HOUSE BILL 551 "An Act relating to the lapse of unexpended balances of one-year appropriations; and providing for an effective date." 1 Representative Martin stated that a review of the Alaska FY95 year-end operating encumbrances completed March 5, 1996, by Legislative Audit found that interpretation of the Alaska Administrative Manual used by agencies to validate their encumbrances is not reasonable. FY95 year end encumbrances were checked in all departments, with emphasis on encumbered funds used to purchase equipment and contractual services. Of the seventy-nine (79) encumbrances tested, thirty-four (34) appeared invalid. The value of those encumbrances was $11.8 million dollars; a total of $15.9 million dollars in encumbrances were examined. Representative Martin continued, it is Legislative Audit's recommendation that changes be made in order to avoid further misunderstandings and misinterpretation of encumbrance policy. The legislation proposed will modify AS 37.25.010 to require that unexpended balances of an operating appropriation lapse on June 30th of the fiscal year for which the appropriation was made. RANDY WELKER, LEGISLATIVE AUDIT DIVISION, spoke to the proposed legislation. In accordance with the provisions of Title 24 of the Alaska Statutes, the Division conducted a review to determine the reasonableness of operating encumbrances established by State agencies at the end of FY95. The review included year end encumbrances established for the purchase of equipment and contractual services, with a primary focus on encumbrances related to reimbursable service agreements (RSA's) and other contractual services. Additionally, the Division reviewed the encumbrances related to the Department of Law's oil and gas litigation appropriation. The primary intent of the review focused on encumbrances either established or increased at the end of FY95 in the agencies' operating appropriations. The criteria used for the evaluation was developed from the State of Alaska Administrative Manual (AAM) and the Office of Management and Budget (OMB) RSA handbook. Mr. Welker continued, the review included: * Extracting and analyzing financial information from the State's accounting system regarding encumbrances and related subsequent expenditures. * Discussions on the AAM criteria with the state accountant. * Review of agency documentation supporting the encumbrances and a review of OMB's RSA files. 2 * Discussing the results of the review with agency staff. Mr. Welker referenced the AUDIT REPORT "REVIEW OF FY95 YEAR- END OPERATING ENCUMBRANCES". [Copy on file]. Alaska Statute 37.25.010, titled "Unexpended Balances of One-Year Appropriations", states that the unexpended balances of a one-year appropriation authorized in an appropriation bill lapses on June 30th of the fiscal year for which appropriated. However, a valid obligation existing on June 30th is automatically reappropriated for the fiscal year beginning on the succeeding July 1st, if it is recorded with the Department of Administration by August 31st of the succeeding fiscal year. Mr. Welker continued, the audit was focused primarily on contractual services. Mr. Welker referenced Page 7 of the handout which lists the invalid encumbrances and the associated amounts. The majority of the money identified existed within the Department of Law. The Division reviewed several contracts charged to the Department of Law's oil and gas litigation appropriation, including the supplemental funding for the FY95 appropriation. The encumbrances reviewed were related to on-going litigation matters. The scope of the contracts are very broad and generally do not reference any case or project in particular. Of the thirteen encumbrances reviewed, six were originally established in the 1980's with the other seven established in the 1990's; only two were initiated in FY95. Mr. Welker noted that the Department of Law disagrees with the Division's conclusions and observations of the encumbrances. The Department of Law believes that once a contract is signed, it is okay to encumber the entire amount. To due otherwise, they feel would do harm to the State's litigation effort. Mr. Welker disagreed with the Department's position. Mr. Welker stated that the primary recommendations focused on the guidelines established in the State of Alaska Administrative Manual (AMM). The Division has recommended that the commissioner of the Department of Administration revise AAM to provide more explicit instruction on determining the proper fiscal year's appropriation to be charged for year-end obligations. The revisions should realign the AAM criteria to embody the basic purpose of an operating appropriation, which is, to fund the operations of a state agency for one fiscal year. Representative Kelly spoke to the purchasing problems resulting from passage of the legislation. He thought that 3 the legislation could adversely affect certain