1.1.

Pursuant to Article 248 of the EC Treaty, the Court of Auditors provides the European Parliament and the Council with a Statement of Assurance concerning the reliability of the accounts and the legality and regularity of the underlying transactions (the DAS). The Treaty also authorises the Court to supplement this statement with specific assessments of each major area of Community activity.

1.2.

The aim of the work on the reliability of the accounts of the European Communities is to obtain sufficient evidence to conclude on the extent to which revenue, expenditure, assets and liabilities have been properly registered and that the annual accounts faithfully reflect the financial position at the end of the year (see paragraphs 1.5 to 1.58).

1.3.

The aim of the work on the legality and regularity of the underlying transactions is to gather sufficient evidence, of a direct or indirect nature, to give an opinion on whether they are in accordance with the applicable regulations or contractual provisions, and have been correctly calculated (see paragraphs 1.59 to 1.65 of this chapter for horizontal issues and chapters 2 and 4 to 10 for details).

1.4.

In the absence of systematic indicators presented by the Commission (5), the Court provides certain indicators to monitor progress in improving internal controls both overall, and for each income and expenditure area (see annexes to this chapter and to chapters 2 and 4 to 10).

1.5.

The Court's observations concern the final annual accounts for the financial year 2005, which are drawn up by the Commission's Accounting Officer and approved by the Commission in compliance with Articles 128 and 129 of the Financial Regulation of 25 June 2002 (6) and sent to the Court on 28 July 2006. The annual accounts comprise the ‘consolidated financial statements’ — covering, in particular, the balance sheet setting out the assets and liabilities at the end of the year and the ‘consolidated reports on the implementation of the budget’ — covering the revenue and expenditure for the year.

1.6.

The financial year 2005 was a key milestone in the implementation of new elements of the Action Plan for the modernisation of the Communities' accounting system which the Commission adopted on 17 December 2002 (7). This was in response to a number of previous observations by the Court and took into account the provisions of the Financial Regulation (in particular Articles 123 to 138):

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since 1 January 2005, the consolidated financial statements have to be prepared by applying accruals accounting principles, while the consolidated reports on the implementation of the budget are still based on cash movements as foreseen in the Financial Regulation,

—

while the content of the budgetary reporting was not changed, the financial statements have to comprise new elements: an economic outturn account (including segment reporting), a cash-flow table and a statement of changes in net assets,

—

the scope of consolidation was extended to include various Community bodies for the first time,

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a new accounting system had to be implemented which ensures that each accounting event, and not just each cash movement, is fully recorded when it occurs. This should provide internal users with more complete and relevant information as a tool for decision-making. It should also translate into a more transparent and informative statement for external readers.

1.7.

The Court's audit on the reliability of the accounts focussed on:

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the Commission's management of the change-over from cash-based to an accruals-based accounting (see paragraphs 1.10 to 1.27),

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the verification of the accuracy of various elements in the accounts (see paragraphs 1.28 to 1.58).

1.8.

In its work on the management of change the Court considered in particular:

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whether the Commission had ensured the effective application of the relevant accounting standards,

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whether measures taken within the Commission contribute to the reasonable assurance that the accounts are true and fair.

1.9.

In verifying the reliability of the 2005 accounts, the Court concentrated in particular on:

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the 2005 opening balance sheet (which has to disclose the impact of the changes made to restate the balance sheet as at 31 December 2004 under the new accounting principles),

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the closing balance sheet as at 31 December 2005,

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within the above two elements, data not available under the previous system, but which need to be reflected in the accruals accounts (pre-financing and related guarantees, invoices/cost statements).

1.10.

The Commission had to plan and implement the modernisation of the accounting system within the calendar and organisational framework imposed by the Financial Regulation. As already observed by the Court in previous Annual Reports (8), the timetable established for the necessary adaptations and validations was very ambitious.

1.10.

The Commission recognises the extraordinary effort made by its departments to move to accrual-based accounting within a very ambitious timetable.

1.11.

Experience in public administrations undertaking similar reforms (9) shows that projects of a scale and complexity similar to the modernisation of the Communities' accounts inevitably face a variety of problems which complicate and delay their complete implementation. Against this background, important progress has been achieved:

—

on 1 January 2005, the Commission moved the general accounting of the EU from cash-based to accruals-based accounts. New accounting rules (10) and methods, a new harmonised chart of accounts and new consolidation tools were introduced in all Community institutions and agencies,

—

stakeholders were provided with individual and consolidated accounts which comprise the new obligatory elements and contain more detailed information about the resources controlled by the different entities, the costs of their operations and the cash flow operations.

1.11.

Despite the complexity of certain issues, the variety of problems and big challenges, the Commission managed the project without delays regarding the key deadlines. Noteworthy achievements include:

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the IT systems developed in order to support the new accounting requirements;

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the transition to the new system was successfully managed which allowed the opening of the new system at the beginning of January 2005;

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administrative procedures of all the Commission's services were adapted to the needs of accruals based accounting;

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the opening balances for the first accrual-based accounts were determined and validated;

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an integrated treasury module was developed to account for the financial activities managed by the Directorate-General for Economic and Financial Affairs;

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the expenses to be accrued at the end of each year were estimated by all departments;

—

the Commission's accounts were prepared, and consolidated with those of other institutions and agencies.

1.12.

Table 1.1 contains a follow-up of the Court's reservation concerning the reliability of the accounts which was expressed in the Statement of Assurance for the 2004 financial year, as well as the other points raised by the Court which were (partly) settled in the context of the modernisation of the Community accounting framework. However, as in any new accruals-based accounting system of such a magnitude, certain weaknesses still exist (see below).

1.12.

The Commission has always recognised in the ABAC progress reports that work remains to be done.

1.13.

Key elements in the process of the preparation of the Commission's 2005 financial statements were the implementation in the different Directorates-General of the overall cut-off methodology/instructions given by the Commission's Accounting Officer and the validation of opening and closing balances by all Authorising Officers (11). These validations were in most cases delayed, in particular at the level of the operational Directorates-General.

1.13.

Some delays compared with the challenging internal working timetables established by the Directorate-General for Budget did occur. A good working programme usually allows for a margin so as to anticipate potential delays. This was the case with the timetables of the Commission. Despite these internal delays the Commission was none-the-less able to meet the deadline set by the Financial Regulation and present the financial statements on time.

1.14.

In many Directorates-General audited by the Court, several weaknesses were identified concerning the validation of the data: weak supervision, lack of staff assigned to the task and inadequate documentation of the work done. The figures presented in the financial annex of the annual activity reports by some operational Directorates-General contained errors (see paragraph 1.16).

1.14.

The Commission services made a major effort during almost two years to identify and record data which were not previously in the old system.

1.15.

The individual methodologies for Directorates-General were frequently not finalised/formalised by the different Authorising Officers before the presentation of the accounts. As a result, cut-off entries for the opening and closing balances were made in the absence of a formalised methodological basis implementing, at the level of a Directorate-General, the overall cut-off methodology/instructions given by the Commission's Accounting Officer.

1.15.

Given that no benchmarks were available in the public sector for the cut off exercise, priority was given to finalising the calculation of the cut-off rather than to formalising the procedure.

1.16.

Furthermore, the Resource Directors (12) were asked to validate formally the financial reports, containing in particular opening and closing balances, in the process of preparation of the annual activity reports (i.e. at the end of March 2006). However, as Directorate-General for the Budget was working to the same deadline, not all validations were received before the provisional accounts were finalised. Validations for the final accounts were received in due time.

1.17.

The delays referred to in paragraph 1.13 had an impact on the Court's substantive testing since the Court received opening balances before cut-off (on 18 January 2006) and after cut-off (on 15 March 2006) which were still subject to modifications. The complete provisional opening balance sheet, giving an indication of the impact of the changes made to restate the balance sheet as at 31 December 2004 under the new accounting principles, was obtained on 31 March 2006, together with the consolidated provisional accounts.

1.17.

The Commission understands the Court's audit work this year was challenging, as was the entire project for the Commission.

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sound procedures were followed and the system was documented;

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the balances other than cut-off were first uploaded in January 2005;

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by mid-2005 approximately 95 % of these balances were final and

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the changes made since then were documented and an audit trail specifically made.

1.18.

Following the implementation of a comprehensive action plan to reinforce security within the central accounting system, two issues remain to be completed, namely the revision of access rights in the Directorate-General for the Budget and a reassessment of security in ABAC Workflow (13). As the work remaining on these issues is not considered material by the Director-General for the Budget, in particular because an effective monitoring system is in place, the reservation on system security and access rights, which was introduced in the 2004 annual activity report, was lifted. The Court's audit confirms the improved security of ABAC.

1.19.

Many Directorates-General use their own IT systems for financial management purposes and for the creation of transactions which are sent to the central accounting system (ABAC) via an interface. However, it will take longer to validate and modernize such systems.

1.19.

As the situation is constantly evolving, the accounting services' validation team needs to keep track of this evolution, and has also introduced, with effect from 1 June 2006, a procedure for the validation of changes in the local systems, as foreseen in the implementing rules of the Financial Regulation.

1.20.

