What Is Modified Accrual Basis of Accounting?
Modified accrual basis of accounting is a hybrid accounting method primarily used by state and local governments in the United States. It combines elements of both cash basis accounting and accrual basis accounting to meet the unique reporting needs of governmental entities. This method, a cornerstone of governmental accounting, focuses on the flow of current financial resources rather than on measuring economic income or total financial position. Revenues are recognized when they are both measurable and "available"—meaning collectible within the current period or soon enough thereafter to pay current liabilities. Expenditures, on the other hand, are generally recognized when the liability is incurred, similar to accrual accounting, with some modifications for items like capital outlays and debt service.
21, 22, 23## History and Origin
The development and adoption of the modified accrual basis of accounting are intrinsically linked to the evolution of financial reporting for U.S. state and local governments. Prior to its formalization, government entities often relied heavily on cash-based accounting, which offered simplicity but lacked the comprehensive financial picture needed for effective public oversight and long-term planning. The Governmental Accounting Standards Board (GASB), established in 1984, emerged as the independent, private-sector organization responsible for setting Generally Accepted Accounting Principles (GAAP) for state and local governments.
20The GASB recognized that governmental entities have distinct financial objectives compared to for-profit businesses. Governments are primarily concerned with demonstrating accountability for their fiscal resources and ensuring they operate within their budgetary control. To address these unique requirements, the GASB developed and mandated the modified accrual basis, which balances the immediate focus on current financial resources (similar to cash accounting) with the longer-term perspective of incurred obligations (similar to accrual accounting). This approach helps governments report whether current-year revenues are sufficient to cover current-year expenditures, thereby aiding in budgetary transparency and financial accountability.
- Modified accrual basis of accounting is a hybrid method used by state and local governments, combining aspects of cash and accrual accounting.
- It focuses on current financial resources, recognizing revenues when measurable and available, and expenditures when liabilities are incurred.
- This method helps governmental entities demonstrate budgetary compliance and track the flow of short-term funds.
- The Governmental Accounting Standards Board (GASB) establishes the standards for modified accrual accounting.
- It is distinct from the full accrual basis of accounting typically used by private sector companies.
Interpreting the Modified Accrual Basis of Accounting
Understanding the modified accrual basis of accounting is crucial for anyone analyzing the financial statements of governmental entities. Unlike private sector accounting, which often emphasizes profitability and long-term economic position, modified accrual primarily illuminates whether a government has sufficient current financial resources to meet its current obligations. This focus allows stakeholders, such as taxpayers, bondholders, and policymakers, to assess a government's short-term fiscal health and its ability to fund immediate public services.
16When interpreting financial reports prepared under the modified accrual basis, it's important to remember that revenues are only recognized when they are both measurable and available for use in the current fiscal period. This "availability" criterion is a key differentiator from full accrual accounting. For example, property taxes levied in one fiscal year but not expected to be collected until well into the next fiscal year might not be recognized as revenue in the current period under modified accrual, even though the legal claim exists. Conversely, expenditures are generally recognized when a liability is incurred, reflecting the government's commitment to spend its current resources. This distinction highlights the system's emphasis on accountability for budgetary compliance and the management of current financial flows.
Consider the City of Harmony, which uses a fiscal year ending on December 31, and prepares its financial statements using the modified accrual basis of accounting for its general fund.
Scenario 1: Property Tax Revenue
In December, the City of Harmony levies $10 million in property taxes. Historically, only 80% of these taxes are collected by January 31 of the following year, which is considered "available" for the current fiscal period's expenditures. The remaining 20% is collected later.
- Under Modified Accrual: The City of Harmony would recognize $8 million (80% of $10 million) as property tax revenue in the current fiscal year (ending December 31). The remaining $2 million would not be recognized as current revenue, as it is not considered "available" in time to pay current period liabilities. This approach directly ties revenue recognition to the immediacy of cash availability for current period spending.
Scenario 2: Purchase of Equipment
In December, the City of Harmony orders and receives a new street sweeping vehicle for $300,000. The invoice is received in December, but payment is scheduled for January of the following year.
- Under Modified Accrual: The City of Harmony would record a $300,000 expenditure for the street sweeper in December, the month the liability was incurred and the asset received. Even though the cash payment will occur in the next fiscal year, the commitment of current financial resources has been made. Note that under modified accrual, the purchase of a capital asset is treated as an expenditure when purchased, rather than being depreciated over its useful life as it would be under full accrual.
13These examples illustrate how modified accrual emphasizes current financial operations and the ability to meet short-term obligations within a given fiscal period.
