Finance

Are Comprehensive Annual Financial Reports Useless?

For all their charts and graphs, CAFRs don’t tell public officials -- or the public -- anything about fiscal sustainability or whether a locality’s finances might be trending south.
by | September 2012

They’re dense. Only the hardiest of souls would dig into a city or county comprehensive annual financial report (CAFR), called “kafers” by those hip to the inner workings of public finance and auditing.

Characterized by a mind-numbing array of charts, graphs and number columns, CAFRs include such heart-palpitating headings as, “Expenditures and Changes in Fund Balances of Governmental Funds” and “Statement of Activities For the Year Ended September 30, 2006.”

That latter and particularly mundane title can be found on page 10 of the Jefferson County, Ala., CAFR. Sept. 30, 2006, however, is anything but an ordinary date in the history of Jefferson County’s finances. By that date, the county was well on its way toward experiencing the largest local government fiscal meltdown in U.S. history.

Yet even a trained auditor reading the 2006 CAFR would conclude that the county’s finances were OK. That, of course, is more than a little surprising inasmuch as the financial misconduct that eventually led to the county’s defaulting on billions of dollars in sewer upgrade bonds had been in full swing for a decade.

In other words, the scandal that would sweep a host of public officials into jail and the county into a financial sinkhole had been whirlpooling along for nearly a dozen years. Those years had been covered by as many CAFRs, apparently without a hint of what was actually going down with the county’s finances.

Indeed, the only concern expressed by the 2006 CAFR related to the county sewer system was on the fourth-to-last page of the 128-page report: a short note indicating that the county might not be properly billing every customer who was tapped into the county’s gold-plated new sewer system.

“You look at the Harrisburgs and the Scrantons and the Jefferson Counties and you naturally ask, ‘How did we not know this was coming five or 10 years in advance?’” says Joe Stefco, who follows public finance for the Rochester, N.Y.-based Center for Governmental Research. And for that matter, one might question where the red flags were on Stockton, Compton or San Bernardino, Calif., or even Central Falls, R.I.?

The question of how officials failed to foresee such colossal fiscal calamities is naturally linked with the question of who ought to be blamed for such blindness. In Jefferson County’s case, looking beyond the actual perpetrators, it would be natural to blame the person who signed off on the CAFRs, including the very last one released before the scandal splashed across the national news, the Sept. 30, 2006 report. In that case, the seeming culprit would be Ronald L. Jones, chief examiner for the Alabama Department of Public Accounts, who expressed no concern whatsoever about the contents of the county’s CAFR. Blaming Jones, however, wouldn’t really be fair.

“Comprehensive” may have the ring of authority to it, suggesting that CAFRs are some sort of exhaustive and accurate look at a government’s true financial health. Certainly trying to lift one off a desk would suggest that there’s nothing the report could possibly have missed by way of financial accounting and investigation. But all CAFRs really are is a snapshot of a government’s finances at a given point in time; at best, they’re a look backward for a year. “It’s a thorough documentation of financial actions over the course of a fiscal year,” says Sam Tyler, president of the Boston Municipal Research Bureau. “But it’s a year after the fact.”

For all their charts and graphs, CAFRs don’t tell public officials -- or the public -- anything about fiscal sustainability or whether a locality’s finances might be trending south. That’s just as true for those localities teetering toward insolvency for mundane reasons -- like lousy fiscal management or just unhappy circumstances -- as it is for those that have been fleeced by a crowd of bad actors (or as in the recent case of Dixon, Ill., merely one bad actress).

That’s the key point worth making, say those who want to improve government financial reports. They want the information to offer earlier warnings of fiscal trouble ahead. What might push a local government into deep fiscal despair probably won’t be a scandal like Jefferson County’s or Bell, Calif.’s.

What actually sinks city and county finances is that slow, steady accretion of bad -- and hidden -- fiscal news that either nobody is getting or no one wants to hear. That news invariably takes the form of commitments to future spending, like bond and pension obligations, as well as other liabilities, such as deteriorating or outdated infrastructure versus the jurisdiction’s revenues to cover those commitments and liabilities.

What really cripples municipal finances comes on relatively slowly -- then avalanches. By the time anyone figures out something’s wrong, it’s often too late for any moderate corrective action; only bankruptcy, state oversight or emergency fiscal managers will do.

What do I do with a CAFR?” asks Cameron Smith, who, as policy director for the Alabama Policy Institute, has spent a considerable amount of time sifting through the wreckage of the Jefferson County crash. Even if there was truly damning information contained in a CAFR, it would be hard to find, says Smith. He sees CAFRs as a potentially insidious exercise in “flood[ing] the market with data that no one knows what to do with.”