The Court examined the programme of in-depth controls of local accounting systems undertaken by the services of the Commission's Accounting Officer in 2005 for 13 Directorates-General (i.e. eight for which the high level assessment in 2004 had identified risks (14) plus another five selected on grounds of their financial importance and/or organisational complexity (15)). The Court's audit confirmed the basis of the Commission's Accounting Officer's decision to refuse, due to material deficiencies, validation concerning three local systems in the EuropeAid Co-operation Office, the Directorate-General for Education and Culture and the Directorate-General for External Relations. However, in some cases it is not clear why insufficient results for several validation criteria did not lead to a qualified validation.

1.20.

The validation exercise is not an audit. The conclusions cannot be compared to audit opinions. The validation of local systems is a rather new activity, which translates Article 61 of the Financial Regulation into concrete tasks. The validation reports are produced in order to provide to the Accounting Officer sufficient information for the validation. The scope and limitations are explained in the preamble of the validation reports.

1.21.

The Court considers that, based on the results obtained and issues remaining to be solved, most of the positive validation opinions issued by the Commission's Accounting Officer on local systems have to be regarded as conditional or qualified opinions. This situation is also confirmed by the number and importance of horizontal issues (16) and matters for further consideration (17) highlighted in the Commission's Accounting Officer's final report at the end of 2005.

1.21.

The accounting services are committed to making a follow-up concerning the issues and matters for further consideration, mentioned in the 2005 validation reports.

1.22.

The Director-General for the Budget included a reservation in his declaration, which is also confirmed by the Court's audit (see paragraphs 1.18 to 1.21 and 1.28 to 1.58), concerning ‘three local systems not validated and coherence checks on accounting still to be completed’. In the overall conclusion on the combined impact of the weaknesses identified in his declaration he stated: ‘DG BUDGET, together with the other Commission services, will take further action on remaining errors or uncertainties and continue investing over the year 2006 to strengthen the ABAC accounting system for the Community… It is a matter of appropriate tools such as training, documentation and IT systems but also of working on the related cultural change. On this basis, reasonable assurance along the lines foreseen by the declaration can be given’.

1.22.

The Commission recognises the extraordinary effort made by its departments to allow the move to accrual-based accounting. However, three local systems have not been validated by the accounting services. For these reasons, and also because the provisional accounts were to be audited by the Court of Auditors and corrections may be necessary before the approval of the final accounts on 31 July 2006, the Director General for Budget issued on 31 March 2006 a systemic, provisional and time-bound reservation in its 2005 annual activity report.

1.23.

The Director-General for Education and Culture also presented a reservation covering the lack of assurance as regards the correctness of the amounts included in the Commission's balance sheet. Although important risks were also identified by the Commission's services and the Court in other Directorates-General, no other Authorising Officer has presented a reservation (18). However, 26 out of 40 Resource Directors indicated that, due to weaknesses identified in the Annual Activity Reports and/or taking into consideration that this is the first year of the provisional closure of the accounts based on accruals accounting, verifications and, where necessary, corrections may still be needed before the final closure of the accounts.

1.23.

Inconsistent treatment of accrual accounting requirements in the Directorate-General for Education and Culture local accounting system APPFIN had led to differences in the opening and closing balances of its accounts. Modifications to the local system are underway and will ensure correct treatment of transactions in the future; corrections of past errors are ongoing and should be completed by the end of the year.

1.24.

The scope of consolidation defined in Accounting Rule No 1 adopted by the Commission's Accounting Officer is larger than the scope foreseen in Article 121 of the Financial Regulation (19) (e.g. inclusion of the Joint Sickness Insurance Scheme or agencies not falling under Article 185 of the Financial Regulation) (20).

1.24.

The scope of consolidation foreseen in the Accounting Rule No 1 takes into account the principle of control and is based on international accounting standards. On the other hand, Article 121 of the Financial Regulation (FR) foresees only the consolidation of Institutions and subsidised Agencies.

1.25.

Nevertheless, the Joint Sickness Insurance Scheme and two agencies (Community Plant Variety Office and Office for Harmonisation in the Internal Market) were not included in the 2005 consolidated accounts (see also paragraph 1.29). Based on the analysis of the type of control that the European Communities have over the Joint Sickness Insurance Scheme, the Court considers that it should not have been included in the scope of consolidation, as defined in Accounting Rule No 1, and therefore the latter should be reassessed.

1.25.

The accounting rule will be updated with regard to the non-consolidation of the sickness insurance scheme.

1.26.

In its Opinion No 2/2001 (21), on a proposal for a Council Regulation on the Financial Regulation applicable to the general budget of the European Communities, the Court addressed the risks arising from a situation where the provisional consolidated financial statements sent to the Court of Auditors are not yet stabilised. The Court stressed that it was important that ‘The provisional financial statements are exhaustive and consistent documents, and are duly drafted by the stipulated deadlines. They are provisional only in that the Commission has not yet formally adopted them and that they may, where appropriate, be subject to corrections proposed by the Court.’

1.27.

The Commission did not respect this latter principle that no changes should be made other than those proposed by the Court, as 2005 was a transitional year. Therefore the Commission had to ensure that the Court was informed in due form and time about corrections which, based on the continuing work on the provisional accounts, it considered necessary.

1.27.

It is difficult to respect this principle as the provisional accounts must now be finalised by the same date as the Annual Activity Reports. However, changes will be kept to a minimum.

1.28.

The Court's examination of the adequacy and accuracy of the adjustments made, in connection with the preparation of the consolidated financial statements as at 1 January 2005, to bring the figures and information of the consolidated financial statements as at 31 December 2004 into line with the new accruals-based accounting principles, is presented hereafter (see paragraphs 1.29 to 1.49).

1.29.

Almost the entire impact of the changes made concerns the Commission's financial statements. The inclusion, for the first time, of the agencies in the scope of consolidation has had only a limited impact on the consolidated accounts, the main effect being an increase in cash balances. Thus, the omission of two agencies did not affect the true and fair view.

1.30.

The Court's review of items which were only affected by limited adjustments did not reveal significant findings (i.e. intangible and tangible fixed assets, (short-term) investments, loans, long-term and short-term receivables (22), stocks, employee benefits, provisions for risks and charges, financial and other liabilities and reserves).

1.30.

With regard to footnote 18, the information was not available for the amounts due at 31 December.

1.31.

Pre-financing relates to payments intended to provide the beneficiaries with a cash advance. If the beneficiaries do not incur eligible expenditure during the period defined in the agreement, they have to return the pre-financing to the Communities.

1.32.

For a number of years the Court has stated that the recording of sundry debtors poses problems because pre-financing was entered as final expenditure and amounts to be recovered were not entered immediately (23). On this basis, it qualified the accounts for the years in question (24).

1.33.

In order to remedy these deficiencies, during 2004 an inventory of all open pre-financing amounts paid up to 31 December 2004 was prepared by every institution and agency, leading to approximately 30 000 pre-financing entries for a total amount of 28 013 million euro (25).

1.33.

As required by the new accounting rules, the inventory of the pre-financing amounts was done and from January 2005, the pre-financing amounts not yet cleared are included on the asset side of the balance sheet.

1.34.

However, not all technical and conceptual issues and problems of implementation, which had already been partly identified in connection with the Annual Report concerning the financial year 2004 (26), had been solved by the presentation of the opening balance sheet as at 1 January 2005. The resulting deficiencies are presented below.

1.34.

As explained in its replies to the Court's 2004 Annual Report, the follow up of the pre-financing amounts has to take into account the conditions of the various contracts with third parties. Nevertheless, the presentation of the net amount in the balance sheet shows the economic reality of outstanding pre-financing amounts.

1.35.

The audit of a representative sample of 147 pre-financing transactions from the population of pre-financing records, as at November 2005, in the accounting system identified a material level of error in terms of frequency and financial impact. The most common types of errors are:

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pre-financing entries were recorded for the wrong amount,

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pre-financing amounts were recorded although they were cleared before 1 January 2005.

1.35.

The Commission will examine the transactions notified by the Court.

1.36.

Furthermore, additional audit work on the identification and validation of pre-financing entries revealed the following problems of completeness/accuracy for the opening balance sheet:

1.36.

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the split between long-term pre-financing (21 285 million euro) and short- term pre-financing (6 728 million euro) took only into consideration amounts related to the Structural Funds, the Cohesion Fund, ISPA and the Solidarity Fund for the 2000 to 2006 programming period. This leads to an underestimation of long-term pre-financing and a corresponding overestimation of short-term pre-financing because contracts for other policy areas with pre-financing where the remaining duration was more than one year were classified as being short-term,

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The split between long-term and short-term is only made for Structural Fund amounts as the former constitute the ‘real’ long-term pre-financing of the Commission. For other policy areas the long-term amount could not be quantified, and a split can only be made on estimations on implementation of the projects. For the 2006 accounts, following two years experience with the new accounting system, the Commission will have more information on which to base an analysis of the feasibility of making this split.

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for Directorate-General for Education and Culture, despite work performed after the issuance of the provisional accounts, there is still a risk that omissions and double or wrong postings could lead to errors which are unquantifiable due to the complexity of the problems (27).

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Material errors identified in the Directorate-General for Education and Culture which resulted from the wrong treatment of pre-financing payments have been corrected.

1.37.

Accounts payable essentially include accrued charges, which are covered under the section for cut-off (see paragraphs 1.42 to 1.46), and current payables, which comprise invoices and cost statements. The Court's findings concerning current payables are dealt with in this section.

1.38.

