Public Sector Accounting 9780415683142, 9780415683159, 9781315848389

As change sweeps across the public sector, a huge range of accounting and financial management challenges are created. T

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Table of contents :
Title Page
Copyright Page
Table of Contents
List of illustrations
List of contributors
List of abbreviations
1 The conditions for and the users of public sector accounting
2 Accounting reforms, standard setting and compliance
3 International Public Sector Accounting Standards (IPSAS)
4 Consolidated financial statements in the public sector
5 Public sector management control tools
6 Public sector management accounting
7 Public sector budgeting
8 Financial audit in the public sector
9 Performance auditing in the public sector
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‘Since the global economic crisis in 2008, governments have provided large amounts of public money for financial and economic interventions. These interventions have strained public budgets significantly and raise an issue of fiscal transparency and stability. Today, in 2014, the question of whether taxpayers money is spent wisely, is still very relevant. Responsive accountability, harmonised international accounting standards and adequate management information are an important prerequisite for answering this question. It is therefore with pleasure that I recommend reading this book.’ Ellen van Schoten, Secretary General Netherlands Court of Audit, the Netherlands ‘The book is an excellent introduction to public sector accounting. It ranges from theoretical concerns of several aspects of public sector accounting to empirical presentations of how public sector dilemmas unfold in different settings around the world. I recommend this book as a good introduction for students of public sector accounting.’ Bino Catasus, Professor, Stockholm University, Sweden ‘Public sector accounting systems currently have significant strains and stresses associated with existing social, cultural, economic and environmental challenges. This textbook presents significant advances in the theoretical and practical understanding of public sector accounting in its context. The book provides a contemporary public sector accounting and auditing perspective that is geared to comprehend the current and future challenges and provide sign posts for students and public sector actors to strategically act on the many contemporary challenges.’ James Guthrie, Professor, Macquarie University, Australia and University of Bologna, Italy

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Public Sector Accounting

As change sweeps across the public sector, a huge range of accounting and financial management challenges are created. This textbook analyses the reforms that are being introduced to deal with these challenges and their global impact on the public sector. Readers are provided with an international overview of government accounting, reporting, management control, cost accounting, budgeting and auditing. In explaining how innovative financial management tools are utilized in the public sector, the authors address a number of emerging issues:  Harmonization trends in public financial management and International Public Sector Accounting Standards (IPSAS)  Financial reporting and consolidated financial statements in the public sector  Public sector management accounting and control methods  Financial and performance auditing in the public sector This concise and accessible textbook will be core reading for public sector accounting and financial management students and will also be required reading for students of public management and administration more generally. Managers, accountants, consultants and auditors working in the public sector will also find the book a useful reference. Tjerk Budding is Senior Lecturer in Public Management and Financial Accounting at VU University Amsterdam, the Netherlands. Giuseppe Grossi is Professor of Public Management and Accounting at Kristianstad University, Sweden. Torbjörn Tagesson is Professor of Accounting at Linköping University, Sweden.

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Public Sector Accounting

Edited by Tjerk Budding, Giuseppe Grossi and Torbjörn Tagesson

First published 2015 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN and by Routledge 711 Third Avenue, New York, NY 10017 Routledge is an imprint of the Taylor & Francis Group, an informa business © 2015 selection and editorial matter Tjerk Budding, Giuseppe Grossi and Torbjörn Tagesson; contributors their contributions. The right of Tjerk Budding, Giuseppe Grossi and Torbjörn Tagesson to be identified as editors of this work has been asserted by them in accordance with the Copyright, Designs and Patent Act 1988. All rights reserved. No part of this book may be reprinted or reproduced or utilized in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. Trademark notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation without intent to infringe. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data Budding, Tjerk. Public sector accounting / Tjerk Budding, Giuseppe Grossi and Torbjörn Tagesson. pages cm Includes bibliographical references and index. 1. Finance, Public–Accounting. 2. Government business enterprises– Accounting. I. Tagesson, Torbjörn. II. Title. HJ9733.B825 2014 657'.835–dc23 2014001438 ISBN: 978-0-415-68314-2 (hbk) ISBN: 978-0-415-68315-9 (pbk) ISBN: 978-1-315-84838-9 (ebk) Typeset in Times New Roman by Taylor & Francis Books


List of illustrations List of contributors Preface Acknowledgements List of abbreviations 1

The conditions for and the users of public sector accounting

viii x xii xiii xiv 1



Accounting reforms, standard setting and compliance




International Public Sector Accounting Standards (IPSAS)




Consolidated financial statements in the public sector




Public sector management control tools




Public sector management accounting




Public sector budgeting




Financial audit in the public sector




Performance auditing in the public sector





List of illustrations

Figures 1.1 3.1 3.2 3.3 3.4 3.5 5.1 5.2 5.3 5.4 6.1

Ends and means in public and private sector organizations Structure around the IPSASB Due process Major steps in a conversion project Accounting systems in local governments Accounting systems in central governments Key control object feasibility determinants Simons’s control framework Hofstede’s management control framework Framework for performance measurement The traditional two-stage cost allocation method versus activitybased costing 9.1 The ‘three Es’ in relation to the value chain

4 29 30 43 54 55 80 81 84 89 107 166

Tables 3.1 Summary of all the advantages that the IPSAS can bring and all the current disadvantages and limitations that get in the way of proper implementation 5.1 Differences between TPM, NPM and PV 5.2 Agency theory versus stewardship theory 7.1 Performance budgeting categories 9.1 A performance audit classification scheme

51 88 97 129 171

Boxes 3.1 3.2 4.1 4.2 5.1

Overview of IPSAS 1–2 Overview of IPSAS 3–32 The European Commission’s global consolidation Alternative approaches to IPSAS The ten-step benchmarking process

33 35 69 71 93

List of iIlustrations 5.2 5.3 6.1 6.2 6.3 6.4 6.5 6.6 7.1 7.2 7.3 7.4 7.5 7.6 7.7 7.8

Benchmarking in Swedish municipalities Trust in Dutch central government Cost allocation bases Some evidence on the design of cost accounting systems in governmental organizations Some examples of the use of a capital charge Bases for setting prices Illustration of capital investment appraisal (project car replacement) The basic steps of cost-benefit analysis (CBA) Budgets in Dutch local government Budgeting in times of austerity Performance budgeting in four countries PBB in the Swedish central government The use of performance information in budgetary decision making in Estonian central government Accrual budgeting in the United Kingdom, Australia and New Zealand Participatory budgeting in Porto Alegre Long-term council community plans in New Zealand

ix 95 98 106 108 111 113 116 117 124 125 131 131 132 134 139 140

List of contributors

Tjerk Budding is Senior Lecturer in Public Management and Financial Accounting at the Zijlstra Centre for Public Control and Governance, an institute that is part of the VU University Amsterdam, the Netherlands, and he is also employed in the Department of Accounting of this university. He received his PhD in Business Administration in 2008 and is the author of several articles on management and financial accounting topics in public sector organizations, which have been published in international accounting journals such as Financial Accountability & Management and Management Accounting Research. Filip Cassel is the author of several books and articles on auditing. He is a Bachelor of Business Administration and received his PhD in Philosophy of Science in 1984. He has been a Chartered Accountant and served as Audit Counsellor at the Swedish National Audit Office. He has been adviser to the European Court of Auditors, to the International Organisation of Supreme Audit Institutions (INTOSAI), and to the International Auditing and Assurance Standards Board (IAASB) regarding auditing standards. Johan Christiaens is Professor of Public Sector Accounting at Ghent University, Belgium. He earned his PhD in Applied Economic Sciences in 1997 and is the author of a number of papers on public sector accounting and auditing. He is a registered auditor and Director of the Accounting Research Public Sector (ARPS) University of Ghent, Ernst & Young (UGent-EY). Giuseppe Grossi is Professor of Public Management and Accounting and Leader of the Research Environment on Governance, Regulation, Internationalization and Performance (GRIP) at Kristianstad University, Sweden. He received his PhD in Business Administration in 2000 and is the author of several books and articles on accounting, public management and governance. Simon Neyt is Staff Assistant EY public sector and assistant ARPS UGent-EY.

List of contributors


Peter Öhman is Associate Professor of Business Administration at Mid Sweden University in Sundsvall, and Director of the Centre for Research on Economic Relations (CER). He received his PhD in Business Administration in 2007 and is the author of several books and articles on accounting, auditing and public administration. Martijn Schoute is Assistant Professor in Management Accounting at the VU University Amsterdam, the Netherlands. He received his PhD in Business Administration in 2009 and is the author of several articles on management accounting topics, which have been published in international accounting journals such as Behavioral Research in Accounting, The British Accounting Review, Journal of Business Finance & Accounting and Journal of Management Accounting Research. Torbjörn Tagesson is Professor of Accounting at Linköping University, Sweden, and the Executive Director of the Swedish Council for Municipal Accounting. He received his PhD in Business Administration in 2002 and is the author of several books and articles on accounting, auditing and public administration.


This book has been written to provide readers with a discussion of different aspects of financial and management accounting in the public sector. The book provides relevant information and guidance needed for accountability and decision making in this context, and explains how financial management tools are implemented and used in the public sector. By inviting various authors with different perspectives and experience, we hope that the book will provide a multi-faceted picture of the various problems in the field. However, this also means that the approaches and arguments presented in the different chapters sometimes differ, depending on the author’s position, view and conception of knowledge. Each chapter has been subject to a peer-review process; however, each author is responsible for his own contribution(s). In Chapter 1 Torbjörn Tagesson discusses the users and the legal and institutional prerequisites applicable to public sector entities. Chapter 2 is also written by Torbjörn Tagesson, and in this chapter he discusses the standardsetting process and research approaches concerned with explaining accounting practice. Where Tagesson gives a quite sceptical view on harmonization and international standard setting, a more positive view is given by Johan Christiaens and Simon Neyt in Chapter 3, where they describe the standards and standard-setting process by the International Public Sector Accounting Standards Board (IPSASB). Chapter 4, written by Giuseppe Grossi, introduces the different consolidation theories and methods for public sector organizations. In Chapter 5 Tjerk Budding provides an overview of management control theories and their application to the public sector. Chapter 6, co-authored by Tjerk Budding and Martijn Schoute, is about management accounting and deals with cost allocation, price setting and capital investment appraisal. Budgeting is the topic of Chapter 7, which is co-authored by Tjerk Budding and Giuseppe Grossi. In this chapter the authors deal with both traditional budgeting (such as incremental budgeting) and innovative forms of budgeting (such as performance budgeting, accrual budgeting and participatory budgeting). Auditing is the topic of Chapters 8 and 9. Chapter 8 is written by Filip Cassel and deals with financial auditing with a special focus on central government entities. Peter Öhman is the author of Chapter 9, dealing with performance auditing.


We are grateful to many individuals for their assistance in the preparation of this manuscript. These include: Tineke Yürümez-Kroon, Gilbert Rip and Curt Johansson (The Swedish National Financial Management Authority). Furthermore, we greatly appreciate the support and assistance of Dominic Corti, Sinead Waldron and Terry Clague, all employed at Routledge.

List of abbreviations


Australian Accounting Standards Board activity-based costing Asian Development Bank Accounting Research Public Sector Beyond Budgeting Round Table cost-benefit analysis cost-effectiveness analysis chief financial officer consolidated financial statement central processing unit data envelopment analysis European Commission exposure draft European Public Sector Accounting Standards European System of Accounts European Union Federal Accounting Standards Advisory Board Financial Accounting Standards Board Fédération des Experts Comptables Européens Financial Reporting Standard generally accepted accounting principles Governmental Accounting Standards Board General Purpose Financial Reports General Purpose Financial Statements International Auditing and Assurance Standards Board International Accounting Standards International Accounting Standards Board information communications technology International Federation of Accountants International Financial Reporting Standards International Monetary Fund International Organisation of Supreme Audit Institutions International Public Sector Accounting Standards



International Public Sector Accounting Standards Board internal rate of return International Standards of Auditing International Standards of Supreme Audit Institutions information technology institutional theory Invitation to Comment Local Government Act multi-criteria analysis North Atlantic Treaty Organization National Benchmarking Project New Public Governance New Public Management net present value New Zealand International Accounting Standards official centres for mutual welfare Organisation for Economic Co-operation and Development positive accounting theory performance-based budgeting public interest entities planning programming budgeting system public sector public value Public Benefit Entities reliance on accounting performance measures research and development recommended practice guidelines supreme audit institution time-driven activity-based costing Traditional Public Management United Nations United Nations Educational, Scientific and Cultural Organization United Nations Children’s Fund World Food Programme External Reporting Board zero-based budgeting

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The conditions for and the users of public sector accounting Torbjörn Tagesson

Learning objectives  To be aware of the specific conditions that apply to public sector accounting entities as a result of their legal and institutional prerequisites.  To have knowledge about potential and primary users of governmental financial reporting.

Key words    

The accruals assumption Externalities Public goods Stakeholder

1.1 Introduction The emergence of accounting and bookkeeping is often associated with Fra Luca Pacioli and the emerging trade in Italy during the fifteenth century. However, the history of accounting dates back thousands of years. This is a fact that also applies to public sector accounting. Already Alexander the Great used accounting and bookkeeping in order to control and manage his client kings. The development of accounting goes hand in hand with social and economic development in society. In the same way as the separation of ownership and control had a major impact on the development of private sector accounting, public sector accounting has affected but has also been influenced by the development of democracy. According to the famous sociologist C. Wright Mills, ‘democracy implies that those who bear the consequences of decisions have enough knowledge – not to speak of power – to hold the decision-makers accountable’ (Mills, 1957: 325). Although institutional, contextual and legal prerequisites vary among different sectors of society and between different countries, the starting point for accounting is basically the same. Accounting is about recording, recognizing, measuring and reporting economic events and transactions. Double-entry


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bookkeeping is the usual method used for recording accounting transactions such as purchase or sale, respectively, money received or paid. Recognizing is about determination of when revenues and costs are earned or incurred. This separation between recording and recognition is known as the accruals assumption.1 The accruals assumption requires that one can measure the value of economic events and transactions. This measurement problem is one of the most fundamental but also most difficult questions in accounting theory. An unequivocal answer cannot be given to this question, but one way to start is to discuss and determine/identify the users and their information needs. The users and their information needs are, of course, also crucial regarding form and content of the financial reporting that is based on the recording, recognition and measurement of economic events and transactions. Thus, based on the users and their information needs, one can deduce the purpose of financial reporting, taking into account the specific conditions that apply to the accounting entity as a result of its legal and institutional prerequisites.

1.2 Specific conditions for public sector entities Before discussing the users and their information needs, we will highlight some of the most important aspects that characterize public sector entities. Although prerequisites may be partly different between different levels of public sector and different public sector entities, there are some unique characteristics that apply to the entire public sector and must be considered regarding its accounting and financial reporting. Governmental organizations such as local and central government entities use common and public resources to provide public goods and services to citizens and users. According to Barton (1999), the existence of externalities and market failure form the basis for government provision of goods and services. By externalities, ‘we mean situations where consumption benefits are shared and cannot be limited to particular consumers, or where economic activity results in social costs which are not paid for by the producer or the consumer who causes them’ (Musgrave and Musgrave, 1988: 42). The first type of externality, i.e. the sharing of consumption benefits, means that the use of a service or facility by one consumer does not mean that others are excluded from using and taking advantage of the benefits provided. Hence, in situations when a good or service is required, but the free-rider problem makes it unprofitable for private operators to provide the product or service, we need the government to provide it. Barton refers to these goods and services as ‘pure public goods’. He exemplifies with citizens’ access to the system of law, order and defence, broadcasting, street lighting, roads, public parks and so on. The situation where production of goods and services results in social costs that are not paid for by the producer or the consumer who causes them, e.g. pollution of water and air, is an example of impure or mixed public goods with a negative externality. In these situations government can try to use regulation, e.g. ‘green taxes’, in order to realign the private and social

Public sector accounting


costs, or they can choose to provide the good itself using a pricing structure that ensures the ability to recover some of the social costs (Barton, 1999). There are also situations where social benefits exceed private costs. Also in these situations government can choose to provide the service or goods themselves or to subsidize private provision of the good. Education and health services are such examples (Barton, 1999). In some cases governments also choose to regulate or provide private goods and services, when they are considered to be essential for the community. In rural areas this may include services relating to, for example, pharmacy, vehicle inspection, mail distribution and so on. However, in many cases it concerns natural monopolies in the infrastructure and utilities sector such as railway, water and sewage, gas distribution, waste management, etc. As pointed out by Barton (1999), many of these operations also involve significant externalities. Thus, in practice, it is not always easy to make a clear-cut distinction between private goods and public goods. What goods and services the governmental sector chooses to provide to its citizens vary between different countries and political systems. The powers of government and range of government activities are ultimately matters of political choice which may take many factors into consideration in addition to narrowly-defined economic ones. (Barton, 1999: 23) Whether the services are provided by the public sector because they are unlikely to be provided by other entities or because it is not considered appropriate for them to be provided through competitive market mechanisms on public policy grounds, it means that government services and goods in many cases are provided in a non-competitive environment (e.g. IPSASB, 2011) by using production means that have the character of public utilities that are not saleable on an open market. The primary objective of public sector organizations is not to make a profit or generate return on capital, but to meet different political policy objectives and provide goods and services to citizens. In some countries, like Sweden, it is even forbidden for public organizations without specific statutory regulation to engage in businesses for profit. The right to levy taxes secures the obligations and commitments of public sector organizations. Besides revenues from tax, public sector activities are also financed by fees and grants, which are not retrieved from a free market, but are guaranteed by political decisions and regulation. In relation to commercial enterprises, the structure in terms of means and ends are reversed to public sector organizations: while commercial enterprises run operations in order to generate resources and make a profit, public sector organizations receive resources in order to run operations and activities (see Figure 1.1). Thus, in contrast to private sector entities, the capital and revenue of which must rely on exchange transactions that are entered into voluntarily by its


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Public sector organizations

Commercial enterprises


Goods and services

Goods and services


Figure 1.1 Ends and means in public and private sector organizations Source: Rådet för kommunal redovisning, 2011: 12

stakeholders (e.g. IPSASB, 2011), public sector organizations have the character of mandatory associations, meaning that the relationship between the organization and its users is not always of a voluntary nature. Under public property rights, ownership cannot be concentrated or capitalized as in a limited company. One citizenship means one vote. This vote is personal and cannot be sold or purchased, at least not in a functioning democracy. This also means that there is no owner who can decide on dividends or withdrawals of capital. The meaning of equity is therefore different in the public sector compared to the private sector. There are no owners who are the residual risk takers; instead, it is the economic and political freedom of action of future taxpayers and citizens that is at stake. Considering the fact that governmental entities have no explicit owners and thus no current or potential investors, the objective of financial reporting in public sector entities is not to provide investors with information useful for forward-looking economic decision making. In the public sector the more future-oriented information is communicated through the budget. In many jurisdictions the budget is statutory and has a special legal significance. It is usually the basis for setting taxation levels and is a part of the process of obtaining legislative approval for spending and resource allocation (IPSASB, 2011), and decisions on the budget are key elements in the political management of governments. Hence, it is through the budget that the politicians communicate and articulate ideologies and future-oriented information to external stakeholders. In the light of the budget’s significance and specific role, ex-post accounting provides important accountability information and serves as an important tool in following up and evaluating if the public sector entities have met the financial objectives that were defined and set in the budget. Thus, the link between budget and financial reporting provides conditions for

Public sector accounting


voters and other stakeholders to obtain knowledge in order to hold politicians responsible and accountable for their decisions.

1.3 Users An organization can have many different stakeholders and consequently a wide range of users or potential users of financial reporting. To produce financial reports tailored to each individual stakeholder would not be economically viable or even possible. Legislators and standard setters have the task of ensuring a minimum level and balance various stakeholders’ interests. Thus, financial reporting must meet the general and common information needs of potential external users who cannot demand reports tailored to meet their specific information needs. For public sector entities, this range of potential users can be wide – almost every person or company has some kind of relation or exchange with some public sector entity. Governments and public sector entities raise resources from taxpayers, subscribers, lenders and other public sector entities for their use of the provision of services and goods to citizens and other service recipients. In their consultation paper regarding the Conceptual Framework for General Purpose Financial Reports (GPFR) by Public Sector Entities (2008), the International Public Sector Accounting Standards Board (IPSASB) identifies three major groups of potential users:  Recipients of services or their representatives.  Providers of resources or their representatives.  Other parties, including special interest groups and their representatives. The IPSASB particularly emphasizes that the legislature, which acts in the interests of members of the community, is a major user of GPFRs. Besides citizens, who both receive services from and provide resources to the public sector entities, there are a number of other potential users, for example subscribers, creditors, statisticians, the media, suppliers, other governmental entities and other organizations that rely on compensation or compete with governmental entities, etc. By providing a financial report of high quality, governmental entities can also satisfy some of the information needs of organizations and users that have the authority to require reports tailored to meet their own specific information needs – e.g. politicians, officials, auditors, regulators and oversight bodies, subcommittees of the legislature or other governing bodies. The wide range of potential users and the broad definition reflects the diversity and heterogeneity of the stakeholders. To accommodate all potential users would involve extensive and almost impenetrable accounting and reporting. Thus, in their exposure draft from 2010, Conceptual Framework for General Purpose Financial Reporting by Public Sector Entities (phase 1), the IPSASB identifies citizens as primary users of GPFRs. Also this clarification and definition of primary users includes a wide range of users with different interests. The interest group citizens can be divided into different,


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though overlapping, subgroups such as service recipients, voters, taxpayers, etc. Among the subgroup voters, there may be different and conflicting interests, and therefore different information needs.

Summary Compared to the private sector, the public sector differs in organizational goals, financing, ownership and users of accounting information:  Governmental organization entities use common and public resources to provide public goods and services to citizens and users.  The primary objective of public sector organizations is not to make a profit or generate return on capital, but to meet different political policy objectives and provide goods and services to citizens.  All obligations are secured by the power of taxation.  Public sector organizations have the character of mandatory associations, meaning that the relationship between the organization and its users is not always of a voluntary nature.  Public sector entities have no owners who are the residual risk takers; instead, it is the economic and political freedom of action of future taxpayers and citizens that is at stake. The meaning of equity is therefore different in the public sector compared with the private sector.  The budget plays a crucial role in the public sector: it is through the budget that the politicians communicate and articulate ideologies and future-oriented information to external stakeholders.  Accounting and financial reporting provides important accountability information and serves as an important tool in following up and evaluating the budget.  Financial reporting must meet the general and common information needs of potential external users, who cannot demand reports tailored to meet their specific information needs.  Public sector accounting has a wide and heterogeneous range of users.  Citizens are considered to be the primary users.

Discussion questions 1 The IPSASB identifies citizens as primary users of GPFRs. Is it reasonable to assume that citizens actually read GPFRs produced by public sector entities? If not, does it still make sense to design the GPFRs based on their information needs? 2 It is not always easy to make a clear-cut distinction between private goods and public goods. Give examples of goods and services that are not pure public goods, but which are produced by the public sector. Discuss the reason why these types of goods and services are produced by public sector entities.

Public sector accounting


3 In addition to financial information, what other information do you think is important in order to evaluate the achievement of a public sector entity?

Note 1 Many countries still use cash accounting for the public sector.

References Barton, A. (1999) ‘Public and Private Sector Accounting – The Non-identical Twins’, Australian Accounting Review 9(2): 22–31. IPSASB (International Public Sector Accounting Standards Board) (2008) Conceptual Framework for General Purposes Financial Reporting by Public Sector Entities (Consultation Paper, September 2008), Toronto: International Federation of Accountants. ——(2010) Conceptual Framework for General Purpose Financial Reporting by Public Sector Entities (phase 1) (Exposure Draft, December 2010), Toronto: International Federation of Accountants. ——(2011) Key Characteristics of the Public Sector with Potential Implications for Financial Reporting (Exposure Draft, April 2011), Toronto: International Federation of Accountants. Mills, C.W. (1957) The Power Elite, London: Oxford University Press. Musgrave, R. and Musgrave, P. (1988) Public Finance in Theory and Practice, 5th edn, New York: McGraw-Hill. Rådet för kommunal redovisning [The Swedish Council for Municipal Accounting] (2011) Konceptuellt ramverk för finansiell rapportering i kommuner och landsting [Conceptual Framework for Financial Reporting in Municipalities and County Councils], Stockholm: Rådet för kommunal redovisning.


Accounting reforms, standard setting and compliance Torbjörn Tagesson

Learning objectives  To be aware of the political aspects of accounting standard setting.  To understand that a common set of accounting standards does not automatically mean that comparability is achieved.  To understand how opportunistic behaviour and the relationship between agents and principals may affect accounting practices.  To understand how institutional pressure may influence accounting practice and harmonization.

Key words         

Accounting choice Accounting practice Accounting standards Decoupling Eclectic Institutional theory Isomorphism Opportunistic behaviour Positive accounting theory

2.1 Introduction The move to accounting on an accrual basis in the public sector began in the late 1980s and early 1990s. In many countries this accounting model was first introduced in the local government sector and then at national government level (Lüder and Jones, 2003). In several of the countries that early introduced accounting on an accrual basis, this reform was part of a major administrative reform agenda often referred to as New Public Management (NPM). NPM is the collection of management and leadership practices gradually introduced in the public sector since the 1980s. NPM is a broad term for a variety of management ideas, often borrowed from the private sector, introducing ideas and

Reforms, standard setting and compliance


tools like competition, privatization, management by objectives, decentralization, etc., in the public sector (e.g. Hood, 1991, 1995). The NPM movement has its origins in a critique of the ‘traditional’ way of exerting control and management of public organizations and as a requirement for increased efficiency in the public sector. In recent years NPM has endured much criticism from both researchers and practitioners (e.g. Lapsley, 2009; Pollitt, 2009). No matter what is thought about the underlying assumptions and ideas of NPM, it is noted that several of the techniques and management tools are here to stay (e.g. Lapsley, 2008), including accounting on an accrual basis. However, various failures and criticisms are likely to improve and adjust the tools and techniques in order better to conform to public sector requirements and conditions.

2.2 Standard setting In order to codify and standardize particular accounting principles and rules, and to support the implementation of accrual-based accounting, several countries have established national standard-setting bodies. In the same manner as the scope and scale of the public sector differ between different counties, the structure, operation and authority of the national standard setters also differ. In some countries the standard-setting body is an internal or nearly internal governmental body, while in other countries the standard-setting body is external and private. Of course, when different countries use different accounting standards to regulate financial reporting, it is difficult to make comparisons between public sector organizations from different countries. The extent to which there is a need to make such international comparisons of public sector entities can be discussed. Although the situation and need is different compared with cross-listed international companies, one can assume that, with a greater element of supranationalism and international cooperation (e.g. the European Union (EU) and the World Bank), the need for comparability and international harmonization within the public sector will increase. In the late 1990s the International Federation of Accountants (IFAC) established the International Public Sector Accounting Standards Board (IPSASB) to set internationally accepted accounting and financial reporting standards for the public sector for application by governments of all levels and other international governmental organizations such as the European Commission, North Atlantic Treaty Organization (NATO), the United Nations (UN) and others. According to the IPSASB, their objective is: to serve the public interest by developing high-quality accounting standards and other publications for use by public sector entities around the world in the preparation of general purpose financial reports. (IPSASB, 2013: 10) Today the IPSASB has issued 32 International Public Sector Accounting Standards (IPSAS) using the accrual basis of accounting (as well as one


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standard for jurisdictions using the cash basis of accounting before moving towards accrual accounting). The IPSASB’s impact has been limited to such an extent that only a few countries have fully implemented all the accrualbased IPSAS. However implicit, the IPSASB has had an impact by influencing and inspiring national standard setters in their work. The main criticism levelled against the IPSASB is that their standards have not been adequately adapted to the specific needs of the public sector and that the standards are not comprehensive enough to meet all public sector accounting and reporting requirements. A proposal to introduce the IPSAS as regulatory frameworks for public sector accounting within the EU was rejected by the Parliament. Instead, the possibility of developing EPSAS (European Public Sector Accounting Standards) is now being discussed. Presently there are many question marks. Will Germany and other countries that primarily still use cash accounting accept a directive stipulating EPSAS based on accrual accounting – i.e. will EPSAS actually be developed and implemented? How detailed and comprehensive will these possible EPSAS be? Who should have influence and decide the content and design of these standards? The economic consequences of the accounting regulation makes the standardsetting process highly political. Influence over standard setting also allows indirect effect over how resources are distributed among different stakeholders in society. As pointed out by Gerboth: the critical issues are not technical; they are political … Technical competence will be presumed and must be present, but an accounting rulemaking body will not succeed on its technical competence but rather on its political competence … In the face of conflict between competing interests, rationality as well as prudence lies not in seeking final answers, but rather in compromise – essentially a political process. (Gerboth, 1973: 479) Watts and Zimmerman emphasize the political aspects of accounting standard setting: Rationales differ (and are inconsistent) across accounting standards because a standard is the result of political action … We will observe the nature of accounting theory changing as political issues change. Accounting theory will change contemporaneously with or lag political issues. We will not observe accounting theory generally leading political action … (Watts and Zimmerman, 1979: 287–88) It is important to remember that Gerboth as well as Watts and Zimmerman address standard setting in general, implicit standard setting related to company accounting. However, the issue of accounting standard setting and

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regulation is probably not less politically charged when it comes to regulating accounting of political institutions reporting. Regarding the development and quality of financial accounting and regulation in the Swedish municipal sector, Brorström notes that: To a certain point it seems like municipal accounting can be developed in accordance with generally accepted accounting principles, but when it encroaches on the space for political action, it stops. (Brorström, 2007: 150, author’s translation)

2.3 Explaining and predicting accounting practice Whether standard setting takes place at national or supranational level, a common set of standards does not automatically mean that comparability is achieved between the entities that must comply with the same standards. A critical factor is obviously whether standards are designed in a way that facilitate and enable comparability, i.e. it is not enough to do the same things, one also has to do the right things in order to achieve comparability. However, even if the standards support comparability, it does not mean that comparability actually is achieved. Interpretation and application of accounting standards are critical factors that largely affect comparability and how the performance and financial position of the reporting entity is reflected. As pointed out by Tay and Parker (1990), one has to distinguish between regulation and practice, i.e. de jure, which refers to legislation and accounting standards, and de facto, which refers to actual accounting practices of preparers. Bergevärn et al. (1995) make a similar distinction but refer to them as the norm system and the action system, respectively. In the same manner as standard setters have to consider the context and political environment, the preparers – i.e. action system – have to consider not only the accounting standards and regulation but also its context. Thus, preparers do not always adapt to rules and expectations (Oliver, 1991), e.g. the normative and regulatory standards issued by standard setters. Depending on the situation and possible consequences, organizations and their agents may respond in a variety of ways, ranging from passive conformity, compromise and avoidance, to defiance and proactive manipulation (Oliver, 1991). In Oliver’s theory about how organizations strategically treat institutional pressure for change, political self-interest (cf. Downs, 1957; Zimmerman, 1977) plays a crucial role. According to Falkman and Tagesson (2008) and Collin et al. (2009), there are two main theories concerned with explaining accounting practice: positive accounting theory and institutional theory. Positive accounting theory (PAT) is based on the assumption of self-interest, while institutional theory (IT) is based on the assumption that organizations adapt to structures and processes in order to gain legitimacy and avoid uncertainty.


Torbjörn Tagesson

Positive accounting theory and an economic theory of democracy According to the founders of PAT, ‘the only accounting theory that will provide a set of predictions that are consistent with observed phenomena is one based on self-interest’ (Watts and Zimmerman, 1979: 300). PAT is a theory that derives predictions about accounting choice from the wealth effects the choice has on the agent and important stakeholders (Watts and Zimmerman, 1986). Thus, the agency problem assuming conflicting interests between the agent and the principals and the existence of information asymmetry, where the agent has an information advantage over the principals, are important assumptions. The theory assumes a clear correlation between companies’ accounting choices and their characteristics. In order to explain accounting choice in corporations, primarily three sets of variables have been used, namely ‘variables representing the manager’s incentives to choose accounting methods under bonus plans, debt contracts, and the political process’ (Watts and Zimmerman, 1990: 138). These three sets of variables are in line with the basic hypotheses presented by Watts and Zimmerman (1986, 1990).  The bonus plan hypothesis predicts that managers of firms with bonus plans are more likely to use accounting methods that increase current period reported income.  The debt/equity hypothesis predicts the higher the firm’s debt/equity ratio, the more likely the manager is to use accounting methods that increase income.  The political cost hypothesis (also called the size hypothesis) predicts that large firms are more likely than small firms to use accounting choices that reduce reported profits (size being a proxy for political attention). In Chapter 1, I emphasized that public sector organizations differ from private sector organizations regarding organizational goals, financing, ownership and users of accounting information. Another important difference, which also has implications for how PAT can be used in order to explain accounting choices in the public sector, is the principals’ rationale for monitoring. In the public sector there is no existence of a capital market for residual claims that motivate individuals to monitor the agents (e.g. Zimmerman, 1977). Thus, even if voters have incentives to monitor the behaviour of the politicians, one cannot ignore that the high transaction costs associated with monitoring and the absence of capitalization under public property reduce the net benefits of monitoring the agent (Zimmerman, 1977). Still, it is reasonable to assume that both agents (i.e. politicians) and principals (i.e. voters and other stakeholders) are rational, evaluative individuals trying to maximize their own utility (Zimmerman, 1977). However, instead of assuming that the agent acts in order to maximize his own wealth, Downs argues that politicians in a democracy can be assumed to maximize the number of votes:

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In effect, it is an entrepreneur selling policies for votes instead of products for money. Furthermore, it must compete for votes with other parties, just as two or more oligopolists compete for sales in a market. (Downs, 1957: 137) Thus, even if there are differences between public sector organizations and private sector organizations, the basic assumptions on which PAT is based – an existing agency problem, information asymmetry, conflicts of interest and utility maximizing individuals – are valid also for the public sector. Politicians are the elected agents of the electorate and hence an agency problem exists. The interest of the principal (i.e., voters) and agent (i.e., politician) can differ in a number of ways … The voters are the politician’s principals. The voters’ welfare is tied to the actions of their agents (politicians) directly through the politician’s power to levy taxes and to determine the mix and quality of the services provided … (Zimmerman, 1977: 188) Hence, the information asymmetry and conflicting interests are moral hazards, arising from the unobservability of the politicians’ efforts in creating social welfare – that is, the politicians’ problem to decide on how much effort to devote to create social welfare on behalf of the citizens (i.e., voters). Since effort is unobservable, the politicians may be tempted to shirk on effort or consume perquisites (e.g. Zimmerman, 1977). However, since the number of votes reflects political performance, it operates as an indirect measure of the politicians’ efforts. However, available resources are ultimately provided by the citizens (i.e., voters), against which politicians are responsible. As mentioned in Chapter 1, politicians communicate through the budget and articulate their ideologies and ambitions. Ex-post accounting provides important accountability information. Thus, based on the notions of PAT it can be assumed that politicians will opportunistically select particular accounting methods whenever they believe that this will favour their chances of re-election (e.g. Downs, 1957; Zimmerman, 1977; Blais and Nadeu, 1992; Copley et al., 1995). Hence, even if the conditions differ between the public sector and the private sector, one can assume that opportunistic behaviour and the relationship between agents and principals affect accounting practice. Even if the transaction costs associated with monitoring the agent are high (Zimmerman, 1977), one cannot ignore the principals’ incentives. According to Jensen and Payne (2005), citizens’ interest in municipal decisions, and thus information, can be explained by their level of economic input. Their economic input is related to two factors: income level (tax base) and tax rate. Thus, the higher the income, the higher the taxes paid (= economic input) and, therefore, the higher the interest in political decisions and the demand for information from public sector entities (e.g. Tagesson et al., 2013). Considering the assumption


Torbjörn Tagesson

that politicians try to maximize the number of votes (Downs, 1957) and seek re-election (Downs, 1957; Copley et al., 1995), a high tax rate can also be assumed to affect the agents’ needs and willingness to signal accountability to the voters (Ward et al., 1994). Thus, high tax rates affect not only the principals’ information requirements but also the politicians’ need to convince the voters that the tax money is used in a responsible way (Tagesson et al., 2013). Another important factor is political competition (Zimmerman, 1977; Baber, 1983). Political candidates have incentive to monitor the majority and, according to Zimmerman (1977: 120), ‘potential officeholders therefore serve to restrain the deviation between voter and political interests’. Thus, in a competitive situation the requirements of monitoring increase (Baber, 1983), which also means that the political risk of deviating from regulation and standards increases. When there is strong competition for voters, the incentive for the ruling majority to report to voters and other stakeholders in order to signal that they are responsible in their actions increases (Copley et al., 1995). Zimmerman (1977) argues that politicians have incentive to reduce the cost of debt in order to free up resources and improve conditions for political action, which increases the politician’s welfare more than paying higher interest (the debt/equity hypothesis). That governments and political organizations are subject to scrutiny and demands from their creditors, and that this affects the conditions for political action, has been shown during the recent financial crisis in different EU countries. A free press is usually seen as an important prerequisite for a functioning democracy. The press and mass media are also involved as intermediaries in the agency relationship between voters and politicians (Zimmerman, 1977). The mass media and their journalists have economic interests in uncovering political scandals and other ills (Zimmerman, 1977). However, as pointed out by Zimmerman, there is other, better-selling and more easily documented news than uncovering inaccuracies in politicians’ accounting and reporting. Still, the mass media are a factor that could put political pressure on governmental organizations. According to Falkman and Tagesson (2008), size is a factor that affects media interest: large organizations are more closely scrutinized by the mass media than smaller organizations (the political cost hypothesis). As mentioned in the previous section, tradition and imitation constitute two major concepts in institutional theory. However, Collin et al. (2009) argue that tradition, i.e. to do today what one did yesterday, as well as imitation can be regarded as a rational choice, and is therefore a valid explanation in line with the assumptions of PAT. In order to change policy, an entity has to engage in collecting information and finding alternatives and evaluating the economic consequences and effects on the utility of agents and principals (Collin et al., 2009). These activities create what Luft and Shields (2002: 799) call ‘costs of thinking’. If the entity decides to change accounting policy, it must also have to count the costs of social innovation, ‘i.e., the necessary resources and activities to implement and motivate an accounting change’

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(Collin et al., 2009: 148). Collin et al. (2009) also refer to Holthausen and Leftwich (1983), who argue that, if there are no apparent benefits in finding a specific accounting method, it is rational to copy the mainstream method. By following the mainstream method the entity does not have to spend resources in explaining its choice and thus avoids costs of social innovation and thinking (Collin et al., 2009). Institutional theory If PAT focuses on the allocation of scarce resources and the relationship between the agent and the principals, IT focuses on the organization and its problems associated with uncertainty, legitimacy and mobilization of resources. The theory is based on the assumption that organizations are influenced by pressure from their institutional environment and adopt the structures and/ or procedures that are considered legitimate and are regarded as the appropriate choice. The theory, which has its roots in organizational research, has ‘great relevance to accounting research’ (Carruthers, 1995: 313) and is, according to Dillard et al. (2004: 506), ‘increasingly being applied in accounting research to study the practice of accounting in organizations’. According to Deegan (2009), there are two main dimensions of IT, relevant to accounting research. One dimension is the three mechanisms of institutional isomorphic change identified by DiMaggio and Powell (1983) in their classic article. The other dimension is decoupling (Meyer and Rowan, 1977), i.e. when formal practice is separated from the actual practice (e.g. Dillard et al., 2004). The role of institutional isomorphism Thus, IT assumes that organizations will apply structures and practices that are considered legitimate by other organizations within its organizational field, which ultimately will lead to homogenization and harmonization around certain dominant norms. By organizational field, DiMaggio and Powell mean ‘those organizations that, in the aggregate, constitute a recognized area of institutional life: key suppliers, resource and product consumers, regulatory agencies, and other organizations that produce similar services or products’ (DiMaggio and Powell, 1983: 147). DiMaggio and Powell (1983) identify three institutional mechanisms: 1) coercive isomorphism, attributed to the problem of legitimacy inflicted by pressure from external organizations upon which the organization is dependent; 2) mimetic isomorphism, a response to uncertainty by imitation and modelling successful concepts; and 3) normative isomorphism, which is associated with professionalization and primarily stems from members of a professional group’s collective struggle to define the conditions and methods of their work. Coercive isomorphism is related to power (Tuttle and Dillard, 2007; Deegan, 2009) and resource dependency (Carpenter and Feroz, 2001; Collin


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et al., 2009). ‘Organizations can put pressure on the focal organization to behave and to structure itself in a certain way; otherwise the focal organization will not gain the needed resources or will suffer from sanctions’ (Collin et al., 2009: 151). Therefore, coercive pressure can be exerted by organizations and stakeholders – like creditors, customers and owners – which directly and indirectly provide the organization with resources, as well as influence due to legislation. For example, supranational organizations like the International Monetary Fund (IMF) and the EU can put pressure on states and national governments to adopt certain structures and procedures. In the same way, national governments can put pressure on lower-level entities in the government sector, like municipalities and county councils, both directly through legislation but also indirectly by imposing requirements in connection with financing. According to DiMaggio and Powell, ‘organizations are increasingly homogeneous within given domains and increasingly organized around rituals of conformity to wider institutions’ (DiMaggio and Powell, 1983: 150), and these institutions, depending on the situation, could be national or supranational institutions. The mimetic mechanism is mainly related to uncertainty. In situations of ambiguity and uncertainty, organizations tend to mimic and model themselves after similar organizations, within their organizational field, which they perceive to be legitimate or successful (DiMaggio and Powell, 1983). According to Collin et al. (2009), this mimetic behaviour is partly based on the same reasoning as the costs of thinking and social innovation, although the underlying cause is perhaps more legitimacy endeavour than cost reasons. The normative isomorphism is related to professionalization, i.e. ‘the collective struggle of members of an occupation to define the conditions and methods of their work’ (DiMaggio and Powell 1983: 152), and is performed mainly through professional groups promoting their competence in society (Collin et al., 2009). Professional groups and identities are mainly formed through formal education and professional association and networks (DiMaggio and Powell, 1983). The normative isomorphism ‘relates to the pressures arising from group norms to adopt particular institutional practices[, e.g.] the professional expectation that accountants will comply with accounting standards’ (Deegan, 2009: 362). However, it is also a matter of relative power: professionals must compromise with other groups (c.f. DiMaggio and Powell, 1983), for example auditors, regulators and not least politicians. In Falkman and Tagesson (2008: 280), ‘6 out of 12 interviewed financial managers claimed that political standpoint, rather than accounting standards, was considered when the accounting treatment was decided upon’. It is important to remember that the typology of isomorphism ‘is an analytic one: the types are not always empirically distinct’ (DiMaggio and Powell, 1983: 150). Therefore, many scholars only distinguish between coercive and voluntary diffusion of institutional structures and practice (Modell, 2001; Oliver, 1991). However, even this division is not always possible to apply in the operationalization of factors into variables. For example, it is

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quite common in studies on accounting choice and accounting practice that a correlation between auditor/audit firm and the dependent variable is assumed. As members of a professional group, auditors can be expected to put normative pressure on their clients (Falkman and Tagesson, 2008). Considering auditors’ authority to decide whether an organization will receive a qualified auditor’s report or not, it is reasonable to assume that they also exert coercive pressure on their clients (c.f. Tagesson and Eriksson, 2011). Thus, the ‘coercive tendency is reinforced by the professional group of auditors and accountants that support the observance of the regulations since it supports their profession and its extension, and because their professional attitude demands it’ (Collin et al., 2009: 155). Finally, there is also a mimetic explanation why the audit firm/auditor would affect accounting choice or accounting practice: ‘Culture and client portfolio may influence the audit habits of the professional auditors, and models of auditing may by coincidence be diffused by the auditor’ (Tagesson and Eriksson, 2011: 227). Carpenter and Feroz (2001) also point out that it is difficult to distinguish and separate the three forms of isomorphic pressure, and they conclude that ‘the power and potency of the various institutional pressures for change may vary over time’ (Carpenter and Feroz, 2001: 573). In their study about four US state governments’ decision to adopt generally accepted accounting principles (GAAP), they state: Our evidence shows that an early decision to adopt GAAP can be understood in terms of coercive isomorphic pressures from credit markets, while later adoption seems to be associated with the combined influence of normative and mimetic institutional pressures. (Carpenter and Feroz, 2001: 588)

Decoupling As pointed out earlier, it is important to distinguish between regulation and practice, i.e. the norm system and the action system (Bergevärn et al., 1995). Daske et al. (2007) make a distinction between what they call serious and label adopters. Carmona and Trombetta explain the difference: The distinction captured the idea that some adopters seriously modify their financial reporting strategy after adoption (serious), whereas others use the flexibility of … standards to keep on using their usual financial reporting strategy under the new … label (label). (Carmona and Trombetta, 2008: 458) The decoupling, i.e. the separation of the actual practice from the formal practice, can be done more or less consciously by the organization.


