Required Changes in Financial Reporting to Ensure Accountability

To strengthen the new performance accountability relationships, performance measures and reporting should mirror those of the private sector, and hence it is argued, government should adopt the private sector’s form of accounting. Under accrual accounting, reporting requirements for government are basically the same as for the private sector. Three main reports—statement of financial position, operating statement, and statement of cash flows—are supplemented by a number of other reports, including statements of objectives, service performance, commitments, contingent liabilities, and accounting practices. Often, the argument that the public sector should adopt generally accepted private sector accounting practices is taken too far, lending support to those that have taken a contrary view. They would argue that in the private sector, annual financial accounts identify the financial impact of a company on its individual shareholders. Accrual accounting is designed to put the focus on the bottom line—the concept of profit—and to satisfy the predominantly financial accountability of the management of a private sector company to its shareholders.⁹⁸ In public sector organizations, the same concept, profit (or surplus), cannot be expected to govern decision making. For example, a surplus need not equate with good management, but only that the service was over-funded.⁹⁹ Perhaps more important, for government there is a wider political accountability to the electorate and its elected representatives that should also guide financial reporting.¹⁰⁰ In the government sector, financial information is primarily used for making political rather than economic decisions.

Accountability requirements for government do not preclude those applicable to the private sector, but are likely to be much broader. For the public sector, accountability requires that government accounts identify the financial consequences of government policies for individual citizens. Adopting a narrow financial viewpoint refocuses and dilutes the stewardship function of financial accounting in government and often can result in financial statements that do not include a comparison of actual income and expenditure with the amounts authorized in the annual budget—a crucial concept of the accountability framework for government. In the government sector, the budget-setting process is still seen as a fundamental aspect of financial control. A government’s financial accountability arises from the budget-setting process by which agreement is obtained on the level of taxation and the funding allocated to provide various services. Thus the budget outturn report is the prime document by which governments are held to account for the regularity and probity of their financial management. Unfortunately, both the Accounting Standards Board (2003) and the International Federation of Accountants (2003a, 2003b) have deemed the budget outturn reports one of the optional additional statements that public sector organizations produce.

Parallel Changes in the Budget Process

If accrual accounting is adopted, is there also a need to move government to accrual budgeting? Logically, the budgetary process should be consistent with the ex post reporting format.¹⁰¹ If this position is carried to its logical conclusion, there are two main budgetary implications of accrual accounting. First, ex ante and ex post performance information should be harmonized. Agencies should move both their ex post reporting and ex ante budgetary documentation to an accrual basis. This would require agencies to prepare prospective financial statements as well as prospective service performance (output) information for inclusion in the estimates. Second, the major budgetary constraint on agencies—the appropriation process—should be in a format that is consistent with the performance system. The appropriation process under an accrual budgetary regime would appropriate for:

• the purchase of goods and services (outputs) from agencies, other government-owned entities, and private sector entities;¹⁰²

• capital injections to increase the government’s net asset holding in a department or agency; and

• other payments of benefits and grants.

A handful of countries appropriate on an accrual basis, but having an accrual-based, performance-oriented PEM system does not necessarily imply accrual appropriations (Athukorala and Reid, 2003, pp. 51ff). It is conceivable that performance projections can be established on an accrual basis, the cash requirements assessed, and appropriations made accordingly for the cash required for the period.¹⁰³ This approach, however, could result in dual, and potentially conflicting, performance objectives: on the one hand, accrual performance against accrual expectations, and, on the other, compliance with cash appropriations. In short, the appropriation process would determine, rather than reflect, the criteria for agency performance. Moreover, focusing on cash would again fail to give the legislature effective control over the true consumption of resources and negate one of the great advantages of moving to an accrual system.

Although accrual accounting records past events and provides more informed public reports on the true use of resources, it perhaps does not serve well for the discrete ex ante resource decisions that are taken in the course of budget approval. The budget is a system of authorization and control that benefits from the simplicity provided by recording resource costs up front, and arguably is more readily measured by cash. In this way, the essential budget process requirement is to include all costs for budget decision making. Apart from its direct costs, a program could be charged for its indirect costs, including support goods and services, joint costs such as building maintenance and security, and the costs of accruing employee pensions and retiree health care. Even for capital costs, some capital charge could be assigned, as well as some rent for the use of premises.

