Key Conceptual Differences between Cash and Accruals

The concept behind accruals accounting is very simple. Under cash accounting, payments and receipts are recognized and brought to account when they are paid or received. In contrast, under accruals accounting, transactions and other events are recognized at the time they occur and in the accounting period to which they relate (and not at the time when cash or its equivalent is received or paid).³ So, for example, under accruals an advance payment of rent for five years is brought to account in the five years to which the rent relates, and not when the cash payment is made. Therefore, transactions and events are recorded and recognized in financial statements, based on the period to which they relate.

Behind what appears to be an apparently simple idea, however, there is considerable complexity associated with new concepts for those accountants accustomed to working only on a cash basis.

Perhaps the most significant conceptual difference with cash accounting is that accrual accounting concerns the full range of assets and liabilities of the accounting entity, as well as changes in their value. Cash accounting relates only to one asset: cash,⁴ including its related movements through cash payments and receipts. This extension of the accounting perspective—from cash to all forms of value—is most clearly visible in the comparison between the principal financial statements that are produced under the two approaches (Figure 5.1):

• Under cash accounting,⁵ it is generally sufficient to produce a statement of cash receipts and payments, including opening and closing cash balances.

• Under accruals accounting, it is also necessary to produce a balance sheet⁶ which shows the assets, liabilities, and net worth or equity (i.e., assets less liabilities) of the entity at the start and end of the accounting period; an operating statement which shows the revenue,⁷ expenses, and surplus or deficit for the period; and a statement of any other changes in net worth (or equity), which are not reflected in the operating statement. Standards also require a cash flow statement and a full set of disclosure notes.

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Comparison of Cash-Based and Accrual-Based Financial Statements

Source: Authors’ elaboration.

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A second major variance between cash and accruals accounting is that the latter tends to break away from the focus on the annual budget and budget performance. Traditional cash-based government accounting is often based on accounting for budget allocations and associated parliamentary appropriations to show whether ministries, as well as government as a whole, have under- or over-spent against their budgetary allocations and the sums voted by the legislature. Similarly, cash accounting is often restricted to accounting for budgetary moneys only—where the accounting entity is usually a budgetary entity (or budget holder). In contrast, accruals accounting covers all the resources used or belonging to an entity, including budgetary funds; and the accounting entity itself is defined in terms of economic concepts of ownership and control rather than in terms of budgetary accountability or boundaries. There is still scope for budgetary accounting within an accruals regime—elaborated on later in this publication—but the main determinants of accrual accounting coverage and presentation are economic rather than budgetary.

This wider perspective is interesting for other areas of PFM as an element that positively contributes to second-generation reform in treasury management which, today, is being pursued in some countries within the Latin American region. The new financial instruments that have come into use, such as treasury bills and treasury bonds, as well as other more complex financial instruments, would not be recognized in financial statements under a traditional pure-cash basis. A switch to accrual accounting will improve the comprehensiveness of financial statements and reporting, as well as the fiscal credibility of a country. Those countries with more fiscal credibility usually have better credit ratings and, hence, have increased access to international financial markets at lower interest rates.

A third significant difference between cash and accruals is the extent to which professional judgment is required concerning the basis of measurement and the boundary for capture. Under the cash basis, it is generally straightforward to decide which transactions should be captured within the accounts and how they will be measured (i.e., any transaction that affects cash balances, measured by its direct cash impact). Under accruals, however, it is not so straightforward: decisions are required about what constitutes the accounting entity or boundary, which assets and liabilities should be included, and how these should be measured and reported in the accounts. In accruals accounting there is far more scope for professional judgment, governed or guided by accounting principles or standards and exercised by professional accountants. This is a sharp contrast to cash accounting, where such matters may be determined by financial administrators who are responsible for the budget and its delivery, probably working with accountants who may be trained only in the specifics of budget accounting. The move to accruals accounting, therefore, will doubtless bring a shift in the balance of influence toward professional accountants (and auditors).

One final conceptual difference that is important between cash and accruals is the degree of certainty and verifiability attached to figures in the accounts. Under cash accounting, it is not unusual for accounting and financial reporting to be in fine detail—to the last cent—and for balances to be directly and fully reconcilable with bank records or physical checks on cash equivalents. Under accrual accounting, accounts are composed of cash-based transactions, which can be directly verified, and accounting estimates and calculations, based on professional judgment and accounting standards. These latter items will include, for example, figures based on algorithms and formulas (e.g., depreciation, work in progress, bad debts provision), or estimates (e.g., actuarial estimates of pension liabilities, external professional valuations of assets). In essence, cash accounting measures and reports on one asset with great accuracy: cash. In contrast, accrual accounting reports on the entire range of assets and liabilities, although with some inherent inaccuracy or fuzziness (i.e., including accounting judgments and calculations that represent a best estimate of the value being reported).

What should be included and how best to value some economic account items are examples of questions that generate most debate. Nevertheless, despite the imperfections, it should be better to have a more complete picture of financial performance and position rather than focusing only on cash. Furthermore, full accruals accounting does not relinquish or reduce cash control and analysis; it actually supplements cash-basis accounting information by providing a cash flow statement, which is one of the financial statements prepared under accrual accounting that reflects all inflows and outflows of funds related to economic activity.

Links between Accruals and International Accounting Standards

The inherent need for professional judgment in accruals accounting leads directly to the question of how such judgment should be exercised. It is, of course, up to the discretion of a government or individual entity to develop and determine its own accounting policies, according to its own logic. However, this does not suggest that a government may set its own rules so as to present a more favorable picture of its finance and financial management.

There is much to be gained, therefore, from the development of standards that have some external validity. There is now a considerable body of international accounting standards and established practices, on which governments can draw. Much of this work has its roots in the efforts to standardize accounting practices in the private sector, now reflected in the International Financial Reporting Standards (IFRS), produced by the International Accounting Standards Board. For the public sector, and since the late 1990s, IPSASB—which is a part of the International Federation of Accountants (IFAC)—has been producing the International Public Sector Accounting Standards (IPSAS). The latter are largely based on IFRS, although they are adapted to or developed for the public sector. The only internationally recognized set of standards for the public sector are IPSAS (European Commission, 2013).⁸ The choice of international standards, therefore, will largely come down to IFRS for government business enterprises and IPSAS for the rest of the public sector (see Figure 5.2).⁹ Commercial entities within the public sector should apply IFRS or the national equivalent.

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International Accounting Standards for Various Public Sector Units

Source: Authors’ elaboration.

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The advantage of basing national standards on international ones is that the latter have been developed after an arduous work on behalf of international experts, and based on national accounting best practices. In addition, private sector—and more recently public sector—standards are based on a conceptual framework that defines the purposes of financial reporting, outlining the main concepts that underlie accounting and the standards-setting process. As such, international standards increasingly provide a sound and integrated framework of guidance. As a result, it should be easy, when viewing a set of accounts that follow international standards, to find the relevant information and understand it. Accounts that comply with international standards will almost certainly be more credible to the public and the legislature, as well as the international development community, lenders, and the rating agencies that monitor the financial health and performance of countries. While the work on these standards is already substantial, it is not yet complete. The process of developing and amending them, as well as identifying new requirements, continues.

International standards are framed in terms of financial reporting requirements; that is, they specify what should be reported or disclosed in annual financial statements. They do not specify the manner in which this information should be obtained or how accrual accounting should be implemented. They are, however, the key driver that informs the transition to accrual accounting.

With one exception, all standards apply to accruals accounting. There is, so far, only one (unnumbered) IPSAS for cash accounts and, as of end-2014, 32 accrual-based IPSAS (Table 5.1), of which one (IPSAS 15) has been superseded by later standards.¹⁰

Table 5.1

Accrual-Based IPSAS

Source: Authors’ elaboration.

