15 April 2009


by Soepomo Prodjoharjono

1. Introduction

This paper describes, in broad terms, overall aspects of accrual accounting in the public sector , including financial reporting, budgeting and its users. First of all, the public sector financial reporting will be addressed to identify its users and their needs. Then financial accounting techniques under different accounting bases will be explained to give a clear position of the accrual accounting among other bases, including the debate in depth on accrual versus cash based accounting. Relationship between accrual accounting and accrual budgeting will also be presented next. Issues on definition for government entity, as well as the applicability of accrual accounting in government unit, will also be discussed. The next discussion is about the capital accounting, while the chapter will be concluded in the last section.

2. Financial Reporting: Objectives, Users and Their Needs

2.1. The New Public Management

Since the last decade or so, there has been a growing demand of politicians, as well as accounting expertise, that public sector entities should not only be accountable for cash flows and their balances but also they must be responsible for how they spend the public money. The demand has been demonstrated by, among other measures, the introduction of public management reforms, known as the New Public Management (NPM), in many developed countries. These reforms may include an emphasis on the cost effectiveness of activities, a range of incentives (to encourage better management), providing greater flexibility in the allocation of total resources, and stimulating a focus on value for money. Therefore, important issue here that has to be solved is costs of providing services by the government unit in question.
In a world of economic scarcity, costs of every service provided by the government would be a centre point of most financial report users. This is simply because, it has an impact on the citizen, i.e., how much, council tax for example, they have to pay to the local government, in providing the services they received. This issue has led to the requirement of better accounting system, that is, to enhance decision making and control over the long term financial consequences of government policies. Some authors (UN, 1984; Jones & Pendlebury, 1996; OECD, 1993) believe that accrual accounting is suitable to fulfil such requirements as it is able to provide more than that under cash basis, in terms of quantity and quality. No wonder that most of the developed countries which previously adopted a cash based accounting or budgetary accounting, have recently already introduced some forms of accrual accounting into their public sectors as part of a broader public sector reform process mainly in Anglo-Saxon countries.
Furthermore, within the framework, financial accounting and reporting system is seen to have an important role to play in providing necessary information to reflect accountability in value for money terms and, of course, to support every decision making made by every public sector's managers (OECD, 1993). Accordingly, public sector reforms should include the need to enhance accounting and financial reporting beyond cash considerations alone. In other words, its existing system is to be converted to accounting and financial reporting on the allocation and use of total economic resources (whether cash or non-cash outlays), i.e., the basis of accounting that recognises transactions or events when they occur, irrespective of when cash is paid or received.

2.2. Objectives, Users and Their Needs

Objectives of financial reporting should be discussed in accountability context as it is the fundamental value of government accounting and reporting. A democratic government should be accountable for its integrity, stewardship and performance (FASAB, 1994). In exercising accountability, government needs to provide information useful for assessing the accountability of the reporting entity. Hence, accountability must come first amongst the government objectives, whereas providing information useful for making decisions is the result of exercising accountability.
In the public sector, the financial reporting objectives have been developed in 'decision-usefulness' framework which is in coherence with accountability. Any potential conflict between them is relevant to governmental accounting policy choices (Patton, 1992). In line with this assertion, the AICPA's Trueblood report (1974) suggests that the objective of financial statements for governmental and not-for-profit organisations as: 'to provide information useful for evaluating the effectiveness of the management of resources in achieving the organisation's goals. Performance measures should be quantified in terms of identified goals.'
Jones and Pendlebury (1996) link the government accounting's objectives to the users and their needs. They introduce two approaches to explain the public sector accounting objectives, i.e., the differential approach, which emphasises the complexity of financial accounting and, accordingly, produces many users groups; and the integral approach, which emphasises the commonalties and, therefore, produces few user groups. In this regard, Jones and Pendlebury point out that the NCGA's report prepared by Drebin et al. entitled ‘Objectives of Accounting and Financial Reporting for Governmental Units’ as the best example of the differential approach (Jones and Pendlebury, 1996). This report categorised the users into ten users groups, compressed into four parties:
• Financial resources providers, constitute of the taxpayers, grantors, investors, and fee-paying service recipients.
• Labour and material resources providers, comprise of the employees and vendors.
• Resources allocation decision-makers, comprise of the legislative bodies and management.
• Controller of the above bodies, i.e, by voters and oversight bodies.
The report, then, set up the overall goal of government accounting and financial reporting as "To provide (1) financial information useful for making economic, political and social decisions, and demonstrating accountability and stewardship; (2) information useful for evaluating managerial and organisational performance" (Drebin et al., 1981). These objectives distinguish between accountability and performance measurement, the likelihood narrow definition in the sense of accountability.
On the other hands, the Anthony's integral approach produces an easily understood bedrock upon which “the specific nuances” of particular organisations can be built. To have validity in financial reports, for him, budget must be produced on the same basis as the financial accounts. Since it cannot be conceived of a situation where the financial accounts would be determined by the budgetary information, he suggests that the user's needs can be developed in financial accounting terms and then, if budgetary information is required, it should be made consistent with the financial accounts. He, therefore, introduces five user groups of accounting information, namely, the governing bodies, investors and creditors, resource providers, oversight bodies, and constituents (Jones and Pendlebury, 1996). In the light of these users, Anthony then offers the following users' needs:
• Financial viability, which refers to the ability of the organisations to continue in its present form or in its planned form.
• Fiscal compliance, which refers to the extent to which the organisations has complied with the conditions laid down in its authority to spend.
• Management performance, which explicitly concerns with economy and to the exclusion of efficiency and effectiveness. Since there is no generally accepted way of defining and reporting the measurement of outputs in non profit organisations, efficiency and effectiveness, therefore, do not necessarily have to be measured.
• Cost of services provided, which is needed for comparison purposes, both between organisations and the needs of present and future generations.
The different emphasis on defining the accounting objectives was demonstrated by UN in its ‘Manual for Government Accounting’ (UN, 1970). The UN has invented the objectives for government accounting systems that emphasised on the accountability. According to UN, accounting objectives can be grouped into three types of accountability objective:
1. Fiscal accountability, which, by the accounting system
• ensures that applicable laws and regulations are followed;
• guarantees that financial records and reports are accurate and represent a fair result of government operations;
• assures that the accounts and reports are issued in time;
• secures that the expenditure is within legislative appropriations;
2. Managerial accountability, which stresses the needs:
• to provide essential information for the use of managers;
• to ensure efficiency and economy of operations, avoidance of waste, etc;
3. Programme results accountability, which:
• demands the evaluation of programmes in terms of effectiveness;
• to find out whether a programme or activity is achieving the intended goals.
Interestingly, the term accountability itself is criticised by Patton (1992) as it suffers from imprecise meaning and makes complication on the cost-benefit analysis of information. Furthermore, users of government reports are diverse. It may be impossible to provide information in any one report sufficient to meet all the needs of all users. We have to admit that financial report is only one source of information. Users should combine the information provided by financial reporting with other pertinent information.
Whatever obvious the objectives are, however, every organisation does exist in order to achieve one or more objectives which, usually, vary from one organisation to another. But, by nature, they confront with similar problem: the limitation of the available resources, i.e., manpower, capital, plant facilities, or raw materials, to permit the achievement of every desired aim. Thus, it is not sufficient merely to decide on objectives but it is also necessary to make plans for their achievement. Preparing the planning only is not adequate, however, since what should be done is not the same as what is being done. For this reason, Jones and Pendlebury (1996), among others, believe that control is still needed to ensure that the planned activities are followed and the ultimate objectives achieved. Hence, according to them, there are two of the most important tasks undertaken by the managers of an organisation, i.e., the planning and control tasks, which together they form the nucleus of the overall management system.
As far as the government accounting system is concerned, accounting must provide data to many users and the varied information needs of those users should be anticipated to the fullest possible extent. Government accounting system, therefore, should also provide assurance to executives, constituents and investors that adequate internal accounting control does exist for safeguarding assets.
To fulfil these requirements, that is, information that is readily available for planning, performance evaluation and other financial analyses, financial reports must be timely, reliable, relevant and understandable. To be reliable and relevant and well understood, financial information should be prepared based on generally accepted accounting principles which, unfortunately, these principles are relatively well developed in the commercial accounting profession. Of course, this does not mean to ignore the role of the public sector bodies, such as NCGA (the National Council on Government Accounting), in the US or, similarly, CIPFA (the Chartered Institute of Public Finance and Accountancy), in the UK.
In this regard, Jones (1992a) states that the United Nations took the more optimistic view of the role of governmental accounting systems in providing useful financial information. It recognised an urgent need for additional information that envisaged the government accounting. In particular, the overall information on accrual basis is much more meaningful to policy makers than information organised on other bases.
From the above point of views, the aims of accounting information are therefore can be described as, first, to show that all receipts and payments of the organisation to which the accounts relate have been accounted for. In general terms, this is often called the probity or stewardship aspect of accountancy. Secondly, to present the numerical side of the organisation in a meaningful way. This has to be done in a variety of ways such as performance indicator based on value for money traditions, balance sheet, cash flow statement, etc., to match the abundance of differing uses to which the numerical information is put together.
It is worth noting that most guidance, FRSs and SSAPs and other product of accounting standard setters bodies are from the producer and accountant’s point of view. Users of the financial information which take the biggest part of the financial world are being neglected simply because, as Jones (1994) claims, "users often are not competent to determine what information is most useful to them or at least are not articulate in stating their needs".

