PART I:

The six phases of the budget cycle

Introduction: overview of the budget cycle
Figure 1 shows the budget cycle. The budget cycle is made up of six phases:

1. Phase 1 Strategic planning: determine the strategic priorities
2. Phase 2 Budget preparation: mobilise and allocate resources
3. Phase 3 Budget execution: implement planned activities
4. Phase 4 Accounting and reporting: generate financial information on
public expenditure
5. Phase 5 External audit: ensure the reliability of financial reports
6. Phase 6 Policy review: evaluate the results of public expenditure.

Below, each phase of the budget cycle is explained to you in more detail.


Figure 1: The six phases of the budget cycle

Revi ew Pol i c y
(6)
St r at egi c
pl anni ng (1)
Budget
Pr epar at i on (2)
Budget
Ex ec ut i on (3)
Ac c ount i ng &
moni t or i ng (4)
Repor t i ng
& audi t (5)
Revi ew Pol i c y
(6)
Policy
review (6)
Strategic
planning (1)
Budget
preparation (2)
Budget
execution (3)
Accounting &
reporting (4)
External
audit (5)



Phase 1: Strategic planning
Strategic planning is the first phase of the budget cycle. This phase should
result in:

1. setting the governments medium-term policy agenda
2. matching the policy agenda with the countrys medium-term
macroeconomic and fiscal framework.
Module 2: The budget cycle - Phases and tools (Part I) 1

Setting the governments strategic policy agenda
A starting point for the budget cycle is identification of the medium-term
policy agenda and assessment of the level of expenditure needed to effect this
agenda.

In many countries, the time horizon for such a strategic policy agenda
coincides with the cycle of parliamentary elections. In developing countries
the strategic policy agenda is generally formulated in the countrys Poverty
Reduction Strategy Paper (PRSP) or a similar national development plan.
PRSPs describe the country's structural and social policies and programmes
over a three-year or longer time frame to promote broad-based growth and
reduce poverty. The plans are prepared by recipient countries through a
participatory process involving domestic stakeholders, as well as the donor
community. The Ministry of Economic Planning (or Development) usually
takes the lead in the preparation of the PRSP. In many countries, the World
Bank has played a strong role in initiating PRSPs.

In practice, realistic costing of the PRSP to assess the level of expenditure
needed for its implementation is often insufficient. Consequently, in the
implementation of the PRSP, its policy objectives frequently appear to be too
ambitious in financial terms.

Matching the policy agenda with the macroeconomic and fiscal
framework
The expenditure level that is required to implement the governments
medium-term policy agenda should fit within a macroeconomic and fiscal
framework. This framework should include government objectives for two key
variables:

the fiscal position as indicated by the budget deficit, which is the
difference between government revenues and government expenditure
fiscal sustainability as indicated by the relative size of total debt.

Figure 2 shows the relationship between these two variables. It shows that a
budget deficit in any fiscal year results in an increase of the size of total debt.
The size of total debt has, on its turn, consequences for the fiscal position in
the forthcoming year through the requisite to pay the interest on total debt. A
fiscal position is regarded as non-sustainable if it results in such an increase
of total debt that the forthcoming annual budgets cannot meet the resulting
interest payments.





Module 2: The budget cycle - Phases and tools (Part I)
2

Figure 2: Sustainability of fiscal policy


Total revenues
Total expenditure
Budget deficit
Increase in costs
of total debt
Total revenues
Increase in total expenditure
Increase in budget deficit
Budget year T: Budget years T + 1, 2, 3:
Further increase in
costs of total debt
I
n
t
e
r
e
s
t

p
a
y
m
e
n
t
s


To get insight into the level of the budget deficit that is fiscally sustainable,
medium-term macroeconomic projections are a necessary tool. However,
making these macroeconomic forecasts is not an easy task. Resources and
expenditure are both influenced by macroeconomic variables that are outside
the direct influence of the government, such as interest rates, the exchange
rate, inflation, the oil price and economic growth. Furthermore, these
variables are interrelated. For example, raising the tax rate may positively
affect the fiscal deficit in the short term by increasing total revenue, but it
may negatively affect the budget deficit in the medium term by its downward
effect on economic growth. Moreover, in developing countries a major source
of uncertainty over the medium term is the availability of donor funds, which
often constitute a substantial part of financing government expenditure.

