Financial Statements - GAAP or Cash Basis? You Decide
This Advisor column was originally published in June 2011.
One of the more interesting questions I’ve been asked by an elected official recently was whether GAAP (generally accepted accounting principles) was better for their city than the non-GAAP alternative offered by the Washington State Auditor's Office. We will explore the issues you should consider as you develop the answer to this question for yourself.
Author's Note: GAAP refers to the use of recognized standards for external financial reporting. There are GAAP for the private sector established by the Financial Accounting Standards Board, and the public sector largely established by the Government Accounting Standards Board (GASB). You can learn more about the GASB at www.gasb.org. This article will always be referring to the GASB form of GAAP unless otherwise noted.
In the public sector accounting profession this issue is commonly known as GAAP versus Cash (or “Other Comprehensive Basis Of Accounting”). That is the notion that to produce full GAAP statements requires a sophisticated understanding of increasingly complicated standards. This understanding translates into a certain level of costs to maintain the organizational ability to produce GAAP statements. As a result of the high (and growing) costs, the arguments for an acceptable alternative have increasingly grown louder.
The key to this discussion is the word “acceptable”. Any alternative to GAAP must have some basis for evaluation by outside parties. If the purpose of producing such financial statements is to illustrate the financial condition and results of operations for an organization – then we need standards to assure us that the illustration is sound. If there were no alternative to GAAP – we accountants could make up most any way to illustrate the effect of financial transactions, call it a report and offer it to those interested. Clearly some guidelines for the basis of presentation which provides commonly understood information is much better.
Washington State’s Innovative Approach
Many years ago the Washington State Auditor was granted the responsibility to prescribe a system of accounting and reporting for local governments in Washington State (RCW 43.09.200). To respond to this obligation the Auditor’s Office (SAO) created the “Budgeting, Accounting and Reporting System” (commonly known as BARS). Recognizing the concerns related to the amount of effort and resource required to comply with GAAP described above, the SAO created two sets of such guidelines for use by local governments. These are referred to as GAAP and a non-GAAP cash basis of accounting and reporting (Those of us who have been doing this for a while remember these options as Category 1 and Category 2 reporting respectively). Essentially the cash basis of accounting and reporting is an “OCBOA” approach. These are documented in the SAO’s BARS manuals (there is a separate manual for each set of guidelines).
The result is that most of Washington State’s local governments use the cash basis manual as the guide for their accounting and reporting obligations. Over the years there has been a lot of discussion about who should use which set of guidelines. The SAO has the authority to dictate the answer to this question – but most recently delegated that decision to the policymakers of each entity (an approach which I happen to agree with). With 75% of cities in Washington being less than 10,000 in population it seems appropriate that a “cash” approach to accounting and reporting be available.
Making the Choice – Using GAAP or OCBOA
I’m not familiar with any recent studies on what it actually costs a local government to use GAAP standards rather than an OCBOA (such as Washington State’s cash). However the complexity of complying with GAAP has become increasingly challenging. Recent and significant changes have certainly added to the complexity and therefore to the cost. Of these changes the following are the most notable (in my opinion) in part due to their broad applicability to most local entities:
- GASB Statement 34 – This statement was a fundamental change in what constituted core financial statements. It introduced full accrual accounting for governmental activity at the entity wide level. This required the capitalization and depreciation of assets in the entity wide statements for governmental activities (such as roads, trails and parks) as well as the recognition of long-term liabilities on the balance sheets (such as debt, compensated absences and others). It introduced the entity wide statements referred to above and the crosswalk between them and the fund level statements (in many cases using a different basis of accounting).
- GASB Statement 45 (and related statements) – while previous GASB statements dealt with the complicated issue of accounting for and reporting on public employee pensions, GASB 45 introduced the issue of “other post-employment benefits”. This new reporting obligation required an assessment of the medical or other benefits promised to qualifying public employees after the termination of their employment.
- GASB Statement 54 – covering a wide variety of issues, including fund classifications (especially for special revenue funds) and fund balance classifications.
The reason I’ve included this statement on this list is the additional complications in such areas as sorting through capital improvement related expenditures to properly classify them as resulting in a capital asset and those that do not; refinements in the classifications of special revenue funds; and refinements in the classifications of fund balances. While not individually significant these changes together continue to add to the complexities of complying with GAAP.
GASB is not done yet and there is no end to their development of new standards in sight. The latest adopted statement of a substantive nature is number 60 - Service Concession Arrangements. They are also contemplating expanding the scope of GAAP to include fiscal sustainability issues. The complexity of complying with GAAP is significant and growing more challenging all the time.