Table 5.1

Accrual-Based IPSAS

Standard	Title of the standard
IPSAS 1	Presentation of Financial Statements
IPSAS 2	Cash Flow Statements
IPSAS 3	Accounting Policies, Changes in Accounting Estimates, and Errors
IPSAS 4	The Effects of Changes in Foreign Exchange Rates
IPSAS 5	Borrowing Costs
IPSAS 6	Consolidated and Separate Financial Statements
IPSAS 7	Investments in Associates
IPSAS 8	Interests in Joint Ventures
IPSAS 9	Revenue from Exchange Transaction
IPSAS 10	Financial Reporting in Hyperinflationary Economies
IPSAS 11	Construction Contracts
IPSAS 12	Inventories
IPSAS 13	Leases
IPSAS 14	Events after the Reporting Date
IPSAS 15	Financial Instruments: Disclosure and Presentation
IPSAS 16	Investment Property
IPSAS 17	Property, Plant, and Equipment
IPSAS 18	Segment Reporting
IPSAS 19	Provisions, Contingent Liabilities, Contingent Assets
IPSAS 20	Related Party Disclosures
IPSAS 21	Impairment of Noncash-Generating Assets
IPSAS 22	Disclosure of Financial Information about the General Government Sector
IPSAS 23	Revenue from Non-Exchange Transactions (Taxes and Transfers)
IPSAS 24	Presentation of Budget Information in Financial Statements
IPSAS 25	Employee Benefits
IPSAS 26	Impairment of Cash-Generating Assets
IPSAS 27	Agriculture
IPSAS 28	Financial Instruments: Presentation
IPSAS 29	Financial Instruments: Recognition and Measurement
IPSAS 30	Financial Instruments: Disclosures
IPSAS 31	Intangible Assets
IPSAS 32	Service Concession Arrangements: Grantor

Source: Authors’ elaboration.

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Table 5.1

Accrual-Based IPSAS

Standard	Title of the standard
IPSAS 1	Presentation of Financial Statements
IPSAS 2	Cash Flow Statements
IPSAS 3	Accounting Policies, Changes in Accounting Estimates, and Errors
IPSAS 4	The Effects of Changes in Foreign Exchange Rates
IPSAS 5	Borrowing Costs
IPSAS 6	Consolidated and Separate Financial Statements
IPSAS 7	Investments in Associates
IPSAS 8	Interests in Joint Ventures
IPSAS 9	Revenue from Exchange Transaction
IPSAS 10	Financial Reporting in Hyperinflationary Economies
IPSAS 11	Construction Contracts
IPSAS 12	Inventories
IPSAS 13	Leases
IPSAS 14	Events after the Reporting Date
IPSAS 15	Financial Instruments: Disclosure and Presentation
IPSAS 16	Investment Property
IPSAS 17	Property, Plant, and Equipment
IPSAS 18	Segment Reporting
IPSAS 19	Provisions, Contingent Liabilities, Contingent Assets
IPSAS 20	Related Party Disclosures
IPSAS 21	Impairment of Noncash-Generating Assets
IPSAS 22	Disclosure of Financial Information about the General Government Sector
IPSAS 23	Revenue from Non-Exchange Transactions (Taxes and Transfers)
IPSAS 24	Presentation of Budget Information in Financial Statements
IPSAS 25	Employee Benefits
IPSAS 26	Impairment of Cash-Generating Assets
IPSAS 27	Agriculture
IPSAS 28	Financial Instruments: Presentation
IPSAS 29	Financial Instruments: Recognition and Measurement
IPSAS 30	Financial Instruments: Disclosures
IPSAS 31	Intangible Assets
IPSAS 32	Service Concession Arrangements: Grantor

Source: Authors’ elaboration.

At least in theory, it is possible to remain on a cash basis and claim compliance with international standards. It is evident, however, that IPSASB never intended for cash basis to be a permanent solution. The cash IPSAS even includes sections on accrual-type disclosures and the transition to accrual accounting. Furthermore, IPSASB has published a separate study paper that provides guidance on the transition from cash to accruals (IPSAS, 2011). It is therefore fair to say that the adoption of international standards will often go hand in hand with a switch to accruals. Transition to accrual accounting will usually involve the gradual adoption of relevant standards, as discussed later in this chapter.

International accounting standards are not mandatory; there is no international law that requires their adoption. Instead, each country should adopt or adapt the relevant standards into its own national law or regulations.¹¹ Nevertheless, countries that fully transition to accruals usually take the standards into consideration to some extent, which is certainly the case in Latin America.

The adoption of standards can take place directly or indirectly (Bergmann, 2009). Directly, the legislation of the country refers specifically to the adoption of the original IPSAS text (e.g., Dominican Republic). Indirectly, as in the case of Brazil and Chile, the country approves standards in its legislation, based on IPSAS to a greater or lesser extent. These are followed by secondary regulations that put them into force. In both approaches, an accounting manual is the vehicle to promulgate national standards, while technical consultations with regard to their implementation are carried out through administrative resolutions.

Similarly, “adoption of IPSAS” can be distinguished from “adaptation to IPSAS.” In the former case, standards that are applicable to a country are transposed into national legislation without significant change. In the latter case, a country that adapts its government accounting to IPSAS usually does not entirely change its national legislation; rather, it includes some changes to bring it closer to international standards, such as in the case of Brazil. In addition, some countries may opt not to apply certain standards, as is the case of most of Latin America in terms of the IPSAS relating to financial reporting in hyperinflationary economies.

Advantages and Disadvantages of Switching to Accrual-Based Accounting

There is considerable debate about the advantages and disadvantages of switching to full accruals accounting. The growing weight of opinion, however, is in favor of accruals accounting, demonstrated by the increasing number of countries, worldwide, that have adopted or intend to adopt accrual accounting and international standards.¹²

Those who make the case against accrual accounting argue that cash accounting has served governments well for a very long time¹³—that it is well suited to the needs of the public sector, especially to budgetary accounting; and that accruals can undermine cash and expenditure control. Opponents also state that much of the additional information that accruals accounting requires and produces (e.g., fixed assets, investments, or public debt) already exists and can be reported separately or as an adjunct to the cash accounts. They also contend that the cost of moving to accruals accounting is significant, and that the required systems and technical expertise may be beyond the capacity of governments in many developing countries. Finally, they contest that accrual accounting results in financial statements are difficult to understand and interpret; that they rely too much on judgment rather than on certainty; and that they include numbers that are less accurate than cash numbers. These arguments are worth considering, for at the very least they highlight some of the key risks to avoid or which should be minimized when transitioning to accrual-based accounting.

In contrast, advocates of accrual accounting argue that it represents a significant change in the coverage and the transparency of governments’ financial information. They claim that it provides public financial managers, parliamentarians, analysts, commentators, and members of the public with a more complete view of government financial performance and position, prepared within a coherent framework of international standards. Users of the accounts will be able to focus beyond cash and budgetary numbers, with the availability of structured information on material assets and liabilities. Users also will be privy to information that may never have been published before or that was only available in separate or highly technical publications. Supporters argue that accrual accounting is entirely compatible with cash control and management, stating that some of the weaknesses in public finance—exposed by the recent global economic crisis—such as high government indebtedness, would have been apparent sooner had accruals accounting been in place. On the issues of cost and transition challenges, these should not be avoided; rather, they should be appropriately managed, with a transition that is well planned and compatible with a country’s capacity. Proponents of accruals accounting also believe that its adoption will strengthen or revive the various systems and controls that are required to achieve sound financial management (e.g., monitoring of asset holdings, public debts, and other liabilities). Furthermore, they point out that accruals accounting has been the norm in the private sector since the nineteenth century or earlier.

The intelligibility and reliability of accruals information presents challenges to government accountants. These can be overcome by the application of international standards to ensure that financial statements are comprehensible, comprehensive, useful, and reliable (i.e., fit for purpose). Their reliability is reinforced by the scrutiny of independent and professional public audit institutions. A final benefit is that accruals accounting, when well implemented, may improve a government’s standing with rating agencies, which influences the cost of borrowing. A half a percentage point less in interest rates can make a very significant difference in borrowing costs.

Overall, therefore, the balance of argument is more in favor of accruals. Implementation should be tailored to the needs and capacities of each country: transition should be at a pace that allows the costs to be managed and which is compatible with the capacity to undertake such reform.

Accounting Reforms in Latin America

Latin America has experienced a growing interest in international accounting standards during recent years. Several countries have moved toward adoption, reflecting the advantages of fully applied accruals—as explained in the previous section of this chapter. None of the countries, however, has yet completed the transition. The concept behind accounting reform is to improve the reliability of data, transparency, and fiscal credibility of financial statements and to enhance the quality of decision making and the formulation of national policies.

