OGGO Committee Report

CHAPTER FOUR — PUBLIC SECTOR ACCOUNTING CHALLENGES: LONG-TERM ASSETS AND LIABILITIES

The adoption of full accrual budgeting by governments raises certain technical difficulties that do not exist in the private sector, where accrual accounting has long been in use.

The essential problem is that there are unique assets and liabilities in the public sector for which there exist no set rules to guide officials tasked with preparing government estimates documents and financial statements. This lack of guidance can result in the inappropriate treatment of assets and liabilities which in turn could have an impact on fiscal policy.

Before recommending the adoption of accrual-based budgeting and appropriations, the Committee wanted to clarify the situation with experts in the field. The aim was to ensure that the difficulties encountered in the public sector were not insurmountable obstacles that would turn the proposed accounting reform into a nightmare for the government and end in failure.

A) Long-term assets and liabilities

During its hearings, the Committee focused its efforts on the difficulties associated with infrastructure, heritage and military goods and equipment and with environmental liabilities.

1. Public infrastructure

First, the inherent difficulties in the valuation of infrastructure assets have led some Committee members to wonder whether the benefits of valuing them for accountability, management, and insurance purposes outweigh the potentially enormous valuation costs.

In countries that have adopted accrual-based accounting, there are different approaches to valuating infrastructure assets of governments, each with potentially different impacts on the ultimate value of the assets. For instance, in New Zealand, highways are recorded at depreciated replacement cost based on the estimated present cost of constructing the existing asset. The land on which roads are constructed is valued using an opportunity cost based on adjacent use. In the United Kingdom, road networks are valued on the basis of current replacement cost depreciated to reflect the overall condition of the network. In Sweden, roads and railways are recognized at acquisition value minus depreciation. Another approach is to use historic cost less any accumulated depreciation and any accumulated impairment losses as the benchmark.

Basically, the different valuation bases are related to the question of capital maintenance and this is important in designing the appropriate accrual budgeting system. Moreover, according to the accounting literature, choosing a current cost accounting base might be helpful in maintaining the operating capability of infrastructure.

Along with these rather technical considerations, the issue of preserving assets and the “infrastructure deficit” quickly became an important concern of the Committee. It is generally recognized that Canada faces a major "infrastructure deficit" in terms of infrastructure maintenance and upgrading that many compare to a “national debt.” As a portion of these infrastructures belong to the federal government, the deficit associated with it could well show up on the government's balance sheet.

However, according to Ronald Salole, while financial statements prepared using the accrual basis of accounting very clearly describe the transactions and events that occurred in a particular period, they are not as clear when accounting for what has not yet been spent on maintaining the asset. Currently, accrual accounting aims primarily at providing information about historical costs and actual transactions, rather than fair market values.

Given the potentially astronomical costs of the different liabilities that the government might be called upon to cover, in addition to those relating to infrastructures, the Committee then explored the need to report or refer to certain liabilities in the government’s books, and the validity of considering the infrastructure deficit as a liability. According to the CICA definition, a liability becomes an actual liability when a future economic benefit is going to be lost and there is no way of avoiding it or there is a constructive liability (an amount allocated to settle a specific debt).

In this regard, the Committee understood that items that may be considered long-term liabilities and to which the government has not made a commitment should be accounted for in a manner that allows for an objective statement of the value of the obligation. This might take the form of a note to the financial statements and not necessarily as an item in the financial statements.

Today it might be the infrastructure deficit. Why wouldn't somebody down the road come up and say there's an education deficit, we have a liability, we have to put it up there? Or some other deficit somewhere else. Those things do not, the way we think in standards setting, meet the definition we have for a liability.¹³

2. Heritage assets

The Committee also looked into accounting for heritage assets, that is just as problematic as infrastructure because of the numerous practical difficulties in setting a value on a country’s cultural, historical or environmental assets.

No one disagrees that these are national assets and as such should appear in the government's financial statements. Furthermore, it is usually agreed that these assets are not generally subject to a depreciation allowance (with the possible exception of buildings). In New Zealand, they are listed as government "Property, Plant, and Equipment" and are accompanied by additional explanations in the supplementary information to the financial statements. They are valued on a "modified historic cost basis" (historical cost adjusted for revaluations). In the United Kingdom, a value must be set on what is referred to as operational heritage assets (heritage assets that continue to provide services to the country). This valuation is set at the lower of replacement cost and recoverable amount (the higher of net realizable value and value in use). For a number of other assets, described as non-operational heritage assets (including museum and gallery collections, archaeological sites, burial mounds, ruins, monuments and statues), there is no requirement to enter a value in the government financial statements. However, if there is a market in assets of that type, then they may be valued in government financial statements at the lower of depreciated replacement cost and net realizable value.

