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VII. ACCOUNTING SYSTEMS: TRADITIONAL MECHANISMS OF FISCAL CONTROL
An effective accounting system provides quantitative information for three broad purposes:
(1) External reporting to various constituencies (i.e., stockholders, elected officials, regulatory bodies, and the general public);
(2) Internal reporting for use in management planning and control of routine operations; and
(3) Assistance in formulating overall policies and long-range plans.
BASIC ACCOUNTING INFORMATION
Accounting serves as an information system through which fiscal data and events are recorded, classified, summarized, interpreted, and communicated for decision-making purposes.
Financial accounting is concerned with the results of fiscal transactions and the consequent fiscal position of an organizational entity.
o Financial statements involve monetary information which describes the past operations of an accounting entity.
o The life of the entity is divided into accounting periods so that measurements can be made at regular intervals (quarterly, monthly, weekly).
A sound governmental accounting system must be built around four components:
(1) Funds or groups of funds are accounting entities that embody a whole group of self-balancing accounts used to denote transactions.
(2) Major nonfund, self-balancing groups of accounts that focus on general fixed assets and general long-term debt.
(3) A general ledger contains summary accounts, with supporting details maintained in subsidiary ledgers.
(4) Basic accounting classifications that record revenues by fund and by source and expenditures by fund, organizational unit, function, activity, character, and/or object.
A fund is an independent fiscal and accounting entity to which resources are assigned, together with all related liabilities, obligations, reserves, and equities.
Financial transactions are made between funds and are recorded in accounting ledgers according to a predetermined chart of accounts..
Three important financial statements are:
(1) Income statement reflects the profit performance of an entity for some specific period of time.
(2) Balance sheet shows the fiscal position of an entity at a particular time, i.e., available resources (assets) and outstanding liabilities (obligations and debts).
(3) Statement of changes in fiscal position provides information about inflows and outflows of fiscal resources arising from financing and investing activities.
Revenues represent an inflow of money and/or other representations of value in return for selling goods or providing some type of service.
Expenses represent outflows of resources, or the incurring of obligations, for goods and services required to generate revenues.
Net income is simply the excess of revenues over expenses.
Owner's equity, an important concept in commercial accounting, is sometimes called net worth, capital, or proprietorship.
Fund equity is substituted for owner's equity in governmental accounting and represents the residual in a fund after obligations have been deducted.
Equity is always equal to the assets minus the liabilities of an entity.
The Basic Accounting Equation
The basic accounting equation can be expressed as follows:
Assets = Liabilities + Fund Equity + Revenue - Expense
Profit-seeking entities seek to generate net income; not-for-profit organizations strive to "break even," that is, to balance revenues and expenses.
Debits (increases) must equal credits (decreases)--the effect on the accounting system is described in terms of double-entry mechanics.
Accounting transaction are recorded as journal entries.
o General journal includes date of transaction, accounts to be debited/credited, an explanation of the transaction, account number, and fiscal effect on the accounts involved.
o Special journals often are established for purposes of separating duties and respon-sibilities and for improving management controls.
A trial balance provides proof that the ledger is in balance, but it does not verify that transactions have been correctly recorded in the proper accounts.
Funds are established within public organizations for the purposes of maintaining accounting records, controlling government activities, and preparing financial statements.
o Revenues are controlled through the appropriation process, and proposed expenditures are controlled through a line-item budget.
o Expenditures for any line item--such as salaries, supplies and materials, travel, contractual services, or equipment--cannot exceed the dollar amount that has been appropriated or allocated to that particular line item.
The funds most commonly found in public organizations include:
(1) General Funds account for all fiscal resources--and activities financed by them--which are not accounted for in some special fund, including property taxes, licenses, fees, permits, penalties, and fines.
(2) Special Revenue Funds account for taxes and other revenues (except special assessments) legally restricted for a particular purpose (e.g., schools, street improvement, parks).
(3) Special Assessment Funds account for the financing of improvements or services deemed to benefit properties against which the special assessments are levied.
(4) Debt Service Funds account for the financing of interest and retirement of general long-term debt principal.
(5) Capital Project Funds account for the major improvements financed either on a "pay-as-you-go" basis or out of capital reserves, grants-in-aid, or transfers from other funds. Such funds are limited to an accounting of receipts and expenditures on capital projects paid out of current revenues.
