California’s financial house must be put in order so that the state can move forward.

Governor Schwarzenegger called for a line-by-line audit of the state’s fiscal operation for precisely that reason. CPR created an audit team to perform such a review in accordance with Generally Accepted Government Audit Standards (GAGAS). California’s condition, for this audit, was viewed as if it were a business entity being acquired. Taken in combination with the CPR report, the audit report establishes the “line-by-line” framework and sets the stage for the state oversight function’s continuing duty to monitor and assess program performance. The review examined three areas: budget, finances, and performance. The descriptions of the review and summary findings areas follow:

• Provide an overview of the state’s budget process—from budget development, through enactment, appropriation, mid-year adjustments, total expenditures, deficiencies and future period activities.
• Identify and assess the mid-year appropriation adjustment process when revenue projections and other funding sources vary from estimates.
• Display historical data and trend analysis of state revenues, expenditures and encumbrances for the past five Fiscal Year (FY) 1998–1999 to 2002–2003.
• Display historical data on state operations and the state’s balance sheet to identify the amount of, and to determine reasons for deficiency funding.

(Percents based on actual amounts, not rounded amounts shown here.)

• General Fund ending balance decreased by $11.4 billion from $3.9 billion in FY 1998–1999 to (negative) –$7.5 billion in FY 2002–2003. The ending balance reached $9.6 billion in FY 1999–2000.
• General Fund expenditure increases outpaced revenue increases by 285 percent— expenditures increased by $20.3 billion, while revenues increased by $7.1 billion.
• Operating deficits in FYs 2001–2002 and 2002–2003 totaled $24 billion ($12.5 billion in FY 2001–2002 and $11.5 billion in FY 2002–2003).
• The operating deficits were funded by temporary borrowing and transfers and the $12.2 billion Economic Recovery Bonds issued in 2004.

• General Fund revenues increased by $7.1 billion (12.1 percent) from FY 1998–1999 to 2002–2003.
• From FY 1998–1999 to 2000–2001, revenues increased by $18.7 billion (31.7 percent) while from FY 2001–2002 to 2002–2003 revenues fell by $11.6 billion (14.9 percent).
• Revenue growth in FY 1999–2000 and 2000–2001 was primarily caused by an increase in tax revenues from stock market driven sources such as capital gains, stock options and dividends.
• Revenues returned to more typical levels, such as in FY 1998–1999, when stock market driven revenue sources diminished beginning in FY 2001–2002.

• From FY 1998–1999 to 2002–2003, General Fund expenditures increased by $20.3 billion (35.4 percent) from $57.3 billion in FY 1998–1999 to $77.6 billion in FY 2002–2003.
• The surge in General Fund revenue in FY 1999–2000 to 2000–2001 drove the increase.
• General Fund expenditures have increased by $3.5 billion for state operations and $16.9 billion for local assistance, but decreased by $0.1 billion for capital outlay.
• For five of the six entities with the largest expenditure growth, the majority of the increased funding was provided for local assistance entitlement programs.

• Six state departments/functions accounted for $15.2 billion or 75.1 percent of the $20.3 billion General Fund expenditure increase, as follows:

Department of Education	$4.1 billion
Tax Relief/Aid to Local Government	$4.0 billion
Department of Health Services	$3.2 billion
Department of Social Services	$1.8 billion
Department of Developmental Services	$1.2 billion
Department of Corrections	$0.9 billion

• Details of the increases are presented in the body of the report.

• Deficiencies account for a small percentage of total General Fund expenditures and were not a material factor to the operating deficits of FY 2001–2002 and 2002–2003.
• From FY 1998–1999 to 2002–2003, deficiencies account for 0.5 percent to 1.7 percent of total General Fund expenditures ranging from a low of $0.4 billion in FY 2000–2001 to a high of $1.3 billion in FY 2002–2003.
• Four departments have recurring deficiencies: Health Services, Corrections, Developmental Services and Forestry and Fire. These four departments accounted for $3.3 billion (84.9 percent) of the total $3.9 billion deficiencies from FY 1998–1999 to 2002–2003.

• From FY 1999–2000 to 2002–2003, General Fund unliquidated encumbrance balances increased by $0.3 billion (47.9 percent) from $0.7 billion in FY 1999-2000 to $1 billion in FY 2002–2003.
• From FY 1999–2000 to 2000–01, unliquidated encumbrance balances increased by $1.1 billion (161.6 percent) to a total of $1.8 billion.
• From FY 2001–2002 to 2002–2003, the balance was reduced by $0.8 billion (43.4 percent) to $1 billion.

• The state’s fiscal control system does not allow departments to exceed spending authority (that is, if the appropriation runs out, a deficiency must be obtained).
• From FY 1998–1999 to 2002–2003, General Fund expenditures increased consistently with spending authority increases. General Fund expenditures have increased by $20.3 billion while the state’s spending authority has increased by $21.3 billion.
• From FY 1998–1999 to 2002–2003, the state has spent an average of 97.9 percent of its spending authority.
• Reducing the spending authority by the total amount of deficiencies, the state has spent an average of 98.9 percent of its spending authority, exceeding it only in FY 1998–1999.

