CREATIVE ACCRUAL ACCOUNTING IN THE PUBLIC SECTOR: ‘MILKING’WATER UTILITIES TO BALANCE MUNICIPAL BUDGETS AND ACCOUNTS pot

CREATIVE ACCRUAL ACCOUNTING IN THE PUBLIC SECTOR: ‘MILKING’ WATER UTILITIES TO BALANCE MUNICIPAL BUDGETS AND ACCOUNTS EIJAM.. The authors’ view is that the heterogeneity of accrual accou

CREATIVE ACCRUAL ACCOUNTING IN THE PUBLIC SECTOR: ‘MILKING’ WATER UTILITIES TO BALANCE

MUNICIPAL BUDGETS AND ACCOUNTS

EIJAM VINNARI ANDSALMEN¨ASI∗

INTRODUCTION

A balanced public sector economy requires that sufficient taxes and other revenues are collected to cover public expenditures Tax revenues are crucial

in financing a public economy, yet the various modes of levying taxes cannot

be multiplied indiscriminately and there are limits to how high taxation rates can be raised The demand for public services is invariably greater than the resources available for their provision, in other words scarcity and the allocation

of resources have always caused problems in all public economies

Recent attempts to solve the problems of public finance have included adopting models from the private sector (see e.g., Hood, 1995; and Gruening, 2001) A case in point is New Public Management (NPM), which highlights the role of financial management and accounting as a basis for reforms The conventional wisdom has been that public sector accounting, in particular the fields of financial management and cost accounting, must be developed to emulate business sector practices The terms New Public Financial Management (NPFM) and accountingization have been used in an attempt to stress the economic and accounting orientation of public sector reforms (Olson et al., 1998; and Power and Laughlin, 1992) In their article (1999, p 210) Guthrie

et al observe that:

an increasingly notable element of the NPM movement is the seemingly endless list of accounting-based, ‘financial management’ techniques that are being drawn on in the pursuit of reform

and that:

the field of NPFM is replete with jargon – terms such as ‘accrual accounts’,

‘performance indicators’, ‘delegated budgets’, ‘full costs’, .to name just a few.

The adoption of NPM ideology also involves attempts to streamline the public sector and reduce its costs Very often the core public sector has been reduced by separating the units producing utility-type services, such as energy

∗The authors are respectively Research Scientist, Tampere University of Technology, Institute

of Environmental Engineering and Biotechnology; and Professor, University of Tampere, Department of Economics and Accounting.

Address for correspondence: Eija M Vinnari, Tampere University of Technology, Institute

of Environmental Engineering and Biotechnology, PO Box 541, FIN-33101 Tampere, Finland e-mail: eija.vinnari@tut.fi

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and water services production, into public enterprises or public companies, which then operate as result-controlled responsibility or profit centres and accounting entities on commercial lines The formation of public enterprises can

be considered an intermediate phase on the way towards the probable ultimate outcome of NPM: the privatization of most publicly owned utilities

The purpose of this paper is to explore and analyse the effects of the two aforementioned types of NPM reforms: accountingization, i.e the application of business-sector accounting models in the municipal sector, and the formation

of profit-making municipal enterprises More specifically, the paper aims to determine whether these reforms have succeeded in attaining the oft-cited goals of increased accountability, transparency and intergenerational equity, or whether, on the other hand, any indications can be found of the contradictions, ambiguities and paradoxes that have been suggested to underlie NPM reforms (e.g., Olson et al., 1998) These questions are investigated through an in-depth explanatory case study set in the context of Finnish local government, a city and the city’s water utility

