BACK

POLICY PAPER

MORE PAPERS

Accounting for Government

The Hon. Donald Tsang, JP
Financial Secretary

12 August 1996

Dear Mr Tsang

ACCOUNTING FOR GOVERNMENT

We are writing to propose the introduction of full accrual accounting for Government activities.

As an interim step towards this goal we would urge that the Government's current Departmental Resource Accounting initiative be speeded up and fully implemented. However, we believe that the ultimate aim should be the production of full accrual-based accounts for the Government as a whole.

A short paper setting out our proposal, including brief form example accounts, is attached for your consideration.

We believe that the introduction of accrual accounting would reveal for the first time the full financial strength of the Government, and boost confidence in Hong Kong. It would also facilitate the Government's own financial management and control. Finally, accrual accounting would greatly raise the transparency and accountability of Government, and strengthen the bond between Government and people at this critical juncture in Hong Kong's history.

We hope that our proposal will receive your serious consideration.

Yours sincerely

Dr Patrick Shiu
Chairman

PROPOSAL FOR THE PREPARATION OF ACCRUAL ACCOUNTS BY THE HONG KONG GOVERNMENT

The purpose of this paper is to present a proposal for the preparation of full accrual-based financial statements by the Hong Kong Government. Formats of the proposed financial statements are included in the Appendix for illustrative purposes.

1. DRAWBACKS OF THE EXISTING BASIS OF GOVERNMENT ACCOUNTING

The existing basis of Government accounting has certain drawbacks as follows.

1.1 Cash-based

At present, most Government activities are accounted for on a cash basis. Incomings and outgoings of cash are recorded in the accounts when received and paid, not when the underlying income or expenditure is earned or accrued. This has the drawback that liabilities may go unrecorded, or income relating to future periods may be anticipated, and a misleading picture of the Government's financial position may be presented to the public. Further, since it is difficult to make management decisions based on such cash accounts, additional costing exercises must be performed to support decisions, which can result in duplication of work. Also, units may rush to spend their budget in cash before the end of the financial year, because there is no mechanism for carrying items forward. For these and others reasons, the private sector in Hong Kong and overseas prepares accounts on an accruals or matching basis.

In recognition of the advantages of accrual accounting, a number of Government units that have quasi-commercial operations do prepare their accounts on an accrual basis. Such units include, Water Supplies, statutory authorities such as the Airport Authority, and the Post Office, and more recently, the Monetary Authority. Government services operated as Trading Funds, such as the Land and Companies Registries, also prepare accrual-based accounts. However, the great majority of Government Departments continue to use cash-based accounting. One reason for this practice is that most overseas governments use the cash-based method. Another is that the payments that the Government is permitted to make in a financial year are limited under the Public Finance Ordinance and the Appropriation Ordinance. Given this form of cash appropriation system, it has up to now been felt appropriate to prepare accounts on a cash basis.

Accordingly, the view of a joint Working Group of public and private sector accounting experts, convened by the Director of Accounting in 1993, was that the Government should continue to use the cash basis of accounting. Nonetheless, in his 1994/95 Budget speech, the then Financial Secretary, Sir Hamish Macleod, acknowledged popular demand for the Government to move from a cash basis to a system nearer that used by the private sector (ie accruals-based accounting). He proposed on an experimental basis to prepare supplementary statements to enable the full cost of selected government activities to be seen. This experiment would assist in making a judgement on the merits of providing such additional information about government activities as a whole.

In his reply to a question asked on 24 January 1996 by the Honourable Christine Loh as to the status of this initiative, the Financial Secretary confirmed that a pilot study had been conducted involving the production of Resource Accounts for four selected departments, and a consultancy study on the accounting issues had also been undertaken. The studies indicated that while Resource Accounts would provide information to aid management, the applicability for management decisions would vary. A further pilot study would therefore by conducted, to enable further consideration of how Resource Accounts could be fully utilized for management purposes.

1.2 Fund-based

Current Government accounting is also fund-based. The Government maintains a number of fund accounts, including the General Revenue Account, the Capital Works Reserve Fund, the Capital Investment Fund, the Civil Service Pension Reserve Fund, the Disaster Relief Fund, and the Loan Fund. Each of these funds has its own rationale and (as is normal fund accounting practice) is accounted for as an entity in its own right. This makes it difficult for the public to form a view on the overall financial position of Government. No complete consolidated statement of the Government's financial position is produced. The Consolidated Statement of Assets And Liabilities produced each quarter does not include the suspense account of the Capital Works Reserve Fund, nor the investments in the Capital Investment Fund. There is no complete picture of the Government's financial position even on the existing cash basis.

