ADB Grant No.0133-CAM/Component 1: PFMRD ADB Grant 0133-CAM: Public Financial Management in Rural Development Ministries (Component 1) Day 1: June 07, 2010: Accounting Concepts Advanced Accounting 1 - The Conceptual Basis of Government Accounting

ADB Grant No.0133-CAM/Component 1: PFMRD Content 2 Day 1 Accounting concepts

ADB Grant No.0133-CAM/Component 1: PFMRD Purpose of accounts 3

ADB Grant No.0133-CAM/Component 1: PFMRD Users of Government Accounts 4

Reporting to Users 5 Government organisations report accounting results to users by issuing Financial Statements...

Types of financial statements ADB Grant No.0133-CAM/Component 1: PFMRD 6

General Purpose Financial Statements 7 These are Financial statements issued for users who are unable to demand financial information to meet their specific needs For government accounts this means the general public:

Special Purpose Financial Statements 8 These are Financial statements issued for users who can demand financial statements tailored to meet their specific information needs Users include:

Examples of General and Special Purpose Financial Statements ADB Grant No.0133-CAM/Component 1: PFMRD 9

Internal management accounts 10 In addition to financial statements, government organisations keep detailed management accounting records, for internal use only... (same as commercial organisations) ADB Grant No.0133-CAM/Component 1: PFMRD

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Government accounting compared with commercial accounting 12 There are many similarities between Government Accounting and Commercial Accounting, but there are some significant differences...

Government accounting compared with commercial accounting 13 Differences between government accounting and commercial accounting Note: Government owned ‘for profit’ agencies should use commercial accounting standards

Government accounting compared with commercial accounting 14 Differences between government accounting and commercial accounting

Government accounting compared with commercial accounting ADB Grant No.0133-CAM/Component 1: PFMRD 15 Differences between government accounting and commercial accounting These differences are examined on Day 2 of the course

Government accounting compared with commercial accounting 16 As a result of these differences between government accounting and commercial accounting.... There are separate accounting standards for commercial and government organisations.... BUT There is now a convergence between these standards IPSAS are covered on Day 3 of the course IFRS = International Financial Reporting Standards IPSAS = International Public Sector Accounting Standards

Accounting Rules and Concepts We will describe: 1.Boundary Rules 2.Measurement Rules 3.Ethical rules 4.Capital and Revenue items 5.Asset valuation rules ADB Grant No.0133-CAM/Component 1: PFMRD 17

1. Boundary Rules Entity boundaries: (what is the boundary of the organisation we are accounting for?) o Controlled v Controlling Entities o Individual Ministries o Central Government o (Total) Whole of Government o Self Accounting Agencies ADB Grant No.0133-CAM/Component 1: PFMRD 18

1. Boundary Rules Period boundaries: (what is the time period of the accounts?) o Usually 12 Months – for Statutory Accounts o But Also – Periodic In-Year Budgetary Control Accounts o Important to Compare Like with Like ADB Grant No.0133-CAM/Component 1: PFMRD 19

2. Measurement Rules 20

2. Measurement Rules: The ‘Matching’ concept 21 Match transactions to the period in which they occur This concept is used in accrual accounting but not in cash accounting Examples.....

Exercise 1 A government department buys 50 office chairs for $90 each from its supplier. It sells 40 chairs at $120. So it pays out $4,500 (50 x 90) and receives in $4,800 (40 x 120). Is its profit $4,800 – $4,500 = $300? If not what is the profit on this transaction? ADB Grant No.0133-CAM/Component 1: PFMRD 22

Solution 1 In order to comply with the matching concept, the sales figure (revenue) must be compared with the cost of the chairs sold, rather than the cost of all the chairs. This would be done as follows: Total Sales Price120 x 40 4,800 Cost of Chairs Sold 90 x 40 3,600 Profit 1,200 The correct accounting profit using the matching concept is therefore $1,200. Note that the sales have: 1.generated a cash surplus of $300 and 2.Left a stock of 10 chairs worth $900 (at cost, i.e. 10 x $90) So it has increased its worth by $300 + $900 = $1,200 23

