The Scandalous State of Government Accounting

Brian Sturgess - March 2012


‘Why does the economics profession continue to use misleading,

inaccurate and often fraudulent public-sector accounting data?’


Governments are called to intervene to control fraudulent accounting practices when self-regulation has failed. These actions usually follow large corporate failures such as the spectacular demises of Enron, Worldcom and Parmalat. Rapid action is often needed to restore the confidence of capital markets, and legislators acted swiftly with the passage of the Sarbanes-Oxley Act (SOX) in the United States in 2002 in order to renew the faith held by investors in the diligence of auditors and in the probity of corporate internal controls over financial reporting. Since then, much progress has been made on an international level to raise the standards of financial reporting of public corporations since Enron by building on a structure of decades of accumulated improvements in standards, practices and techniques.

 

The latest issue of World Economics – Volume 13 (1) (www.world-economics-journal.com)  is concerned with a related, but different, theme – that of the quality of public accounting where inaccurate, badly compiled, misleading and even fraudulent standards appear to be the norm. This is an urgent issue. One of the main problems facing global financial markets currently, given the high level of sovereign risk, is the danger that many more countries other than Greece may not be able to refinance their debt.

 

In 2012 the OECD countries alone need to borrow a sum estimated by the Financial Times at US$11.5 trillion. But, in sharp contrast to the rapid governmental action a decade ago following the bankruptcy of Enron, now, as our two lead authors, Ian Ball and Gary Pflugrath, point out, ‘it is a lack of confidence in government debt markets that currently confronts investors, and potential investors’. However, if the problem lies with the reliability of government accounts, the classical dilemma is invoked – Quis custodietipsos custodes?or ‘Who then guards the guardians?’. The authors, respectively the CEO and Deputy of Public Policy and Regulation at the International Federation of Accountants (IFAC), succinctly state this problem:

 

In response to the loss of confidence in capital markets earlier this century, governments sought to establish a high bar for reporting and disclosures by private-sector entities. There is an obvious hypocrisy in that when it is their own accounting at issue, governments are taking little serious action to address the problem. This raises the question ‘Why are governments that impose such stringent reporting requirements on others – in the private sector – not prepared to impose similar disciplines on themselves?

 

For Ball and Pflugrath, the essence of the problem is that most governments persist in employing cash-based budgeting and auditing techniques as a basis for financial reporting instead of accrual methods. This ignores economic reality by excluding valuations of all physical assets, and non-debt liabilities, which can be determined only when an accrual-based accounting system is used. To provide another example, government budgeting generally does not account for the non-cash impact of decisions with long-term consequences for public debt such as the accumulation of public pension liabilities. An important and a growing class of fiscal decision within the public sector that generates contingent liabilities that are rarely recorded on public balance sheets are those arising from public–private partnerships (PPPs). PPPs involve the state contracting with private bodies to provide public services, but although much of the financial reporting of the capital cost of such activities is shifted away from declared public debt, the risk remains squarely on the shoulders of taxpayers and investors in government securities

.

Another area where contingent liabilities can raise risk results from the activities of sub-national or regional governments. These issues are the focus of the second themed article of this issue, written by Hana Polackova Brixi, Senior Economist at the World Bank, who notes the attraction of fiscal activities that produce contingent liabilities to governments in both developed and developing countries partly because they allow governments to achieve political objectives without immediately having to report higher deficits, and raise taxes or borrow. She also points out that ‘they are particularly common at times of fiscal adjustment, involving tight control of reported fiscal deficit and debt’, but whatever the objective behind their introduction, nevertheless, she warns that ‘contingent liabilities have often turned out to be very costly’. At a time when governments are trying desperately to demonstrate to bond markets and rating agencies that public finances are under control, the temptation to resort to off-balance-sheet activities when fiscal reporting standards are weak is strong. Brixi notes that the prevalence of such practices is global, and suggests that the temptation be resisted. She concludes that policymakers and researchers need to consider, test and further research the tools to bring government contingent liabilities and other fiscal risks under control in order to enhance government net worth while conducting their legitimate fiscal activities. Otherwise, she warns:

 

At some point in time, many guarantees fall due, state insurance programmes

require subsidies, and banks involved in policy lending or exposed to excessive risk with the hope of a government bail-out eventually file for such bail-outs. International experience suggests that contingent liabilities tend to surface simultaneously, in times of economic difficulties, generating a sudden jump in public debt. In the end, a string of years of reported low deficits and debt is not necessarily an indication of past fiscal prudence or future fiscal stability.

