INDIA - KARNATAKA STATE RURAL LOCAL GOVERNMENTS

(A detailed Background Report on Public Financial Accountability in Panchayat Raj Institutions in Karnataka is available. This has more information and details on the aspects discussed below)

I. Overview of Rural Local Governments (PRIs)

3.1 Karnataka has a 3-tier Rural Local Government System (called Panchayat Raj Institutions PRIs). These include 27 Zilla Panchayats (ZPs, district level), 175 Taluk Panchayats (TPs, blocklevel), and 5659 Gram Panchayats (GPs, village-level). The PRIs are local governments that report to their own elected peoples representatives. Indias 73 rd Constitutional Amendment (1993) mandates substantial functions to be transferred from the State Government to the PRIs. Officially, these functions have been transferred to the PRIs in Karnataka. In practice, however, the concept of PRIs as local governments is still evolving; they are still substantially under the State Governments control, and act primarily as local implementing agencies for the latter. These institutions are also almost fully funded by the State Government, and their staff are predominantly those of the State Government. 3.2 Public Funds of PRIs:

Total expenditures of PRIs in 2001-02 were about Rs. 4800 crores 1. The source of financing for these expenditures was almost fully from the State Government or the Central Government. ZPs and TPs do not have any own revenues; the GPs have limited own revenues (currently about Rs. 65 crores annually). Most funds provided by the State and Central Governments are tied funds i.e., for specific schemes or types of expenditures (e.g., salaries). Limited amounts are provided in the form of untied grants from the State Government. PRIs do not borrow any monies. Transfers from the State Government in 2002-03 to PRIs amounted to about Rs. 4400 crores (about 21% of total state government expenditure) 2. All transfers were in the form of grants to the PRIs. As detailed in Annex 5 State Government Financial Reporting, amounts transferred by the State Government to the PRIs are reflected as expenditures in the State Governments accounts3. Revenues and expenditures of the PRIs per-se are not incorporated or consolidated into the State Governments accounts.

These numbers are indicative based on various sources. There are no reliable numbers on the total expenditures, and the sources of funds. This could include some funds provided by the Central Government, for end-use by PRIs, channeled through the State Government. Expenditures shown in the State Governments accounts are not based on expenditures actually incurred by the PRIs. The State Government accounts as expenditures the amounts that are released to the PRIs (i.e., the amounts that the PRIs are authorized to withdraw). These amounts are not immediately paid out to the PRIs but continued to lie in the PRIs accounts with the State Government Treasury. Amounts not drawn by the end of the fiscal year lapse (i.e., cannot be withdrawn), but are considered as expenditures by the State Government.

II. Legal and Institutional Framework for PFMA

3.3 The process of rural decentralization is currently evolving. Although PRIs are rural local governments, currently the PRIs are substantially controlled by the State Government; and sometimes function as extension of the State Government (e.g., the staff of the various Departments of the PRI report to both the PRI and to the State Government Department). At the same time, however, various measures are also being taken to progressively involve the local people and the Panchayats more in the decision-making and accountability process, to move towards fuller decentralization. Within this overall constraint, a sound overall framework for PFMA in PRIs has been established. The main features are summarized below: Karnataka was one of the first states, and is probably one of the few states, that has specified clear rules and guidelines for the various PFMA-related aspects of PRIs. The working of the PRIs is governed by the Karnataka Panchayat Raj Act, 1993. Rules and Regulations relating to PFMA are detailed in this Act as well as in the Karnataka ZP/TP (Finance and Accounts Rules), 1996 and the Karnataka GP (Finance and Accounts) Rules, 1995. In addition, the various Codes and Rules of the State Government are also used. All the 3-tiers of the PRI system have their own elected representatives organized into a Panchayat. The elected members in turn elect a President and a Vice-President. The Panchayat is a policy-making and oversight body of the PRI. The State Government has substantial powers over the functioning of the PRIs, and also has a major policy-making and oversight role. The Rural Development and Panchayat Raj Department of the State Government administers this role. The Chief Executives of all the 3 tiers are appointed by the State Government. The Executive/Management of the PRI, headed by a Chief Executive Officer (ZP) /Executive Officer (TP), or Secretary (GP) , manages the various activities of the PRI , and all staff of the upper 2-tiers (except staff such as drivers, etc.) are appointed by the State Government; and are deputed by the State Government. The Executive reports both to the PRIs public representatives (Panchayats) and to the State Government. The Chief Executive is also required to ensure that the Panchayats conform to the law and the various rules/codes. The framework has substantial emphasis on local-level transparency: it provides for a social audit for the village-level PRIs (Jamabandhi), and for regular consultation with the local citizens of the PRIs (Gram Sabha). Major PFMA instruments used are budgets, monthly and annual accounts, audits, and publicly-displayed information on developmental works.