(6) Fiduciary Funds account for assets held by a governmental unit as an agent or trustee for other governmental units, others funds, private organizations, or individuals (e.g., employee pension funds).
(7) Proprietary Funds account for the financing of services rendered primarily to the general public for compensation, such as the operation of a public utility.
Separate financial statements are prepared for each of the major funds, and combined statements of funds with similar purposes often are distributed.
General Fixed Assets Account Group records all fixed assets--long-term resources of the governmental unit--acquired through Governmental Funds.
Long-Term Debt Account Group records general, long-term liabilities assumed by the governmental unit involving the commitment of Governmental Funds (except those associated with Special Assessment Funds).
The line-item budget is the primary fiscal mechanism to control governmental activities.
The budget serves as both a mandate for and a limitation on public spending--actual expenditures should closely coincide with budgetary appropriations.
Appropriations may be subdivided in to allocations according to agencies, programs, and classes of expenditures.
o Allocations become the first accounting entries for the new fiscal period.
o Allocations may be made to specific line items or object codes, with limitations imposed as to the deviations permitted within these expenditure categories.
A system of encumbrances records the placement of purchase orders or the letting of contracts as an obligation against the agency's allocation and are liquidated on an "as-billed" basis.
An allotment system further subdivides appropriations into time elements.
Budget classification systems provide the means for organizing and facilitating comparisons among data on revenues and expenditures.
o The principal objective of an object classification is to control expenditures at the departmental or agency level.
o A chart of accounts that is uniform through out the whole of government can be established since public agencies tend to buy the same things.
Accounting Equation for Governmental Funds
The expanded accounting equation for governmental funds can be expressed follows:
Assets + Estimated Revenue + Expenditures + Encumbrances = Liabilities + Fund Balance + Revenues + Reserves for Encumbrances + Appropriations
The following debit and credit conditions apply when recording items in accounts:
o Debits are increases in assets, estimated revenue, expenditures, and encumbrances or decreases in liabilities, fund balance, revenues, reserve for encumbrances, and appropriations
o Credits are increases in liabilities, fund balances, revenues, reserve for encumbrance, and appropriations or decreases in assets, estimated revenue, expenditures, and encumbrances.
Bases for Accounting
On the revenue side, two bases for accounting are possible: the cash basis and the accrued revenue basis.
On the commitment (outflow) side, four bases are used: cash, obligations, accrued expenditure, and accrued cost.
Under a strict cash basis, revenues are recorded only when they are actually received, and expenditures are recorded when payments are made (as a cash disbursement).
Under a strict accrual basis:
o Revenues are recorded as soon as they are levied, billed, or earned, regardless of the fiscal period in which they are collected;
o Expenditures are recorded when goods are received or services are performed, when a liability is incurred, or when an invoice is received.
Under a modified accrual basis:
o Revenues are recorded as received in cash, except for revenues susceptible to accrual (e.g., commitments from intergovernmental transfers); and
o Expenditures are recorded on an accrual basis except for disbursements for inventory-type items, prepaid expenses and long-term debt.
Under a modified cost basis, property taxes and other receivables are placed on the books for control purposes when they are levied, but not accounted for as revenue until actually collected.
Under an accrued cost basis, unspent funds are carried over to the next fiscal period, as are encumbered obligations.
Use of Subsidiary Ledgers
Accounts are kept in the subsidiary ledger for the particular budgeted revenue, appropriations, actual revenue, expenditures, and encumbrances accounts.
Records must be kept in much greater detail in the subsidiary ledgers for a breakdown of other classes of revenue and expenditures than those usually shown in the general ledger.
The budget may need to be adjusted at various times during the fiscal year to reflect additional information concerning estimated revenues and appropriations.
It may become necessary to decrease the appropriation if revenues fall short of the initial estimates and the fund balance is insufficient to cover the amount appropriated.
In many governmental accounting systems, accounts are closed out at the end of the fiscal year and appropriated funds revert to the general fund.
Closing entries may be made in one of two ways:
(1) By reversing the budget adoption transactions or
(2) By closing the actual revenue account to the budget revenue account (estimated revenue) and the actual expenditures account to the appropriation account.
