are assessed to meet Bank’s own fiduciary requirements. The practice i s to have acceptable financial management arrangements (i.e. project accounting, financial reporting, internal control, and auditing and financial management staff) early in the project cycle (prior to presenting to the project to the Bank’s Board). This avoids disbursement delays during project implementation. These Bank requirements have generally been met in Uzbekistan.

Financial Management Supervision

154. Bank staff conducts risk-based financial management supervision to ensure that financial management arrangements remain effective throughout project implementation. This supervision takes place once or twice a year depending on the assessed level o f fiduciary risk.

155. Project financial management systems have generally been satisfactory however some weaknesses have been noted in budgeting, financial reporting and internal control in the Uzbekistan portfolio.

156. Only a .few qualified project audit reports - timeliness remains an issue: A desk review o f the audit reports for FY 2002 indicates that the most projects received an unqualified audit opinion. Only two o f the audit reports contained qualified audit opinion. However, compliance with audit covenants was low. Out o f eleven projects with audit reports due by June 30, 2003, only six had submitted their audit reports on time. One project had i t s audit requirement waived due to delays in implementation, while four projects (about 36 percent o f the portfolio) had overdue audits, including one audit report that did not meet Bank requirements.

157. received:

The following issues have been identified from bank supervision and audit reports

158. Budgeting: i s usually l imited to procurement plans and counterpart funds; it i s not consolidated to show the overall position o f the project. Budget figures used for quarterly Project Management Reports (PMRs) have been, lifted from the Project Appraisal Documents (PAD) with l i t t l e reference to the realities o f project implementation.

159. Internal control: weak organizational structures resul t in inadequate segregation o f responsibilities for executing accounting transactions and reporting on project activities. This has given r ise to cases o f inaccuracies, errors and incomplete records. None o f the PIUs have an internal audit function. Weaknesses in the internal control systems are not detected on a timely basis and often only highlighted in the auditor’s annual management letter. Visits to PIUs by the M O F Control and Revision Unit are generally for inspection purposes to establish non-compliance with tax and other government regulations, not for internal control audits.

160. Non-compliance with Bank requirements: On occasion Bank funds have been commingled with other funds and not separately maintained as required. There have also been instances o f inadequate accounting for counterpart resources. Due to a lack o f counterpart funds, the Bank funds have been often used to pre-finance ineligible expenditures that should have been paid out o f counterpart funds.

Uzbekistan CFAA: Financial Manaqement Arranqemenfs in Bank-Funded Projects 42

161. External Audit: Uzbekistan i s s t i l l to develop an independent Supreme Audit Institution which the Bank could rely on for auditing Bank-funds. Current ly external audits o f Bank-financed projects are performed by independent private sector auditors who are selected in accordance with procurement guidelines and terms o f reference approved by the Bank.

162. M o s t local firms lack either the technical capacity o r the requisite experience to carry out audits o f Bank-financed projects. The Bank carries out periodic on-site assessments o f audit f i r m s to determine their eligibility to audit Bank-financed project^.^' Other than two o f the international audit f i r m s , on ly one local firm was considered conditionally eligible to carry out project audits.31 The major i ty o f Bank-financed projects are audited by international audit f i r m s based in Almaty, Kazakhstan or Tashkent.

Towards Mainstreaming Project Financial Management

163. Stand-alone project implementation units have been a necessary short-term, risk- mit igat ing strategy. Generally f iduciary arrangements for B a n k projects h n c t i o n w e l l in Uzbekistan. However, establishing fiduciary safeguards and financial management arrangements outside the national institutions o f accountability does nothing to contribute to the development o f sustainable financial management capacities in publ ic institutions.

164. The Government’s current efforts in publ ic finance reforms will strengthen public sector financial management arrangements. W o r k discussed elsewhere in this Report should strengthen accounting and reporting, increase transparency and accountability, create a m o d e m treasury function and institutions o f control, audit and supervision. As the government demonstrates progress in addressing i t s internal control weaknesses the Bank could envisage placing gradual reliance o n elements o f the Government’s financial management systems, reviewed o n a case-by-case basis.