III. Current working of the PFMA system in PRIs

3.4 Basic transaction-level systems, that provide for tight controls over individual payments and receipts work reasonably well. Most payments (about 80%) are made through the State Government Treasury, and the verification system that is applicable for State Government

payments is used for these payments. Payment verification is further reinforced by requiring prior authorization of payments by upper tier (e.g., TP Bills by the ZP). Detailed line-item budgets are specified; there is a basic system of budgetary controls before payments are made, that works reasonably well. Basic accounting records are maintained all receipts and payments are recorded. Beyond this, systems are weak. 3.5 The quality of accounting and financial reporting is unsatisfactory. Accounts are delayed and there is a huge backlog, ranging from 1 year to 4 years for the upper 2 tiers (ZPs and TPs). Information presented in the accounts is incomplete they omit some transactions. The information presented in the annual financial reports (Annual Accounts) is not easily understandable e.g., Annual Accounts do not present in a single statement all receipts and expenditures -- these are prepared separately for each source of funding; the formats of the Annual Accounts make it further difficult to read and understand these accounts. Reliability of the numbers is also an issue due to non-adherence to standard accounting practices such as reconciliations. Underlying many of the accounting problems are: (i) a complicated funds flow system -- funds flow through multiple layers, instead of flowing directly from the Treasury to the respective PRIs (ZP/TP/GP); (ii) a complex information flow system for TP accounting e.g., compilation of accounts of the TP is done at the ZPs. Further, PRIs do not have all the information required for complete accounting. For example, sometimes utility payments are deducted at source for electricity (a major cost for the PRIs) from the amount of grants due to them, without corresponding information flows. 3.6 Audit performance is also unsatisfactory. Audits of the ZPs and TPs are carried out by the Comptroller and Auditor General of India, and of the GPs by the Karnataka State Accounts Department (KSAD). Follow-up on and responses to audits is unsatisfactory. There is a huge backlog regarding audits of the upper 2 tiers (ZPs and TPs) ranging from 1 to 4 years. Current legislation requires that a single report be prepared for all TPs. This is impractical, and requires amendment, but in any case there are no TP accounts to audit. Audit methodology also needs to be substantially improved. The internal audit system is also weak or non-existent. 3.7 Although budgets are prepared, these need to be substantially improved. PRIs are not aware of their total budgets. Budgets formats are not easily readable. Budgets are basically prepared top-down and without much local-level participation. 3.8 Local-level transparency and State Government monitoring are both limited by the above.

IV. Priorities going forward - PRIs

3.9 Governments Initiatives: The State Government prepared a report on improving various aspects of rural decentralization (Report of the Working Group on Decentralization, March 2002). The report has outlined several measures for improvements, including in the following areas: (i) providing for more participation by local communities in the decision-making process; (ii) streamlining funds flow and payment systems; (iii) ensuring transparency in budgetary allocations and funds provided to PRIs; (iv) enhancing staffing; (v) improving accounting, including computerization. 3.10 In the immediate term, the aim should be to ensure that the basic requirements under the current system/statute are adhered to. Examples of such urgent and immediate priorities include ensuring that: (i) periodic (e.g. Monthly or Quarterly Accounts) and annual

