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Review of Accounting Studies

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02-07-2018

Opportunistic financial reporting around municipal bond issues

Author: Amanda W. Beck

Published in: Review of Accounting Studies | Issue 3/2018

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Abstract

Understanding how government officials exercise discretion over financial reporting is essential for citizens, regulators, and researchers to interpret and monitor financial performance. I examine two measures of discretion in governmental financial statements: abnormal accruals in full accrual financial statements, and other financing sources and uses in modified accrual financial statements. Using a unique dataset of hand-collected financial data from California, I document empirically that municipal governments pursue a break-even income in both sets of financial statements, and that they focus particularly on avoiding deficits. Further, I find evidence that municipalities employ discretionary accruals but not other financing sources and uses to a greater extent before issuing bonds. Prior to bond issuance, officials facing deficits use less discretion. The results highlight the multidimensional and sometimes conflicting incentives government officials face, and the reporting strategies they use as they weigh the expected costs and benefits of using accounting gimmicks to report favorable bottom lines.

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KPMG surveys employees of different industries on a broad range of misconduct, including financial reporting misconduct. The report does not separately describe the specific types of misconduct observed by government employees, but almost all of the specific types of misconduct reported by survey respondents as a whole are financial reporting–related.

Internal actors such as politicians, legislators, and bureaucrats, as well as external actors such as special interest groups, the press, and voters, may influence the accounting decisions made by governments (Cheng 1992). I collectively refer to the internal actors who actually make accounting decisions as “municipalities,” “municipal governments,” or similar. I also refer to these decision-makers generically as “administrators,” “officials,” or “managers.”

“Net income” is not generally considered the proper term for the bottom line in the governmental setting. “Changes in net position” in the government-wide financial statements and “change in fund balance” in the modified accrual financial statements are analogous to the traditional net income figure found in other sectors but are measured using different bases of accounting. In the paper, I describe the bottom line in either set of financial statements simply as “net income” (NI) to avoid the redundancy of referring to the two income figures separately.

Costello et al.’s (2017) findings suggest that states sell assets to meet state balanced-budget requirements.

I refer to underwriters, bondholders, credit rating agencies, and other bond market participants collectively as “creditors.”

Felix (2015) uses an indicator equal to 1 in the year of a bond issue to measure the effect of bond issuance. This measurement is problematic because governments provide underwriters with the most recent financial statements when they issue new bonds. For this reason, I use an indicator equal to 1 in the year leading up to a bond issue.

Naughton et al. (2015) find an association between state pension liability understatement and short-term debt issues but not long-term debt issues. Since states often issue short-term debt to balance budgets, this result is consistent with the study’s other finding, that states understate pension liabilities to close budget gaps. The study does not investigate the effect of accrual manipulations on net income or examine accrual manipulations in the year leading up to a bond offering.

GAAP does not require governments to present a CAFR, but if a government does choose to issue one, it must follow the guidelines of GASB 34. In California, most cities (including all with populations over 30,000) present a CAFR, as evidenced by over half of California cities receiving the Government Finance Officers Association Certificate of Achievement for Excellence in Financial Reporting (GFOA 2013). Since this paper focuses on both full and modified accrual reporting, “financial statements” and “annual report” are understood to refer to a CAFR.

In addition to this evidence that full accrual financial statements, specifically, are of use to creditors, Baber and Gore (2008) find that municipalities in states that require GAAP compliance enjoy lower costs of debt during the sample period 1995–2002 (the full accrual requirement was implemented in 1999), and Gore (2004) documents that municipalities issuing debt are likely to comply with GAAP even when not required by statute.

Beck et al. (2018b) replicate municipal bond ratings using the Moody’s (2009) methodology. The methodology includes examining modified accrual financial statements to evaluate liquidity and short-term flexibility, as well as examining long-term debt and pensions, which are found only within full accrual financial statements, to evaluate leverage.

Managerial discretion in governments’ business-type activities is better suited for a separate study because (a) governments use a single accounting measure (full accrual accounting) to account for these operations, (b) governments’ business-type activities are intended to be self-funding rather than supported by taxes, and (c) the activities are almost identical to those of their nongovernmental counterparts.

The standards are called the International Public Sector Accounting Standards.

This reasoning is consistent with Fama and Jensen’s (1983) analysis of principal-agent relationships in nonprofit organizations, where they contend that “one solution to [the] agency problem [in nonprofits] is to . . . contract with donors to apply all net cash flows to output” (p. 342).

Approximately one-half of municipal bondholders are institutional investors, a group that researchers generally consider highly sophisticated. Jorion et al. (2009) assert that credit rating agencies (who rate municipal bonds) are also highly sophisticated.

Yetman and Yetman (2013) do not test whether managers choose ratio management methods based on donor sophistication.

For example, Moody’s (2014a, p. 17) and S&P (Standard and Poor’s 2013, p. 24) both include assessments of management in their bond rating methodologies. If the credit rating agencies detect management’s use of discretion and believe it to be opportunistic, that could negatively affect their assessments of management and thus bond ratings.

One challenge of measuring specific accruals in government is that U.S. governments do not provide a consistent level of detail (e.g., specificity of account descriptions, aggregating versus not aggregating accounts, etc.) in their reports. In contrast, the Jones (1991) model uses broad financial variables (e.g., revenues, capital assets, income) that governments do report consistently.

