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Migration from Cash to Accruals Challenges, pre-requisites and critical success factors: 

Noel Hepworth Chairman, CIPFA International Migration from Cash to Accruals Challenges, pre-requisites and critical success factors

Slide2: 

Comparison of risks: cash v accrual ISSUES 2 Benefits and risks of cash accounting What is the aim of the reform? The costs of changing to accruals Pre conditions for success A conclusion for developing countries Reflecting on Enron! Benefits and risks of accrual accounting

The aim of the reform - some questions!: 

The aim of the reform - some questions! Are financial reports ‘the whole truth’ What are the accounting system & financial reports for Is there an ‘Enron’ type risk in the public sector Does the system of accounting make any difference If there is a risk, what can be done

Purpose of the accounting system - to provide information for:: 

Purpose of the accounting system - to provide information for: External stakeholders – both general and specific reports – key element in accountability. Management – for internal financial control, decision making & performance assessment. Are these objectives achieved? If not, is the accounting base a factor? The Accountant General is responsible for quality and integrity of the financial information system 4

Do public sector financial reports tell ‘the whole truth’?: 

Do public sector financial reports tell ‘the whole truth’? Are the accounts complete? Possible omissions: ‘Off-balance sheet transactions’ Some public sector entities, control is the issue? Some transfers, guarantees, other obligations? Pension liabilities for civil servants? Some assets and liabilities Uncollected tax revenues? Anything else? 5

Is an Enron type situation possible in your country? (1): 

Is an Enron type situation possible in your country? (1) The accounts are incomplete Accounting is on a cash basis Budget is the focus of interest, not accounts The overall concern is with inputs, not outputs Distinction between capital and revenue lacks clarity 6

Is an Enron type situation possible in your country? (2): 

Is an Enron type situation possible in your country? (2) Audit and scrutiny process in inadequate Published accounts are not understandable with no clear user of financial statements Political aim is to present best position Is it the form of the accounting system that creates the risk in government accounting? Would a change from cash to accruals make the difference? 7

Can there be an Enron type situation possible in your country?: 

Can there be an Enron type situation possible in your country? Yes! – there are serious risks in many countries, but politics hides them: the cash basis is convenient. Examples: borrow to finance revenue – California Not providing adequately for pensions – Germany Not accounting properly for assets – Greece But Enron accounted on an accruals basis! Other factors more important than accounting base Governments claim ‘sovereignty’ – can they be trusted to be objective? 8

Factors to prevent or reduce risk of an Enron in the public sector (1): 

Factors to prevent or reduce risk of an Enron in the public sector (1) 9 Strong audit/ accountability arrangements ‘Risk’ to be genuinely transferred to private sector before exclusion from public sector b.s. Clear separation of capital from revenue expenditure & income Devices like ‘leasing’ & private finance of public assets carefully assessed for impact

Factors to prevent or reduce risk of an Enron in the public sector (1): 

Factors to prevent or reduce risk of an Enron in the public sector (1) 10 Political willingness to challenge and cause change in accounts if necessary Independent accountability of civil service Independence of Government standard setting A constitutional requirement that future commitments fully accounted for, including leases/guarantees. pension/ social obligations

Benefits of cash accounting: 

Benefits of cash accounting Simple Links with cash budget and taxation systems Easy to understand Easy to audit and control 11

Risks of cash accounting: 

Risks of cash accounting Ability to manipulate cash flows Assets and liabilities ignored Cash statement does not provide a full picture of the financial position Does not facilitate efficient use of resources No link with economic analyses. Hides intergenerational transfers of cost. 12

The purpose of accrual accounting - is to improve the quality of:: 

The purpose of accrual accounting - is to improve the quality of: Financial reporting. Financial management of government as a whole? Financial management of individual services and cost centres? And so tell at least more of the truth. But, will it do any of these, who is interested and what actions will result? 13

Benefits and risks of accrual accounting – benefits – in theory: 

Benefits and risks of accrual accounting – benefits – in theory 14 Requires a record of assets and liabilities Facilities better quality management Accrual accounts more complete than cash Opportunity to change organisation behaviour Provides better assessment of financial health & can link with economic data Scope for manipulation of cash removed