financial reports (Annual Accounts) are prepared in a timely manner, and are made transparent to the local community. The focus should be first on the current periods accounts (as contrasted with backlog); (ii) basic accounting controls such as reconciliations and confirmations are done regularly; (iii) accounting is complete i.e., it covers all receipts and payments; (iv) external audits are done on timely basis; (v) follow-up actions on audits are taken in a regular and timely manner. All the above do not involve any changes to the current system, but would require enforcement and monitoring. Addressing these basic priorities is necessary, but not sufficient. The modernization process outlined below is also essential. 3.11 In addition to the above, the PFMA system needs to be significantly improved to support the governments rural decentralization agenda, specifically to enable better local-level transparency and support local-level decision-making. The major priorities in this direction are: a) The accounting and financial reporting system which constitutes the core central foundations of the PFMA system needs to be substantially improved. The priority should be to get a cash-basis accounting system using satisfactory Accounting Standards to work satisfactorily first. Towards this end: (i) a self-balancing bookkeeping system (doubleentry bookkeeping system) needs to be introduced; (ii) accounting and financial reporting need to be made timely and complete (i.e., reflect all the transactions of the PRIs); (iii) standard accounting practices such as reconciliations, confirmation of balances, matching of main accounts with sub-accounts, need to be done regularly; and (iv) appropriate financial reporting formats should be developed. Mainstream reporting formats (such as a Balance Sheet or Statement of Financial Position, Cash Flow Statement or Receipts and Payments Account) should be used, wherever possible. The objective should be to ensure that the financial statements present the financial performance and position of the PRIs in a simple and readable manner; (v) each PRI should be responsible for compiling and preparing its own accounts and financial statements. Information flows should be revamped to facilitate this. b) Computerization of accounting is a major priority. This is essential for any significant improvements on accounting and financial reporting to be made. Since many of the transactions flow through the State Government Treasury, possibilities of drawing on information from the computerized treasury system could be explored. However, the State Governments treasury system alone will not be sufficient for computerizing accounts of the PRIs. The first priority could be to computerize the ZPs and TPs accounting. Initially, stand-alone systems could be installed in each ZP and TP. Further advances such as networking with Treasuries, could be considered at a later stage. GP accounting could also be selectively computerized wherever feasible. GoK has now launched an accounting computerization initiative covering all three tiers of rural local government. The pilot in 3 ZP jurisdictions is aimed for September, with roll-out by December. c) Auditing: (i) A major priority should be on follow-up action on audit reports, both on individual audit reports, and on systemic issues arising out of audit reports of various PRIs. (ii) There is need for a more systematic financial audit (and certification of financial reports). There is scope for partnership with the professional accounting firms (e.g., Chartered Accountants) in this regard; (iii) An internal audit system, engaging professional accounting firms (e.g., Chartered Accountants) should be introduced. A major focus of such internal audit should be identification of systemic weaknesses and improvement needed.

d) Improving local-level transparency is an important priority. Measures should be taken to improve local-level transparency such as publishing and providing information on budgets, funds released, financial reports, and developmental works, in local community forums, and local offices of the PRIs. e) Improvements to the budgeting system need to be made so that the budgeting process can become more participatory and responsive to local communities needs. The upper two tiers of the rural local government system in Karnataka are largely implementing agencies for state schemes. However, even accepting this perspective, first, PRIs, like Departments, could be given the freedom to budget on the basis of broad Programs rather than narrow schemes. Second, The link document which links the district and state budgets could be computerized, and the coding system at the district level rationalized so that state and district expenditure numbers can be much more easily reconciled e.g., the same Object code system should be used by both the state and local governments. Since much salary expenditure (e.g. for teachers) is currently incurred by the PRIs, funded by transfers from GoK, it is not that easy at the current time to work out how much the state government is spending on salaries including for state employees paid by the PRIs. f) Human resources skills upgradation: There is need to enhance the available human resource through recruitment/posting of better qualified personnel especially in GPs, use of outside qualified consultants, training and on-the-job learning. g) Payment System: Transfer of funds from the State Government to PRIs through the banking system, and making of all PRI payments through the banking system could be considered and progressively introduced. A prerequisite is sound accounting, auditing and internal control systems. Direct payments through the banking system for selected PRIs could be introduced selectively based on each PRIs satisfactory performance on these parameters. h) Changes to Statutes and Rules and Regulations: Some of the above may require changes to the legal framework i.e., the Statutes and/or Rules and Regulations. 3.12 Need for strong leadership, monitoring and follow-up by the State Government. The PRIs own representatives capacity to hold their (PRIs) Executives accountable is still developing. The PRIs are also substantially dependent on the State Government for financing. The State Government therefore needs to play a strong monitoring role, particularly in ensuring that the PRIs conform to the PFMA requirements. The State Government itself needs to establish the necessary capacity and systems to carry out this role, including the necessary database and information flow mechanisms. Appropriate measures, including linking fund transfers from the State Government to adherence to stipulated PFMA requirements, need to be considered and introduced. The State Government (Finance Department and the Panchayat Raj Department) also needs to take a lead role in the PFMA modernization and improvement effort for PRIs.