 

In the United Kingdom, an expansive use has been made of PPPs, coming under the umbrella of the Private Finance Initiative scheme, which has been actively encouraged by the previous Labour government and the current Conservative–Liberal Democrat coalition. The third article in this issue is written by economic consultants Jim and Margaret Cuthbert, who use data obtained under the Freedom of Information Act to look at eight PFI projects in order to assess effective value for money. They conclude that, while risk-adjusted returns to the equity shareholders of the private partners in PFI initiatives appear to be exceedingly high, the risks that would normally justify high returns are borne by the public sector, albeit in a form that is off-the-books. They note that, despite the introduction of International Financial Reporting Standards for accounting for PFI within the public sector, its obligations with respect to capital assets arising from such activities are reported differently in departmental accounts from the national accounts. The two authors estimate that a declared PFI liability of £5 billion in the national accounts ‘would probably be greater than £60 billion – perhaps much greater’.

 

In general, the accounts of government departments are governed by rules for government financial reporting that, as discussed above, are often not consistent with the best international standards, while national accounts are governed by the rules of the UN System of National Accounts and the European System of Accounts, as interpreted by national statistical offices. The two sets of standards are significantly different with respect to what constitutes a liability for the public sector. The fourth article in this themed issue looks at this general problem caused by the application of different standards, requirements and uses made of data by accountants as opposed to economists. The focus is on the US national accounts in a paper written jointly by James L. Chan, an acknowledged academic expert on the history and practice of government accounting in the US, whose present position is Distinguished Overseas Professor at the Universities of Peking and Shandong in China, and Yunxiao Xu, Associate Professor of Public Finance at Peking University. They explain the reasons why the two perspectives provide different answers to similar questions concerning the level of government indebtedness, and note that:

 

During the past decade accounting measures tended to make the American federal government look worse fiscally than economic measures did because of two factors: (1) economic realities often turned out to be less favourable than economists had projected; and (2) accrual basis took into account the future financial burdens of current activities in carrying fiscal policies.

 

However, in the case of the US, Chan and Xu comment that the difference in the analysis of accountants and economists has not created a hidden fiscal crisis, but rather one that appears to have been ignored by many commentators and analysts. Specifically, they comment, by those:

 

who only consult the budget of the US government, because the budget projects cash deficits and Treasury debt securities held by the public. The severity of the US government’s fiscal problems is on display in the year-end Consolidated Financial Statements in its Financial Reports prepared under the accrual basis (Chan 1999) as required by Generally Accepted Accounting Principles promulgated by the Federal Accounting Standards Advisory Board (FASAB) (Chan 2009).

 

The following paper, written by Avantika Chilkoti, earlier at World Economics now employed at the RAND Corporation, looks at the broad causes of the unfunded liabilities of the US government, which has led one commentator to estimate that the net worth of USA Inc. would be around minus $44 trillion if its accounts were consolidated as if it were a corporation. The sixth paper, by Masanaga Kumakura, Professor of International Economics at Osaka City University, looks in detail at a more specific distortion by revealing how successive Japanese governments’ handling of the country’s massive foreign currency reserves ‘not only distort[s] Japan’s external monetary policy but also present[s] a serious threat to the country’s public finances by encouraging the government to engage in cross-budget accounting manipulation’.

 

The comment in James L. Chan and Yunxiao Xu’s paper that the liabilities of the US government are not in fact ‘hidden’, but rather need to be analysed properly, places a much greater onus on investors, rating agencies and taxpayers’ pressure groups to dig more deeply and to take little on trust. In the case of Greece, as Sturgess (2010) points out, the failure to do due diligence by the rating agencies was spectacular given the public availability of the data, suggesting serious problems with the official data. This admonition, however, can only be fulfilled as long as the underlying data are available, and this suggests an expanded role not only for the improvement of public accounting standards, but also for greater transparency and the promotion of e-government. The World Bank has been a leading proponent of e-government and defines it as follows:

 

E-Government’ refers to the use by government agencies of information technologies (such as Wide Area Networks, the Internet, and mobile computing) that have the ability to transform relations with citizens, businesses, and other arms of government. These technologies can serve a variety of different ends: better delivery of government services to citizens, improved interactions with business and industry, citizen empowerment through access to information, or more efficient government management. The resulting benefits can be less corruption, increased transparency, greater convenience, revenue growth, and/or cost reductions.[1]

 

In the developed world, where internet penetration is highest, only a limited number of countries, including the US, Canada, the UK and Australia, have created large government data portals. The US site Data. gov, launched in May 2009, now hosts more than a quarter of a million datasets. The World Bank has been leading by example. It opened a great deal of its data to the public in 2010, with the objective of encouraging software development to aid development problems. In September 2011, the Bank launched a new Open Government Data Community of Practice on the global networking website LinkedIn, in collaboration with the World Wide Web Foundation. The purpose was to connect open data experts with governments. Persuading governments to open data access to the public using the internet is seen by many experts as a means of creating greater transparency and building citizen pressure to expose and minimise corrupt practices. Corruption is seen by many analysts as a brake on development and economic growth.