Practical Applications
The modified accrual basis of accounting is fundamental to how state and local governments manage and report their finances, showing up across various aspects of public financial management. Its primary application is in the preparation of financial statements for governmental funds, which typically include the General Fund and various special revenue, capital projects, and debt service funds. These funds account for the core activities of government that are financed primarily by taxes and intergovernmental grants.
12This accounting method aids governments in achieving key objectives: ensuring current-year revenues are sufficient to finance current-year expenditures, and demonstrating that financial resources are utilized in accordance with legally adopted budgets. For instance, when a municipality plans its annual budget, the modified accrual framework allows it to project current revenues and match them against anticipated spending needs, promoting budgetary control and fiscal responsibility. I10, 11t also helps in the management of short-term assets and liabilities, offering a clear view of liquid resources available to meet immediate obligations like payroll or vendor payments. The Governmental Accounting Standards Board (GASB) sets the authoritative standards for this accounting method.
9## Limitations and Criticisms
While the modified accrual basis of accounting serves the specific needs of governmental financial reporting, it is not without its limitations and criticisms. One significant critique is that its focus on current financial resources can sometimes obscure the full long-term financial health and obligations of a government. For instance, while expenditures are generally recognized when incurred, certain long-term liabilities like unfunded pension obligations or post-employment benefits are often not fully reflected in the governmental fund statements under modified accrual, or are only shown to the extent that they will be liquidated with current expendable resources. This can potentially create a misleading impression of a balanced budget in the short term, even if significant long-term debts are accumulating.
8Critics argue that this approach, particularly its "current financial resources measurement focus," lacks a strong conceptual basis when compared to the comprehensive economic resources measurement focus of full accrual accounting. F7or example, the acquisition of capital assets is recorded as an expenditure when purchased, rather than being capitalized and depreciated over its useful life. This can distort the true cost of providing services over time. Furthermore, because modified accrual accounting does not fully comply with International Financial Reporting Standards (IFRS) or the Generally Accepted Accounting Principles (GAAP) used by most public companies, it can make direct comparisons between governmental entities and private sector organizations challenging. D6espite these criticisms, proponents argue that the modified accrual basis effectively addresses the unique accountability requirements of governmental entities, focusing on the annual budget and current period spending..
5
Modified Accrual Basis of Accounting vs. Full Accrual Basis of Accounting
The distinction between the modified accrual basis of accounting and the full accrual basis of accounting is fundamental to understanding financial reporting in different sectors. While both are accounting methods that move beyond simple cash receipts and disbursements, their core objectives and measurement focuses differ significantly.
Modified accrual is primarily used by U.S. state and local governments and is designed to reflect the flow of current financial resources. Its key characteristic is that revenue recognition occurs when revenues are both "measurable" and "available" to finance current period expenditures. Expenditures are generally recognized when the liability is incurred, but long-term assets are expensed when acquired, and long-term liabilities are recognized when they mature or become due. This approach prioritizes budgetary accountability and the assessment of a government's ability to meet short-term obligations.
In contrast, full accrual basis of accounting is the standard for most for-profit businesses and many governmental proprietary and fiduciary funds. It focuses on the economic resources measurement, recognizing revenues when they are earned (regardless of when cash is received) and expenses when they are incurred (regardless of when cash is paid). This method aims to provide a comprehensive view of an entity's overall economic position, including its long-term assets and liabilities, matching revenues with the expenses incurred to generate them. Confusion often arises because both methods involve recognizing items beyond just cash transactions, but their differing treatment of availability, long-term assets, and long-term liabilities leads to distinct financial pictures.
FAQs
What is the primary purpose of modified accrual accounting?
The primary purpose of the modified accrual basis of accounting is to provide state and local governments with a method to report on their current financial resources and to demonstrate compliance with their legally adopted budgets. It helps ensure accountability for current-year revenues and expenditures.
4Who uses modified accrual accounting?
Modified accrual accounting is predominantly used by state and local government entities in the United States for their governmental funds. It is not generally used by private businesses, which typically adhere to full accrual accounting.
How does revenue recognition work under modified accrual?
Under the modified accrual basis of accounting, revenues are recognized when they are both measurable (the amount can be reasonably estimated) and available (collectible within the current period or soon enough thereafter to pay current liabilities).
3Are long-term assets and liabilities reported differently under modified accrual?
Yes. Under modified accrual, the purchase of capital assets is typically recorded as an expenditure when acquired, rather than being capitalized and depreciated. Long-term debt instruments are generally recognized as expenditures when the principal portion matures and is payable from current expendable resources, rather than recognizing the full liability upfront.1, 2