Analysis of the 2008-09 Budget Bill: General Government

Financial Information System for California (8880)

This item appropriates funds for the Financial Information System for California (FI$Cal). FI$Cal is an information technology (IT) project managed by a partnership of the Department of Finance (DOF), the State Treasurer’s Office (STO), the State Controller’s Office (SCO), and the Department of General Services (DGS). The purpose of this project is to create and implement a new statewide financial system.

For FI$Cal, the 2008–09 budget proposes 98 positions and $40.1 million ($2.4 million General Fund, and $37.7 million special funds).

Increasing Legislative Oversight For the Proposed FI$Cal

The 2008–09 Governor’s Budget proposes to proceed with statewide implementation of the Financial Information System for California at a total cost over a multiyear time frame of $1.6 billion, with a 30–day legislative review period after the initial departments are implemented. We recommend an alternative which limits the initial scope of the project, allows for a more extensive legislative review before proceeding with statewide implementation, results in lower initial expenditures, and reduces the project’s reliance on borrowing.

Background: 2007 Project Proposal

Expanding on the New System for DOF. Since 2005, DOF has been working on a project to modernize its existing budget system, known as Budget Information System (BIS). In planning for the development of BIS, DOF came to the conclusion that it made more sense to replace all of the state’s financial and accounting systems, rather than just modernize the one system within its department.

Project Description. In the 2007–08 budget, the Governor proposed an IT project, referred to as FI$Cal, that would take eight years to develop and implement a statewide automated financial system in all state departments, with a total cost of $1.3 billion. The new financial system would encompass budgeting, purchasing, accounting, and cash management. The project effort would be managed by a partnership of the four control agencies responsible for California’s financial management: DOF for budgeting, DGS for procurement, SCO for accounts payable and receivable, and STO for cash management. Independent project oversight would be provided by a consulting contractor reporting directly to DOF.

Last Year’s Analysis: Project Risks Significant. In the Analysis of the 2007–08 Budget Bill, we noted that there are significant risks involved in a project as large as FI$Cal. And, like all such IT projects, these risks must be managed and mitigated. Accordingly, we recommended that increased project oversight be imposed in order to maximize the potential for project success. In addition, we discussed a number of key project components which imposed further project risk including:

• The proposed eight–year project schedule seemed aggressive for implementing more than 100 state entities.
• Redesigning the control agencies’ work processes would present major organizational challenges. Therefore, control agency leadership would need to maintain its commitment to the project’s high priority and to the required organizational change.
• The funding proposal called for a 100 percent General Fund ($784 million) investment during the first five years with no assurances of federal reimbursement.

Legislative Direction

During the spring 2007 budget hearings, the Legislature acknowledged that the state’s financial systems were aging and in need of replacement. However, the FI$Cal project risks were a concern. In the 2007–08 Budget Act, the Legislature appropriated $6.6 million for FI$Cal and adopted language which required (1) transferring an existing oversight contract to the Bureau of State Audits (BSA) and (2) delivering a series of reports to the Legislature by April 2008 to address various project implementation issues. Key elements of the required reports include:

• Alternatives. The administration was required to develop alternatives including, but not limited to, a “proof of concept” pilot project, the original BIS project, and no project.
• Formalization of Control Agency Roles. The four partnering agency sponsors were to formalize their roles through a memorandum of understanding (MOU).
• Succession Planning. A plan for leadership and project staff succession was to be developed.
• Vendor Accountability. A plan for managing the vendor and ensuring accountability was to be provided.
• Project Oversight and Communication. A plan which formalizes the oversight roles of the Office of Technology, Review, Oversight, and Security, and BSA was to be developed along with a plan for how the oversight entities and the vendor would communicate among themselves.

Assessment of the Response to Budget Control Language

In November 2007, DOF submitted a revised special project report (SPR) to the Legislative Analyst’s Office (LAO)—five months early. This SPR is generally responsive to the requirements of the budget act. For example, an MOU has been entered into among the control agencies and a detailed process to hold the vendor accountable is documented. However, the alternative project plans required by the budget act came up short in some respects. Figure 1 summarizes the alternative FI$Cal plans. One of the alternatives specified by the Legislature to be included in the SPR is a pilot project. The SPR included a proof–of–concept project which on the surface may look like a pilot project, however, as presented in the SPR, this alternative is not viable because it would implement less than 10 percent of the departments for nearly $800 million—one–half of the full FI$Cal cost. Finally, we note that the oversight communication plan, also due in April 2008, has not yet been provided to the Legislature.

