Governmental Accounting: Part 2 (#275)
/In this podcast episode, we discuss the basis of accounting and the measurement focus in governmental accounting. Key points made are noted below.
In this episode, we go a little deeper into the fund accounting concept, and talk about the basis of accounting and the measurement focus. You probably already know about the basis of accounting. A business might use the cash basis of accounting, where revenue is recorded when cash is received, and expenses are recorded when payments are made. Or, a business might use the accrual basis of accounting, where revenue is recorded when earned and expenses are recorded when incurred. And you might have thought that those were the only two options.
Modified Accrual Basis of Accounting
No. In fund accounting, we also have the modified accrual basis of accounting. This involves a lot of tweaks to the accrual basis of accounting. For example, revenue is recognized when it becomes susceptible to accrual. I always thought that susceptible meant being susceptible to the common cold, but in this case, the meaning is a little bit different. Instead, revenue transactions have to be available to finance the planned expenditures for the period. The “availability” concept means that the revenue should be collectible within the period or right after it, so it can be used to pay the bills. In addition, the revenue has to be measurable, which is a bit of an odd concept in governmental accounting. A government can accrue revenue even when it’s not exactly sure about the amount to be collected. So, a revenue accrual could be based on historical collection patterns from prior years.
For example, you could accrue as revenue those property taxes that are expected to be collected in the current period. Or, you could accrue grants expected from other governments, or inter-fund transfers, or maybe income taxes where the taxpayer’s liability is pretty well established, and the probability of collection is fairly good. Obviously, revenue recognition under the modified accrual basis is a bit different, which can make someone raised on the other two methods a bit uncomfortable. So, to make things a bit easier, it can be more practical to recognize miscellaneous revenue items when cash is received – in other words, using the cash basis of accounting. For example, parking fee revenue might be recognized on the cash basis, rather than the modified accrual basis.
So what about the recognition of expenditures? They’re accrued in the period in which the associated fund incurs a liability. This approach normally applies to any liability that’s paid in full and in a timely manner from current financial resources. Examples of the types of liabilities that are recognized like this are employee compensation and professional services. That sounds easy enough, but not every expenditure is treated that way.
For example, the employee of a city government has been piling up sick time for years, and hasn’t yet used it. The city’s policy is to pay out unused sick time only when an employee leaves the employment of the city. Therefore, the liability associated with the sick time isn’t accrued until the employee actually leaves the city. To extend the example a bit more, let’s say that the government has a fiscal year end of June 30. If the employee were to stop working for the government the next day, on July 1, the city would not record a liability or an expenditure for the sick time in its June 30 financials. But, if the person had instead left one day sooner, on June 30, then the city would have to recognize the full amount of the payment, since it’s due within the fiscal year. In short, when dealing with expenditures under the modified accrual basis, the key point is whether and to what extent the associated liability has matured.
So far, we’ve been talking about the basis of accounting, which is all about when transactions will be recorded. In governmental accounting, there’s also the concept of the measurement focus, which is what transactions will be recorded.
The Measurement Focus
The focus used by governmental funds is the current financial resources measurement focus. This means that the focus of these funds is on assets that can be converted into cash and liabilities that will be paid for with that cash. When there’s an increase in spendable resources, this is reported as revenues or a source of financing. When there’s a decrease in spendable resources, this is reported as an expenditure or a use of financing. Or, stated another way, the balance sheets of governmental funds don’t include long-term assets or any other assets that won’t be converted into cash to settle current liabilities. This approach is only used in governmental accounting.
A proprietary fund, which is used to account for the business activities of a government, uses the economic resources measurement focus. This approach focuses on whether a proprietary fund is economically better off because of transactions occurring within the fiscal period being reported. In this case, there’s no consideration of whether there are current financial resources, so a proprietary fund will include long-term assets and liabilities on its balance sheet. When there’s an improvement in the economic position of a proprietary fund, this is reported as revenue or a gain. When there’s a decline in the economic position of a proprietary fund, this is reported as an expense or a loss. Out of the two, the economic resources measurement focus will sound more familiar, since this is what a commercial business uses.
Concept Usage in Government Entities
How are all of these concepts used within a government entity? Governmental funds, such as the general fund and the permanent fund, use the modified accrual basis of accounting and the current financial resources measurement focus, while proprietary and fiduciary funds use the accrual basis of accounting and the economic resources measurement focus. And on top of that, when preparing government-wide financial statements, you should use the accrual basis of accounting and the economic resources measurement focus.
Another way of looking at the situation is that long-term assets and liabilities are recorded in the government-wide financial statements, but they’re not recorded in the general fund or any of the special revenue funds.
As you can see, these concepts can be pretty confusing, especially because which concept is used depends on the type of fund for which you’re doing the accounting. Why would anyone adopt such a complicated system? The easy answer is that we’re accountants and we always take the most complicated approach. And if you don’t believe me on that one, just look at the accounting rules for derivatives!
But the real reason is that governments are working with a fairly fixed amount of available cash, and so they have to produce financial statements that show them exactly what resources are available to provide the funding for expenditures in the current period, as well as what has to be paid in the current period. They’re less concerned with longer-term assets and liabilities, because they have to pay the bills now, and the financial reports have to assist with these shorter-term issues. And that’s why these complicated rules are used.