INDIA - KARNATAKA URBAN LOCAL GOVERNMENTS

(A detailed Background Report on Public Financial Accountability in Urban Local Bodies in Karnataka is available for interested readers. This has more information and details on the aspects discussed below)

I. Overview of Urban Local Governments (ULBs)

3.13 Karnataka has 224 Urban Local Governments (commonly referred to as Urban Local Bodies ULBs). These include 6 City Corporations (CCs) for the states largest cities, and 218 City Municipal Councils, Town Municipal Councils, and Town Panchayats for smaller towns (the ULBs, unlike the PRIs, exist in a single-tier structure). The 6 CCs are the big ULBs and account for about 70% of the total receipts and expenditures of the ULBs. The ULBs are also substantially under the State Governments control. 3.14 Public Funds of ULBs ULBs entities have limited own revenues, and also receive a proportion of the State Governments tax collections that are devolved to them. In addition, the ULBs also receive loans and grants from the State Government. Total receipts of the ULBs in 199899 were about Rs.750 crores4. Approximately 40% of total receipts were from devolution of taxes and grants, and additional 9% were from loans from the State Government. The balance was from ULBs own revenue sources such as taxes and fees. Salary and other revenue expenditure accounted for approximately 33% and 29% respectively of expenditure, and capital expenditure accounted for about 20% of expenditure. The remaining expenditure was on items such as debt redemption, grants to various institutions, and subsidies. Borrowings by ULBs require prior State Government approval. Transfers from the State Government in the form of devolutions of tax collections to ULBs in 2001-02 was about Rs. 564 crores (about 2.6% of total state government expenditure). In addition, there were transfers in the form of grants and loans; the amount of these transfers are not separately disclosed in the State Governments accounts or not easily available. The State Government also provides repayment guarantees for borrowings by some ULBs. Some of these are similar to Special Purpose Vehicle borrowings i.e., debt-servicing of these a priori is the responsibility of the State Government. As detailed in Annex 5 State Government Financial Reporting, amounts transferred by the State Government to the ULBs (devolution of taxes, grants and loans) are reflected as expenditures/loans in the State Governments accounts. Revenues and expenditures of the ULBs per-se are not incorporated or consolidated into the State Governments accounts.

Reliable consolidated data for all the ULBs is not available. Numbers provided are highly indicative.

II. Legal and Institutional Framework for PFMA

3.15 Key features are summarized below: Two main statutes govern the functioning of ULBs: the CCs are governed by the Karnataka Municipal Corporations Act, 1976 (KMC Act), and the other ULBs by the Karnataka Municipalities Act, 1964 (KM Act). These two statutes provide for different PFMA arrangements. This does not seem necessary and needs to be rationalized. Each ULB has a Council that is comprised of the ULBs own public representatives (mostly elected by its citizens, some nominated). The Council is a policy-making and oversight body of the ULB. The State Government has substantial powers over the functioning of the ULBs, and also has a major policy-making and oversight role. The Urban Development Department of the State Government administers the State Governments role. A Directorate of Municipal Administration within the UDD directly oversees the ULBs other than the 6 City Corporations. The Executive/Management of each ULB, headed by a Commissioner/Chief Officer, manages the various activities of the ULB. The Commissioner/Chief Officer is appointed by the State Government. The Executive reports both to the ULBs public representatives and to the State Government. Major PFMA instruments are budgets, annual accounts, audits, Annual Administrative Reports, and Performance Budgets (in some limited cases).