Revised Project Proposal

The revised SPR proposes the original project scope to modernize the control agencies’ processes and then implements the FI$Cal system in all departments over a schedule that has been extended by two years. The costs have been revised from $1.3 billion to $1.6 billion to reflect the extended schedule. Industry best practices that improve the project’s opportunity for success continue to be part of the proposal. These include having knowledgeable state financial staff on the project and conducting classroom training prior to putting the system into production. Below we describe the plans for implementation and financing.

Implementation Approach. Under the recommended approach, the first wave of departments will be implemented by 2012. These include the four control agencies (DOF, SCO, DGS, and STO) plus four program departments. The program departments are the Departments of Social Services (DSS), Justice (DOJ), Parks and Recreation (DPR), and the Board of Equalization (BOE). These program departments were selected for their broad representation of different state financial functions. For example, the DSS administers many different federal programs involving block grants and entitlements. The BOE is a revenue–generating department. The DOJ has the same 1970s financial system as BOE. The DPR does capital outlay projects, grant management, and bond financing. Together, these departments will test the system’s ability to meet a wide range of public sector financial requirements.

By October 2012, the project would submit a status report to the Legislature for a 30–day review period. At this point, the project will have spent $490 million and the second wave of 11 departments will be 15 months into their 24–month implementation. Assuming legislative approval, the remaining statewide implementation would continue and be completed over the following five years. This proposal assumes statewide implementation in 2017 at a total estimated cost of $1.6 billion.

Financing Approach. The administration proposes to borrow $1.2 billion of the $1.6 billion total project costs, initially through short–term bond anticipation notes (BANS). The BANs will include “capitalized” interest so as to eliminate debt–service costs until permanent financing is issued in the form of Certificates of Participation (COPs). (Capitalized interest is the practice of borrowing expected future interest payments so as to avoid debt service costs in the short term.) Debt service would begin in 2012–13. Ongoing maintenance and operations costs (M&O), including repayment of the borrowing, are to be funded through cost allocation to the departments.

Debt Repayment by Departments. The administration’s fiscal estimates reflect M&O costs of $101 million starting in 2017, after statewide implementation is complete. The repayment schedule estimates that total debt–service payments in 2017 will be $99 million, rising to $142 million in 2020. Departments will be allocated their share of these combined amounts. Currently, departments share in the cost of existing financial systems such as CalSTARS. Savings from not having to pay their share of CalSTARS operations will in part offset the departments’ new obligations to pay M&O and debt–service costs for FI$Cal. The amount of any such savings will only be determined after each department is implemented and is not likely to be significant. However, there may be management efficiencies in that better information is available from the new system for analysis.

Cost Allocation Plan and Federal Participation. The administration indicates that the federal government will share in about 18 percent of project costs. However, federal participation will not begin until 2012–13, after the system is operational in the control agencies and Wave 1 departments. This is because the federal government does not participate during the development phase of financial projects such as FI$Cal. In addition to the federal 18 percent share, the administration estimates that the General Fund will cover about 31 percent of project costs, with special funds covering the remaining 51 percent.

Figure 2 shows the estimated annual project costs through 2017–18. The first BAN would be issued in June 2009. This BAN would repay a proposed General Fund loan to cover FI$Cal costs during 2008–09 and fund project costs during 2009–10.

Assessing the Advantages and Disadvantages of Administration’s Approach

Below we assess the advantages and limitations of proceeding now with FI$Cal or a FI$Cal–like IT project.

Benefits of Proceeding Now

Replacing Old Systems in Danger of Failing. Most of the state’s financial infrastructure is comprised of individual department systems which were primarily developed in the 1970s and 1980s. Many of these ‘legacy’ systems are written in programming languages that have been out of use for more than a decade. These systems must be updated regularly for changes to law, policy, or to add new functions—such as direct deposit. Locating programmers skilled in these outdated languages is becoming increasingly difficult. In addition, these older systems are inefficient and labor intensive. Their limitations inhibit the state’s ability to meet growing financial reporting requirements. Many departments struggle to close their accounting books within regulatory time frames each year.

