Table of Contents

Bosnia and Herzegovina

Special Audit Report Summary

June, 2001

Objective

The purpose of the audit of Bosnia and Herzegovina was to:

• Obtain a high-level level overview of selected internal controls concentrating on financial and disbursement controls;

• Recommend improvements to the control system;

• Recommend further audit work and/or financial investigations for the purposes of planning and coordinating future audit work done by the Supreme Auditor, Financial Police and various international groups.

The focus of the audit and our reports is on improving control systems. General recommendations for improving control are included in all reports. By necessity recommendations are general due to the magnitude of the problems observed and the need for major vs. minor improvements. In most cases improvement will involve detailed study of the environment and the development and/or redevelopment of entire control systems with considerably more emphasis on improving enforcement, which is beyond the scope of this audit.

This audit was not intended to be a complete or sufficient review of BiH or any individual Ministry or canton to enable the auditor to form an opinion on financial statements or overall system of internal control nor was it intended to detect fraud. Resources were limited by design, and the work to be accomplished was hampered by the large number of unusual transactions requiring additional follow up, poor and/or incomplete (or not provided) documentation and unreliable financial records and control systems. The poor state of documentation and weak (or overridden) financial controls resulted in significantly more investigation at the transaction level than would have been required if the control systems could have been relied upon. In many cases it was almost impossible to verify transactions due to the lack of sufficient documentation. In some cases we questioned the validity of the documents provided.

The individual transactions and examples given in our reports are presented as illustrations of the poor control observed. Although some of these transactions may turn out to be fraudulent, others may not and are presented to illustrate bypassed or lax controls and/or the potential for error and/or fraud. Based on our findings we recommended further Financial Police investigations be conducted of some areas. Detailed transaction-by-transaction analyses of potentially fraudulent activities are the responsibility of the Financial Police and are beyond the scope of this audit. On-going, comprehensive evaluations of the existing control systems for individual ministries, cantons, agencies, etc., for the purpose of drawing a conclusion as to the overall adequacy of that control system are the responsibility of the Supreme Audit Institutions. The focus of Financial Police investigations is forensic in that they look to investigate past abuses. The purpose of the Supreme Audit Institutions is to evaluate existing control systems, recommend improvements and monitor corrective action.

Scope

We selected the Federation and the Republic of Srpska and four cantons located in both the Croat and Bosniak areas for our review. The cantons include Cantons 7, 8, 9 and 10. Limited work was also done in Cantons 4 and 6. The selection of the areas reviewed was intended to provide a broad overview of controls throughout BiH. Selection of ministries, agencies within each entity or canton was made on a judgmental basis. Transactions within the ministries and agencies were also selected on a judgmental basis emphasizing larger KM value transactions. Time was the limiting factor. Staffing for this audit consisted of 6 international auditors, who, with one exception, spent from 5 to 7 weeks performing the fieldwork assisted by one local translator/assistant. Therefore, each entity, canton or ministry had one international auditor assigned who spent anywhere from 2 days to 7 weeks. In the case of the RS, the international auditor was assisted by a competent, contributing member of the Supreme Auditors staff for 7 weeks, who was instrumental in surfacing a number of serious issues.

Conclusion

Although the audit only examined selected transactions in selected cantons, ministries and agencies, we were struck by the consistent and frequent repetition of the same sorts of problems in every area observed. This frequency and consistency of issues resulted in our concluding that the problems are likely systemic throughout Bosnia and Herzegovina. Based on the limited audit work performed, we do not believe the system of internal control as it is currently administered is adequate to protect the public assets of Bosnia and Herzegovina against losses due to fraud, incompetence and carelessness. We noted that many documents, which we sampled, were officially stamped, approved and supported by government decisions. This evidence along with discussions with various Ministers and staff suggest an adequate system of internal controls is in place. However, upon further investigation, we found the substance of these apparent controls to be lacking. For example, decisions were often vague and/or illegal, little or no follow up was performed to ensure the funds were expended as intended, supporting documentation was incomplete, methods of selecting vendors were inappropriate and it is evident that controls can be easily circumvented.

• In both the Federation and the RS, we found a significant number of government decisions, conclusions, etc. were used to support inappropriate uses of government funds. Many of these decisions did not appear in the Official Gazette and appear to be illegal.

• We found practices for selecting vendors to be weak resulting in biased selection of vendors and paying too much for goods, services and freight. Where controls did exist, they were often overridden for a number of "reasons" and/or the agency/ministry decided on the companies to invite to bid rather than going to public tender, which enabled the system to be manipulated. We noted several other examples where no bidding took place, and prices paid were significantly higher than could be obtained from other vendors. We found instances of changing final bid prices and "unexpected works" doubling the project cost over the accepted bid price. In some cases we recommended the Financial Police investigate certain suspect vendors.

• We noted numerous three-party barter style transactions were used, which effectively obscured the underlying purpose of the transaction; and in some cases, appears to have covered up for diverting funds.

• Poor financial control and lax record keeping was evident in throughout the areas we examined. Budgets were not actively used to control spending. Financial analysis to support spending was non-existent or weak. Financial reporting was significantly after the fact or not done at all, negating its value. Follow up to ensure monies advanced were spent as intended could not be located. Evidence of proper matching of appropriate documents to support expenditures prior to releasing funds was not present.

• We found ministries who borrowed unchecked from government agencies and other sources. They claimed this was their right and they were not required to obtain approval from the Minister of Finance or even notify him.

• Duties are incompatible and not adequately segregated. For example, cashier and payroll duties are usually handled by one individual including calculating pay, obtaining the money from the bank, stuffing envelopes, distributing pay and posting records.

• Although in some cases we were provided with volumes of documentation, it was often inconsistent, insufficient, illogical and/or inappropriate. In some cases we suspect documents may have been fictitious. In many cases the supporting documentation was vague as to reason for expending the funds or the work to be accomplished.

• In the case of Cantons 7 and 8 our audit efforts were deliberately obstructed. In other cases, documentation was delayed for a matter of weeks and/or the documentation provided was not what was requested. Some explanations or reasons for expenditures changed drastically upon confronting individuals with additional facts.

Although our audit was not intended to detect fraud, we detected numerous irregularities, which may have resulted in fraud, and we recommended the Financial Police complete a detailed investigation of these areas.

During our audit, members of our team received first-hand knowledge from individuals who were asked to produce fake bids or invoices, employees asked/forced to sign for cash they never received and the existence of two sets of books in at least one Ministry. Understandably, the individuals who talked to us were not willing to go on the record due to fear of losing their jobs or worse. We present this information here merely to illustrate how easy and common it is to override controls within Bosnia.

We are especially concerned with the control environment and control consciousness, which resulted in lax controls and known abuses. This overarching issue will not be corrected by merely adding additional controls or processes regardless of their sophistication or breadth. As long as individuals in positions of power at all levels can individually or in collusion with others override internal controls, these controls are reduced to meaningless bureaucratic steps, which must be followed to produce the "illusion" of control. Therefore, as controls are developed alone or with assistance of various international organizations, we caution the developers to include and emphasize enforcement and independent review as an integral part of the control design.

We do not believe anything substantive will change without a strong and truly independent oversight body such as the Supreme Audit function. We understand the Swedish National Audit Office is working to strengthen these institutions, and we fully support this activity. However, we believe progress will be slow and can be easily stagnated and eroded as long as the Supreme Audit functions are dependent on those they audit for their funding and decisions as to what will be audited. We believe ensuring substantive effective independent oversight is critical to improving control. We recommend options for building, improving and protecting the Supreme Audit functions be explored and a plan developed. Given the nature of the issues and the state of the controls, we believe significantly more resources will need to be dedicated to the Supreme Audit functions for the foreseeable future in order to provide adequate coverage. These resources will need to be trained and developed in the application of internationally recognized standards. Audit staff will need to be compensated at a level, which attracts and retains highly professional staff and is sufficient to reduce the temptation to accept bribes. Government officials will need to be educated as to the role of the Supreme Auditor as well as their own role in helping establish, improve and enforce internal controls.

Additional actions to be explored for improving oversight include establishing an audit committee at the BiH level, and having the Supreme Auditor(s) report directly to this committee. Other options include evaluating if and/or how to involve the international community in the audit process to strengthen the oversight process and protect their interests until such a time as the appropriate Parliamentary Committee(s) are strong enough to ensure audit results are dealt with in an appropriate, independent and non-political manner.

Unfortunately, the controls, which need to be developed and implemented, are not quick fixes. Lasting corrective action requires additional study and analysis, carefully developed polices and procedures, new and/or revised laws, training, development and careful implementation, which is tailored to the control environment in Bosnia. In the short to medium term, these actions will require more controls and significantly more oversight than would be required in other environments. These actions will require significant resources to be dedicated to improving the controls.

Although we received considerable cooperation from newly elected public officials in locations where the government changed hands, we are not convinced that substantive changes will take place. In some cases we were disappointed at the apparent lack of interest in correcting the problems. Instead, the emphasis appears to be on discrediting the outgoing government for political purposes and weakening the effectiveness of the Supreme Audit function and not on serious corrective action to prevent future abuses. We fear that, as in the past, any corrective action will be more cosmetic than substantive; and the abuses will continue.

Republika Srpska

Special Audit Report

May 2, 2001

Purpose

An international team under the authority of the Supreme Auditor undertook this limited review of the RS. This audit was conducted at no cost to the RS or the Supreme Auditor. This audit is part of a larger Bosnia and Herzegovina planning audit to obtain a financial overview of government institutions, identify some major risk areas and recommend priorities for future audit work to be done by Supreme Auditor, national or international agencies under his authority within the RS. The audit was and is not intended to be a complete or sufficient review of the RS to enable the auditor to form an opinion on the financial statements or overall system of internal control or was it intended to detect fraud. By design, audit resources were limited and consisted of one international auditor in the RS, one member of the Supreme Auditors staff and an assistant for six to seven weeks each plus limited time of international and local staff in Sarajevo. A complete audit of the RS including municipalities and ministries properly falls within the competencies of the Supreme Audit Institution of the RS.

The cooperation of the RS government, Ministry of Finance, Supreme Auditor and other agencies we dealt with was instrumental in enabling the audit team to surface a number of significant issues in a short period of time. Ms. Raujkovic from Mr. Cekos staff was extremely helpful and a welcome addition to the audit team.

Conclusion

Based on the limited audit work performed we do not believe the control system is adequate to protect the public assets from losses due to fraud, incompetence and carelessness. Although our audit work was limited, we nevertheless surfaced serious problems and abuses. Most of the known abuses resulted from compensation transactions processed through Commodity Reserves, which were supported by illegal Government Decisions. Timely detection and reporting of the problems was seriously impeded by the outgoing governments failure to adequately fund and support the Supreme Audit function.

The system of internal control needs to be significantly strengthened in order to prevent similar abuses in the future. We are especially concerned about the control environment and overall attitude toward implementation and enforcement of internal controls. The recently installed new government has expressed a strong desire to implement necessary changes to prevent future abuses. We support and encourage this activity and recommend they start by implementing and enforcing a strong framework and system of internal controls. We further recommend steps be taken to ensure the on-going independence and effectiveness of the Supreme Auditor function. We also recommend reports of the Supreme Auditor go beyond the RS and include regular reporting at the BiH level. Adequate measures should be taken to protect the funding of the Supreme Auditor in order to prevent the problems, which occurred under the old government, from recurring.

We recognize that the new RS government has a political interest in exposing the inadequacies of the previous government. However, the true test of their commitment to good government and transparency will be the budgetary reforms that they enact to prevent future abuses.

Scope

We identified and flowcharted major money flows through the RS budget accounts and various government departments and agencies. (See attached charts.) We judgmentally selected government accounts for review primarily concentrating on higher KM value accounts as well as items identified by government officials, newspaper articles or international staff. The Department of Defense was excluded from this review. The audit coverage was limited to what could realistically be covered by two auditors within the predetermined seven-week timeframe.

The following areas were chosen for more detailed examination:

• Compensations undertaken in the 2000 RS government accounts. A compensation is a transaction (sometimes translated as an "offset") representing a barter-style arrangement. If A owes B, and B owes C, and C owes A; then the three parties agree to settle each other debts without money flows. It is a requirement under the old SPP system that all parties enter an equal and opposite debit and credit in their own giro account.

• Commodity Reserves. This is a department set up to manage strategic reserves of oil and foodstuffs for the RS. It, however, in practice plays a large part on the use of oil for barter payments and for specific grants.

• Government Decisions and Potential Obligations. Because it was clear that Government Decisions had a significant impact on finances for 2000, a review was undertaken of the effect of Government Decisions; and, as far as possible, those that were promulgated in the last three months of 2000, just prior to the change in government.

Internal Control Recommendations

Ensure government decisions are in accordance with the laws of BiH and are properly approved and gazetted. Eliminate any and all business dealings, which are in fact, conflicts of interest or have the appearance of conflicts of interest. The new government provided us with a decision of the former Prime Minister exempting NIRS oil refinery from customs taxes. (The latest estimate from CAFAO is that this decision cost the RS KM 29 million in lost revenue.) Upon investigation by our legal staff in Sarajevo, we found that this decision was not legal in that it overrode the law of BiH. In this particular case the decision benefited the NIRS oil refinery at the expense of the citizens of the RS. We also found decisions which were not logged and which never appeared in the Official Gazette. Decisions, which were not gazetted, are considered deliberate attempts to circumvent the law. Inappropriate decisions and conflicts of interest enabled many of the problems noted in this report to occur.

Since government decisions often involved extra-budgetary expenses, we reviewed all decisions made in the last three months of 2000. The review was not fully comprehensive due to limited available audit resources. However, we identified KM 20.4 million of expenditures, which do not appear to have been included in the budget. We recommend a thorough investigation of the decisions be immediately undertaken to surface all expenditures and liabilities. If we add the KM 20.4 million noted here to the KM 87 million in liabilities relating to Commodity Reserves and other known losses (excluding doubtful debts and inventory) and the claims made by Electroprivredna, we identified a potential total of over 120 million in unbudgeted expenses. (Further detail is provided later in this report.)

Other expenditures supported by decisions appear to be outside the responsibility of the government. For example, it is difficult to see how a specific separate decision (GD 769/00 to award KM 16,390 to the daughter of the mayor of Prijedor to study Spanish at London University is appropriate or within the scope of government.

Within the government itself there was difficulty in locating copies of a full set of relevant documents. There appeared to be no register since government staff did not produce one when we requested it. We were told that one decision we requested was referred to as a contract, and we would need to ask the supplier since there was no copy held in the government archives.

Eliminate the use of compensation transactions or significantly improve the budgeting, accounting and administration of these transactions to prevent abuse and ensure transparency in reporting. Compensation transactions represent barter-style arrangements where debts are settled without cash changing hands. Compensation transactions for 2000 were valued at approximately KM 101 million. This included Oil Excise Taxes representing 59.6% of the total oil excise taxes booked in the RS accounts for 2000.

Compensations circumvent budgetary controls, distort income and expenditures and make it difficult to match transactions to the correct accounting year. The recording for such transactions has been confusing and often obstructed the true purpose of the underlying transactions. As shown below, compensations encompassed a wide range of transactions, most of which were hidden in the apparent loss of KM 33 million of Commodity Reserves.