The establishment of an inventory listing about 7 000 invoices and cost statements received but not yet paid as at 1 January 2005 began in the fourth quarter of 2004 and led to an amount of current payables of 9 412 million euro (28).

1.39.

By the presentation of the opening balance sheet as at 1 January 2005 (29), not all technical issues and problems of implementation had been solved. The resulting deficiencies are presented below.

1.39.

The Commission will improve its internal controls to address the technical issues and problems remaining in some Directorates-General.

1.40.

The audit of a representative sample of 141 invoices/cost statements from the population of accounts payable recorded, as at November 2005, in the accounting system identified a material level of error in terms of frequency and financial impact. The most common types of errors are:

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invoices or cost statements were recorded for the wrong amounts,

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invoices or cost statements were recorded although they were already paid.

1.40.

The six errors with an impact on the accounts amongst the 141 transactions audited will be examined by the Commission.

1.41.

For Directorate-General for Education and Culture, despite work performed after the issuance of the provisional accounts, there is still a risk that omissions and double or wrong postings could lead to errors which are unquantifiable, due to the complexity of the problems.

1.41.

Material errors identified in the Directorate-General for Education and Culture which resulted from the wrong treatment of invoices/cost statements have been corrected.

1.42.

One of the most important aspects of the move to accruals accounting is the exercise of ensuring that transactions made during the year are recognised in the accounting period to which they relate (cut-off exercise). In particular an assessment has to be made concerning eligible expenses that have been incurred by beneficiaries of Community funds but not yet reported (accrued charges), revenue not yet received although services have been rendered, goods have been delivered or a legal obligation exists (accrued revenue), or expenses or revenue recorded in the current year which relate to subsequent periods (deferred charges or revenues).

1.43.

Adjustments for accrued charges totalled 64 205 million euro (30). The Court's audit of the other cut-off elements did not reveal significant errors. The findings concerning accrued charges are presented hereafter.

1.44.

As described above (see paragraph 1.15), the implementation of the overall cut-off methodology per Directorate-General was not finalised before the cut-off bookings. Furthermore, most of the Directorates-General have not performed sufficient testing as to whether the methodology developed ensures that transactions made during the year are correctly recognised in the accounting period to which they relate. In addition, given that 2005 is the first year of a cut-off exercise and given the particularities of the Communities' activities, no benchmark methods are available which could be used to check the adequacy of the methods and the results of estimations.

1.44.

Apart from the remarks concerning implementation/control, the Commission notes that the Court makes no observation on the overall methodology itself.

1.45.

The following weaknesses identified in the cut-off procedures put at risk the correctness of calculations performed by many Directorates-General:

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only limited checks have been made by the Directorates-General on the result of the calculations,

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data used were in certain cases of insufficient quality,

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knowledge and work was often concentrated in one person without appropriate supervision.

1.45.

In 2006, the Commission will strengthen its controls over the application of the cut-off methodology.

1.46.

All Directorates-General (except Directorates-General for Regional Policy, Employment, Social Affairs and Equal Opportunities and Agriculture and Rural Development) decided to estimate the accrued charges on the basis of all open contracts. All Directorates-General audited (except Directorate-General for Education and Culture) could reconcile the data used in the calculations with the basic accounting data, except for some unexplained differences, which, although not material, confirm a certain level of risk as identified above (see paragraph 1.45).

1.46.

Material errors identified in the Directorate-General for Education and Culture which resulted from the wrong treatment of accrued charges have been corrected.

1.47.

Because of the adjustments introduced as a part of the move to accruals accounting, total liabilities in the opening balance sheet (as at 1 January 2005) exceed total assets by 51 597 million euro, whereas before the adjustments total assets exceeded the liabilities by 14 507 million euro.

1.48.

One major factor explaining this change is the fact that the introduction of pre-financing (total amount of 28 013 million euro) does not compensate for the introduction of accrued charges (total amount of 64 205 million euro). In addition, long-term receivables have greatly decreased because the Communities' pension obligations towards Members of institutions and staff (net present value of 26 012 million euro) are no longer neutralised by a corresponding asset representing the amount receivable from the Member States. The difference between assets and liabilities mainly represents the amounts to be called in future years from Member States.

1.49.

The Court observed that the Accounting Officer did not fully comply with Accounting Rules Nos 2 and 12 with regard to the new structure and presentation of the balance sheet and the revised treatment of the Communities' pension liabilities (31). Therefore, action should be taken in order to introduce the necessary amendments. Furthermore, the different character of the liabilities to be covered by the amounts to be called from Member States should be disclosed further, in particular the short-term and long-term nature of those amounts.

1.49.

The Accounting rules Nos 2 and 12 will be adapted.

1.50.

During 2005, efforts were made by the Commission with a view to ensuring the complete and correct recording of new pre-financing payments as well as of new open invoices/cost statements, and their clearance. However, a number of errors were identified which are presented hereafter. Furthermore, the deficiencies concerning the adjustments made for the opening balance sheet as at 1 January 2005 have an impact on the economic outturn for the year 2005 and consequently on the consolidated balance sheet and the statement of changes in net assets.

1.50.

During 2005, several controls and validation were done by Directorates-General and Services to assure the correctness of the total amount of the opening balance sheet. Most of the necessary corrections were made against the opening balance sheet without impact on the 2005 economic outturn.

1.51.

The Court's analytical review of intangible and tangible fixed assets, (short-term) investments, loans, long-term and short-term receivables, stocks, financial and other liabilities, employee benefits, provisions for risks and charges and reserves did not produce any significant findings.

1.52.

The audit of a representative sample of 162 pre-financings from the population of pre-financings registered, as at March 2006, in the accounting system (29 349 million euro) identified a material level of error in terms of frequency and of financial impact. The same types of errors as for the consolidated opening balance sheet have been identified for the consolidated closing balance sheet (see paragraph 1.35).

1.52.

The nine errors identified with an impact on the accounts amongst the 162 transactions audited will be examined by the Commission.

1.53.

Furthermore, additional audit work on the identification and validation of pre-financings revealed problems of completeness/accuracy for the closing balance sheet:

1.53.

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the split between long-term pre-financing (22 732 million euro) and short -term pre-financing (6 633 million euro) only took into consideration amounts related to the Structural Funds, the Cohesion Fund, ISPA and the Solidarity Fund for the 2000 to 2006 programming period. This leads to an underestimation of long-term pre-financing, and a corresponding overestimation of short-term pre-financing because contracts for other policy areas with pre-financing where the remaining duration was more than one year were classified as being short-term,

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The split between long-term and short-term is basically only made for Structural Fund amounts as the former constitute the ‘real’ long-term pre-financing of the Commission. For other policy areas the financial impact of the Court's finding could not be quantified. For the 2006 accounts, following two years experience with the new accounting system, the Commission will have more information on which to base an analysis of the feasibility of making this split.

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for Directorate-General for Education and Culture, despite work performed after the issuance of the provisional accounts, there is still a risk that omissions and double or wrong postings could lead to errors which are unquantifiable due to the complexity of the problems.

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Material errors identified in DG EAC which resulted from the wrong treatment of pre-financing payments have been corrected.

1.54.

The audit of a representative sample of 148 invoices/cost statements from the population of accounts payable registered, as at March 2006, in the accounting system (16 194 million euro) identified a material level of error in terms of frequency and financial impact. The same types of errors as for the consolidated opening balance sheet have been identified for the consolidated closing balance sheet (see paragraph 1.40).

1.54.

The nine errors identified with an impact on the accounts amongst the 148 transactions audited will be examined by the Commission.

1.55.

For Directorate-General for Education and Culture, despite work performed after the issuance of the provisional accounts, there is still a risk that omissions and double or wrong postings could lead to errors which are unquantifiable due to the complexity of the problems.

1.55.

Material errors identified in the Directorate-General for Education and Culture which resulted from the wrong treatment of invoices/cost statements have been corrected.

1.56.

The problems mentioned for the consolidated opening balance sheet (see paragraphs 1.44 to 1.46) led to the following deficiencies for the consolidated closing balance sheet. All Directorates-General audited (except Directorate-General for Education and Culture) could reconcile the data used in the calculations with the basic accounting data, except for some unexplained differences, which, although not material confirm a certain level of risk as identified above (see paragraph 1.45).

1.56.

Material errors identified in the Directorate-General for Education and Culture which resulted from the wrong treatment of cut-off elements have been corrected.

1.57.

The explanatory notes to the consolidated accounts contain more information than in the past (32) about the fact that some transactions are likely to be corrected at a later date by the Commission's departments or by the Member States. However, the notes do not identify the amount of expenditure which may be subject to verification and clearance of accounts procedures (see also paragraphs 1.63 to 1.65).

1.57.

In addition to the annual financial clearance of the paying agencies' accounts, the Commission has the right to make corrections under conformity decisions. The Commission has acted on the recommendation made in the Court's 2004 report concerning possible compliance corrections still to be made. For example, the Directorate-General for Agriculture and Rural Development has for the financial years 2001-2005 clearly set out in its Annual Activity Report 2005 (33) the corrections to be decided in future conformity decisions and this amount is disclosed as a contingent asset in the Commission's accountings. It is considered that the total amount to be recovered in the future is EUR 1 151 million, based on an average rate of financial correction of 0,95 % — see also the reply to paragraphs 5.56 and 5.62.

