In the United States various initiatives dating back to the 1940s - including two Hoover Commission reports, 1949 and 1955 - recommended the adoption of governmentwide accrual accounting. In 1967, the President's Commission on Budget Concepts - a temporary 'blue ribbon' commission headed by the Secretary of Treasury - recommended that the accrual basis of accounting replace the 'cash basis' (as soon as feasible) for measuring receipts and disbursements. President Johnson accepted the Commission's recommendation and ordered that the conversion be made in the 1971 budget. President Nixon reaffirmed Johnson's decision shortly after he took office. In a memo dated August 12, 1969, Nixon reaffirmed the importance of accrual accounting as part of the Joint Financial Management Improvement Program, led by the U.S. Department of the Treasury (Treasury), the Government Accountability Office (GAO), and the Office of Management and Budget (OMB); but he deferred the conversion process to the 1972 budget. Then, the issue lost momentum in Washington, until the passage of the Chief Financial Officer's (CFO) Act of 1990, which required Annual Consolidated Financial Statements for the United States of America. The CFO Act provided for the creation of the Federal Accounting Standards Advisory Board (FASAB) to promulgate accrual concepts for the preparation of these financial statements. (The FASAB is specifically precluded from doing anything in connection with the federal budget process.)
Accrual versus Cash Basis of Accounting - the Basic Difference
First, let me say that the independent accounting professions promulgating 'generally accepted accounting principles' (GAAP) for the United States (U.S.), Australia, New Zealand, Canada, and the United Kingdom have accrual concepts as the foundation for these principles. So, what is the accrual basis of accounting, and why should we continue to be concerned about it? Simply stated, the 'cash basis' of accounting records financial transactions when income is received (by cash or check) and expenses are paid (by cash or check). Whereas the accrual basis of accounting recognizes as income what the government has either earned or is entitled to receive, even before payment is received; and, it recognizes as an expense what the government is obligated to pay, when billed or contractually liable, even before payment is made. Accrual/GAAP accounting is considered a better way to measure a large and complex entity's financial condition and the results of its operation, not only in financial terms, but in an economic sense.
In fact, former U.S. Comptroller General Elmer Staats so accurately described the advantages of using government-wide accrual accounting for financial reporting in his remarks before the Committee to Investigate a Balanced Federal Budget of the Democratic Research Organization on Implementing Accrual Accounting within the Federal Budget in 1976:
"In summary, accrual accounting in the federal government has been a legal requirement since 1956. Since accrual accounting is fundamental to sound financial management it has always been a basic tenet of our principles and standards. I believe that current economic conditions and the extensive Government use of deficit financing have accentuated the need for the federal government to provide better overall financial reports that show clearly for the benefit of the Congress and the public the major aspects of its financial position and operations."
It should be noted, as addressed in the September 7, 1971 report from the staff steering committee on budget concepts, that accrual accounting proposals would not abandon the use of a cash basis by Treasury for cash position and debt management.6 (The cash basis is a necessary system for determining the amount and timing of the buying and selling of bonds and other Treasury securities by the federal government, to implement fiscal and monetary policies). As has been recommended in the past, the accrual basis of accounting would also serve as a clear measure of the U.S. government's finances, since it would be 'anchored' to the cash basis data and reconciled with the cash basis in public reports. Finally, the recommendation of a conversion to the accrual basis of accounting would not have the intention of changing the appropriations process in any way. The task of appropriating federal funds and collecting those funds - through taxation, fees and borrowing - is an explicit power of Congress and its respective committees. The implementation of government-wide accounting on an accrual basis would not infringe on this power.
The Pioneering Work of Arthur Andersen & Co.
In 1975, Arthur Andersen & Co. conducted groundbreaking professional work to enable the U.S. government to bailout New York City through the preparation of conventional, accrual-based financial statements that were required by Treasury and investment bankers on Wall Street to facilitate the now historic bailout. Acting on its own initiative and based on its experience in New York City, the firm prepared the first published U.S. Consolidated Financial Statements on accrual/GAAP basis. Arthur Andersen's 1975 report, entitled Sound Financial Reporting in the Public Sector, pointed out that that a 1956 law (Public Law 84-863) required all government agencies to prepare business-type, accrual-basis financial reports. The 1975 report also resulted in the appointment of the Advisory Committee on Federal Consolidated Financial Statements by Treasury Secretary William E. Simon. (The committee developed a guide for preparing annual consolidated financial statements for the U.S. government.)
