Accrual Accounting-transition From Cash To Accrual

Transition from Cash to Accrual Accounting – Tarun Das

Transition from Cash to Accrual Accounting

This report describes the basic requirements and the steps for successful transition from cash to accrual accounting.

Prof. Tarun Das1 Glocom Inc. (USA) Strategic Planning Expert Ministry of Finance Government of Mongolia November 2007

1

This report is primarily based on the Government Finance Statistics Manual 2001 (GFSM 2001) and a working paper (IMF/WP/02/240) entitled “Performance Budgeting- Is Accrual Accounting Required” by Jack Diamond, published by the International Monetary Fund (IMF), Washington, D.C. It may be mentioned here that the present author was a Member of the Expert Group Meeting at IMF, Washington D.C. in February 2001 to discuss the Draft GFS Manual 2001 and to incorporate final round changes and conclusions in GFSM 2001 (refer the Preface by Mrs. Carol S. Carson, the then Director, Statistics Department, IMF in the GFS Manual 2001, p.ix).The present author was also Country Reporter for India on IMF Government Finance Statistics when he worked as Economic Adviser in the Ministry of Finance, Government of India during 1989-2006.

Glocoms Inc. (USA)

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MOF, Govt. of Mongolia

Transition from Cash to Accrual Accounting – Tarun Das

Transition from Cash to Accrual Accounting Prof. Tarun Das2

CONTENTS Executive Summary 1. Different compilation approaches by member countries 1.1 Cash and Accrual Reporting 1.2 Data for IMF GFS Yearbook 2. Preconditions for the move to accrual 3. Steps for successful transition from cash to accrual accounting 4. Migration to IMF GFSM 2001 reporting 5. Current Status of IMF GFSM 2001 in Mongolia

Selected References Annex-1: Capital Charges for the Government of Mongolia, Report by Jim Yardley, Accounting Advisor and Andrew Hilton, Valuation Consultant, 25 November 2005.

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This report is primarily based on the Government Finance Statistics Manual 2001 (GFSM 2001) and a working paper (IMF/WP/02/240) entitled “Performance Budgeting- Is Accrual Accounting Required” by Jack Diamond, published by the International Monetary Fund (IMF), Washington, D.C. It may be mentioned here that the present author was a Member of the Expert Group Meeting at IMF, Washington D.C. in February 2001 to discuss the Draft GFS Manual 2001 and to incorporate final round changes and conclusions in GFSM 2001 (refer the Preface by Mrs. Carol S. Carson, the then Director, Statistics Department, IMF in the GFS Manual 2001, p.ix).The present author was also Country Reporter for India on IMF Government Finance Statistics when he worked as Economic Adviser in the Ministry of Finance, Government of India during 1989-2006.

Glocoms Inc. (USA)

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MOF, Govt. of Mongolia

Transition from Cash to Accrual Accounting – Tarun Das

Transition from Cash to Accrual Accounting Professor Tarun Das Executive Summary Transition to an accrual based accounting and budgeting systems is an integral part of overall fiscal reforms and wider public sector governance reforms. However, as OECD (2002) concluded “accruals basis is not a magic bullet for improving performance of the public sector. It is simply a tool for getting better information about the cost of government. It needs to be used effectively and in tandem with a number of other management reforms in order to achieve the desired improvement in decision making in government.” An accounting system performs two important functions. First, it provides an account of the financial position of the government for the fiscal year as required by the legal system to ensure accountability for public funds. Second, day-to-day recording of government financial transactions provides useful information for formulation of desired public policies and to aid management decision making. It is generally recognized that an accrual accounting is better than cash accounting as an accrual system identifies, measures and reveals all government liabilities and revenues, both balance-sheet and off-balance-sheet items, which may be concealed in cash accounting. Since accrual accounting also allows the generation of cash accounts, these systems should not be regarded as mere substitutes. IMF GFSM 2001 recognizes that in a developing country like Mongolia with constraints in resources, technical manpower and information technology, transition to a full fledged accrual accounting and budgeting and GFSM 2001 reporting systems cannot be created overnight and have to be evolved through various stages over a number of years. These stages span from a cash basis accounting to cash-plus-accrual accounting (alternatively known as modified accounting or partial accounting) to full accrual accounting. However, the transitional path and the journey time can be shortened and better planned by learning lessons from international experiences and best practices. Migration to IMF GFSM 2001 reporting Government of Mongolia already adopts some amount of accrual data, particularly for government commitments towards terminal benefits of government staff. It is also making an attempt to list and value physical assets. Usually, the accounting of assets may not include common assets such as infrastructure assets (e.g. roads, rails, sea ports, air ports, brides and water Glocoms Inc. (USA)

