Modern Financial Management Practices

Topics: Investment, Asset, Cash flow Pages: 30 (11215 words) Published: November 27, 2014
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ISSN 1608-7143
OECD JOURNAL ON BUDGETING – Vol. 2, No. 2
© OECD 2002

Modern Financial Management Practices
by
Ian Ball*

* Ian Ball is Chief Executive, International Federation of Accountants (IFAC) and former Central Financial Controller, New Zealand Treasury.

OECD JOURNAL ON BUDGETING – Vol. 2, No. 2 – ISSN 1608-7143 – © OECD 2002

49

MODERN FINANCIAL MANAGEMENT PRACTICES

1. Executive summary
The paper highlights two incentive regimes which have been used by governments to improve their financial management systems: the capital charge regime to improve asset management and the interest rate regime to improve cash management.

Capital charge regime. The capital charge regime is designed to capture the financing cost associated with government assets. In the private sector, firms obtain their funds either by borrowing or from owners’ equity (including returned earnings). The firm must provide a return on both sources of finance: lenders require interest and owners require a return on capital (either as dividends or as an increase in share price). Although governments do not provide an explicit return to taxpayers, they do pay interest on borrowed funds. Whenever funds from borrowing or from taxation are tied up in assets or held in the form of surplus cash balances, there is a cost. Although borrowing costs are significant costs to the government as a whole, they may not be obvious to individual government agencies and may have no impact upon agency financial statements. For example, public sector borrowing is usually undertaken by a central borrowing agency and then allocated to agencies at no cost. This prevents agencies from seeing the true cost of their financing and also makes it less likely that they will be motivated to manage assets efficiently.

A capital charge is levied on an agency and is designed to be a substitute for interest costs and a return on capital. At a minimum, the charge should cover the government’s cost of borrowing. This is the bottom line cost of government. However, the activities conducted by governments are not without risk, and it is possible to argue that some form of risk premium in addition to the government’s borrowing cost is also appropriate. If the government contracted a private sector firm to provide goods and services on its behalf, then firms would be financed by a mix of debt and equity. The holders of both debt and equity would expect a return on their investment, commensurate with the risk of investing in the firm. Although the risk of bankruptcy will not normally be relevant for a government, the other operational risks faced by a private sector firm would also be faced by the government.

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