CASH VERSUS ACCRUAL ACCOUNTING IN PUBLIC SECTORAdriana TIRON TUDOR assoc. prof. PhD Alexandra MUTIU lect. PhD University Babes Bolyai, Cluj Napoca, Romania [email protected] Abstract: In public sector the cash basis of accounting has been traditionally used, but in the last period there have been discussions over the benefits of a change to the accrual basis. There are a lot of important supporters of cash basis like IFAC,who issued 21 IPSAS, based on IAS/IFRS, EU commission and IMF. Many organizations like SIGMA and the DFID which work in transitional and developing countries, question the priority, for these countries at least, of moving from the cash to the accrual basis of accounting. So, the move to the accrual basis for public sector financial reporting has not gained universal acceptance. In Europe, there are a lot of countries who refuse to make the exchange, or who have increased doubts. In this confuse international context Romania starting with 2006 implement the accrual accounting for public sector. In our article we intend to analyze the evolution of movement from cash to accrual accounting in public sector, the factors who influenced the movement in the case of Romanian accounting public sector and to respond at the follows questions: - It is better or not for romanian public sector accounting to make the movement from cash to accrual accounting ? - Romania had or not the chance to choose the system ? Keywords: public sector, accrual accounting, harmonization

1. International Context 1.1.

Cash versus accrual accounting

There are two basic accounting methods used to determine when and how to report income and expenses in the books: cash method and accrual method. These methods differ

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only in the timing of when transactions, including sales and purchases are counted to accounts. Under the cash method, income is not counted until cash is actually received, and expenses are not counted until actually paid. Under the cash basis, revenues and expenses are recognized when payment is made or received. Like advantages of cash basis accounting we can mention: easiest to do, it is objective, with few choices to make. Like disadvantages of cash basis accounting we can mention: no attempt is made to match an expense with the revenue it generates. This means that the income statement and balance sheet may not be good pictures of recent activity and present activity conditions. Cash-based accounting can distort the true operations of the activity and incorrectly reflect income. Under the accrual method, transactions are counted when the order is made, the item is delivered, or the services occur, regardless of when the money for them (receivables) is actually received or paid. In other words, income is counted when the sale occurs, and expenses are counted when are received the goods or services. The advantages and disadvantages of accrual basis accounting are the follow: - accrual accounting measures current income more accurately than the cash method. This means that the balance sheet is a more accurate estimate of financial position (value). Accurate, current information makes it easier to predict future income and financial position. - accrual accounting is difficult to understand. Confusion exists because net income does not equal the period's change in cash. The cash balance of a company with high income may even decrease during the year. Since in the history of accounting there have been periods when one or the other method dominated clearly.

1.2.

Cash versus accrual accounting for public sector

In the field of the public sector accounting, there were two thinking trends, a traditional one based on cash accounting, and a modern one based on accrual accounting. Under the traditional model, of public administration cash accounting or budget accounting, cash based system initially considered as being more appropriate for the public sector, the emphasis was on compliance with rules and regulations. One of the results of this system is the budget out-turn report looked upon as a basic part of the usual financial statements in the public sector. According to the modern model the emphasis is on efficiency, so it is recommended that the public sector should introduce the set of financial statements applied in the private sector, which is made according to accrual accounting. Through accrual accounting we can maximize the effects of the process of competition enabling and public management efficiency so that this should be achieved with minimal costs for the society. The passing to the new system is not a purpose in itself but rather a change of mentality regarding the budgetary process, by passing from a rigid situation of cashed incomes and paid expenses to a situation where the emphasis is on achievements and forecasts hoping that this last system will lead to the increase of public management efficiency.