Greater Emphasis on Efficient Asset Management

The new performance-oriented accountability places more emphasis on efficient use of assets. However, the concept of government assets has not proved an easy one to accommodate in accounting principles designed for the private sector. The Accounting Standards Board adopted the private sector definition of an asset as “rights or other access to future economic benefits controlled by an entity as a result of past transactions or events” and then extended this to include future service potential. This concept is further stretched to include heritage assets. The fact is that definition of assets in government is very complex. Some public facilities may be provided by natural endowment or gift and so there is no equivalent of historical cost incurred by the purchase of these assets. Some facilities must be maintained and preserved for future public use, and there may be no private market available to realize the economic benefits from their use. Additionally, there may be restrictions imposed so that disposal of the facilities is prohibited or requires government/political approval.

Even so, too much can be made of these definition and valuation problems. Perhaps more significant is the focus on the maintenance of assets. In the private sector, the recognition and valuation of the company’s assets have a significant impact on the bottom-line profit that is reported. In the public sector, the valuation of assets is much less important; reporting the extent to which public sector capital assets are maintained is far more important than reporting their total value. Recognizing this, the U.K. Treasury adopted a cost-benefit trade-off in determining which assets are to be valued in its resource accounts. Nonoperating assets such as the crown jewels, Stonehenge, and paintings in the National Portrait Gallery are all given a nominal value, but new additions to the latter collection will be included in the balance sheet at their purchase price or value when acquired.

Parallel Changes Required in the PEM System

The most important implications of the move to an accrual-based accounting system are for the PEM system. Accounting for agency activities is probably best decentralized to the agencies themselves, and the central accounting functions of the MoF would then focus on provision of bookkeeping for payments and receipts of the core central government functions; consolidation of departmental information; promulgation of accounting policies for the government; and production of financial reports at the government level. Along with decentralization of the accounting function, there may also be a case for the delegation of asset management. The government’s investment of capital assets in agencies is usually significant. To improve the performance of capital assets, it could be argued, an agency should have the freedom to sell and buy those assets insofar as doing so would not increase the government’s total investment in the agency. The rationale is that it is difficult to hold agencies accountable for their performance if they do not have the delegated authority to meet the performance goals. With this delegated authority over assets, internal control and audit would also need to be decentralized (albeit with central oversight). Similarly, audit and finance regulations would most likely need amending. Agencies would provide new sets of financial statements under the accrual accounting system. The impact on the audit procedure needs to be carefully examined in the implementation process, not least because successful implementation of accrual accounting depends heavily on the willingness of the external auditor to support the move. Significant revisions are likely to be required in financial regulations to provide for accrual accounting policies and procedures, departmental reporting requirements and formats, and management of departmental assets and bank accounts. Last, but far from insignificant, is the need to upgrade computer and human resource capacities. Accrual accounting is more complicated than cash accounting and requires a heavier investment in computerization and skilled labor.

The change to public sector personnel policies is perhaps the most profound and revolutionary. At the same time that the above changes create demand for skilled labor, the agencies will be shifting to a mode of operating that has more in common with the private sector, which means that there will be greater opportunities for labor mobility between the public and private sectors—especially for workers with managerial and accounting skills. In fact, the new reforms not only present such possibilities, but also provide incentives to exploit them. For example, if agency heads are to be held much more tightly accountable for the performance of their departments, they will become much more interested in the quality of the staff assigned to assist them in this task. They are likely to want the major say in key appointments, and they may also want a freer hand in dismissing nonperforming staff. This could lead, and in some OECD countries has led, to fundamental changes in public sector employment arrangements.

Stage One: Get Cash Accounting to Work Well

This will typically involve a two-pronged approach. First, purge the system of common abuses, and second, supplement the cash accounts with adjustments to improve fiscal reporting.

As suggested, some benefits of accrual accounting can be derived by adjusting the cash basis to include accrual data. For example, accrual accounting may better reflect emerging liabilities such as unfunded public service pensions, but multiyear cash-based expenditure plans equally highlight the problem. Similarly, most cash systems are weak in providing information on payment arrears. A logical step is to add systems that can generate information on commitments undertaken, bills payable, and bills due for payment.