situations. Mr. Welker agreed that there are many legitimate reasons which could need an extension. Representative Kelly suggested that managers hold off on purchases until the end of the fiscal year, in order to plan for contingencies. He felt these are legitimate management decisions. Mr. Welker agreed. Co-Chair Hanley also agreed that there are legitimate concerns, although, he noted concern with the "roll forward" monies not used. The Department of Law is using the language to justify encumbrances of those funds. He requested more details on the contract extensions. Co-Chair Hanley suggested that the Department of Law is rolling forward money into a fund well beyond what the anticipated expenditures are. Mr. Welker noted that the bulk of money was in the contractual field. He provided the Committee with a handout "Schedule of Year End Operating Encumbrances for FY95" which provided a break down of the sections of encumbrances. [Copy on file]. In the grants category, the total encumbrances for FY95 was $33.8 million dollars, equipment amounting to $9.2 million dollars, supplies at $4.4 million dollars, contractual services were $7.4 million dollars and travel amounted to $269.9 thousand dollars. Representative Brown asked if the legislation would apply to the Legislature. Mr. Welker replied that the Legislature has no "innocent" parties involved. Representative Brown agreed, pointing out that the Legislative majority used $1.8 million dollars in FY95 appropriations to carry out work performed after the fiscal year; $878 thousand dollars to pay salaries and benefits for twenty-four staffers. She continued, twenty-three of the contracts covered work beginning on June 16, 1995, and ending on January 7, 1996. There were forty-eight contracts, paid for from funds which would have otherwise lapsed. Representative Brown questioned if the Legislature was exempt from the Executive Budget Act. Mr. Welker stated that the Executive Budget Act was included in Section 37.07, whereas, the language proposed, changes to Section 37.25, a provision in the finances of government, but not part of the Executive Budget Act. Representative Brown asked if Mr. Welker was prohibited from investigating the practices of the Legislature. Mr. Welker stated that the Audit Division does not audit the Legislature as part of the financial auditing of State government. The Legislature is audited separately. Representative Brown asked who made the request for the 4 forty-eight encumbrances which were extended beyond the fiscal year. Mr. Welker replied that the majority of the money passed through the Legislative Affairs Agency. Representative Brown asked if the Director of the Legislative Affairs Agency (LAA) had the authority to enter into the encumbrances. Mr. Welker believed that the rules of those funds originate from several different appropriations. Each appropriation originates with a different chairperson. There is a variety of approval for authority in that function. Representative Brown inquired if the Governor's Office activities had been audited. Mr. Welker acknowledged they were, noting the Office of the Governor maintains a clean operation. Co-Chair Hanley stated that in the past, when the budget had not been rolled off, there was a "roll forward" of money, appropriated for the next fiscal year. The Office of the Governor had $3 million dollars of carry forward money which their encumbrances were charged against. He emphasized that the Legislature did not roll money forward last year. Co- Chair Hanley reiterated his concern with the Department of Law's encumbrances. He thought it appeared that money was being rolled forward as it had been done in the past, without the roll-forward language. In response to Representative Brown's question regarding contract legislative employees, Mr. Welker noted that they had been "run through" a personal service contract rather than a professional service contract. They were "run through" the State payroll system with taxes withheld. He added, State government books get closed and are audited on a timely basis. Representative Martin inquired if an administrative procedure was in place which required each agency to report to the Department of Administration (DOA) for any money encumbered. Mr. Welker replied that through the Department of Administration and the State accounting schedule, the information could be pulled, although, DOA does not have the ability to know if that is a valid encumbrance. That decision is made at the agency level. Mr. Welker added that the report held to the encumbrances of the Administrative Manual. Neither the Legislature nor the Court System is bound by that manual. NANCY SLAGLE, DIRECTOR, DIVISION OF BUDGET REVIEW, OFFICE OF MANAGEMENT AND BUDGET (OMB), OFFICE OF THE GOVERNOR, stated that the proposed legislation was not needed. The 5 Administration has responded to the legislative audit report and agrees that there