3. Financial Accounting Technique

It is common to believe that the different public sector organisations adopt the different accounting practices. A different view of the division of accounting technique came from most of US textbooks, including the United Nations publications (United Nations, 1984; Hay and Mikesell, 1974; Vargo, 1977; Herbert et al., 1977). There are, at least, five major accounting techniques: budgetary accounting, cash accounting, accrual accounting, commitment accounting, and fund accounting (Jones and Pendlebury, 1996). These systems are not mutually exclusive since one organisation might adopt more than one accounting techniques simultaneously, even it is theoretically possible to adopt all the five simultaneously.
Special note goes to the term fund accounting, which has been described as the government accounting itself, not as an accounting technique. Hay and Mikesell (1974), for example, explain that the most distinctive characteristics of governmental accounting (compare with the other entities) are the grouping of accounts by funds. The word fund, according to him, has a special, technical, meaning in governmental accounting. He defines fund as:
".... [A]n independent fiscal and accounting entity with a self-balancing set of accounts recording cash and/or other resources together with all related liabilities, obligations, reserves, and equities which are segregated for the purpose of carrying on specific activities or attaining certain objectives in accordance with special regulations, restrictions, or limitations" [Hay and Mikesell, 1974].

In line to Hay and Mikesell’s thought, the United Nations (1984) classifies the accounting techniques based on the basis of recording financial transactions. Or, in other words, it is based on the recognition of revenues and expenditures, i.e., either cash, obligation, or accrual/modified accrual. For the United Nations, fund accounting is one of the classification of public sector accounting in terms of the accounting systems used by its organisation.
Implicitly, however, there is no different interpretations of the accounting technique between US and UK textbooks, as Jones and Pendlebury (1996) admit that cash accounting, accrual accounting, and commitment accounting are distinguished from one another at a point in time when expenses and revenues are recognised in the accounts, i.e., the point at which a given transaction generates a bookkeeping entry. Again, for them, fund accounting refers to the practice of accounting in terms of its separate, independent, constituent parts (Jones and Pendlebury, 1996). It is therefore, following Jones and Pendlebury’s classification, this section will particularly discuss three of the available accounting techniques, i.e., commitment, cash, and accrual basis of accounting and its modification. Fund accounting as a technique is also presented here. The emphasis of the discussions is on their uses in government accounting.

3.1. Commitment Basis of Accounting

The primary function of commitment accounting is in fact in budgetary control. It is, therefore, the commitment accounting concentrates on orders issued.
This system recognises transactions when the organisation is committed to them, or, in other words, transactions will be recorded at the time when orders are issued or received. The main weakness of this system is on the legal point of view. It is generally accepted that the issuance of purchase order has no legal liability incurred and, accordingly, the order could easily be cancelled. Recognising the issuance of purchase order as an expense of the accounting period, is likely to be too difficult to accept (Jones and Pendlebury, 1996).
Furthermore, the problem of manipulation becomes greater under this basis, compared with those under the accrual basis, because of its much more subjectivity. It also provides the opportunity for executives to contribute to general reserve at the year-end and to treat the contributions as expenses. To avoid budget cutting for the next year, for example, in a few days before the fiscal year-end the executives can easily issue the purchase orders to fill-up as much as the budget appropriated for them. When the new fiscal year commences, some of the orders will be cancelled.
Because of those weaknesses, commitment accounting is much less widely adopted in practice. Even when it is adopted, the final accounts are adjusted to appear as accrual accounts.

