Introduction
Purpose of the Article
In this article, we’ll cover how to calculate expenditures to be recognized under the modified accrual basis of accounting for governments and prepare journal entries. The modified accrual basis of accounting plays a pivotal role in how state and local governments report their financial activities. Understanding this accounting method is crucial for CPA candidates, especially those focused on government accounting or preparing for the BAR CPA exam. Unlike the private sector, government entities prioritize fiscal accountability, ensuring that resources are managed effectively to meet budgetary requirements. Therefore, mastering the modified accrual basis allows professionals to accurately calculate expenditures, assess available financial resources, and ensure compliance with governmental accounting standards.
In this article, we will explore how to calculate expenditures to be recognized under the modified accrual basis of accounting, with a focus on state and local governments. Additionally, we will outline the journal entries necessary to properly account for these expenditures, paying special attention to the unique requirements of governmental accounting.
Overview of the Modified Accrual Basis
The modified accrual basis of accounting is a hybrid method that combines elements of both the cash and accrual basis. It is specifically designed for governmental accounting, emphasizing the current financial resources available for expenditure. Under this system, revenues are recognized when they become both measurable and available, while expenditures are recognized when the related liability is incurred, provided that it can be paid from available financial resources.
In contrast, full accrual accounting, used primarily in the private sector and for certain government-wide financial statements, recognizes revenues when earned and expenses when incurred, regardless of when cash changes hands. The modified accrual basis, however, focuses more narrowly on the flow of current financial resources, making it ideal for governmental funds such as the General Fund and Special Revenue Funds, where the goal is to maintain budgetary control and fiscal responsibility.
The modified accrual basis of accounting is tailored to meet the financial reporting needs of governments, focusing on ensuring that current obligations are met using available resources. This accounting method is essential for proper fiscal management in state and local governments, allowing them to align financial reporting with budgetary compliance and short-term fiscal accountability.
Key Concepts in Modified Accrual Accounting for Governments
Definition of Modified Accrual Basis
The modified accrual basis of accounting is a specialized accounting method used predominantly by state and local governments to account for their funds. This approach emphasizes the importance of current financial resources—those that are expected to be available for expenditure in the near term—and focuses on short-term fiscal accountability.
In this system, revenues are recognized when they are both measurable and available, meaning the resources can be collected within the current period or shortly thereafter to cover liabilities of the current fiscal period. Conversely, expenditures are recognized when the corresponding liability is incurred, but only if it can be satisfied with available resources. The emphasis on available financial resources ensures that governments are accounting for funds they can actually use within the short-term fiscal period.
Unlike full accrual accounting, which considers the total economic resources of an entity, the modified accrual basis provides a snapshot of the financial position focused on fiscal accountability—ensuring that governmental entities can meet their obligations as they come due.
Expenditures vs. Expenses
One of the critical differences between the modified accrual basis and the full accrual basis is the distinction between expenditures and expenses.
- Expenditures are recognized under the modified accrual basis and refer to the use of current financial resources. They are recognized when a liability is incurred that can be paid from available resources. This includes payments for goods and services, debt service, and other outlays that use up current financial resources. The focus is on when the cash is expected to leave the fund or when the resources are no longer available.
- Expenses, on the other hand, are a concept tied to the full accrual basis of accounting. Under the accrual method, expenses are recognized when incurred, regardless of when the cash is actually disbursed. The emphasis here is on matching expenses with the revenues they help generate, even if that occurs in different accounting periods.
For example, under the modified accrual basis, a capital outlay (like purchasing equipment) would be recorded as an expenditure in the year the transaction takes place. However, under the accrual basis, the equipment would be capitalized and depreciated over its useful life as an expense.
Available Fund Financial Resources
A core concept in the modified accrual basis is the idea of available financial resources. In governmental accounting, “available” means that the resources must be collectible within the current period or soon enough after the fiscal period ends to cover current obligations, typically within 60 days. This concept ensures that governments only recognize revenues and expenditures for resources they can realistically use in the short term.