are some problems in interpretation of the Administrative Manual. A drafting group has been formed to write revisions to the manual. She strongly recommended that contingency allowances be available to division managers for ordering equipment. She noted the unpredictable situations which exist within the agencies throughout the year. Consequently, orders are delayed until the end of the year to guarantee that funds be available. The legislation counters the intent of streamlining administrative burdens. Ms. Slagle listed some areas in which the agencies do not have control over ordering. Many agencies have seasonal projects, causing a split of contracts between fiscal years. Federal budget problems often cause situations to get backed up, making it difficult for the agencies. There is no control for successful delivery of products. Back orders exist. Grant negotiations take a long time. The grantee situation is out of the Administration's control. (Tape Change, HFC 96-129, Side 2). Ms. Slagle continued, purchasing of specialized equipment often takes many months to receive. The Administration has no control of the grantee situation for the K-12 foundation which is basically shut down during the summer making it outside the August 31st deadline. All these costs would require supplemental funding. The result could be potential penalties, and will result with special requests to the Legislative Budget and Audit Committee (LA). Ms. Slagle advised that other states allow carry forward each year. The Administration does not support the proposed legislation and suggests that these concerns be addressed administratively. Representative Martin reminded Committee members that the amount at question was $83 million dollars. Co-Chair Hanley agreed that a timing question exists in regard to some of the departments carry forward money, while suggesting that some departments need to "tighten up". Co- Chair Hanley stressed concern with the Department of Law's encumbrances. He advised that the Department of Law had encumbered money for a project for the Department of Revenue to update the fiscal forecast method indicating that justification was not warranted. He suggested that Department has too much flexibility. Ms. Slagle reiterated that $33.8 million dollars had been encumbered for grants, $37.4 for contractual dollars. Many 6 of the agencies have billings which are tied to federal programs. RSA's add an additional layer of reporting and billing requirements. Representative Martin asked if it would be possible during the legislative session that each agency provide a report of how much money will be encumbered for the following fiscal year. Ms. Slagle stated that access exists through the state accounting system specifying the agencies encumbered funds. JANET CLARKE, DIRECTOR, DIVISION, DIVISION OF ADMINISTRATIVE SERVICES, DEPARTMENT OF HEALTH AND SOCIAL SERVICES, spoke to the grant encumbrances for the Department. Common practice is to "hold back" ten percent of the final quarters advance until the final fiscal report comes forward from the grantees. That amount is 2.5%. She added, if the bill passes, the Department would have a few options. They could change the grant regulations and discontinue the practice of "holding back" grant funds. That would increase the miscellaneous claim line in the supplemental request. Accounts payable could be established, although she felt that passage of the legislation would create many problems with the grantees. Ms. Clarke commented that Medicaid was spread throughout the Department in order to get the 50% federal participation in those areas. There are many RSA's attached to that service. Co-Chair Hanley asked if money was spent in FY96 which reimbursed people for services provided during that time. Ms. Clarke responded that some of those services were performed during FY95, but the final payment and billings were made in FY96. Co-Chair Hanley asked if the money should be accounted for when it is spent, received or when the service is provided. Ms. Clarke clarified that the rules are that encumbrances can only last for one year unless the Division of Finance allows them to be extended for special circumstances. A time certain does exist. Ms. Slagle explained that encumbrances are established on regulations and practices. The encumbrance is the funds reserved before the final payment is made. All services should have been provided for the year that the funds were appropriated. Representative Kelly asked if the encumbered money could be applied to another category. Mr. Welker advised that the Legislature appropriates a total dollar amount; the limitations exist only on the appropriation. The appropriation can be moved within the category of 7 expenditure with OMB's approval. He added, the audit focus for the Department of Health and Social Services (DHSS) was only on contractual services. Mr. Welker interjected from information