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The European Commission has already made IAS/IFRS adoption compulsory for the financial statements and consolidated financial statements of all EU member states' listed companies. It is now evaluating the possibility to impose IPSAS compulsory adoption for all EU member states in the public sector as a way of reform after the financial crisis. The EC itself, however, has already adopted IPSAS and the EC annual accounts have been totally based on the new accrual accounting system since 2005, but it has only adopted accrual based accounting with cash based budgeting. This article explains the differences between IPSAS and IAS/IFRS and points out some difficulties for the EC to adopt accrual based accounting. It also compares the accrual based budgeting and the cash based budgeting. Finally, the article gives a simply evaluation of the outcomes of the adoption of accrual based accounting in the EC.
Key words: European Commission, accrual accounting, cash based budgeting
It is well known that the EC (European Commission) has already made the adoption of IAS/IFRS compulsory for the financial statements and consolidated financial statements of all EU member states' listed companies. At the same time a reformation is going on within the public sector in Europe. The European Commission started to reform after the scandal happened in 1999. The White Book was published setting the goal of giving the EC an efficient administrative structure to achieve its institutional purposes. It also set an action plan based on the principles of accountability, effectiveness and efficiency of actions, also on transparency both to external stakeholders and within the Commission. The plan outlines three main intervention areas: the implementation of an activity-based management system, which led to a reform of the arrangements for setting policy priorities and resources allocation with the budgeting procedure; the reassessment of human resources policies and management; and the reform of financial management, control and audit systems (European Commission, 2000; Kassim, 2004; Levy, 2004; Ellinas and Suleiman, 2008). In the third area there is the EC accounting modernization project, which is accrual based accounting. The EC adopted IPSAS (International Public Sector Accounting Standards) to conduct accrual based accounting. And the EC annual accounts have been totally based on the new accrual accounting system since 2005.
Many European countries have been suffering a serious financial crisis in recent years. This leads to a series suggestion of reformation, both in the public sector and the private sector. The European Commission has started to assess whether IPSAS is suitable for adoption by all European Union member states. If this suggestion is passed by the EC, it means that all the EU countries will adopt IPSAS and use accrual based accounting.
Some countries and governmental organisations have already adopted accrual based accounting. However, there're two major kinds. One is accrual based accounting with accrual based budgeting, of which UK is the typical example. And the other one is accrual based accounting with cash based budgeting, of which the European Commission and the US are typical examples. Both kinds have their own advantages and disadvantages. But accrual based budgeting is the major trend.
In the past few years, many scholars have been studying the transformation from cash based accounting to accrual based accounting in the public sector all over the world.
Traditionally, governments and governmental organisations used to use cash-based accounting systems and input-based budgeting systems. However, these systems can't provide the information that is necessary for a government or governmental organisation to operate efficiently and effectively. Among governments of industrialized countries and several governmental organisations all over the world, we can observe a growing trend to shift from cash based accounting to accrual based accounting. Half of the OECD (Organisation for Economic Co-operation and Development) member countries use some form of accrual based accounting in their financial reporting system, although only few also use accrual based budgeting. (M. Peter van der Hoek, 2005)
It is also noticed that several national governments, including the UK, have successfully implemented a change from cash based accounting to accrual based accounting. But the change should not be treated as an end in itself: it will not solve the problems that arise where inadequate cash based accounting systems exist; it will not improve management or control where poor management and inadequate control exist; nor will it improve the legislature's control over the executives or external audit. To make sure that all of the benefits of accrual accounting are achieved, governments and governmental organisations need to meet some preconditions: first, acceptance and consultation are necessary to the introduction of accrual accounting. Second, the accounting and auditing profession must have the capacity and be interested in and be prepared to get involved with the public sector. Third, the government or governmental organisation should increase the number of financial managers employed and make an integrated management-training program for them to help them get prepared for the accrual based accounting system. Fourth, the government or governmental organisation need the co-operation and help by the accounting profession in the development of accounting standards for the public sector. Fifth, successful implementation of accrual based accounting depends a lot on the understanding of, and willingness to support, the system by the external auditor of the central government or the governmental organisation. Sixth, an essential element is a public sector cultural ethic that has internalized the requirements for a neutral civil service. Seventh, there must be no systemic corruption, and no informal parallel processes that are allowed to complement the formal processes should exist. In a word, before this reform is introduced, cash based accounting should be strong, control should be secure, external audit should be functioning well and the legislature should be able to call the executive to account. (Noel Hepworth, 2003)
With all these governments and governmental organizations moving from cash based accounting to accrual based accounting, it becomes a problem that which accounting standards should be used. The 1993 SNA (Systm of National Accounts) and the ESA (European System of Accounts) are the leading standards for national accounting, but they are not designed for government budgets and financial reports. The IPSAS are the authoritative requirements established by the PSC (The Public Sector Committee) of the IFAC to improve the quality of financial reporting in the public sector around the world. (M. Peter van der Hoek, 2005) The publication of IPSAS in the field of public sector financial reporting has raised the necessity for a wide discussion about the harmonization of public sector accounting systems. (Bernardino Benito, Isabel Brusca and Vicente Montesinos, 2007) By means of a survey among experts, some scholars examined the extent to which some European governments adopt IPSAS accrual accounting and how the different levels of adoption can be explained. The study shows diversity in the process of adopting IPSAS and accrual accounting. Some governments still use cash based accounting. Only a minority apply IPSAS. The majority of local and central governments use accrual based accounting but they've developed their own system instead of adopting IPSAS. The trend towards accrual based accounting can be explained by the need for transparency and efficiency in the public sector. The fact that the IPSAS is unique and offers specific techniques for accrual accounting in the public sector is the main argument for making use of them. However, a number of governments and governmental organisations do not adopt IPSAS because they transfer their own local business accounting rules to public sector accounting rules. (Johan Christiaens, Brecht Reyniers, Caroline Rolle, 2010)
