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April 09, 2010

Accrual Accounting: Is it “all or nothing”?

Posted by Julie Cooper and Holger van Eden 

Government accounting reform might not seem the most eye-catching item on developing countries’ agendas. Nevertheless it is important. To achieve economic growth and social development, good governance and the capacity to implement policy is essential. For that well-functioning PFM systems are necessary, and accounting systems are an integral part of those PFM systems — although some of our colleagues here at the IMF might not all agree on the prominence of government accounting in well-functioning PFM systems.

The link between government accounting reform and national development is one of a long and perhaps tentative causal chain, and is rarely addressed in academic or practitioner literature. James Chan in a paper published sometime ago, however, provides a convincing case for the importance of government accounting reforms, but also criticizes the lack of support provided by the accounting profession for the needs of developing countries. Concretely, Chan makes a rather strong case for intermediate accounting standards between cash and accrual basis accounting standards.1 [Download Chan2006IPSASGAFDC]

Until very recently the doctrine of accounting has largely been ignored in the discussion of economic development, or at least scoffed at as mere bean-counting with little or no connectivity with the achievement of the government policy agenda. However, with the increased understanding that transparency and accountability are at the core of good governance, the interest in government accounting has surged in recent years. Ten years ago the Fiscal Affairs Department (FAD) had very few if any professional accountants amongst its staff. The situation in many budget and treasury offices around the world was not much different. Now the tide is turning: in FAD and many Ministries of Finance the number of accountants has grown substantially. But is change happening too fast, perhaps?

For example, the pressure is on for developing nations to adopt and implement accrual accounting. There is no doubt that, when properly implemented, accrual accounting is a vast improvement on cash accounting. It provides better information to managers about the use of resources, not just cash. It also promotes accountability and transparency through the adoption of strict accounting standards that reduce or eliminate the ability for “creative” accounting.

However, too often developing nations lack the capacity (or commitment) to implement accrual accounting in accordance with internationally recognized standards of best practice. This leads to the adoption of selective accrual accounting practices most commonly termed modified accrual accounting or modified cash accounting. The problem with this is that there are no internationally accepted accounting practices or standards that support either modified accrual or modified cash accounting. This means that instead of enhancing the integrity and usefulness of the financial data it lessens it. This may in fact decrease accountability and transparency – the very essence of good governance. As espoused by Dr. Chan there is a strong link between government accounting and the success of implementing government policy objectives.

To enjoy the full benefits of accrual accounting which provides greater transparency, accountability and improved data integrity, changes are necessary to public sector managerial arrangements. Accrual accounting is a management tool and not an end in itself. It is a tool for decision makers that provide information which is important in helping managers improve their decisions. Under accrual accounting systems there is a shift away from traditional performance measurement where accountability is focused on managers’ stewardship of public cash resources and on compliance within strict detailed appropriations. Accrual accounting systems require managers to be held accountable for assets and liabilities and to report on their financial position, balance sheet and cash flows. Managers will be required to report on commitments, contingencies, and accounting practices. As such governments need to discuss what the new accountability requirements for public sector managers will be before moving to full accrual accounting. These requirements have quite fundamental consequences for traditional PFM systems and takes time to develop and implement.

However, during the transitional period from cash to full accrual accounting, governments can benefit from incremental changes to strict cash accounting such as the recognition of financial assets and liabilities on an accrual basis. These incremental changes can be very helpful to achieving the fundamental institutional changes of management. The problem is current international accrual accounting standards, such as IPSAS, do not provide any guidance to cover the transitional period, which can easily be a period of decades given the complexities of moving to full accruals. This begs the question, could there be intermediate, internationally accepted accrual accounting standards to cover the transitional period and what would these include? Should there be several stages or degrees of accrual accounting as suggested in Dr. Chan’s paper (see below)?


Assets Recognized

Liabilities Recognized

Mild accrual

Current financial resources

Current liabilities

Moderate accrual

Long-term financial resources in addition to current financial resources

Long-term liabilities in addition to current liabilities

Strong accrual

Capital resources in addition to current and long-term financial resource

Contingent liabilities in addition to current and long-term liabilities

The issues that arise from a lack of transparency, accountability and data integrity that comes about with the adoption of unregulated modified accrual or modified cash accounting need to be addressed by the accounting profession. There is an urgent need to explore the options to provide accounting standards that are useful to developing nations in achieving their development goals which also better assists them in their transition from cash to accrual accounting.