According to Ronald Salole, from the Canadian Institute of Chartered Accountants, the accounting treatment of heritage assets is an issue that has not yet been totally resolved and that illustrates very clearly the limitations of financial reporting. Accounting for heritage assets, in addition to being costly, is likely to overburden the financial statements. Despite the experiences of other countries, and at a time when the International Public Sector Accounting Standards Board (IPSASB) is looking into the relevance of entering heritage assets in accounts at their fair market value, the major trend is to deal with them outside of the financial statements. The Committee shares this view and recommends:

RECOMMENDATION 2

That the Government of Canada include a note in the financial statements and in the estimates documents on its infrastructure and heritage asset liabilities.

3. Military goods and equipment

Another issue involves the accounting treatment of military assets used in war. The difficulty lies mainly with equipment and munitions, rather than with bases, naval facilities or airfields as the later can be valuated in the same way as other government land and buildings. The problem in accounting for military assets is determining whether the items are to be considered assets that can be amortized over several years or as an annual expense because the economic nature of military items changes when the country goes to war. In peacetime, military equipment and munitions can be considered assets in the government's balance sheet, subject to some form of depreciation. In wartime, however, they can be used and destroyed very quickly. In New Zealand, they are considered special equipment and recorded as assets in the government's balance sheet. In the United Kingdom, they are considered capital expenses, and their value is amortized over time.

Despite these differences, military equipment, like other assets, can be recorded in government financial statements. In wartime, they may be treated like an extraordinary item and posted in the financial statement as operating costs. The importance of including these items in government financial statements is that it gives a better idea of the magnitude of public spending on military equipment and highlights the government's ability to manage its resources. Disclosing the amount of military spending can also contribute to greater transparency in a democracy where decisions have to be made on the allocation of government funds to meet competing demands. Therefore, the Committee recommends:

RECOMMENDATION 3

That, for the purpose of greater transparency, explanatory notes to the financial statements and budgetary documents should record any changes in the accounting treatment of military goods and equipment.

4. Other Departments and Organizations

Other government departments and organizations, not only the Department of Defence, can also suffer a sudden loss of their goods and equipment, although perhaps not with the same frequency. However, as in the case of military goods and equipment, the Committee expects that in the event of a catastrophic loss of government assets, that the impact on the financial statements and estimates be accompanied by an explanatory note. The Committee therefore recommends:

RECOMMENDATION 4

That, for the purpose of greater transparency, explanatory notes to the financial statements and budgetary documents should record any changes in the accounting treatment of any government goods and equipment.

5. Environmental liabilities

Governments have a general responsibility to maintain the overall quality of the country's environment. They also have a specific responsibility to rectify any impact their activities, in particular their past activities, may have on environmental quality. These responsibilities translate to possible government obligations that must be mentioned in the financial accounts.

In this respect accrual accounting requires that the estimated costs of clean-up and remediation work be recorded as a liability. The actual amounts spent on the clean-up, remediation and management of affected sites are considered expenses that reduce the value of the liability. Under the cash accounting system, the clean-up, remediation and site management costs appear simply as expenses and only when funds are spent to carry out the work.

In the 2005-2006 fiscal year, a new accounting standard came into effect, whereby federal government departments are to record an estimated liability for a contingency¹⁴ once it is assessed as likely to result in a liability and it can be reasonably estimated.

The application of the accounting treatment related to contingent liabilities in specific situations is illustrated below:

Table 3

	Event Likely	Event Not Determinable	Event Unlikely
Amount Estimable	Record an estimated liability	Disclose in notes	Do not disclose in notes or record
Amount Not Estimable	Disclose in notes	Disclose in notes	Do not disclose in notes or record

Source: Treasury Board Secretariat

The liability recorded for a likely contingency continues to be recognized until it is settled or otherwise extinguished, or until the probability of the occurrence of the future confirming event is considered unlikely.

That being said, to improve the reporting of environmental liabilities and to enhance transparency in the move to full accrual appropriations, the Committee believes it is important that the government continue the objective declaration of environmental liabilities by each department through a statutory appropriation. Moreover, to strengthen parliamentary oversight, the Committee feels it important that members of Parliament vote on the allocation of funding for remediation or site management activities. Therefore, the Committee recommends:

RECOMMENDATION 5

That the Government of Canada introduce a double-appropriation system for environmental liabilities, which would include a statutory appropriation for the valuation of liabilities and an annual voted appropriation for the expenses related to remediation and site management.

RECOMMENDATION 6

That explanatory information relating to potential environmental liabilities be included in the financial statements and the estimates documents prepared by the government.

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13	Ronald Salole, hearings of the House of Commons Standing Committee on Government Operations and Estimates, Thursday, October 5, 2006.

14	Treasury Board Accounting Standard 3.6 — Contingencies http://www.tbs-sct.gc.ca/pubs_pol/dcgpubs/accstd/con-eve1_e.asp