Though IPSAS has already been adopted by some countries and some important organisations such as the EC and the UN (United Nations), it doesn't mean that the reformation is as simple as using IPSAS as the accounting standards. Usually, the implementation of some accrual based system is linked to wider financial management reforms including performance management requiring information on cost. (M. Peter van der Hoek, 2005) Vicente Pina and Lourdes Torres studied the governmental accounting transformations carried out in 16 member countries of the Organization for Economic Coordination and Development (OECD) and the European Community, taking IPSAS as a benchmark. To carry out the study they have used the de facto information disclosed by central government financial reports. The study shows that between the extremes of cash and full accrual based accounting the countries studied have put numerous intermediate variants into practice. Accrual based accounting developments seem more related to New Public Management (NPM) initiatives than to the cultural categories studied. (Vicente Pina and Lourdes Torres, 2003)
The main idea of theory of the market-based approach New Public Management is that market orientation improves public service performance. Market orientation is carried out through the dominant theoretical framework in the business literature: customer orientation, competitor orientation, and interfunctional coordination. Research findings show that market orientation works best for increasing citizen satisfaction with local services, but its impacts on the performance judgments of local managers or the Audit Commission are not that obvious. Some people believe that yesterday's NPM is today's public sector, which means that many market orientation reforms already have been made and institutionalized in the public sector. Indeed, as we have allowed, the public sector already was quite adept at some of these techniques before the emergence of NPM, and it has continued to develop its capacity and skill in this regard. The recent wave of NPM reforms emphasizing more extreme forms of market orientation, such as deregulating whole sectors of the economy and contracting out government services, now look like a proverbial trial by fire for government, especially as this period of radical experimentation seems to be drawing nigh. With the global financial crisis and regional market failures occurring in many parts of the world, a new wave of reforms is required. These reforms raise questions on the efficiency and power of free markets, and they tend to emphasize the role of government in stabilizing the economy, stimulating economic growth, and regulating markets for the public sake. With this background, some elements of market orientation, such as knowledge of markets, customer orientation, and the ability to integrate and deliver services smoothly, will still be important goals for both business and government. ( Richard M. Walker, George A. Boyne, Gene A. Brewer and Claudia N. Avellaneda, 2011)
With all the countries and organisations changing rapidly, the EC actually has actually never stopped reforming. Since the mid-1990s during the Santer, Prodi, and Barroso presidencies, the European Commission has experienced several public management policy cycles. Included in the Barroso Commission's (2004-2008) policy agenda was the reform of internal financial control, prompted by significant irregularities in budget execution signalled repeatedly by the European Court of Auditors (ECA) in its annual Declaration of Assurance (DAS) and Annual Reports. This led to a declared Barroso Commission strategic objective of achieving a 'positive DAS' by 2009. The proposed solution was 'integrated internal control' based on an international reference point within the accounting and auditing professions. The result was a centrally co-ordinated Commission project aiming to reform management and audit practices within both the Commission and EU member states. (Roger P. Levy, Michael Barzelay and Antonio-Martin Porras-Gomez, 2011)
As a measure to correct the 'management deficit' of the European Commission, the institution's authorities decided to introduce new forms of commission-wide strategic planning and programming in 2000. Drawing on semi structured interviews with Commission officials, Michael Barzelay and Anne Sofie Jacobsen tracked the key turning points, tracks, and outcomes of events within the implementation stage of this part of the Commission managerial reform. Major conceptual issues addressed include how reform decisions serve to activate the social mechanism of actor certification and how actor conduct amplifies such certification. Actor certification provides a link from reform choices to organizational change. In this respect and others, the research argument contrasts and integrates social theory mind-sets deriving from institutionalism and social interactionism (processualism) in line with research trends in historical sociology, organization science, and public management. (Michael Barzelay and Anne Sofie Jacobsen, 2009)
The EC has been reforming its accounting system throughout the last decade. The reformed accounting system is a dual one: it is based both on accrual accounting, to draw up the financial statements, and on cash accounting, to manage budget appropriations. The EC drew seventeen accounting rules upon IPSAS. These rules are based on accrual accounting. They were issued by the EC and become the foundation of this reformed accounting system. The compilation of the consolidated financial statement (CFS) has become more complex. Since a few more agencies were created during the early 1990s, the original European Union (EU) organizational structure (Parliament, Commission, Council, Court of Justice and Court of Auditors) has broadened. Since 2005, some of these new agencies have been included in the consolidated financial statements of the EU, compiled according to IPSAS 6, 7 and 8. G. Grossi and M. Soverchia examined how the EU consolidation process has evolved over time and what the drivers behind the reformed accounting systems are and in particular what the new consolidation approach is. They believe the approach is a result of the combination of the Continental and Anglo-Saxon governmental accounting approaches. (G. Grossi and M. Soverchia, 2011)