The bulk of the transactions are oil based. However, in the case of the Ministry of Defense, substantial amounts of food (primarily meat) supplied through Commodity Reserves is included in their totals.

Much of the compensation activity was used to settle government liabilities, primarily road contractors, in oil rather than cash. This activity is difficult to control and subject to abuse and manipulation. In relation to the refinery NIRS, we noted several important matters:

• Prices paid on all transactions were established by NIRS. Although recent high fluctuations in oil prices together with the effect of sales tax makes it difficult to be precise, the prices charged appear to be the same prices as charged at the roadside pumps. There is no apparent discount for government purchases of substantial amounts of oil. Although a small 2.25 percent discount is given to the Minister of the Interior, this is for paying in advance.

• The payee has to bear the cost of selling the oil and has to do it at a discount from the marker price set by NIRS. The Roads Director estimated that the discount is in the order of 20% to 25%. Although contractors prefer to be paid in cash, they are told they have to accept oil and presumably build the cost of the discount into their prices, further increasing the cost to the government.

• The primary beneficiary of these oil related compensation transactions appears to be the NIRS oil refinery. The Prime Minister of the RS at the time these transactions took place personally signed the documents, approving these activities.

The government of the RS periodically issued Government Decrees ordering "grants" or "gifts" of oil to be given to certain organizations.

• The stated purpose of some of these grants is vague ("for administrative efficiency") and some of the volumes given appear to be grossly inconsistent with the stated purpose. For example 3 million liters of heating oil was allocated to Prijedor in 2000. In the case of Electropirvredna, the stated purpose was to compensate for poor quality of coal from the mines. This reason was not upheld by Electroprivredna. Apart from grants to Electroprevdna, the grants were administered through Commodity Reserves, a separate entity not under Government control.

• Not all of the recipients of "gifts" or "grants" are within the Republika Srpska. The recipients include a municipality in Serbia, Cacak and a Belgrade Newspaper, "Politika".

In addition to the above, we noted the following financial control and reporting problems due to the use of compensations:

• Compensations are outside normal budgetary controls and are seen as a way of obtaining more resources than allocated through the budget. One individual we interviewed said that his department had been particularly successful at getting compensations, which enabled them to supply electricity to Collective Centers.

• Compensations incorrectly allocated costs to departments. A KM 18 million of Roads expenditure was charged as a loss to Commodity Reserves. A further 10.3 million of road expenditures was agreed as a compensation but not activated. However, the related obligations were omitted from the year-end statement of the Roads Department.

• Compensations resulted in recording expenses in the wrong period. KM 3 million of the 2000 Budget Compensation relates to an advance payment by the Minister of Interior in respect to their estimated fuel consumption for 2001. KM 2 million of the agriculture support is from 1999 or earlier together with KM 16 million of the amount charged to Ministries. A series of compensations for KM 2.5 million with Elektroprivredna relates to discounts given refugees in the period 1995 to 1997. There is a further unactioned compensation for KM 2.1 million for the same matter.

Although compensations have historically been justified on the basis of cash flow difficulties, they offer significant opportunity for abuse and misreporting, which obscures the substance of the individual transactions. We recommend they be eliminated totally, however, if this cannot be accomplished, we recommend implementation and enforcement of strict policies and procedures, which ensure total and complete control over the budgeting, disbursement, approval, pricing, and accounting be adopted and enforced. The accounting should highlight the underlying purpose as well as the details of the transactions and ensure expenses are recorded in the proper accounting period.

Eliminate Commodity Reserves or significantly improve oversight, accounting and control of this function. Many of the problems noted with regard to compensation transactions were realized due to the relationship between compensations and Commodity Reserves. Commodity Reserves is a separate department, which is not included in the consolidation of the RS government accounts and is not under their direct control. During our review, Commodity Reserves was under investigation by the Financial Police, and the former Director of Commodity Reserves was recently arrested for financial irregularities.

The powers of Commodity Reserves are very wide:

To provide professional and other activities relating to the acquisition, disbursement, supply, storage and use of the republics commodity reserves. They are also responsible for taking measures to intervene on the market, taking measures for building of warehouse space for storing of the republics commodity reserves as well as co-operation with organizations for commodity reserves in municipalities and companies.

Clause 45 of Commodity Reserves Terms of Reference

In practice, Commodity Reserves activity can be divided into three parts.

1. Agricultural Support to support farmers in the harvest and sowing season by charging for diesel fuel at special prices (normally without excise tax). They also engage in barter activity at the request of the Ministry of Agriculture.
2. Implementations of Government Decisions to pay in oil (petroleum) executed by government decree, formal letter or after the event authorization.
3. Trading on their own account principally importing meat products, cooking oil and petroleum products. These transactions were primarily undertaken at the discretion of the Director and his staff at the request of their end customer.

We noted a number of serious problems, irregularities and control weaknesses, which present significant opportunities for fraud.

• There is no knowledge of where the petrol goes after it leaves the refinery. All Commodity Reserves has is the vehicle number and the drivers signature. Although practical issues such as the customers lack of storage facilities may require the load to go elsewhere, this does not mitigate the lack of control. Financial Police in conjunction with their own investigation into Commodity Reserves have taken statements from apparent recipients of oil cargoes to the effect that they never received the consignment.

• There are no controls in the department to stop deliveries in excess of the agreed amounts prior to delivery. In the year-end compensation balances there is an amount of KM 876,000 described as "borrowed money according to the decision of the government." In fact this amount represents deliveries in excess of allocation. In the case of the milk company, Commodity Reserves staff expected to be paid back in milk but were not sure. However, repayment is not likely since we were later told that the State controlled milk company was operating at only 3 percent of capacity despite substantial investment by USAID.

• The Commodity Reserve system appears to be a blank check to increase the resources available to government ministries and their personnel. The volumes being used are difficult to reconcile with the needs of the ministry. In the case of the Ministry of the Interior, they are buying petrol direct. Commodity Reserves staff told us that the purpose of the Education Departments petrol requirement was to transport students. However, they did not know why the Ministry of Justice required such large amounts. The largest requirements were for the Ministry of Defense and the Army, but the totals charged include significant quantities of food, which were not separated in the records.

• Commodity Reserves accounting for compensations requires matching with proforma invoices. Therefore, deliveries made in 2001 were not included as payable in the 2000 accounts. Of KM 4 million granted for Banja Luka roads, only KM 330,456 was included in 2000. The Banja Luka Mayors office understood that a further KM 1.6 million has since been paid. Significant resources will be needed to identify both the amounts delivered in 2001 and the amounts, which remain undelivered and payable at year end. We estimate this amount to be approximately KM 3 million.

• Only certain customers were allowed to import oil. These included the refinery at Srpski Brod (NIRS), its subsidiaries and Commodity Reserves. Commodity Reserves would arrange the import of oil from the customers nominated foreign supplier. The customer would provide his or her own transport. Commodity Reserves then charged the customer the suppliers cost, forwarding costs, excise tax and a KM 0.01 per liter commission. Method of payment varied from full payment in cash to cash payment of excise tax and assumption of the suppliers debt. There was no verification of the appropriateness of the customer or supplier. Customers were required to pay in cash unless they "trusted" them in which case they would be allowed credit. There was no credit criteria or evaluation of credit worthiness. In one case a customer who always paid in cash in advance turned out not to exist, which is a common scam to avoid paying RS sales tax. Suppliers existed in a number of countries including Lichtenstein (Oil from Slovenia) and the British Virgin Islands (Oil from Russia).

• Inventory value at December 31, 2000 was KM 15.8 million of which KM 946,000 is in the USA and KM 801,000 is in the Federation. The Trade Department Inspectors report dated February 26,2001 shows book-physical losses of KM 5.8 million while the accounting records show a loss of only KM 19,000. From this we can only conclude that controls over inventory and accounting are extremely lax. We were told that there were no stocks of petroleum products and the only item in Commodity reserves records in excess of KM 1.6 million was 21,000 tons of wheat valued at KM 6.1 million. There are 168 warehouses and no clear understanding of how the goods stored would be sold.

• BIM-Galames a meat-processing factory headquartered in Brcko, owed the refinery KM 2,350,000. Commodity Reserves had the debt assigned to them and should have paid the refinery but had not done so as of the date of our audit. The Banja Luka branch of BIM-Galames issued two invoices for KM 2,350,000 for meat goods held in their warehouse. The only "order" for these goods was a certificate from Commodity Reserves saying that the goods were for onward sale. Commodity Reserve staff suggested this order might be used by the army. Government Decision 1309/00 instructs this order to be a compensation for Food for the Army of KM 2.8 million, but it was not accounted for in 2000. KM 600,000 has been invoiced in 2001. We understand the new government stopped this compensation. However, the problem with the meat products remains unresolved. This transaction should be investigated further to find out what is behind it.

• Commodity Reserves Accounts Receivable include a number of balances brought forward from when Commodity Reserves was based in Pale (prior to March 1998). Although a provision of KM 25.5 million was made for those items, there were no details available as to how this amount was determined.

• While reviewing balances over KM 500,000, we identified KM 28.6 million owed by government or public bodies. These include KM 10 million in respect to pensioner food parcels, which are potential losses to the RS budget. In addition, we found a debit balance of KM 18 million described as money owing to the budget. According to Commodity Reserves staff they are awaiting instructions for compensation.

• Commodity Reserve bank loans of KM 5 million date back to March 1998 when they were located in Pale. In 2000 KM 3 million was borrowed from Kristal Bank to be repaid on 31-8-00. The loan was not repaid, and Kristal Bank has frozen all accounts with Commodity Reserves.

• The accuracy of the amount of taxes owed by Commodity Reserves to the RS Government is the focus of a current investigation by the Financial Police. Since Commodity Reserves is not consolidated into the RS Government Accounts, any tax remittances to the RS Government will increase the losses of Commodity Reserves.

• According to a 2000 Trade and Tourism Ministry Audit Report on Commodity Reserves, many of the peasant co-ops could not take delivery of the oil they were entitled to for agriculture support because they were too poor to pay even the subsidized price. However, no reference was made to where the oil may have gone.

• Most decisions for Agriculture support require Commodity Reserves to go through a public tender process for petroleum purchases. We could find no evidence that this was done. Although 5 percent of the oil come from Slovenia, the balance came from the refinery at Srpski Brod. As previously noted the refinery appears to be charging the same price as charged at the pump.

The entire system of compensations needs to be overhauled. The need for these transactions should be studied to eliminate those transactions, which are better controlled by other means. If there remains a need for Commodity Reserves, a rigorous system of internal controls should be developed, adopted and enforced. Controls should include but not be limited to:

• regular inventories and investigation of losses,
• prompt collection of amounts due,
• independent reconciliations,
• controls over deliveries (amount, beneficiary, location, etc.)
• adequate segregation of duties,
• recording liabilities in the period incurred,
• financial analysis to justify compensation amounts,

• prompt remittance of taxes,
• write off of uncollectable amounts,
• government approval for taking on bank debt,
• inclusion of amounts received via commodity reserves under budgetary control to prevent overspending,
• public tender to obtain best price
• monthly financial statements and analysis and
• regular annual or more frequent independent audits by the Supreme Auditor.

Simplify the tax collection, distribution and expenditure systems to help ensure ease of understanding, consistency and transparent reporting. Schematic diagrams of the tax system, budget flows and expenditures are attached. These charts reveal at a glance complicated and inconsistent processes for collecting, allocating, budgeting and spending of government revenues. The current system includes many inconsistencies including how taxes are remitted to Ministries, since some taxes, such as Forest, Water and Railways, bypass primary budgetary control and go directly to the Ministry involved. The use of compensations for several transactions further complicates the picture. Complexity needlessly increases confusion, administration costs and the potential for abuse. We recommend management simplify their systems to:

• Improve understanding and control.
• Ensure transparency of reporting.
• Adopt internationally recognised best practices for governmental accounting.
• Ensure consistency in hypothecation, allocation, budgeting, collection, processing, payment, documentation, etc.
• Ensure remittance to central tax accounts for further distribution to Ministries in accordance with a consistent policy.

We understand that these issues are being addressed by the RS government in conjunction with various international agencies.

Eliminate the use of compensations as a means of paying taxes. As noted above, the use of compensations often distorts and obstructs the true underlying purpose of a transaction and can result in abuses of the system. In addition, the administration cost of processing compensations vs. cash collection of taxes is significantly higher. Therefore, we recommend all taxes be paid in cash in accordance with the prescribed procedure. This will enable money to flow into the Treasury as expected and flow through the prescribed budgeting and expenditure processes improving accountability for the funds and resulting transparency of recording.

Substantially improve the control environment. Although the new government is working toward improving controls, we are very concerned about the control consciousness, which enabled the prior abuses to take place and fear that the potential for further problems remains high. A significant overall shift in attitude toward control must take place before any internal control system will be effective. A strong control environment is the basis on which all other internal controls rest. It provides the discipline and structure of the organization and includes managements philosophy, ethical values, operating style, assignment of authority and responsibility, competence of staff, development of people and attention provided by Parliament.

Based on our audit work throughout the RS and the rest the country, we observed that it is often possible for controls to be easily overridden individually or in collusion at all levels of government. We saw this in the RS where the former Prime Minister, directly or indirectly approved significant transactions which benefited the oil company NIRS, at the expense of RS citizens. When it is possible to override controls, they become meaningless bureaucratic steps that must be taken to produce the illusion of control. We encourage management to adopt and demonstrate the highest commitment (in substance as well as form) to a strong control environment to protect the public interests.

Rigorous selection and training of staff will be necessary to help make strong ethical commitment to control a reality. Staff will need to be trained to look beyond the form of transactions to their substance before proceeding. Employees at all levels should have a protected means of reporting breaches of control to someone independent of their reporting chain for investigation without fear of losing their jobs. Individuals who deliberately and knowingly disregard controls (for personal gain, convenience, etc.) should be quickly dismissed to ensure the problem does not recur.

Building a strong Supreme Audit function, which follows international best practices and reports to the highest level of government, will help reinforce good control practices. We understand that the Supreme Auditor in conjunction with the Swedish National Audit Office, is in the process of strengthening this function. We strongly support this activity and further recommend that the resources for the Supreme Audit function not be under the control of anyone they audit. This was a problem in the prior administration where the function was effectively made mute by failing to provide adequate resources. A hallmark of a well-controlled organization is regular auditing by independent auditors, who are not controlled (directly or indirectly) by the people they audit. International best practices support regular independent reporting to the highest levels of government. We suggest audit reporting go beyond the RS and include regular reporting at the BiH level.

Build a strong system of internal controls, which conform to internationally recognized standards. Early in our review members of the new government expressed their strong desire to improve the overall control structure and financial transparency within the RS and are dedicating resources to ensure this happens. We support and encourage this activity and recommend that they adopt an internal control framework, which is in compliance with recommended best practices for internal control. The Integrated Framework for Internal Control published by the Committee of Sponsoring Organizations (COSO) as well as similar reports from Canada and the United Kingdom (Cadbury, COCO) can provide guidance in this critical area.

