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Government Debt Defaults Linked to Absence of Accrual Accounting

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August 15, 2014

Governments that default on their sovereign debt could be falling victim to the absence of accrual accounting in most public sector entities, and the International Federation of Accountants wants to change that.

IFAC noted that Argentina’s most recent default adds to a long list of government defaults, bailouts and restructurings over the years. It also serves to highlight the fact that sovereign debt problems that were evident during the recent global financial crisis continue to exist.

Argentina petitioned the International Court of Justice last week to allow it to sue the U.S. government to resolve a long-running dispute with a group of U.S. hedge funds that have refused to agree to a deal to restructure the country’s debt after an earlier default in 2001. The dispute led the country to default on its debt again at the end of July.

Fayezul Choudhury

Like many countries, Argentina does not prepare accrual-based financial statements, which can help with effective financial management, IFAC noted. Accrual-based financial statements show a government’s total assets, liabilities and cash flows, as well as provide other important disclosures about future commitments and contingencies. All of that is essential information for making proper decisions and ensuring there is sound financial management today and in the future. IFAC pointed out that many countries around the world—including many in Europe that received multibillion dollar bailouts in the last few years—are also in need of better government financial reporting.

“The problem is that public sector financial management is in many, if not most, cases not based on sound accrual accounting, which means the data is not comprehensive, comparable, consistent, or decision friendly,” said IFAC CEO Fayezul Choudhury in an interview Wednesday. “The government ensures that private sector entities are required to report on those bases, but in the public sector they don’t hold themselves to that same standard. That’s the problem. I think what we are seeing relatively frequently now is a manifestation of that problem in the guise of these debt defaults. We saw it was one of the underlying causes of the sovereign debt crisis.”

Here in the U.S., the absence of accrual accounting can have a negative impact as well, especially when the full obligations of a government entity such as state pension funds are not known or fully disclosed. “It’s really a serious problem,” Choudhury pointed out. “If it were a private sector issue, governments would have regulated the private sector to make sure it didn’t happen.”

IFAC is calling on the G-20 finance ministers around the world to become more engaged on the issue. Last month, IFAC and the Chartered Institute of Public Finance and Accountancy released a new International Framework for Good Governance in the Public Sector to encourage more effective public sector governance (see IFAC and CIPFA Offer Framework for Improving Public Sector Governance).

Despite IFAC’s push for accrual accounting in the public sector, one of its member organizations, the American Institute of CPAs, has been lobbying Congress to prevent it from enacting tax reforms that would require businesses to use the accrual method of accounting for tax purposes. There is little danger of that happening, though. Last week nearly half the members of the Senate signed a letter in support of the AICPA’s position (see Senators Express Concern about Accrual Accounting Proposal). As part of the tax reform effort, the Senate Finance Committee had included a proposal to prohibit the option of using the cash method of accounting in a discussion draft that its former chairman released last year. The AICPA has argued that the cash method is much simpler to use, particularly for smaller companies, and has made the issue one of its legislative priorities.

Choudhury doesn’t believe there is a contradiction in the two positions, as IFAC is pushing for accrual accounting in government entities, while the AICPA is chiefly concerned with continuing to allow the option of cash accounting for tax purposes at private companies. “I’m not a tax expert, but tax accounting is very different from financial accounting or management accounting,” he pointed out. “I think there can be legitimate differences of view in terms of whether for tax purposes you should include accruals, because that is simply how the government wants to levy taxes, and that’s the choice. But I think for decision friendly information on which to make choices and obligations to future generations, you have to do so on the basis of a knowledge of all of your assets and all of your liabilities, and all of your income and all of your revenue. You can’t just do it arbitrarily based on what cash you happen to get in and what cash you get out.”

He also sees a need for governments to set aside enough reserves to meet their pension obligations. “Until you actually capture all your assets and liabilities in one place, i.e., the balance sheet, you’re not really making it transparent that you have these obligations and you’re not really enabling the public and other watchdogs to hold you accountable for making sure that you are setting aside enough money to meet those future obligations,” he said, recalling his time at the World Bank as vice president and controller. “Let me just give you an example. There was a country where the government campaigned on a platform of increasing civil service pay. They got elected and then when they actually started looking at the books, they found out they couldn’t afford it. What they did instead was negotiate a significant increase in retirement benefits with the civil service union. Basically they managed to avoid disclosing that this had happened, and they passed the obligation on to future generations. That’s just one small example of the types of shenanigans that you can have when you can be selective about what you disclose or not. The irony is that you can be fully transparent, but if you’re transparent on only part of the data because you’re not bothering to capture the rest, it doesn’t really help.”

Even before Argentina’s default in 2001, Mexico also went through a debt crisis back in 1982, he recalled. To avoid future sovereign debt crises, such as those in Iceland, Greece, Ireland and Portugal in the wake of the 2008 financial crisis, accrual accounting may provide the key.

“For many this notion of accrual accounting might be seen as some sort of pet bug bear of bean counter accountants and it’s typically economists who are the participants in fiscal management,” said Choudhury. “The economist’s view of data is very different from the accountant’s view of data. As far as the economists are concerned, they can do ad hoc analyses when the need arises. As far as accountants are concerned, they have a different discipline, which is founded on consistency, comprehensiveness and reliability. I think it is those disciplines that you need to create decision-friendly information that not only the policymakers can act on, but others who monitor what the policymakers are doing and hold them accountable can also use. The economists’ view of ad hoc analyses and ad hoc data collection to inform a specific issue is really inimical to the whole concept of the public holding the elected officials accountable for the decisions they make, why they made them and then for the outcomes of those decisions.”

1 Comments

Call me cynical, but I don't think the basis of accounting is the underlying problem. Governing bodies make financial decisions based on political expediencies and legislative agendas, not on "decision-friendly" information. At best, the information justifies the decision; it does not dictate it. Does anyone really believe that the reason the US faces recurring fiscal cliff and debt management crises is our failure to publish full accrual financial statments?

Posted by: Tom G | August 18, 2014 10:07 AM

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