Antonis Ellinas and Ezra Suleiman conducted an original survey of 200 top officials of the European Commission to highlight the nature of the Kinnock reforms. The survey shows that the push toward the 'modernization' of the EC has also been accompanied by a trend towards 'bureaucratization'. The findings of the survey challenged the dominant view that believed the reform project was a huge move towards the institutional form set by NPM. Based on the views of some top Commission officials, the reforms can best be described as a marriage of 'Weberian-bureaucratic' and NPM ideas. This mix of largely incompatible reform measures was a result of the simultaneous effort to maximize the efficiency of the organization while responding to the legitimacy crisis that created demands for more accountability. The political nature of these demands suggests that it will be hard for the Barroso Commission to change the turn toward bureaucratization in substance. (Antonis Ellinas and Ezra Suleiman, 2008)
Although a lot of governments and governmental organisations have adopted accrual based accounting, very few of them adopted accrual budgeting at the same time. There're three pioneer countries in the implementation of accrual budgeting and accounting: the United Kingdom, Sweden, and New Zealand. Budgeting in accrual terms is one of the most controversial issues in public sector accounting. (Caridad Marti, 2006) So far, the IPSAS is only about financial accounts, but the PSC also intends to introduce accrual budgeting in the future. (M. Peter van der Hoek, 2005)
Budgets are future-oriented financial plans for allocating resources among alternative uses. Financial reports describe the results of an organization's financial transactions and events in terms of its financial position and performance retrospectively. Cash-based allocations of funds give governments and governmental organisations rights to make cash payments over a limited period of time. They are most widely used in budgets. However, in accounting there is a wide spectrum of bases ranging from cash to full accrual. Usually, the implementation of some accrual based system is linked to wider reforms in financial management which includes performance management requiring information on cost. Countries that changed to an accrual-based system have, to a large extent, common goals. But they also show differences as to the way they have designed and implemented the new system. (M. Peter van der Hoek, 2005)
In conclusion, the fact that the EC adopted IPSAS to reform its accounting system is positively valued. It represents a synthesis of the Anglo-Saxon, and continental European cultures (Benito et al., 2002; Jones, 2007; Grossi and Pepe, 2009) and shows all the benefits and also the limits of the IPSAS approach in a supranational public organization. (G. Grossi and M. Soverchia, 2011)
â-ŽAdoption of IPSAS
International Public Sector Accounting Standards (IPSAS)Â are a set of accounting standards issued by the IPSAS Board for public sector entities around the world to use in the preparation of financial statements. These standards are based on International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB). IPSAS aims to improve the quality of general purpose financial reporting in public sector entities, leading to better informed assessments of the resource allocation decisions made by governments and governmental organisations, thereby increasing transparency and accountability. They are accounting standards that are applied to national governments, regional (e.g., state, provincial, territorial) governments, local (e.g., city, town) governments and related governmental entities (e.g., agencies, boards and commissions).
IPSAS are issued by IPSASB (International Public Sector Accounting Standards Board), which is an independent organ of IFAC (International Federation of Accountants). The IPSASB adopts a due process for the development of IPSAS. The process provides the opportunity for comment by interested parties includingÂ auditors, preparers (includingÂ finance ministries), standard setters, and individuals.
IPSAS standards are based on IFRS. In general, there are significant areas of similarity between IFRS and IPSAS, and since the IPSASB has been carrying out convergence efforts, such similarity will improve. But there're differences between these two sets of standards. Some IPSAS standards can't find corresponding IFRS. This is due to the obvious differences between the public sector and the private sector. The following form shows the relationship between IPSAS and IFRS/IAS standards.
Presentation of Financial Statements
Cash Flow Statements
Net Surplus or Deficit for the Period, Fundamental Errors and Changes in Accounting Policies
The Effect of Changes in Foreign Exchange Rates
Consolidated Financial Statements and Accounting for Controlled Entities
Accounting for Investments in Associates
Financial Reporting of Interests in Joint Ventures
Revenue from Exchange Transactions
Financial Reporting in Hyperinflationary Economies
Events After the Reporting Date
Financial Instruments: Disclosure and Presentation
Property, Plant and Equipment
Provisions, Contingent Liabilities and Contingent Assets
Related Party Disclosures
Impairment of Non-Cash Generating Assets
Disclosure of Financial Information About the General Government Sector
Revenue from Non-Exchange Transactions (Taxes and Transfers)
Presentation of Budget Information in Financial Statements
Impairment of Cash-Generating Assets
Financial Instruments: Presentation
Financial Instruments: Recognition and Measurement
Financial Instruments: Disclosure
When we compare the IPSAS with IAS/IFRS, we can find major differences in the areas of revenue (IPSAS 23, Revenue from Non-exchange Transactions) and budget reporting in financial statements (IPSAS 24, Presentation of Budget Information in Financial Statements). In addition, IPSAS 22 about the disclosure of financial information in the general government sector has no corresponding IFRS.
IPSAS 22 sets requirements for preparing and presenting information in the general government sector (GGS). The standard is optional. It's applied only in respect of a government's or a governmental organisation's consolidated financial statements. Information disclosed in accordance with this standard disaggregates those consolidated financial statements according to the GGS boundaries as specified in statistical bases of financial reporting. When consolidating statistical information about government finance, a statistical agency will usually include entities that are not subject to common control. But when consolidating financial statements according to IPSAS 22, reporting entities are not permitted to consolidate information about these entities.
The objective of IPSAS 22 is to set disclosure requirements for governments which elect to disclose information about the GGS in their consolidated financial statements. The proper disclosure of appropriate information about the GGS of a government can help provide a better understanding of the relationship between financial statements and the statistical bases of financial reporting as well as the relationship between the market and non-market activities of the government.
ï‚·According to IPSAS 22, financial information of the general government sector should be disclosed according to the accounting policies which are adopted to prepare and present the consolidated financial statements of the government. But two exceptions are allowed: first, the general government sector does not apply the requirements of IPSAS 6, "Consolidated and Separate Financial Statements" as for entities both in the public financial corporations sectors and public non-financial corporations sectors. And second, the general government sector does recognise its investment in the public financial corporations sectors and public non-financial corporations sectors as an asset and it records that asset at the carrying value of the net assets of its investees.