This section broadly presents the status of accounting reform in various Latin American countries. The relevant data has been collected from various sources, including country websites, public documents, and the exchange of information that took place during the first seminar of the Latin American Government Accounting Forum (Foro de Contadores Gubernamentales de América Latina (FOCAL)) (Box 5.1).

To date, no country in the region has fully applied IPSAS or accrual-based accounting practices. However, none are applying simple cash accounting. Most countries are implementing a mixed system that combines accruals accounting for various elements and cash accounting for others.

Accounting reform is a custom-made process. Several conditions can affect the pace and rhythm of such reform, such as the degree of support from the highest authorities, level of capacity, and appetite for reform within the ministry of finance, as well as the specific functionalities within financial systems. A further key underpinning is the need to update accounting policies to fully complete the implementation process. These factors make it very difficult to categorize countries. Nevertheless, to present a view of the status of Latin America, four groups have been distinguished and are represented in Figure 5.3.

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Accruals Implementation in Latin America

Source: Authors’ elaboration.

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Excluding those countries (white) that fall outside of the national legislation sample, the first group of countries (light pink) (i.e., Argentina, Bolivia, Paraguay, Uruguay) includes those that have not formally initiated the transition process nor have adopted IPSAS. They account within their own legislation, usually with a mix of cash and accrual methods. It is very common, for example, that revenues are identified when cash flow takes place, in contrast to expenses that are identified on an accrual basis (e.g., ensuring budgetary payments are made in the thirteenth month or similar extended period). In some cases, the national legislation is already broadly consistent with IPSAS, placing these countries in a better position at the start to enable them to complete the reform.

The case of Argentina reflects this particular stage—a country that has not changed its national regulation since 1996 and which, to date, has not yet published a strategy encompassing the adoption of IPSAS. The current system was approved by a resolution, submitted by the Secretary of Finance in 1996 to modify a previous resolution that was passed in 1993. The Secretary of Finance, through this resolution, delegates to the General Accountant the power to approve secondary legislation, referred to as Disposiciones. The resolution approves the Manual of Government Accounting, comprising a glossary, chart of accounts (CoA), operating instructions, and examples of financial statements.

Paraguay and Uruguay are in the process of analyzing the benefits of reform. So far, no strategy has been officially adopted.

The second category of countries (medium pink) includes those (i.e., El Salvador, Guatemala, Nicaragua, Panama) that are in the process of IPSAS accounting reform, having already implemented a strategy. In Guatemala, for example, accrual-based accounting began subsequent to the enactment of the Organic Budget Law in 1997, and the IPSAS implementation process commenced in 2005 as part of a financial systems project.

The transition to IPSAS in Panama also relates to a new IFMIS, now a priority of the Ministry of Economy and Finance. While IPSAS adoption is intended, the strategy has yet to be approved, (i.e., supported by the government’s Director of General Accounting and the Contraloría, who are responsible for approving the new regulation).

The third group of countries (dark pink) (i.e., Colombia, Dominican Republic, Ecuador, Honduras) have prepared a transition strategy or are at the stage where an official pronouncement to transition to IPSAS has been made, although the transition has not yet officially begun. For instance, in Colombia, the Public Accounting Regime (Régimen Contable Público) approved a resolution in 2007 that comprises the General Public Accounting Plan, Operating Procedures Manual (Manual de Procedimientos), and Public Accounting Principles. In June 2013, the National Comptroller General (Contraloría General de la Nación) published a strategy to incorporate IFRS and IPSAS (Colombian Government, 2013). The strategy presents the background to the public accounting regulation, as well as the conceptual framework for IPSAS, and it demonstrates the intention of the General Accountant to adopt IPSAS in the near future. The next step will include the approval of accounting policies in line with IPSAS, followed by the gradual introduction of the new framework. On its end, Ecuador enacted a law in 2010 that defines accruals as the accounting principle to be observed by entities in the nonfinancial public sector. The government plans to implement IPSAS by 2019.

Lastly, the fourth group of countries (red) shows those (i.e., Brazil, Chile, Costa Rica, Mexico, Peru) that have approved a plan to include legal authority to implement IPSAS or full accrual accounting. In Peru, for instance, IPSAS have been officially adopted and the authorities are working on applying the standards. In Brazil, however, there has been an official adaptation, or convergence, toward IPSAS.

In the case of Mexico, the General Law of Government Accounting (Ley General de Contabilidad Gubernamental) was approved on December 31, 2008. The law is applicable to the entire government. The initial date for implementation of the new accounting procedures was January 1, 2009, but the deadline has been extended successively to January 2013 and January 2014. In April 2015, the financial statements of the executive, legislative, and judiciary branches; autonomous entities; and the parastatal sector of the federal government were finally presented for the first time, following the harmonization of the framework.¹⁴ The law requires that revenues and expenditures be calculated according to accrual-based accounting procedures. In August 2009, the National Council of Accounting Harmonization (Consejo Nacional de Armonización Contable (CONAC)) published a conceptual framework relating to government accounting, which defined the accounting standards to be issued by CONAC, along with IPSAS standards, as well as supplementary IFRS ones.

Alternative Methods to Assess Progress

The survey that was presented at the FOCAL seminar represents those countries that are considering government accounting reform. Each anticipates issuing financial statements according to IPSAS standards over the medium to long term, despite the variation in their strategies, which will become apparent in the survey.

The application process will differ between countries, although most have established 2019—or later—as the expected first year to issue IPSAS financial statements for their respective central government. The later date, for example, applies to Brazil (2020), Chile (2019), Costa Rica (2021), and Panama (2021). Countries that are in the initial stage of transition should expect a longer implementation period.

Most countries prefer to fully adopt IPSAS rather than assume specific amendments for their current frameworks. Countries, essentially, are not required to adopt the IPSAS standards in their entirety since some of the standards do not apply to them (e.g., IPSAS 10 regarding hyperinflation). Furthermore, various areas are missing from the current version of the IPSAS framework (e.g., mineral rights and reserves), for which other principles are more relevant. Some countries are adopting the standards in stages, such as in Honduras where the standards will be divided for the short, medium and long term. Chile categorized the standards in four groups, as shown in Figure 5.4, but issued all the standards at the same time in the Resolution of the General Controller Office number 16, approved in March 2015.

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Phased Study of Accounting Standards: Chile

Source: Contraloría General de la República de Chile.

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All the countries in the sample, with the exception of Uruguay, prepare financial position and financial performance statements (Uruguay prepares a Treasury Position statement, as well as a comparative statement of budget-to-actual amounts). Most countries also prepare a cash flow statement and one that compares budget to actual amounts; others (e.g., Costa Rica, El Salvador, Panama) add a statement of changes to net assets.

The coverage of financial statements varies significantly among Latin American countries. Some include information that only covers the central government, while others include the public sector. For example, Mexico prepares financial statements that cover only a limited number of entities within central government; Honduras includes only the central government, although it intends to eventually expand the framework to embody its municipalities. Chile and El Salvador incorporate general government, although they do not consolidate the accounts by layer of government which, instead, are presented in separate tables that make up the same document; and Peru’s financial statements include the entire public sector. In nearly all countries, these statements are published, most of which are accompanied by an external audit review.

The timeline for financial statements varies. It takes up to 18 months in some countries, which is somewhat longer than the ideal under-six-month period, previously mentioned.

Finally, the comprehensiveness of disclosure notes varies significantly among countries. Most will present information on accounting policies, cash and cash equivalents, and public debt. In contrast, data relating to salaries and benefits of public officials and the details of uncleared, suspended accounts may also be reported.

Challenges

The survey of Latin American countries has revealed that countries that seek to upgrade their government accounting system to full accruals usually face two kinds of challenges:

• Transition process—how to prepare a strategy to adopt (or adapt) IPSAS: Four case studies on accounting reforms are presented to assist in the identification of the most important obstacles that countries face during transition.