Exercise 2 A government department has a financial year 1 st January 2009 – 31 st December It receives and pays for quarterly electricity Bills as follows: Paid 28/01/09 (Invoice Oct-Dec 2008)$1,000 Paid 26/04/09 (Invoice Jan-Mar 2009)$1,200 Paid 29/07/09 (Invoice Apr-Jun 2009)$1,400 Paid 04/11/09 (Invoice Jul-Sep 2009)$1,300 Paid 23/01/10 (Invoice Oct-Dec 2009)$1,250 What figure should the 2009 accounts reflect for electricity? Using Cash Basis? Using Accrual Basis? ADB Grant No.0133-CAM/Component 1: PFMRD 24

Solution 2 Under the Cash Basis of Accounting, the only consideration is when the electricity bills were actually paid. Under the accrual basis, it needs to recognise in which period the electricity was actually consumed. Under Cash: 1, , , ,300 = $4,900 Accrual basis: 1, , , ,250 = $5,150 Under the accrual basis, the 1,000 bill would be included under the 2005 Accounts Cash Basis (Payment) -1,000+1,200+1,400+1,3001,250 Accrual (When Consumed) 1,0001,200+1,400+1,300+1,250 25

Exercise 3 A government department pays annual rent in advance as follows: Paid 01/10/2008 (Rent for Oct 2008 to Sep 2009)$10,000 Paid 01/10/2009 (Rent for Oct 2009 to Sep 2010)$12,000 What should the rent figure be in the 2010 accounts? Using Cash Basis? Using Accrual Basis? What is the advance payment of rent called? ADB Grant No.0133-CAM/Component 1: PFMRD 26

Solution 3 (a) Under Cash Basis the charge for Rent in 2009 is $12,000 (i.e. when the actual payment was made (b) Under the Accrual Basis the Rent Figure for 2009 would be: 10,000 x 9/12 (Jan-Sep 2009) = 7,500 12,000 x 3/12 (Oct-Dec 2009)= 3,000 10,500 (c) Under accrual accounting these advance payments are called prepayments. 27

3. Ethical Rules Objectivity Legality Consistency Prudence ADB Grant No.0133-CAM/Component 1: PFMRD 28

3. Ethical Rules: Objectivity ADB Grant No.0133-CAM/Component 1: PFMRD 29

3. Ethical Rules: Legality ADB Grant No.0133-CAM/Component 1: PFMRD 30 Accounts should be prepared in accordance with the Law and accounting regulations Also in accordance with accepted accounting standards Examples: Every transaction should be included in the accounting records Every transaction should be recorded completely and accurately Only transactions related to the entity should be included in its accounts Transactions must be classified correctly You should not attempt to prepare misleading or false accounts You should preserve a full audit trail for each accounting entry You should retain records of all transactions for the period required by law You must not delete or conceal the record of any transaction

3. Ethical Rules: Consistency 31

3. Ethical Rules: Prudence ADB Grant No.0133-CAM/Component 1: PFMRD 32 See later

3. Ethical Rules: Prudence ADB Grant No.0133-CAM/Component 1: PFMRD 33 Prudence is an important accounting concept, and normally over-rides other concepts, if there is a conflict. For example: If a government has made a loan to one of its agencies, and the agency has no funds to meet the repayment, the loan receivable should be ‘written off’, not shown as an asset.