Torbjörn Tagesson Even if an organization does not actively resist institutional change, institutional inertia and the existence of old institutionalized norms (e.g. Tolbert and Zucker, 1996; Seo and Creed, 2002), may delay the implementation of new rules and routines. (Tagesson, 2007: 251)

Oliver (1991) points out that organizations and their agents may strategically respond to institutional pressure in a variety of ways, ranging from passive conformity, compromise and avoidance, to defiance and proactive manipulation. ‘[D]ecoupling enables organizations to maintain standardized, legitimating formal structures while their activities vary in response to practical considerations’ (Meyer and Rowan, 1977: 357). An eclectic approach towards the explanation and understanding of accounting choice and accounting practice Both the choice of methodology and theoretical approach are questions that often evoke strong emotions and debate within the scientific community. According to Collin et al. (2009), PAT studies tend to have a nomothetic orientation, using large samples and statistical testing, while studies using IT tend to have a more ideographic orientation, using case studies. According to Humphrey and Scapens (1996), there has been a reluctance to combine different social theories in accounting research and the single theoretical approach has been dominating. However, the use of mixed methods (e.g. Falkman and Tagesson, 2008) as well as studies with a multi-theoretical or eclectic approach (e.g. Anessi-Pessina et al., 2008; Collin et al., 2009) are becoming more and more common and accepted within public sector accounting research. A pragmatic way of relating to theory and methodology is to let the aim of the study determine both a methodological and theoretical approach. If the aim of the study is to test or develop a theory, it is of course natural to make use of a single theory approach. However, if the aim of the study is to explain or understand an empirical phenomenon, it could be fruitful to blend theories (Humphrey and Scapens, 1996) and look at them as complementary rather than competitive (e.g. Collin et al., 2009). According to Collin et al. (2009), who combined PAT and IT in order to explain the accounting choices of municipal corporations, the theories to a large extent created the same hypotheses even though they used different logics. According to DiMaggio (1995), ‘[t]he best theory often combines approaches to theorizing, and the act of combination requires compromise between competing and mutually incompatible values’ (DiMaggio, 1995: 396). Another advocate for the eclectic approach is Jacobs. His review paper, ‘Making Sense of Social Practice: Theoretical Pluralism in Public Sector Accounting Research’, concludes with the following sentences:

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This paper provides evidence that researchers do not have to be theoretically committed or theoretically pure to be held in high esteem in the academic community. Long live theoretical promiscuity. (Jacobs, 2012: 18) Thus, even though theory development is important, there is also a need for analytical research that critically analyses empirical phenomena. Such research can benefit from using an eclectic approach and also have a justification in social science.

Summary  The move to accounting on an accrual basis in the public sector began in the late 1980s and early 1990s.  A proposal to introduce the IPSAS as regulatory frameworks for public sector accounting within the EU was rejected by the Parliament. Instead, the possibility of developing EPSAS is now being discussed.  The economic consequences of accounting regulation make the standardsetting process highly political.  Preparers do not always adapt to rules and expectations. Hence, even if the accounting standards support comparability, it does not mean that comparability actually is achieved.  There are two main theories concerned with explaining accounting practice: positive accounting theory (PAT) and institutional theory (IT).  PAT is based on the assumption of self-interest. However, instead of assuming that the agent acts in order to maximize his own wealth, politicians in a democracy can be assumed to maximize the number of votes and opportunistically select particular accounting methods whenever they believe that this will favour their chances of re-election.  IT focuses on the organization and its problems associated with uncertainty, legitimacy and mobilization of resources. The theory is based on the assumption that organizations are influenced by pressure from their institutional environment and adopt the structures and/or procedures that are considered legitimate and are regarded as the appropriate choice.  The use of mixed methods as well as studies with a multi-theoretical or eclectic approach are becoming more and more common and accepted within public sector accounting research. A pragmatic way of relating to theory and methodology is to let the aim of the study determine both methodological and theoretical approach.

Discussion questions 1 Why might there be resistance to establishing common international accounting standards?


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2 Why does the principals’ rationale for monitoring the agent differ between the private and the public sector? 3 According to IT, organizations will apply structures and practices that are considered legitimate by other organizations within their organizational field. Why is it important for an organization to be perceived as legitimate? Can you think of examples of public authorities/entities that have lost their legitimacy? What have been the consequences? 4 Argue for and against theoretical and methodological pluralism in accounting research.

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DiMaggio, P.J. (1995) ‘Comments on “What Theory is Not”’, Administrative Science Quarterly 40(3): 391–97. DiMaggio, P.J. and Powell, W.W. (1983) ‘The Iron Cage Revisited: Institutional Isomorphism and Collective Rationality in Organizational Fields’, American Sociological Review 48(2): 147–60. Downs, A. (1957) ‘An Economic Theory of Political Action in a Democracy’, Journal of Political Economy 65(2): 135–50. Falkman, P. and Tagesson, T. (2008) ‘Accrual Accounting Does Not Necessarily Mean Accrual Accounting: Factors that Counteract Compliance with Accounting Standards in Swedish Municipal Accounting’, Scandinavian Journal of Management 24 (3): 271–83. Gerboth, D.L. (1973) ‘Research, Intuition, and Politics in Accounting Inquiry’, The Accounting Review 48(3): 475–82. Holthausen, R.W. and Leftwich, R.W. (1983) ‘The Economic Consequences of Accounting Choice’, Journal of Accounting and Economics 5(2): 77–117. Hood, C. (1991) ‘A Public Management for All Seasons’, Public Administration 69(1): 3–19. ——(1995) ‘The “New Public Management” in the 1980s – Variations on a Theme’, Accounting Organization and Society 20(2–3): 93–109. Humphrey, C. and Scapens, R.W. (1996) ‘Theories and Case Studies of Organizational Accounting Practices: Limitations or Liberation?’ Accounting, Auditing and Accountability Journal 9(4): 86–106. IPSASB (International Public Sector Accounting Standards Board) (2013) Handbook of International Public Sector Accounting Pronouncements 2013 Edition, International Federation of Accountants. Jacobs, K. (2012) ‘Making Sense of Social Practice: Theoretical Pluralism in Public Sector Accounting Research’, Financial Accountability & Management 28(1): 1–25. Jensen, K.L. and Payne, J.L. (2005) ‘Audit Procurement: Managing Audit Quality and Audit Fees in Response to Agency Costs’, Auditing: A Journal of Practice and Theory 24(2): 27–48. Lapsley, I. (2008) ‘The NPM Agenda: Back to the Future’, Financial Accountability & Management 24(1): 77–96. ——(2009) ‘New Public Management: The Cruellest Invention of the Human Spirit?’ ABACUS 45(1): 1–21. Lüder, K. and Jones, R. (2003) Reforming Governmental Accounting and Budgeting in Europe, Frankfurt: Fachverlag Moderne Wirtschaft. Luft, J. and Shields, M.D. (2002) ‘Zimmerman’s Contentious Conjectures: Describing the Present and Prescribing the Future of Empirical Accounting Research’, The European Accounting Review 11(4): 795–803. Meyer, J.W. and Rowan, B. (1977) ‘Institutionalized Organizations: Formal Structures as Myth and Ceremony’, American Journal of Sociology 83(2): 310–63. Modell, S. (2001) ‘Performance Measurement and Institutional Processes: A Study of Managerial Responses to Public Sector Reform’, Management Accounting Research 12(4): 437–64. Oliver, C. (1991) ‘Strategic Response to Institutional Processes’, Academy of Management Review 16(1): 145–79. Pollitt, C. (2009) ‘Bureaucracies Remember. Post-Bureaucratic Organizations Forget?’ Public Administration 87(2): 198–218.


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Seo, M.-E. and Creed, W.E.D. (2002) ‘Institutional Contradictions, Praxis, and Institutional Change: A Dialectic Perspective’, Academy of Management Review 27(2): 222–47. Tagesson, T. (2007) ‘Does Legislation or Form of Association Influence the Harmonization of Accounting? – A Study of the Swedish Water and Sewage Sector’, Utilities Policy 15(4): 248–60. Tagesson, T. and Eriksson, O. (2011) ‘What Do Auditors Do? – Obviously they Do Not Scrutinize the Accounting and Reporting’, Financial Accountability and Management 27(3): 272–85. Tagesson, T., Klugman, M. and Lindvall Ekström, M. (2013) ‘What Explains the Extent and Content of Social Disclosures in Swedish Municipalities’ Annual Reports’, Journal of Management and Governance 17(2): 217–35, DOI 10.1007/ s10997-011-9174-5. Tay, J.S.L. and Parker, R.H. (1990) ‘Measuring International Harmonization and Standardization’, ABACUS 26(1): 71–88. Tolbert, P.S. and Zucker, L.G. (1996) ‘The Institutionalisation of Institutional Theory’, in S.R. Clegg, C. Hardy and W.R. Nord (eds) Handbook of Organizational Studies, London: Sage Publications. Tuttle, B. and Dillard, J. (2007) ‘Beyond Competition: Institutional Isomorphism in US Accounting Research’, Accounting Horizons 21(4): 387–409. Ward, D.D., Elder, R.J. and Kattelus, S.C. (1994) ‘Further Evidence on the Determinants of Municipal Audit Fees’, The Accounting Review 69: 399–411. Watts, R.L. and Zimmerman, J.L. (1979) ‘The Demand for and Supply of Accounting Theories: The Market for Excuses’, The Accounting Review 54(2): 273–305. ——(1986) Positive Accounting Theory, New Jersey: Prentice-Hall. ——(1990) ‘Positive Accounting Theory: A Ten Year Perspective’, The Accounting Review 65(1): 131–56. Zimmerman, J.L. (1977) ‘The Municipal Accounting Maze: An Analysis of Political Incentives’, Journal of Accounting Research 15(Supplement): 107–44.


International Public Sector Accounting Standards (IPSAS) Johan Christiaens and Simon Neyt

Learning objectives  Understand the context by which the International Public Sector Accounting Standards (IPSAS) project has been developed.  Know the meaning of IPSAS.  Explain how the International Public Sector Accounting Standards Board (IPSASB) is organized.  Be aware of the different publications published by the Board and the importance of the conceptual framework.  Name some of the advantages, disadvantages and limits of the current IPSAS.  Draw up some similarities and differences between the International Financial Reporting Standards (IFRS) and the IPSAS.  Have an understanding of the complexity of the IPSAS implementation and the impact on an entity’s organization.  Be aware of the current situation on the worldwide implementation of the IPSAS.  Have an understanding of the current efforts towards the IPSAS by the European Union.  Indicate the available scientific literature on this topic.

Key words        

Accountancy EPSAS (European Public Sector Accounting Standards) IFAC (International Federation of Accountants) IFRS IPSAS IPSASB IPSAS implementation and adoption Public sector

3.1 Introduction In recent years, the sovereign debt crisis has underlined the importance of good governance through rigorous and transparent reporting of fiscal data.


Johan Christiaens and Simon Neyt

At present, governments and other public sector entities widely develop diverse accounting and auditing practices and many countries do not even have authoritative (homogeneous, well-specified) standards (Christiaens and van den Berghe, 2006). Governments have been repeatedly criticized for their incomplete and inadequate financial reporting. The reporting is often too bulky and consists of complex and conflicting information. The enormous diversity in regulations, accounting practices and financial reporting at different levels of government and types of public entities strengthens this problem. In spite of all these regulations, some of the specific public sector matters are still inadequately regulated, untreated or modified too often. This has created a general dissatisfaction with the manner in which and the methods by which governments and public sector institutions register their work and report to parliament, taxpayers and citizens (Müller-Marqués Berger, 2012). Governments currently cannot meet the basic needs of a good governance system. These needs are the preparation of financial reports in accordance with generally accepted accounting standards, the development of these reports in the interests of their users, and the monitoring of these reports through an audit that provides assurance on compliance with those standards (Christiaens and van den Berghe, 2006). Research has shown the need for more harmonized regulations, driven by New Public Management (NPM) (Müller-Marqués Berger, 2012). Businesslike management tools have been introduced in local as well as central governments to improve efficiency, reliability and transparency (da Costa Carvalho et al., 2007; FEE, 2007; Hood, 1995; Lapsley, 1999). An essential part of NPM is the modernization of financial information systems by the introduction of accrual accounting, which is supposed to facilitate transparency, decision making and accountability (Anessi-Pessina and Steccolini, 2007; Groot and Budding, 2008; Guthrie et al., 1999). Although the international trend to modernize the public sector is businesslike, previous research reveals that the adoption of accrual accounting is drifting apart across and within different countries (Christiaens, 2001; da Costa Carvalho et al., 2007). Therefore, the recent NPM reforms in financial information systems are not homogenous when looking at the content of reforms (Benito et al., 2007; Guthrie et al., 1999; Pina and Torres, 2003). These differences are not only limited to the legislation, but are also noticeable in the implementation of these accounting systems. This diversity in national financial information systems created a need for harmonization and international accounting standards. The search for more harmonized regulation and the need for more businesslike tools in government resulted in the formation of the International Federation of Accountants (IFAC) Public Sector Committee in 1986, later changed into the International Public Sector Accounting Standards Board (IPSASB) in 2004. Departing from their experience in the public sector and the developments of the IAS/IFRS (International Accounting Standards/ International Financial Reporting Standards) for the private sector, IFAC was best placed to work on the global standardization of public sector



accountancy and financial reporting. That is how they gave birth to a series of accounting standards for the public sector, called the International Public Sector Accounting Standards (IPSAS). The underlining philosophy of the IPSASB is that, while most of the basic principles of accounting and auditing seem to be the same across both public and private sectors, the application of these principles raises a number of specific issues in the public sector context (Christiaens and van den Berghe, 2006). The first part of this chapter will provide facts on the IPSAS and the Board. Information on the content, scope and purpose of these IPSAS will be presented. Next, the goals, strategy and authority of the IPSASB will be addressed, together with the standard development process it applies for the standards. A short overview of all IPSAS will follow, with particular attention to the differences between the available accounting systems. Attention will be given to current developments in the conceptual framework and a brief explanation of the differences between the accrual accounting system for private (IFRS) and public sector entities (IPSAS). The second part of the chapter will focus solely on the implementation process of the IPSAS. It starts off with an overview of all processes to go through in order to adopt and implement the IPSAS accounting system. This is followed by an overview of all (dis)advantages of the current IPSAS accounting system. Next, an overview is given of the current situation of the IPSAS implementation in international organizations, countries and on both the central and local levels of government. The section ends with the particular developments towards the IPSAS in the European Union (EU). Part three will provide a short overview of the current scientific literature on the IPSAS and a list of possible topics on the IPSAS to be investigated in the future.

3.2 IPSAS issued by IPSASB IPSAS Accounting standards The IPSAS are a set of accounting standards issued by the IPSASB for use by public sector entities around the world in the preparation of their financial statements (Christiaens and Vanhee, 2012). Public sector The IPSAS are designed to apply to the general purpose financial statements of all public sector entities. In this regard, public sector entities include national governments, regional (e.g. state, provincial, territorial) governments, local (e.g. city, town) governments and related governmental entities (e.g. agencies, boards, commissions and enterprises), unless otherwise stated


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(Christiaens and Vanhee, 2012). Although the IPSAS provide some examples, they remain unclear about the definition of a public sector entity. Moreover, it has not been made clear in what perspective an entity is defined: as a juridical entity, as an economic entity, as a political accountability entity or as something else. Chan (2008) also addressed this problematic nature of defining the boundary of government. The standards do not apply to governmental business enterprises because they comply with the IFRS. A governmental business enterprise within the meaning of the IPSAS is an entity that has all of the following characteristics:  It is an entity with the power to contract in its own name.  It has been assigned the financial and operational authority to carry on a business.  It sells goods and services, in the normal course of its business, to other entities at profit or full cost recovery.  It is not reliant on continuing government funding to be a going concern (other than purchases of outputs at arm’s length).  It is controlled by a public sector entity. The standards do not apply to privately organized non-profit organizations either, and there are no international agreements for this type of organization (Christiaens and Vanhee, 2012). Nowadays, the number of non-profit organizations, often linked to public sector entities, is growing, which emphasizes the importance of developing according standards. General purpose financial reporting The financial reporting system regulated by the IPSAS only concerns General Purpose Financial Statements (GPFS). These are issued for a general audience of stakeholders. These users are unable to demand financial information that meets their specific information needs. Examples of such users are citizens, voters, their representatives, etc. The term financial statements used in the standards covers all statements and explanatory material identified as being part of the GPFS. When the accrual basis of accounting underlies the preparation of the financial statements, the financial statements will include the statement of financial position, the statement of financial performance, the cash flow statement, the statement of changes in net assets, and the notes. For financial statements prepared on the cash basis of accounting, the statement of cash receipts and payments is the primary component. The IPSAS do not handle so-called special purpose financial statements – that is, the statements for those parties who can demand financial statements tailored to meet their specific information needs, such as oversight bodies (Christiaens and van den Berghe, 2006).



The IPSAS Board Goals The IPSASB was established to address, on a coordinated worldwide basis, the needs for those involved in public sector financial management, reporting, accounting and auditing. In order to create a universal system for the financial management and the accountability of the public sector, the IPSASB has been given the authority to develop standards for the public sector. The purpose of the IPSASB is to develop regulations and guidelines on how to improve accountancy, financial reporting and financial management in the public sector, including the promotion of the application of the standards. Convergence is sought between both international and national financial reporting. The IPSASB aims to improve the quality of financial reporting so that it can lead to a better-informed assessment of the resource allocation decisions made by governments, and thereby increase the transparency and accountability, but also simplify benchmarking. The IPSASB achieves these goals by (Christiaens and Vanhee, 2012):  Publishing the IPSAS.  Promoting acceptance and compliance on an international scale with these standards.  Publishing other documents that contain guidance on issues and experience with financial reporting in the public sector. Authority of the IPSASB The IPSASB recognizes the right of governments and national standard setters to establish accounting standards and associated guidance within their own jurisdictions. It has to be emphasized that the IPSASB has no legitimate power whatsoever. This means that the IPSAS are not enforceable on territorial authorities or other public sector entities. The IPSASB sees itself in a supportive function, assisting the legislators and national standard setters in developing new standards or revising existing ones in order to achieve greater comparability of public sector entities’ financial statements at a national and international level. The success of the IPSASB’s efforts is dependent upon the recognition and support for its work from many different interested groups within the limits of their own jurisdiction. The IPSAS can be of great help, especially for all jurisdictions that do not yet have accrual-basis accounting standards for the public sector. That is why developing countries are one of the main target groups, as IPSAS are the only internationally accepted public sector accounting model and therefore can be used as a guideline (Christiaens and van den Berghe, 2006; Christiaens and Vanhee, 2012).


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Strategy and approach The IPSASB takes the view that accrual-based accounting is ‘the way to go’. The main reason is that the disclosure of financial information regarding assets, liabilities, costs of services, taxation, other revenues and cost recoveries is necessary adequately to discharge accountability obligations and meet higher levels of transparency in financial reporting. It further provides managers with better information on their resources, changes in those resources and the costs (recoveries) related to the provision of particular services. The establishment and enforcement of international accrual-based financial reporting standards should enhance the quality and comparability of financial reports of governments and their agencies. The IPSASB decided to use the IFRS as a basis for the development of their own set of appropriate public sector standards. The Board thus pursues the aim of convergence of the public sector standards (IPSAS) with those used in the private sector (IFRS). It develops accrual IPSAS that are converged with the IFRS by adapting them to a public sector context when appropriate. In undertaking that process, the IPSASB attempts, wherever possible, to maintain the accounting treatment and original text of the IFRS unless there is a significant public sector issue that warrants a departure. The specific requirements of the public sector such as transactions without consideration (e.g. taxes and transfers) or public fund management, however, mean that the IPSASB does issue accounting standards for which there is no corresponding IFRS. These IPSAS principally contain rules not dealt with, or only to a minor extent, by existing IFRS (Christiaens and van den Berghe, 2006; Christiaens and Vanhee, 2012). The convergence between IFRS and IPSAS (and its consequences) is one of the main topics in the debate about the IPSAS. This debate will be discussed below. Structure and organization The IPSASB is an independent standard-setting board comprising 18 members. These members are all practitioners with particular public sector experience. Some of them are derived from accountancy or audit firms, others from the financial departments of certain governments. The members are appointed based on recommendations by a Nominating Committee of the IFAC (see Figure 3.1). Elections are held annually in such a way that one third of the members retires each year. The countries represented on the Board at time of writing were Switzerland, Canada (two members), the United Kingdom, the USA, Italy, Morocco, China, Japan, Germany, Pakistan, Kenya, France, South Africa, Malaysia, Romania, New Zealand and Australia. The structures and processes that support the operations of the IPSASB are facilitated by the IFAC. The IPSASB may delegate responsibility for conducting the necessary research and drafting of proposed standards and guidance or draft surveys to steering committees, subcommittees, individuals or



Nominates members

Nominating Committee

IFAC Board

Appoints members

IPSASB Observers .,...- .,...Permanent support



Observe Support for special projects

(a) Land Tenure

of interest IPSASB


Support for special standardization

(a) Land Tenure


Project Advisory

Prepares and issues


(a) Land Tenure


Figure 3.1 Structure around the IPSASB Source: Müller-Marqués Berger, 2012

staff. The observers of the IPSASB include organizations that have an interest in public sector financial reporting, such as the EU, the International Monetary Fund (IMF), the Organisation for Economic (a) Land Tenure . Co-operation and Development (OECD) or the World Bank. As their role is of a supervisory nature, they are not entitled to vote. The fact that the IPSASB lacks an independent oversight board has been a point of criticism; therefore, the development of an oversight board is one of the points on the current agenda. The last development on this topic is that the World Bank, IMF, OECD and other international institutions (IPSASB Governance Review Group) are currently developing oversight proposals (Ernst & Young Government and Public Sector, 2013c). The Board is primarily supported by the IFAC. Apart from financial support from the IFAC, the IPSASB also receives funding from external sources. It enjoys significant financial support from international organizations such as the Asian Development Bank (ADB), the European Commission (EC) and the United Nations (UN). Further financial resources are provided by the governments of Canada, New Zealand, the USA and Switzerland (Christiaens and Vanhee, 2012). Due process To develop a standard, the IPSASB has chosen a due process that gives interested parties such as the IFAC member organizations, auditors and accountants, preparers of financial statements, standard setters and


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individuals the opportunity to submit their comments. This way, the Board tries to get as much input and support as possible from all stakeholders. The due process is a typical example of the Anglo-Saxon influences on the IPSASB, where practitioners and outsiders have a bigger leverage on the development of accounting systems than they do in Europe. In addition, the IPSASB has a consultative group to discuss important projects, technical questions and priorities relating to the working programme. The due process for a project generally comprises the steps illustrated in Figure 3.2. The process of developing a standard starts with a study on national accounting requirements and practices and an exchange of views about the issues with national standard setters. Second, the decision has to be made by the Board whether a standard should be developed on a certain matter or not. While the IPSASB is ultimately responsible for selecting the subject matter to be addressed by its standards, guidelines, studies and occasional papers, suggestions and proposals from interested individuals and organizations are encouraged. Depending on the project, the IPSASB will either choose to develop an exposure draft (ED) directly or to start with a consultation paper and develop the ED afterwards. Consultation papers explore the subject in detail and provide the basis for further discussion, development and policy formation. Both the consultation papers and EDs are usually developed with the input of a task force or project advisory panel, and have to be approved by the Board. After this approval, the documents will be made available to the general public on the website of the IFAC. The process further foresees a phase for comment and subsequent revision (Invitation to Comment, or ITC), which lasts for at least four months. If changes to the ED are made after the initial exposure, the IPSASB will re-expose the document for review and comment. Based on the comments received, the IPSASB will revise the proposed standard and finally approve it. A majority of two thirds of the voting rights on the IPSASB is required for approval of consultation papers, EDs or standards. English is the common language used for all of the documents involved in these working procedures (Christiaens and Vanhee, 2012).

Study 'as is'

& exchange ---+ of views

Decision to develop

Exposure Draft (ED)



Consultation paper

Figure 3.2 Due process

/ r---+

Invitation to Comment


Invitation to Comment





IPSASB publications The primary goals is to develop the IPSAS themselves. In addition to the IPSAS, the Board issues other, non-binding publications such as guidelines, studies, occasional papers, information papers, research papers, special reports, consultation papers and exposure drafts, all dealing with specific accounting issues for the public sector (Christiaens and van den Berghe, 2006). Standards The standards consist of unambiguous rules that public entities are required to apply in their accounting practices and financial statements. The IPSAS recognize two governmental accounting systems: accrual accounting and cash accounting. The IPSASB has issued one standard on the cash basis of accounting. All other IPSAS are developed exclusively on the accrual basis of accounting, in line with the accounting concept applied in the IFRS. This documents the IPSASB’s preference for this basis of accounting. It should be noted that, initially, the standards programme also encompassed the development of standards for the modified cash and modified accrual basis. This is also the case in the preceding IPSAS studies, in which four kinds of governmental accounting systems were considered:  Cash accounting: a basis of accounting that recognizes transactions and other events only when cash is received or paid. It measures financial results for a period as the difference between cash receipts and cash payments. Cash flow statements and cash balances are the most common documents. However, this definition of cash accounting lacks the importance of the authorizing budgetary accounting aspects. In many governments, traditionally the focus is on budgetary accounting in which the different budgetary stages are considered and not on cash accounting just like that.  Modified cash accounting: this system recognizes transactions and other events on a cash basis during the year, but it also takes into account the unpaid accounts and/or receivables at year end. In fact, the books are held open for around a month after year end.  Modified accrual accounting: this system recognizes transactions and other events on an accrual basis, but certain classes of assets or liabilities are not recognized. A typical example is the expensing of all non-financial assets at the time of purchase.  Accrual accounting: a basis of accounting under which transactions and other events are recognized when they occur, regardless of when the payment is actually received or made. Therefore, the transactions and events are recorded in the accounting records and recognized in the financial statements of the periods to which they relate (IFAC, 2008).


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However, many constituents argued strongly and convincingly that it was not appropriate further to develop standards for the modified cash and modified accrual bases. After issuing an ITC on this matter in 1999 and receiving an overwhelming response in support of developing IPSAS for only the cash and accrual bases, the programme was refocused on developing standards for only these two bases. The subdivision into four systems has thus been outdated. Modified cash systems are still present, but only in countries that are in the transition towards an accrual-based system. Cash Budgetary or cash accounting used to be the mainstream accounting and financial reporting system in the public sector. It is based on the registration of appropriated and authorized budgets and the recording of the stages of spending those budgets. Its biggest advantage is its simplicity and accuracy, which makes it easy to control and monitor. The main downside of this system is that it provides little information concerning liabilities and future potential benefits of assets. The need for better accounting information, comparability and improved accountability has led to the transition towards accrual-based accounting. Nevertheless, budgetary accounting is still used to manage budget appropriations in a number of governments, i.e. in the context of annual discussion and approval as well as follow-up of the budget to spend (Christiaens et al., 2013; Vašicˇ ek et al., 2010). There is only one standard that is addressed to entities that prefer cash accounting. In this standard (CASH BASIS IPSAS Financial Reporting Under the Cash Basis of Accounting, 1/2003), the principles are described for the presentation of general purpose financial statements on a cash basis. The financial report provided by the IPSAS CASH standard is the ‘Statement of Cash Receipts and Payments’ (statement of revenue and expenditure). The standard comprises two parts: the first part includes mandatory requirements that are to be complied with and a second part that identifies encouraged (but not required) disclosures and treatments (Christiaens and van den Berghe, 2006). Accrual During recent decades and driven by NPM, many governments have reformed their accounting systems towards accrual accounting, often as an additional accounting system alongside their traditional budgetary accounting system. Accrual accounting, particularly the IPSAS, is better suited for planning, financial management and decision making, as it delivers a better view on the (financial) impact of public policies. It provides a greater (internal and external) accountability of public resources and improves cost awareness. The downsides of this system are the increasing complexity and cost (Christiaens et al., 2013; Vašicˇ ek et al., 2010).



At present, there are 32 accrual-based standards, of which 28 standards are based on the IAS/IFRS applicable for private sector companies. Standards 21, 22, 23 and 24 relate to situations that only occur in the public sector. The most important standards are IPSAS 1 and 2, as they deal with the presentation of financial statements and thus form the basis for all the other standards. These standards on presentation of financial statements and accounting policies are detailed in Box 3.1.

Box 3.1 Overview of IPSAS 1–2 IPSAS 1: Presentation of financial statements 5/2000 (Revised 2006) The standard sets out overall requirements for the presentation of financial statements prepared under the accrual basis of accounting, and provides guidance for the structure and minimum requirements of the content of such financial statements. The objective is to provide information about the financial position, financial performance and cash flows of an entity that is useful to a wide range of users in making and evaluating economic decisions. A second important objective is that it provides information to make a prediction on the level of resources required for continued operations, the resources that may be generated by continued operations and the associated risks and uncertainties (Christiaens and van den Berghe, 2006). To meet this objective, IPSAS 1 requires financial statements to provide information about an entity’s assets, liabilities, net assets/equity, revenue, expenses and cash flows. It sums up a complete set of required components:     

A statement of financial position (Balance Sheet). A statement of financial performance (Profit/Loss Statement). A statement of Changes in Net Assets. A cash flow statement. A comparison of budget and actual amounts (when the entity makes publicly available its approved budget). This is possible either as a separate additional financial statement or as a budget column in the financial statements.

Notes With regard to the financial statements, certain principles have to be followed:  When preparing financial statements, a public sector entity is required to assess whether it can be assumed that it is able to continue as a going concern. This is called the going concern assumption. This is required


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unless there is an intention to liquidate the entity or discontinue business or administrative operations. Should the management of a public sector entity have significant doubt as to the entity’s ability to continue as a going concern, such uncertainties must be disclosed. The presentation and classification of items in the financial statements must be consistent from one period to another unless required otherwise by a significant change in the nature of the entity’s operations. Each material class of items in the financial statement must be presented separately. Aggregating items of a different nature or function is permitted only if they are immaterial individually. Comparative prior-period information must be presented for all amounts shown in the financial statements and notes. Comparative information is included for narrative and descriptive information where relevant to an understanding of the current period’s financial statements. Financial statements are presented at least annually. If the financial statements are presented for a period other than one year, disclosure thereof is required. The IPSAS require that financial statements complying with IPSAS make an explicit and unreserved statement of such compliance in the notes. As this statement itself is required for full compliance, its absence would render the whole financial statement non-compliant, even if there were otherwise full compliance (Christiaens and van den Berghe, 2006).

IPSAS 2: Cash flow statements 5/2000 This standard requires the presentation of information about the historical changes in cash and cash equivalents of an entity by means of a cash flow statement, which classifies cash flows during the period by operating, investing and financing activities. The cash flow statement identifies the sources of cash inflows, the items on which cash was expended during the reporting period, and the cash and cash equivalents as at the reporting date. The cash flow statement is intended to provide users of financial statements with information for both accountability and decision-making purposes. Cash flow information allows users to understand how a public sector entity raised the cash it required to fund its business and administrative operations, and how that cash was used. These cash flows are reported separately by operating activities, investing activities and financing activities (Christiaens and Vanhee, 2012).

The standards on specific transactions and items up to time of writing are detailed in Box 3.2. The following topics are discussed further in the IPSAS: consolidation, equity, income from exchange and non-exchange transactions, inventory, leasing, financial instruments, tangible assets, provisions, impairments, cost of personnel, etc.


Box 3.2 Overview of IPSAS 3–32 IPSAS 3: Net surplus or deficit for the period, fundamental errors and changes in accounting policies 5/2000 (Revised 2006) This standard prescribes the criteria that must be observed when selecting and changing the principles of financial reporting, together with the accounting treatment and disclosure of changes in these principles, changes in accounting estimates and the correction of errors.

IPSAS 4: The effects of changes in foreign exchange rates 5/2000 (Revised 2006) Determines how changes in exchange rates in financial statements are reported.

IPSAS 5: Borrowing costs 5/2000 This standard requires that financial costs are recognized immediately as an expense in the period in which they are realized. As an alternative method, the standard suggests that financial costs that are directly attributable to the acquisition, construction or production of a qualifying asset are activated.

IPSAS 6: Consolidated and separate financial statements 5/2000 (Revised 2006) IPSAS 6 requires all controlling entities to prepare consolidated financial statements which consolidate all controlled entities on a line by line basis. The Standard also contains a detailed discussion of the concept of control as it applies in the public sector and guidance on determining whether control exists for financial reporting purposes.

IPSAS 7: Accounting for investments in associates 5/2000 (Revised 2006) Determines the way in which investments should be included in the consolidated financial statements (based on the ‘equity method’ or the ‘cost method’) in affiliated entities.

IPSAS 8: Financial reporting of interest in joint ventures 5/2000 (Revised 2006) Describes the accounting and reporting methods that have to be applied for joint ventures in which public and non-profit entities are participating (proportionate consolidation or equity method).



Johan Christiaens and Simon Neyt IPSAS 9: Revenue from exchange transactions 7/2001 This standard sets out the conditions for the recognition of revenues arising from exchange transactions. Revenues are recognized when it is probable that future economic benefits or service potential will flow to the public entity and when these benefits can be measured reliably.

IPSAS 10: Financial reporting in hyperinflationary economies 7/2001 This standard prescribes how financial statements of public entities that report in the currency of a hyperinflationary economy should be presented.

IPSAS 11: Construction contracts 7/2001 This standard specifies the accounting treatment of revenues and costs for contracts in progress.

IPSAS 12: Inventories 7/2001 (Revised 2006) The accounting treatment of inventories is addressed in this standard, in particular the cost formulas that are used to allocate the (in)direct costs of stocks.

IPSAS 13: Leases 12/2001 (Revised 2006) The basis of accounting and reporting of financial and operational leasing agreements, followed by the proper explanation of both the lessor and lessee.

IPSAS 14: Events after the reporting date 12/2001 (Revised 2006) This standard prescribes when an entity should adjust its financial statements for events after the balance sheet date and the information that the entity has to include about the date on which the financial statement has been issued for publication and about the events after that date. The standard also requires that an entity not prepare its financial statements on the continuity principle if events after the balance sheet date indicate that the concern of the continuity principle is not appropriate.

IPSAS 15: Financial instruments – disclosure and presentation 12/2001 This IPSAS has been replaced by IPSAS 28, 29 and 30.

IPSAS IPSAS 16: Investment property 12/2001 (Revised 2006) The accounting treatment and presentation of investment properties are the subject of this standard. An investment property is defined as a property (land, building, part of a building, or both) that is held to earn rentals, a capital appreciation or both, and which is not used for the production or supply of goods and services in the ordinary course of business.

IPSAS 17: Property, plant and equipment 12/2001 (Revised 2006) Describes the accounting treatment of tangible assets. A specific case involves so-called ‘heritage assets’. These assets have a particular cultural or historical significance. An entity is not required to recognize such capital goods as assets. However, if the entity decides to recognize them as assets anyway, then they must follow the reporting requirements of this standard.

IPSAS 18: Segment reporting 6/2002 The accounting policies for segment reporting are prescribed here. A segment is a separate activity or group of activities of an entity for which it is advisable to provide a separate report in order to assess the entity’s performance in this activity, in relation to the predetermined objectives. This makes it possible to make more informed decisions on the allocation of resources in the future. A distinction can be made between geographical segments and service segments.

IPSAS 19: Provisions, contingent liabilities and contingent assets 10/2002 This standard identifies the circumstances in which provisions, liabilities and contingent assets should be included, how they should be valued and how they should be reported.

IPSAS 20: Related party disclosures 10/2002 This standard regulates the information an entity has to provide about related party disclosures and transactions. Major components that are reported are about related parties: the identification of the parties that have some kind of control power or significant influence and information about the transactions between those parties.



Johan Christiaens and Simon Neyt IPSAS 21: Impairment of non-cash-generating assets 12/2004 This standard describes the procedures that an entity shall apply on the impairment of non-cash-generating assets (i.e. assets that are not held to generate commercial revenues).

IPSAS 22: Disclosure of financial information about the general government sector 12/2006 Governments that prepare a consolidated financial statement must follow certain rules if they choose to provide information about the entire public sector (system of national accounts) to which they belong.

IPSAS 23: Revenue from non-exchange transactions (taxes and transfers) 12/2006 This standard prescribes the obligations on the financial reporting of revenue from non-exchange transactions, other than those that give rise to a merger of entities.

IPSAS 24: Presentation of budget information in financial statements 12/2006 In the case of entities that do/do not require their approved budget in the financial statement, they need to make a comparison between the budgeted amounts and actual amounts that flow from the execution of that budget. This can be presented in a separate report or by adding some columns to the financial statement. If there appear to be material differences between the budget and the actual figures, the standard suggests that explanation for the cause be given.

IPSAS 25: Employee benefits 02/2008 Describes the reporting requirements for different categories of personnel costs and fees.

IPSAS 26: Impairment of cash-generating assets 02/2008 This standard describes the procedures that an entity shall apply on the impairment of cash-generating assets (i.e. assets held to generate commercial revenues).



IPSAS 27: Agriculture 12/2009 The accounting, presentation and disclosure regarding agricultural activities (such as cattle, plantations, fruit trees, etc., as well as the agricultural products thus to be achieved, e.g. dairy products, wool, fruit, wood, etc.) and government grants related to it are addressed in this standard.

IPSAS 28: Financial instruments – presentation 01/2010 Covers the reporting of financial instruments and the distinction between financial assets and liabilities from the perspective of the issuer. The content of this standard is related to the principles addressed in IPSAS 29 and 30.

IPSAS 29: Financial instruments – recognition and measurement 01/2010 This standard is about the recognition and measurement of financial instruments.

IPSAS 30: Financial instruments – disclosures 01/2010 This standard regulates the presentation of financial instruments.

IPSAS 31: Intangible assets 01/2010 Focuses on the recognition and accounting treatment of intangible assets that are not dealt with specifically in a different standard. It specifically deals with government licensing, broadcasting rights, etc.

IPSAS 32: Service concession arrangements – grantor 10/2011 Deals with contracts that governments make with other (public) entities to establish infrastructure (e.g. roads). This standard deals with accounting and reporting prescriptions from the standpoint of the grantor. Please note that some of the IPSAS standards have been amended by other IPSAS that were published later.

Conceptual framework As mentioned before, the IPSASB develops accrual IPSAS that are copied from IFRS by adapting them to a public sector context when appropriate. However, the Board has realized that the specific nature of the public sector calls for an individual framework. In cooperation with national standard


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setters, they are taking steps towards drafting such a framework for the public sector. An accounting system is defined by its conceptual accounting framework, which is a perspective through which the financial reporting is driven. Since there are different accounting frameworks caused by different user needs, it is quite obvious that there are different possible accounting systems each having their own principles, policies and disclosures. For example, reporting in the perspective of subsidized entities like hospitals or education will differ from financial reports of private sector organizations that are only interested in profitability. Based on these different perspectives and on the different user needs, the accounting system will make choices in valuation rules, accounting processes and disclosures. One should not forget that accounting standards and rules actually have no meaning if they are not based on a predefined conceptual framework. This framework has to keep in mind the aim of the accounting system, its targets, to whom they will be reported and thus how the report should be conceptualized. For those reasons, the IPSASB is occupied with the development of its own conceptual framework, which should be finished by June 2014. The purpose of this project is to develop concepts, definitions and principles that respond to the objectives, environment and circumstances of governments and other public sector entities (Ernst & Young Government and Public Sector, 2013c). The process towards this conceptual framework has been divided into four phases, namely:  Phase 1: defining the role, authority, scope, objectives and users of the framework.  Phase 2: the elements and recognition in financial statements.  Phase 3: the measurement of assets and liabilities in financial statements.  Phase 4: presentation in General Purpose Financial Reports. All of these phases are carried out in three steps, starting off with a consultation paper, followed by an exposure draft that is open for comment, and ending with the final conceptual framework. The whole process should be finished by June 2014. This framework should assist the standard setters in developing consistent and relevant standards and provide broad guidance to prepare auditors on the resolution of specific issues not yet the subject of specific standards (Christiaens and Vanhee, 2012). Despite all the efforts, some critical remarks have been made on the Board’s approach to this topic. One of the major criticisms is that the framework is formulated too broadly. The framework should be limited to the ‘architecture work’ for actual standards and should be based on preceding user needs research. Making this framework too extensive creates the danger that the framework will be perpendicular to previously developed standards. This problem arises from the fact that these standards were developed earlier than the framework, whereas this should normally happen the other way around.



Additionally, a conceptual framework should be based on user needs research, but, in the IPSAS conceptual framework, this is hardly the case as they have only sent out a consultation paper rather than researching user needs. Other publications Alongside the standards, the IPSASB also develops other non-binding publications such as guidelines, studies, occasional studies, information papers, research reports, special reports, consultation papers and exposure drafts. All these publications have different purposes. The guidelines developed by the IPSASB contain recommendations concerning accounting, financial reporting and auditing in the public sector. The studies offer advice on financial reporting in public sector entities, based on research of best practices and most effective methods for dealing with the issues being addressed. Occasional papers try to provide more information on particular topics in the public sector, based on case studies in some of the IPSAS-compliant countries. All these publications are non-mandatory. However, over the years, the other IPSASB publications have evolved. The transition from the IFAC Public Sector Committee into the IPSASB has been of particular importance in this regard. After publishing two guidelines at the end of the 1980s, the Committee switched its attention to studies, occasional papers in the 1990s, and information papers, research reports and special reports between 2004 and 2006. Since the change into the IPSASB in 2004, the focus has altered to making the conceptual framework. Only one study has been published since that time, on the transition to accrual-based accounting, in 2011. The Board is now working on the development of recommended practice guidelines (RPGs). In July 2013, the IPSAS issued its first Recommended Practice Guideline (RPG 1), called ‘Reporting on the Long-Term Sustainability of and Entity’s Finances’. The focus on making standards, on the other hand, has always been high, as this is the core task of the current Board and the previous Committee. IPSAS versus IFRS IPSAS are based on IFRS and, in many respects, are almost identical. This is a logical consequence of the fact that the IPSASB does not have the resources to start from scratch with every standard it develops. Furthermore, those standards that are not copied from IFRS are often of a lower quality, just because of this lack of resources. Having said that, there are a number of key conceptual differences that underpin the IPSASB to make the standards relevant to the public sector. One can also see an increase in the number of public sector-specific standards being developed by the IPSASB, signifying a possibly greater degree of divergence from IFRS in the future. In particular, we can expect to see more


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significant differences in the future due to the separate conceptual framework projects currently being undertaken. The point of departure between IPSAS and IFRS is as follows. IFRS primarily provides investors, lenders and other users of financial statements with information about the entity’s financial performance and position to help those users to make investment and credit decisions. This commercial ‘bottom-line’ profit focus of private sector financial reports is not appropriate for the non-trading government sector. IPSAS financial statements are designed to provide information about how an entity has utilized its resources, and about the cost of service delivery. This has an effect on the way in which the elements of the financial statements are defined and the criteria for when they should be recognized. Furthermore, there is a need for standards to be developed to deal with the specific information needs of the users of public sector financial statements. These are some of the particular differences between IFRS and IPSAS:  IPSAS introduce the concept of service potential into the definition of assets, liability, income and expenditure. Therefore, they recognize an item as an asset even though it might not be expected to generate future cash flows for the entity. IPSAS recognize that the entity’s primary intention is not to earn income, but to provide a public service. In some cases, governments need to continue a public service even though it does not generate enough money to be profitable.  The IPSAS recognize the concept of non-exchange transactions, covered in IPSAS 23. This covers revenues arising from transfers, grants, taxes, fines and levies. These are all transactions for which there are no conditions attached that give rise to a corresponding obligation to repay or return the transaction.  IPSAS 24, Presentation of budget information in financial statements, requires entities that make their annual budgets publicly available to present a comparison of the budgeted and actual information as part of their financial statements.  IPSAS 21 deals with the matter of non-cash-generating assets, a topic that only appears in the public sector.  The IPSASB has also not yet considered many of the recent new or amended IFRS, because it is focusing on the completion of the conceptual framework. Therefore, it is not yet clear to what extent these changes will be adopted, which also enhances the differences between both systems. (Summarized from Ernst & Young Government and Public Sector, 2013b; Aggestam-Pontoppidan, 2011)

3.3 Adoption and implementation of IPSAS The IPSAS are not a ready-made package of accounting standards that can easily be implemented in every country or jurisdiction in the same way.



