Debate! In the coming weeks the PFM Blog will present a number of posts on government accounting reforms: the introduction, sequencing and content of accrual-based government accounting standards and how these reforms interact and benefit (or not) the management of public finances. Readers are invited to present their views in the comments section below, or send in posts of their own, or on behalf of their institution. The kick-off to this series is by our colleague Ian Lienert who presents arguments made by two accounting professors: he cites liberally from their article, which raises some fundamental questions about the accruals revolution.
Posted by Ian Lienert
Can governments be run like businesses? If yes, then government accounting standards and techniques would follow those of the private sector. In the 1980s, Australia and New Zealand pioneered the application of business-style accounting practices to all government activities. These two countries believed that it was appropriate to treat government as a business. Since then, business-style accounting practices are advocated for governments around the world, either via the International Financial Reporting Standards (IFRS) or the similar International Public Sector Accounting Standards (IPSAS).
In a somewhat under-reported paper, Alan Robb and Susan Newberry argue that the purpose of government accounting is quite different from than that of private businesses. Government financial activity is not geared to making profits or examining equity positions in balance sheets. Business-style accounting was never devised for governments, nor is it suitable for providing the essential constitutional safeguards or fulfilling governments’ public accountability obligations. The authors urge government accountants to consider carefully the constitutional and political implications of adopting business accounting techniques.
The remainder of this blog excerpts sections of the article “Globalization: governmental accounting and International Financial Reporting Standards” which was published by Oxford University in Socio-Economic Review (2007) 5, 725–754 and available online at http://ser.oxfordjournals.org/cgi/reprint/5/4/725?maxtoshow=&hits=10&RESULTFORMAT=&fulltext=government+accounting&searchid=1&FIRSTINDEX=0&resourcetype=HWCIT The authors are Alan Robb of St. Mary’s University, Halifax, Nova Scotia, Canada, and Susan Newberry of the Faculty of Economics and Business, University of Sydney, New South Wales, Australia.
The authors first examine how New Zealand pioneered the application of business accounting in government. In 1989, New Zealand adopted legislation that required accrual-based budget appropriations and business-sector style accounting throughout the public sector. The first accrual-based financial statements for the central government were prepared for the year ending 30 June 1992. These ‘whole of government’ financial statements use business-style consolidation practices to combine the financial reports of the various parts of government.
Based on their experience, New Zealand’s governmental accounting reformers went on to promote, in international circles, the application and adoption of accounting standards based on business-style accounting, either directly by applying the IFRS that were devised for companies by the International Accounting Standards Board (IASB) or indirectly by applying the IPSAS developed by the International Federation of Accountants (IFAC) as from the 1990s.
The authors appropriately point to some of the ways in which a government is significantly different from a business and therefore the purpose of government accounting must also be significantly different. Parliamentary scrutiny and control of the government’s handling of public finance is a fundamental constitutional convention in all democratic countries. This power of control is crucial because debt incurred by a government is guaranteed in full by the people through the government’s coercive power to tax. Business-style accounting practices were never devised to address such serious consequences of financial mismanagement.
The article argues that business-style accrual accounting and financial reporting is not suitable for application to governments since the underlying purpose of the accounting system is parliamentary scrutiny and control over the executive government’s use of funds. Accrual accounting has some advantages. In particular, it extends the focus of cash accounting by including in financial reports, transactions and events that occurred in the current year even though they have not necessarily involved the receipt or payment of cash. However, accrual accounting shifts the focus away from cash control. It also has other shortcomings, including off-balance sheet financing techniques which are potentially dangerous in a governmental environment of unlimited liability (c.f., the limited liabilities of companies). Careful consideration is therefore required to develop a governmental accounting system that maintains constitutional controls and must address adequately matters of particular concern to governments.
With a balance sheet, an income statement, and a cash flow statement, the structure of private business financial reports suits their activities. Businesses aim at profitable performance and increasing equity and these are items of focus in financial reporting. During the year, there is considerable attention on the components of the income statement through which profit is determined. In contrast, relatively little attention is paid to changes in the balance sheet. Management of the balance sheet tends to be seen as the responsibility of those operating the company; a corporate financial controller is typically granted considerable discretion to manage investments and liabilities. Financial control is, therefore, centered at the management level of a business, albeit within broader policies set by the board of directors. These arrangements are very different in government.
With this background, the authors develop four critiques of the application of business-style accrual accounting to government, notably that:
• Business-style accrual accounting undermines the fundamental constitutional principle of parliamentary control. An accrual-based output budgeting and appropriations structure was adopted in New Zealand, along with a procurement (contracting out) model that makes sense only if all government services were to be purchased from non-government sources. The authors conclude that the accrual-based budgeting and financial reporting practices adopted have shifted the balance of power in favor of centralized controls exercised by the executive government, notably the Treasury (New Zealand’s equivalent to a “ministry of finance”), undermining the Auditor-General’s controller function and reducing parliament’s role.
