Public Policy and Government Accounting
Social contract theories like Hobbes, Locke, and Rousseau were not in the first instance trying to give empirical accounts of how the state arose. They were attempting rather to understand a government’s basis of legitimacy.
—Francis Fukuyama
In healthy capital democracies, there are usually two basic political tendencies. Each group recognizes the need for a public sector and a private sector, and political debate concerns where to draw the line between them.
—Barney Frank
Government is a system of political administration of a state or some other legal or geographical jurisdiction. Public policy is the administrative guidelines to run a state, including a constitution, rules and regulations, as well as the institutional structures used to carry out day-to-day (short-term) operations and long-term goals. Effective governments are powerful, regulation bound (based on the rule of law), and accountable. As stated by Fukuyama: “most people around the world would strongly prefer to live in a society in which their government was accountable and effective, where it delivered the sorts of services demanded by citizens in a timely and cost-effective way.”1
Anthropologists identify human stages of society as bands, tribal, chiefdoms or kingdoms, and states. The key point is the shift from kinship-based societies to broader-based city-state, regions, and empires. Religion apparently played a major part in the transformation. Fukuyama gives the Chinese credit for inventing political bureaucracy: “China alone created a modern state in the terms defined by Max Weber. That is, China succeeded in developing a centralized uniform system of bureaucratic administration that was capable of governing a huge population and territory.”2
Empires and civilizations needed laws, such as Hammurabi’s law code and Moses’ ancient and famous Ten Commandments. Athens apparently invented democracy, but collapsed quickly. Plato—not a proponent of democracy—waxed eloquently about a philosopher/king, but the philosopher part proved rare in the history of the world. Rome became the dominant player for a thousand years or so, with kings, then a republic, followed by emperors. The Roman Empire worked well on multiple dimensions, but not on benevolence and enlightened rule—the levels of cruelty and corruption were matched but seldom exceeded in the history of the world. Republics like early Rome did not fare well in nation building, suggesting that monarchs were superior for governing empires. Thomas Hobbes in Leviathan proposed the first social contract theory: that people traded freedom (plus taxes and conscription) for the security provided by a strong monarch.3 The potential for rule of law and property rights could be an added bonus, but typically occurred only after conflict and civil war or revolution.
Because governments (and nonprofits) have no obvious profit motive, accounting data are more problematic. Unlike corporations, governments rely on publicly available operating budgets as the primary mechanism to fund operations and deal with the public. This is cumbersome and sometimes misleading (actual results can be wildly off-the-mark for example; the budget/actual/proposed (that is, this-year’s-budget to last-year’s-actual to next-year’s-proposed) budget cycle makes apples-to-apples comparisons a multiyear challenge; budgets can be cash-based, actual-financial accrual, and modified accrual). With corporations, profitability is the analytical stating point. With governments, it’s usually a balanced budget. This tells little about efficiency or effectiveness except how close the entity came to meeting the budget. Budget-to-actual (that is, comparing the actual results to the budget) is an obvious first step, but evaluating governments is difficult. Generally, most users rely on experts for analysis, such as summary reports, review committees, and the media. Legislative oversight may work, except for the obvious political biases. The best hope is to focus on nonpartisan review groups: increasingly pragmatic inspectors, professional panels, citizen groups. Elections, even with all the inherent problems, are the best hope in a democracy.
The old close-to-cash-base accounting standards for state and local governments had the obvious advantage of relative simplicity and the near-cash focus seemed logical relative to the focus on budgets. New standards are more complex and the rationale seems puzzling. The rules follow the idea of transparency in the sense that vast amounts of information are presented in multiple forms in comprehensive annual financial reports (CAFRs). But are CAFRs useful or is the most common use of these monsters as doorstops? An additional issue is government size from tiny local governments (I now live in a village) to the giant national governments. The state/federal split resulted in two very difference accounting systems. The financial statements of my village have the same general format as California, but are nothing like Treasury Department and other financial statements at the federal level. These can be viewed as specialized reporting systems for the experts, with little interest in voters or taxpayers.
Rule of Law and Accountable Government
Property rights for individuals were common in some locations from medieval times, with the potential to conduct business, trade and moving around with some freedom. Many European states formed under Feudalism after periods of anarchy and conquests, with commitments of loyalty and service. Of course, monarchs often took back or violated these rights, with various elite groups forming parliaments or similar organizations to maintain rights. Capitalism was a budding development during this period.4 Catholicism and later Protestantism were major considerations and various social scientists such as Max Weber considered the “Protestant work ethic” a major causal factor in capitalism and the Industrial Revolution.
