2002/07 Research & Review
Public Sector Accounting System and Public Governance
SAKURAUCHI Fumiki Faculty Fellow, RIETI
Public sector accounting is an accounting method applied to non-profit pursuing entities in the public sector - including central and local governments, and quasi-governmental special corporations - for which the size of profits does not provide an effective measurement for evaluating performance. Toward reforming Japan's public sector accounting system, a series of steps have been taken such as "The Japanese Government Balance Sheet (Preliminary trial)" by the Ministry of Finance, "Working Balance Sheet - Cool Tool to Reform Management of Tokyo" by the Tokyo Metropolitan Government and accounting standard for administrative institutions by the Ministry of Public Management, Home Affairs, Posts and Telecommunications. At the same time, however, there has been good amount of skepticism. Some question rational behind introducing a corporate-style accrual basis accounting system to public entities and others complain that a balance sheet created based on such new guidelines would be of no use. This confusion seems to stem partly from the lack of common understanding of the "purpose" and "function" of the public sector accounting system. Another reason for the confusion may be that debates on the issue have proceeded without sufficient understanding of the basic accounting concepts such as the "accrual basis principle" and the calculation of profits and losses under the corporate accounting rules.
Given this backdrop, I would like to attempt to straighten things up by giving them some theoretical backgrounds.
2.Peculiarities of Public Sector Accounting
(1) Superiority in procuring resources
One peculiarity of the public sector accounting system is in a government's superiority in procuring resources. In the world of neoclassical economics, all the economic entities are supposed to behave rationally and on an equal footing on the market to maximize profits and effects. In reality, however, hierarchical structure exists between a government and other entities in the distribution of resources. A government has the authority to impose and collect taxes and the right to issue - through the central bank - bills and coins. This enables the forcible procurement of resources by a government and involuntary submission of resources by other entities.
Among the public sector entities, a central government, holding both the taxation and money issuance authority, faces almost no external restrictions in procuring economic resources. Even when its debts accumulate to reach an enormous amount, a government is left with means to smoothly fulfill its debt obligations. Financial authorities can raise actual taxes, for instance. Or, the government can have the central bank underwrite government bonds so as to increase money in circulation, thereby generating inflation and effectively reducing the burden of repaying its debts, whose amount is nominally fixed. (This is tantamount to offsetting government debts with revenue from the inflation tax.) Other public sector entities such as local governments and quasi-governmental special corporations have peculiarities in that they are hardly exposed to external restrictions except for soft budget constraint imposed by the central government in the form of subsidies.
(2) Supply of goods and services through formation of budget
Like those in the private sector, economic entities in the public sector take in economic resources (input) to produce goods and services (output). In the world of public sector accounting, however, public-sector economic entities hold peculiarities not only in the above-mentioned superiority in resources procurement on the input side but also on the output side. Specifically, goods and services produced and supplied by public sector economic entities are not subjected to the market mechanism in which prices are determined by the balance of supply and demand. In other words, optimal distribution of resources and optimal supply of goods and services through the market mechanism cannot be automatically achieved in the public sector. Therefore, a government is counted on to provide public and semi-public goods and services - which are inexcludable and noncompetitive in nature - in optimal quantity to its governed society by intervening the market mechanism by means of subsidies and taxation or by directly providing such goods and services to the society. In this context, distribution of economic resources and transfer of goods and services through budgetary planning, which is closely linked to various political processes, are quite important.
3.Accounting Principles Based on Peculiarities of Public Sector Accounting
(1) Cash basis versus accrual basis
As such, the pursuance of profits is not the purpose of public sector economic entities. Thus, in the world of public sector accounting, the "calculation of profits and losses" on the "accrual basis" accounting has long been perceived unnecessary and the "cash basis" accounting, which primarily focuses on cash flows, has been used. The prime advantage of the cash basis accounting is that it can capture not only the flow of revenue expenditures but also the flows of capital expenditures for infrastructure construction and transfer expenditures such as social security allowances. Such system has been able to provide more useful information for public policy decision-making.
The cash basis accounting, however, is not without disadvantages. Cash, a key measurement in the cash basis accounting, represents just one item of assets and liabilities. Lacking information on other stock such as fixed assets and long-term debts, the cash basis accounting does not provide hints as to the potential impact and burdens that the ongoing fiscal management might bring in the future. When we look at Japan's fiscal conditions today, we can see that roughly 40 percent of the national revenue comes from the issuance of government bonds. Given this circumstance, it has become extremely important to properly manage assets and liabilities on a stock basis and achieve better balance in intergeneration burden sharing. This is why the accrual basis accounting and the disclosure of outstanding assets and liabilities on a balance sheet have become a necessity in the world of public sector accounting.