Benefits and risks of accrual accounting – risks – in practice: 

Benefits and risks of accrual accounting – risks – in practice 15 No linkage with budget (unless reformed) therefore risk of loss of financial control Standards capable of manipulation Seen as technocratic exercise, not management Politicians will not impose discipline Management unwilling or unable to use accrual information to improve services Lack of independent accounting standards

Benefits and risks: 

Benefits and risks 16 Who considers the accounts – just who is interested? There is great scope for judgement in accrual accounting – more so than with cash – who will monitor the exercise of judgement – will Parliament? Isn’t the focus of political and NGO interest on the budget? What can the auditor do that is effective?

Changes to accruals – the costs: 

Changes to accruals – the costs Opportunity cost of change: can you afford it? Training of financial managers. Training of managers and culture change. Changing software and hardware. Appointing/retaining skilled accountants. Diversion from other activity – e.g. PRS Commitment to long run investment – not a 1 year reform Higher costs have to be offset by benefits from management gain! 17

Comparison of risks - cash v accrual: 

Comparison of risks - cash v accrual Accruals creates illusion of quality system, but reality is that quality depends upon: Independence of the standard setting process. The skills of government accountants. Management capacity to use the information. Political willingness to address issues. Quality of audit and reporting process. Use of reports by politicians and stakeholders. 18

An accruals system – pre-conditions for success (1): 

An accruals system – pre-conditions for success (1) Politicians/management understand the change and can use information to improve efficiency. Existing cash accounting system works well. MoF authority respected with a culture that also respects MoF regulations. No parallel accounting systems exist because MoF system is so deficient. No systemic corruption. 19

An accruals system – pre-conditions for success (2): 

An accruals system – pre-conditions for success (2) An annual, comprehensive ext. audit exists. Accounting standards can be set independently of Government, or jointly with third parties. Acceptance that accounting standards are dynamic and need to be regularly updated. The accountancy profession is willing/able to cooperate with civil service, train accountants in Government and to educate staff about standards. 20

An accruals system – pre-conditions for success (3): 

An accruals system – pre-conditions for success (3) Govt auditor supports/participates in reform. Management training programme to focus on resources used rather than cash paid. The budget prepared on same accruals basis. An IT capacity exists to manage the information promptly and efficiently. Managers can and will improve efficiency – shift emphasis from inputs to outputs. Politicians will make decisions. 21

An accruals system: 

An accruals system 22 Political willingness to act on new information ie to require management improvement Can be clear independence in standard setting Willingness to accept the opportunity cost Political willingness to recognise long term nature of the process Overall judgement: only worthwhile if: Cash system works well change will not solve problems, only make them worse

Moving to accrual accounting: 

Moving to accrual accounting Some Governments are/have adopted full/partial accrual accounting: e.g. Finland, Iceland, Sweden*, United Kingdom*, New Zealand*, Australia*, Iceland, European Commission (* and accrual budgeting) Others are considering it: South Africa, Canada, Norway, France, Croatia, Israel. 23

Moving to accrual accounting: 

Moving to accrual accounting As developing countries, should you move to accruals? Some consultants are pressing for change. Some aid agencies, like DFID, do not feel this appropriate. For some countries (not all) the opportunity costs will be considerable. Is it such a priority over other priorities? 25

Conclusion: 

Conclusion Unless accruals system is used effectively and right conditions exist, the greater risk of loss of financial control lies with an accruals system than with a cash based system To change, takes time with high opportunity cost unless management reforms made to work Do not make the change unless prepared to carry through the political / management consequences 26

Concluding Advice: 

Concluding Advice 26 Change will not solve current problems only worsen them – solve problems before making a change and then ensure the right conditions exist before changing!

Contacts: 

Contacts Noel.Hepworth@IPF.co.uk Phone: - CIPFA: 00 44 20 7543 5600 - IPF: 00 44 20 8667 1144 Fax: - IPF: 00 44 20 8681 8058 Web site: CIPFA: www.cipfa.org.uk IPF: www.ipf.com 27