Benefits of accrual basis accounting and its transition in the Indian public finance

On the basis of the expert pilot studies that the accounting standards in the Indian public finance need to be reformed with the changing conception, it is imperative to have a transition to accrual basis accounting system since India has been a favorite of international investors. This resource, thus narrates the importance of accrual basis accounting, its benefits in the public sector and transition from deficient cash-based to accrued-basis accounting in the Indian public finance.

Basics of accounting

Accounting can be defined as a systematic process of registering, reporting and analyzing of fiscal transactions and net outcome involved in a business entity or a public sector entity and a set of principles to be followed for the accounting procedure has been known as GAAP, i.e., Generally Accepted Accounting Principles.

We all in our daily life, knowingly or unknowingly pursue our own principles/ideas of planning our income in such a way that how we need to spend as expenses whilst how much of our money need to be kept back as savings with preparation of household budgeting. This concept of accounting, which has been a globally acceptable perception for business firms and accounting is the basic requirement for a business to get started and to be well-informed of inflow and out flow of resources and the outcome.

Being recognized as, "Language of business" accounting method/accountancy has been instrumental to manage planning, controlling and decision making processes of the business. Accounting system involves four stages reciprocally. The beginning phase, known as journalizing, implies to create a chronological record of financial transactions or events detailing their occurrences in the account books known as journals. Next stage has been ledger posting in which all transactions have been compiled on the basis of the accounts in order to determine the overall balance of each and every account and the outcome of various transactions throughout the financial year. The third stage takes up the preparation of trial balance in which the entire ledger accounts have been aggregated into debit and credit balances to further ensure that overall debits have been equivalent to that of credits. Final stage reveals presentation of financial reports at the end of financial year to conclude the accounts determinant of profit or loss and to prepare balance sheet that furnishes information regarding the financial position and performance of the business entities, i.e., assets owed and liabilities to be owed by the entity during that particular time period.

Major types of accounting methods

Using the generally accepted accounting principles, there have been two major types of accounting methods and these can be classified as the accrual method of accounting and the cash basis accounting type, each having its own advantages and disadvantages. A business entity may be practicing either of these methods or both accounting methods. To be exemplified, a firm can use the cash basis for taxation purposes and accrual type for reports of shareholders at certain times.

Cash basis accounting

Being the most straightforward and simpler method of accounting, cash basis accounting has been that in which the records have been maintained on the basis of the real transaction of cash in and out of the business. Income has been recorded or registered when it has been received and expenses have been reported as they have been made. The cash method is an ideal type for business firms with no inventory and sole proprietors. From a taxation standpoint, operating with the cash accounting method will be beneficial for any new business entity in which income recording can be withheld up until the next financial year with the expenses being recorded right away.

Accrual basis accounting

The term accrue by its name goes with the definition "accumulate" and accrual accounting describes earnings and expenditures on the basis of what has to be anticipated regardless of the inflow and outflow of money. In other words, income earned by a firm has been recorded when the firm sends out the bill though the bill amount has yet to be paid and the expenditures have been recorded as and when the bills received though not been paid. Income will be computed with the sum that the business invoices and expenses that the business owes. Most of the financial experts acclaim that the accrual method of accounting provides an accurate picture of the overall business from its financial health point of view since this type of report presents how much a business entity owes and has been owed at various time intervals.

Limitations to cash-based system of accounting

A cash-based accounting report in the govt. financial sector does not furnish a complete picture of the government's liabilities, since accrued liabilities from unfunded projects like pensions and commitments have not been taken into consideration.
On cash-based statement, no information has been provided about the government's assets, nor any costs of holding the assets, their consumption or usage.
More seriously speaking, cash basis accounting method allows room for financial opportunism since taxes may be garnered in surplus during a given period of time and may be refunded at a later date, expenses may be under-reported by postponing payments and revenues through taxation of the upcoming years would be preempted with single payments and so on. Moreover, the liabilities can be budgeted outside provided the government agencies being independent bodies.

When and what type of accounting method to be used?