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MOF, Govt. of Mongolia

Transition from Cash to Accrual Accounting – Tarun Das supply). So, it will be opportune to adopt a “cash plus accruals” strategy based on the availability of accrual-based data. The conversion path to the IMF GFSM 2001 reporting system and can follow the path outlined in Flow Chart-1. Stage one: Restructure existing cash data Without the need of additional data, cash data may be reorganized on the basis of new statements required under IMF GFSM 2001. This will require preparing operating statements and balance sheets (for details, see “Accrual Accounting Rules for GFS” prepared by Tarun Das). In brief, taxes and other current revenues, wages and salaries, purchases of goods and services, interests and other current payments are included in a cash operating account. Purchases of non-financial assets are classified to an investment account and changes in financial assets and liabilities are shown in a separate financing account. It is necessary to prepare consolidated general statement of financial position, statement of financial performance, and cash flow statement. Attempts may also be made to prepare consolidated public sector accounts. • Adopt simplifying recognition rules For revenue recognition, adopt a rule that is very close to cash realisation while recognizing tax revenues on accrual basis. For expenses, do not adopt category no.22 “use of goods and services” (see Flow Chart-1), and distinguish between current expenditure and longer lasting materials assets acquisitions. In respect of these assets, adopt a 100 percent first year depreciation rule (as used in Canada). Also do not adopt category no.23 “consumption of fixed capital”, a periodic depreciation of fixed assets. Article 26.3 of the Public Sector Management and Finance Act (PSMFA, 27 June 2002) of Mongolia mandates that “Cost of outputs shall be determined on the basis of full accrual cost of production, including management overheads and capital charges”. In our opinion, inclusion of capital charge may not be necessary for Mongolia as most of the surplus public assets have been privatized, and most of the budgetary bodies do not have their own resources and depend on the central government for investment. The issues on depreciation and capital charges have earlier been examined by international consultants Jim Yardley and Andrew Hilton in November 2005 (see Annex-1). They concluded that “Capital charges and current value accounting are complicated, expensive, and may not provide much benefit in return.” Depreciation estimated on the basis of the book value of capital investment may provide reliable and inexpensive approximations of capital charge for five or ten years. We agree with their conclusions. Stage two: Use partial accrual data Glocoms Inc. (USA)

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MOF, Govt. of Mongolia

Transition from Cash to Accrual Accounting – Tarun Das • Accommodate some elements of statement of economic flows Most flows under this category involve revaluation of fixed and financial assets and liabilities at market prices. At the early period, only some flows may be recognized such as write-off of assets, revaluation of financial assets/ liabilities due to exchange rate fluctuations, windfall gains/ losses due to natural disasters, unforeseen accretion to wealth due to discovery of new mineral assets; privatisation of corporations with unremunerative assets (by reclassification) etc. • Progressive recognition of existing financial and nonfinancial assets. A possible transition path is as follows: first priority is financial assets including on-lending, and then easily quantifiable non-financial assets such as government buildings and lands. The most difficult assets like public infrastructure assets (e.g. roads, rails, air ports, sea ports etc.) would follow, but can be avoided for an indefinite period, and can be assumed to be sunk capital stock. Only at the last stage, a developing country like Mongolia may make an attempt to include mineral resources and other hard-to-define assets like forest wealth, national parks, and heritage assets. It may be mentioned here that even the developed countries have not yet developed methodologies for valuation of heritage assets. • Begin to replace cash transactions in the operating account by the corresponding accrual transactions. All liabilities, including contingent liabilities (like placed orders for supply), be recognized as soon as they arise by opening account heads to capture accounts receivable in revenues and accounts payable in expenses. The depreciation cost could also be included as an expense for these assets. For this stage, it is necessary to prepare GFSM 2001 compatible chart of accounts and to generate new fiscal reports consistent with partial accrual accounting. • Stage three: A progressive move to full accrual data. GFSM 2001 recognizes that since GFS is a reporting system, it can differ in many respects from the budgeting accounting systems of a country. It is possible for a country (e.g. Australia) operating an accrual accounting system with national accounting standards and coding structures, which are different from those of GFSM 2001. Alternatively, it is possible to adopt GFSM 2001 accrual based system but with significant dilutions of accrual concepts e.g. depreciating new buildings 100 percent in the first year so as to reflect the entire capital cost as an expenditure in the same fiscal year (as Canada); eliminating difference between expense and expenditure by assuming immediate consumption of stocks, or valuing heritage assets by a token value etc. Flow Chart-1: Steps for Migration to IMF GFSM 2001 Glocoms Inc. (USA)

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MOF, Govt. of Mongolia

Transition from Cash to Accrual Accounting – Tarun Das

Source: Jack Diamond, IMF WP/02/240, Washington D.C., December 2002.

Glocoms Inc. (USA)

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MOF, Govt. of Mongolia

Transition from Cash to Accrual Accounting – Tarun Das

Transition from Cash to Accrual Accounting Professor Tarun Das 1. Different Compilation Approaches for Member Countries The GFSM 2001 recommends recording economic stocks and flows on an accrual basis. However, it is recognized that, in most countries, the development of accrual information will take time. Therefore, for each sub-sector of general government, a country may complete GFS tables according to the accounting rules underlying the fiscal data currently being compiled by the reporting country. The accounting method (cash, accrual or others) for each sub-sector of general government should be indicated clearly. Countries may use different approaches for compiling statistics in accordance with the GFSM 2001 framework. The approaches may vary according to the country’s accounting and budgeting practice, and the amount of resources devoted to the process. Most governments currently use a cash basis of recording in their accounting and budgeting systems. Some have started to use an accrual basis of recording and others use various stages along a wide spectrum between cash and accrual. The GFSM 2001 analytic framework, though conceived from an accrual perspective, can be used to present data generated by a variety of accounting practices. 1.1 Cash and Accrual Reporting The majority of 133 countries reported cash data for publication in the Government Finance Statistics Yearbook 2006, and will, most likely, continue to do so for the foreseeable future. Beginning with the 2003 GFSY, the historical cash data that were reported in accordance with the 1986 methodology are published in the GFSM 2001 framework. The conversion of the historical cash data to the framework of the GFSM 2001 results in a number of coverage and classification gaps and does not lead to accrual accounting. 1.2 Data for IMF GFS Yearbook Information for IMF GFS Yearbook requires that a country is required to provide a brief description of the GFSM 2001 implementation status and plans of the country. If a country plans to migrate to the GFSM 2001(or has already started doing so), it is required to indicate the main steps of the plan and their target dates. If a country has not yet developed plans to migrate to the GFSM 2001, they may indicate so. Implementation of the GFSM 2001 can take numerous forms and will depend on each country’s circumstances. For countries that have data only on a cash basis, a first step could be to reclassify these data in the GFSM 2001 framework. Introduction of accrual reporting can take the form of Glocoms Inc. (USA)