1.3 Inadequate distinction between capital and revenue

Since Government expenditure is recorded on a cash basis, there is inadequate distinction between capital and revenue expenditure. Capital expenditure is recorded separately from revenue expenditure, but the capital assets which it gives rise to are not recorded on the Government's books. In other words, the expenditure is effectively written off in the year when the payment is made. The exceptions to this practice include those where the cash is spent on investments or loans - and these are recorded in the Capital Investments Fund. However, other forms of capital expenditure disappear from the Government's books.

1.4 Incomplete recording of assets and liabilities

As discussed above, Government accounts are incomplete because of the non-capitalisation of physical assets. However, there are other assets and liabilities which belong to Government activities but which are not reflected in the books at all because no cash flows in relation to them have yet taken place. Examples of uncapitalized assets include the Government's land and property assets. An example of an uncapitalized liability is the Government's liability to pay future pensions to its current and former employees.

1.5 Historical cost

While the assets recorded in the Government's books are incomplete, consisting mainly of loans and equity investments, they are also stated at historical values (ie representing the cash invested or lent), rather than at current values. Given the rapid changes in asset values that are commonplace in Hong Kong, the picture presented by historical cost based accounts is likely to be misleading.

2 PROPOSAL FOR ACCRUAL ACCOUNTING

2.1 Departmental Resource Accounts a welcome step forward

We believe that the Government's current Departmental Resource Accounting initiative should be vigorously progressed. Departmental Resource Accounts will bring in many of the benefits of accrual accounting described in section 1 above, will improve management control within the Department, and will enable the public to focus more easily on the achievement of departmental objectives. The Departmental Resource Accounting programme in the UK has enjoyed wide public support.

2.2 ...But full accrual accounts needed

Although the Departmental Accounting Resource initiative will be a very major advance over the present cash-based system of accounting, we believe that the ultimate objective should be to produce full accrual-based accounts, not just at the departmental level but for the entire Government.

Departmental Resource Accounts focus mainly on the individual departments of Government. Yet it is also important that the Government presents a picture of its activities as a whole, not merely in cash-based terms but in accrual-based terms. Only with such overall picture can appropriate macro decisions be made an to the level and nature of taxation, the balance between Government and the private sector, and the Government's ability to undertake new programmed. Since not all Government expenditure will be reflected in accounts at the department level, aggregate accruals-based accounts for the entire Government are needed for the Government to discharge its stewardship function.

We believe that each year the Government should prepare the following accounting statements.

1. Statement of Financial Position (balance sheet). Such statement should be prepared on an accruals basis and include all Government assets and liabilities, including those currently omitted from the accounting records or included at historical cost.
   
   
2. Statement of Financial Performance (revenue and expenditure statement). Such statement should be prepared on an accruals basis, ie it should not include expenditure on capital items but should include depreciation on capital items.
   
   
3. Statement of Cash Flows. Such statement would be similar in nature to the existing Consolidated Statement of Receipts and Payments, but would be more complete. The presentation would focus on the movement in the cash position shown in the Statement of Financial Position and would be reconciled to the Statement of Financial Performance.
   

The above statements are similar in concept to those prepared by private sector organizations. Because certain of the activities of Government are different from those normally undertaken by the private sector, it will be necessary to devise accounting policies that are appropriate. However, this obstacle is not insuperable, and in fact the Government of New Zealand has been preparing accounts on the above principles since 1991, to which further reference can be made.

To illustrate our proposal, we have prepared formats for the above statements for the Government of Hong Kong, together with short notes thereon, which we attach as the Appendix to this paper.

Such accrual accounts should be prepared initially as supplementary statements. The existing cash-based accounts should continue to be prepared to fulfil the Government's statutory obligations, until sufficient confidence has been gained in their operation to switch the entire Government accounting system to accrual accounting.

3. WHY THE GOVERNMENT SHOULD ACT

It may be asked why the Government should make the effort to prepare accrual accounts when most governments around the world manage with cash accounting.

We believe that all governments would benefit from adopting accrual accounting, as New Zealand has undoubtedly benefited. However, the Hong Kong Government has special reasons to prepare such accounts.

• Firstly, proper accounting is essential to the accountability of Government. Without meaningful financial information, the people lack the means to hold their government to account. Transparent and complete accounting empowers the people; opaque and incomplete accounting disenfranchises them. At this critical juncture in Hong Kong's development, it is vital to aim at the highest possible transparency and intelligibility in the Government's accounts.
  
