This Annual Financial Report Says <i>What</i>?

If there’s a bright side to governments’ money problems, it’s that it’s forcing them to use plain English to talk about their finances.

David Kidd
It’s hard to see the bright side to the financial upheaval in Detroit and other distressed governments. But if there is one, it’s that taxpayers, journalists and others are starting to pay attention to government financial statements. In a prescient comment, a group of accounting professors once said our model for government financial reporting is—with apologies to Kevin Costner—“if you build it, they will come.” In this case the “it” is not a baseball stadium in a cornfield. It’s a set of financial statements chock full of details about a government’s financial inner workings. And the “they” is not baseball fans. It’s people who actually read those statements. Thanks to Detroit and other distressed cities, the “they” are starting to arrive. 

As new users come into the fold we’re reminded that the defining feature of government financial reporting is complexity. A typical state or municipality’s comprehensive annual financial report, or CAFR, is hundreds of pages long and different parts of it follow different accounting assumptions. Critics say this is because those that set accounting standards are too ambitious. Others say it’s because government financial operations are enormously sophisticated, so reporting on those operations is inescapably complex.

When the Governmental Accounting Standards Board revamped the financial reporting model about 15 years ago, it gave governments a powerful tool to deal with that complexity: the Management’s Discussion and Analysis, or the MD&A, which gives the government a chance to tell its financial story. It can use plain language to explain to readers the causes for trends in its revenues and spending, why its budgeted spending was more than its actual spending, why it chose to dip into its reserve funds, and other dimensions of its financial picture that might not be clear from the financial statements alone.

There are key disclosures that have added to the complexity of government financial statements, such as the value of infrastructure assets or the size of liabilities for pensions and retiree health care. We know that these have affected how financial statement users perceive a government’s financial condition. However, we know little about how and when the MD&A affects those same perceptions. Fortunately, some recent research by Rebecca Bloch from Rutgers University sheds some light on these questions.

Bloch points out two key facts about the MD&A. First, many local governments don’t invest much in it. Most MD&As follow the same basic format and report the same information each year. They rarely convey any context or explanations for the financial dynamics unique to a given fiscal year. Many governments apparently see the MD&A as a compliance exercise to be carried out with minimal time and effort. This is understandable, I suppose, given the time and effort it takes to compile the rest of the CAFR.

Second, and more important, a boilerplate MD&A can actually hurt a government’s credibility. Bloch surveyed municipal credit analysts and found that not only do they read the MD&A, but they consider a boilerplate MD&A a potential sign of careless management. In their view, if a government doesn’t take the time to explain itself, it must not care what the market thinks of it. In addition, jurisdictions with MD&As that explained financial trends tended to receive higher bond ratings. One analyst characterized this as, “If we think we know your full story, we tend to see you as less risky.”

Our financial reporting model is more than capable of fully informing financial statement users. The key task for many local governments going forward is how to use that model to maximum effect. Better use of the MD&A is a big step in that direction. 

A research professor at the University of Chicago’s Harris School of Public Policy