• Standards—how to technically implement some of them: Based on the survey previously mentioned, some countries face accounting elements that are challenging. These include fixed and intangible assets (IPSAS 17, 31), accounting for contingent liabilities and provisions (IPSAS 19), tax revenue recognition (IPSAS 23), and financial instruments (IPSAS 28, 29, 30). Box 5.2 summarizes the implications of these specific standards.

Other issues that relate to accounting reform, which are considered key to its success, include the integration of government accounting with budget and treasury processes. These aspects highlight the significance of developing a standardized CoA and clear budget execution process; having a modernized IFMIS in place; and ensuring the relevant technical capacities. These issues are covered in the following section of this chapter.

Case Studies: Accounting Reforms in Chile, Brazil, Costa Rica, and Peru

Sequential Model of IPSAS Adoption: The Case of Chile

Experience has shown that the preferred way to implement IPSAS in the region is by doing it gradually and in phases. While there is no unique path to follow, Figure 5.5 presents a general approach, based on the experience of Chile—a simplified process of preparation and implementation of IPSAS and one that can be applied in other Latin American countries.

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Approach to the Adoption of IPSAS in Gradual Steps

Source: Authors’ elaboration.

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Box 5.2.

Challenges Regarding Accounting for Economic Activities in Latin America

Fixed assets

Infrastructure assets (e.g., road networks, sewer systems, power and telecommunications networks) represent a major class of asset that is relevant to the public sector. Currently, no Latin American country has a complete inventory of its fixed assets. Such information can provide multiple benefits. In particular, it will make policymakers aware of the country’s asset holdings and help to identify unproductive assets. By actively managing public commercial assets, a country can generate more income, thus lowering public debt and contributing savings on debt interest. Compiling an inventory, however, and obtaining valuations of the many types of public asset, can represent a major challenge, especially where asset management systems are obsolete or nonexistent.

From an accounting perspective, these elements (with the exception of heritage assets) are covered by IPSAS 17 and must follow the standard’s requirements for recognition, valuation, and disclosure. The same applies to specialized military equipment. Physical assets covered by IPSAS 17 would normally be recognized at cost, including those costs associated with acquisition and preparation for use. Where there is no exchange transaction, the asset must be recognized at fair value. Thereafter, the asset is depreciated over its useful life, applying either the cost or revaluation method. The same method (cost or revaluation) must be applied to all assets within the same class:

• Cost method: The asset is carried at cost, less accumulated depreciation and impairment losses. Depreciation is charged as an expense over the asset’s useful life, using a systematic basis (e.g., straight line, unit of use/production, diminishing balance).

• Revaluation method: The asset is carried at revalued amount, which is fair value at revaluation date, less accumulated depreciation and impairment losses. Fair value would normally be based on market values, although the absence of a market may require other approaches, such as the market value of analogous assets, depreciated replacement cost, or restoration cost. Valuations and revaluations would normally be carried out by professional valuers on a frequency determined by the nature of the asset and the volatility in value: the more volatile the value, the more frequent the valuation. Some assets may require annual valuation, while other classes may justify a three- or five-year revaluation cycle.

Upon disposal or retirement of an asset, there may well be a gain or loss that also needs to be recognized.

Heritage assets (e.g., historical buildings and monuments, archaeological sites, conservation areas and nature reserves, and works of art) are not required to be recognized; however, if recognized, they can be valued by using an appropriate method or methods, depending on their type.

Intangible assets

An intangible asset is an identifiable nonmonetary asset without physical substance. While it is tempting to consider that these are relatively rare, they are more common than might be imagined. They include copyrights, patents, and other intellectual property rights; software; websites; advertising, startup, research and development activities; airport landing rights; and broadcasting and telecommunication licenses. The recognition of these kinds of assets could facilitate better management of administrative concessions and the improved delivery of public services.

IPSAS 31 provides guidance on the accounting treatment of such assets. Under the standard, recognition of heritage intangible assets is optional, and the standard excludes concession or mineral extraction rights. Intangible assets should be measured initially at cost, unless they are acquired through a nonexchange transaction, when they should be measured at their fair value on acquisition. Subsequent valuation should use the cost or revaluation method, with all assets in the same class adopting the same method. Intangible assets with a definite lifespan are amortized, using a systematic method over their useful lives, while those with an indefinite life are not depreciated. An asset is derecognized when disposed of or it no longer brings economic benefit.

Provisions and contingent liabilities

The recognition of provisions in the balance sheet and the disclosure of information on contingent liabilities are important elements that can improve financial reporting for a country. IPSAS 19 concerns the reporting of probable or possible events which will have an effect on the entity’s finances.

• A provision is a present probable liability of an entity, of uncertain timing or amount. The recording of the liability in the entity’s balance sheet is matched to an appropriate expense account in the entity’s operating statement.

• Contingent assets and liabilities, on the other hand, are possible and outside the control of the entity (e.g., liabilities that depend on judicial disputes), or (less commonly) are present obligations whose value cannot be estimated reliably. Contingent assets and liabilities are disclosed in the notes to the accounts.

Since the last global economic crisis, countries are paying more attention to fiscal risks and contingent liabilities. Several countries in the region are interested in preparing a report that reflects both components and, in some cases, are in the process of doing so.

Revenue recognition

This is probably one of the most challenging changes that a country in transition may face. So far, no Latin American country has recognized revenues under an accrual basis. The revenue recognition principle is a key component of accrual accounting, together with matching principle. They both determine the accounting period in which revenues should be recognized. According to the principle, revenues are recognized when they are earned (usually when goods are transferred or services rendered, or when a taxable event occurs), no matter when cash is received. In cash accounting, in contrast, revenues are recognized when cash is received, regardless of when it was earned. The implications are significant; think, for example, about income taxes; these are accrued during a fiscal year, but often collected during the following year.

Regarding taxes, IPSAS 23 suggests the recognition point or event for typical tax streams (i.e., when the legal right to receive has been established). IPSAS 23 poses special challenges in administrations where tax assessments are subject to regular legal challenge and other factors which may delay or impede eventual collection. Countries may, therefore, hesitate to apply the standard as recommended. If applied, however, the accounts would then show taxes assessed, as well as taxes “lost,” though legal challenge and other reasons—which are items of legitimate management and taxpayer interest, reflecting on the efficiency of tax administration.

Financial Instruments

The use of financial instruments is becoming very popular and sophisticated in Latin America. Under a cash basis, some are not recognized in the budget, since they do not have any impact from a budgetary perspective. That is why the accounting recognition becomes a cornerstone for providing this kind of information to policymakers and third parties interested in the financial situation of a country.

The term “financial instrument” is defined as “any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity.” The asset or liability will be settled in cash or a contractual right to receive cash, or an equity instrument (e.g., shares). In practice, the term covers a range of assets and liabilities, such as cash, loans made and received, bonds held and issued, and equity investments. In addition to these “primary” financial instruments, it also covers derivatives, financial guarantee contracts, and other more complex arrangements. There are IPSAS standards that deal with the presentation (IPSAS 28) and the recognition and measurement (IPSAS 29) of financial instruments. A further standard (IPSAS 30) deals with additional disclosures in relation to financial instruments and risk.

Type of tax	Recognition point
Income tax	The earning of assessable income during the taxation period by the taxpayer
Value-added tax	The undertaking of taxable activity during the taxation period by the taxpayer
Goods and services tax	The purchase or sale of taxable goods and services during the taxation period
Customs duty	The movement of dutiable goods or services across the customs boundary
Death duty	The death of a person owning taxable property
Property tax	The passing of the date on which the tax is levied, or the period for which the tax is levied, if the tax is levied on a periodic basis

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Type of tax	Recognition point
Income tax	The earning of assessable income during the taxation period by the taxpayer
Value-added tax	The undertaking of taxable activity during the taxation period by the taxpayer
Goods and services tax	The purchase or sale of taxable goods and services during the taxation period
Customs duty	The movement of dutiable goods or services across the customs boundary
Death duty	The death of a person owning taxable property
Property tax	The passing of the date on which the tax is levied, or the period for which the tax is levied, if the tax is levied on a periodic basis

IPSAS 28 sets out the principles for classifying financial instruments as assets, liabilities, or net assets, as well as principles for offsetting financial assets and liabilities. It discusses the various types of financial instruments and establishes some basic principles as to their accounting treatment:

• Classification is based on substance, not the form, of the instrument and is made at the time of issue of the instrument.