The analysis in this paper is based on the financial statements, budgets and other official documents of the case city and its water utility Newspaper articles and information obtained through discussions with city officials are also used

as empirical data Even though the analysis is to a large degree founded on accounting techniques, the study represents interpretative and to some extent critical accounting research (Burrell and Morgan, 1979; Chua, 1986; Hopper and Powell, 1985; Baker and Bettner, 1997; and Ryan et al., 2002) The authors’ view is that the heterogeneity of accrual accounting applications may lead

to creative accounting solutions especially in the public sector context, with the consequence that accounting information is not sufficiently transparent, users may be misled, and accounting does not properly fulfil its accountability functions The authors are critical (cf Mouritsen et al., 2002) and wish to facilitate ordered change towards more straightforward practices This paper therefore contributes to national and international efforts to develop and improve public sector accounting principles and practices

The paper proceeds as follows The second section presents the concepts

of intergenerational and interperiod equity, accrual accounting, and creative accounting, which provide the theoretical background for the research The third section describes the case, the sale of a public water utility (henceforth referred to as Water Utility) to a public energy company (Energy Company) by the parent or owner of the two aforementioned units, Owner1City (or the City) The fourth section analyses the sale, its motivations and consequences in the light of the theoretical framework provided, and the final section sets out the authors’ conclusions

THEORETICAL BACKGROUND The theoretical background of this paper consists of three elements: the concepts

of intergenerational equity and interperiod equity in the public sector, accrual

accounting and interperiod equity measures in the public sector context, and creative accounting These concepts are briefly discussed in the remainder of this section

The intergenerational equity requirement is often regarded as the key criterion for the fiscal stance of a government Intergenerational equity is based upon the principle that the taxpayers of a certain generation should finance all the current expenditure and contribute to financing inherited productive assets

in proportion to how much benefit they receive from those assets (Robinson, 1998) As an abstract concept, it is operationalized through interperiod equity, which in turn requires that enough taxes and charges are collected in each fiscal period to cover the costs incurred in the provision of services during that period (Robinson, 1998; and N¨asi, 1999) This, in turn, requires balanced annual budgets and accounts Controlling interperiod equity calls for appropriate budgeting and accounting systems, and also equity measures, although the latter are in practice ambiguous and controversial

Public sector budgeting and budgetary accounting are traditionally based on the concepts of expenditure and revenue, and the principle that annual revenues should cover annual expenditures, i.e the budgets and accounts should be in balance The balance principle belongs to traditional budgetary doctrine and is part of the practice of most governments In budgetary accounting, expenditures and revenues are largely equated with cash expenditures and cash revenues, i.e accounting is cash-based, although not necessarily in a pure form Furthermore, the degree of interperiod equity of the economy or finances can be measured as a balance between all cash revenues (including borrowing) and cash expenditures (including long-term capital investments, repayment of loans and lending) The superiority of accrual-based accounting compared to traditional public sector (budgetary) accounting has been argued by many practitioners and academics since the late 1980s and early 1990s The debate on accrual vs budgetary accounting has inspired a plethora of articles, in which various arguments for and against accrual accounting have been made Most of the arguments in favour of accrual accounting belong to one of the following themes: (1) enhanced internal and external transparency; (2) better organizational performance through improved resource allocation; and (3) more information

on the full costs of operations, leading to greater efficiency (for a review see e.g., Carlin, 2005) Conversely, accrual accounting has been criticized for the misallocation of resources and inadequate disclosure of assets and liabilities,

as well as for the ability of organizations to defer liabilities and thus burden future taxpayers with these costs (e.g., Hoque and Moll, 2001) It has also been claimed that the application of accrual accounting in the public sector leads to measurements that are not reliable, fair, or neutral (McCrae and Aiken, 2000), and that the microeconomic basis for its application is weak (Robinson, 1998; and Monsen and N¨asi, 1996) Guthrie et al (1999) have called for further research

on the claimed potentiality of accrual accounting reforms and their practical implications

