More thoughts on accrual accounting

This is a part of a series on Defence Economics. Previous blogs on the same topic can be found here, here, and here.

In continuation with the last piece that dealt with democratic accountability and defence economics, this post provides some more sources that have analytically written about the importance of an accrual-based accounting system.

Gur Saroop Sood  in this excellent article refers to the cash-based accounting thus:

 “Under the cash-based system, the currency transactions, pertaining to a Financial Year, are available till the closing of accounts. Once the accounts are closed, past transactions do not become readily available. In this system, committed liabilities incurred do not get recorded in the accounts at the time of their occurrence. Therefore, for commitment control, such information has necessarily to be generated through additional reports. If the committed liabilities are not available, the possibility of over or under committing resources vis-à-vis available funds in a Financial Year cannot be ruled out. The accounting system also does not generate information for the decision-makers to know whether the money is being spent on core or peripheral activities. Due to the principle of lapse, the Executive tends to spend the earmarked funds during the month of March, sometimes also referred to as ‘March rush’, in order to avoid surrender of unspent funds spend the earmarked funds during the month of March, sometimes also referred to as ‘March rush’, in order to avoid surrender of unspent funds.”

Amaresh Bagchi in his Business Standard piece says

Such a system 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”

The 12th Finance Commission’s recommendations are as follows

“Compared to the cash based system, the system of 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. It is different from cash based system in that it records flow of resources. Expenses are recorded when the resources (labour, goods and services and capital) are consumed, and income when it is earned, i.e. when the goods are sold or the services rendered. The associated cash flows generally follow the event after some time and may or may not take place during the same accounting period. Thus, in addition to cash flow, unpaid consumptions (payables) and unrealized income (receivables) are also recorded. Resources acquired but not fully consumed during an accounting period are treated as assets (inventory and fixed assets). Payments made for acquisition of inventory are included in the operating cost for the period in which it is consumed. Payments made for acquisition of physical assets, that have future service potential, are amortized over the entire useful life of the asset by charging depreciation

The system of accrual accounting thus, inter alia, allows better cost – price calculations, records capital use properly, distinguishes between current and capital expenditures, presents a complete picture of debt and other liabilities and focuses policy attention on financial position, as shown in the whole balance sheet not just cash flows or debts thereby providing a complete measure of cost of various services and provides net worth and their changes over time

The Controller General of Defence Accounts while talking about implementation of accrual accounting in Government says the following

Accrual accounting system enables system enables a more effective assessment of the performance and provides the necessary information for linking the input costs to outputs and outcomes that is required by services.

The challenge of moving to an accrual based accounting is the time that is required for the transition. Also, the switch will place considerable demands on the accounting personnel particularly at the lower and middle levels of the accounting hierarchy.

Amaresh Bagchi’s Business Standard piece has a solution to this problem as well where he suggests

 transitioning in a phased manner and in the interim both cash and accrual accounting can run in parallel to ensure a smooth transition.

There is overwhelming evidence, and scholarly  agreement about moving towards an accrual based accounting system. It is a matter of wonder that the move has not yet happened. Perhaps, an analysis on why cash based accounting  system is still in vogue is an exercise worth undertaking.

Varun Ramachandra is a policy analyst at Takshashila Institution, he tweets @_quale

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