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2006 May Status Report of the Auditor General of Canada

May 2006 Status Report—Chapter 1

Appendix A—The accrual method of accounting

What is accrual accounting? Accrual accounting refers to a method of accounting that records an entity's financial transactions and other economic events when they occur, rather than when the entity receives or pays cash or its equivalent. It records expenses as goods or services are consumed, and it records revenues in the period to which they pertain. It recognizes the life-cycle costs associated with long-lived assets.

An example. Assume that in 2005, a department purchases a fleet of trucks for $1.2 million. The trucks have a useful service life of six years. Under the cash method, government accounts would record the trucks in 2005 as a one-time expenditure of $1.2 million. However, under the accrual method, the accounts would record the same purchase much differently. Because the trucks have an expected service life of six years, the purchase would appear as follows in the 2005 accounts:

• Expense in 2005: $200,000, or one sixth of $1.2 million—the expected use per year
• Assets (trucks): $1 million ($1.2 million purchase price less the $200,000 expense for the use of the assets)

Accrual information clearly presents a very different—but more accurate—picture of the organization's financial results for 2005. On the basis of this information, managers become aware of the cost of owning the fleet over time. They can focus on the stewardship of assets, because the assets are now clearly and transparently recorded in the department's financial accounts. For example, the $200,000 will be an expense recorded every year for the life of the trucks, and the trucks will also continue to be reflected as assets until they are fully consumed or sold. Thus, managers can see the need to consider the costs of maintaining, disposing, and replacing assets. When these costs are visible, managers are also more likely to consider risks, such as loss due to damage or theft.

Benefits. Accrual accounting records the estimated costs and liabilities associated with events, such as an environmental event or accident, when they occur. For example, if a serious chemical spill occurred on government property, the government would record in the accounts the estimated cost of cleaning it up, along with other potential financial liabilities, when the accident happened, not when the bills were paid in the future. Because the costs and future liabilities are recognized and recorded, managers are more likely to be concerned about how to manage them.

In essence, accrual accounting improves government decision making because what "gets recorded, gets managed." When all the costs are visible, managers are more likely to consider those costs when making decisions.