3.2. Cash Basis of Accounting

Under the cash basis, financial transactions are recorded in the accounts only when cash is received or disbursed. Similarly, goods and services for which payments are made are considered to be consumed when suppliers are paid (United Nations, 1984).
Further, long-term assets are not capitalised, and, therefore, no depreciation or amortisation is recorded. In addition, disbursements always coincide with expenditures. The resulting final accounts, then, are nothing more than summarised cash books. Since there are no assets and liabilities, no balance sheet is prepared. Also, there are no stock adjustments because the accounts are not concerned with record usage, but with the only fact that cash has been paid for purchases. By the same reason, consequently, there are no fixed assets (Jones and Pendlebury, 1996).
Indeed, this system actually shows actual cash transactions, and therefore, for the financial staff are easily to understand and interpret. In terms of administration and accounting expertise, this system requires much lower costs compared with the other systems. In addition, the International Monetary Fund favours this system for its financial statistics since cash accounts are clear cut and their results can be made available at frequent intervals (Enthoven, 1978).
In short, cash basis of accounting provides its simplicity, essential information, inexpensive in terms of administrative and accounting expertise, and it is much more objective than other systems.
However, despite the advantages that have already been mentioned, it does not provide information about income and capital, nor about the operating cost of the organisation during the fiscal year. Accordingly, it has a great potential for deliberate manipulation of the executive.

3.3. Accrual Basis of Accounting

Under the accrual basis, expenditures are essentially recorded at the time when goods and services are received, regardless of whether the cash payments have been made or the invoices have been rendered. Similarly, revenues are recorded when the right to collect them is generated (United Nations, 1984). Thus, the critical event of the accrual basis is on the occurrence of transactions.
It should be noted, however, that because of the prudence consideration, the revenue recognition should not be anticipated unless those revenues can definitely be collected.
Unlike under the cash basis of accounting, which the disbursements always coincide with expenditures, under the accrual accounting, the disbursements of money do not necessarily mean the recognition of expenditures, or vice versa. Consequently, certain deferral adjustments have to be made on every fiscal year-end. These adjustment include: the recognition of accrued assets, such as interest receivables; accrued liabilities, such as salaries or interest payable; adjustment to prepaid expenses; allowance for bad debts; year-end inventory adjustment if necessary; and depreciation or amortisation (Schwartz, 1991).
Final accounts, under the accrual concept, are not produced uniformly. What they have in common is that they produce a balance sheet and an operating statement, which are in contrast to the cash basis of accounting (Jones and Pendlebury, 1996).
Hay and Mikesell (1974) state that the use of the accrual accounting is considered appropriate for governmental units as well as profit seeking businesses. In government, use of the accrual basis enables a better comparison between actual expenditures and revenues and the amounts authorised in the budget approved by the legislative body, as well as enabling computation of the cost of rendering services.
In addition, UN outlines three benefits of using the accrual basis. Firstly, it measures inputs in terms of resources consumed. Secondly, it makes possible the identification of economic cost, i.e., the consumption of resources either paid for in prior years or to be paid for in the future, which are both considered in the annual result of operations in the relevant year. And lastly, it provides a more accurate and more comprehensive picture of the financial position at the period end than that given by the cash basis. Because of these benefits, the United Nations suggests:

" ...... one of the important accounting reforms which merits serious consideration in providing additional financial information for policy formulation, management and control of resources and effective audit is the use of accrual accounting."

Surprisingly, as United Nations asserts, the adoption of accrual accounting is not suggested as a replacement for the cash and obligation bases that are currently employed. On balance, it is desirable to maintain cash and obligation bases for budgetary and to some extent for accountability purposes. Accrual accounting for recording transactions should be used on a ‘selective and supplementary basis’ in areas where supplementary financial information provided by such accounting is considered to be most essential (United Nations, 1984). In this sense, the UN lost its argument that accrual accounting gives a better performance in the expense of public money used to produce the report.
An opposite view comes from Nobes (1989). He claims that accrual accounting has been used in commercial accounting and is not, therefore, relevant to government. He continues that the accrual basis is not without criticism in the commercial sectors. In this regard, Craner and Jones (1990) have proved that local governments in the UK have developed accrual accounting since the 19th century and continues to develop in its own form of accrual accounting with its rationale, even though it was not for income determination.
As it has been stated in the previous chapter, the 1966 AAA Committee affirmed that matching ideally involves establishing causal relationships between costs and revenues. However, it recognised that this was not practical and offered the weaker test of costs and revenues which have positive correlation. Most (1977) argues that the concept should be abandoned in favour of the older idea that expenses and revenues are simply period measurements. This proposition is important to the public sector environment, as the relationship between revenues and expenditures is, in most cases, totally unclear.
To sum up, accounts on accrual basis reflect the status of funds, inventories, and other resources available, the receipt of goods and services, the use of available resources in relation to work performed in a given time period, and the liabilities of the government. The relevance of accrual accounting in government accounting practice, though still in debate, is undoubtedly a matter of accountability and stewardship improvements.
An important point which is often overlooked is that the term 'accrual accounting' is not synonymous with private sector practices, nor is it synonymous with historical cost accounting (Jones, 1994).