- Revenues are considered available if they can be used to finance expenditures in the current fiscal period. Taxes, for example, are typically recognized as revenue when collected, provided they are received within the 60-day window after the end of the fiscal period.
- Expenditures are recognized when the government incurs a liability and can pay it with available resources. This might include items such as salaries and wages, supplies, or payments on debt service. If the resources aren’t expected to be available until a future period, the government would not record the expenditure in the current period.
The concept of available resources helps governments avoid recognizing obligations that they cannot meet within the current fiscal period, promoting better budgetary control and ensuring that financial reports accurately reflect a government’s ability to cover its current liabilities with available funds.
Identifying Expenditures to Be Recognized
Definition of Expenditures
In the context of modified accrual accounting used by state and local governments, an expenditure refers to the use of current financial resources to meet liabilities. Unlike in accrual accounting, where expenses represent the use of both current and long-term resources, expenditures are strictly tied to the outflow of cash or other current assets. This distinction is key for government entities, as their financial reporting focuses on short-term fiscal accountability and the availability of resources to pay for current obligations.
Under the modified accrual basis, expenditures are typically recorded when a liability is incurred, provided the liability will be settled with available financial resources. This method reflects the immediate impact of financial transactions on a government’s resources, making it ideal for governments that must operate within strict budgetary constraints.
Timing of Expenditure Recognition
One of the defining features of the modified accrual basis is the timing of expenditure recognition. In general, expenditures are recognized when the liability is incurred, meaning the government becomes obligated to pay, but only if the payment can be made using available fund resources. This is important for distinguishing between obligations that can be satisfied in the current period and those that will require resources from future periods.
For example, salaries and wages would be recognized as expenditures at the point when the employees perform the work, not when the payment is made, assuming the wages can be paid with currently available funds. In contrast, long-term liabilities such as long-term debt principal payments are not recognized as expenditures until the government is obligated to make payments in the short term.
The timing of recognition in modified accrual accounting ensures that expenditures reflect the use of current financial resources rather than long-term financial obligations, allowing governments to maintain budgetary control and accountability over their fiscal operations.
Common Examples of Expenditures
State and local governments incur a wide variety of expenditures as part of their operations. The following are common types of expenditures recognized under the modified accrual basis:
Salaries and Wages
Salaries and wages represent the compensation paid to government employees for services rendered. These expenditures are recognized when the liability is incurred—typically at the end of a payroll period—provided there are sufficient available resources to meet the obligation. For example, if employees complete work by the end of the fiscal year and there are available funds, their wages would be recognized as expenditures at that time.
Capital Outlays
Capital outlays refer to expenditures for acquiring or constructing long-term assets, such as buildings, equipment, or infrastructure. Unlike full accrual accounting, where such purchases would be capitalized and depreciated, under the modified accrual basis, the full cost of the asset is recognized as an expenditure in the period when the liability is incurred. For example, purchasing new equipment for a city department would be recognized as a capital outlay expenditure when the equipment is acquired and the payment obligation is established.
Debt Service (Interest and Principal)
Expenditures for debt service include payments of interest and principal on governmental debt obligations. Under the modified accrual basis, only current period debt service payments are recognized as expenditures. For instance, if a government makes a payment on its bond debt during the fiscal year, the interest and principal due in that period are recorded as expenditures, while future payments are not recognized until they come due and can be paid from available resources.
Supplies and Other Operating Costs
Governments also incur operating costs, such as supplies, utilities, and other necessary services, to support their daily functions. These expenditures are recognized when the liability is incurred and are paid from current available resources. For example, when a government purchases office supplies, the expenditure is recorded when the supplies are received and the government becomes obligated to pay for them.
Expenditures in modified accrual accounting represent the immediate outflow of current resources to satisfy government liabilities. Whether for employee compensation, capital investments, debt payments, or daily operating costs, expenditures are only recognized when they can be paid from the resources available within the current fiscal period.