In implementing a framework for control, we recommend management immediately set up and enforce a system of independent checks and balances over the processing of each type of financial transaction. In many cases this will involve segregating duties that have not been traditionally segregated within Bosnia. For example payroll transactions within Bosnia are frequently handled by one individual. His/her duties may include calculating pay, posting individual and accounting records, processing additions, deletions and changes to the payroll, ordering and picking up cash from the bank, stuffing pay envelopes and distributing pay. Although this may be considered more efficient, it provides the opportunity for abuse and increases the risk of loss. In a case such as payroll, control could be enhanced by having different individuals do different pieces of the processing where they serve as a check on each other. For example, the person who makes entries should not have access to cash at any time. The individual who initiates or processes additions and deletions to the payroll should not distribute pays envelopes. Bank accounts should be reconciled by someone independent of the entire process. This example is only presented for illustration purposes. Each transaction type should be studied, and appropriate segregation of duties and controls designed and implemented. In each case management will have to take extreme care to determine how each of these functions reports up the government chain since they will likely be consolidated at a higher level. This level needs to be high enough to help ensure the integrity of the entire process. To continue with our example, if duties are segregated as described above but within a single department reporting to the same manager, segregation would be considered inadequate since the Manager could easily override the entire process.

Significantly strengthen accounting controls.

• The Directorate of Privatisation is financed in part by funds allocated from the RS Budget (KM 2.2 million) and partly through receipts from the issue of vouchers and carrying out of various privatisation functions (KM 1.3 million) Government Regulations and Government Decision No. 1038/00. Accounting records have not been set up for trust funds collected on behalf of the companies being sold. The Directorate receives the bank accounts and reports year-end balances. At December 31, 2000 this amounted to KM 4.2 million in cash and KM 15 million in coupons derived from the old RS residents blocked foreign currency accounts. Lack of accounting records could result in the misuse or misallocation of these trust funds.

• During the course of our work we noted that many of the government agencies (legal entities with specific administrative functions such as Privatisation or Commodity Reserves) had not prepared their accounts or were still preparing accounts even though the Government had issued its official accounts. We understand less than half of the 40 agencies together with some Ministries (e.g. Agriculture) have submitted accounts. The figures included in the final RS Government accounts for 2000 were Ministry of Finance estimates. Consolidation of agencies does not appear to have been done on a consistent basis.

The basis of good internal control is the quality of the accounting records from which to prepare analyses, reconciliations and inventories. Without accurate records the possibility of losses due to fraud, incompetence and mistakes increases dramatically. The ability to use the records to improve efficiency and effectiveness is lost, and accountability to the taxpayer is compromised.

Further Audit Work

In addition to the follow up items regarding the Commodity Reserves and compensation transactions mentioned in this report, we noted other risk areas, we believe should be examined further. Much of this work can be facilitated by making use of the electronic database of payment bureau information, which was consolidated by the OSCE audit staff. A copy of this database can be supplied to Mr. Ceko or his designated staff upon written request of the Supreme Auditor. Some specific areas worth noting for further audit include:

• The well publicized payment of substantial funds for housing for outgoing government officials was examined during our review, but not completed due to lack of time. In addition to verifying the legality of these transactions, the amounts spent and other items need to be explored including prices paid for apartments. We verified prices paid for housing and found cases where payments made appear to be three times higher than market prices for housing in the same area as well as several cases where apartments were given to individuals who already had apartments. These follow up items are included in the workpapers and other documentation provided to the Supreme Auditor for further follow-up.

• The Ministry of Defense receives substantial funds from the RS government and a number of concerns and queries we encountered during our review concerned this area. An OSCE audit of Defense Institutions within Bosnia is planned.

• As noted throughout this report, there are a number of serious questions and concerns regarding the NIRS oil refinery and their relationship to government officials and bodies. Although we understand the Financial Police are investigating NIRS, their focus appears to be primarily on unpaid taxes. A complete and thorough audit/investigation of NIRS should be undertaken to fully understand sources and uses of income including propriety of transactions and relationships with government officials.

• A letter from Ambassador Ralph R. Johnson, dated August 24, 2000, required an audit be made of Customs accounts by the appropriate RS authority, which "must be supervised by CAFAO". This was to investigate KM 46 million in unexplained differences between the amount of funds actually transferred from Customs Authorities to the budget and the amount that should have been transferred. This audit has not been conducted and should be followed up.

• Companies, which received over half of their income from government sources. This type of analysis can easily be performed for the Year 2000 by making use of the database of payment bureau information referred to earlier.

• Srpsko Sarajevo Municipality (SSM) funded the local company Pretis with KM 2 million in production facilities. According to the Director of Pretis, the money was for construction of a plant to be repaid within five years in oil or cash. SSM had access to oil from the refinery at Srpski Brod, although Commodity reserves does not appear to be involved. The RS arranged for Energoptrol (RS petrol distributor) to collect diesel fuel from NIRS at Srpski Brod. (Energopetrol is part of the NIRS group of companies.) The petrol was sold for KM 2 million and the proceeds placed in a Special Purposes account. Pretis contracted with Integral Engineering from Laktasi to build the facilities. The KM 2 million was paid out of the Special Purposes account to Integral Engineering. The decision to support this transaction was signed by M. Dodik. The Director of Pretis agreed to provide supporting documents, but later reneged saying he was too busy. Pretis did not answer their phone following this contact. These transactions and the relationship of Pretis to SSM, NIRS and the RS government should be followed up.

• A number of round sum amounts were paid to EuroIntegra from the RS budget. We were told that these payments were for War Veterans houses. We were unable to trace the amounts to supporting documentation and perform other checks to ensure monies were spent on housing for bona fide veterans due to lack of time. We recommend this be done.

• The RS Railways headquartered in Doboi operates a single 200 km route to Novi Grad on the Croatian boarder through Prijedor and Banja Luka. The railroads receive approximately KM 35 million in income of which KM 29 million comes from 2 percent additional sales tax for railways. Approximately KM 14 million passes through Kristal Bank of which KM 2.5 million appears to be for wages. Within the time allotted we were unable to determine the reason for the remaining expenditures. Further work should be done to substantiate the railroad expenses.

We also wish to emphasize that we support the Supreme Auditor in his mission to perform full scope audits of the Ministries and Agencies, which are the major beneficiaries of RS Budget funds. Our limited scope review touched on some elements of these audits; and our results reinforce the need for more complete audits.

Dale Ralph

Special Auditor by Appointment of the Supreme Auditor

Federation of BiH

Special Audit Report

June, 2001

Objective

The audit of the Federation was part of a larger Bosnia and Herzegovina high-level survey of selected internal controls and includes recommendations for further audit work and/or financial investigations. The primary emphasis of our work was on selected financial and disbursement controls. General recommendations for improving control are included in this report. The recommendations are general rather than specific due to the magnitude of the problems observed and the need for major vs. minor improvements.

The audit was not intended to be a complete or sufficient review of the Federation or any individual Ministry to enable the auditor to form an opinion on financial statements or overall system of internal control nor was it intended to detect fraud. Resources were limited by design, and the work to be accomplished was hampered by the large number of unusual transactions requiring additional follow up, poor and/or incomplete (or not provided) documentation and unreliable financial records and control systems. The poor state of documentation and weak (or overridden) financial controls resulted in significantly more investigation at the transaction level than would have been required if the control systems could have been relied upon. In many cases it was almost impossible to verify transactions due to the lack of sufficient documentation. In some cases we questioned the validity of the documents provided.

The individual transactions and examples given in this report are presented as illustrations of the poor control observed. Although some of these transactions may turn out to be fraudulent, others may not and are presented to illustrate bypassed or lax controls and/or the potential for fraud and error. Investigations by the Financial Police are recommended. Detailed transaction by transaction analysis of potentially fraudulent transactions are the responsibility of the Financial Police and are beyond the scope of this audit.

Conclusion

Although the audit only examined selected transactions in selected ministries, we were struck by the consistent and frequent repetition of the same sorts of problems in every area observed. This frequency and consistency of issues resulted in our concluding that the problems are likely systemic throughout the Federation. Based on the limited audit work performed, we do not believe the system of internal control as it is currently administered is adequate to protect the assets of the Federation and ministries against losses due to fraud, incompetence and carelessness. We noted that many documents, which we sampled, were officially stamped, approved and supported by decisions. This evidence along with discussions with various Ministers and staff suggest an adequate system of internal controls is in place. However, upon further investigation, we found the substance of these apparent controls to be lacking. For example, decisions were often vague and/or illegal, little or no follow up was performed to ensure the funds were expended as intended, supporting documentation was incomplete, methods of selecting vendors were inappropriate and it is evident that controls can be easily circumvented.

The system of internal control and the enforcement process needs to be significantly strengthened. We are especially concerned about the control environment and overall attitude toward implementation and enforcement of internal controls. We recommend implementing a strong framework and system of internal controls in accordance with internationally recognized standards. We further recommend steps be taken to build a strong independent oversight body, such as the Supreme Audit Institution. Adequate measures should be taken to ensure on-going independence of this function including protecting the funding of the Supreme Auditor in order to prevent the problems noted in this report from recurring. We understand that the Swedish National Audit Organization is working with the Supreme Audit Institution toward this end. We support this goal and strongly encourage government to make this a priority since we do not believe any substantive change will take place without independent review and reporting.

Background

Early in this audit we obtained electronic information from the payment bureau and reformatted it into a database including all income and expense transactions over KM 10,000 for the Year 2000. These records consist of the postings made to ZPP accounts, but do not provide information on the purpose of each transaction. This electronic information enabled us to determine which accounts initially received funds from the Federation and where the recipient of the funds spent them. When completed we provided our electronic database on CD to the Financial Police, the Office of the High Representative Anti Corruption Unit, and the Supreme Auditors to help assist them in their work.

We consolidated the Federation Ministry of Finance primary budget accounts to determine the major recipients of the funds. Over KM 126 million was classified as "Out of Area", meaning that we could not determine the accounts these funds went to without examining the paper ZPP slips since the electronic account detail was not maintained by the payment bureau for Cantons 1, 3, 4, 5, and 6. Some amounts originating from "Out of Area" were traced to payment bureau slips during our review of selected transactions from selected ministries. The payments to the Central Bank were for repaying international debt. From our consolidation, the following are ministries or accounts which received over KM 1.9 million during 2000. The numbers presented are the total of all transactions over KM 10,000 and not all transactions.

From the total of all ministries, we judgmentally sampled transactions from the following ministries.

• Ministry of Agriculture
• Ministry of Justice
• Ministry of Social Policy
• Federal Ministry for Welfare of Demobilized and Disabled Soldiers
• Federal Ministry of Transport and Communication (Main account maintained outside of region. Therefore, only daily totals available electronically.)

The Ministry of Defense was excluded from this audit since it will be audited as part of a separate Military audit to be completed by OSCE.

This report contains a section on overall internal control recommendations, which apply to the Federation as well as separate control recommendations for selected ministries.

Federation Internal Control Recommendations

Based on the limited audit work performed to date, we noted a number of areas where we believe internal control could be significantly improved. However, due to the volume of problems we noted in our short review, we wish to stress that the control recommendations presented represent only a small portion of the overall controls, which should be implemented. A significant amount of work remains to be done in order to fully evaluate the entire system. This work is the on-going responsibility of the Supreme Audit Institute. In order to establish accountability, transparency and fiscal responsibility, a basic framework and system for internal control will need to be adopted using an internationally recognized framework such as the Committee of Sponsoring Organizations Integrated Framework for Internal Control. The very basics of good internal control practices were not evident. Highlights include the following recommendations.

• Significantly improve budget, disbursement and accounting controls to prevent inappropriate diversion of funds.

• Merhamet, a humanitarian organization, located in Tuzla received KM 100,000 during the year. KM 70,000 of these funds were disbursed to "Omladinski Fund"; however, the funds ended up in the SDA (Party for Democratic Action) account. The SDA claimed this was because the "Omladinski Fund" did not have an account; therefore, they used an SDA account. When we asked to see payments for the "Omladinski Fund", we were told by the SDA that the SDA account had been blocked at the time, and the money was taken by Tuzlanska Bank to repay debt owed by the SDA to the bank. However, these claims do not make sense, since Merhamet forwarded the money to the SDA on four separate occasions over a seven-week period. We cant imagine anyone would continue to place money into a blocked account. It is likely the intent of the transfer from the budget reserves was to repay the SDAs bank debt. This motive is supported by one of the ZPP payment slips from Merhamet to "Omladinski Fund", which states that the money is for Tuzlanska Bank. The SDA in Tuzla had been prevented from operating properly due to their debt to the bank; therefore, it was imperative that they obtain money to continue their activities.

• Two payments totaling to KM 700,000 meant for S.W. Mostar Municipality were paid to the company, "Soko" in Mostar. The payment bureau documentation was prepared to mislead since it gives the name of the municipality while the funds were diverted to the company. The Minister of Finance ran this private company before and after he was Minister of Finance. This decision did not appear in the Official Gazette.

• KM 850,000 described as "Cantonal Assistance" to "Unatrans", a company in Bihac. KM 710,000 was then transferred from "Unitrans" to "Soko Eurobus" in Mostar. This decision did not appear in the Official Gazette.

• KM 800,000 from the budget reserves was funneled through the SDA linked Widows and Orphans fund and ultimately used to purchase shares in SEH-IN Bank. (This was part of a total of KM 2.1 million diversion of funds from budget accounts and Federal Ministry for Welfare of Demobilized and Disabled Soldiers funds used to capitalize this bank.) This decision did not appear in the Official Gazette and was made when the government was not in session.

• KM 500,000 was paid to Elektroprivreda. Apparently, Air Bosna wanted to buy an airplane and Elektroprivreda opted to provide a guarantee for this purchase. The Ministry of Finance sent Elektroprivreda KM 500,000 for their trouble. The Prime Minister, who signed these decisions, went on to run Elektroprivreda following his term in office. This decision did not appear in the Official Gazette.

• KM 40,000 was made to HN Canton for assistance. Once again, the money went to "Soko". This decision did not appear in the Official Gazette.

• KM 24,500 identified on the payment bureau documentation as being paid to the Head Office of the Islamic Community actually went to ASA PVA, a private company, which sells automobiles.

• KM 100,000 was paid to the private football club, FK Buducnost to bring the stadium up to European standards. Public money was provided in spite of the fact that the club had a good season. The club is run by hard line SDA members. This decision did not appear in the Official Gazette.

We noted a number of other payments, which need to be followed up. These include KM 100,000 to a tennis club, KM 500,000 to a publishing company called "Ljiljan"/"Euroljiljan" and so on. We have a list of 143 decisions, which were reclassified during the last quarter of 2000.

• Ensure decisions are within the law. In addition to the decisions already listed, we noted a number of other payments, which were also based on illegal decisions. These include:

• Decision by the former Prime Minister to create a Federation Employment agency. The General Director of the ZPP then ordered the ZPP branches to divert tax revenue to this agency.

• Decisions by former Prime Minister to make payments from the budget reserves to the SDA party through the SDA controlled Federal Ministry for Welfare of Demobilized and Disabled Soldiers and the Organization for Families of Fallen Soldiers.

The system of internal control was totally ineffective and was easily circumvented in these cases. In order for controls to be effective, mechanisms must be in place to ensure that they apply to everyone. These examples help illustrate the need for effective independent oversight, which is not directed by those who may choose to circumvent controls

• Substantially improve the control environment. The control system is only as good as those who administer it. As long as individuals at all levels within the government can individually or in collusion with others override the system, internal controls are meaningless and only represent additional bureaucratic steps that must be taken to produce the "illusion" of control. Form over substance often prevails and those responsible for administering and/or checking controls too often fail to look beyond the documents to the substance of the transaction.