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Nowadays Financial Statements must show the true and fair value of equity financial situation and profit and losses. Commission for Public Sector Accounting Principles and Standards has established a new conceptual framework. The developing of it brings us two kinds of P&L: - Net income: Variation in equity as a result of its budgetary and non budgetary transactions - Budgetary P&L: Difference between all the budgetary revenues and expenses realized during the accounting year, excluding those derived from financial liabilities. The international movement of New Public Management from cash to accrual accounting is a consequence of: • Increased diversification of accounting systems • Quality of government reports • Interest of international finance institutions • System of National Accounts moved to accrual basis in 1993 • Strong engagement of IFAC-PSC chair

1.3.

The movement from cash to accrual accounting in public sector

In the public sector literature, has been investigated the process of change by identifying and defining the relevant environmental variables that represent its important dimensions (Luder, 1992, 1994; Pallot, 1996). Other studies have researched the introduction of accrual reporting for governments and their agencies (Ryan, 1998). In the international scene, researchers have highlighted the managerial philosophy underpinning public sector accounting change in the UK, USA, Australia and New Zealand (Humphrey et al., 1993; Christopher et al., 1993; Parker and Guthrie, 1990; McCulloch and Ball, 1992; Mayston, 1993; Castles et al., 1996). Chile was the first state that introduced accrual accounting for the public sector in early 70s, followed by New Zealand in 1990. However, unlike New Zealand where the change was comprehensive, other countries have made gradual changes. For example, in the USA the generally accepted accounting principles (accrual accounting) have been adopted only by some states (Carpenter and Feroz, 2001). In USA and Australia the passing to accrual accounting occurred in 1997 but only in central governmental administration, in local administration the change being implemented just now. Canada took over the system in 2001-2002. In the early 1990s, Bourn (1993) identified New Zealand’s shift to accrual accounting as a model for the UK to follow. The United Kingdom has adopted accrual accounting at the agency level and is looking to produce aggregate consolidated financial statements for 2006. It plans to prepare consolidated financial statements in a staged manner: stage 1 - consolidation of the non audited central government accounts using 2001-02 National Accounts information, stage 2 - consolidation of the accrual 2003-04 central government accounts and stage 3 - whole-of-government accounts consolidation for 2005-06. By the turn of the millennium, New Zealand had become one of the countries with the most extensive set of accrual accounting disclosures (Piana and Torres, 2003).

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A few other governments have subsequently agreed to follow this path, but an increasing number are adopting a policy of ‘wait and see’. Starting with 2000, out of the 30 of the most developed OECD members only 22 adopted accrual accounting for all the fields of the public sector. Since 2000 Malaysia and Tanzania were the only non-OECD-members, which have planned to adopt accrual accounting for central administrations1, but later they gave up. Since July 2002 only three EU members have succeeded completely in the transition towards accrual accounting, following that The European Commission itself will make the transition after 2005. In Europe the accrual accounting reform start gradually as is presented follow:

At national government level in six countries: Spain, United Kingdom, Finland, Sweden, Swiss, France have begun the reform process. Three national governments Finland, Spain and Sweden have by-and-large completed the reform (legal requirements, new system) At local level, the reform commenced in all nine countries, and in five countries the reform have been completed: Finland, France, Nederland, United Kingdom and Swiss. Accounting has traditionally served the function of budgetary control in the sense of comparing spending against the budget (budgetary accounting). Most accounting systems at national level are double entry system (Spain, France, Finland, Sweden) with some exceptions (United Kingdom and Swiss) and most accounting systems at local level are single entry systems (France, Nederland, Finland, Spain, Swiss, Denmark). In Europe, Sweden and the UK followed suit, while other countries - including Germany and the Netherlands - are shifting or are planning to shift to an accrual basis. Half of OECD member countries use some form of accrual accounting in their financial reporting, although only a few use accruals in their budget process. Extending accruals to budgeting is controversial (Matheson, 2002, p. 44). 1

We can conclude that: accrual accounting reform comes first and budgeting follows. IFAC Public Sector Committee (2000) - IPSAS 1 – Presentation of Financial Statements IFAC;

- dual accounting systems prevail on the national level content of accrual accounting reforms differs between countries and even within countries between different levels - increasing international divergence of public sector accounting practices due to countryspecific reforms.

