Andrew Graham Queens University School of Policy Studies 827/2015

Andrew Graham Queens University School of Policy Studies 827/2015
Accounting Concepts Andrew Graham Queens University School of Policy Studies 827/2015 Accounting standards are evolving quickly in the public sector. What is emerging is a set of standards that are intended to bring consistency, comparability and clarity to financial statements and reports. Further, accounting standards are affecting how we think about what government actually is in an era of extended government entities and also the cost of things like capital investments and pensions. More later.

“Accounting is the fairest invention of the human mind.”
- Goethe At first it seems like Goethe was out of his mind when he pronounced these words. Still accounting is one of the most logical (does not mean it's easy) and oldest human invention (more than 7000 years old). The philosophy of accounting is the conceptual framework for the professional preparation and auditing of financial statements and accounts. The issues which arise include the difficulty of establishing a true and fair value of an enterprise and its assets; the moral basis of disclosure and discretion; the standards and laws required to satisfy the political needs of investors, employees and other stakeholders.

"It's not the economy anymore, stupid. It's the accounting.”
Source: Browning, E.S. and Jonathan Weil. "Burden of Doubtful: Stocks Take a Beating As Accounting Worries Spread Beyond Enron." The Wall Street Journal, January 30, 2002, pp. A1. Increasingly we see major gaps in how people and organizations see and count their wealth. Concepts such as leveraging, capital reserves, credit worthiness, deficits and surpluses, let alone the real cost of things are having larger and larger consequences.

The Accounting Module What is accounting Accounting Cycle
Financial & Managerial Accounting GAAP/IFRS Accrual Today Accounting Cycle Accounting Equation Recording Financial Information Financial Statements Tomorrow 1. Who? Who uses the product that Financial Accounting Concepts provide? Decision makers who have a reasonable understanding of Business and Economics. 2. Why? Why do decision makers need Financial Accounting Concepts? The objectives of Financial Accounting Concepts explain decision maker’s needs. a. For credit or investment decisions. b. To analyze cash flows. c. To identify economic resources and the claims on those resources. (To reach these objectives, Financial Accounting Concepts must be Understandable and promote Decision Usefulness.) 3. Where? Where do Financial Accounting Concepts take place? In an environment that contains certain assumptions. a. An economic entity rather than a legal entity. b. Periodicity not to exceed one year. c. A going concern free from the burdens of imminent bankruptcy. d. A monetary unit consisting of the stable United States dollar. 4. What? What constitutes Financial Accounting Concepts? The concepts consist of fundamental financial statement building blocks (elements) and resulting information that contains certain qualitative characteristics. a. The Financial Accounting Elements are defined: 1. Assets 2. Liabilities 3. Equity or Net Assets 4. Investments by and Distributions to Owners 5. Comprehensive Income 6. Revenues 7. Expenses 8. Gains and Losses b. Primary Qualitative Characteristics 1. Relevance (Predictive value, feedback value, and timeliness.) 2. Reliability (Representational faithfulness, verifiability, and neutrality). c. Secondary Qualitative Characteristics 1. Comparability (between entities) 2. Consistency (within an entity’s accounting periods.) 5. How? How are Financial Accounting Concepts implemented? By following Certain principles the concepts are put into practice. a. Historical Cost principle forms the basis for asset recognition. b. Realization principle provides a guide for revenue recognition. c. Matching principle facilitates expense recognition and ultimately income calculation. d. Full disclosure principle enables footnotes to fill in information gaps left by currently required financial statements. 6. When? When should Financial Accounting Concepts modify the principles that form implementation theory found in the answer to the “How” question. Certain modifying conventions answer the “When” question. a. Materiality allows convenience over conventional accounting methods when the difference in treatments is not significant. b. The cost benefit rule maintains that the cost of information should not be greater than the benefit derived. c. Industry practices allow a unique accounting treatment when its implementation presents information that is more useful to decision makers. d. Conservatism provides guidance as to what to do when more than one acceptable method is available. Conservatism says to select the principle that has the least favorable result on the financial report.

The purposes of accounting
Common platform so that we all understand what the numbers mean and what we mean by the numbers – no small feat Public accountability, including information to your political masters – Parliament, Legislature, Board Information to stakeholders – essential in a democracy Demonstrating that revenues have been properly collected and accounted for Showing that assets and liabilities have been properly valued and accounted for So we can know what the money figures mean and follow them.