Existing financial reporting systems cannot just be replaced by a new one. The transition or implementation towards a new system of financial reporting involves changes in the organization and functioning of government and its entities. The modification process will therefore be different in every country, jurisdiction and organization. Implementation process The implementation process is often preceded by a number of preparatory activities. The importance and duration of this preparation phase cannot be underestimated. Figure 3.3 gives an overview of how a conversion process towards the IPSAS should look and includes the major steps that need to be taken. Extensive planning in this process is crucial for success (AggestamPontoppidan, 2011). It starts with running a sensitivity campaign and a search for support to develop national public sector accounting standards based on the IPSAS. The importance of communication with all internal and external stakeholders should not be underestimated (Aggestam-Pontoppidan, 2011). Visible highlevel governmental support is needed at first, but a top-level conversion to the IPSAS may not be sufficient as it impacts all levels of accounting in government. Some countries might prefer a centralized approach (e.g. New Zealand), others a decentralized method (Sweden) (Guthrie et al., 1999). All key decision makers and stakeholders need to support the conversion process. Gap analyses, feasibility studies or IPSAS readiness checks need to be performed once support has been established. It is not merely about imposing standards – the organization and its current transactions have to be taken into account. A gap analysis (a comparison between the current and potential situation) will provide a quantified presentation of the main differences between the current accounting system and the IPSAS, and should highlight the key accounting and reporting issues that need to be addressed, as well as

GAP-analysts/ feasibility


Capacity building

IT S processes


First-time adoption, opening balance sheet

Figure 3.3 Major steps in a conversion project Source: Ernst & Young Government and Public Sector, 2013d



Johan Christiaens and Simon Neyt

the business processes that may be impacted by IPSAS. These results will be the basis for an informed decision on how to proceed with the IPSAS conversion and on the options offered in some of the IPSAS. The next step is to create the necessary knowledge of public sector accounting and financial reporting standards, based on the readiness of the country, jurisdiction or organization. The development of a project plan is the first step in this capacity building, as it defines the needs and estimates the cost of the entire process. The implementation process is a project, so objectives, planning, monitoring and evaluation have to be defined. The project set-up should also enable the organization to manage the change while continuing to run its normal business activities. Capacity building includes the development of an accounting manual, guidelines, checklists, templates, etc. which deal with some of the key transactions. Recruitment and training will also contribute to a growing capacity, as entities often have a low number of personnel with proper financial management competencies or IPSAS knowledge. The IPSAS conversion further requires the design or redesign of business processes, the design and testing of controls, user management, etc. This includes changing the IT support tools of an organization as well. The importance of change management and IT implementation is often underestimated. A multidisciplinary steering committee could provide the proper accounting, technology, internal audit and management aspects in this regard. All additional and/or modified reporting requirements for the consolidated annual report have to be listed, and translated into the financial reporting package. One of the most difficult steps in this process is the opening IPSAS statement of financial position. This includes the registration and valuation of assets and liabilities, design and implementation of a financial statement closing process, etc. The conversion process also includes the roll-out of new business processes and procedures, including internal control and risk management. This includes the audit or pre-audit compliance review of the IPSAS financial statements (audit readiness check), as the IPSAS implementation also requires different expertise on the audit activities (Christiaens and Vanhee, 2012). The whole implementation process is clearly no purely technical exercise, involving the reordering of information and the rearrangement of financial statements. It affects the entity’s organizational model. Among the strategic decisions to be taken when an entity plans a conversion to IPSAS is the question of whether to undertake the conversion gradually or go for a ‘big bang’. Although there may be many practical as well as strategic reasons to opt for a gradual conversion, such as spreading the investment, it is generally preferable to avoid gradual conversion if at all possible. It is important to plan carefully all aspects of the conversion, so that a rollout goes smoothly. Christiaens and van den Berghe (2006) prefer a phased approach, with both a transformational and transactional phase. The transformational phase, which could take some two or three years, continues the



existing (traditional) accounting system with regulations towards IPSAS reporting at the end of every year. During the transactional phase, the entities are allowed additional time to meet the full requirements of specific accrualbased IPSAS or are provided relief from certain requirements when initially applying the IPSAS. At this point, the entity applies all the accrual-based IPSAS and could choose to apply any transitional provisions in an individual accrual-based IPSAS. These transitional provisions are also supported by the IPSASB and should facilitate full compliance with accrual-based IPSAS (Christiaens et al., 2010; Christiaens and Vanhee, 2012). The story does not end with the completion of the conversion process. Embedding these changes is needed to enable the organization to get used to the new language and business operations in a comfortable way. Continuous learning and training throughout the entity, completing systems design, testing new processes and procedures and the modification of existing (budgeting) processes are all part of this embedding process. Critical perspectives on IPSAS Advantages Obviously, the IPSAS and their implementation can bring some significant advantages to government financial reporting and management.  First of all, the IPSAS should bring a significant enhancement to the quality of GPFS prepared by public sector entities. They establish appropriate financial reporting practices and consistency in the application of those practices, ensuring that different governments apply the same rules. Such standards can provide governments with cost-effective means of ensuring that the financial reports of public sector entities within their jurisdiction include financial information of sufficient quality to discharge accountability obligations to users and to support informed decision making by a wide range of external users. The adoption of the IPSAS will also provide greater efficiency and effectiveness in the audit and analysis of governmental financial reports, as common rules are adopted around the world for the financial reporting of similar transactions and events. In turn, this improves the basis for decisions on the appropriation of funds by public authorities allowing for greater transparency and accountability. Given the poor quality of financial information currently available to public sector managers in many jurisdictions, it is likely that internal users will also benefit from the development and application of the IPSAS (Christiaens and Vanhee, 2012).  The worldwide harmonization of regulations should enhance the comparability for users of the financial statements and all others concerned about financial transparency, both within a country or jurisdiction from period to period, and between entities for the same period. The development and


Johan Christiaens and Simon Neyt maintenance of standards that reflect internationally agreed minimum benchmarks of best practice in financial reporting by governments and non-business public sector entities can also support governments concerned with enhancing the quality and consistency of financial reporting by public sector entities within their jurisdiction (Christiaens and Vanhee, 2012). Both local and central governments applying the IPSAS could enhance (inter)national comparability of financial information, and facilitate the consolidation of financial statements in accordance with international organizations. Convergence with existing IFRS standards further increases the usability of the standards by accountants who are familiar with the IFRS standards. The IPSAS do not reinvent something that already exists. Despite their convergence with the existing IFRS, the IPSAS deal with some public sector-specific issues in financial reporting that are necessary to make the system work in this sector. The recognition of two possible accounting scenarios in their design is positive: both the cash and accrual accounting systems are taken into account. The IPSASB also pays attention to both the output of financial reporting and to alignment with statistical reports. The IPSASB not only focuses on the development of standards, but also provides support for the implementation process. It further foresees a transition period, which is crucial for proper implementation of a new accounting system. The fact that the IPSAS are created by the IPSASB, an independent team of experts, as part of the independent IFAC, ensures that there is no bias when making these standards.

Limits Despite the great efforts and progress made by the IPSASB in recent years, there are a number of limits to the current IPSAS accounting system that get in the way of worldwide implementation (Christiaens and Vanhee, 2012). These limits are in both content and system. Some of the major concerns around the current IPSAS are regarding content. Unconditional adoption of the businesslike accounting framework (IFRS) facilitates the use of the IPSAS system for accountants familiar with the IFRS. However, public administrators, the eventual users of the new accounting system, are not interested in this advantage as they are unfamiliar with the IFRS.  Scientific research has shown that private sector practices are not necessarily well suited to the public sector (Guthrie, 1998). The IFRS framework of enterprises was assumed to be perfectly transferable to the government and not-for-profit sector, but this is not the case. Consequently, there is no conceptual accounting framework that suits the public sector (yet). As mentioned above, the IPSASB has acknowledged this need to define its



own conceptual accounting framework and for that reason has started work on one. The work in progress, however, has already been criticized for its lack of proper user needs research as a basis for the framework, and the fact that the framework is formulated too broadly, which makes it contradictory to existing standards.  One of the problems arising from the adoption of the IFRS is the measurement of assets by IPSAS for certain non-businesslike governmental assets. The IPSASB, inspired by the IFRS, defines all capital goods as businesslike assets in the balance sheet. Consequently, the IPSAS use ‘fair value accounting’ as the valuation principle for the measurement of assets, using the economic value as the valuation standard for all assets. However, this definition does not embrace the specific purpose, nature and environment of certain governmental capital goods such as heritage assets, collections in museums, landscapes, historical artefacts and military assets. These are retained and maintained to provide services individually or collectively to the public mostly free of charge. Hence, they have a social rather than an economic status. These social benefits do not flow back to the government as the owner of the asset. The businesslike system, recommended by the IPSAS, therefore creates some difficulties and dilemmas during the measurement of valuation of assets. Christiaens et al. (2012) argued that the measurement of the assets should be dependent on the status given to these assets by the government or legislator: capital goods given the status of businesslike assets should be included on the balance sheet, while governmental capital goods (merit goods and collective public goods), given a societal status leading to social benefits rather than economic benefits, should not be included as assets on the balance sheet, but reported separately. Until now, the IPSASB has not tackled this public sector-specific issue.  Some of the IFRS-based standards have not been adapted enough to make them applicable in the public sector. IPSAS 19, for example, lacks guidance on how the state should deal with the situation of being both the legislator and accountant. Another example is IPSAS 29 on the reporting of loans, which has been written on market terms. This is not the case in many countries, though, like Sweden for example.  Despite the specific topics on public sector issues in IPSAS 21, 22, 23, 24 and 32, the IPSASB’s standards still lack guidance on some (public sectorspecific) topics. There are gaps in the IPSAS framework (e.g. social benefits) and consolidation principles, which do not cover the practical issues of consolidation of general government financial statements. The Board has acknowledged these problems and is currently working on some projects to fill these gaps (Ernst & Young Government and Public Sector, 2013a, 2013c). Some of the other limits in the contents of the IPSAS that should be resolved in the future are:


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 The IPSAS lack a uniform chart of accounts so that every entity has to develop its own system of accounts in order to publish the financial statements (Christiaens and Vanhee, 2012).  The transition to the IPSAS involves the preparation of an opening IPSAS statement of financial position at the date of transition to IPSAS (a first balance sheet). This opening statement plays a vital role because it is the starting point for subsequent accounting under the IPSAS. However, there is a lack of attention to the problems with these first statements of financial position.  On top of these problems, the financial reporting seems to have an inadequate alignment with the statistical reports required in the context of the European System of Accounts (ESA 2010).  Furthermore, the IPSAS accounting system has created no arrangements for the non-profit sector (yet), a growing sector within the public sector.  The IPSAS could be seen as a missed opportunity to discuss the role of accounting in the control and governance of agencies. We will use the Flemish local governments as an example here: the IPSAS-like ‘policy and management cycle’ (BBC, ‘Beleids – en beheerscyclus’) reform uses accounting both as a way of controlling the budget and as a tool for expost monitoring of the autonomous entity of local governments. The use of BBC as a governance tool has been a particular decision by the Flemish regional government, adding to the fact that BBC has been made IPSASlike. The IPSAS merely concentrate on proper control of the budget and not on the use of this new financial reporting as a tool to control agencies. We could conclude that this idea of governance and control of agencies has not been embedded in the IPSAS accounting system, but the IPSAS, on the contrary, could be used as a tool to open new doors to better governance of the autonomous entities of government. All of the other limits are owing to the way that the IPSAS and existing accounting systems are organized and institutionalized.  Another limit of the IPSAS is the fact that they are not enforceable. Neither the IPSASB nor the IFAC has the authority to impose the standards. Consequently, the success of the IPSAS depends on the recognition and support of various interest groups acting within the limits of their own jurisdiction (Christiaens and Vanhee, 2012). In other words, the IPSAS are acknowledged as recommendations, since the IPSASB does not have enough authority to demand that public sector entities from sovereign governments comply with them. The independence of the IPSASB from national governments, while having its merits, might therefore lead to the IPSAS being ignored or even opposed, unless within each country there is more involvement from senior budget and accounting officers, as well as engagement with private sector auditors to perform governmental financial audits on the IPSAS. To make the IPSAS mandatory for all EU member



states, it would be essential for public authorities to be involved in the process of drafting and issuing such standards. Moreover, a costly interpretative body needs to be established to avoid different national interpretations (Ernst & Young Government and Public Sector, 2013a; Grossi and Soverchia, 2011; Oulasvirta, 2013). The potential costs of harmonization for a medium-sized EU country of moving from a cash-based accounting system to an accrual-based accounting system, for central government but no other layers of government, could be up to €50 million. In France, for example, the costs reached a total of €1,500 million. Some stakeholders are therefore concerned that the potential costs of implementing the IPSAS could outweigh the benefits (Ernst & Young Government and Public Sector, 2013a). This immense cost is owing to the whole implementation process, as discussed, including the rewriting of accounting manuals to conform to local requirements, the necessary training, the changes made to organizational processes, etc. The IPSASB prefers a short transition period. This is somewhat problematic for European countries with an extensive portfolio of assets and capital goods, as accrual accounting requires the identification and valuation of assets. An extension of the transitional period would be a more desirable approach, for example by having a transformational period. Making the transition period too long, on the other hand, creates the danger of postponement and cancellation (Christiaens and Vanhee, 2012). The implementation process has to be considered a medium- to long-term project, taking into account the scale and costs. Depending on the degree of preparedness, it could take three or four years of legislation and five years of technical implementation (Ernst & Young Government and Public Sector, 2013a). Existing and dominating local or country-wide business accounting rules often influenced the decision not to change (Christiaens et al., 2012; Oulasvirta, 2013). Legal and institutional differences between countries would make a common set of standards difficult. There are indicators of some reluctance in certain governments to change their budgetary/cash accounting systems, due to their explicit political need for budgetary accounting and their important macroeconomic perspective (Ernst & Young Government and Public Sector, 2013a; Christiaens et al., 2013). The apparent complexity of existing accounting systems across cultures and governments limits the transition towards a common language of accounting. There are fundamental differences in how the administration is designed in different countries and how the state wants to control the government. Some terminologies used in the IPSAS may not apply to some governments’ financial reporting systems due to their uniqueness in financial operations. IPSAS adoption is not only about the consolidation of financial statements at central government levels. The IPSAS apply as much to local hospitals as they do to the central government. These differences at the organizational level enhance the already existing complexity


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at the country level. The accounting systems will never be identical in every organization, although they might all be IPSAS-like. This obviously harms comparability, but the implementation of IPSAS-like accounting would benefit comparability, even if it meant that not all accounting systems would be identical.  Substantial work is required to help the governments and entities in their capacity building by providing the necessary systems, training and internal reorganization to comply with new requirements (Ernst & Young Government and Public Sector, 2013a). The readiness of government departments and agencies, some of them still using traditional modified cash-based accounting, is questionable and creates a huge limit to the proper implementation of the IPSAS. The availability of qualified accountants is often limited, governments lack the necessary personnel to carry out the changes to the current financial reporting system adequately due to IPSAS implementation. Also a certain amount of resistance in the administrative machinery towards a possible IPSAS implementation has to be taken into account, as not all administrations are open to the huge changes and effort that IPSAS implementation involves.  IPSAS 1, Presentation of financial standards, paragraph 25 states: ‘Financial statements should not be described as complying with International Public Sector Accounting Standards unless they comply with all the requirements of each applicable International Public Sector Accounting Standard.’ This paragraph states the principle that claiming IPSAS compliance implies full compliance and that it is not acceptable to present financial statements labelled ‘in compliance with IPSAS’ when there are one or more deviations from the accounting or disclosure requirements of the standards (Christiaens et al., 2013).  The limited amount of resources that the IPSASB can address slows down the completion of a fully finished public sector accounting system. Looking at both the advantages and disadvantages of the IPSAS accounting system (see Table 3.1), one could say that the IPSAS could provide some substantial advantages but that the system currently has some serious shortcomings too. Problems are occurring both in the way it is developed and the way it has to be implemented. The current worldwide situation on IPSAS implementation International organizations There is an international trend towards the adoption of accrual accounting in the public sector, but there is still huge diversity in accounting reforms and practices. This is partly due to the difficult implementation process of these kinds of reforms (Christiaens and Vanhee, 2012). This trend towards modernizing financial information systems is likely to continue in coming years



Table 3.1 Summary of all the advantages that the IPSAS can bring and all the current disadvantages and limitations that get in the way of proper implementation Pros


General purpose financial statements: enhancement of quality, consistency, accountability and transparency

Unconditional adoption of businesslike accounting framework: no conceptual framework that suits public sector (yet)

Worldwide harmonization of regulations: increasing the comparability

Progress on conceptual framework: no user needs research and too broad

Convergence with existing IFRS: not Measurement of assets and fair value reinventing something that already exists accounting for public sector-specific capital goods like heritage assets and military assets Recognition of two accounting scenarios: cash and accrual

Some IFRS-based IPSAS have not been adapted enough to make them useful for the public sector

Support on implementation and transition period foreseen

Lacking some public sector-specific topics: e.g. social benefits + no uniform chart of accounts + lack of attention for first statement of financial position

The IPSASB is independent

Inadequate alignment with ESA 2010

Adopting the IPSAS in a country imposes convergence of its government’s accounting systems

No arrangements for non-profit sector

Missing attention for role of accounting in the control and governance of agencies Not enforceable Potential costs of harmonization: costs outweigh benefits? Short transition period Existing and dominating accounting rules getting in the way of IPSAS adoption Apparent complexity across cultures, governments and different types of organizations Limited availability of qualified accountants + resistance in administrative machinery Need for full compliance Limited amount of resources of the IPSASB


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(OECD, 2002; Lüder and Jones, 2003; Grossi and Soverchia, 2011). An important stimulus in the evolution is the support of international organizations. Some, such as the European Commission, North Atlantic Treaty Organization (NATO), OECD, UN (including all its institutions such as UNESCO, UNICEF, the WFP, etc.) and Interpol, adopted and implemented the IPSAS standards some years ago. Such ‘good practices’ have a moral influence on countries around the world. In addition, the International Organisation of Supreme Audit Institutions (INTOSAI) promotes the use of the IPSAS (Algemene Rekenkamer, 2003). Countries Christiaens et al. (2013) have investigated the adoption process of IPSASinspired accrual accounting around the world. Their study investigated to what extent IPSAS-inspired accrual accounting has been adopted in central and/or local governments. Based on the answers to their questionnaire and previous results from similar research in 2009 concerning Europe, they determined some evolution in the adoption of IPSAS over time. Some of the examined European countries that are IPSAS compliant to date are Sweden, Switzerland, Estonia, Lithuania, Latvia and the Flemish local authorities. There seems to be a substantial difference between the implementation of the IPSAS in ‘old’ European countries (such as France, Denmark, Germany, the Netherlands, Spain, Sweden, etc.) and ‘new’ European countries (such as Hungary, Estonia, Latvia, Romania, etc.). Many of the ‘older’ European countries are still in the planning phase of implementing the IPSAS. Apparently, the length and importance of the planning stage should not be underestimated. ‘New’ European countries are often in a later stage of IPSAS compliance, which can be explained partly by the different timing of state reform those countries underwent. A second explanation is that emerging countries often needed IMF support and therefore made use of the IPSAS when reforming their financial information systems from a resource dependence theory point of view. In general, it can be concluded that there is much heterogeneity in the accounting practices between the European governments (Brusca and Montesinos, 2010; Pina et al., 2009). In Belgium, only the Flemish local governments are IPSAS compliant. Until recently, these IPSAS were still relatively unknown in Belgium, yet they gradually spread across the sector, partly because of the modernization of the State Accountancy Department (Rijkscomptabiliteit, or FEDCOM) and the decisions made relating to the new policy and management cycle (BBC) for the Flemish local governments (municipalities, official centres for mutual welfare (OCMW) and provinces). The Belgian federal government considered the application of the IPSAS standards, but ultimately decided not to apply them. The Flemish legislator went further and decided to adjust the accrual accounting for municipalities, OCMWs and provinces to IPSAS. Also noteworthy is the public institution for social security, wherein the Federal



Department of Social Security recently decided to modernize the existing accounting standards, taking into account the IPSAS standards (Christiaens and Vanhee, 2012). In Wallonia, the situation is a little different. Their local government is currently working with an IPSAS non-compliant accrual accounting system. The central government is in the phase of a planned accrual reform. Except for Ireland, as could be expected the Anglo-Saxon countries are used to applying accrual accounting in their central as well as local governments. This is due to the ‘principles-driven’ character behind the IFRS and IPSAS, which is an Anglo-Saxon feature instead of the rather ‘rules-driven’ accounting prescriptions existing in continental European countries. Some have explicitly decided to adopt the IPSAS, while others prefer the IFRS, being very close to the IPSAS. This is the case in the United Kingdom and Australia, for example. The USA has its own accrual accounting system (the Governmental Accounting Standards Board (GASB) and the Federal Accounting Standards Advisory Board (FASAB)), an accrual accounting system more or less consistent with the IPSAS. The case of New Zealand is particularly interesting, as they originally used NZ IFRS (the financial reporting accounting standards in New Zealand based on IFRS) for both the private and public sectors. In 2011, the External Reporting Board (XRB) decided that New Zealand should move to a multi-standards framework. The for-profit entities continue to follow the NZ IFRS, but separate Public Benefit Entities (PBE) standards were developed for the public and not-for-profit sectors, based on the IPSAS. The process of implementation is currently underway and should be effective from 1 April 2015. African countries mostly use a budgetary/cash accounting system. It is noticeable that accrual accounting necessitates a more developed administrative IT background, which is not always present in these countries with limited financial means. Central and South America favour accrual accounting, particularly for the IPSAS. This is also the case on the Asian continent, where many jurisdictions are striving to implement accrual accounting and the IPSAS. It is easier for these developing countries voluntarily to adopt the IPSAS accounting system than it is for developed countries where different accrual accounting systems (different from IPSAS) have already been installed. The assumption is that developing countries will be using the IPSAS increasingly in the future due to pressure from international organizations (Oulasvirta, 2013). From a worldwide perspective, 44% of local governments have chosen the IPSAS, whereas 39% use a different system of accrual accounting. At central government level, the former figure is about 51% and the latter 22% (Christiaens et al., 2013). One could conclude that there is still an important number of central governments applying budgetary/cash accounting compared with local governments, but, in the group of governments that have chosen accrual accounting, central governments often prefer the IPSAS accrual accounting system. Despite the ongoing debate about whether the


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accounting needs of the public sector are well served by the accrual accounting practices (Aggestam-Pontoppidan, 2011) and the limited evidence available on the efficacy of accrual-based accounting systems in the public sector (Lapsley et al., 2009), the trend in practice seems clear: as more public entities and governments are in the process of adopting accrual accounting, this seems to be the way to go, but without neglecting the existence of budgetary accounting. Local versus central government Christiaens et al. (2013) investigated the current worldwide status of IPSAS implementation in March 2012. They conducted a field study across 81 countries/jurisdictions by means of a survey, using a specific questionnaire to obtain relevant information from local experts. A comparison of these results with previous data from a similar study by Christiaens et al. (2010) in 2009, revealed significant differences in the evolution towards the IPSAS on the local and central levels of government. European local governments are clearly moving from budgetary/cash accounting to accrual accounting and even to the IPSAS. This is shown in Figure 3.4, whereby a move from the right (cash/budgetary accounting) to the left (IPSAS compliance) is visible. As a matter of fact, none of the ‘old’ European local governments is still applying just the budgetary/cash accounting system. The transformation at the central government level on the other hand is moving slowly (see Figure 3.5). There seems to be an important but slow movement towards accrual accounting, particularly to IPSAS accrual accounting, although there still remains a level of reluctance, mainly in central governments. There seems to be a great diversity in the implementation of structural (accounting) reforms, both between countries and between different levels of government (Christiaens et al., 2010; Benito et al., 2007; Brusca and Condor, 2002; Pollitt and

9X 8 4­




51 4 3


2 1


0 Ipsas Planned Ipsas Reform

Accrual Accounting

Planned Accrual Reform

Budgetary/Cash Accounting

Figure 3.4 Accounting systems in local governments Source: Christiaens et al., 2013



10 8

6 4

2 J

2009 2012

Figure 3.5 Accounting systems in central governments Source: Christiaens et al., 2013

Bouckaert, 2004; EC Eurostat, 2012). This clearly shows the need for an individual approach to adoption, one of the biggest challenges facing further worldwide implementation of the IPSAS. The IPSAS in the EU: towards EPSAS The incidence of incomplete and inappropriate financial reporting in Greece has demonstrated the possible impact it can have on a country’s economy. Some argue that the financial crisis has highlighted the need to strengthen the economic governance structure for the euro area and the European Union as a whole. Council Directive 2011/85/EU (2011) on requirements for budgetary frameworks of the EU member states (the Budgetary Frameworks Directive) recognizes the need for more rigorous and transparent reporting of comparable fiscal data for EU budgetary surveillance and for financial stability, alongside complete and reliable data. The Commission responded by adopting a package of legislative proposals, the European Economic Governance Package (the Six Pack). These seek to extend and improve the surveillance of fiscal policies, macroeconomic policies and structural reforms. New enforcement mechanisms are planned in the event of non-compliance by member states. Therefore, the EC must be able to rely on high-quality statistical information, produced on the basis of robust and harmonized accounting standards. Therefore, the European Commission (Eurostat) launched a Public Consultation on the suitability of the IPSAS for the EU member states. The results revealed that only 38% of the respondents considered the IPSAS suitable for implementation. Some 28% of all respondents found the IPSAS unsuitable. However, the majority of these respondents were in favour of putting in place a single harmonized set of accrual-based public sector accounting standards, a sign that they believe in the need for harmonized


Johan Christiaens and Simon Neyt

accounting standards, a need that also has been addressed by Directive 2011/ 85/EU. The results were used in a report by the EC on the suitability of the IPSAS for EU member states, in which the need for harmonized accrual standards was confirmed, but the EC is not convinced that the IPSAS is the ideal set of standards to be used. Their conclusion on the suitability of the IPSAS was twofold: ‘On the one hand, it seems clear that IPSAS cannot easily be implemented in EU Member States as it stands currently. On the other hand, the IPSAS standards represent an indisputable reference for potential EU harmonized public sector accounts’ (EC Eurostat, 2012). Some of the reasons given why the IPSAS cannot be implemented easily are the fact that the IPSAS are not yet complete and therefore are insufficiently stable at this time; the fact that some accounting practices have not yet been described precisely enough to be easily implemented; and the lack of participation by the EU authorities in the whole development process of the IPSAS. This last point is a typical Central European reflex, where legislators – an elite group within the ranks of government and not the practitioners – have the power to enforce standards across both public and private spheres (Montesinos and Vela, 2000). The European Commission has therefore shown its intention to develop its own set of European Public Sector Accounting Standards (EPSAS), using the IPSAS as a reference framework. The EPSAS will be similar to the IPSAS, but rearranged for the EU. In this way, the Commission can take into account all specific requirements that the harmonized accrual accounting system will be facing. EPSAS will give the EU and its member states the ability to control the agenda and the content of the standards. The EPSAS will also ensure the rapid development of the new standards, whereas the IPSASB is unable to develop its standards at the same pace, due to its limited resources. The EPSAS, furthermore, will empower the EU member states to influence the design of the IPSAS, which they are currently unable to do owing to insufficient insights and opportunities. Another particular advantage of the EPSAS strategy is the possibility to limit the differences between fiscal statistics (ESA 2010) and the harmonized accrual accounting system (EPSAS), as budgetary surveillance in the EU is based on the ESA. The ESA is a macroeconomic accounting framework based on accrual principles. Despite being based on accrual accounting, there are some fundamental differences between the IPSAS and the ESA. The IPSAS intend to support the different management tools in government, whereas the ESA is used to analyse general policies in the public sector. The IPSAS are developed from a bottom-up approach, the ESA from a top-down approach. This makes the two systems difficult to unite. These differences could be minimized when developing the EPSAS. Legislative regulation by the European Commission on this topic is not expected before the end of 2014 or the beginning of 2015. The aim is to use a phased, tailored approach for member states (Ernst & Young Government and Public Sector, 2013c). This would need to be an approach of strong EU



governance and close contact with the IPSAS in order to avoid unnecessary divergence between the EPSAS and IPSAS. The European Commission pushing the EU countries to adopt the EPSAS could therefore be a huge leverage for united harmonization with the IPSAS around the world.

3.4 IPSAS literature The available literature focusing solely on the IPSAS is still limited, but attention for the IPSAS in the wider literature on cash and accrual accounting and financial management in general has been increasing over the last decade. Some information on the IPSAS can be found in the enormous amount of available literature on accrual accounting in general and its usefulness/transferability, as in the studies by Barton (2005), Arnaboldi and Lapsley (2009), and Christensen and Lægreid (2007). Other available literature, focusing on IPSAS in particular, can be divided into one group of publications providing further explanation of the IPSAS, and one focusing on the adoption and implementation of these standards. The former group has been fully developed over the last decade as multiple books have been published, providing assistance on the intelligibility of the standards. Some of these guides were developed by the IPSASB itself (the Handbook of International Public Sector Accounting Pronouncements; IFAC, 2008), but most were developed by accounting experts and private sector accountancy firms. The literature on the IPSAS has been focusing on the technical issues of the IPSAS in the first place, focusing on public sector-specific topics like pension benefits liability (Oulasvirta, 2008) or capital assets (Christiaens et al., 2012). Still, there will be more to learn about lots of other public sectorspecific topics, like the connection between accounting (IPSAS), budgeting and reporting systems (like ESA 2010) in the future. The latter group is currently in full development, as there is a significant number of studies and publications on the IPSAS adoption and implementation in progress. The limited number of studies on the adoption and implementation up to today is a consequence of the limited adoption of the IPSAS in practice (by countries and international organizations). As the number of reforms towards an accrual accounting system – some of them towards IPSAS compliance – in countries around the world rises, so it will provide more opportunities to do research on IPSAS adoption and implementation in practice. Some research was done on the conceptual and institutional issues of IPSAS implementation, such as the study by Chan (2008). There are a number of studies on the comparison of different countries and their degree of IPSAS adoption, such as research by Brusca and Montesinos (2010), Grossi and Soverchia (2011), Pina et al. (2009), Benito et al. (2007), Christiaens et al. (2010) and Christiaens et al. (2013). Still, there is a substantial lack of countryspecific case studies explicitly addressing IPSAS standards adoption (Oulasvirta, 2013). The availability of these country-specific case studies is particularly important, as most of the implementation problems with IPSAS


Johan Christiaens and Simon Neyt

are country specific (Vašicˇ ek et al., 2010). In this regard, the IPSAS literature could be of great importance for the further adoption of the IPSAS, as much more needs to be learned from best practices and problems arising in these processes towards IPSAS. There is much more to be learned, especially in countries outside Europe and the USA, as most of the current case studies have been conducted in these areas. Making the IPSAS, a harmonized accrual accounting system, fit all around the world will be one of the greatest challenges, as the adoption of accrual accounting is drifting apart across and within different countries (Christiaens, 2001; da Costa Carvalho et al., 2007).

3.5 Conclusion IPSAS development has already been undergoing important transformations since the beginning in 1986, but it seems as if we are on the verge of more changes in the near future. There are clearly a lot of dynamics going on around this topic. There has been a rapid take-up of the IPSAS standards in a variety of different countries, in particular in developing countries and local governments. The trend is likely to be that more countries and organizations will join the path towards the IPSAS. The IPSAS still have the great advantage of being a unique set of accrual accounting standards. They are an instrument for legitimation of governments and the improvement of their credibility. On the other hand, they still suffer the supremacy of the private sector IFRS and more attention on public sector-specific topics is needed. The development of the EPSAS could be of particular importance in the future development of the IPSAS, as the world is awaiting the decision on this topic within the European Union. Making the EPSAS compulsory in all member states could be a huge improvement in worldwide implementation of a harmonized accrual accounting system, as it could be a leverage for countries currently in doubt about the conversion towards the IPSAS. This evolution will be supported by a growing number of IPSAS studies and publications, particularly on the adoption and implementation processes. The ongoing process of implementation of the standards in countries such as New Zealand can be used as a learning experience to facilitate the adoption process of IPSAS in multiple new countries in the future. The IPSASB itself is tackling some of the core issues with the current IPSAS too. So what’s still to come? The development of the conceptual framework is still a major topic on the IPSASB’s agenda, and should be finished by June 2014. They are also working on public sector-specific topics, such as the alignment of the IPSAS with statistical reporting (like ESA 2010), the treatment of social benefits and the development of standards on the firsttime adoption of accrual-basis IPSAS, and on government business enterprises (Ernst & Young Government and Public Sector, 2013c). This should all lead to the further adoption of the IPSAS around the world.



Summary  This chapter focused on the IPSAS, the International Public Sector Accounting Standards issued by the IPSAS Board. IPSAS are a unique set of accrual accounting standards for the public sector, which could be implemented around the globe. The IPSAS are designed to apply to the general purpose financial statements of all public sector entities. This does not include governmental business enterprises, nor privately organized non-profit organizations. Driven by New Public Management, they want to provide an answer to the problematic and diverse set of accounting standards that are applicable in public sector entities nowadays. The IPSAS could enhance the quality of general purpose financial statements and establish consistency, transparency, accountability and comparability in the application of those practices. The IPSASB created a special due process to include possible comments from all stakeholders in the development of these standards. So far, 32 IPSAS have been published, with only one standard on the use of cash accounting.  The IPSASB, as part of the IFAC (the organization that issues IFRS for private sector entities), develops accrual accounting IPSAS based on IFRS by adapting them to a public sector context when appropriate. The unconditional adoption of the IFRS is often named as one of the shortcomings in the development of the IPSAS, as it makes them not necessarily well suited to the public sector. The Board has realized the specific nature of the public sector and therefore has started the process of creating an individual conceptual framework for the public sector.  There is an international trend towards the adoption of IPSAS-like accrual accounting in the public sector, but there is still a huge diversity in the existing accounting reforms and practices. Research has shown a slow movement towards the implementation of IPSAS-like accounting systems throughout countries in all regions of the world. This positive interest in the IPSAS is also noticeable in the rise of available literature and research on this topic. Nonetheless, there is still a level of reluctance, especially in central governments, due to the limits of the IPSAS and the difficulty of their implementation.  The adoption and implementation of a new accounting system involves huge changes that affect the functioning of a government as a whole. Existing differences between accounting systems around the world mean that the modification process towards the IPSAS will be different in every country, jurisdiction or organization. Nonetheless, a number of general preparatory steps have been listed that can facilitate a smoother implementation of the IPSAS. Other arguments against the implementation of an IPSAS-like accrual accounting system are the fact that the IPSAS are not yet a complete set of standards, their insufficient stability at this moment, and the lack of participation by legislative authorities in the development process.


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 The European Commission has shown its intention to develop its own set of European Public Sector Accounting Standards (EPSAS), using the IPSAS as a reference framework. The EPSAS will be similar to the IPSAS, but rearranged for the EU. This could neutralize some of these problems, including the fact that the IPSAS are not currently enforceable. This evolution towards EPSAS could be of great importance for the further implementation of a unique set of accounting standards for the public sector around the world.

Discussion questions 1 Do you think that the implementation of a global accounting system is possible? 2 Do you think that the development of a worldwide accounting system should be organized by an intergovernmental organization like the EU or UN, instead of a group of independent members who are not directly related to government? What could be the possible advantages/ disadvantages? 3 Is it a good idea to implement a uniform accounting system in the EU, knowing the cost and effort it takes, in these times of economic instability? 4 Would you, as a government, use the IPSAS as a reference/basis for the implementation of an accrual-based accounting system in your country/ jurisdiction, or would you start from scratch? Why (not)? 5 What do you think of the due process that the IPSASB is using for its standard development? What is good/bad about it? 6 What could be the possible reasons for the difference in growth rate towards the IPSAS at local and central levels of government? 7 Compare the transformational and transactional approaches and formulate their (dis)advantages.

References Aggestam-Pontoppidan, C. (2011) ‘Selecting International Standards of Accrual-Based Accounting in the Public Sector: IPSAS or IFRS?’ Journal of Government Financial Management 60(3): 28–35. Algemene Rekenkamer (2003) Begroting en verantwoording in balans. Het batenlastenstelsel voor de rijksoverheid, Tweede Kamer, vergaderjaar 2002–3, 28 860, No. 1–2, Den Haag: Sdu Uitgevers. Anessi-Pessina, E. and Steccolini, I. (2007) ‘Effects of Budgetary and Accruals Accounting Coexistence: Evidence from Italian Local Governments’, Financial Accountability & Management 23(22): 113–31. Arnaboldi, M. and Lapsley, I. (2009) ‘On the Implementation of Accrual Accounting: A Study of Conflict and Ambiguity’, European Accounting Review 18(4): 809–36. Barton, A. (2005) ‘Professional Accounting Standards and the Public Sector – A Mismatch’, Abacus 41(2): 138–58.



Benito, B., Brusca, I. and Montesinos, V. (2007) ‘The Harmonization of Government Financial Information Systems: The Role of the IPSAS’, International Review of Administrative Sciences 73(2): 293–317. Brusca, I. and Condor, V. (2002) ‘Towards the Harmonisation of Local Accounting Systems in the International Context’, Financial Accountability & Management 18 (2): 129–62. Brusca, I. and Montesinos, V. (2010) ‘Accrual Financial Reporting in Public Sector: Is it a Reality?’ 12th Comparative International Governmental Accounting Research (CIGAR) Biennial Conference, Modena. Chan, J.L. (2008) ‘International Public Sector Accounting Standards: Conceptual and Institutional Issues’, IPSAS Workshop at the University of Napoli Parthenope, (accessed 3 May 2013). Christensen, T. and Lægreid, P. (2007) ‘The Whole-of-Government Approach to Public Sector Reform’, Public Administration Review 67: 1059–66. Christiaens, J. (2001) ‘Converging New Public Management Reforms and Diverging Accounting Practices in Flemish Local Governments’, Financial Accountability & Management 17(2): 153–70. Christiaens, J., Reyniers, B. and Rollé, C. (2010) ‘Impact of IPSAS on Reforming Governmental Financial Information Systems: A Comparative Study’, International Review of Administrative Sciences 76(3): 537–54. Christiaens, J., Rommel, J., Barton, A. and Everaert, P. (2012) ‘Should All Capital Goods of Governments be Recognised as Assets in Financial Accounting?’ Baltic Journal of Management 7(4): 429–43. Christiaens, J. and van den Berghe, M. (eds) (2006) The Ernst & Young Guide to Applying IPSAS, Brugge: die Keure. Christiaens, J. and Vanhee, C. (2012) Handboek Accountancy in de Publieke en Nonprofitsector: Accounting, Financieel Management en Auditing, Brugge: Die Keure. Christiaens, J., Vanhee, C., Manes-Rossi, F. and Aversano, N. (2013) The Effect of IPSAS on Reforming Governmental Financial Reporting: An International Comparison, Working paper presented at the ARPS seminar, 25 March, Gent, Belgium. da Costa Carvalho, J.B., Camões, P.J., Jorge, S.M. and Fernandes, M.J. (2007) ‘Conformity and Diversity of Accounting and Financial Reporting Practices in Portuguese Local Government’, Canadian Journal of Administrative Sciences/Revue Canadienne des Sciences de l’Administration 24(1): 2–14. EC Eurostat (2012) Public Consultation – Assessment of the Suitability of the IPSAS for the Member States, Luxembourg, December. Ernst & Young Government and Public Sector (2013a) Responses are in: EC Eurostat Public Consultation on the Suitability of IPSAS for EU Member States, February, IPSAS Outlook, issues_for_public_finance_management/$FILE/Outlook_IPSAS_AU1432.pdf. ——(2013b) A Snapshot of GAAP Differences between IPSAS and IFRS, April, S/$FILE/IPSAS_vs_IFRS_AU1506.pdf. ——(2013c) Public Sector Accounting: IPSAS Update 2013 (video webcast), GL/en/Issues/webcast_2013-06-25-1500_public-sector-accounting-ipsas-update-2013. ——(2013c) Major Steps in a Conversion Project (diagram), tries/Government-Public-Sector/IPSAS-Our-services-offerings (accessed 24 May 2013). European Council (2011) Council Directive 2011/85/EU of 8 November 2011 on Requirements for Budgetary Frameworks of Member States.


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FEE (Fédération des Experts Comptables Européens) (2007) Accrual Accounting in the Public Sector, Paper from the FEE Public Sector Committee. Groot, T. and Budding, T. (2008) ‘New Public Management’s Current Issues and Future Prospects’, Financial Accountability & Management 24(1): 1–13. Grossi, G. and Soverchia, M. (2011) ‘European Adoption of IPSAS to Reform Financial Reporting’, Abacus 47(4): 525–52. Guthrie, J. (1998) ‘Application of Accrual Accounting in the Australian Public Sector – Rhetoric or Reality?’ Financial Accountability & Management 14(1): 1–19. Guthrie, J., Olson, O. and Humphrey, C. (1999) ‘Debating Developments in New Public Financial Management: The Limits of Global Theorising and Some New Ways Forward’, Financial Accountability & Management 15(3–4): 209–28. Hood, C. (1995) ‘The “New Public Management” in the 1980s: Variations on a Theme’, Accounting Organizations and Society 20(2–3): 93–109. IFAC (2008) 2008 Handbook of International Public Sector Accounting Pronouncements, New York: IFAC. Lapsley, I. (1999) ‘Accounting and the New Public Management: Instruments of Substantive Efficiency or a Rationalising Modernity’, Financial Accountability & Management 15(3–4): 201–7. Lapsley, I., Mussari, R. and Paulsson, G. (2009) ‘On the Adoption of Accrual Accounting in the Public Sector: A Self-evident and Problematic Reform’, European Accounting Review 18(4): 719–23. Lüder, K. and Jones, R. (2003) ‘Reforming Governmental Accounting and Budgeting in Europe’, Fachverlag Moderne Wirtschafts, Frankfurt am Main. Montesinos, V. and Vela, J.M. (2000) ‘Governmental Accounting in Spain and the European Monetary Union: A Critical Perspective’, Financial Accountability & Management 16(2): 129–50. Müller-Marqués Berger, T. (2012) IPSAS Explained: A Summary of International Public Sector Accounting Standards, Wiley. OECD (2002) ‘Models of Public Budgeting and Accounting Reform’, OECD Journal on Budgeting 2(1), Paris: OECD Publications. Oulasvirta, L. (2008) ‘How Should Pension Benefit Liabilities and Social Policy Cash Transfer Liabilities be Presented in the Government Financial Statements: Current Presentation more or the Mode of International IPSAS Standards?’ The Finnish Journal of Business Economics 2: 223–37. ——(2013) ‘Reluctance of a Developed Country to Choose International Public Sector Accounting Standards of the IFAC. A Critical Case Study’, Critical Perspectives on Accounting, doi:10.1016/ Pina, V. and Torres, L. (2003) ‘Reshaping Public Sector Accounting: An International Comparative View’, Canadian Journal of Administrative Sciences 20: 334–50. Pina, V., Torres, L. and Yetano, A. (2009) ‘Accrual Accounting in EU Local Governments: One Method, Several Approaches’, European Accounting Review 18: 765–807. Pollitt, C. and Bouckaert, G. (2004) Public Management Reform, A Comparative Analysis: New Public Management, Governance and the Neo-Weberian State, second edn, Oxford: University of Oxford. Vašicˇ ek, V., Dragija, M. and Hladika, M. (2010) ‘Convergence of Financial Reporting in the Public Sector to the Practice of Business Sector’, International Conference ICES 2010: Economic Development Perspectives of SEE Region in the Global Recession Context.

Consolidated financial statements in the public sector


Giuseppe Grossi

Learning objectives      

To To To To To To

be aware of consolidation theories. be aware of methods of consolidation. understand the purposes of consolidation in the public sector. define internal and external users. understand the different ways to define the area of consolidation. understand how real governments are consolidating their entities.

Key words       

Benefits and users Entity concept Full consolidation Parent company concept Proportional consolidation Proprietary approach Reporting entity

4.1 Introduction Consolidated financial statements (CFSs) were created in the private sector to provide information on the financial situation and position of business groups (Walker, 1978; Wise, 2006). In this realm, CFSs perform a dual function. On the one hand, they are communication tools to external users (financial markets, investors and backers, government, competitive businesses, etc.). On the other hand, they are tools to be used by internal users in the planning of activities and in monitoring the impact of group strategies (Childs, 1949; Dodge, 1996). A CFS is an accounting technique in which two or more individual entities are reported as if they are one entity. A CFS provides measures of revenues, expenses, assets, liabilities and cash flows for each organization as a whole (Jones, 2007). According to Schuster:


Giuseppe Grossi It is also necessary to complement the accounting of each of the individual parts for an accounting for the whole they comprise. This complement is the consolidated financial statements made up for a new economic entity, the group, which consists of all the legal entities that have a common interest. (Schuster, 2005: 11)

The CFS of the corporate group only shows external transactions that are made with the surrounding and, therefore, the internal transactions that are done within the group are eliminated. Differences may emerge from ‘internal’ transactions between the companies within the same groups as well as with transactions with companies outside the group. This chapter discusses the main issues related to consolidation in the public sector. The first section will provide a general description of consolidation theories (entity, parent company and proprietary approaches) and methods (full, proportional and equity methods) adopted in both the private and public sectors. The second section will focus on the specific benefits and users (internal as well external) of CFSs in the public sector. The third and final section will give an international overview of the different ways (concepts of control and accountability) to define the area of consolidation. A detailed description of specific International Public Sector Accounting Standards (IPSAS) on consolidation will follow, with particular attention to the benefits and limits of the IPSAS approach and alternative approaches to the IPSAS. This section also presents a short description of some experiences (i.e. the European Commission, Swedish and Dutch local governments) of consolidation in the public sector.

4.2 Theories and methods of consolidation There are several theories on how to compile CFSs and to define the concept of a group that concerns the matter of including or excluding non-controlling interest in the subsidiaries (Jones and Pendlebury, 2000). The different theoretical perspectives are the following: entity, parent company and proprietary perspective. The entity perspective of a group emphasizes the economic unity of all enterprises and treats all shareholders similarly, whether controlling or not (Nobes and Parker, 2011). This means that minority shareholders are not seen as outsider interests and are included in the equity. The parent company concept focuses mainly on the shareholders of the parent company. This means that minority shareholders are seen as outsider interests, and the equity that belongs to minority interests is seen as a liability. According to Nobes and Parker (2011: 395–96), the parent company concept is generally based on legal control and its weaknesses are:  It assumes that the group consists of a parent company that dominates a number of dependent or subsidiary companies.

Consolidated financial statements


 It does not allow for companies dominated jointly by more than one company, or for companies over which another company exercises a significant influence but not control.  It treats all other external parties as unimportant users (so-called ‘minority interests’), which are shown outside shareholders’ equity. Many standard setters have found inspiration in the parent company approach as a theoretical model of accounting rules for consolidated accounts (e.g. the Financial Accounting Standards Board (FASB), the International Accounting Standards Board (IASB), and also the International Public Sector Accounting Standards Board (IPSASB)). The proprietary approach emphasizes neither legal control nor economic unity, but ownership or proprietorship, which gives the possibility of exercising significant influence over commercial and financial policy decisions (Nobes and Parker, 2011). The non-controlled interest does not belong to the group and, therefore, it is not disclosed in the consolidated financial statement. The share of profit and loss for the year and proportionate share of assets and liabilities are brought into the CFS, either item by item (the proportional method of consolidation) or on a one-line basis (the equity method of consolidation). There are different methods that can be used to solve the practical problems involved with the preparation of the CFS. There are two kinds of problem when the CFS is established: one method solves the problem with valuation issues and the other solves the problem with minority interests. The methods that are used to solve the problem with minority interests are the full, the proportional and the equity methods of consolidation. These methods handle whether or not the minority interests should be included, and how, in the CFS. The full method of consolidation is on a full line-by-line basis under the acquisition approach where no distinction is made in equity between majority and minority shares, and the net assets and goodwill of subsidiaries are revaluated at their fair value, consistent with the ‘full goodwill method’. Minority interests are reported as a separate item in the group consolidated financial position between equity and provisions. The part of the result that belongs to the minority interest is also distinguished. The proportional method is line by line, where revenue, expenses, assets and liabilities are combined with similar items or reported as a separate line in the financial statement. The non-controlling interest is excluded from the CFS. The proportional method of consolidation, for example, stresses the ownership interests of the parent company shareholders (Tagesson and Grossi, 2012). The CFS is viewed as a modification of the parent company’s financial statement in order to account for the ownership interests of the parent company in other entities (Heald and Georgiou, 2000). An alternative to the proportional method of consolidation is the equity method, where only an owned share of the subsidiary’s net assets and share of


Giuseppe Grossi

net income are included in the CFS. The equity method changes the book values on the shares, which is a separate item in the assets, of associates in the consolidated financial position. The equity method is mostly used in associated companies.