Understanding Available Fund Financial Resources
Definition of Available Resources
In governmental accounting under the modified accrual basis, available resources refer to financial resources that can be used to meet current obligations within a specific time frame. For a resource to be considered available, it must be collectible during the current period or shortly after the fiscal year-end, typically within 60 days. This concept is fundamental because governments must ensure they have sufficient resources on hand to meet their short-term liabilities, which often aligns with the budgetary focus of governmental entities.
For example, property taxes receivable are recognized as revenue only if the taxes will be collected within 60 days of the fiscal year-end. If the government expects to receive those funds beyond that period, they are deferred and not recognized as available resources for the current period.
Recognizing Fund Availability
Governments assess fund availability by determining whether current financial resources are expected to be available for spending within the fiscal year or soon after. This assessment involves evaluating whether incoming revenues, such as tax collections, grants, or fees, will be realized within the window necessary to cover expenditures.
To recognize fund availability, governments consider two critical factors:
- Measurable Revenues: The revenue can be reasonably estimated, such as property taxes or sales taxes.
- Availability for Expenditure: The revenue is expected to be collected within the current fiscal period or within a short window (typically 60 days) after the period ends, making it available to pay for current obligations.
If a revenue source does not meet these criteria, it is deferred as a deferred inflow of resources and not recognized as available to meet current liabilities.
Types of Governmental Funds
Under modified accrual accounting, governmental entities manage their finances using various governmental funds. These funds are set up to account for specific financial activities, each with different purposes and rules governing how resources are recognized and expended. The most common types of governmental funds relevant under modified accrual accounting include:
General Fund
The General Fund is the primary operating fund for most governments and is used to account for all financial resources not allocated to other specific funds. This fund is used to pay for general services like public safety, education, and administration. The General Fund is highly reliant on available financial resources since it must meet the government’s core operational needs, making the recognition of revenues and expenditures closely tied to the availability of current resources.
Special Revenue Funds
Special Revenue Funds are used to account for specific revenue sources that are restricted or committed for specific purposes, such as transportation, health services, or education programs. These funds ensure that designated revenues (like federal or state grants) are used only for the intended purposes, and the availability of these resources depends on when the funds are received and when they can be spent.
Debt Service Funds
Debt Service Funds account for the resources allocated to pay interest and principal on long-term debt. Under modified accrual accounting, only current debt service payments due within the fiscal year are recognized as expenditures. Resources in these funds are considered available when there are sufficient revenues to meet debt obligations as they come due within the current fiscal year.
Capital Projects Funds
Capital Projects Funds are used to account for financial resources intended for acquiring or constructing major capital facilities, such as buildings, infrastructure, or equipment. Expenditures in these funds are recorded when the government incurs liabilities related to these projects, provided the resources are available to make payments in the current fiscal period.
Permanent Funds
Permanent Funds account for resources that are restricted such that only the earnings, and not the principal, may be used to support government programs. These funds are unique in that the principal remains intact while earnings are used for specified purposes. Availability here pertains to the investment earnings generated from the fund rather than the principal.
Each of these funds operates under the modified accrual basis to ensure that governments manage and report on the use of resources in a way that aligns with short-term fiscal accountability. By focusing on available financial resources, these funds allow governments to maintain effective budgetary control and ensure they can meet their immediate financial obligations.
Journal Entries for Recognizing Expenditures
Basic Journal Entry Format
Under the modified accrual basis of accounting, journal entries are designed to recognize expenditures when the related liabilities are incurred, provided the payments can be made from available financial resources. The general format for a journal entry involves debiting the Expenditures account and crediting the appropriate liabilities or cash account, depending on the nature of the transaction.
The basic format of a journal entry is as follows:
- Debit: Expenditures – This reflects the outflow of current financial resources for the particular expenditure.
- Credit: Liabilities or Cash – This records either a liability that will be paid in the future or a reduction in cash when the payment is made.
This approach ensures that expenditures are properly matched with the period in which they are incurred, reflecting the immediate impact on a government’s available financial resources.
Examples of Journal Entries
Recording Salaries and Wages Payable
Salaries and wages are among the most common expenditures for governments. Under the modified accrual basis, these expenditures are recognized when the liability is incurred (when employees have performed the services), even if the payment will be made in the future.