The purposes of accounting
Provides a consistent year on year picture and basis for comparison. Comprehensive reporting of financial activity Managers properly control the activities of the state/organisation they are responsible for There is accurate preparation of budgets using definitions that are understood and accurate. Successful management depends upon good quality and timely financial information

Sound Accounting Performance Control Audit Budgetary control
Common Basis of Understanding Budgetary control Performance Control Audit Accountability Confidence in the Entity

A History of Accounting
Some scholars claim that writing arose in order to record accounting information. Account records date back to the ancient civilizations of China, Babylonia, Greece, and Egypt. In China, the focus of early financial records was on public administration not business Accounting began when one person had someone else do something for them in exchange of something of value. The very notion of tokens suggests the need to count them, record them, keep them safe. Did you know that cost accounting is mentioned in the Bible? Luke 14:28 says, “Suppose one of you wants to build a tower. Will he not first sit down and estimate the cost to see if he has enough money to complete it?"

The rulers of these civilizations used accounting to keep track of the cost of labour and materials used in building structures like the great pyramids. The need for accounting has existed as long as there has been activity involving money or resources.

An Early iPad: Accounts Tablet with Cuneiform Script, circa 2400 BC
by Mesopotamian Bookkeeper This is really a complex token information system. Still in use in Queen’s Financial Department.

Accounting developed further as a result of the information needs of merchants in the city-states of Italy during the 1400s. The monk Luca Pacioli, a mathematician and friend of Leonardo da Vinci, published the first known description of double-entry bookkeeping in 1494. Luca Pacioli ( ), the wandering Franciscan monk and mathematician, was a contemporary of Columbus and a friend and collaborator of Leonardo da Vinci. His seminal work, Summa de Arithmetica, Geometrica,Propotioni et Proportionalite, published in 1494, contained a section, "Particularis de Computis et Scripturis" (Details of Accounting and Recording) that described "the system used in Venice". This was four decades after the Gutenberg invention of movable type and printing centers all over Europe allowed Pacioli's Summa to be translated, printed, and spread across the continent. Pacioli's Summa is the first known complete description of double entry bookkeeping. Three books were to be used: memorandum book, journal, and ledger. Journal entry postings from the memorandum book required debits on the left and credits on the right. Although many currencies existed, Summa required that all entries be translated to a single monetary unit. A trial balance was necessary when the books were closed. The balances from the profit and loss account were entered in the capital account. In other words, Summa described a system remarkably like modern bookkeeping. The Summa was translated into Dutch, German, French, Russian, and English and Pacioli's system spread across Europe. For this reason Pacioli is the "Father of Accounting". Relatively little progress was made beyond Pacioli's Summa for several generations. In fact, it is difficult to identify pioneering accountants before the Industrial Revolution.

In the Industrial Revolution of the nineteenth century, the growth of corporations spurred the development of accounting. The corporation owners—the shareholders—were no longer necessarily the managers of their business. Managers had to create accounting systems to report to the owners how well the company was performing

What is Accounting? Accounting and its boundaries are dynamic in nature, always responding to new needs as they arise. The boundaries of accounting are fuzzy and changeable as a result Accounting is both an art and a science that involves judgment and molding information to the demands of the situation while being to claim objectivity and independence. But, be warned. Accounting is not an exact science as its image might sometimes suggest. Accounting data is not absolute or concrete. Considerable amounts of judgment and estimation are necessary to develop the specific accounting measurements that are reported during a particular month, quarter, or year (e.g., how much pension expense should be reported now for the future benefits that are being earned by employees now, but the amounts will not be known with certainly until many years to come?). About the only way around the problem of utilizing estimation in accounting is to wait until all facts are known with certainty before issuing any reports. However, by the time any information could be reported, it would be so stale as to lose its usefulness. Thus, in order to timely present information, it is considered to be far better to embrace reasonable estimations in the normal preparation of ongoing financial reports.

What is Accounting? Identifies, measures and communicates financial information Focuses on economic entities Provides this information to interested parties, these being the users of financial information Provides this information with the purpose to assist the organization in reaching its stated goals Enhances the understanding of what is being measured as well as providing information for decision making. Bookkeeping is the practice of recording financial information – the entry and reporting. Accounting ups the game in that it involves the creation of the structure for that recording – the chart of accounts and rules of recognition as well as the ways in which the information will be used in a predicatiable and credible way.