• Develop, implement and/or strictly enforce financial controls. If controls have been developed, their implementation and/or enforcement was not readily apparent for many of the transactions we reviewed. Descriptions to authorize expenditures were often vague, supporting financial analysis non existent, ineffective or weak, evidence of review and/or collection of supporting documentation prior to releasing funds not present and weak or non-existent documentation of follow up of advance payments.

• Upgrade and strengthen the Supreme Audit Institution. The responsibility for timely on-going monitoring and reporting on internal controls throughout the Federation is the responsibility of the Supreme Audit Institution. The Swedish National Audit Office is responsible for working with the Supreme Audit Institution to upgrade policies, procedures and staff in order to bring the Institution in compliance with internationally recognized standards. We do not believe this job can be accomplished until the Federation allocates sufficient resources to this function, and steps are taken to ensure the staff is independent of political influence and control. As long as the Supreme Auditor is dependent on those he audits for his appointment, funding and/or direction as to what is to be examined, independence is compromised. Given the poor state of internal controls observed throughout our work, we believe significantly more and different resources are necessary in order to provide adequate audit coverage to the Federation. Improving independent oversight is key to improving many of the issues addressed in this report. Annual reviews of the Supreme Auditor function by an independent experienced and qualified internationally recognized firm are also recommended to help ensure on-going independence and adherence to standards.

MINISTRY OF AGRICULTURE

Major categories of expenditures for the Ministry of Agriculture include:

Internal Control Recommendations

Improve financial control and ensure all expenditures and transfers are fully supported by complete documents, which contain sufficient transaction details.

During 2000 the Ministry spent approximately KM 18 million(payment bureau and bank account) most of which was not included in their payment bureau accounts as required by law at the time. Due to the confusing payment process, it is not obvious where the money went. We were told the expenditures were for subsidies for a number of agriculture-related activities for farmers and the industry.

During 2000, the Ministry of Agriculture was run by a Bosniak Minister and an Croat Deputy-Minister and payments seem to be paired between the interests of these two peoples in a 2:1 ratio. For example a payment of KM 400,000 to the Ministry of Social Policy was paired with a payment of KM 200,000 for Orasje Canton . When we talked to the Secretary to obtain supporting documentation, she volunteered the information regarding each pairing. When we asked a question about one payment, she pulled its partner transaction also.

We noted funds flowing between the Ministry of Agriculture and the Ministry of Social Policy, Displaced Persons and Refugees. We noted other transactions in both Ministries, which appear to be the responsibility of the other ministry. (See Ministry of Social Policy section for additional information).

• KM 600,000 was transferred via ZPP to the Ministry of Agriculture from the budget. Two payments totaling KM 400,000 (KM 125,000 on October 31, 2000, and KM 275,000 on November 11, 2000) were transferred via ZPP accounts to the Ministry of Social Policy while the sister payment of KM 200,000 went to Orasje Canton. The money for Social Policy was to "assist returnees", which is not part of the mission of the Ministry of Agriculture. The Ministry of Social Policy has their own funds for this mission. This alone obscures what is happening and charges expenses to the inappropriate ministry. Approximately half of the KM 400,000 amount was transferred to a private company, Kuvet (see below), KM 50,000 was used for a luxury 4 wheel drive vehicle and KM 101,474 was given to the UPI Agriculture Institute.

• This Ministry sent KM 25,000 to the Office of Returnees and KM 12,500 to the Parish Office, Uzdol. This latter payment went to a bank account of the parish at Zagrebacka Bank on July 18, 2000. Two weeks later KM 50,000 was withdrawn from the Parish Office account and paid to a private company to help with "running costs", and KM 20,000 was withdrawn in cash. The total of these two transactions emptied the account; and, therefore, included the funds transferred from the Ministry of Agriculture. Not only does assisting returnees appear to be outside the responsibility of the Ministry of Agriculture; but in this case, the final use of the funds does not appear to have anything to do with the return process.

On October 25, 2000, the Ministry of Social Policy transferred KM 270,000 to the Ministry of Agriculture. KM 250,100 went to the company, Poljooprema, for the purchase of ten tractors with trailers and plows from a company in Italy. We were told the remaining money went to purchase seedlings, which we asked to see. In spite of our requests, we were not been given the location of the seedlings or the tractors as of the date we completed our fieldwork for this audit. We noted other transactions for which complete documentation did not exist or was not provided as requested.

• We asked the Orasje Canton to provide documentation to support the transfers made in the year 2000 of KM 200,000 and KM 166,500 for agriculture use. The documents provided dated from 1998 to January of 2001 and did not fully support either amount.

• Payments were made to the UPI Agriculture Institute (KM 300,000) and the Mostar Agriculture Institute (KM 200,000) for contracts between the Institutes and the Ministry. We could find no other documentation or details to support the expenditure or indication of follow up to determine that the funds had been expended appropriately.

• KM 80,000 was paid to the Tuzla ZPP for the Tuzla Agriculture Fair while KM 30,000 was paid to the Citluk Municipality Wine Festival and KM 10,000 was paid to the Mostar Chamber of Commerce. Once again no documentation existed within the Ministry to show that the money was spent for its intended purpose.

• We found payments totaling to KM 449,990 to Sjemenarna for seed subsidies to farmers. In order to receive payment the company submitted two invoices. That was the entire process. There was no documentation of verification to ensure the farmers had received the seeds or that contract terms had been adhered to. The Ministry had no idea of who the end receivers were. We reviewed Siemenaras ZPP account and saw that the money received was immediately transferred to a bank account.

• A fuel subsidy to Energopetrol of KM 33,000 and Zovko Transport of 16,500 was similar to the above situation. The only proof required to receive the money was submission of an invoice.

Ensure all subsidies are calculated and awarded based on objective criteria, and simplify the payment process and improve documentation.

The Ministry used one ZPP account for their main business. Then they moved money to a second ZPP account for "milk and tobacco subsidies". They also held accounts at UPI Bank and Hipotekarna Bank, which involved approximately 20 accounts and sub-accounts. The new Minister recently closed all these accounts and now uses just one. The new Minister is also suspicious of the necessity of having more than one ZPP account during 2000. We noted the following:

• Butmir is a company that received money for milk subsidies. The system works by giving money to milk producers for each liter of milk sold depending on fat content. To receive a subsidy, a milk producer submits a receipt from the milk production plant they sell the milk to. Butmir primarily uses a manufacturer called Movita or Milko for most of their sales. The manufacturer arrives at the dairy (Butmir), collects the milk in a tanker and gives the dairy a handwritten receipt for the amount, which is based on a counter reading from the tanker. The dairy then sends in this receipt plus a receipt as to the quality of the milk. There are no checks performed by the Ministry. The whole system is open to abuse, and we noted potential abuses.

• Movita, Mostar is another recipient of milk subsidies. From Butmirs records they appear to be a manufacturer, but they are receiving milk subsidies as if they were a dairy. Since there was no available documentation at the Ministry, we could not obtain further information without spending several days driving throughout the country. Payments were likely made solely on the basis of the request from the canton.

• The Tobacco Producers of Siroki Brijeg received tobacco subsidies, which work in a similar manner to the milk subsidies. Companies are required to send in receipts in order to obtain the tobacco subsidy. This company showed no income on its ZAP account other than two subsidy payment totaling approximately KM 30,000. Again the Ministry could provide no documents to support the transactions and appears to have paid the subsidies on the strength of a canton letter.

In general, the cantons seem to be responsible for controlling the Federal Ministry of Agriculture funds in respect to milk and tobacco subsidies. Documentation was difficult to get and had to be obtained by the Ministry from the Cantons. Controls over and verification of the final use of funds did not exist.

Multiple accounts and complicated methods and routes for disbursing funds can obscure the true purpose of the transactions and increases the risk of error and inappropriate use or diversion of funds. It unnecessarily complicates the process, increases administrative costs, and makes analysis and research more difficult. We recommend the subsidy process be evaluated and revised to:

• Simplify the process
• Ensure appropriate objective criteria are applied to determine who gets subsidies
• Reduce costs
• Enhance transparency
• Ensure each transaction is supported by appropriate analysis and approval
• Require adequate segregation of duties

Based on the problems we noted during our limited review, we also recommend the Financial Police conduct a thorough investigation of this Ministry to determine where the funds ended up.

Ministry Response

The Ministry replied to draft of this report during the 15-day comment period. As a result we made a few changes which are reflected above. Most of the remainder of their response is based on their claim that all their spending was based on government decisions, which they merely implemented. However, their reference to the supporting decisions is vague. They did not submit copies of these decisions or give us a citation reference.

The purpose of this audit was to determine whether controls are adequate to protect public funds. Just because a payment complies with a decision or law does mean that it is controlled. There is little or no evidence to confirm that adequate controls actually exist. Substantial improvement is necessary in order to adequately substiantiate the vast sums of public money spent by this Ministry. In the case of the milk and tobacco subsidies, the Ministry states that this was "supposed to be the responsibility of an inspection service". At no time have we been able to see the work of this inspection service; and in nearly every case we examined, nothing more than a letter or an invoice exists to support a payment.

MINISTRY OF JUSTICE

The Ministry appears to be a clearing point for directing funds to each area of work covered by the Ministry including exhumation, courts, jails, etc. They do not have actual power over the amounts spent. The breakdown of expenditure transactions over KM 10,000 is as follows:

Internal Control Recommendations

Ensure all decisions are appropriately approved within the legal framework of the law.

The former Prime Minister of the Federation of BiH, approved two payments for approximately KM 700,000 each for improvements to the Zenica jail in 1999 and 2000. These amounts are above his individual signing authority, and he used a Conclusion, which is the lowest legal act, rather than a decision to approve these amounts. Conclusions are used to regulate "the attitudes with regard to the government policies adopted, internal affairs within the Government and assign the tasks to the administrative organs and the services of the Federation." Conclusions do not need to be published in the Official Gazette. Therefore, approval of these large expenditures was not published. This appears to be an inappropriate and illegal use of a conclusion. The expenditures were for an iron factory, which is housed within the jail. The first expenditure was for a new roof and machinery and the second was used to create a metal testing laboratory and renovate one of the wings to the jail, which is to contain a new workshops and new cells. It is unclear why government money would be necessary for this factory since it is operated as a separate company and no funds were returned to the government.

Ensure adequate financial controls over factories operated on government property endowed with government funds.

• There is an iron factory operated at the Zenica jail called New Life. This factory is publicly owned and manufactures metal products using prison labor. Machinery, equipment and space were paid for with government funds. Prison labor salaries are between KM 60 and KM 120 per month per employee. In spite of this very low cost arrangement, no funds were returned to the jails funds as profits, and the government spent approximately KM 700,000 on improvements to the factory in both 1999 and 2000.

• "Miljacka" is a company manufacturing building materials such as aggregates and gravel by crushing stone at an area owned by the jail on the outskirts of Sarajevo. The Sarajevo jail transferred KM 140,000 from the jail account to the company during 2000. The funds were spent to transport workers from the jail to sites and to pay the company for work carried out at the jail. No profits or money were returned to the jail.

These types of arrangements can easily lend themselves to a number of abuses including fraud. Both companies should logically be making a profit; however, if so, it doesnt appear to be benefiting the jail or the government. The Financial Police were investigating the Zenica jail issues at the time of our audit. Therefore, we left the investigation up to them and did not pursue the issues any further. Strict controls should be established over any operation of this nature to ensure all funds are accounted for including sales, inventory, improvements, salaries, etc.

Develop, implement and enforce controls over Ministry borrowings.

During our audit we noticed that the Ministry borrowed KM 25,400 from the Public Administration office in Orasje. The loan was appropriately repaid. These specific transactions are not unusual or suspicious except that the Minister told us he was entitled to borrow when he felt like it from departments and offices within the Ministry. He said he did not need to obtain approval from the Minister of Finance or even let him know. This is an area where controls and limits should be implemented and enforced to prevent Ministries incurring large debts, which cannot be repaid, thereby, increasing overall government debt.

Improve controls over unexpected spending.

Exhumation spending is allowed in the budget and is paid to cantons throughout the year. Although it is usually recommended that predictable spending be appropriately budgeted, exhumations are not the type of expense that is easily predictable by canton. Therefore, when a situation arises requiring exhumation, we believe it would be better controlled by preparing a cost analysis at the time of discovery and obtaining the funds for the specific project based on that analysis.

Improve budget analysis and control.

The total income for the year was approximately KM 14.0 million against a budget of KM 14.7 million. The Federal Election Commission had their request reduced from KM 2.0 million to KM .8 million. The Federal Commission for Missing Persons had their income reduced from KM .4 million to KM .2 million. These changes should have resulted in a savings of KM 1.4 million from the original KM 14.7 million resulting in a new target of KM 13.3 million. However the total received as stated above was KM 14 million. The difference as explained to us was the inappropriate transfer of KM 700,000 from the Ministry of Finance for the Zenica jail (see above).

FEDERAL MINISTRY OF SOCIAL POLICY, DISPLACED PERSONS AND REFUGEES

Major expense categories for Year 2000 include:

In violation of the existing laws at the time, the Ministry of Social Policy paid ninety percent (90%) of their expenditures through a bank account and not through the ZPP account assigned to the Ministry. The only transactions appearing in the ZPP account were large transfers totaling over KM 22 million to Universal Bank and Post Bank. This resulted in detail expenditures not showing up on their ZPP account, which made it difficult to easily determine where the funds were spent. We judgmentally selected a number of transactions from the bank accounts, and noted several unusual transactions or activities, which are discussed below.

Internal Control Recommendations

Ensure unbiased selection of vendors based on objective criteria. Avoid conflicts of interest and the appearance of conflicts of interest.

During the audit we found companies which received substantial funds from The Ministry of Social Policy and/or other government sources.

Kuvet

One example is Kuvet, a small private engineering/building contractor, which received substantially all of their KM 4.3 million for 2000 income from government related sources. Over 92 percent of this income came from the Ministry of Social Policy. All but one percent of the remaining income came from other government sources. The funds paid to Kuvet drastically accelerated during the last four months of 2000 when they received over 76 percent of their total income from Social Policy for the entire year. During this same period the average size of the payments increased by over 350 percent. An additional KM 986,000 was transferred to Kuvet during the first two months of 2001.

When we visited Kuvet to obtain supporting documentation and information, we were treated to a number of confusing and conflicting reasons as to why they were the company selected to provide building supplies and food. There was no competitive bidding process, and the reasons the Director gave us for their selection did not make logical sense and were easily disproven. Other "facts" he told us about his business including the number of employees, contracts, etc., turned out to be false.

During this same meeting we tried to get the Director of Kuvet to show us the support for one entire billing. In spite of spending two hours with him on this item alone, he was unable to provide complete documentation for even one invoice included in a billing. Some of the few documents we did see contradicted information he previously told us. For example, the amount received on the delivery report was lower than the amount invoiced. Another invoice included four truckloads of material, but he could only find delivery reports for three trucks. Another invoice he provided was dated 12 days prior to the delivery reports he showed us to support the delivery. This contradicted a previous comment when he told us he didnt bill in advance.