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MOF, Govt. of Mongolia

Transition from Cash to Accrual Accounting – Tarun Das either (i) the implementation of ad hoc adjustments to the cash data (for example, the recognition of in-kind transactions and the accrual of interest) or (ii) the implementation of accrual accounting for the source data. 2. Preconditions for move to accrual As discussed in the earlier report on Accrual Accounting and Accrual Budgeting (Tarun Das, October 2007), the experiences of the OECD countries indicate that the implementation of accrual accounting is not easy; and it takes time and requires political commitment. For any country, much preparatory works are needed to launch the new accounting system. The costs and challenges of introducing accrual accounting are great for most of the developing countries. Complete and consistent accounting rules, methodology, standards, practices and codes need to be developed. Information bases need to be built up and a significant capacity building is required to upgrade the information technology, to train the people preparing and using the new information and to enhance the skill of accountants and auditors engaged in the job. In sum, a significant amount of investment is required in introducing the accrual system and to reform the budget management system to gain the full benefits. For all these reasons, it is necessary to have full political commitment to move towards accrual accounting. Ministers and politicians need to be convinced about the benefits of accrual accounting as indicated in Box-1. Box-1: Benefits of Accrual Accounting for Government • Facilitate assessment of program performance by showing the full cost of programs (including the capital costs and government’s future commitments towards the terminal benefits of government employees). • Facilitate assessment of financial position by recognizing all resources and all obligations. • Enhance the accountability of management for their performance. • Act as a spur to better performance management due to increased transparency. • Provide a wider range of information needed for decision making. • Enable more effective use to be made of a given level of resources. • Provide a more effective basis for decisions about such matters as user charges for government supply of goods and services, identifying savings options to finance high priority objectives, and workplace contracts. Source: Jack Diamond, IMF WP/02/240, Washington D.C., December 2002.

Glocoms Inc. (USA)

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MOF, Govt. of Mongolia

Transition from Cash to Accrual Accounting – Tarun Das

One example is the introduction of capital charge. Traditional budgets based on cash accounting are very weak in asset management. A major change in accrual accounting is to consider investments of assets and to account for depreciation and capital charge. Alternative models for capital charge are shown in Table-1. Table-1: Designs of Capital Use Charge

Source: Jack Diamond, IMF WP/02/240, Washington D.C., December 2002.

Glocoms Inc. (USA)

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MOF, Govt. of Mongolia

Transition from Cash to Accrual Accounting – Tarun Das 3. Steps for successful transition from cash to accrual accounting Jack Diamond (IMF WP/02/240, December 2002) has suggested the following steps for successful transition from cash to accrual accounting. Stage one: Get cash accounting to work well. This requires supplementing the cash accounts with items to improve fiscal reporting and to introduce memoranda items for government’s future liabilities. Stage two: Integrate operating accounts and financial asset and liability accounts to move to modified accrual. An essential requirement of modified accrual accounting is to introduce payables and receivables in the government accounts. • Accounts payable: This allows for the recording of liabilities that have not resulted in the payment of cash in the current accounting period. It includes goods delivered but not paid for and agreements to pay subsidies and grants to the private sector. • Accounts receivable: This allows for the recording of revenue earned by the government that has not resulted in the receipt of cash although it is sufficiently close to cash receipts. It includes taxes and non-tax revenues that are due but not paid and also credit sales of goods and services. Other measures required at this stage are indicated in Box-2. Box-2: Measures involved in moving to modified accrual accounting • Adopt a classification structure that facilitates the recording of revenues, expenses, assets, liabilities and cash flows as per requirements by GFSM 2001. • Ensure that the general ledger is based on double-entry system. • Explore best option for recording and reporting selected assets and liabilities. • Generate and agree trial balances. • Establish process of reconciliation of assets and liabilities in the general ledger with subsidiary records, such as accounts receivable and payable and fixed assets. • Reconcile accounts with independent third party information where available (e.g. ledger balances with bank statements). • Publish statements of contingent liabilities and outstanding commitments as part of budget documentation. • Establish and train an asset valuation unit, which will develop appropriate valuation methods and value all government financial assets. • Prepare a list of government financial assets (initially at historic cost, unless market valuation has already been done) including investments in all parastatals and liabilities.

Glocoms Inc. (USA)

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MOF, Govt. of Mongolia

Transition from Cash to Accrual Accounting – Tarun Das Stage three: Introduce more elements of accrual recording and move to a partial accounting presentation in ex post reporting. At this stage the following additional items of accrual accounting could be considered: • Provisions for employee entitlements such as contributions to pension, provident, insurance and terminal benefits funds for the government staff. • Prepayments received by government: These receipts can range from deposits on the sale of assets to installment payments on the provisions of government goods and services. • Interests payable: Interests on debt can be significant drain on budget resources and simply recording interests when paid may not provide adequate information on government liabilities for interest payments in future. This is particularly the case with the zero coupon bonds (see Box-3).