Basic Functions of Accounting
. Interpret and record financial transactions Classify transactions into useful categories and reports Summarize and communicate information to those who need it

How it works NOT GAAP/IFRS GAAP/IFRS Economic Entity
Financial Information Identify Measure Communicate Financial Statements Balance Sheet Income Statement Cash Flows Net Debt Note Disclosures Management Information CEO’s Briefings Performance Reporting Regular internal reports Exercise: who or what groups would be interested in Financial Statements and who or what groups would be interested in Management Information? 5 Minutes. GAAP/IFRS NOT GAAP/IFRS

Accounting View of Time
While we say that most accounting information is retrospective, that is not really right. However, as we report information that has a future orientation, we can increase both uncertainty and risk, let alone recklessness. From, Gouws, 2003, Accounting’s Time Paradigm

Accounting for Whom? Managerial Accounting meetings the internal needs of the organization. Financial Accounting meetings the needs of external stakeholders.

Contrasting the Accounting Viewpoint with the Budgeting Perspective
Although the basic principles of accounting apply in government as in commerce, certain features of governmental accounting make its pattern quite different from that of the typical set of commercial accounts. The underlying differences should be understood to avoid confusion that sometimes results in attempting to apply, with little or no modification, conventional commercial accounts to a governmental unit. The distinctive features of governmental accounting are the reflection of the essential difference in the method of financing governmental operations as contrasted with business undertakings. Private business must obtain its capital from voluntary investments made with the hope of deriving an increment. Private business, then, to survive must realize a profit over and above the cost of the commodities or services it sells in order to preserve its capital and to return a profit to its proprietors or shareholders. Accordingly, commercial accounts are focused upon "net profit"-the amount gained over costs, the difference between income and expenses-and "net worth"-the current value of the invested capital, the difference between assets and liabilities. Government furnishes services to all directly or indirectly and levies taxes or provides other revenue measures to meet the cost of those services. Governmental accounting usually has no "net profit" to report. Particular sources of revenue generally have no direct relation to particular items of expenditures. An excess of revenues over expenditures is not "net profit" and is not necessarily an indication of good financial policy in the government unit. Capital invested in government by its citizen-proprietors (represented by such capital assets as land, buildings, highways, and equipment) is investment in future public services. "Net worth," if that term can be employed, of a governmental unit has an entirely different significance from "net worth" of a commercial enterprise. Another difference is the necessity that the governmental unit account its authorizations to incur expenditures. It is a long established principle of free government that public moneys be expended only as authorized by the legislative body. Hence, the governmental unit must maintain budgetary accounts in which are reflected the authorization for expenditures. While large commercial organizations are coming more and more to establish budget procedures somewhat similar to those employed by government, the budget and the accounts essential to its operation are still largely a distinctive feature of governmental accounting. Still another peculiar characteristic of governmental accounting is the employment of separate funds. A business enterprise, even the largest and most extensive, usually is engaged in activities closely interrelated with the ultimate objective of profit in one particular field. The governmental unit, on the other hand, is engaged in an ever-growing number of operations and activities which are quite unrelated to each other. Particular sources of revenue or income often are dedicated to use for a particular phase of the government's operations. The accounts must segregate these specially dedicated resources and isolate them from all other transactions in a separate "fund." While a business concern can maintain a single set of accounts for all of its transactions, a governmental agency must maintain a number of independent sets of accounts, one for each "fund." From James L. Chan, A Comparison of Government Accounting and Business Accounting,

Managerial Accounting
Planning Control Reporting Future Present Past

Managerial Accounting Information
Quarterly reports Income/loss statements Cash forecasts Budget/actual reports Cash at hand reports Activity reports Variance reports

Financial Management External financial reporting requirements by law
Generally set as a matter of governmental policy Highly unlikely that it will be used actively within the organization Senior levels of management, however, and also at the political level, the organization has to be able to explain and defend the financial reports as they are made public

Financial Accounting uses formally defined financial statements– More to Follow
Balance Sheet: Statement of Financial Position Statement of Cash Flows Income Statement: Statement of Comprehensive Financial Results Statement of Change in Net Debt Notes to Statements