Journal Entry:
- Debit: Expenditures – Salaries and Wages
- Credit: Salaries and Wages Payable
This entry reflects the government’s obligation to pay its employees for work performed, creating a liability that will be settled when wages are paid.
Capital Outlay for Equipment Purchase
When a government acquires equipment or other capital assets, the expenditure is recognized immediately under the modified accrual basis, rather than being capitalized and depreciated over time. The full cost of the asset is recorded as an expenditure in the period it is incurred.
Journal Entry:
- Debit: Expenditures – Capital Outlay
- Credit: Cash or Accounts Payable
This entry shows that the government has incurred a liability for the purchase of equipment, either paying for it immediately with cash or creating a payable to be settled in the future.
Debt Service Payment (Interest and Principal)
For governments, debt service payments (including both interest and principal) are recognized as expenditures when they come due and can be paid with available resources. Only the payments due in the current fiscal period are recognized under the modified accrual basis.
Journal Entry:
- Debit: Expenditures – Debt Service
- Credit: Cash
This entry reflects the payment of debt service, reducing the government’s cash while recognizing the expenditure associated with repaying debt obligations.
Accrued Expenses at Year-End
Governments may incur various expenses near the end of the fiscal year that have not yet been paid, such as utility bills or vendor payments. These accrued liabilities are recognized as expenditures in the period they are incurred, even though the cash outflow will occur in the next fiscal period.
Journal Entry:
- Debit: Expenditures
- Credit: Accounts Payable
This entry records the accrued expense as a payable, ensuring that the expenditure is recognized in the period in which the liability was incurred.
Treatment of Prepaid Expenses and Long-Term Debt
Under the modified accrual basis of accounting, prepaid expenses and long-term debt are treated differently than under the full accrual basis.
- Prepaid Expenses: In the modified accrual system, governments typically record prepaid items as expenditures when the cash outflow occurs, even if the benefit of the expenditure spans multiple periods. Unlike full accrual accounting, which spreads out the expense over time (as in the case of insurance premiums or rent), modified accrual accounting recognizes the prepaid item as an expenditure when the payment is made.
Journal Entry for Prepaid Expenses:
- Debit: Expenditures
- Credit: Cash
This reflects the immediate recognition of the prepaid expense, simplifying the process by avoiding the need for amortization over future periods.
- Long-Term Debt: Long-term debt is not recognized as a liability under modified accrual accounting until the payments are due and can be made from available resources. Only the current portion of long-term debt (i.e., the principal and interest payments due within the fiscal year) is recognized as an expenditure in the current period. The remaining long-term debt is reported in government-wide financial statements, prepared under full accrual accounting.
Journal Entry for Current Portion of Long-Term Debt:
- Debit: Expenditures – Debt Service
- Credit: Cash
This entry reflects the payment of the current portion of long-term debt, ensuring that only short-term liabilities are recognized as expenditures in the current fiscal period.
By focusing on the immediate outflow of current financial resources, the modified accrual basis simplifies the recognition of expenses and liabilities, aligning governmental financial reporting with the principles of budgetary control and fiscal accountability.
Adjusting Entries at Year-End
Accrued Liabilities
At the end of the fiscal year, governments often have liabilities that have been incurred but not yet paid. These are referred to as accrued liabilities and are recorded through adjusting entries to ensure that expenditures are recognized in the correct accounting period. Under the modified accrual basis of accounting, accrued liabilities include items like unpaid interest, wages earned by employees, and vendor payments for goods or services received before year-end.
To record accrued liabilities, the government makes the following journal entries to reflect the incurred expense:
Example: Recording Accrued Interest Payable at Year-End
- Debit: Expenditures – Interest Expense
- Credit: Interest Payable
This entry ensures that the interest expense related to debt obligations is recognized in the correct period, even though payment will occur in the next fiscal period.
Example: Recording Accrued Wages Payable
- Debit: Expenditures – Salaries and Wages
- Credit: Salaries and Wages Payable
This entry records the wages earned by employees during the fiscal year but not yet paid, reflecting the government’s obligation.