1.58.

A detailed reconciliation between budgetary outturn and economic outturn is indispensable for obtaining reasonable assurance concerning the reliability of the accounts. Except for the Commission this information only became available after the presentation of the final accounts. Nonetheless, the Court was able to use this data to reconcile the budgetary and economic outturn.

1.59.

Taking into consideration the requirements of Article 248(1) of the Treaty, the changing audit environment (which is extremely complex and has changed fundamentally due to the financial reform of the Commission) and the expectations of the DAS's ‘users’ (namely the discharge authority), the Court decided in 2002 (34) that its audit opinion would be the result of a consolidation of the specific assessments concerning own resources and each of the six operational chapters of the 2000 to 2006 financial perspective (35). These specific assessments, which aim to give the discharge authority the possibility of monitoring the quality of the management of the funds in each of the major fields of Community intervention (36), are based on four sources of evidence:

(a)

an examination of the way in which the supervisory and control systems set up both in the Community institutions and in the Member States and third countries work;

(b)

testing of samples of transactions for each major area by carrying out checks down to final beneficiary level;

(c)

an analysis of the annual activity reports and declarations by the Directors-General and of the procedures applied in drawing them up;

(d)

where possible, an examination of the work of other auditors who are independent of Community management procedures.

1.60.

The objective of the audit of supervisory and control systems is to assess the extent to which they manage the risks concerning the legality and regularity of underlying transactions. The testing of transactions seeks to obtain direct evidence as to legality and regularity and to provide indications on the origin, frequency, nature and impact of errors found. The results of the transaction testing are used to complement and contribute to the conclusions on the systems. Information from both sources is used to identify recommendations for corrective actions. In accordance with international audit standards, the Court also takes account of the ‘management representations’ contained in the annual activity reports and declarations by the Directors-General, as well as in the synthesis thereof which is adopted by the Commission. Finally, the work of other auditors (37) is reviewed in order to evaluate its potential relevance for the specific assessments.

1.61.

As in the past, the conclusions of the specific assessments to be drawn concerning the different DAS sources available are broadly consistent. In areas where, according to the Court's audit, supervisory and control systems are implemented that allow risk to be managed adequately, the Court's substantive testing does not identify material findings as regards the legality and regularity of underlying transactions (see paragraphs 4.26 to 4.30, 5.53, 9.19 and 10.20) and the Court's assessment of the declarations by Directors-General and authorising officers by delegation confirmed that no, or only minor, reservations had to be presented (see paragraphs 2.14 to 2.19).

1.62.

In areas where, according to the Court's evaluation, supervisory and control systems exist but their effectiveness in managing the associated risk has to be improved, the Court's substantive testing still tends to identify material findings as regards the legality and regularity of underlying transactions (see paragraphs 5.52 to 5.57, 6.38 to 6.41, 7.28 and, as regards implementing organisations 8.21 to 8.22). Furthermore, the Court's assessment of the declarations by Directors-General confirmed that major reservations were either presented or, in the Court's view, should have been presented (see paragraphs 2.14 to 2.19).

1.62.

The Commission has taken steps to manage the risks associated with shared management through audit work, application of action plans in Member States to rectify systems deficiencies, financial corrections, guidance on key controls, and improved reporting of audit results of national auditors. The Annual Activity Reports of the Structural Funds Directorates General report on these actions and provide indications of improvements made in the Member States' systems. It is inherent in the system of shared management that certain errors and deficiencies will only be corrected after reimbursement of the expenditure concerned. The Commission refers to its replies to the Court's observations at paragraphs 2.8, 2.25 and 2.26.

1.63.

In the discussions concerning the DAS observations, it is often said that shortcomings identified by the Court at the level of underlying transactions only have a temporary impact and that the DAS does not take into account the multiannual nature of certain Community activities. Thus, it is argued that the Commission takes errors into consideration when clearing accounts in the EAGGF Guarantee section, when closing operational programmes in the Structural Funds, and when concluding audits relating to decentralised management.

1.63.

The Commission's argument is that under shared management there is a control cycle in relation to Community-funded expenditure which is carried out over a period of years. For Structural Funds this starts with first-level checks by the Member States and ends with the ex post audits of the Commission. The fact that the Court finds errors in transactions which are at a particular point in the control cycle does not signify that the control system is not functioning effectively. This is not, however, to deny the paramount importance of the checks on underlying transactions at source by management before expenditure is reported for reimbursement and of preventive measures such as guidance and information activities.

1.64.

In line with Article 53(5) of the Financial Regulation and Article 42 of the detailed rules for the implementation of the Financial Regulation (38), these decisions and corrective measures do indeed constitute important components of the Commission's supervisory and control systems. However, the weaknesses identified in the Court's audits show that ‘conformity decisions’ under the clearance of agricultural accounts, closure procedures for operational programmes under the Structural Funds and concluding audits relating to decentralised management cannot be regarded as mechanisms to ensure the prevention and timely identification and correction of errors (see paragraphs 5.56 to 5.57, 6.31 to 6.37, 6.41, 7.21 to 7.24 and 7.26 to 7.28).

1.64.

The objective of the conformity clearance of accounts decisions is to exclude from Community financing expenditure which has not been effected in compliance with Community rules. These decisions are addressed to Member States and protect the EU-taxpayer from the burden of financing undue expenditure. Under shared management the prevention, identification and correction of errors at the level of the final beneficiary is the responsibility of Member States. The clearance of accounts decisions encourage Member States to do their best to ensure that the error rate is kept at a tolerable level and that identified irregularities are recovered. The control systems are also combined with the application of dissuasive sanctions when errors are discovered by the Member States.

1.65.

Additionally, decisions on financial corrections taken in the area of shared management, recovering from Member States which have not implemented and/or operated reliable systems, do not make the underlying transactions any less illegal/irregular, even if they may have a dissuasive effect. Furthermore, as the financial corrections applied result from systems weaknesses, they cannot directly be related to errors at the level of underlying transactions. The effect of imposing financial corrections is to shift the cost of the (disallowed) illegal/irregular transactions from the EU budget to national taxpayers.

1.65.

The conformity clearance process is not in itself a mechanism by which irregular payments to beneficiaries are recovered since it focuses on the system of controls established by the Member States. In case those controls discover irregularities it is the responsibility of the Member States, as clearly stated in Article 9(1) of Regulation (EC) No 1290/2005.

2.1.

As in previous years, the Court has examined progress made by the Commission in implementing the financial aspects of its reform programme. In particular it has examined:

—

the annual activity reports by the Commission's Directors-General. These indicate how each Director-General has discharged his responsibilities and contain an assessment of the extent to which the expenditure for which he or she is responsible is legal and regular. The quality and reliability of these documents is thus of importance in permitting the Commission to satisfy itself that it has satisfactorily carried out its responsibilities for implementing the budget;

—

the Commission's ‘synthesis report’, which contains an overall assessment of the Commission's internal control system, drawing on the annual activity reports;

—

the Commission's system of internal controls.

2.2.

In 2005, the Commission continued with its efforts to embed risk management (1) into the existing planning and decision making processes, with the aim of developing a coherent (Commission-wide) approach and management culture in its Directorates-General.

2.2.

In 2005 a common methodological framework for risk management was adopted by the Commission, following the evaluation of the pilot exercises. The 2006 Annual Management Plan (AMP) process (launched in 2005) of the Commission's Directorates-General and Services contained for the first time an assessment of major risks for the Directorates-General's overall strategic objectives and a review of existing or placement of the necessary mitigating controls.

2.3.

On 17 January 2006 the Commission adopted an ‘action plan towards an integrated internal control framework’ (2), which took into account the results of the ‘gap assessment’ carried out by its services in 2005 for all management modes (3). The Court will evaluate the action plan when the relevant measures have been implemented and it is possible to assess their impact.

2.3.

Although the Commission appreciates the Court's results oriented approach, the Action Plan reflects the efforts made by the Commission to reinforce its internal control system in order to provide the Court of Auditors with sufficient audit evidence on the satisfactory management of the risk of error. The actions are to be implemented by Directorates-General and Services in close collaboration with Member States.

2.4.

The Court examined the extent to which the management representations contained in the annual activity reports and declarations of the Directors-General, and in the Commission's synthesis, are confirmed by the Court’s audit findings and are relevant for the DAS. It also analysed the progress made in the implementation of the internal control standards and assessed the effectiveness of the procedures introduced and tools developed in order to ensure the legality and regularity of the transactions underlying the budgetary payments.

2.5.

For the first time, the 2005 synthesis of the annual activity reports has been divided into two separate reports: one (4) dealing with the policy achievements during 2005 in terms of realising the Commission's strategic objectives, and the other (5) taking stock of the management of the Directorates-General and deciding on the measures that are necessary to address the major weaknesses in the supervisory and control systems. By adopting the latter, the Commission assumes its political responsibility for management by its Directors-General, on the basis of the assurances and reservations issued by them in their annual activity reports.

2.6.

In its 2005 Synthesis on the management achievements, the Commission considers that ‘Overall, … the internal control systems in place, with the limitations described in the 2005 annual activity reports, provide reasonable assurance on the legality and regularity of operations, for which the Commission is responsible under Article 274 EC. However, it acknowledges that further efforts are needed to solve a number of weaknesses, in particular those highlighted in the reservations of the delegated authorising officers.’

