The Foundations of Public Sector Budgeting and Accounting: Understanding Cash and Accrual Andrew Graham Queens University School of Policy Studies

Canadian Public Sector Management2 Why here? Why now? In run up to both budgeting and accounting, it is important to have a technical grasp of key concepts The basis of accounting and possibly budgeting: cash or accrual is one of them There have been major shifts in how the public sector manages its basis of accounting that will affect an understanding of both budgets and accounting

Canadian Public Sector Management3 Private and Public Sector Accounting Environments Private sector accounting records are maintained to assess levels of profitability Public sector accounting records are maintained to ensure that public servants (politicians, bureaucrats, officials) have been properly accountable of the funds they have used Greater emphasis on accountability and stewardship

Canadian Public Sector Management4 What is the End Product and how do you Build Accounts to match it? Private sector accounting based on matching revenue and expense in order to measure profit This leads to using accrual accounting which recognizes both revenues and expenses when they occur: bottom line is profitability not cash situation What accrual has developed is an overall assessment of the financial condition of the organization

Canadian Public Sector Management5 What is the End Product and how do you Build Accounts to match it? Public sector focus on accountability for funds at hand has lead to using a cash basis as it is more easily understood and more sensitive to annual budgetary approvals of governing body Significant gaps in the cash approach has created a growing trend of governments and other parts of the public sector to adopt the accrual approach to both accounting and budgeting.

Canadian Public Sector Management6 Quick Snapshot Cash Accounting recognizes –revenues when cash is received and –expenses in the form of expenditures when bills are paid (focus on cash movement). Accrual Accounting recognizes –revenue when goods or services have been provided and –expenses when resources have been used (focus on when revenues are earned or resources are consumed).

Canadian Public Sector Management7 Quick Snapshot Governmental funds have also used Modified Accrual Accounting. –Expenditures are recognized when resources are received. –Revenues are recognized when they are measurable and available within the accounting period or shortly afterwards (focus on financial resources). This is on its way out!

Canadian Public Sector Management8 Accrual Accounting  Capital assets are reported on the financial statements  Non cash transactions – depreciation, amortization, provisions, accruals, receivables are recorded  Recognition of (retirement and pension benefits, accumulated leave) employee benefits in the financial statements  Financial and reporting practices are similar to private sector

Canadian Public Sector Management9 Why Do This? The adoption of accrual basis represents an effort to bring into both accounting and budgeting a totally inclusive approach to identifying costs and revenues, thereby providing a fuller picture Accrual budgeting represents a major challenge to the concept of annualized budgets approved by legislatures, although it in no way reduces the authority of those legislatures Accrual accounting forces a better integration of finance, operations and strategic direction because of its inclusive nature

Canadian Public Sector Management10 Why Do This? Accrual accounting demands a higher level of sophistication on the part of public sector managers, their overseers, be they legislatures or boards of directors The shift to both accrual accounting and accrual budgeting is a major change process for any organization creating work and the need to manage the change, often with the adoption of new financial information systems.

Canadian Public Sector Management11 Why to Not Do This? Smaller public sector organizations do not need to do this Size and scale only require limited financial information Limited assets being held for a long period No capital Little or no long term liability Day to day existence Simple bookkeeping will suffice.

Canadian Public Sector Management12 Weaknesses of the Cash Basis Failure to accurately represent the amount of resource usage. For instance, a large capital acquisition will distort expenditure upward in the first year but the usage of that asset will not be recognized in following years. Information about assets and liabilities is frequently very limited Lack of an effective balance sheet to reflect true worth (or net debt) of the organization

Canadian Public Sector Management13 Weaknesses of the Cash Basis Failure to take account of future commitments, guarantees, or other contingent liabilities. A liability will not be recognized until the cash is paid to settle the debt. Concentration on cash payments alone, sometimes resulting in an unnoticed deterioration in fixed assets. Focus on control of the inputs purchased rather than the outputs produced. Distortion of incentives by encouraging managers to underestimate the costs of programs and to spend their full annual appropriations. Encourages end of year spending

Canadian Public Sector Management14 Claimed Benefits of Accrual Better measurement of costs and revenues including comparisons over time Full cost of providing a service can be compared with outside suppliers Greater focus on outputs rather than inputs A better indication of the sustainability of Government policy Greater comparability of management performance results.

Canadian Public Sector Management15 Claimed Benefits of Accrual Provides a full picture of a government’s financial position Shows how activities of government were financed and how government met its cash requirements Provides useful information about the real level of government’s liabilities

Canadian Public Sector Management16 Claimed Benefits of Accrual Improve management of government’s assets and liabilities

Canadian Public Sector Management17 Squaring Accrual with the Westminster Model of Government We will see that accrual accounting deals with both cash and non-cash costs Notion that governments only vote funds or cash for one year appears to contradict this Vehicle for voting such funds in appropriations No contradiction as the approval of cash expenditures through appropriations is needed in both systems.

Canadian Public Sector Management18 Cash Treatment of Capital Capital Item New Computer System 1,750,000750,000 What is recorded here is the movement of cash to pay for the system Buying a computer system at a cost of $2.5 M

Canadian Public Sector Management19 Accrual Treatment of Capital Item Computer System 500,00 500,000 What is recorded here is the amount of the total value that is consumed in the time period in which it is being consumed.

Canadian Public Sector Management20 Accrual Treatment of Capital However, accrual would never have a single entry such as this in its Balance Sheet Rather, there would be two entries, perhaps three, depending on the circumstances: –Accounts payable or cash reduction entry –Inventory (Assets) entry and, –Depreciation.

