Madam Chair, members of the Committee, good morning.
I'm very pleased to have an opportunity to make this presentation in order to help the Committee launch its study of accrual-based budgeting and appropriations.
Because this is a very complex subject, even for accountants, we will review it step by step. First of all, we will briefly explain the concept of accrual accounting; following that we will explain how it applies to budgeting and talk about the issues related to both budgets and appropriations.
Let's review the agenda first. Our presentation will address the following topics: accrual accounting, the basics; accrual budgeting and appropriations; why moving forward with this issue is important; some challenges and concerns; what is happening internationally; what is happening domestically; possible Committee questions for government; and the conclusion.
On page 3 of the presentation, we go through the basics. We thought we would begin with the basic concepts of accrual accounting. I know the objective today is to talk about accrual appropriations and budgets, but I'll just go through the basics of the accrual accounting difference. I'll come back to explain it as we move through the other issues.
Accounting on an accrual basis is recommended by CICA and by international standards. It's generally used in most environments in government these days, or it's certainly moving in that direction.
Accrual accounting recognizes income when earned and expenses when incurred, whereas on the old basis, the cash or the equivalent is received or paid. Accrual accounting does not wait until the cash changes hands to record the transaction. It keeps track of assets and liabilities from the initial recording until they're finally settled, paid, or used in terms of assets. So it's the costs of consuming them over time, particularly in terms of assets.
Turning to page 4, I'll go through a simple example. If an organization purchases and receives supplies for $1,000 in the month of March, it pays for the supplies only in April. Under the accrual method, the $1,000 of supplies would be recorded as soon as the expense was incurred, in this case March. Under the cash method, it would be when it was paid, in April.
I'll go through another example that is slightly more complex. The government purchases equipment costing $100,000 on April 1, 2004. It's expecting to use that equipment for ten years. Under the accrual method, you would record the $100,000 cost of the asset in the year ending March 31, 2005. Then you would record amortization of $10,000 for each year it is used over the ten years.
Under the former method, the entire $100,000 would have been recorded in the year in which it was purchased, the year of expenditure. There is no recognition of the usage of the asset over time. The accrual method continues to track the outstanding balance of the asset until it's sold or removed from service.
Continuing that example on slide 6, the accounting would look as it is shown here. You have the impact on operations in the first year, 2005. Under the accrual basis it would be $10,000, and in 2006 it would be $10,000. That's the amortization that would be reflected in each of those years. Under the former basis, the second line, the impact on operations, you would have the whole $100,000 being recorded in 2005 and nothing in the future years.
Below that we reflect the impact on the balance sheet. In this case, for the current under the accrual basis you would continue to carry the depreciated value of that asset, so at the end of the first year you would have the $100,000 less the $10,000 of amortization, for $90,000. The second year you would have another $10,000 of amortization, which would reduce that balance to $80,000. That would continue through. Under the former method you would have nothing recorded; it would be nil, because the former basis recorded the full purchase of $100,000 when it was originally done.
I have one more example on slide 7. This one I will come back to and explain later in terms of accrual appropriations and budgeting. In this example, on March 31 the government recognizes that it has an environmental cost for remediation of a toxic site, and it's estimated to cost $100,000 over the next 10 years, but the work will begin on July 31, 2005, and the cost in that year will be $10,000.
Under the accrual method the government would record the entire $100,000 cost on March 31, 2005. It would recognize the full liability at that time. Under the former method only $10,000 would have been recognized because that's the amount that was paid. The accrual method continues to track this liability until the outstanding balance owing has been fully paid. The initial $10,000 would be reduced against the $100,000, similar to the example I explained on capital assets.
Turning to slide 8, we again see the accounting of the effect of this transaction. Under the current accrual basis, $100,000 would be recorded against operations in 2005. This is the incurring of the liability, because the full obligation is the $100,000 known at that time. The former basis would show nothing in 2005 and would only recognize the payment of $10,000 in 2006. The impact on the balance sheet is somewhat similar to the capital asset example. Under the accrual basis we would record $100,00 the first year, $90,000 the second year because $10,000 has been paid or reduced against it. Under the former basis, the balance sheet would reflect nothing because it was on a cash basis and would only record the $10,000 as paid.
I've now discussed three examples of accrual accounting. The important part of this is the timing of the recognition of the expense that occurs when the event happens, even if the payment is many years apart from that. The difference is most significant or visible when you have long-term liabilities or long-term assets. For anything that tends to be relatively short-term or immediate, there is not much impact. Things like buildings or equipment, pension liabilities, and environmental liabilities are where the big differences occur. Under accrual accounting, the recognized liability and the assets remain on the statements, and they are reduced through usage or payment over time.
Turning to slide 9, I'll explain a few basic advantages that accrual accounting provides. It provides a reflection of the full scope and size of government, so you have all the resources, all the financial and non-financial assets, recognized. The obligations, or all liabilities, are recognized and the costs are reflected. The focus is on the consumption of resources. It links the full cost of running a particular program with the results achieved, and it retains information, particularly on assets, until things are fully used in operations.
Slide 10 continues the explanation of some of the advantages.
Accrual accounting allows Parliament and the public to hold government accountable for stewardship of its assets, the full costs of its programs, and its ability to pay down the national debt.
As a result, it better reflects the impacts of all the decisions made by a government, rather than being limited to showing only those decisions made to pay for loans, assets, acquisitions and services.
Fuller information is available to government under this method. There's more focus on assets. There's more attention to managing liabilities and more focus on the full cost of programs and services.
Slide 12 is a snapshot of the different methods we currently have, which ones are using accrual and which ones are using near-cash. You will see later on that a similar summary of this is provided in the Comptroller General's presentation.