2.7.

In some respects, the assessments of the Commission are consistent with the analysis of the Court, in particular concerning reinforced guidelines of the annual activity reports (see paragraphs 2.11 and 2.12) and the need for developing indicators concerning the legality and regularity of underlying transactions and the functioning of key controls (see paragraphs 2.13 and 2.20), for continued efforts to ensure effectiveness of internal control (see paragraphs 2.21 to 2.23) and for further strengthening of accounting processes and systems to improve financial information (see paragraphs 1.5 to 1.58).

2.8.

However, in the areas of the common agricultural policy and structural operations the Court’s audit findings indicate that measures are needed, which go beyond those deemed necessary by the Director-General, in order to ensure that reasonable assurance in the declarations accompanying the annual activity reports is effectively underpinned by appropriate supervisory and control systems (see paragraphs 2.18 to 2.19).

2.8.

The Commission considers that the actions being implemented in the performance of its supervisory role already satisfactorily support the reasonable assurance expressed by the Directors General for the expenditure under their responsibility. As the audit work is carried out under a multi-annual strategy, the results enable the level of assurance on national systems to be built up year on year. The basis of the assurance will be further strengthened by the measures designed to achieve a higher level of compliance and effective control under the Action Plan towards an integrated internal control framework and by the improvements in the regulatory framework for the 2007-2013 programme period.

2.9.

The Court notes the emphasis that the Commission has placed on establishing an integrated internal control framework (see paragraph 2.3). Furthermore, it appreciates that the Commission updated the multi-annual objectives of its 2004 action plan (6), addressing the major cross-cutting issues identified in the financial year 2005 and recognising that most of the weaknesses identified can be eliminated only in the medium term (7).

2.10.

The Court considers that one of the most important objectives approved by the Commission is represented by the proportionality and cost-effectiveness of controls. In this context, the process of simplification of the spending programmes for the financial perspectives 2007 to 2013 (e.g. greater use of flat-rate and lump-sum payments, simplified rules on procurement and grants) and the use of audit certificates and assurance declarations from third parties responsible for budget implementation tasks could play a significant role.

2.11.

The central departments of the Commission (8) drafted a circular (9) for the 2005 annual activity reports aiming to simplify and improve the preparation process and provide guidance on the materiality threshold of weaknesses. Furthermore, the peer review exercise (10) ensured an improvement as regards the content and impact of reservations on the reasonable assurance (materiality, scope and quantification).

2.11.

Through its ongoing efforts to improve the content of declarations and monitoring of compliance with the standards on which they are based, the Commission is endeavouring to make the annual activity reports and annual declarations an effective management tool and reliable indicator of its performance and of the strategy it uses for dealing with the risks identified so that the Court can use them as a basis for its assurance.

2.12.

The Court considers that the measures taken by the Commission strengthened the preparation process of the annual activity reports, particularly insofar as the establishment of clear guidelines for the assessment of significant system weaknesses (11) that supplement the basic principles on materiality are concerned (12). Nevertheless, the Court notes that these guidelines were not completely followed in some cases (see paragraph 2.15).

2.12.

The Commission believes that significant progress has been achieved in this respect in 2005, in particular through the agreement of a common approach on materiality by ‘family’, the emphasis in Part 2 of the annual activity reports on the bases of the declaration of assurance and the outline in Part 3 of the materiality criteria used and the combined impact of the reservations on the declaration of assurance.

2.13.

Furthermore, the Court finds that there is still scope for improvement, especially insofar as the presentation of indicators having a direct link with legality and regularity is concerned. Despite the fact that relevant key figures and performance indicators (including legality and regularity) (13) should be presented by the Directors-General, there is no specific indication of which monitoring elements (indicators) should be used (14).

2.13.

In its guidelines, the Commission wanted to allow its services some flexibility in the choice of key figures and performance indicators.

2.14.

In their declarations attached to the annual activity reports, the Directors-General state that the internal control procedures put in place provide reasonable assurance that the underlying transactions are legal and regular. In the event of material internal control weaknesses or irregularities, they qualify the declarations and issue reservations (15).

2.15.

The Court’s analysis of the declarations of the Directors-General for the financial year 2005 reveals that the definition of the materiality criteria, as well as their application for the formulation of the reservations should sometimes be further clarified. For example, in some cases (16) the selected (qualitative and/or quantitative) criteria, and in others (17) the financial impact of the reservations, could be better specified.

2.15.

The Commission believes that its services have followed the guidelines in the circular on annual activity reports and in communication COM(2003) 28, which included clarification of the methodology for the establishment of annual activity reports. Materiality is basically a matter of the authorising officer by delegation's judgment and commitment vis-à-vis stakeholders. The materiality of a weakness is examined from a quantitative and/or qualitative perspective. Where systemic weaknesses are found, qualitative factors can also give rise to the formulation of a reservation.

2.16.

All the Directors-General stated that they had obtained reasonable assurance that the resources allocated to them had been used for the specified purposes, and that the internal controls which they had introduced ensured the legality and regularity of the underlying transactions. The Court notes that 21 of the 40 declarations contain one or more reservations.

2.16.

The formulation of reservations to the declaration of assurance by Directors-General is the logical conclusion of the reasoning in Parts 2 (bases of the declaration of assurance) and 3 (materiality criteria used, reservations and the combined impact of the reservations on the declaration of assurance), ensuring consistency between the annual activity report, the declaration and the reservations.

2.17.

The total number of reservations remained essentially unchanged from 2004 (32) to 2005 (31). The majority (18) concern weaknesses already identified in 2004 (18). The most important reservations in the context of the DAS are shown in Table 2.1 .

2.17.

The Commission is conscious that most reservations are recurring ones. Indeed, in its 2005 Synthesis it analysed the different types of recurring reservations (reservations whose underlying problem is being solved, in some cases with further efforts needed from third parties; reservations relating to structural problems; reservations relating to weaknesses affecting operations carried out outside headquarters).

2.18.

In comparison with 2004 (19), the Court notes in general an improvement in the quality of the assessment of the functioning of supervisory and control systems and of the overall impact of the relevant reservations on the assurance given in the declarations. However, the Court considers that some significant weaknesses singled out by its audits (20), should have been included as reservations in the declarations of the Directors-General (see Table 2.1 and paragraphs 6.38 to 6.40 and 7.17).

2.18.

The Directorates-General concerned, which manage the bulk of the budget, consider that the operation of the systems in place to control expenditure provides a solid basis for their declaration of assurance. They entered reservations in their declarations where the information they had built up from their own and the Member States' audit work on the functioning of systems indicated significant deficiencies posing a material risk to the Community budget that could not be adequately managed through the normal corrective mechanisms of the control system. Where a risk was adequately managed, the Director-General considered that there was assurance and no reserve was necessary.

2.19.

Despite the strengthened preparation process (see paragraphs 2.11 to 2.13), the Court considers that some annual activity reports (27) do not yet provide sufficient evidence for its Statement of Assurance (see paragraphs 2.15 and 2.18).

2.19.

The Directors-General and Heads of Service concerned have substantiated the bases of the declaration of assurance (Part 2 of the annual activity reports) and given an indication, by explicit arguments, of the impact of the reservations made on the reasonable assurance relating to the use of resources and the legality and regularity of the operations. They all concluded that they could give their assurance.

2.20.

The Court notes that a certain number (28) of Directorates-General present legality and regularity indicators in their 2005 annual activity reports. However, the design and use of these monitoring elements by the Commission's services could be further improved to measure the quality of the supervisory and control systems, as well as the legality and regularity of the underlying transactions.

2.20.

Most of the services managing Community programmes presented legality and regularity indicators. They also outlined the bases of their assurance in Part 2 of their annual activity report.

2.21.

The Court examined the application of the internal control standards (29) by 14 (30) of the Commission's services, with the view to assessing not only the degree of implementation of the minimum requirements (baselines), but also to evaluate the extent to which they contributed to ensuring that transactions were legal and regular. The immediate direct impact of the internal control standards varies, depending on the management mode for the budget implementation. For example for agriculture and structural funds, where day-to-day management is carried out by national or regional authorities, the Commission's internal controls extend to supervision of management and control systems in the Member States.

2.21.

This is also the understanding behind the Commission's Action Plan towards an integrated internal control framework.

2.22.

The ‘overview on the state of internal control in the Commission DGs and services in 2005’ (31), presented by the Directorate-General for the Budget, shows that, for the 2005 financial year, the Directorates-General comply on average with 95 % of the baseline requirements. Given that the baseline requirements remained essentially unchanged (32), the Court notes a slight increase in compliance with the internal control standards, as compared with 2004 (93 %). The Court’s analysis of the implementation of internal control standards is generally consistent with the Commission's assessment and is presented in Table 2.2 .

2.23.

Despite this high level of compliance with the baseline requirements, the Court’s review of the annual activity reports and audit results reveals that in the majority (33) of Directorates-General audited, the effectiveness of some internal control components (34) could be further improved, with a view to contribute to an improvement in the legality and regularity of underlying transactions. This analysis is in line with the Commission's assessment presented in the ‘overview of the state of internal control’ and with the annual report of the Commission's Internal Audit Service (35).

2.23.