At this stage of accrual accounting, ex post reporting of budget performance would include a partial balance sheet with selected financial assets and liabilities, and the adjusted cash flow operating statement would include some items on an accrual basis.

Glocoms Inc. (USA)

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MOF, Govt. of Mongolia

Transition from Cash to Accrual Accounting – Tarun Das Stage four: Recognize non-financial assets- final stage of accrual accounting The transition from recognizing only financial assets to recognizing both financial and non-financial assets leads to greater complexities in the accounting process. This requires development of valuation techniques and continual valuation of all government non-financial assets, many of which may not be easily subjected to a market related assessment of value. Once this task is accomplished, depreciation can be charged as an expense. At this stage, full accrual ex post reporting may include the following items: • Operating performance statement showing how revenues and expenses explain the change in the net stock of assets; • Balance sheet of financial position at the beginning and at the end of the accounting period; • Cash flow statement showing cash flows embodied in assets, liabilities, revenues and expenses distinguished by operations, investments like loans and advances and the financing of cash flows through the issue of government securities. Stage five: Move from accrual accounting to accrual accounting and budgeting Accrual budgeting should be differentiated from accrual accounting. As of December 2002, only New Zealand, Australia and Iceland had moved to a system of output budgeting, while all other OECD countries were adopting only accrual accounting, but budgets were prepared on cash basis. Major additional information are required to shift from accrual accounting to accrual budgeting: • Movements in cash and cash equivalents, the cash being spent on purchase of assets and receipts for sale of assets, and estimated financial transactions; • Movements in inventories, receivables, payables, employee entitlements and other liabilities; and • Details of asset depreciation policies. Accrual budgets will show projected cash flow (as traditional budgets), projected revenues, expenses, and operating statement; and projected assets, liabilities, and equity in the statement of financial position.

Glocoms Inc. (USA)

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MOF, Govt. of Mongolia

Transition from Cash to Accrual Accounting – Tarun Das 4. Migration to IMF GFSM 2001 reporting Mongolia already adopts some amount of accrual data, particularly for government commitments towards terminal benefits of government staff. It is also making an attempt to list and value physical assets. Usually, the accounting of assets does not include common assets such as infrastructure assets (e.g. roads, brides and water supply). So, it will be opportune to adopt a “cash plus accruals” strategy based on the basis of available data. The conversion path to the IMF GFSM 2001 reporting can follow the path outlined in Flow Chart-1. Stage one: Restructure existing cash data Without the need of additional data, cash data may be reorganized on the basis of new statements required under IMF GFSM 2001. This will require preparing operating statements and balance sheets (for details, see “Accrual Accounting Rules for GFS” prepared by Tarun Das). In brief, taxes and other current revenues, wages and salaries, purchases of goods and services, interests and other current payments are included in a cash operating account. Purchases of non-financial assets are classified to an investment account and changes in financial assets and liabilities are shown in a separate financing account. It is necessary to prepare consolidated general govt financial statement and make an attempt to prepare consolidated public sector accounts. • Adopt simplifying recognition rules For revenue recognition, adopt a rule that is very close to cash realisation while recognizing tax revenues on accrual basis. For expenses, do not adopt category no.22 “use of goods and services” (Flow Chart-1). Distinguish between current expenditure and longer lasting materials assets acquisitions. In respect of these assets, adopt a 100 percent first year depreciation rule (as used in Canada). Also do not adopt category no.23 “consumption of fixed capital”, a periodic depreciation of fixed assets. Article 26.3 of Mongolia PSMFA (27 June 2002) mandates that “Cost of outputs shall be determined on the basis of full accrual cost of production, including management overheads and capital charges”. In our opinion, inclusion of capital charge may not be necessary as most of the surplus public assets have been privatized, and most of the budgetary bodies donot have their own resources and depend on the central government for investment. The issues on depreciation and capital charges have earlier been examined by international consultants Jim Yardley and Andrew Hilton in November 2005 (see Annex-1). They concluded that “Capital charges and current value accounting are complicated, expensive, and may not provide much benefit in return.” However, depreciation estimated on the basis of the book value of capital investment may provide reliable and inexpensive approximations of capital charge for five or ten years. We agree with their conclusions.

Glocoms Inc. (USA)