  
• Secondly, government has an obligation as trustee to report to the people on its stewardship of their assets. The Hong Kong Government has a special obligation because of the size of the assets it has accumulated. It must be remembered that every dollar the Government holds is a dollar taken directly or indirectly from the people. The more dollars the Government takes and holds, the greater its obligation to account properly to the people for what it has taken. Having accumulated vast reserves, the Hong Kong Government has a heavy obligation to the people for which it should fully account.
  
  
• Thirdly, the current cash based and incomplete nature of Government accounting has led to widespread misperception about the state of the Government's finances. The welcome but modest increases in social provisions in the 1996/97 Budget were likened by one Chinese official to a racing car racing out of control, and similar comments were made by others. We believe that full and proper accounting by the Government would expose such criticisms as entirely unfounded.
  
  
• Fourthly, better accounting would help the Government in its own planning. We believe that there is a serious misalignment between Government revenue and expenditure and between Government assets and current and future liabilities. The revenue and the assets are simply too large. Either the Government should spend substantially more or it should tax substantially less. However, the full financial picture cannot be known without proper accounts.
  

4. IMPLEMENTATION

We accept that it will be a substantial undertaking for the Government to prepare full accrual-based financial statements, albeit an undertaking that the Government can well afford. The tasks to be performed include

• Public consultation
  
  
• Conducting an inventory of Government assets not currently recorded;
  
  
• Valuing assets currently not recorded or stated at historical values;
  
  
• Developing appropriate accrual-based accounting policies and accounting bases. In this regard we would recommend the establishment of a permanent advisory mechanism to the Treasury, perhaps along the lines of the UK Financial Reporting Advisory Board;
  
  
• Developing the requisite accounting systems and procedures;
  
  
• Training of staff in the operation of such systems
  
  
• Training management to use the new systems;
  
  
• Running the new system in parallel with the old for a period;
  
  
• Cutting over to the accrual-based accounting system (subject to enactment of the necessary legislative changes).
  

We therefore suggest that it may take perhaps three years before the first accrual-based accounts for the Government can be produced.

Appendix

STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 1995

Note

(a) Items are presented in approximate order of liquidity.

(b) Some items are omitted; therefore totals may be understated.

(c) Items are stated on a cash basis for illustration only.

NOTES TO THE PROFORMA STATEMENT OF FINANCIAL POSITION

1. Marketable securities and deposits

Source: Consolidated statement of assets and liabilities as at 31.12.95.

2. Advances

Source: Capital Investment Fund Schedule as at 31.12.95.

3. Government-owned enterprises and Government entities

Source: Capital Investment Fund Schedule at 31.12.95.

Share and capital investments in Government enterprises are stated at cost. (They should be accounted for on an equity basis, but information is not available.) Investments in Government entities are accounted for on the equity basis.

4. Government property assets

A list of Government property assets was released in January 1996. However, the various types of property and their land areas were not totalled, nor were they valued. Also, the list includes assets managed by the Housing Authority and other Government enterprises, the Government's investment in which is included elsewhere in the statement of assets and liabilities.

Government property assets should be stated at valuation. In view of the highly liquid nature of the Hong Kong property market, valuation could be based on land value based on permitted alternative use. Depreciating assets, such as buildings, should be stated at cost or valuation, less depreciation.

5. Public fixed assets

Public fixed assets would include roads, bridges, formed land and other physical assets not included in Government property assets. They should be stated at cost or valuation, less depreciation.

6. Government land

Government land not included in Government property assets or public fixed assets should be stated at valuation based on permitted or anticipated use.

7. Other Government assets

Other Government assets would include non-property assets of Government departments.

8. Payables and provisions

Source: Consolidated statement of assets and liabilities

9. Pension liabilities

The unfunded obligation of the Government to pay pensions to its past and former employees should be actuarially calculated on a periodic basis.

STATEMENT OF FINANCIAL PERFORMANCE

Note: Actual figures would be compiled on an accruals basis, and are not currently available.

NOTES TO STATEMENT OF FINANCIAL PERFORMANCE

1. Revenue levied through the Government's fiscal power

Revenues levied through the Government's fiscal power are those revenues in respect of which the Government does not give proportionate value to the person paying. The amount of tax paid by the individual taxpayer bears no relation to the value of benefits he or she receives. The Government raises such revenue by virtue of its fiscal power. It is important to distinguish such revenue from that earned through Government operations (note 4).

2. Direct taxation

Direct taxation includes salaries tax and profits tax.

3. Indirect taxation

Indirect taxation includes customs duties.

4. Revenue earned through the Government's operations

Revenue earned through the Government's operations comprises revenues in respect of which the Government gives value to the payer in proportion to the amount paid.

5. Expenses

Expenses would be presented by policy area group, eg education, health, housing.