The Commission considers that the internal control structures of its services are in place but Directorates-General have constantly to fine-tune their systems for achieving efficient and effective management and controls. The particular areas being focused are objective and indicator setting, evolving a dynamic internal control strategy, continuity and staff competences in human resources management, reporting on accountability and enhancing ex-ante control.

2.24.

In the financial year 2005, the Court notes a continued improvement in the Commission's internal control system. The action plan towards an integrated internal control framework is a step forward in the context of the roadmap exercise (36). The Court will evaluate its results when the relevant measures have been implemented and it is possible to assess their impact.

2.24.

Although the Commission appreciates the Court's results oriented approach, the Action Plan reflects the efforts made by the Commission to reinforce its internal control system in order to provide the Court of Auditors with audit evidence on the satisfactory management of the risk of error. The actions are to be implemented by Directorates-General and Services in close collaboration with Member States.

2.25.

Despite the progress made by the Commission in strengthening the annual activity reports as an instrument to improve accountability and communication, the Court’s audits revealed significant weaknesses in the supervisory and control systems in several areas of the financial perspectives (37), which have not been taken into consideration in the (annual activity reports and) declarations of the Directors-General.

2.25.

The Directorates-General for structural measures based their assessments of the assurance obtained from management and control systems in the Member States on information from their own and Member States' audit work, taking into account the various instruments available to them to manage the risk of irregular payments.

2.26.

The Court recommends that the Commission continues its efforts to strengthen the supervisory and control systems of its Directorates-General focusing on the following areas:

2.26.

(a)

ensuring the full application of the guidelines on the annual activity reports from the central services, especially concerning the materiality and the impact of reservations on the declarations;

(a)

The Directorates-General concerned, which manage the bulk of the budget, consider that the operation of the systems in place to control expenditure provides a solid basis for their declaration of assurance. They entered reservations in their declarations where the information they had built up from their own and the Member States' audit work on the functioning of systems indicated significant deficiencies posing a material risk to the Community budget that could not be adequately managed through the normal corrective mechanisms of the control system. Where a risk was adequately managed, the Director-General considered that there was assurance and no reserve was necessary.

(b)

improving the effectiveness in the application of the internal control standards by analysing systematically the impacts achieved;

(b)

The Commission acknowledges that improvements in internal control will always be possible and further efforts are constantly being made in this area. The effectiveness of internal controls, however, relies largely on qualitative assessments which cannot always be reduced to simple indicators.

(c)

developing specific indicators regarding the effective functioning of key controls and the legality and regularity of underlying transactions in order to allow the assessment of improvements over time in supervisory and control system.

(c)

The Commission is currently working on the 2004 Synthesis action on objectives and indicators which aims at analysing and defining relevant objectives and indicators for legality and regularity of operations. In addition, the actions under the ‘Commission's action plan towards an integrated internal control framework’ [COM(2006) 9] should in future provide for improved presentation of the key controls used to support reasonable assurance.

3.1.

This chapter analyses issues arising from the implementation of the EU general budget in 2005 (1). Within the budget there are separate appropriations for commitments and payments. Appropriations for commitment represent the amounts for which the Union can enter into budgetary commitments in the current year in order to honour longer term legal commitments (or agreements) to spend. Appropriations for payment represent amounts that can be spent during the current year. In the case of ‘non-differentiated’ expenditure (such as much of agricultural spending) commitments and payments within the budget are equal and liquidated during the year.

3.2.

Most expenditure on structural operations and on internal and external policies takes the form of programmes managed over a number of years (e.g. 2000 to 2006 for the current Structural Funds programming period). In the case of this ‘differentiated’ expenditure, the legal obligations are reflected as budgetary commitments in yearly tranches over the life of the programmes. Since most budgetary commitments are not liquidated in the year in which they are made, but in subsequent years, there remains a ‘stock’ or balance of outstanding budgetary commitments. For more detailed information on the budget see Annex I .

3.3.

2005 was the first full year of the enlarged Union. Total appropriations for commitments (116,6 billion euro) and payments (106,3 billion euro) were respectively 6,2 and 4,4 % higher than the 2004 final budget. The increase for commitments is proportionally larger because they can cover expenditure for more than one year (see paragraph 3.2), while payment appropriations are linked to absorption capacity. Overall, the commitment and payment appropriations remain below the financial perspective ceilings by 3,0 billion euro and 7,9 billion euro respectively.

3.4.

The eight amending budgets voted during the year resulted in an overall 0,6 billion euro reduction in both appropriations for commitments and payments, mainly in agriculture and structural operations.

3.5.

The budgetary outturn for 2005 is given in Diagrams III and IV of Annex I :

—

utilisation rates for both commitments and payments — at 99 and 96 % respectively — were at a similar high level to 2004 (98 and 95 %),

—

2,7 billion euro of unused payment appropriations were not cancelled but carried over from 2005 to 2006, a similar level to the carryover from 2004 to 2005 (2,8 billion euro) (2),

—

the budgetary surplus (3) for the year totalled 2,4 billion euro, a small reduction compared with 2,7 billion euro in 2004.

3.6.

Outstanding budgetary commitments (4) increased by 9,1 billion euro, or 8 %, to 119 billion euro (see Table 3.1 ). 94 % of the increase was related to structural operations, with 4 billion euro for the EU-15 programmes and 3 billion euro for the EU-10. Almost 3 billion euro of the increase for structural operations related to the Cohesion Fund. Outstanding budgetary commitments for differentiated expenditure as a whole represented 2,4 years of payments at the current spending rate (2,2 years in 2004).

3.6.

An increase in outstanding budgetary commitments (RAL) related to structural operations in EU-10 was to be expected as budgeted commitments are normally somewhat higher than payments in the early years of programming.

3.7.

Graph 3.1 shows the value of outstanding budgetary commitments on differentiated expenditure since 1994, and the steady increase in both absolute and relative terms. The increase is due to:

—

the cumulative effect of underspending between 1999 and 2003 which resulted in 40 billion euro of payment appropriations being cancelled (5), and

—

a growing budget — partly due to enlargement — in which appropriations for commitment are generally higher than those for payments.

3.7.

A significant increase in the absolute level of RAL was to be expected, as it is a natural consequence of the changed commitment and payment rules for the Structural Funds for the 2000 to 2006 period.

3.8.

Due to the nature of the budgetary process the balance of outstanding budgetary commitments does not reflect the full extent of the European Communities' legal commitments (see paragraph 3.1). At the end of 2005, 48,4 billion euro of legal commitments remained uncommitted at the budgetary level. As such, total outstanding legal commitments represented 3,4 years' of payments. This should be viewed in the light of the various time limits for making payments within the different budgetary areas.

3.8.

The indicators used in paragraphs 3.8 to 3.11 should be interpreted with care. The ratio of ‘outstanding legal commitments’ relative to payments in a given year, is not by itself a useful indicator for the reasons cited by the Court.

3.9.

The majority of the balance of outstanding budgetary commitments concerns structural operations. At the end of 2005, outstanding budgetary commitments for the Structural Funds 2000 to 2006 programming period were 67 billion euro, representing 2,3 years' expenditure at the 2005 spending rate, a slight increase over 2004. Legal commitments not yet transformed into budgetary commitments total 39 billion euro. Accordingly, total outstanding legal commitments for the Structural Funds 2000 to 2006 programming period at the end of 2005 were 106 billion euro. This represents 3,6 years' payments at the 2005 spending rate, compared with the nearly five years' worth of payments in 2004. The fall is partly due to the higher level of payments in 2005 compared with 2004, and more particularly a natural consequence of 2005 being one year nearer the end of the programme payment cycle (see Graph 3.2 ).

3.10.

The amount of expenditure needed to liquidate the outstanding legal commitments for Structural Funds should be viewed in the context of the time limit of end of 2008 (6) for beneficiaries to incur expenditure. In order to meet this deadline Member States will have to increase further their current high level of spending. This will be difficult to ensure as spending tends to reduce towards the end of the programming cycle as projects are finalised. Furthermore, from 2007 spending should start on the 2007 to 2013 programming cycle, but the need to complete the current cycle risks delaying the start and subsequent implementation of the new programmes (7).

3.10.

Member States and the Commission are aware that vigilance is needed to ensure that the switch between cycles is made smoothly, both in terms of ensuring programme implementation, and in tackling the additional workload relating to the establishment of new programmes. The closure of the 2000-2006 programmes is already being prepared by the Commission and Member States.

3.11.

Spending was less than expected for the Cohesion Fund largely due to lower than planned spending in the new Member States. An amending budget reduced the payment appropriations by 0,9 billion euro or 30 % and outstanding budgetary commitments increased from 9,7 billion euro in 2004 to 12,5 billion euro at the end of 2005. As a result, total outstanding legal commitments for the Cohesion Fund were 18,6 billion euro which represents 8,5 years' of payments at the 2005 spending rate. However, in contrast to the Structural Funds, there is no general legal deadline by which payments must be made.

3.11.

Enlargement in May 2004 brought a significant addition to the total stock of outstanding legal commitments, while the impact of new programmes on payments is necessarily limited at the start-up of programmes.

3.12.

The year n + 2 rule applies to the Structural Funds and provides for the cancellation of commitments when no payment claim is made within the two years following the year the commitment is made and is intended to prevent an excessive accumulation of outstanding budgetary commitments (9). In 2005, only 286 million euro of outstanding budgetary commitments were cancelled following application of the n + 2 rule. This was slightly higher than in 2004 (245 million euro) but still represented just 0,9 % of the commitment tranches more than two years old and therefore potentially subject to cancellation (and 0,4 % of the total balance of outstanding budgetary commitments).