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MOF, Govt. of Mongolia

Transition from Cash to Accrual Accounting – Tarun Das Stage two: Use partial accrual data • Accommodate some elements of statement of economic flows Most flows under this category involve revaluation of fixed and financial assets and liabilities at market prices. At the early period, only some flows may be recognized such as write-off of assets, revaluation of financial assets/ liabilities due to exchange rate fluctuations, windfall gains/ losses due to natural disasters, unforeseen accretion to wealth due to discovery of new mineral assets; privatisation of corporations with unremunerative assets (by reclassification) etc. • Progressive recognition of existing financial and nonfinancial assets. A possible transition path is as follows: first priority is financial assets including on-lending, and then easily quantifiable non-financial assets such as government buildings and lands. The most difficult assets like public infrastructure assets (e.g. roads, rails, air ports, sea ports etc.) would follow, but can be avoided for an indefinite period, and can be assumed to be sunk capital stock. Only at the last stage, a developing country like Mongolia may make an attempt to include mineral resources and other hard-to-define assets like forest wealth, national parks, and heritage assets. It may be mentioned here that even the developed countries have not yet developed methodologies for valuation of heritage assets. • Begin to replace cash transactions in the operating account by the corresponding accrual transactions. All liabilities, including contingent liabilities (like placed orders for supply), be recognized as soon as they arise by opening account heads to capture accounts receivable in revenues and accounts payable in expenses. The depreciation cost could also be included as an expense for these assets. For this stage, it is necessary to prepare GFSM 2001 compatible chart of accounts and to generate new fiscal reports consistent with partial accrual accounting. • Stage three: A progressive move to full accrual data. GFSM 2001 recognizes that since GFS is a reporting system, it can differ in many respects from the budgeting accounting systems of a country. It is possible for a country (e.g. Australia) operating an accrual accounting system with national accounting standards and coding structures, which are different from those of GFSM 2001. Alternatively, it is possible to adopt GFSM 2001 accrual based system but with significant dilutions of accrual concepts e.g. depreciating new buildings 100 percent in the first year so as to reflect the entire capital cost as an expenditure in the same fiscal year (as Canada); eliminating difference between expense and expenditure by assuming immediate consumption of stocks, or valuing heritage assets by a token value etc. Glocoms Inc. (USA)

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MOF, Govt. of Mongolia

Transition from Cash to Accrual Accounting – Tarun Das

Box-4: Steps for Migration to IMF GFSM 2001

Source: Jack Diamond, IMF WP/02/240, Washington D.C., December 2002.

Glocoms Inc. (USA)

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MOF, Govt. of Mongolia

Transition from Cash to Accrual Accounting – Tarun Das 5. Present Status of GFSM 2001 in Mongolia The following table, obtained from the Government Finance Statistics Year Book published by the International Monetary Fund, provides the Fiscal Statements for Mongolian General Government sector for the year 2003 (JanuaryDecember) as per GFS Accounting standards. However, it has the following two limitations: (a) It does not estimate the Consumption for Fixed Capital, and (b) It does not provide the Statement for Cash Balance for 2003 (in this table the cash balance is given for 2002, but not for the year 2003). GFS Accounts for Mongolia General Government (GG) 2003 in Billion MNT Billion B. Statement of sources and A. Statement of govt operations MNT uses of cash (2002) Billion MNT 1 Cash receipts from 1. Revenue 599.94 operating activities 489.77 2. Expense 465.85 11 Taxes 287.27 GOB Gross operating balance (1-2) 134.09 12 Social securities 54.93 Less Consumption of fixed capital 0 13 Grants 19.31 NOB Net operating balance 134.09 14 Other receipts 128.26 2 Cash payments for 31 Net acquisition of nonfinancial assets 139.02 operating expenses 402.92 NLB Net lending/ borrowing (NOB-31) -4.93 21 Compen. of employees 112.1 32 Net acquisition of financial assets 54.86 22 Purchase of goods/services 163.93 33 Net incurrence of liabilities 63.22 24 Interest 20.04 NLB Statistical discrepancy 3.43 25 Subsidies 8.79 Statement of other economic flows 26 Grants 0.62 Balance sheet 27 Social Benefits 90.62 6 Net worth -449.42 28 Other payments 6.82 CIO Net cash inflow from 61 Nonfinancial assets 1306.79 oper.activities 86.85 31.1 Purchases of 62 Financial assets 0 nonfinancial assets 99.65 63 Liabilities 1756.21 31.2 Sales of nonfinan. assets 0 31 Net cash outflow from investments in nonfinancial assets CSD Cash surplus/ deficit 32x Net acquisition of fin.assets,excl.cash 321x Domestic 322x Foreign 323 Monetary gold and SDR 33 Net incurrence of liability 331 Domestic 332 Foreign NFB Net cash inflow from financial activities NCB Net change in the stock of cash CSD Statistical discrepancy

Glocoms Inc. (USA)

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99.65 -12.8 37.04 36.74 0.3 0 65.36 -16.86 82.22 28.32 15.52 0

MOF, Govt. of Mongolia

Transition from Cash to Accrual Accounting – Tarun Das

Table-1 Revenue 1 Revenue

Billion MNT 599.94

11 Taxes 111 taxes on income, profits, capital gains 1111 Individuals 1112 Corporations and other enterprises

353.69 97.58 28.8 68.78

112 Taxes on payroll and workforce 113 Taxes on property 114 Taxes on goods and services 1141 General taxes on goods and services 1142 Excises

0 12.66 209.96 121.87 58.58

115 Taxes on Intnl. trade & transactions

32.65

116 Other taxes 12 Social contributions 121 Social security contributions 122 Other social contributions 13 Grants

0.84 90.84 90.84 0 8.73

131 From foreign governments 132 From international organisations 133 For other general govt units 14 other revenue

Glocoms Inc. (USA)

8.66 0.06 0.01 146.68

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Table-2 Expense by economic type 2 Expense 21 Compensation of employees 211 Wages and salaries 212 Social contributions 22 Use of goods and services 23 Consumption of fixed capital 24 Interest 25 Subsidies 26 Grants 261 To foreign governments 262 To international organisations 263 To other general govt units 2631 Current 2632 Capital 27 Social Benefits 28 Other expense 281 Property expense other than interest 282 Miscellaneous other expense 2821 Current 2822 Capital