“Modern political systems are built on a tripod consisting of a modern state, rule of law, and democratic accountability. States are about accumulating and using power, while law and accountability seek to constrain and channel power.” Fukuyama define law as “a body of abstract rules of justice that bind a community together,”5 based on some power or authority. This could be religious or a powerful secular leader issuing rules and mandates. The key point: Effective government is based on several important factors and the lack of balance can result in failure. America for example had democracy (a fundamental form of accountability), rule of law, but a state/federal split (although under the celebrated Constitution) with both federal and state patronage (plus related corrupt political machines throughout state and local governments) that limited bureaucratic effectiveness for over a hundred years.
The European developments of professional administrations, democracy, rule of law, and capitalism are considered postfeudal system breakthroughs that took hundreds of years to establish. Wars, chaos, revolutions, and other forms of instability were part of the process. Most of the characteristics of modern effective government happened in Britain first. The beginnings of English rule of law and even democracy had their start (albeit slowly) in Anglo-Saxon days. Anglo-Saxon moot courts, for example, made decisions based on testimony of accuser and accused as part of the development of Common Law.
Common Law developed as legal precedence was established in local courts and spread and evolved over time. After William the Conqueror’s invasion, the Norman kings’ court followed the Anglo-Saxon precedents and royal courts were seen as relatively impartial. Key characteristics were incremental decentralized decisions, experimentation, and focus on precedent-setting of well thought-out court decisions. It proved to be adaptive to property rights, business, and developing markets, characteristics appreciated by later libertarians beginning with Frederick Hayek.
The United States and other former colonies adopted common law and developed their own versions. America’s federal/state system meant that states generally have jurisdiction in such areas as contract laws, tort, property, criminal, and family law. However, federal law preempts conflicts in many areas including when laws are ruled unconstitutional. The relative role of state versus federal jurisdiction and power had been debated (and fought over) from the beginning.
Anglo-Saxon kings of England had an advisory council called the Witengemot and King Ethelbert issued a law code in about 600. William the Conqueror replaced the Witengemot with a King’s Council (Curia Regis) as part of the evolution to Parliament. In 1215 King John signed the Magna Carta, giving the barons certain tax relief and solutions to other grievances—including the right of “free men” to justice and a fair trial. Parliament demanded the authority to approve the king’s tax levies. Parliament thus gained considerable power as various kings needed money, usually to fight in France (or Scotland, Wales, and Ireland). Representatives from towns and shires were later added and Parliamentary power increased over time. The authority of Parliament and the courts would lead to relatively stable political order and eventually to laws favoring such things as public education, universal suffrage, and an economic safety net.
Most of continental Europe used civil codes, top-down structures that began at least with Hammurabi’s Codes and Old Testament commandments. Emperor Justinian codified Roman law in the Corpus Juris. It took the French Revolution and the rise of Napoleon for France to create a modern civil code (but following earlier German examples), rule of law, and a relatively professional administration—democracy proved more difficult, with additional revolutions and other disruptions to democracy. Most of continental Europe developed some form of civil code.
Development of the U.S. Government
Colonial legislatures became common points of public policy and the beginning of representative government. Abundant land meant many settlers became immediate landowners and property rights and rule of law basic tenants adopted from British common law. The Virginia Company established the first legislature in America, later called the House of Burgesses6 in 1619. It had limited power, but established a democratic mindset. George Washington first won election to the House in 1761.7 Other future founding fathers from Virginia also members included Thomas Jefferson, Patrick Henry, and George Mason. In the 1760s the House of Burgesses claimed theirs was the sole right to tax Virginians, a contentious position according to the British before the American Revolution.
Like the Virginia Company, the Pilgrims of the Plymouth Colony functioned on a joint stock company charter and not a royal charter. The Mayflower Compact of 1620, based partly on common law and partly on biblical interpretations, became the governing document giving most adult males citizenship as “freemen.” The colony functioned under a governor and a general court that functioned as both a legislature and judiciary. Freemen originally elected the governor and members of the general court. The proclamations of the general court were first codified as the Book of Laws in 1636.