Stage Two: Integrate Operating Accounts and Financial Asset and Liability Accounts to Move to Modified Accrual

Integrating asset and liability accounts and operating accounts is a significant step forward. It has the advantage of ensuring that all transactions are treated in a consistent, self-balancing framework. For example, the practice, say, of financing the recapitalization of banks by issuing government debt to build up a bank’s assets, without showing a corresponding deficit above the line, would be fully reflected in any form of accrual accounts. An acceptable second-best solution may be to propose an explicit standard for reporting such transactions, such as a memorandum item in the operating accounts of cash-based systems.

An essential element of this adjustment of cash accounts is to include payables and receivables:

• Accounts payable: This allows for the recording of liabilities that have not resulted in the payment of cash in the current accounting period. It should include goods delivered but not paid for and agreements to pay subsidies and grants to the private sector.

• Accounts receivable: This allows for the recording of revenue earned by the government that has not resulted in the receipt of cash, although it is sufficiently close to cash to be reasonably secured. It should include taxation and nontaxation revenues being processed, including credit sales of goods and services.

Stage two should be regarded as a reasonable target for most developing countries, because any movement to incorporate accrual concepts results in more useful information for fiscal policymakers. A system based on cash recording and reporting but with an integrated set of operating and financial asset and liability accounts would achieve the operational advantages of integration, while not involving the additional complexities of maintaining accounts on an accrual basis. Box 34 indicates some of the steps involved in moving to this stage.

Stage Three: Introduce More Elements of Accrual Recording and Move to a Partial Accrual Presentation in ex post Reporting

Additional elements of accrual accounting that could be recognized in this stage include the following:

• Provisions for employee entitlements, such as pensions (linked to years of service and leave), as the employee earns them: Such entitlements have been generally shown to be a significant hidden cost of government which result in large unfunded demands on budget resources in future years. Recognition of the buildup in such demands through provisioning provides budget managers with useful early warnings of possible future problems in the cash funding of these entitlements and enables corrective action to be implemented.

• Prepayments received by government: These receipts can range from deposits on the sale of assets to installment payments on the provision of government goods and services. Such receipts can be used to inflate the fiscal result for the current accounting period and consequently understate the fiscal result for future periods. However, because conditions have not been met for their recognition as government revenue, they should not be treated as revenues, but shown as financial transactions affecting assets and accounts receivable.

• Interest payable: Interest on debt can be a significant drain on budget resources, and simply recording interest as it is paid may not provide adequate information on future trends in interest payments and whether they will place acceptable demands on budget finances. This is particularly the case with zero coupon bonds. This information would complement expenditure control and the level of funds held within the commercial agency banks.

At the end of this stage of the move to accrual accounting, ex post reporting of the budget would include a partial balance sheet with selected financial assets and liabilities, and the adjusted cash flow operating statement would include some items on an accrual basis.

Stage Four: Recognize Nonfinancial Assets—Final Stage for Accrual Accounting

This transition from recognizing only financial assets to recognizing both financial and nonfinancial assets greatly complicates the accounting process. This requires that consistent valuation practices be applied to all government nonfinancial assets—many of which are not easily subject to a market-related assessment of value. Once this task has been completed, depreciation can be charged as an expense for each accounting period, thereby providing a better indication of the full costs of government operations. This stage has not proved easy, even for the most advanced OECD countries.

Only at this stage would full accrual ex post reporting be introduced to include:

• operating statement of performance showing how revenues and expenses explain the movement in the net stock of assets;

• balance sheet of financial position for the beginning and end of the accounting period; and

• cash flow statement showing cash flows embodied in assets, liabilities, revenues, and expenses clearly distinguishing between operations, investment activities like loans, and advances and the financing of cash flows through the issue of government securities.