 

The final paper in this themed issue is by three academics – César Daniel Vargas Diaz, Manuel Antonio López Hernandez and El Housin Helal Ouriachen, all from the University of Granada, Spain. It assesses and ranks the quality of the information provided by the finance ministries of 19 Latin American countries for public access on their websites according to a number of desirable criteria. They find that Mexico has the highest overall level of e-government transparency.[2]

 

Advocating open government and fiscal transparency, and releasing data for public inspection is one thing, while actually producing regular, informative and meaningful consolidated reports on the entire state of public-sector finances is another. The UK’s transparency project – the Whole Government Accounts (WGA), published in November of last year – has come under attack for taking too long to produce, for being out of date and for making serious reporting omissions that negate its usefulness. In corporate financial markets an unexpected delay in the publication of a preliminary income statement and balance sheet after the record date can signal problems. HM Treasury only published the first audited WGA, covering the year 1 April 2009 to 31 March 2010, 20 months after the balance sheet record date. Furthermore, the project has been ten years in preparation – but, despite the time and resources devoted to the WGA project, the UK government’s maiden report has also been damned by both the National Audit Office (NAO) and the Public Accounts Committee of the House of Commons. The National Audit Office gave the WGA only a ‘qualified’ approval, an indication of very serious issues if the government were a private corporation.

 

The WGA showed that, in 2009–2010, the public sector owned assets to the value of £1.2 trillion and liabilities totalling £2.4 trillion, giving a net liability of £1.2 trillion. The shortfall between operating revenues and expenses (including finance costs) during the year was £165 billion. Furthermore, the NAO states that the WGA significantly understates the true value of public assets and liabilities by excluding the publicly owned banks, the Bank of England and Network Rail which, in the opinion of the Comptroller and Auditor General, are owned and controlled by government. It also gives limited analysis of spending across the main functions of government, such as defence and education, or on services such as consultancy, which would make the account more useful to the reader. The report of the Public Accounts Committee (PAC) was, if anything, more damning. The Rt Hon Margaret Hodge MP, Chair of the Committee of Public Accounts, said:

 

The 2009–10 WGA reveals some staggering numbers and shows that the total effect of individual financial decisions can be very significant. The cost to the taxpayer of settling outstanding claims for clinical negligence was estimated at £15.7 billion, while the amount of unpaid tax written off by the government was as high as £10.9 billion. The accumulated value of future commitments under PFI schemes was £131.5 billion – four times the value of the assets secured through the deals. The provision for nuclear decommissioning was £56.7 billion and increasing. This is the first time either Treasury officials, or ministers, or MPs and the public have been able to look at the total cost of policies over time.

 

The PAC also expressed surprise that the Treasury ‘did not have a grip on trends in some key areas of risk or plans for managing them’, such as clinical negligence claims which, at 31 March 2010, accounted for 15% of provisions for future government spending.

 

Economists should not be surprised that public sector-sector officials and politicians do not push for stricter audits of their actions. Indeed, Ian Ball and Gary Pflugrath answer their own question of why governments appear to be strict on corporate accounting failures, but not on their own. They invoke the aid of public choice theory,which simply transfers ‘the rational actor model of economic theory to the realm of politics’. What is hard to explain is the deafening silence of the economics profession, which for years has put up with and used misleading, inaccurate and often fraudulent public-sector accounting data.

 

  

References

Chan, J.L. (1999) The bases of accounting for budgeting and financial reporting. In:

Meyers, R.T. (ed.) Handbook of Government Budgeting. San Francisco: Jossey-Bass Publishers, pp. 357–380.

 

Chan, J. L. (2009) American Government Accounting Standards and Their Relevance to China. Beijing: China Finance and Economics Publishing House.

 

Jerven, M. (2011) Counting the bottom billion: measuring the wealth and progress

of African economies. World Economics, 12, 4, October–December, pp. 35–52.

 

Sturgess, B. (2010) Greek economic statistics: a decade of deceit. World Economics, 11, 2, April–June, pp. 67–99.



[1] Source: http://go.worldbank.org/M1JHE0Z280

 

[2] In this respect it is interesting that three recent national experiments in open-data: Kenya,Moldova and Georgia, are all developing countries

who have in the recent past earned a reputation for corruption. The open data initiatives in

Kenya and Moldova were both assisted by World Bank staff. In Kenya, the open data website was

launched in July 2011. The catalyst was the energy of Dr Bitange Ndemo, Kenya’s Information and

Communications Minister. The impetus came from newly available population census data with

the recognition that the information contained was a valuable national asset that would assist both

governments and private enterprises. In many African countries population data, which is often

blatantly inaccurate (see Jerven 2011) is viewed almost on a par with military secrets.