4.3 The purposes and need for consolidation in the public sector The practice of compiling CFSs in the private sector has long been established in many countries including the USA, European countries and Australia (Walker, 1978). In the public sector, their diffusion reflects the changes in public functions labelled ‘steering and not rowing’ (Osborne and Gaebler, 1992). These changes involve the provision of public services through decentralized entities and the increasing role of coordination and control performed by governments (Kettl, 1993; Osborne and Brown, 2005; Bundred, 2006). One of the faces of this phenomenon is the externalization of service provision to legally separate entities. These entities often remain totally or partially owned by the relevant government. These trends are present in European countries, as well as in Australia and New Zealand (Torres and Pina, 2002; Grossi and Reichard, 2008). This produces several consequences. On the one hand, this may require these entities to raise resources and account for their use to financial markets. On the other hand, it poses new challenges to governments that are expected to steer and control service providers towards the fulfilment of public interest, to be accountable for the whole basket of services provided (including their financial impacts), and to define comprehensive and consistent fiscal policies (Grossi and Newberry, 2009). Internal and external users of financial information are not able to base their decisions on reliable and relevant information about the financial position, financial performance and cash flows of the ‘whole’ government, or they may find it more difficult to form an idea on it when relevant parts of the government are autonomized and services are contracted out. Indeed, it must be recognized that consolidated financial statements are not mutually exclusive of financial statements or financial information of other kinds. However, this might translate into more fragmented information. In order to avoid this lack of information, CFSs have often been presented as a necessary step (Heald and Georgiou, 2000). Politicians and public managers consider the CFS a useful tool for steering and controlling the direct and indirect provision of public services. It is a fundamental tool for public decision making in programming and controlling different public policies. The CFS is also a very useful tool for external stakeholders (e.g. citizens, voters, taxpayers, suppliers, other public administrations, banks and rating agencies). Since the compilation of the CFS helps to give a true and fair view of the whole situation of the government and its publicly owned corporations, accountability is improved. In particular, banks and financial institutions are interested in the CFS to understand the real and effective opportunities of

Consolidated financial statements


creditworthiness of the governments and their owned corporations. Moreover, the CFS could be useful as an informative tool for rating agencies to determine solvency and risk (Grossi and Soverchia, 2011). The compilation of a CFS in the public sector should provide an overview of the financial performance and position not only of the single government but of the whole group of organizations that are under its control and provide public services (Broadbent et al., 1996; Chan, 2003; Chow et al., 2007). This is especially crucial if we consider that, in some European cases, one of the causes of financial distress of some governments is represented by the bad financial results of government-owned companies. Moreover, even if they are formally autonomous and the law tends to prevent or discourage governments from helping their companies in dire financial conditions, the governments have often an interest in bailing them out so that they will ensure continuity in the provision of services and employment of people. However, there are some problems with using CFSs in the public sector, including the difficulty of comparing consolidated information across different levels of government and defining the area of consolidation (Heald and Georgiou, 2000; Robb and Newberry, 2007; Grossi and Pepe, 2009).

4.4 Determining the area of consolidation: international trends Internationally, there are two ways of defining the area of consolidation. The first (more widespread) way uses the existence of control, while the second requires the presence of financial accountability. In the criterion of control, the controlling entity needs to be able to govern decision making of the controlled entity in order to be able to benefit from its activities (IPSAS 6, FRS 2, PS 1300, NZ IAS 27, AASB 127; IAS 27). The financial accountability criterion is followed by GASB 14 (Grossi and Pepe, 2009). However, the stimuli behind these accounting reforms and the key factors in the reform processes have varied between different countries (Lüder and Jones, 2003). Although not all countries have adopted CFSs (Benito et al., 2007), often – as in the case of some Anglo-Saxon countries – independent bodies and experts offer the input necessary to carry out the changes. In some countries (Australia, New Zealand, Canada, Sweden, the UK and the USA), accounting standards for the consolidation of annual accounts have already been established. In European continental countries, a similar process has not yet been completed (Brusca and Montesinos, 2009; Grossi and Newberry, 2009). At the international level, the IPSASB has defined three standards concerning consolidation issues (IPSAS 6, 7 and 8), which seem to reflect the private sector-driven approach generally taken in the definition of standards for the public sector. One of the clearest examples of the profound influence exerted in the public sector by private sector practices can be found in the process of development of the IPSAS, which have been defined on the basis of the relevant standards for the private sector (International Accounting Standards (IAS) and


Giuseppe Grossi

International Financial Reporting Standards (IFRS)) (see Chan, 2003; Jones, 2007; Benito et al., 2007; Bergmann, 2009). Several countries are adopting accrual-basis IPSAS (including France, South Africa, Switzerland, Russia, Israel, Slovakia and Brazil). Some countries are adopting the IPSAS directly (e.g. Switzerland, Slovakia), and some are doing so through national standards (e.g. South Africa, Brazil). In addition, sub-national governments are adopting the IPSAS when the decentralized structure allows them to move independently (e.g. the prefecture of Tokyo, state of Hesse, state of Zurich). Also international institutions – the United Nations (UN), Organisation for Economic Co-operation and Development (OECD), North Atlantic Treaty Organization (NATO), Interpol and the European Commission (EC) – are adopting the IPSAS. Some authors agree that governmental accounting must approach them (see in this respect Chan, 2003; FEE, 2007), even when some opposition to the IPSAS exists. A crucial issue, which illustrates the IPSASB’s private sector-driven approach to standards and consolidation, is the definition of a reporting entity. In May 2000, the IPSASB of the International Federation of Accountants (IFAC), which is responsible for setting public sector international accounting standards, published IPSAS 6, 7 and 8, pertaining to the consolidation of controlled entities, associate entities and joint ventures, respectively. The selection of the entities to be included within the area of consolidation is the first problem to be solved before compiling a CFS and should be carried out on the basis of the ‘reporting entity’ concept. After defining the government-owned enterprises, the relationships between the single corporations and the holding company should be identified in order to define the area of consolidation. The search for a solution in the public sector is not as simple as it is in the private one, because contractual and control relationships are not based on the same concepts of ownership. First of all, not all entities have an equity or autonomous legal personality (e.g. some government agencies). Second, in some circumstances, legislation gives local government the power to steer and control corporations without any ownership relationship. Despite the declared differences in objectives and users – the IASB focuses on investors and other capital providers, while the IPSASB focuses on recipients of services, providers of resources and other parties including special interest groups and the legislature – the IPSASB has come to the same conclusion as the IASB regarding the criteria for inclusion within the reporting entity. In the private sector, the obligation to compile a CFS, as well as to define the area of consolidation, is defined according to the concept of control. If a company controls another company, the controlling organization must prepare a CFS. According to the IPSASB (IFAC, 2012a), a reporting entity exists when:  The government has the power to govern the strategic financing and operational policies of the other entities (a ‘power criterion’).

Consolidated financial statements


 The government can benefit from the activities of the other entities, or is exposed to a financial burden that can arise as a result of the operation or action of those entities; and can use its power to increase, maintain or protect the amount of those benefits; or to reduce, or otherwise influence, the financial burden that may arise as a result of the operations or actions of those entities (a ‘benefit or financial burden/loss’ criterion). The power element means that the government or the parent of a subgroup must be able to exercise the power to govern the financial and operational policies of the decentralized organization. This does not require a majority of voting rights, but the power must be conferred by law or another formal agreement. The formal agreement must already exist. If the ability to exercise the power requires the changing of laws or the renegotiation of agreements, the power is not presently exercisable. The existence of power to control does not mean that the controlling government or parent of a subgroup has to use this power. It is sufficient that the controlling entity is able to use it. It is possible that the controlling entity never gives any instruction to the decentralized organizations (IPSAS 6.28). Although IPSAS 6 seems to respect the specific characteristics of the public sector, the main driver behind government consolidation is the criterion of control, which was transferred from the private sector. This implies that some related parties (e.g. entities that are founded but not controlled by the government) are not included in the CFS. Although such entities do not meet the definition of control, they may still have a relevant financial and contractual relationship with the government. Control – defined by the two elements of power and benefits – is difficult to find in the public sector, because power does not always go hand in hand with ownership or capital invested. Control criteria in the public context are not always shares held or seats on boards, but are, for example, such entities that fulfil public sector functions and are mainly dependent on the government budget. According to the budgetary perspective, entities should be consolidated if they are relevant for the budget or budgetary decisions are influential or even critical for them. The budgetary perspective includes the control principle, but is adopting it in a more rigorous way as it requires budgetary influence. Therefore, the scope of consolidation is smaller and excludes entities that are neither receiving funds from the government budgets nor contributing to it (Bergmann, 2009; Brusca and Montesinos, 2009).

Box 4.1 The European Commission’s global consolidation The consolidation process within the European Commission has evolved over time. The compilation of the CFS has become more complex. The original European Union (EU) organizational structure (Parliament, Council, Commission, Court of Justice and Court of Auditors) has broadened with the addition of agencies that were created during the early 1990s. Since 2005,


Giuseppe Grossi these agencies have been included in the CFS of the EU, compiled according to IPSAS 6, 7 and 8. In the first phase (until 2005), in which the CFS was compiled by the European Commission, the area of consolidation included only the European institutions and advisory bodies financed through the general budget of the EU – that is, the European Parliament, the Council, the Commission, the Court of Justice, the Court of Auditors, the Social and Economic Committee, the Committee of the Regions and the Ombudsman. In this phase, the EU followed the criterion of a single budget in order to set the area of consolidation (European Commission, 2003). In the first phase, only the EU institutions and advisory bodies were included in the consolidated accounts. According to the IPSAS, the criterion is the existence of control and, consequently, the policy employed was revised to include all the decentralized entities under the control of the EU institutions. In the second phase (since 2005), the annual report of the EC was globally consolidated to include other institutions and bodies that have a legal status and receive grants charged to the European budget (agencies), the businesses that are under exclusive control (IPSAS 6), the agencies subjected to significant influence (IPSAS 7), and the agencies under joint control (IPSAS 8). The EU compiles its CFS according to a hybrid approach, including both the control criteria of the IPSAS consolidation standards (since 2005) and the budgetary principle that characterizes the EU’s organizational structure, which is simultaneously centralized (institutions) and decentralized (agencies). The solution adopted by the EC appears to be a fair compromise between the traditional public (budgetary) approach and the privatistic approach also supported by the IPSASB, which is more focused on the concept of control. The new area of consolidation, defined as beginning in the 2005 financial year, is based on two criteria: a budgetary one (for the European institutions and agencies financed through the EU general budget); and a control one (for all other European agencies, according to IPSAS 6, 7 and 8). (Grossi and Soverchia, 2011)

If control does not exist, then it becomes necessary to investigate whether the decentralized organization might be a joint venture or an associate company. The consolidation method is determined depending on whether control, a joint venture or an associate exist; therefore, the decentralized organization will be represented in the CFS depending on the type of influence that a government is able to exercise. The consolidation methods should represent the different types of influence the public sector entity has on its subsidiaries. If a public sector entity is under the control of another public sector entity, it should be fully consolidated (IPSAS 6.17). If it is a joint venture, the entity should be consolidated proportionally or by using the equity method (IPSAS

Consolidated financial statements


8.36). If a public sector entity has a significant influence on another public sector entity, the equity method should be used (IPSAS 7.18). Governments can hold shares in companies that are owned also by a large number of governments, or in companies that are more regionally organized with only a relatively small number of shareholders. Share-based participations generally do not qualify for consolidation due to the lack of power. In this case, consolidation under IPSAS 6 might be applicable, but only if one government has a majority stake. In general, this means that only one government is required to consolidate a corporation with fragmented ownership. This analysis clearly shows that, also in the definition of the reporting entity, the IPSAS are essentially based on the standards issued for the private sector by the IASB. This means that the fundamental feature of the standards is based on a narrow accountability and decision-making approach that aims to produce information primarily for investors (Grossi and Tagesson, 2008).

Box 4.2 Alternative approaches to IPSAS The case of the Swedish local governments Sweden is one of the few European countries actually to have introduced CFSs at local level. In the latter part of the 1980s, CFRs were introduced on a voluntary basis by the Swedish local governments. The introduction was encouraged by the Swedish Association of Local Authorities, which published a booklet in 1989 with instructions and ideas about objectives and techniques for consolidated reporting in a municipal context. The municipal accounting act includes a paragraph that lays down that municipalities should establish a consolidated accounting report including a balance sheet and an income statement. In the more detailed issues about CFSs the law refers to generally accepted accounting principles (GAAP) and standard setters. The Swedish Council on Municipal Accounting has issued a standard (first RKR 8.1 and later RKR 8.2), which is essentially built upon the same fundamental presumptions as earlier GAAP and guidelines. According to the standard (RKR 8.2), subsidiaries should be included in the CFS if the municipality directly or indirectly has a material/significant influence. A rule of thumb is that the municipality control 20% of the number of votes. However, according to the standard, there are situations when the number of votes can fall short of 20% but the ownership involve a material economic commitment for the municipality. In these cases, the subsidiary should be included in the CFS. The municipality is required to produce a CFS if (RKR 8.2, 2009):  The municipality’s share of the company’s turnover is equal to or more than 5% of the income of taxes and government grants of the municipality.


Giuseppe Grossi  The municipality’s total share of the company’s balance sheet total is equal to or more than 5% of the municipality’s balance sheet total. Entities that can be excluded from the area of consolidation (RKR 8.2, 2009):  Should have been acquired with the purpose to sell within a year.  Should have a substantial and permanent obstacle for the municipality to exercise its power. An individual subsidiary can also be excluded if the subsidiary’s share of turnover or balance sheet total is less than 2% of the municipality’s turnover or balance sheet total. However, if a number of subsidiaries go below the 2% limit but together exceed the 5% limit, they have to be included. According to the standard, the general rule is that the proportional method should be used when consolidating the companies. The standpoint is based on the fact that it is quite common in Sweden but also in other EU countries for several municipalities to form jointly owned companies with a fragmented ownership in order to run different activities and operations serving the inhabitants in all the neighbouring municipalities (e.g. regarding waste management, water, sewage, and also social and recreational services). A full consolidation method may imply that a company that is jointly owned by several municipalities only can be included in the CFS of one of the municipalities. (Tagesson and Grossi, 2012)

The case of the Dutch local governments A different approach to consolidation at the local level can be found in the Netherlands. Since 2004, Dutch municipalities and provinces have no longer been allowed to consolidate entities in which they financially participate, even in situations in which they have 100% of the shares. In the explanatory memorandum of the BBV (the Dutch legislation for financial reporting of provinces and municipalities), several reasons are given for this. First, the memorandum states that a financial criterion for consolidation is not enough to determine whether or not an entity should be consolidated. In a situation in which a government entity has only a small percentage of the shares of another entity, this does not mean that the risk for the government is also small. An example is given of a small municipality owing a small percentage of the shares in a large business corporation. Second, the memorandum states that municipalities (and provinces) can have relationships with several entities, including non-profit foundations and associations. Therefore, the

Consolidated financial statements


law on financial reporting of businesses is considered unusable for municipalities. Instead of consolidation, another solution is laid down in the law. Municipalities should provide an overview of all related parties in their budget and annual report. This has to be done in a separate paragraph, ‘related parties’. This section should deal (according to the law) with at least the following two elements. First, it should specify how these parties contribute to the accomplishment of the policy targets. Second, it should indicate the policy intentions of the municipality with these parties. Furthermore, the memorandum on the budget and the annual report should contain a list, indicating the following for all related entities:  The name and place of business.  The public interest that is promoted this way.  Changes in the municipality’s interest in the entity during the budget year.  The shareholder equity and the liabilities at the beginning and the end of the budget year.  The financial return of the entity. Instead of consolidation, financial participation in other entities should be recognized under ‘associates’. Dutch law dictates that shares be recorded at their acquisition price or permanent lower value. However, if a municipality intends to sell its shares, the actual price should be presented in the notes to the balance sheet. The effect of these rules can be illustrated by examining the sale of Dutch power company Nuon to its Swedish competitor Vattenfall in 2009. Whereas the municipalities and provinces that owned Nuon reported a total share value of about €315 million in their balance sheets, the company was sold for €10.3 billion – 33 times the value in the balance sheet.

Summary  There are three main theoretical approaches for the preparation of CFSs: entity theory, parent company theory and proprietary theory. The different theoretical approaches significantly impact on the corporate group concept, the consolidation area and methods.  CFSs are useful financial tools for improving accountability to internal and external users. This aggregate view is only a part of the information needed in order to give politicians, managers, citizens and other external users a view of a whole of government performance. In particular, the need emerges to have segmental information, covering specific areas and policies of intervention for which it is appropriate to report financial


Giuseppe Grossi

information separately. The growing development of decentralized entities has led to the fact that the traditional annual reports of governments disclose only a partial view of their economic and financial activities, because the financial consequences of subsidiaries, joint ventures and associates are not necessarily considered. CFSs in the public sector are recognized and promoted as essential to support decision-making processes and to ensure public accountability (IFAC, 2012a, 2012b, 2012c).  The area of consolidation can be defined in two ways. The first, which is more widespread, uses the existence of control, on which IPSAS 6 is based. The second requires the presence of financial accountability, on which GASB 14 is based.  Control – as defined by IPSAS 6 with the two elements of power and benefits – is difficult to find in the public sector, because power does not always go hand in hand with ownership or capital invested. Control criteria in the public context are not always shares held or seats on boards, but are, for example, such entities that fulfil public sector functions and are mainly dependent on the government budget (such as the case of the European Commission).

Discussion questions 1 2 3 4 5

What are the main consolidation approaches? What pressures led to the implementation of CFSs in the public sector? What are the benefits of CFSs in the public sector? Who are the main internal and external users of CFSs? What are the standards (international or national) used in the consolidation process? 6 What are the characteristics and the limits of the IPSASB’s approach to consolidation? 7 What are the alternative approaches to the IPSAS?

References Alfredson, K., Leo, K., Picker, R., Loftus, J., Clark, K. and Wise, V. (2009) Applying International Financial Reporting Standards, second edn, Milton, Qld: Wiley Australia. Benito, B., Brusca, I. and Montesinos, V. (2007) ‘The Harmonization of Government Financial Information Systems: The Role of the IPSASs’, International Review of Administrative Sciences 73(2): 293–317. Bergmann, A. (2009) Public Sector Financial Management, Harlow: Financial Times Prentice Hall. Broadbent, J., Dietrich, M. and Laughlin, R. (1996) ‘The Development of PrincipalAgent, Contracting and Accountability Relationships in the Public Sector: Conceptual and Cultural Problems’, Critical Perspectives on Accounting 7(3): 259–84. Brusca, I. and Montesinos, V. (2009) ‘International Experiences in Whole of Government Financial Reporting: Lesson Drawing for Spain’, Public Money & Management 29 (1): 243–50.

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Bundred, S. (2006) ‘The Future of Regulation in the Public Sector’, Public Money and Management 26(3): 181–88. Chan, J.L. (2003) ‘Government Accounting: An Assessment of Theory, Purpose and Standards’, Public Money & Management 25(1): 13–20. Childs, W.H. (1949) Consolidated Financial Statements: Principles and Procedures, New York: Cornell University Press. Chow, D., Humphrey, C. and Moll, J. (2007) ‘Developing Whole of Government Accounting in the UK: Grand Claims, Practical Complexities and a Suggested Future Research Agenda’, Financial Accountability and Management 23(1): 27–54. Dodge, R. (1996) Group Financial Statements, London: Chapman & Hall. European Commission (2003) ‘Modernizing of the Accounting System of the European Communities’, in K. Lüder and R. Jones (eds) Reforming Governmental Accounting and Budgeting in Europe, Frankfurt am main: Fachverlag Moderne Wirtschaft. FEE (Fédération des Experts Comptables Européens) (2007) Accrual Accounting in the Public Sector, Paper from the FEE Public Sector Committee. Grossi, G. and Mussari, R. (2008) ‘Effects of Outsourcing on Performance Measurement and Reporting: The Experience of Italian Local Government’, Public Budgeting and Finance 28(1): 22–38. Grossi, G. and Newberry, S. (2009) ‘Theme: Whole-of-Government Accounting: International Trends’, Public Money and Management 29(4): 209–15. Grossi, G. and Pepe, F. (2009) ‘Consolidation in the Public Sector: A Cross-country Comparison’, Public Money & Management 29(4): 251–56. Grossi, G. and Reichard, C. (2008) ‘Municipal Corporatization in Germany and Italy’, Public Management Review 10(5): 597–617. Grossi, G. and Soverchia, M. (2011) ‘European Commission Adoption of IPSAS to Reform Financial Reporting’, ABACUS 47(4): 525–42. Grossi, G. and Tagesson, T. (2008) ‘Consolidated Financial Reports in Local Governments: A Comparative Analysis between IPSAS and SCMA’, in S. Jorge (ed.) Implementing Reforms in Public Sector Accounting: Problems, Changes and Results, Coimbra: University of Coimbra Press, 337–49. Heald, D. and Georgiou, G. (2000) ‘Consolidation Principles and Practices for UK Government Sector’, Accounting and Business Research 30(2): 153–67. IFAC (International Federation of Accountants) (2012a) ‘IPSAS 6 – Consolidated Financial Statements and Accounting for Controlled Entities’, tions/international-public-sector-accounting-standards-board/handbooks. ——(2012b) ‘IPSAS 7 – Investments in Associates’, ——(2012c) ‘IPSAS 8 – Interests in Joint Ventures’, Jones, R. (2007) ‘The Functions of Government Accounting in Europe’, Revista de Estudos Politécnicos/Polytechnical Studies Review 4(7): 89–110. Jones, R. and Pendlebury, M. (2000) Public Sector Accounting, fifth edn, Harlow, UK: Prentice Hall. Kam, V. (1990) Accounting Theory, 2nd edn, New York: Wiley. Kettl, D. (1993) Sharing Power: Public Governance and Private Markets, Washington: Brookings Institution. Kothavala, K. (2003) ‘Proportional Consolidation Versus the Equity Method: A Risk Measurement Perspective on Reporting Interests in Joint Ventures’, Journal of Accounting and Public Policy 22(6): 517–38.


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Lüder, K. and Jones, R. (eds) (2003) Reforming Governmental Accounting and Budgeting in Europe, Frankfurt am main: Fachverlag ModerneWirtschaft. Nobes, C. and Parker, R. (2011) Comparative International Accounting, Harlow, UK: Prentice Hall. Osborne, S. and Brown, K. (2005) Managing Change and Innovation in Public Service Organizations, London: Routledge. Osborne, S. and Gaebler, T. (1992) Reinventing Government, New York: Plume. Robb, A. and Newberry, S. (2007) ‘Globalization: Governmental Accounting and International Financial Reporting Standards’, Socio-Economic Review 5(4): 725–54. Schuster, W. (2005) Group Accounting: An Analytical Approach, Studentlitteratur. Tagesson, T. and Grossi, G. (2012) ‘The Materiality of Consolidated Financial Reporting – An Alternative Approach to IPSASB’, International Journal of Public Sector Performance Management 2(1): 81–95. Torres, L. and Pina, V. (2002) ‘Changes in Public Service Delivery in the EU Countries’, Public Money & Management 22(4): 41–48. Walker, R.G. (1978) ‘International Accounting Compromises: The Case of Consolidation Accounting’, Abacus 14(2): 97–111. ——(2009) ‘Public Sector Consolidated Statements – An Assessment’, ABACUS 45 (2): 171–220. Wise, V. (2006) ‘Cross-Sector Transfer of Consolidated Financial Reporting – Conceptual Concerns’, Australian Journal of Public Administration 65(3): 62–73.


Public sector management control tools Tjerk Budding

Learning objectives  To have knowledge of the frameworks for management control, as constructed by Merchant (1982), Simons (1995) and Hofstede (1981), and to be able to apply these in daily practice.  To understand the differences in characteristics between profit and non-profit organizations (including public sector entities) that affect the management control process.  To know the difference between Traditional Public Management (TPM), New Public Management (NPM) and public value (PV).  To be aware of the purposes of, conditions for and problems with performance measurement in the public sector.  To have an understanding of the balanced scorecard and benchmarking.  To be able to indicate how the principle of trust has influenced management control theory.

Key words         

Benchmarking Management control New Public Management Performance indicators Performance management Public governance Public value Soft control Trust

5.1 Introduction History of management control theory As a result of the Industrial Revolution in the eighteenth and nineteenth centuries, organizations grew from one-man businesses to large organizations.


Tjerk Budding

The need increased to have a mechanism to ensure that people in organizations were engaged in those activities in the interests of the owners. In the nineteenth century, in fact, the first management accounting instruments were introduced, such as calculating the costs per machine and working hour (refer to Chapter 6 for a more extended overview). However, the term management control was not used until 1938. In that year a book entitled Cost Accounting: principles and practice was published in which William Vatter from the University of Chicago wrote a chapter about management control (Vatter, 1942). In this chapter Vatter proposed that cost accounting information should be considered from a managerial point of view. This managerial view of using accounting information was also used by Robert Anthony, who showed in his book Management Accounting: Text and Cases (1956) how financial statements may be useful not only to outside partners, but also to management. A new breakthrough came in 1965, when Harvard Professor Robert Anthony published his book Planning and Control Systems: A Framework for Analysis. This book did much to establish management control as a separate field of study. Anthony defined management control as ‘the process by which managers assure that resources are obtained and used effectively and efficiently in the accomplishment of the organization’s objectives’ (Anthony, 1965: 17). He stressed that management control is especially about the motivation of employees. Anthony distinguishes management control from strategic control. While the latter is about setting goals and policies, the former is about carrying out the necessary plans to ensure that the strategies are fulfilled as envisaged. Alone and together with co-authors, he wrote many books about Management Control Theory and the application of this theory in specific contexts. He co-authored (first with Regina E. Herzlinger, later with David Young) book Management Control in Nonprofit Organizations, was used on many courses and was last published in 2003. This book was written to apply to all types of non-profit organizations, including government entities. However, before going into detail on the specific characteristics of management control in these kinds of entities, the two most popular frameworks for management control will be dealt with. Merchant’s framework Although Anthony’s work was of great significance, it was also criticized because it was considered rather normative and theoretical, i.e. it did not take empirical findings into account (Groot, 2013). In the 1980s and 1990s Harvard Professor Kenneth Merchant and Professor David Otley from the UK wrote many books and articles in which they used a more descriptiveempirical approach (Groot, 2013). This approach was characterized by empirical analysis as to how management control worked in daily practice and which lessons could be learned from it. One of the main contributions of Merchant’s work was the fact that he emphasized that, before implementing a management control system, first one

Public sector management control tools


should consider whether a control system is really required. In Merchant’s words: ‘If all personnel always did what was best for the organization, control – and even management – would not be needed’ (Merchant, 1982: 43). If this is not the case, in other words if there is a deviation between the goals of the organization and the behaviour of its employees, its causes should be analysed. Personal limitations may constitute a first cause. People do not always understand what is expected of them nor how they can best perform their jobs, as they may lack appropriate skills, training or information. A second possible cause is that individual goals and organizational goals may not coincide perfectly – in other words, there is a lack of goal congruence. Control systems may be helpful in overcoming these problems, but other solutions, such as offering training and providing information, may also contribute. Before further analysing how control systems can be used to overcome these problems, Merchant remarks that perfect control (meaning that there is complete certainty that actual accomplishment will proceed according to plan) is never possible as there is always a chance of unforeseen events. Furthermore, some problems can be avoided by specific actions, such as automation, centralization, risk sharing and elimination of activities. Merchant states that computers and other forms of automation reduce the organization’s exposure to control problems, because they can be set to perform appropriately (that is, as the organization desires), and they will perform more consistently than human beings do. Centralization diminishes the risk that people in the organization take decisions that are not in the company’s best interests. Risk sharing with an outside body, such as a risk insurance company, does not remove the problems, but reduces the financial exposure. The most far-reaching action is the entire elimination of a business or an operation. If management cannot, or chooses not to, avoid the control problems, they must address the problems by implementing one or more control tactics. Merchant introduced three categories of tactics, according to the object of control: 1) action control; 2) results control; and 3) personnel and cultural control. Action or behavioural control is about trying to ensure that individuals perform those actions that are desirable (or undesirable), e.g. by holding employees accountable for their actions or using constraints, including both physical constraints (locks, etc.) and administrative constraints (e.g. segregation of duties). If results control is applied, employees are held accountable for the results accomplished. Use of results control requires: 1) defining the dimensions along which results are desired, such as efficiency, quality and service; 2) measuring performance on these dimensions; and 3) providing rewards/punishments to encourage/discourage behaviour that will lead/not lead to those results (Merchant, 1982: 45–46). Personnel control emphasizes a reliance on the personnel involved to do what is best for the organization. Mechanisms of personnel control include selection and training. Merchant emphasizes that not every control system can be used in every situation. Its feasibility depends on the specific situation in which it will be


Tjerk Budding Ability to measure results on important performance dimensions High



Specific-actions and/or results control

Specific-action control (e.g., real-estate venture)


Results control (e.g., movie director)

Personnel control (e.g., research laboratory)

Knowledge of which specific actions are desirable

Figure 5.1 Key control object feasibility determinants Source: Merchant, 1982: 47

used. He identifies two main factors: 1) is there knowledge of which specific actions are desirable? And 2) what is the ability to measure results? Figure 5.1 shows these factors and the feasible control mechanisms. Since the publication of Merchant’s study, a lot of research has been conducted on the question of which control system is feasible in which circumstances. In the so-called contingency approach to management accounting and control, it was analysed which determinants seemed relevant and what influence these determinants had. This is based on the premise that there is no universally appropriate accounting system that applies equally to all organizations in all circumstances, but rather that the particular features of an appropriate accounting system will depend on the specific circumstances in which an organization finds itself. Attention was paid – amongst other things – to environmental uncertainty, size and culture (for an extended overview of findings, see Chenhall, 2003). Although many papers used a contingency-based approach, the number of papers dealing with public sector organizations is limited.

Simons’s framework It was again a Harvard professor who introduced another scientific approach to management control. In a number of papers and books in the 1990s, Robert Simons stressed that strategic issues and management control systems are interwoven. Whereas earlier authors (such as Anthony) regarded

Public sector management control tools


management control systems as systems used to ensure that strategies developed by top managers were implemented, Simons (1994) showed that management control systems could be used to set strategies. Furthermore, he stated that the mix of control systems used was contingent on the strategic phase of an organization. In order to learn more about this interplay between control systems on the one hand and strategy on the other, his research did not focus on one point in time, but rather used a longitudinal approach. In Simons’s vocabulary, ‘opportunity’ is an important term. He explains that business scholars generally think that decision makers are constrained by the number of available opportunities. However, in his view, the problem for today’s managers is not one of constrained opportunities, but one of too many opportunities (Simons, 1995: 14). Unexpected opportunities present themselves every day, such as the initiation of a new project by an employee or the proposition of a joint venture by a competitor. Therefore, these opportunities need to be stimulated and controlled. For his analysis, Simons introduces the term ‘opportunity space’, which refers to all the opportunities an organization can potentially identify or create at a given moment in time, regarding its resources and competences. Simons observed that control systems may help in controlling these opportunity spaces by providing boundaries for which actions may or may not be taken (boundary systems), communicating core values (beliefs systems), measuring and controlling critical performance variables (diagnostic control systems) and providing a mechanism for interaction within the organization (interactive control systems), so that strategic uncertainties can be dealt with (see Figure 5.2). Beliefs Systems

Boundary Systems


/ Core Values

Risks To Be Avoided


\ Business Strategy

/ Critical Performance Variables

Diagnostic Control Systems

Figure 5.2 Simons’s control framework Source: Simons, 1994: 173

Strategic Uncertainties

Interactive Control Systems Systems


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Simons’s research also showed that managers could use management control systems as levers for strategic renewal. He found that the ten top managers whom he observed empirically showed great similarities in the way they used control systems for strategic renewal (Simons, 1994). In such a situation of strategic renewal, the first step these managers generally took was to formalize core values (beliefs). The second step was to set boundaries on acceptable strategic behaviour. This was followed by a definition and measurement of critical performance variables. Finally, in order also to be successful in the long run, organizational dialogue and debate between top management and others in the organization were stimulated.

5.2 Management control in public sector organizations Differences in characteristics In their seminal book Management Control in Nonprofit Organizations, Anthony and Young (2003) sum up nine differences between profit and nonprofit organizations (including public sector entities) that affect the management control process:  The absence of a profit measure: If such a measure is available, this can be used for several purposes, such as comparing the performance of units that perform different functions in the organization and offering a single broad measure of performance. Now this measure is absent in non-profit organizations, alternative measures should be found for control purposes.  Differences in tax and legal arrangements: Generally non-profit organizations do not have to pay value-added tax (VAT) or income tax. Furthermore, non-profit organizations are not owned by shareholders.  Most often, non-profit organizations are service organizations: Generally non-profit organizations do not produce physical products, but rather provide services for society, so their output cannot be stored. Furthermore, service organizations are labour intensive and their quantity and quality is often difficult to measure.  There are constraints in goals and strategies: Often non-profit organizations are not (completely) free in setting goals and strategies, but have to provide certain services.  Source of financial support: Some non-profit organizations obtain their financial resources from sales revenue, while other non-profit organizations receive financial support from sources other than revenue from services rendered. In these public-supported organizations, there is no direct connection between the amount of services received by clients and the amount of resources provided by the organization.  Dominance of professionals: In many non-profit organizations, success in achieving goals depends upon the behaviour of professionals (e.g. physicians,

Public sector management control tools


scientists and teachers), who often have motivations that are inconsistent with good resource utilization.  Differences in governance: In private sector organizations, shareholders have ultimate authority. This is different in non-profit organizations. Generally, governance is exercised by a governing board. Furthermore, in government organizations, there often is a division of authority among executive, legislative and judicial branches. This fragmentation of authority may conflict with management control.  Political influence: Many non-profit organizations are political. In these organizations, decisions result from multiple, often conflicting, pressures. Furthermore, in some instances, the need for improved management arises because of the high visibility of the actions performed by non-profit organizations.  Tradition of inadequate management controls: In Anthony and Young’s view, non-profit organizations have been slow to adopt twentieth-century accounting and control concepts and practices, particularly the accrual concept. Hofstede’s framework In the previous paragraphs, two popular frameworks for management control were presented. However, one could question whether these frameworks fit with the characteristics of public sector organizations. In 1981, Hofstede published a paper in which he presented an alternative framework specifically aimed at the public and non-profit sector. In his view, it is better to relate forms of control to activities rather than to organizations, as within each organization a range of activities can be found, which demand quite different forms of control. He distinguishes four criteria that have to be taken into account and that determine the way in which activities can or cannot be controlled (see Figure 5.3):    

Are the objectives of the activity unambiguous or ambiguous? Are its outputs measurable or non-measurable? Are the effects of management interventions known or unknown? Is the activity repetitive or non-repetitive?

If the objectives of activities are ambiguous and this cannot be resolved, political control (indicated with (6) in Figure 5.3) is feasible. In this form, one way to resolve ambiguities is the use of hierarchy: higher authorities or bureaucracies set the objectives, which then, for those lower in the organizational hierarchy, become unambiguous. Another method is negotiation: the negotiated settlement then becomes the (unambiguous) objective for the organization. If objectives are unambiguous, but outputs are not measurable, judgemental control (5) may be applicable. Here control depends on the power and


Tjerk Budding Organizational activity


Are \ objectives unam biguous





Can ambiguity be resolved >



Are \ outputs measurable




Political control









Can \ acceptable surrogate measures be found


Judgem ental control




Are \ effects of interventions \ known / 9




activity repetitive



Intuitive control




Trial and error control


Is ^ activity repetitive


Expert control



Yes Routine control


Figure 5.3 Hofstede’s management control framework Source: Hofstede, 1981: 196

influence structure of the organization. Judgemental control proposes the use of a supreme judge (or coalition of judges) whose judgements do not have to be negotiated, so this judge can assess whether objectives have been reached (in his or her opinion) and whether further action has to be undertaken if this is not the case. If the first two conditions are fulfilled, the third question becomes relevant: are the effects of interventions known? If not, one should consider whether the activity is repetitive. If this is not the case, the organization has to rely on a person who can be trusted to find intuitively the proper way of intervention

Public sector management control tools


needed to achieve the desired results. Hofstede calls this intuitive control (4). An example of this is leading a demoralized football club. If the activity is repetitive, trial-and-error control (3) becomes feasible. This implies that the organization can learn from analysing its own successes and failures. If the first three of Hofstede’s four questions can be answered positively (so objectives are unambiguous, outputs measurable and effects of management interventions are known), one should consider if the activity is repetitive. If not, in Hofstede’s view, it makes sense to entrust control to someone for whom such activities are repetitive, whom he calls an expert (2). Such a person is able to learn from the effects of interventions on previous occasions. Finally, if all conditions are fulfilled, routine control (1) can be used. This type of control can be prescribed in precise rules and regulations, can often be carried out by personnel on the shop floor, and can sometimes be programmed into a computer. Hofstede (1981) states that the dominant model for a control process is that of a ‘thermostat’. In this perspective, the objective setting is analogous to the setting of a temperature. Measuring output corresponds with measuring actual temperature, comparing output to objectives is analogous to comparing actual to set temperature, feeding back unwanted variances to management is analogous to the negative feedback signal in the thermostat cycle, and, finally, corrective intervention in the process is analogous to intervention in the flow of heat to the system. Seen from this perspective, only routine control complies with this cybernetic model. Many scholars cited Hofstede’s (1981) work in discussing the feasibility of certain control models for government and non-profit organizations. In particular, the use of cybernetic models (such as result control in Merchant’s terms) was criticized. However, at the same time, the use of a more results-oriented control approach in public organizations was stimulated in the so-called New Public Management (NPM) approach. This approach will be discussed further below.

5.3 Performance management In the private sector, both practitioners and academics expressed dissatisfaction with traditional (especially financial) performance measurement in the 1970s and 1980s. The traditional systems, developed from costing and accounting systems, were criticized for encouraging short-term behaviour, lacking strategic focus, encouraging local optimization, encouraging minimization of variance rather than continuous improvement and not being externally focused (Bourne et al., 2000). In the public sector, performance management also became an important theme. This was especially the case from the 1980s onwards, and is often regarded as an element of the NPM reforms. However, in the first decades of the twentieth century, in the USA the first initiatives were already undertaken to measure performance, mainly in the form of measuring the efficiency of


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government entities (Bouckaert and Halligan, 2008). In this period there was not much interest in results and outcomes. However, before discussing the purposes, conditions and possible side-effects of performance management, we will first pay attention to the management doctrines that can be identified. Management doctrines As already discussed in Chapter 2, section 2.1 of this book, from the 1980s onwards, major reforms were implemented in the public sector of many countries, which are often referred to as New Public Management (NPM) reforms. NPM is a broad term for a variety of management ideas, often borrowed from the private sector, introducing ideas and tools such as competition, privatization, management by objectives, and decentralization in the public sector. NPM replaced (Traditional) Public Management (TPM), which was used in many countries from the late nineteenth century, and which reached its climax in Western European countries in the post-Second World War period (Osborne, 2006). At that time (1945–75), in most developed countries the post-welfare state emerged, when the state was expected to meet all social and economic needs of citizens and government expenditures increased each year. This period ended, or at least began to end, with the oil-triggered economic crisis of 1975. The elections of Margaret Thatcher in 1979 in the United Kingdom and Ronald Reagan in 1980 in the USA are generally regarded as the starting points of the implementation of NPM (Osborne, 2006). Although NPM techniques (such as accrual accounting and output measurement) were implemented in many countries, it was also subject to severe criticism. Osborne (2006) states that this criticism especially had to do with its intra-governmental focus in an increasingly plural world and its adherence to the application of outdated private sector techniques to public administration and management. Several authors in the 1990s stressed that one should consider that, in order to execute public policy effectively, governments should realize that they belong to a network of citizens and other entities. This argument formed the main starting point for developing alternative frameworks, of which New Public Governance (NPG) and public value (PV) attracted most attention. Both terms have many elements in common (especially the focus on interorganizational relationships, i.e. networks). The concept ‘public value’ was introduced by Harvard Professor Mark Moore in his 1995 book Creating Public Value, in which he stated that ‘the aim of managerial work in the public sector is to create public value just as the aim of managerial work in the private sector is to create private value’ (Moore, 1995: 28). Furthermore, in his book he explains how public managers can create public value: ‘public value can be envisioned by public managers if they integrate: (1) substantive judgements of what would be valuable and effective; (2) a diagnosis of political expectations’ (Moore, 1995: 22). Another influential author on this topic

Public sector management control tools


is UK Professor Colin Talbot. He is of the opinion that public value essentially tries to weld together ideas about efficiency and effectiveness in the provision of public services with notions of democratic legitimacy and trust. He sees (in some ways) that public value can be seen as a synthesis of elements of TPM and NPM. In his view, public value is about balancing and securing three interests in a single framework (Talbot, 2011: 30):  Self-interest, which captures the need for public services to provide good quality and efficient services at an optimum price to both the taxpayer/ citizen and the ‘customer’.  Public interest, which stresses the social outcomes aspects of public services – providing taxes and legitimacy for ‘common good’ activities that improve the welfare of all citizens (and have an inherently redistributional content).  Procedural interest, which emphasizes the need for equity, fairness and due process in the way in which people get to participate in shaping public decisions and even individual services. PV was paid much attention to, particularly in the UK, where it was considered ‘the next “big thing” in public management’ (Talbot, 2009) in academia and several organizations (e.g. the BBC), and committees paid attention to the subject. Table 5.1 provides an overview of the differences between TPM, NPM and PV as identified by Kelly et al. (2002) in their study for the UK Cabinet Office. Performance indicators As we saw in the previous section, three management doctrines can be identified (TPM, NPM and PV), which all aim to ensure that public sector organizations provide good services, and use proper processes in order to do so. However, these management doctrines differ in their focus on the relevant aspects of performance. In order to disentangle what could be measured, we follow the framework for performance measurement as developed by Bouckaert and Halligan (2008). This model (see Figure 5.4) assumes that institutions and/or programmes are set up to address some specific socio-economic need(s) in society. Institutions establish objectives concerned with these needs, and acquire inputs (staff, buildings, resources) with which to conduct activities in pursuit of those objectives. In order to generate outputs, activities (or processes) are undertaken. The outputs are the product of these activities – what the institutions deliver to the outside world. These then interact with the environment (especially with those individuals and groups at which they are specifically aimed), leading to ‘results’ and, in the longer term, more fundamental impacts. Both results and impacts may be called outcomes (results are sometimes called intermediate outcomes and impacts final outcomes). The model assumes that,


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Table 5.1 Differences between TPM, NPM and PV Traditional Public Management

New Public Management

Public Value

Public interest

Defined by politicians/experts

Individual and public preferences (resulting from public deliberation)

Performance objective

Managing inputs

Aggregation of individual preferences, demonstrated by customer choice Managing inputs and outputs

Dominant model of accountability

Upwards through departments to politicians and through them to Parliament

Preferred system for delivery

Hierarchical department of self-regulating profession

Approach to public service ethos

Public sector has monopoly on service ethos, and all public bodies have it

Role of public participation

Limited to voting in elections and pressure on elected representatives Respond to political direction

Goal of managers

Source: Kelly et al., 2002

Multiple objectives:  Service outputs  Satisfaction  Outcomes  Maintaining  Trust/legitimacy Upwards through Multiple: performance  Citizens are overseers contracts; of government sometimes outwards  Citizens as users to customers  Taxpayers as funders through market mechanisms Private sector or Menu of alternatives tightly defined selected pragmatically arms-length public (public sector agencies, agency private companies, joint venture companies, community interest companies, community groups as well as increasing role for user choice) Sceptical of public No one sector has a sector ethos (leads monopoly on ethos, to inefficiency and and no one ethos empire building) – always appropriate; as favours customer a valuable resource it service needs to be carefully managed Crucial: multi-faceted Limited, apart (customers, citizens, from use of key stakeholders) customer satisfaction surveys Meet agreed Respond to citizen/user performance targets preferences, renew mandate and trust through guaranteeing quality services

Public sector management control tools Needs





2.Infancy 2.Infancy






11 11


'------------161-------+-----' '---------------171------------------'

1. 2. 3. 4. 5. 6. 7.

Input/output: economy Input/output: efficiency/productivity Output/( effect-outcome): effectiveness Input/(effect-outcome): cost effectiveness (effect-outcome): trust Output: trust Input: trust

Figure 5.4 Framework for performance measurement Source: Bouckaert and Halligan, 2008: 16

if entities are doing those things that contribute to the well-being of society, this increases trust in government. The performance of an organization can be measured by focusing on various elements of the model. First, one can focus on the inputs and ‘savings’. Here the main question is how many inputs (generally expressed in monetary terms) the institution has used, without analysing the results achieved with these inputs. Other perspectives to analyse the performance can be found in the so-called ‘3Es’: economy, efficiency and effectiveness. Economy expresses the costs that were associated with acquiring the inputs (e.g. the costs of labour). Efficiency (or productivity) is about relating outputs produced to inputs consumed, which is the organization’s output per unit of input. For governmental activities, the objective is often not to produce outputs as high as possible per se, but to realize some societal effect. Effectiveness is the relationship between an institution’s outputs and its outcomes. However, one could also analyse whether the outcomes are cost effective, i.e. how the outcomes relate to the inputs consumed. In course of time, the focus on performance indicators has shifted from input indicators, via process and output indicators, to outcome indicators.