Financial accounting focuses on accurate and objective recording of fiscal transactions and the preparation of reports on the fiscal affair of an organization for external users.
Cost accounting involves the assembly and recording of the elements of expense incurred to attain a purpose, to carry out an activity, operation, or program, to complete a unit of work or project, or to do a specific job.
Basic Concepts of Cost
Cost can be defined as a release of value required to accomplish some goal, objective, or purpose.
o Direct costs represent costs incurred for a specific purpose which is uniquely associated with that purpose.
o Indirect costs are costs associated with more than one activity or program that cannot be traced directly to any of the individual activities.
o Overhead is defined as all costs other than direct labor and materials that are associated with the production process.
o Controllable costs are defined as those costs subject to the influence of a given manager of a given program or organizational unit for a given time.
o Noncontrollable costs include all costs that do not meet this test of "significant influence" by a given manager.
Measurement of Costs
Absorption or full costing considers all the fixed and variable costs associated with the provision of the goods or services in question.
Direct costing considers only the variable or incremental costs of a particular operation.
Responsibility costing assigns to an operating unit only those costs that its managers can control or at least influence.
Job order costing is used by companies in which products are readily identifiable by individual units or batches.
Process costing is most often used in the mass production of like units, which usually pass in continuous fashion through a series of uniform production steps.
Unit costs often are determined by dividing the current budget allocation for a given activity by the number of performance units.
Average unit costs may be determined by dividing accumulated costs by the quantities produced during the period.
Cost allocation is necessary whenever the full cost of a service or product must be determined.
Variable costs can be measured and assigned to appropriate activities or programs that generate such expenses.
Variable costs usually increase in some predictable and measurable fashion as additional units of work are undertaken.
Direct fixed costs do not vary with the activities being measured, and therefore, the allocation of these costs to specific services or projects can be more problematic.
Direct fixed costs (such as rent) might be allocated on the basis of some arbitrary physical measure, such as the floor space occupied by various activities, or by assuming some level of operation, such as number of persons to be served.
Overhead often is divided into two categories.
(1) Actual overhead costs incurred by an organizational unit typically are recorded by means of an overhead clearing account and some type of subsidiary record, such as a departmental expense analysis or overhead cost sheet.
(2) Allocated or applied overhead (indirect costs) is distributed through the use of predetermined rates.
Standard Costs and Variance Analysis
Standard costs relate the cost of production to predetermined indices of operational efficiency.
Optimal or desired (planned) unit costs and related workload measures may be established for each job or activity.
Workload measures usually focus on time-and-effort indices, such as number of persons served per hour, yards of dirt moved per day, or more generally, volume of activity per unit of time.
Unit costs can be estimated for each of the cost elements by adjusting trend data for expected changes during the next fiscal period.
Managerial accounting is involved in formulating fiscal estimates of future performance (the planning and budgeting processes) and in analyzing actual performance in relation to these estimates (program evaluation and performance auditing).
Managerial accounting focuses on four basic functions: (1) management planning, (2) cost determination, (3) cost control, and (4) performance evaluation.
Significant features of managerial accounting include:
o Greater emphasis on the generation of information for planning and programming purposes, seeking to establish a balance with the control function of accounting.
o Performance standards (workload and unit cost data) are added to traditional control mechanisms based on legal compliance and fiscal accountability.
o Experimentation and innovation in the types of information are supplied to management.
o Greater cost consciousness generated among operation units through the identification of cost and responsibility centers and the use of performance standards.
o The linkage between management control, program budgeting, and performance auditing is facilitated by cost analyses.
Cost Approximation Methods
Cost approximation involves an attempt to find predictable relationships between a dependent variable (cost) and an independent variable (some relevant activity) so that costs can be estimated over time based on the behavior of the independent variable.
Cost approximations typically are based on three major assumptions:
(1) Linear cost functions can be used to approximate nonlinear situations;
(2) All costs can be categorized as either fixed or variable within a relevant range; and
(3) The true cost behavior can be sufficiently explained by one independent variable instead of more than one variable.
The five most commonly applied methods for approximating costs include:
(1) Analytic or industrial engineering methods entail a systematic examination of labor, materials, supplies, support services, and facilities--sometimes using time-and-motion studies--to determine physically observable input-output relationships.