The joint stock charter of the Massachusetts Bay Company, founded in 1628, gave all government authority to local magistrates. Public grievances led to the 1641 “Body of Liberties,” codifying laws giving specific personal freedoms. The Puritans of Massachusetts Bay Colony joined with the Pilgrims of the Plymouth Colony to create the Province of Massachusetts Bay in 1692.
The remaining colonies each had unique histories of royal and joint stock company charters, different religious tenants, and their own version of executive and legislative control. Generally, they created alternative form of public policy usually with an elected legislature, but often under a royal governor. These evolved into the 13 colonies plus somewhat informal areas that became separate states after independence. The key points are the long colonial histories of property rights, rule of law, considerable de facto independence, and democratic institutions. Readily available land and property rights (as part of the rule of law) made the colonies different from much of Europe.
The Federal Government
Under the Articles of Confederation, the states had most of the political power and little inclination to give this up to a central authority. Unfortunately, the result was a post-Revolution depression and little chance of solving basic public policy problems (e.g., dealing with foreign trade and even commerce between states; any sort of national tax; paying off the war debt). This led to a not entirely authorized constitutional convention in 1787. The convention claimed the authority to revise the Articles of Confederation and then proceeded to develop an entirely new document. American mythology suggests a perfect document, but in fact it was the result of many compromises (e.g., the two-house legislature as constructed was a compromise for sharing power between big and small states). The major unsolved problem was slavery, where substantive action was deferred, ultimately resulting in a disastrous Civil War some 75 years later. Despite the shortcomings, the American Constitution was approved by the necessary states in 1788 and a new national government under George Washington put in place by 1789. The role of public policy and federal versus state or local responsibilities have been debated ever since.8 The Constitution was established as a republic, not especially representative nor close to universal suffrage. “Democracy” was often used as a term of derision for the “crowd,” as, for example, the mob rule during the French Revolution.
The regime of Washington attempted a strong federal presence, with considerable support from Treasury Secretary Alexander Hamilton. His robust financial plan called for most federal revenues coming from customs duties, assuming (and paying) both federal and state debts accumulated during the Revolution, and creating the First Bank of the United States with some of the functions of a central bank. In addition, Hamilton called for an excise tax on spirits, especially whiskey which was distilled throughout the western states and territories. The tax led to the Whiskey Rebellion of 1794 around western Pennsylvania, brutally put down by federal troops.9
Hamilton as Treasury Secretary established the largest department by far in the federal government.10 His responsibilities included a budget and accounting system, tax plan, central bank, customs service, and coast guard—all of which he had to personally create. These issues involved questions of constitutionality and sometimes a balking Congress. Hamilton created a simple bookkeeping system. He required exact figures for customs duties from custom collectors—after all, this was the primary tax source. The duties could be paid in gold or notes from the major banks, effectively encouraging paper money and commercial banking. Hamilton hoped that notes of the Bank of the United States would be used as currency.
Hamilton, Washington, and second President John Adams became known as Federalists (a term Washington and Adams rejected), focusing on a strong central government to meet the needs of a changing economy and international threats. Anti-Federalists, wanting a weak central government and more power to the states, evolved into Jefferson’s Democratic-Republican Party. Jefferson, as third president following one of the most vicious presidential campaigns in presidential history in 1800, discovered that executive power could be a good thing in his hands. During his term, he completed the Louisiana Purchase and sent out Lewis and Clarke to explore the new territory—neither sanctioned by the Constitution.
By today’s standards, the federal government remained relatively inactive, maintaining a small military, a postal system, federal court system, and modest incursions into such things as transportation and business. Thanks mainly to President James Polk’s decision to invade Mexico, the country expanded to the Pacific by mid-century—manifest destiny-trumped indigenous rights. The major controversy was slavery, which ultimately proved catastrophic. Federal revenue was mainly generated from customs duties and the sale of western lands.
Federal power grew over the century. The southern succession allowed the Union to build the first transcontinental railroad, create agricultural schools and encourage homesteading. The need for revenue to fight the Civil War created the first federal income tax and the Bureau of Internal Revenue (later the IRS). Progressive legislation after the Civil War followed, mainly with a substantial lag especially with the presidencies of Teddy Roosevelt and Woodrow Wilson. The 16th Amendment brought in a permanent income tax and World War I substantial tax revenues.