Following the spread of NPFM ideologies, governments in many countries have adopted business sector accounting thinking and models, not only in public enterprises but also in the core functions of the public sector (e.g., Guthrie

et al., 1999; OECD, 2002; Christiaens, 2003; Schedler, 2003; L¨uder and Jones, 2003; Groot and Budding, 2004; Ridder et al., 2005; and Paulsson, 2006) In the field of financial accounting, this can be seen in the application of accrual-based accounting and financial reporting, including an income statement, a comprehensive balance sheet and a statement of financial inflows and outflows The driving forces behind such reforms have been identified as the wish

to instil greater financial awareness into public sector decision-making, to provide comprehensive financial information to facilitate efficient and effective decisions, and to provide information that allows citizens and other stakeholder groups to assess the extent to which revenues meet the full costs of public service provision (Guthrie et al., 1999; Stalebrink and Stacco, 2003; and Connolly and Hyndman, 2006) Politicians, financial institutions, management consultants, scholars, the media, and international organizations have all been influential in bringing about these reforms (Pina and Torres, 2004)

However, accrual accounting is not just one specific accounting model There are many versions of it; starting with static and dynamic theories and models

In Finland, until the obligatory adoption of IAS/IFRS by quoted companies in line with EU policy, prevailing accounting thinking in the business sector was strongly dynamic in nature.2 The Finnish municipalities adopted the dynamic accrual accounting model in their financial accounting reform in 1997, and they are still using it today

The core of the Finnish dynamic accrual accounting model lies in the categorizing and recording of transactions, i.e the bookkeeping of revenues, expenditures and finance transactions, and in periodic income measurement Transactions are measured and recorded at their historical costs and at the exchange prices of the transaction date The matching principle is applied in the closing of accounts, i.e expenditures are matched against the corresponding revenues to calculate annual income (cf e.g., Skousen et al., 1991) The Profit and Loss (P/L) Statement is the primary financial statement in dynamic accounting thinking, and the Balance Sheet has more or less only the role of transferring the balances of different assets and liabilities accounts to the next accounting period

The municipal accrual accounting model in Finland differs from the business-sector model in several ways, an important one of which is a terminology tailored for the local government sector only This concerns, for instance, the terms describing the intermediate results on the P/L Statement and the terms used on the Balance Sheet referring to equity/net assets This problem of self-invented terminology is discussed in more detail in the empirical part of this paper The third concept forming the theoretical background in this paper is creative accounting This is a term used in European accounting literature, while the preferred term in the United States, and consequently in most of the literature

on the subject, is ‘earnings management’, but such terms as ‘income smoothing’,

‘earnings smoothing’, ‘financial engineering’, and ‘cosmetic accounting’ are also found in the literature (see Amat and Gowthorpe, 2004) Healy and Wahlen (1999, p 368) define earnings management as follows:

Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers. Amat and Gowthorpe (2004) see creative accounting as the use of accounting

to mislead rather than help the intended user, deliberately taking advantage of areas where there are ambiguities and discontinuities Regulatory flexibility may permit a choice of policy in, for example, fixed asset valuation, such as in the case

of IAS, which allow carrying non-current assets at either revalued amounts or depreciated historical cost (ibid.) The problem related to fixed asset valuation has also been noted by Griffiths (1986, p 97):

Be it as part of bid defense or an attempt to beef up the balance sheet, or a genuine effort to reflect true value to the business, fixed asset valuations will always present opportunities for creative accounting These opportunities are not restricted

to the balance sheet since the consequent charge to the profit and loss account for depreciation will also be affected Fixed assets are pliable, flexible and mobile Everything then except fixed!

Artificial transactions, in turn, can be entered into both to manipulate balance sheet amounts and to transfer profits between accounting periods (Amat and Gowthorpe, 2004) Thomas et al (2004) tested for earnings management in the case of transactions between an owner company and its affiliates:

For example, the [o]wner company can sell assets (e.g., inventory, land, etc.) to its subsidiary .The [o]wner company can report the sale and increased earnings in the

current period For consolidated purposes, the affiliated transaction will be eliminated and not affect the financial statements (p 3).