The preparation of the macroeconomic framework can involve advanced
econometric modelling conducted by specialised departments of the Ministry
of Economic Planning or Ministry of Finance. However, in most developing
countries, more basic economic models are being used, often with the support
of the IMF.

In theory, the PRSP should relate strategic policy objectives to a country's
macroeconomic and fiscal prospects. In practice, the link between a countrys
policy ambitions (in terms of poverty reduction) and budgetary feasibility is
often not well developed in PRSPs. A serious risk is that the PRSP remains a
wish list on paper without realistic prospects for implementation. You will find
Module 2: The budget cycle - Phases and tools (Part I)
3
more on this issue in module 3 on the Medium-term Expenditure Framework
(MTEF).



The preparation of a macroeconomic and fiscal framework should be an ongoing activity. The
framework needs to be prepared at the start of each budget cycle, but it must then be updated
throughout the further stages of budget preparation and budget execution. External changes,
such as a sudden sharp appreciation of the exchange rate, may require updating of the annual
budget.
Text box 1: Macroeconomic and fiscal framework

Phase 2: Budget preparation
In the second phase of the budget cycle, the budget for the forthcoming year
is prepared, possibly linked to the following years if a Medium-term
Expenditure Framework is in place. Budget preparation requires five basic
steps, which involve both the Ministry of Finance (the budget department)
and the line ministries. Figure 3 shows the five basic steps. Below the figure,
each step is examined in more detail.
Module 2: The budget cycle - Phases and tools (Part I)
4

Figure 3: Budget preparations in five basic steps


I. Determine
budgetary ceiling
M
i
n
i
s
t
r
y

o
f

F
i
n
a
n
c
e

L
i
n
e

m
i
n
i
s
t
r
i
e
s

V. Submit to
Parliament for
authorisation
II. Send budget
circular
III. Submit bid
IV. Negotiations
Parliament
Cabinet


1. Determine the aggregate expenditure ceiling
The Ministry of Finance prepares the aggregate expenditure ceiling for the
annual budget of the forthcoming year, which needs to be determined by the
cabinet. The aggregate expenditure ceiling gives the total available resources,
based on the medium-term macroeconomic projections and the fiscal policy of
the government (e.g. the maximum level of the deficit it aims at).

2. Prepare a budget circular
In the second step, the Ministry of Finance prepares a budget circular and
sends it to the line ministries. The budget circular presents indicative
spending ceilings (resource envelopes) for each ministry. It includes
instructions that enable line ministries to calculate their estimates for line
items. It also covers procedural matters such as the budget calendar.



Module 2: The budget cycle - Phases and tools (Part I)
5
3. Submission of bids by line ministries
Based on the instructions of the budget circular and their own priorities, the
line ministries formulate a draft budget. If the level of spending in the draft
budget exceeds the available resources in the envelope, the line ministry
submits a budget request to the Ministry of Finance for additional resources.

4. Negotiations between the Ministry of Finance and line ministries
If the total budget requested by line ministries exceeds the available
resources, the Ministry of Finance engages in negotiations with the line
ministries to lower their budget bids and to decide which budget items should
receive priority.

5. Cabinet endorsement and parliamentary authorisation
Finally, via approval by the cabinet, the budget proposals are sent to
parliament for authorisation.


Phase 3: Budget execution
After parliament has approved the budget, line ministries are authorised to
spend money. This involves five stages, as shown in Figure 4. Below the
figure, each stage is examined in more detail.
Module 2: The budget cycle - Phases and tools (Part I)
6

Figure 4: Budget execution in five steps


Authorisation
Commitment
Verification
Payment Authorisation
Cash payment

1. Authorisation
After parliament has approved the budget, line ministries are authorised to
spend money. However, this authorisation is limited to:

budget items: money approved for one line item (e.g. public
transportation) cannot be spent on other line items (e.g. building
schools) unless there are specific rules that regulate such virements
budget year: money that remains unspent in the authorised budget
year cannot be carried forward to be spent in the next year unless
there are specific rules that regulate such carry-overs.



