The preparation and compilation of municipal budgets are regulated by the Local Government: Municipal Finance Management Act, 2003 (Act no 56 of 2003) (hereafter referred to as the MFMA) and the Municipal Budget and Reporting Regulations, 2008 (hereafter referred to as the MBRR).
Chapter 4 of the MFMA prescribes the procedures for the compilation of the budget, while chapters 2 and 3 of the MBRR specifically address the budget processes and procedures.
Previously municipalities’ budgets were for one year only. With the promulgation of the MFMA and the MBRR, municipalities had to budget for a three-year period. The purpose was to ensure municipalities have a three-year plan and budget accordingly. Unfortunately, most municipalities do not pay any attention to the outer years but focus only on the first year of the budget. Mostly the outer years are only a percentage increase of the first year ’s budget. This defies the purpose of the three-year budget schedule.
Many municipalities are not concerned if the outer years of the budget are funded. The normal response is that they are only concerned if the first year is funded. As a result, no proper planning is done. The budget is completed to comply with the prescriptions of Section 16 of the MFMA that the annual budget must be tabled at least 90 days before the start of the budget year, and Section 24 of the MFMA prescribes that the annual budget must be approved before the beginning of the budget year.
In many instances, the budget is prepared on a percentage increase of the current budget, with no consideration of actual results and/or historical factors. For example, tariffs for property rates and essential services are determined with a percentage increase on the current year’s tariffs. In many instances, the revenue is calculated in the same way, irrespective of the revenue that was levied during the current year.
The following basic principles should at least be considered when preparing and compiling the budget:
1. REVENUE CALCULATION
As mentioned above, many municipalities calculate their revenue based on a percentage increase of the current year ’s budget. No consideration is given to the actual results of the current year or the historical trends of the previous years.
Section 18 of the MFMA determines as follows:
(1) An annual budget may only be funded from –
(a) Realistically anticipated revenues to be collected;
(b) Cash-backed accumulated funds from previous years’ surpluses not committed for other purposes; and
(c) Borrowed funds, but only for the capital budget referred to in Section 17(2).
(2) Revenue projections in the budget must be realistic, taking into account –
(a) Projected revenue for the current year based on collection levels to date; and
(b) Actual revenue collected in previous financial years.
Many municipalities, however, calculate revenue using the current year’s budgeted amounts and add a percentage in line with the annual budget circular. In most instances, this is a total overstatement of the actual revenue to be levied.
The MFMA determines that the expenditure can only be funded from actual revenue collected. There are two significant problems with the incorrect calculation of revenue:
(1) The revenue to be levied is mostly overstated; and
(2) As soon as the municipality struggles to fund the budget, they increase collection rates.
The net effect of this practice is enormous and has been the downfall of many municipalities. If the revenue to be levied is overstated and the collection rate is inflated, it has a duplicated negative effect on the actual results. The main problem is that expenditure is budgeted based on the calculated revenue budgeted. The result is that the expenditure is incurred according to the budgeted amounts, but the revenue does not realize.
The following table is an example of how incorrect budgeted amounts can influence actual revenue:
Table 1 is a comparison of the budgeted amounts versus the actual amounts for 2018/19:
Table 1: Budgeted vs Actual for 2018/19
The municipality used the budgeted amounts for 2018/19 as the basis for calculating the budget for the 2019/20 – 2021/22 MTREF period. Table 2 reflects the budgeted amounts for the MTREF period:
Table 2: Budgeted amounts for the MTREF 2019/20 to 2021/22
The increases applied for the MTREF period are reflected in Table 3:
Table 3: Increases applied to calculate budgeted amounts for the MTREF 2019/20 to 2021/22
Suppose the same principles are applied to calculate the revenue for the MTREF period, but the increases are applied to the actual results for 2018/19 versus the budgeted amounts for 2018/19. In that case, there is a significant decrease in the budgeted amounts.
Table 4 reflects the budgeted amounts if the actual results for 2018/19 are used to calculate the revenue for the MTREF period:
Table 4: Revenue calculations using 2018/19 actual results as basis
The results comparing the budgeted amounts using the 2018/19 budgeted amounts and the 2018/19 actual results are reflected in Table 5:
Table 5: Decrease in revenue using actual results versus budgeted amounts as basis
The results, as reflected in Table 5, indicate the loss of revenue for this municipality when the wrong basis for calculations is used. For the MTREF period, 2019/20 to 2021/22, this municipality overstated their budgeted revenue with a shocking R116 689 309. Please bear in mind that this was before Covid-19. The effects of Covid-19 on the budget would be disastrous.
If the municipality had done a proper evaluation of their revenue and performed tariff modelling and proper calculations of revenue, they would have noticed that their revenue is overstated. However, the real problem that developed is that expenditure was calculated on the budgeted revenue, and the expenditure was incurred, resulting in severe cash flow constraints.