As a result of our examination of documents provided by Kuvet and the Ministry of Social Policy, verification of prices for similar products sold by other suppliers, and discussions with the Director and staff of Kuvet, we noted the following:

• The companys capital, according to their most recent registration documents, was valued at approximately KM 71,000. An employee of another agency, who did business with Kuvet, told us that Kuvet was a small engineering/construction company engaged in reconstructing apartments. He was unaware of Kuvet being in the business of selling building materials and food, even though the income from this line of business was considerably greater than their engineering/construction business. The Kuvet Director admitted that they do not have a warehouse. We visited their offices, which consist of three small rooms. The Director of Kuvet claimed that he was purchasing and delivering large amounts of building materials via convoys to build and repair homes damaged during the war. He claimed he was widely known throughout Bosnia for the quality of the building materials he sold and his ability to arrange large convoys and quickly deliver products where no one else could. He also claimed that they were purchasing and delivering food products. Purchasing goods in one location and transporting them all over the country does not make sense when cheaper sources of these materials already existed throughout the country.

• Kuvet charged the highest prices of any other building materials supplier we checked and offered no discounts for volume in spite of the significant volumes invoiced. On one invoice we examined for food products, Kuvets markup was approximately 33 percent.

• Kuvet was overcharging for delivery and transport costs. In some cases they delivered goods on the same truck to two or more locations, which were only a few kilometers from each other, but billed the full delivery cost from Sarajevo to the construction site on each invoice. In other cases the kilometers charged were overstated. For example they billed for 440 kilometers to transport materials from Sarajevo to Bjeljina; however, the distance is only 180 kilometers.

• Invoices were dated the same date or prior to the date on the delivery reports even though the Director insisted delivery took place before the invoice was prepared. In several other cases the delivery reports were not provided as requested or did not account for all items invoiced. Several delivery reports contained no dates. Individuals signing for receipt of goods throughout the country do not appear to be located anywhere near the delivery area since their ID numbers and phone numbers are from Ilidiza.

We recommend the Financial Police conduct a full fraud investigation of this company including verification of existence of all material sold to Social Policy, who goods were delivered to, and where all sold goods originated from (valid purchases, fake invoices and/or donations from NGOs). We recommend special attention be given to the period from September of 2000 to February of 2001 when over KM 4 million was billed to Social Policy in a series of large billings.

At a minimum the dealings with Kuvet are not the result of arms-length transaction or good business practices. Many serious questions have been raised and we believe the potential for fraud is significant. Immediate steps should be taken to implement and enforce controls, which ensure this situation does not recur.

Poin and BMP

The situation with Poin and BMP appears to be similar to Kuvet. According to the court documents, Poin and Bosmer are two of the establishers of BMP. Merhamet  Muslim Charitable Association, a SDA run organization, owns Bosmer. (We also understand that there is a criminal referral for loan fraud against BMP, Poin and Merhamet.) We noted a number of discrepancies in the documentation we reviewed including:

• Poins prices on selected invoices were 10 to 26% higher than other suppliers we checked with. In addition we saw no indication that Poin gave any quantity discounts in spite of the volumes purchased.

• Poin was overcharging for transport. For example, they charged transport costs for 670 KM from Sarajevo to Doboj. The actual distance is 168 KM.

• Although some delivery forms required from 5-7 different signatures, all signatures appear to be in the same handwriting.

• Three party transactions were missing information including dates and reason for the agreement, copies of the invoices (or sufficient details) to be compensated. Some of these agreements were between Poin, BMP and Social Policy. When we telephoned Poin to get information, they answered the phone "Merhamet". In one instance we noted that the Ministry of Social Policy made a loan payment for BMP as part of a three party transaction.

• There was no evidence of public tender on BMP contract.

We recommend the Financial Police complete a thorough investigation of Poin, Merhamet and BMP including their relationship to the Federal Ministry of Social Policy, verification of existence of all material sold to Social Policy, who goods were delivered to, and where all sold goods originated from (valid purchases, fake invoices and/or donations from NGOs).

Interneon

This company is of mixed public and private ownership. They received over half of their income from the Ministry of Social Policy, at the time the Secretary of the Ministry of Social Policy was also the Acting Director of Interneon. The payments stopped when Mr. Fadil Haveric left his post at the Ministry.

Each of these examples, Kuvet, Poin and Interneon, raise serious question as to the method used to select vendors, value received and the relationship between Ministry staff and the companies.

Improve financial control.

During our review of supporting documentation for expenditures, we noted a number of controls, which are ineffective, non-existent or need to be improved. These include:

• Vague descriptions on decisions, which support payments (i.e. "realization of the program of return") and no supporting cost analysis or specifics as to how the money is to be used.

• No evidence of independent and appropriate matching of the purchase authorization to invoice and evidence of receipt. The documentation supporting receipt of goods provided by the Ministry was missing documents, and we saw no indication that verification procedures were conducted by Ministry staff prior to releasing payment.

• Funds were provided to a number of associations and municipalities for the program of return. However, we saw no evidence of follow up to ensure funds provided by the Ministry of Social Policy were used appropriately. In most cases the documentation was vague and consisted of a letter from the Ministry to the bank asking the bank to make a payment. In some cases where we were provided with copies of the supporting decisions, the wording was vague making it difficult to determine exactly what the funds were spent on. Sampled transactions include:

• Transfer of KM 270,000 to the Ministry of Agriculture for the purchase of tractors, trailers, plows and seedlings.
• KM 100,000 to the Sarajevo Agriculture Institute.
• KM 100,000 to Srebrenik Orchard and KM 100,000 to Rubos Strawberry Farm
• KM 10,000 donation to the Agriculture Faculty
• KM 58,000 cash withdraws for one-time support for the UPI Market in Sarajevo
• KM 15,000 to Sekovici Municipality to complete construction of a mosque

Due to the large number of questionable transactions and poor documentation, we recommend this Ministry be thoroughly investigated by the Financial Police. The investigation should include determining the ultimate use and propriety of expenditures including accounting for all significant payments made from the Ministrys account at Universal Bank during 2000 and 2001.

FEDERAL MINISTRY FOR WELFARE OF DEMOBILIZED AND DISABLED SOLDIERS

Major expense categories as a result of consolidating all the related 637 and 638s accounts for Federal Ministry for Welfare of Demobilized and Disabled Soldiers are as follows:

Internal Control Recommendations

Develop criteria for determining which banks to select for distributing pension and IMO payments. Avoid conflicts of interest and the appearance of conflicts of interest in making selections.

During 2000 over KM 42 million was distributed to SEH-IN Bank for pension and IMO payments. The payments are transferred to the bank where they are primarily disbursed in cash. This bank was undercapitalized, and no objective criteria was applied to support the Ministrys decision to use this bank. When we asked the Minister of the Federal Ministry for Welfare of Demobilized and Disabled Soldiers how they came to select this bank, the only reason given was that they were a veterans bank. We were not provided with any response to our questions and concerns regarding placing large sums of money in this undercapitalized bank. As noted in the Political Party Financing Audit at the end of 2000, this bank has SDA connections and at least one capital infusion of KM 2.1 million came from illegally transferred government funds funneled through various Widows and Orphans funds.

The criteria used to select a bank to deposit and/or distribute government funds should be objective and include such elements as liquidity, capitalization, asset size, ability to handle increased business, quality of service, FBA rating, etc. Placing large amounts of government funds in a known undercapitalized institution puts those funds at risk. Conflicts of interest and the mere appearance of conflicts of interest should be avoided in the selection decisions.

Develop, apply and enforce strict criteria and limits on borrowings by government institutions and agencies.

The Federal Ministry for Welfare of Demobilized and Disabled Soldiers received large amounts of funds through borrowing from the Federal Employment Bureau (KM 36 million), Lottery (KM 6 million), Elektroprivreda and Central Profit Bank. The loans from Elektroprivreda and the bank were repaid. However, the funds from the Lottery and the Employment Bureau were not repaid (or intended to be repaid) even though the payments from the Employment Bureau amounted to 80 percent of the total income of the Employment Bureau for the year. The Minister told us there were no limits on borrowing and he did not need approval. He said their job was to "get as much money as possible for these soldiers and families from whatever sources" including borrowing.

Failure to set limits on borrowing and/or not being aware of where funds are coming from can result in uncontrolled extra budgetary expenses and obligate the government without appropriate approval, analysis and review. At a later meeting the Minister told us that borrowing from the Employment Bureau had been disallowed.

Improve and/or develop, implement and enforce budgeting and forecasting process and control.

When we asked the Minister how he determined his 2000 and 2001 budget figures he said they usually ask for a lot and then get told what they can have by the Ministry of Finance. This was his entire budgeting process. He had no idea of what the requirements of the Institute are and just hoped to get as much as possible to "improve the life of these citizens". He provided no analysis or justification for the budget figures.

In addition, we questioned the priority and basis for certain decisions regarding expenditures. For example, this ministry purchased 423 automobiles "for the disabled", when they claimed they could not meet their basic pension obligations.

Budget figures should be based on careful analysis of what is required and priorities should be established in the event that the entire budget figure will not be funded.

We understand that the Financial Police has been investigating this Ministry. We concur with the need for this investigation.

FEDERAL MINISTRY OF TRANSPORT AND COMMUNICATION

The main accounts for this ministry are located in Mostar. Therefore, we do not have complete payment bureau expense information for them. Daily totals had to be obtained from the payment bureau and transaction selections made from these. Unfortunately, due to time restrictions we were not able to review this Ministry. However, we did note a few items from our meeting with the Minister as well as our review of some of the documents provided.

Ensure public tender process is enforced.

The Minister and his staff claimed it was not possible to use the public tender process due to the limited number of companies qualified to perform road maintenance and other road work contracts. Failure to obtain bids was confirmed by our review of documents for over KM 8 million in expenditures without a public tender or even selection criteria documented in the files. The Minister further stated that the Ministry of Transport and Communication is responsible for appointing members to Managing Boards of state-owned companies in accordance with the proportion of state ownership. Both of these practices hamper competition and increase the risk of paying higher prices for the work performed. Failure to require public bidding also increases the risk of overcharging and/or poor product delivery as companies continue to be awarded contracts without fear of competition.

Eliminate the use of three-party transactions or significantly improve the control over these transactions.

A significant number of transactions are three-party transactions. The Minister claimed this was done because the contractors they hired required it or because the Ministry of Transport was short of cash. We question these reasons as the other Ministries we looked at do not seem to have these problems. We also question contractors "preferring" this method over cash. When the head of finance for this ministry explained a few large three party transactions, he said that the contractor took money from the bank, the bank owed the Ministry of Finance and the Ministry of Finance owed the Ministry of Transport who owed the contractor.

The potential for misrouted funds and the ability to obscure the true purpose of transactions significantly increases when three-party transactions are involved. We believe all large three party transactions should be carefully audited to determine the ultimate use of the funds and how they were accounted for. We are especially concerned with the three-party transactions involving the Ministry of Finance given the issues noted earlier in this report. If this audit results in a number of suspicious transactions, we recommend a full investigation by the Financial Police. We also recommend the necessity of using three-party transactions be carefully reviewed and alternative better controlled practices be developed, adopted, enforced and periodically reviewed by an independent party.

Ministry of Transport and Communication Response

The Ministry of Transport agreed that they have not conducted a bidding process for road maintenance since 1998, and do not believe they needed to do so since the contracts involve the same contractors. We do not agree on this point for reasons previously stated.

The Minister of Transport responded to our comments regarding third-party transactions by saying that there are no obstacles to three-party transactions under the law and they are controlled by going through the appropriate gyro account. We concur that they are allowed under law. However, the fact that they are allowed and went through the gyro account, does not mean that they are adequately controlled. This type of transactions enhances the ability to obscure the true purpose of the transactions, and we maintain that the need for these transactions should be studied. At a minimum control over three-party transactions should be considerably enhanced to ensure the transactions are transparent and appropriately approved and supported.

RECOMMENDED ADDITONAL AUDIT WORK

Given the weak controls, questionable transactions and poor documentation observed in all of the ministries we examined, we believe the types of problems noted here are likely to be common throughout the Federation. If a full accounting for most of the monies expended is desired, a complete independent audit of each ministry is recommended. In addition some specific recommendations include:

Public Companies

During our audit we took a high level look at companies receiving large amounts of money from public sources including Electroprivreda, PTT and the tobacco companies and other government sources. We recommend these companies be audited to determine the propriety of the funds received and the public tender process. Although bids may have been received, we believe the validity of the process and genuineness of the competing bids is questionable. Although receiving large amounts of public business is not necessarily a problem, in and of itself, it may be an indication of weaknesses in the procurement and public tender process or the enforcement of that process. We believe in most cases it is unlikely that companies (especially private companies) winning significant public business would not also be winning significant private business. We know of one instance where competing companies were asked to submit fake bids in order that one of these favored companies would ultimately win the business. Given the substantial public business transacted with these companies and procurement problems previously identified in this report, we recommend additional audit work be performed to identify and physically examine the assets purchased and to investigate the relationship between the companies. Some of the companies to be considered for review include the following. They are all private unless otherwise noted.

*Significant business with each other and believed to be related. Related business was eliminated from this analysis.

** Bank activity represents bank receipts, which can be account transfers, loans received or receipts from customers.

*** Unidentified are transactions shown as "Out of Area" on ZPP records or from unidentified sources and need to be individually analyzed by pulling transaction slips in order to determine where funds originated.

We also recommend full and complete audits of the major public companies, such as Electroprivdra, PTT and the tobacco company. We understand at least one of these companies was being audited by the World Bank during the same time our audit was taking place.

Federal Ministry for Welfare of Demobilized and Disabled Soldiers

Federal Ministry for Welfare of Demobilized and Disabled Soldiers purchased 423 Skoda automobiles from ASA Auto and 16 minibuses from Eurobus. The Minister told us the cars were the most basic model and were not modified in any way in order to keep costs down. He went on to tell us the cars were for the most disabled soldiers including the blind! We understand that ASA auto likely has SDA connections while Eurobus has HDZ connections. Given the large amount spent on vehicles (KM 6 million) and weak explanations, we recommend the cars be physically identified by matching the serial numbers on the vehicle to invoices and paperwork. Additional steps should be taken to identify who vehicles were given to determine if they went to appropriate people using objective criteria.

Over KM 42 million went from the Federal Institute for the Welfare of Solders to the SEH-IN bank for IMO and Pension payments. Most of this went out in cash. We recommend significant testing take place in this area to determine if the individuals who received funds exist and are eligible to receive funds. We recommend testing include confirmations from individuals eligible for such payments. We recommend similar procedures be performed for payments processed through the Post Bank.

Federal Ministry of Social Policy, Refugees and Displaced Persons

KM 742,171 was transferred to Veletex, a state-owned clothing company in Tuzla. This payment was the result of a law suit brought by Veletex to collect rent of approximately KM 88,000 plus interest dating back to 1994. There are many strange twists to this case. These include the fact that the payment was made from the Ministry of Social Policy via forced transfer from a blocked ZPP account four days after the Sarajevo Court annulled an earlier judgement allowing the debt. In addition, the case is naming the Ministry of Social Policy as the successor organization to the Logistic Center of the Tuzla County, which originally owed the rent. Since this organization is not a legal entity, it appears as if the defendant should have been the Federation and not the Ministry. Veletex claims they spent the money on back salaries and other items and cannot return it. The dates, amounts and circumstances are unusual and should be followed through to conclusion.

