In commercial financial operations, the accrual method of accounting is used because it reflects fully the earnings process of the financial operation. Accrual accounting matches revenue and expenses and reports the results of operations and financial position in a way that permits the assessment of management’s accomplishments.
The basis of accounting for the governmental funds within a state, county, or local government unit is not how much was earned and the amount of expenses. Instead, the emphasis in these governmental funds is on reporting how well the government performed by focusing on when the revenue and expenditures are recognized in the accounts and reported in the financial statements.
The reason for this is due to the nature of government activities: except for the proprietary funds and some trust funds, governments do not try to earn income. If the resources received are not expended, then the citizens have not received all the services the government could provide. If the decision is made to pave a road, for example, and revenue is collected for this purpose, there is no benefit if the funds are not expended to pave the road. Therefore the general purpose of government accounting is not to show a large difference between revenue earned and expenditures made, but rather to show that the revenue received has been expended for the appropriate purpose and at an appropriate time. In this respect, revenue is the means of financing expenditures incurred during the year.
Both the accrual method and an adaptation of this method called the modified accrual method are used in governmental accounting.
The modified accrual method includes some aspects of accrual accounting and some aspects of cash-basis accounting. The accounting method used in each of the funds depends on the needs and motives of the governing entity for that fund. The modified accrual method is used when the concern of the governing entity is to ensure that resources have been expended for the designated purposes and to determine the resources still remaining to be expended, for example, in the four governmental funds, the agency funds, and in expendable trust funds. The accrual method is used when the concern of the governing entity is to determine the profitability of the operation and to maintain the fund’s financial capital, for example, in the proprietary funds and in the non-expendable trust funds.
Accrual Basis of Accounting in Governmental Funds
The modified accrual method is used to account for the four governmental funds because the resources of these funds will be expended to carry out the objectives of the fund. The modified accrual method is applied as follows:
- Revenue: is recorded when it becomes both measurable and available to finance expenditures of the current period.
- Expenditures: are generally recognized in the period in which the related liability arises.
Applications of the modified accrual method to revenue transactions are presented below. Note that the revenue must be both measurable and available before recognition is made.
- Property taxes are recorded when the taxes are levied, provided they apply to and are collectible within the current fiscal period, or within a short time after the end of the fiscal period. NCGA Interpretation No.3, “Revenue Recognition-Property Taxes,” (NCGA 3) specifies that property taxes must be collectible within a maximum of 60 days after the end of the current fiscal period to be accrued in the current period. Taxes collectible 60 days after the current period ends are accounted for as next period’s revenue.If property taxes receivables are not available for current expenditures, or if the property taxes are collected in advance of the year for which they are levied, they are recorded in a deferred revenue account such as Deferred Property Tax Revenue. The deferred amounts become revenue as the taxes become available for current expenditure.Revenue from another government unit in lieu of taxes, such as a payment by a university to a city for police and fire protection; should be recorded as revenue when it becomes billable.Revenue from property taxes should be recorded net of any un-collectible or abatement. The Property Taxes Receivable account is debited for the full amount of the taxes levied, with estimated un-collectible recorded separately in an allowance account reported as a contra account to the receivable.
- Taxpayer-assessed income, gross receipts, and sales taxes are recorded when taxpayer liability, measure-ability, and collect-ability have been clearly established. Typically this occurs only when the tax returns have been filed and the tax paid. Sales taxes held by another government unit (for example the state government) may be accrued if they are both measurable and available for expenditure. Measure-ability in this case is based on an estimate of the sales taxes to be received, and availability is based on the ability of the governing entity to obtain current resources through credit by using future sales tax collections as collateral for the loan.
- Miscellaneous revenue, such as license fees, fines, parking meter revenue, and charges for services are recorded when the cash is received because these cannot be predicted accurately.
- Grants, entitlements, and shared revenue are funds received from other government units. Grants are contributions from another government unit to be used for a specified purpose, activity, or facility. Entitlements are payments local governments are entitled to receive as determined by the federal government. Shared revenue is from revenue such as taxes on the retail sale of gasoline collected by the state. This revenue is levied by one government unit but shared with others on some predetermined basis. Grants are recognized as revenue in the period in which tile local government receives an irrevocable right to the grant. This may be at the point the grant is authorized, but, in practice, most government units wait until the cash is received because the grant may be withdrawn by the grantor. Some grants are made to reimburse a government unit for expenditures made in accordance with legal requirements. The revenue from such grants should be recognized only when the expenditure is made.
NCGA Statement No.2, “Grant, Entitlement, and Shared Revenue Accounting and Reporting by State and Local
Governments,” (NCGA 2) indicates that the legal and contractual requirements of the grant or entitlement should be reviewed carefully to determine the proper accounting.
Proceeds from the sale of bonds are not revenue. These proceeds are reported as other financing sources on the statement of revenue, expenditures, and changes in fund balance. Although bond sales do increase the resources available for expenditure, bonds must be repaid while other revenue of the government unit does not need to be repaid.
Recognition of Expenditures
Expenditures are recorded in the period in which the related liability arises. Specific examples are:
- Costs for personal services, such as wages and salaries, are generally recorded in the period paid because they are normal, recurring expenditures of a government unit.
- Goods and services obtained from outside the government entity are recorded as expenditures in the period in which the goods or services are received.
- Capital outlays for equipment, buildings, and other long-term facilities are recorded as expenditure in the period of acquisition.
- Interest on long-term debt is recorded in the period in which it is legally payable.
Basis of Accounting-Proprietary Funds
The two major proprietary funds are the internal service fund and the enterprise fund. Proprietary funds are established for government operations that have a management focus of income determination and capital maintenance; therefore, the accrual method is used to account for these funds in the same manner as for profit-seeking corporate entities. Proprietary funds record their own long-term assets and depreciation is recognized on these assets. Long-term debt is recorded and interest is accrued as for commercial operations.
Basis of Accounting-Fiduciary Funds
Fiduciary funds generally are concerned with maintaining the financial capital of the fund; therefore, most fiduciary funds use the accrual method of accounting. Some trust arrangements, however, require that the governing entity expend the resources in the fiduciary fund in a specific manner. For example, assume a long-term resident of a city bequeathed $100,000 to the city to be used to acquire and develop a tract of land for a city park. In this case, the trust fund is expendable to satisfy the terms of the bequest.
The modified accrual method is used to account for expendable trusts. Therefore, the terms of the trust agreement must be closely examined to determine the basis of accounting to be used.