2. TARIFF CALCULATION
It is common knowledge that the practice of tariff modelling and calculation of tariffs is no longer used to determine tariffs for the budget.
Most municipalities increment current tariffs with a percentage irrespective of the results for the current year are in line with the budgeted amounts for the current year.
Tariff modelling is a complex exercise and an expertise that has almost entirely disappeared in municipalities. To be honest, very few municipalities have any idea of what their actual revenue will be when preparing the budget.
As mentioned above, these calculations are used to determine expenditure levels. As mentioned above, the expenditure is incurred, but the revenue does not realize. Therefore, it is just a matter of time before the municipality experience severe cash flow constraints.
Many municipalities cannot pay their Eskom accounts, and numerous other commitments are neglected because of cash flow constraints.
Tariffs are supposed to cover all expenditure, but many municipalities consider non-cash items, such as depreciation and contribution to provisions, as expenditure that does not need to be covered by revenue.
Let us be bold and consider the reason for the calculation of depreciation and the contribution to the provision for rehabilitation of landf ill sites. Both these items have no direct advantage for municipalities. However, in the private sector, companies can subtract these items from turnover and get a direct advantage through tax savings.
The main objective of these items is to ensure that the tariffs of the municipality are sufficient to cover this expenditure.
The municipality must make provision for the maintenance and replacement of assets. That is why depreciation and amortization of assets were included in GR AP. The replacement of the assets must be covered by way of sufficient tariffs to cover the maintenance and replacement costs.
The same principle applies to the contribution to the provision for the rehabilitation of landfill sites. The municipality must provide for the rehabilitation while the landfill sites are in use. How do municipalities intend to fund the rehabilitation if they do not provide for it while using it?
No budget can be credible if the municipality cannot provide evidence of how the revenue was calculated.
3. OPERATING EXPENDITURE
As mentioned previously, the concept of a three-year budget is to ensure that municipalities plan their expenditure for a three-year period after consideration of funds that will be available during this period. Many municipalities, however, use current budgeted amounts and increase budgeted amounts for the new budget with a percentage increase.
Many debates have been held on the principle of zero-based budgeting. The concept of this method is acceptable, but the current trend in most municipalities doesn’t allow for this principle to be applied. Applying this principle without thorough and accurate planning will result in an even greater disaster for municipalities than what is experienced with the current principles applied.
Although the roll-over budget, in terms of Section 28(2)( g ) of the MFMA and Regulation 23( 5) of the MBRR, is only allowed to approve expenditure in respect of roll-overs from the prior year, many municipalities must provide in this adjustments budget for virements done during the first two months of the financial year. Indeed, if a municipality must do virements during the first two months of a financial year, it clearly indicates that no planning was done during the budget process.
No municipality can adequately budget for repairs and maintenance without a proper asset management plan. The accepted norm for repairs and maintenance is 8% of the carrying value of assets. Unfortunately, many municipalities don’t come close to this norm, and a problem with this norm is that the percentage is based on the carrying value of assets. This doesn’t make sense as the decrease in carrying value means that repairs and maintenance decrease on older assets. Shouldn’t older assets require more repairs and maintenance than new assets? The only logic behind this norm is new assets acquired from grants, as many municipalities cannot install new assets from their own funding.
4. CAPITAL EXPENDITURE
This is probably the one area of municipal budgets where planning is done. Unfortunately, most of the planning is only done for the first year of the three-year budget cycle. As mentioned under operational expenditure above, no proper planning can be done without a detailed and proper asset management plan.
All assets of a municipality have an economic useful life. This expected useful life of any asset is determined by professionals based on historical facts. This implies that assets need to be replaced after their economic useful life. The trend in municipalities, however, is that when assets near the end of their useful life, the remaining useful life is extended as no provision was made for the replacement of the assets.
The reason why useful lives are determined upfront is to ensure that proper planning can be done to replace assets when they reach their useful life. Every municipality should have an asset management plan to replace assets when they reach the end of their useful lives. As mentioned above, that is the exclusive reason why depreciation and amortization were included in GR AP. Tariffs levied for services should provide to cover the cost of depreciation and amortization. Although the accumulated depreciation of assets at the end of their useful lives wouldn’t be sufficient to replace them, it would go a long way in ensuring that funds exist to assist with the replacement of the assets.
The asset management plan should be populated from the fixed asset register. The plan should record the end of the useful lives of all assets. The municipality can determine exactly when an asset will need replacement from this plan.
The Capital Replacement Reserve (CRR) was created to provide for the replacement of assets from its own funding. As this is a reserve, it must be cash-backed. With the cash flow constraints of municipalities, municipalities opted to remove the CRR. At least they comply as they don’t have a reserve that is not cash-backed, but they have zero reserves for the replacement of assets. The easy solution for municipalities is to extend the useful lives of their assets when they near the end of their useful lives.