Stage Five: Move from Accrual Accounting to Accrual Accounting and Budgeting¹¹²

Accrual budgeting should be differentiated from accrual accounting. Only New Zealand, Australia, and Iceland have so far moved to a system where the budget is targeted, appropriated, and reported on an accruals basis. Others may report on an accruals basis ex post, but they budget (and also report ex post) on a cash basis. Logic may suggest that this final stage is required for introducing a performance-oriented system, but there has been a lot more resistance to this than to the move to accrual accounting. Undoubtedly, a major reason is the difficulty of implementing this final stage, notably the additional information required to prepare an accrual-based budget that shows projected cash flow (as existing budgets); projected revenues, expenses, and operating result in the operating statement; and projected assets, liabilities, and equity in the statement of financial position. The additional information required includes:

• information included in the cash budgets currently prepared, namely, movements in cash and cash equivalents, cash being spent on purchase of assets and received for sale of assets, and estimated financing transactions;

• estimated movements in inventories, receivables, payables, employee entitlements, and other liabilities; and

• details of asset depreciation policies.

A second reason for the lack of enthusiasm for accrual budgeting, especially on the part of legislators, is the suspicion that the move carries the risk of loosening fiscal discipline. Cash gives a very clear matching of the political decision to spend and the actual amounts spent, but the methodological complexity of accruals is thought to undermine the ability to maintain this basic check on the executive.¹¹³

A third reason is the general lack of experience with accrual budgeting. Accrual budgeting has been neither well defined nor widely discussed in the general literature, and there is not adequate country experience to form a basis for guidelines in its use.

Accrual Budgeting Can Take Place at Different Levels

First, it is possible to envisage accrual budgeting being applied at different levels of budget decision making, addressing three different objectives:

• Macroeconomic stabilization: At the aggregate level, fiscal targets and/or rules could be specified in terms of accrual concepts such as net worth, the operating balance, net financial worth, and net lending/borrowing.

• Resource allocation: Accrual concepts—particularly expense concepts—could be used for making decisions about resource allocation between agencies, specifically, in prioritizing agency budget bids and refining agency estimates, but perhaps also in determining legislative appropriations to agencies.

• Internal resource use within agencies: As the basis of operationalizing a performance-based budget management system within an agency, accrual expense concepts could be incorporated into the product costing systems used for deciding resource allocation between different activities within individual agencies.

These three uses of accrual budgeting are, to a considerable degree, separable. That is, it would be possible to adopt an accrual budgeting approach at an aggregate level to address stabilization issues (specifying fiscal targets and/or rules) while having budget appropriations to agencies on a largely cash, or modified cash, basis. The decision to introduce accrual budgeting, therefore, cannot be made without considering its use. Instead, each country has to determine which uses of accrual budgeting make sense given its specific circumstances.

Accrual Budgeting Can Be on a Partial Basis

Just as for accrual accounting, budgeting can be on a partial or full accruals basis.

• Macroeconomic stabilization: For this purpose, aggregate accrual budgeting on a partial accruals basis would involve either or both (i) using net lending/borrowing as one’s budget balance measure for fiscal policy purposes instead of the cash (or modified cash) budget balance, and (ii) setting targets/limits for net financial worth (instead of the narrower cash net debt measure). By contrast, aggregate accrual budgeting on a full accrual basis would set targets for the operating balance and/or net worth (quite possibly in addition to, rather than as substitutes for, partial accrual variables such as net financial worth).

• Resource allocation: Resource allocation on a partial accruals basis would mean that agencies would bid for “current” budgets that would include not only cash expenses, but also those noncash expenses that create financial liabilities (obligations to make future payments, such as accruing leave and pension entitlements of civil servants). It might (or might not) also involve placing agency appropriations on the same basis. By contrast, budgetary resource allocation on a full accruals basis would involve taking the further step of including depreciation as a component of agency’s current budgets (as in Australia and New Zealand).¹¹⁴

• Internal resource use within agencies: In the partial accruals approach to the internal allocation of costs of programs and their activities, agencies would be expected to include cash and most noncash expenses. Similarly, a full accruals performance budgeting system might also include depreciation when estimating program or output costs.

There Is a Logical Sequence for Introducing Accrual Budgeting

There is very limited experience on which to base good practice for accrual budgeting and even less on which to delineate the appropriate sequencing of accrual budgeting for emerging economies. International experience to date suggests the following tentative conclusions:

• Most of the benefits of accrual budgetary resource allocation and accrual-based performance budgeting can be realized by placing them on a partial accruals basis. The advantages are less clear, even for advanced OECD countries, of moving these forms of budgeting to a full accruals basis.