1.3. International bodies position regarding the movement from cash to accrual accounting in public sector The use of accrual accounting in the public sector is a relatively recent phenomenon and the balance between costs and benefits is still the subject of substantial debates both for academics and practitioners. The idea of New Public Management is shared by the international bodies, the International Monetary System, The World Bank, The European Bank and OECD that require adopting accrual accounting in the public sector. EU encourages the candidate states to adopt the accrual accounting system for the public sector. There are increasing doubts over whether the change to accrual accounting by governments is worth the costs and the additional risks involved. The countries which decide to pass from cash accounting to accrual accounting are warned by IFAC to analyze very carefully the validity and the benefits expected from this reform taking into account the conditions, the priorities and the local characteristics. Also, the European Federation of Accountants issued a paper outlining the risks involved and explaining the essential pre-conditions for the successful implementation of accrual accounting. If accrual accounting succeeded in reaching its goals, is an open question. A complete analysis is possible only if the new system is applied in a certain number of years.

1.4. International Public Sector Accounting Standards The International Federation of Accountants (IFAC) by the Public Sector Committee developed International Public Sector Accounting Standards (IPSAS). The IFAC has been encouraging governments and other public sector entities to adopt the accrual basis of accounting for their general-purpose financial statements. In recent years, the IPSAS Board has made considerable progress in developing a set of standards for public sector financial reporting on the accrual basis of accounting and other guidance for public sector entities but IFAC- PSC has no power to require compliance with IPSAS. Comparison of IAS and IPSAS shows very little material differences (additional commentary, different terminology and definition) As of February 2006, PSC had issued 21 IPSASs. However, these standards are not yet complete or comprehensive. IPSAS objectives are the improvement of quality (transparency and thus accountability) and comparability of financial information, assistance to national standard-setters.

The IFAC scope is the appliance of IPSAS in all public sector entities (national, regional and local governments and their component entities [departments, agencies, boards, commissions]) Current IPSAS landscape looks like follow: - National governments with the intention to change to the accrual basis having expressed to consult IPSAS: France, South Africa, United Arab Emirates, Netherlands, Malta, Hong Kong, Thailand, Cayman Islands, Mongolia, Israel - Countries currently adopting the accrual basis which comply with most of the IPSAS requirements: Australia, Finland, Iceland, Canada, Sweden, New Zealand, UK and Fiji - OECD issues IPSAS-compliant financial statements since FY 2000 (audited by PWC) - European Commission will issue first IPSAS-compliant financial statements for FY 2005 - NATO will adopt IPSAS as of FY 2006 There are, for example, currently no agreed standards for taxation or social policy obligations, such as state pensions. In addition, there is no universally agreed approach to the valuation of particular sets of assets such as heritage, infrastructure or military assets. As a result, individual governments moving to the accrual basis would have to develop their own standards in those areas. For these reasons, the IPSAS do not yet have the same standing as International Financial Reporting Standards (IFRS) in the private sector. As yet no country has fully implemented the IPSAS. In addition, the range of countries planning to move to accrual accounting is rather limited. There are compelling arguments in favor of accrual-based budgeting and reporting for governments.

1.5. EU Commission position Starting the modernization project in the year 2000 with a study, deciding then already a year later to enshrine new accounting rules in the new Financial Regulation, the Commission adopted its plan to introduce fully accrual-based accounts and to comply with IPSAS by 2005 at the end of 2002. In recent years, it has emerged that the European Communities' accounts need to be modernized to change from a cash accounting system, focusing on a mere description of effects in terms of cash movements in the implementation of the budget, to an accrualbased system1 with the objective of presenting the Communities' financial situation in a more comprehensive form, showing all its entitlements and debts. The European Community is gradually falling into line with the approach adopted by a large number of States and supported by international bodies such as the IFAC and OECD. Even though the public sector still pursues objectives, which differ, in part from those in the private sector, the whole world now considers it inevitable that cash accounting should be abandoned and that a relative degree of harmonization should be sought for new practices. The current international standardization will tend to increase, shifting the old public accounting concepts towards a system closer to that of company accounts, while retaining the specific features of the public sector.