Some of the best auditors in the country find even their own jurisdiction’s CAFRs daunting. Mike Eglinski, performance auditor for Lawrence, Kan., says he remembers the day four years ago when the Lawrence CAFR landed on his desk for the first time. “What am I going to with this?” Eglinski remembers asking himself. “It’s half an inch thick, 121 pages long and there could easily be something fascinating and important on page 79 right in the middle of the page,” which, he hastens to add, even the most astute and conscientious auditor might miss for the sheer density of the surrounding 120 pages. “And some of the things you’ll read, you can’t tell whether it’s a good thing or a bad thing. Is it up or is it down?”

The questions about CAFRs now being debated in the publicsector finance and auditing community are very much along the lines of Smith’s and Eglinski’s: What, in the larger sense, should we make of CAFRs? What should we do with them? Can they be made more useful?

The focus of the debate on these questions currently revolves around a proposal floated earlier this year by the Governmental Accounting Standards Board (GASB) to include more “forward-looking” information in CAFRs based on current policy and known facts. It is a very preliminary proposal for how CAFRs might be made more useful in recognizing potential financial trouble. Details for how that might be done have yet to be worked out, but would involve some sort of out-years projections model that would take into consideration significant projected spending obligations in relation to projected revenues.

The proposal already is taking a lot of flak from the public-sector finance community. This is not an unfamiliar position for a GASB proposal. Finance officers often complain that the board is overly meddlesome when it comes to telling governments what they ought to reveal about their long-range fiscal prospects.

“Unless someone has a crystal ball and is smarter than anyone born today, no one can predict with certainty in five years what the fiscal condition of a state or locality is going to be,” says Jeff Esser, executive director of the Government Finance Officers Association, which has come out against the new GASB standard. “The Federal Reserve can’t do it with the U.S. or the global economy, and I don’t know of anyone who can do it for state or local economies.”

Esser has a lot of company in his skepticism around GASB’s idea for a more meaningful CAFR. Utah Deputy State Auditor Joe Christensen, in a Feb. 13, 2012, comment letter, argues that any such projections would be way too subjective to be meaningful, and that any benefit derived from such attempts would not be worth the cost. “It really comes down to the fact that auditors and financial people are used to dealing with informatioun that comes from the past,” says Christensen, who has been a public-sector auditor for 26 years. “Shifting from historic financial statement to projections is something that auditors aren’t comfortable with.”

Tyler at the Boston Municipal Research Board sees this as myopia. He, like Stefco in Rochester, notes the number of cities nationally that are now in or very near bankruptcy. “There’s plenty of evidence out there that a number of cities could have used this information to see that they were headed in the wrong direction,” Tyler says.

Furthermore, Tyler notes, some jurisdictions are already doing projections, including Boston, where the budget office does an annual, internal three-year-out budget. “If a state or a city is well managed, they’re already doing it,” Tyler says. “We just wish that the information was more public. But CAFR doesn’t require that, and it would be helpful if there was a requirement.”

While the debate over CAFR and budget projections continues, some in the public sector aren’t waiting around for the financial world to figure out how to make CAFRs more useful. They’re doing it themselves. One of those people is Lawrence’s Eglinski.

Rather than succumb to the brain numbness delivered by the Lawrence CAFR, Eglinski decided he needed some context, so he started doing two things: Looking at past Lawrence CAFRs and collecting CAFRs from cities with similar characteristics to Lawrence. “It takes comparison and looking at CAFRs over time,” Eglinski says, for them to begin to reveal important trends.

By going through several years’ worth of Lawrence CAFRs, for example, Eglinski noticed that revenues for municipal trash collection previously had covered the city’s costs of collection and disposal, but were no longer doing so. Eglinski put this in the “risk” category and alerted city officials to focus on turning it around. Changes in staffing and equipment have moved the program back into the black. Eglinski also noticed a troubling trend around Lawrence’s own sewer and water system: More and more revenues from sewer and water fees were being diverted to the general fund, which he worried might threaten system upkeep.

By comparing Lawrence’s CAFR to other cities, Eglinski says he’s helped elected officials ask much better questions about the cost of longer-term obligations, like the potential cost of the city’s promises for pensions and other post-employment benefits (OPEB). “You’ll see cities that have 10 or 20 times larger OPEB obligations, so the question is whether that city’s governing body knows that, but you only learn that through comparison.”

That’s pretty much where the Alabama Policy Institute has arrived. Policy director Smith says the institute has spent “a tremendous amount of resources trying to chew through the information in a couple of Jefferson County CAFRs pre-meltdown.” So far, he says, there haven’t been any striking revelations that would have suggested disaster. The institute is also doing a multi-jurisdictional CAFR analysis to see whether such comparisons might yield valuable intelligence about whether one jurisdiction might be in a more precarious fiscal position than another.

But absent some more predictive, digestible reporting model, it’s clear that slogging away in the trenches is the only way to make CAFRs more meaningful. “It’s information that on its own certainly isn’t going to identify problems,” says Eglinski. “The CAFR is a document that people understand is significant. It’s just hard to figure out what in it is critical.”

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