In view of filing tax returns initially, it has been necessary to decide an accounting method for taxation benefits. On cash basis of accounting, transaction has been registered in terms of money received and paid whilst in accrual accounting transaction is recorded once the bill for a service or a product has been realized.

Mostly cash basis accounting has been benefited by the small business entities, cash-based business firms or a service company due to its simplicity and the easiest access to recording of income and expenses.

Accrual basis accounting needs to be considered in the following instances.
1. Annual sales of a business firm exceed $5 million.
2. The inventory of items (stocks) that can be sold to the public and the gross receipts are more than $1 million yearly.
3. The business that sells on credit since it has more precise matching of income and expenses in the given period of time.

A combination or hybrid of the two accounting methods may also be chosen. For instance, accrual accounting method may be recorded for revenue while payment of bills may be presented using cash basis accounting.

With the closing of the financial year, appropriate basis of accounting should be taken into consideration in terms of transactions, i.e., revenue and expenses calculation in the following manner.

Revenue: While using accrual basis of accounting, to obtain revenue in the current financial year itself the bills have to be processed prior to the closing of the year and in case to get the revenue delayed to the next fiscal year the bills must not be sent out up until the beginning of the succeeding year. On cash accounting basis, the bill can be sent out in the same year realizing the total income.
Expenses: On cash basis, in order to minimize taxation, expenses of the year if required may be counted. If accrual method is used it will not be necessary to pay the bills in the current fiscal year.

Hence, it is obvious that the choice of the accounting basis may depend on the issues such as the nature of the business, its simplified usage and regulations enacted by the legislation of a nation.

Importance of accrual accounting

Due to the inefficient cash-based accounting method that does not provide effective framework for assets and liabilities accounting, streamlining the financial system with a more functional accounting basis has become essential and the transition to accrual accounting has been essential in view of its emerging importance.

It plays an important role in preparing financial statements. The performance of an entity for the current year should be based completely on the activities to be carried over in the given period of time, but not the actual cash that has been channeled. It becomes crucial for some kind of businesses depending on the grants of the government and unless work gets completed during certain period of time the government grants would not be available and for that purpose actual revenue to be earned in the stipulated time needs to be reported.
In accordance with the matching principle, accrual method is considered to be significant. One of the generally accepted accounting principles formulated for businesses is that the revenues and expenses need to be matched in the given period in which they happen. It realizes the revenues on the books when they are flowing in corresponding to the expenses when they are flowing out.
On accrual basis accounting report, the records of the revenue earned and expenses incurred have been consistent in a given time period

The accrual method presents a true picture of the business of the reporting entity. By recording all transactions as and when they happen, accessing complete record of finances has been enabled.

Financial statements dealt on an accrual basis let the users to evaluate the accountability of the resources that the business entity contains and the gearing up of these resources. It also helps the users to assess the financial position, functioning and cash flow of the entity in order to make determinations to carry over the business with the entity. Elaborately speaking, an accrual basis reporting reveals how the government's cash requirements have been fulfilled and its activities being financed.
1. Allows the users to make an evaluation on the government's ability to finance its activities and to meet its liabilities and commitments.
2. Displays the financial position and variances in financial position of a government or a public sector entity.
3. Helps to manifest successful management of resources in its possession.
4. The performance of the entity in regard to its service costs, efficiency and achievements can be evaluated by the user.

Benefits of accrual accounting

Based on the studies conducted by the Public Service Committee of the International Federation of Accountants (IFAC), the benefits of accrual basis accounting for government and individual public sector firms have been summarized panoptically with the following interpretations.

Transparency of financial position

The information about the overall financial position and current stockpile of assets and liabilities of a public sector entity or a government will be obtained through accrual basis reporting since this information is essential:
1. To decide the reliability of financing the services they provide.
2. To prove the accountability to the public for assets and liabilities management realized in the financial statements.
3. To devise a plan for future financial requisites of asset maintenance and replenishment and to repay liabilities that exist and to manage the financial needs.