Subsequent Arthur Andersen reports listed the economic and financial reasons for public sector accrual accounting. These included the need to accrue federal pensions and social security costs, to capitalize expenditures for long-term assets, and to consolidate financial reporting for the U.S. government. Andersen's 1986 report entitled, Sound Financial Reporting in the U.S. Government, aptly described the main difference in government accountability that occurs under a cash basis system of accounting as opposed to an accrual system:
"Given the existing practice of cash-basis budgeting and reporting, programs can be adopted and promises can be made without knowledge of their full cost. This lack of accountability creates an incentive for elected officials to curry favor with today's voters at the expense of tomorrow's taxpayers. This lack of accountability has long been a root cause of fiscal mismanagement within the U.S. government. In fact, excluding interest expense, nearly all growth in government spending as a percentage of Gross National Product (GNP) since World War II is related to programs that involve promises to make future payments."
The Reasons for the Emergence of
Accrual Accounting Concepts in the Public Sector
Looking back on the economic and political environments that led to the adoption of the accrual method of accounting in New Zealand, Australia, Canada, the United Kingdom, and the hybrid method used today in the U.S., we see similar reasons motivating a change from the cash basis of accounting since the 1970s. In the case of New Zealand, public debt and government deficits continued to grow throughout the 1970s and 1980s. Along with this, New Zealand was experiencing double-digit inflation, and in 1983 its credit rating, for bonds issued to fund its rapidly increasing budget deficits, was downgraded. New Zealand publicized its first accrual-based Crown financial statements in 1992 and, became the first national government to do so for its public sector. At the same time, the U.S. government has been unable to convert its annual financial statements (legally required by the 1990 CFO Act) onto a true accrual basis. Instead, the most recent "Financial Report of the United States Government," prepared by Treasury, has deemed the accounting system it uses for preparing the annual financial report to be a 'modified cash basis.' Today, Australia and New Zealand are portrayed as paragons of fiscal responsibility, having achieved number one and two rankings out of thirty-four major countries in the attached Sovereign Fiscal Responsibility Index prepared in 2011 by Stanford University (see Figure 1). In the same study, the U.S. is ranked poorly at number twenty-eight.
In looking at the economic and political environments common to all countries adopting the accrual basis of accounting, the following phenomena were present in all cases:
1. Substantial growth of government operations, employees and overhead;
2. Increasing levels of taxation;
3. Rapid increases in the cost of government programs for healthcare and entitlements;
4. Badly needed investment in deferred infrastructure maintenance and infrastructure improvements;
5. Unchecked growth of budget deficits and national debt; and
6. Declining standards of living and a decrease in the size of the middle-class.
Uses of Accrual Accounting
Unlike New Zealand, Australia, Canada and the United Kingdom, the U.S. takes a different approach in applying accrual concepts to:
1. Annual budgeting;
2. Preparation of annual financial statements;
3. Improving financial management and performance measures at the department and agency levels; and
4. Monitoring the true cost of the growth of procurement contracts in economic terms, especially for the U.S. Department of Defense (DoD).
The U.S., in particular, does not use the accrual basis of accounting for calculating its annual budget deficits and the resulting national debt. Also, FASAB has proposed accrual standards for use in the preparation of annual U.S. Consolidated Financial Statements, but such standards do not include using traditional accrual/GAAP for reporting federal pension liabilities and obligations for social security and Medicare. Actuaries have estimated these obligations to be over $40 trillion, well above the outstanding current Treasury debt of nearly $16.9 trillion that is subject to the statutory debt limit. For the U.S. government, the implementation of government-wide accounting standards on an accrual basis would have at least two important effects. First, budget and financial reports on an accrual basis would provide a more accurate measure of the U.S. government's finances and its impact on the nation's economy. And, second, the use of accrual accounting standards can assist in management improvement for the agencies and departments of the federal government - promoting greater efficiency, publicizing true costs, minimizing government waste, and controlling inefficient spending, especially on long-term government contracts.
It is past time for the U.S. government to adopt (as have the governments of Australia, New Zealand the United Kingdom and Canada) accrual-based accounting standards similar to those of America's private sector, as mandated by the Securities and Exchange Commission for publicly-traded companies. And, they should be applied to all important financial and accounting functions in the federal government - budgeting, preparation of annual financial statements, and evaluating performance at the department and agency levels of the U.S. government. In implementing accrual accounting at all levels of government, Congress will validate the recommendations of Arthur Andersen & Co., the firm that led the accounting profession as the first public advocate for financial accountability in the public sector. To do this, Congress needs to pass legislation that implements the recommendations of the Hoover Commission reports of 1949 and 1955 (endorsed by President Truman and then by President Eisenhower). In doing so, Congress will be implementing Public Law 84-863 (passed in 1956), calling for accrual accounting for all federal agencies.13 Congress will also be fulfilling the main recommendation of the President's Commission on Budget Concepts (endorsed by President Johnson in 1967 and reaffirmed by President Nixon in 1971).
This Article was Originally Published in The Journal of Government Financial Management