What I would point out here is that the federal budget at the government-wide level is on accrual, the summary financial statements are on accrual, and the departmental financial statements are on accrual. Those departmental financial statements presently are unaudited, but there is a plan to move towards auditing them.
The key that I'm going to be talking about in the rest of the presentation is what is on this slide: the second line under budgeting, departmental budgeting and estimates; and the third line, appropriations. Those are, as you will see in the departmental column, near-cash. We are suggesting that it would be appropriate particularly to move departmental budgeting and estimates to an accrual basis to make them consistent with the reporting that you have at the departmental financial statement level and to be consistent with the federal budget level, which is accrual.
Accrual exists, as I say, but where it is lacking the most is in departments. There certainly has been an increase in the use of accrual. Cabinet submissions are now using accrual, but it's not routine for departmental management to focus accrual information. They continue to be accountable for the budgets and the appropriations, which are on a near-cash basis.
Later on, I'll speak to that a bit more.
Slide 13 deals with, if budgeting and appropriations were accrual, what would be the impact of that.
Well, the budgets, estimates, and appropriations would more closely be related to costs and revenues anticipated, regardless of when items are paid or received; budgeting and forecasting would be based on anticipated economic events, revenues, and costs in the fiscal year, not anticipated receipts or payments; and departmental managers would be more accountable for accrual financial information. This, we think, is important. They need to be thinking about more than just the near-cash information when they're making decisions. To us, this is a key change, which I'll speak to again a little later.
There are certainly some issues that have to be dealt with, the issues related to capital assets and long-term obligations, particularly for appropriations, and I think we'll hear some of that suggested by the Comptroller General when he speaks later.
It is important, in my view, that we think about potentially separating the issues of budgeting and appropriations. Certainly it's easier to move forward on the issue of budgeting. There are some issues perhaps with appropriations that you will pursue as you discuss this further.
I'll go now to slide 14.
Some of the advantages of using accrual accounting for budgeting include: more comparable information, better control and monitoring of actual performance; improved transparency of the government's performance; improved accountability at department and agency levels -- the use of financial resources on the same basis as the budget; better information for planning; controlling operating and capital spending, and decision-making; and more focus on long-term consequences of current decisions.
There are some challenges and concerns.
Retraining of financial managers is certainly an issue that's been raised. The concept is difficult to understand. I hope we are helping people understand it a bit today.
It's still important for government to manage cash, and yes, we acknowledge that's true. There's the difficulty of managing the large non-cash expenditures or the accrued liabilities that will be paid at some time in the future. There's also a learning curve and a change management issue that I think is a bit connected to the issue of retraining.
We believe that leadership will be critical to making this happen, and managing the long-term non-cash items is certainly a challenge, particularly for appropriations. But as I'll explain in a few minutes, others have found a way to address it and we think Canada can do it as well.
I think it's important to note, and I've said this a couple of times already, that departmental managers need to be more accountable on managing non-financial assets and certain liabilities.
I'm going back to the example that I talked about earlier on the environmental remediation costs. The current method of departmental budgeting and appropriations—and this is important; this is departmental budgeting and appropriations, not the accrual accounting in the financial statements—would recognize in 2006 only the amount that was paid towards the cleanup. Even though the entire $100,000 cost would be reflected in the government's summary financial statements, at the level of departmental budgeting and in the appropriation, it's not there. The inconsistency of that information is something that we think needs to be addressed.
The current budgeting does not require departmental managers to think about the full cost of the remediation. They only need to think about the short-term costs. The key challenge for us is to see that departmental managers focus on accrual costs, concentrate on the broader perspective of the cost of programs, and leave the conversion of the accrual information back to cash, which is still important to manage, to the financial managers in the organizations.
In my view, it is exactly the reverse of where we are today. Currently, the financial information is done in the financial shop at the end of the year to produce the accrual departmental financial statements and the accrual financial statements of the Government of Canada, but the management in the organization is managing only the cash appropriation.
We're saying that should be changed around. Make the information that is presented in the budgets and the estimates on an accrual basis. Managers will manage that information and then do the reconciliation to the cash number that needs to be appropriated. Let the financial managers, not the operational managers, worry about whether there's sufficient cash. That's a key point in this.
I'll quickly reflect on a couple of further points on what's happening internationally.
Most of the OECD countries have or are moving to accrual accounting. France has decided to move to accrual accounting but to retain cash-based budgeting. Accrual-based budgeting and appropriations are used in Australia, New Zealand, and the United Kingdom. These ones are the leaders and they've been advancing the matter. I know there are some views as to whether they are fully satisfied, but to our knowledge, they are continuing to move in that direction.
It's moving even faster domestically. Most of the provinces and territories have accrual-based government-wide budgets, and many of them have departmental budgets and appropriations that are on an accrual basis. We think the committee may wish to discuss with representatives of some of these provinces how they've addressed the issues and challenges. We can certainly recommend a few that would be ready and willing to discuss their approach with the committee.
Within Canada, our view is that the federal government is clearly behind. We think they should move forward on this issue.
Finally, we believe the Committee could play a very significant role by putting a number of questions to the government.
For example, who in government is the champion advancing this issue? Has that person received enough support?
What does the government propose as a strategy for moving toward accrual-based budgeting and appropriations, including addressing the unique issues associated with capital acquisitions and long-term liabilities?
Does the government have enough human resources and skills to make such a change? If not, how can it overcome this limitation?
Has government set aside enough funds to undertake a change in the budgeting and appropriation process?
In conclusion, it is our view that the concerns do not need to impede the progress. The committee support, we think, will help persuade the government to move forward in this area.
I thank you for your interest in this subject. Merci.
