Limitations of Cash Accounting & Benefits of Accrual Accounting in Govt. Finances, Study Guides, Projects, Research of Accounting

Download Limitations of Cash Accounting & Benefits of Accrual Accounting in Govt. Finances and more Study Guides, Projects, Research Accounting in PDF only on Docsity! GOVERNMENT ACCOUNTING STANDARDS ADVISORY BOARD PRIMER ON ACCRUAL ACCOUNTING Compiled by GASAB Secretariat O/o the Comptroller and Auditor general of India 10, Bahadur Shah Zafar Marg, New Delhi-110002 Accrual Accounting It is a system of accounting in which transaction are entered in the books of accounts, when they become due. The transactions are recognised as soon as a right to receive revenue and/or an obligation to pay a liability is created. The expenses are recognised when the resources are consumed and incomes are booked when they are earned. Therefore, the focus is on the recording of flow of resources i.e. labour, goods, services and capital., the related cash flow may take place after some time (of event) or it may or may not take place in the same accounting period. Cash Accounting In this system of accounting transactions are recorded when there is actual flow of cash. Revenue is recognised only when it is actually received. Expenditure is recognised only on the outflow of cash. No consideration is given to the “due” fact of the transaction. This system of accounting is simple to understand and as such needs less skill on the part of the accountant. Its whole focus is on cash management. The recognition trigger is simply the flow of cash. Budgetary and legislative compliance is easier under this system. Limitations of cash system of accounting The limitations of cash based accounting are: - It does not provide the complete picture of the financial position i.e. information on assets and liabilities are not available for fixed assets (land, building, machineries, defence, heritage assets etc.) - No information about capital work-in-progress like dams, power plants, roads and bridges etc. is available. - It does not give the full information on current assets e.g. accrued income like outstanding royalty, fees, service charges, tax arrears etc. - Comprehensive information is not available about government liabilities (pensionary commitments, interest due, bills payable, depreciation for replacement of assets etc.) - Unit cost and total cost of services provided by the Government departments like health, education, water supply, transportation etc. is not ascertainable (as depreciation, interest etc. are not apportionable) - It ignores certain transactions by not recording expenditure already incurred but payment not made e.g. supplies made, salary, telephone charges, overdue interest etc. and also revenue earned but cash not received e.g. licence fees, services delivered (electricity, water etc.) - It gives a wrong picture of income received, as advance tax receipts are recognised as income. - No weightage is given to the concept of ‘matching’ i.e. expenses of a specific period should be set off against the revenue of the same period. - No disclosure is made about contingent assets and contingent liabilities which may turn into committed ones on account of guarantees given or letter of comforts issued by the government. 1 Budgeting on cash basis and accounts on accrual basis It should be noted that the “basis of accounting” is independent of the Chart of Accounts. The basic Chart of Accounts can be similar for both bases of accounting - cash or accrual. The system based on accrual accounting would have some additional account heads. When the accounts are compiled, it will have certain account heads in addition to the budget heads. These account heads will relate to accrued transactions. For example, the Chart of Accounts will have the following heads for treating fixed assets: - Fixed Assets - Depreciation - Accumulated Depreciation - Profit or loss on sale of assets Under the cash system of accounting only the purchase of asset is recorded. The budget heads will continue to show the asset acquisition as capital expenditure. In addition to showing the expenditure, accounts based on accrual concept will also show the extent of depreciation, the accumulated depreciation till date and the profit or loss, if any, when the asset is sold. Accounting reforms vis-à-vis concomitant budgetary reforms Budgeting and accounting systems are closely linked to each other. In the long run it is desirable to have concomitant reforms in the budgeting and accounting systems, if government were seeking the full benefit of reform in its accounting system. However, implementing reforms simultaneously in both accounting and budgeting systems is very complex, and the task of managing the change is extremely difficult. Most countries that embarked on reforms first undertook accounting reforms, followed by budgetary reforms within a few years. Examples include New Zealand, Canada and UK. Therefore, commencing by modifying the accounting system is a good way to start the reform process, but it needs to be continued to its logical conclusion. Experience of other countries, which prepare Appropriation Accounts under the accrual system In most countries, government needs funds for the purposes of the development from their respective consolidated funds. Accordingly their legislatures authorise the appropriations through according of approvals to the appropriations bills proposed by the concerned government. Once an appropriation is authorised, an appropriation account is established, which disclose expenditure at the same level of detail as in the estimates, to make amounts available for expenditure from the Treasury. Various countries follow different types of appropriation. The different types of appropriation accounts include: - Open Appropriation Account: An open appropriation account is an account that has not had the balance transferred to a successor account or to surplus. The appropriation