Human Capital Risks of Delay. Over the years, the limitations of the state’s out–dated financial systems have led state staff to develop external processes and subsystems to supplement these legacy systems. For the most part, these staff are near or at retirement age. These subsystems and processes are largely undocumented. Tapping this knowledge base before it is lost is seen by the administration as an important reason for proceeding now.

Efficiency Gains From Automated Interfaces. FI$Cal will automate the control agencies’ processes, many of which still require receipt of hardcopy information. This should introduce efficiencies that result in savings. In addition, there are several departments that have replaced, or are in the process of replacing, their outdated financial systems. These replacement systems allow automated transmission of data. If the control agencies can receive automated data transmissions from these departments, it will maximize the success and efficiency of these newer systems at departments like the Department of Water Resources (DWR), Department of Technology Services (DTS), California Department of Corrections and Rehabilitation (CDCR), Department of Transportation (Caltrans), and the Administrative Office of the Courts (AOC).

Limitations of Administration’s Approach

High Risk Nature of Project. FI$Cal would be one of the most complex and most expensive information technology projects undertaken to date by state government. It is designed to integrate the budgeting, purchasing, accounting, and cash management systems of the State of California and thus involves more than 100 different entities. Each department will have to adjust its business processes to accommodate commercial software that is different than is being used today. During each department’s implementation period, which is estimated to span a year, state staff will continue to be responsible for accomplishing their ongoing workload using current processes while at the same time transitioning to new business practices. This will create a significant level of organizational stress. At this stage of the project, there is no absolute assurance of project success. Given the project’s complexity, time delays and cost overruns can be expected.

Degree of Financing Is Unprecedented for an IT Project. The FI$Cal proposal to finance the majority of project development costs using BANS and COPs is a departure from the way IT projects have been paid for in the past. It is common practice for the state to borrow for the acquisition of tangible capital assets. Equipment purchases by the state data centers are financed to align their cash flow with their cost recovery schedule. Borrowing is also used for large IT development projects to acquire the hardware and software products needed to implement the system. For FI$Cal, these costs are $83 million of the $1.2 billion that will be financed. The balance of the borrowing, however, would cover staff and contractor salaries in addition to leased facilities and payments to the state data center for processing and telecommunications costs. For past IT projects, these types of costs were funded with pay–as–you–go appropriations.

Typically, debt financing is used to acquire tangible assets such as buildings and equipment, which have an economic value. In essence, this plan finances a less tangible asset, something that has value to the state, but could not be valued as collateral because it would have little or no value to an outsider. The proposed borrowing adds $400 million in debt–service costs over the life of the project. Although we believe this financing is feasible, it is not necessarily desirable, especially in the magnitude proposed. Given that this is a less tangible capital asset, it is likely that bond buyers would demand a higher interest rate to compensate for the lack of hard collateral that would typically be available when capital assets such as office buildings are financed. The amount of this risk premium is unknown. Finally, we would note that using bond financing increases the cost of project failure because, even if the project is never completed, the bond buyers would need to be repaid with interest.

Impact on Departments. The future cost of maintaining the FI$Cal system would be paid for by allocating its cost to departments based on their share of use. Adding debt repayment costs to the ongoing maintenance cost would increase costs to departments. Using 2017 as an example, departments would be allocated a total of $200 million; $99 million to repay the debt service plus $101 million for the M&O of the system. Of this amount, the federal government would pay 18 percent, while special funds would pay 51 percent and the General Fund would pay 31 percent. To some extent, this cost would be offset by some unknown savings. In order for departments to maintain their program service levels, the Legislature would most likely be asked to appropriate additional funds to cover these FI$Cal costs.

Borrowing Versus Pay–as–You–Go. Given the state’s fiscal condition and the need to update the state’s financial systems, a reasonable case can be made to finance the first two or three years of project costs. However, by the third or fourth year, it makes sense to use a more balanced approach between borrowing and “pay–as–you–go” appropriations of special funds and General Fund monies. This would reduce the future debt service burden on the state and its departments.

