Tag Archives | Accrual Accounting

Challenges of Defence Economics

There are several operational difficulties that one faces while analysing the economics of defence in the Indian context – Varun Ramachandra(_quale)

Keith Hartley in his book “The Economics of Defence Policy” describes defence choices as complex because they have to be made in world of uncertainty and assumptions are on the basis of likely future threats(internal, external, and/or via non-state actors). Today’s choices may not be sufficient for tomorrow’s threats or worse still, today’s choices might be irrelevant tomorrow.

In such a scenario, the defence budget cannot be viewed as a stand alone entity. The larger question of how much of our national resources be directed to defence is an important one and deserves holistic treatment(pardon the cliche).  As AK Ghosh in his book “India’s Defence Budget and Expenditure Managament in a Wider Context” suggests “to say that it(defence budget) ought to be larger or smaller, without regard to its internal components or the external components that define it, is worse than useless”.

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There are several operational difficulties that one faces while analysing the economics of defence in the Indian context(or perhaps even in a global context) and this post explores the complexities one faces while studying this area.  The challenges can be classified as

  • Semantic
  • Accounting
  • Obfuscation

Semantic – Currently, there is no clarity on what constitutes as military expenditure and what constitutes as security expenditure. For constitutional and operational reasons internal security is the mandate of Ministry on Home Affairrs whereas the external defence is the mandate of Ministry of Defence. That said, there are several grey areas. Eg., Border Roads Organisation under the MoD has a peace time mission of “Contributing to the Socio-Economic Development of the Border States”. There are several strategic reasons for such assuming such roles, primarily being development and nation-building, but an analysis on whether this constitutes as military expenditure(and if it is being accounted for) is required.

Accounting – Currently, the services follow a cash accounting model which does not capture the market value of current asset and liabilities. A cash based process is a single entry accounting process which records cash transactions but does not capture non-cash transactions. This is a major challenge because large swathes of land and precious resources like spectrum and human resource are not captured while allocating newer resources. This results in unknown spending as opportunity costs are involved. (Some thoughts on accrual accounting by experts can be accessed here)

Obfuscation – As a strategic and a security measure there is definitely a need to obfuscate certain aspects of the defence budget. But care must be taken to ensure that the defence expenditure does not come under civilian heads (if however there is a case for it, it must certainly be justified and necessarily not concealed) . This adds an extra layer of complexity while analysing the economics of defence services.

Varun Ramachandra is a policy analyst at Takshashila Institution. He tweets @_quale

photo credit: Crossed wires via photopin (license)

 

 

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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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Democratic accountability and defence economics

The previous post on defence economics described the need to study the subject. it was concluded that: development of defence economics is necessary from the perspectives of

  • democratic accountability
  • efficiency of resource allocation to ensure preparedness
  • military effectiveness to ensure the right mix of services are deployed to ensure peace
  • improvement of service conditions — that ensures state of the art quality of life for servicemen, ex-servicemen and their families

This post focusses on democratic accountability and the need to maintain it even while dealing with complex choices in defence.

Sound financial management of a country’s security sector is key to maintain an efficient and effective security force that is capable of responding to the population’s legitimate security needs. Avoiding excessive, wasteful, and corrupt military expenditures and procurement thus requires high levels of transparency and accountability in military budgeting and procurement processes.”Such processes should adhere to government-wide financial management and oversight practices, within a rigorously-observed defence policy and planning framework. This includes adherence to public expenditure management (PEM) principles of comprehensiveness, discipline, legitimacy, flexibility, predictability, contestability, honesty, information, transparency and accountability”[1].

In the Indian context, the government and citizens must know the full costs of national security and this can be achieved by making the asset value of services explicit without compromising the strategic secrecy that is the imperative of any defence service.  All the forces together own valuable land, spectrum, human resources, and equipment. Arriving at an explicit asset value creates incentives for increasing the efficiency of all these assets and creates a defence establishment that is effective, efficient, and fiscally prudent.

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The process is easier said than done. For example, a simple step that is tedious to implement is a shift towards accrual based accounting. Currently, the defence budgeting system is based on a cash accounting model which ignores all non-cash transactions. This has masked the exact net present value of all the resources that the services currently possess. 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”[2].  An accrual based accounting system enables more effective performance assessment and provides the necessary information to link the input costs to outputs, and outcomes that is required by services[3].

That said, the complexities of a process should not stifle measures that ensure democratic accountability.

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

References:

[1] “Transparency and accountability in military spending and procurement” http://www.sipri.org/research/armaments/milex/transparency, accessed 15-July-2015

[2] Amaresh Bagchi, Accrual accounting in government, Business Standard, 5-April-2005, http://www.business-standard.com/article/opinion/amaresh-bagchi-accrual-accounting-in-government-105040501073_1.html, accessed on 15-July-2015

[3] Implementation of accrual accounting in Government, Controller General of Defence Accounts, http://cgda.nic.in/accounts/accrual.html, accessed on 15-July-2015

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