3.4. Modified Accrual Basis of Accounting

Between cash and accrual bases, some UK local authorities adopt what it is called modified accrual accounting. Jones in his research found out that there are two versions of this type of accounting: the first is the ‘income and converted payments’ method. Under this method, all revenues are accrued when they are earned, while payments throughout the year are not continually accrued. The second method is ‘converted receipts and payments’. Under this method, by contrast, all payments are accrued, but revenues are not continually accrued (Jones and Pendlebury, 1996).
In distinguishing between the cash basis and the modified accrual basis, it is important to recall that the cash basis recognises revenues when collected rather than when earned, and recognises expenses when paid rather than when incurred. Modifications to the accrual basis accounting, which is commonly used in US government accounting practice, include items such as, the capitalisation of assets and the accrual of income taxes. If these modifications were made, the resulting balance sheet would include long-term assets, accumulated depreciation, and a liability for income taxes. In US, if modifications are so extensive to the cash basis that the statements more closely resemble accrual basis statements, the accountant should treat them as accrual basis statements and note their departure from GAAP in the audit of review report (Schwartz, 1991).
However, it must be borne in mind that moving from ‘receipts and payments’ towards ‘income and expenditures’ approach would boost on the ‘expenditures’ side than the ‘income’ side, meaning that it would produce a greater cost for the year, which in turn increase the rates paid by the citizen. As a result, because rates would probably have to increase in the year of changeover from cash to modified accrual, meaning that there was some reluctance to recommend the changes. Also, the additional administrative effort involved in accruing payments was perceived by some to be significant enough to justify accrual of only irregular payments, despite the potential manipulation on the uses of cash basis.

3.5. Fund Accounting

This technique is usually used in government organisations, particularly local government. Local government revenues are obtained from sources other than the sale of goods and services. It receives most of its finance from local taxes, grants and borrowings (Jones and Pendlebury, 1996).
The consequences of the uses of different funds is that accounting reports should show the extent to which these differing goal of every fund are achieved. For example, local government that provides health, education and general public services has different specific goals for each service. Consequently, the local government should need a series of accounts for each service.
Secondly, because its finance has been provided in indirect exchange for goods and services, there are often restriction schemes on what the organisation can, or cannot, do with the finance. For example, there may be a grant that is specifically assigned for a school building project. In this case it would be wrong to spend the money in any other way. In this respect, accounting system has to be developed to handle these kinds of restrictions that is, among other things, using a fund accounting.
On the other hands, the fund theory that has been introduced by Vatter (1947) found a main weakness on the entity theory, which is how to define the entity. Thus the fund theory concerns the funds as a reporting unit. In the organisation context, local government must be viewed as a series of funds . Each fund has its own income and expenditure account, balance sheets, and other financial statements. The apparent difference of the uses of fund accounting between private sector accounting and local government accounting is the extent of its use and the extent to which consolidations of fund accounts are processed.
In local authorities, unlike in a parent-subsidiary relationship in the private sector, there is tight control of inter fund transfers, known as virement. These practices are not common in the private sector.

4. The Need For Accrual Accounting in the Public Sector

Most accountants agree that accrual accounting has a significant position in the private sector financial reporting. By default, accrual accounting has been used for preparing the financial report of the private sector companies, dating back to the beginning of accounting developments in the sixteenth century, when Frater Luca Pacioli published his Summa.
In the public sector, however, this role becomes a focus of debates. The fact that, as a cross-country experiences have proven (El-Batanani and Jones, 1996; Lüder, 1989, 1993; Bac, 1990, 1996), the public sector reforms that recently have been introduced world-wide are significantly moving towards accrual based reporting. Indeed, accrual accounting is beginning to generate interest in the public sector because of its potentiality to contribute to improve public management and public sector performance. The uses of accrual accounting has also been a common feature of public sector budgeting and financial reporting requirements (Likierman, 1992). Its application to the core elements of the public sector financial accounting, including its budgeting, is about to be a prevalent one, mostly, at the central government of some developed countries (OECD, 1993; UN, 1984; HM Treasury, 1994, 1995).
Basically, the accrual basis of accounting and reporting has been recognised as useful in providing information on matters such as the resources controlled by an entity, the full cost of operations (or of providing services) and the assessment of economy and efficiency of operations. In addition, it will also be needed for matching the costs incurred during a particular accounting period with the benefits earned and revenues with goods or services provided.
Since the public sector is not dealing with the profit and there is no relationship between revenues and costs, thus the public sector financial reporting tends to show a 'value for money' performance. This can be achieved if the financial report is based on the accrual accounting, as it does clearly show a relevant input and output measurement based on periodical reporting. Costs of providing services then becomes a major issue for whoever the users and whatever the users needs are. This is in line with the issue on income determination in the private sector where the matching concept can be interpreted as matching costs and benefit arises from the costs incurred.
However, in an effort to draw conclusions on the degree to which accrual accounting may be useful in the public sector is somewhat difficult if not impossible, as no report on it is available. The only thing we know is that state owned enterprises, public corporations, nationalised industries, as well as the private sector companies have a long time experienced to use accrual accounting for its financial reporting and for profit measurement.
Raman (1979), quoted by Jones (1992a), offers the relevance of Tiebout hypothesis for financial reporting. He suggests that voters will be able to judge whether there is fiscal equivalence (that is, whether each voter is getting benefit equal to the taxes paid) if the accounts of the government sector adopt full accrual accounting. However, Jones argues that this suggestion was absurd, for not to say impossible, as it requires at least two conditions that have to be met (Jones, 1992a):
it requires that accrual accounts for an individual program or for the organisation as a whole are capable of explaining to the individual that he or she is experiencing fiscal equivalence (which is not obvious since fiscal equivalence relates to each individual not the community as a whole), and
it requires unswerving belief that the measurement problems associated with accrual accounts are always outweighed by any feelings that it produces better measurements of benefit than modified accrual or cash flows.