1James L. Chan, "IPSAS and Government Accounting Reform in Developing Countries," in Accounting Reform in the Public Sector: Mimicry, Fad or Necessity, edited by Evelyne Lande and Jean-Claude Scheid (France: Expert Comptable Media, 2006), pp. 31-42.


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Shouldn't the IMF be the champion of an international standard of accrual accounting? As the authors in this blog point out, effective governance can not exist with out effective financial management. With the money developing countries recieve from organisations like the IMF, it's no secret that there is plenty of waste in these nations due to weak financial management and accountability.

I like the candidness in the article admitting the fact that public sector accounting was largely ignored up until recently by most including the IMF! Well, accountants themselves are no less responsible for this. IPSAS (cash or accrual) are the product of this century – no standards existed for public sector accounting until the end of last century!

I, however, do not agree with the notion that accrual accounting financial statements leads to better accountability and governance – just look at what happened to Enron or Lehman Brothers in the private sector. These organizations prepared accrual-based US GAPP compliant financial statements which masked the realities of what was going on. We will do ourselves a great disservice if we were to tout that accrual accounting provides “greater transparency, accountability and improved data integrity” as our USP to bring about changes in government accounting practices around the world. I strongly believe that we will have to be modest in raising expectations of policy makers by citing real advantages of accrual accounting – better management of liabilities and debt and improved monitoring of assets. I would advise against linking accounting and accountability (though it is true that without accounting there will be no accountability, it is still ill-advisable to say that accounting ensures accountability!).

I would also like to draw your attention to the fact that IPSAS do have transitional provisions to care of situations where governments decide to move to full accrual accounting – in a way, these transitional provisions provide some guidance when moving from cash to accrual. However, it is a moot point whether there is a need for separate standards for in between cash and accrual bases realizing that many countries neither follow pure cash or full accrual system.

The missing link between accounting and accountability and the missing link very often in transition processes between cash to accruals is the quality of external audit. Are supreme audit institutions in developing countries ready to provide a professionally sound and independant opinion on accrual based public accounts? Enron and Lehman Brothers pointed also to a lack of sound and independant audit. The new interest in accounting and in accrual accounting in particular in technical assistance in PFM and in development work should be accompanied with an interest in developing capacity in supreme audit institutions.

I have a couple of difficulties with the approach suggested by Julie and Holger. First, cash-based accounting and accrual-based accounting have a relatively clear and unambiguous conceptual basis. But "modified cash" and "modified accrual" accounting have no such basis. Their definition is to a large degree arbitrary, depending on which of the many possible adjustments to the cash or accrual concept are preferred. What degree of modification to the cash or accrual standard is deemed desirable or acceptable? Views can and do differ widely on this. There are many available stopping points on the road from cash to accrual, and none are necessarily better or worse than any other. It would be extremely difficult for standard setters to agree among themselves on what constitutes an appropriate approach. While there was some discussion of moving in this direction by the Public Sector Committee of IFAC (IPSASB's predecessor) ten years or so ago, I suspect that this difficulty was paramount in persuading standard setters to continue working with the much more objective concepts of cash and accrual.

Second, accounting standards have already been developed by IPSASB for many of the individual "adjustments" that Julie and Holger recommend -- for example, to record financial assets and liabilities in the government's balance sheet. So if govenment X wants to develop its financial reporting beyond the narrow cash-based standard in this way, it has all the necessary accounting tools at its disposal. The issue raised by Julie and Holger would appear to be a straw man in this regard.