III. Current working of the PFMA system in ULBs

3.16 While the ULBs have strong procedural controls on individual transactions particularly expenditures, the overall state of public financial accountability and the control environment in ULBs is weak. Examples of the major weaknesses are: a) Weak budgeting. (i) Budgets need to be more complete; currently these omit some major capital grants or loans provided by the Government and related expenditures. (ii) Budgets need to be more realistic. The budgeting process needs to be based on Departments estimates and public inputs rather than top-down centralized estimates as currently done. Basis for budget estimates are often questionable. (iii) Budgets are sometimes not timely. (iv) The budgets are difficult to read and understand. (v) Budgets for transfers from the State Government need to be better related to corresponding amounts in the State Governments budget. (vi) Given that budgets a priori are not satisfactory, budgetary controls are also weak; (vii) Budgets need to be used as an instrument for budgetary control and monitoring financial performance, and not merely for obtaining State Government funds, as seems to be the current practice; b) Weak accounting and financial reporting. Major issues are non-regular maintenance of accounts, unreliable bookkeeping techniques (incomplete double-entry bookkeeping), incomplete accounting, several unreconciled items, incomplete and unreliable annual

accounts (i.e., financial reporting), and backlog in maintaining accounts and financial reporting; c) Unsatisfactory audit arrangements and follow-up to audits: Major issues include lack of an independent auditor for City Corporations (CCs), lack of certification of financial statements, unsatisfactory audit techniques, backlogs in audits of CCs; and lack of follow-up to audits. d) Weak public oversight system, and weak state government monitoring and enforcement of the PFMA requirements.

IV. Priorities going forward - ULBs

3.17 Government and citizens groups are starting to make efforts to strengthen PFMA in some ULBs. There are some notable initiatives that have tremendous potential for improving PFMA in ULBs, and changing the PFMA landscape. First, major efforts have been made to improve citizens participation and interface with ULBs public representatives in the Bangalore City Corporation (BCC, the biggest ULB), and create demand for better performance and accountability. These initiatives have been major successes: (a) Janaagraha -- a collaborative movement to bring the voice of the citizen into the decision-making process of government, that aims at bringing together citizens communities and their elected representatives. It has worked on several successful initiatives, such as introducing the concept of participatory budgeting getting the local citizens citizens' voices into the BCCs budget particularly in determining budget priorities, and furthering citizen participation in monitoring maintenance works; (b) Public Record of Operations and Finance ( PROOF) -- another initiative started in 2002 to improve transparency and citizens involvement in monitoring the performance of the BCC. Second, a major initiative was undertaken to modernize accounting and budgeting systems in 2 ULBs -- the BCC and the Tumkur Municipality (based on Fund-Based Accounting System FBAS, which is a variation of the accrual accounting system). These are in advanced stages of implementation, but are not fully operational yet due to the earlier backlog. These would provide useful models for the accounting and financial reporting modernization discussed below. These initiatives are extremely useful and welcome, though it should be noted that the current scale of these initiatives is somewhat limited in relation to the whole ULB system. 3.18 In the immediate term, the aim should be to ensure that the basic requirements under the current system/statute are adhered to. Examples of such urgent and immediate priorities include ensuring that: (i) the ULBs maintain accounts regularly; (ii) basic accounting controls such as reconciliations and confirmations are done regularly; (iii) accounting is complete; (iv) financial statements (Annual Accounts) are prepared in a timely manner. (v) external audits are done on timely basis; (vi) follow-up actions on audits are taken in a regular and timely manner. All the above do not involve any changes to the current system, but would require enforcement and monitoring. Addressing these basic priorities is necessary, but not sufficient. 3.19 In addition, major modernization of the PFMA system is essential to support the Governments objectives of enhancing accountability and financial soundness of ULBs. The major priorities are: a) The PFMA framework needs to be improved to provide a more central role for the ULBs local citizens representatives (i.e., the Councilors) in the public financial accountability

