Modified accrual basis

What Is Modified Accrual Basis?

The modified accrual basis of accounting is a hybrid accounting method primarily used by state and local governments in the United States, forming a core component of governmental accounting. This method combines elements of both the accrual basis and the cash basis of accounting. It aims to provide a comprehensive view of a government's current financial resources and their related obligations, focusing on the flow of expendable financial resources. The Governmental Accounting Standards Board (GASB) sets the standards for its application in the public sector.¹²,

History and Origin

The need for a distinct accounting method for governmental entities arose from their unique objectives, which differ significantly from those of private businesses. Unlike commercial enterprises focused on profit generation, governments aim to provide services to citizens and manage public funds. This fundamental difference led to the development of fund accounting principles, a system that tracks financial resources restricted for specific purposes.¹¹,¹⁰

Historically, many governments operated on a pure cash basis. However, as governmental operations grew in complexity and public accountability became more critical, a need emerged for financial reporting that offered a clearer picture of both short-term fiscal accountability and long-term financial health. The modified accrual basis evolved to meet this need, allowing governments to recognize certain revenues when measurable and available, and most expenditures when liabilities are incurred. The establishment of authoritative bodies like the Governmental Accounting Standards Board (GASB) in 1984 formalized these practices, ensuring consistency and transparency in financial reporting for state and local governments.⁹, The Government Finance Officers Association (GFOA) also provides extensive resources and guidance on these principles, helping to shape the application of modified accrual accounting across the public sector.⁸

Key Takeaways

• The modified accrual basis is a hybrid accounting method used primarily by U.S. state and local governments.
• It focuses on the flow of current financial resources and their related liabilities.
• Revenues are recognized when they are both measurable and available.
• Expenditures are generally recognized when the liability is incurred, similar to accrual accounting, but with specific modifications for certain long-term items.
• This basis of accounting is crucial for demonstrating fiscal accountability for short-term operations and budgeting.

Interpreting the Modified Accrual Basis

The modified accrual basis helps users of government financial statements understand the near-term financial condition and operational results of governmental funds. When interpreting reports prepared under this method, it's important to focus on the "flow of current financial resources" rather than the "flow of economic resources" (which is the focus of full accrual accounting). For instance, under modified accrual, bond proceeds are recognized as a "financing source" when received, and debt service payments are recognized as "expenditures" when due, reflecting the impact on current expendable resources. This differs from a full accrual approach, which would recognize the long-term liability for the bonds and allocate interest expense over time.

This method aids in assessing whether a government has sufficient liquid assets to meet its current liabilities and short-term operational needs. It directly ties into the annual budgeting cycle, where the emphasis is on the current period's revenues and expenditures.

Hypothetical Example

Consider the City of Harmony, which operates on a modified accrual basis.

Scenario 1: Property Tax Revenue
On December 15, Year 1, the City assesses $1,000,000 in property taxes for the fiscal year ending June 30, Year 2. These taxes are legally due on January 15, Year 2, and the City expects to collect 95% of them within 60 days of the fiscal year-end (August 29, Year 2).

Under the modified accrual basis, the City of Harmony would recognize $950,000 ($1,000,000 * 95%) in property tax revenue in Fiscal Year 2. This is because the taxes are both measurable (95% expected collection) and available (expected to be collected within 60 days of fiscal year-end, which is considered "available" for current period expenditures).

Scenario 2: Purchase of Supplies
On May 10, Year 2, the City's Public Works Department orders office supplies costing $5,000. The supplies are received and an invoice dated May 20, Year 2, is issued. The City pays the invoice on July 5, Year 2.

Under the modified accrual basis, the $5,000 for office supplies would be recorded as an expenditure in Fiscal Year 2 (ending June 30, Year 2), when the liability was incurred (supplies received and invoiced). The actual payment date in July does not affect the expenditure recognition for the prior fiscal year, as it pertains to a current period liability. This directly impacts the City's reported expenditures for that fiscal period.

