Why have so many state and local governments accumulated massive debts, even as they claimed to balance their budgets every year? Political math.
Wait, how can math be political? In accounting, we use math. But we also use words to describe numbers. We quantify concepts with numbers, and then describe those numbers with names and definitions. Financial reporting adds a layer of rhetoric on top of accounting results. But accounting results are themselves infused with rhetoric—words produced by political forces.
Consider the word “budget” and what most people think if they are told their government “balanced the budget.” The first definition for “budget” on Dictionary.com states it is “an estimate, often itemized, of expected income and expense for a given period in the future.” This is a reasonable version of what most people think a budget is. But it is important to note we are talking about “expected” income and expense, for a “period in the future.”
Consider another definition. The first definition for “budget” in the American Heritage Dictionary reads “an itemized summary of estimated or intended expenditures for a given period, along with proposals for financing them.”
The differences between these two definitions hint at deeper issues. For example, the “expenses” in the first definition from Dictionary.com are not exactly the “expenditures” in the American Heritage Dictionary definition. And the second definition also includes “proposals for financing them.”
What are expenses as opposed to expenditures? If you are talking about “expenses,” you may be talking about either cash or accrual expenses. If you are talking about “expenses” as opposed to “expenditures,” you are more likely to be talking accrual basis for the former and cash for the latter.
In Illinois, the slippery slope of expenses versus expenditures played a critical role in enabling politicians to claim they were balancing their budgets—not only in principle, but as required by law—while running up debt.
Article VIII of the Illinois Constitution contains a provision long advertised to serve as a “balanced budget requirement,” despite the fact that it doesn’t use the word “balanced.” This provision directs that “Proposed expenditures shall not exceed funds estimated to be available for the fiscal year as shown in the budget.”
Those words don’t include “balanced,” nor do they include “expenses” or “income.” They do include “proposed” and “funds estimated to be available.” Strictly speaking, under this language, elected officials could propose expenditures less than funds estimated to be available every year, but still spend more money than they take in every year—as long as people stood for it, anyway. There are words, and there are deeds. Budgets can be thought of as the words, while audited results really are the deeds.
But there are other problems with that Illinois provision. The use of the word “expenditures” helped politicians distribute promises to pay future money as current compensation, without cash going out the door and unbalancing the budget. In turn, and perhaps more egregiously, the provision helped politicians claim to balance the budget in part with plans to borrow money, thereby boosting “funds estimated to be available” through future debt.
A Closer Look at Two Cities
In late 2014, amid a highly contested reelection battle, Chicago Mayor Rahm Emanuel presented his 2015 budget to the city council. The mayor’s office issued a press release quoting Emanuel: “To balance our budget for the past three years without any increase in property, sales or gas taxes was only possible by changing the way Chicago does its business … We have reduced our structural deficit by making city government smaller, smarter, and simpler” (http://bit.ly/2GIWO9g).
When the city’s financial statements for 2014 arrived in mid-2015, several months after Emanuel won reelection in a runoff race, those statements showed expenses running about $1.5 billion more than total general revenue, fees, and grants in each of the previous three years. In turn, the city’s unrestricted net assets dropped significantly, from −$7.2 billion in 2011 to −$11.7 billion in 2014. A negative unrestricted net asset position represents costs the government has incurred but has chosen to pay in the future.
Chicago’s reported results have actually deteriorated sharply since then, largely because leaders of the city’s pension plans revised the assumptions underlying the estimated liabilities, effectively admitting that they had been underestimating the cost of those plans.
New York City.
New York City financial leaders regularly boast of their budget discipline, citing reforms dating to the Financial Emergency Act of 1975 following the city’s near-bankruptcy. In a 2015 article, for example, NYC Comptroller Scott Stringer claimed that “New York City however, is required to balance its operating budget according to generally accepted accounting principles (GAAP) which mandates that revenues in a given year must equal or exceed expenditures in the General Fund in that year … While all governments in the country practice GAAP accounting, New York City is the only major government in the country subject to GAAP budgeting” (http://on.nyc.gov/2FTPjZG).
And in delivering his 2018 budget, New York City Mayor Bill de Blasio said: “This is the thirty-eighth consecutive budget which is balanced under Generally Accepted Accounting Principles (GAAP), except for the application of Statement No. 49 of the Government Accounting Standards Board (GASB 49), which prescribes the accounting treatment of pollution remediation costs” (http://on.nyc.gov/2FUi5Jr).