This is a significant concern as many municipal services are rendered with infrastructure assets that are long overdue for replacement.
5. BALANCE SHEET BUDGETING
Many municipalities only do this because they must. No proper planning goes into this, and many of these municipalities cannot prove how they got to the amounts reflected in the balance sheet budget.
The balance sheet budget is a direct result of the operating and capital budgets, considering the collection of debtors, raising of loans, and other items that influence the balance sheet. Unfortunately, many municipalities struggle with their operating budgets resulting in the budgeted amounts for the balance sheet being totally unrealistic.
The setup of a municipality’s transactions on their financial system of ten is the main issue of struggling to do proper balance sheet budgeting. The setup is done so that numerous transactions are captured against the opening balance of a particular item. If the balance sheet budget is done with incorrect opening balances, it will be impossible to calculate any budgeted amounts accurately.
An easy example of problems experienced is between revenue and debtors’ control accounts. If a municipality budgets for water revenue of R25m, then the debtors’ control account for water should have the same amount against monthly billing. If the setup were done incorrectly, this would never reflect as such.
6. CASH FLOW BUDGETING
Most municipalities struggle to prepare a cash flow statement for the AFS, let alone do a cash flow budget for the next three years.
If a budget is adequately planned and all factors in respect of the cash flow are considered logically, the cash flow budget is not that complicated. National Treasury provides clear guidelines for the compilation of the cash flow budget. If these guidelines are followed, the results should be credible and defendable.
Municipalities should determine which items in the budget are directly linked to the cash flow. For example, levies for property rates and services will influence the debtors’ control account, and only the collection of these debtors’ accounts will influence the cash flow. Furthermore, pre-paid water and electricity will directly influence the cash flow budget and will not affect the debtors’ control accounts. Unfortunately, many municipalities make no distinction between pre-paid accounts and debtors’ accounts in the balance sheet and cash flow budgets. This is a basic principle when applied incorrectly, will have a significant impact on both the balance sheet and cash flow budgeting.
To demonstrate the effects of inflated collection rates, the same municipality’s budget is used as in revenue above. To fund their budget, the municipality calculated collections for property rates at 98%, electricity at 99% and water, sanitation and refuse removal at 97%. On scrutinizing the results for the prior year, it was discovered that actual collection rates were significantly less than budgeted for. Table 6 reflects the actual collection rates calculated on actual results in the prior year:
Table 6: Actual collection rates calculated on historical results
The inflated collection rates on the incorrect revenue budgeted resulted in estimated collections as reflected in Table 7:
Table 7: Estimated collections on inflated revenue and collections rates
The estimated collections using historical facts to determine revenue and based on collections rates as calculated from actual results in the prior year are reflected in Table 8:
Table 8: Estimated collections based on historical facts
The total reduction in cash collected between the budgeted amounts and expected results based on actual results from the prior year is reflected in Table 9:
Table 9: Reduction in cash collection based on actual results vs budgeted amounts
Table 9 clearly indicates the reduced results when a municipality does their calculations on actual results and facts versus inflated budgeted amounts to “balance” the budget. Expenditure budgets are based on revenue budgeted for and are incurred according to the budgeted amounts. Therefore, the reduced revenue to be collected clearly indicates why numerous municipalities are experiencing severe cash constraints.
Municipalities are, in terms of the MFMA and the MBRR, obliged to prepare a three-year budget known as the Medium-Term Revenue and Expenditure Framework (MTREF ). The MFMA is extremely prescriptive on the process to follow, and the MBRR determines exactly when any adjustments to the approved budget may be done.
The most significant issue that the budgets are not a true reflection of the actual results is clear when the adjustments budget for the current year is compared with the tabled budget for the new MTREF.
When municipalities prepare an adjustment budget to be approved during February of a particular year, it must include the budgeted amounts for the two outer years. Before the end of March of the same year, a three-year budget for the new MTREF must be tabled in Council.
When the two outer years of the adjustments budget, tabled during February, and the first two years of the budget, tabled during March, are compared, it is of ten totally different amounts budgeted for. This clearly indicates that the outer years of the adjustments budget were not planned but merely an exercise to comply with the prescriptions of the MFMA and the MBRR.
Funny enough, most municipalities receive green status on their strings for the submitted budgets. That is the biggest problem during the budget process, municipalities strive to comply with the requirements of the MFMA and to obtain green status in respect of mSCOA, but the contents of the budget do not reflect what will be happening during the next three years.
It must be stressed that many municipalities compile budgets to comply with the prescriptions of the MFMA and the MBRR without considering actual historical facts. As a result, budgets are prepared because they must be done, and no proper planning for the medium term is done and included in the compilation of the budgets.
Until municipalities adapt to ensure that their budgets are credible and a true reflection of what is really happening, the current state of municipal financial affairs will not improve.
Senior Manager: Mubesko Africa (Pty) Ltd