in the account may be expired or unexpired. - Closed appropriation account: A closed appropriation account is an account that has had the balance transferred to a successor account or to surplus. The appropriation in the account is lapsed. - Successor Account: A successor account is an account established for the payment of obligations applicable to appropriations for the same general purposes, but which have 4 either lapsed or been discontinued. A successor account is available indefinitely for the payment of obligations chargeable to any of its predecessor accounts. Further, appropriation accounts may include not only accounts to which money is directly appropriated, but also other funds. A fund, as used in connection with appropriations, is a sum of money or other resources, usually segregated, to be expended or used for specified purposes. Funds differ from appropriations in that they are usually permanent in nature and do not expire unless they are revoked by the Parliament. Thus, in USA, appropriation accounts are prepared for General Fund, Trust Fund and Revolving Fund. Nevertheless, appropriation accounts as prepares in India, are similar to the system followed in the Commonwealth countries like UK, Canada and Australia. Thus, in UK, the Resource Accounts for each financial year are prepared and laid before Parliament under the Government Resources and Accounts Act 2000. They show the extent to which the resources granted by Parliament through Consolidated Fund Acts (following voting by the House of Commons on Estimates presented to it) have been used, and are signed by senior civil servants from the departments concerned (Accounting Officers). They are audited by the Comptroller and Auditor General. In addition to giving his certificate that the financial statements give a true and fair view of the state of affairs of the audited department concerned and that expenditure has been applied for the purposes authorised by Parliament, he may make additional comments on the accounts. Disadvantages in add-on statements of accrual transactions to Reports of cash accounting system If accrual transactions are added to the annual accounts without accrual based information being integrally accounted for, the accuracy of the accounting statements would be suspect. As a system, this would not be robust and, therefore, somewhat suspect in its integrity. For instance, if a bill has not been paid under an accrual accounting system, the expense will be recorded and a corresponding entry for ‘Creditors Bills payable’ will be made. If these accounting entries are not integrally accounted for, it is likely the information may not be captured correctly. Further, any error in recording the entries will also not come to light. On the other hand when these accounting entries are passed under accrual system of accounting, the errors, if any, will be highlighted as the Trial Balance and Balance Sheet will throw up the difference. Accrual accounting is a complete, double entry and a self-balancing system with built-in checks, which substantially minimises errors and frauds. Recording of assets and their depreciation in Government transactions/operations even when such transactions/operations are not undertaken for profit. It is essential to record assets in the books of accounts and provide for depreciation not only in a commercial environment, but also for entities that do not operate for profit. Governments, particularly those that operate in a Parliamentary democracy, are custodians of the money raised from the citizens and other sources. They have a duty to ensure that assets created out of such borrowings are looked after properly, so that they are not frittered away or used inefficiently. This duty of the government is irrespective of whether the assets are put to use to generate profit or otherwise. Depreciation is the diminution in value of assets due to wear and tear and efflux of time. The value of an asset after depreciation reflects its “true value”. It is essential to ascertain this value in order to evaluate whether the desired outputs and outcomes are obtained from the use of the asset. Irrespective of the nature of the entity (commercial or otherwise), it is important to know the true value of the asset and depreciation helps in assessing the correct value. To continue to show the assets at their original value will be to over-estimate the value of the assets. 5 Policy of provisioning for bad debts and its impact Accounting for bad debts and provisioning are essentially prudent policies, and do not mean surrendering the claim to receive payment. Treating a debt as bad or provisioning for it does not mean that efforts need not be undertaken to recover the debt. The policy for providing for bad debts merely denotes the fact that recovery from such a receivable may not be certain, and to present a more accurate position (of assets in this case), a possible erosion in value of the assets is recognised in the books of accounts. The act of provisioning does not and should not change the right of government over the particular claim. If this principle is understood and practiced, there should be no issue of “encouraging defaulters”. Use of IT/computerisation at transaction level for smooth flow of information and their compilation Computerisation at transaction level is desirable for smooth flow of information and their compilation. Initially, the Treasury and District Treasury offices need to computerised. The extent of computerisation will depend on user capabilities, extent of networks, availability of computers etc. A detailed study needs to be undertaken to ascertain the readiness of computerisation at a location before it can be recommended. Impact of recognising expenses on accrual basis and income on more or less cash basis - What is important to note is that the accounting treatment that best represents the actual situation (in other words the “true and fair” view) should