5. Accrual Accounting in the Government Entity: Its application

5.1. The Government Characteristics

Every government elsewhere delivers functions to its citizen such as the provision of goods and services that markets fail to provide, the distribution of income and wealth, the management of the economy, and the protection of the public by enacting laws and regulations (Goode, 1989). To carry out such functions, the government should have certain powers: the power to enact legislation by which citizens must abide, the power to levy taxes to support its activities, and the power to conduct monopolies in certain operations where charges are made to the users of certain services or products based on the amount of services or products received (AAA, 1972). The government then with its powers can obtain the resources to produce the goods and services.
It is, therefore, the duty of the government to be accountable to the citizen by publishing a report that is suitable for such purposes. Of course, the type of accounting will be influenced by the structure and the services delivered by government, which is, to a greater extent, differ from the private sector.
From the economic point of view, government has three main characteristics:
• the absence of the profit motive. Profit motive is the most fundamental measure of performance in the private sector.
• the lack of a competitive market place because of the government's monopolistic power.
• the difficulty in measuring the government output in terms of quantity and quality.
However, as far as financial reporting is concerned, there are several government characteristics which make it different from other organisation. Evans (1992) identified such characteristics as follows:
The focus on expenditures. The private sector company's reports usually concentrate on 'profit and loss' and 'earning per share' figures. The company usually tends to boost these figures, by using a creative accounting for example. This probably understood as the ‘death or life’ of the company, much depends on its share value in stock market. The public sector organisation, by contrast, tends to show its expenditures compared to its budget as the organisation tend to show the achievement of what has been set for in the budget. The 'value for money' figures, as a performance indicator, will be more important than the balance sheet figures.
The role of the budget. Budget in the private sector company is somewhat confidential because it contains a strategic planning of the company in competing with other companies. But this is not the case in the public sector. Budget must be published to the citizen to show how efficient the expenditures will be, how they do get the money, and how they do assign every money to each activity.
The treatment of long lived assets and depreciation. In the private sector, assets can easily be defined. All long lived equipments which are used in the operational activities of the company in producing company profit must be treated as assets and should be depreciated. In the public sector organisation, by contrast, there are at least two different assets that can be identified: assets as an input to generate outputs and assets as an outcome itself which are readily used by the public. Museums, city garden are assets which fall into a second criteria. They are not a productive goods even though has a limited life, and cannot easily be a subject of depreciation.
Concerning the application of the regulation and rules for financial reporting such as FRSs and SSAPs, there is also the difference between the public and private sectors. In the case of private sector there is a constant tension between standard-setters body in one end and companies in other end in the way in which they have to abide by standards. This tension is far less, for not to say none, in the case of public sector because of the low expectation of the public sector organisation about how much freedom is open to them.
In addition to those characteristics mentioned above, since public sector entities are financed at whatever proportion by public money i.e. taxation, it is sensible that those entities should provide a set of financial report which clearly view the money used, unused or reallocated sources completed with any necessary explanation. In general, the public sector is characterised by complicated systems in which institutional, economic, social and political factors interact.

5.2. Defining Entity in the Government Sector

IFAC-PSC of the US (1991) in its study no. 8, defines entity as “[the units] of which it is reasonable to expect the existence of users dependent on financial reports for information which will be useful to them for accountability and decision making purposes.”
In the business sector, identifying company’s entity is not generating any problem, as the company’s property rights are very clear. For example, it may easily identify which assets; liabilities and capital are owned by the enterprise in question.
The public sector, however, is totally different. Sometimes it will not be easy to identify some elements that belong to the entity. For example, which assets should be included in hospital financial report as the owner of certain assets is unclear, whether they are owned by the hospital or National Health Service Authority.
In practice, there are two distinct concepts of the financial reporting entity, i.e., the legal entity concept and the control concept. The former concept maintains that each non-profit organisation represents a separate financial reporting entity. Management and governing boards of the organisation select organisational arrangement appropriate for the financial and operational characteristics of the organisation. The latter concept defines the financial reporting entity in terms of the authority and responsibility for establishing policies, the ability and responsibility to direct operations, and the access to and responsibility to assets and liabilities (Holder, 1987).
Despite the differences between public and private sector financial reporting entity, both of them should produce or provide a set of financial report in order to meet their users' needs. Indeed, both have different emphasis on which and how to report sensibly. Albeit these differences, financial reporting in the public sector is also seen as is a key element in the accountability of public sector bodies. Yet, to whom the public sectors are accountable should be defined clearly as to establish a 'fairly presented' value.
Issue on consolidated report is also hardly to have an agreement since the level of the reporting unit is ambiguous. For example, should the primary school publish its own financial report or its report should be included in the Local Government’s? Thus defining the output and throughput are not quite easily to define them (Jones & Pendlebury, 1996; Likierman, 1994).
Nevertheless, government entity is different in some respects from private sector organisation, they are not sufficiently different to reject the notion of accrual accounting. One of the fundamental flaws in the arguments is, as Jones (1992a) asserted, on a going concern concept. Clearly, the apparent ownership of government operations may change periodically with the election of new governments, however, the business, management, assets and clientele of government continue more or less unchanged through successive governments.
Sometimes reporting entity is different to the organisational entity itself. Fund accounting is a good example for the extent to which several financial reports are published within one public sector organisation. As it has been asserted by Jones and Pendlebury (1996) that fund accounting report is based on type of fund, where each fund accounts for specified items of income and expenditure. Consequently, each fund will produce an operating account and a balance sheet. If all fund within the organisation are consolidated, then there will be only one set of financial reports for the organisation, which consists of a balance sheet, a statement of profit and loss and a statement of cash flow (Jones and Pendlebury, 1996).