(2) Pitfall of "corporate-style accrual basis accounting"
However, there is a pitfall in introducing a "corporate-style accrual basis accounting" system. A corporate accounting uses "profits" on an income statement (revenue minus expenses) as flow-based information measuring a company's performance during one accounting term. But the government and other public-sector entities, by their nature, do not aim to pursue "profits." And government activities provide goods and services in accordance with budget allocation and without getting paid by the recipients of the goods and services. For instance, capital expenditures such as those on infrastructure construction and transfer expenditures such as social security allowances are not "profit and loss transactions" in accounting terms. Instead, they are treated either as "capital transactions" which directly reduce capital or "exchange transactions." Meanwhile, most government activities fall into these categories.
Therefore, in public sector accounting, simply introducing corporate-style accrual basis accounting and figuring out profits based on profit and loss transactions do not serve as a meaningful measurement to assess the performance of government activities. Rather, as flow-based information to show performance in one accounting term, it is necessary to focus not only on profit and loss transactions but also on capital transactions (including exchange transactions related to capital formation) that cover capital and transfer expenditures, or changes in assets and liabilities, thereby linking the flow-based information and stock-based information on a balance sheet to clarify the government's accountability for its fiscal management (See Table 1).
4.Formation of Public Account Financial Statements
Based on the above argument, public account financial statements should be composed of (1) a public account balance sheet, (2) a statement of administrative costs (statement of net current expenditures), (3) a statement of supporting revenue and changes in taxpayers' equity and (4) a statement of cash revenue and expenditures. Of the four inter-related statements, (1) a public account balance sheet is equivalent to a balance sheet in corporate accounting and (2) a statement of administrative costs to an income statement, and (4) a statement of cash revenue and expenditures to a cash flow statement. In addition to those three, (3) a statement of supporting revenue and changes in taxpayers' equity - which is a capital statement with an expanded focus to cover changes in stock (assets and liabilities) - is required. This statement provides foundation for examining the advisability of capital expenditures and social security systems with potentially significant future influence.
Up to now, the government has only provided (4) a statement of cash revenue and expenditure to account for its fiscal management. But systematic compilation of the above mentioned comprehensive set of financial statements allow for overcoming problems of the cash-basis accounting while taking in advantages of the accrual-basis accounting.
5.Purpose of Public Sector Accounting
(1) Establishment of public governance system
The purpose of the public sector accounting system should be determined in accordance with the needs of its users. There would be various views but I believe the absolute purpose of the public accounting system is to establish a system for good public governance. Public governance is a mechanism to discipline decision-making by those in charge of state affairs in a way to maximize the interest of the general public under the governing system where people - the absolute principal of the state - entrust the Cabinet or executive power as their agent to take charge of state affairs. The public sector accounting system can be defined as a tool to check and correct decision-making by the agent - the Cabinet or executive power - from the fiscal side to better protect people's interests (See Table 2).
(2) Taxes and taxpayers within state governance structure
The conceptual framework of public sector accounting is also determined in line with the purpose of public sector accounting.
Taxes, a prime revenue source of the government, should be recognized and assessed as an increase in taxpayers' equity. This is because: (1) taxes provide fiscal foundation for the government to manage state affairs entrusted by the people (almost equal to taxpayers and voters) who are the constituent members of the state (internal members) and it is inappropriate to recognize tax receipts as "income" which is supposed to be derived from transactions with third parties (external members), and (2) relation between benefits and burden from taxpayers' point of view is unclear, thus, it is difficult to recognize matching income to an injection of resources by the government (as required under the cost matching income principle).
Taxpayers, through their tax payment, entrust the government with the management of economic resources. This gives taxpayers a status equivalent to a truster under the trust law or an equity holder. At the same time, however, both the current and future taxpayers are sort of jointly and unlimitedly held liable for the government debts accumulated over generations as a result of the management of state affairs. The government, on the other hand, is to properly administer and manage economic resources entrusted by taxpayers, thereby, fulfilling its obligations and responsibility as a trustee under the trust law.
Concerning taxes, however, there is one way of thinking that regards them as remuneration for - or income earned on - goods and services provided by the government. In this case, taxpayers are regarded as a customer who pays for goods and services by the government in accordance with the extent of their satisfaction. Taxpayers as the customer in this context means current taxpayers, those who actually receive the benefits of goods and services provided by the government and pay the costs.
Nowadays, many point to the adverse effects of a "tax-eater democracy," in which tax-eaters alone exert influence over the government's decisions as seen in the rampant influence-peddling by politicians representing specific interest groups. In other words, certain groups of taxpayers, by using political pressure as a leverage, are trying to reduce their own tax burden yet seek the government-provided goods and services distributed or transferred to them. The public sector accounting aims to change this, establishing a good public governance system and realizing "taxpayers democracy" to protect the interests of both the current and future taxpayers who are the absolute equity holder of the state.
February 26, 2002
Article(s) by this author
February 26, 2002［Keizai Sangyo Journal］