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TPM stressed the legitimacy of government expenditures and, therefore, it was considered important that the budget, the amount of money to be spent on a certain programme or an organizational unit, was not overrun, as this budget was the politically approved sum to be spent. Under NPM, the focus was on efficiency. PV and public governance stress multiple goals: government entities should not only aim to realize the goals the citizens want them to, but they also should offer ‘value for money’ in the taxpayers’ view, so they should also ensure that the entity is performing economically and efficiently. In other words, a full span of measurement is taken into account: economy, efficiency, effectiveness and trust (Bouckaert and Halligan, 2008). Measurement of indicators Indicators have several characteristics. So far, we have discussed the difference between input, process, output and outcome indicators. However, indicators can also be distinguished along the following dimensions, which relate to the way in which they can be measured (Anthony and Young, 2003: 629–34):  Subjective versus objective: to what extent is that indicator free of bias because of human judgement?  Quantitative versus non-quantitative: can the measurement be expressed in numbers that can be summarized and compared?  Discrete versus scalar: is the measurement expressed in a dichotomous form (yes/no) or can it be measured along a scale?  Actual versus surrogate measures: if the actual output cannot be measured (efficiently), a surrogate measure may be used, which should be closely related to an objective.  Quantity versus quality: does the measurement express the quality of the output or a quantity of services/products? In practice, it is often difficult to measure output and outcomes. Problems that can be encountered include the following (Hofstede, 1981; Anthony and Young, 2003: 623–26): 1) ambiguity – goals may be ambiguous, e.g. because different actors often do not agree on the ultimate goals of the organization; 2) measurability problems – can the output of an activity be identified and measured?, and 3) terminology problems – do all participants define output in the same way (e.g. what is a result in a hospital: how many patients have been treated or how many patients have been cured?)? Another problem regarding output measurement in public sector organizations is that these often have multiple goals that cannot be summarized into one ultimate goal, such as profit. However, specific techniques such as data envelopment analysis (DEA) may be helpful as they analyse the relative efficiency of entities (decision-making units) within organizations (Charnes et al., 1978). The heart of this method lies in finding the ‘best’ virtual producer for each real producer. If the virtual producer is better than the original producer

Public sector management control tools


by either producing more output with the same input or producing the same output with less input, then the original producer is inefficient. DEA studies have been done at banks, police stations, hospitals, tax offices, prisons, defence bases (army, navy, air force), schools and university departments. Although the DEA technique may be helpful as it can take multiple input and output indicators into account in one analysis, its disadvantage is that it restricts the analysis to efficiency indicators and does not take qualitative indicators into account. Balanced scorecard As explained above, in the 1970s and 1980s, dissatisfaction was expressed with regard to traditional performance measures, which had a predominantly financial focus. In an attempt to overcome these criticisms, performance management frameworks were developed to encourage a more balanced view. The most well-known instrument resulting from these attempts is the balanced scorecard, developed by Kaplan and Norton (1992). Kaplan and Norton assigned the adjective ‘balanced’ to their scorecard as it represents a balance between: 1) external measures for shareholders and customers and internal measures for critical business processes, innovation, learning and growth; 2) outcome measures – the results from past efforts – and the measures that drive future performance; and 3) objectives, easily quantified outcome measures and subjective, somewhat judgemental, performance drivers of the outcome measures (Kaplan and Norton, 1996: 10). Although the balanced scorecard was originally developed for the private sector, studies also demonstrate the usefulness of the balanced scorecard for non-profit (Kaplan, 2001) and government organizations (Wisniewski and Olafsson, 2004; Northcott and Ma’amora Taulapapa, 2012). The balanced scorecard is regarded as one of the boosters for increased attention given to performance indicators. Purposes and conditions In literature, there has been a lot of discussion about the use of performance measurement and management in the public sector. One of its advocates is Harvard University lecturer Robert Behn. He claims that performance measurement is inherently good, ‘Because business firms all measure their performance, and everyone knows that the private sector is managed better than the public sector’ (Behn, 2003: 586–87). He distinguishes eight purposes that public managers have for measuring performance:  Evaluate – How well is my public agency performing?  Control – How can I ensure that my subordinates are doing the right things?


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 Budget – On what programmes, people or projects should my agency spend the public’s money?  Motivate – How can I motivate line staff, middle managers, non-profit and for-profit collaborators, stakeholders and citizens to do the things necessary to improve performance?  Promote – How can I convince political superiors, legislators, stakeholders, journalists and citizens that my agency is doing a good job?  Celebrate – What accomplishments are worthy of the important organizational ritual of celebrating success?  Learn – What is working or not working?  Improve – What exactly should we do differently to improve performance? However, there is also great concern about the suitability of performance measurement for public sector organizations. Only under some conditions can performance measurement be used. In his book Managing Performance in the Public Sector, Dutch Professor Hans de Bruijn (2007) provides an extended overview of these conditions. Here a short overview will be provided based on that work. First, products should have single and not multiple (conflicting) values. An example of this difference is a court that must pass judgments as soon as possible, but the judgments of such court should also be well considered. Therefore, this court experiences two multiple and conflicting values. Second, products should be isolated and not interwoven. This relates to the fact that, in practice, products of public sector organizations may interfere with one another. The performance of one department may affect the performance of another. An individual organization scoring high on its own indicators (e.g. a fast processing time) may harm the collective performance. Another problem may be that causalities are unknown, or ‘contested’. Here de Bruijn gives the example of after-care and resettlement of discharged prisoners, where it is common to have interviews with the former prisoners in order to make sure that they reintegrate into society. However, having these interviews is just one of the factors that determine whether or not former prisoners will reoffend. Another condition that could be problematic is whether quality is measurable with performance indicators. A final condition for performance measurement that may not always be fulfilled is that the environment is static. The situation may occur that the behaviour of co-producers in a network continually changes. Objectives (e.g. in the form of what is considered ‘good’) might also change during policy execution. Furthermore, according to de Bruijn, performance measurement may have several perverse effects. Here we will discuss four of them. For a complete overview, please refer to de Bruijn (2007: 17–33). One of these is the incentive for strategic behaviour. Here he gives the example of a police force in which police officers are held accountable for the number of fines issued. In this case, there is an incentive for the police officers to issue fines for those offences that can be observed rather easily, such as cycling in the dark without lights. Another side

Public sector management control tools


effect is that performance measurement may block ambition. An example of this is provided by Llewellyn and Northcott (2005) in their paper ‘The Average Hospital’. This paper shows that performance measurement (in the form of comparing cost prices) in British hospitals resulted in a lower ambition of hospitals in more complex care. Furthermore, a side effect may be that performance measurement veils actual performance. The higher the extent to which information is aggregated, the more remote it is from the primary process in which it was generated. Consequently, insight may be lost into the causal connections between effort and performance that exist on the primary level of the process and give meaning to the figures.

5.4 Benchmarking In the 1980s, the first benchmarking studies were published. A pioneer organization in that period was Xerox, which used benchmarking to improve the performance of its warehousing activities. Many success stories followed and, from the 1990s onwards, benchmarking also became popular in the public sector.1 Benchmarking can be defined as ‘the search for and implementation of best practices’ (Camp, 1995: 15). It can relate to strategic and operational issues. If it is used for strategic issues, benchmarking concentrates on strategic competitive strengths and weaknesses, such as how to develop competitive product and service strategies. Operationally focused benchmarking concentrates on the work processes through which continuous improvement is delivered by incorporating best practices in the work steps (Camp, 1995: 17). Four types of benchmarking can be distinguished, which relate to the scope of the benchmarked entity (Camp, 1995):  Internal: this is a comparison of similar departments within one’s own organization.  Competitive: this is a comparison with the best of the direct competitors.  Functional: this is a comparison of methods with companies with similar processes in the same function outside one’s industry.  Generic process: this is a comparison of work processes with others that have innovative, exemplar work processes. In literature, it is emphasized that a systematic process has to be carried out when benchmarking is conducted. In Box 5.1, the ten-step process, as described by Camp (1995), is displayed.

Box 5.1 The ten-step benchmarking process 1 Decide what to benchmark. Identify the largest opportunities to improve performance in the organization. This requires identifying the key work


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2 3






9 10

processes, prioritizing them to the vital few, and flowcharting them for analysis and comparison of practices. Identify whom to benchmark. Determine which other companies employ superior work practices that can be adopted or adapted. Plan and conduct the investigation. Determine what data are needed and how to conduct the benchmarking investigation. Observe the superior practices firsthand. Document the best practices found. Determine the current performance gap. After completing the benchmarking investigation and observation, decide how much better the best practices are than the current work methods. Project future performance levels. Decide how much the performance gap will narrow or widen in the near future and what repercussions this has for the organization. Communicate benchmarking findings and gain acceptance. Communicate the findings to all those who have a need to know in order to gain acceptance and commitment. Revise performance goals. Convert findings into operational statements that describe what is to be improved based on the implementation of the best practices in the business process. Develop action plans. Create specific implementation plans, measurements, assignments and timetables for taking action on the best practices. Implement specific actions and monitor progress. Implement the plan and report progress to key process owners and management. Recalibrate the benchmarks. Continue to benchmark and update work practices to stay current with ongoing industry changes. Determine where the organization is in its quality pursuit and the implications for benchmarking. (Camp, 1995: 19–22)

Experiences with benchmarking projects have been extensively documented in the literature (refer to the review papers of Dorsch and Yasin, 1998; Dattakumar and Jagadeesh, 2003). However, the number of papers dealing with public sector organizations is more limited. Keehley et al. (1997) observe seven practical reasons for public administrators to undertake benchmarking: it works, recognition is likely to follow, other organizations have already started, building on the work of others makes sense, you cannot afford not to, it leads to cooperation, and taxpayers are viewed as customers. In the UK public sector, benchmarking attracted a lot of attention, especially in healthcare and local authorities. One of the catalysts for the implementation of benchmarking in the last-mentioned sector was the so-called best value regime. This regime came into effect in England and Wales in 2000, and it forced local authorities to make arrangements to secure ‘continuous

Public sector management control tools


improvement’ of local services, while providing a combination of economy, efficiency and effectiveness (Bowerman and Ball, 2000). Best value arrangements include the publication of annual best value performance plans and a process of regular performance reviews designed to raise standards and reduce costs. Authorities are expected to compare their performance under this regime. Bowerman and Ball (2000) show that, while private sector organizations use benchmarking voluntarily as a management tool, local governments have been motivated to benchmark to satisfy the central government. For local authorities, benchmarking is identified primarily with a need to compare (favourably). This may explain why local authorities (at that time) were reluctant with respect to competitive benchmarking, i.e. comparing their own practices and results with those of alternative, out-of-sector partners. Furthermore, while Bowerman and her co-author(s) empirically found that local authorities at the time of their research were enthusiastic about benchmarking (Bowerman and Ball, 2000: 25), they also expected that in the medium term, under best value, defensive benchmarking would proliferate (Bowerman et al., 2001). The word defensive refers to the situation that benchmarking will be used for accountability reasons, and issues of tangible improvements will be of secondary concern. In still another publication, Bowerman et al. (2002) add another form of benchmarking (next to voluntary and defensive benchmarking): compulsory benchmarking. This form is characterized by the engagement of public sector bodies in collecting and comparing performance data on the instruction of an external agency. Bowerman et al. (2002) state that defensive and compulsory benchmarking have much in common in that they both meet the need to demonstrate accountability. Furthermore, they point to the fact that benchmarking in the public sector functions as a form of political control. However, according to Triantafillou (2007), the problems mentioned above are not the real dangers. Instead, he points to the fact that comparison has the effect of ranking or positioning the participating organizations to the normal. Therefore, there are always organizations that fall below the normal and, therefore, these organizations are stimulated to launch procedural or organizational changes, even if their employees and users are happy with their services. Using data from Dutch water boards, van Helden and Tillema (2005) indeed empirically found this effect: when faced with low benchmarking scores, the water boards responded by taking measures that were not directed to performance improvement. Knutson et al. (2012) concluded the same, analysing a benchmarking project in which Swedish municipalities were involved (see Box 5.2).

Box 5.2 Benchmarking in Swedish municipalities Knutson et al. (2012) analysed the results of the Swedish National Benchmarking Project (NBP). This project ran between September 2007 and March 2010, and 190 out of 290 municipalities participated. Its goal was to identify and highlight good examples in order to inspire other municipalities to take


Tjerk Budding action to improve their operations. The project was carried out by using networks of five to ten municipalities, which together developed measures and compared performance. The authors found that it was politicians who made the decision to apply for the benchmarking project. According to Knutson et al. (2012), this could be seen as a way for them to gain legitimacy in a municipal context with more and more focus on performance measurement and comparisons, which may represent a move towards compulsory benchmarking. Furthermore, they found that the climate for discussing and comparing performance had improved as a result of the NBP. However, the analysis also showed that measurements actually played a very modest role in the search for improvement. It was, first and foremost, experiences at the operational level that guided improvement efforts. Furthermore, the authors could only find a few examples of cost rationalizations. Finally, they observed that some well-performing municipalities lowered their ambitions, indicating that performance disparities have been reduced rather than performance continuously improved. (Knutson et al., 2012)

5.5 Soft control and trust As we have seen in this chapter, attention to management control systems and their associated instruments (such as performance management and benchmarking) has grown steadily in the public sector over the last few decades. This growth was stimulated by a more managerial view on public management, often under the umbrella of New Public Management. In the course of time, criticism of specific instruments came up, e.g. with respect to the implementation of performance measurement (refer to the side effects mentioned by de Bruijn, 2007). However, in daily practice no turn back was observed, and governments did not stop implementing new and often more elaborate control systems. However, recently critique of management control systems has become more manifest and seems to stem from at least two arguments. The first argument is more pragmatic and has to do with the costs of control systems. As already expressed by Merchant in 1982, one should analyse whether control systems are really needed as these systems cause both direct and indirect costs. The direct costs are the costs associated with the system itself, e.g. the registration of financial and non-financial information in the system, the preparation of budgets, etc. The indirect costs are the costs of the side effects of control systems, such as deviant behaviour of employees (e.g. because they only focus on the activities that are being measured). In the present time of austerity in the public sector, organizations should consider whether the advantages of the control system outweigh the disadvantages.

Public sector management control tools


The second argument is more fundamental and has to do with the view of mutual relationships. The critique is that control systems – and especially those based on NPM principles – are based upon the principal–agent model, which expects a role conflict between a principal and his/her agent, because the incentives between an agent and his/her principal are not perfectly aligned and conflicts of interest may arise. As a result, the agent may be tempted to act in his or her own interests rather than the principal’s. With regard to public servants, these are seen as people pursuing their own interests, who are not intrinsically motivated to do their job well. This view is not considered realistic, and it has been remarked that more pronounced views should be used, for example the stewardship approach (Davis et al., 1997). In this approach, the model of man is based on a steward whose behaviour is ordered in such a way that pro-organizational, collectivistic behaviours have a higher utility than individualistic, self-serving behaviours (see Table 5.2). Following the stewardship approach, control systems should focus more on enhancing the intrinsic motivation of employees and making use of systems of self-regulation. These kinds of controls are increasingly coined in the term ‘soft controls’. These controls are measures aimed at changing employee behaviour that appeal to the inner world of management and employees, and are focused on the realization of the organizational goals. Generally, these measures are not formally recorded, whereas hard controls are. However, formal controls may still be needed in order to create a situation in which trust can be built (Vosselman and van der Meer-Kooistra, 2009).

Table 5.2 Agency theory versus stewardship theory

Model of man Behaviour Psychological mechanisms Motivation Social comparison Identification Power Situational mechanisms Management philosophy Risk orientation Time frame Objective Cultural differences

Agency theory

Stewardship theory

Economic man Self-serving

Self-actualizing man Collective serving

Lower-order/economic needs (physiological, security, economic) Other managers Low-value commitment Institutional (legitimate, coercive, reward)

Higher-order needs (growth, achievement, self-actualization) Principal High-value commitment Personal (expert, referent)

Control oriented Control mechanisms Short term Cost control Individualism High-power distance

Involvement oriented Trust Long term Performance enhancement Collectivism Low-power distance

Source: Davis et al., 1997: 37


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Furthermore, certain conditions should be fulfilled in order to work from a perspective of trust (refer to Box 5.3). Over the last few years, many books and articles have been published about the role of trust in relationships. Francis Fukuyama (1996) distinguished ‘high trust’ and ‘low trust’ societies and stated that the former will be more successful as transaction costs will be lower and innovation is more possible. Stephen Covey observes that ‘we have a crisis of trust on our hands’, but that ‘relationships of all kinds are built on and sustained by trust’ (Covey, 2006: 10, 12). He stresses that, if trust in an organization goes up, speed goes up and cost goes down. Bouckaert (2012: 99) observes that ‘Within the public sector of OECD [Organisation for Economic Co-operation and Development] countries trust is increasingly becoming a crucial element of performance and for a performing public sector, especially with the current financial crisis’. He distinguished three clusters of trust: 1) from society in the public sector; 2) from the public sector in society; and 3) within the public sector. Bouckaert states that these three clusters form a complementary set of trusts that determines the functioning of the public sector. Therefore, he finds that ‘the level of trust, the policies for trust building and trust keeping, and the impact on system performance in its broadest meaning become crucial elements in reform policies’ (Bouckaert, 2012: 99). In management control literature, attention was especially paid to the role of trust in inter-firm relationships. In this literature, generally a distinction is made between goodwill trust and capability trust, where the former is ‘the expectation that another will perform in the interests of the relationship, even if it is not in the other’s interest to do so, and essentially relates to not behaving opportunistically’, and the latter ‘relates to expectations about another’s competencies to perform a task satisfactorily’ (Dekker, 2004: 32–33).

Box 5.3 Trust in Dutch central government In the Netherlands, the Ministry of Finance developed a so-called ‘Trust Scan’ in which the conditions (so-called Critical Success Factors, or CFSs) are explicated, which have to be met in order to rely more on trust in mutual relationships (Vos and Witte, 2010):  CSF 1: The other party is clearly informed of the essential expectations.  CSF 2: The other party possesses the required qualities in order to fulfil expectations.  CSF 3: Parties have (and will continue to have) a shared interest.  CSF 4: There is (and will be) a positive image of the other party.  CSF 5: There is a good exchange of information (open communication).  CSF 6: Risks are known and there is a readiness to accept these.  CSF 7: With regard to fundamental issues that determine whether expectations will be met, others are allowed to pose questions/control.

Public sector management control tools


 CSF 8: In case of encroachment the cause will be analysed and discussed.  CSF 9: There are effective sanctions in place in case of ill intent/deliberate violation. A number of Dutch central government entities use the Trust Scan or are rebuilding their control system, based on the principles of stewardship theory instead of those of agency theory. One example of such an organization is the Legal Aid Board, an externally autonomized part of the Ministry of Safety and Justice. This board provides financial support in case clients are not able to pay the full costs of legal aid. This is done by paying lawyers for (a proportion of) the costs for their work with these clients. In the past the process in which it was determined if and how much aid was to be provided was rather time consuming. This was due to the fact that, before a decision was taken, extensive research was done in which all kinds of documents had to be handed over. Nowadays, the board works from the principle of high trust (RvR, 2011). This means that the board and lawyers cooperate on a basis of transparency, trust and understanding. As part of that, lawyers may choose to follow a new procedure in order to get their financial compensation. In this new procedure, just one form has to be filled in and sent to the board. The Legal Aid Board limits itself to a short check in which it is determined whether the application will be approved or not. Normally, a decision is taken within five days. Furthermore, afterwards random extensive audits are carried out. A first evaluation shows that lawyers on average value the new system with a score of 6 on a 7-point Likert scale (RvR, 2012). Also, the Legal Aid Board itself is satisfied with the new system, although the fact that the old and new systems still co-exist has negative consequences (RvR, 2013).

Summary  This chapter began discussing the historical background of management control theory.  This was followed by a presentation of two often used frameworks in management control theory: those of Kenneth Merchant (1982) and Robert Simons (1994, 1995).  Nine characteristics that affect the management control process in nonprofit (including public sector) organizations, as identified by Anthony and Young (2003), were presented.  An overview was given of a management control framework specifically aimed at public and non-profit entities, as developed by Hofstede (1981).  We discussed the topic of performance measurement, including the purposes, conditions and possible problems. Attention was also paid to the balanced scorecard.


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 Benchmarking was dealt with, discussing its types and experiences, and also presenting the steps to be undertaken to conduct a benchmark.  Finally, we discussed the subjects of soft control and trust, which have garnered increasing attention in recent years.

Discussion questions 1 To what extent are general frameworks for management control (such as those of Merchant and Simons) applicable to public sector organizations? 2 Do public sector organizations still have inadequate management controls (as was observed by Anthony and Young)? 3 Is management control fundamentally different in public sector organizations compared with their private sector counterparts? 4 Is performance measurement possible in public sector entities? 5 Should public sector organizations work more on the principle of trust?

Note 1 Note that some forms of benchmarking were already used in the public sector before it was popularized in the private sector, e.g. by UK local authorities in the 1970s (Bowerman et al., 2001; Bowerman et al., 2002), and by Dutch municipalities in the 1980s, which used a kind of cost benchmarking.

References Anthony, R.A. (1956) Management Accounting: Text and Cases, Homewood: Irwin. ——(1965) Planning and Control Systems: A Framework for Analysis, Boston: Harvard Business School Publications. Anthony, R.A. and Young, D. (2003) Management Control in Nonprofit Organizations, seventh edn, Boston: McGraw-Hill. Behn, R.D. (2003) ‘Why Measure Performance? Different Purposes Require Different Measures’, Public Administration Review 63(5): 586–606. Bouckaert, G. (2012) ‘Trust and Public Administration’, Administration 60(1): 91–115. Bouckaert, G. and Halligan, J. (2008) Managing Performance, London: Routledge. Bourne, M., Mills, J., Wilcox, M., Neely, A. and Platts, K. (2000) ‘Designing, Implementing and Updating Performance Measurement Systems’, International Journal of Operations & Production Management 20(7): 754–71. Bowerman, M. and Ball, A. (2000) ‘Great Expectations: Benchmarking for Best Value’, Public Money & Management 20(2): 21–26. Bowerman, M., Ball, A. and Francis, G. (2001) ‘Benchmarking as a Tool for the Modernization of Local Government’, Financial Accountability & Management 17 (4): 321–29. Bowerman, M., Francis, G., Ball, A. and Frey, J. (2002) ‘The Evolution of Benchmarking in UK Local Authorities’, Benchmarking, An International Journal 9(5): 429–49. Camp, R.C. (1995) Business Process Benchmarking, Milwaukee: ASQC Quality Press.

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Charnes, A., Cooper, W.W. and Rhodes, E. (1978) ‘Measuring the Efficiency of Decision Making Units’, European Journal of Operations Research 2(6): 429–44. Chenhall, R. (2003) ‘Management Control Systems Design within its Organizational Context: Findings from Contingency-based Research and Directions for the Future’, Accounting, Organizations and Society 28(2–3): 127–68. Covey, S.M. (2006) The Speed of Trust: The One Thing that Changes Everything, New York: Free Press. Dattakumar, R. and Jagadeesh, R. (2003) ‘A Review of Literature on Benchmarking’, Benchmarking: An International Journal 10(3): 176–209. Davis, J.H., Schoorman, F.D. and Donaldson, L. (1997) ‘Toward a Stewardship Theory of Management’, The Academy of Management Review 22(1): 20–47. de Bruijn, H. (2007) Managing Performance in the Public Sector, second edn, London: Routledge. Dekker, H.C. (2004) ‘Control of Inter-organizational Relationships: Evidence on Appropriation Concerns and Coordination Requirements’, Accounting, Organizations and Society 29(1): 27–49. Dorsch, J.J. and Yasin, M.M. (1998) ‘A Framework for Benchmarking in the Public Sector: Literature Review and Directions for Future Research’, International Journal of Public Sector Management 11(3/4): 91–115. Fukuyama, F. (1996) Trust: The Social Virtues and the Creation of Prosperity, New York: Touchstone Books. Groot, T.L.C.M. (2013) Syllabus Performance Management and Control, Amsterdam: VU University Amsterdam. Hofstede, G. (1981) ‘Management Control of Public and Not-for-profit Activities’, Accounting, Organizations and Society 6(3): 193–211. Kaplan, R.S. (2001) ‘Strategic Performance Measurement and Management in Nonprofit Organizations’, Non-profit Management and Leadership 11(3): 353–70. Kaplan, R.S. and Norton, D.P. (1992) ‘The Balanced Scorecard – Measures that Drive Performance’, Harvard Business Review 70(1): 71–79. ——(1996) The Balanced Scorecard: Translating Strategy into Action, Boston, MA: Harvard Business School Press. Keehley, P., Medlin, S., MacBride, S. and Longmire, L. (1997) Benchmarking for Best Practices in the Public Sector, San Francisco, CA: Jossey-Bass Publishers. Kelly, G., Mulgan, G. and Muers, S. (2002) Creating Public Value: An Analytical Framework for Public Service Reform, London: Strategy Unit, Cabinet Office. Knutson, H., Ramberg, U. and Tagesson, T. (2012) ‘Impact Through Municipal Benchmarking Networks’, Public Performance & Management Review 36(1): 102– 23. Llewellyn, S. and Northcott, D. (2005) ‘The Average Hospital’, Accounting, Organizations and Society 30(6): 555–83. Merchant, K.A. (1982) ‘The Control Function of Management’, Sloan Management Review 23(4): 43–55. Moore, M. (1995) Creating Public Value: Strategic Management in Government, Cambridge: Harvard University Press. Northcott, D. and Ma’amora Taulapapa, T. (2012) ‘Using the Balanced Scorecard to Manage Performance in Public Sector Organizations’, International Journal of Public Sector Management 25(3): 166–92. Osborne, S.P. (2006) ‘The New Public Governance?’ Public Management Review 8(3): 377–87.


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RvR (Raad voor de Rechtsbijstand) (2011) Brochure High Trust. Transparantie – Vertrouwen – Begrip, Utrecht: Raad voor de Rechtsbijstand. ——(2012) Evaluatieonderzoek High Trust-werkwijze, Utrecht: Raad voor de Rechtsbijstand. ——(2013) Jaarverslag 2013, Utrecht: Raad voor de Rechtsbijstand. Simons, R. (1994) ‘How New Top Managers Use Control Systems as Levers of Strategic Renewal’, Strategic Management Journal 15(3): 169–89. ——(1995) Levers of Control: How Managers Use Innovative Control Systems to Drive Strategic Renewal, Boston: Harvard Business School Press. Talbot, C. (2009) ‘Public Value – The Next “Big Thing” in Public Management?’ International Journal of Public Administration 32(3–4): 167–70. ——(2011) ‘Paradoxes and Prospects of “Public Value”’, Public Money & Management 31(1): 27–34. Triantafillou, P. (2007) ‘Benchmarking in the Public Sector: A Critical Conceptual Framework’, Public Administration 85(3): 829–46. van Helden, G.J. and Tillema, S. (2005) ‘In Search of a Benchmarking Theory for the Public Sector’, Financial Accountability & Management 21(3): 337–61. Vatter, W.J. (1942) ‘A Reexamination of Cost Accounting from a Managerial Viewpoint’, in J.J.W. Neuner, Cost Accounting: principles and practice, 2nd edn, Chicago: Business Publications, Inc. Vos, R. and Witte, R. (2010) Vertrouwen geven en in control zijn; Hoe doe je dat? Den Haag: Ministerie van Financiën, Directie Begrotingszaken. Vosselman, E. and van der Meer-Kooistra, J. (2009) ‘Accounting for Control and Trust Building in Interfirm Transactional Relationships’, Accounting, Organizations and Society 34(2): 267–83. Wisniewski, M. and Olafsson, S. (2004) ‘Developing Balanced Scorecards in Local Authorities: A Comparison of Experience’, International Journal of Productivity and Performance Measurement 53(7): 602–10.


Public sector management accounting Tjerk Budding and Martijn Schoute

Learning objectives  To have an understanding of cost accounting purposes, and cost allocation considerations and methods.  To know how costs can behave, and which costs are relevant in certain situations.  To be aware of the factors and considerations behind price-setting policies and practices in public sector organizations.  To have knowledge of the most widely used methods for capital investment appraisal.

Key words     

Capital investment appraisal Cost accounting Cost allocation Cost behaviour Price setting

6.1 Introduction As we have seen in the previous chapter of this book, in the nineteenth century already the first management accounting methods and techniques were used. These methods and techniques were especially focused on cost and efficiency management, for example by calculating the costs per labour hour and per machine hour. Furthermore, general ratios, such as the operating ratio (i.e. the ratio of revenues versus costs), were already being used (Johnson and Kaplan, 1987). Nowadays, many of the methods and techniques developed more than a century ago are still being used, but also some new ones have been introduced. Furthermore, increasingly, attention is paid to the role of these methods and techniques in daily practice. In this chapter, we mainly focus on two specific management accounting methods and techniques, namely cost accounting and capital investment appraisal. We also pay


Tjerk Budding and Martijn Schoute

attention to price setting, given that this is a major managerial decisionmaking purpose for which cost accounting information is frequently used. The subject of budgeting will be dealt with in the next chapter of this book.

6.2 Cost accounting In a study on the usefulness of cost accounting in governmental organizations, the International Federation of Accountants (IFAC) Public Sector Committee (the precursor to the International Public Sector Accounting Standards Board, or IPSASB) describes cost accounting as: an activity that provides information on costs and related data to satisfy a variety of management needs for decision-relevant information. It is concerned with how cost information is used in the management process and with the values generated by the financial accounting system to the extent that they may affect the quality of cost information. (IFAC, 2000: 5) In this study, the following functions of cost accounting are distinguished (IFAC, 2000):       

Budgeting. Cost control and reduction. Setting prices and fees. Performance measurement. Programme evaluations. A variety of economic choice decisions (such as contracting out). Determining values for inventories or other types of property.

It should be emphasized that costs may be calculated in alternative ways in different decision-making situations – i.e. there are different costs for different purposes. For example, for decisions concerning whether to outsource (part of) an organization’s activities, a different cost calculation is required from decisions concerning selling prices and/or user fees. Overall, there is little large-scale empirical evidence available on the purposes and users of cost accounting systems and information in public sector organizations. What research has consistently shown, however, is that in governmental settings the design of such systems quite generally tends to be dominated by the information needs of external stakeholders (i.e. by financial reporting purposes) (e.g. Lapsley and Wright, 2004; Verbeeten, 2011). Schoute and Budding (2013) have studied the managerial decision-making purposes for which cost accounting systems are used in Dutch local government. They identified two underlying dimensions of cost system intensity of use among seven widely used purposes: intensity of use for operational control purposes (such as to manage activities and/or programmes), and intensity

Public sector management accounting


of use for product costing purposes (such as to determine selling prices and/or user fees). On average, the municipalities’ cost accounting systems were used about equally intensively for operational control purposes as for product costing purposes. Of the seven individual purposes, the systems were used most intensively for budget formulation, budget execution (budgetary control) and to determine selling prices and/or user fees, whereas they were used least intensively to manage, and to measure the performance of, activities and/or programmes. Overall, these results are broadly consistent with those of a study by Geiger and Ittner (1996) among 59 units of the US federal government, although these units were found to use their cost accounting system relatively more for managing, and for measuring the performance of, activities and/or programmes, as well as with those of a study by Verbeeten (2011) among 57 Dutch public sector organizations. This latter study found some differences among central, local and other governmental organizations, however. Verbeeten (2011) has also studied who are the main users of the cost accounting system and of the information that it provides. His results show that, in Dutch governmental organizations, financial managers (partly acting as intermediary for other managers), but also general and operational managers, are the most important internal users of cost accounting information. This chapter will discuss some major cost concepts and methods. For a more elaborate discussion of these concepts and methods, we refer to specific textbooks on this topic, such as Horngren et al. (2012). Cost allocation The most fundamental issue in the design of cost accounting systems is whether the system only assigns direct costs or whether it also assigns indirect costs to the cost objects (e.g. products, activities and programmes) of an organization and, if so, how. The distinction between direct and indirect costs is based on whether the costs can be identified specifically and exclusively with a given cost object in an economically feasible (i.e. cost-effective) way: for direct costs (such as direct labour costs and direct material costs) this can be done rather easily; for indirect costs (such as general and administration costs and the costs of top civil servants) this cannot. Direct costing systems only assign direct variable costs, whereas absorption costing systems also assign indirect costs. In order to assign indirect costs, various cost allocation methods have been developed, ranging from rather simple to quite complex. In general, these methods consist of two stages. In the first stage, the homogeneous costs of resources are gathered in cost pools, which refer to groupings of individual cost items (Horngren et al., 2012: 870). Dependent on the type of allocation method, these cost pools are functionally (e.g. based on departments) or process (e.g. based on activities) oriented. In the second stage, the costs from the cost pools are assigned to the cost objects using cost allocation


Tjerk Budding and Martijn Schoute

bases, which refer to factors that link in a systematic way an indirect cost or group of indirect costs to a cost object (Horngren et al., 2012: 869). Dependent on the type of allocation method, volume-based or hierarchical cost allocation bases are used (see Box 6.1). The complexity of a cost accounting system is thus predominantly determined by the number and the nature of cost pools and cost allocation bases used (Schoute, 2009). Relatively simple cost accounting systems use only one or a few responsibility-based cost pool (s) and only one or a few volume-based cost allocation base(s). On the other hand, relatively complex cost accounting systems use many activity-based cost pools and many hierarchical cost allocation bases.

Box 6.1 Cost allocation bases In absorption costing systems, dependent on the type of allocation method, volume-based or hierarchical cost allocation bases are used. With regard to the latter, a distinction can be made between bases that relate to batchlevel, product-sustaining and facility-sustaining activities. Batch-level activities are only needed once when a group of related production or service activities commences; product-sustaining activities are performed to support the production of each different product or service category; and facilitysustaining activities sustain a facility’s general production process (Groot and Schoute, 2002). Activity-based costing (ABC) systems take advantage of this hierarchy of activities (which can be extended beyond the categories of activities mentioned here) by assigning the costs of the first two categories to cost objects by using activity cost drivers that vary in proportion to the consumption of the activities. Well-designed ABC systems match the level of the underlying activity and cost driver (i.e. cost allocation base), thus avoiding the distortions in the traditional cost accounting systems that rely entirely on unit-level (i.e. volume-based) cost drivers.

In most (especially Anglo-Saxon) organizations, indirect costs are traditionally allocated to cost objects by the so-called two-stage cost allocation method (Groot and Schoute, 2002). In the first stage, indirect costs are accumulated in cost pools by some ‘natural’ classification such as materials or labour. In the second stage, the accumulated costs in the cost pools are traced and reassigned to one or more cost objects. The relation between indirect costs and cost objects is determined by cost drivers. In the two-stage cost allocation system, these cost drivers (i.e. cost allocation bases) are mostly related to volume or direct costs (e.g. direct labour costs or direct material costs) of operations. During the 1980s, it became increasingly recognized that the internal and external environment in which many organizations operated had undergone substantial changes with respect to, for example, information technology, cost structures and market competition. Traditional cost accounting systems were heavily criticized for no longer being sufficient in this

Public sector management accounting


new environment (e.g. Johnson and Kaplan, 1987), and an alternative cost accounting system, activity-based costing (ABC), emerged. The fundamental characteristic of this system is its focus on activities performed by supporting units as the basis for assigning these units’ costs to cost objects. ABC systems try to identify the causal relations between cost objects and the indirect costs they generate by measuring cost objects’ demand for supporting activities. As such, two assumptions underlie ABC (Groot and Schoute, 2002). The first assumption is that activities cause costs, while the second is that cost objects create the demand for activities. These two assumptions are reflected in the ABC two-stage allocation process. In the first stage of this procedure, resources are assigned to activities (such as the ICT services in an organization), using so-called resource cost drivers. In the second stage, each activity’s expenses are then assigned to cost objects, using so-called activity cost drivers (for example, the assignment of the ICT services costs to a specific programme by using CPU time and/or registration of storage use).

Activity -Based Costing

Traditional Two-Stage Cost Allocation Method

2.Infancy 2.Infancy

Indirect Resources


First Stage


Cost Pools







bJ~ FS ~ ~ ~ ~



Second Stage


Cost Objects

Cost Objects


UL = unit-level activities BL = batch-level activities PS = product-sustaining activities FS = facility-sustaining activities

Figure 6.1 The traditional two-stage cost allocation method versus activity-based costing Source: Groot and Schoute, 2002: 21-22


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Compared to the two-stage cost allocation method, ABC has at least two important distinctive features (Groot and Schoute, 2002; see also Figure 6.1). First, instead of accumulating indirect costs in traditional, ‘natural’ cost categories, an ABC system accumulates indirect costs to activities. Second, instead of using only one or a few (mostly volume-related) cost allocation base(s), ABC aims to establish a causal relationship between the size and composition of the activity cost pools and cost objects. In this way, ABC provides additional insights into the factors that drive indirect costs by defining cost drivers. These cost drivers may represent a linear relationship between cost objects and their demand for indirect costs, as is the case in most traditional twostage allocation systems, but this relationship can also be non-linear. Recently, an alternative for ABC was introduced, referred to as time-driven activity-based costing (TDABC) (Kaplan and Anderson, 2007). The main difference from ‘traditional’ ABC is that in TDABC the amount of time spent on a certain activity is seen as the primary cost driver. In such systems, first, for each resource in the organization, a rate per time unit is calculated, and, second, based on a time registration, the costs of using the resource are allocated to a cost object, by multiplying the time and rate per time unit. It is important to emphasize that both traditional and activity-based cost accounting systems, instead of consisting of only two stages as suggested above, may also consist of multiple stages, in which the accumulated costs of particular cost pools are not directly traced and reassigned to one or more cost objects, but indirectly via other (‘secondary’) cost pools (e.g. Kaplan and Cooper, 1998). It is also important to emphasize that, although in the AngloSaxon textbooks on management accounting only ABC and TDABC are identified as advanced cost allocation methods, in non-Anglo-Saxon countries other methods can be distinguished. For example, in various (especially north-west European) countries, the German/Dutch cost pool method can be considered a widely used, advanced method. This method, which is grounded in German cost theory, allocates indirect costs to cost objects using multiple cost allocation bases, which in principle may also include non-volume-based allocation bases. Under this method, direct costs are traced directly to the cost objects. The indirect costs are first assigned to ‘cost pools’ (or ‘cost centres’), which may be physical entities (such as a personnel department), but also imaginary entities, representing a certain type of costs (e.g. housing costs). Next, the accumulated costs in the cost pools are traced and reassigned to one or more cost objects, in most cases partly indirectly via other ‘secondary cost pools’.

Box 6.2 Some evidence on the design of cost accounting systems in governmental organizations Similar to the purposes and users of cost accounting systems and information in public sector organizations, there is also little large-scale empirical evidence available on their design in such organizations. Focusing especially

Public sector management accounting


on the above-mentioned cost system design characteristics, Budding and Schoute (2013) have studied the design of the cost accounting systems used in Dutch local government. Consistent with the results of earlier studies by Groot and Budding (2004) and Verbeeten (2011), their results mainly show that the large majority of Dutch municipalities uses the German/Dutch cost pool method, as well as that a substantial number of them uses a direct costing system (i.e. these municipalities only assign direct variable costs to the cost objects). ABC systems are hardly used by Dutch municipalities. Also, on average, the municipalities’ cost accounting systems had 9–16 cost pools (with a range between 1–2 and > 64), and 3–4 cost allocation bases (with a range between 1–2 and 9–16). Similar to Groot and Budding (2004), the three most widely used cost allocation bases were number of full-time equivalents, labour hours of direct personnel and square metres of housing. In addition, Schoute and Budding (2013) have also studied how the design of the systems is related to their usage for different purposes. Their results show that intensity of use for operational control and for product costing purposes are differently related to cost system design characteristics. Where cost system complexity (based on the number of cost pools and cost allocation bases) is positively related to their intensity of use for operational control purposes, cost system inclusiveness (the extent to which indirect costs are allocated to major types of cost objects) is positively related to their intensity of use for product costing purposes. These different purposes thus clearly put different demands on cost system design, reinforcing the importance of purposes of use as cost system design criteria (cf. Kaplan and Cooper, 1998; Schoute, 2009).

Cost behaviour In order to facilitate decision making and variance analysis, it may be desirable to analyse how costs behave. One way of doing so is by investigating whether the amount of costs changes when the activity level changes. For example, if an organization stops offering a certain service, this probably will not change housing costs in the short term. A commonly made distinction concerning cost behaviour is that between fixed and variable costs. Fixed costs are those that remain unchanged in total for a given time period, despite changes in the related level of total activity or volume. Variable costs do change in total in proportion to changes in the related level of total activity or volume. Note that in the long term all costs are variable: when the level of activities changes, management will make decisions to adapt the organization to the new activity level. Furthermore, in the literature, increasingly, attention is paid to the phenomenon that costs may be sticky. When this phenomenon applies, costs increase more when the level of activity rises than they decrease when the


Tjerk Budding and Martijn Schoute

level of activity falls by an equivalent amount (Anderson et al., 2003). The stickiness of costs can partly be explained by making a distinction between discretionary and engineered costs. Discretionary costs have two important features (Horngren et al., 2012): first, they arise from periodic (usually annual) decisions regarding the maximum amount to be incurred; and, second, they have no measurable cause-and-effect relationship between output and resources used. Examples of discretionary costs are R&D costs and the costs of public relations. Engineered costs result from a cause-and-effect relationship between the cost driver – output – and the (direct and indirect) resources used to produce that output. These costs have a detailed, physically observable and repetitive relationship with output. Generally, the larger the proportion of discretionary costs, the more there is a risk of stickiness. For example, if the activity level goes down in an organization, the number of personnel for public relations is not always adapted proportionally. Note, however, that there may be valid reasons for stickiness: if an activity level goes down in an organization, but management expects a recovery in the short term, then it may be more cost efficient not to dismiss employees than to fire current employees and hire new personnel, who possibly have to be trained, within a few months. Relevant costs Earlier in this chapter we saw that not all costs are relevant in all situations. Generally, one should take only those costs into account that are relevant in a given situation. That is, in decision making only the costs that differ among the alternative courses of action are generally taken into consideration. These are called the differential costs, which may consist of fixed as well as variable costs. For example, if a municipality chooses to offer commercial waste disposal as a new service, this will increase not only fixed costs (e.g. housing costs), but also the variable costs (e.g. the costs of burning the garbage). An important cost category that is generally irrelevant are the so-called sunk costs. These are costs that were incurred in the past and cannot be changed regardless of the decision made. An example of sunk costs is depreciation costs. If one considers replacing an asset (e.g. a car) with a new one, the depreciation costs of the old asset should not be taken into account. Remember that these costs do not differ among the courses of action: the depreciation costs should be experienced in any case, either immediately (at the moment of replacement), or during the remaining years of the use of the asset. On the other hand, there are also costs that should be taken into account in cases of decision making that are not part of the registered costs. If a resource is used to perform a certain activity, an alternative use is probably not possible, which may lead to unrealized benefits. The opportunity cost is the foregone benefit that could have been realized from the best foregone alternative use of a resource. An example of opportunity costs of governmental organizations are investments in corporations, such as electricity companies.

Public sector management accounting


As in this situation governmental resources are tied up in these organizations, these resources cannot be used for other policies, which may have offered a higher return. For this reason, and also to secure a level playing field between public and private sector, some governments have decided to introduce a capital charge. This is a charge that has to be paid as compensation for using public sector means and which mimics the costs of capital in the public sector. However, the use of this charge is not undisputed and setting too high a rate may even lead to placing governmental organizations at a distance (see Box 6.3 for some examples).

Box 6.3 Some examples of the use of a capital charge Newberry and Pallot (2005) describe the commercialization strategy in New Zealand, which was based on the idea that ministries should buy from departments or from other providers. As part of this, the full costs of public sector products should be calculated including a capital charge. The authors document that, although there was a rhetoric of neutrality, the combination of a charge rate, which (according to previous research) was intentionally biased upward, and the requirement that assets must be revalued (unlike in the private sector) prevented such neutrality in practice. Carnegie and West (2005) document that the collection of the National Library of New Zealand was valued at fair value for financial accounting purposes. An unforeseen economic consequence of this action became apparent when the New Zealand government levied a capital charge on the reported assets of governmental departments, and therefore the library had to pay a charge based on this value to the Crown. This was prevented by transferring one of the collections, the ‘Heritage Collection’, valued at NZ $522 million at 30 June 1994, to the Crown.

6.3 Price setting In businesses, pricing is considered important as generally almost all revenues are collected by prices customers are willing to pay for products or services. In public sector organizations, only (a small) part of the income is collected from tariffs for services. Nevertheless, also in these organizations pricing is relevant for at least the following three reasons (Anthony and Young, 2003). First, prices influence the behaviour of clients. An example is that citizens have to pay for each kilogram of garbage that is collected by the municipal garbage collection service. If such a charge is used, it is expected that citizens will reduce the volume of garbage offered. Second, it may have a function in comparing organizations. The total turnover of an organization can be used to compare organizations. Take, for example, service departments (registry


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offices) of Dutch municipalities, which offer a range of services for citizens and businesses. For these organizations, it is hard to compare their output in non-monetary terms (as one cannot simply add up the number of services offered, because they differ to a large extent in terms of their characteristics, such as their complexity), but the turnover may be a (rough) way to compare the size of these departments. Third, the use of prices may motivate managers to: 1) render additional services so as to increase revenue; 2) reduce costs; or 3) change prices. In management accounting textbooks, generally a distinction is made between two strategies by which prices can be set: market-based pricing or cost-plus pricing. Market-based pricing starts with a target price, the estimated price for a product or service that potential customers are willing to pay. This estimate is based on an understanding of customers’ perceived value for a product or service and how competitors will price competing products or services (Horngren et al., 2012). On the other hand, cost-plus prices are set by adding up a mark-up component to the cost base to determine a prospective selling price. According to Anthony and Young (2003), in general the price of a product provided by a non-profit (including governmental) organization should be its full cost plus a surplus, or margin. However, they identify some situations where a variation from this normal approach may be used. First, the situation can occur that prices are influenced or even set by outside forces, such as ceiling prices set by outside agencies. Second, sometimes costs are actually incurred by an organization, but may not be included in the reimbursable cost pool (or only to a specified ceiling). Third, in dealing with peripheral activities, managers usually make sure their prices correspond to market prices for similar services. Furthermore, prices can deviate from cost prices because some products are subsidized. Finally, services can even be free of charge, which usually happens when public policy officials determine it would be discriminatory to charge for a particular service, or when managers believe that attempting to collect for a service would be impossible or unfeasible (Anthony and Young, 2003). In their discussion of Australian local government price-setting practices, Carnegie and Baxter (2006) state that prices can deviate from costs, because public sector organizations may want to gain some margin on the services delivered (e.g. in order to be able to renew underlying facilities utilized), or want to subsidize it (e.g. because of perceptions of the service users’ ability to pay). Therefore, they propose the following price formula: price = costs + margin - subsidy, which use could also enhance the accountability of Australian local governments. Furthermore, they distinguish six principles that may guide price-setting practices (Carnegie and Baxter, 2006: 107):    

Efficiency: the fees are simple and not cumbersome to administer. Transparency: the nature and use of the service is understood by users. Effectiveness: the fees provide value for money for users. Clarity: users are clear about when and how fees apply.

