the foundations of public sector budgeting and accounting: understanding cash and accrual andrew...

The Foundations of Public The Foundations of Public Sector Budgeting and Sector Budgeting and

Accounting: Understanding Accounting: Understanding Cash and AccrualCash and Accrual

Andrew GrahamQueens University

School of Policy Studieshttp://post.queensu.ca/

~grahama/

Canadian Public Sector Management

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Why here? Why now?Why here? Why now?

• In run up to both budgeting and accounting, it is important to have a technical grasp of key concepts

• The basis of accounting and possibly budgeting: cash or accrual is one of them

• There have been major shifts in how the public sector manages its basis of accounting that will affect an understanding of both budgets and accounting


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Private and Public Sector Accounting Private and Public Sector Accounting EnvironmentsEnvironments

• Private sector accounting records are maintained to assess levels of profitability

• Public sector accounting records are maintained to ensure that public servants (politicians, bureaucrats, officials) have been properly accountable of the funds they have used

• Greater emphasis on accountability and stewardship


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What is the End Product and how do you What is the End Product and how do you Build Accounts to match it?Build Accounts to match it?

• Private sector accounting based on matching revenue and expense in order to measure profit

• This leads to using accrual accounting which recognizes both revenues and expenses when they occur: bottom line is profitability not cash situation

• What accrual has developed is an overall assessment of the financial condition of the organization


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What is the End Product and how do you What is the End Product and how do you Build Accounts to match it?Build Accounts to match it?

• Public sector focus on accountability for funds at hand has lead to using a cash basis as it is more easily understood and more sensitive to annual budgetary approvals of governing body

• Significant gaps in the cash approach has created a growing trend of governments and other parts of the public sector to adopt the accrual approach to both accounting and budgeting.


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Quick Snapshot Quick Snapshot

• Cash Accounting recognizes – revenues when cash is received and – expenses in the form of expenditures when

bills are paid (focus on cash movement).

• Accrual Accounting recognizes – revenue when goods or services have

been provided and – expenses when resources have been used

(focus on when revenues are earned or resources are consumed).


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Quick Snapshot Quick Snapshot

• Governmental funds have also used Modified Accrual Accounting. – Expenditures are recognized when

resources are received.

– Revenues are recognized when they are measurable and available within the accounting period or shortly afterwards (focus on financial resources).

This is on its way out!


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Accrual AccountingAccrual Accounting

Capital assets are reported on the financial statements

Non cash transactions – depreciation, amortization, provisions, accruals, receivables are recorded

Recognition of (retirement and pension benefits, accumulated leave) employee benefits in the financial statements

Financial and reporting practices are similar to private sector


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Why Do This?

• The adoption of accrual basis represents an effort to bring into both accounting and budgeting a totally inclusive approach to identifying costs and revenues, thereby providing a fuller picture

• Accrual budgeting represents a major challenge to the concept of annualized budgets approved by legislatures, although it in no way reduces the authority of those legislatures

• Accrual accounting forces a better integration of finance, operations and strategic direction because of its inclusive nature


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Why Do This?

• Accrual accounting demands a higher level of sophistication on the part of public sector managers, their overseers, be they legislatures or boards of directors

• The shift to both accrual accounting and accrual budgeting is a major change process for any organization creating work and the need to manage the change, often with the adoption of new financial information systems.


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Why to Not Do This?

• Smaller public sector organizations do not need to do this

• Size and scale only require limited financial information

• Limited assets being held for a long period• No capital• Little or no long term liability• Day to day existence• Simple bookkeeping will suffice.


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Weaknesses of the Cash BasisWeaknesses of the Cash Basis

• Failure to accurately represent the amount of resource usage. For instance, a large capital acquisition will distort expenditure upward in the first year but the usage of that asset will not be recognized in following years.

• Information about assets and liabilities is frequently very limited

• Lack of an effective balance sheet to reflect true worth (or net debt) of the organization


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Weaknesses of the Cash BasisWeaknesses of the Cash Basis

• Failure to take account of future commitments, guarantees, or other contingent liabilities. A liability will not be recognized until the cash is paid to settle the debt.