An Argument for GAAP
This complexity is in response to an increasingly complex environment in which local governments operate. Standards often respond to a new issue (for example exotic investment instruments) or perceived issue (for example bankruptcy). As a result, it could be argued that all local governments operate in this complex environment and therefore should keep up with the highest standards for accounting and reporting. The growing concern over the fiscal condition (and accuracy of the information used to gauge fiscal condition) is one of the arguments I’ve often heard for full compliance with GAAP as described by the GASB’s standards. The argument goes that if the information used to make such an assessment does not include the full effect of promised post-employment benefits, or the deterioration of the infrastructure enjoyed by the community (just two examples addressed by GAAP) then it is impossible to make an accurate assessment as to fiscal condition.
As decision makers (including policy decision makers like councils and boards) it is important to have the highest quality information available on which to base the best decisions. Such local government issues as future budgets, appropriate tax and fee rates, compensation and staffing levels and many other very important decisions are based in part on accurate financial information. The ability to compare one organization to another is also an important basis for decision making. Public debt is one of the more often cited reasons for adherence to a recognized standard for financial reporting. Those who are asked to consider investing in a community by purchasing their public debt need a full understanding of the risks that may entail – to which the published financial statements are often the best source.
The Government Finance Officers Association (GFOA) helps our profession provide a very high quality of service to our communities through several methods. Their advice to finance professionals on such topics is in the form of “best practices” vetted by a committee of subject matter experts and adopted by their board of directors. The best practice adopted on this topic says (emphasis added),
“GFOA urges every state and local government to do all of the following to fulfill its financial reporting responsibilities:
- Maintain an accounting system adequate to provide all of the data needed to allow for the timely preparation of financial statements for the entire financial reporting entity in conformity with GAAP;
- Issue timely financial statements for the entire financial reporting entity in conformity with GAAP as part of a comprehensive annual financial report; and
- Have those financial statements independently audited in accordance with either GAAS or GAS, as appropriate.” (author’s note – here in Washington the SAO conforms to this best practice)
An Argument for Cash Basis
Essentially the argument for a cash basis of accounting (the acceptable OCBOA in Washington State) is one of cost benefit. Having described the challenges of complying with GAAP above, the question becomes, “what will we be missing if we don’t follow GAAP?” The alternative in Washington is cash basis. The net effect is that your reports will reflect the effect of activity and decisions as they impact cash. Revenues will be recognized when cash is received rather than earned. Expenditures will be recognized when the checks are written rather than when a commitment is made to a vendor through the acceptance of goods or services.
For smaller organizations the cash basis model may suit your needs as it more closely aligns with budgetary decision making. Often the decision making regarding fiscal issues is of a shorter term nature focused on providing resources to meet current needs. The cash basis of accounting aligns much more directly with such an approach.
Cash basis also provides very practical information related more closely to the nature of these smaller organizations. Discussions and decisions in smaller Washington local governments are often about making ends meet through the budget period. In our training and consulting work we have advised that these local governments should develop financial policies and information upon which to base sound decisions. The reality is most city councils I’ve worked with can do an excellent job of managing their responsibilities and are very comfortable with the cash basis information in the context of the budget.
As I said earlier, the Washington State Auditor’s Office recognized long ago that while preferable, the cost to comply with GAAP did not always offset the benefits for many smaller entities. As a result they have developed (and refined quite well over the years) a form of “other comprehensive basis of accounting” or OCBOA. As the debate about how small an entity should really be in order to be able to use OCBOA for reporting the auditor eventually determined that that decision is best left up to the policymakers for each entity.
The issues that your entity should discuss when considering if OCBOA is sufficient include:
- How will you be able to assess the long-term issues that won’t be as evident if not included in your financial statements
- What is the realistic assessment of your organizations ability to comply with the complexities of GAAP (getting an adverse audit opinion because you really are not capable of following GAAP is not good either)
- What information do you believe you need to be good stewards of public funds; what do you have today; and how can you fill any identified gaps.
As we often say in our training seminars for the Association of Washington Cities, Washington Finance Officers Association and many other forums – the best answer is the result of a good, open conversation about all the issues relevant to your entity. This should then be included in a financial policy that will serve to document the decisions and conclusions and be a starting place for the next time the issue comes up for review. Hopefully some of the issues raised in this article help you to have a great conversation and come to the conclusion that is best for your entity.
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