The answer lies in a lesser-known part of government financial statements called the reconciliation between budgeting and accounting. It explains line by line what constitutes the difference between the budget and the deficit (or surplus) of the fiscal year budget. In jurisdictions where the budget deficit is prepared on a cash basis mixed with data on short-term liabilities, the difference can be considerable.
One of the main causes of this difference is the pension promises that governments make to their employees. The accumulated deficit includes a charge for pensions earned by civil servants during the year, while pensions only appear in the cash budget deficit when benefit payments are made, which can take years or even decades later. The reconciliation starts with the budget deficit, eliminates pension benefit payments made from the current budget, and inserts the generally much larger accumulated pension expense, to arrive at the accumulated deficit.
Another cause of the difference between the two deficits, although much smaller, is the provision for environmental clean-up costs and the costs of dismantling state-owned defense installations and nuclear power plants. To the extent that the government is obligated to repair damage already caused, environmental and disposal liabilities are recognized on the balance sheet with an associated expense in the statement of financial performance in the accrual accounting financial statements. These long-term obligations are generally not budgeted for.
There are, however, mitigating factors, such as the treatment of non-financial assets, mainly infrastructure. When calculating the accrual deficit, depreciation is deducted, while for the cash budget deficit, payments for newly acquired fixed assets are deducted. In a steady state, depreciation and capital expenditure are equal, but in practice capital expenditure often exceeds depreciation. This may be due to an expanding asset base.
A high capital-to-depreciation ratio indicates that the government is investing more in its long-term assets than in the past. In times of inflation, capital expenditures may also exceed depreciation, even for a simple replacement investment, if depreciation charges are based on historical costs while capital expenditures are measured at current costs. . Depreciation may also be artificially low due to overly optimistic expected useful lives of capital, and some assets, such as land, are never depreciated.
These questions are familiar to many governments, but can be demonstrated using figures from the US federal government which prepares its financial statements in accordance with standards published by the Federal Accounting Standards Advisory Board, FASAB. The graph below shows the net cost of operations (accounting) and budget surplus or deficit (cash) over a 22-year period. With the exception of 1999 and 2000, the last years of the Clinton administration, every year shows a deficit. The net cost of operation consistently exceeds the budget deficit, the government’s main performance indicator. A reconciliation of the two indicators is necessary for stakeholders to understand the underlying causes of these persistent differences.
US federal government: net cost of operations (accrual) and budget deficit (cash) as % of GDP
Source: United States Government Financial Report 1999-2020
The second chart shows the average reconciliation over a 22-year period and expressed as a percentage of GDP. The average budget deficit is 3.9% and the average net operating cost is 5.9% of GDP. The reconciliation shows that the main cause of the difference is the increase in long-term liabilities for civil and military employee benefits and veterans compensation (pensions and post-employment medical care). These benefits are included in the government’s net cost of operation as soon as they are earned, but will not be included in the budget deficit until later when they are paid.
U.S. Federal Government: Reconciliation of Net Operating Expenses (Accounting) to Fiscal Deficit (Cash) – 22-Year Average as a Percent of GDP
Source: United States Government Financial Report 1999-2020
These and other differences between the cash budget deficit and the accrual deficit are evident from the reconciliation of budgeting and accounting. Such reconciliation is a required component of financial statements prepared in accordance with IPSAS, the International Public Sector Accounting Standards, and in national accounting practices that do not apply IPSAS, such as the United States and France.
Recently published research in Public money and management reveals widely divergent practices between countries in the presentation of budget and accounting reconciliations, limiting comparability even between financial statements prepared in accordance with IPSAS. By their nature, reconciliations will rarely be fully consistent across entities as they serve as a bridge between financial statements, which follow international or national standards, and budgets, which generally do not. The budget execution statements and the accrual accounting financial statements are complementary but report different revenues, expenditures and deficits. Some differences between budgeting and accounting are unavoidable because their underlying logic is not the same: budgets serve to control public spending while accrual accounting serves to reflect economic reality.
Trying to bridge budgeting and accrual by introducing accrual into budgeting is akin to couples therapy. To make irreconcilable differences understandable and comparable, the IPSAS Board should consider issuing more specific guidance on reconciling budgeting and accounting.
Professor of Accounting, University of Amsterdam.
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