Recognizing accrued liabilities through these adjusting entries is essential for maintaining accurate and transparent financial records under the modified accrual basis, ensuring that the government’s expenditures are matched with the period in which the liabilities were incurred.
Reclassification of Expenditures
At year-end, it may be necessary to reclassify expenditures to ensure that the correct portion of a liability is reflected as a current expenditure. This often occurs with long-term contracts, such as construction projects, where only a portion of the total cost is due within the fiscal year. Governments must adjust their records to reflect the current portion of the liability as an expenditure and defer the remainder.
Example: Adjusting for the Current Portion of a Long-Term Contract
Assume a government has a $1 million construction contract, with $300,000 due in the current fiscal year and the remaining $700,000 due in future periods. The adjusting entry would reflect the $300,000 as a current expenditure:
- Debit: Expenditures – Capital Outlay
- Credit: Accounts Payable or Cash (if paid)
The remaining $700,000 is not recognized as an expenditure in the current period, ensuring that only current financial obligations are recorded in the current fiscal year.
Reclassification of expenditures ensures that the financial statements accurately reflect the current financial resource focus of the modified accrual basis, aligning expenditures with the availability of resources to meet short-term obligations.
Deferred Inflows/Outflows of Resources
A unique concept in governmental accounting is the recognition of deferred inflows and outflows of resources. These represent future resources or obligations that affect current financial reporting but do not meet the criteria for immediate recognition as revenues or expenditures.
- Deferred Inflows of Resources occur when resources are received or recognized before the government has a legal claim to them, such as property tax collections received in advance. These amounts are not recognized as revenue until they are available to finance current expenditures.
Example: Recording Deferred Property Tax Revenues- Debit: Property Taxes Receivable
- Credit: Deferred Inflows of Resources – Property Taxes
- This entry reflects that the government has received tax payments that are not yet available to cover current liabilities, deferring the recognition of the revenue to the next period when it becomes available.
- Deferred Outflows of Resources represent the consumption of resources that apply to future periods. These typically include items such as prepaid expenses or certain pension-related costs.
Example: Recording a Deferred Outflow for Pension Contributions- Debit: Deferred Outflows of Resources – Pension Contributions
- Credit: Cash
- This entry defers recognition of the pension contribution as an expenditure until a future period when the related pension liability is due.
Deferred inflows and outflows play a crucial role in aligning revenues and expenditures with the periods in which they are available or applicable, ensuring that financial reporting under the modified accrual basis accurately reflects the government’s short-term fiscal condition. These adjustments help ensure that financial statements present a clear and transparent view of a government’s financial position at year-end.
Key Considerations for State and Local Government Accounting
Budgetary Constraints and Control
One of the primary reasons for using the modified accrual basis in state and local government accounting is to maintain budgetary compliance and control. Governments operate within legally adopted budgets that outline the resources available and the expenditures allowed for various programs and services. The modified accrual basis of accounting is specifically designed to support this budgetary framework by focusing on current financial resources—those available in the short term to meet the government’s obligations.
Because expenditures are recognized when a liability is incurred and can be paid with available resources, governments are able to closely monitor their spending and ensure that it aligns with the approved budget. This system helps avoid overspending and supports adherence to budgetary laws and regulations, as expenditures cannot exceed available financial resources.
For example, if a government has budgeted $1 million for public safety expenditures and only $900,000 is available by year-end, the government is prevented from recognizing additional expenditures beyond what is available. This process ensures that financial statements accurately reflect the government’s ability to meet current obligations without exceeding the approved budget, thus maintaining fiscal discipline.
Focus on Fiscal Accountability
Government accounting under the modified accrual basis places a strong emphasis on fiscal accountability, which is fundamentally different from the operational accountability that drives private sector accounting. In private sector accounting, the focus is on accurately reporting profits, matching revenues with related expenses, and providing a comprehensive view of an entity’s financial performance over time.