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 Equity: the fees are fairly applied across a range of users.  Ethics: users with special service needs (e.g. due to temporary or permanent disabilities) are not charged exorbitant fees directly in accordance with the cost of higher servicing requirements. Using survey data from 162 Australian local governments, Carnegie et al. (2011) show that most respondents in their study consider all these six principles to be important or very important. However, ‘transparency’ and ‘clarity’ are seen as most important, given that more than half of the respondents indicate that they consider these principles to be ‘very important’ (with 54.3% and 51.9% of the respondents giving this score, respectively). Empirical research shows that pricing may have a large impact on public sector organizations, and that a broad range of factors may have an influence on pricesetting practices. Geiger and Ittner (1996) found that governmental organizations that are required to recover their costs fully through revenues or fees not only implement more ‘sophisticated’ cost accounting systems than units funded by appropriated budgets or reimbursements of expenses by other governmental units, but also make more extensive use of cost system output for a wide range of internal purposes. Cavalluzzo et al. (1998) document that the introduction of external competition and fees for service requirements caused managers of the Federal Reserve System not only to improve efficiency, but also to reallocate costs to less competitive services. Groot and Budding (2004) showed that Dutch municipalities not only take the relevant costs into account when setting prices, but also look at prices of neighbouring or comparable municipalities (see Box 6.4). Carnegie et al. (2011) found that the majority of the Australian local governments they surveyed consider the generation of revenue to balance the budget to be the most important factor determining the overall fees and charges regime – much more than the discouraging or encouraging of the use of services and facilities (Carnegie et al., 2011).

Box 6.4 Bases for setting prices Groot and Budding (2004) analysed the way Dutch municipalities set prices for those services for which they may ask a payment. It is legally determined that the income of these services may not exceed the full costs of them, but Dutch law does not prescribe how the full costs should be calculated, such as which costs exactly should be included and how costs should be assigned to the services provided. For contracting marriages they asked their respondents how their municipality sets prices for this service. Some 36% of them answered that these prices are mainly based on full costs, 19% mainly base prices on comparisons with other municipalities, 5% base their prices on other considerations, and 40% take both the full costs and price comparisons into account when prices are set.


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Furthermore, the authors found large differences in how costs were allocated to the products. They found that decentralized municipalities included more indirect costs in product cost calculations, and that municipalities with a product budgeting system used a larger number of cost drivers to attribute indirect costs to their products. (Groot and Budding, 2004)

6.4 Capital investment appraisal Anthony and Young (2003) distinguish the following six steps for considering newly proposed programmes in non-profit organizations. First, someone from inside or outside the organization may come up with a new idea, which is the step of initiation. Second, a screening takes place of which ideas are worth detailed analysis. An important criterion in this step is whether the proposal is consistent with the goals of the organization. Third, a technical analysis is conducted, involving an estimation of the costs of a proposed programme, attempting to quantify its benefits and, if feasible, assessing alternative ways of carrying it out. Fourth, a political analysis takes place, where economic, social and organizational considerations are taken into account. Fifth and sixth, the final steps are those of making a decision and selling it to resource providers (such as governing boards). According to Anthony and Young (2003), usually the decision maker takes political considerations into account separately and subsequently to the technical analysis. Although this argument normatively may be true, this does not always seem to correspond to experiences in daily practice. First, by nature political and technical analysis cannot be fully independent in a political environment, as generally assumptions have to be made for technical analysis, which may have been explicated by politicians. Furthermore, sometimes civil servants get the impression that the political analysis has already taken place before they are asked to do a technical analysis, i.e. the technical analysis is only done to legitimize political decision making. In business, finance and accounting literature, considerable attention is paid to the technical analysis of project proposals, or (in other words) to capital budgeting and investment appraisal. Haka (2007) provides an extensive overview of the literature on this topic, as well as its historical development. We will now briefly discuss the most widely used methods. First of all, a distinction has to be made between methods that use accounting or cash flow data. An example of the first category is the accounting rate-ofreturn method (also known as the return on investment and return on capital employed; refer to Drury, 2004). In this method the return is calculated by dividing the average annual (accrual-based accounting) income of a project by a measure of the investment in it, e.g. the net initial investment in it or the average investment. A major advantage of such a method is that in most situations the

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data for these calculations are already available. The disadvantages are, however, that both profitability and asset valuation are subject to (subjective) accounting choices. Therefore, the use of cash flow data may be advisable. The payback method is considered the simplest method of capital investment appraisal that uses cash flow data. This method measures the time it takes the cumulative expected cash flows from a project to recover or pay back the investment costs (the payback period), and then compares this period with a pre-specified maximum time period. If the payback period is less than this maximum time period, the project is accepted; if not, it is rejected. This is also called the payback investment rule. A major advantage of the payback method is that it is simple to understand and to apply. Furthermore, as Horngren et al. (2012: 769) note, it is a useful measure when: 1) preliminary screening of many proposals is necessary; 2) interest rates are high; and 3) the expected cash flows in later years of a project are highly uncertain. However, it also has a number of defects (Berk and DeMarzo, 2011): 1) it ignores the project’s cost of capital and the time value of money; 2) it ignores cash flows after the payback period; and 3) it relies on an ad hoc decision criterion (what is the right number of years to require for the payback period?). The use of a discounted cash flow method may help in overcoming these defects. The two most well-known discounted cash flow methods are the net present value (NPV) and the internal rate of return (IRR). The NPV is defined as the present value of cash flows expected from the project, discounted at appropriate rates given by the opportunity costs of capital. The NPV investment rule is that, when an investment decision is taken, the alternative with the highest NPV should be chosen. The IRR is the discount rate(s) equating the present value of the investment’s cash inflow stream to the present value of the investment’s cash outlays. The IRR investment rule is that any investment should be undertaken where the IRR exceeds the opportunity cost of capital. In both management accounting (e.g. Horngren et al., 2012) and corporate finance literature (e.g. Berk and DeMarzo, 2011), NPV is considered the most accurate and reliable decision rule and should be preferred to IRR. Some reasons underlying this claim are (Drury, 2004):  IRR expresses a percentage, not a monetary value. This could be misleading, e.g. a large project with a relatively small IRR can have a higher monetary value than a small project with a large IRR. Using NPV, projects with unequal lives and unequal levels of investment can be compared, which is not possible with IRR.  The IRR method assumes that all the cash flows of a project can be reinvested to earn a return equal to the IRR of the original project, whereas the NPV method only assumes that this reinvestment takes place at the cost of capital.  IRR has a technical shortcoming as it cannot deal appropriately with unconventional cash flows (e.g. in the case of positive cash flows followed by negative cash flows, multiple IRRs are possible).


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In Box 6.5, an example of the above-mentioned methods is provided.

Box 6.5 Illustration of capital investment appraisal (project car replacement) The proposal The municipality Lakeland is considering replacing its fleet of automobiles for new ones. Currently, the municipality has five Mercedes-Benz C180 vehicles at its disposal. These cars were bought in January 2011 for a price of €40,000 each. Now, in January 2014, the cars have driven 90,000 km (on average) and have a book value of €20,000 each. However, the current actual price for such vehicles is only €10,000. The municipality considers replacing these cars with an electric car, the Renault Fluence Z.E. The price of these cars is €30,000 each, excluding the hire of a battery pack, which costs €125 per pack per month. If these cars are bought, the Renault dealer is willing to buy the Mercedes cars for €12,000 each. The variable costs of the Mercedes-Benz C180 are €0.17 per km, excluding depreciation, but including fuel costs, insurance, etc. The variable costs of the Renault Fluence Z.E.s are €0.02 per km, excluding depreciation, but including electricity costs. The average number of kilometres per car per year is 30,000. The municipality expects to run the new cars for six years. After this period they have a salvage value of €1,000 per car. Furthermore, the (opportunity) cost of capital are 5%. All cash flows (except the initial one) are assumed to take place at the end of each year.

Technical analysis In this example, the initial buying prices of the Mercedes-Benzes are sunk costs. The relevant costs are the buying prices of the new cars as well as the current value of the Mercedes-Benzes. If the cars are replaced, the relevant costs (which equals the net investment) are €18,000 per car. Furthermore, if replaced, each year 30,000 x €0.15 = € 4,500 of variable costs (per vehicle) will be saved, but this amount should be corrected for the hire of the battery back (€1,500 per year), resulting in net savings of €3,000 per year. Therefore, the payback period is six years, as six times €3,000 exactly equals the net investment of €18,000. Based on these assumptions the NPV is: -/-€18,000 + (€3,000 / 1.05) + (€3,000 / (1.05)2) + (€3,000 / (1.05)3) + (€3,000 / (1.05)4) + (€3,000 / (1.05)5) + (€3,000 / (1.05)6) + (€1,000 / (1.05)6) = -/-€2,027. Note that with NPV the opportunity cost of capital are used to calculate present values. With IRR the percentage is calculated with which the present value calculation gives an NPV of zero, so: -/-€18,000 + (€3,000 / (1+r)) + (€3,000 / (1+r)2) + (€3,000 / (1+r)3) + (€3,000 / (1+r)4) + (€3,000 / (1+r)5) +

Public sector management accounting


(€3,000 / (1+r)6) + (€1,000 / (1+r)6) = 0. By trial and error or by using Microsoft Excel, it is found that the IRR is only approximately 1.5%.

Haka (2007) documents that the use of discounted cash flow methods gained popularity from the 1960s onwards. Brounen et al. (2004) analysed the use of discounted cash flow methods by CFOs of business organizations in the UK, Germany, France and the Netherlands. They found that, in these countries, these methods were used in 53% (UK), 48% (Germany), 44% (France) and 70% (the Netherlands) of the companies. However, the payback period method also remained popular in the surveyed European countries, with 69% (UK), 50% (Germany), 51% (France) and 65% (the Netherlands). Finally, the accounting rate of return methods (such as return on investment) are also frequently used (38%, 32%, 16% and 25%, respectively). However, the use of discounted cash flow methods seems to be less popular in public sector organizations. Using data from Canadian municipal governments, Chan (2004) found that only one out of three of these used discounted cash flow methods. In daily practice, setting a proper rate for present value calculations is considered a difficult task. On the one hand, governments’ loans are generally considered less risky than loans of businesses, and therefore lower discount rates can be used. On the other hand, it should be taken into consideration that money from the state can also be used for other purposes instead of investing in a certain project and therefore government money is not free. An important disadvantage of the capital investment appraisal techniques discussed so far is that they only take monetary values of projects into account. In the public sector, it is not always possible to quantify the costs and benefits of a project. Cost-benefit analysis (CBA) is a technique that analyses and measures the costs and benefits to the community of capital projects. Although CBA also uses monetary values, it does so in much wider terms than those that would be included in traditional capital budgeting techniques – e.g. by assessing how much time is saved if a new metro service is opened, and by attaching a monetary value to that (Drury, 2004). It has been used in the public sector from the 1980s onwards and is used in many countries (including the USA, Canada and the Netherlands). In Box 6.6, the basic steps of CBA are presented.

Box 6.6 The basic steps of cost-benefit analysis (CBA) Boardman et al. (2006) describe the nine basis steps of cost-benefit analysis:  Specify the set of alternative projects.  Decide whose benefits and costs count (who has standing, which perspective is used?).  Catalogue the impacts and select measurement indicators.  Predict the impacts quantitatively over the life of the project.


Tjerk Budding and Martijn Schoute Monetize (attach dollar values to) all impacts. Discount benefits and costs to obtain present values. Compute the net present value of each alternative. Perform sensitivity analyses. Make a recommendation. (Boardman et al., 2006)

In the UK, an alternative to CBA, cost-effectiveness analysis (CEA), has also gained much popularity. This method aims to assess the lowest-cost way of achieving the objective(s), and is described as ‘an assessment of the costs of alternative options which all achieve the same project’ (Department for Communities and Local Government, 2009: 15). Despite its popularity, CBA has been criticized on several grounds, including political and philosophical grounds, to the effect that it is the role of government to apply judgements that are not necessarily a reflection of current preferences (Department for Communities and Local Government, 2009). However, the main critique is that it is not always possible to establish monetary values of impacts. Multi-criteria analysis (MCA) is considered a way to overcome this problem. MCA establishes preferences between options by reference to an explicit set of objectives that the decision-making body has identified, and for which it has established measurable criteria to assess the extent to which the objectives have been achieved (Department for Communities and Local Government, 2009).

Summary  Cost accounting systems provide information that can be (and in practice is) used for many different purposes.  The most fundamental issue in the design of cost accounting systems is whether the system only assigns direct costs or whether it also assigns indirect costs to the cost objects of an organization and, if so, how.  The complexity of a cost accounting system is predominantly determined by the number and the nature of cost pools and cost allocation bases used.  The behaviour of costs can be described with several terms, including fixed/variable costs, stickiness of costs, and discretionary/engineered costs.  Not all costs are relevant in all circumstances.  Pricing can perform several functions in public sector organizations, including influencing the behaviour of clients.  A distinction can be made between two strategies by which prices are set: market-based pricing and cost-plus pricing. In general, the price in a nonprofit and governmental organization should be its full costs plus a surplus. However, there may be situations where a variation from this approach could be used.

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 Six steps can be identified in capital investment appraisal: 1) initiation; 2) screening; 3) technical analysis; 4) political analysis; 5) decision making; and 6) selling the decision. However, in public sector organizations the political and technical analyses frequently are not fully independent and do not take place in this order.  In capital investment appraisal techniques, a distinction can be made between methods that use accounting or cash flow data. The accounting rate-of-return method is an example of the former category; the payback method and the net present value (NPV) and internal rate of return (IRR) methods are examples of the latter.  In public sector organizations, it is not always possible to quantify the costs and benefits of projects in monetary terms. By using a much wider approach to attach monetary values to impacts of a project, cost-benefit analysis (CBA) aims to contribute to overcoming this problem. Multicriteria analysis (MCA) facilitates the analysis of projects by providing a framework in which also non-monetary values can be considered.

Discussion questions 1 In what circumstances might using direct costing (i.e. assigning only direct variable costs to cost objects) have advantages compared with using absorption costing (i.e. assigning both direct and indirect costs to cost objects), and vice versa? 2 In what circumstances might using a rather simple cost accounting system have advantages compared with using a more complex cost accounting system, and vice versa? Is there a potential level of complexity that would be optimal for all circumstances? 3 What reasons might explain the (apparently) low usage rate of activitybased costing (ABC) systems in governmental organizations? 4 Do you agree with the statement that, in general, the price of a product provided by non-profit and governmental organizations should be its full costs plus a surplus? 5 What role do capital investment appraisal techniques have in investment appraisal in public sector organizations? 6 Which capital investment appraisal techniques are most suitable for use in public sector organizations?

References Anderson, M.A., Banker, R.D. and Janakiraman, S. (2003) ‘Are Selling, General, and Administrative Costs “Sticky”?’ Journal of Accounting Research 41: 47–63. Anthony, R.N. and Young, D.W. (2003) Management Control in Nonprofit Organizations, seventh edn, Boston, MA: McGraw-Hill. Berk, J. and DeMarzo, P. (2011) Corporate Finance, second edn, Boston: Pearson.


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Boardman, A.E., Greenberg, D.H., Vining, A.R. and Weimer, D.L. (2006) CostBenefit Analysis: Concepts and Practice, third edn, Upper Saddle River, NJ: Pearson Education. Brounen, D., de Jong, A. and Koedijk, K. (2004) ‘Corporate Finance in Europe: Confronting Theory with Practice’, Financial Management 33(4): 71–101. Budding, G.T. and Schoute, M. (2013) ‘Ontwerp en gebruik van kostensystemen in Nederlandse gemeenten’, in F.A. Roozen, H.B.A. Steens and E. de With (eds) Handboek Management Accounting, Deventer: Kluwer, B1595-1–B1595-26. Carnegie, G.D. and Baxter, C. (2006) ‘Price Setting for Local Government Service Delivery: An Exploration of Key Issues’, Australian Journal of Public Administration 65(3): 103–11. Carnegie, G.D., Tuck, J. and West, B.P. (2011) ‘Price Setting in Australian Local Government’, Australian Accounting Review 21(2): 193–201. Carnegie, G.D. and West, B.P. (2005) ‘Making Accounting Accountable in the Public Sector’, Critical Perspectives on Accounting 16(7): 905–28. Cavalluzzo, K.S., Ittner, C.D. and Larcker, D.F. (1998) ‘Competition, Efficiency, and Cost Allocation in Government Agencies: Evidence on the Federal Reserve System’, Journal of Accounting Research 36(1): 1–32. Chan, Y.L. (2004) ‘Use of Capital Budgeting Techniques and an Analytical Approach to Capital Investment in Canadian Municipal Governments’, Public Budgeting & Finance 24(2): 40–58. Department for Communities and Local Government (2009) Multi-Criteria Analysis: A Manual, London: Department for Communities and Local Government. Drury, C. (2004) Management and Cost Accounting, sixth edn, London: Thomson Learning. Geiger, D.R. and Ittner, C.D. (1996) ‘The Influence of Funding Source and Legislative Requirements on Government Cost Allocation Practices’, Accounting, Organizations and Society 21(6): 549–67. Groot, T.L.C.M. and Budding, G.T. (2004) ‘The Influence of New Public Management Practices on Product Costing and Service Pricing Decisions in Dutch Municipalities’, Financial Accountability & Management 20(4): 421–43. Groot, T.L.C.M. and Schoute, M. (2002) ‘Activity-Based Costing’, in H.-U. Küpper and A. Wagenhofer (eds) Handwörterbuch Unternehmensrechnung und Controlling (4. Auflage), Stuttgart: Schäffer-Poeschel Verlag, 19–28. Haka, S.F. (2007) ‘A Review of the Literature on Capital Budgeting and Investment Appraisal: Past, Present, and Future Musings’, in C.S. Chapman, A.G. Hopwood and M.D. Shields (Eds., 2007) Handbook of Management Accounting Research (Volume 2), Oxford: Elsevier, 697–728. Horngren, C.T., Datar, S.M. and Rajan, M.V. (2012) Cost Accounting; A Managerial Emphasis, 14th edn, Harlow, UK: Pearson Education. IFAC (2000) Perspectives on Cost Accounting for Government; International Public Sector Study, New York, NY: IFAC. Johnson, T.H. and Kaplan, R.S. (1987) Relevance Lost: The Rise and Fall of Management Accounting, Boston, MA: Harvard Business School Press. Kaplan, R.S. and Anderson, S.R. (2007) Time-Driven Activity-Based Costing: A Simpler and More Powerful Path to Higher Profits, Boston, MA: Harvard Business School Press. Kaplan, R.S. and Cooper, R. (1998) Cost and Effect: Using Integrated Cost Systems to Drive Profitability and Performance, Boston, MA: Harvard Business School Press.

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Lapsley, I. and Wright, E. (2004) ‘The Diffusion of Management Accounting Innovations in the Public Sector: A Research Agenda’, Management Accounting Research 15(3): 355–74. Newberry, S. and Pallot, J. (2005) ‘New Zealand Public Sector Management and Accounting Reforms: The Hidden Agenda’, in J. Guthrie, C. Humphrey, O. Olson and L. Jones (eds) International Public Financial Management Reform: Progress, Contradictions and Challenges, Greenwich: InformationAge Press, 169–93. Schoute, M. (2009) ‘The Relationship between Cost System Complexity, Purposes of Use, and Cost System Effectiveness’, The British Accounting Review 41(4): 208–26. Schoute, M. and Budding, G.T. (2013) ‘Stakeholders’ Information Needs, Cost System Design, and Cost System Effectiveness in Dutch Local Government’, working paper, VU University Amsterdam. Verbeeten, F.H.M. (2011) ‘Public Sector Cost Management Practices in the Netherlands’, International Journal of Public Sector Management 24(6): 492–506.


Public sector budgeting Tjerk Budding and Giuseppe Grossi

Learning objectives  To be aware of the functions of budgets.  To understand that budgets can relate to line items, organizational entities and programmes.  To have knowledge of the characteristics of incremental budgeting, planning programming budgeting system, zero-based budgeting, performancebased budgeting, accrual budgeting, beyond budgeting and participatory budgeting.  To have an understanding of the role of budgeting in decentralization and in performance evaluation of managers.

Key words         

Accrual budgeting Beyond budgeting Budget Budget evaluation styles Budgetary slack Budgeting Participatory budgeting Performance-based budgeting Zero-based budgeting

7.1 Introduction History The English word ‘budget’ stems from the French ‘bougette’ (in Latin: ‘bulga’), a leather bag or large-sized purse, which travellers in former centuries hung on the saddle of their horse. The treasurer’s ‘bougette’ was the predecessor of the small leather case from which the finance ministers in countries like the Netherlands and the United Kingdom still present their

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yearly financial plan for the state (Hofstede, 1967: 19–20). From an historical point of view, the use of budgets as financial control tools for business enterprises is a rather young phenomenon; it seems to date from around 1920 (Hofstede, 1967: 20). In European governments, the French Revolution (1789–99) can be seen as a starting point of budgeting (Bergmann, 2009: 45). One element of this revolution was that the power to authorize the budget was moved to the legislative body. In the USA, budgeting has been used in public sector organizations since the early twentieth century (Schick, 1966). Importance and role of the budget Nowadays, budgets are regarded as important devices to control organizations’ expenditures, both in private and public sector organizations (cf. Libby and Lindsay, 2010). But what exactly are budgets? According to Anthony and Young (2003: 19), a budget is a plan, expressed in quantitative, usually monetary terms. These authors also state that budgeting follows, but is separate from, programming. Horngren et al. (2012: 206) see a budget as ‘(a) the quantitative expression of a proposed plan of action by management for a specified period and (b) an aid to coordinate what needs to be done to implement that plan’. They add that a budget generally includes both financial and non-financial aspects of the plan, and it serves as a blueprint for the company to follow in an upcoming period. As follows from these definitions, the monetary side of budgets should not be decoupled from the non-monetary side, more precisely the activities to be conducted. However, in daily practice, public servants sometimes experience a budget simply as the maximum amount of money to be spent in their responsibility area and/or programme. This maximum amount does not depend upon the activities (to be) conducted. This view seems to stem from the fact that budgets not only are important devices for managers, but also serve an important role in the political process. By setting budgets, politicians authorize responsible politicians (such as ministers and aldermen) or managers (such as the secretary-general of a ministry or the municipal executive) to spend a certain amount of money on specified activities and/or costs. Anthony and Young (2003) use the term legislative budget to indicate this budget, which they define as ‘essentially a request for funds’. They state that this budget does not correspond to the budget in for-profit companies and that its closest counterpart in these companies is the prospectus that a company prepares when it seeks to raise money. The name of this budget already indicates that it is a document of the legislative power and sometimes even has the status of a formal law. After the legislative budget is prepared, a management budget can be formulated, expressing the amount of authorized spending for each responsibility centre. This management budget corresponds to the budget as prepared in for-profit companies. Although there are differences in the meaning of budgets between public sector and private sector organizations, the general functions of budgets are


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more or less comparable (see Hofstede, 1967; Merchant and van der Stede, 2012). First of all, budgets may be helpful for planning purposes. They force politicians and managers to think about the future and to make decisions with regard to tasks to be performed as well as the resources to be spent. Second, budgets serve as a tool for a number of control purposes: they authorize managers (or politicians) to spend money. Furthermore, they function as a coordination and communication device, as they enforce communication about organizational goals and priorities. Finally, as plans and budgets become targets, they have a role in the motivation of managers, because these targets are linked to performance evaluations.

7.2 Budgeting entities and techniques Budgeting entity Apart from the question of how budgets have to be prepared, a choice has to be made on the entity of the budgets. Budgets can relate to line items, organizational entities and programmes. Line-item budgeting involves preparing budgets for each line item in the operating statement, balance sheet and cash flow statement. For the operating statement, this means defining how much money can be spent on each cost category and how much revenue is expected to be received. This kind of budgeting is also called budgeting by nature, i.e. the characteristics of the revenues and expenditures are taken into account. A budget can also be set on the level of organizational entities, which are the departments in an organization that perform certain activities or deliver services. This is also called an institutional perspective. Finally, a budget can be associated with a product or programme, limiting the resources to be spent on each of them (see Box 7.1).

Box 7.1 Budgets in Dutch local government In the Netherlands, municipalities have to publish both a programme budget and a product budget. The programme budget is the municipal council’s policy document, stipulating political priorities, future activities, the resources involved and the outcomes to be achieved. It is supposed to contain clear information on the municipal council’s political programme, enabling political decision makers to focus on the main political issues in coherent policy programmes. The Board of Mayor and Aldermen is responsible for the execution of the programme budget, and is held accountable by the municipal council. In the product budget, the necessary municipal output is specified. It translates the programme budget into a specific work programme for the municipal bureaucracy after the municipal council has made its final decision on the programme budget. The municipal council only approves the programme budget, and not the product budget. The municipalities are free

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to determine the number of programmes and products, as well as the choice of these programmes and products. (van Hengel et al., 2014)

In order to prepare budgets, a certain technique has to be used. Here we will describe some traditional forms, and then in section 7.3 we will discuss more recent forms, i.e. performance and accrual budgeting.

Incremental budgeting Incremental budgeting is a technique that is often used in public sector organizations. It involves using the previous year’s budget as the starting point for setting the upcoming year’s budget. Only marginal changes are made; most often budgets are raised by adding a compensation for inflation. With incremental budgeting, the activities or outputs to be performed are not taken into account. Therefore, incremental budgeting is not considered a mechanism to stimulate efficiency. It is rather seen as a mechanism for expenditure control and as a guard against administrative abuses. The incremental approach to budgeting stems mostly from a practical viewpoint. It is not possible for budget makers to collect all data and make all computations necessary to re-examine fully every item in a budget and compare different programmes (Schick, 1983). By simplifying the analytical task of budgeting, the process has become more manageable (Behn, 1985). Furthermore, reexamination of budgets would also lead to conflicts over money between programmes, whereas incrementalism allows every programme to gain something (Schick, 1983; Behn, 1985). Incremental budgeting can also be used in times of declining resources. Then, each budget may have to be lowered by a certain percentage. In Box 7.2, we will discuss budgeting in times of austerity.

Box 7.2 Budgeting in times of austerity In literature on cutback management, generally a distinction is made between across-the-board cuts and targeted cuts. Across-the-board measures refer to cuts in equal amounts or percentages for all institutions, while targeted cuts imply that some institutions and sectors face a larger cut than others (Raudla et al., 2013). The across-the-board tactics have also been called cheese slicing, decrementalism and the equal misery approach. Based on a comprehensive literature overview, Raudla et al. (2013: 7) document the following advantages of decrementalism:  It reduces decision-making costs as it does not require extensive ex ante analysis for identifying the expenditures categories that will be cut.


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 It minimizes conflict (both within the organization and between the organization and pressure groups), as it avoids ‘specifying the victims’.  It is perceived as being equitable, because of ‘pain sharing’. However, decrementalism also has a number of disadvantages (Raudla et al., 2013: 8):    

The cuts may not reflect public needs and preferences. They may penalize efficient organizations. Varying needs of different units may be ignored. They may lead to a decline in service levels and quality.

The process of cutback budgeting that occurs in an era of austerity differs significantly from budgeting in circumstances of revenue growth (Jogiste et al., 2012). According to Behn (1985: 156), the contrasts between incremental and decremental budgeting suggest general points of any budget-cutting strategy: centralise the budget process under strong leadership; put together a comprehensive budget package and devise incentives and procedures to hold together an unstable coalition in support of this package; be prepared to accept and cope with chaos, mistrust, and public conflict, because the cutback process cannot be made routine and cannot be based on historical precedent; analyse the specific situation to determine how best to apply these abstract generalizations. The study from Jogiste et al. (2012) examines the behaviour of the Estonian central government and the basis of its budget decisions when planning drastic cost reductions through the theoretical lens of cutback management. The foremost results reveal that the crisis pushed the government to establish a different institutional framework, which facilitated fast and effective decision making during the budget process. The savings proposals came from the Ministry of Finance; however, running a cash-basis line-item budgeting system in practice, the centre possessed only limited performance data for developing the proposals. Consequently, the longterm impacts of the budget adjustments had not been assessed and are as yet unknown. A further conclusion of their study is that the current budgeting framework should be revised and replaced step by step with a more advanced approach.

A number of points of criticism of the traditional incremental budget have become apparent (Curristine et al., 2007: 28), for example:

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 It does not supply useful information for making decisions or focus on consumer needs. Moreover, it provides little understanding of the creation of value because it is based more on input than on output and outcomes.  It does not clearly demonstrate the manner in which the products cause variations or changes in an organization; thus, managers will have difficulty in understanding what business area needs to improve.  It does not support improvement over time, which requires definition of actual performance. Planning programming budgeting system Born from dissatisfaction with incremental budgeting, several alternative budgeting systems were developed from the 1950s onwards. The old system was criticized because there was a gap between planners, who cared about requirements but not about resources, and budget people, who were narrowly concerned with financial costs but not necessarily with effective policies (Wildavsky, 1969: 191). The planning programming budgeting system (PPBS) was developed as a means to bridge this gap to some extent. Its underlying idea is that programmatic and resource allocation decisions based on clearly stated goals and objectives (i.e. a rational-comprehensive method of decision making) are superior to fragmented, incremental decisions (Jablonsky and Dirsmith, 1978: 216). The PPBS process can be described in five steps: 1) the careful specification and analysis of basic programme objectives in each major area of governmental activity; 2) the analysis of the output of a given programme in terms of objectives; 3) to measure the total costs of the programme, at least several years ahead; 4) to analyse alternatives, seeking those that have the greatest effectiveness in achieving the basic objectives; and 5) the establishment of analytical techniques throughout government in a systematic way, so that budgetary decisions can be subjected to rigorous analysis (Padgett, 1971: 356). US President John F. Kennedy was the first to use the PPBS method, and the system was implemented in the Department of Defense (Jablonsky and Dirsmith, 1978). His successor, Lyndon B. Johnson, implemented the system in all main US government departments in 1965. However, almost five years later (in 1971) the system was changed by President Richard Nixon. In practice, PPBS made little difference in federal budgeting (Botner, 1970). Studies showed that the system did not penetrate the bureaucracy and financial realities were ignored. Several reasons were identified for its failure, including the point that the framework encouraged an inward-looking perspective, which assumed that the organization and the environment were fixed. It was considered insensitive to conflict situations, traditional roles and interpersonal relationships. Furthermore, it seemed to be only successful in situations in which underlying decision processes were analytical or computational in nature, and not in situations that called for more judgemental decision processes (Jablonsky and Dirsmith, 1978).


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Although PPBS was only granted a short life, the principles of PPBS came back in budgetary principles in later legislation in several countries. An example of this can be found in Dutch legislation for local governments, which imposes the explication of three so-called ‘W’ questions in annual budgets: What are our goals? What activities are we going to perform to achieve these goals? What means are related to these activities?

Zero-based budgeting Former US President Jimmy Carter is considered one of the main ambassadors of zero-based budgeting (ZBB). While he was governor of the state of Georgia (1971–74), he experimented with this method in the state, and after he became president in 1977 he made its use obligatory for all federal budgets. It was abandoned by the Ronald Reagan Administration in 1981, which found the approach cumbersome and unproductive (Anthony and Reece, 1989: 896). With ZBB, the costs estimates, which are used to decide the appropriate costs for a programme, are built up ‘from scratch’ – from ‘zero’ (Anthony and Reece, 1989: 896). ZBB has two distinctive characteristics (Ogden, 1978: 528): First, budget requests are formulated in ‘decision packages’ in each management unit. The first block consists of the minimum package, in which all existing functions must be justified at the lowest practical level of operation. Additional decision packages offer more programme results for greater costs. Second, each unit manager ranks all ‘decision packages’ by priority and each successively higher manager similarly ranks packages across programme lines clear to the top of the organization. ZBB was entrusted to the same offices responsible for year-round budget work; no separate staff was organized (Schick, 1978). In practice, zero-based budgeting was considered expensive and time consuming. Schick (1978) observes that zero-based budgeting changed the terminology of budgeting, and did little more. It was found that not much could be learned about most programmes from an annual zero-based budget (Ogden, 1978). Therefore, an alternative was developed in the form of a zero-based review, which in fact is a ZBB approach on a periodical (three to five years) instead of a yearly basis (Anthony and Reece, 1989). In such reviews, five basic questions should be asked about each activity (Anthony and Reece, 1989: 896–97):  Should the activity be performed at all?  Is too much being done? Too little?  Should it be done internally, or should it be contracted to an outside firm (a make-or-buy decision)?  Is there a more efficient way of obtaining the desired results?  How much should it cost?

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7.3 Performance and accrual budgeting Performance-based budgeting Reform of the budget focused attention on the input (how many resources can be used?) and the measurement of results (what can be achieved with such resources?). The introduction of performance-based budgeting (PBB) is part of a widespread continuous process to improve control of expenditures and/or the efficiency and performance of the public sector. To achieve a ‘performing state’, governments need a ‘performing budget’, as it is impossible to govern well without commensurate budget capacity (Schick, 2009). Especially from the 1990s onwards, performance budgeting has been paid much attention. However, already in the 1950s, the US government used a form of performance budgeting. The performance budget, introduced by the Hoover Commission in 1949, was concerned with the efficient performance of work and prescribed activities (Schick, 1966). Where a traditional input-oriented budget focuses on incremental levels of funding, a PBB focuses primarily on the results (Joyce, 2003). PBB does not just develop information from the results; rather, it is a broader concept that regards the use of this information in both the budgeting process and the allocation of resources. Some authors refer to ‘procedures or mechanisms intended to strengthen links between the funds provided to public sector entities and their outcomes and/or outputs through the use of formal performance information in resource allocation decision-making’ (Robinson and Brumby, 2005: 5). The Organisation for Economic Co-operation and Development (OECD, 2007) defines PBB as a form of budgeting that relates allocated funds to measurable results, and distinguishes three forms: presentational, performance-informed and direct/formula performance budgeting (see Table 7.1). Table 7.1 Performance budgeting categories Type

Linkage between performance information and funding

Planned or actual performance

Main purpose in the budget process


No link

Performance targets and/or performance results Performance targets and/or performance results Performance results


PerformanceLoose/indirect link informed budgeting Direct/formula performance budgeting

Tight/direct link

Source: OECD, 2007: 21

Planning and/or accountability Resource allocation and accountability


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 Under presentational budgeting, performance information is presented in budgeting documents or other government documents, which include this information for accountability and dialogue. There is no link between the performance information and funding.  Under performance-informed budgeting, performance information is used for budget decisions, but there is only an indirect link between performance targets or results and funding.  Under direct/formula performance budgeting, a direct and explicit link between performance (generally outputs) and funding is established. In a study analysing the results of implementing performance budgeting in eight OECD countries, the authors conclude that the use of performance information facilitates better decision making for the efficient use of resources, the management of programmes, central resource allocation and expenditure prioritization decisions. However, they also find a number of challenges regarding the development and use of performance information in the budget process, including: how to improve the use of performance information in budgetary decision making; how and if performance information should be related to resources; how to improve the measurement of activities; how to improve the quality of information; and how to get politicians to use it in decision making (OECD, 2007: 11–12). Most OECD countries continue to struggle with these reforms. Some common challenges include: improving measurement; finding appropriate ways to integrate performance information into the budget process; gaining the attention of key decision makers; and improving the quality of the information. Although there are exceptions, most governments find it difficult to provide decision makers with good-quality, credible and relevant information in a timely manner, let alone incentives to use this information in budgetary decision making. PBB is a costly exercise but it yields positive net benefits if accompanied by a performance management culture and results accountability to citizens (Shah and Shen, 2007). Performance information can be used for planning and/or accountability purposes. Most budget negotiations have traditionally included some output information, as budgetary estimates generally state what a spending ministry aims to achieve with its funding, e.g. the number of roads or hospitals. Forms of uses of performance information in the budget process may also vary with respect to the level of government. The past two decades have shown a growing trend among industrial countries to bring about a stronger performance orientation into public financial management. New Zealand and Australia were considered initiators of the present round of performance management and/or budgeting in the late 1980s, followed in the early and middle 1990s by Canada, Denmark, Finland, France, the Netherlands, Sweden, the UK and the USA. In the late 1990s to early 2000s, Austria, Germany and Switzerland joined the team and introduced various versions of these reforms (OECD, 2004) (see also Box 7.3 and

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Box 7.4). For most countries, the efforts have been limited to producing more performance data and better programme evaluations. Only a few countries have adopted system-wide reforms, including aligning performance information with budgetary decision making.

Box 7.3 Performance budgeting in four countries Sterck (2007) describes and explains the effects of performance budgeting on the role of the legislature in the budget process. In his study, he compares performance budgeting in Australia, the Netherlands, Sweden and Canada. In the Australian Commonwealth government, an accrual-based output and outcome budget has been in place since 1999. The Dutch central government introduced an outcome-based appropriation bill in 2002 following the VBTB (Van Beleidsbegroting tot Beleidsverantwoording, or From policy budgets to policy accountability) project. The Canadian federal government set up the Improved Reporting to Parliament project in 1994. The Swedish central government launched a performance budgeting project named VESTA2 in 1997 and introduced policy area objectives in the Budget Bill in 2001. The conclusion of this study is that the performance budgeting initiatives studied have a dominant focus on changing the budget structure, but do not seem very successful in altering the budget functions. Sterck concludes that changes in the budget procedures and the budget format do not seem to have a lot of impact on the use of performance information. (Sterck, 2007: 189–203)

Box 7.4 PBB in the Swedish central government During the 1980s, the Swedish budget system underwent significant reforms. Flexibility and performance were the key words of these reforms, linked to an increase in accountability for financial and operating results, and the annual report is a very important tool in this respect. The last reform of the public accounting system introduced the new budget process in 1996, and the new activity structure proposed in the Performance Budgeting Project was implemented in the Budget Bill 2001. The reason for introducing performance management in the Swedish central government was that it was expected to lead to a more efficient administration and also strengthen possibilities available to the government and parliament to manage and control the administration (ESV, 2003). The Swedish Budget Bill contains a financial and non-financial information structure (Sterck, 2007). The Budget Bill has been organized into 27 expenditure areas, for which parliament in a first stage defines an expenditure ceiling within the total expenditure limit (see In a second stage, parliament votes on the appropriations to individual agencies.


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The performance budgeting project (called VESTA) has also introduced a non-financial activity structure into the Budget Bill. According to the Budget Bill, the basis of all performance management is that it must be adapted to specific activities. This means choosing and combining those means of control that overall are best suited to the management of a specific agency and its particular activities (Küchen and Nordman, 2008). This is used to allocate resources in accordance with political priorities and thus to relate the planning and budgeting process. It consists of policy areas and programmes for which objectives, outcome budgets and costs are defined (Sterck, 2007: 198). Currently the budget is divided into 18 policy areas (such as rural affairs, animals and food; asylum, migration and integration; central, regional and local government; etc.) and most of the policy areas are subdivided into activity areas.

Shah and Shen (2007) observed four important advantages of PBB gleaned from recent experiences. In particular, PBB can enhance communication between budget actors (politicians and public managers) and citizens, improve public management in terms of efficiency and effectiveness, facilitate more informed budgetary decision making, and achieve high transparency and accountability. While there are several benefits to highlight, previous studies showed that implementing PBB is not without problems, such as differing perceptions of use and success among budget players (Melkers and Willoughby, 2001), the way in which the legislature in the long run uses performance information to inform resource allocation, and the way in which it incentivizes or sanctions programmes that achieve or fail to achieve their performance standards (Grizzle and Pettijohn, 2002). Shah and Shen (2007) also identified the critical factors affecting whether PBB penetrates the routines and procedures of budgeting, such as motivation to make a change, importance of legislative support, support and engagement from citizens, minimum administrative capacity and a bottom-up approach, staff training, information technology, accounting system and financial costs of the reform. Other empirical studies also showed that the performance information available in, for example, budgets and other planning and control documents is hardly used by citizens, politicians or managers (see, e.g., Franklin, 2000; ter Bogt, 2001; Melkers and Willoughby, 2005) (see Box 7.5).

Box 7.5 The use of performance information in budgetary decision making in Estonian central government Raudla (2012: 1000–15) examines to what extent legislators in Estonia use performance information in budgetary decision making. Interviews with the members of the finance committee of the parliament reinforce the findings of

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most of the existing empirical studies and show that legislators pay only limited attention to performance information in budgetary decision making. According to the legislators, the main reasons for this limited use are as follows: the documents containing performance information are too long and cumbersome; the legislative budget process is too time constrained; and the parliament has only a limited role in making substantive changes to the budget. The study also showed that the more experienced politicians were less interested in performance information than the novices were, but there were no significant differences between legislators from governing and opposition parties.

Accrual-based budgeting As we have seen in previous chapters, accruals and cash are often portrayed as opposing end points on a spectrum of possible bases for accounting and budgeting. Traditionally, the currency focus of the governmental budgeting process has been cash. Carlin and Guthrie (2003) state that the reason for this is simple: cash is the resource extracted by governments from households and the corporate sector, and cash is, despite suggestions from some quarters to the contrary, the resource that governments transform into the goods and services consumed by the public. However, using cash accounting has an important shortcoming, as it does not relate all relevant costs to services performed, but only the expenditures made in one specific period. In other words, it does not comply with the matching principle. Advocates point to many specific benefits that accrual budgeting could bring. According to Blöndal (2004: 105–7), these can usefully be divided into the following six groups:  First, accrual budgeting provides improved cost information to decision makers and improved discipline for budget execution purposes.  Second, accruals focus attention on improving the management of capital stock.  Third, accrual budgeting eliminates biases perceived to exist with the recording of capital investments as a ‘lump sum’ rather than being capitalized and depreciated over its useful life.  Fourth, accrual budgeting will illuminate the long-term sustainability of public finances by highlighting the long-term consequences of current decisions.  Fifth, the adoption of accrual budgeting is a catalyst for other management reforms in the public sector.  Sixth, proponents claim that accrual budgeting is necessary in order to ensure symmetry with accrual financial reporting (accounting).


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Some critics point out that an accrual budgeting system cannot be the system for a government for two reasons (van der Hoek, 2005: 37). First, budgetary laws often require the legislature to authorize cash payments. Second, an accrual system is tailored to income formation: it matches revenues and cost. In the public sector, however, it is impossible to match tax revenues with production cost. According to Schick (2007: 131), only a few governments systematically accrue revenues and expenditures in the budget. The short list of countries that have full accrual budgets is Australia, New Zealand and the United Kingdom (see Box 7.6). Other countries have adopted accruals for certain types of transactions, including Iceland, Sweden and the USA. All these countries differ from one another in applying accrual principles to the budget.

Box 7.6 Accrual budgeting in the United Kingdom, Australia and New Zealand Martí (2013: 33–58) analyses accrual-based performance budgeting systems in the United Kingdom, Australia and New Zealand. In all three countries, full accrual-based costs, revenues and funding appropriations are linked to specifications of planned and actual performance in terms of outputs/outcomes, thereby increasing the quality of departmental performance reporting. Some differences between the accrual-based performance budgeting models in the three countries are identified by the author. Financial information about full accrual-based costs, revenues and funding appropriations is linked to the specification of planned performance in terms of outputs/outcomes. In the British central government, the change from cash to accrual in the budget and the accounts took place in 2001/02, and it was considered a new stage in the financial management of the public sector. In Australia, the move to accrual budgeting and an outcomes and outputs management framework took place in 1999/2000. In New Zealand, by 1991, all departments were accounting and budgeting on a full accrual basis, and in the mid-1990s there was an increased emphasis on outcomes.