3.12.

The payments on account made at the beginning of the programming period, which represented 7 % of the total EU-15 2000 to 2006 envelope of each programme, provide a relatively long term protection against n + 2 de-commitments as advance payments reduce the level of reimbursements needed to avoid automatic de-commitments.

3.13.

In practice the year n + 2 rule may encourage Member States to make claims as soon as they have made the underlying payments to final beneficiaries rather than when expenditure has actually been incurred by these beneficiaries. The risk is that Member States will submit claims of ineligible or anticipated (rather than actual) expenditure in order to prevent cancellations. Such practices may diminish the effectiveness of the year n + 2 rule.

3.13.

The Commission is aware of the risk and checks for abuses when it carries out its own audits.

3.14.

Most of the cancellations under the n + 2 rule relate to the European Social Fund. Moreover, in practice new commitments from the performance reserve (10) were — as in 2004 — in some cases allocated to the programmes from which commitments were cancelled, thereby partly negating the effect of the procedure (11).

3.14.

As appropriations cannot be shifted between Objectives (amounts fixed at the Berlin European Council in 1999 and in the Structural Funds Regulation), competition for the Performance Reserve is limited to programmes of one Member State within one Objective.

3.15.

The high rate of spending in 2005 and active management of the budget built upon the improved budgetary performance of 2004. In particular the large spending programmes continued at the expected levels, although absorption difficulties were encountered in the EU-10, particularly the Cohesion Fund. Despite the high spending rate, outstanding budgetary commitments increased by 8 % to an all time high of 119 billion euro, or 2,4 years’ worth of spending.

3.15.

Some increase in outstanding budgetary commitments is to be expected as a consequence of the increase of the budget of differentiated commitments for multiannual programmes to reflect enlargement.

3.16.

For the Structural Funds (which represents the major proportion of differentiated expenditure and the outstanding commitments) the high level of spending needs to be further increased to ensure that the deadline for beneficiaries to incur expenditure (end of 2008) is met for the 2000 to 2006 programmes. This will be particularly difficult as spending tends to reduce as the programmes end. There is, therefore, a risk that subsequent closure of the current programmes will delay the start and implementation of the 2007 to 2013 programmes as in the past.

3.16.

Expenditure will not necessarily reduce in the final years of the current period. Available evidence on execution trends of the programmes of the current programming period does not suggest any significant deceleration. Member States and the Commission are aware that vigilance is needed to ensure that the switch between cycles is made smoothly, both in terms of ensuring programme implementation, and in tackling the additional workload relating to the establishment of new programmes. The closure of the 2000 to 2006 programmes is already being prepared by the Commission and Member States.

3.17.

Effective budgetary management requires a realistic and appropriate budget taking into account the expected profile of payments, particularly the absorption capacity of Member and beneficiary States. This was not the case for the first three years of the current programming period. Commitments on major spending programmes are made in equal tranches which do not reflect the timing or profile of payments. The low level of spending at the beginning of programmes resulted in a build up of outstanding budgetary commitments, and commitments are only liquidated many years after they are made.

3.17.

In terms of execution of the available payment appropriations 2005 was a very good year, which partly reflects realistic and appropriate budgeting.

3.18.

This situation is caused by constant and smoothly increasing annual commitment and payment budgets. The Commission based the latter on the expectation that when programming cycles overlap the lower demand for payment at the start of the new period will be compensated for by payments from the end of the old period (12). When this is not the case (such as 2000 to 2003) there is considerable underspending. As a result there is a risk that significant levels of spending will continue far beyond the 2000 to 2006 financial perspective period.

3.18.

The Commission's budgets are based on a detailed analysis of the requirements for each programme period.

3.19.

For the Structural Funds the year n + 2 rule has resulted in little cancellation of commitments to date. Its effectiveness as a budgetary management tool may be compromised if Member States make claims based on ineligible or anticipated payments in order to prevent commitments being cancelled.

3.19.

The level of de-commitments is not in itself a proper indicator of the effectiveness of the n + 2 rule, precisely because the rule also has an effect on promoting budget execution.

3.20.

The Court recommends that the Commission makes a careful analysis of the forthcoming completion of the current structural operations spending programmes and the effect this will have on the start of the next. Furthermore, the Commission will have to ensure for the Structural Funds the effective application of the year n + 2 rule with the consequence that it will have to cancel a significant value of budgetary commitments unless Member States succeed in increasing the rate of eligible spending even further.

3.20.

The Commission agrees with the recommendation.

3.21.

For the 2007 to 2013 programming period, the Commission should:

—

ensure that programmes are adopted quickly and are based on reasonable assumptions,

—

review critically Member States' payment forecast, and

—

ensure that annual budgeting over the life of the period is consistent with realistic assumptions about the rate of spending.

3.21.

The Commission agrees with the recommendation.

4.1.

The revenue in the budget of the European Union consists of own resources and other revenue. As shown in Table 4.1, Graph 4.1 and Graph 4.2 own resources are by far the main source of financing for budgetary expenditure (94,3 %).

4.2.

There are three categories of own resources: traditional own resources (2) (customs duties, agricultural duties, and sugar levies) (13,3 %), own resources calculated on the basis of value added tax (VAT) collected by Member States (14,9 %), and own resources derived from the Member States' gross national income (GNI) (3) (66,1 %).

4.3.

The main risks to the collection of traditional own resources are evasion of duty by the taxpayer, whether by misrepresentation or simply by smuggling; miscalculations or failures to establish duty because of undetected errors or weaknesses in customs authorities' systems; and errors or omissions in Member States' accounting for the duty established.

4.4.

The Court's audit of the accounts cannot cover undeclared imports and imports that have escaped customs surveillance. However, its audit work included an evaluation of supervisory and control systems, both at the Commission and in Member States, to assess whether they gave reasonable assurance of completeness. It consisted of a review of the organisation of customs supervision and of the national systems for accounting for traditional own resources in eight Member States (4) (see paragraph 4.22); an examination of the effectiveness of the mutual assistance arrangements (paragraphs 4.10 to 4.12); an examination of the Commission's accounts for traditional own resources; and an analysis of the flow of duties in order to gain reasonable assurance that the amounts recorded were complete and correct.

4.5.

The VAT and GNI own resources reflect macroeconomic statistics whose underlying data cannot be audited directly. For this reason, the VAT/GNI audit took as its starting point the receipt by the Commission of the macroeconomic aggregates prepared by the Member States (either as forecasts or as final figures) and sought to assess the Commission's system for handling the data until they are ultimately included in the final accounts. The audit thus covered the establishment of the annual budget and its implementation in respect of the payments by Member States. In addition, the Court continued its review of supervisory and control systems in relation to the compilation of national accounts at Statistical Offices in Member States.

4.6.

Minor errors were found in customs declarations (the underlying transactions for traditional own resources) but these have no material effect on the accounts. However, certain traditional own resources transactions, which should have been made available to the Commission without delay were incorrectly withheld and entered in separate accounts (the B accounts).

4.6.

The Commission requires Member States to pay interest for any delays discovered in making traditional own resources available.

4.7.

As in previous years the Court's audit and the Commission's inspections (see paragraph 4.9) found systematic problems with the B accounts in a number of Member States (5). Some errors are related to the conditions for entry in the accounts. In Member States whose B accounts represent 34 % of the balance, customs debts that are partly secured are nevertheless entered in full in the B accounts, leading to delay in making the secured part available to the Commission. Other errors arise because Member States have not adapted their accounting systems so as to record the appeal or recovery accurately, or because there is insufficient internal control over the compilation of reports. 22,7 million euro of potential duties remain under discussion between the Commission and Germany as a result of such a problem.

4.7.

The Commission agrees with the Court’s findings. The practice of including unchallenged amounts in the B account because the guarantee held may be insufficient is incorrect. It is also contrary to the advice the Commission has given Member States. The Commission will take all appropriate measures including infringement proceedings against this incorrect practice.

4.8.

The Court's audit did not reveal any material irregularities in respect of the payments of VAT and GNI own resources by Member States.

4.9.

The Court has reviewed the inspections carried out by the Commission (6) and has taken the results into account. As in previous years the Commission's methodology and documentation were found to be respectively soundly-based and good. The inspections found that the own resources collection systems were generally satisfactory, but confirmed the continued poor reliability of the B accounts in some Member States (see paragraph 4.7).

4.10.

An important aspect of the supervisory and control systems is coordination of action between Member States and the Commission to protect the financial interests of the Community against fraud and irregularities (7). Weaknesses in these systems would put the completeness of collection of duties at risk. Specific provisions on mutual assistance in the customs and agricultural sectors are given in Council Regulation (EC) No 515/97 (8). The European Anti-Fraud Office (OLAF) provides the Commission's support for this cooperative task.

4.11.

There are still inconsistencies in Member States' reporting of mutual assistance cases, and very long delays, sometimes exceeding five years, at the administrative investigation stage which could result in loss of revenue since time-barring generally applies after three years. This finding is consistent with the observation in the Court's recent audit of the management of OLAF (9), that there were no rules for consistent monitoring of progress on mutual assistance cases in the Member States.

4.11.