The use of creative accounting has generally been associated with the private sector, yet it can also be practised in public administration, where in fact the context and regulations often offer ample opportunities to indulge in it This is especially the case when the accounting practices depend on the public sector’s own regulations and not on any generally accepted accounting standards

In Finland, for example, the adoption of the IPSAS standards has not been considered in the municipal sector The central government’s Accounting Board did conduct a preliminary review of the standards but decided not to implement them as long as they are incomplete Furthermore, as the national legislation in Finland only provides the general framework for municipal accounting, more detailed principles and practices rely upon self-regulation, i.e a municipal accrual accounting model devised by the municipalities’ interest organizations This presents opportunities for the use of creative accounting as will be demonstrated in the next sections

CASE STUDY – CREATIVE ACCRUAL ACCOUNTING SOLUTIONS IN THE

MUNICIPAL SECTOR

Accrual Accounting and Budgeting and Interperiod Equity Measures in Finnish Municipalities

Local government reform in Finland took place with the implementation of the Local Government Act (365/1995), in which there was a reference to the application of the Accounting Act of 1973, reformed in 1997 (1336/1997) Taken together, these two Acts meant that the municipal sector adopted the accrual accounting method for both budgeting and financial accounts

The Local Government Act also introduced the requirement that each municipality should draft a three-year financial plan which must be accepted

by the municipal council concurrently with the municipality’s budget for the coming fiscal year If the municipality’s financial result for the current or the coming year is expected to be negative in accrual terms, the municipal board (executive body) has to present the municipal council (decision-making body) with a plan of how it intends to cover the deficit during the planning period (§65) Thus, calculated over a period of three years, the municipality’s budget must at least break even The aim of this system is to guarantee interperiod, and, in the long run, intergenerational equity in Finnish municipal economies Yet, although the aim is clear, agreeing upon the most appropriate accounting system and the corresponding equity indicators is more problematic In the accrual budgeting and accounting system devised specifically for the Finnish municipalities, certain P/L Account figures clearly play a crucial role in measuring the balance of budgets and accounts One such figure is the Annual Margin (see the Appendix), the difference between a municipality’s running revenues and expenses Another important measure is the bottom-line figure, the Surplus/Deficit for the Financial Year, which is the official equity measure that should at least break even in the three-year period Achieving interperiod equity using these measures is a problem in numerous Finnish municipalities,3 and this difficulty was also the key factor in the application of creative accounting solutions in the case municipality, Owner City

Owner City and the Formation of the Public Enterprise, Water Utility

Owner City is located in central Finland and has a population of 83,000 During the last few years, the City has suffered from financial problems that are threefold: an uncovered deficit in the annual budgets and accounts, a small Annual Margin that has to cover at least depreciation, and increasing long-term debt Because of the requirement to achieve balance, Owner City has been compelled to try and improve its finances In this effort, the City has taken advantage of its formal position as the owner of municipal public enterprises and companies, in particular its water utility

Owner City’s Water Works was established in 1910, and it operated as part

of the city administration until the mid-1990s In 1994, Water Works underwent

an organizational change to become a public enterprise, Water Utility, i.e., an independent municipal profit centre and accounting entity with its own Balance Sheet As a hybrid of a municipal department and a public company, a public enterprise in Finland is not required to pay Corporation Tax.4Another notable difference between a public enterprise and a private or public company in Finland relates to a Balance Sheet item called ‘Basic Capital’ on the liabilities, which is defined as the owner municipality’s permanent equity investment in its public enterprise When a public enterprise is formed, the opening balance sheet value

of the Basic Capital is calculated as the difference between the value of its assets and debts (Accounting Board, Municipal Section, 1999) Thus, for the purpose of constructing the first Balance Sheet for Water Utility, its infrastructure assets needed to be recognized, valued and separated from the other assets of Owner City Because no official guidelines on public enterprise asset valuation existed

in 1994, Water Utility’s infrastructure assets were entered in the balance sheet

at acquisition cost, EUR 31.1 million, based on the investment made during the period 1975–1993.5This amount was also considered to reflect Owner City’s capital investment in Water Utility, that is its Basic Capital Thus, the sum (EUR 31.9 million after minor adjustments) was entered on Water Utility’s opening Balance Sheet as the value of the infrastructure assets and, on the liabilities side, as the Basic Capital