• Concentration on cash payments alone, sometimes resulting in an unnoticed deterioration in fixed assets.

• Focus on control of the inputs purchased rather than the outputs produced.

• Distortion of incentives by encouraging managers to underestimate the costs of programs and to spend their full annual appropriations.

• Encourages end of year spending


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Claimed Benefits of AccrualClaimed Benefits of Accrual

• Better measurement of costs and revenues including comparisons over time

• Full cost of providing a service can be compared with outside suppliers

• Greater focus on outputs rather than inputs• A better indication of the sustainability of

Government policy• Greater comparability of management

performance results.


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• Provides a full picture of a government’s

financial position

• Shows how activities of government were

financed and how government met its cash

requirements

• Provides useful information about the real

level of government’s liabilities


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• Improve management of government’s

assets and liabilities


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Squaring Accrual with the Westminster Model Squaring Accrual with the Westminster Model of Governmentof Government

• We will see that accrual accounting deals with both cash and non-cash costs

• Notion that governments only vote funds or cash for one year appears to contradict this

• Vehicle for voting such funds in appropriations

• No contradiction as the approval of cash expenditures through appropriations is needed in both systems.


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Cash Treatment of CapitalCash Treatment of Capital

Capital Item 2005-06 2006-07

New Computer System

1,750,000

750,000

What is recorded here is the movement of cash to pay for the system

Buying a computer system at a cost of $2.5 MBuying a computer system at a cost of $2.5 M


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Accrual Treatment of CapitalAccrual Treatment of Capital

Item 2004-05

2005-06

2006-07

2007-08

2008-09

Computer System

500,00

500,00

500,000

500,000

500,000

What is recorded here is the amount of the total value that is consumed in the time period in which it is being consumed.


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Accrual Treatment of CapitalAccrual Treatment of Capital

• However, accrual would never have a single entry such as this in its Balance Sheet

• Rather, there would be two entries, perhaps three, depending on the circumstances: – Accounts payable or cash reduction

entry– Inventory (Assets) entry and, – Depreciation.


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Recognition of Long Term Assets & Recognition of Long Term Assets & LiabilitiesLiabilities

• Public Debt

• Government has an accurate record of

existing borrowings

• Pension Obligations

• Contractual agreement treated as a

liability

• Asset Register to be maintained


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Event Cash Basis Accrual Basis Modified Accrual Basis

Article ordered from

supplier

No effect No effect No effect

Article arrives in Inventory

No effect Increase accounts

payable and Increase Inventory

Increase accounts

payable and Decrease

funds balance

Article is used

No effect Decrease inventory

and Decrease

fund balance

No effect

Article is paid for

Decrease cash

Decrease fund balance

Decrease cash

Decrease accounts payable

Decrease cash

Decrease accounts payable


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Word of Warning: Cash Accounting Word of Warning: Cash Accounting versus Cash Managementversus Cash Management

• Even in a cash system, the ordering of an article involves the commitment of funds for cash forecasting purposes.

• While this commitment would not be recorded or recognized as it does not involve a formal transaction in cash accounting terms, it does represent an encumbrance of funds and restricts their alternative use.


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Word of Warning: Cash Accounting Word of Warning: Cash Accounting versus Cashversus Cash ManagementManagement

• As will be seen when discussing cash management, most organizations have ways of recording significant commitments for forecasting purposes, even if such commitment are ‘off balance sheet’.

• This is a way for organizations on the cash basis to get a hold of their actual financial position and also to manage their cash flows within year.


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Significant Definitions and ConceptsSignificant Definitions and Concepts

Expenditure: – An expenditure is the amount of cash

paid for goods and services. – It can also be seen as the creation of

the legal obligation to pay.


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Expense: – Expenses represent the cost of goods and

services consumed in the process of fulfilling the organization’s objectives.

– They are measured by the amount of an asset used (e.g. depreciation) or the amount of a liability incurred (e.g. creditor's amount).