In contrast, governmental entities are primarily concerned with ensuring that they have sufficient financial resources to meet current obligations and that public funds are spent in accordance with the adopted budget. Fiscal accountability refers to a government’s responsibility to demonstrate how public resources are used and whether spending complies with legal and budgetary constraints. It requires governments to focus on the availability of financial resources and the efficient use of those resources to deliver public services.
Under the modified accrual basis, this focus on fiscal accountability ensures that governments report financial activities that reflect their ability to meet immediate financial commitments and fulfill their obligations to taxpayers, rather than focusing solely on long-term profitability or performance.
Impact of GASB Standards
The Governmental Accounting Standards Board (GASB) plays a crucial role in establishing the accounting and financial reporting standards for state and local governments in the United States. GASB pronouncements are designed to enhance transparency, consistency, and accountability in government financial reporting, and several key standards specifically guide the application of the modified accrual basis of accounting.
- GASB Statement No. 34 (Basic Financial Statements—and Management’s Discussion and Analysis—for State and Local Governments): This standard is one of the most significant GASB pronouncements affecting modified accrual accounting. It requires governments to present both government-wide financial statements (prepared on the accrual basis) and fund financial statements (prepared on the modified accrual basis). GASB 34 ensures that financial reporting provides a comprehensive view of a government’s fiscal health, while the modified accrual statements focus on short-term resources and obligations.
- GASB Statement No. 54 (Fund Balance Reporting and Governmental Fund Type Definitions): GASB 54 provides clear guidance on how governmental funds should be classified and reported under the modified accrual basis. It establishes categories for fund balance, including nonspendable, restricted, committed, assigned, and unassigned fund balances, which help clarify the availability and use of resources in governmental funds.
- GASB Statement No. 63 (Financial Reporting of Deferred Outflows of Resources, Deferred Inflows of Resources, and Net Position): This standard introduces the concepts of deferred inflows and deferred outflows of resources, ensuring that governments properly account for future resources and obligations that affect financial reporting under the modified accrual basis. It requires that deferred resources are recognized and reported separately from assets and liabilities, improving transparency and accuracy in financial statements.
The GASB standards provide the framework for how governments recognize revenues, expenditures, and other financial activities, ensuring that financial statements prepared under the modified accrual basis reflect the short-term fiscal realities faced by governments. By adhering to these standards, governments can provide stakeholders with reliable financial information that supports accountability, transparency, and effective financial management.
Conclusion
Summary of Key Points
Understanding and applying the modified accrual basis of accounting is essential for ensuring accurate financial reporting and effective budgetary control in state and local governments. This method focuses on current financial resources and emphasizes short-term fiscal accountability by recognizing expenditures when liabilities are incurred and can be paid with available resources. The modified accrual system contrasts with full accrual accounting by focusing on governmental funds that track day-to-day operations, such as the General Fund, Special Revenue Funds, and Debt Service Funds. Key to this system is properly recording expenditures like salaries, capital outlays, and debt service payments, as well as managing year-end adjustments for accrued liabilities and reclassifying expenditures when necessary.
Additionally, the role of deferred inflows and outflows of resources is critical in ensuring that financial statements align with the availability of resources and obligations over time. Governments must adhere to the Governmental Accounting Standards Board (GASB) guidelines, which provide a consistent framework for recognizing and reporting financial activities under the modified accrual basis, ensuring transparency and fiscal accountability.
Relevance to CPA Exams
For individuals preparing for the BAR CPA exam, a solid grasp of the modified accrual basis of accounting is crucial. This accounting method is not only foundational to understanding government finance but also directly relevant to the exam’s coverage of governmental accounting and financial reporting standards. The ability to accurately calculate and recognize expenditures, understand the concept of available resources, and prepare journal entries are all essential skills that are tested in the BAR CPA exam.
Additionally, for professionals working in state and local government finance, mastering the principles of the modified accrual basis ensures effective financial management, compliance with legal and budgetary requirements, and the ability to produce reliable financial statements that support transparency and accountability. As governmental entities continue to evolve, the knowledge gained in this area will be invaluable for advancing a career in public sector finance.