be used. If revenue from tax is not measurable and is uncertain or difficult to realise, then the correct principle would be to recognise such income on cash basis. The accrual-based system that intrinsically follows the principles of conservatism and measurability, requires that we “anticipate no gains, but provide for losses”. In the context of government accounting, recognising expenditure on accrual basis meets the criteria of conservatism, measurability and practicability. Government should bring in place procedures to accrue expenditure. Information on expenses is to be complied to assess the cost of mobilizing revenue and sustainability of existing programs. It is also required to know the likely cost of proposed activities and services or alternative proposals and to determine that whether to fund the production of services within government sub-entities or to purchase directly from non- government organizations. Generation of surplus or deficit is not as much an issue as is a transparent depiction of the underlying situation. It may be noted that banks (including public sector banks and the Reserve Bank of India) recognise all expenditure on accrual basis, and revenue from impaired assets on cash basis. Experience of other countries The following countries have moved over to accrual accounting and accrual budgeting: i. Australia ii. New Zealand iii. The Netherlands (in the process of introducing full accrual budgeting) iv. Sweden (in the process of introducing full accrual budgeting) v. Switzerland (in the process of introducing full accrual budgeting) The following countries have adopted full accrual accounting but follow cash based budgeting: 6 - Revenue forgone approach- measures how much tax revenue is reduced (relative to a benchmark) because tax expenditure exists. It compares the current and/or prospective treatment and the benchmark treatment, assuming taxpayer behavior is unchanged. - Revenue gain approach- measures how much revenue could increase if a particular tax concession were removed. Accurate estimation of this cost would require estimates of the secondary or behavioural effects associated with such a change. - Outlay equivalence approach- estimates how much direct expenditure would be needed to provide a benefit equivalent to the tax expenditure. This approach measures the expenditure required, in pre-tax rupees, to achieve the same after- tax rupee benefit as a tax expenditure where the direct expenditure receives the tax treatment appropriate to that type of income in the hands of the recipient. Management of small savings by government Government can use the money collected as small savings for meeting its fund requirements. However, a transparent system should be put in place to track the small savings maturity pattern year-wise and identify probable sources for meeting the maturity payments as and when they fall due. This would help in better fund management. Concepts of ‘Public Account’ type fund in other countries The public account, as maintained in India, is primarily to account for funds that the government receives and manages as a banker or trustee, rather than funding general expenditure. However, there are a number of funds which are not held in trust but included in the public account. For instance, the government maintains depreciation reserve funds and sinking funds under the Public Account. These are not funds held in trust. Similarly, security deposits and other deposits, short- term investments and some cash balances, which the government maintains under the Public Account are liabilities that the government has to repay or appropriate on completion of contracts. Like India, other countries like UK, USA, Canada and New Zealand also need to maintain public account. However, unlike in India where the public and consolidated accounts are separate and appropriation account prepared only for the consolidated fund, in other countries, appropriation accounts are prepared for even public account. Further, instead of being termed as public account, it may be defined as public fund or trust fund. Thus, in USA, the following types of funds are accounted for in the appropriation accounts: General Fund: The general fund of the Treasury is the fund into which all receipts of the United States Government are deposited, except those from specific sources required by law to be deposited into other designated funds. Appropriations from the general fund are made by Congress to carry on the general and ordinary operations of the government. Trust Fund: A trust fund is used to deposit amounts received or appropriated and held in trust according to an agreement or a legislative act. These amounts may only be used or expended according to the terms of the trust or act. Revolving Fund: A revolving fund is established to finance a cycle of operations to which reimbursements and collections are returned for reuse in such a manner as to maintain the principal of the fund. The amount of the fund may be in the form of cash, inventory, receivables, or other assets. 9 Inclusion of defence, heritage and environmental assets as part of asset accounting New Zealand is the only country, which recognises heritage, defence and environmental assets. United Kingdom follows a policy of valuing operational heritage assets. Non operational heritage assets such as art collections, archaeological sites, monuments and ruins are not valued. However, should some non-operational assets be valued, they are valued generally at the lower of depreciated replacement cost or net realisable value. In the United States, if a collection is held in furtherance of public service and not for gain; protected, preserved, cared for, and kept unencumbered; the same is not valued. Differences between a receipt and payment statement under the cash system and cash flow statements/ Statement of Sources and Application of Funds under the accrual system. The cash flow statement is similar to