Fixing Public Sector Finances: The Accounting and Reporting Lever

Detroit’s bankruptcy highlighted the precarious financial situation of many states, cities, and other localities (collectively referred to as municipalities). In an article just published in the UCLA Law Review, we argue that part of the blame for this situation lies with the outdated and ineffective financial reporting regime for public entities and that fixing this regime is a necessary first step toward fiscal recovery. We provide concrete examples of advisable changes in accounting rules and advocate for institutional changes, particularly involvement of the Securities and Exchange Commission (SEC).

The current reporting regime is misleading and dangerous because of features that are not required by any particularity of public sector finances. The regime is misleading because it omits foreseeable long-term consequences from reported financial numbers. And it is dangerous because the omission of consequences blinds citizens and perhaps even politicians to the long-term repercussions of politicians’ choices. At worst, it may prompt politicians to choose economically suboptimal measures precisely because it allows them to misrepresent their financial performance to voters.

Our article emphasizes the distinction between financial reporting on the one hand, and the budget on the other. The budget focuses primarily on cash, and hence is quite uninformative about long-term fiscal health. That is the reason several public entities have massive debts even though they are required to balance their budgets each year. What is missing in the budget is information about other components of state wealth, in particular obligations and other non-cash assets. Such information appears in the consolidated annual financial report that is the subject of our article.

Most U.S. states and local entities prepare consolidated financial reports in accordance with a separate set of GAAP developed by the Governmental Accounting Standards Board (GASB). Superficially, public sector GAAP resembles its private sector counterpart. Like FASB, GASB is organized by the private Financial Accounting Foundation with the purpose of crafting principles to “[a]ssess the finances of the government in its entirety” using a modified accrual system. [1] Beneath the surface, however, GASB deviates considerably from FASB. We argue that many of these deviations are misguided and have disastrous consequences for public sector finances.

Perhaps the most striking deviation is that the current regime does not provide the information necessary to understand why the cash-based performance reported on the budget differs from the accrual-based performance on the financial statements (a so-called “reconciliation”). Another crucial deviation is that the accrual measures themselves are incomplete, as GASB deviates in some important respects from true accrual accounting. Our article illustrates these shortcomings with examples in concrete settings.

Importantly, there is now strong empirical evidence that the reporting failures not only conceal, but partially cause, fiscal problems. Much of this evidence relates to municipal pension obligations, which are notoriously understated. [2] For example, one of us shows in a separate paper that understating pension costs can result in public sector employees appearing less expensive, which in turn, causes states to hire more workers. The costs associated with this increased hiring can exacerbate fiscal weakness. [3] This means that improving government accounting will not only clarify states’ existing financial problems but also help improve decision making, be it by raising taxes or cutting spending. These changes will limit the likelihood of similar fiscal problems in the future.

In most of our discussion, we contrast GASB rules to the superior FASB rules. Since better rules are readily available, it is unclear why GASB has not adopted them. In a recent white paper, GASB argued that its rules are required by particularities of the public sector. [4] As we discuss in detail, however, these arguments do not withstand scrutiny.

Given GASB’s reticence in spite of evidence of mounting problems, we are skeptical that GASB will reform by itself. In fact, GASB is presently moving in the wrong direction, away from accruals toward more cash-based measures. [5] Some have speculated that this is due to incompetence or capture by the regulated public entities from where GASB’s members hail. [6] We consider the problem too pressing to wait for the resolution of such debates. We point out that one important legal difference between GASB and FASB is that the former is not subject to SEC oversight. This may explain the differences in substantive rules and suggests that the SEC could serve as a natural, qualified regulator to fix the current problem.

The SEC currently interprets section 15B(d)(1) of the Exchange Act as a bar to its involvement in public sector accounting. [7] Substantively, public sector accounting is squarely within the ambit of SEC expertise and responsibility in as far as the SEC is responsible for investor protection in the municipal bond market, which most public entities use for their financing. We therefore support the SEC’s recent request to Congress for authority to regulate financial reporting of municipal bond issuers. [8] In contrast to the SEC, however, we believe that merely mandating compliance with existing GASB will not be sufficient. The GASB rules themselves must be improved to ameliorate the problems caused by insufficient financial reporting of public finances.

The full article is available for download here.

Endnotes:

[1] Summary of Statement No. 34, Governmental Accounting Standards Bd., http://www.gasb.org/st/summary/gstsm34.html.
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[2] See, e.g., Robert Novy-Marx & Josh Rauh, Public Pension Promises: How Big Are They and What Are They Worth?, 66 J. FIN. 1211 (2011).
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[3] James Naughton et al., Economic Consequences of Public Pension Accounting Rules (Sept. 5, 2014) (unpublished working paper), available at http://ssrn.com/abstract=2199067.
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[4] Governmental Accounting Standards Bd., Why Governmental Accounting and Financial Reporting Is—and Should Be—Different 1 (revised Apr. 2013), available at http://gasb.org/cs/ContentServer?c=Document_C&pagename=GASB%2FDocument_ C%2FGASBDocumentPage&cid=1176162354189
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[5] Compare Governmental Accounting Standards Bd., No. 3-20, Preliminary Views on Concepts Related to Recognition of Elements of Financial Statements and Measurement Approaches, at viii (2011) (“This document proposes a recognition framework for both the economic resources measurement focus and the near-term financial resources measurement focus.”), with id. at 23 (“These minority members believe that the near-term measurement focus as proposed would further undermine the objective of providing information to assess inter-period equity … ”).
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[6] Consider the following quote from Arthur Levitt, Chairman of the United States Securities and Exchange Commission from 1993 to 2001:

While the Sarbanes-Oxley Act created an independent funding mechanism for the FASB, the GASB, in order to operate, still relies on donations from those for whom they write standards . . . . Congress should also create an independent source of funding for the GASB, as it has for the FASB. The potential for crisis in municipal finance arguably is worse than that in corporate America; the public sector needs an equally independent and strong standard-setter.

Arthur Levitt, Jr., Opinion, Standards Deviation, Wall St. J. (Mar. 9, 2007, 12:01 AM), http://online.wsj.com/news/articles/SB117341014938031922.
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[7] See U.S. Sec. & Exch. Comm’n, Report on the Municipal Securities Market (2012). available at http://www.sec.gov/news/studies/2012/munireport073112.pdf.
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[8] See id.
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