Billion MNT 465.85 142.92 117.34 25.58 178.23 0 17.65 9.38 0.73 0 0.72 0.01 0.01 0 116.81 0.13 0 0.13 0.13 0

MOF, Govt. of Mongolia

Transition from Cash to Accrual Accounting – Tarun Das

Table-3 Transactions in assets & liabilities 3 Change in net worth from transacts. 31 Net acquisition of nonfinl. assets 311 Fixed assets 3111 Buildings and structures 3112 Machinery and equipment 3113 Other fixed assets 312 Inventories 313 Valuables 314 Nonproduced assets 3141 Land 3142 Subsoil assets 3143 Other naturally occurring assets 3144 Intangible nonproduced assets 32 Net acquisition of financial assets by instruments 3202 Currency and deposits 3203 Securities other than shares 3204 Loans 3205 Shares and other equity 3206 Insurance technical services 3207 Financial derivatives 3208 other accounts receivables By debtor 321 Domestic 322 Foreign 323 Monetary gold and SDR 33 Net incurrence of liabilities by instruments 3302 Currency and deposits 3303 Securities other than shares 3304 Loans 3305 Shares and other equity 3306 Insurance technical reserves 3307 Financial derivatives 3308 Other accounts payable By creditor 331 Domestic 332 Foreign Table 4 Holding gains in assets & liabl. Table-5 Other changes in the volume of assets and liabilities

Glocoms Inc. (USA)

139.02 100.14 96.77 1.38 1.99 38.01 0 0.87 0 0 0.64 0.23 54.86 160.4 0 19.17 -19.37 0 0 0 62.67 -7.81 0 63.22 0 78 -22.66 0 0 0 0 162.98 -99.76

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Table-6 Balance Sheet 6 Net worth 61 Nonfinancial assets 611 Fixed assets 6111 Building and structures 6112 Machinery & equipment 6113 Other fixed assets 612 Inventories 613 Valuables 614 Nonproduced assets 6141 Land 6142 Subsoil assets 6143 Other natural assets 6144 Intangible nonprd. asset 62 Financial assets by instruments 6202 Currency and deposits 6203 Securities except shares 6204 Loans 6205 Shares and other equity 6206 Ins. technical reserves 6207 Financial derivatives 6208 Other accounts payable By creditor 621 Domestic 622 Foreign 623 Monetary god and SDR 63 Liabilities by instruments 6302 Currency and deposits 6303 Securities except shares 6304 Loans 6305 Shares and other equity 6306 Insurance tech. services 6307 Financial derivatives 6308 other accounts payable By debtor 631 Domestic 632 Foreign Memo. items 6M2 Net financial worth 6M3 Debt at market value 6M35 Debt at face value 6M4 Debt at nominal value 6M5 Arrears 6M6 Obligation for social security 6M7 Contingent liabilities

-449.42 1306.79 1140.59 788.79 309.16 42.64 165.97 0 0.23 0 0 0 0.23 1477.94 162.96 0 931.38 357.7 0 0 25.9 1477.94 1477.94 0 0 1756.21 0 108.84 1626.92 0 0 0 20.45 320.72 1435.49 -278.28 n.a. n.a. n.a. n.a. n.a. n.a.

MOF, Govt. of Mongolia

Transition from Cash to Accrual Accounting – Tarun Das

Table-7 Outlays by functions of govt. 7 Total outlays

(for 2002) 502.58

701 General public services 7017 Public debt transactions 7018 General transfers between levels of govt 702 Defense

88.94 20.04

703 Public order and safety

29.76

704 Economic affairs

95.88

7042 Agriculture and allied

15.07

7043 Fuel and energy 7044 Mining, manufacturing, construction 7045 Transport

17.28 3.57 31.78

0 24.91

7046 Communications

20.4

705 Environmental protection

1.47

706 Housing and community services 707 Health 7072 Outpatient services

7.57 52.54 48.7

7073 Hospital services 7074 Public health services 708 Recreation, culture and religion 709 Education

0 3.84 15.88 88.23

7091 Pre-primary and primary education

67.25

7092 Secondary education

15.12

7094 Tertiary education

5.86

710 Social protection 7 Statistical discrepancy, total outlay

97.4 0

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Table-8 Transactions in financial assets and liabilities by sector 82 Net acquisition of financial assets 821 Domestic 8211 General government 8212 Central bank 8213 Other depository corporations 8214 Financial corporations n.i.e. 8215 Nonfinancial corporations 8216 Households & NPIs serving households 822 Foreign 8221 General government 8227 International organisations 8228 Financial operations other than international organisations 8229 Other non-residents 823 Monetary gold and SDR 83 Net incurrence of liabilities 831 Domestic 8311 General government 8312 Central bank 8313 Other depository corporations 8314 Financial corporations n.i.e. 8315 Nonfinancial corporations 8316 Households & NPIs serving households 832 Foreign 8321 General government 8327 International organisations 8328 Financial operations other than international organisations 8329 Other non-residents

54.87 62.68 -35.3 58.57 20.37 0 15.81 3.23 -7.81 0 0 -7.81 0 0 63.22 162.98 -34.73 169.28 19.55 0 8.88 0 -99.76 0 0 0 -99.76