the receipt and payment statement under the cash system in terms of aggregate income and expenditure figures. Impetus for adopting accrual concepts differently from private sector The private sector focuses on commercial viability whereas the government plays a developmental and social role. Therefore, the need for economic and rural development might necessitate governments to adopt accrual concepts differently from private sector. The concept of ‘true and fair’ is different in government from that of the private sector. Further the concept of net worth in government is not as important as in the private sector. The focus of accrual accounting in government is to ensure that the output and outcome of the spending are commensurate with the inputs and the long term fiscal sustainability of government is captured appropriately. Incorporation of the information on unpaid bills, subsidies, tax expenditure, tax arrears, etc, in the proposed system State Government: The cash income and expenses will flow to the AG’s office from the Treasury. It is proposed that every month end, the DDOs submit details of unpaid bills to the AG’s office. Similarly, the Department of Revenue will furnish details of tax expenditure and tax arrears to the AG’s office. The Department of Revenue has a statistical cell, which maintains trends in the same. Central Government departments: The DDO of the concerned department at the end of the period, say a month, apart from the approved bills also sends copies of bills raised but not yet approved/paid to the Accounts Officers. The Accounts Officers enters the details of such bills under the relevant heads, which will appear as liabilities of the concerned department. The relevant heads to take into consideration such expenditure like accounts payable, subsidies etc. Accrual accounting as a tool for governments to take sound decisions of financial and managerial nature By following accrual system of accounting, governments will be better positioned to assess their financial performance and financial position. Accrual system of accounting will help in preparing the position of assets and liabilities of the government, which is not possible under the current system. This would help in better fund management and evaluation of performance of various departments. Further, accrual system of accounting would help in estimating cost of services more appropriately, which could form a crucial input for managerial decision-making. 10 Sampling of peculiar government activities/functions/departments for pilot study for migration to accrual accounting The transition to an accrual based system should be on the following lines. To start with Ministries/Departments with a commercial focus should implement the new accounting system. These departments (and the organisations under these departments) essentially provide commercial products/services, and compete with private sector entities. In these departments, there are tangible commercial benefits flowing from accounting reform which are essential for their competitiveness and economic viability. The next phase should cover departments with a social orientation. These departments fulfill the social responsibilities of the government. As opposed to the departments that have a certain amount of commercial and revenue focus, these are typically “spending” departments. The thrust here is on the delivery of services and ensuring that the output and outcome are commensurate with the inputs and targets. Transition to an improved system will provide these departments with better tools to monitor and evaluate service delivery and the costs. Finally, administrative/regulatory departments concerned with general administration and/or provision of regulatory functions should transit to accrual accounting. The accent of these departments is not as much on costs or revenues but on providing the necessary support and administrative services for overall running of the government and the economy. Select departments in each of the categories may be identified for pilot implementation. In the case of state governments, either an entire state government or a geographical unit such as a district or a set of districts, should be chosen for pilot implementation. If a district is chosen care should be to ensure that it is representative of all the major activities in the state. Benefits of accrual accounting in social sector as the government mostly engage in such activities A sound accounting system should assist the government in meeting its objectives. The information that the system disseminates should be of high quality in terms of the following parameters:- - Accuracy - Granularity (level of detail) - Comparability (across periods) - Appropriateness of metric(s). Such metric(s) should indicate the basic objectives of existence of the entity concerned (e.g. profit for a commercial entity, unit cost for a service centre, sustainability of operations as indicated by fiscal position and debt level, and so on) - Adequacy of disclosures (of assumptions and financial position) - Better control on resources and operations so as to be able to stand up to the scrutiny of stewardship - an essential element of democratic functioning Accomplishment of the above parameters is necessary for any sector including social sector. Relation of performance evaluation/outcome to accrual accounting The purpose of accrual concept is to make sure that all revenues and costs are recorded in the appropriate statement at the appropriate time period. Costs concerning a future period must be carried forward as a prepayment for that period and not charged in the current profit statement. For example, payments made in advance such as the prepayment of rent would be treated in this way. Therefore, accrual basis of accounting helps in reflecting true picture of expenditure in an accounting period. For example, one of the parameters in government for performance evaluation 11