Canadian Public Sector Management21 Recognition of Long Term Assets & Liabilities Public Debt Government has an accurate record of existing borrowings Pension Obligations Contractual agreement treated as a liability Asset Register to be maintained

Canadian Public Sector Management22 EventCash BasisAccrual BasisModified Accrual Basis Article ordered from supplier No effect Article arrives in Inventory No effectIncrease accounts payable and Increase Inventory Increase accounts payable and Decrease funds balance Article is usedNo effectDecrease inventory and Decrease fund balance No effect Article is paid for Decrease cash Decrease fund balance Decrease cash Decrease accounts payable Decrease cash Decrease accounts payable

Canadian Public Sector Management23 Word of Warning: Cash Accounting versus Cash Management Even in a cash system, the ordering of an article involves the commitment of funds for cash forecasting purposes. While this commitment would not be recorded or recognized as it does not involve a formal transaction in cash accounting terms, it does represent an encumbrance of funds and restricts their alternative use.

Canadian Public Sector Management24 Word of Warning: Cash Accounting versus Cash Management As will be seen when discussing cash management, most organizations have ways of recording significant commitments for forecasting purposes, even if such commitment are ‘off balance sheet’. This is a way for organizations on the cash basis to get a hold of their actual financial position and also to manage their cash flows within year.

Canadian Public Sector Management25 Significant Definitions and Concepts Expenditure: –An expenditure is the amount of cash paid for goods and services. –It can also be seen as the creation of the legal obligation to pay.

Canadian Public Sector Management26 Significant Definitions and Concepts Expense: –Expenses represent the cost of goods and services consumed in the process of fulfilling the organization’s objectives. –They are measured by the amount of an asset used (e.g. depreciation) or the amount of a liability incurred (e.g. creditor's amount). –Expense, used both as a noun and a verb, refers to the identification, in the accounting system of an obligation to pay, a liability or unpaid obligation

Canadian Public Sector Management27 Significant Definitions and Concepts Treatment of Non-cash transactions: –Accrual accounting entails recording non-cash transactions such as depreciation, provisions, bad debts, etc. –Non-cash transactions have a monetary value and contribute to the government, organization or unit’s financial position. –Examples of non-cash transactions: Depreciation Future liabilities, e.g. pensions, vacation leave

Canadian Public Sector Management28 Significant Definitions and Concepts Recognition: –Point at which an asset or liability is formally recorded in the accounting system is the point of recognition –Possible to be aware of a liability and not recognize it: example: commitment to partner on a building project but costs not understood sufficiently to plug in the numbers

Canadian Public Sector Management29 Inflow (Revenue) Recognition CollectedMeasurable and Available Modified Accrual Basis Earned Accrual Basis Cash Basis Note: Governmental resource inflows are available if they are deemed to be collectable during or shortly after the end of the accounting period. This may happen before cash is received. Payment has been received or will be received soon. Service has been provided. Payment has been received.

Canadian Public Sector Management30 Outflow (Expense or Expenditure) Recognition Appropriatio n Encumbranc e Delivery Payment Use Modified Accrual Basis - Expenditure now. Cash Basis Expense now. Accrual Basis Expense now. Authorization to spend money. Order has been placed. Order has been received. Payment is made. Item is consumed. No expense at this time - any basis. No expense at this time - any basis.

Canadian Public Sector Management31 Significant Definitions and Concepts Recognition can get carried away: Example: When should state pensions become a liability on government’s balance sheet? –When a person is born? –When they start work? –When they retire? Usual technique is to take these off-balance sheet and create a separate self-accounting fund.

Canadian Public Sector Management32 A Week in the Life of a Small Government Example

Canadian Public Sector Management33 Accrual Budgeting Includes details of the accrued expenses, revenues, payments, receipts, assets and liabilities in annual estimates Financial Reports will be in the form of : Statement of Financial Performance (Income Statement) Statement of Financial Position (Balance Sheet) Statement of Cash Flow

Canadian Public Sector Management34 Benefits Improved resource allocation Better quality policy making Better control of capital Better identification of liabilities Opportunity for private/public comparison Financial management becomes a central concern Better quality management of cash flow and current assets/liabilities

Canadian Public Sector Management35 Is Accrual the be-all of public sector financial Management? Not quite Accrual accounting only provides better quality ex-post information –Unless there is a context for this information then it is purely a technical exercise Accrual accounting is not a panacea for poor Government performance

Canadian Public Sector Management36 Is Accrual the be-all of public sector financial Management? Its greatest value is as part of an integrated management system: –Accrual budgeting as well as accrual reporting –Fiscal framework based around a “suite of measures” –Focus on balance sheet (asset & liability) management –Focus on “whole of government” –Results oriented financial management system

Canadian Public Sector Management37 Can Accrual Accounting and Budgeting prevent a public sector Enron? Is it the form of the accounting system that creates the risk in government accounting? Would a change from cash to accruals make the difference? No – Enron accounted on an accruals basis! – well, sort of, it even abused its accounting standards: mark-to-market accounting Other factors are far more important

Canadian Public Sector Management38 Can Accrual Accounting and Budgeting prevent a public sector Enron? Strong audit/accountability arrangements Clear separation of capital from revenue expenditure and income Political willingness to challenge and cause change in accounts if necessary Independence of standard setting from Government Independence of External Audit function Capacity of managers to ‘read the balance sheet’ Internal systems of control