• An equity instrument gives the holder a residual interest in the net assets of another entity.

• Other financial assets or liabilities oblige the issuer, or confer on the holder, the right to receive cash or another financial instrument.

• Interest, dividends or similar distributions, and losses and gains relating to a financial instrument are reported as revenue or expense.

• Offsetting of financial assets and liabilities is permitted only when an entity has a legally enforceable right to set off the amounts and has the intention to settle on a net basis or realize the asset and settle the liability simultaneously.

IPSAS 29 requires that all financial assets and financial liabilities, including all derivatives and certain embedded derivatives, are recognized in the statement of financial position. On initial recognition, the asset or liability is measured at its fair value where possible. Where the financial asset or financial liability is not recognized at fair value through surplus or deficit (in effect, assets and liabilities not held for trading), these are measured at fair value plus those transaction costs directly attributable to the acquisition or issue of the financial asset or financial liability. Interest, dividends or similar distributions, losses, and gains relating to financial instruments should be recognized as revenue or expense in surplus or deficit. The standard requires the distinction to be drawn between financial assets and liabilities, as distinct from equity instruments (where the holder has a residual interest in the net assets of another entity).

These steps are taken in turn:

• Legal framework. Due to the legal tradition of public administration in Latin America, the starting point would be the preparation or modification of national legislation. Practice varies from country to country on what types of legislation or norms govern public accounting and which part of government is responsible for them. These legal provisions need to be reviewed to support the transition and adoption to accruals.

• Strategy. The second stage is the development of a strategy and timeframe for the reform. In Chile, the Comptroller General of the Republic (Contraloría General de la República (CGR)) took the lead in the process, and aligned its strategy with other bodies involved with or affected by the reform. Once the support of these other organizations was obtained, the CGR established a timetable that aims to fully apply IPSAS by 2019. The process formally started in 2010, with the intention to start in 2016 with the implementation of IPSAS in the central government.¹⁵ The statements will cover all entities included in the budget, those that are centralized and decentralized, and some autonomous bodies, such as the CGR. The coverage will be expanded gradually, including the municipalities at the final stage. The strategy revolves around three main components: legislation, ICT systems, and capacity building.

• Gap analysis. The third step involves the official adoption of IPSAS and the undertaking of a gap analysis, which compares existing practices with IPSAS requirements. This facilitates the preparation of a timetable and set of tasks that can be agreed and shared with all the actors in the process. In Chile, the IPSAS gap analysis has allowed the authorities to identify four groups of standards, varying in their degree of difficulty. The analysis also identified some standards that were not applicable in the country.

• Guidelines. The fourth step is to develop guidelines and timetables for implementing the new standards in the different layers of government. In this phase, it is essential to invest in capacity building and to adjust the IFMIS to the requirements of the new accounting system.

• Implementation. The fifth and last step relates to the actual implementation of the standards and the preparation of financial statements. This phase is expected to be achieved gradually, and will not end with the first release of government financial statements. The full implementation of accrual accounting requires continuing improvement, to be managed in subsequent years, and the assurance that accrual practices are embedded as part of the normal business of the organization. The accounting reform is more than a mere accounting enhancement—it is a transformation of the government PFM system and will be of benefit to the entire country.

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Prioritize Conversion to Ipsas: Chile

Source: Comptroller General of the Republic of Chile.

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Accounting reform: The Case of Costa Rica

Costa Rica¹⁶ has been implementing IPSAS since 2001, when the National Accounting Office (responsible for elaborating the general accounting standards) signed an agreement to formally adopt IPSAS with the Inter-American Accounting Association (member of IFAC) and the Inter-American Development Bank under the framework of the Public Accounts Accountability Program. The first step taken after this pronouncement was to build a legal framework to support its adoption. In 2001, the Financial Administration and Public Budget Law was approved, and it included “government accounting” as a subsystem of the new Financial Administration System. The Regulation under that Law declared that the National Accounting Office is the body responsible for the elaboration of the specific rules and technical guidelines on government accounting.

Several decrees have been approved since 2008, including a National Accounting General Plan for the public sector entities of Costa Rica. Initially, a decree established that the adoption and implementation of IPSAS should commence in January 2009 and be completed by January 2012 by the central government. Due to the difficulties in achieving that deadline, in 2011 the deadline was extended to 2016. Among the difficulties are the complexities of applying the new standards, lack of a well-structured plan to complete the reform, and lack of the necessary resources (i.e., legal support, consultants, systems, and investment in capacity building). The implementation plan of IPSAS adoption by the central government is gradual, and Costa Rica has distinguished two phases: the first includes standards that can be applied in 2016 and the second includes the “transition regulations,” which is supposed to be completed by 2021. Government business enterprises, however, are required to present their first financial statements under IFRS by 2016.

In 2011, together with the review of the deadline for IPSAS execution, other significant steps were undertaken: (i) elaboration of an action plan; (ii) update of the General Accounting Plan with the new standards issued (at inception in 2008, it included 18 IPSAS, and it was extended in December 2011); (iii) update of the Accounting Action Plan for the nonfinancial and nonbusiness public sector; (iv) elaboration of the IPSASs Implementation Methodology, using the IFAC guidelines of Study 14 on the Transition to the Accounting on the Basis of Accruals; and (v) investment in capacity building.

As a result, Costa Rica currently is working on the implementation process with the challenge of issuing the first IPSAS financial statements for the central public sector by January 2016 (excluding transitional regulations). The action plan includes the milestones that are shown in Figure 5.7.

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Application of Milestones for Implementation: Costa Rica

Source: IBSASB/IFAC (2014).

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Organizing for Reform: Key Actors and Participants

It will come as no great surprise that the principal participants in the reform will be public sector accountants. These will be involved at the central level to develop strategies, establish accounting standards, and monitor implementation. In Latin America, this role usually falls to the responsibility of an Accountant General, Comptroller General, or equivalent official (see Box 5.3). Accountants will also play a role at the entity level—that is, in each accountable organization such as a Ministry or agency—to oversee implementation and continued operation of accounting systems.

The central cadre will need to work with teams or networks of accountants in each subsector or individual entity. Much of the transition work will fall to these people at the operational level. It is also quite possible, however, that the training and experience of these public accountants—at the central and operational levels—will have been acquired in the existing system. If that is so, there will need to be a major educational program to expand their acquaintance and expertise in accruals accounting.

Public auditors will also have a key role, since their expertise will need to grow in parallel with the accountants. A switch to accruals will throw up new challenges for audit offices, and they too may need significant additional training to equip them for this new environment. Auditors will require as much skill and acquaintance with the new accounting standards as do the accountants who compile the accounts. Furthermore, the audit office or offices should be involved in the transition strategy to ensure that audit opinions are taken into account and to minimize subsequent avoidable disagreements over accounting policies and presentation.

Accountants and auditors are not the only ones interested in this new type of accounting. In any public administration, there will be a wide range of people who have to work with accounting systems and data. These include staff in the treasury and in economic planning and budgetary departments, who develop the annual or multiyear budgets and monitor budget implementation. A change to accruals may well affect the basis on which the budget is drawn up, or it may affect other expenditure control mechanisms. There are also senior managers, financial managers, and budget holders who need to understand how the new accruals will be executed. Finally, the national statistics department will have an interest since they also have to produce data according to international standards, established by the IMF and others and, often, they need to rely on government accounting systems for much of their information.

Transition will almost certainly require changes to ICT systems and manual procedures. This, in turn, will involve ICT departments and business analysts throughout the public administration. The scale of such changes should not be underestimated, and poor systems implementation is one of the greatest risks to a successful transition. Equally, these system changes should neither be seen as the central driver or focal point of reform, nor the reform be viewed as ICT-led. There are many dimensions to reform, of which ICT is an important one; it should be the servant of reform and not the master.

One final and important body with an interest in the transition will be the legislature. It will almost certainly be called upon to sanction or authorize the legislation required to introduce accruals accounting. Those in the legislature will also be interested in the progress made with transition. Most importantly, they will need support to be able to interpret and use the new information that accruals accounting will provide. As mentioned earlier, it is important to approve the legal framework that supports accounting reform within the different layers of the legal framework.

