The Fantasy World of Financial Reporting

The rules that governments work under have little to do with reality.
May 2015
By Mark Funkhouser  |  Former Publisher
Former publisher of Governing and former mayor of Kansas City

During an accounting class I took in the early 1980s, the professor explained methods for calculating and recording business depreciation. Being a government guy, I asked him how those costs were reflected on the financial statements of a government. He told me they weren’t and that it didn’t make sense to try to calculate depreciation on the Statue of Liberty. I thought his explanation was absurd, and a short time later the Statue of Liberty got more than $250 million in repairs.

There was finally an attempt to correct this ridiculous situation in 1999. The Governmental Accounting Standards Board (GASB) required for the first time that governments report as assets roads, bridges, dams and other structures, along with related depreciation or preservation costs.

In 2012, GASB issued rules for pensions that required that a government 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.

All of these rules were compromises emerging from long and bitter public fights. In the case of both infrastructure and pensions, the arguments by GASB’s opponents, when stripped to their bare essence, were that adopting these standards would make governments look bad. Today, deteriorating infrastructure and unfunded pension obligations are clearly the salient threats to the financial health of state and local governments, and I have long thought that their financial reporting systems were major contributors to the problems.

Now two scholars, James P. Naughton and Holger Spamann, have produced a paper that offers evidence to support my thinking. In “Fixing Public Sector Finances: The Accounting and Reporting Lever,” published in the UCLA Law Review, they examine rules promulgated for the private sector by GASB’s sister agency, the Financial Accounting Standards Board, and conclude that the FASB standards would result in financial reporting more closely representing the underlying economic circumstances of governments than GASB’s.

One particularly eye-opening example involves the “going concern” opinion issued by auditors on financial statements. Under FASB, an auditor must identify whether a business is expected to operate as a going concern indefinitely. GASB only requires consideration of whether a government entity will be able to continue for the next 12 months. If that seems strange to you, you’re not alone. The authors note that “even Detroit did not receive an unfavorable going concern opinion for the financial statements issued before its bankruptcy filing.”

Naughton and Spamann conclude their paper by making a case for an idea that is anathema to many in the public sector: greater intervention by the Securities and Exchange Commission in state and local government financial reporting. I wonder how those I know and respect in the field of public finance would react to that and to the other ideas and evidence that Naughton and Spamann have put together. In the coming months, I hope to find out.