7.4 Budgeting, decentralization and performance evaluation Decentralization As we have seen, budgets serve as a controlling device. They authorize managers to spend a certain amount of money and provide a means to hold managers accountable. However, when budgets are used in these instances, it should be determined for which elements managers in an organization are to

Public sector budgeting


be held accountable. In responsibility accounting, organizational units (such as divisions or departments) are classified into centres, according to the decision authority delegated to the centre’s manager. Generally, four main forms of centres are distinguished:  Cost centre: In these centres, managers are accountable for costs of activities only. For this main form, two alternatives are distinguished: the first alternative is standard cost centres in which there is a well-defined relationship between costs and output. Therefore, a manager is held responsible for the costs and volumes of inputs used to produce an output. These centres are a main form in manufacturing companies. The second alternative is discretionary cost centres, in which there is no well-established relationship between costs and outputs. Therefore, managers in these centres are held responsible for not exceeding the budget as well as for other (non-financial) bases, such as the percentage of sick leave.  Revenue centre: In revenue centres, managers are typically responsible for selling a product and, therefore, for revenues only, except for the costs they can influence directly (e.g. marketing costs). This form is generally used in sales departments.  Profit centre: In profit centres, managers’ decisions affect both revenues and costs, and therefore managers are held responsible for the relation between these.  Investment centre: In investment centres, managers are responsible for profits and investments in assets. Therefore, they are evaluated on the relation between the profit and the invested assets in the centre. Although traditionally budgeting in public sector organizations was generally based on cost centre principles (more precisely: discretionary cost centres), aspects of profit centres and investment centres are also visible. In several countries, (executive) agencies have been set up, in which managers are held responsible for the relation between output and the inputs consumed. Furthermore, especially in New Zealand and Australia, governmental units were held responsible for the public means invested in their entities (see Chapter 6). Using budgets in performance evaluation In (general) management accounting and control literature, a vast number of studies has been published on the role of budgets in performance evaluation, or, more broadly, the use of accounting performance measures in performance evaluation. This literature is generally referred to as reliance on accounting performance measures (RAPM) literature. The starting point for this literature are the studies by Hopwood (1972) and Otley (1978). Hopwood analysed the behavioural consequences of evaluation styles of managers. He distinguished three evaluation styles (Hopwood, 1972: 160):


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 Budget Constrained Style: in organizations using this style, evaluation is primarily based on the subordinate manager’s ability to meet the budget on a short-term basis.  Profit Conscious Style: the performance of the subordinate manager is evaluated on the basis of his or her ability to increase the general effectiveness of the unit’s operations in relation to the long-term purposes of the organization.  Nonaccounting Style: accounting data play a relatively unimportant part in the supervisor’s evaluation of the subordinate manager’s performance. In his study, Hopwood found that the budget-constrained style could lead to higher job-related tension. However, some years later, Otley (1978) replicated Hopwood’s study and found contradictory results. In Otley’s study, the use of the budget-constrained style was more associated with higher managerial performance than with other performance evaluation styles. Since there are no fundamental differences in the measurement instruments used by Hopwood and Otley, the differences in their findings might be attributed to situational differences (Hartmann, 2000). The contradictory findings of these studies provided a strong incentive for further empirical research. In 2000, more than 20 years after Otley’s publication, a special issue of Accounting, Organizations and Society was published on RAPM. It contained a paper written by Dutch Professor Frank Hartmann, who examined the state of affairs in RAPM research. Analysing 57 papers, Hartmann (2000) found that the studies conducted still failed to provide clear insight into the behavioural consequences of using accounting measures for performance evaluation. Furthermore, he observed that the studies show contradictory findings, which might be attributed to differences in measurement and the selection of contingency factors, such as environmental uncertainty. Ter Bogt (2003) analysed the performance evaluation of top professional managers by aldermen. As part of his research, he adapted Hopwood’s styles to the government sector. He found that the top professional managers he surveyed were evaluated on a rather large and wide range of criteria. Therefore, he developed an additional style, the operations-conscious style, which involves (ter Bogt, 2003: 328):  Emphasizing performance and outputs, without paying much attention to quantitative output data.  Emphasizing ‘expertise’ and all kinds of other performance aspects (managers’ activities) that affect the functioning of organizations and which are regarded as important for long-term outputs and outcomes.  Paying much attention to ‘the extent to which managers have a feeling for politics’ and the way in which managers deal with all kinds of short-term problems and politicians’ subjective, personal opinions and wishes.  Doing all these on condition that financial budgets not be exceeded.

Public sector budgeting


Budding (2008) analysed the performance evaluation of Dutch municipal middle managers by their top (bureaucratic) manager, using an RAPM approach. He found that these managers perceived the use of non-financial performance measures to be far more positive than the use of accounting performance measures. However, in line with research in the private sector (Marginson and Ogden, 2005), Budding (2008) also found that accounting performance measures may be as useful as problematic. Under high levels of uncertainty, accounting performance measures might be useful in providing more clarity about the goals to be achieved, enhancing the ‘line of sight’. However, it was also observed that, in these circumstances, managers express more concern with respect to their evaluation. This calls for implementing mechanisms to ensure middle managers will be fairly evaluated. The use of non-financial performance measures, as well as having open communications and trust in superiors, can hereby contribute to such fairness. All in all, budgets seem to serve an important role in performance evaluation in public sector organizations, as they provide clarity about the resources to be spent. Although this view is known to be too narrow in order to capture all relevant items for performance evaluation, empirical research shows that it is often a starting point (or hygiene factor) in evaluations in public sector organizations. Humans aspects in budgeting An item that was paid much attention in previous literature is to what extent lower-level managers should participate in the budgeting process. Advantages that are mentioned include: more credibility to the budgeting process, greater commitment and accountability towards the budget, better-informed decisions, and the point that budgeting can serve as a training device (Dunk, 1993; Horngren et al., 2012). However, there may also be some disadvantages, of which budgetary slack is one of the most prominent. Budgetary slack describes the practice of overestimating budgeted costs, or underestimating budgeted revenues, to make budgetary targets more achievable. It provides managers with a hedge against unexpected adverse circumstances. Although it seems straightforward that more budgetary participation by lower-level managers will result in more budgetary slack, empirical research shows contradictory findings (e.g. see Dunk, 1993; Merchant, 1985). One possible explanation could be that organizations use budgetary slack deliberately in order to motivate managers to think long term (van der Stede, 2000) and to make clear to local managers that product quality and service are at least as important as meeting budget objectives (Davila and Wouters, 2005).

7.5 Beyond budgeting At the end of the 1990s, several companies expressed discontent about current budgeting practices. Representatives of organizations (including large


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multinationals such as AC Nielsen, Unilever and Novartis) and academics organized a group around this theme, the Beyond Budgeting Round Table (BBRT). This group was established in 1998 and investigated organizations that had replaced their traditional centralized ‘budgeting’ management model with an alternative model. Hope and Fraser (2003) observe three main reasons for the dissatisfaction. First, they find that budgeting is experienced as cumbersome and too expensive; it absorbs huge amounts of time for an uncertain benefit. Second, they state that budgeting is out of kilter with the current competitive environment, in which prices and margins are under pressure. Therefore, it is more important for firms to be at or near their industry peer group than to accomplish a certain result. Third, the authors think that gaming the numbers is taking place at unacceptable levels. The cases of Enron and WorldCom illustrate that budgeting may lead to fraud. According to Hope and Fraser (2003), companies can ‘break free’ by:  Setting stretch goals aimed at relative improvement. Goals should be set based on the highest aspirations of the team and be set relative to external benchmarks.  Basing evaluation and rewards on relative improvement contracts with hindsight. Rather than linking rewards to fixed targets agreed upon in advance, bonuses should be based on a relative improvement contract that involves a whole team setting and meeting a range of performance benchmarks over a period of time.  Making action planning a continuous and inclusive process. With this point, Hope and Fraser draw attention to the fact that the calendar or fiscal year may be an appropriate time period for reporting results to investors, but this time frame is unlikely to be appropriate for managing the business. Instead of focusing on budget years, the focus should be on continuous value creation.  Making needed resources available. Fast-track approval should be provided for major projects outside the budgeting process. Major projects should be approved as required, not because it is the right time of the year. Managers should have the power to implement small projects.  Coordinating cross-company actions according to prevailing customer demand. Let the pace of market demand set commitments. Whenever possible, respond to unanticipated customer requests.  Basing controls on effective governance and on a range of relative performance indicators. Ensure that there is effective governance from the centre that supports local decision making. Implementing all principles of beyond budgeting could be problematic in public sector organizations. One of the obstacles is that budgets may be approved by politicians, and (top) civil servants may not be entitled to make changes to it. However, some of the above-mentioned recommendations may

Public sector budgeting


be inspiring for those organizations striving to make improvements to their current budgeting practices.

7.6 Participatory budgeting Participatory budgeting allows the participation of non-elected citizens in the conception and/or allocation of public finances (Sintomer et al., 2008). Its starting point is considered to be its use in the city of Porto Alegre in Brazil, where one third of the city’s population lived in isolated slums on the outskirts and lacked access to facilities such as clean water and sanitation. In order to overcome these problems, certain innovative reform programmes were started in 1989. Participatory budgeting emerged as the centrepiece of these programmes. It resulted in improved facilities for the citizens. The participation and influence of people belonging to low-income groups in the budget allocation process grew substantially (World Bank, 2003). Box 7.7 describes the process of participatory budgeting in Porto Alegre.

Box 7.7 Participatory budgeting in Porto Alegre Participatory budgeting involves three parallel streams of meeting: neighbourhood assemblies, ‘thematic’ assemblies, and meetings of delegates for city-wide coordination sessions. These meetings continue throughout the year. The first stream discusses fund allocations among 16 districts or neighbourhoods of the city for the usual departmental responsibilities, such as water supply and sewage, street paving, parks and schools. The districtbased meetings begin with 16 ‘great assemblies’ in public places, including union centres, gyms, churches, clubs and even a circus tent. The city government’s ‘presentation of accounts’ from the previous year marks the beginning of events every year. The government also presents its investment plan for the current year, as decided in the previous year’s meetings. Then a debate starts for the next year. The debates continue for nine months, and each district gives two sets of rankings, one set for requirements within the district (such as pavements, school construction or water pipes), and the other set for efforts that affect the whole city (such as cleaning up the beaches). A public debate decides the criteria for allocating the investment budget among districts. These criteria can be population, an index of poverty, a measure of shortages (such as lack of pavements or the lack of a school), assigned priorities, and so on. (Adapted from World Bank, 2003)

Participatory budgeting has become increasingly popular, first in Latin America, and then all over the world. In 2002, the Local Government Act in New Zealand was changed. It obliged local authorities to identify the needs of communities, and community outcomes are expected to be taken into


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account when government entities are deciding on their own resource allocations (Menon and Thomas, 2006; see Box 7.8). In 2008, more than 100 European cities had a participatory budget (Sintomer et al., 2008). In the UK, in 2010, 100 local authorities implemented participatory budgeting processes and there was a national participatory budgeting strategy. However, as Davidson and Elstub (2013) observe, the UK cases do not reproduce the more radical participatory and deliberative nature of the Latin American cases. Rather, they tend to be small-scale, engage third-sector organizations rather than individuals, are typically standalone rather than cyclical, and are restricted by national targets and ring-fenced budgets. Therefore, Davidson and Elstub (2013) see participatory budgeting in the UK as in essence ‘participatory grant making’ rather than budgeting, with relatively small grants distributed to third-sector organizations to fund projects that they themselves will deliver (Davidson and Elstub, 2013; see also Pateman, 2012).

Box 7.8 Long-term council community plans in New Zealand Accounting to the Local Government Act (LGA) 2002, in New Zealand, each council must prepare at least every three years a ten-year Long-Term Council Community Plan. The strategic cornerstone of the plan is the set of community outcomes identified by communities. These are medium- to long-term goals for social, economic, environmental and cultural well-being for the community and their relative importance and priorities, developed through a community engagement process facilitated by the local authority at least every six years. The LGA requires councils to report back to the community at least every three years on progress made towards achieving the community outcomes. It is anticipated that the community outcomes will be taken into account when government entities are deciding on their own resource allocation. Although this link is strongly promoted in the law, there is no requirement for councils to plan specifically to achieve community outcomes or even to work towards achieving these. (Menon and Thomas, 2006)

Summary  Budgeting is a technique that has already been used in European governments since the eighteenth century.  According to its most concise definition, a budget is a plan, expressed in quantitative, usually monetary terms.  In public sector organizations, legislative budgets and management budgets can be distinguished.

Public sector budgeting


 Budgets play a role in planning and control activities. They force politicians and managers to think about the future and to make decisions with regard to tasks to be performed as well as the resources to be spent. Furthermore, they authorize managers (or politicians) to spend money and may be helpful as a coordination and communication device, and have a role in the motivation of managers.  Performance-based budgeting and accrual budgeting are among the most prominent reforms on the budget agenda.  A performance-based budget does not just consider developing information of the results; rather, it is a broader concept that embraces the use of this information in both the budgeting process and the allocation of resources (OECD, 2004). Performance budgeting is about relating allocated funds to measurable results. Accrual budgeting is related to the use of accrual accounting information and measures in the budgeting process.  In responsibility accounting organizational units (such as divisions or departments) are classified into centres based on the decision authority delegated to the centre’s manager. Generally, four main forms of centres are distinguished: cost centres (including standard cost centres and discretionary cost centres), revenue centres, profit centres and investment centres.  Three evaluation styles are generally distinguished in management accounting and control literature: budget-constrained style, profit-consciousness style and non-accounting style. Ter Bogt (2003) finds that Dutch top civil servants are evaluated by their aldermen on a rather large range of criteria. Based on this finding, he develops a fourth style: operations-consciousness style.  As a response to critique on traditional budgeting, beyond budgeting proposes to use an alternative management concept in which budgets are no longer used, instead employing other measures.  Participatory budgeting is about allowing non-elected citizens participating in the conception and/or allocation of public finances.

Discussion questions 1 To what extent do budgets (in your country, situation, etc.) include both financial and non-financial (goals and activities to be performed) elements? What is your opinion of this? 2 What is the role of budgeting in stimulating the efficiency of public sector entities? 3 What label best fits the characteristics of governmental entities (in your country, situation, etc.), in terms of responsibility accounting (standard cost centre, discretionary cost centre, revenue centre, profit centre or investment centre)? 4 Are the recommendations of Hope and Fraser (2003) to ‘break free’ from traditional budgeting applicable to public sector entities? 5 What are the main differences between traditional budgets and performancebased budgets?


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6 What are the possible categories of performance-based budgets? 7 What are the most important advantages of PBB that have emerged from recent experience? 8 What are the benefits of accrual budgeting? 9 Do you observe that citizens are (more) involved in budgeting? If so, in what way? 10 How does the historical development of budgeting match the development of management doctrines, as discussed in section 5.3 of Chapter 5?

References Anthony, R.N. and Reece, J.S. (1989) Accounting: Text and Cases, eighth edn, Homewood, IL: Irwin. Anthony, R.N. and Young, D. (2003) Management Control in Nonprofit Organizations, seventh edn, Boston: McGraw-Hill. Behn, R.D. (1985) ‘Cutback Budgeting’, Journal of Policy Analysis and Management 4 (2): 155–77. Bergmann, A. (2009) Public Sector Financial Management, Harlow, UK: Pearson Education Ltd. Blöndal, G.R. (2004) ‘Issues in Accrual Budgeting’, OECD Journal on Budgeting 4(1): 103–19. Botner, S.B. (1970) ‘Four Years of PPBS: An Appraisal’, Public Administration Review 16(4): 423–31. Budding, G.T. (2008) Decentralization, Performance Evaluation and Government Performance, PhD thesis, Amsterdam: VU University Amsterdam. Carlin, T.M. and Guthrie, J. (2003) ‘Accrual Output Based Budgeting Systems in Australia’, Public Management Review 5(2): 145–62. Curristine, T., Lonti, Z. and Joumard, S. (2007) ‘Improving Public Sector Efficiency: Challenges and Opportunities’, OECD Journal on Budgeting 7(1): 1–41. Davidson, S. and Elstub, S. (2013) ‘Deliberative and Participatory Democracy in the UK’, The British Journal of Politics and International Relations, published online, forthcoming. Davila, T. and Wouters, M.J.F. (2005) ‘Managing Budget Emphasis through the Explicit Design of Conditional Budgetary Slack’, Accounting, Organizations and Society 30(7–8): 587–608. Dunk, A.S. (1993) ‘The Effect of Budget Emphasis and Information Asymmetry on the Relation between Budgetary Participation and Slack’, The Accounting Review 68 (2): 400–10. ESV (2003) Performance Management in the Swedish Central Government, 2003:22, ESV: Stockholm. Franklin, A.L. (2000) ‘An Examination of Bureaucratic Reactions to Institutional Controls’, Public Performance & Management Review 24(1): 8–21. Greenhouse, S.M. (1966) ‘The Planning-Programming-Budgeting System: Rationale, Language, and Idea-Relationships’, Public Administration Review 26(4): 271–77. Grizzle, G.A. and Pettijohn, C.D. (2002) ‘An Examination of Bureaucratic Reactions to Institutional Controls’, Public Performance & Management Review 24(1): 8–21. Hartmann, F.G.H. (2000) ‘The Appropriateness of RAPM: Toward the Further Development of Theory’, Accounting, Organizations and Society 25(4–5): 451–82.

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Hofstede, G.H. (1967) The Game of Budget Control, Assen: Van Gorcum & Comp. Hope, J. and Fraser, R. (2003) Beyond Budgeting, Boston, MA: Harvard Business Press. Hopwood, A.G. (1972) ‘An Empirical Study of the Role of Accounting Data in Performance Evaluation’, Journal of Accounting Research 10: 156–82. Horngren, C.T., Datar, S.M. and Rajan, M.V. (2012) Cost Accounting; A Managerial Emphasis, 14th edn, Harlow, UK: Pearson Education. Jablonsky, S.F. and Dirsmith, M.W. (1978) ‘The Pattern of PPB Rejection: Something About Organizations, Something About PPS’, Accounting, Organizations and Society 30(3–4): 215–25. Jogiste, K., Peda, P. and Grossi, G. (2012) ‘Budgeting in a Time of Austerity. The Case of the Estonian Central Government’, Public Administration and Development 31(2): 181–95. Joyce, P.G. (2003) Linking Performance and Budgeting: Opportunities in the Federal Budget Process, Arlington, VA: IBM Center for the Business of Government. Küchen, T. and Nordman, P. (2008) ‘Performance Budgeting in Sweden’, OECD Journal on Budgeting 8(1): 1–11. Libby, T. and Lindsay, M.W. (2010) ‘Beyond Budgeting or Budgeting Reconsidered? A Survey of North-American Budgeting Practice’, Management Accounting Research 21(1): 56–75. Marginson, D. and Ogden, S. (2005) ‘Coping with Ambiguity through the Budget: The Positive Effects of Budgetary Targets on Manager’s Budgetary Behaviours’, Accounting, Organizations and Society 30(5): 435–56. Martí, C. (2013) ‘Performance Budgeting and Accrual Budgeting. A Study of the United Kingdom, Australia and New Zealand’, Public Performance & Management Review 37(1): 33–58. Melkers, J.E. and Willoughby, K.G. (2001) ‘Budgeters’ Views of State PerformanceBudgeting Systems: Distinctions Across Branches’, Public Administration Review 61 (1): 54–64. ——(2005) ‘Models of Performance-Measurement Use in Local Governments: Understanding Budgeting, Communication, and Lasting Effects’, Public Administration Review 65(2): 180–90. Menon, A. and Thomas, G. (2006) ‘New Zealand’s New Local Government Act: A Paradigm for Participatory Planning or Business as Usual?’ Urban Policy and Research 24(1): 135–44. Merchant, K.A. (1985) ‘Budgeting and the Propensity to Create Budget Slack’, Accounting, Organizations and Society 10(2): 201–10. Merchant, K.A. and van der Stede, W.A. (2012) Management Control Systems, third edn, Harlow, UK: Pearson Education. OECD (2004) Public Sector Modernisation: Governing for Performance, Paris: OECD. ——(2007) Performance Budgeting in OECD Countries, Paris: OECD Publishing. Ogden, D.M., Jr (1978) ‘Beyond Zero Based Budgeting’, Public Administration Review 38(6): 528–29. Otley, D.T. (1978) ‘Budget Use and Managerial Performance’, Journal of Accounting Research 16: 122–49. Padgett, E.R. (1971) ‘Programming-Planning-Budgeting: Some Reflections upon the American Experiences with PPBS’, International Review of Administrative Sciences 37(3): 353–62.


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Pateman, C. (2012) ‘Participatory Democracy Revisited’, Perspectives on Politics 10 (1): 7–19. Raudla, R. (2012) ‘The Use of Performance Information in Budgetary Decisionmaking by Legislators: Is Estonia Any Different?’ Public Administration 90(4): 1000–15. Raudla, R., Savi, R. and Randma-Liiv, T. (2013) Literature Review on Cutback Management, COCOPS Workpackage 7 Deliverable 1. Robinson, M. and Brumby, J. (2005) Does Performance Budgeting Work? An Analytical Review of the Empirical Literature, Washington, DC: International Monetary Fund. Schick, A. (1966) ‘Planning-Programming-Budgeting System: A Symposium’, Public Administration Review 26(4): 243–58. ——(1978) ‘The Road from ZBB’, Public Administration Review 38(2): 177–80. ——(1983) ‘Incremental Budgeting in a Decremental Age’, Policy Sciences 16(1): 1–25. ——(2007) ‘Performance Budgeting and Accrual Budgeting: Decisions Rules or Analytical Tools?’ OECD Journal on Budgeting 7(2): 109–38. ——(2009) ‘Crisis Budgeting’, OECD Journal on Budgeting 9(3): 1–14. Shah, A. and Shen, C. (2007) ‘A Primer on Performance Budgeting’, in A. Shah (ed.) Budgeting & Budgetary Institutions, Washington, DC: The World Bank. Sintomer, Y., Hertzberg, C. and Röcke, A. (2008) ‘Participatory Budgeting in Europe: Potentials and Challenges’, International Journal of Urban and Regional Research 32 (1): 164–78. Sterck, M. (2007) ‘The Impact of Performance Budgeting on the Role of the Legislature: A Four Country Study’, International Review of Administrative Sciences 73(2): 189–203. ter Bogt, H.J. (2001) ‘Politicians and Output-oriented Performance Evaluation in Municipalities’, European Accounting Review 10(3): 621–43. ——(2003) ‘Performance Evaluation Styles in Governmental Organizations: How do Professional Managers Facilitate Politician’s Work?’ Management Accounting Research 14(4): 311–22. van der Hoek, P.M. (2005) ‘From Cash to Accrual Budgeting and Accounting in the Public Sector: The Dutch Experience’, Public Budgeting & Finance 25(1): 32–45. van der Stede, W.A. (2000) ‘The Relationship between Two Consequences of Budgetary Controls: Budgetary Slack Creation and Managerial Short-term Orientation’, Accounting, Organizations and Society 25(6): 609–22. van Hengel, H.G., Budding, G.T. and Groot, T.L.C.M. (2014) ‘Loosely Coupled Results Control in Dutch Municipalities’, Financial Accountability & Management 30(1): 49–74. Wildavsky, A. (1969) ‘Rescuing Policy Analysis from PPBS’, Public Administration Review 29(2): 189–202. World Bank (2003) ‘Participatory Budgeting in Brazil’, Empowerment Case Studies.


Financial audit in the public sector Filip Cassel

Learning objectives  To be informed on financial audit in the public sector.  To understand why it is done and how it is carried out.

Key words     

Accountability Auditing standards Financial audit ISSAIs (International Standards of Supreme Audit Institutions) Public sector audit

8.1 Background Citizens as principals for agents: the public interest Why is there a need for audit in the public sector? It could be said that there are already other means for citizens to exercise democratic control of the expenditures of state entities, for example general elections of members of parliament. However, that is not meant to be a form of professional control. Audit, on the other hand, should be professional. In many nations, there is a chain of principal and agents starting with the citizens followed by a parliament, a cabinet, ministries, state agencies and state-owned companies. From a formal point of view, it is, in most cases, a parliament that asks a supreme audit institution (SAI) to undertake audit of the public sector. From a more fundamental point of view, it is, however, on behalf of the citizens that the SAI is working. This is the reason why it is important to audit the public sector, carried out in the public interest. To return to the question above in a more detailed manner, one might ask what reasons could be found for mis-statements in annual financial reporting from state entities? Apart from clear cases of fraud and corruption being concealed in the reporting, there might be various reasons for exaggerating or


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underestimating figures in the reporting. For example, an entity might want to exaggerate costs in the hope of securing a larger allowance next year, or an entity might want to underestimate costs in the hope of giving the impression that it is more efficient than it actually is.

Increasing trust when reasonable It is sometimes said that the function of audit is to earn citizens’ trust. However, this is too simplistic. When financial statements or other accounts furnished by a state agency are in fact reliable, citizens’ trust should be increased by auditors. When, on the other hand, the information is significantly unreliable, auditors should reveal that and consequently decrease citizens’ trust.

Constitutional aspects of SAIs For each state there is normally one supreme audit institution. There are two main categories of SAIs. In some states the constitutional arrangement is such that an auditor-general is appointed, while in other states there is a court of auditors. In Europe, for example, you can find the former system in an AngloSaxon tradition and the latter in a Latin tradition. To a great extent, their tasks and methods are the same. There are differences, however, and a court of auditors might have more specifically judicial tasks such as, for example, to decide what legal consequences a revealed error would have. In most states the SAI is positioned among the various state institutions at the highest level, being accountable directly to parliament. In many states the SAI is free to choose whether to use only its own staff or to outsource some tasks to private firms of auditors working on behalf of the SAI.

INTOSAI: an international organization Briefly, the aim and purpose of the International Organisation of Supreme Audit Institutions (INTOSAI) is to promote progress of government auditing by exchanging experience among its members and providing professional guidance. Within INTOSAI, the congress, which meets every fourth year, has the highest authority. There are also a governing board, a secretariat, and several committees and working groups. The rules and regulations relevant for financial audit are developed and prepared by the working group on financial audit guidelines under the auditing standards committee. Normally, SAIs of United Nations (UN) members are members of INTOSAI, making it an international organization. Parenthetically, it should be observed that the International Federation of Accountants (IFAC), the corresponding organization for the private sector, is a global non-governmental organization (NGO), with only indirect links to the UN.

Financial audit in the public sector


8.2 Relevant rules and regulations In this chapter, the description and analysis is restricted to financial audit. Performance audit and compliance audit are excluded, but will be dealt with in Chapter 9. Audit in the public sector at the municipal level is also excluded, as there are great variations at that level. Nevertheless, some brief comments outside this scope and demarcation might be given to illuminate the topic in focus. The rules and regulations specifically relevant to audit in the public sector can be presented in four categories: the Lima Declaration, the Code of Ethics, auditing standards and practice notes. The Lima Declaration An important step to form a modern set of rules for audit in the public sector was taken by INTOSAI at a conference in 1977 in Lima, Peru. Representatives of SAIs of most of the nations of the world then and there agreed on the socalled Lima Declaration. One of its goals was to stress the importance of the independence of audit. Since public funds are entrusted to management by the public sector, it is argued that audit is an indispensable part of the regulatory system. The declaration is of such a general character that it should be interpreted as referring to both financial and performance audit. The criteria against which the audit should be carried out are nevertheless summarized as the principles of legality, efficiency, effectiveness and economy of financial management, which might give an impression of a focus on performance audit. The Code of Ethics In 1998, another step was taken in the process of harmonizing concepts within INTOSAI. In that year, the Code of Ethics for auditors in the public sector was agreed.1 The code is directed at the individual auditor irrespective of whether he or she is an auditor-general or a junior employee, or even an individual working for or on behalf of an SAI. The code considers the ethical requirements for civil servants in general but in particular the requirements for auditors, including the latter’s professional obligations. In order to sustain public confidence, integrity is the core value of the code. Auditors should be honest and work with the public interest in mind. There is a need for independence, objectivity and impartiality in all work conducted by auditors. Furthermore, this is not only a question of how this work is in fact done but also of how it appears to be done. Political neutrality is an important element. The code also elaborates on professional secrecy and the importance of sufficient professional competence of the auditors. ISSAIs: auditing standards based on ISAs Since 2001, there has been intensive development of the standards for financial audit in the public sector. The INTOSAI and IFAC initiated close


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cooperation resulting in a harmonization of standards. As historical background, it should be noted that this was preceded by intensive debate including strong criticism of auditors’ insufficient professionalism. One result of this debate was the fact that both organizations were inclined to make great efforts to improve both the content and form of the standards. From the point of view of the public sector, it was concluded that the most efficient way would be to influence the private sector standard setting, both by improving it as such, and by making it more applicable to the public sector. In the private sector, the International Standards of Auditing (ISAs) had been developed and successively improved. These standards are issued by the International Auditing and Assurance Standards Board (IAASB), which operates under the auspices of the IFAC. The ISAs now, as a result of the above-mentioned cooperation, include aspects of a public sector perspective in their requirements as well as in their application material. The ISAs are divided in several categories, for example concerning overall objectives, planning, audit evidence, the use of internal audit, the use of experts, and auditors’ reporting. Each ISA includes an objective, definitions of concepts and scope, requirements and application materials. In 2011, INTOSAI decided that the new ISAs should be applied in the public sector. The way to do this was to introduce the new International Standards of Supreme Audit Institutions (ISSAIs). For financial audit, each ISSAI comprised an ISA accompanied by a practice note, which will be explained below. If an audit is claimed to have been carried out in accordance with the ISAs, this must not be interpreted as ‘comply or explain’, but rather as ‘all or nothing’. In other words, either every ISA is complied with or it is not considered an ISA audit. Furthermore, with regards to a specific ISA, every requirement must be complied with unless, on very rare occasions, it can be proven that the objective has been achieved by other means. Although, as will be explained in section 8.3, rules and regulations within the INTOSAI are not compulsory in the same way as within the IFAC, this constraint is also valid for audit in the public sector. As will be explained in section 8.4, it is, however, not always possible to carry out an ISA audit, or, to be more exact, an ISSAI audit, when in some states the prerequisites are not at hand. Practice notes As explained above, the ISAs have been developed and designed by means of cooperation between the IFAC and INTOSAI. However, they only form part of the INTOSAI guidelines for financial audit. In order to make them complete and ready for application in the public sector, INTOSAI has added practice notes. A practice note may include information as well as warnings and suggestions. An auditor might, for example, be reminded of the fact that the chain of principals and agents in the public sector sometimes is more

Financial audit in the public sector


complicated than in the private sector because of various constitutional structures. In the public sector, it might therefore not be sufficient to address a board of directors when seeking audit evidence or when reporting. Instead, the auditor might be recommended to address public committees, ministries, or some other part of the government.

8.3 Adoption of the rules Harmonization If, as a point of departure, you look at the audit profession in general from outside, you find a rather heterogeneous picture. There are geographical variations because of constitutional differences between nations. There are also historical variations explained by technical developments, for example regarding IT. Even when the concept ‘audit’ is delimited to ‘external audit in the public sector’, a great deal of variation is found. In some cases pre-audit is included and in some cases audit merely consists of comparing results with a budget. Nevertheless, efforts have been made to harmonize auditing standards. In recent years, the harmonization of standards has been debated. In some jurisdictions it has been said that actual local standards are good enough, so there is no reason to harmonize them with, or even compare them with, other standards, as for example ISSAIs. In other jurisdictions, for example some new democracies, there has been a wish to create modern standards focusing on best praxis. A lot of arguments for and against harmonizing auditing standards have been brought forward. Advantages include that, if SAIs use the same standards, they can operate more cost efficiently when two or more are engaged in a joint audit of, for example, a foreign aid project. Also, as in many cases SAIs use private sector auditors to assist the SAI or audit on behalf of the SAI, it is efficient if they use the same standards. Disadvantages include that to change actual standards in order to harmonize them with other standards will incur costs. Regarding harmonization, there has been a lot more lobbying than reasoning. Adoption versus implementation When it is said that new standards have been introduced, it is important to be aware of the difference between ‘endorsement’, ‘adoption’ and ‘implementation’. Label adopters should be distinguished from real adopters. Reasons for introducing new standards may vary significantly. One state might wish to increase its internal legitimacy by demonstrating to its citizens that its audit will be of high quality. Another state might wish to increase its external legitimacy by demonstrating the same for those who would furnish it with foreign capital, either in the form of foreign aid or in the form of private


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investments. A first step in such cases might be the decision to endorse the standards. A second step might be the adoption of the standards, i.e. a serious declaration of the willingness to comply with them. A third step, finally, might be actually to implement the standards. As mentioned in section 8.1, auditors might increase citizens’ trust in the audited organizations. The reason why high-quality auditing standards should be not only endorsed or adopted but also implemented is the importance of having a reason to trust the auditors. If citizens do not trust the auditors, they have no reason to listen to the auditors recommending them to trust the audited organizations. Several occurrences of financial crisis, as, for example, in Europe and in South-East Asia, have demonstrated the importance of this observation. If auditors in these cases had actually applied high-quality standards, they would have revealed that many financial statements were not trustworthy. It is important to be aware also of the difference between the concepts of ‘de jure’ and ‘de facto’. The decisive question is whether standards actually (de facto) have been introduced or not, i.e. whether they have actually been implemented. If certain standards are endorsed and adopted but not implemented, it could be either because it will take some time for efforts to be successful or because resources are more permanently lacking. The rules are not compulsory within the INTOSAI As mentioned in section 8.2, rules and regulations within the INTOSAI are not compulsory in the same way as within the IFAC. The INTOSAI has furnished its members with guidance and recommends them to make use of it, whereas the IFAC has a set of membership obligations including compliance with standards. Therefore, the fact that the INTOSAI has endorsed the new standards, i.e. the ISSAIs, does not mean that the SAIs have been compelled to follow them.

8.4 Applicability of the rules The scope and demarcation of financial audit It is not always possible to carry out an ISSAI audit in the public sector, as in some states the prerequisites are not at hand. Generally speaking, necessary conditions for an ISA audit, as well as an ISSAI audit, include the fact that the audited organization has applied an acceptable framework for accounting and for financial reports. Another condition for such an audit is that one or more persons have been unambiguously appointed to head the audited organization and have actually accepted responsibility for preparing and delivering the organization’s financial reports. There have to be three parties: a principal, an agent and an auditor. In the public sector, this is sometimes problematic, inter alia because of constitutional factors. The various nations have different legal frameworks

Financial audit in the public sector


making the conditions for accountability different. In some nations the power is very clearly divided into legislation, execution and judgment. Furthermore, in some nations the degree of delegation of power from principal, e.g. the cabinet, to agents, e.g. state agencies, is also very evident. In such cases, it is quite easy to find what is generally required for an audit, i.e. the existence of three relatively autonomous parties in the shape of a principal, an agent and an auditor asked by the principal to scrutinize the agent, and especially the reporting of the agent to the principal. In other nations this is not the case. In other words, it cannot be taken for granted that clearly identifiable principals and agents can always be found for the organizations to be audited. Nevertheless, the focus of the present description and analysis will be an ISSAI audit in line with what has been endorsed by the INTOSAI. Owing to the risk of misunderstanding, it is important to clarify the scope and demarcation of audit from other aspects of control in the public sector. Financial audit is not to be confused with supervision. Auditors do not have a position in the chain of command. In other words, they are not principals or agents. They do not even help principals by means of looking after or supervising agents. They facilitate accountability by means of supplying principals with their opinions on whether the information that agents give to their principals is reliable or not. This is the core contribution made by auditors of financial reports. Another possible misunderstanding refers to the question of who or what is the object of audit. The object of audit might be an organization but not an individual. For example, state agencies, ministries, state-owned companies, but not civil servants or other employees, might be audited. There is a variation among nations as to which entities are accountable in the sense of being compelled to deliver financial reports or, broadly speaking, annual reports. Normally, such entities are also the object of audit. There might be audited financial reports regarding the state as aggregated (refer to Chapter 4), the ministries, the agencies, the state-owned companies, foundations in the public sector, etc. In some nations private firms of auditors are assigned to audit the state-owned companies and foundations, while in others the SAI audits such entities, and in others still there is a combination of procedures. What, then, is audited by means of the mentioned standards of financial audit? It is the financial or annual reports and thus only indirectly the activities and results reported by the accountable entities. The reports being audited might be financial reports interpreted in a rather limited way, i.e. focused on figures based on quantitative measurement accompanied by explanation only to a small extent. In other cases, the financial reports might be rather extensive, including figures based on qualitative measurement and accompanied by a lot of explanation. The annual reports might thus include management reports or, more recently, sustainability reports. There are separate standards available for performance audit, which will not be dealt with here. The same holds for compliance audit. The former


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focuses upon the efficiency, economy and effectiveness of transactions and other activities. The latter focuses upon their legality. The municipal level implying special challenges In some nations, regions at the municipal level are rather autonomous from a constitutional point of view. This can have far-reaching impacts on the preconditions for audit in that part of the public sector. On the one hand, one might wish to accompany local autonomy with local rules for accounting and auditing, but, on the other hand, there is sometimes a wish to stress the responsibility of central government for the spending of taxpayers’ money whether emanating from local or central taxation. These two desires are not easily reconciled. Such problems are handled in different ways in different nations. As an illustration, auditors in the public sector at the municipal level might be elected locally but supervised by the SAI or another central state agency. The quality of audit of local government seems to vary a lot. There is a risk of misunderstanding, taking for granted that an SAI always could and should exercise control and take responsibility for all audit done in the public sector of a nation irrespective of the level concerned, i.e. including the municipal level.

8.5 Auditing practice Differing practices Within the public sector there is a great deal of variation regarding the practice of auditing. There are many causes of this. As mentioned above, the financial audit standards endorsed by the INTOSAI are not compulsory. Some nations make use of their sovereignty by instructing their SAI to apply local auditing standards instead of the guidelines supplied by the INTOSAI. Another cause of differing audit practice is the fact that the resources available differ significantly. This refers not only to financial resources but also to the education of employees and technical resources available, such as IT. Illustrations of how it is done Depending on how the public sector of a nation is structured, the SAI may have one or several audit assignments. At the one extreme, there might be just one audit, i.e. of the financial report at the level of aggregation for the whole public sector. At the other extreme, there might be a number of audits because of the existence of financial reports for every part of the public sector and possibly also for the aggregation. As a consequence, there might be either one auditor’s report for the public sector as aggregated or several reports.

Financial audit in the public sector


To what extent auditors in the public sector are helpful to the audited entities varies a lot. Generally speaking, auditors not only examine and report, but also give advice. Having found, for example, that a figure in a financial report is mis-stated, an auditor might say what the figure correctly should have been or even give advice as to what new procedures should be introduced in order to decrease the risk of the mistake being repeated. SAIs have very different traditions in this respect, with some limiting themselves to recommending that audited entities follow the rules without telling them which rules might be applicable, while other SAIs act as consultants, even assisting in implementing adequate procedures to decrease the risk of misstatements. In Chapter 9, the roles SAIs may fulfil will be dealt with in more detail. Despite the causes of variation, there is a common core of practice of public sector audit. An ISSAI audit is not always possible in the public sector, but, when such an audit is possible, the deliberations and procedures for starting up an audit assignment, as required by the standards, could be quite simple. If, for example, parliament or the cabinet has constituted a new state agency and an audit by the SAI is compulsory for such agencies, then the standard of how to accept and how to clarify the conditions for a specific audit can be complied with quite easily. The phase of planning the audit and gathering sufficient knowledge about the entity could be more difficult. It is important to understand how powers have been delegated to the leadership of the entity and what the relevant rules governing the entity are. In order to do this, the auditor might have to make investigations outside the entity in question, for example in a ministry. The concepts of materiality and relative risk are central to auditors. They assess the risk for material mis-statements of financial reporting. By means of this procedure, they get guidance on what facts and figures to examine. One of the preliminary steps in an audit is to decide a level of materiality. Speaking of audit in general, materiality often refers only to a quantitative level, i.e. whether some quantity is lower or higher. For public sector audit, however, there are also qualitative aspects of quantitative figures to take into account when judging materiality. It should be remembered that in the public sector it is often relevant to see not only if some figure is correctly measured but also why the figure occurred. For example, the figure might be the result of a forbidden allocation of an allowance. This means that a certain error might be material even if the mis-statement as such is not quantitatively material. By way of illustration, an account of receivables might be overestimated by 1% without the error being material. On the other hand, it might be a material error if an allowance is underestimated by 1% in order to conceal that it was in fact 1% more than what had been decided. Before starting the actual detailed examination, the auditor also has to analyse the risks in general and specifically for the entity to be audited. As was mentioned in the introduction to this chapter, risks for mis-statements might concern both exaggerations and underestimations.


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The auditor should bear in mind that it is not always easy for the civil servants preparing financial reports to be completely impartial. By way of illustration, suppose politicians have decided on a reform, hoping that the cost of it is rather limited. Suppose furthermore that the civil servants in the agency in question are personally in favour of the reform, although formally they are politically strictly neutral. In such a case, there is a risk that the civil servants will not be very eager to find costs to include in the financial reports. Furthermore, the goals set for an accountable entity, for example a state agency, are often not very clear, which makes it difficult to prepare financial reports. The fact that it is sometimes impossible to measure the result quantitatively, i.e. the degree to which a goal is fulfilled, although there is a strong wish to be able to do so, entails complex risks of mis-statements. The auditor might conclude that the risk is not that a figure is wrong but rather that the reader is misled to believe that it would be possible to find a correct figure to report. Another aspect of the audit that might be complex is the gathering of sufficient audit evidence. Broadly speaking, the auditor is faced with two rather different categories of information to be scrutinized. The first category concerns financial information in a narrow sense, for example money spent. The second category concerns financial information in a broader sense, for example results achieved. The first category is normally more easily handled, but there might be problems, for example, regarding external verifications. There are two aspects of the concept ‘external’ here. One refers to entities outside the public sector, for example a private sector supplier of goods. Another refers to entities inside the public sector but outside the audited entity, for example a state agency for the pensions of civil servants. The former should be used for auditors’ requests for confirmation. The latter, on the other hand, might question such procedures of giving written confirmation, as information in one state entity concerning another state entity seems sufficiently reliable. The second category, concerning results achieved, might be more difficult for the auditor to handle. The quality of supporting documentation for these parts of the financial reports varies a great deal. It is sometimes not easy to agree upon what would be sufficient to underpin the various statements, descriptive as well as quantitative, made by those preparing the reports. This should of course also be viewed in connection with what was said above on problems of measurability. From a practical point of view, the timeliness of the various activities of the audit is important. As much as possible should be done early. Following a tradition in the private sector, it is sometimes appropriate and efficient to examine a so-called ‘hard close’ preliminary financial report after three quarters of the year, if the entity prepares such a report. In recent years, the requirement to document an audit has increased significantly. This is the case irrespective of whether the documentation is mostly

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kept secret or mostly open to the public. A reason for these requirements is that it should be possible for another auditor later to carry out a control of the quality of the audit. This means that not only audit evidence but also the reasoning of the auditor should be available for scrutiny without the necessity to interview the auditor. The auditor’s report is the most important product of the audit. This is, by definition, intended for a broad group of readers. An audit might also result in other forms of reporting, inter alia memoranda for a closer group of readers and merely oral reports. The auditor’s report, one or several, is normally directed to parliament and the cabinet. It is thereby often made available to citizens. Other written reports, which are often more detailed, might be directed to the board of directors or management of the various state agencies. Oral reports might be exemplified by a hearing in parliament. Generally speaking, auditors’ reporting lately has been extensively criticized. For the public sector it is not easy to make a report suitable for a small committee of more knowledgeable and interested members of parliament and, at the same time, interesting and understandable for the citizen in general. As regards audit practice in the public sector, it might be helpful to study the practice notes in more detail for further guidance. In some aspects, there are interesting differences between public sector and private sector audit practice. As regards audit findings, classification errors may be more relevant, as ways of reaching results are important in the public sector. A decision by parliament on allowances, for example, might be rather detailed concerning for what purpose the money should be used. Thus, a correct detailed reporting of the character of some costs might be important. Auditors’ focus is guided by the concepts of risk and materiality. Furthermore, they normally choose to refer in their reports only to what is material. In the public sector, however, there are cases of very detailed reporting. This can in some cases be explained by a wish to avoid suspicion of corruption. In other words, the auditor reports the details for fear of being suspected of having been bribed to conceal negative findings. Reporting by auditors is sometimes viewed from a different perspective in the private sector and the public sector. In the private sector audit has in recent years often been referred to as one of several so-called assurance services. A focus for the investors is often to view audit as something normally resulting in an assurance that financial reporting is correct. This is in contrast to the public sector. A point of departure here is that taxes are spent according to decisions made by a parliamentary majority. This means that there may be many controversial issues reflected in the financial reports. A focus for citizens is often to view audit as an investigation resulting sometimes in assurance and sometimes in clarification or criticism. With these observations in mind, it is interesting to observe that auditors’ reports that deviate from the standard format seem to be more frequent in the public sector. It is also interesting to note that the effects of such criticism are often less dramatic than in the private sector.


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Benchmarking There are several ways in which the quality of audit in the public sector is evaluated, including benchmarking and similar methods. An SAI might be evaluated by other SAIs as well as by other organizations. Frequently, a peer review of one SAI is carried out by a team constituting auditors from a few other SAIs. The World Bank, International Monetary Fund (IMF) and Organisation for Economic Co-operation and Development (OECD) are examples of other organizations evaluating SAIs. Apart from these ways to evaluate the quality in general of an SAI, there are many examples of donor organizations having a contractual right to examine certain aspects of the work done by an SAI, for example the audit of a foreign aid project. One aspect of the work within the INTOSAI has long been to promote the sharing of experience of best practice among SAIs. Cooperation between SAIs and private audit firms also gives many opportunities to benchmark on an informal, day-to-day basis. The use of private audit firms Sometimes an SAI makes use of private audit firms. One way of doing this is to outsource the audit of some entities in the public sector. A chartered accountant from a firm or an audit firm might be assigned to carry out a complete audit on behalf of the SAI. Another way is to ask an audit firm to furnish the SAI with extra team members for a specific audit because of a temporary lack of staff. A third way is to engage experts from an audit firm to assist the SAI when needed. In all such cases, it is important to remember the responsibility of the SAI regarding the quality of the audit.

