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A Message from the Editor-in-Chief: Accounting for State and Municipal Government

Richard H. Kravitz, MBA, CPA

It was nearly 85 years ago that Colonel Arthur Carter, then-president of the NYSSCPA, reported, “In these days and in these times, municipalities are encountering great difficulty in balancing their budgets, and they will encounter greater difficulties during the next few years unless radical steps are taken to reduce departmental expenditures to a point equal to or less than income [The NYSS Yearbook, August 1932, pp. 104–105].” Carter was referring to the use of cash accounting to balance the books, a practice that is still used today by many state and local governments. As many CPAs know, cash accounting can be materially misleading and lead to bad decision making. As I have said before, “what is counted often does not matter, and what matters is often not counted” (“A Message from the Editor-in-Chief,” The CPA Journal, April 2015, p. 10). The hidden liabilities of governments—such as unfunded pension obligations, underfunded postretirement welfare benefits, and inadequate reserves to fund an aging infrastructure—do matter, even if they do not show up on the balance sheet.

Carter's description of the issues that faced state and municipal government in the 1930s is remarkably similar to the issues facing governmental entities today in the wake of the “Great Recession.” Today, some—including Professors Naughton and Spamann, on page 16 of this issue—would question whether regulators have contributed to the difficulty, and whether private sector accounting standards might present a clearer picture of a government entity's financial health.

Exclusion of Independent Audits of State and Local Governments

Carter was the only CPA to testify before the SEC in the 1930s era hearings that ultimately led to CPAs being granted the mandate to audit public companies (Mark Ernest Jobe, “The Accounting Profession Goes to War: Accounting Contributions to WWII,” https://mtsu.edu/accounting/seminars.php, Dec. 3, 2010, University of Mississippi, p. 97). This historic grant of authority to independently audit issuers was secured only by one vote, stated luminary securities law author Joe Seligman, a professor and current president of the University of Rochester, in a conversation with this author.

What is not as well known is that Carter unsuccessfully championed independent audits of state and municipal governments, as well as SEC oversight of municipal securities. “The high rating of municipals,” wrote Carter 85 years ago, “has been based upon income with which to meet the interest charges and not upon the assets behind the bonds—in fact, the last thing the buyers of these bonds have given any thought to has been their theoretical ‘book value.’ Almost 90% of the municipal securities at that time were ‘under-written by members of the Investment Bankers Association [IBA] … who in turn sell to investors’” (Yearbook, August 1932, pp. 104-105). According to Carter, bankers needed these rules to protect “their own good names and the funds of their clients and investors.”

Little Has Changed

Naughton and Spamann argue that “the finances of many states, cities, and other localities are [still] in dire straits,” and that partial blame for this situation lies with “the outdated and ineffective financial reporting regime for public entities … ineffective reporting has obscured and continues to obscure the extent of municipal financial problems, thus delaying or even preventing corrective actions” (“Fixing Public Sector Finances: The Accounting and Reporting Lever,” UCLA Law Review, vol. 62, pp. 572–620, 2015).

Along these lines, Mark Funkhouser, former Kansas City mayor, city auditor, and current publisher of Governing magazine, argues that “today, deteriorating infrastructure and unfunded pension obligations are clearly threats to the financial health of state and local governments … [and] financial reporting systems were major contributors to the problem” (“The Fantasy World of Financial Reporting,” Governing, May 2015).

Closer to home is a report from former lieutenant governor of New York, Richard Ravitch, and former chairman of the Federal Reserve System, Paul Volcker, who co-chaired a task force on the fiscal stress on state governments. In their 2014 report, Ravitch and Volcker conclude that “the ability of states to meet their obligations to public employees, to creditors, and most critically to the education and well-being of their citizens, is threatened,” that “New York has had a structural deficit, papered over with gimmicks, for decades,” and that “lawmakers have struggled to wrench the upcoming year's budget into balance temporarily and on a cash or checkbook basis … such machinations are only possible because of cash accounting” (“Report of the State Budget Crisis Task Force,” http://www.statebudgetcrisis.org/wpcms/wp-content/images/SBCTF_FINALREPORT.pdf, p. 12, p. 18; see a further discussion in “The DATA Act” on page 37 of this issue).

Naughton and Spamann believe it is time for the SEC to intervene in state and municipal government accounting and financial reporting, and investigate whether to replace GASB standards with “superior” standards from FASB (Naughton and Spamann, p. 614).