Federal Ministry of Transport and Communication

Due to the risk of failing to obtain public bids on jobs coupled with the size of payments and the use of three-party transactions, we recommend this Ministry be thoroughly audited to substantiate propriety of expenditures and value received for funds expended.

We further recommend special attention be given to substantial payments made to the railroads since the war including 12 invoices in 2000 totaling KM 8.3 million for co-financing of the railroads. The Minister admitted that since the end of the war, they received substantial payments from the international community to rebuild the railroads. However, when we noted that not much progress is visible, he could not adequately explain how the large sums of money spent for railroads were used or what had been accomplished. However, he did mention that they were currently negotiating with the international community for an additional KM 20 million. We recommend all payments going to the railroads since the end of the war be accounted for by someone independent of the Federal Ministry of Transport and Communication and the Federation. This accounting should include tracing expenditures to source documents and visually inspecting the work which took place to verify value received.

Federation Government Response

The draft of this report was sent out to the Prime Minister of the Federation for comment. We did not receive any response from him but did hear from a couple of Ministries. Their comments are included in the appropriate sections.

Dale Ralph

Special Auditor for the Federation of Bosnia and Herzegovina

Per Decision of the High Representatifve Number 88/01

Canton 7

Special Audit Report

May 29, 2001

Objective

The audit of the Canton 7 was part of a larger Bosnia and Herzegovina survey audit of selected internal controls and includes recommendations for further audit work and/or financial investigations. The primary focus of our work was on selected financial and disbursement controls. General recommendations for improving control are included in this report. The recommendations are general rather than specific due to the magnitude of the problems observed and the need for major vs. minor improvements.

The audit was not intended to be a complete or sufficient review of the Canton to form an opinion on financial statements or overall system of internal control nor was it intended to detect fraud. By design resources were limited, and the work to be accomplished was hampered by obstruction in West Mostar, the number of unusual transactions requiring additional follow up, poor and/or incomplete (or not provided) documentation, unreliable financial records and control systems. The poor state of documentation and weak (or overridden) financial controls resulted in more investigation at the transaction level than would have been required if the control systems could have been relied upon. In some cases it was almost impossible to verify transactions due to the lack of sufficient documentation.

The individual transactions and examples given in this report are presented as illustrations of the poor control observed. Although some of these transactions may turn out to be fraudulent, others may not and are presented to illustrate bypassed or lax controls and/or the potential for error and fraud. Investigations by the Financial Police are recommended. Detailed transaction-by-transaction analyses of potentially fraudulent transactions are the responsibility of the Financial Police and are beyond the scope of this audit.

Conclusion

The attempted audit of West Mostar was not able to be fully accomplished due to what we believe to be deliberate and concerted attempts to block the auditors access to critical information and documents. The attitude of some officials we dealt with was that they did not need an audit. Cooperation was mixed and worsened following the March 3 decision to establish the Croat National Congress. We were severely restricted in our examination of the West by obstructed access to adequate supporting documentation. We recommend immediate steps be taken to secure and protect the financial records from the Payment Bureaus and Ministries. Once access to documentation is assured, audit work should resume. On-going obstruction and lack of transparency within West Mostar heightens our concern about this area and the need for additional audit work. Government officials and payment bureau staff in East Mostar were cooperative throughout the audit.

Based on the limited work we were able to perform, we do not believe the system of internal control as it is currently administered is adequate to protect the assets of the canton against losses due to fraud, incompetence and carelessness. We are especially concerned about potentially diverted funds, the overall control environment and the lack of the basic accounting, budgeting and reporting controls necessary to ensure protection of and accountability for the assets of the canton. In addition, the division in Canton 7 between West Mostar (Croat) and East Mostar (Bosniak) is inefficient and costly due to the duplication it requires.

The system of internal control and enforcement process needs to be significantly strengthened. We are especially concerned about the control environment and overall attitude toward implementation and enforcement of internal controls. We recommend implementing a strong framework and system of internal controls in accordance with internationally recognized standards. We further recommend steps be taken to build a strong oversight body, such as the Supreme Audit Institute, which is independent of the functions it audits. Adequate measures should be taken to ensure on-going independence of this function including protecting the funding of the Supreme Auditor in order to prevent the problems noted in this report from recurring. We understand that the Swedish National Audit Organization is working toward strengthening the Federation Supreme Audit Institutions to bring them in line with internationally recognized standards. We support this goal and strongly encourage government to make this a priority since we do not believe any substantive change will take place without independent review and reporting.

Scope

From the 2000 Canton 7 budget, we judgmentally selected a few primarily larger ministries and organizations, which received some or all of their funding from the canton budget. Where access was not deliberately blocked, we reviewed payment bureau records for the chosen entities, judgmentally selected a limited number of transactions and traced them to supporting documentation (ZPP transaction slips, invoices, contracts, resolutions, payroll records, etc.). This documentation was reviewed for reasonability of the expenditure and propriety of the documentation. We visited the selected ministries and organizations in the course of our audit work to obtain information on the transactions and their processes. We performed limited testing of selected payroll records.

Background

The Canton 7 is split into East Mostar and West Mostar ethnicities, with two different party affiliations and for all practical purposes acting as two separate governments. Throughout the audit we experienced cooperation from East Mostar and obstruction from West Mostar.

Early in this audit we obtained electronic information from the payment bureau and reformatted it into a database of 100 percent of the expense transactions. These records consist of the postings made to payment bureau accounts, but do not provide information on the purpose of each transaction. This electronic information enabled us to determine which accounts initially received funds from the canton and where the recipient of the funds spent them. Although we have some income information, our records do not include the distribution from tax accounts, which is the largest source of income. When completed, we provided our electronic database on CD to the Financial Police and Supreme Auditors to assist them in their work.

Actual Year 2000 expenditures for the joint canton as reconstructed from payment bureau records are as follows:

According to Canton records available at the time of our audit, which were not reconciled to payment bureau records (see recommendation below), expenses were categorized as follows.

Internal Control Recommendations

Based on the limited audit work performed to date, we noted a number of areas where we believe internal control could be significantly improved. In order to establish accountability, transparency and fiscal responsibility, a basic framework and system for internal control will need to be adopted using an internationally recognized framework such as the Committee of Sponsoring Organizations Integrated Framework for Internal Control. The very basics of good internal control practices were not evident. Highlights include the following recommendations.

• Ensure canton assets are not inappropriately diverted. Canton 7 was one of the original shareholders of the Hercegovacka Bank along with Cantons 8 and 10. Each canton contributed KM 500,000 at the end of 1997. Mostar denied having access to any of the requested documentation regarding their ownership interest. Therefore, we examined court records and found that each of the cantons "donated" their shares in April of 1998. Canton 7 gave their shares to "Mondo". The original purchase of shares and the subsequent "donation" appear to be inappropriate and potentially fraudulent diversions of public funds.

• Substantially improve the control environment. The control system is only as good as those who administer it. As long as individuals at all levels within the government can individually or in collusion with others override the system, internal controls are meaningless and only represent additional bureaucratic steps that must be taken to produce the illusion of control. This issue is not only a problem in Mostar but exists throughout Bosnia. Form over substance often prevails and those responsible for administering and/or checking controls too often fail to look beyond the documents to the substance of the transaction.

• Implement independent and enforced policies and procedures to ensure financial transparency, accountability and reporting. Throughout the audit we asked for various types of supporting documentation including items such as "Grants to non-profit organizations and common institutions". Much of this documentation was never produced. As previously mentioned, we believe much of the failure to produce documents was deliberate. In other cases, we believe the documentation does not exist. Much work remains to be done to improve the documentation and accountability for financial transactions.

• Improve budgetary control, support and analysis. In spite of multiple requests, we were unable to obtain any support for how the budget amount for each category was determined. We found analyses and documentation did not exist or were insufficient to support the increases, decreases and changes to canton budgets. If a category of expenditure was in the original budget, the explanation for a payment against that category was "in the framework of the budget". However, there was no tabulation of payments and comparisons to budget to monitor spending. When actual funds fell short of original expectations, there were no analyses to support distribution of limited funds.

• Upgrade Canton Internal Audit Function. The West Mostar part of Canton 7 has one auditor and an assistant. The auditor attended a book study course on audit methodology and has a Certificate of Attendance from the US Agency for International Development. However, contrary to his claims, he does not hold any internationally recognized certification. He claims he works part time on an "as needed" basis. He was unable to provide a work plan, policies, procedures, methodology, standards, or any other standard documentation you would expect from someone in his position. In addition to previous recommendations concerning auditing, if the canton wishes to employ their own staff to help improve and monitor controls, they should ensure that the individual is qualified and is adhering to internationally recognized standards of practice for the profession. However, under no circumstances should the work of any canton auditors be allowed to replace the requirement for independent audits of the canton by the Supreme Auditor of the Federation, as noted earlier in this report.

• Formalize and tighten controls over cash payrolls. Salary payments are made in cash, which demands a significantly higher level of control than is normally exercised over less liquid assets. During our examination of payroll processing for selected sub ministries and one hospital, which received funding from the canton, we found inadequate segregation of duties. It was common practice to have one employee in charge of the entire payroll process including calculation of pay, ordering of cash, stuffing envelopes, distribution and recording. Although this may be considered more efficient, it introduces significant risk of loss of funds and does not conform to international best practices. No one person should be in a position which enables them to divert cash and cover up by making entries to the records. Once segregated, the divided functions should not report up to a common manager who can override the process.

Recommend Future Audit Work

St. Stephan Tomasevic Organization. We requested documentation for KM 840,500 of canton funds, which were transferred to this account in 2000. The documentation received from the Ministry of Finance only provides a vague general description such as "decision in the frame of the budget". Requests for further information were met with resistance and evasive answers. Further investigation is recommended of these original transactions and others to determine the basis for these transactions and support for the transfers. The relationship between the West Mostar Canton government and officials and this organization should be thoroughly researched.

Croat Community Herzeg-Bosnia (HZHB) Fund Each of the Croat controlled cantons throughout the Federation are "asked" to pay a "tax" to the HZHB in Mostar. During the Year 2000, approximately KM 4.3 million of the KM 4.6 million in income of HZHB was received from Cantons 2, 7, 8 and 10. Another KM 261,000 was received from Mostar Pension Fund, Mostar Health Fund and the Mostar ZAP. The money was primarily used to fund parallel structures, which exist in Mostar. Approximately KM 4.3 million went to parallel organizations which included: University of Mostar, HRT, Student Center, Center for Legal Aid, Croat National Theatre, Bureau for Schools, Habena, Mostar Orchestra, Croat Lexicon, Erotel, Croat Archive, Croat Museum, Center for Research, Protection of Monuments, Union of Croat Writers and Union of Artists. Other payments totaling approximately KM 400,000 went to HDZ, Auto Kuca Jelic, Cash, Financing of the November Referendum, Hotel Ero, Hercegovina Osiguranje and Reiseservice Travel.

The normal pattern of funds flow is from the canton to the Croat Community Fund. The Croat Community Fund then disburses funds to the parallel structures. However, for the month of September the pattern changed. In that month, funds from all cantons were paid into the Croat Community fund as usual. However, the Fund then disbursed these monies to the budget account of Canton 8, which then distributed the funds to the end users. This was a strange pattern, which should be further investigated.

With difficulty and several delays, we managed to obtain selected documentation for a number of transactions from the HZHB. However, this information is inconclusive and further research is necessary in order to substantiate the validity of payments from this account. Work is also recommended to determine if the payments to the fund are in fact voluntary or forced. The staff of the Canton 7 told our auditor that they were "required" to give 3 percent per year to this fund.

In addition to KM 2.40 million in payments to the University of Mostar from the cantons through this fund, two of these cantons supplied another almost KM 1.4 million directly to the university. Canton 6 also gave KM 300,000. We recommend further follow up and research be completed to substantiate payments to and from the University of Mostar. The University of Mostar is run by a Director of the Hercegovacka Bank.

Information regarding the KM 200,000 in funds received from the Pension Fund has been given to the OHR and is now in the hands of the Financial Police for further investigation in relationship to their work on the Pension Fund.

Legal Support Center. We were told this is an association established to provide legal help to "defenders and families of deceased defenders from the homeland war". Most of the 1.6 million income from this account came from government related sources, while most of the expenditures are going out to banks or in cash. We were unable to obtain adequate documentation to support the transactions and recommend this account and the centers relationship to the government be followed up.

Ministry of the Interior. We noted a number of transactions for which we could not obtain adequate supporting documentation.

• A large portion of the expenses related to payroll. When we requested documentation from the Chief and Deputy Chief of Finance, they made it clear that our inquiries were not welcome. The documentation they eventually provided wasnt of much value. For example KM 1,234,000 was transferred monthly from the Minister of Finance for salaries. However, the July transfer (KM 1,014,849) decreased, but we could not obtain a satisfactory reason for this decrease.

• Financial management did not provide reasonable explanations for monthly transfers of KM 225,000 for materials and the October transfer of KM 260,000.

• The Minister of Finance told us payments to Vakufska Bank totaling KM 2.07 million were for repayments on a rolling loan facility (revolving line of credit) arranged by the Ministry of Finance. Supporting documentation was not provided.

• Six payments of KM 66,000 were made to the company "POLICEMAN" ("REDARSTVENIK"). During our visit they could supply no supporting documentation. The following day a clerk from the Ministry showed up with a government decision granting KM 66,000 per month to "obtain physical security of objects." The legality of the decisions and supporting documentation need to be verified.

Offices for Invalid Fighters and Families There are offices in each major town, which make monthly payments to invalids from past wars. Payments are in the range of KM 50 to KM 240 per month depending on the extent of disability. Some funding comes from the Canton, but the Federation provides most. We reviewed limited records at the Konjic branch. However, we believe this entire area should be examined in detail in order to ensure payments are going to individuals who are entitled to receive them, and the amounts are being calculated based on objective criteria. Special attention should be paid to controls over adding and removing individuals from the list of pensioners.

Salaries Based on the poor controls observed, and large amounts expended in cash, we recommend this area be examined in depth including personally identifying individuals, ensuring they are appropriately employed, salary is accurately calculated and controls over increasing pay and adding and deleting individuals from the payroll are appropriate. We further recommend that confirmation procedures be used to verify payments went to the appropriate people in the appropriate amounts. In cases where individuals have not been paid, reasons for non payment should be carefully investigated including substantiation of alternative use of the cash.

Dale Ralph

Special Auditor for the Federation of Bosnia and Herzegovina

Per Decision of the High Representatifve Number 88/01

Canton 8

Special Audit Report

June, 2001

Summary

The attempted preliminary audit of Siroki Brijeg could not be accomplished due to outright obstruction by public officials and the Siroki Brijeg Payment Bureau staff. What little initial cooperation the auditor did receive, stopped immediately following the March 3 decision to establish the Croat National Congress. Although a few meetings took place and a few documents were provided, it became obvious early on that they were not going to cooperate. Multiple verbal and written requests for meetings, documents and answers produced little more than a litany of reasons and excuses for failing to provide requested information. OSCE experienced similar problems with obtaining information during the political party audit in October and November of 2000. Siroki Brijeg has an on-going history of obstructing any meaningful access to information.

We strongly recommend that immediate steps be taken to secure and protect the financial records from the Payment Bureaus and Ministries. Once access to documentation is assured, we recommend a complete audit take place.