Along with the general adoption of accrual accounting models by all the Finnish municipalities in 1997, Water Utility’s infrastructure assets had to be revalued to reflect the assets’ historical cost minus accumulated depreciation The value of the assets and, correspondingly, the value of the Basic Capital were reduced to EUR 24.3 million A year later, Water Utility acquired more property, and the Basic Capital was raised to EUR 25.2 million, at which level

it remained until 2005 Since the publication of public enterprise accounting guidelines (Accounting Board, Municipal Section, 1999), the revaluation of fixed assets other than land or water areas has been forbidden

Compensation for Owner City’s Basic Capital as an Expense Item on the Profit

and Loss Account

The Finnish Water Services Act (119/2001) defines ‘water services’ as the conveyance, treatment and delivery of water to be used as household water,

as well as the disposal and treatment of wastewater, rainwater and drainage water from foundations (§ 1) The Act stipulates that water services charges should cover the running costs and investments of the water undertaking in the long run, and that the charges may, but do not have to, include a reasonable rate of return on the owner’s capital investment (§18) Since the Act provides

no further definition for the term ‘reasonable’ and the rates of return are not regulated by any authority,6 they vary widely in Finland and can amount to

as much as 45.5 percent of a water utility’s annual turnover (Vinnari, 2006) Owner City’s interpretation of this regulation can be seen in Water Utility’s P/L Accounts (Table 1) In accordance with the Finnish municipal accounting guidelines, the return on Owner City’s Basic Capital was entered in the P/L Accounts as a financial expense item entitled ‘Compensation for Basic Capital’, despite its dividend-like nature

In accordance with the full cost recovery principle set out in the Water Services Act, the Turnover from selling water should cover the operating costs, depreciation, and financial costs of Water Utility The bottom line figure (Surplus/Deficit for the Financial Year) in Water Utility’s P/L Accounts seems

to indicate that it succeeded in breaking even but made very modest annual profits Interpreted in standard accrual accounting terms, this would mean that the Utility would have had few funds to distribute to the owner Yet, a more careful scrutiny of the accounts reveals that in fact Water Utility paid, and the City received, significant sums of money as Compensation for the Basic Capital This item was, however, presented as a financial expense, not an appropriation

of profit

In other words, Owner City used Water Utility to collect an income of EUR 2.51–3.53 million annually in the form of customer charges During 1994–

2004, the compensation rate paid by Water Utility ranged from 7.9 percent to 14.5 percent on the Basic Capital Expressed as a percentage of annual turnover, this equals 20–27.5 percent (Table 2)

The income from Water Utility was not earmarked for any water services related purpose, so the City was able to use it to balance its budgets and finances This practice is not immediately detectable by looking at Water Utility’s P/L Accounts because, first of all, like most users of accounting information, the municipal council members very obviously monitor and understand first and foremost the bottom line figure, which in this case shows modest and acceptable profits Secondly, the heading ‘Compensation for the Basic Capital’ misleads rather than helps the reader to understand the financial information of Water Utility: she or he may assume that the item is equal to real external spending and expense, such as interest on a bank loan, rather than a return on Owner City’s ‘invested’ capital The arrangement conforms to Finnish public sector accounting regulations, but its adherence to the spirit of the Water Services Act, which calls for a ‘reasonable’ rate of return, can be questioned Therefore, the Compensation for the Basic Capital can be interpreted as creative accounting and hidden taxation, not only in the case city but also more generally in the accounts of Finnish municipal enterprises

Despite the steady income flow from the Water Utility, Owner City’s financial predicament intensified at the beginning of 2000, and the City had to resort to further measures to balance its budgets and accounts

Note: ∗ Voluntary

Note: ∗ Value