ï‚·IPSAS 22 also requires that the following should be included when disclosing consolidated financial statements in respect of the general government sector: Assets by major class with the investment in other sectors showed separately; Liabilities by major class; Net assets/equity; Revenue and expenses by major class; Total revaluation increments and decrements and other items of revenue and expense which are recognized directly in net assets/equity; Surplus or deficit; Cash flows from operating activities by major class; Cash flows from investing activities; And cash flows from financing activities.
ï‚·IPSAS 22 requires that the reporting entity must make disclosures of the significant controlled entities that are included in the general government sector as well as any changes in those entities during the prior period. Also, if the significant controlled entities are changed, the reporting entity should provide an explanation of the reasons why any such entity that was previously included in the general government sector is not included any more. The general government sector disclosures are required to be reconciled to the consolidated financial statements of the government. The amount of the adjustment to each equivalent item in those financial statements should be disclosed separately.
IPSAS 23 is another major difference between the IPSAS and the IAS/IFRS. The aim of IPSAS 23 is to help record transactions in which entities in the public sector receive taxes and transfers (cash or non-cash) without directly giving approximately equal value in exchange, or give value to another entity without directly receiving approximately equal value in exchange. In the public sector, the major source of income is taxes and transfers. The nature of such income is quite different from that of revenue in the private sector. Therefore, the accounting treatment can be very different.
Transactions in which one entity receives services or assets, or has liabilities extinguished, and directly gives approximately same value of cash, goods, services, or use of assets to another entity as an exchange are exchange transactions. While non-exchange transactions are transactions that are not exchange transactions. Normally, in a non-exchange transaction, an entity either receives value from another entity without giving approximately same value in exchange directly, or gives value to another entity without receiving approximately equal value in exchange directly. The distinction between non-exchange and exchange transactions is necessary for entities in the public sector because these entities will often have transactions which are a combination of both types. The IPSAS established different recognition criteria for non-exchange and exchange revenue transactions. IPSAS 23 calls for entities in the public sector to analyze the inflow of resources, and the standard also states that as long as the entity gains control of resources that meet the definition of an asset and satisfy the recognition criteria, it can recognize an asset arising from a non-exchange transaction.
Transfers are inflows of future service potential or economic benefits from non-exchange transactions, other than taxes. Provisions on transferred assets are terms in regulation or laws, or a binding arrangement, imposed upon the use of a transferred asset by entities external to the reporting entity. Conditions on transferred assets specify that the future service potential or economic benefits embodied in the asset is required to be consumed by the recipient as specified or future service potential or economic benefits must be returned to the transferor. Restrictions on transferred assets are provisions that limit or direct the purposes for which a transferred asset may be used, but do not specify that future service potential or economic benefits is required to be returned to the transferor if not deployed as specified (Deloitte, 2012)
ï‚· An inflow of resources from a non-exchange transaction, other than services in-kind, that meets the definition of an asset should be recognized as an asset when, and only when the following criteria of recognition are met: It is probable that the future service potential or economic benefits associated with the asset will become inflow to the entity; and the fair value of the asset can be measured reliably. An asset acquired from a non-exchange transaction should initially be measured at its fair value as at the date of acquisition.
ï‚· Taxation revenue is required to be determined and recorded at a gross amount. There're situations where amounts that are available to beneficiaries regardless of whether or not they pay taxes. Such expenses paid through the tax system should not be reduced for the calculation of taxation revenue. There may also be preferential provisions of the tax law that provide concessions which are not available to others to certain taxpayers. Taxation revenue should not be grossed up for the amount of such tax expenditures.
ï‚· An entity can recognize an asset in respect of transfers as long as the transferred resources meet the definition of an asset and satisfy the criteria for recognition as an asset. However, an entity may also, though is not required to, recognize services in-kind as an asset and as revenue.
ï‚· An entity is required to disclose the following facts either on the face of, or in the notes to, the general purpose financial statements: The amount of revenue from non-exchange transactions recognized during the period by major classes showing taxes and transfers separately; The amount of receivables recognized in respect of non-exchange revenue; The amount of liabilities recognized in respect of transferred assets subject to conditions; The amount of assets recognized that are subject to restrictions and the nature of these restrictions; The existence and amounts of any advance receipts in respect of non-exchange transactions; and the amount of any liabilities forgiven (Deloitte, 2012).
An entity should also disclose the following facts in the notes to the general purpose financial statements: The accounting policies adopted for the recognition of revenue from non-exchange transactions; The basis on which the fair value of inflowing resources was measured for major classes of revenue from non-exchange transactions; For major classes of taxation revenue which the entity cannot measure reliably during the period in which the taxable event occurs, information about the nature of the tax; And the nature and type of major classes of bequests, gifts, donations showing major classes of goods in-kind received separately (Deloitte, 2012).
IPSAS 24 is also a significant difference between the IPSAS and the IAS/IFRS. It is about the presentation of the budget information in financial statements. The objective of IPSAS 24 is to make sure that entities in the public sector discharge their accountability obligations and improve the transparency of their financial statements. It helps entities demonstrate compliance with the approved budget for which they are held publicly accountable and their financial performance in achieving the budgeted results where the budget and the financial statements are prepared on the same basis.
IPSAS 24 applies to entities in the public sector, other than Government Business Enterprises. These entities are required or elect to make publicly available their approved budget. IPSAS 24 requires that the financial statements of public sector entities include a comparison of budget amount and the actual amounts from execution of the budget. In addition, IPSAS 24 also requires that if there're any material differences between the budget and actual amounts, entities in the public sector reporting according to IPSAS disclose an explanation of those differences.