Strategists should not lose sight of the essential need for action at the central, subnational, and decentralized entity levels. In theory, the transition to accruals accounting could be left entirely to the individual entities working within international standards. Such a libertarian approach, however, is unlikely to be successful and would certainly not support proper consolidation, since each entity will probably interpret standards differently and on different timescales.

Instead, the transition to accruals may offer an opportunity to rethink the architecture of public accounting. The demands of consolidation will swing the balance of advantage toward central solutions, since full and successful consolidation requires the coordination of accounting policies across a wide range of bodies. Furthermore, if all or many types of organizations need to develop new ICT systems, there may be an advantage to central, rather than distributed solutions. Solutions may range from “central light,” in which the minimum is centralized (e.g., a consolidation system only)—for example, in the case of Brazil—to “central heavy” (in which all systems are provided centrally)—for example, in the case of Peru.

At the very least, successful transition requires strong central coordinating forces, even if implementation is left to the lower levels or individual entities. It is very likely, though, that these central mechanisms will need to be accompanied by subsectoral mechanisms, since each subsector may face particular challenges (e.g., legacy systems and procedures, different legal requirements, special classes of transaction) which need to be worked on within a central framework of standards and other requirements. Such sub-sectoral mechanisms will also be important in achieving buy-in and support from those most closely involved in implementation.

Implementation Process and Timeframe

A full switch to accrual accounting is unlikely to be quick. Advanced economies have taken five or more years to make the transition. In emerging countries, a full transition could last 10 or more years. The timescale and degree of effort will very much depend on the starting point.

In the particular case of Latin America, countries begin from a position where some parts of the public sector may have already adopted or have always been using accrual-based accounting, thus providing the advantage of a cadre of public accountants already versed in accrual accounting. The reform can be more challenging in subnational governments, since implementation at this level will have to start from a position of little expertise in this area. For these levels of government, the trajectory toward transition could be a very long one.

In considering implementation, it is useful to think of transition as a number of different dimensions in which public accounting will need to change. For each part of the public sector, planners will have to think about:

• Growth in the range of transactions (revenues, expenses, assets and liabilities) to be captured within the accounts, so that all material items are included.

• Development of the financial statements to include these additional classes of transactions and associated disclosures.

• Development and application of more advanced techniques for valuing account items, so that the financial statements give the most accurate and useful view of public finances.

Design and Delivery of Strategies for a Transition to Accruals

As is the case for any major reform, a vital first step is to research, develop, and put in place an overarching strategy. As we saw in the case studies, some countries have suffered from delays in the reform process due to the lack of a clear action plan and strategy to guide the reform. It is recommended that the strategy first be informed by a gap analysis and that the strategy itself cover all the key areas (Box 5.4).

For most governments, implementation will almost certainly entail a gradual expansion of accounting systems and financial reporting to include more accrual accounting features until full accruals status is achieved. This means expanding the classes of assets and liabilities, applying more international standards, and developing financial statements and related disclosures, year on year, until the required degree of compliance is achieved.

International accounting standards allow for this gradual adoption, with many including provisions (“waivers”) that give entities more time to meet all the requirements during the transition period. The maximum waiver period is five years, although most standards provide for three years. In many cases, however, it is likely that the practical challenges will be of a scale such that the implementation period will extend beyond five years, in which case it is inevitable that interim or intermediate financial statements will not be fully compliant with international standards, despite the transition waivers. This, however, does not imply that there is no value in striving toward adopting these standards; rather, it is better to be fully aware of this fact and to manage expectations accordingly.

Note that during the interim period, countries in transition are unable to claim that they are in compliance with international standards until the final few years prior to this achievement, based on the waivers. During the trajectory, transparency is essential, and an indication of what is or is not compliant with international standards must be included in the notes to the financial statements, as well as what the next steps are in terms of the transition.

A question often asked is whether it is advisable or necessary to achieve compliance with cash-based IPSAS prior to embarking on the road toward accrual accounting. This, however, may not be the best way forward for countries that have already moved beyond pure cash-based accounting, as is the case in Latin America. The cash-based IPSAS is, undoubtedly, a useful benchmark for countries within a pure cash environment. Many countries will, nevertheless, start their transition from a point where they already operate on a modified cash basis (especially where accounting is based on budgetary rules). In such cases, they will already be in an early stage of transition, thus making it senseless to return to pure cash accounting.

Rollout across the Public Sector

At the outset of implementation, it is useful to consider a planned and gradual rollout across the various parts of the public sector. International accounting standards require “consolidated” accounts that include all the transactions and balances of those entities and resources that are controlled by the reporting entity. In the case of government, therefore, there is an expectation that the accounts consolidate many, if not all, public bodies. Likewise, international statistical standards apply to public sector data and other aggregates. From reform inception, implementation should be coordinated for each group or type of public entity, with each group being consolidated during the transition period. Table 5.3 shows how the public sector is divided into subsectors.

Table 5.3

Components of the Public Sector^a

Source: Authors’ elaboration. Note: Each sector of government may have social security institutions that are constituted as separate or semi-independent authorities/funds.

^aThe terminology and classification here derives from statistical conventions; although accounting standards use slightly different terminology (especially Government Business Enterprises instead of Public Corporation), the meanings are the same for all practical purposes.

Table 5.3

Components of the Public Sector^a

Public sector	Public corporations	Public financial corporations Public nonfinancial corporations
	General government (see note)	Central or national government Subnational government (e.g., region, province, state, municipality)

Source: Authors’ elaboration. Note: Each sector of government may have social security institutions that are constituted as separate or semi-independent authorities/funds.

^aThe terminology and classification here derives from statistical conventions; although accounting standards use slightly different terminology (especially Government Business Enterprises instead of Public Corporation), the meanings are the same for all practical purposes.

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Table 5.3

Components of the Public Sector^a

Public sector	Public corporations	Public financial corporations Public nonfinancial corporations
	General government (see note)	Central or national government Subnational government (e.g., region, province, state, municipality)

Source: Authors’ elaboration. Note: Each sector of government may have social security institutions that are constituted as separate or semi-independent authorities/funds.

^aThe terminology and classification here derives from statistical conventions; although accounting standards use slightly different terminology (especially Government Business Enterprises instead of Public Corporation), the meanings are the same for all practical purposes.

A typical sequencing for consolidation purposes, which gradually encompasses the entire public sector, is exemplified by the following:

• Start with central government (i.e., ministries, departments, and associated decentralized entities).

• Rollout to subnational government levels, including noncommercial satellite entities. At this point, the national and subnational governments can be consolidated to produce accounts for general government.¹⁷

• Lastly, include public corporations to provide a public sector or whole of government account.¹⁸

The sequence above may need to be adjusted, especially where different sectors are more or less advanced, or have started from different positions in the trajectory toward accruals accounting. Execution in each subsector should proceed as resources and existing capacities dictate. There is little point in delaying or stalling execution in one sector while other sectors catch up or overtake. In some instances, for example, entities that are at arm’s length may already be applying accrual-based accounting, and will need to continue toward IPSAS compliance, in parallel to introducing accruals from inception into central government. Figure 5.8 provides such an example, demonstrating how the various parts of a general government may proceed toward accruals and eventual consolidation.

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Sequence of Implementation in General Government: An Example

Source: Authors’ elaboration.

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Capturing Additional Classes of Assets and Liabilities

As previously explained, the transition period will entail a steady growth in assets and liabilities (and associated transactions) for capture and disclosure; the gradual development of the financial statements and other disclosures; and eventual adoption of international standards in parallel with these two other developments. It is essential to have a transition strategy in place; while there may be a single objective (full accruals across all public bodies), there are many alternative paths toward its achievement. The essence of a transition strategy is to ensure that the path selected is custom-made for local capacity and existing arrangements, and that it takes into consideration the legal and institutional traditions.

In an ideal situation, this expansion of the accounts to include additional categories of assets and liabilities will follow a sequence that is dictated by cost (assembling the data) and benefit (materiality of the data to be disclosed), prioritizing those that are most cost beneficial. In practice, however, the sequencing may well be dictated by the capacity of existing systems, as well as the cost of adding or developing new ones for additional information.