Federal income tax (and the IRS) stayed on the books after World War I, although rates fell under the Republican presidencies in the 1920s. Rates grew under Franklin Roosevelt’s New Deal, although budget deficits remained because of declining revenues of economic depression. Expenditures exploded during World War II, while the top tax rates were over 90 percent and remained there until the 1960s. Federal expenditures rose substantially, both military spending because of the Cold War and increased social programs. Budget deficits proved a continuing problem, with periodic attempts at fixes.
By the turn of the 21st century federal finance was a trillion-dollar monster. For fiscal year 2000 revenues were a bit over $2 trillion (over $1 trillion in individual income tax and $653 billion in Social Security and other payroll taxes), while expenditures were a bit under $1.8 trillion. This created the unusual case of a federal surplus of $236 billion. This ended shortly with the Bush administration’s push for tax cuts and added drug benefits to Medicare. The 2016 budget called for revenues of $3.5 trillion ($1.65 trillion in individual income tax and $1.1 trillion in payroll taxes) and expenditures of $4 trillion. The result was a substantial projected deficit of $474 billion. The right amount of taxes and spending—and how to distribute both—continues to be a major public policy issue and intertwined with many other issues (e.g., health care, Social Security, defense).
Federal Accounting
Accounting at the federal level was entirely different from state and local governments. The history goes back to the administration of George Washington in 1789 (or around 1775 if the Continental Congress is included). The Treasury Department was one of the original cabinet posts created by Congress and Hamilton, as first treasury secretary, responsible for creating revenues, paying expenditures and dealing with the massive debt accumulated during the Revolution. His accounting system, while primitive by later standards, was masterful for the time and would not be much changed until major reforms of the 1920s.
The Bureau of the Budget was created by the Budget and Accounting Act of 1921 primarily to centralize government spending. A national budget system was established, with a required annual budget submitted by the president to Congress. The bureau director would consolidate all revenue forecasts and department or agency spending requests. The Bureau was initially part of the Treasury Department, but became an independent agency in 1939 called the Office of Management and Budget (OMB), which currently has a staff of about 500 professionals. Each agency submits an annual budget request to OMB. In addition, they must maintain accounting and financial reporting systems and maintain appropriate internal controls. Each agency or department also has an inspector general staff which serves an internal audit and investigation function.
The 1921 Budget Act also created the Governmental Accountability Office (GAO—originally called the General Accounting Office) as a nonpartisan economic analyst, investigator, and auditor for Congress. The GAO performs annual financial and performance audits of all executive departments and agencies. In addition, the GAO investigates illegal and improper activities, how well programs meet objectives, and issues various legal opinions.
The Congressional Budget Office (CBO) was created in 1974 to analyze economic and budget data for Congress. This included detecting techniques to manipulate the financial or political system. Phillip Joyce identified four manipulation categories:
The camel’s nose strategy, which relies on a slow phase-in of a program to hide the substantial future commitments being made.
Accounting tactics, among them creation of costly nonbudgetary entities that actually open the door to large future payouts—such as Fannie Mae and Freddie Mac, characterized as costless when established as government sponsored enterprises, but ultimately bailed out at an estimated cost of $283 billion.
Explicitly creating future costs, in other words, avoiding counting costs when commitments are made to pay them, such as loan guarantees or lease purchase agreements—such as the effort to provide Boeing with funds to purchase a fleet of refueling tankers, which were to be purchased over a number of years through operating leases, in an attempt to obscure the ultimate cost to the federal government.
Misestimating the macro-budgetary effects of policies—such as occurred when President Reagan underestimated the deficit effects of his tax cutting policies in 1981, and George W. Bush did the same 20 years later.11
As a nonpartisan research organization, CBO budget numbers (and other pronouncements) have greater credibility.
The Chief Financial Officer Act of 1990 required annual financial audits for the federal government and all departments and agencies (“federal reporting entities”). The accounting-related groups—Treasury, OMB, and GAO—created the Federal Accounting Standards Advisory Board (FASAB) to establish GAAP for the federal departments and agencies. These standards are unique and not at all related to state and local GAAP. According the FASAB’s missions statement:
the Board plays a major role in fulfilling the government’s responsibility to be publicly accountable. Federal financial reports should be useful in assessing (1) the government’s accountability and its efficiency and effectiveness, and (2) the economic, political, and social consequences, whether positive or negative, of the allocation and various uses of federal resources.12
Through 2016 FASAB issued 50 standards.