• For macro stabilization objectives, accrual budgeting could be generally applied at the aggregate level, based upon partial accrual concepts. Certainly, an accruals budget produces economic indicators that are of great importance for fiscal analysis. For example, it is much better for fiscal sustainability purposes to target net financial worth than to target net (let alone gross) debt, because net financial worth takes into account highly relevant forms of quasi-debt.¹¹⁵ This suggests that, at the time when countries are ready to move to partial accrual accounting (stage three), they should perhaps also formulate at least some of their fiscal targets/rules in partial accrual terms.

• Aggregate accrual budgeting on a full accruals basis—in the sense of setting targets and/or rules for the net worth and operating balance—is a useful means of bringing a longer-run perspective to budgeting, particularly in the management of aggregate public investment. However, this is most relevant to more advanced countries with assured fiscal sustainability (in particular, no present or prospective debt problems), and therefore could wait until after stage four, when accrual accounting is more firmly entrenched and accrual concepts are also more acceptable to the legislature.

• With respect to using accrual budgeting for resource allocation, a case could be made to move quickly after stage three to place agency budget bids and estimates on a partial accruals basis. This is because partial accrual accounting introduces noncash expenses which are variable costs and which are therefore as relevant to decision making as cash expenses. However, to make this move, for consistency it would be necessary also to place appropriations on a partial accruals basis. Similarly, the case could be made for partial accrual budgeting in an agency’s internal resource allocation decisions. Again, providing an incentive system for managers to productively employ accrual-based decisions would also imply making appropriations on a partial accruals basis. However, until a full performance budgeting framework is in place to enforce accountability, this move to partial accrual appropriations may prove dangerous.

• The speed of moving to accrual budgeting should be linked to wider budget management reforms. Appropriating even on a partial accruals basis assumes a well-developed performance budgeting system. It means that agencies are given up front the funds to cover such accruing liabilities as depreciation and then are expected to reserve those funds to meet the relevant payments when they fall due.¹¹⁶ Unless performance management is well established, a more prudent option is for such funds to be held back by the MoF or other appropriate central bodies (e.g., civil service pension fund). But if the latter approach is followed, then placing appropriations on a partial accruals basis would remain something of a fiction—the reality would be that the portion of the appropriations that agencies were actually given would continue to be determined on a cash or modified cash basis. This suggests that moving appropriations even to a partial accruals basis for use in resource allocation and for internal agency budgeting is less pressing and perhaps should wait until accrual-based accounting and financial reporting are well established.

Stage One: Restructure Existing Cash Data

Without the need for additional data, the cash transactions are restructured. Those relating to the operations of government (tax and other current revenue, wages and salaries, purchases of goods and services, interest and other current payments) are included in a cash operating accounting.¹¹⁷ Purchases of nonfinancial assets are classified in an investment account, and changes in financial assets and liabilities would be shown in a separate financing account.

Recognition rules would be simplified. The rules for revenue recognition would stay very similar to those in the cash system, although tax revenues would be recognized on an accrual basis. In terms of expense categories, category No. 22 (“use of goods and services”) would not be used except to distinguish current expenditures from longer-lasting material assets acquisitions (Box 36). The latter assets would be subject to a 100 percent first-year depreciation rule to achieve a better correlation between budget “expenditure” under a cash basis and accrual-based “expense.”¹¹⁸ Category No. 23 (“consumption of fixed capital”), a periodic depreciation of fixed assets, would not be adopted at this stage.

There are four advantages to implementing this first stage. The first is the ease at which it can be done. Second, the generation of a cash operating account and a separate investment account distinguishes the government’s operating activity from its investment programs, which cause considerable problems in a pure cash-based GFS system. Third, although the cash operating statement excludes depreciation and may have significant timing problems, it provides a more useful measure of government operations than the previous cash-based GFS aggregates. Fourth, all changes in financial assets and liabilities are included in the financing account, eliminating distortions resulting from, for example, privatization proceeds.