MOF, Govt. of Mongolia

Transition from Cash to Accrual Accounting – Tarun Das Selected References

Das, Tarun (2007a) Accrual Accounting and Accrual Budgeting- Basic Concepts and Methodology, pp.1-43, Ministry of Finance, Government of Mongolia, Ulaanbaatar, October 2007. _______ (2007b) Accrual Accounting Rules for Government Finance Statistics, Ministry of Finance, Government of Mongolia, Ulaanbaatar, December 2007, under preparation. _______ (2007c) Accrual Accounting and Government Finance Statistics Glossary, Ministry of Finance, Government of Mongolia, Ulaanbaatar, December 2007, under preparation. Dees, Martin and Paul Neelissen (2004) Five Countries Pioneering Accrual Budgeting and Accounting in Central Government, International Journal of Auditing, January 2004 Diamond, Jack (2002) Performance Budgeting: Is Accrual Accounting Required?, Working Paper WP/02/240. Washington, DC: IMF. International Federation of Accountants (IFAC) (1996) Perspectives on Accrual Accounting. Occasional Paper 3, Public Sector Committee, New York. ______ (1998) Guidelines for Government Financial Reporting, Public Sector Committee, New York. ______ (2002) Transition to the Accrual Basis of Accounting: Guidelines for Governments and Government Entities, Study 14, New York. International Monetary Fund (2001) Government Finance Statistics Manual (GFSM) 2001, International Monetary Fund (IMF), Washington D.C., USA. _______ (2002) Government Finance Statistics 2001 Companion Material. Washington, DC. _______ (2005) Balance of Payments Manual, Washington, DC. _______ (2006a) Government Finance Statistics (GFS) Yearbook 2006, International Monetary Fund (IMF), Washington D.C., USA. _______ (2006b) Government Finance Statistics (GFS) Yearbook 2006 Accompanying Document, international Monetary Fund (IMF), Washington D.C. Glocoms Inc. (USA)

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Transition from Cash to Accrual Accounting – Tarun Das

_______ (2007a) Washington, DC.

Monetary

and

Financial

Statistics

Manual

(MFSM),

_______ (2007b) Monetary and Financial Statistics (MFS): Compilation Guide, Washington, DC. Lakshman Athukorala, S. and Barry Reid (2003) Accrual Budgeting and Accounting in Government and its Relevance for Developing Member Countries, Asian Development Bank, Manila. OECD Public Management Committee (2002) Accrual Accounting and Budgeting: Key Issues and Recent Developments, prepared for the Twenty-third Annual Meeting of OECD Senior Budget Officials at Washington D.C., 3-4 June 2002, published by the PUMA/SBO (2002)10, Paris. Yardley, Jim and Andrew Hilton (2005) Capital Charges for the Government of Mongolia, pp.1-5, Consultancy Report prepared for the Ministry of Finance, Government of Mongolia, Ulaanbaatar, 25 November 2005. _______________________________________________________________________ _

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Annex-1

Capital Charges for the Government of Mongolia Jim Yardley, Accounting Advisor, and Andrew Hilton, Valuation Consultant 25 November 2005 Government is considering the implementation of a system of capital charges. The objective is twofold: • To encourage the sale of excess government assets, and • To assess the full cost of delivering services by budgetary bodies. The purpose of this paper is to discuss the use of capital charges to accomplish these objectives and to describe alternative methods that could achieve similar results. The resulting recommendation is that government should not implement a system of capital charges. Alternative methods can achieve the objectives at a lower cost. Sale of Excess Assets Capital charges assist in the identification and sale of excess assets as follows: • Capital charges are computed by multiplying a rate times the value of assets and reporting the charge as an expense for the period. If a budgetary body has a large asset value, its capital charge will be large. To avoid a large charge each period, management will dispose of excess assets. This scenario assumes: 1. The capital charges are large enough relative to the budgetary body’s financial performance to make a difference. 2. A system is in place to evaluate management’s financial performance and the evaluation has serious consequences for management. First assumption To meet the first assumption, the asset value used to compute capital charges must be current market value. An alternative asset value is book value. However, book value is inappropriate for this purpose. Traditionally, the purpose of financial reporting is to measure income (or revenue and expenses in the case of government) using the matching principle. Matching Glocoms Inc. (USA)

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Transition from Cash to Accrual Accounting – Tarun Das means that expenditure is subtracted from revenue in the period that revenue is earned. If expenditure is incurred now to earn revenue in the future, the expenditure is not charged against current revenue; it is held in the balance sheet as the “value” of an asset. As revenue generated by the expenditure is earned, portions of the expenditure are matched against revenue on the income statement. A book value, traditionally, is simply a past expenditure that is waiting to be matched with revenue. For government, an asset is a past expenditure that will be matched with service delivery in the future. Book value is not an attempt to value an asset; it is a measure of past expenditure that has not been used to provide service. Depreciation is a process of allocation and is not a process of valuation. For the purpose of identifying excess assets, computing capital charges using book value will not work. The book value decreases as the asset ages. Excess assets probably are older assets that still have market value but have little book value. Capital charges based on book value would not be large enough to make a difference in the financial performance of a budgetary body. Current market valuation is an expensive process. Accountants are not trained to perform asset valuations and do not have the time to perform the number of valuations required. If current market values are used in the financial statements, international accounting standards require re-valuation every five years. We estimate that, if current value accounting is implemented for government buildings only, the cost to government will be approximately $100,000 every year. If all government assets are current valued, the cost multiplies. This cost will be even greater if valuations are performed more often than every five years; five years is sufficient for accounting standards but may not be sufficient for identification of excess assets. Second assumption The second assumption is that management’s financial performance will be assessed using capital charges and serious consequences will result from the evaluation. The evaluation of financial performance using financial statements is a complicated analysis that requires appropriate educational background, training and experience. It helps to have an accounting background with additional education in finance and management. The consequences must be carefully considered so that management receives a reprimand but service delivery of the budgetary body is not disturbed. The processes for evaluating and imposing consequences are not yet established and may prove difficult.