The 2015 report of the U.S. government, consolidated by Treasury and OMB reported assets of $3,230 billion, liabilities of $21,452 billion, and a net position of $18,222. Total expenditures were $4,254 billion with major spending by Health and Human Services of $1,131 billion, Social Security of $945 billion, defense of $646 billion, and interest on debt of $251 billion. The report was audited by GAO, with finding of material interest control weaknesses and significant uncertainties (especially Medicare cost growth). The Department of Defense was considered “not auditable” and no opinion was given by the GAO on the consolidated statements.
State and Local Government
The Constitution gave all authority not reserved to the federal government to the states, while states determined the responsibilities of cities and other local governments. The initial roles of local governments were determined by the original colonies, founded as a combination of royal and joint stock company charters. Over time basic public services were considered local government functions, including drinking water and sewage, public health, police and fire protection, roads and other infrastructure, public education, and parks. Particularly when electricity became widespread, utilities often were provided by governments; otherwise they became highly regulated private enterprises.
More on Local Services
One of the early public policy issues was education, with New England leading the way. Boston Latin School was the first public school, founded in 1635. Massachusetts Bay Colony then made “proper education” a rule in 1642, with specific requirement based on community size. Other colonies followed New England with the South trailing. By the mid-19th century some 95 percent of New Englanders were literate. One result was that most important patented inventions came from the North, with half from New England.13 Cities with lots of potential entrepreneurs and skilled people succeed. This was true of early 19th-century New York City (e.g., Wall Street), early 20th-century Detroit (especially the auto industry) or around 21st-century Silicon Valley (high tech).
Government corruption increased throughout the 19th century, especially the rise of political machines. Tammany Hall, the democratic machine of New York City discovered political power early in the 19th century (partly because of Aaron Burr’s dirty tricks in the 1800 election). Voter fraud proved particularly rampant, as was the spoils system—hiring party loyalists with little regard to qualifications or honesty. That power grew, peaking with William “Boss” Tweed after the Civil War. He was one of the few corrupt politicians sent to jail. Political machines spread throughout major cities, counties, and state governments, including a fair amount of corruption at the federal level. It was so bad in the post-Civil War period (“The Gilded Age” per Mark Twain) that bribery and various forms of extortion became ordinary business costs of corporations.
The progressive movement affected local and state governments, especially around the turn of the 20th century. This first progressive movement (the 1890s to 1920, roughly during the presidencies from Teddy Roosevelt to Woodrow Wilson14) called for various reforms. Professional management was encouraged, especially full-time city managers appointed by city councils to run the operations of relatively larger cities. Various research projects I conducted indicated that cities with a population over 100,000 run by city managers rather than mayors were more professional (in terms of such things as better audits or being awarded certificates of achievement) and operations more efficient in terms of expenditures and tax dollars.15 As Franklin Roosevelt’s New Deal attempted to deal with the Great Depression, uniform government accounting was encouraged, eventually resulting in the National Council on Governmental Accounting’s (NCGA) 1968 “Blue Book,” Governmental Accounting, Auditing, and Financial Reporting (GAAFR). This (plus revisions) constituted GAAP for state and local governments at the time.
Beginning with larger cities, local governments mainly switched to GAAP; however, states were slow to adapt, either because of perceived threats to sovereignty or avoiding transparency. Among the cities in the 1970s that failed to adopt GAAP and remained unaudited were New York City and Cleveland. New York City had a fiscal crisis in 1975 and saved from bankruptcy by a New York State bailout (after the federal government refused aid). Cleveland defaulted on major debt in 1977 and the city’s annual report claimed the accounting system “inauditable.” The Federal government’s 1976 Revenue Sharing Act required all but the smallest local governments to have financial audits. New York City and Boston had their first audits in 1978. Cleveland retained an auditor in 1977, but did not receive its first audit opinion until 1980. As local governments obtained their first audits, most were qualified, indicating serious accounting deficiencies. Since then, most larger cities had annual audits and obtained unqualified (clean) opinions. In addition, most received certificates of achievement indicating excellence in financial reporting.
One of the unique characteristics of state and local governments is the use of municipal bonds. Most municipal-bonded debt is exempt from federal income taxes (and often from state and local income taxes) and therefor an attractive feature for high-income individuals as well as banks and other financial institutions. As with commercial firms, the credit ratings of state and local governments is important to price the bonds (basically setting the interest rate) and many institutions are required to hold investment grade bonds. Municipal bonds pay a lower interest rate than comparably rated commercial bonds, making long-term debt an attractive feature of governments. A rationale for long-term debt is the concept of intergenerational equity, matching the payment of goods and services consumed with debt repayment. The cost of a road projected to last 30 years could be matched by a 30-year municipal bond under this concept.