There're several different kinds of budgets. Original budget is the initial approved budget for the budget period. Approved budget means the expenditure authority derived from laws, government ordinances, appropriation bills, and other decisions related to the anticipated revenue or receipts for the budgetary period. We can get the final budget by adjusting the original budget for all reserves, transfers, allocations, supplemental appropriations, carry over amounts, and other authorized legislative, or similar authority, changes applicable to the budget period. The comparison of budget and actual amounts should present separately for each level of legislative oversight: the original and final budget amounts, the actual amounts on a comparable basis and also an explanation of material differences between the budget and actual amounts in the notes to the financial statements. Such explanation can also be included in other public documents issued in conjunction with the financial statements but a cross reference should be made to those documents in the notes. With IPSAS 24, there will be more transparency and comparability between budget and actual amounts as reported in the financial statements.
The IPSAS is based on IAS/IFRS. But they have the above major differences at the same time. These differences make the IPSAS more suitable for the public sector. When the EC decided to adopt accrual based accounting in its financial reporting system, it chose the IPSAS.
The European Commission started to reform after the scandal happened in 1999. The reform initiative of the Prodi Commission was launched in March 2000 with the approval and publication of the White Paper. The overall reform strategy of the Commission was divided into four themes set out in the first part of the White Paper. One central aim of the reform of the EC is to create an administrative culture that encourages officials to take responsibility for activities over which they have control - and gives them control over the activities for which they are responsible. The Commission as a whole has a particular responsibility for managing EU funds, i.e. the taxpayers' money. Improving and modernising financial management is, therefore, desirable on its own merits and can make a direct and practical contribution to lifting operational performance generally. The EC explained the reason that it adopted IPSAS in its White Book:
"The Commission's systems for financial management and control are no longer suited to the type and number of transactions which they have to deal with. When the present centralised systems were designed, the Commission was processing sums of money very much smaller than today's. Financial transactions have grown exponentially - for instance, they have doubled in the past five years to more than 620,000. External aid has increased by a factor of three over the last ten years and is set to grow by a further 44% between 1999 and 2000.
These realities mean that procedures need to be made simpler and faster, more transparent and decentralised. There has to be a clear distribution of tasks and responsibilities among all participants - both financial and 'technical' - who have a role in managing operations that have financial implications. Adequate organisational rules and structures are also essential. Specific arrangements will be needed to equip the Commission's external delegations to handle these new responsibilities. " (the EC, White Book, 2000)
One of the EC officers also explained that the IPSAS choice is based on the fact that they are accounting rules specifically dedicated to the public sector: that means they are much more appropriate for the EU than other international standards such as IAS/IFRS. Although IASB's rules are business oriented, the underlying idea of investor orientation and the focus on future economic benefits (future cash inflows) do not reflect the 'business model' of the Commission and do not always provide the addressees (i.e., members of the European Parliament and the public in general) with the information they require. Furthermore, the notion of 'service potential', as implemented within IPSAS, better reflects the information needs of addresses of public sector financial statements, showing donations, grants and similar transactions within the Commission. (G. Grossi and M. Soverchia, 2011)
There're usually several aspects of difficulties when it comes to accrual based accounting in public sector. Since EC is not a government but a governmental organisation, it doesn't have heritage assets. And the EC is just is the executive body of theÂ European Union, responsible for proposing legislation, implementing decisions, upholding theÂ Union's treatiesÂ and day-to-day running of the EU, it's not responsible to building roads, highways, water supply and drainage systems. So there is also no need to worry about infrastructure assets. But it still has many other problems.
(1) Assets or liabilities?
(2) Community assets
(3) Capital maintenance and erosion
(4) Consolidated financial statements
(5) Higher demand on skills of public service accountants and auditors
(6) The valuation of assets
In accrual based accounting, there is a classification of assets and liabilities. It's not hard to distinguish between these two definitions in the private sector. AssetsÂ are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset. AÂ liabilityÂ is defined as anÂ obligationÂ of an entity arising fromÂ pastÂ transactions or events, the settlement of which may result in the transfer or use ofÂ assets, provision of services or other yielding of economic benefits in the future.
But in a public sector entity like the EC, it's sometimes difficult to distinguish assets and liabilities. Robert Mautz (1988) asked the challenging question of whether many 'so-called' assets, such as public monuments, should actually be regarded as liabilities. Many such assets are the subject of more cash outflows than inflows, as many such assets have to be maintained, but generate no income. The concept of asset recognition and valuation in the private sector does not fit the public sector well.
As to community assets, Pallot (1990, 1997) has advocated the case for this as a new asset classification. Pallot's rationale is that public sector accountants should recognise such assets, based on the idea of communitarian values. This extends the narrow concept of private property rights embedded in conventional asset recognition and valuation. However, this raises the prospect of incorporating social benefits into the valuation of assets, which moves significantly away from conventional asset accounting.
When it comes to capital maintenance and erosion, the rationale of asset recognition and valuation is that the charging of depreciation will maintain capital. However, in public services, where identification, recognition, measurement and evaluation of assets may prove intractable, there is a danger of capital erosion, rather than maintenance. Newberry and Pallot (2005) have demonstrated this, in the context of the capital asset accounting deployed in central government departments in New Zealand. This suggests that this is not a precise, well-honed management tool, but a crude measure of asset consumption.
In the accounting reformation in the public sector, consolidated financial statements are seen as one important accounting technique. Consolidated financial statements were created in the private sector to provide information about the financial position and situation of business groups. In the private sector, consolidated financial statementsÂ areÂ financial statementsÂ that factor the holding company'sÂ subsidiariesÂ into its aggregatedÂ accountingÂ figure. It is a representation of how the holding company is doing as a group. It's a communication tool for external as well as internal users (shareholders, employees, financial markets, creditors, government, investors and backers, competitive businesses, etc.)