Proposed Legislative Review Period Unworkable. The project plan requires the administration to submit a report to the Legislature that will discuss the status of the project after implementing the new system in the four control agencies and four program departments. The report would share lessons learned and how these lessons will improve the implementation of the project as it goes forward. However, the report is to be delivered to the Legislature in October, when the Legislature is not in session. Presumably, the Legislature already would have had to make a funding decision regarding the project by July as part of final actions on the state budget.

We believe the proposed 30–day review period is unworkable. First, the Legislature will already have had to make a funding decision as noted above. Second, the review mechanism does not allow adequate time for the Legislature to explore fully the project’s challenges and accomplishments and make an informed decision regarding whether to continue with statewide implementation. Moreover, during the proposed review and approval period, the next group of departments will already be more than 60 percent complete in their FI$CAL implementation, thus compromising legislative review of the project.

LAO Alternative: Limit Initial Scope and Then Pause for Legislative Approval After Wave 1

Although it is a close call, we believe the benefits of proceeding with FI$Cal at this time outweigh the benefits of canceling the project altogether. If the project were canceled, it would take many years before it could begin to be implemented in the first wave departments. In the meantime, departmental systems will continue to be at risk of failure and some may have to be replaced, reducing the benefits of FI$Cal.

Below we present the key features of an alternative which provides for greater legislative oversight and review, lower initial costs, and less reliance on borrowing.

Key Features of LAO Alternative

Initial Project Scope. The LAO alternative would go forward with the implementation of “Wave 1” departments. Wave 1 develops the FI$Cal system and installs it in the four control agencies (DOF, SCO, DGS, and STO) plus four program departments (DSS, BOE, DOJ, and DPR). We concur with the administration that these program departments are reasonable choices for the first wave because of their broad representation of state financial functions.

Adjust the Schedule. In order to facilitate legislative review and oversight, the project schedule should be adjusted so that the report on the status of Wave 1 implementation would be presented to the Legislature no later than March 1 after implementation.

Pause for Legislative Approval. Rather than the 30–day review period provided in the administration’s plan, we recommend that the Legislature decide whether to proceed with full implementation during the regular budget process or through separate legislation. Unlike the administration’s proposal, the project would not proceed with activities to prepare additional departments for system installation until the Legislature has reviewed the report and decided to continue the project. The advantage of this approach is twofold, (1) the Legislature has time to conduct a full inquiry about the project status and, (2) departments that will be implemented in the second phase of the project are not spending project implementation funds until the Legislature has approved the project to continue.

This approach will add a year to the total project schedule because subsequent departments would not begin their one–year preparation until after the Legislature’s review. Over the ten–year schedule, this will increase project cost by approximately $67 million, (about $20 million in 2008–09 dollars) compared to the administration’s estimates. One might argue that increasing the Legislative review would slow the project down and, therefore, add costs beyond this estimate. We would note that any cost impact could be minimized by (1) adjusting the project schedule to deliver the status report in March instead of October and (2) having the vendor plan for this legislative pause.

Limit Borrowing to $250 Million During the Initial Phase of Development. We estimate the total cost of the first four years of the LAO alternative through Wave 1 implementation to be $461 million. This is $29 million less that the administration’s proposal. Given the state’s fiscal situation and the need to update the state’s financial systems, we recognize a reasonable case can be made to borrow during 2008–09 and 2009–10. However, beginning in 2010–11, we think it makes sense to use a more balanced approach—a combination of additional bond financing and pay–as–you–go appropriations. Bond authority of $250 million represents about 55 percent of estimated Wave 1 project costs. While we see value in replacing the state’s aging financial system in the near future, this financing approach will allow adequate time for the administration to set budget priorities that could substantially reduce or even eliminate further borrowing. The Legislature could revisit the issue of additional bond financing, if and when it decides to authorize the remainder of statewide implementation.

Expenditure of Bond Proceeds Subject to Appropriation. In order to increase legislative oversight of funding, we recommend requiring the administration to obtain annual budget act authority to expend bond proceeds.

Analyst’s Recommendation

We recommend that the Legislature adopt the LAO Alternative described above. This alternative would enable the control agencies’ processes to be modernized and critical system requirements to be tested fully in four diverse departments by 2012. In contrast to the administration’s proposal, this alternative would also ensure the Legislature has time to explore fully the project’s status in order to determine if continuing implementation is in the state’s best interest. In addition, it results in lower initial expenditures and reduces the reliance on borrowing, thereby avoiding future interest costs.