Many OECD countries tend to provide line ministries with more freedom to manage their
expenditure, by broadening the description of budget items and permitting carry-overs.
However, when the public financial management system of a country is not (yet) well-developed,
such loosening of budget authorisation is generally not encouraged, in the interest of fiscal
discipline.
Text box 2: Flexibility in budget authorisation
2. Commitment
In the commitment stage, a future obligation is incurred. For example, by
signing a contract, a ministry may be bound to purchase some goods. The
gap between entering into a commitment and the associated cash payments
varies across expenditure categories. For large capital goods (e.g.
construction of a government building), the lag may be large and is likely to
extend beyond the end of the fiscal year. The registration of commitments is,
therefore, crucial for maintaining a precise overview of the available resources
Module 2: The budget cycle - Phases and tools (Part I)
7
for new expenditure. Nevertheless, in some systems, commitments are not
recorded on a timely basis.


3. Verification
The verification stage entails checking whether goods have been delivered or
services have been rendered. This is to determine whether the bills that have
been received should be recognised as a liability of the public sector.

4. Payment authorisation
In this stage, the payment order is given. To prevent fraud, a division of
responsibilities is a basic requirement. This means that the person who
authorises the payment should never be the same as the one who ordered the
supply/goods. Three systems for attributing responsibility for payment can be
distinguished:

Commonwealth system: the responsibility for payment orders is
decentralised towards spending ministries
Francophone system: the responsibility for payment orders is
centralised in the Ministry of Finance
Latin American system: the responsibility for payment orders is
centralised in the so-called contralora general, which also exerts a
pre-audit function on commitments.

5. Cash payment
The final stage concerns the actual cash payment. In some countries (mainly
Francophone), payments take place through a single account in a designated
bank administered by the Ministry of Finance. In others, payments are
conducted through the commercial banking system via bank accounts held in
the name of individual line ministries.


Phase 4: Accounting and reporting
During the budget execution phase, the commitments and payments need to
be monitored. This is done by accounting, which can be defined as the
maintenance of basic records of government transactions. The primary aim of
the accounting system is to deliver reliable information on the governments
financial position. Accordingly, accounting systems are also referred to as
financial management information systems. The financial management
information system is being used by line ministries as well as the Ministry of
Finance, and should ideally be integrated.

Phase 4 ends with the presentation of the governments annual statement or
financial report. The aim of this financial report is to inform parliament on the
results of the budget execution phase. On the basis of this document,
Module 2: The budget cycle - Phases and tools (Part I)
8
parliament can conclude whether the budget has been executed in accordance
with the appropriations.

For various information requirements, the governments transactions can be
reported using different classifications. Four classifications can be
distinguished (see Figure 5).

Figure 5: Budget classifications
Economic classification
Administrative classification
Functional classification
Programme classification

Economic classification categorises expenditure into economic categories,
such as expenditure on wages/salaries, subsidies and capital expenditure. For
international comparative purposes, the IMF has developed the GFS
(Government Finance Statistics) economic classification scheme.

Administrative classification categorises expenditure according to
administrative responsibilities. The governments organisational structure
(ministry, department or agency) constitutes the basis for this classification.

Functional classification categorises expenditure according to its purpose,
such as education, social security, housing etc. It is independent of the
governments organisational structure. For international comparative
purposes, the United Nations has developed the COFOG (Classification of the
Functions of Government) functional classification scheme.

Programme classification categorises expenditure according to government
programmes. A programme is a set of activities that aim to meet the same
set of objectives. Such programmes may transcend administrative and
functional boundaries. For example, a government programme that aims to
decrease the number of HIV/AIDS victims would not generally be confined to
the health ministry, but may include a broad array of activities ranging from
education to social welfare.



Most countries apply a combination of an administrative and an economic classification. First of all,
expenditure is divided across ministries. Within ministries, the division among line items is then
traditionally based on economic classifications. In the development towards performance-oriented
budgeting, some OECD countries combine an administrative classification with a programme
classification.
Text box 3: Combination of classifications
Module 2: The budget cycle - Phases and tools (Part I)
9
Phase 5: External audit
As noted above, phase 4 ends with the governments financial report. This
report informs parliament on how the budget has been executed and the
countrys financial position at the end of the fiscal year.

To assure the reliability of the information included in the financial report, it
must be accompanied by a statement from an external auditor. In most
countries, the role of external auditor is fulfilled by the supreme audit
institution (SAI). The legal position of the SAI and its legal tasks vary across
countries. These differences are examined in detail in Module 6.

A common feature of SAIs is their responsibility to issue a judgement
concerning the quality of the information included in the financial statement to
parliament. With the objective of issuing such a judgement, the SAI performs
a regularity audit. In a regularity audit, two audit types with different
objectives can be identified:

Financial audit
This form of auditing makes an assessment of the financial statements.
It seeks to determine the accuracy of the data contained in financial
statements and reports. The purpose is to assess the assurance that
these statements properly depict the financial activity and conditions of
the audited entity.

Compliance audit
This form of auditing aims to ensure the legal propriety of transactions.
For individual transactions, it examines whether the appropriate
authorisations and documents are present. This type of audit enables
the auditor to identify any instances of illegal or improper transactions.



Besides regularity audits, the SAIs of most western countries also conduct performance audits, which
aim to evaluate the efficiency and effectiveness of government expenditure. These are less concerned
with financial issues, as they focus on government expenditures added value for society (value for
money). Such performance audits are not related to the quality of the annual report of the government.
As such, they are not part of phase 5 of the budget cycle, but belong in phase 6: policy review.
Text box 4: Performance audit

Phase 6: Policy review
The last phase of the budget cycle concentrates on the evaluation of
government policies. Based on policy evaluation, a government can decide to
alter its policies. Such policy changes need to be taken into account in the
strategic planning stage of the next budget. Accordingly, policy review should
Module 2: The budget cycle - Phases and tools (Part I)
10
be an integrated phase of the budget cycle. However, it is not necessary to
evaluate all government policies in-depth each year. This would be too costly
and add too little value. A more efficient approach is to schedule evaluation at
intervals of various years. The planning and control of such an evaluation
schedule forms part of the budget cycle.

The responsibility for policy review is not clearly established, with various
actors involved (if any policy review takes place at all). The first actor is the
line ministry in charge of the policy, but other ministries, such as the Ministry
of Finance, can also be involved. The SAI can do policy review through its
ability to conduct performance audits. Furthermore, in developing countries,
the Ministry of Economic Development and international organisations such as
the World Bank, often play a role in the review of the countrys policies.

The review of policies can focus on various aspects. The following three
criteria are often used in policy review:

Relevance
Relevance refers to review of the assumptions relating to the needs to
be satisfied or socio-economic problems to be solved that are used to
justify the intervention. Evaluation verifies the real existence of these
needs and problems, and ensures that they cannot be met or solved by
existing private or public initiatives.

Effectiveness
Effectiveness relates the policies to the effects (or outcomes) that have
been obtained. Evaluation investigates whether the policy objectives
have been achieved, and whether this is because of the policy
instruments that the government has implemented.

Efficiency
Efficiency concerns the costs of the policy. Evaluation assesses whether
the goods/services produced by the government (outputs) and the
policy effects in the society (outcomes) have been obtained at a
reasonable cost. Efficiency can be assessed by answering the following
question: Could more outputs (and effects) have been obtained with
the same use of resources by organising the implementation differently,
or could similar outputs (and effects) have been obtained using fewer
resources?


In this module, strategic planning is presented as the first stage of the budget cycle. However, strategic
planning is based on review of the policies of the previous budget cycle since policy review determines
whether current government policies will be continued. It can therefore be argued that policy review
constitutes not only the last stage of the budget cycle, but also the first stage of the next budget cycle.
Text box 5: The budget cycle is like a spiral with no end or beginning
Module 2: The budget cycle - Phases and tools (Part I)
11