Financial Reporting in Government (introduction)

Introduction to Financial Reporting in Government
By Dr. John Sacco , George Mason University
Revised Sunday, October 12, 1997

Purpose

This text has four broad purposes.

The initial purpose is to define financial reporting for state and local governments and to examine the difficulties associated with candid reporting.
The second purpose is to survey the pressures shaping governmental accounting and financial reporting for states and localities.
Another purpose is to cover the current accounting rules , principles and standards used in state and local governmental accounting.
A fourth intention is to consider alternatives to the current model, particularly alternatives that are responsive to the competitive pressures faced by state and local governments.

Definition of Financial Reporting

Financial reporting frequently involves conveying to outsiders how well or how poorly an operating unit has done. It is external reporting (reporting to interested parties outside the entity) that is the main focus of this text. Although many types of information can be conveyed in a financial report, three types are significant -- the financial success , conditions , and compliance . In government, under the present compliance and liquidity model, success often assesses whether money coming in equals money flowing out for the current period. Conditions reflect the ability of the unit to meet debt (usually current debt in the case of government and what are called governmental funds) or to take advantage of opportunities. Compliance often means following or obeying the legal authorizations for inflows and outflows of money such as taxes, borrowing, and administrative expenditures. These stipulations are frequently expressed in the adopted budget. Following laws such as prevailing pay scales constitute other types of compliance. In some cases, governments and business struggle with candidly revealing bad news about financial success, conditions, and compliance. "Creative accounting" might be used to make matters look better than they are.

Factors and Forces Shaping Governmental Accounting

Although governmental accounting and financial reporting are highly technical, the models that determine the characteristics of the reports are not chosen for pure technical or scientific reasons. Selection is open to both technical and political forces.

Several different views have emerged in explaining what has shaped governmental accounting. One, and the most common one, is that the environment of government is considerably different from business and thus government needs different accounting rules, that is, different principles and standards. In this view, government is highly legalistic and needs an accounting system to track legal requirements. Preservation of democracy and lack of market forces create the need for this legally oriented model. In a sense this is a non-political view. Governmental accounting is the way it is because of the environment in which it resides and not because of political forces.

Another view is less benign. According to it, government is a monopoly and makes rules to protect itself. As a monopoly, it over charges and under produces. Accounting and financial reporting rules are designed to reduce disclosure of this inefficiency. According to this view, the business accounting model is the one that government should use. This model, supposedly, forces a fuller disclosure. However, even the business model is only marginally effective in the eyes of some critiques of government. The best solution to governments' ineffectiveness, in the eyes of these critics, is to reduce the size of government. This view comes from the public choice literature.

The Prevailing Model, Compliance and Liquidity (see chapter 2, lesson 3)

The model that has emerged for governmental accounting and financial reporting can be called the compliance and liquidity model. It results from the argument that government is driven by its legal and budgetary environment. Thus, governmental accounting must emphasize a compliance elements, that is, legal compliance with legislative mandates. Funds, or placing money and spending money according to categories mandated by the legislature, are integral to governmental accounting. Government must also stress liquidity, that is, having enough money coming in to meet or "balance" money going out during the budget year. Saving for promises made or severe restrictions on future promises and obligations are not an integral aspect of this model.

The Alternative Model, Accrual and Consolidation (see chapter 2, lesson 4)

The alternative business model is called the accrual and consolidation model and derives from the business accounting model. It is considerably different from the compliance and liquidity model. It emphasizes something called intergenerational equity or interperiod equity . With this intergenerational equity concept government must collect enough revenue to cover all costs for the period, not just cash payments. Every promise that places future liabilities on the government and all uses of resources, whether or not in cash, must be covered by sufficient revenue. In the business or commercial world, this is a called a matching concept . Furthermore, the accounting must assess the the cumulative excesses or shortfalls (i.e., matching revenue with all costs) for the entire government not just individual funds. Thus, the name, accrual and consolidation.

As intimated, the business model for accounting and report defines financial success and conditions differently than the compliance and liquidity model. Success depends on matching all costs against all revenue for the period, regardless of when the cash exchange takes place. If a business promises large pension benefits the business must calculate the cost of those benefit for the current period even though the actual benefits will not be paid until future dates. Financial conditions in the business accounting model include both current and long term debt. For a business to have good financial conditions or health it must be able to cover both money due this year as well as have assets that will be able to cover future obligations. Governmental accounting is concerned mainly with current debt. Future obligations can be covered by the full faith and credit of the jurisdiction. .

The Emergence and Impact of Competitive Forces in Government

The accrual and consolidation model has been proposed for over a hundred years but never adopted. Now, both those who want to reinvent government and reduce government, think that the accrual and consolidation model is essential to efficient government. Other countries in the world, such as New Zealand and Australia, have moved to an accrual and consolidation model for governmental accounting and financial reporting. They feel that if government is to be competitive with business and survive in a globally competitive world, government must move to the more disciplining model of business accounting. The rule making authority for state and local accounting, the Governmental Accounting Standards Board (GASB), has proposed that the accrual and consolidated model be added to the compliance and liquidity so that both short term and long term performance can be judged for separate categories (funds) as well as the jurisdiction as a whole. Exactly what will happen remains to be seen.

Summary

All these issues -- the definition and difficulty of candid financial reporting, factors shaping governmental accounting, the different models, the prevailing approach, and the pressures of local and global competitive -- are addressed in this text.