(2) Account analysis involves a classification of all relevant accounts into variable or fixed cost categories by observing how total costs behave over several fiscal periods.
(3) High-low methods call for estimations of total costs at two different activity levels, usually at a low point and a high point within the relevant range. The difference of the dependent variable is divided by the difference of the independent variable to estimate the slope of the line represented by b.
(4) Visual fit method is applied by drawing a straight line through the cost points on a scatter diagram, which consists of a plot of various costs experienced at various levels of activities.
(5) Regression methods refer to the measurement of the average amount of change in one variable associated with unit increases in the amounts of one or more other variables.
Responsibility Accounting and Performance Evaluation
Responsibility accounting attempts to report results so that: (1) significant variances from planned performance can be identified; (2) reasons for the variances can be determined; (3) responsibility can be fixed; and (4) timely action can be taken to correct problems.
Responsibility centers may take several forms:
(1) A cost center is the smallest segment of activity or area of responsibility for which costs are accumulated;
(2) A profit center is a segment of a business, often called a division, that is responsible for both revenue and expenses, and
(3) An investment center, like a profit center, is responsible both for revenue and expenses but also for related investments of capital.
Costs charged to responsibility centers should be separated between direct and indirect costs.
Direct expenses should be further broken down between those which are controllable and non-controllable at the responsibility center level.
A variance can is the difference between the amount budgeted for a particular activity (during a given period) and the actual cost of carrying out that activity and may be positive (under budget) or negative (over budget).
Management by exception--at each level in the organizational hierarchy, the manager's attention can be concentrated on the variance from the budget items deemed to be most important.
Responsibility accounting seeks to assign accountability to those individuals who have the greatest potential influence, on a day-to-day basis, over the costs in question.
A delicate balance must be maintained between the careful delineation of responsibility on the one hand and a too-rigid separation of responsibility on the other.
Responsibility Center Management
Responsibility Center Management combines principles and techniques of responsibility accounting and activity-based costing.
All sources of financial support (income/revenue) and all costs (direct and indirect) are attributed to responsibility centers on some consistent basis.
Costs associated with internal service centers (i.e., units that do not receive revenue or income from external sources) are charged to responsibility centers on a "fee for sevice basis" or are recovered through some form of assessment.
Activity-Based Costing provides a method for tracing costs from the traditional cost accounting structure to activities--which relates why resources are being consumed.
Responsibility Center Management may require the use of subvention--a central allocation to cover deficits between the income/revenue and the costs assigned to responsibility centers.
MULTIPURPOSE ACCOUNTING SYSTEM
A multipurpose accounting system incorporates the advantages of the object-of-expenditure budget and accounting approach with the timely management information of cost-managerial accounting procedures.
The term crosswalk refers to any data conversion that involves a change in budget and accounting classification systems (for example, from objects of expenditures to programs, or vice versa).
Program managers must have timely data on expenditures both by programs and by the agencies authorized to make such commitments.
Expenditures Versus Costs
To determine where the costs come from, it is necessary to know the amount of costs from each department or agency that goes into each program.
o From an accounting standpoint, the most valuable type of program crosswalk is one that brings together the types of costs by cost center or department for each program.
o In order to compare program costs with the overall effectiveness of program activities, it is essential that a program budget be based on costs rather than expenditures.
SUMMARY: FUTURE-ORIENTED ACCOUNTING INFORMATION
Fund accounting produces financial statements and reports that can be audited in accordance with generally accepted accounting principles.
Budgetary accounting permits comparisons between actual revenues and expenditures recorded during the fiscal year and revenues and expenditures appropriated in agency budgets.
The basic objective of cost and managerial accounting is the provision of information for improved fiscal management decisions.
An important step in controlling costs is to determine how they function under various conditions--to find predictable relationships between cost and one or more independent variables (organizational activities).
Responsibility accounting seeks to assign accountability to those sectors of an organization (cost centers and responsibility centers) in which day-to-day influence/control can be exercised over the costs in question.
A multipurpose accounting system facilitates the crosswalk of data between agencies and programs to provide important management information essential to an evaluation of the overall effectiveness of program activities.