Most state and local governments did not report employee pension and other retirement benefits adequately if at all. Most were on a pay-as-you-go system which, for accounting purposes, ignored future obligations for current employees. This often resulted in generous pensions because the liabilities could be ignored until the distant future. The federal pension plan, Social Security, still uses a pay-as-you-go system.
Local Government Accounting
The logic of accounting for governments differs from commercial firms on several levels. The focus typically is the concept of a “balanced budget” rather than profits, although surpluses are usually considered preferred to deficits. (The exception: allowing deficits to avoid tax increases, something many politicians avoid at all costs.) Local revenues often came from multiple sources, including property, sales, and income taxes, grants and other revenues from state and federal sources, fines and forfeitures, and user fees. Revenues typically did not match spending; that is, revenue sources were not directly related to spending. Accounting for costs relied on expenditures rather than expenses; that is, acquisition and maintenance costs rather than accrual accounting (most obvious with fixed assets, immediate expenditures when acquired).
The rationale for fixed assets and long-term debt is complex and treated differently from business. For example, infrastructure such as municipal roads and bridges is for general use rather than the exclusive use of the entity building and maintaining these projects, plus the somewhat strange question of whether this is really an asset of the government. It seems more of an obligation to meet the demands of a potentially irate citizenry. Depreciation, a long-term dilemma for commercial firms, seems unique for governments. Since a government’s budget is logically cash-based (matching taxpayer services with costs), the accrual associated with accumulated depreciation seems misplaced. Historically, local governments often did a poor job of keeping track of fixed assets, especially roads and bridges. Costs could be shared among local, state, and federal entities and determining ownership and responsibility for maintenance could be difficult.
Many government operations run by selling services similar to commercial firms and the accounting procedures are similar. The most common example is government-owned utilities, especially electric, water, and sanitation. The major revenues are charges for services by users. Depreciation is a cost of services and recorded as an expense. Recording an income number is important, although maximizing profit is not. As a matter of policy utilities can be run at a profit or loss. A typical policy is a net profit that can be transferred back to the general fund (the basic operating fund). A rationale would be to charge customers a fair rate (often in line with a commercial utility) while keeping property taxes down.
Two key points. Government accounting in the United States was substantially different from commercial accounting. Outside of government officials it could be hard to find users of annual reports of governments, which differed from standard commercial reports and quite complex and cumbersome.16 Over time the reports got more complex and longer. Standardizing accounting practices was an ongoing battle. On the one hand, comparability across governments demanded standardization, while on the other was the concept of sovereignty. (The ability to manipulate the finances was downplayed.) The NCGA’s 1968 GAAFR (Blue Book) became GAAP for local governments, using “modified accrual accounting” (with revenues recognized on a near-cash basis and costs recorded as expenditures rather than expenses—based on spending rather than use over time).
Issues with huge future obligations proved problematic, especially defined benefit pension (basically providing annuity payments based primarily on final salary and length of service) and other retirement benefits. Two big issues: (1) these did not fit in well with the near-cash mind set and (2) recording future obligations and impact on current costs or expenditures dramatically changed budgeted spending. Recording future pension on a pay-as-you-go basis is a cheap form of compensation, while recording the real impact means more spending recognized and therefore cutting spending on other needs or raising taxes.
Governments use fund accounting. The Blue Book defined a fund as:
an independent fiscal and accounting entity with a self-balancing set of accounts recording cash and/or resources together with all related liabilities, obligations, reserves, and equities which are segregated for the purpose of carrying on specific activities or attaining certain objectives in accordance with special regulations, restrictions, or limitations.17
The major rationale for fund accounting is meeting legal compliance when dealing with complex and diverse operations. According to The Blue Book, the general fund is the primary operating fund, including most nonrestricted revenues and typical spending categories. Special revenue funds include revenue sources restricted for specific uses and spending on those activities. Debt service funds include payments of interest and principal on long-term debt (particularly general obligation bonds), and capital projects funds for most public buildings, road and bridge projects, and so on. Enterprise funds include operations of utilities and other activities funded by charges for services. Trust and agency funds account for government employee pensions and activities where the government is acting as agent or trustee. Property, plant and equipment and long-term debt for governmental funds are held in accounting groups (general fixed assets and general long-term debt, respectively).