The ultimate aim of changing to accrual accounting is to present accounts and statements, which provide a more accurate picture of the institution's assets and liabilities. The reference accounting framework, which should serve as a basis for the development of the European Communities’ accounts is consistent with the IPSAS international standards.

2. Background of local public sector accounting in Romania 2.1. Accounting Legal framework The local public administration is organized in the following administrative units: counties, cities, towns and communes. There are two levels of local government in Romania: first level consists of the 41 county councils and the second level of the 3003 local councils: 276 towns and municipalities and 2727 communes. In 1991, was issued the Accounting law, which stipulates that all entities, including public institutions, have the obligation to organize and manage their own accounting system and the financial accounting, and the management accounting adapted to the particular aspect of the activity. The accounting system of the public institutions shall ensure information to the loan managers with regard to the incomes and expenditure budget execution, the patrimony under administration, as well as for the drawing up of the general annual accounts of state budget execution, of the annual account of the state social insurance budget execution, of the special funds, as well as of the annual accounts of the local budget execution.

2.2. Local public sector accounting harmonization process Until 2000 the accounting system for the public sector applied in Romania was characterized as being an accounting system based on cash. For Romania, in the context of European integration, the achievement of the public sector accounting reform has become an urgent necessity. The key-element that confirms the need of reform in public sector accounting is the informational gaps of the actual system based on cash accounting. An example is the extreme case of local governments from villages which were strictly in the limits of pure cash accounting, by the overlapping of the expenses notion with the payment notion, of the income notion with cashing-in, low-training level of the staff, over standardization of activity, low technical endowment or even the lack of it. The harmonization process of Romanian local public sector accounting suppose some main adjustments regarding: 1. Accrual systems, for inventories, receivables (taxes, social contributions and interests) and payables: these are necessary for the recognition of expenditures (and receipts) made in financial periods other than those in which the costs were actually incurred.

2. Recognition of full depreciation of fixed assets: to ensure full incorporation into the costs of activities of the consumption, use and deterioration of fixed assets. This is often a significant cost component of capital-intensive public sector activities. 3. Assessment of normal profits as "costs of capital": will recognize the return on investment implicit in the use of the funding of fixed and working capital by owners or by other funding sources in addition to loans. 4. Revaluation of fixed assets to allow for inflation: will result in recognition of current fixed asset values and the related current costs of depreciation. It also affects the proper recognition of the return on investment, when expressed as a percentage of the real (opportunity) costs of capital. For comply with ESA 95 methodology, the Ministry of Public Finance promised to introduce the accrual accounting system for public institutions, starting with 2003. In August 2001, the Government Ordinance no. 61/2001 for completing and amending the Accounting Law no. 82/1991 was adopted in order to establish the general implementation framework. One important requirement regards the compulsory use of double entry accounting for all entities. By the fourth quarter of 2002, the following methodological norms were promised to be prepared: norms regarding the accounting of budget provisions, norms regarding the organization and management of the assets accounting for public institutions, the Accounts’ List for public institutions as well as the norms regarding the accounting of the main operations. In order to take over the EU aquis chapter 11 Economic and Monetary Union and chapter 29 Financial and Budgetary Expenses, Romania has started rather shyly than transition process towards accrual accounting, which will require additional capacity and resources. Through the position document regarding the negotiation of chapter 11 Romania engaged to report to EC according to ESA 95 requirements European standard Accounts regarding public accounting and debt. By introducing the new budgetary classification (July 2005) applicable starting with 2006 an important step was achieved in harmonizing the accounting system for the public sector with the European and international regulations. In order to make the Romanian accounting specialists know the best international accounting practices for the public sector The Chartered Accountants Body from Romania translated into Romanian in April 2005 the International Accounting Standards for the Public Sector, issued by the International Federation of Accountants, edition January 2005. With the intention of harmonizing the public sector accounting system with the European and international regulations, in the last 5 year a few reform elements have been introduced which aim at: • The induction, liquidation, ordering and payment of public institutions expenses (OMFP 1792/2002), the four stages of the budget execution of expenses are carried out by all public institutions no matter their subordination and the way of financing expenses with compulsory pre-observance of procedures. Public institutions are also compelled to organize, lead the record and report the budgetary and legal arrangements starting with 2003.