Siroki Brijegs strong defense against any form of transparency raises serious concerns about the control consciousness of the government officials and the resulting control environment they have established. In addition, based on the limited work we were able to complete, we do not believe the system of internal control as it is currently administered is adequate to protect the assets of the canton against losses due to fraud, incompetence or carelessness. We are especially concerned about the possible diversion of funds and the overall control environment.

Although we were prevented from auditing this canton and later prohibited from entering the town, we identified questionable activities and transactions, which we believe need to be further investigated once we can obtain unobstructed access to the documentation. Therefore, this report is split in three sections: General Information, Internal Control Recommendations and Items for Further Investigation.

General Information

Early in this audit we obtained electronic information from the payment bureau and reformatted it into a database including all expense transactions. Therefore, we were able to determine which accounts initially received funds from the canton. As of the date of this report we were only able to access very limited income information amounting to perhaps seven to nine percent of the total income. When completed, we provided our electronic database of expense transactions on CD to the Financial Police and the Supreme Auditors to help assist them in their work.

Spending for the Canton 8 for the Year 2000 as reconstructed from these partial electronic payment bureau records consists of the following categories:

Internal Control Recommendations

Failure to provide any meaningful access to information leads us to believe there are significant problems with the control structure and environment, and we recommend immediate steps be taken to establish and enforce adequate internal controls.

Ensure canton assets are not inappropriately diverted.

• Canton 8 was one of the original shareholders of the Hercegovacka Bank along with the Cantons 7 and 10. Each canton contributed KM 500,000 at the end of 1997. Canton 8 officials told us they could not supply information regarding their ownership interest as they were moving offices. Therefore, we examined court records and found that each of the cantons "donated" their shares in April of 1998. Canton 8 gave their shares to the private enterprises "AG Karmen", "Mucic & Co", GP Toming" and "Graming" The original purchase of shares and the subsequent "donation" appear to be inappropriate and potentially fraudulent diversions of public funds. G.P. Toming obtains practically all of their funding from government sources."

Substantially improve the control environment. The control environment is the foundation for all other components of internal control and provides the discipline and structure for government processes. It encompasses the ethical values, integrity, competence of staff, philosophy, operating style and the way management assigns authority and responsibility.

The control system is only as good as those who administer it. As long as individuals at all levels within the government can individually or in collusion with others override the system, internal controls are meaningless and only represent additional bureaucratic steps that must be taken to produce the illusion of control. Form over substance often prevails and those responsible for administering and/or checking controls too often fail to look beyond the documents to the substance of the transaction.

Improving the control environment at the substantive level is a difficult but critical undertaking, which will necessitate verification and reporting by individuals independent (in form and substance) of the persons and political parties in charge. Care should be taken to verify the selection and maintenance of independent staff in critical control positions. Suggestions to improve the process include strengthening the Supreme Auditor function to bring this department in line with internationally recognised standards including ensuring that the Supreme Auditor reports to the highest level possible and is independent of those they audit to help ensure issues are reported and appropriate action taken without government interference. Resources for independent auditing should not be controlled by the departments they review.

Annual reviews of the Supreme Auditor function by an independent, experienced and qualified internationally recognised firm are also recommended to help ensure on-going independence and adherence to standards. We understand the Swedish Audit Organization is working to strengthen the audit institutions. We support and encourage this activity.

Items for Further Investigation

Compensation Transactions with Elektroprivreda On December 14 and 15, 2000, Canton 8 processed an entry to compensate Elektroprivredna for KM 771,734, which is part of a larger compensation of KM 1,994,933, of debts between Elektroprivreda, municipalities and the Canton. These debts went back several years and were never paid "because of the war". Coincidentally, on the same date (December 14, 2000) we found KM 2 million was deposited to Elektroprivrednas Account at Hercegovacka Banka. The next day KM 1.5 million was withdrawn and the remaining KM .5 million was withdrawn on December 18, 2000. In addition another KM 3 million was deposited to Elektroprivrednas Account at Hercegovacka on December 28, 2000 and withdrawn in total the next day. Further investigation needs to take place to determine if these transactions are valid and/or related to each other.

Compensation transactions are considered high-risk in that they can easily be used to cover up the true essence of what is happening. Therefore, we believe the compensation transactions as well as the potentially related cash transactions should be thoroughly followed up and investigated since they could potentially be used as a method of diverting cash.

We further recommend compensation transactions be totally eliminated because of the high potential risk for diverting funds and obscuring the transaction details.

Payments to Ljanovice via Compensation The contract between this large meat company and the Ministry of Defense requires the company to supply meat to the Ministry in return for payments from a third party, which can be made by compensation. In spite of our requests, we never received a copy of the decision to support this method of payment. In addition this company obtains a large amount of their business from government sources and does a significant amount of its business in cash. Selected transactions should be carefully examined for validity, the process used to select this vendor, evidence of receipt of all items billed to the appropriate person at the appropriate location, and competitive pricing for large quantity purchases. The process used to select the vendor should also be examined. We will need to obtain the required supporting documentation, which was denied to us during our audit.

Transactions Related to the Government of Canton 8 We selected three transactions paid by the government of West-Herzegovina Canton for KM 250,000 to G.P. Toming, a construction company. We obtained a copy of the contract between G.P. Toming and the Canton for the construction of a sports center in Drinovic-Grude for KM 266,820. However, we noted that a total of KM 750,000 has been paid to this company. An additional KM 357,842 of Canton budget funds were also spent with this company. We requested 22 payment slips from G.P. Toming in order to investigate further. The payment Bureau was uncooperative, and the company provided a number of "reasons" for failing to provide requested information.

We found two transactions dealing with a KM 450,000 loan from the government of West-Herzegovina to the Budget of West-Herzegovina Canton and a repayment of KM 200,000 from the Canton to West-Herzegovina. We could not obtain an explanation for these transactions and were told to "ask the Prime Minister". We sent faxes requesting required information, which went unanswered. Following the submission of our draft of this report, the Canton responded by saying that the West Herzegovina Canton adopted Conclusion No. 01-454/00 approving the loan. However, once again the appropriate documents were not submitted.

Payments to "Roads" Ceste (Roads) received KM 197,350 from the canton during 2000. We requested 17 payment slips from Roads. The payment bureau was uncooperative and we have not been able to obtain the required information.

The above follow up items are in no way to be construed as the only items requiring follow up. As previously stated, we were unable to audit Canton 8 due to the significant obstruction we encountered. We believe that a number of additional items would be identified if we are provided access to required documentation.

Response of Canton Management

The Canton submitted a response in which they denied our comments regarding their lack of cooperation. Most of the claims made in their response were not supported by appropriate documentation. Where appropriate, we made changes to this report as a result of their response. We maintain that this Canton should be thoroughly investigated by someone independent of the Canton and the Federation once cooperation is assured and complete, unrestricted and timely access to information is provided.

Dale Ralph

Special Auditor for the Federation of Bosnia and Herzegovina

Per Decision of the High Representatifve Number 88/01

Canton 9

Special Audit Report

June, 2001

Objective

The audit of the Sarajevo Canton was part of a larger Bosnia and Herzegovina high-level survey of selected internal controls and includes recommendations for further audit work and/or financial investigations. The primary emphasis of our work was on financial and disbursement controls. General recommendations for improving control are included in this report. The recommendations are general rather than specific due to the magnitude of the problems observed and the need for major vs. minor improvements.

The audit was not intended to be a complete or sufficient review of the Canton or any individual Agency to enable the auditor to form an opinion on financial statements or overall system of internal control nor was it intended to detect fraud. Resources were limited by design, and the work to be accomplished was hampered by the large number of unusual transactions requiring additional follow up, poor and/or incomplete (or not provided) documentation and unreliable financial records and control systems. The poor state of documentation and weak (or overridden) financial controls resulted in significantly more investigation at the transaction level than would have been required if the control systems could have been relied upon. In many cases it was almost impossible to verify transactions due to the lack of sufficient documentation. In some cases we questioned the validity of the documents provided.

The individual transactions and examples given in this report are presented as illustrations of the poor control observed. Although some of these transactions may turn out to be fraudulent, others may not and are presented to illustrate bypassed or lax controls, which could result in the potential for error and fraud. In some cases investigations by the Financial Police may be warranted. Detailed transaction by transaction analyses of potentially fraudulent transactions is the responsibility of the Financial Police and is beyond the scope of this audit. However, regardless of the outcome of any further investigations, the illustrations given in this report show the need for enhanced control. Control should not be measured only at the time a transaction is found to be fraudulent. Measures must be taken to help ensure that fraud is not possible. If the control system is weak enough to permit fraud (whether or not it is taken advantage of), it needs to be improved immediately. The emphasis of this report is to assess and improve the quality of the existing systems of internal control.

Conclusion

Although we examined limited areas, we found frequent and consistent problems in all areas we looked at. For the areas we examined we did not find evidence that the internal control system as it is currently administered is adequate to protect the assets of the canton against losses due to error, incompetence and possibly fraud. We are especially concerned about the controls over disbursements and the overall control environment.

We noted that many documents, which we sampled, were officially stamped, approved and supported by decisions. This evidence, along with discussions with various Agencies and staff, suggest an adequate system of internal controls is in place. However, upon further investigation, we found the substance of these apparent controls to be lacking. For example, there was little or no evidence of follow up to ensure the funds were expended as intended, supporting documentation was incomplete, methods of selecting vendors were inappropriate, and it is evident that controls can be easily circumvented.

The system of internal control and the enforcement process needs to be significantly strengthened. We are especially concerned about the control environment and overall attitude toward implementation and enforcement of internal controls. We recommend implementing a strong framework and system of internal controls in accordance with internationally recognized standards. We further recommend steps be taken to build a strong independent oversight body for canton governments, such as the Supreme Audit Institution of the Federation. Adequate measures should be taken to ensure on-going independence of this function including protecting the funding of the Supreme Auditor in order to prevent the problems noted in this report from recurring. We understand that the Swedish National Audit Organization is working with the Supreme Audit Institution toward this end. We support this goal and strongly encourage government to make this a priority since we do not believe any substantive change will take place without independent review and reporting.

Background

Early in this audit we obtained electronic information from the payment bureau (ZPP) and reformatted it into a database that includes all income and expense transactions over KM 10,000 for the Year 2000. These records consist of the postings made to ZPP accounts, but do not provide information on the purpose of each transaction. This electronic information enabled us to determine which accounts initially received funds from the canton and where the recipient of the funds spent them. When completed, we provided our electronic database on CD to the Financial Police and the Supreme Auditors o help assist them in their work.

We consolidated the Canton main budget accounts to determine the major (over KM 5 million) recipients of the funds, which are shown below. The totals only reflect the totals of individual disbursement transactions over KM 10,000.

Internal Control Recommendations

Implement and enforce policies, which ensure appropriate quality at lowest cost and protect against special interests and conflicts of interest including the "appearance" of any conflict of interest.

We noted the Sarajevo Canton and related Ministries and Agencies transact business with a relatively small number of companies. Many of these companies derive most of their income from public sources. Below is a partial listing of such companies.

*Bank activity represents payments from banks, which may consist of withdrawals from bank accounts or funds which went directly to the bank and did not pass through the payment bureau accounts.

** Unidentified are transactions categorized as "Out of Area" on electronic payment bureau records or with unidentified entities. Determination of accounts requires analysis of paper-based records.

*** See comments regarding this company in the Federation Special Audit Report, Ministry of Social Policy section.

In addition to the above, Projekt is a company of mixed public/private ownership, which derives practically its entire KM 3.4 million annual income from Sarajevo Canton. From the above list Gradnja Union Radovi is a private construction company, which derives over half of its KM 1.3 million income from Sarajevo Canton alone.

Although receiving large amounts of canton and other public business is not necessarily a problem, in and of itself, it may be an indication of weaknesses in the procurement and public tender process or the enforcement of that process. Weaknesses in this process can lead to favoritism at public expense, overpaying for goods and services and potential diversion of funds for goods not received. As noted below we found weaknesses in the procurement process in the Agency reviewed in this canton, and we noted similar problems during our audits of the Federation and other cantons. Therefore, we recommend the Canton procurement policies, including the means of enforcement, be carefully reviewed. We further recommend the Supreme Audit Institute annually review expenditures of the Canton to determine companies, which derive significant income from the canton and their agencies. The relationship of the company to the canton or agency should be investigated along with procurement process and individual selected transactions.

SARAJEVO CANTON BUILDING INSTITUTE

Income and expenditure of Sarajevo Canton Building Institute funds (totals over KM 10,000) are as follows:

Internal Control Recommendations

Ensure strict adherence to public tender process. Improve controls over disbursement of public funds.

Institute management told us that the Sarajevo Canton Building Institute is required by law go through a public tender process for any project, which makes use of canton funds. However, Building Institute staff told us only a limited number of companies are qualified to do the required work, limiting their choices. We reviewed a number of supporting documents for work performed by Sarajevo Canton Building Institute and noted the following:

• The amount of winning bids opened in public was changed. The original minutes had one price and the contract contained a second price. In at least one instance this change made a difference to the company the bid was awarded to. In other instances the price was increased from the price contained in the minutes.

• Requested proof of public tender was not provided on some contracts. On the larger contracts, we were told by Building Institute staff they didnt conduct the bidding since they only supervised the work for the Ministry of Transport and Communications. (Please see the Ministry of Transport and Communications section of this report. Ministry of Transport and Communications has not put a contract out to bid since 1998.)

• In some cases the signature date on the contract was after the date the work began.

• Proof of public tender was not available for SES and other companies that worked on city lighting. Sarajevo Canton Building Institute management told us these are cases where they needed several contractors; therefore, the Sarajevo Canton Building Institute selected the vendors and obtained their agreement as to prices, which would be charged.

• The final cost paid for some projects exceeded the original winning bid or contract due to the addition of "unexpected works" and additions not included in the bid process. In one case this difference was over twice the cost of the winning bid. Although it is normal for things to change during construction resulting is pricing differences, we do not expect to see differences to the extent observed.

• We were not provided with documentation of public tender for Butmir for the "urgent recovery of the facades in Sarajevo". The signature date on the contract was a month after the start date and the attached price list is dated six weeks after both the start date and date quoted in the contact for the price list. (In our other audits we noted other problems with this "construction" company, which also received milk subsides as well as payments from the Ministry of Defense, Sarajevo Canton and Federal Employment Fund. See additional comments regarding Butmir in the Federation Audit Report under the Ministry of Agriculture section.)

Even though Sarajevo Canton Building Institute management assured us that there was a control system in place, which they described in detail, the reality of the number of exceptions noted above tells us that it isnt strictly adhered to and can be easily overridden. In addition, for a variety of reasons, not all contracts go through a public tender process. When they do not go through public tender, the Canton Building Institute ultimately decides who to ask to bid, which ultimately enables the system to be manipulated. We recommend the entire process be reviewed and revised to provide better control and enforcement to ensure contractors are selected in an unbiased manner based on objective criteria without any real or apparent conflicts of interest. Extra effort should be expended in developing enforcement mechanisms including regular audits by an independent oversight body.

Improve controls over calculating and paying compensation and expropriation payments.

• Damages caused by building of the Blue Road

• Other

SARAJEVO PRIVITIZATION AGENCY

We consolidated the Privatization Agency accounts. Major uses of funds are presented below. This represents the total of transactions over KM 10,000.