There are several approaches to the sequencing of accounting reform. One was prepared by Flynn, Moretti and Cavanagh (2015), according to which the sequence is as follows:

• Cash and cash movements (i.e., the starting point, a cash basis);

• Then add payables and receivables;

• Then add other financial assets (debt, investments, others);

• Then add physical assets, including inventories; and

• Lastly, add intangible assets and liabilities.

There is nothing sacrosanct about this particular sequence; for example, if reliable data on physical assets is available, there will be no need to delay or defer its inclusion to a later stage. Likewise, the government may also have sufficient data to include public service pension liabilities, based on actuarial valuations. For some data classes (e.g., fixed assets), however, it may be a challenge to develop and verify opening balances, since the data may be incomplete and a major stocktake will be needed to bring the data and systems up to date.

This gradual expansion also implies that the various IPSAS will come into play at different stages of the transition. Those relating to the fundamentals of accounts presentation and accounting policies (e.g., IPSAS 1-4, 6, 14, 18, 19, 20, 24) will be applicable from the outset, although their provisions may only be achievable in stages. Thereafter, as each type of asset and liability is added to the mix, the related standards will come into the picture. For instance, standards relating to operating revenues, borrowing costs, various investments, and other financial instruments, as well as leases (IPSAS 5, 7, 8, 9, 13, 28-30) may come earlier within the transition. Subsequently, inventories and physical assets may be added (IPSAS 11, 12, 16, 17, 21, 26), with intangible assets (IPSAS 31) following on. Public-private partnerships represent a special class of asset (and liability) that can be included in these later stages (IPSAS 32—see Box 5.5). The timing of employee benefits (IPSAS 25) and the accrual of tax revenues (IPSAS 23) have traditionally posed challenges, and these may occur sooner or later during transition, depending on the degree of preparedness.

Note that although each standard may apply at a given stage during transition, each may need to be implemented gradually (e.g., if a recommended valuation method is not possible from the outset).

Once each class of asset or liability is added to the balance sheet, the associated revenues and expenses—as well as other changes in value—are added to the operating statement. In this way, the financial statements extend to include all relevant stocks and flows. Moreover, the integrity of the accounts is maintained; all changes in balance sheet values are captured in the operating statement (or, as in a few cases, in the statement of changes in net assets).

Another dimension of this gradual growth in coverage is the potential to move valuation methods gradually for some classes of assets or liabilities from the most simple (typically, historic cost) to the more sophisticated methods that are recommended or required for full compliance with the relevant accounting standard (see Box 5.6).

This sequencing of transaction classes above can be applied to one type of entity as a group (e.g., all central ministries), but the timing and sequencing may be different for each type of entity (e.g., central and local government), depending on the systems and data that are available at the outset. The availability of accounting data for each type of entity would also need to be coordinated with the strategy and sequencing for consolidation.

During this gradual transition and adoption of standards, the accounts will provide a progressively more complete and accurate picture of a country’s financial performance and position. At the outset, these will be seen solely in terms of cash balances and changes in them; by the end, however, the accounts should capture all material assets and liabilities and how these change over the year. Interim accounts will lay somewhere in between. The degree of completeness at any stage in the trajectory will depend on the materiality of assets and liabilities yet to be included. Accuracy will also increase as accounting policies approach those required by the standards.¹⁹ It is essential, however, that the notes to the accounts explain this transition strategy and identify such exclusions and departures from standards, so that the user of the account is fully aware of these gaps. The initial gap analysis—which is an integral part of the transition strategy—would be expected to help ensure that the more material exceptions are tackled sooner rather than later.

Implications for Budgetary, Treasury, and Financial Control Systems

A significant challenge in any transition to accrual-based accounting—and one of particular interest to treasurers—is how the new accounting methods will integrate with the budgeting system and associated financial controls. The centrality of budgets and legislative approvals, together with subsequent accountability for budget execution, are the key differences between public sector and private sector accounting modalities. Traditionally, budget regimes have focused on cash or modified cash control.

Governments that are considering a move toward accrual accounting face three issues that relate to budgetary and other financial control systems:

• Whether or not to move budgeting to an accruals basis;

• How to report on budget outturns in an accruals accounting environment; and

• How to reconcile accruals accounting with traditional controls over cash and other stages of the spending process.

On the first of these questions, one simple option is that accruals accounting is introduced without any change to cash-based budgetary systems and rules. This, however, would mean that new accruals financial reporting is completely divorced from budgetary accounting; not only because budgeting remains on the basis of cash or modified cash, but also because the coverage of the budget is likely to vary from that of financial statements. As previously stated, the boundaries and presentations of accrual accounting are governed by economic concepts and not by administrative or budgetary rules.

A complete separation of systems for accounting and budgeting has other drawbacks. First, there would be the burden of running two separate and parallel systems. Second, there is the risk that financial reporting may be seen as a tiresome and irrelevant afterthought, since administrative and parliamentary oversights focus on budget approval and performance. Third, it would be very complicated to link or make connections between the two presentations of the public finances, and there would be confusion over which presents the more useful or correct picture and for which purposes.

There may be advantages, therefore, in better integration between accounting and budget. Experience to date, however, shows that accrual accounting is not automatically accompanied by accrual-based budgeting; many countries have retained cash-based budgeting or some hybrid alongside accrual-based financial reporting (Blöndal, 2004; Schick, 2007). There are several reasons for this:

• Finance ministries and legislatures may be reluctant to let go of cash as the basis for their control over the public purse, either because of tradition or the “concreteness” of cash.

• Accrual budgeting requires greater financial literacy, as well as a strong framework of rules and accompanying policing, to ensure that budget numbers are realistic to begin with and that budget outturn numbers are reliable. Without strong discipline, spending departments may be tempted to use the flexibility inherent in accrual accounting to circumvent budget rules.

• An accrual budget regime may be difficult to reconcile with the idea that the budget is an absolute limit which cannot be exceeded, and this problem is likely to be exacerbated where budgets and budget limits are very detailed. This issue arises because some account or budget items are noncash or may be outside the full control of the spending body (say, for example, that debtors are worse than anticipated, or an actuarial cost is revised upwards, or assets revalued downwards—all leading to an excess over budget). An accruals budget regime, therefore, is better suited to a more flexible regime where budget variations (negative and positive) are allowed but must, nonetheless, be accounted for.

In practice, most countries have opted to retain cash or modified cash-based budgeting, or to place budget limits only on those budget components which are more directly controllable. In other cases, they may have adopted dual budgeting, whereby departments have budgets for accruals alongside an overall cash control, which is also subject to budget approval.

On the second question—the reporting of budget performance within accrual accounts—international standards (IPSAS 24) require an entity to show outturn against original and final approved budgets, either as an additional financial statement or as additional columns to one of the other main financial statements. IPSAS 24 only applies where the budget is published, as is the case in the majority of Latin American countries. The standard also requires, in the notes to the account, an explanation of material differences between outturn and budget, unless such information is already published elsewhere and a suitable cross-reference is provided in the notes. In those cases where the final budget is always the same as the outturn—because the budget is revised and approved on a continuous or near-continuous basis—the explanations should focus on variations between outturn and the original budget.²⁰

This requirement may seem straightforward enough, although in practice there may well be complications in meeting it. The degree of difficulty will depend on three things: the coverage, classification, and accounting basis for the budget:

• If the coverage of the budget is less than that of the financial statements, then budget comparisons may only be possible within segmental reporting and not in the principal statements.²¹ This would almost certainly be the case for consolidated accounts of general government or the public sector, since not all expenditures will be covered by the budget. In this context, for example, one segment could be “budgetary central government,” with another for “other central government,” with similar distinctions between budgetary and nonbudgetary expenses being included for other subsectors or levels of government. Another complication of coverage would be the use of multiyear budgets—the standard provides guidance on how these might be matched to annual financial reporting.

• If the principal classification of the budget differs from that used in the main financial statements, a separate statement of budgetary performance will be needed, with reconciliation to the totals shown in the main financial statements. This could well be the case, for example, where the principal budget classification is organic (by ministry or sector), while the classification in the main financial statements is economic (e.g., staff costs, goods and services, grants).