• Assess whether state agencies have effective systems of internal control to help detect errors and to help prevent fraud or waste.
• Verify assurances that state agencies’ financial information is timely, reliable and fairly stated—the external reporting.
• Assess whether timely, accurate and appropriate financial information is available to program managers—the internal reporting.
• Validate that Chief Financial Officers have an adequate basis to attest to their financial statements’ fair presentation.

• Many state agencies have neglected to comply with the applicable law requiring effective systems of internal controls. Consequently, the risk of fraud, waste and abuse is increased for the individual agencies and for the state as a whole.
• Additionally, the agencies, without adequate oversight may produce misstated financial statements and not be aware of the extent of the misstatement.
• Many of the state agencies required to complete internal control audits do not do so, nor do they complete required certifications as to the accuracy of their internal controls’ effectiveness. The required audits frequently identify deficiencies related to accounting and administrative controls.
• For the most part, management takes corrective action to fix identified deficiencies, but items continue to be reported from year to year. The continued internal control deficiencies could suggest that the audit function is not at the proper organizational level to effectively change the state’s control environment.
• The Financial Integrity and State Manager’s Accountability Act is being ignored by many state agencies; monitoring efforts are ineffective to ensure compliance.
• Internal auditors identified many control deficiencies that management appropriately corrects. However, systematic problems may exist.

• Numerous smaller agencies do not receive routine audits of their financial information as is typically performed on larger departments. The Bureau of State Audits (BSA) annual audit of the state’s financial statements will rarely include smaller agencies because of its high materiality audit levels.
• Most state agencies do not have internal audit units and are unable to perform routine accounting/administrative control audits. Control agency audits typically are directed at agencies with high expenditure amounts.
• Sometimes, a department’s only financial statement review comes from the State Controller’s Office (SCO), but that review is more form than substance. Nevertheless, these reviews identified problems with many agencies financial reports’ timeliness and with the accuracy of financial data. Given these conditions, we believe the state is at risk of unreliable financial information being prepared by smaller agencies.

• The large number of existing financial systems is not efficient or effective.
• The existing systems lack sufficient oversight or audit.
• Many existing systems are obsolete due to deferred maintenance.
• The state is dependent on diminishing staff resources to maintain and operate its systems and to ensure data integrity.
• The decentralization of the state’s systems has created a risk (no complete, accurate centralized inventory of fiscal systems exists).
• Systems’ design limits their use and increases maintenance (especially for systems that co-mingle accounting and program functionality).
• State laws, regulations and policies have requirements that are so complicated, standard commercial off-the-shelf software is frequently not applicable or requires customization.
• Organizationally, the state lacks a clear definition as to who is accountable for financial management and related systems (individual departments, Department of Finance, (DOF) SCO, State Treasurer’s Office, the state’s Chief Information Officer).
• The state lacks a strategic direction for financial management and related systems, and currently has no plan to get there.

• Assess the applicability and enforcement of strategic planning/performance-based budgeting, Government Code Sections and Department of Finance Budget Letter 98-07.
• Determine levels of compliance, i.e., the extent to which Agencies, Departments, Boards, Commissions, or Offices are preparing and using strategic plans.
• Assess effectiveness of agencies’ strategic planning efforts and whether adopted performance measures are useful to measure agency performance (outcome/results-oriented rather than output measures).
• Review other audits of agencies’ strategic plans and/or performance measures, assess the results, and analyze the level of statewide audit coverage of strategic planning/ performed-based budgeting processes.

• No centralized tracking/monitoring of statewide strategic planning efforts exists.
• The Legislature authorized a performance budgeting pilot in 1993, but that effort has been largely abandoned.

One hundred and six agencies were surveyed and 80 responses received (75.5 percent). Summary results follow:

• Majority of agencies perform some type of strategic planning.
• Half of reporting agencies use internal staff to develop strategic plans.
• Most agencies provide training on strategic planning, but don’t use the State Training Center (which provides some guidance).
• Most agencies prepare strategic plans but don’t forward them to DOF or submit them to the Governor’s Office.
• Annual costs (unaudited) associated with strategic planning varied greatly, but averaged $57,000.
• Less than half of the agencies responding indicated that their plans tie to an overall plan.
• An existing “Strategic Planners Group” is not well known among state agencies.
• Biggest obstacle to strategic planning is a lack of resources.

• Eighty-eight percent of responding agencies are currently using benchmarks/ performance measures.
• Most agencies have processes in place to gather/measure data.
• Performance results are regularly monitored by agency management teams.
• Agencies analyze and adjust measures and integrate changes into plans.
• Insufficient resources and inability to develop performance measures often derail efforts to establish/fine-tune performance measures.
• Agencies use of performance measures improved their focus on strategic goals and objectives.