Managerial and Financial Accounting
Both forms of accounting information have to derive from the same basic financial information, They use the same Chart of Accounts and the same financial accounting technology that is in use in the organizations. At times, internally reported information has to be reconciled with external reporting. A Chart of Accounts is a Listing of All of the Accounts of an Organization A Chart of Accounts represents how financial information is gathered, stored, combined and used within a general ledger The objective of the Government-wide Chart of Accounts (COA) is to establish the accounts and codes that are required to report the financial transactions of the Government of Canada. The various classifications provide the framework for identifying, aggregating, and reporting the financial transactions prescribed by the central agencies. The Government-wide COA describes the standard classifications, as well as the accounts and codes, that are used for accounting and reporting.

GAAP/IFRS – ACCOUNTING STANDARDS
In Canada, GAAP is what is known as principles-based while in the US it is rules-based. What is now emerging is a new international standard – IFMS – which is also more principles-based. However, the original Canadian public sector GAAP was created by CICA in partnership with Queen’s University in 1939.

Generally Accepted Accounting Principles (GAAP)
Provide guidance on the creation of financial reports Encompass broad principles and conventions of general application, as well as rules and procedures that determine accepted accounting practices at a particular time. Set out by the Public Sector Accounting Board Complex system of guidance to public sector and not-for-profit entities

Canada’s Move to IFRS IFRS is a comprehensive set of high quality accounting standards issued by the International Accounting Standards Board (IASB) Accepted or required in over 100 jurisdictions around the world. Consistent with Canadian GAAP in that IFRS: Consists of a principles-based set of standards Has many choices available for application Key point for public sector is that we have GAAP standards created by a public-sector focused standard setter

Accounting Principles
Entity Money Denominator Objectivity Accrual Matching Costing Conservatisms Going Concern Materiality Consistency Full Disclosure

Basic Accounting Principles
Entity Concept Requires that you define the organizational component for which you are trying to account The unit stands apart from other organizations and individuals as a separate economic unit From an accounting perspective, sharp boundaries are drawn around each entity so as not to confuse its affairs with those of other entities Need to know what is being taken into account on a consistent basis Accounting principles are by no means detailed - consider them instead to be general guidelines similar to the Ten Commandments. Within these principles, only one (the cost principle) is being seriously challenged. All of the others have stood the test of time, and will likely continue to be the guiding principles upon which accounting activities will be based in the future.You have to know what is in your financial structure and what is not. In business, this is important to separate the individual from the business. In government it is important to understand just what you are looking at, responsible for and reporting on. Remember not all the resources that you need and will use are necessarily in your unit’s budget and possibly not even in your Ministry or Department. However, for financial clarity, those resources that you actually are responsible for, have some authority to spend and must account for should be. The economic entity reports all assets, liabilities, revenues and expenses it controls. Thus it requires full consolidation of all entities controlled Unless you have full consolidation, the true measure of financial position and performance is not shown. However, for government, where does it end. What about entities that are under very heavy regulatory control?

Money Denominator/Stable Monetary Unit Concept Requires that all items included on the financial statements be measurable in dollar (yen, Euro) terms Should be stable over time Cannot record non-quantifiable items

Objectivity/ Reliability Principle Require that values be based on an objective valuation of resources Objective evidence means that different people looking at the evidence will arrive at the same values for the transaction Reliable data are verifiable Third party sources, e.g. bank statements, receipts Verifiable by an independent observer The reliability principle is particularly difficult to meet when you are recording a reserve, such as an inventory obsolescence reserve or an allowance for doubtful accounts, since these reserves are essentially opinion-based. In these cases, it is particularly important to justify your actions with a detailed analysis of the reasons for the reserve. This is frequently based on verifiable historical experience with similar transactions, and which you expect to be repeated in the future. From a practical perspective, you should only record those transactions that an auditor could reasonably be expected to verify through normal audit procedures.

Accrual Concept/ Recognition Revenues are recorded when the organization is entitled to them Expenses are recorded when resources are used to generate revenues When properly implemented, the accrual principle allows you to aggregate all revenue and expense information for an accounting period, without the distortions and delays caused by the cash flows arising from that accounting period.

