Posted by Holger van Eden
In the Netherlands, but also in a number of other OECD countries, the debate on the usefulness of accrual accounting standards, both for financial reporting and budgeting, has led to a hybrid set of accounting standards being used in government. This hybrid approach has been questioned by the Dutch Supreme Audit Office, and is generally not appreciated by accounting purists. However, the hybrid approach, in which part of government works under accrual standards, and part remains under cash, may be a practical way to reap some of the benefits of accrual reporting and budgeting, while not incurring the substantial costs of implementing accrual accounting standards government-wide. Accountability and transparency at the national level may also be better served by a straightforward cash-based approach.
The discussion on the choice between cash and accrual standards for budgeting and accounting in the Netherlands is nicely summarized in M. Peter van der Hoek’s paper “From Cash to Accrual Budgeting and Accounting in the Public Sector: the Dutch Experience” (Public Budgeting & Finance, Spring 2005; pp, 32-45). The author discusses the Dutch government’s position of not transitioning fully to accrual accounting standards, even though on balance he does not favor the halfway position reached.
Andy Wynne of the UK’s Association of Chartered Certified Accountants, however, is quite critical about the move towards full accrual accounting standards that has taken place in the UK for both financial reporting and budgeting. In his paper “Is the Move to Accrual Based Accounting a Real Priority for Public Sector Accounting?” published in the February 2007 issue of Public Fund Digest (available on-line at the link above), he questions the extent to which using accrual accounting standards in government makes sense from a cost benefit point of view. Both papers are useful documents for countries reviewing the pros and cons of moving towards accrual accounting and budgeting, and whether in between positions can be a useful compromise, at least for the foreseeable future.
Central government in the Netherlands has imposed accrual accounting standards for government agencies and local government, but has retained cash accounting for the center of government, i.e. for line ministry central offices and the Ministry of Finance, and for the government as a whole. Consolidated accounts are presented on a cash basis, as is the State budget. (The accounting and budgeting system in effect actually registers both expenditure commitments and expenditures, and could thus be seen as a cash-commitment system of accounting. In the formal accounts the cash data is then adjusted to ESA95 standards, i.e. economic transaction based.) Countries like the US and Belgium also use similar hybrid accounting standards.
There are a number of arguments for the hybrid approach.
First, accrual accounting may not in all circumstances be the most appropriate tool for the public sector as it introduces subjective elements in government accounting and reporting practices. Accrual accounting is an accounting standard originally developed for private companies. It assumes production of a good or service against a certain cost and sale of this good for profit. Determination of cost and profit can be complex issues as the financial pages of newspapers illustrate daily. The accounting axiom: “cash is fact, profit is an opinion” introduces subjectivity into accrual accounting practices and such subjectivity leads to complexities and non-transparencies which, one could argue, are not always desirable in government accounting. Cash accounting may provide less economic information, but is more straightforward, and less prone to manipulation. These issues are not theoretical, in implementing accrual accounting difficult choices have to be made about asset valuation, depreciation, the recognition moment of the economic transaction, and so. These choices are not always straightforward. The hybrid argument is that for the whole of government, and for political accountability, cash accounting provides a perhaps less sophisticated, but more consistent and transparent measure of government operations.
Second, the hybrid point of view is that accrual standards do make sense for government agencies that produce identifiable, relatively homogenous goods and services similar to the private sector. In such circumstances accounting for costs rather than for inputs can promote better resource allocation and more efficient production and “pricing “ of government goods. In the Netherlands more than 70 percent of central government employees work in such agencies. Hybrid advocates argue, however, that where government activities are very different from market-based production, accrual accounting standards do not add much value. For central government ministries much of government production has a regulatory or policy-oriented focus and is very heterogeneous in nature. This makes full costing of these services difficult. Even if cost information is assembled it often does not lead to other decisions than input costing. Cost information is especially useful when substitution between personnel and capital is important. However, many regulatory and policy activities are by their nature labor-intensive, while infrastructure investment is by its nature capital intensive. So the choice between alternative production functions does not really come up that often, and thus cost information does not have much value-added for decision-makers.
The argument that public investment decisions are by themselves improved by cost of capital considerations, neglects, according to the “hybrid view” the fact that such calculations are already used in feasibility studies, so that evaluation by introducing accrual costing would not improve project selection. Moreover, line ministry expenditure envelopes are for all practical purposes cash constrained, not cost constrained. This is even the case in some countries that have adopted accrual budgeting. In the UK for example, parliament has reintroduced a cash ceiling next to a “resource ceiling” on departmental expenditure, with according to some the cash ceiling being the more important. If cash is the real constraint within government, allocative decision making should focus on it rather than on cost totals.
Third, the change of the accounting basis for the whole of government does imply significant capacity building and operating costs. Evidence from the UK is that especially the registration and valuation of government non-physical assets is a costly and time-consuming exercise. The preparation for accrual accounting in the UK took almost a decade, and cost estimates range into the hundreds of millions of pounds mostly due to the asset registration and valuation exercise. Operating accrual accounting systems also has significant cost in IT systems and personnel. The number of public sector accountants alone has quadrupled in the UK. The “hybrid answer” to these concerns is to use accrual accounting standards only when operational efficiency of government is expected to be influenced significantly.
A final important argument for the hybrid solution is that at the macro level the government budget is an instrument of fiscal policy, and fiscal policy is more linked to cash or near-cash measures than to cost or expense totals. In some countries, fiscal rules are explicitly based on cash limits to borrowing or balanced budget rules formulated in cash term. The Maastricht three percent deficit limit is based on an ESA95 economic transaction definition, which is a near cash measure. Fiscal policy itself is based on an estimation of the fiscal impact of total expenditure minus revenues on aggregate demand, rather than total expenses minus revenues.
This short discussion can not elaborate on all the existing arguments for transitioning to full accrual standards, nor, for example, on separating the decision to move to accrual accounting on the one hand and to accrual budgeting on the other. There are indeed further arguments to made for both positions. Nor have some of the disadvantages of a hybrid system been expanded on, for example in the Netherlands consolidated reporting during budget execution has suffered, although linkage between accrual and cash systems should in principle be possible.
It is an interesting observation, however, that important OECD countries are still not convinced of the overall benefits of moving to full accrual budgeting and accounting. A recent multi-country overview of the US General Accountability Office “Accrual Budgeting useful in certain areas but does not provide sufficient information for reporting on our nation’s longer-term fiscal challenge” reinforces the skepticism on the full transition to accrual accounting standards.