5.3. The Applicability of Accrual Accounting in the Government Entity

Accrual accounting provides a framework within which the focus on inputs can be related and redirected to a focus on outputs. Information on an accrual basis is much more meaningful to policy makers than information organised on other bases, i.e., in measuring projects costs and benefits, asset valuation, management control and in general, to raise the efficiency with which resources are being used in government (Craner & Jones, 1990)
The reason for its introduction is similar to the reason for the introduction of program/zero based budgeting in the 1970s. The objective should always be to achieve better management practices so those public sector programs can be delivered more efficiently. The introduction of accrual accounting, like the introduction of any new system, must be accomplished in such a way that management practices are achieved.
The applicability of accrual accounting in the public sector is very wide. In the US Federal Government, the first real impetus for the adoption of accrual accounting came in February 1949 when the first Hoover Commission recommended to Congress the adoption of an accrual accounting system which would show resources, liabilities and actual operating costs. In its report, the Commission observed that
".... there are serious weaknesses in the internal operations of the Federal Government in the fiscal field. These weaknesses penetrate into the heart of every governmental transaction. The President's budget, as submitted to Congress annually, does not indicate accurately what the costs of each activity will be over the coming year; and the government's accounting system, outmoded and cumbersome, does not indicate what was accomplished with the money spent in the year past" [UN, 1984].
In the UK, resource accounting, which focusing on outputs, was introduced by Conservative Government across government by year 1998 (and resource budgeting in year 2000) (HM Treasury, 1994, 1995; Efficiency Unit Scrutiny, 1995). The system was claimed to achieve improved management and value for money by:
"- focusing more on resources consumed and not just a cash spent
- treating capital and current expenditure in a way which better reflects their economic significance
- encouraging the discipline of a greater emphasis on outputs and the achievement of aims and objectives” [HM Treasury, 1995].
However, Craner and Jones (1990) have a different argument on its application in the public sector. They argue that government accounting has two dimensions by which accrual accounting may be thought as an acceptable accounting base. Firstly, to finance all or some of the budgeted expenditures taxes are determined annually. Accordingly, financial accountability in government is annual. Secondly, politicians are subject to some form of periodic election. Consequently, politicians are endowed with short and finite time horizons. Political accountability then must be periodical. Because of these, there will be a fundamental consequence on the interest: this year's taxpayers and this period's voters cannot be assumed to be the same as future years'.
Yet, two problem may arise on an application of accrual accounting in the public sector. Firstly, with respect to non-monetary assets since full accrual accounting requires financial values for them. However, for accountability purposes, Jones and Pendlebury argue that government could still have control over non-monetary assets without using financial values since physical inventories were systematically kept.
The second problem is with respect to the budgeting system. Craner and Jones (1990) assume that accrual accounting will be the best implemented in the accrual based budget, as well as the financial accounts. Most of the accounting professionals were very rare to recommend the use of accrual accounting incorporation into the budgeting system. In the UK, for example, accrual accounting and budgeting is still being urged to be used to a number of public sector organisations such as national accounts, government departments, non-departmental public bodies, nationalised industries, public corporations, NHS, local authorities, charities, educational institutions and housing associations (HM Treasury, 1995).
It is worth noting that for the business-like public sector organisations such as British rail, Royal Mail and other similar companies, the uses of full accrual accounting is indirectly driven by the UK’s company law, i.e., in order to give a true and fair view, their financial reports should comply with FRSs, SSAPs and other SORPs.
One of the critical factors hampering the successful implementation of accrual accounting across the public sector has been the absence of adequate training for those at the accounting office, as the South Australian Auditor-General wrote in its 1991 annual report (MoF, 1994) that "the need to develop and implement systems and policies to accommodate accrual accounting requires professional up-to-date accounting skills". Furthermore, many of the key personnel in the public sector have not had any significant private sector accounting experience for many years. Accordingly, the skill base in some organisations requires updating or enhancing. In most instances this can be achieved through training and management programs. However, there are many instances where external public sector consultants are required and skills must be brought in to supplement the existing skill base.
Another factors which also hampers such implementation is the effect on budgeting. There is a pessimistic view of the implementation of accrual accounting in the public sector, particularly in local authorities, that comes from the public finance expertise. Davey and Devas (1996) believe that budget deficits occur primarily because revenue is estimated at unrealistic levels. The use of accrual based accounting system, revenue side in particular, will give unrealistic revenue estimates, which would lead to inflate expenditure levels as in the case of Ahmedabad LA (Pakistan) and Jinja LA (Uganda). However, this problem has been recognised by the UN in 1984 in its recommendations,
"25. In regard to revenue, the adoption of accrual accounting faces some problems irrespective of the importance and necessity of obtaining information on the amounts to be collected by the revenue-producing operations in governmental entities. It is also essential to take into account that in the majority of cases revenues become uncollectible for different reasons, some of them of a political nature, especially when receivables originate from inter-agency transactions. Accordingly, the final results of operations may reveal inappropriate situations because accrued revenues contain amounts which cannot be collected. A similar situation is presented when revenues originate from income and other taxes. In such cases, the estimation becomes more difficult since the available information does not provide precise data indicating the amount of revenues that will be eventually received" [UN, 1984]
Thus, the application of the accrual accounting in the government entities such as local authority must be considering the prudence factors by, for example, day-to-day examining the prospects of revenue collection, and adjust the expenditures as soon as the income target does appear not be met.