Examine process for controlling disbursement of Privatization Agency funds.

The revised Federation law permits funds derived from privatization activities to be distributed to the Pension Fund. We understand from discussions that the use of Canton (vs. Federation) privatization funds is also governed by this law. During 2000 approximately KM 4.8 million was distributed to the Federation Pension Fund. In addition, KM 3.5 million went directly to the Sarajevo Canton Building Institute for infrastructure projects. Federation law once again permits this use of funds. However, we question the process of disbursing funds directly from the Privatization Fund, which increases the risk of circumventing cantonal financial and budgetary controls over these funds to help ensure they are expended appropriately as allowed by the Privatization law. (See Sarajevo Canton Building Institute section of this report). We recommend the process for controlling the distribution and use of these funds be examined.

Items for Further Investigation

Sarajevo Privatization Agency

We observed a number of areas within this agency that warrant detailed review. We are especially concerned about the transfer of funds back to the companies, which were privatized. Although we understand this is allowed under the law in certain circumstances, we believe independent verification of the circumstances and qualification should be undertaken by someone well versed in the law and totally independent of the Canton, selling companies and the Privatization Agency. We are concerned that the legal framework may not provide adequate control to prevent the Director or Management of companies to be privatized from manipulating the process for personal gain in a variety of scenarios. We reviewed selected files and noted the following, which should be followed up.

• Allowing the use of uncollectable pre-war foreign currency accounts as substantial part of the cash down payment.

• Reducing cash down payment for earlier reinvestment in premises

• Price per square meter varied from KM 14 to KM 3,500. Although we expect prices to vary depending on location and condition, the variations presented here do not appear reasonable.

The issues concerning manipulating the amount of cash required is especially worrisome given the fact that certificates can be purchased for 2-3 percent of their face value resulting in obtaining the business for next to nothing. We recommend the Financial Police look into this agency.

Canton Governments Response

A draft of this report was previously sent out for comment. The Prime Minister of Sarajevo Canton Government responded positively by accepting the recommendations. He stated that they have very seriously begun to resolve the issues indicated in this report and included a copy of Conclusion No. 02-05-559/01, which addresses the issues including improved additional auditing by the canton. We encourage this enhanced oversight and wish to stress that audits conducted or commissioned by the canton should under no circumstance be allowed to replace our recommendation that audits be conducted (or commissioned) by an independent oversight body, which is completely separate from canton.

Dale Ralph

Special Auditor for the Federation of Bosnia and Herzegovina

Per Decision of the High Representatifve Number 88/01

Canton 10

Special Audit Report

May 29, 2001

Objective

The audit of Canton 10 was part of a larger Bosnia and Herzegovina survey audit of selected internal controls and includes recommendations for further audit work and/or financial investigations. The primary focus of our work was on selected financial and disbursement controls. General recommendations for improving control are included in this report. The recommendations are general rather than specific due to the magnitude of the problems observed and the need for major vs. minor improvements.

The audit was not intended to be a complete or sufficient review of the Canton to form an opinion on financial statements or overall system of internal control nor was it intended to detect fraud. By design resources were limited, and the work to be accomplished was hampered by the number of unusual transactions requiring additional follow up, poor and/or incomplete documentation, unreliable financial records and control systems. Although Canton 10 staff was cooperative throughout the audit and promptly provided information when requested, we found the existing documentation and financial controls to be weak resulting in more investigation at the transaction level than would have been required if the control systems could have been relied upon. In some cases it was almost impossible to verify transactions due to the lack of sufficient documentation.

The individual transactions and examples given in this report are presented as illustrations of the poor control observed. Although some of these transactions may turn out to be fraudulent, others may not and are presented to illustrate bypassed or lax controls and/or the potential for error and fraud. Detailed transaction-by-transaction analyses of potentially fraudulent transactions are the responsibility of the Financial Police and are beyond the scope of this audit.

Conclusion

Based on the limited work performed, we do not believe the controls as currently administered are adequate to protect the assets of the canton against losses due to incompetence, carelessness or fraud. We are particularly concerned about the overall control environment as well as weak controls over financial reporting, monitoring and analysis, appropriate segregation of duties and the selection of vendors based on price and quality vs. relationships. Implementing, enforcing and independently monitoring adequate controls, which cannot be overridden, is a hallmark of fiscal responsibility and good management of pubic funds.

We believe the system of internal control and enforcement process needs to be significantly strengthened. We recommend implementing a strong framework and system of internal controls in accordance with internationally recognized standards. We further recommend steps be taken to build a strong independent oversight body, such as the Federation Supreme Audit Institution. Once built, adequate measures should be taken to ensure on-going independence of this function including protecting the funding of the Supreme Auditor in order to prevent the problems noted in this report from recurring. We do not believe any substantive change will take place without independent review and reporting.

Scope

From the 2000 Canton 10 budget, we judgementally selected a few primarily larger ministries and organisations, which received some or all of their funding from the canton budget. We reviewed payment bureau records for the chosen entities and judgementally selected a limited number of transactions and traced to supporting documentation (ZPP transaction slips, invoices, contracts, resolutions, payroll records, etc.). This documentation was reviewed for reasonability of the expenditure and propriety of the documentation. We visited the Livno payment bureau in order to pull our own supporting documentation. We also visited selected ministries and organisations in the course of our audit work to obtain information on the transactions and their processes.

Background

Early in this audit we obtained 100 percent of the expense transactions from the Cantons payment bureau records and reformatted it into a database. These records consist of the postings made to ZPP accounts, but do not provide information on the purpose of each transaction. This electronic information enabled us to determine which accounts initially received funds from the canton and where the recipient of the funds spent them. Although we have some income information, our records do not include the distribution of income from the tax accounts, which is the largest source of income. When completed, we provided our electronic database on CD to the Financial Police and the Supreme Auditors to help assist them in their work.

Spending for Canton 10 for the Year 2000 based on our electronic payment bureau records was.

According to Canton manual records the actual amount spent was KM 26,877,173, which is KM 3,249,308 greater than our records. We were not able to reconcile this difference, and the Canton was unable to fully explain the difference. The canton did not provide a final accounting by the end of our fieldwork claiming it was not yet prepared. According to the records the canton could supply, total expenses for Year 2000 were categorized as follows:

• 70% - Human Resources
• 15% - Grants for welfare of various groups of citizens and municipalities
• 7% - Goods and services
• 7% - Capitalized expenses

Internal Control Recommendations

Ensure canton assets are not inappropriately diverted. Canton 10 was one of the original shareholders of the Hercegovacka Bank along with the Cantons 7 and 8. Each canton contributed KM 500,000 at the end of 1997. Canton 10 failed to respond to our requests for documentation of their ownership interest. Therefore, we examined court records and found that each of the cantons "donated" their shares in April of 1998. Canton 10 gave KM 255,000 of their shares to "Mondo", and we do not have records for the remaining KM 245,000. However, we do know that they no longer have these shares. The original purchase of shares and the subsequent "donation" appear to be inappropriate and potentially fraudulent diversions of public funds.

Build a strong control environment. A strong control environment is the basis on which all other internal controls rest. It provides the discipline and structure of the organization and includes managements philosophy, ethical values, operating style, assignment of authority and responsibility, competence of staff, development of people and attention provided by Parliament.

Based on our audit work throughout Bosnia and this canton, we observed that it is possible for controls to be easily overridden (in substance if not technically in form) individually or collusion at all levels of government. When it is possible to override controls, they become meaningless bureaucratic steps that must be taken to produce the illusion of control. We encourage management to adopt and demonstrate the highest commitment (in substance as well as form) to a strong control environment to protect the public interests.

We recommend management develop and adopt a framework of internal control, which is consistent with internationally recognized standards, such as the Committee of Sponsoring Organizations (COSO) Integrated Framework. Adopted controls must be enforced. A program of zero tolerance for non-compliance should be aggressively employed. A series of independent audits by auditors, who do not report to the canton management and who are not dependent on the canton for their funding, can help ensure that irregularities are identified, reported and corrected in a timely manner.

Improve financial control and reporting.

As of the date of this report, the Canton still did not have (or did not provide) a final accounting for the Year 2000. The records we did see were manual and did not agree with our payment bureau records indicating that their manual records were not reconciled to payment bureau records limiting their accuracy and usefulness as a financial tool. Also, the long delay between year end and preparation of statements leads us to the conclusion that these records were not actively used as a means of monitoring spending or as a tool for financial analysis. Reporting, reconciling and analyzing months after the close of the year is of little value since the money is already spent. As of the time of our review, the adoption of internationally accepted accounting standards for governmental entities was not evident. Supporting computer software and basic financial controls did not exist. Therefore, we could not rely on the financial records and reporting.

A strong system of internationally accepted financial controls should be immediately adopted which encompass fair and accurate reporting as well as appropriate segregation of duties. Controls should be supported with appropriate software to enable prompt reporting and analysis. We understand that a project in underway in Bosnia to implement appropriate financial software.

Improve bidding process to ensure unbiased, cost effective selection of vendors and the appearance or reality of conflicts of interest. During the year a portion of the Government Building in Livno was renovated. This job consisted of adding one floor and the roof. The documentation shows five companies bidding but only two showing up for the opening of the bids. Although the selected bidder, Li-Grad, had the lowest price of KM 260,347, according to the documentation supplied, the total amount paid to them was considerably more than the bid price. There were additional charges for the same government building, which were covered under two additional annex contracts for KM 90,100 (building façade) and KM 40,530 (heating) plus an additional billing for KM 85,940.91 for "unexpected works". Although the initial bid acceptance appears to be in compliance with the form of the law, final price is considerably greater than the accepted bid, which appears to violate the intent and spirit of this same law.

The total cost of this renovation appears excessive when compared to the cost of building an entirely new structure of the same size. In addition, it is not clear why the full cost of the additional floor was not included in the original bid. Parceling out portions of projects can obscure the total price and enable controls designed to obtain the most favorable price to be easily circumvented. In addition, hiring a company, which does not have substantial income from non-government sources, is suspect both in terms of selection and ability to do the work. Approximately 80% of Li-Grads KM 600,837 income for 2000 is from government sources (KM 482,837), primarily from the Livno Support Services account (KM 462,550). Mirko Mihaljevic, who may no longer hold public office per the decision of the High Representative, approved the renovation. We do not believe the hiring of Li-Grad was an appropriate arms-length transaction.

Appropriate substantive (vs. form) procedures to ensure qualified companies with competitive prices are chosen for government projects should be adopted, enforced and independently evaluated. The level of controls within Bosnia makes it all too easy to circumvent controls to benefit selected companies at the expense of the tax-paying public.

Follow Up Items

Seventy percent of the money expended for this canton relates to Human Resource expenditures, which appears high. Due to delays in providing information and the way the records were prepared, the auditor located in Livno was unable to complete sufficient audit work to express an opinion of the accuracy and completeness of the net salaries, taxes and social contributions paid within the timeframe of our audit. However, he did obtain lists of all local government employees with ID numbers, but did not perform physical verification procedures. We recommend physical checks and other testing be completed to ensure all monies expended went to valid bona fide employees (at appropriate competitive rates) who were employed and working during the period under review. We believe this testing is especially critical given the weak controls in the canton and traditionally weak controls throughout Bosnia regarding payroll.

Canton Governments Response

A draft of our report was sent out for comment. Based on the response of Canton 10 to our audit, we made some changes to the basic report, which are reflected above. Canton 10 management reinforced the need to improve both Treasury and accounting systems throughout BiH to improve control and accountability. We concur.

Dale Ralph

Special Auditor for the Federation of Bosnia and Herzegovina

Per Decision of the High Representatifve Number 88/01

Canton 4

Special Audit Report

May 29, 2001

Purpose

The audit of the Canton 4 was part of larger Bosnia and Herzegovina high-level survey of selected internal controls to include recommendations for further audit work and/or financial investigations. The audit was not intended to be a complete or sufficient review of the Canton to enable the auditor to form an opinion on financial statements or overall system of internal control nor was it intended to detect fraud. On-going comprehensive internal control audits are the responsibility of the Supreme Auditor. Detailed transaction-by-transaction analyses of potentially fraudulent transactions are the responsibility of the Financial Police.

Situation

During our initial meetings with the new Governor of Canton 4, he raised a number of serious concerns regarding the financial practices of the former government including:

• Diverted canton funds to 140 companies the Governor believes to be fictitious.
• Manipulation of the Canton budget resulting in a deficit of KM 30 million
• Cantonal Tax Administrators diverting funds to a political party (SDA)
• Inflated charges for road maintenance invoiced by a number of firms

At the time of our visit, we found the Financial Police and a number of other organizations were auditing and investigating Canton 4 at the request of the new government. For this reason we left the investigation of the government charges up to them and truncated our audit effort until such time as the results of these financial investigations became public.

Internal Control Recommendations

The issues raised by the new government, if proven even partially true, are consistent with poor financial controls we have observed in other Cantons, Federation Ministries, and the Republic of Srpska. In cases such as this we recommend that the entire control system be reviewed and controls be built from the ground up. Care should be taken to ensure that controls are enforced and cannot be overridden. We believe building a strong independent oversight function, such as the Supreme Auditor is critical to improving internal controls and do not believe significant progress will be made without this oversight.

Ensure unbiased selection of vendors and avoid any potential or apparent conflicts of interest.

In addition to the issues raised by the new government, we noted lack of public tender on a large (KM 2.5 million) insulin contract with the Ministry of Health. There was also a payment of KM 500,000 for a hospital study. Looking at the circumstances surrounding this study, it appears that these funds were not spent in the best interests of the public.

We recommend the public tender process be reviewed and adequate controls implemented and enforced to prevent conflicts of interest and diverted funds.

Dale Ralph

Special Auditor for the Federation of Bosnia and Herzegovina

Per Decision of the High Representatifve Number 88/01

Canton 6

Special Audit Report

May 29, 2001

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Objective

Canton 6was not included in our survey audit of Bosnia and Herzegovina. However, during our review of other Ministries and Cantons, we identified a control weakness involving the Canton 6 Privatization Agency, which is presented here.

Internal Control Recommendations

Improve controls over use of privatization income. The uses of income from the privatization sales are limited by law and include expenses of the Privatization Agency, financing development and employment in the Cantons and Municipalities and pension funds. In the case of Canton 6 Privatization Agency, they placed KM 1.6 million on deposit at Gospordarska Bank in November of 2000. The following week the bank made a loan to the Canton government of KM 1.0 million using the Privatization Agency funds as security. (We also noted another KM 3.5 million of Privatization funds were put on deposit with two other banks, which we did not have time to follow up.)

This method of disbursing Privatization Agency funds appears to circumvent the law and enabled the Canton to use privatization funds for purposes other than those allowed by the Law on Privatization. The bank made another loan to the Canton in April of KM 550,000. This loan is classified as "short term"; however, if they continue to renew it as they have been doing with the KM 1.0 million loan, this classification is questionable.

We recommend the methods of controlling the ultimate use of privatization funds be reviewed and appropriate procedures be developed which ensure compliance with the spirit and substance of the law. Also, see Canton 9 - Sarajevo Special Audit Report for additional privatization control issues.

Dale Ralph

Special Auditor for the Federation of Bosnia and Herzegovina

Per Decision of the High Representative Number 88/01