Managing cash position and financing requirements

On accrual basis accounting, the organizations need to maintain complete records of assets and liabilities. It helps in the management of assets such as better maintenance, replacing assets more appropriately, recognition and disposal of assets that are redundant and asset risk management in case of loss arising out of damage or theft. This will help the management of the entity to consider alternate means of handling costs and delivering services.

Consistency

Rendering consistent framework for the identification of existing potential liabilities on accrual basis accounting, it facilitates to recognize the financial obligations and the criteria for recognition of liabilities:
1. Obliges the entity/government to accept and formulate a plan for the payment of the entire recognized liabilities.
2. Gives information on the effect of existing liabilities on the resources for the future.
3. Provides substantial input for government to access whether current services can be provided continuously and to what extent new services or schemes may be catered to.

Financial decision-making

The impact of financial decision-making on net assets/equity is the limelight of accrual method influencing the public sector units and government to make long-term fiscal decisions rather than relying upon cash reporting. While using accrual basis, the financial statement discloses the fact about assets and liabilities and if the assets and liabilities have not been matched, a report containing residual figure for net assets/equity may be viewed. If the residual figure remains positive it may be represented as net resources for the future whereas the figure has been on the negative side, it can be considered as taxable amount in the future or other revenues that have been consigned initially to payoff debt and other liabilities. Net assets/equity may include contributed capital, accumulated surpluses or deficits and reserves, such as revaluation reserve and foreign currency translation reserve.

Accurate information on revenues and expenses

Accrual accounting portrays information about revenues and expenses to include transactions of money that has yet to be received and paid. Exact information on revenues facilitates the users and the government to assess the impact of taxation, other sources of revenue, probable monetary value of planned services and activities and the requirement of long-term borrowings.

Cash flow and management

Detailed report on current cash flows, projected cash flows and cash flows related with debts and credits can be incurred on accrual basis accounting. Thus, it may guide to have more efficient cash management and may help them to prepare better cash budgets.

The sole disadvantage of accrual method is that it is more complex to minimize taxes by transferring the items of income and expense from one year to another and complicated to control revenues and expenses while reported on accrual basis since the owner of the individual entity or government needs to put off some revenue into the next fiscal year by shipping and invoicing to the least extent at the end of the fiscal year.

Transformation process to accrual basis accounting in the Indian public finance

With a changeover in the priorities of fiscal management and hence financial reporting to be synchronized with this transition in the public sector in recent years throughout the world, there is a need for an emphasis on the transition from cash-based to a more standard based accrual basis accounting for Indian Public Finance as it cannot be refrained to go ahead with this transition process. In accordance with this shifting, in 2002 the Government Accounting Standards Advisory Board (GASAB) under the Comptroller and Auditor General of India was constituted by the Government of India to propose amendments in the Government accounting system. The GASAB was committed with sketching out a "Roadmap for Accrual Accounting" and "Operational Framework" to facilitate this transition.

Various projects undertaken by the Indian government for the transition to accrual accounting

Of late, the following strategies have been instituted in the Indian public finance in response to this reformation.

The 12th Finance Commission (2004)

This was established by the Government to motivate the initiation of accrual basis of accounting and its recommendations were acknowledged by the Indian Government in-principle. Noticed with the limitations of the cash-based system, the TFC has urged the central government to transit gradually towards accrual basis of accounting and the Government Accounting Standards Advisory Board (GASAB) under the Office of the Comptroller and Auditor General of India was confided to gear up the accounting reformation.

The 13th Finance Commission (2009)

The 13th Finance Commission instituted in 2009 also recommended that the reformation to accrual based accounting should be approached cautiously since the changeover has been resource and time-intensive process considering a "bubble up" approach in which the local bodies (within local bodies) would choose accrual accounting first, given that the National Municipal Accounting Manual integrating the principles of accrual accounting has already been devised under the guidance of the Comptroller and Auditor General of India.