165. M o v i n g towards reliance o n national institutions and publ ic f inancial management systems will require a phased approach based o n demonstrable progress towards strengthening these institutions and systems. In the medium term the Government should w o r k towards integrating the PIP and external f inancing in to the budgetary process.32 The Ministry o f Economy should b e responsible for developing a methodology for project appraisal and quality control o f proposed projects, wh ich w o u l d include financial management arrangements.

The last review for Uzbekistan was carried out in M a y 2003. Conditional eligibil i ty means the audit firm does not meet al l the requirements fo; full eligibil i ty; and may only

This i s discussed in more detail in the PER.

30

3 1

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ANNEX I1 - INTERNATIONAL STANDARDS AND CODES

IASB

IFAC

I IA IMF

INTOSAI OECD

For the purpose o f conducting quality CFAAs in a l l o f the Bank’s borrower countries, guidelines and questionnaires have been developed to assist the Bank’s staff in the process o f assessing the financial accountability arrangements. The structure o f the C F A A follows from these guidelines. Since the administrations o f the borrower countries are often looking for benchmarks against which their systems can be measured, this report contains clear references to those internationally accepted standards and codes that employed to develop the C F A A guidelines. In the case o f many poor/low capacity countries these standards and codes should be seen as long term goals rather than benchmarks which can be used in the assessment o f current systems.

International Accounting Standards (IAS) 0

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Intemational Financial Reporting Standards (IFRS) Intemational Public Sector Accounting Standards (IPSAS) Intemational Standards on Auditing (ISA) Standards for the Professional Practice o f Intemal Auditing (SPPIA) Code o f Good Practices on Fiscal Transparency Government Financial Statistics (GFS 2001) System o f National Accounts 93 (SNA 93) INTOSAI Auditing Standards (INTOSAI AS) Best Practices for Budget Transparency System of National Accounts 93 (SNA93)

One way o f facilitating financial accountability i s to promote the application o f standards and codes for the practice o f the most essential financial management tasks, such as budgeting, accounting, internal control, internal audit and external audit. The internationally accepted standards and codes used in the CFAA report includes those promoted by the Council o f Europe, Wor ld Bank, IMF, the Organization o f Economic Cooperation and Development (OECD), the Committee o f the Sponsoring Organizations o f the Treadway Commission (COSO), the International Accounting Standards Board (IASB), the International Federation o f Accountants (IFAC), the Institute o f Internal Auditors (IIA), and the International Organization o f Supreme Audit Institutions (INTOSAI). An overview o f the standards and codes referred to in this CFAA i s presented in table 1.

World Bank

Table 4: Standards and Codes Promoting Financial Accountability

Treasury Reference Model OECD Principles o f Corporate Governance

I Organization 1 Standards & Codes I I cos0 1 Framework for Intemal Control I

I Systembf National Accounts 93 (SNA 93)

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hbekistan CFAA Annex IV Ovenliew of Governance Arranaements-Major Extra Budqefaw Funds 52

ANNEX IV: OVERVIEW OF GOVERNANCE ARRANGEMENTS - MAJOR EXTRA BUDGETARY FUNDS

jItem Legal Basis

Revenues

Expenditures

Road Fund

L a w on the Road Fund # I20 (2 Feb 1996)

C O M Decree #334 (5Jun93);

Resolution 36 1 (21 August 2003)

Percentage charges on al l entities and vehicle p ~ r c h a s e r s ~ ~ . 5% o f revenues go t o a Contingency Fund, unexpended funds carryover at year end

Construction and reconstruction, equipment for road construction & maintenance. W o r k performed by Uzavtoyol, a Public Enterprise construction company

Pension Fund

C O M Decree # 459 (27Dec96);

Resolution 498 (23 Dec 2000)

Resolution 444 (1 5 N o v 2000)

- 3 1.6 YO o f Gross Revenues F rom Economic entities collected by State Tax Commission as part o f the Un i f ied Social Payment, - 2.5% o f salary f rom employees and

revenues o f products (goods and services sold). Pensions and social benefits and compensatory cash payments for communal services.