• If the budget is accruals-based, reconciliation would be to the numbers in the operating statement or the segment operating statement. If the budget is cash-based, then the reconciliation would be to the cash flow statement or segment cash flow statement. If the budget is based on modified cash, however, reconciliation would be more complicated—there would need to be a reconciliation between account and budget totals before a breakdown of budget performance could be provided.

Budget reporting practices vary from country to country. In many economies, the tradition will be to have a sizeable set of public accounts that show consolidated information for budgetary central government, together with detailed outturn and budget information for each ministry or sector. In other traditions, the consolidated account is the main accounting output, with departmental accounts and other analyses published separately (or unpublished). In this latter situation, the new consolidated accrual accounts could include only high-level budget comparisons with a cross-reference to the detailed budget analyses available elsewhere.

The third question relates to the natural concern of treasurers that accruals accounting may undermine a government’s ability to control cash or other aspects of the spending regime. The short answer is “no.” Budgeting and spending control systems usually comprise controls which are based on Parliamentary approvals and on other controls (usually more detailed ones), exercised by the Ministry of Finance under its delegated authority. Cash controls can either be embedded within the Parliamentary appropriation or budget approval system—subject directly to legal limits—or, instead, they can be implemented as one of a set of administrative controls under the jurisdiction of the ministry of finance. For example, a ministry of finance could, alongside accrual budgets, also impose controls on cash releases, as it might do for staff expenditures or numbers, administrative expenditures, capital expenditures, or any other control items in a year. Spending departments would need ministry of finance authority to vary these limits. Furthermore, of course, a ministry of finance would still wish to keep a close eye on cash flow and liquidity as part of its treasury management or financial programming function. Such cash-based controls will still be possible, since an accrual accounting system also facilitates control over cash flows—in the same way that the millions of businesses worldwide, which use accrual accounting systems, continue to exercise control over their cash flows.

One particular issue of interest to treasurers will be that the traditional control and monitoring over commitments may not be executed directly through the accounting system. The link between the budget execution process, financial statements, and treasury management is shown in Figure 5.9.

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Links Between Budget Execution, Financial Statements, and Treasury Management

Source: Authors’ elaboration.

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From this illustration, it can be seen that the traditional and broad concept of a commitment—the earmarking or release of funds for specific expenditures before an order is placed or an invoice is raised—has no direct equivalent in the accounting sphere (being neither an accrual nor a payment). Instead, commitment control would need to operate at an earlier stage in the expense cycle, or through financial programming which limits the cash releases available in any given period. Alternatively, if a government is building its own accounting system, it may wish to incorporate this additional functionality within its system design.

In Latin America, budget execution is reported on a mix of cash and modified cash basis: budget execution reports present revenue on a cash basis and expenditures on a modified cash basis, which means that expenditures are registered when the obligation for payment is recognized (devengado or liquidado, depending on the country). In general, this obligation crystalizes on the invoice date. In some countries, however—mainly due to weak internal controls—the date included in the system is a different one, which undermines the credibility of data.

Depending on the country and on the ICT system applied, accounting entities may generate two entries into the system, one for accounting purposes and the other for reporting budget execution—which can jeopardize the uniformity of data. Modern financial systems promote the integration of such information and the simplification of data entry to avoid this kind of problem.

Accounting and Other Financial Information Systems

Transition often involves major changes to government financial systems, and it requires much more systems integration than modified cash accounting does. Although accruals accounting will still obtain much of the required data from transactions passing through the payment or receipts cycles, it will also need data that may come from satellite or separate systems (e.g., debt management systems, human resource systems for staff benefits). Furthermore, accruals accounting will also use accounts figures that are based on algorithms, formulas, or estimates. Accrual accounts also require additional disclosures (e.g., contingent liabilities, related party transactions) that may require new data not previously assembled or analyzed. Transition is thus not simply a matter of modifying an accounting system; it involves integrating or using data from a number of sources.

Indeed, integration is so central that accrual accounting may be one of the key drivers behind implementation of an IFMIS, since it is best served by close integration of various financial systems (e.g., General Ledger, Accounts Payable and Receivable, Revenue Management, Procurement, Fixed Assets, Personnel, among others) that were previously operated on a standalone basis or were loosely integrated. Many countries in Latin America use an IFMIS project as a driver and enabler of their new government accounting system (see Box 5.7). Chapter 7 of this book discusses, in more detail, the reforms of the IFMIS systems in Latin America.

Classification of Accounting Transactions

One area of transition which could have consequences for non-accountants is that of the classification of transactions. This may appear to be a rather dry and technical matter, strictly for bookkeepers; however, in modern financial systems, classification is central to many financial management activities and to the production of useful management information. Transition should take into account the need to align, as far as possible, accounting and budgetary classifications—preferably from reform inception.

A CoA is a set of codes that are used to classify accounting transactions. While a principal use of a CoA is to provide the classifications required for financial reporting, in modern integrated systems the CoA also provides the classifications for other purposes such as budgetary control and reporting, management information, and statistical reporting. A CoA, therefore, will often have several dimensions or segments, each containing a different classification system (Cooper and Pattanayak, 2011). The CoA needs to reflect the interests of many parties and, most especially, the budget, control, and accounting officials.

In many countries, government use of cash or modified cash accounting will already have a standard CoA to be used by all entities within central government, with possibly another for local government and yet another for satellite bodies. These charts of accounts will cover receipts and payments, and the internal structure of the CoA will probably reflect the classifications used in the budget. For public enterprises, these are more likely to maintain their own CoAs, capable of supporting IFRS-style accrual reporting. In the transition to accruals, one of the first developments should be the production of a new CoA, to be used by all public noncommercial entities, extending the CoA to cover assets and liabilities, as well as other changes in net worth (i.e., other than receipts and payments).

One tension which this new standard CoA may introduce is the inability of each institution or type of institution to include elements that cater to their own specific characteristics or operational needs. Ideally, therefore, the standard CoA should leave room for such user-defined classifications of expense and revenue, among others. The degree of standardization, in part, will depend on the degree of detail to be provided in the consolidated accounts. In some countries, the tradition is for the government consolidated account to be the only place where such detail is provided (with individual entities not producing their own accounts). In other countries, this detail is disclosed in individual entity accounts, while the consolidated accounts (and, thus, the standard CoA) are more summarized. Nevertheless, where a country elects to present highly summarized consolidated accounts, the standardization at lower levels may be justified by the needs of financial control or detailed analyses of government finances.

Potential confusion may arise between the CoA needed for financial reporting, based on IPSAS, and the coding systems needed to support statistical (often referred to as “fiscal”) reporting under the IMF’s GFS. In contrast to IPSAS, GFS does come with a standard reporting template and a standard classification system. At first glance, there is a great deal of commonality between GFS and the way in which a government may present its financial statements. There are, however, important differences between IPSAS and GFS, reflecting their different objectives and perspectives, and it would be wrong to use a GFS-based reporting template and coding system for financial reporting without modification.²² A better solution is to adopt one of the classification systems (IPSAS or GFS) as the principal coding to be used in everyday operations and data entry, with the ICT system automatically mapping this coding system to the other classification system. In this way, a single coding entry and set of coded transactions can be used to produce IPSAS accounts, as well as GFS statistical reports. The principal coding structure may be IPSAS or it might be GFS—the choice will mostly depend on whether the budget is intended to mirror the eventual accounts, or whether it is based on GFS classifications.

Finally, this standard government CoA is very unlikely to be suited or applicable to government business enterprises that should be following IFRS reporting requirements. If the eventual intention, however, is to produce whole-of-government accounts that cover all commercial and noncommercial parts of government, there will be a need for a further mapping system, allowing IFRS-based accounts to be translated into IPSAS-based accounts and then merged with the IPSAS-based data. This conversion may not be wholly straightforward, however, since one difference between IFRS and IPSAS will be in the valuation methods used for certain types of assets or liabilities. The original IFRS data, therefore, may need to be reworked first before mapping. Clearly, such mapping and reworking will be easier if the consolidated accounts are in summarized form—it will be much more onerous if the financial activities and position of government enterprises have to be reclassified to three or four levels of detail.