The implementation of accrual accounting in government is a complex reform initiative. It demands a high degree of expertise and commitment from ministries of finance to be implemented as a useful tool for decision making and budgetary accountability. The existing accrual accounting standards developed by the International Public Sector Accounting Standards Board (IPSASB) provide useful guidance for those countries that have considerable government accounting capacity and are wishing to commit to the long haul in adopting accrual accounting in its entirety. Unfortunately, many governments, even those that are seeking to or in fact have legislation demanding the adoption of accrual accounting either lack the capacity or commitment to implement accrual accounting in the form of a one-off major reform initiative. The end result in many developing and emerging market economies is that the initiative to implement accrual accounting is undertaken with the ad hoc adoption of selected accrual concepts. These countries refer to their accounting methodology as either modified cash or modified accrual depending on where they are along the vast spectrum between cash and accrual accounting. The reality is that the implementation of accrual accounting is often done in phases that can cover decades. . The lack of fully developed accounting standards that provide guidance across the spectrum between cash and accrual accounting leaves governments free to arbitrarily choose “modifications” to their accounts that most often produce financial reports that fail even the most basic tests of useful financial information such as completeness, accuracy and relevance and reliability. Of course IPSAS does allow for a transition period to fully implementing accrual accounting and provides guidance on the intermediate steps, but still governments, especially those from developing countries, are having difficulty in attaining full accruals within the transition period allowed, and according to a well-defined path of intermediate steps.

Our point remains that the accounting profession could do more in helping governments define acceptable intermediate accounting standards that minimize the creativity observed when governments choose modified accrual or modified cash accounting. IPSAS presently indicates that there are only two recognized accounting standards, cash-based or accrual based. Our view would be that IPSAS, as Dr. Chan suggests, could identify accounting standards that provide guidance along the continuum between strictly cash and accrual accounting. This would be particularly helpful for developing countries in preparing better quality financial reports in the potentially long intermediate period when full accrual accounting is not yet within their grasp.

I can understand the frustration of Julie and Holger, but I think they may misunderstand or overstate the role of accounting standards and the standard-setters. IPSASB develop such standards through consultation papers and exposure drafts. They provide information and guidance on how standards should be interpreted and applied in specific cases -- for example, to refer to a politically charged topic, whether a central bank should be regarded as a government entity or not. They have already issued numerous standards, and a useful 2003 paper that provides guidance on the transition to the accrual basis of accounting. A consultation paper has been issued on the conceptual framework for financial reporting in the public sector. Another discussion paper has been prepared on the long-term sustainability of public finances. An exposure draft has been issued on service concession arrangements such as PPPs. All these are enormously valuable initiatives, and technically very demanding, which explains why the development of standards takes a long time, typically several years.

It is clearly the consensus view of the accounting profession that the public sector should report on an accrual basis, and many accountants are surprised (not to say astonished) that this is not already done (no accountant working in the private sector -- where accrual has been the basic standard for generations -- would understand the notion of cash accounting !). It is unrealistic to expect professional accountants to turn their face against years of good practice and recommend some hybrid accounting approach that has little basis in theory or practice.

Of course, the transition is both important and quite difficult. However, this is where the scene changes from the the IPSASB conference chamber to the minister of finance's court with his assembled experts and advisors (including perhaps FAD). It is the minister's responsibility to decide on the appropriate set of financial reports that the government should issue, and what transactions and operations should be covered. Even for countries that decide to maintain the cash-basis of accounting, this might usefully include selected information on the government's balance sheet, and its long-term liabilities, where such data can be properly estimated. The finance minister's advisors might want to point to examples of countries such as Australia, New Zealand, Switzerland, the U.K., and the United States from whose practices other countries can learn. FAD can prepare good practice guidance notes on these matters, taking into account that disclosure of financial information is both a technical issue and a highly politicised one. Even standard setters are not immune from political pressure, as recent experience in the U.S. and other countries concerning practices for disclosing government support to failing financial institutions, and for reporting toxic assets, has demonstrated. It is of course for the auditors to decide whether the accounting treatment of such items is appropriate.

It was indeed astonishing to find when moving from private to public sector a few years ago that cash accounting is used (and not without numerous mistakes either). How can organisations not care what their unfunded pension liability is?

As well as political reasons, the huge difference in quality of accounting staff must be a big contributing factor. High flying accountants would in the past very rarely go into the public sector.

Whether intermediate standards are needed is an interesting question. Surely as long as the footnotes make clear exactly which standards are being used, and how (ie effectively stating how far along the spectrum they are) then that would be sufficient.

A new set of standards could take decades in itself by which time hopefully most countries (and all international organisations) may have reached the goal.

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