The Matching Principle
Basic Accounting Principles The Matching Principle The matching principle requires that revenue and expenses be accrued; that is, they are recognized as they are earned or incurred, not just when they are received or paid or when they affect an appropriation Requires the use of accrual basis of accounting Long-term assets are assumed in the public sector to provide benefits over their lives and as such it is not revenues that are matched but depreciated value against results The costs of doing business are recorded in the same period as the revenue they help generate, regardless of when the money is actually paid. Also called accrual basis accounting Example: A company orders merchandise on credit and has 30 days in which to pay. This purchase is recorded immediately, even though no cash has been paid. With minor exceptions, departments do not generate major amounts of non-tax revenue but are funded through appropriations. As such, the matching principle must take on a slightly different interpretation. Consequently, revenues should be recognized when the goods and/or services have been rendered and expenses should be matched to program delivery outputs of services to the public. For example, in the case of tangible capital assets, a systematic and rational allocation policy is used to approximate the matching principle. This type of expense recognition involves making assumptions about the benefits that are being received as well as the cost associated with those benefits. The cost of a long-lived asset is allocated over the accounting periods during which the asset is used because it is assumed that the asset contributes to the generation of program outputs throughout its useful life. 3

Cost Convention: Mix of Ways to Measure Different measurement principles in different areas Old norm of historic cost disappearing Items such as property, plant and equipment usually accounted for based on cost when acquired, less depreciation Here is what the Province of Ontario says about cost of tangilbe capital assets: “Tangible capital assets are recorded at historical cost less accumulated amortization. Historical cost includes the costs directly related to the acquisition, design, construction, development, improvement or betterment of tangible capital assets. Cost includes overheads directly attributable to construction and development, as well as interest related to financing during construction. Estimated historical cost was used to record existing tangible capital assets if actual cost was unknown when the Province first implemented tangible capital assets accounting. Tangible capital assets, except land, are amortized over the estimated useful lives of the assets on a straight-line basis.” Concept of fair market value plays heavily here. IFRS currently allow either the historical cost basis or a method where capital assets are regularly revalued at fair value. The obvious problem with the cost principle is that the historical cost of an asset, liability, or equity investment is simply what it was worth on the acquisition date; it may have changed significantly since that time. In fact, if a public entity were to sell its assets, the sale price might bear little relationship to the amounts recorded on its balance sheet. Thus, the cost principle yields results that may no longer be relevant, and so of all the accounting principles, it has been the most seriously in question. Thus, we see the emergence of Fair Market Value. The cost principle is not applicable to financial investments, where accountants are required to record them at their fair values at the end of each reporting period. Using the cost principle for short-term assets and liabilities is the most justifiable, since an entity will not have possession of them long enough for their values to change markedly. The cost principle is less applicable to long-term assets and liabilities. Though depreciation, amortization, and impairment charges are used to bring them into approximate alignment with their fair values over time, the cost principle leaves little room to revalue these items upward. If a balance sheet is heavily weighted towards long-term assets, as is the case in a capital-intensive industry, then there is a greater risk that the balance sheet will not accurately reflect the actual values of the assets recorded on it. The cost principle implies that you should not revalue an asset, even if its value has clearly appreciated over time. This is not entirely the case under Generally Accepted Accounting Principles, which allows some adjustments to fair value. The cost principle is even less applicable under International Financial Reporting Standards, which not only permits revaluation to fair value, but also allows you to reverse an impairment charge if an asset subsequently appreciates in value. Because historical cost information may be incomplete there are three alternative methods that can be used to estimate the historical cost of a TCA: • Discounted reproduction cost • Discounted replacement cost • Discounted appraisal value Different values are used to support different decisions. For example, fair value is generally used when selling an asset. Replacement value may be used for insurance purposes or in a budgeting exercise to estimate financing requirements. Historical cost is used for accountability and costing. Canada Revenue Agency (CRA) lists the following working definition in its on-line dictionary: Fair market value generally means the highest price, expressed in dollars, that a property would bring in an open and unrestricted market between a willing buyer and a willing seller who are both knowledgeable, informed, and prudent, and who are acting independently of each other.[2]