•

The re-evaluation and depreciation of fixed assets that are in the patrimony of public institutions (OG no.81/2003 and OMFP no.1487/2003) are introduced for the first time in the history of public administration in Romania. By introducing reevaluation it was wished to bring at the current cost or the entrance value actualized in correlation with the utility of goods and their market value and by introducing the depreciation it was wished to reflect the real value of goods and the presentation through financial statements of a real image of the patrimony. • The organization and leading of budgetary incomes accounting (OMFP no.520/2003), according to the Accounting law, that stipulates the compulsoriness of registering in accounting the rights and obligations of the public institutions when they are acknowledged, in this sense there had been until that moment a major contradiction between the national regulation in accounting and the regulations applicable to public institutions. • The introduction of a new budgetary classification (OMFP no.1025/2005) applicable starting with 2006 according to ESA 95 requirements concerning accounting and public debt has contributed to making an important step in the harmonization of the public sector accounting with the European and International regulations. With all the reform elements, the present accounting system in the Romanian public sector has a lot of faults especially concerning the quality of information provided both to managers and third party institutions. Till December 2005 the general opinion was that the passage to accrual accounting in the public sector in order to take over the EU acquis will be applied in Romania the latest in 2007. If until now the public sector accounting has had a secondary role in comparison with the budget, a limited role in patrimony reflection, the cashed incomes and the expenses, by passing to accrual accounting, the accounting system, through the information that it will provide, will regain its deserved place. Ministry of Public Finance issued some versions of a project of new public accounting harmonized with international accounting standards but without publishing or disseminating in period 2002-2005, but finally, in December 2005 was issues and officially published the new accounting system for public sector with applicability from January 20062.

2.3. The main characteristics of the new public accounting system The new public accounting system is based on the European Directives, European accounts system (ESA 95). There are also considered the accounting and information presentation requirements according to International accounting standards for the public sector (IPSAS).

2

OMFP 1719/2005- Romanian Accounting regulations for public sector harmonized with European and International Regulations

Passing over to accrual accounting can be done at once or gradually. In theory and practice there are three options: -Accrual accounting implemented for state budget, local budgets and all budget users – total implementation -Accrual accounting implemented for all budget users, but not for state and local budgets -Accrual accounting implemented for all budget users, except for four state treasuries of public finance (state budget, local budgets, pension and disability fund, health fund) Romania optioned for total implementation. Some international consultancy teams in finalizing the new accounting system for public Romanian sector helped the Finance Ministry by PHARE: Twinning Project contracted by the European Union. The IPSAS 1 Financial statements was fully adopted, in this sense are presented the general purpose financial statements prepared and presented under the accrual basis of accounting. The role of financial statements is to be presented in order to ensure comparability both with the entity’s own financial statements of previous periods and with the financial statements of other entities. General purpose financial statements are those intended to meet the needs of users who are not in a position to demand reports tailored to meet their specific information needs. Users of general-purpose financial statements include taxpayers and ratepayers, members of the legislature, creditors, suppliers, the media, and employees. General-purpose financial statements include those that are presented separately or within another public document such as an annual report. The objectives of general-purpose financial statements are to provide information about the financial position, performance and cash flows of an entity that is useful to a wide range of users in making and evaluating decisions about the allocation of resources. A complete set of financial statements includes the following components: (a) Statement of financial position; balance sheet or statement of assets and liabilities (b) Statement of financial performance (c) Statement of changes in net assets/equity; (d) Cash flow statement; and (e) Accounting policies and notes to the financial statements. The statement of financial performance is a new statement, for Romanian public entities. As far as Romania is concerned, there are opinion that emphasize the benefits of the new system3 but also more reserved opinions4. Thus in some people’s opinion5 as long as the transition towards accrual accounting is valid for developing countries it’s possible that this not necessarily good for less developed countries or with a transition economy. And in Sigma’s opinion (organization that provides assistance to central European countries which are preparing for UE adhesion): both the efficiency of the reform in the countries where it was implemented and the viability for the economies in transition remains a debatable subject both for academics and practitioners. 3