5.4. Cash vs. Accrual Accounting in the Public Sector

This section is intended to assess the usefulness of accrual accounting, compared to cash accounting, in more depth views and discussions. This thought came from the OECD statement that cash and accrual accounting represent two end pools on a spectrum of possible accounting and financial reporting bases (OECD, 1993).
Cash accounting has traditionally been the basis upon which most public sector entities have accounted and reported, largely reflecting the benefit this basis has in demonstrating compliance with cash spending limits. It is the basis upon which governments have traditionally budgeted and for which public sector entities have generally been held accountable. Oshisami (1991) suggests that the fiscal relevance argument in favour of cash accounting outweighs other considerations.
By definition, cash accounting is the basis of accounting records by which it recognises transactions when cash is paid or received. This recognition is not necessarily related to the timing of the services provided or benefit received from transactions. Financial results of the system are reported on the basis of differences between cash received and cash paid. In other words, it is the system that summarises the transactions occurred during the accounting period, manifested into a cash account, on which information is provided for the sources of cash receipts and expenditures statement, to which funds were applied during a reporting period.
In addition, cash accounting does mean that asset registers do not exist or are incomplete; debtor accounts cannot be properly reconciled to sales and cash receipts; aggregate creditor balances are unknown; and departments often act differently in the end of budget period every year.
In facts, almost all governments, both in developed and developing countries, still use the cash basis of accounting system since it offers the simplest procedures, especially useful for stewardship and financial programming. However, despite its advantages, the cash basis actually has some drawbacks. It is in contradictory to the matching concept as described under the SSAP 2. That is, revenues and costs are recognised as they are earned or incurred, not necessarily when the cash flow relating to them is received or paid, and are matched with one another as far as possible (Arnold et al., 1985; Jones and Pendlebury, 1996).
Further drawback of cash basis is on the need to know the financial consequences of the decisions taken during the period, which require recognition of periodic changes in monetary and non-monetary items in the appropriations cycle. The implication is that cash accounting does not, and cannot, account for the year's spending programme in that year (Craner and Jones, 1990).
Further problem that arises from the use of the cash basis is that the balance of appropriations available for expenditure may not be accurately stated when determined on only the basis of cash payments (UN, 1984). Thus, there is a strong potential for over-spending (deliberate manipulation) appropriated amounts to produce preferred results when the system is used. It is recognised that the tight pre-audit for each financial transaction, whether to be followed by the cash payment or not, may avoid the malpractice of the budget execution.
The system also does not provide a useful data in investment projects funded by government since they need data based on cost incurred for cost-benefit analysis of the projects, valuation of fixed assets and properties, accrued interest on external debt, etc.
The proponents of cash accounting, as well as fund accounting, however, always say that the fundamental accountability issue under the system of government is to determine the net cash movement as a result of taxes and other revenue raised during the year and disbursed as commercial and community programs. That is, the net cash movement on year to year basis should be the focus of government reporting. Furthermore, they also rely on the assertion that the government entities are different from private organisations according to how they are managed. On the other hands, accrual accounting has benefits that are significant in their own right. Firstly, it enables more accurate monitoring of the outcomes of investment decision based on capital budgeting techniques. Secondly, it provides an opportunity to budget on accrual basis. And thirdly, it is the most important one, it provides a reliable input and outputs measurement for the costs calculation of providing services.
In the UK, its local authorities has adopted modified accrual accounting for their reporting since the nineteenth century, even though in a very basic method. In its developments, for over a hundred years on, accrual accounting has been a central point issue for debates, especially on the adoption of a full accrual accounting that is used by the private sector.
Modified accrual accounting is fundamentally different from the private sector’s accrual accounting, but there were pressures to affluence local authorities to use commercial accounting. In this regard, Jones (1993b) summarises the rational reasons why local governments adopt the modified, but not fully, accrual accounting. First of all, loan charges and loan principal spread over maximum periods in the revenue accounts, laid down by the government, would give it an important financial control over local government's activities. It forced politicians to bear a proportion of the capital cost of borrowing in increased rates. Since charging depreciation in addition to the loan redemption could not be afforded, the modified accrual basis was effectively mutually exclusive of full accrual. Secondly, because political control depends on periodic elections, the manipulability of cash accounts from one administration to the next was unacceptable.
On the other hand, modified accrual accounting differs from cash basis in respect to the way in which it treates capital acquisition when the sources of finance come from borrowing. In addition, it has been common to adjust operating statements for changes in the opening and closing debtors and creditors accounts. Clearly, cash accounting is to be used in budgetary control on day-to-day basis, the adjustment of receipts and payments has been made to report such accrued accounts such as material stock, interests charges, rents, etc. in the end of every fiscal year.
They then implement this system into local government and argue that revenue, in municipal accounting terminology, is similar in meaning to the same term in private sector accounting, whilst expenditure, is a municipal accounting term which replaces both the term 'cost' and 'expenses' used in the private sector accounting. In addition, Jones and Pendlebury (1996) state that this accounting system is adopted by public sector organisations, especially some UK local authorities.
However, Willits and Bettner (1988) in their survey proved that a number of small governments still produce cash basis financial statements. By questioning the need of requiring modified accrual financial reporting in all US's municipalities, they then suggested that the GASB should consider the acceptability of cash basis reporting in the case of small municipalities. Moreover, regardless the arguments and debates around budgeting system i.e. line item budgeting, programme budgeting, incremental budgeting and zero-based budgeting, as long as simplicity and easy to interpret by the users is concerned, probably local governments, to some extent, preferred to used cash basis along with line-item budgeting in their financial reporting.
Indeed, whether accrual accounting is the right choice for all public sector organisations is a dubious point. But this is not the case to simply reject the uses of accrual accounting. Rather, the many failures in the private sector provide good reasons why private sector accounting methods should be modified before being adopted by the public sector.
One thing however is clear: one of the dangers of cash accounting is that it is open to considerable manipulation. The 1991 Victorian Auditor-General's report cites some examples of expense deferral and revenue advancement that highlight the capacity to manipulate net cash movements. While accrual accounting is not impervious to manipulation, it is not open to the same abuses to which cash accounting is subjected.
But it is hoped that this has all changed by the introduction of accrual accounting. At least, it brings about a balance sheet perspective of the organisation, matching of revenues and its costs, and a framework for better asset management.

5.5. Accrual Accounting and Budgeting

The impact of better accounting system on budgeting system in the public sector organisation has been widely discussed by many authors in public administration and public sector accounting literatures. To named but few, are Aaron Wildavsky, R Anthony, Goode, Enthoven, R H Jones, who are leading authors with their in-depth explanation to this relationship. It is not the intention of this study to discuss more about it. Rather, this review is straight forward to the issue on accrual accounting in the context of accrual budgeting.
Although budgeting system and accounting method are different, they are, of course, intimately related, and in practical terms link each other in a variety of ways. Budgeting provides general framework about how the revenue and expenditure allocated as financial planning by which local government carries out activities and services. Since financial reporting is a last step in budgeting cycle, accounting method then may be used as a based for measuring financial accountability of local government.
So far, as we all know, accrual accounting has been a major topic of government accounting reforms. Unfortunately, sometimes it has been discussed in isolation in accounting technique and theory. Not so many accounting writers whose works link to the external aspect of accounting. Indeed, accounting system must be coherent to the budgeting system that is suitable for the system. Its implementation in the public sector organisation will be successful if it is accompanied by the budgeting that uses the same basis of accounting (that is, accrual budgeting). The system can properly be monitored by the use of accrual accounting. Or, in other words, accrual accounting might not be used as a budget control if the organisation’s budget was prepared based on cash basis.
Accrual budgeting at least can identify a backlogged maintenance and deferred expenses and can determine the extent to which it is expensed in current periods. This enables key decision-makers to determine the extent to which they are passing a time bomb on to the next generation.
However, preparing budget is about gathering data from the lowest units of the organisation, submitted to the higher level of the organisation, then to be compiled together as a budget draft. This is known as bottom-up budgeting process. Consequently, budget preparation will be involving all units and departments within the organisation. The main problem of accrual based budget is clear: lack of skilled staff within the executive body to prepare such budget, politician usually do not care about a complicated calculation, paper and time consuming, and last but not least, the limited budget that is available for the preparation .
In local authorities, however, where a large amount of money is involved, are essential to have a good financial planning system. As part of corporate planning process, financial planning involves a long and medium terms planning, which in turn have to be broken down in a yearly plan, namely annual budget. Jones (1992a) states that budgeting has been the most influential factor to the forms of accounts and financial reports, as well as the contents. For him, the primary reason for this relationship is to serve as a tool for central financial control, either the central government or the central administration within local authorities. It is, therefore, type of accounts and financial reports formats usually are used for financial control purposes (that is, to monitor everyday financial activities of every account against its budget).