Stage Two: Use Partial Accrual Data

Some elements of the statement of economic flows should be accommodated. Although other economic flows are typically not recorded in cash systems, these can be derived by subtracting transactions from the total of changes between the opening and closing balance sheets. While admittedly less useful than accrual recording of these flows, at least this gives a measure of the impact of revaluations and other changes in volume of government assets and liabilities which are implicit in the opening and closing balance sheets.

Most of these other economic flows involve revaluation of fixed and financial assets and liabilities at market rates. This can be substantially diluted during the early transition when these flows could be granted recognition only in some (illustrative) cases: for example, write-off of assets (if on the books) due to irretrievable losses; revaluation of financial assets/liabilities due to exchange rate fluctuations; recognition of windfall gains/losses of assets due to natural disasters or unforeseen accretion to wealth through discovery of new mineral assets; and permanent transfer of functions to a corporation or quasi-corporation without remuneration assets (i.e., by reclassification).¹¹⁹

There should be during this stage a progressive recognition of existing financial and nonfinancial assets. Consolidated government balance sheets covering a substantial proportion of real assets, as well as financial assets and liabilities, could also be provided. A possible transition path is as follows: First priority is given to financial assets including on-lending and then to easily quantifiable assets (government buildings and land). More difficult assets such as infrastructure assets would follow, but these can be avoided for an indefinite period during transition. Only in stage three would it be necessary to attempt to include mineral resources and other hard-to-define assets such as forest wealth, and finally (if at all), heritage assets.

This stage should also bring the replacement of cash transactions in the operating account by the corresponding accrual transactions. All liabilities should, of course, be recognized as soon as they arise. Even contingent liabilities (such as orders placed for supply) can be accommodated in accounts by opening account heads to capture accounts receivable in revenue and accounts payable in expense. Depreciation costs could also be included as expenses for those assets for which they are available.

Box 36.

Stages in Accommodating GFSM 2001 Reporting

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At completion of this stage, it should be possible to switch over to GFSM 2001 classification structures and a GFSM 2001–compatible chart of accounts and to generate new fiscal reports without adopting full accrual accounting. Although the information available will not allow the full implementation of the GFSM 2001 framework, the changes implemented during this stage will provide enhanced analytical information. Even the use of partial accrual data will help get the maximum value from existing accounting systems, and undertaking this work will help identify those areas for which a modification of accounting standards will be required for the full implementation of GFSM 2001.

Stage Three: A Progressive Move to Full Accrual Data

At this stage, full introduction of accrual accounting for government cannot be avoided. GFSM 2001 recognizes that implementation of the fully integrated GFSM 2001 system will take time and will progress according to the circumstances of each country. In particular, it highlights the expectation that, ultimately, countries will have to revise their accounting systems to an accrual basis, as well as adopt the GFSM 2001 classification systems.

During the first two stages, as indicated, accrual accounting is not required. GFSM 2001 does admit that, because GFS is a statistical reporting system, it can differ in important respects from the underlying accounting system of a country from which GFS statistics are derived.¹²⁰ Certainly, it is possible for a country to operate an accrual accounting system with national accounting standards and coding structures that differ from the GFSM 2001 classification structure (for example, Australia). Alternatively, a country could accept the GFSM 2001 accrual-based system but with very significant dilutions of the accrual concepts.¹²¹ The central point is that the migration of cash to accruals increasingly provides more useful information for fiscal policy formulation, execution, and monitoring. For example, accruals allow GFS analytical balances, such as net operating balance and net lending/borrowing, to be derived. In this way, putting even modified data in the GFSM 2001 framework would aid fiscal policy and analysis. At the same time, it is difficult to see how the full GFSM 2001 statistical reports could be derived from an accounting system that is not on an accruals basis. Moreover, to generate GFSM 2001 in-year reports for fiscal management purposes from current rather than historical data requires the integration of GFSM 2001 classifications into the government chart of accounts.

The implications are clear: if countries are to fully meet the new international fiscal reporting standards, they cannot avoid moving to an accrual-based government accounting system. The challenge then, as outlined here, is to ensure that the correct preconditions exist and that an orderly and properly sequenced transition path is formulated and followed.