Horobeanu S., Alecu G. 2003 McKendrick 2003, idem 5 McKendrick 2003, idem 4

This reform of public accounting has impact on all public institutions but especially the communes, which used another type of accounting and have a limited number of personnel with multiple responsibilities and limited access at training. A change in mind is also needed, which implies a redesign of the personal value system. This means to overcome the past reluctance of prepares of financial information to disclose more than was absolutely necessary, in particular in relation to contingent liabilities (including liabilities to State organizations), related parties identification, and disclosure of certain segmental information. In 2001 -2002 was made an empirical study in the frame of the pre-adheration program 6which aimed at the attempts that Romania had to do at that time regarding the taking over of the EU acquis in the field of public sector accounting with a preliminary evaluation of costs and benefits.

5. Conclusions EU encourages the candidate states to adopt the accrual accounting system for the public sector7, which is why Romania adopts the accrual accounting system in the public sector starting with the year 2006. For this, it needs an accounting system which records economic events when they occur, instead of when cash is paid in or out, and hence it needs a greatly improved IT system, and improved administrative procedures, in order to ensure that the accounting information is complete, timely and accurate. We can conclude that it is better for romanian public sector accounting the movement from cash to accrual accounting, knowing the general advantages of accrual accounting for internal and external information users. Since a financial analysis is always wider than a simple budgetary analysis, nowadays it´s necessary to provide a detailed disclosure of the execution of the budget as well as financial information. There is a need of developing the necessary skills and providing training for both the preparers and users of financial information. At the communes level there are few, if any, skilled accountants employed and where financial management is seen as of lesser importance than legal compliance. The first step toward the accrual accounting system was made in Romania, by creating a legal framework. Budget and accounting categories at the national level have a common set of classifications conform to international standards, that facilitate policy analysis and promote accountability. Starting with 2006 Romania is able to produce national accounts conforming to ESA95. Accounting conventions and procedures need to be made compatible with concepts related to the disbursements of EU funds – commitments, payments, eligible expenditures, etc. Fiscal reporting should be timely, comprehensive and reliable, and identify deviations 6

Tait D., Hurduzeu M., Morariu V. (2002) - Impactul pentru Romania al introducerii contabilitatii de angajamente pentru institutiile publice -studiu de impact al preaderarii Proiect Phare RO 9907-02-01; 7 McKendrick J. (2003) - Modernisation of the Public Accounting Systems in Central and Eastern Europe Countries – the case of Romania 9th CIGAR Conference, Bodo, Norway;

from the budget. Procedures for evaluating the efficiency and the effectiveness of expenditure policies and programs – including those funded from EU sources – should be established. Making further progress in these areas will require substantial investment in staff development and training, supported in many cases by EU twinning projects and other technical assistance programs. In addition, Parliament at central level and Local Councils at local level need to strengthen their capacity to analyze budgetary information, so that they can play a full role in balancing the power of the Executive.

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