In the public sector, the widely use of consolidated financial statements reflects the changes in public functions labelled as 'steering and not rowing'. These changes include the provision of public services through decentralized entities and the increasing role of control and coordination performed by governments. But the annual accounts of governments and governmental organisations may disclose only a partial view of their economic and financial activities and the accountability and decision usefulness of these accounts are often reduced. External users of financial information (e.g., voters, citizens, suppliers, taxpayers, rating agencies and banks, other public administrations) and internal ones (e.g., employees, politicians and public managers) are not able to base their decisions on relevant and reliable information about the financial performance, financial position and cash flows of the 'whole' government, or it's possible that they will find it very hard to form an idea on it. We can see from the annual accounts of EC for the financial year 2010 (Appendix). The financial statements of EC are very different from those of a private company. They give an overall view of the economic condition of the EC. Even the names of statements are different: in the EC there is no income statement, it's called economic outturn account; and what is called shareholders' statement in the private is called statement of changes in net assets in the EC.
In a government, it's easy to decide which departments should be consolidated. But in the EC this is also a big problem. The EC is a governmental organisation rather than a government. It's hard to decide which departments are actually controlled by the EC and which are joint ventures or associates. Therefore it's hard to decide the area of consolidated financial statements. And even if this problem is solved, another problem arises: All consolidation procedures require that the financial statements of each consolidated entity are harmonic and are prepared under the same accounting system. The EC managed to carry out the same accounting rules and standards on all controlled entities, associates and joint ventures to solve this problem. In the 2010 EC annual accounts, the consolidated accounts of the European Union cover the accounts of the European Union, the European Atomic Energy Community and the European Coal & Steel Community (in Liquidation). These accounts are kept in accordance with Council Regulation (EC, Euratom) No 1605/2002 of 25 June 2002 (OJ L 248 of 16 September 2002), on the Financial Regulation applicable to the general budget of the European Union and Commission Regulation (EC, Euratom) No 2342/2002 of 23 December 2002 laying down detailed rules for the implementation of this Financial Regulation. (European Commission, 2011)
There're also some small difficulties when consolidating financial statements. For example, foreign exchange can be a headache. In a sovereign government, there's one official currency. In the EC, although Euro is the major currency, there're still other important currencies, such as British pounds, Danish krones, and Swiss francs. A lot of transactions are not made in Euros and a large part of them are even made in other currencies like US dollars. The EC has to translate them into euros using the exchange rates prevailing at the dates of the transactions and record foreign exchange gains and losses at the year end.
When accrual based accounting is adopted, there is a higher demand on skills of both accountants and auditors. This is the same in the EC as in national governments. All kinds of organisations offer training programs for accountants and almost all of these accountants are trained to use accrual based accounting. And there're also a lot of accounting professional bodies, such as the ICAEW (theÂ Institute of Chartered Accountants in England & Wales) in the UK, the AICPA (the American Institute of Certified Public Accountants) in the US, and the CGA (the Certified General Accountant association of Canada) in Canada. However, these accountants and accounting profession are all for businesses, not for governments or governmental organisations like the EC.
The traditional accounting techniques of recording, measuring and communicating, typically using money, provide a fundamental reason for the accounting profession having had less influence over the public sector than it does on business in the private sector. This is because accounting technique itself has less influence on the public sector than it does on the private sector. Most people, especially voters, don't have significant economic incentive to understand the accounting techniques. Rational voters necessarily depend on simple factors and accounting techniques are not simple. Therefore, accounting techniques have long been neglected in the public sector. Meanwhile, cash based accounting has long been used in the public sector. Although national governments such as the UK and the US have adopted accrual based accounting, the EC doesn't have any direct example to follow as it is a governmental organisation instead of a government. Therefore, the improvement of accountants' skills becomes a huge problem when the EC wants to adopt accrual based accounting.
Auditors also face huge challenges during this reform. Auditing is a key part of public sector accounting. In the public sector, independence is as important as it is in the private sector. In sovereign governments, auditors should be independent from both the auditee and the executive. Since the EC is just a governmental organisation, the essence of auditing independence is not that strict. When auditing the EC, the main requirement of independence is just be independent from the auditee. However, auditing the EC is still more complicated than auditing a business in the private sector. The audit has two major parts. One is the audit of financial statements, which is the same as that in the private sector. The change from a cash based accounting to an accrual based accounting will add difficulty to the auditing process and require higher level of skills. The other is the audit of budget. The EC uses a cash based budget instead of an accrual based one. But there're still problems when carrying out budget auditing. Main problems can be lack of standards, lack of experience, lack of comparability, and so on.
In the private sector, accounting standards usually require that assets are valued on an historical cost basis. There is no clear agreement about the basis of valuation to be used in the public sector. Some countries have chosen to use historical costs (for example Sweden) and others have chosen to use current values (for example the UK). The argument often hinges around practicalities and the purposes of valuation.
The EC has chosen to use historical costs for all property, plant and equipment in its accounting recording process. And assets that have an indefinite useful life are not suitable for amortisation but they should be tested annually for impairment. Whenever there're events or changes in circumstances which indicate that the carrying amount of assets might not be recoverable, assets that should be amortised shall also be reviewed for impairment. When dealing with financial assets, the EC classifies its financial assets into the following categories: financial assets at fair value through profit or loss; loans and receivables; available-for-sale financial assets; and held-to-maturity investments. The classification of the financial instruments is determined at initial recognition but it's always re-evaluated at each balance sheet date. Financial instruments are initially recognised at fair value plus transaction costs for all financial assets not carried at fair value through profit or loss. Financial assets carried at fair value through profit or losses are initially recognised at fair value while transaction costs are expensed in the economic outturn account.
However, there is a point of principle that should be addressed which is that all other public sector service delivery costs are current costs and there is no logic in arguing that one cost should be treated differently. Capital assets should be valued and revalued to make sure that the service costs reflect the current cost of those assets and, as those assets are used and wear out over time, they should be depreciated or amortized, and a proper depreciation charge should be included in the service delivery costs. If there is a maintenance failure, and the asset wears out more rapidly as a consequence of the failure, then depreciation expense should be increased. In other words, if governments fail to spend on maintenance, it would not be an apparently costless decision because the true costs accrue to future generations and future costs will increase as a result. The cost should fall on the present generation who is responsible for the failure of maintenance through a higher depreciation charge; this can only be identified if current values are used. In addition, the cost of the asset is more than just the capital cost. There is also the 'interest' charge, or cost of the capital employed to hold that asset. Derivation of this charge raises complex issues, and practice varies across countries. For example, the UK uses a single rate, applied to current valuations, whereas New Zealand uses a range of rates, applied to historical valuations. An annual charge which has no equivalent in cash accounts is constituted with depreciation and the cost of capital. Capital assets in the public sector are not 'free goods' any more. The urgent need to be able to respond to this information shows the culture change that is accompanied with a change to accrual based accounting.
â-Žaccrual based budgeting vs. cash based budgeting
Budgeting and financial reporting are very different from each other though they are both important parts of accounting. Budgets are future-oriented financial plans for allocating resources among alternative uses. Financial reports describe the results of an organisation's financial transactions and events in terms of the organisation's financial position and performance retrospectively. While in budgeting, allocations can be based on different systems. Accrual based budgeting is a method to prepare budget which recognize the financial impact when an event occurs. That is, a transaction is recorded in the same time period when the activity causing the transaction occurs. On the other hand, cash based budgeting is a method which recognize transactions when the cash payment is received or paid out. In the real world, the time when the cash is received or paid out is often different than when the event actually takes place. Nowadays, what most widespread is cash-based budgeting which gives the government or governmental organisation rights to make cash payments over a limited period of time. Commitment-based appropriations give the government or governmental organisation authority to make commitments and then they can make cash payments according to these commitments without a predetermined time limit. Meanwhile, accrual-based appropriations cover the full costs of the operations of the government and cause increases in liabilities or decreases in assets immediately when the event occurs. This kind of appropriations requires special mechanisms for controlling cash. It should also be noted that accrual accounting does not require the total abolition of cash-based appropriations.
The EC has adopted accrual based accounting, but it still uses cash based budgeting. This is the same situation in a lot of countries including the US. However, there're several countries which use both accrual based accounting and accrual based budgeting. The best example is the UK government.
Under accrual based budgeting, if goods are received but not invoiced prior to the end of the fiscal year, they will be recorded and included in expenditures for the fiscal year in which the goods are received. While under cash based budgeting the goods received prior to the end of the year would not be recorded and included in expenditures until the invoiced is received and payment is made.
Another example of accrual based budgeting is employee benefits, which are recorded annually and included in operation and maintenance expenditures. Under the cash based budgeting method, the movement in provisions relate to year-end estimates made in the accrual accounts (employee benefits mainly) that do not impact the budgetary accounts.
The accounting treatment for fixed assets, such as buildings and equipments, is one of the greatest changes between cash based budgeting and accrual based budgeting in the recording of transactions. Under the cash based budgeting system, all the expense is included in expenditures when the transaction occurs and the expenditures for that particular year will be a lot while the expenditures for the following years will be low. But under accrual based budgeting, the expense is amortized over the useful life of the facility; therefore, only the amortization portion is included in expenditures for a fiscal year and the flow of expenditures will be smooth.
Differences in the accounting measurement of the budget are results of the different purposes we want to achieve through the budget. A cash based budget is concerned with the traditional public sector control of legality, insuring compliance with spending authorizations, while an accrual based budget focuses on the objective of decision making usefulness. Cash based budgeting only provides information to assess the short term economic impact on financial policy, but accrual measurement allows us to evaluate the future financial effects at the time financial policy decisions are made. Since accrual based reports also include cash flow statements, the accrual and cash basis should be seen as complementary methods rather than competing ones.
Accrual based budgeting has some obvious benefits when compared with cash based budgeting.
First, accrual based budgeting corresponds with the accounting standards used in financial reporting, therefore it allows a comparison of budget and actual information prepared on a consistent basis. Since the public accounts are prepared on the basis of accrual accounting, the accrual based budgeting method will permit relevant comparative analysis.
Second, given that accrual based budgeting records costs in the same time period in which they will be consumed, it gives a more accurate and complete estimate of the cost of government functions. Further, a more complete and detailed estimate of government obligations is provided when accurate and complete budget information is included. An example of this would be when accruing for employee benefits.
Third, accrual based budgeting will allow internal and external users to make easier and more accurate comparisons with other governments because this practice is becoming the standard throughout the public sector.
Fourth, accounting has always been less important in the public sector as voters usually don't care what accounting standards are used, therefore most politicians don't care about accounting standards. But budgeting has always been an important part in the public sector because it decides what politician can do during the year. Accrual based budgeting can lead to a better internal control in the public sector. It will make the accounts more transparent and more accountable.
However, some critics point out that an accrual budgeting system cannot be the system for the public sector for three reasons. First, budgetary laws often require the legislature to authorize cash payments. Second, an accrual system is tailored to income formation: it matches revenues and cost. In the public sector where revenue is usually taxes and cost is usually production cost, it is impossible to match tax revenues with production cost. Third, the implementation of some accrual based system is linked to wider financial management reforms including performance management requiring information on cost. These shortcomings may have stopped some governments from adopting accrual based budgeting.
And since budgeting has always been an important part in the public sector, changing from cash based budgeting into accrual based budgeting will meet huge difficulties and make a big difference. This may be also the one of the major reasons that many governments and governmental organisations, including the EC, adopt accrual based accounting with cash based budgeting.
Although there're only a few countries and organisations use accrual based budgeting now, it is believed to be the trend as public sector accounting and budgeting develop and new methods are found to overcome the shortcomings of accrual based budgeting.
The nature of the Kinnock reforms should not be a surprise to those close observers of the effort to reform. The experiences of the top management highlighted contradictions which merely reflect the paradoxical objectives that the European Commission set out to achieve. On the one hand, the reformers tried to find a way to benefit from the modernization experience of many western countries by introducing measures to improve the efficiency of the EC. But on the other hand, they had to deal with the legitimacy crisis caused by the allegations of fraud and nepotism. The crisis led to political demands for making the EC more 'accountable,' 'responsible' and 'transparent' (European Commission 2000a: 3). This led to a mixture of contradictory measures, some pushing the organisation towards NPMtype modernization while others drawing the organisation towards bureaucratization.
This mixture of contradictory measures might be disappointing for those who treat the reform effort as an opportunity to improve the efficiency of the organization. But it might be comforting for those who understood it as a way to boost the waning legitimacy of the organization and to eliminate the 'democratic deficit' which the Commission was thought to exacerbate. In this sense, though some top managers seem to imply that the trend towards bureaucratization is the unintended consequence of the reform drive, it is actually not. Instead it is the intended effect of the political process that sought to limit the discretionary power of the EC in order to re-establish its legitimacy.
Is this dual and contradictory course towards bureaucratization and modernization reversible? Can we make the organisation more efficient without risking the loss of accountability? The Barroso Commission seems to think that the answer is yes if it reverses the trend towards bureaucratization. In a report to the EP on the 'reform beyond the reform mandate', the EC states that it wants to strike a 'better balance between the costs and benefits of control'. It sets the 'simplification of procedures and working methods' as its 'cross-cutting objective' and wants to streamline some of the newly introduced controls 'to achieve productivity gains' (2005: 12). But it is doubtful whether the EC can convince its political patrons to substantially alter the turn of the organization towards bureaucratization. Rising levels of Euro-scepticism and growing public anxieties over the loss of national sovereignty are likely to be strong impediments to any such change. In this sense, bureaucratization might be the price that international institutions have to pay when it is faced with a crisis of legitimacy.
The EC just adopted accrual accounting with cash based budgeting. This is another major problem in its reform process. Accrual based budgeting allows comparison of budget and actual information prepared on a consistent basis. Given that accrual based budgeting charges costs to the time period in which they will be consumed, it can lead to a more accurate and complete estimate of the cost of government functions as well as a more complete and detailed estimate of government obligations (for example, employee benefits). Accrual based budgeting will also allow for easier and more accurate comparisons with other governments because this practice is becoming the standard throughout the public sector. What is most important is that the budgeting is what actually controls the organisation. Leaving the budgeting system unchanged means the reformation to adopt accrual accounting actually isn't that meaningful.
Despite all the critics, in general, adopting IPSAS has made the accounts of EC more transparent and more accountable, which is its original goal. The financial statements based on accrual accounting provide more useful information and are in line with the trend of international public sector developments.
Since the EC is considering to implement IPSAS among EU member states, the experience of adopting IPSAS itself can be very valuable and some European countries may learn from this process. When asked about the implications for the practices and the governmental accounting policies of the single EU member states, one officer of the EC stated that in this respect, the EC has no political mandate, therefore there can only be indirect implications at the moment if member states want to benefit from the experience and practice of the supranational organisation to which they belong. But the EU functions and powers are still evolving, so it's still very important to monitor the accounting reform in the EC. this is because that some choices the EC made in this process could influence-in a more or less compulsory way-the EU member states in the future, especially when the EC is considering to make IPSAS adoption compulsory for EU member states. In other words, the EC adopted accrual based accounting and it could become the leading role in determining the modes of government accounting in the Europe, making the governments of EU member states move towards accrual based accounting, even if its intervention clashes with the national autonomy in budgets and accounting models of the EU member state.
Generally, the EC solution can be considered positively. There is still significant diversity in government accounting in Europe. There're different economic, political, and cultural traditions, which lead to significant differences between national governments. And even in the same country, there're huge differences between regions and local governments.
Even though some scholars have made comparative studies between European countries, it is still too hard to say at the moment whether and how the EC reforms have influenced the accounting reform recently carried out in some EU member states. This is also because that in some countries (like Italy) these processes are still a work in progress. It takes a long time to make plans for reformation and put the plans into practice. But it is believed that the IPSAS approach and the dual model could represent a reference experience and a good example for those continental countries that are moving from cash based accounting towards accrual based accounting, not only for EU member states but also for those candidate countries, such as Croatia, Turkey, Iceland and Macedonia, which are working on their EU accession process and that have to meet strict requirements of financial transparency and sustainability.
In conclusion, the hybrid approach of the EC is positively valued, represents a synthesis of the Anglo-Saxon, and continental European cultures and shows both the advantages and the limits of the IPSAS approach to consolidation in a governmental organisation. If the EC finally decides to make all EU member states adopt IPSAS, its experience can become a good example for these member states to follow.
While the EC has made IAS/IFRS adoption for the financial statements and consolidated financial statements of all EU member states' listed companies compulsory, a reformation is also going on within the public sector in Europe. The EC has adopted IPSAS and has published all annual financial reports in according on the basis of accrual accounting ever since 2005.
The transition from cash based accounting into accrual based accounting is not easy. Although it has IPSAS and the experience of some national government reformation as its guide,