Amaresh Bagchi: Accrual accounting in government

The accrual- and cash-based systems have their uses and the two should run in parallel.

While making recommendations that will have a far-reaching impact on the finances and functioning of the government in the country, the Twelfth Finance Commission (TFC) has suggested some "institutional" changes for effectively implementing its recommendations.

One of them relates to the accounting procedure in government. After noting the deficiencies of the present cash-based system, the TFC has urged the central government to "move gradually towards accrual basis of accounting".

As the recommendations contained in the TFC's report have been accepted by the Union government "in toto", presumably action will be initiated soon to implement this suggestion as well.

Moves to change the system of accounting in government from "cash" to "accrual" have been afoot for quite some time.

Recognising the need to reform the system of government accounting to reflect the changing perceptions and emerging demands of the economy, the Comptroller and Auditor General of India (CAG) has set up a board to advise on Government Accounting Standards (GASAB).

The case for and modalities of moving over to accrual accounting in government will surely engage the attention of the board. Meanwhile, an independent agency (ICRA) was commissioned by the CAG last year to chalk out a roadmap for installing accrual accounting in government.

The report of the agency is presumably under examination.The move towards accrual accounting will receive further impetus from the TFC's recommendation.

No doubt, the implications of the change and the alternative ways of implementing the suggestions of the TFC will be carefully gone into before decisions are taken for action.

However, a few words by way of caution may be in order before the plans for ushering in accrual accounting in government are finalised.

That a system of accounting based only on the receipt and disbursement of cash is gravely deficient in providing information required for a full picture of the financial position of the government at a given point of time or the changes that take place over time resulting from government policies is well recognised.

The TFC has enumerated them at some length. Mainly, these are: one, it does not provide a full picture of the government's liabilities, because accrued liabilities such as those from unfunded pensions and commitments are not taken into account; two, it keeps no track of the assets of the government, nor do they provide information on the costs of holding and operating them or of their consumption or use.

More serious, a cash-based accounting system "provides room for fiscal opportunism" because taxes can be collected in excess during a period, to be refunded later; expenditures can be underrecorded by deferring payments, tax revenues for future years can be preempted by taking one-time payments, and so on.

Also, the government's liabilities can be shifted outside its Budget by making its agencies autonomous.

In contrast, accrual accounting "recognizes financial flows at the time economic value is created, transformed, exchanged, transferred or extinguished, whether or not cash is exchanged at that time".

Thus, all payables and receivables, whether or not paid or realised, get recorded. Costs of inventories used up during the accounting period are included in the operating costs while those of long-lasting assets are amortised over their life by charging depreciation.

This facilitates better cost-price calculations and thus the costing of the services provided by the government, and also "takes care of disinvestments receipts and provides adequate information of both fiscal balance and net worth and their changes over time".

All these are essential inputs for bodies like Finance Commissions and agencies monitoring the performance of governments in achieving targets of fiscal correction in terms of revenue deficit and fiscal deficit.

While most of these assertions are incontestable, it needs to be noted that both accrual accounting and the cash-based system have their uses, depending on the purpose one has in view.

Unlike in the private sector, where accounting is needed primarily to assess the profits (loss) earned (incurred) by an entity and changes in its net worth over a period, the primary objective of accounting in government is to ensure that the public finances of the country are managed in conformity with the directions of the legislature, in short establish the government's accountability for raising and spending public funds.

The accounts should also help to assess the net result of the fiscal operations of the government in terms of the surplus or deficit of revenues over expenditures pertaining to the period in view and their likely impact on the Budgets of the future.

That requires attributing the receipts and expenditures to the periods to which they relate and taking note of commitments for expenditure in the years to come.

Accrual accounting is needed to meet these objectives. It helps also to record acquisitions of assets and thus, the requirements for their upkeep and maintenance.

Government accounts should also provide an idea of the demand made by the public sector on the resources of the economy and the gap between expenditures actually incurred and revenue receipts and how they are met, so that the impact of the Budget on aggregate demand, output, and prices can be assessed and analysed.

For this purpose, it is necessary to look at the total expenditure and the receipts of the government over the accounting period, both current and capital.

Cash accounting serves to meet this purpose. Financial statements based on these two systems alone may not, however, suffice to provide the information needed to judge the health of the public finances at a point of time since they may not capture all the liabilities incurred by the government, such as guarantees extended to public sector agencies.

Nor would they reveal all the cost of government operations, e.g. the implicit subsidies. The financial statements, thus, need to be supplemented by additional information that may have a bearing on the revenues and expenditures and the government's net worth, whatever "net worth" may mean in this case.

Operationalising these principles is not simple. In essence, the move from cash-based to accrual-based accounting requires a change in the point of recognition of a transaction.

While expenditures may be recognised when liability for the payment is accepted, defining the criterion for recognising receipts, particularly from taxation, may be problematic.

Should the government accounts recognise receipt as soon as the demand for a tax is raised even when it is contested? Even for expenditures, it is not always simple to quantify a liability at a given point of time because some judgement is required to anticipate the claims likely to arise in the future such as for pensions.

Similarly, while it should be incumbent on the Budget to provide information on all subsidies, how should the implicit subsidies be computed? How does one work out the "tax expenditures" or subsidies implicit in the concessions allowed in tax, such as savings in income tax? It is necessary to set up standards to guide accountants for all such items before accrual accounting is introduced.

In the absence of such standards, the complexities of accrual accounting can be employed to hide and distort.

For all these reasons, instead of aiming to move wholesale to accrual accounting, it may be advisable to have an arrangement whereby both cash and accrual accounting will run in parallel, along with a few supplementary statements to make the government's Budget more transparent and comprehensive.

The author is Professor Emeritus, National Institute of Public Finance and Policy