Under U.S. GAAP, municipalities must capitalize infrastructure acquired since 1980, and they have the option of whether or not to depreciate it (so long as they maintain it at an acceptable level). I use total depreciable capital assets as stated within the notes to the municipality’s financial statements for TCA in Eq. (2).

See footnote 18.

For example, service demands, capacity to provide services and raise taxes, and economies of scale.

Consistent with Kothari et al. (2005) (who control for performance using return on assets), I exclude below-the-line, nonrecurring items from net income in Eq. (2).

Kothari et al. (2005) discuss several points that suggest that including an intercept in the Jones (1991) model provides more precise estimates.

Results are robust when calculating total accruals using the indirect calculation of cash flow from operations. Further details are given in the additional analyses section.

To make full accrual and modified accrual financial statements comparable, I remove the net income of internal service funds (where applicable) from the full accrual financial statements since these are not accounted for in the governmental section of modified accrual financial statements. I obtain the net income from a dataset compiled by the California State Comptroller’s Office; however, the data may also be hand-collected from municipal financial statements. I find generally consistent results when, instead of removing the net income of internal service funds, I control for the existence of an internal service fund with an indicator variable.

Other financing sources and uses are excluded from the calculation because cash proceeds from issuing debt, selling capital assets, and fund transfers are not analogous to cash flows from operations. One potential limitation of my approach is that repayment of debt and capital outlays would not be considered operating cash flows, but are considered expenditures in modified accrual basis financial statements. I attempt to alleviate this concern by controlling for TCA in Eq. (2) and BondDebt in Eq. (1a). Results of Eq. (1a) are also robust to controlling for change in BondDebt and estimating total accruals using cash flow from operations.

My tests focus on discretion in the year prior to a bond issue. Therefore, if a bond issue is planned in year t, other financing sources and uses increase in year t + 1, all else being equal. However, I measure other financing sources and uses in year t, so this relationship does not affect the results. As discussed in the next section, consecutive bond issuance years following the initial issuance are dropped from the analyses.

The supposition that the greater the distance a municipality’s prediscretionary income is from breakeven, the greater the amount of discretion managers will use to close the gap, theoretically suggests a linear association.

I also perform the analysis setting PlanIssue equal to 1 when a bond is issued between the current year and subsequent year’s audit report dates, and I obtain substantially the same results.

For example, Moody’s considers general government financial condition when rating utility revenue bonds, stating, “Utility bond indentures sometimes contain events of default tied to the bankruptcy or insolvency of the general government. . . . Cash can often flow between [general governments and utility systems], sometimes with a formal mechanism. Debt and long-term liabilities are often paid by the same group of constituents. GO and utility issuers may also be exposed to the same pension plan. . . . Because of these linkages, in most cases, ratings of a municipality’s utility debt will be within two notches of its GO rating” (Moody’s 2014b, pg. 5).

This generalization arises from my personal experience with hand-collecting municipal financial data for other studies.

Data is winsorized at the 99th percentile, resulting in DA slightly above zero (despite being the residual of Eq. [2]). Running Eq. (2) cross-sectionally by year results in mean (median) DA of −3.52 (−29.98).

When scaling by total assets, results are consistent if I also control for population.

Calculated as Net income + Depreciation +(−) Decreases (Increases) in Current (noncash) assets +(−) Increases (Decreases) in current liabilities +(−) Losses (Gains). Variables are taken from the full accrual financial statements.

Taxes receivable are generally the most substantial of government receivables, but the data can prove problematic because governments are inconsistent in whether they report all taxes receivable in aggregate; differentiate between property taxes, sales taxes, and others; and report only accounts receivable and do not disaggregate taxes. I use taxes receivable or sum all of the various tax receivable accounts where possible. I use accounts receivable when no taxes receivable are listed. The quality of receivables data likely contributes to the lack of improvement in using the modified Jones model over Eq. (2).

When multiple issuances are planned for a single year, I sum the total principal of the issues for the year.

The California State Comptroller’s Office provides Moody’s and Fitch bond ratings for municipal debt. I place these ratings on a numerical scale that is consistent across agencies. For example, a Moody’s rating of Aaa [A1] is equivalent to a Fitch’s rating of AAA [A+] and is given a numerical category of 12 [8]. (The highest rating is equal to 12 because all bond ratings in the sample fall within the highest 12 rating categories.) For each PlanIssue city-year, I take the average rating, over multiple issuances and rating agencies where applicable.

Cuny (2016, p. 89) summarizes the decline of the municipal bond insurance industry, beginning with credit downgrades of major insurers, which resulted in “less than 9 % of new issues [being] insured” following the beginning of the recession. My sample also follows the recession. In years when PlanIssue equals 1, about 7% (9%) of the issuing municipalities insure all (some) of their bonds.

According to Cuny (2016, p. 89), “Investors in insured debt ha[ve] little incentive to perform robust financial analysis on the underlying credit because they experienc[e] loss only in the event of joint issuer and insurer default.”

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Title: Opportunistic financial reporting around municipal bond issues
Author: Amanda W. Beck
Publication date: 02-07-2018
Publisher: Springer US
Published in: Review of Accounting Studies / Issue 3/2018
Print ISSN: 1380-6653
Electronic ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-018-9454-2

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