contained in the administrative manual, the general rule for encumbrances are when services are received. The majority of disagreements exist with agency interpretation of the exceptions. Those exceptions are being stretched to accommodate things that do not fit the meaning of the change. He added, auditors are working with the Department of Administration to tighten up the manual's language. Co-Chair Hanley asked if invalid encumbrances were illegal. Mr. Welker replied that all information links back to statute. The Administrative Manual is the Administration's attempt to define a valid obligation and the terms used to describe that obligation. Representative Brown asked if the Administrative Manual had the force and effect of law. Mr. Welker replied it would not have the authority of a regulation. Representative Brown asked if the Legislature was under the procurement code. She noted that she did not understand the need for the legislation when, currently, the Legislature practices the same use of fund distribution. Representative Martin agreed that a problem exists and stressed that there needs to be a "time certain" when the money is spent. Representative Brown agreed that there should be reasonable rules, although recognized that a "time specific" would make it very difficult for the agencies. Life is a more "flexible" process than that. (Tape Change, HFC 96-130, Side 1). JOE THOMAS, DIVISION OF FINANCE, DEPARTMENT OF ADMINISTRATION, commented that the proposed legislation would provide a shift from the way that the State has operated to date. The shift would delineate that the agencies operate from an "expenditure base" type system. ART SNOWDEN, ADMINISTRATIVE DIRECTOR, ALASKA COURT SYSTEM, referenced a project currently undertaken by Dr. John Hunsake at Michigan State University to research the effect of agencies who carry money forward. Many states are now going to a new system allowing agencies to carry forward half of the money that they do not spend; those funds are placed in a separate account which encourages savings. The money is not counted against their budget and they are allowed to carry it forward for three years. Mr. Snowden noted that Mr. Hunsake emphasizes that spending patterns 8 become more efficient using that system. Mr. Snowden offered to provide Committee members back-up material supporting the theory. JAMES BALDWIN, ASSISTANT ATTORNEY GENERAL, GOVERNMENTAL AFFAIRS SECTION, DEPARTMENT OF LAW, commented that the Department of Law is prepared to offer assistance in resolving the problems resulting from the need of the proposed legislation. If there is a solution, the Department would like to work toward it in a reasonable manner. He admitted that the Department of Law believes that they have been operating within the boundaries of the Administrative Manual. The Department views the large litigation procedures as being part of a large single project which often expands fiscal years. Carry forward funds have been included in the budget requests for the following year. Co-Chair Hanley commented that could create policy differences when determining the budget amount of total funding, suggesting that would make it impossible to have a legitimate budget debate. Mr. Baldwin stressed that the Department is not requesting any more than they need to pay the contractual agreements. Timing is the issue. Following research of this type of arrangement, legal service contracts are given this treatment when they address single cases that span for many years. He suggested that there be a special treatment for legal service contracts. Co-Chair Hanley thought the funds should be given in years needs and not carried forward. Mr. Baldwin replied that spending can be unpredictable. Representative Brown referenced a written response provided from the Attorney General's office stating that: "The success of the Department's effort is largely due to the consideration and discretion granted to the Attorney General to encourage expenses necessary to prevail in litigation". She summarized that the attorney general needs some discretion to meet the tactics of large companies who have much more money and resources available then the Department has. Representative Brown stressed that tax payers were being protected and that the Legislature should focus on the results. They should focus on whether the Department has used their money to successfully protect the State's interest. She recommended that discretion be maintained. Co-Chair Hanley agreed that the Department needs to have flexibility although questioned if they need double the amount of money projected in the budget. Representative Brown interjected that the amount of money was "tiny" when considering the amount at stake. The Department is making 9 reasonable estimates. Co-Chair Hanley countered that if the ability is abused, then concerns exist. HB 551 was HELD in Committee for further discussion.