5.6. Issues on Capital Accounting

When government acquires fixed assets such as lands, buildings and equipments, they are generally not set up as assets on government account. Rather, they are recorded as expenditures. This is true in the case of the government that uses a traditional cash accounting. However, in the recent years there has been a gradual movement towards the uses of accrual accounting in the public sector.
Depreciation, which was previously harmful to be charged in local government accounts, for example, now becomes an interesting topic of discussions among academicians and accounting professions, although they have already agreed that accrual accounting is a prerequisite to be implemented in the government sector.
Depreciation can be defined as “a systematic allocation of cost or value over the economically useful life of an asset” (Jones & Pendlebury, 1996). A broad definition can be found in SSAP 12: “…… as the measure of the wearing out, consumption or other reduction in the useful economic life of a fixed assets, whether arising from use, effluxion of time, or obsolescence through technological market changes” (ICAEW, 1992).
For business-like public sector company, there will be no doubt to include such calculation for their costs as the concerned assets are in use for generating the profit. But what grounds to be used for depreciating the inheritage assets, such as museums or city garden, owned by local government? Pallot (1990) points out that importing ideas without modification from the commercial sector is often inappropriate, particularly with respect to such fundamental concepts as assets. However, the Code of Practice On Local Authority Accounting in the UK recommends that a full system of depreciation accounting should be implemented in local government report.
Rowles (1991) believes that applying accrual accounting concepts to the preparation of balance sheets for public sector entities has focused attention on the principles relevant to accounting for infrastructure and heritage assets held in government sector. He profoundly argues that when such assets are under control by non-business public sector entities they are in some way different from other types of physical assets held by the same entity. These differences are asserted so as to necessitate adoption of accounting techniques unique to this type of assets. Where capital expenditure is initially funds by borrowings, charging depreciation on these assets imposes intergenerational inequity. Depreciation is seen to add to the financial burden on the future community (Rowles, 1991)
However, if such assets are owned by business-like public sector entities, those assets appear to be accounted for in a way that is consistent with principles applicable to all other types of assets.
Another thought comes from Pallot (1990) in her response to Mautz who has been ‘accused’ that his thought on infrastructure assets are viewed as ‘liabilities’ rather than as ‘assets’. She offers two factors that can be used to distinguish whether certain asset in question is a community or ordinary assets. The two dimensions she offers are: assets as resources and assets as property.
The first dimension tells us that ‘public assets’ cannot only be categorised as ‘inputs’, but also as ‘outcomes’. Assets as resources (inputs) will be treated as an ordinary asset and subject to depreciation, while assets as outcomes do not. For example, motor vehicles owned by local government fall into the input category because they can be used to produce the outputs. Monuments and museums, on the other hands, would fall into the outcome category, as they are directly access by the public in their pursuit outcomes. The two groups of assets are totally different in nature and should not be mixed together in financial statements.
The second dimension is that, assets can also be viewed from the exclusionary aspects. The degree of exclusion of the property can be measured by the right to manage and make decision about the property, the right to benefits arising from the property, and the right to dispose of (sell or destroy) the property (Pallot, 1990). Again, from the example above, motor vehicles are totally exclusive, non public goods as not every body can use them, while monuments and museums both are regarded as public goods.
To support the argument why such community assets are not depreciated is that, according to Pallot, financial statements are rendered almost meaningless when assets have no readily determinable economic value and no readily determinable economic life. Historical cost is meaningless when assets can be upwards of a hundred years old.
A different view comes from Currie (1987). She suggests that a renewal accounting may be more appropriate to these types of assets than depreciation accounting methods. The system is based on the view that certain types of assets have an infinite life if they are maintained by having worn components replaced as necessary. Office buildings, for example, if being neglected without maintenance will ultimately fall down shortly and has no value. By contrast, the building will have an infinite useful life if it well maintained. In fact, there are clear examples in reality: so many historic, well maintained buildings in London, Paris or Brussels which are still in use, all of them have been built more than a hundred years ago and are still being used very well. In this regard, Rowles (1991) doubts over the system whether it can easily be implemented since almost all assets have a finite useful life, though may have very long live. The maintenance costs cannot indefinitely extend the life of the assets.
However, as Jones (1992b) asserts, the confusion on the capital accounting is simply because the boundary between accounting and finance in the public sector organisations nowadays is unclear because they are usually bound up with each other. For example, financial reporting system in the public sector usually has been designed to control the budget. The definition of depreciation, i.e., allocation of initial costs, then can be interpreted as a reserved replacement of such assets.

6. Conclusion

Financial report should provide information that can satisfy the users. However, there are many users with their different needs. Surprisingly, the orientation of financial report standard setting bodies are still on the producers’ side, even till now. They have neglected the user needs consideration. For them, the financial report is not designed for the end users. But Jones gave an argument why it might happen: the users themselves have no intention to read the report, particularly in the public sector.
In addition, government accounting system should also provide assurance to the users that adequate internal control does exist to safeguard the government assets. To fulfil this requirement, the financial report should be prepared timely, reliable, relevant and understandable.
Cash based accounting that has been used by most of the governments in the world has been proven inadequate to provide important information for planning, decision making and analysis. The system which just records the money coming in and out, fails to uncover important information such as creditors, debtors, assets and many others. The wave of reform to replace such system by accrual based accounting has been embraced throughout the world, both national and local levels.
However, there are many scholars who are pro and against the implementation of accrual accounting. At least they are on agreement that cash based accounting alone does not provide a sufficient information for external and internal users. The accrual accounting in government sector, even though with different argument why it is used, gives a better accountability, a clear picture of the entity, a more accurate monitoring, as well as a performance indicator, both in monetary and non monetary terms.
Indeed, accrual accounting cannot give a better result if it is not accompanied by the accrual based budgeting system. The UK government in the right direction: its accounting system reform (resource accounting) does include the requirement to the uses of accrual budgeting in all departments and local authorities. However, its implementation in the developing countries is somewhat arguable as the skills of government accounting players, like politicians, are not the same level as their counterparts in the developed countries.


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DR Soepomo Prodjoharjono, MSc., Acct. is currently a Local Government Accounting Senior Advisor to the Indonesian State Audit Board (Badan Pemeriksa Keuangan Republik Indonesia)

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