8.6 Ethical aspects By way of introduction, it should be observed that ethical aspects will be of the highest relevance in situations when an individual is faced with a dilemma, in the sense that both possible alternative actions might give rise to reasonable criticism. Thus, in such situations of choice, it will not be sufficient to demonstrate that rules of a code of ethics have been followed. There is no such simple algorithm. Individual professional judgement There is a complex and serious dilemma of whether to endorse the reasonable wish that auditors be obedient and carefully fulfil their tasks decided by parliament and standard setters, or the likewise reasonable wish that auditors be independent and personally take responsibility for exercising their own professional judgement. On the one hand, it is important that citizens have good reason to trust auditors to follow relevant rules and regulations and directives

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from parliament. On the other hand, it is equally important that auditors are mentally prepared, and willing to take personal responsibility, for civil disobedience when needed instead of doing what they are told to do. As an illustration, an SAI might be asked to refrain from, or at least postpone, the disclosure of some audit findings until after a general election, despite the fact that the auditors have judged the information to be material. Consider that the citizens are entitled to get updated information to guide them in the election, but at the same time they might be so upset by the information that due process for an election could not be followed, and such a risk should be avoided. There is another ethical dilemma between the idea that the SAI should be independent and that it should comply with relevant rules and regulations. With the Lima Declaration as a point of departure, many states have a law of audit stressing that the SAI should be free to decide what it will examine, which methods it will use, and how it will report the results. However, it is important not to accept too wide a variation in reasonable interpretations of the concept ‘audit’, upon which a supreme audit institution should focus, of course. The independence of an auditor seems to imply great freedom of professional choice. However, an auditor must still act professionally in accordance with the standards in order actually to be an auditor. An auditor in the public sector must not, for example, widen the scope of auditing in ways that may be viewed as political activity. That risk is similar to the risk in the private sector that auditors may be viewed as consultants in ways threatening independence. Audit in the public interest but with political neutrality At first sight, it might seem self-evident that a public sector auditor should work in the public interest, but what does this mean? At the world congress of the IFAC in Paris in 1997, former head of the World Bank James Wolfensohn made a speech urging auditors to view their task as working in the public interest. In the speech he elaborated several arguments for a change in this direction. Both the entities being audited and those giving the auditors their assignments have their own vested interests. The modern form of general elections of parliaments makes politicians short sighted. In general, there is a high risk of disinformation and for requirements of objectivity to be neglected. Not surprisingly, the auditors accepted Wolfensohn’s proposal. Nevertheless, the IFAC has struggled for many years to find ways to explicate the concept. Recently, however, the IFAC published a paper that sheds some light upon this issue. Since private sector auditors now claim that they will work in the public interest, there might be an even stronger urge for public sector auditors to do so. However, for them it is even more difficult to be clear about the meaning of the concept of the public interest. It is hard to see how it might be explained without connecting it with how a democratic process is intended to arrive at a specification of its content. Furthermore, it is relevant to see how


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government is structured with the claimed intention that civil servants should act effectively to carry out the decisions of parliament. Two people who have reflected upon this complicated subject are Noam Chomsky and Dag Hammarskjöld. Chomsky2 took as a point of departure that included in the responsibilities of intellectuals are telling the truth and revealing lies. Although auditors today could not be viewed as intellectuals in the sociological sense of being rather independent agents in society, his urge is of course relevant. Based on integrity being the core value of the Code of Ethics of the INTOSAI, it seems evident that this responsibility should be attributed to public sector auditors. Chomsky, however, from a somewhat pessimistic perspective, found that this is not at all evident for civil servants. He argued that it is important to claim such a responsibility, especially as there are so many vested interests and pressure groups in the public sector, such that the public interest is threatened. He also argued that citizens have the right to expect it and, furthermore, that civil servants cannot refrain from their responsibility by means of referring to the fact that they have done what they have been ordered to do by their principals. Hammarskjöld3 approached this ethical dilemma from a somewhat optimistic perspective. He focused on the structure of democracy and on an individual civil servant facing the dilemma of being politically neutral while working in the public interest. He observed that after a general election a new cabinet might be established with new political goals other than those in place when the individual in question accepted a position as a civil servant. He further noted that the civil servant presumably was initially inclined to contribute with enthusiasm to the achievement of the former political goals. What if the former and the latter goals were contradictory? The civil servant would then be faced with an ethical dilemma. Hammarskjöld elaborated on how the individual could separate official duties from a private sphere and focus on technical aspects when working, bearing in mind the need for accepting moral responsibility for actions taken. A further complication today is the tendency of blurring the distinction between parliamentarians setting goals and civil servants trying to find the professionally most efficient and effective way of reaching the goals. Viewed as civil servants, with the difficult task of being auditors at the same time, auditors in the public sector should find it relevant and thought provoking to make use of the reflections above on how to seek a balanced way in the ethical dilemma of trying to work in the public interest, keeping political neutrality. A comparison with the IFAC’s Code of Ethics When the INTOSAI and IFAC codes of ethics are compared, it is found that they are, broadly speaking, compatible. However, they are different in some ways. The most obvious fact is that the IFAC code is far more voluminous. From the INTOSAI’s point of view, the requirement of auditor independence

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was so strongly emphasized already in the Lima Declaration that it was not deemed necessary to explicate it at length in the code. In the IFAC code the threats to independence and the safeguards are elaborated in a much more detailed way. The applicability of the IFAC code is divided, referring to two categories of audited entities, one comprising the public interest entities (PIEs), for which the ethical requirements on the auditors are stronger; the other category being all other audited entities, namely those not of public interest. Another observation is that the IFAC code in general includes more detailed advice than the INTOSAI code, hence a public sector auditor might sometimes find it valuable to look to the IFAC code for further guidance.

8.7 Challenges of further development Internal challenges There are internal challenges for the audit profession, to some extent in common for both the private and public sectors. These internal challenges might be discussed with the actual individual auditors in focus, but there are also repercussions for recruitment of new auditors. Indirectly, of course, these internal challenges also have external effects. One of the challenges is regarding the standards becoming more detailed, especially regarding requirements. This is sometimes viewed as a burden and also suggests problems of resources. On the other hand, many auditors want further, more hands-on guidance to be included in the standards. An example of a more detailed standard is the increased requirement of documentation of an audit. If available resources are constant, this results in less time to gather and examine audit evidence, for example, and hence a lower quality of reporting. There is also a risk that both actual auditors and candidates recruited will become less enthusiastic when they see the focus moving from central audit activities towards documentation. Another, rather recent, challenge concerns audit of ‘integrated reporting’. What has been proposed is that the various reporting concerning a certain accountable entity should be integrated. In other words, annual reports should consist not only of financial statements in a narrow sense, but also include, for example, more detailed information in notes, management comments, governance reporting, sustainability reporting, and more information about results in other terms than financial. If such a development meant a corresponding widening of the scope of audit, then the audit teams, including experts, would face difficult problems of competence. A more complex challenge concerns the increased use of IT within the audit. Although not new, this might be even more of a challenge in the future. A ‘SWOT’ analysis (strengths, weaknesses, opportunities, threats) would show that there are many aspects to this issue. Of course, IT support for auditors might facilitate the documentation. There might also be many helpful checklists to see whether requirements have been complied with throughout the


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audit process. On the other hand, there is the risk that IT support is viewed too much as an expert system. The required individual professional judgement might be overrun, making it more difficult to see how to take personal responsibility for the audit and especially for its conclusions. Generally speaking, there is a risk that audit is transformed into a mechanical, ‘box-ticking’ activity of following detailed rules. External challenges and expectations There are also some external challenges, connected to the expectation gap. The expectation gap regarding audit in the public sector might appear in two different ways. It might concern what citizens believe or what they wish. Auditors have to comply with the standards in order to reach a conclusion, at a level of reasonable assurance, as to whether a financial report is free from material mis-statements. However, citizens expect auditors both to go into more detail and to have a wider scope for the audit. In other words, they believe that auditors’ reporting is both more reliable and more far reaching, creating an expectation gap. Such a gap is indeed a challenge. The second version of the mentioned expectation gap concerns citizens’ wish for auditors to do something that they do not do. There are several wishes for an increased scope of the audit in various respects, one being the idea that auditors examining a certain area, according to wishes, should do this in detail instead of aiming at a reasonable assurance that there are no material mis-statements in the actual accounts of the area in question. By way of illustration, an auditor looking at travel expenses for a group of civil servants should reach accurate conclusions regarding every transaction and every journey, instead of simply letting journalists and others discover problems. Another aspect is the idea that auditors examining a certain area, according to wishes, should do this with a broader scope, questioning not only whether the actual accounts are correct but also whether they are, generally speaking, sufficient. By way of illustration, an auditor should question whether the accounts should have disclosed more about the travelling civil servants and whether there should have been references to other relevant accounts. A complicating aspect in the public sector is the fact that a certain error in a financial statement might be judged by an auditor to be immaterial, while at the same time be judged to be important from other points of view. Although the error in question might be very small, with an insignificant effect on the correctness of a balance sheet, it might still have far-reaching political consequences. Finally, there is the important challenge of how to improve the conditions for accountability by means of improving audit. In the public sector, conditions of accountability vary greatly. Unfortunately, in many cases it is deemed sufficient if those in charge disclose a few important figures and facts about

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an entity in a truthful way. In view of the public interest, it is important to try to improve the conditions for accountability, demanding both that more should be disclosed about the entity and that efforts should be made to present relevant information in a more adequate manner. It would not be far-fetched to hope that auditors could contribute to such a development. The last mentioned challenge might be viewed in connection with the discussion of ethical aspects in section 8.6. In a democracy it is important both for members of parliament and citizens in general to be furnished with reliable and relevant information about the public sector in order to be able to reach well-founded decisions. Many civil servants indeed try to accomplish this. However, there are strong forces promoting disinformation. An auditor in the public sector should keep in mind the importance of professional scepticism. There are many ways in which it is made difficult for an auditor to accept responsibility for telling the truth and revealing lies.

Summary  A starting point for this chapter was the need for audit of state entities, with the public interest in mind.  A brief presentation of constitutional aspects was then given, followed by the relevant rules regarding auditor independence, ethics and auditing standards.  A discussion of the adoption of the rules for auditing and their applicability followed.  A central part of the chapter was an elaboration of auditing practice within the public sector, with much in the common core but also many differences. Some differences between the public and private sectors were also analysed.  The chapter ended with an analysis of ethical aspects and further challenges for audit in the public sector.

Discussion questions 1 2 3 4

Why is there a need for audit in the public sector? What are the differences between public sector and private sector auditing? How should one approach ethical dilemmas as a public sector auditor? What upcoming challenges might there be, other than those mentioned in the text?

Notes 1 Inga-Britt Ahlenius chaired the committee drafting the code. She was at that time auditor-general of Sweden and later became head of internal audit of the UN. 2 In The New York Review of Books in 1967, Noam Chomsky wrote an essay on the responsibility of intellectuals.


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3 In the Swedish periodical Tiden in 1951, Dag Hammarskjöld, who later became secretary-general of the UN, wrote an essay on the relationship between a civil servant and society. In particular, he discussed the complex problem of the political inclinations of the individual.

References Carmona, S. and Trombetta, M. (2008) ‘On the Global Acceptance of IAS/IFRS Accounting Standards: The Logic and Implications of the Principles-based System’, Journal of Accounting and Public Policy 27(6): 455–61. Cassel, F. (2000) Behovet av kommunal externrevision, 1. uppl. Stockholm: SNS forlag. ——(2005) Arguments on Harmonising Standards for Auditing: An Essay on the Structure and Content of Arguments for and against Aspects of Harmonisation of Codes of Ethics for Auditors and of Financial Auditing Standards, Stockholm: Riksrevisionen. Cowperthwaite, P. (2009) Culture Matters. How Our Culture Affects the Way we Audit, Toronto. Dunn, J. (1996) Auditing: Theory and Practice, second edn, London: Prentice Hall. Gustavson, M. (2012) Auditing the African State: International Standards and Local Adjustments, dissertation, Göteborg: Göteborgs universitet. IFAC (2012) Handbook of International Quality Control, Auditing, Review, Other Assurance, and Related Services Pronouncements, New York. INTOSAI (International Organisation of Supreme Audit Institutions) (1977, 1998) The Lima Declaration, Vienna. ——(1998) Code of Ethics for Auditors in the Public Sector, Vienna. ——(2011) ISSAI 1000–2999 General Auditing Guidelines on Financial Audit, Vienna. Power, M. (1997) The Audit Society: Rituals of Verification, Oxford: Oxford University Press. Lord Sharman of Redlynch (2001) The Review of Audit and Accountability for Central Government, London. Stettler, H.F. (1977) Auditing Principles, fourth edn, Englewood Cliffs, NJ: Prentice Hall. Tagesson, T. and Eriksson, O. (2011) ‘What Do Auditors Do?’ Financial Accountability & Management 27(3): 272–85. World Bank (n.d.) ROSC Reports.


Performance auditing in the public sector Peter Öhman

Learning objectives  To learn about performance audit in the public sector.  To understand how and why traditional and extended performance audits are conducted.  To learn about the extent to which compliance audit can be included in performance audit.  To be aware of the various roles of performance auditors.

Key words        

Compliance audit Economy Effectiveness Efficiency INTOSAI (International Organisation of Supreme Audit Institutions) Performance audit Performance auditor roles Value-for-money audit

9.1 Introduction That performance auditing is a growing phenomenon is a fact that needs some qualification. In much of the private sector, performance audits are considered unnecessary: as for-profit organizations’ primary goal is to make money, doing so is usually a sufficient indicator of business success. A private company’s profitability indicates in black-and-white terms how effectively the business has been run. If the financial information is audited, this means that the company’s effectiveness is indirectly being examined, and this is usually considered adequate. When it comes to private associations, foundations and other non-profit organizations, however, the objectives are not as clear as for private for-profit businesses. In these cases, the goal is not to make a profit and provide a return on shareholders’ investments. Instead, the purpose of such an organization’s


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activities is determined by a specific mandate and, in such a context, a performance review can be demanded by stakeholders. Associations engaged in sporting activities for young people are supposed to use a large portion of their money to do just that, and organizations such as the Red Cross and Save the Children should use their money to conduct charitable activities according to their statutes. Monitoring the activities performed is found to be useful in municipalities as well. Performance audits of municipal operations are intended to examine whether the operations are being conducted appropriately in economic terms. Such a review can focus on whether the operational output and resources are reasonable in relation to each other. In that case, the organization’s resources and productivity are in the spotlight. A review of a municipality’s performance can also focus on whether and how the organization achieves its goals and whether and how those involved follow decisions, guidelines and regulations. In that case, the focus is on effectiveness, output quality and accountability. Overall, performance auditors are supposed to monitor whether the citizens’ money – such as taxes, fees and contributions – is being used in such a way that the organization produces quantitatively and qualitatively acceptable output according to set targets. This means that performance auditors may also focus on whether boards and committees are performing their governance and monitoring roles adequately. One thing that makes performance audits difficult to conduct in municipalities is that the activities’ objectives are often multifaceted and therefore difficult to specify and measure. Questions that may arise are ‘What constitutes good service?’ and ‘What constitutes good quality?’ Another difficult question, as performance audits can provide a basis for the accountability of elected officials, is how to combine accountability with efficiency incentives. Because performance audits of local and state activities resemble each other, in this chapter, the concept of performance audit will be examined primarily from government premises. As will be demonstrated in the following sections, various aspects of performance audits can be distinguished.

9.2 Performance audit of public organization activities Around the world, state audit organizations (i.e. national audit offices) are designed to examine the performance of public organizations to ensure that citizens receive value for their taxes (Guthrie and Parker, 1999; see also Chapter 8 of this book). A key to citizens’ abilities to assess whether they are getting value for their taxes is access to politically unbiased information about how the government and/or its agencies manage their resources and realize their promises. Systematic and independent control is therefore considered crucial for various stakeholders, including citizens. It must be emphasized that performance audits are inherently complex (Funnell, 1998), and that there are still no generally accepted performance auditing standards or even a common understanding of what the term stands

Performance auditing in the public sector


for (Bowerman et al., 2003). In fact, no general agreement exists regarding a distinct definition of performance auditing (Pollitt, 2003; English, 2007). The International Organisation of Supreme Audit Institutions (INTOSAI) introduced the concept in its Lima Declaration of Guidelines on Auditing Precepts of 1997, as follows: Performance audit is oriented towards examining the performance, economy, efficiency and effectiveness of public administration. Performance audit covers not only specific financial operations, but the full range of government activity including both organisational and administrative systems. (INTOSAI, 1997: section 4.2) Although the INTOSAI attempted to pin down what performance audit entails, in practice this type of audit may have various purposes, and its form can vary from case to case. Consequently, there are a number of opinions as to what types of audits are best suited for assessing the performance of public organizations in terms of providing value for money, and various opinions as to whether and to what extent compliance orientation can be included in performance audits (Pollitt et al., 1999; Lonsdale, 2008). One assumption is that the country in which the audit is completed makes a difference (Pollitt et al., 1999; Pollitt, 2003), but performance audits have been found to differ within countries as well (Grönlund et al., 2011). In particular, it is not unusual for performance audits to take various directions in practice depending on the particular context, indicating that they are often conducted without focusing on the economy, efficiency and effectiveness of public administration (Guthrie and Parker, 1999; Schwartz, 1999; van Thiel and Leeuw, 2002; English, 2007; Gendron et al., 2007). However, such an orientation is not supported by the INTOSAI, according to a statement in the Lima Declaration of 1997: ‘Performance audit is oriented towards examining the performance, economy, efficiency and effectiveness of public administration.’ All public sector activities are intended to be useful for citizens. It is therefore important that input can be transformed, via various processes, into output (i.e. services or products) with a satisfactory outcome. This can be illustrated by the value chain model. While the monitoring of public organizations long concentrated on input, process and output, a gradual increase in the emphasis on outcome indicators has been discernible since the late 1990s (Modell and Grönlund, 2007; see also Chapter 5 of this book). Over time, there has also been a tendency towards expanding the breadth of coverage of performance audits (Pollitt et al., 1999; Lonsdale et al., 2011; Nutley et al., 2012), and Bowerman (1996) suggests an extended and broad-based view including ‘everything from economy to policy’. It has been found that, in practice, performance audits are of two main types (e.g. Pollitt et al., 1999): audits of substance (i.e. focusing on economy, efficiency and effectiveness); and audits of system. As will be demonstrated in


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the next two sections, the first type can be labelled traditional performance audit, while the second type can be included in the concept of extended performance audit.

9.3 Traditional performance audit One way to approach the concept of performance audit is to note the relatively strong consensus that the concept is rooted in the ‘value-for-money audit’. Performance audits are therefore often perceived as synonymous with value-for-money audits. Traditional elements treated in such audits are economy, efficiency and effectiveness, often referred to as the ‘three Es’ (Power, 1997). There is a relatively strong consensus that the three Es represent the essence of traditional performance audits (Pollitt et al., 1999; Dittenhofer, 2001; Grönlund et al., 2011; Nutley et al., 2012). The common denominators of economy, efficiency and effectiveness are that they all emphasize public organizations’ core activities, as well as quantification and measurement (Guthrie and Parker, 1999; Pollitt et al., 1999; Lonsdale, 2008). An economy audit is focused on examining input in terms of how well the cost of these resources are minimized. An efficiency audit examines the relationship between output, in terms of services or products, and the input used to produce it. An effectiveness audit focuses on the extent to which goals are achieved. Figure 9.1 illustrates the relationships between the three audit types and the value chain. The three Es not only appear in the INTOSAI’s Lima Declaration of 1997, but are also reportedly applied in practice in several countries. The Danish national audit office is oriented towards efficiency (Skærbæk, 2009), and state auditors in Canada (Gendron et al., 2007), Australia (Funnell, 1998; Guthrie and Parker, 1999), New Zealand (Jacobs, 1998) and Great Britain (Lonsdale, 2008) have, at least initially, been auditing public organizations largely in terms of economy and efficiency. Economy audit is about keeping costs down. A successful organization in this respect is designed to minimize the resources required to perform various tasks. The question posed is whether the organization and its individuals are frugal or if they are less scrupulous when ordering materials, leasing premises, Efficiency audit

Effectiveness audit

Economy audit




Figure 9.1 The ‘three Es’ in relation to the value chain Source: Grönlund et al., 2011


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booking travel, etc. An early example of an audit of cost-consciousness – and hence the focus on effective utilization of resources – occurred in the 1800s. An English accountant criticized a public organization for purchasing materials for 20 shillings from one supplier when they could just as well be purchased for 14 shillings from another (Normanton, 1966). Efficiency audits have to do with productivity. The main issue they examine is the link between the resources expended and what is delivered or produced. The more units one produces from a certain amount of resources, the better one’s efficiency. Focusing on the cost per unit produced is an example of how to examine resource utilization (productivity) in an organization. The lower the unit cost, the more efficient the use of resources. Efficiency audits can focus on the cost a university department incurs per student who undergoes training, or what it costs the police to conduct a certain number of traffic checks or to issue fines for a certain number of traffic violations. Good resource management can thus be an element of, but need not be a prerequisite for, good utilization. Hiring cheap teachers or buying cheap traffic-monitoring equipment certainly reduces costs, but at the same time it can lead to fewer students undergoing relevant training or fewer speeders being detected and fined. Effectiveness audits are contingent on the outcome and impact indicators. More precisely, they have to do with the extent to which objectives have been achieved with a satisfactory level of quality. The focus is on the value of what has been achieved, rather than merely on resources or productivity. Although this type of traditional performance audit takes into account the resources used, it is not necessarily the case that cost-consciousness or productivity is synonymous with effectiveness. A university department that graduates students of high employability is, for example, more effective than another university department that graduates students of low employability, even though the latter may graduate more students and/or do so at a lower unit cost. Assessing an organization’s performance with respect to the effects achieved may involve evaluating whether it is possible to determine whether the objectives have been achieved and measuring progress towards set targets. What, for example, is the relationship between the target (i.e. desired effect) and outcome (i.e. actual impact)?

9.4 Extended performance audit Even though performance audits (value-for-money audits) may be formally oriented towards the three Es, it is not unusual to see audits taking other directions in practice (Guthrie and Parker, 1999; Pollitt, 2003). Gendron et al. (2001) suggest that this is because state auditors try to satisfy demands for action outside the scope of traditional performance audits. A related reason concerns the false impression of a linear transformation of resources to output and outcome through processes, an impression that does not take the complexity of public life into consideration (Kyrillidou, 2002). Consequently,


Peter Öhman

it can be difficult to measure economy, efficiency and effectiveness in such a complex reality. Although it can be difficult consistently to distinguish between various types of performance audits (Pollitt et al., 1999), several extended performance audit types are described in the literature. For example, it has been suggested that performance audits can compare the performance of similar public organizations in order to identify best practices (Bowerman, 1996). The previously mentioned distinction between audits of substance and of systems is based on whether a performance audit examines an organization’s core activities (substance) or the systems developed to manage and control those activities (Power, 1997; Pollitt et al., 1999). Performance audits can examine the systems used to manage and control the activities performed, as good processes are supposed to reduce interference and errors, while bad processes increase the risk of problems in terms of organizational inefficiency. According to the INTOSAI, and as stated in the Lima Declaration, it can be appropriate to examine both core activities and control or supporting systems: ‘Performance audit covers not only specific financial operations, but the full range of government activity including both organisational and administrative systems’ (INTOSAI, 1997: section 4.2). In the same vein, Pollitt et al. (1999) suggest that it is usual to conduct performance audits with respect to both core activities and systems. Power (2003) identifies an augmented performance audit focus on organizations’ systems, or a focus on the control of organizations’ own control systems, and audits of control or supporting systems are emphasized by public audit entities in Canada (Gendron et al., 2007). Accordingly, system audits can be regarded as an extended type of performance audit. It should also be mentioned that the term ‘operational audit’ is often used instead of system audit, as operational audits also pay attention to organizations’ control or supporting systems. Financial calculations are normally not emphasized in audits of control or supporting systems (Dittenhofer, 2001). Extended performance audits can take other forms. Examinations of the information that governments or governmental agencies produce and provide can be regarded as an extended performance audit (Bowerman, 1996). Information and communications often serve as a proxy for other administrative activities, such as organizing and monitoring (Power, 2007). One may argue that information and communication are about accountability, and therefore constitute a suboptimal proxy for other administrative activities. In any case, whether a public organization has a good or bad administration from a broader perspective can justify performance audits (Pollitt, 2003), although it may be difficult to define what constitutes such audits. Nevertheless, administration audits are supposed to cover the administrative activities of the government and/or its agencies, including reporting between parliament, government and governmental agencies (Bowerman, 1996). Financial calculations are not normally emphasized in this type of audit (Grönlund et al., 2011).

Performance auditing in the public sector


It is difficult to audit the outcomes of public activities (Gendron et al., 2001) as their goals tend to be ambiguous and sometimes contradictory. Moreover, the relationship between cause and effect is normally complicated, making it difficult to focus solely on the outcome of a specific organization’s activity (Sanger, 2008). As public activities are carried out in ways that make their outcomes difficult to measure quantitatively, it can also be complicated to carry out effectiveness audits. Accordingly, a goal-related audit has a place within an extended performance audit. This type of audit can examine whether goals have been formulated or whether goals are clear, unambiguous and consistent at various organizational levels (Gendron et al., 2007). Consequently, performance audits can involve assessing whether government authorities have set goals at different levels, how these goals are linked to a more or less clear vision, and how authorities handle unclear cases. An important aim of this extended type of performance audit is to provide a basis for how goals should be clarified or changed. The last type of extended performance audit covered in this chapter is the policy audit, which examines whether political programmes are financially appropriate (Bowerman, 1996). This type of audit is supported by Dittenhofer (2001) and Pollitt et al. (1999), and is carried out in countries such as Canada (Gendron et al., 2007) and Great Britain (Lonsdale, 2008). In this context, one can distinguish between Politics (with a capital P, i.e. large-scale political programmes) and politics (with a small p, i.e. a specific part of a large-scale political programme). Large-scale political programmes (e.g. foreign policy) exist outside the domain of performance audits, but state auditors may examine how a foreign ministry manages a certain crisis, as it relates to politics. A policy audit can also review whether or not an Olympic Games achieved its anticipated financial performance, or focus on other time-limited projects with specific goals. However, it is not within the scope of performance audits to complain that a country needs state guarantees to arrange an Olympic Games.

9.5 Performance audit and compliance One can argue that performance audits of organizational efficiency or effectiveness are one thing, and that audits of compliance with laws, regulations, directives and policies are another. According to this view, it is undesirable to take account of compliance in performance audits (Behn, 2001). One argument for such an approach is that performance audits and compliance audits involve different types of examinations. Policies, directives and legal certainty should not be confused with goals, and compliance with rules and directives does not automatically lead to efficiency or effectiveness. Those who advocate such an approach argue that performance audits should assess whether something is good or bad, while compliance audits determine whether something is right or wrong.


Peter Öhman

However, a cornerstone of modern democracies is that citizens should be able to demand accountability from those who are elected or otherwise occupy positions of power. Unfiltered information lets everyone keep abreast of what is happening in the state administration, to permit retrospective accountability for policy and for officials’ actions and interpretations. Regarding this point, it is desirable to link performance and accountability, and to include accountability or compliance in performance audits. In such cases, the audit focuses on an organization’s adherence to legislation, rules and policies, and the extent to which those responsible have ensured that such adherence is evaluated. In the Implementation Guidelines for Performance Auditing, presented at the Stockholm International Congress of 2004, the INTOSAI suggests that it may be necessary to examine a public organization’s level of compliance, if it is significant for the output and outcome of the organization’s activities: Auditing accountability can be described as judging how well those responsible at different levels have reached relevant goals and met other requirements for which they are fully accountable. (INTOSAI, 2004: part 1.8) According to this view, one can argue that contravening the rules can be both detrimental and demoralizing to an organization, and that adherence to legislation, rules and policies can contribute to value for money (Olsen, 2005; Goolsarran, 2007). Audits that occupy the area between how the government and/or its agencies create value for money (good or bad), and how they comply with legislation, rules and policies (right or wrong), have been observed in Denmark (Skærbæk, 2009), Sweden (Grönlund et al., 2011) and Canada (Gendron et al., 2007), and especially in Brunei (Athmay, 2008). Accordingly, part of a performance audit can be related to objectives, while another part can involve regulatory compliance. The focus on compliance audits is not surprising given the broad interpretation of what constitutes a performance audit. Unusually, in Sweden compliance audits are in some cases considered equivalent to performance audits (Grönlund et al., 2011). In several of these cases, it was observed that the audit focused solely on whether the public organizations investigated had followed established guidelines for representation. One case that illustrates different views of compliance as a part of performance audits is that of a state official who violated internal rules when he ordered a service trip. Instead of going through the contracted travel agency, in accordance with the directives, and paying more than €700 for the trip, he booked it via the Internet for €250. Some might think that the official’s conduct was culpable because he contravened existing directives, while others would applaud him because he saved the organization money. From still another perspective, a performance audit might focus on whether the money was disbursed in accordance with applicable requirements for recipients and

Performance auditing in the public sector


amounts. What might initially be assessed as an effective use of resources could prove more doubtful if the person responsible violated rules that were important in defining the assignment. If someone pays more money than intended and/or pays it to individuals other than those intended, the organization has not realized its intentions. If someone pays money to others than those intended, it seems easier to argue that efficiency and compliance are related to each other than in the travel agency case.

9.6 A performance audit classification scheme In response to the lack of a commonly agreed classification, Grönlund et al. (2011) presented 21 possible orientations of performance audits. Table 9.1 shows that an economy audit with no degree of compliance audit is indicated as 1:0, while a policy audit with a strong degree of compliance audit is indicated as 7:2. When investigating all 150 audit reports published by the Swedish national audit office from its establishment in 2003 to the end of 2008, Grönlund et al. (2011) found that administration audits and system audits were the most common types. Traditional performance audits (‘the three Es’) were carried out only occasionally, as were policy audits. Furthermore, an audit orientation towards goals was less prominent, indicating that it is difficult for governments and/or their agencies to measure goals, and for state auditors to audit the effectiveness of public organizations. In relation to the classification scheme presented here, it could be concluded that audits of the performance of public organizations are far from uniform (Pollitt et al., 1999; Bowerman et al., 2003), which supports the view that performance audits are inherently complex. It can also be noted that Grönlund et al. (2011) classified a great majority of performance audits as multi-organization audits, with only one out of five audits being limited to one organization. Performance auditors can, consciously or unconsciously, examine several things at once. The fact that many audits include more than one type of performance audit suggests that it is difficult to distinguish consistently and clearly between different audit types, particularly when more than one organization is being examined. According to Pollitt et al. (1999), the degree of a compliance audit also depends on whether one or more public organizations is being audited, because it is normally easier to carry out compliance audits when only one organization is being reviewed. Table 9.1 A performance audit classification scheme Audit type

Economy Efficiency Effectiveness System Administration Goal-related Policy

Degree of compliance audit








No degree (0) 1:0 Some degree (1) 1:1 Strong degree (2) 1:2

2:0 2:1 2:2

3:0 3:1 3:2

4:0 4:1 4:2

5:0 5:1 5:2

6:0 6:1 6:2

7:0 7:1 7:2


Peter Öhman

9.7 The possible conflict between different performance auditor roles In the public sector, the ambiguity of what constitutes desirable achievements and the lack of predetermined criteria make auditing a challenging task for performance auditors. In situations of great uncertainty, the approved tasks of public organizations and the desired results are open to interpretation by performance auditors (Everett, 2003). While performance audits could be dynamic, the force of habit is great when performance auditors are designing their audit plans, which can lead to a single-minded focus on certain areas, certain examination items and certain audit methods. Accordingly, the work of state auditors can become rather single minded, characterized by a lack of focus on traditional performance audits in certain countries (Grönlund et al., 2011) and a strong focus on compliance issues in others (Athmay, 2008). There is also a risk that some state spending areas may be disproportionately examined compared with other areas, relative to the expenditure area’s size (English, 2007). Similarly, some agencies may be selected for relatively large-scale monitoring and certain audit methodologies may be preferred over others. Performance audits can thus be developed in such a way that they become rather static. In line with what is stated above, auditors’ habits are claimed to influence how audits are carried out (Pollitt et al., 1999; Grönlund et al., 2011). For example, it has been demonstrated that those carrying out performance audits can assume various roles, namely, the controller, consultant, researcher and sentencing roles (Morin, 2003). In practice, state auditors rarely play any one role exclusively; instead, they often mix the various roles, while favouring one of them. An auditor’s background and experience are known to be important in determining what role becomes dominant. The controller and sentencing roles often lead to an increased focus on providing a basis for accountability or compliance (right or wrong), while the role of consultant often leads to an increased willingness to encourage the audited organization to improve its efficiency (from poor to good). The researcher role has potential to balance efficiency and compliance. The controller and consultant roles have both advantages and disadvantages. Calling those responsible to account may be justified, but too strong a focus on the controlling role of performance auditing can counteract possible efficiency improvements in the audited organization. In addition, a desire to point out defects, and to ask someone to take responsibility for them, may create discomfort for those affected by the review. The consulting role has a somewhat different problem. While the recommendations made by a consultant may help improve an organization’s efficiency or effectiveness, these same recommendations may threaten auditor independence. Can performance auditors be, as well as appear to be, free of conflicting interests in the eyes of the public if they review the results of their own advice? It has been demonstrated that there may be situations in which the citizens – the party for whom performance audits are supposed to be most

Performance auditing in the public sector


useful – cannot be sure that a performance auditor is independent of the audited party. The solution to this problem is not to suggest that state auditors should be confined to the controller role, but to require that they display great integrity. Here it is tempting to refer to the notion of an appropriate balance between the controller and consultant roles. Such a requirement is easy to formulate, but not always easy to enforce. Key issues are in what situations and to what extent advice should be given, and how this may affect independence in fact and in appearance. Studies illustrate the difficulties experienced by those who conduct performance audits when it comes to maintaining independence from political power (e.g. Pollitt et al., 1999). Performance auditors need to question the skill of those in charge of government departments and agencies. A question is then how performance auditors are to maintain their independence from the ruling power, which is not always very receptive to criticism (Reichborn-Kjennerud, 2013). It can be difficult for auditors to criticize politicians and officials – in order to win the confidence of citizens – while creating a climate of confidence when auditing these same politicians and officials.

Summary  A starting point of this chapter was the need for performance audits in the public sector, to ensure that citizens receive value for their taxes.  The concept of performance audit and the complexity of the concept were discussed, as were traditional performance audits (i.e. economy, efficiency and effectiveness audits) and extended performance audits (i.e. system, administration, goal-related and policy audits).  It was emphasized that an audit that occupies the area between how the government and/or their agencies create value for money (good or bad) and how they comply with legislation, rules and policies (right or wrong) can be viewed from different perspectives.  The chapter ended with a discussion of the potential for conflict between different performance auditor roles, and of the difficulties performance auditors have in maintaining actual and apparent independence.

Discussion questions 1 Why is there a need for performance audits in the public sector? 2 What types of traditional and extended performance audits exist, and what are the differences between the two main types of performance audits? 3 Why and to what extent can compliance be included in performance audits? 4 What roles can a performance auditor adopt and what conflicts can arise between these roles?


Peter Öhman

References Athmay, A. (2008) ‘Performance Auditing and Public Sector Management in Brunei Darussalam’, International Journal of Public Sector Management 21(7): 798–811. Behn, R. (2001) Rethinking Democratic Accountability, Washington: Brookings. Bowerman, M. (1996) Accounting and Performance Measurement: Issues in the Private and Public Sectors, London: Paul Chapman Publishing Ltd. Bowerman, M., Humphrey, C. and Owen, D. (2003) ‘Struggling for Supremacy: The Case of UK Public Audit Institutions’, Critical Perspectives on Accounting 14(1): 1–22. Dittenhofer, M. (2001) ‘Performance Auditing in Governments’, Managerial Auditing Journal 16(8): 438–42. English, L. (2007) ‘Performance Audit of Australian Public Private Partnerships: Legitimising Government Policies or Providing Independent Oversight?’ Financial Accountability & Management 23(3): 313–36. Everett, J. (2003) ‘The Politics of Comprehensive Auditing in Fields of High Outcome and Cause Uncertainty’, Critical Perspectives on Accounting 14(1–2): 77–104. Funnell, W. (1998) ‘Executive Coercion and State Audit. A Processual Analysis of the Responses of the Australian Audit Office to the Dilemmas of Efficiency Auditing 1978–84’, Accounting, Auditing and Accountability Journal 11(4): 436–58. Gendron, Y., Cooper, D.J. and Townley, B. (2001) ‘In the Name of Accountability. State Auditing, Independence and New Public Management’, Accounting, Auditing & Accountability Journal 14(3): 278–310. ——(2007) ‘The Construction of Auditing Expertise in Measuring Government Performance’, Accounting, Organization and Society 32(1–2): 101–29. Goolsarran, S. (2007) ‘The Evolving Role of Supreme Audit Institutions’, Journal of Government Financial Management 56(3): 28–32. Grönlund, A., Svärdsten, F. and Öhman, P. (2011) ‘Value for Money and the Rule of Law: The (New) Performance Audit in Sweden’, International Journal of Public Sector Management 24(2): 107–21. Guthrie, J. and Parker, L. (1999) ‘A Quarter of a Century of Performance Auditing in the Australian Federal Public Sector’, ABACUS 35(3): 302–32. INTOSAI (1997) Lima Declaration of Guidelines on Auditing Precepts, Lima: INTOSAI International Congress. ——(2004) Implementation Guidelines for Performance Auditing, Stockholm: INTOSAI International Congress. Jacobs, K. (1998) ‘Value for Money Auditing in New Zealand: Competing for Control in the Public Sector’, British Accounting Review 30(4): 343–60. Kyrillidou, M. (2002) ‘From Input and Output Measures to Quality and Outcome Measures, or, from the User in the Life of the Library to the Library in the Life of the User’, The Journal of Academic Librarianship 28(1): 42–46. Lonsdale, J. (2008) ‘Balancing Independence and Responsiveness: A Practitioner Perspective on the Relationships Shaping Performance Audit’, Evaluation 14(2): 227–48. Lonsdale, J., Wilkins, P. and Ling, T. (2011) Performance Auditing: Contributing to Accountability in Democratic Government, Cheltenham: Edward Elgar Publishing. Modell, S. and Grönlund, A. (2007) ‘Outcome-based Performance Management: Experiences from Swedish Central Government’, Public Performance and Management Review 31(2): 274–87.

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Morin, D. (2003) ‘Controllers and Catalysts for Change and Improvement: Would the Real Value for Money Auditors Please Stand Up?’ Managerial Auditing Journal 18 (1): 19–30. Normanton, E.L. (1966) The Accountability and Audit of Governments: A Comparative Study, Manchester: Manchester University Press. Nutley, S., Levitt, R., Solesbury, W. and Martin, S. (2012) ‘Scrutinizing Performance: How Assessors Reach Judgements About Public Services’, Public Administration 90 (4): 869–85. Olsen, J.P. (2005) ‘Maybe it is Time to Rediscover Bureaucracy’, Journal of Public Administration Research and Theory 16(1): 1–24. Pollitt, C. (2003) ‘Performance Audit in Western Europe: Trends and Choices’, Critical Perspectives on Accounting 30(1–2): 157–70. Pollitt, C., Girre, X., Lonsdale, J., Mul, R., Summa, H. and Waerness, M. (1999) Performance or Compliance? Performance Audit and Public Management in Five Countries, Oxford: Oxford University Press. Power, M. (1997) The Audit Society: Rituals of Verification, Oxford: Oxford University Press. ——(2003) ‘Auditing and the Production of Legitimacy’, Accounting, Organizations and Society 28(4): 379–94. ——(2007) Organizing Uncertainty: Designing a World of Risk Management, Oxford: Oxford University Press. Reichborn-Kjennerud, K. (2013) ‘Resistance to Control Norwegian Ministries’ and Agencies’ Reactions to Performance Audit’, Public Organization Review. A Global Journal 13, New York: Springer. Sanger, M.B. (2008) ‘From Measurement to Management: Breaking through the Barriers to State and Local Performance’, Public Administration Review 68 (Supplement): 70–85. Schwartz, R. (1999) ‘Coping with the Effectiveness Dilemma: Strategies Adopted by State Auditors’, International Review of Administrative Sciences 65(4): 511–26. Skærbæk, P. (2009) ‘Public Sector Auditor Identities in Making Efficiency Auditable: The National Audit Office of Denmark as Independent Auditor and Modernizer’, Accounting, Organizations and Society 34(8): 971–87. van Thiel, S. and Leeuw, F.L. (2002) ‘The Performance Paradox in the Public Sector’, Public Performance and Management Review 25(3): 267–81.


Across the board cuts 125 Accrual-based budgeting (ABB) see budgeting Activity-based costing (ABC) 106–9 Accountability 4, 6, 13–14 Accountability 170 Accounting choice 8, 11, 13, 17–19 Accounting practice 8, 11, 13, 17–19 Accounting Standards 8–11, 16, 19 Accrual accounting 31–32, 46 Accruals assumption 1, 2 Administration audit 168, 171 Agency theory 97 Anthony’s control framework 78 Audit evidence 154 Auditor independence 172–73 Auditors report 155 Austerity 125–26 Australia 130–31, 134 Austria 130: municipalities 112–13 Balanced Scorecard (BSC) 91 Belgium: BBC 48, 52–53 Beliefs systems 81–82 Benchmarking 93–96 Best value regime 94 Beyond budgeting see budgeting Boundary systems 81–82 Brazil 139 Budget: 4, 5, 6, 13; definition 122–23; entities 123; functions 123–24 Budget constrained style 136 Budget evaluation styles 135–37 Budgetary participation 137 Budgetary slack 137 Budgeting 122–40; accrual-based 133–34; beyond budgeting 137–39; history 122–23; human aspects 137; in times

of austerity 125–26; incremental 125–27; line-item budgeting 124; participatory 139–40; performance-based 129–33; planning programming budgeting system 127–28; zero-based 128 Canada 117, 130–31 Capital charge 111 Capital investment appraisal 114–18 Cash accounting: 31, 32, 46 Classification scheme 171 Code of ethics 147, 158 Compliance audit 169–71 Conceptual Framework 39–40 Consolidated Financial Statement: purposes 63, 66; users, 63, 66–67 Consolidation, area of: control criterion 66–69, 71; financial accountability criterion 66 Consolidation, method of: Full method 65; Proportional 65; Equity Method 65–66 Consolidation, theories of: Entity Theory 64; Parent Company Theory 64–65; Proprietary Theory 65 Consultation paper (CP) 30 Council Directive 2011/85/EU 55 Contingency approach 80 Control: action 79; cybernetic models of control 85; expert 84–85; intuitive 84–85; judgmental 83–84; levers of control 81; personnel and cultural 79; political 83–84; results 78; routine 84–85; trial and error 84–85 Cost accounting 104–11 Cost allocation 105–9 Cost-benefit analysis (CBA) 117–18 Cost centres 135 Cost drivers 106–7

Index Cost-effectiveness analysis (CEA) 118 Cost pool method 108–9 Cost pools 105–9 Cost-plus pricing 112–13 Costs: behaviour 109–10; direct 105–9; discretionary 110; engineered 110; fixed 109; indirect 105–9; opportunity 110–11; relevant 110–11; stickiness 109–10; sunk 110; variable 109 Cutback management 125 Data envelopment analysis (DEA) 90–91 Decoupling 8, 17–18 Democracy 1, 4, 12, 14, 19 Decentralization of decision rights 134–35 Denmark 130 Diagnostic control systems 81 Eclectic 8, 18–19 Economy 89 Economy audit 166–67, 171 Effectiveness 89–90 Effectiveness audit 166–67, 171 Efficiency 89–90 Efficiency audit 166–67, 171 EPSAS 55–57 Ethical dilemma 156–58 Expectation gap 160 European Economic Governance Package (Six Pack): 55 Eurostat Public Consultation on the suitability of the IPSAS for the EU member states 55–56 Exposure draft (ED) 30 Externalities 1–3 Estonia: central government 126, 132–33 European Commission (EC) 52, 69–70 Finland 130 France 130 GASB: GASB 14 67, 74 General Purpose Financial Statements (GPFS) 26; quality 45 Germany 130 Goal-related audit 169, 171 Hofstede’s control framework 83–85 IAS: IAS 27 67 Iceland 134 Incremental budgeting see budgeting Institutional Theory 8, 11, 14–15, 19


Interactive control systems 81 Internal rate of return (IRR) 115–17 International Federation of Accountants (IFAC) 104 International Financial Reporting Standards (IFRS) 24; differences with IPSAS 41–42, 46–47 INTOSAI 146, 165, 170 Investment centres 135 IPSAS: definition 25–27; IPSAS 1 33–34; IPSAS 2 34, 45; IPSAS 6 67–71; IPSAS 7 67–68, 70–71; IPSAS 8 68–70 critical perspectives 45–50; literature 57; IPSAS implementation: process 43–45; international organizations 51–52; countries 52–53; local governments 54; central governments 54 IPSASB: goals 27; authority 27; strategy 28; structure 28–29; due process 29–30; publications 31–41 Isomorphism 8, 15–16 ISSAI 147–48 Line item budgeting see budgeting Long-term council community plans (LTCCPs) 140 Management control: definition 78; differences between profit and nonprofit organizations that affect the management control process 82–83 Market-based pricing 112–13 Materiality and relative risk 153 Merchant’s control framework 78–80 Multi-criteria analysis (MCA) 118 Netherlands: municipalities 72–73; provinces 72–73 Net Present Value (NPV) 115–17 New public management (NPM) 8, 9, 24, 32, 86–88 Netherlands 95, 117: budgeting 130–31; central government 98–99; municipalities 104–5; 108–9; 113–14; 124–25, 137 New Zealand 53, 111, 130, 134, 139–40 Non-accounting style 136 North Atlantic Treaty Organization (NATO) 52, 68 Operations consciousness style 136 Opportunistic behaviour 8, 13



Organisation of Economic Co-operation and Development (OECD) 52, 68, 129–30

Responsibility accounting and responsibility centres 134–35 Revenue centres 135

Participatory budgeting (PB) see budgeting Payback method 115–17 Performance audit: general 163–65, 171; traditional 166–67; extended 167–69 Performance auditor 164, 172 Performance auditor roles 172 Performance-based budgeting (PBB) see budgeting Performance evaluation 135–37 Performance indicators 87, 89–91 Performance measurement and management 85–93: conditions for 92–93; purposes of 91–92 Planning programming budgeting system (PBBS) see budgeting Policy audit 169, 171 Positive accounting theory 8, 11–12, 19 Practice notes 148 Price setting 111–14 Profit centres 135 Profit consciousness style 136 Public goods 1–3,6–7 Public governance 86–87 Public Value (PV) 86–88

SAI 146 Simons’ control framework 80–82 Soft control 96–99 Standard setting 8–11 Stakeholder 1, 4–6, 10, 12, 14, 16 State audit organization 164 Stewardship theory 97 Sweden 130–32, 134: Council on Municipal Accounting 71–72; local governments 71–72; municipalities 95–96 Switzerland 130 System audit 168, 171

Recommended Practice Guidelines (RPG) 41 Reliance on accounting performance measures (RAPM) 135–37

Targeted cuts 125 Traditional Public Management (TPM) 86–88 Three EEEs (‘3Es’) 89, 166 Time-driven activity-based costing (TDABC) 108 Trust 89–90, 96–99 Trust scan 98–99 United Kingdom (UK) 86–87, 93, 118, 130, 134, 140 United Nations (UN) 52 United States of America (USA) 53, 86, 95, 105, 113, 117, 127–29, 130, 134 Value chain 166 Value-for-money audit 166