The Crisis in Confidence

It was not until 1984, more than a decade after FASB's formation, that the Government Accounting Standards Board (GASB) was formed, similarly under the auspices of the Financial Accounting Foundation (FAF). Its funding originally came from voluntary donations from state and local governments, the same entities governed by its standards. With the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, however, Carter's rationale for GASB's funding arrangement was finally realized. The Financial Industry Regulatory Authority (FINRA) now levies accounting support fees on their institutional members, and these fees have become GASB's principal source of revenue. Unlike FASB, however, whose “standards are officially recognized as authoritative by the SEC” (https://www.fasb.org), “GASB's standards are not federal laws or regulations and the organization does not have enforcement authority” (“Facts about GASB,” 2015–2016, https://www.gasb.org).

Cash Basis

The argument against cash-basis accounting can be defined by the errors made as a result of using this generally accepted accounting treatment. Consider the following example of mis-accounting for assets: In 2008, Chicago sold off the city's 36,000 parking meters to a private investment group. This enabled then-Mayor Richard Daley to balance the annual budget, but it “may cost Chicago drivers 10 times [$11.6 billion] in future revenue based on what the system was sold for because the valuation of the parking meters on the books was not properly valued” (Michelle Conlon, “States and Cities Selling Public Assets to Cover their Costs,” CNS News, May 13, 2011, http://cnsnews.com/news/article/states-and-cities-selling-public-assets-cover-their-costs). On the liability side, capital expenditures are clearly needed to support infrastructure as well as fund health and welfare plans; however, the non-recognition of these liabilities until recently is the reason why one of America's greatest cities is now saddled with $30 billion in pension liabilities which financially has put Chicago in junk bond status (Fran Spielman, “Expert: Chicago in Better Shape than Motor City but Is now ‘Paying Detroit's’ Bills,’” Chicago Sun-Times, May 19, 2015).

Cash-based accounting is apparently also a factor behind the bankruptcy of Jefferson County, Alabama—at $4.2 billion, the largest local government bankruptcy in the United States at the time. Immediately prior to bankruptcy, “there were no reports in its financial statements [that] there was anything wrong” (Jonathan Walters, “Are the Comprehensive Annual Financial Reports Useless?” Governing, September 2012). As far as reconciling cash statements to financial reports, Warren Ruppel, author and CPA Journal contributor, writes that “there is nothing in the current governmental regime that allows a user to reconcile the cash-based performance of the budget with the accrual-based performance of the financial statements” (GAAP for Governments 2014, Wiley, pp. 201–203).

Readers may recall that it took until 1999 (15 years after GASB's establishment) for it to require “for the first time that governments report as assets, roads, bridges, dams and other structures along with related depreciation or preservation costs.” Then it took another 13 years, until 2012, before GASB required “government [to] include net pension obligations as a liability on the balance sheet and put restrictions on the method governments can use to calculate a pension plan's future benefit obligations” (Funkhouser 2015). FASB has required an accrual-based measure of post-retirement welfare costs since its 1994 issuance of SFAS 106. “Had GASB used FASB's GAAP, in the case of the Detroit bankruptcy, Detroit, for example, would have reported post-retirement welfare obligations of $5.7 billion,” when up until that time, their reported liabilities were substantially different (Naughton and Spamann 2015, p. 597, fn. 123).

There have also been criticisms of GASB's slowness to act. Critics point to its funding mechanism and its part-time board. Other than GASB's full-time chairman, David Vaudt from KPMG, its six other board members serve on a part-time basis. To its credit, almost all part-time board members are CPAs (http://http://www.gasb.org/jsp/GASB/Page/GASBSectionPage&cid=1176156726930]). Of the 25-member GASB oversight board (the Governmental Accounting Standards Advisory Council), however, only three members are CPAs or auditors from independent public accounting firms.

Better Now than Never

Naughton and Spamann argue that too many years have elapsed to wait for alternatives to GASB for state and local accounting and financial reporting—now is the time. They look to modifying FASB's standards and recommend regulatory intervention by the SEC. Arguably, adopting some of FASB's standards may be eye-opening to the public, but isn't government transparency critical in a democratic society? Eight decades have elapsed since the SEC's grant of authority to independent auditors. With confidence in our institutions at an all-time low, now is a good time for CPAs, in service to the public, to insert ourselves into this debate in order to help ensure trust in our government institutions.

As CPAs, we are unquestionably in the best position as financial professionals, gatekeepers, and protectors of the public interest. We are the largest global community of outside, independent observers of financial behavior. There is no other profession, governmental agency, or institution whose voice is as strong as ours.

The opinions expressed here are my own and do not reflect those of the NYSSCPA, its management, or its staff.

Richard H. Kravitz, MBA, CPA. Editor-in-Chief.

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