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January 06, 2010

Almost All You Ever Need (or Want) to Know About Budget Classification

Posted by Davina Jacobs

Budget Classification_Page_01
Why should budget and treasury officials see the “budget classification” as one of their most important tools? What exactly is the budget classification? A new IMF Technical Note and Manual on Budget Classification (TNM/09/06) (attached below) prepared by Davina Jacobs, Jean-Luc Hélis and Dominique Bouley of the Fiscal Affairs Department addresses the following main issues:

• Why is a budget classification system important?
• What are the main features of a sound budget classification system?
• How should a budget classification system be structured?
• What is the relationship between budget classification and the chart of accounts (COA)?
• What are the pre-conditions for successful implementation of a new budget classification system?
• What are likely to be the critical steps and milestones in the reform of a budget classification?

This note draws on the extensive practical experience gained from FAD technical assistance missions to a wide variety of developing and transition countries over the last fifteen years. The main reasons why the budget classification is so important, are:

• First, the budget classification is one of the fundamental building blocks of a sound budget management system, as it determines the manner in which budgetary data is classified and presented, and as such has a direct impact on the transparency and coherence of the budget as a primary policy instrument of government. In countries where the budget nomenclature is weak, upgrading the budget classification system should itself be considered a basic step—indeed a pre-condition—before embarking on other reforms of the public financial management (PFM) system.
• Second, a budget classification system provides a normative framework for both policy decision-making and accountability. Classifying expenditures and revenues correctly is important for: (1) policy formulation and performance analysis; (2) allocating resources efficiently among sectors; (3) ensuring compliance with the budgetary resources approved by the legislature; and (4) day-to-day administration of the budget.  A sound budget classification scheme should also make it possible, for example, to determine the budget lines linked to poverty-reducing expenditure.

To make use of this functionality, a sound budget classification system should at a minimum comprise:

• a classification of revenues; and
• an administrative, economic, and functional classifications of expenditures.

Many countries use additional classification schemes to enhance transparency and accountability, and to better manage their finances (such as classification by geographical location, by beneficiaries of government transfers and subsidies, by source of financing, and by program classification). However, it is necessary to be careful in expanding the different types of classifications to be used. Such an expansion could possibly lead to unreliable information, due to the complexity of the budget nomenclature. It also requires more capacity and resources (both accounting staff and IT systems) to generate the required information and maintain the system.

Depending on the scope of the reform, and the conditions prevailing in a country, a reform of the budget classification can be a lengthy process, in particular to achieve full integration of the budget classification and the chart of accounts. The chart of accounts refers to the accounting classification (or financial reporting classification) that is primarily used for the administration, recording, and reporting on financial transactions. Changes are likely to be required in the legal and regulatory framework for the budget, the government’s financial management and information system, and training and outreach programs to raise awareness and upgrade the skills of staff in the ministry of finance and other government entities.

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This technical note provides a good case for the importance of budget classifications. It provides some good high-level technical advice in designing budget classifications. Some of the assertions, though, do not appear to follow standard practice.

Sequencing PFM reform is considered a good practice. This technical note generally supports this approach. But, the implied sequence does not appear to follow the typical pattern.

Issues to consider:

1. “Separate presentation in the accounting classification to ensure the proper recording of budgetary transactions” does not seem to follow typical practices. The (COA) Chart of Accounts should include all budget and accounting classifications. That does not mean that accounting data entry is more complex in automated systems. And, budget preparation and execution can be managed by filtering out any unnecessary accounting details.

2. “Once established on a sound basis, a classification scheme should not be substantially changed unless there are strong reasons; a stable classification facilitates both the analysis of trends in fiscal policy over time and intercountry comparisons.” This is an interesting ideal. In practice, governments adapt the classification scheme to improve outcomes. And, as indicated in Section VII, governments are constantly reforming. So, an ideal budget classification for any government, should it exist, often requires time to implement because of legal reform. And, there is no reason why changing details in the classifications can inhibit intercountry comparisons. Like with GFS, the intercountry comparisons can roll-up from the detailed COA. And, financial systems with multi-year Charts of Accounts enable comparisons such as viewing the 2007 fiscal year based on the 2010 fiscal year classifications.

3. The technical note recommends that 3 mutually exclusive classifications, administrative, economic, and functional should be used. These would represent segments within the COA. (Of course, the standard accounting or object segment is needed to support accounting functions.) The note suggests that financing source should be considered as an additional classification. This does not seem to be wise for emerging countries that have a high percentage of Official Development Assistance. The use of a financing source segment enables governments to track donor conditions. This makes it more likely that governments, rather than 3rd parties, will be entrusted in executing donor funds. This reduces transaction costs.

4. The addition of a program segment is typically sequenced later. The example provided shows how the addition of the program concept can extend the administrative segment. This approach is effective only when administrative units own programs. This is sometimes not the case. Expenditures can be controlled when there is a separate segment for program and administration. Automated financial systems support valid code combinations so that the 1 to 1 or 1 to many association between program and administration can be modeled and controlled. We have found a higher likelihood that functional and program classifications share the same segment.

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