Practical Applications

The modified accrual basis is universally applied in the general governmental funds of U.S. state and local governments. These funds typically account for the bulk of a government's traditional services, such as public safety, general administration, and public works. This method is mandated by Generally Accepted Accounting Principles (GAAP) for governmental funds, as established by the Governmental Accounting Standards Board (GASB).⁷,⁶

Specifically, it applies to:

• General Fund: Used to account for all financial resources except those required to be accounted for in another fund.
• Special Revenue Funds: Used to account for specific revenue sources that are legally restricted or committed to finance particular functions or activities.
• Capital Projects Funds: Used to account for financial resources to be used for the acquisition or construction of major capital assets.
• Debt Service Funds: Used to account for the accumulation of resources for, and the payment of, general long-term debt principal and interest.
• Permanent Funds: Used to account for resources that are legally restricted to the extent that only earnings, and not principal, may be used for purposes that support the reporting government's programs.

The principles guiding the use of modified accrual are detailed in comprehensive manuals provided by oversight bodies like the Office of the New York State Comptroller, which outlines the accounting and reporting requirements for local governments.⁵ These guidelines ensure that financial reports provide useful information for various stakeholders, including taxpayers, investors in municipal bonds, and elected officials, enabling them to make informed decisions and assess fiscal accountability.⁴,³

Limitations and Criticisms

While the modified accrual basis offers crucial insights into a government's fiscal accountability and budgetary compliance, it has certain limitations. A primary criticism is that it does not present a complete picture of a government's overall financial condition because it omits certain long-term assets and liabilities from the fund financial statements. For example, depreciation of fixed assets is typically not recorded in governmental funds under modified accrual, nor are long-term employee benefit obligations fully recognized until they become due and payable.²

This can make it challenging for users to assess the full economic cost of providing services or the true long-term solvency of a government entity. For a comprehensive economic view, users must refer to the government-wide financial statements, which are prepared using the full accrual basis. Critics argue that the disconnect between fund-level reporting (modified accrual) and government-wide reporting (full accrual) can create confusion and make it difficult for the public to fully grasp the financial implications of governmental operations. The Government Finance Officers Association (GFOA) acknowledges these challenges and has engaged in initiatives to rethink financial reporting to enhance user value.¹

Modified Accrual Basis vs. Full Accrual Basis

The core distinction between the modified accrual basis and the full accrual basis lies in their measurement focus and basis of accounting.

The modified accrual basis is a critical component of fund accounting for governmental operations, emphasizing accountability over expendable financial resources. In contrast, the full accrual basis, used by businesses and for a government's proprietary and fiduciary funds, and across its government-wide financial statements, provides a more comprehensive economic view of assets, long-term liabilities, revenues, and expenses. The full accrual basis aligns more closely with the cash basis in terms of recognizing all assets and liabilities, but differs fundamentally in its timing of revenue and expense recognition.

FAQs

Why do governments use modified accrual accounting?

Governments primarily use the modified accrual basis to demonstrate fiscal accountability for their current financial resources and to ensure compliance with budgetary authorizations. It helps them show whether they have enough liquid resources to cover current period expenditures.

What does "measurable and available" mean for revenue recognition?

For a revenue to be "measurable and available" under modified accrual, it must be subject to reasonable estimation (measurable) and legally available to finance expenditures of the current fiscal period (available). Often, "available" is defined as collectible within the current period or soon enough thereafter (e.g., 60 days) to pay current period liabilities.

Does modified accrual basis apply to all government financial statements?

No. The modified accrual basis applies to the governmental fund financial statements. However, governments also prepare government-wide financial statements and often proprietary and fiduciary fund statements, which typically use the full accrual basis of accounting to provide a broader economic perspective.

How does modified accrual affect how debt is reported?

Under modified accrual, when a government issues debt (like bonds), the proceeds are typically reported as "other financing sources" in the governmental fund statement. The actual long-term liability for the debt is not recorded in the governmental fund itself but rather in the government-wide financial statements. When principal and interest payments on the debt are due, they are recorded as expenditures in the governmental fund.