• Group accounting practices used to produce ‘whole of government’ financial statements override the constitutional separation of powers. In New Zealand, “whole of government” reports include the financial activities of three major groups: (1) Government departments, which includes all central agencies, as well as the courts and offices of parliament; (2) Crown entities—autonomous government agencies that require some government funding but may also impose user fees (e.g., hospitals, universities, public schools); and (3) State-Owned Enterprises (SOEs). Entities in these three sectors must prepare individual financial reports for submission to Parliament. The financial reports of each reporting entity are combined to produce a single financial report for the whole of government. This is in keeping with business-style accounting practices, where the central idea is the dominance of business entities by a central controlling body. However, this accounting practice makes less sense for government accountability. In New Zealand, consistent with the “central controlling body” concept in business accounting, the national treasury was designated as a corporate controller in the 1989 Public Finance Act, casting it on behalf of the executive government as the overall controlling power. This suggests, in the view of the authors, that the courts and offices of parliament should no longer be regarded as counter-balancing powers to the executive government. Instead, they might be regarded as subsidiaries of the executive. This dominance idea conflicts with the constitutional conventions which require the separation and balancing of power among parliament, the executive government and the judiciary.
• Business-style “whole of government” financial reports challenge efforts to monitor the level of public debt. New Zealand adopted a law in 1994 specifying principles of fiscal responsibility. The principles specify the application of any operating surplus to repay debt until debt is reduced to an unspecified ‘prudent’ level. An operating surplus determined using accrual accounting is not necessarily a measure of the net cash inflow and cannot, therefore, be expected to reduce debt. For example, the determination of operating surplus includes unrealized changes in the assessed value of commercial forests. The reported level of public debt is also affected by the accounting policies adopted. Between 1992 and 2002, a ‘modified equity method’ was used when including the financial reports of the SOEs in the “whole of government” financial reports. When the dividend required to be paid exceeds the funds held by the SOEs, the SOE raises debt to pay the dividend. Application of the modified equity method to SOEs resulted in the exclusion of the debt raised by the SOEs from the whole of government reports, while the dividends received from the SOEs were reported in the whole of government reports as investment income and cash inflows. The authors indicate that the combined effect was absurd: while the principles of fiscal responsibility suggest that an operating surplus would reduce public debt, the accounting policy adopted regarding the consolidation of SOEs’ financial reports in the whole of government financial report meant that increases in SOE debt were not reported even though the SOEs directly boosted the reported operating surplus. The authors conclude that whole of government reports prepared using business sector-derived consolidation techniques are not helpful.
• ‘Fair value’ policies to revalue assets and liabilities facilitate the disposal of public assets without parliamentary or public knowledge. The paper cites the example of Transpower, which has sole responsibility for owning and operating New Zealand’s high-voltage electricity transmission grid. In 2003, Transpower sold a portion of the national grid to a U.S. commercial bank, and then leased the operation of the grid back from the bank via the Cayman Islands, a tax haven. There was also an option for Transpower to repurchase the transmission grid after 25 years. This lease-to-service contract is a variant of abusive tax-driven arrangements banned in the United States. The application of fair value accounting policies contributed to the lack of information about this deal in Transpower’s financial reports. In the financial year immediately preceding this transaction, Transpower revalued its transmission assets to the latest ‘fair value’, and then changed its accounting policy back to historical cost, announcing that the carrying amounts of all assets would forthwith be regarded as their cost. When assets are sold, they are removed from the balance sheet and the gain or loss on sale is reported in the income statement. The restatement to fair value meant Transpower reported no loss or gain because the ‘cost’ was approximately equal to the selling price. Neither was there any noticeable change in the total assets reported in Transpower’s balance sheet because the lease-back part of this arrangement resulted in a similar but smaller amount showing up as leased assets. The authors cite two other examples before reiterating that the use of business-style accrual accounting practices should not be accepted as automatically appropriate for application to governments.
In the fourth and final section of the paper, the authors trace how New Zealand accountants were influential in disseminating business-style accrual accounting for governments around the world. In New Zealand, efforts to develop accrual accounting standards specific to the public sector were rejected, with some influential reformers favoring instead the ‘sector-neutral’ approach. The application of business-style accrual accounting was then promoted in international accounting bodies. The paper traces how New Zealanders of the “sector-neutral” school took up international positions, such as the chair of the IFAC’s Public Sector Committee (PSC) or PSC’s technical adviser. In these international accounting bodies, the idea of developing specific standards to govern accounting for the public sector was dismissed as being “extremely expensive and would duplicate much of the work which has already been done in the private sector”.
The article notes that, while those pursuing governmental accounting developments have asserted that the business-style changes to governmental accounting contribute to good governance, such claims should not be accepted at face value. The implications of governments adopting business-style practices require careful consideration. With the IPSAS accounting standards now increasingly being adopted worldwide, their initial development and the eventual intention of merging the IPSAS with IFRS should be understood. Their appropriateness for government purposes should not be assumed.
The authors conclude that the early stages of this business-style governmental accounting development, driven from New Zealand by only a few people, may not have fully thought through the constitutional and conceptual implications.
Robb and Newberry therefore urge public debate on these issues before governments adopt business-style accounting and financial reporting practices as standardized either through IFRS or through IPSAS. Adherence to these standards is now espoused as the epitome of good governance. Although New Zealand is well recognized for its world leadership of these accounting and financial reporting reforms, it that does not mean that other countries should follow without question. Rather, there is a need to scrutinize carefully and learn from New Zealand’s efforts. While the authors do not object to the use of accrual accounting per se, the form of accrual accounting adopted and the uses to which it is put should support democratic principles through the scrutiny and control of public finance.