Michael Granof states four objectives of financing reporting for governments:
Assess financial condition based on past results to determine if the government can meet its future obligations and provide necessary services.
Compare actual reports at the end of the period with the budget; variations suggest poor management or unexpected circumstances.
Determine compliance with relevant laws, regulations, and restrictions on using the funds. The government must meet both legal and contract requirements.
Evaluate efficiency and effectiveness. The government achieves its objectives based primarily on these two criteria; that is, compare accomplishments relative to costs and effort.18
Government Accounting Standards Board (GASB)
The GASB was established in 1984 to set GAAP for state and local governments, with a structure like the FASB. Like the FASB it is under the Financial Accounting Foundation (FAF); the FAF picks the seven-member GASB board and provides funding—as it does for the FASB (although with a much smaller budget). The standard process is similar, starting with projects to be researched by the staff, discussion memoranda, exposure drafts, and statements (or other pronouncements), all fairly transparent with public comments and input. The GASB encouraged the use of CAFRs, including very detailed analysis by fund.
GASB 34 (Basic Financial Statements—and Management’s Discussion and Analysis—for State and Local Governments) was arguably the most important and generated the most controversy of all the pronouncements. In addition to the regular reporting, additional overview financial statements were required based on full accrual accounting (i.e., the GASB’s version of full accrual). Of concern to governments was the requirement to report detailed information on fixed assets (property, plant, and equipment) including depreciation and maintenance. Because governments’ focus previously was not on expenses or profit, they often maintained only sparse fixed asset records. The major complaint was lack of user interest in this or the additional statements required on an accrual basis.
Several GAAP issues have been difficult to resolve (also true of the FASB and commercial accounting and reporting). Two major issues include (1) defined benefit pensions and other postemployment benefits (OPEB), which historically had been ignored and represented major obligations; and (2) the reporting entity and the concept of component units. The fundamental problem with pension accounting is the need to estimate many items far into the future and determine what obligations exist on the current balance sheet and what additional obligations were associated with the current year. Both the GASB and FASB have revisited this issue and changed the calculations and reporting requirements. The same basic issues exist for OPEB—the biggest is the impact of health care costs.19 Early pension or OPEB GASB statements included Nos. 4 and 5; updates and revisions include Nos. 12, 25, 27, 43, 45, 50, 67, 68, 73, and 82. Consensus proved to be hard to achieve and maintain.
The GASB first addressed the reporting entity issues early in GASB Statement 14, issued in 1991. The most important issue is financial accountability of the primary government relative to joint ventures (and other jointly owned or government entities) and “standalone governments”—such as special districts. Troubling concerns are what entities to include and how to report them. The component units can be reported in separate columns of the combined financial statements plus detailed footnotes. GASB reporting entity GAAP was revisited in Statements Nos. 34, 39, 61, and 80.
Government and Business
Under the U.S. Constitution, business faced few government restrictions initially and virtually none at the federal level. Mainly governments maintained property rights and contract enforcement. Early business abuses such as predatory pricing or wildcat banking were handled at the local or state level with mixed success. By 1850 few big corporations existed and none on a national scale. Business was regional and regulated at the state level. By the end of the century, many mammoth enterprises existed with monopoly power either through consolidation or conspiracies.
New federal regulations followed progressive movements beginning with the Interstate Commerce Commission Act of 1887 and the 1890 Sherman Act. Additional early 20th-century regulations followed downturns and election of progressive President Woodrow Wilson, creating the Federal Reserve and the Federal Trade Commission, and strengthening antitrust with the Clayton Act. Substantial regulation of finance and investment markets had to wait until the New Deal following the Great Depression. Legislation created the Securities and Exchange Commission, the Federal Deposit Insurance Corporation, and separation of commercial and investment banks. Additional social legislation followed, including Medicare in 1965 and the Environmental Protections Agency in 1970.
The same pattern followed in the 21st century. Innovation gave rise to the tech boom and bust, followed by securitization and an exploding derivatives market resulting in the near collapse of world finance and the Great Recession. The attempted fixes were the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Act of 2010. Regulation typically followed innovation and abuse, which proved partially effective until a new cycle ran its course: innovation, followed by euphoria and manipulation, bust and prosecutions, finally new legislation.