The investigation phase may be both complex and time-consuming. Where Member States are shown to have been dilatory in pursuing evidence of irregularity and revenue is consequently lost, the Commission requested those countries to pay for the duties forgone together with interest on the delay in making them available.

4.12.

The Taxation and Customs Union Directorate General (DG TAXUD) has recently introduced a RIF (Risk Information Form) system for exchanging control- and risk-related information between the Member States' customs services. 90 % of the RIF data fields are also on the standard mutual assistance communication, and the information obtained from these two systems is used in many cases by the same services in the Member States, including investigation/intelligence and control services. Even if a potential risk has been reported using a RIF, the regulation requires a parallel message to OLAF using the mutual assistance procedure in cases of breaches of customs legislation.

4.12.

Council Regulation (EC) No 648/2005 introduced a general requirement for a Community Customs Risk management framework. The RIF exchange is an integral part of the framework and the Commission's experience is that RIF information is presently fulfilling a key aim of reaching a wider range of front-line control officers.

4.13.

The Commission succeeded in maintaining the frequency and quality of its on-the-spot inspections during the financial year 2005 in the enlarged European Union.

4.14.

The number of outstanding reservations (10) in respect of Member States' VAT statements remains high. With 37 reservations lifted and 41 new reservations set, the number increased to 111 at the end of the year 2005 and its breakdown between the Member States concerned is given in Table 4.2 . Their financial impact has not been estimated by the Commission.

4.14.

The Commission places reservations where it disagrees with the Member State's figures or method, or where it requires evidence to justify the figures or method used, or where the Member State presents no figures. For these reasons their financial impact is seldom easy to estimate with accuracy. Moreover, the Commission would not want such estimation to discourage Member States from performing the sometimes difficult work of producing accurate data and appropriate methods of calculation. The Commission will nonetheless reexamine this question.

4.15.

The Court notes that the lifting of a reservation largely depends on appropriate action being undertaken by the Member State in question. For certain reservations an infringement procedure can be started at the European Court of Justice. Apart from this there is at present no effective instrument for ensuring that Member States provide adequate information within clearly defined deadlines, so enabling the Commission to decide on the lifting of outstanding reservations within reasonable timescales.

4.15.

Reservations are a device for keeping weak elements in VAT statements open for correction after the statutory time-limit of four years. The Commission considers that in those cases where the Member States apply either VAT or own resources legislation incorrectly, the infringement procedure may provide a remedy. For other cases, the Commission will examine the possibility and opportuneness of introducing, for instance into Council Regulation (EC) No 1553/89, an instrument of the kind suggested by the Court.

4.16.

As regards the GNI own resource, there was still insufficient verification by the Commission of the underlying national accounts that form the basis for the figures forwarded in the GNI questionnaires (12). During 2005 Commission inspections as part of supervisory and control systems were limited to desk checks (13) in respect of the quality and consistency of data in the annual GNI questionnaires submitted by Member States.

4.16.

In autumn, the Commission verifies the annual GNI questionnaires, using the same standardised checklist for all Member States, drawing extensively on Commission experts’ knowledge of the countries’ practices, and requesting additional information from the Member States, if necessary. The GNI questionnaires are submitted to the GNI Committee for examination. This approach makes the data adequate for provisional use in the budgetary calculations, taking account of existing reservations for Member States.

4.17.

In its Annual Report concerning the financial year 2004 (14) the Court drew attention to some weaknesses in the quality reports submitted by Member States. A review of the quality reports submitted in 2005 showed that most of these weaknesses had been addressed. However, there was still no reporting on the results of investigations of the quality of GNI and its components carried out by Member States.

4.17.

The Commission has urged Member States to step up their efforts in reporting the results of their investigations of GNI quality (see reply to 4.30(c)).

4.18.

At the end of the 2005 financial year there were 63 outstanding specific reservations (15) in total (the majority for years 1995 to 2001), with an unequal spread between the EU-15 Member States, both in respect of the number of reservations and the action taken to have them lifted, see Table 4.3 .

4.19.

The Commission will have to put in place a further reservation applicable to all EU-15 Member States in respect of the inclusion of illegal activities in GNI, to allow adjustments to be made in the aggregates concerned, going back to the year 2002 (18).

4.19.

The Commission notified a reservation covering illegal activities to the Member States in July 2006.

4.20.

Since 2005 new rules on the allocation of FISIM within the European system of national and regional accounts (ESA 95) apply (19). The objective is to achieve a more accurate intra-Community comparison of GNI levels of Member States. According to Eurostat (20), the application of these new rules would result in a significant increase of GNI which varies across Member States and years, but roughly ranges between 0,5 and 2 %.

4.21.

In cases where modifications to the ESA 95 result in significant changes in the GNI, the Council is required to decide whether these modifications shall apply for the purpose of own resources on the basis of a proposal made by the Commission (21). Although the decision setting new rules for the allocation of FISIM within ESA 95 had already been taken in 2002, the Commission has not yet presented any proposal for FISIM allocation for own resources purposes. Such an allocation would have an impact on the incidence of the financial burden on the Member States.

4.21.

Statistical changes adopted by the EU in order to improve the methodology of ESA and achieve a more accurate comparison of economic activity among Member States should apply also to own resources payments, once agreed changes are applied in a uniform manner across Member States. The Commission will therefore present a proposal to include allocated FISIM for GNI own resources when it considers that all Member States are able to implement this adjustment in a uniform manner.

4.22.

The systems for customs supervision and for accounting for traditional own resources were generally found to be functioning correctly. However, an examination of Community transit found that many Member States (22) did not have effective systems for starting enquiries on time when there was doubt about the arrival of consignments, and there were also considerable delays in later stages of the enquiry and recovery procedures. As a result duties were frequently collected late in such cases. In several Member States (23) customs control of goods in temporary storage (24) was not sufficient to ensure that the time-limits and other rules in the Community Customs Code were observed. In one Member State (25) the intervals between customs audits of economic operators could routinely exceed three years, thus putting traditional own resources at risk because of time-barring.

4.22.

All the Court’s comments will be followed up with the relevant Member States.

4.23.

In its Annual Report concerning the financial year 2004, the Court noted that there were significant differences between Member States as regards the existence and implementation of certain elements of supervisory and control systems at Statistical Offices with respect to the compilation of national accounts. In 2005 the examination was extended to six more Member States (26) and a number of weaknesses were identified in the following areas:

(a)

the performance of a formal and structured risk analysis in respect of the process of national accounts compilation (27);

(b)

the existence of agreements or equivalent arrangements between national accounts departments and units providing basic statistical data, which set out the conditions for the delivery and the quality of data (28);

(c)

the systematic production of ‘quality reports’ accompanying statistical surveys (29);

(d)

the performance of internal audits on the process of statistical data collection and compilation (30).

4.23.

See reply to 4.25.

4.24.

In 2005 the European Statistics Code of Practice (31) was adopted, providing basic principles for enhancing the quality of statistical products (including national accounts). During 2005 National Statistical Offices had to perform a self-assessment on their compliance with the basic principles of this code. These self-assessments will be complemented and validated by peer reviews taking place in 2006 and 2007 and co-ordinated by the Commission.

4.25.

The Court remains of the view that the differences in the existence and implementation of supervisory and control systems could lead to varying degrees of reliability, comparability and exhaustiveness of national accounts.

4.25.

The Commission uses a standardised tool to verify the reliability, comparability and exhaustiveness of all Member States’ GNI data used for own resources, including detailed descriptions of sources and methods (GNI inventories) with annual updates in the form of the quality reports. The Commission considers that this approach is essential for the validation of the reliability, comparability and exhaustiveness of GNI data.

4.26.

Taking into account the scope of the audit (see paragraph 4.3) and with the exception of the B-account matters noted in paragraphs 4.6 to 4.7, the Court found that in all material respects the systems for customs supervision were satisfactory, the accounts recording traditional own resources were reliable and the underlying transactions were legal and regular.

4.27.

As regards traditional own resources, the Court recommends that:

4.27.

(a)

in order to improve the effectiveness of mutual assistance and reduce the risk of time-barred claims, OLAF and DG TAXUD should streamline both reporting and monitoring systems and work towards a more integrated approach, for example by means of an inter-DG action plan (paragraph 4.12) and,

(a)

OLAF and DG TAXUD are already cooperating on a more integrated approach to streamlining reporting and monitoring systems, see reply to 4.12.

(b)

in the light of the continued problems with the B accounts, the Commission should consider in due course whether the current Regulation specifies the requirements with sufficient clarity, whether there is scope for providing guidance on best practice, and whether the procedures can be simplified in order to reduce the level of errors (paragraph 4.7).

(b)

In 2004, the Commission obtained Council approval of regulatory amendments to the B account arrangements. There is a transitional period for the changes ending in 2009. The effect of these changes should be evaluated before any further alterations are embarked upon. In the meantime the Commission will continue to inform Member States about the correct use of B accounts and the implications of Court of Justice judgments affecting the accounting treatment of traditional own resources.

4.28.

Taking into account the scope of the audit as set out in paragraph 4.5 the Court found that, on the basis of data supplied by Member States, the VAT and GNI resources in all material respects were correctly calculated, collected and entered in the Community accounts by the Commission.

4.29.

In respect of the Commission's controls on the systems underlying the calculation of the VAT own resource, the Court: