The Differences between Full Accrual, Modified Accrual, and Cash Budget - Essay Example

Differences between full accrual, modified accrual and cash budget Carlin (2005, p. 75), argues that budgeting is a future oriented plan for resource allocation among alternative uses. Full accrual based budgets cover the full government operations and increases in liabilities or decreases in assets. Full accrual is an accounting reporting that recognizes changes in inventories and depreciates assets progressively in accordance to their useful life. It utilizes matching principle, which involves recording of expenses in the same period of related revenue recognition. It produces financial statements that cover assets, expenses, revenues, net assets, and liabilities. The accrual based budgeting system requires special mechanism for controlling cash. An example of full accrual budgeting system is that used in Australia. Full accrual budgets are usually result oriented. The system focuses on managerial responsiveness and involves outcome oriented, long-term budget and planning process. Accrual based budgets provide a framework for managing complexity in a better way. Moreover, the system aligns departmental outputs with the outcomes specified by the government in a more expressive way (Carlin, 2005, p.74). In addition, adoption of a full accrual budgeting improves the quality decision-making process within government agencies. Furthermore, full accrual budgeting system enhances the transparency of decisions and activities made by the management. Finally, full accrual system has the advantage of providing a management and accountability system that is based on effectiveness and performance indicators. Full accrual budgeting allows the appropriation of a country to be explicitly made for outcomes. Accrual budgets emphasize budgetary process to full cost estimates. The system has separate cash plans that are not directly derived from appropriation. Thus sound cost estimates and good fiscal discipline is required to avoid depreciation being used as an excuse for cash overruns. In the case of Australia, which uses this system of budgeting, portfolio statements are used to provide additional explanation and details of the budget concerning the allocation of resources to government outcomes (Nicholls, 1991, p. 60). It is apparent that use of full accrual budgeting is usually structured around outcomes as exemplified by Australian case. Moreover, full accrual budgets allow the appropriated amount to be based on the full cost of outputs and outcomes delivery instead of being based on the expected cash outflow for the year. The use of full accrual based budgeting system allows legislators to have an increased control over the budget. This is because the legislators are able to access more information as opposed to that they are given when cash based budgeting system is used. The system also provides the public and legislators with information on contribution of means to the appropriation outcomes. In addition, this system avails cash information and information concerning full cost of outcomes and outputs delivery provided in the budget (Carlin, 2005, p. 72). In spite the advantages; the system arguably weakens the legislative control over the budget. This is because an aggregated level is used to authorize appropriation. For instance, the Australian full accrual system involves authorization at outcome level (Wanna et el. 1999, p. 133). The accrual budget system is also said to be complex in addition to having an increased complex accounts. Moreover, the separate cash plans provided under the system that are not directly derived from appropriation is said to be too aggregated and it is more complex to visualize the contributions of various agencies to the outputs (Nicholls, 1991, p. 60). Furthermore, the information provided in these separate cash plans such as portfolio budget statements in the case of Australia is not binding since legislators are not required to vote for them. Despite the shortcomings outlined above, full accrual budgeting system is argued to provide more accurate and complete financial information than cash based budgeting systems. In spite this; some issues still linger about the system in relation to consistency, transparency and comprehensiveness of information provided by the full accrual budgeting system. Modified accrual refers to accounting reporting where transactions and events are recognized as they occur notwithstanding whether cash is received or paid. The system lacks deferral of costs for future period consumption. It involves writing off physical assets that will be used for future at acquisition period. The system assumes that supplies consumed and assets are thus written off immediately they are acquired. It differs from cash accounting system in that it recognizes expenditures during verification stage and thus liabilities and arrears are adequately assessed (Nicholls, 1991, p. 133). It produces financial statements that cover financial assets, expenditures, revenues, net financial resources, and liabilities. Unlike full accrual budgets, modified accrual budgets are usually more policy oriented. It provides detailed plans of the government based on the government agencies and departments. Each government expenditure is outlined and usually requires legislators to approve it. They present information related to intended and achieved policy measures, policy objectives of instruments, and their costs. Thus, the modified accrual budget structure involves appropriations for policy lines for various departments. These policy lines refer to the outcomes that should be attained by each department (Wanna et el., 1999, p. 140). Thus, the modified accrual budgets describe in an explanatory statement the policy objectives, the instruments to be used to attain them, the outputs to be delivered and the estimated means. The system requires that each department of a firm or government to have an average of ten policy lines that are systematically worked out. This implies that there is a very large reduction in the number of policy lines required when preparing modified accrual budget in comparison to other methods. Modified accrual budget is said to be advantageous since it gives rise to budget documents that are more concise and transparent as opposed to full accrual budget system. The system is capable of providing information on expenditures and outputs. The Dutch government uses an example of a modified accrual budget system. Studies show that when the Dutch government instituted this system by shifting away from the cash based system; there was increased transparency and conciseness in the budget documents prepared (Nicholls, 1991, p. 102). The system does not have an aggregated level of authorization as seen under the full accrual system. The reports derived from the budget provide more detailed information by focusing on results in a more strategic, multiyear perspective on program delivery. These reports contain information related to objectives, initiatives and planned results. They also provide information linking these plans to resource requirements for a specified period. The system is however limited because it often does not provide information on the linkage that exists between outputs and expenditures. This usually results in insufficient translation of savings in results. Thus, results that are reported in the annual report are not sufficiently compared with objectives that were stated earlier on in the budget. Cash based budgets restricts the amount of money the government is authorized to spend. Cash based budgets gives government authority to make cash payments over a limited period of time. Cash based budgets are said to be political statement that vary from country to country in which they are used. Calculation of fiscal balance under this system involves arithmetical differences between cash received and cash paid out during the financial year (Wacziarg & Keith, 2003, p. 94). Such calculations do not include extra budgetary or off-budget items. Thus, cash based budgets are said to be prone to political manipulation. The internationalization of accounting rules and auditing has seen this system being challenged. In addition, the rapid spread of fiscal rules has constrained budget options and outcomes and hence challenging the cash based budgetary system. In spite the shortcomings of the cash based system, it has several advantages. First, it is better understood by the public and the government than the complex accrual based systems. In addition, it is less prone to manipulation if the standard accounting standards are used in its formulation (Wacziarg & Keith, 2003, p. 100). Moreover, the cash based budget system provides more reliable indicators of the short term fiscal condition of the government. Transparency Transparency is the act of providing a clear, concise and balanced picture of the financial situation of a firm to its stakeholders. Accounting transparency requires firms to comply with accounting standards and it emerged following widespread business and accounting scandals (Victor, 2003, p. 100). It is theorized that the quality of information disclosure by a firm impacts on the term structure of its corporate yield spreads. It is further believed that market transparency is an essential mechanism that is employed to reduce information asymmetry among participants in the market and as such facilitating market efficiency. The widespread occurrence of recent financial scandals is attributed to opaqueness of the firms involved. The opaqueness of firm’s in terms of their information disclosure usually results in late discovery of pertinent information that could otherwise be utilized for averting a potential crisis from happening if it were disclosed early (Wacziarg & Keith, 2003, p. 101). Transparency is an important concept since it provides a complete and understandable view of a firm’s financial state that reduces uncertainty in the markets. Transparent firms report issues that can impact its financiers and investors. Such firms are involved in voluntary and mandatory widespread provision of relevant and reliable information about the periodic financial position, performance, value, governance, risk of publicly traded firms, and investment opportunities (Victor, 2003, p. 100). There is evidence that the level of disclosure intensity differs from country to country and hence the level of accounting or corporate transparency. The differences are associated with differences in efficient allocation of investment, economic growth, sensitivity of investment to internal cash flow, IPO under pricing, financial intermediaries’ development and concentration of stock ownership (Victor, 2003, p. 122). A firm that fosters transparency often transmits corporate reports voluntarily and makes it mandatory. In addition, such firms or governments disseminate information via the media and the internet channels. Moreover, such firms are involved in acquisition and communication of private information by institutional investors, financial analysts and corporate insiders (Wanna et el, 1999, p. 132). The information disseminated need to be both high quality and credible. Studies have shown that countries in which firms are more opaque to outside investors are prone to higher frequencies of financial crushes. It is argued that countries with high share of state owned firms have lower financial transparency. Studies also indicate that transparent corporate governance is more likely to thrive in countries with higher levels of common law backgrounds, judicial efficiency and countries which have more active and well developed stock markets (Hannagan, 2005, p. 133). It is also reported that cost accounting regimes with higher degree of opaqueness are more prone to more frequent and more severe asset price crashes. This argument is based on the proposition that cost accounting regime can act as a tool for hiding the true performance of a firm which can consequently result in the firm’s financial crashes. Some actions such as the implementation of the Sarbanes Oxley Act of 2002 were aimed at increasing transparency in markets and reducing opaqueness in firms to reduce financial scandals (Gareht & Colin, 2009, p. 690). In addition, adoption of accounting standards have been hailed for being capable of reducing market opaqueness and occurrence of financial scandals in markets. Reforms in accounting standards such as marking to market have been touted as possible ways of increasing market transparency. Mark-to-market accounting refer to accounting standards which calls fair pricing of toxic assets at their current market price on the basis of the prices of similar assets in the market and not their assumed past or future prices when markets are stable. It involves updating the value of an asset to its current market levels (Hannagan, 2005). This is based on the fact that investments may gain or loose its value as it ages. However, the mark to markets standard has been criticized for its effect on the value of companies during financial crisis. The value of companies is greatly affected during financial crisis when mark to market accounting method is used because the method does not work well when trading stops. Since market price cannot be determined under such circumstances. During financial crisis a market dries up and no active trading takes place and hence prices do not exists (Victor, 2003, p. 155). Thus assets held by companies are perceived by investors as involving high level of risk and hence they shy away from investing in such assets. In such circumstances, companies are forced to write down assets to the mark to market rule and thus they end up writing off billions of dollars of losses. Thus, it has been argued that during financial crisis asset values may be misrepresented if they are valued at the prevailing market prices. Thus the difficulty and infeasibility of implementation of mark to market standards makes a mixed compromise unavoidable (Gareht & Colin, 2009, p. 705). In spite this; it is argued that marking to market can provide an early warning to investors concerning the true performance of the firm. It is also argued that detection of earnings management in markets can be enhanced by more transparent disclosures of financial information. Examples of reporting distortions or discrepancies when using specific accounting tools (i.e accrual versus cash) According to (Allen &Smith, 2005, p. 70) GAAP, revenue and expenses need to be recorded on the basis of accrual. Accrual accounting is based on three basic accounting principles and conventions: the revenue recognition principle, the accounting period convention and the matching principle. The method is able to report net income accurately for each accounting period in spite the length of the period. This system is able to do this via recognizing revenue at the point at which it is earned; and recording the revenue in the period similar to the associated expenses. It requires that expenses be recorded at the point at which a legal obligation to pay was made. This differs from cash accounting system, which records revenues and expenses at the time cash is actually exchanged. Cash based accounting involves recording revenue only when cash is received and expenses on when they are paid for (Intal & Findlay, 2008, p. 64). Moreover, cash accounting does not attempt to match revenues with associated expenses incurred in earning. The cash based system reports revenue and associated expenses within the same accounting period. Moreover, the cash based accounting results in distortion of operating results due to economic reality following a specified short period of time. This distortion is a consequence of transactions which occur near the end of accounting period. Cash based accounting systems are not able to provide necessary information for efficient and effective government operation. Unlike accrual based accounting system, cash based accounting system is not able to provide a linkage between means, instruments and performance. Cash based budgeting is not capable of providing better cost information t to decision makers. Cash budgets also provide less attention to management of cash stock. Cash budgets often have biases in regard to capital investment recording since they are lumped together instead of being capitalized and depreciated over its useful time. In addition, cash based budgets are incapable of illuminating long term sustainability of public finances the way accrual based systems could do. Moreover, cash based budgets are incapable of providing sound budget execution as could be realized under accrual budgeting. On the other hand, accrual based budgeting are arguably not appropriate system since budgetary laws often require (Intal & Findlay, 2008, p. 40). References Allen, D. &Smith, M. (2005). ‘External policy development’. In Nugent, N, (ed). The European Union : an annual review of activities (journal of common market studies),34(4), 63-84. Carlin, T.M. (2005). Debating the impact of accrual accounting and reporting in the public sector. Financial Accountability & Management, 21(3), 67-102. Gareht, R. & Colin, K. (2009). Reorientation interregional co-operation in the global political economy: Europe’s East Asian policy: Journal of Common Market Studies, 37(4), 683-710. Hannagan, M. (2005). Management concepts and practice. England: Prentice hall. Intal, P. & Findlay, C. (2008). Beyond Liberalization of Trade in Goods: Alternative Strategies for Regional Trade and Investment Facilitation. In Europe East Asia and APEC." A Shared global Agenda. Cambridge: Cambridge University Press, pp. 19-67. Nicholls, D. (1991). Managing State finance: The NSW experience. Sydney: NSW Treasury. Victor, G. 2003. personal financial planning. London: McGraw-Hill Professional. Wacziarg, R & Keith, W. (2003). “Trade Liberalization and Growth: New Evidence”, NBER Working Paper No.10152, Cambridge MA: National Bureau of Economic Research, pp. 89-102. Wanna, J., O'Faircheallough, C., & Weller, P. (1999). Reform of budgeting and financial management (Chapter 8, pp. 126-144). Public Sector Management in Australia (2nd ed.). South Yarra: Macmillan. Read More