framework both in the statutes and in practice. This is in line with the overall concept of decentralization that calls for accountability to the local citizens and their representatives. The Council needs to have a more clearly defined role in approving budgets, holding the executive of the ULBs accountable for financial and operational performance, and in oversight over PFMA aspects such as accounts, finances, and audits. Providing more information and training to the Councilors on PFMA aspects, is also an important priority. b) Increased transparency disclosure of information to and facilitating access to information by the ULBs constituents (citizens), on financial and performance aspects of the ULBs is an important priority. Making information available to the public on aspects such as ward works planning, budget, performance, accounts, audits, statistics, major achievements, including through web sites and citizen forums would help improve citizen understanding and help build demand for ULB performance. c) The budgeting system needs to be substantially improved so that the budget is linked to the ULBs objectives, is more realistic, and becomes a better monitoring and control tool. There is also need for more public involvement in the budgeting process. d) The accounting and financial reporting system which constitutes the core central foundations of the public financial accountability system needs to be substantially modernized. A self-balancing bookkeeping system (double-entry bookkeeping system) needs to be introduced, along with computerization. Similarly the cash-basis of accounting should be progressively changed to an accrual-basis or appropriate variations (such as the Fund Based Accounting System FBAS). The financial reporting system needs to evolve towards more mainstream reporting practices such as balance sheet, cash flow statement, and income and expenditure account. Accounting and financial reporting Standards need to be developed and codified and adhered to by ULBs. Accounting and financial reporting need to be become more timely and complete (i.e., reflect all the transactions of the ULB); currently there are huge backlogs and these are incomplete. Standard accounting practices such as reconciliations, confirmation of balances, matching of main accounts with sub-accounts, need to be done regularly. These are major weaknesses in the current system that also compromise the overall control environment. Given the scale of effort involved on the accounting and financial reporting modernization agenda, prioritization and sequencing is important e.g., initially improving reliability by moving to a double-entry bookkeeping system, and ensuring that all transactions are captured and reported, modernizing accounting manuals and rules, and improving financial reporting under the cash basis in the first instance. The major priorities are the 6 CCs, although the other ULBs are also important. e) The external audit system needs to be substantially modernized . Independent and qualified auditors need to be appointed to audit the ULB accounts. Audit standards and methodology need to be modernized, to expand from the current emphasis on transaction auditing (of compliance with procedures), to include certification of financial statements, and audit of internal controls systems. Audit capacity of the Karnataka State Accounts Department, (KSAD), the auditor of most of the ULBs, is a major issue. Involvement of professional auditors (Chartered Accountants) to carry out financial audits and audits of the larger ULBs, and to partner with the KSAD, needs to be actively considered and implemented. External audits also need to be timely. There is need to ensure that satisfactory follow-up action on audit reports are taken on timely basis.

f) Internal controls systems currently focus on strong transaction controls. More modern internal control systems focusing on managerial accountability, reporting on financial and performance aspects, information and transparency also need to be progressively emphasized. Appropriate internal audit systems need to be introduced. g) Human resources skills upgradation: There is need to enhance the available human resource through recruitment of better qualified personnel, use of outside qualified consultants, training and on-the-job learning. h) Payment System: Transfer of funds from the State Government to ULBs through the banking system, and making of all ULB payments through the banking system could be progressively considered (in place of the current system in which payments made out of funds provided by the State Government are made through the State Treasury system, and payments made out of self-generated resources are made through the banking system). A prerequisite is sound accounting, auditing and internal control systems. Direct payments through the banking system could be introduced selectively in some ULBs based on each ULBs satisfactory performance on these parameters. i) Changes to Statutes and Rules and Regulations: Some of the above may require changes to the legal framework i.e., the Statutes and/or Rules and Regulations. As indicated earlier, the PFMA framework in the two statutes also need to be rationalized and made consistent.

3.20 There is need for strong leadership, monitoring and follow-up by the State Government. The ULBs own representatives capacity to hold their (ULBs) Executive accountable is still developing. The ULBs are also substantially dependent on the State Government for financing. The State Government therefore needs to play a strong monitoring role, particularly in ensuring that the ULBs conform to the PFMA requirements of the statute. The State Government itself needs to establish the necessary capacity and systems to carry out this role, including the necessary database and information flow mechanisms. Appropriate measures, including linking fund transfers from the State Government to adherence to stipulated PFMA requirements, need to be considered and introduced. The State Government also needs to take a lead role in helping the development of standards, and in the modernization effort.

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