Glossary

accounting rules: The phrase accounting standards or principles is also used as a synonym for rules. However, the purpose is the same. In order to increase compatibility among governments issuing financial reports, rules or standards are established so that similar transactions and events will be handled similarly. For instance, what is the rule for handling real estate property tax? Is it included at the beginning of the year before the tax is actually collected or only as the tax is collected?
accrual: In developing a conceptual framework for accounting and financial reporting, accrual recognizes transactions and events when the activity occurs regardless of when the cash changes hands. As long as something is estimable and probable it is recognized. Estimating how much pension a person is due from working one year even though the person might not receive the pension for many years is an example of accrual. Some definitions the phrase legally enforceable. That is when a claim is legally enforceable it is accrued. Additionally, accrual is a basis of accounting or a timing question: when to recognize.
business accounting model: Sometimes called the commercial accounting model, it emphasizes accrual and consolidation. In other words, success is measured by whether sufficient revenue has been collected to cover all costs, including promises, and used resources. This matching must exist for the entire entity (i.e., consolidated report) not just parts of it.
compliance: Compliance assesses whether actual money raised and spent adhere to budget mandates set by the legislative body. All the financial statements can help judge compliance, but one in particular, called budget versus actual, is used to assess compliance. Historically, annual compliance with the budget has been the main factor shaping governmental financial reports. Compliance can also mean adherence to laws such as the Davis Bacon law on wages or compliance for eligibility for distributing money.
conditions: Financial conditions or position or health go mainly with the balance sheet. The idea behind the financial conditions is an assessment of whether the government has sufficient assets to cover its liabilities. Since governmental balance sheets are mainly for current or annual activities, conditions refer to whether current assets can cover current liabilities. However, long term liabilities can be introduced in a variety of ways to assess conditions that go beyond the annual situation. Long term debt can be compared to indicators of tax capacity to determine if a government is putting too much pressure on its tax or revenue capacity. Debt as a ratio of total real estate value is sometimes used to assess long term financial conditions.
consolidation: For sundry reasons, including economic, legal or tax laws, activities are operated in separate units (usually called funds) and not brought together or consolidated for the jurisdiction as a whole. However, if all these activities are summed or aggregated in the financial report (of course eliminating any double counting) then the report is said to be consolidated. In business, consolidated reports are the practice and there are specific accounting rules for consolidation. Governments, even though one unit may be accountable for many subunits or subentities, do not report on a consolidated basis. Thus, no one set of numbers exits for the entire unit or jurisdiction, although consideration is being given to a consolidated or entity-wide report for the entire jurisdiction.
financial reporting: The financial reports are a large category that include many types of reports, one of which is a financial statement. These reports are designed to capture different aspects of past financial performance and future financial prospects. The budget is another financial report. A prospectus for the sale of bonds is still another financial report. Most of the attention in this text is with financial statements.
funds: One of the fundamental principles of governmental accounting is the fund. Funds are usually established by legislation and provide an accounting mechanism for keeping track of money raised and spent for a specific activity or set of activities. Governments have three broad types of funds (governmental, proprietary, and fiduciary) and specific funds within those broad types of funds. According to GASB, "a fund is ...a fiscal and accounting entity with a self balancing set of accounts which are segregated for the purpose of carrying out specific activities or attaining certain objectives in accordance with special regulations, restrictions or limitations."
full faith and credit of the jurisdiction: Ordinarily, certain types of bonds (e.g., general obligation) or borrowed money are covered by a promise of the jurisdiction to raise the necessary revenue or cut back on other expenditures to cover these bonds. However, many types of obligations can be covered by such as promise. It is the word of the government to make every effort to pay the obligations.
governmental accounting: In general, accounting is designed to capture financial transactions and report on financial performance. State and local governments have their own set of rules apart from business. While there are many differences one major one is that governments focus heavily on judging legal compliance and business focuses on profit and loss. Future changes in standards may blur the distinction and add a commercial set of accounting rules to the traditional compliance rules.
intergeneration equity: Future generations should not have to pay for benefits received by current generations. If the current generation pays for all the benefits it receives and does not pass those on to future generations then there is intergenerational equity.
interperiod equity: Similar to intergenerational equity but more generic. Taxpayers for future periods should not have to pay for benefits received by those living during the current period.
liquidity: Liquidity refers to how quick an asset can be converted to cash. A three-month treasury note is probably more liquid than a backhoe, but probably less liquid than money in a checking account. Liquidity translates into a firm or entity paying its bills on time or having the money readily available to take advantage of opportunities as they arise.
matching concept: In accrual accounting, one of the goals is to equate or match all the costs against all the revenue those costs help to earn. The matching will show the profit or loss for the period. It is not the only approach to assessing income but it has been a main one.
public choice: A school of thought that assumes government is driven by self interest just like business or individuals who want to maximize their own benefits. Further, if government is a monopoly, it will pursue its own self interest with little to stand in its way; it will not seek the public interest. In essence, when government is in a monopolistic position it will overcharge and underproduce in order to benefit its own self interested members.
reinvent government: The phrase comes from those who wish to make government more efficient and responsive by reducing the rules or bureaucracy surrounding government. They want government to compete in a fashion similar to business. They do not want to dramatically reduce government although they will accept a smaller government or government role in society. In their view, good government cannot be produced by rules alone. If government competes with the private sector, the efficiency and responsiveness of government will increase.
success: Financial success goes with the operating statement or operating results. It is measured by whether the government was able to raise enough money during a given period to cover its outlays. In government, operating success is affected or shaped by the annual and cash nature of the accounting rules. Inflows of money can include borrowing during the period; outflow include only those items due and payable during the period, not those promised but not payable this period nor those resources already paid but used during the period.