– Expense, used both as a noun and a verb, refers to the identification, in the accounting system of an obligation to pay, a liability or unpaid obligation


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Treatment of Non-cash transactions: – Accrual accounting entails recording non-

cash transactions such as depreciation, provisions, bad debts, etc.

– Non-cash transactions have a monetary value and contribute to the government, organization or unit’s financial position.

– Examples of non-cash transactions:• Depreciation• Future liabilities, e.g. pensions, vacation leave


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• Recognition: – Point at which an asset or liability is

formally recorded in the accounting system is the point of recognition

– Possible to be aware of a liability and not recognize it: example: commitment to partner on a building project but costs not understood sufficiently to plug in the numbers


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Inflow (Revenue) RecognitionInflow (Revenue) Recognition

CollectedMeasurable and

Available

ModifiedAccrual Basis

Earned

AccrualBasis

CashBasis

Note: Governmental resource inflows are available if they are deemed to becollectable during or shortly after the end of the accounting period. This mayhappen before cash is received.

Payment has been received or will be received soon.

Service hasbeen provided.

Payment hasbeen received.


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Outflow (Expense or Expenditure) Outflow (Expense or Expenditure) RecognitionRecognition

Appropriation

Encumbrance Delivery Payment Use

ModifiedAccrualBasis -

Expenditurenow.

CashBasis

Expensenow.

AccrualBasis

Expensenow.

Authorization to spend money.

Order hasbeen placed.

Order has been received.

Payment ismade.

Item isconsumed.

No expenseat this time -any basis.

No expenseat this time -any basis.


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• Recognition can get carried away: Example: When should state pensions become a liability on government’s balance sheet?– When a person is born?– When they start work?– When they retire?

Usual technique is to take these off-balance sheet and create a separate self-accounting fund.


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A Week in the A Week in the Life of a Small Life of a Small GovernmentGovernment

ExampleExample


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Accrual BudgetingAccrual Budgeting

• Includes details of the accrued expenses, revenues,

payments, receipts, assets and liabilities in annual

estimates

• Financial Reports will be in the form of :

• Statement of Financial Performance (Income

Statement)

• Statement of Financial Position (Balance Sheet)

• Statement of Cash Flow


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BenefitsBenefits

• Improved resource allocation• Better quality policy making• Better control of capital• Better identification of liabilities • Opportunity for private/public

comparison• Financial management becomes a

central concern• Better quality management of cash

flow and current assets/liabilities


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Is Accrual the be-all of public sector Is Accrual the be-all of public sector financial Management?financial Management?

• Not quite• Accrual accounting only provides

better quality ex-post information– Unless there is a context for this

information then it is purely a technical exercise

• Accrual accounting is not a panacea for poor Government performance


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Is Accrual the be-all of public Is Accrual the be-all of public sector financial Management?sector financial Management?

• Its greatest value is as part of an integrated management system:– Accrual budgeting as well as accrual

reporting– Fiscal framework based around a “suite of

measures”– Focus on balance sheet (asset & liability)

management – Focus on “whole of government”– Results oriented financial management

system


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Can Accrual Accounting and Can Accrual Accounting and Budgeting prevent a public sector Budgeting prevent a public sector

Enron?Enron?

• Is it the form of the accounting system that creates the risk in government accounting?

• Would a change from cash to accruals make the difference?

• No – Enron accounted on an accruals basis! – well, sort of, it even abused its accounting standards: mark-to-market accounting

• Other factors are far more important


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Can Accrual Accounting and Can Accrual Accounting and Budgeting prevent a public sector Budgeting prevent a public sector

Enron?Enron?• Strong audit/accountability

arrangements• Clear separation of capital from revenue

expenditure and income• Political willingness to challenge and

cause change in accounts if necessary• Independence of standard setting from

Government• Independence of External Audit function• Capacity of managers to ‘read the

balance sheet’• Internal systems of control

the foundations of public sector budgeting and accounting: understanding cash and accrual andrew...

Documents

accounting slide

public sector focus

basis of accounting

private sector slide

accounting period

modified accrual accounting

cash basis

public servants politicians