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Transition from Cash to Accrual Accounting – Tarun Das An alternative method An alternative method for identifying excess assets and assuring fair value when they are sold is a combination of regularly scheduled performance audits and proper asset disposal procedures. A performance management system should be supported by regular performance audits – similar to financial audits. Performance audits can include, as an audit objective, the discovery of excess assets. Every five years, this objective can be included in the performance audit to identify excess assets. Any excess assets that are discovered can be scheduled for sale. Government should have procedures regarding the sale of government assets. Usually these procedures include a valuation by a professional valuator. If so, at the time of the sale of an asset, a current valuation is available. All assets are not valued; only those assets identified for sale are valued at the time of their sale to assure that government receives approximate fair value on the sale. A system of performance auditing and procedures for sale of government property should prevent the build-up of excess assets and assure that government receives fair value for assets sold. This system should cost considerably less, be more reliable, and provide more relevant information than a system of capital charges. We recommend this alternative method to a system that requires current values for all assets and computes capital charges. Determining Full Cost An important aspect of performance management assessment by government is determining the full cost of providing services. Cash expenditures are easiest to measure, but full cost is not properly reflected in cash expenditures. Capital charges attempt to measure the cost of government’s capital investment in a budgetary body. Using capital charges as a measure of government’s capital costs assumes: 1. Capital charges provide a meaningful measure of cost of capital. 2. Management has the ability to control the capital charges. First assumption In a business environment, capital charges are usually based on the equity invested in an entity and not on the current value of the assets purchased by the equity. The current value of an asset is unrelated to the capital provided. Rather, the current value of assets is a function of the marketplace for those assets. Often neither the investor nor the entity has control over changes in current value. Therefore, most businesses do not measure return on invested

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Transition from Cash to Accrual Accounting – Tarun Das capital, or evaluate management, by assessing current value of assets held by an entity. In government, however, there is no equity investment. It is presumed that the annual “investment” (i.e., the budget) is spent during the year. If accrual accounting is employed, a net asset amount (total assets – total liabilities) serves as a balancing figure on the balance sheet instead of equity. However, net asset is not equity; it is not a measure of government’s investment in the entity. In fact, for many governments, liabilities exceed assets and the net asset figure approximates national debt. If current value of assets is used as a substitute for government’s equity, a greater distortion is introduced. Current value does not represent government’s capital investment in the entity. Government’s capital investment is the cost of the asset and not the current value. Current value represents equity only if sale of the asset is eminent. Second assumption If management is held responsible for financial performance, and part of financial performance is capital charges based on current values, management is being held responsible for changes in asset values that management cannot control. Given that management cannot control asset values, what flexibility will government give management to react to value changes? For example, assume that a budgetary body occupies a building that is in a valuable location. The budgetary body is charged a large sum for occupying a building with such large current value. If management determines that the location is too costly, can management decide to move to a less costly location? If not, management has no control over financial performance and cannot be held accountable. But, as discussed previously, capital charges effectively identify and lead to the disposal of excess assets only if management faces consequences when capital charges are too high. An alternative method Depreciation is a charge for prior expenditure to the current cost of delivering services. If prior expenditure is government’s investment, depreciation is an estimated charge for that investment. In fact, the calculation of capital charges and straight-line depreciation are identical: multiple a base number times an estimated rate. The only difference is the amounts. If current value of assets is measured every five years, the capital charge computed each year between valuations is straight-line depreciation. For assets with a useful life of five years or less, capital charging is irrelevant. Cost and current value are the same at time of purchase, and depreciation approximates a capital charge. Glocoms Inc. (USA)

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Long-lived assets, like buildings and equipment, may still have value after they are fully depreciated. However, when an asset is fully depreciated, its estimated useful life is over. If that asset continues in use, the cost of repair and maintenance increases dramatically. Older buildings, for example, must be continually repaired; wiring and fixtures must be updated; walls must be moved and removed. If the cost of improvements is significant, the additional investment is capitalized in the cost of the building and depreciated. Otherwise, the annual financial performance reflects the repair and maintenance costs. All of these costs are at current value. For older assets, increased repair and maintenance charges and/or additional depreciation charges are analyzed by management. When the amounts are larger than the annual depreciation charges of a replacement, management should purchase a new asset. Each year, repair and maintenance costs and depreciation charges provide an estimate of the cost of holding assets. We recommend this alternative method for estimating full-cost. Conclusion Is depreciation a best estimate of capital charge? Is book value a best estimate of capital investment? May be not, but they are reliable, inexpensive approximations that provide decent information for five or ten years. Is current value a better estimate of capital investment? Is a percentage of current value a better estimate of capital charges? Maybe, but is the benefit of a better estimation worth the additional cost? The danger inherent in current value is that management is being evaluated on uncontrollable variables. The danger inherent in capital charges is that management may be discouraged from investing in the future. There are consequences to current value and capital charges; not all are intended or desirable. Capital charges and current value accounting are complicated, expensive, and may not provide much benefit in return.

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