Items such as investments are measured at fair market value at date of statement Others are measured at amortized costs or other bases No simple answer Often driven by practical considerations: cost of measuring and its utility and relenace Here is what the Province of Ontario says about cost of tangilbe capital assets: “Tangible capital assets are recorded at historical cost less accumulated amortization. Historical cost includes the costs directly related to the acquisition, design, construction, development, improvement or betterment of tangible capital assets. Cost includes overheads directly attributable to construction and development, as well as interest related to financing during construction. Estimated historical cost was used to record existing tangible capital assets if actual cost was unknown when the Province first implemented tangible capital assets accounting. Tangible capital assets, except land, are amortized over the estimated useful lives of the assets on a straight-line basis.” Concept of fair market value plays heavily here. IFRS currently allow either the historical cost basis or a method where capital assets are regularly revalued at fair value. The obvious problem with the cost principle is that the historical cost of an asset, liability, or equity investment is simply what it was worth on the acquisition date; it may have changed significantly since that time. In fact, if a public entity were to sell its assets, the sale price might bear little relationship to the amounts recorded on its balance sheet. Thus, the cost principle yields results that may no longer be relevant, and so of all the accounting principles, it has been the most seriously in question. Thus, we see the emergence of Fair Market Value. The cost principle is not applicable to financial investments, where accountants are required to record them at their fair values at the end of each reporting period. Using the cost principle for short-term assets and liabilities is the most justifiable, since an entity will not have possession of them long enough for their values to change markedly. The cost principle is less applicable to long-term assets and liabilities. Though depreciation, amortization, and impairment charges are used to bring them into approximate alignment with their fair values over time, the cost principle leaves little room to revalue these items upward. If a balance sheet is heavily weighted towards long-term assets, as is the case in a capital-intensive industry, then there is a greater risk that the balance sheet will not accurately reflect the actual values of the assets recorded on it. The cost principle implies that you should not revalue an asset, even if its value has clearly appreciated over time. This is not entirely the case under Generally Accepted Accounting Principles, which allows some adjustments to fair value. The cost principle is even less applicable under International Financial Reporting Standards, which not only permits revaluation to fair value, but also allows you to reverse an impairment charge if an asset subsequently appreciates in value. Because historical cost information may be incomplete there are three alternative methods that can be used to estimate the historical cost of a TCA: • Discounted reproduction cost • Discounted replacement cost • Discounted appraisal value Different values are used to support different decisions. For example, fair value is generally used when selling an asset. Replacement value may be used for insurance purposes or in a budgeting exercise to estimate financing requirements. Historical cost is used for accountability and costing. Canada Revenue Agency (CRA) lists the following working definition in its on-line dictionary: Fair market value generally means the highest price, expressed in dollars, that a property would bring in an open and unrestricted market between a willing buyer and a willing seller who are both knowledgeable, informed, and prudent, and who are acting independently of each other.[2]

Conservatism/Prudence Says that you should anticipate losses but not gains Need to give due regard for risk and risk management Role of prudence in predicting and reporting The conservatism principle is the general concept of recognizing expenses and liabilities as soon as possible when there is uncertainty about the outcome, but to only recognize revenues and assets when they are assured of being received. Thus, when given a choice between several outcomes where the probabilities of occurrence are equally likely, you should recognize that transaction resulting in the lower amount of profit, or at least the deferral of a profit. Under the conservatism principle, if there is uncertainty about incurring a loss, you should tend toward recording the loss. Conversely, if there is uncertainty about recording a gain, you should not record the gain. The conservatism principle can also be applied to recognizing estimates. For example, if the collections staff believes that a cluster of receivables will have a 2% bad debt percentage because of historical trend lines, but the sales staff is leaning towards a higher 5% figure because of a sudden drop in industry sales, then use the 5% figure when creating an allowance for doubtful accounts, unless there is strong evidence to the contrary.

Going Concern Concept Assumes that the organization will continue in operation Assumes the business will remain in operation long enough to use existing assets for their intended purpose This assumption allows you to defer the recognition of some expenses to later periods (such as depreciation), when a business will presumably still be in operation. Bankruptcy values may be lower Amortization policies are only justifiable and appropriate if we assume continuity of the department. While the going concern principle may be of less significance in the public sector, the long-term sustainability of key programs is of increasing relevance. Because the financial consequences of many decisions will only become clear years or even decades into the future, prospective financial information covering lengthy time horizons may be necessary for accountability and decision making purposes. This has implications for the scope of financial reporting By making this assumption, the accountant is justified in deferring the recognition of some expenses until a later period, when the entity will presumably still be in business and using its assets. Amortization usually refers to spreading an intangible asset's cost over that asset's useful life. For example, a patent on a piece of medical equipment usually has a life of 17 years. The cost involved with creating the medical equipment is spread out over the life of the patent, with each portion being recorded as an expense on the company's income statement. Depreciation, on the other hand, refers to prorating a tangible asset's cost over that asset's life. For example, an office building can be used for a number of years before it becomes run down and is sold. The cost of the building is spread out over the predicted life of the building, with a portion of the cost being expensed each accounting year.