4. Capital and Revenue items Important Distinction in Accounting – Both for Accrual Accounting and for Cash Accounting Revenue Items = Short Term Nature (consumed in period) – Income and expenditure – Surplus or deficit is cleared to reserves at the year end Capital Items = Longer Term (consumed over multi- periods) – Fixed assets (land, buildings, equipment, etc) – Balances Carried Forward Each Year (More on this topic in Session 2) 34

5. Asset Valuation Rules (accrual accounting) We will consider: Historical Cost Net Book Value Recoverable amount: – Value in use – Net realisable value And then we will state the normal rule for valuing assets in the accounts ADB Grant No.0133-CAM/Component 1: PFMRD 35

5. Asset Valuation Rules (accrual accounting) HISTORICAL COST NET BOOK VALUE Assets are initially recorded in the books of account at historical cost. Fixed assets are depreciated over their useful life. At the end of each year the asset’s ‘net book value’ is ‘historical cost less accumulated depreciation’. NET BOOK VALUE is the normal valuation of assets in accrual accounts... It is also called the ‘CARRYING AMOUNT’ 36

5. Asset Valuation Rules (accrual accounting) HISTORICAL COST NET BOOK VALUE Example: Cost of vehicle $20,000. Estimated useful life = 5 years Estimated ‘residual’ value after 5 years = $2,000. Annual depreciation (straight line basis) = ($20,000 - $2,000) / 5 = $3,600 per year. Vehicle’s net book value after one year = $20,000 - £3,600 = $16,

5. Asset Valuation Rules (accrual accounting) RECOVERABLE AMOUNT is the higher of (i) VALUE IN USE (ECONOMIC VALUE) The present value of the asset’s remaining service potential – (Often difficult to value, but one method is: Depreciated replacement cost of an asset with the equivalent service potential). or (ii) NET REALISABLE VALUE (FAIR VALUE LESS SELLING COST) The fair (market) value of the asset if it is sold, minus any selling costs. 38

5. Asset Valuation Rules (accrual accounting) WHAT VALUE SHOULD BE USED FOR ASSETS? The general rule is assets should be valued at THE LOWER OF (i) HISTORICAL COST NET BOOK VALUE; and (ii) RECOVERABLE AMOUNT. This is an example of PRUDENCE.... Assets must not be over-valued in the accounts. 39

5. Asset Valuation Rules (accrual accounting) WHAT VALUE SHOULD BE USED FOR ASSETS? Example 1: A ministry has an earth-digging vehicle which originally cost $30,000 and which is being depreciated over 6 years. Two years depreciation, totalling $10,000, has so far been charged. The market value of the vehicle in its present condition is $25,000 and selling costs would be 5%. The cost of buying a new similar vehicle to do the work required would be $36,000. What is the value of the vehicle in the accounts? 40

5. Asset Valuation Rules (accrual accounting) WHAT VALUE SHOULD BE USED FOR ASSETS? Solution: Historical Cost Net Book Value = $30,000 - $10,000 = $20,000. Net Realisable Value = $25,000 – 5% = $23,750. Value in use = $36,000 – 2 x $6000 = $24, Recoverable Amount = $24,000 Value of Asset in the Accounts = Historical Cost Net Book Value = $20,000.

5. Asset Valuation Rules (accrual accounting) WHAT VALUE SHOULD BE USED FOR ASSETS? Example 2: A ministry has some chemicals in its stores which cost $10,000 three months ago. The chemicals have become contaminated and are no longer fit for use in the ministry. However they could be sold to another organisation for $2,000, net of selling costs. What is the value of the fertilizer in the accounts? 42

5. Asset Valuation Rules (accrual accounting) WHAT VALUE SHOULD BE USED FOR ASSETS? Solution: Historical Cost Net Book Value = $10,000 (no depreciation is charged on inventory) Net Realisable Value = $2000. Value in use = $0. 43 Recoverable Amount = $2,000 Value of Asset = Net Realisable Value = $2,000.

5. Asset Valuation Rules (accrual accounting) WHAT VALUE SHOULD BE USED FOR THESE ASSETS? 1.Stock of fertiliser, historical cost $10,000. Cost at today’s price is $11, A short term investment in equities on the Singapore stock exchange. Cost was $30,000, today’s market value is $25, A computer that cost $1,200 one year ago. It is being depreciated over 3 years ($400 per year). It could be sold today at a fair market value of $500. To buy an equivalent computer today would cost $