If New York City has been balancing its budget every year for 38 years, and if it is the “only major government in the country subject to GAAP budgeting,” that would seem to imply its revenues, fees, and grants have been running ahead of expenses, and it hasn’t accumulated debt like financially troubled cities, including Chicago.
That isn’t the case, however. And when you look deeper, you begin to realize that “GAAP budgeting” is actually the source of the problem, not the solution.
The first table in the statistical section of New York City’s Comprehensive Annual Financial Report began reporting historical data on its current format in fiscal year (FY) 2005. That table showed the unrestricted net asset position at −$15 billion in FY 2000. By 2008, New York City reported −$90 billion in unrestricted net assets. Over the next four years, amid a significant recovery in financial markets, that position didn’t improve; it fell a further $35 billion by 2012. From 2012 to 2013, it fell another $7 billion, at least as originally reported.
After restating its 2013 position following the recognition of net pension liabilities long excluded from the balance sheet, New York City’s unrestricted net position has shown some relative improvement, rising from a newly reported −$193 billion for 2013 to −$185 billion in 2014.
Somewhat improved results are also apparent in the last four years in New York City’s income statement (Statement of Activities). But for the 2008–2017 period as a whole, during a huge recovery in financial markets, New York City’s total expenses still ran $40 billion above total general revenue, fees, and grants, with spending exceeding general revenue, fees, and grants in eight of those 10 years. This result was for a city asserted to be “the only major government subject to GAAP budgeting.”
In fact, “GAAP budgeting” helps explain how government officials can regularly claim to balance their budgets, even while spending regularly runs ahead of revenue in their accrual accounting results.
A Better Way—Improve GASB’s Financial Reporting Model
Historically, governmental GAAP has included accrual-based concepts underlying the Statement of Activities. But it has also seen fit to apply a cash-like modified accrual basis to underlying governmental funds accounts. And many state and local governments crafted their budgets in terms of the funds accounts (including the general fund), thereby allowing them to claim “balanced budgets” while showing accrual-based deficits in the results reported in their consolidated financial statements.
That, in a nutshell, is how the game has been played.
Back in 1997, several Illinois senators led an effort resulting in the passage of a law titled the “Truth in Budgeting Act.” It passed the Illinois General Assembly overwhelmingly. But the intent of the law was circumvented in its implementation. In response to criticism, the Illinois State Comptroller’s Office stated that GAAP was indeed being used as required because the law called for GAAP “for governments,” which was interpreted to refer to governmental fund accounting, not the consolidated governmental-wide reported results.
This helped Illinois exclude the full pension expense while “balancing its budgets,” but with disastrous longer-term consequences—even under the Truth in Budgeting Act. This interpretation also helped lay the foundation for related “deceptions,” as local governments have claimed “surpluses” in their funds accounts while running up massive overall debt at the same time.
The Financial Reporting Model Project
Several years ago, GASB announced its Financial Reporting Model project. This initiative dealt with some of the most fundamental principles in government accounting and invited discussion of moving funds accounting to an accrual basis.
Such an initiative could help close the rhetorical windows—or at least keep the drafts from blowing too hard. Unfortunately, responses to GASB’s invitation to comment on the proposals were overwhelmingly dominated by government officials and special interest groups.
If accrual accounting for governmental funds accounts arrives, governments could still propose budgets that were balanced, at least on paper, then claim that things just didn’t work out the way they planned. But at least it would be easier to compare budgeted amounts to actual results because they wouldn’t be comparing apples to oranges.
Financial reporting is, or at least should be, a key vehicle helping citizens secure government accountability. Unfortunately, applied in practice, tools advertised in this manner can become corrupted, and the cure becomes part of the disease.
The Next Step
Government accounting standards setters can, and should, take the logical next step in the centuries-old evolution from cash to accrual accounting. GASB’s financial reporting model project provides a valuable opportunity to move state and local governmental funds accounting to an accrual basis. This can provide productive discipline that might constrain deceptive “balanced budget” claims by government officials.
GASB’s financial reporting model project is still underway. We applaud its leaders, and others elsewhere, on working to move to funds accounting to a full-accrual basis. They deserve our support and gratitude.