Nonprofit Organizations
Millions of nonprofits (NPs) exist in the United States and countless non-governmental organizations (NGOs) operate around the world. Various industries developed large NP components and each evolved unique accounting and reporting rules. NPs share three characteristics: lack of a profit motive, no transferable owner interests, and (hopefully) provide needed social services. Three major NP industries include (1) colleges and universities, (2) nonprofit hospitals and other health care entities, and (3) voluntary health and welfare organizations. In addition are others hard to categorize. Historically, each had an organization establishing accounting and reporting guidelines and the American Institute of Certified Public Accountants (AICPA) developed a separate audit guide for each. Specific funds used and how transacted were treated differently by industry, in part because of the unique focus of each. Hospitals charge for services and accounting followed commercial accounting. Charity organizations (under voluntary health and welfare) count on donations as major revenues sources. Colleges have multiple missions (education, research, and various forms of professional services) and several funding sources (tuition and fees, charges for services, government funding, research grants, and donations). Other NPs include religious organizations, political groups, and hobbyists in specialized fields.
As with governments, fund accounting is used, but the use of budgets, full accrual or something else, and other issues vary. A major factor was the distinctive types of transactions used. Budgeting usually is more formal relative to commercial firms, but less than governments. Without a profit motive, financial control procedures (such as strict budget compliance and use of restricted funds) become more important. The bigger ones usually are run by governing boards and operations placed in the hands of professional managers. As with governments and commercial firms, NPs must be accountable to constituents (and possibly to governments agencies and the public).
The FASB jumped into the NP accounting fray in 1987 by issuing Statement No. 93, Recognition of Depreciation by Not-for-Profit Organizations. Effectively, FASB has been setting NP GAAP ever since.20 Presumably, NP accounting should be more in line with commercial firms than governments. FASB Statement No. 117, Financial Statements of Not-for-Profit Organizations (1993) requires three statements: financial position (balance sheet), statement of activities (equivalent to an income statement), and a statement of cash flows. Net assets (assets less liabilities) are (1) unrestricted net assets, (2) temporarily restricted net assets (usually restricted for specialized purposes in specific periods), and (3) permanently restricted net assets (endowments, where only the income can be used for specified purposes). Separate funds are suggested for each.
The GASB did not consider government-related NP GAAP as the proper role for the FASB and basically took over GAAP for public colleges and universities and some others. This meant that accounting standards for public colleges (such as Texas A&M University) would differ from private colleges (such as Harvard)—not great news for analysts trying to evaluate colleges as a single industry.
NPs, according to the IRS, included charitable organizations, churches and other religious organizations, political organizations, private foundations, and others.21 Most of these are tax exempt (those operated exclusively for “exempt purposes”) as 501(c)(3)s. Donations to these organizations generally are deductible from income taxes. To maintain tax-exempt status, an NP making over $50,000 annually must file an annual financial return, Form 990—first introduced in 1941. The IRS released 990 information on 1.8 million NPs in 2013 (which are useful for financial research on these organizations). Political organizations (political parties, campaign committees, political actions committees) are called 527 organizations, with specific requirements and subject to some taxes.
Across the globe, NGOs are independent of government, generally funded by donations, and provide some social purpose. Because so many activities can be considered NGOs, a long list of acronyms developed: BINGO (business-international or business-friendly NGO), TANGO (technical-assistance NGO), DONGO (donor-organized NGO), MANGO (market-advocacy NGO), and on and on. The term NGO was coined in 1945 about the time of the creation of the United Nations, although NGOs go back at least a couple of centuries dealing with such issues as antislavery, disarmament, and women’s suffrage. Global structures after World War II such as the International Monetary Fund and World Bank focused on capitalism. NGOs, on the other hand, often turned to humanitarian issues (health care, relieving starvation) and sustainable development.
Many technical problems exist related to government and nonprofit accounting and financial reporting. However, the major consistent issues are monitoring and transparency. Answers involve the optimum level of financial and performance auditing, governance (especially by government boards), regulation, and transparency. A major thrust in the United States has been annual reporting requirements, with other developed countries usually following with a substantial lag. The federal government had a census requirement in the Constitution, and substantial accumulation of economic and financial data beginning in the 1790s. The SEC basically started with annual auditing and financial reporting requirements. Presumably, federal agencies and departments report annually, but the Defense Department was declared unauditable and other agencies had less than stellar records. With the requirement of Form 990 for NPs considerable transparency has been added to NP operations and financing. The push for continued transparency and monitoring is expected to continue.