• Twenty-four percent of responding agencies have integrated performance into their budgeting processes.
• Most agencies budgetary responsibilities are established and regularly monitored.
• Lack of resources precludes agencies from implementing a PBB process.

• Nearly half of the reporting agencies indicated that their program performance or measures were reviewed or audited.
• The Bureau of Audits (BSA) identified needed improvements in strategic planning and performance measurement.
• Some state agencies’ internal auditors conduct performance reviews of operations and programs, including assessment of performance measurement.
• The DOF’s evaluation of the performance-based budgeting pilot’s preliminary results was favorable.
• The state needs centralized control for successful oversight, guidance and monitoring.

• Approximately 60 departments employ nearly 4,000 auditors, evaluators and examiners in 90 different, distinct classifications, many with similar entry requirements and pay scales. Given the similarities, the many different classifications may not be necessary or useful.
• No separate civil services classification exists for IT auditor (apart from separate series restricted to the Bureau of State Audits and Public Employees Retirement System).
• Little coordination between state entities and among the audit units encourages inefficiency in resource allocation.
• Most audit units cite auditing standards; few have had peer reviews as required by the standards.

The following sources and information were used to conduct this audit:

The state reports its financial condition in three separate and distinct documents:

• Governor’s Budget Summary (GBS)
• SCO Budgetary Legal Basis (SCO BLB) Annual Report
• SCO Comprehensive Annual Financial Report (CAFR)
• For 2002–2003, these documents report General Fund ending balances of:

Governor’s Budget Summary	$1.6 billion
SCO BLB Annual Report	–$7.5 billion
SCO CAFR	–$13.3 billion

The differences include:

$9.2 billion in bond proceeds recognized by the GBS which is not recognized by the SCO BLB.

$5.8 billion difference between the SCO BLB and CAFR primarily consists of interfund payables ($2.1 billion) and liabilities budgeted in subsequent years ($3 billion).

• Government Code Section 12460 states that the Generally Accepted Accounting Principles basis reporting is the preferred method, which minimizes the opportunity for manipulating financial data to influence fiscal reporting.
In addition, the state’s audit community was surveyed to identify the extent and use of audit resources. To supplement the Budget Review information, a methodology was developed to drill down to the object of expenditure (i.e., salaries and wages, consultants, retirement, etc.) level for most of the entities that experienced the largest expenditure growth for FYs 1998–1999 through 2002–2003.
The following review concentrated its efforts on those broad fiscal policy issues—fiscal management and processes, budgetary control and trends, performance measurement and experience—which cut across all agencies and determine the state’s ability to interact internally and with the public.
The Budget Review provides an overview of the state’s budget process—from budget development, through enactment, appropriation, mid-year adjustments, total expenditures, deficiencies and future period activities. The analysis includes historical data and trend analysis of state revenues, expenditures and encumbrances for the past five FYs 1998–1999 to 2002–2003, as well as historical data on state operations and the state’s balance sheet to identify the amount of, and reasons for deficiency funding. To perform the analysis, a “line-by-line” assessment of budget appropriations and limited “drill-down” into individual items was included. Further, the mid-year appropriation adjustment process was reviewed to show the effects when revenue projections and funding source collections vary from estimates. This section’s conclusions highlight the difficulties in data manipulation for fiscal comparisons and show those areas/entities largely responsible for expenditure growth over a five-year period.
The Financial Review assesses whether state agencies have effective systems of internal control to help detect errors and to help prevent fraud, waste and abuse. The review included a survey of the state’s internal auditors and their impact on the control environment. Additionally, individual state agencies’ externally reported financial information (financial statements) was reviewed for timeliness, reliability and fair presentation. Further, agencies’ systems designed to provide timely, accurate and appropriate financial information to program managers—the internal reporting—were evaluated. The evaluations of these systems and reporting mechanisms provided a basis to assess whether Chief Financial Officers have an adequate basis to attest to their financial statements’ fair presentation. The report conclusions identify opportunities for increased efficiency and economy.
The Performance Review identifies historic applicability and enforcement of strategic planning/performance-based budgeting and levels of compliance currently in existence. State entities were surveyed regarding their preparation and use of strategic plans. Moreover, the effectiveness of strategic planning efforts and whether adopted performance measures are useful to measure department performance (outcome/results-oriented rather than output measures) are included in this section. The discussion includes other audits of strategic plans and/or performance measures to assess results, and analyzes the level of statewide audit coverage of strategic planning/performance-based budgeting processes. Conclusions present strategies for future development and expansion of the premise.
Additionally, an interest in the function and utility of the audit function statewide lead to the inclusion of comments regarding the distribution and coordination of audit resources throughout the state. This section surveys the many audit related classifications, personnel numbers and expenditures, and highlights some departments’ experiences with external auditors.
The Audit Team relied directly on the work of the Bureau of State Audits, the State Controller’s Office, the Department of Finance and the Department of Personnel Administration, and on survey input from the state’s internal auditors, financial, budget and information officers.

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