The 14th report of the Second Administrative Reforms Commission (2009)

As per the recommendations by this Commission, to set up a Task Force to analyze the costs and benefits of inaugurating the accrual basis accounting would be ideal in terms of its implementation. The Task Force should also need to examine the applicability of accrual basis in the appropriation accounts and finance accounts and this would be implemented in a few departments or organizations at the beginning and a committee of experts would analyze the outcome of the initial execution and would recommend its further implementation in other departments or organizations at the Union or State level. This should be carried over stage by stage. Before implementing this, training and capacity building requirements of the accounting professionals and stake holders in the process of decision-making would be addressed in accordance with the road map of implementation. Prior to the adoption of accrual based system, appropriate alignment of the plan, accounts and budget has been essential and a more feasible financial information system should be in place.

Operational Framework and Road Map in 2007

Government Accounting Standards Advisory Board (GASAB) established under the Comptroller and Auditor General of India by the government in 2002 enlisted the Operational Framework and Road Map in 2007 describing different stages for transformation to accrual basis system and rendering guidance for pilot studies undertaken in the selected departments and ministries of the Union and the State Governments.

Various pilot studies undertaken have been as follows:

1. Consolidation of the existing accounting framework.
2. Identification of the accounting entity.
3. Information technology reforms and capacity building.
4. Identification of constructive accounting.
5. Management discussion and analysis of report of authority.
6. Identification of chief accounting authority.
7. Better quality of primary records.
8. Maintenance of primary records.

Outcome of pilot studies

1. Positive and motivated response from stake-holders.
2. Requisition by numerous States to coordinate training modules.
3. Flagging cash accounting drawbacks.
4. Emphasis on the need for operational guidelines.

The Operational Framework is a set of guidelines providing a complete structure of the accounting model. The objective of this framework is to lay down the principles for recognition and measurement for General Purpose Financial Reporting (GPFR).

Goals of General Purpose Financial Reporting

To be informative about the financial position of the reporting entity or organization that would help in decision-making to grant resources to the entity and to assess the efficacy of the entity's usage of the resources.
To have a more transparent and relevant financial statement.
To help the users understand the financial statement.
To enhance performance reporting with Results Framework Document (RFD).

General Purpose Financial Statements (GPFS)

A unified conceptual framework on General Purpose Financial Statements (GPFS) according to the International Public Sector Accounting Standards (IPSAS) helps in guiding to have the structure and basic requirement for the contents of financial statements reported on accrual basis system. The complete set of financial statements to be kept on the basis of the requirement as specified by the Government of India comprises of various statements on financial position, financial performance, net assets, cash flow, appropriation accounts and accounting policies and notes to the financial statements. A management discussion and analysis report is essential pointing out financial statements and highlighting performance indices with a signature of the Chief Accounting Authority as stipulated in GPFR for a complete framework of General Purpose Financial Reporting (GPFR).

The way ahead for accrual based accounting in India

First phase between 2011-12 and 2012-13

An apex body at the Finance Ministry level consisting of key stake-holders from the Union and State level for coordinating, supervision, decision making and managing the implementations has to be established.
Task-based groups should be constituted in every entity to pioneer the transformation process in a timely fashion.
Revamping of accounts chart in order to incorporate accrual accounting requirements is essential.
Expansion of an IT-enabled integrated financial management system and capacity building in terms of human resources.
Centrally Sponsored Scheme for Treasury Modernization released by MoF preparing an accounts module and budget module benefiting the main features of accrual accounting.
Identification and evaluation of assets and liabilities and consolidation of assets categorically.

Second phase between 2013-14 and 2014-15

Appraisal of historical assets.
Provision of depreciation.
Realization of expenses and payables.
Recognition of revenues and receivables.

Third phase from 2015

Preparation of the financial statements including statement of financial position, financial performance, cash flow statements, variations in assets and liabilities, appropriation accounts, accounting policies and notes to the financial statements, and management and discussion analysis report that have been required for General Purpose Financial reporting (GPFR).

Concluding perception

On conceptualizing the above-named highlights of cash-based versus accrual-based reporting, I perceive that accrual and cash-based systems have their own merits depending on the financial functioning and both should go in parallel during changeover process in terms of the public finance accounting principles since the moves to have a transition to accrual basis accounting in the Indian public finance factually are being underway for quite some time. In addition, it may be prudent to make additional fiscal reporting to support a more transparent and comprehensive governmental budget.