Materiality -1 Reporting only needs to contain the level of detail necessary for decision making Don't need to be accurate to the penny or even the nearest $1,000 in some cases but in some cases you do. Depends of risk and interests of the users of the information. A piece of information is material if it would affect a decision maker’s decision The materiality principle is the magnitude of an omission or misstatement in an entity's financial statements that makes it probable that a reasonable person relying on those financial statements would have been influenced by the omitted information or made a different judgment if the correct information had been known. Under generally accepted accounting principles (GAAP), you do not have to implement the provisions of an accounting standard if an item is immaterial. This definition does not provide definitive guidance in distinguishing material information from immaterial information, so you must exercise judgment in deciding if a transaction is material.

Materiality - 2 In determining whether an item or an aggregation of items is material, the following factors should be considered: the size of the item; nature of the item - for example, irregularities or illegal acts by departmental personnel would be material even if the amounts were small; and, cumulative effects - the total effect of individual amounts on the financial statements taken as a whole The materiality principle is the magnitude of an omission or misstatement in an entity's financial statements that makes it probable that a reasonable person relying on those financial statements would have been influenced by the omitted information or made a different judgment if the correct information had been known. Under generally accepted accounting principles (GAAP), you do not have to implement the provisions of an accounting standard if an item is immaterial. This definition does not provide definitive guidance in distinguishing material information from immaterial information, so you must exercise judgment in deciding if a transaction is material.

Consistency Principle Once you follow an accounting principle or method, you should continue to do so in the future. This gives you more consistent reported results. It also ensures an apples-to-apples comparison Any changes in the accounting rules, standards of recognition, costing conventions, etc., need to be recorded in the notes to financial reports and, at times, previous financial statements may have to be restated to re-level the playing field.

Full Disclosure Principle If any information is important to an understanding of a financial report or may have an affect on the reader of the report or a decision-maker, it should be disclosed. Source of the many notes that go along with financial reports.

Accounting Principles: Constraints on Providing Financial Information
Benefits must exceed costs Benefits of the information produced should exceed the costs of producing the information Financial (and all managerial) information is not costless

“We complied with all the required accounting standards…
“We complied with all the required accounting standards…..” and $4 still buys a Skinny Mocha, but not much more…. Standards a set of pretty general principles that dictate the preparation of financial statements Many alternatives often acceptable under GAAP/IFRS Role of recognition Degree of interpretation Acceptable alternatives, from a set of less than perfect accounting treatment available Conforming to GAAP/IFRS does not mean that the information provided is good, but it is the start

This is what you want from your external auditor.
“In my opinion, these financial statements present fairly, in all material respects, the financial position of the Government as at March 31, 2009 and the results of its operations, the changes in its net debt and its cash flows for the year then ended in accordance with the stated accounting policies of the Government set out in Note 1 to the financial statements, which conform with Canadian generally accepted accounting principles. As required by section 6 of the Auditor General Act, I report that, in my opinion, these policies have been applied on a basis consistent with that of the preceding year. “

Cash and Accrual Accounting

Why Accrual? 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.

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).

Example Government purchases a piece of equipment costing $100,000 on April 1, The equipment is expected to last for 10 years and to contribute to operations evenly over that period. Under accrual, the government would record the $100,000 cost as an asset in the fiscal year it was purchased (March 31, 2015) and then record $10,000 of amortization expense for each year that it was used. Under the cash method of accounting, the government would have recorded, in the 2015 fiscal year, the entire cost ($100,000) as an expenditure for that year. In addition, the accrual method continues to track the outstanding balance of the asset until it is sold or removed from service. The former basis, however, would not have reported that any balance was remaining.

