The Virtues of Accrual Accounting

by Reihan Salam

The GAO has a helpful guide to the differences between cash accounting and accrual accounting for the public sector. For more background, however, I recommend a 2006 briefing paper by Mark Champoux: 

In general, an accrual accounting system recognizes economic events when they occur rather than when money is actually exchanged. Revenues are generally recognized when goods and services are delivered, and expenses are recorded for the time periods in which assets are used and liabilities are incurred in generating revenue. As such, accrual methods are often favored in situations where transactions of goods and services are not necessarily completed within one time period.

Most governments, including the U.S. government, use cash-based accounting:

[C]ash-based accounting primarily records the inflow and outflow of cash, regardless of when revenues are earned or liabilities are incurred. As such, future liabilities, for example, are not accounted for until a cash payment is actually made. In the context of government spending, a future liability, such as payment of a retirement pension, is not reflected in the official financial budgets and statements until pension comes due and payment is made.

Recently, however, a number of governments — including those of Australia and New Zealand — have embraced accrual accounting.

Although accrual accounting has been favored by the private sector for several decades, it is only relatively recently that national governments began to seriously consider employing accrual measures for their own financial reporting and budgeting. The motives in turning to accrual accounting vary, but in general, an accrual system is seen as a way of increasing budget transparency, especially in terms of its ability to account for long-term assets and liabilities, and also as a tool for increasing government efficiency through performance-based management.

Champoux goes into detail regarding the experience of Australia and New Zealand to explain exactly how accrual accounting facilitates performance-based management. One of the core ideas is that public sector providers should be evaluated on the basis of outputs, not just inputs. 

An output-based budgeting process, generally speaking, emphasizes “the use of output (product) cost information as a managerial tool and more specifically as the basis for a purchaser/provider (quasi-market) model of budgeting.” In other words, government agencies and departments are viewed as producing outputs (for instance, maintenance of armed forces, prison management, etc.), which Parliament then purchases, so to speak. As such, the departments must use accrual-based projections and reports so that Parliament can know the full costs of the outputs and compare costs with private suppliers if possible.

Accrual-based reforms seem to have been a success in New Zealand, though of course there are many other variables at work:

[M]any believe that the accrual measures have produced much greater fiscal discipline, especially in as much as legislators and other government officials can more easily ascertain the fiscal sustainability (or lack thereof) of government programs.

Indeed, since implementing the reforms, New Zealand has in fact demonstrated strong fiscal restraint. In terms of budgeting, New Zealand has more or less tolerated increases to core budgets of each department at only a constant nominal level. Remarkably, New Zealand’s gross financial liabilities has decreased from 65% of GDP in 1993 to 23% in 2005, while the OECD as a whole has increased from 66% to 76% in the same time period. The country has also reported budget surpluses in nearly every year since the early 1990s. As a result, New Zealand’s net debt has decreased significantly, from approximately 52% of GDP in 1992 to near 10% in 2005. During the same time, New Zealand has enjoyed, for the most part, moderate to strong economic growth, averaging around 3.3% annual growth in real GDP over the last decade. To what extent any economic success can be attributed to New Zealand’s major reforms and, more specifically, to its use of accrual accounting, is highly unclear. [Emphasis added]

To be sure, Champoux was writing in 2006. New Zealand’s gross financial liabilities have increased in the years since as the country has run deficits in recent years. But its debt-to-GDP ratio compares well against other advanced market democracies.

It should go without saying that embracing accrual accounting wouldn’t be some kind of silver bullet for America’s fiscal woes. But it does seem like a reasonable step to add clarity to how we think about public expenditures.

The Agenda

NRO’s domestic-policy blog, by Reihan Salam.