Fixing Public Sector Finances: The Accounting & Financial Reporting Lever by SSRN

James P. Naughton

Northwestern University – Kellogg School of Management

Holger Spamann

Harvard Law School

March 1, 2015

UCLA Law Review, Vol. 62, No. 3, 2015

Harvard University John M. Olin Center for Law, Economics, and Business Discussion Paper No. 814

Abstract:

The finances of many states, cities, and other localities are in dire straits. In this Article, we argue that partial responsibility for this situation lies with the outdated and ineffective financial reporting regime for public entities.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. Worse, ineffective reporting has created incentives for accounting gimmicks that have directly contributed to the dramatic decline of public sector finances. Fixing the reporting regime is thus a necessary first step toward fiscal recovery. We provide concrete examples of advisable changes in accounting rules and advocate for institutional changes, particularly Securities and Exchange Commission involvement, that we hope will lead to better public accounting rules generally.

Fixing Public Sector Finances: The Accounting And Reporting Lever – Introduction

Detroit’s recent bankruptcy filing highlighted what savvy observers have been warning about for years: The finances of many states, cities, and other localities, collectively referred to as municipalities and municipal finances, are in dire straits. Total state debt, not even counting local debt, is now in excess of $5 trillion, which equates to roughly $16,000 per capita. The situation is even more dismal when corrections are made for faulty reporting. For example, the City of Detroit revealed roughly $3.5 billion in previously undisclosed liabilities after reevaluating its pension obligations as part of its bankruptcy petition. Besides Detroit, many other cities, states, and territories, such as Puerto Rico, are widely believed to be close to defaulting on their debt.

In this Article, we argue that this financial calamity is attributable in part to the outdated and ineffective financial reporting regime for public entities and that fixing this regime is a necessary first step toward fiscal recovery. Ineffective reporting has obscured and continues to obscure the extent of the problem, thus delaying or even preventing corrective actions. Worse, ineffective reporting has created incentives for accounting gimmicks that have directly contributed to the dramatic decline of public sector finances. We provide concrete examples of advisable changes in accounting rules and advocate for institutional changes, particularly Securities and Exchange Commission (SEC) involvement that we hope will lead to better public accounting rules generally.

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.

The reporting regime we discuss about is separate from the budget. The budget is a plan of cash outlays and receipts, generally for one year. State constitutions and legislation require a budget and regulate its content and adoption. In most cases, the budget requires a proposal by the executive and approval by the legislature. This budget process tends to attract considerable attention by politicians and the press. As it is only concerned with cash, however, the budget is quite uninformative about long-term fiscal health. Assessment of long-term fiscal health requires information about other components of state wealth, in particular obligations and other non-cash assets. Such information appears in the financial reports that are the subject of this Article.

A simple observation about state finances and budget rules illustrates the preceding point. Almost all states require a balanced budget. That is, they require that the projected inflows are at least equal to the projected outflows. To the extent actual inflows and outflows diverge, many states impose constraints to rebalance the two. And yet, states have amassed massive financial shortfalls over time. This was possible because the budget and hence the balanced budget requirement only relates to cash movements in the states’ so-called general fund. This has allowed states to “balance their budgets” by, for example, reducing the contribution to their state pension fund. The consequence is that, inter alia, the gap between state pension obligations and state pension assets has grown. It is as if one were to balance the inflows and outflows in a checking account by drawing on a credit card. The checking account would not reveal any trouble even while large debts amassed on the credit card.

Financial Reporting

Financial Reporting

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