Example So the accounting for this example would be

Another Example On March 31, 2013, government requires environmental remediation of a toxic site following a regulatory ruling and it is estimated to cost $100,000 over the next 10 years. Work begins July 31, 2013 and costs $10,000 that fiscal year. Under accrual, the government would record the entire $100,000 cost of the clean-up in the fiscal year it was identified (March 2013) Under cash, the government would have recorded, in the fiscal year, only the amount paid toward the clean-up that year -$10,000. In addition, the accrual method continues to track the outstanding balance owing regarding the clean-up after the initial $10,000 is paid. The former basis, however, would not have reported that any balance was remaining.

Another Example – Impact on Financial Statements

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 Under accrual basis, more difficult hide liabilities and pass current cost to future generations

Why to Not Do This? Smaller public sector organizations do not need to do this – I mean small 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.

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 This does not mean you do not record major cash movements. You do that in the Statement of Operations/Cash Flows

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 mentality

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. In 2006, the Auditor General identified the following advantages of introducing full accrual accounting in government finances.12 1. Reflects full scope and size of government’s: • resources (all financial and non-financial assets) • obligations (all liabilities) • costs (resources consumed) 2. Greater focus on consumption of resources 3. Better link of the results to the resources used to achieve them 4. Fuller information available to government for improved decision making • more focus on assets (maintenance requirements, replacement policies, buy vs. lease) • more attention to managing liabilities • more focus on full cost of programs and services

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

Squaring Accrual with the Westminster Model of Government
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. Having both cash (annualized) budgets and accrual accounting means frequent reconciliations

Cash Treatment of Capital
Buying a computer system at a cost of $2.5 M, with a payment spread over two years. Capital Item New Computer System - Expenditure 1,750,000 750,000 What is recorded here is the movement of cash to pay for the system

Accrual Treatment of Capital
Item Income Statement Cash Reduction 1750,000 750,000 Accounts Payable Inventory Increase 2,500,000 Computer System – annual use/depreciation 500,000 Inventory (Asset)Valuation 2,000,000 1,500,00 1,000,00

Accrual Treatment of Capital
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. More to follow next lecture.

Recognition of Long Term Assets & Liabilities
Public Debt Pension Obligations Contingent Liabilities Tax revenues recorded in period in which they are earned. Contractual agreements, e.g. sick leave, leave credits

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

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?

Article ordered from supplier No effect
Event Cash Basis Accrual Basis Article ordered from supplier No effect Article arrives in Inventory Increase accounts payable and Increase Inventory Article is used Decrease inventory and Decrease fund balance Article is paid for Decrease cash Decrease fund balance Decrease accounts payable

Expense: Expenses represent the cost of goods and services consumed or used up 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 In broad terms, expenditure that does not include expenses is long-term, while expenses result in benefits that are likely to be fully utilized in the period in which they are incurred.

Significant Definitions and Concepts in General Accounting
Expenditure: An expenditure is the amount of cash paid for goods and services. May be to purchase an asset or reduce a liability.

Example of the difference between expenditure and expense
A regional office of Ontario Transport makes an expenditure of $255,500 to purchase snow plowing equipment. The expenditure occurs on a single day and the equipment is placed in service. This will appear on the Statement of Cash Flows. Assuming the equipment will be used for seven years, the cost of the equipment will be reported as depreciation expense of $100 per day for the next 2,555 days (7 years of service with 365 days each year). This depreciation expense will appear on the Statement of Operations and then on the Balance Sheet.

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

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

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

The Value of Accounting is achieved if...
It met its primary purpose of accountability, transparency, and usefulness, particularly to stakeholders: There is an analysis of financial performance, rather than a list of activities. One can assess and document performance against targets or other bases for comparison. Provide and review trends in financial and non-financial performance (e.g., “triple-bottom-line reporting”). Integrity of financial data was upheld - compiled under an independently determined and internationally recognized financial reporting framework, and independently audited against international standards

MacKay says gap just accounting.
He’s right, of course. But where he is not right is there is no one accounting, just the need for a common set of definitions. He claims that the Budget Office ‘needlessly’ added such incidental costs as staff. Interesting to see this sucker fly without that ‘incidental’ resource. MacKay says gap just accounting.

“Books and auditing of accounts, instead of exposing frauds, only conceal them; for prudence is never so ready to conceive new precautions as knavery is to elude them.” Rousseau, J.J., The Social Contract and Discourses (ed. G.H. Cole), 1993, London, Dent, p. 154

Andrew Graham Queens University School of Policy Studies 827/2015

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Andrew Graham Queens University School of Policy Studies 827/2015

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