- 0.7% gross

Employment Fund

Law on Employment 5 Jan 1998

- 0.9 % o f Gross Revenues f rom Economic entities collected by State Tax Commission as part o f the Un i f ied Social Charge;

Unemployment allowances, training programs and labor market j o b creation measures targeted for high poverty areas. Mon th l y surplus distributed t o other entities w i th shortfall.

State Property Fund :OM Decree # 481 120 Oct 97)

2oM Resolution #36: :22 Aug 98)

ZoM Resolution #51: 14 N o v 03)

Privatization receipts f rom the sale o f publ ic Enterprises.

In 2003 55.8 B i l l i on soums were generated.

Revenues are allocated as

the State Budget. 30% - Allocated to the appropriate regional administration (Council o f Ministers o f Karakalpakstan, khakeems' offices o f oblasts, C i t y o f Tashkent ) for infrastructure development and social projects 5% - stays at SPC for maintenance and administrative expenses, privatization programs, etc.

fOII0WS:- 40% - to

34 1.5% gross revenue fo r economic entities, 2.5% for transport companies; 1% gross income for Wholesale trades, 1.5% for banks and insurance companies; 6% o f car and 20% o f busltruck purchase value; transit fees for al l vehicles entering or leaving Uzbekistan.

Uzbekistan CFAA: Annex IV: Overview of Governance Arrangements -Major Extra-Budgetaw Funds 53

Item

Organization - Staffin

HQ

- Staffin Regional Offices

Board of Directors

Budget Preparation

Budget Review and Approval

Budget Execution Monitoring and Control

External Board Members

Approve Budget and Annual Report

External Auditor for Annual Report Annual Financial Report Tabled in Parliament Annual Report Made Public

Road Fund commercial banks collect and remit RF fees

45 in Tashkent

Regional Contracts with Uzavoyol for all construction and maintenance Management Council o f 21 person f rom Ministries, RF and key clients Based on Fund forecasts o f each client sub group

Management Council

Execution o f the Road Fund budget performed by Road Fund under the Min is t ry o f Finance. N o non-public entity board members Minister o f Finance as Chair o f the Management Council N o legal requirement for external audit. No. Summary o f major issues and challenges facing RF. No. N o t required

Pension Fund commercial bank for al l Oblasts and another for a l l Rayons collect remittances f rom employers

8 in Tashkent

Approximately 700 in Oblasts and Rayons

No, the M L S P has overall accountability for the management o f the Fund. Pension Fund prepares and submits to M L S P for approval

STC reviews revenue forecasts; M L S P approves and sends to MOF MOF C R U conducts annual inspection.

N o t applicable

Minister o f Labor and Social Protection

Private Sector Audi tor

Yes, by Minister o f Finance as part o f the Budget Execution Report N o . N o t required

Employment Fund make all payments fo r Employment Fund

3 in Tashkent

Approximately 400 in Oblasts and Rayons

No, the M L S P has overall accountability for the management o f the Fund.

Employment Fund prepares their budget

STC reviews revenue forecast; M L S P approves and send to M O F M O F C R U conducts annual inspection.

N o t applicable

Minister o f Labor and Social Protection

N o audit requirement

Yes, by Minister o f Finance as part o f the Budget Execution Report No . N o t required

State Property Fund

10 in Tashkent

About 30 (=2 in each oblast, RK and Tashkent city)

Special Supervisory Board plus State Trustees in each Publ ic Enterprise

Prepared by GKI , if n o financial dependence on the budget, MOF plays n o role. Special Supervisory Board approves budget and sends to MOF

M O F CRU conducts annual inspection. Periodic audit by Chamber o f Accounts.

N o t applicable

Special Supervisory Board

Chamber o f Accounts conducts periodic audits. Yes, by Minister o f Finance as part o f the Budget Execution Report Annual report published in the newspapers