Current economic conditions, including job losses, illiquid credit markets, an ailing construction industry and reduced consumer spending, have combined to increase risk and uncertainty not only across all private industries, but also in the public sector, including local governments, states and, perhaps most importantly, the federal government.
AICPA Statement of Position (SOP) 94-6, Disclosure of Certain Significant Risks and Uncertainties, and FASB Accounting Standards Codification (ASC) Topic 275, Risks and Uncertainties, require certain disclosures about risks and uncertainties relating to the nature of operations, the use and significance of estimates in financial statements and the vulnerability of financial statements to certain concentrations.
With regard to concentrations, SOP 94-6 requires disclosure when information known prior to issuance of the report has met these criteria:
The concentration exists at the date of the financial statements.
The concentration makes the enterprise vulnerable to the risk of a near-term severe impact.
It is at least reasonably possible that events that could cause the severe impact to occur will transpire in the near term.
Consider a typical small business scenario with Company A, a manufacturer of an electronic component for automotive air conditioners. Company A has one primary customer that generates more than 60% of its annual sales revenue. An auditor of Company A’s financial statements, based on the guidance found in SOP 94-6, would conclude that all criteria have been met to disclose a concentration risk: A concentration of sales revenue exists; the concentration exposes the company to near-term severe impact; and a downturn in automotive sales makes it reasonably possible that such an impact would occur.
Now consider a town with a highway fund that accounts for all road maintenance activity for the town and related debt service. Eighty percent of the town’s revenue for the fund comes from a share of gasoline taxes that are distributed to it from the state. During 2009, in an attempt to balance its own budget, the state cuts the distribution to the town by 90%. The town now faces the prospect of either drastically cutting services to its residents or raising taxes.
In contrast to the Company A example, no concentration disclosure will be found in the town’s financial statements. And while a similar scenario to the one described for the town has played out in thousands of state and local governments over the past couple of years, it is difficult in most cases to assess the extent of intergovernmental financial dependency. This lack of transparency occurs despite the fact that federal funds flowing to state and local governments and state funds flowing to local governments account for a substantial percentage of many of these governments’ budgets. The reason for this lack of disclosure may rest with the belief that intergovernmental revenues are stable and that the risk of events negatively impacting these revenues in the near term is considered low.
That theory no longer holds true. The 2008 economic crisis, subsequent recession, 2011 debt ceiling debate and pending legislative actions to further reduce federal deficit spending have taught us that the fiscal sustainability of all three levels of government—federal, state and local—is no longer a given if spending continues on its current course. We all need to become better educated on the fiscal strengths and weaknesses that contribute to the economic sustainability of our governmental units.
With access to relevant, timely and comparable information on intergovernmental financial dependency, elected leaders of state and local governments will be able to plan in advance for enacted and anticipated shifts in federal funding; proactively address the concerns of rating agencies over potential impacts on fiscal capacity due to the risks of changes in direct and indirect intergovernmental flows; communicate to residents and bondholders with greater transparency; and contribute shared leadership to effectively resolving the deficit spending and debt level problems of the federal government.
As financial professionals, it is incumbent upon us to see through the sound bites and political posturing and gain an understanding of the facts. And, as it turns out, there is plenty of reliable data out there. Let’s start with the “800-pound gorilla” of the public sector—the federal government.
UNDERSTANDING THE NUMBERS
Weighing in at 233 pages, the 2010 Financial Report of the U.S. Government (tinyurl.com/3f9flpl) is not for the faint of heart. That said, as with the reports of state and local governments, there is a Management’s Discussion and Analysis (MD&A) section that covers all of the most essential information on the financial condition of our federal government—and it runs 26 pages. Given the enormous complexity of the federal government and the diverse range of services it provides to citizens, it is tough to determine a “corporate style” bottom line. However, there is a “bottom line” of sorts, and it is clearly spelled out in the 2010 Financial Report, which says, “The projections in this Report indicate that the trajectory of current policy is not sustainable.”
Exhibit 1, extracted from the 2010 Financial Report, illustrates the historical and current projections for federal spending and the huge chasm that is growing between total receipts and total spending because of the growth of noninterest spending and net interest. It is important to note that, under current law, only “discretionary spending” can be changed through normal budgetary mechanisms. Discretionary spending includes defense and just about all other federal spending that affects citizens in their daily lives, including road construction, college grants and loans, health research funds, K-12 education and homeland security.
The remaining expenditures—including Medicare, Medicaid and Social Security—are labeled “mandatory expenditures.” This spending, in effect, is on autopilot unless benefits are fundamentally changed by Congress and approved by the president. The congressional “super committee,” formed as part of Washington’s deal on the debt limit in August, was authorized, when it meets this fall, to begin to tackle unsustainable spending in entitlement programs, as well as reductions in discretionary spending.
THE FEDERAL DEBT BURDEN
With the federal government spending more than its revenues in all but a few of the past 40 years, it has built up a substantial debt. The balance of publicly held debt as of Sept. 30, 2010, was $9.06 trillion, or 62% of annual U.S. gross domestic product (GDP). Certain economists believe that, when viewed in relation to GDP, a debt level of 62% is not that bad, since it’s below the approximate 109%-of-GDP level built up by the end of World War II. Before breathing a sigh of relief, however, one must remember the alarming trends illustrated by Exhibit 1.
The MD&A section of the 2010 Financial Report states that “(i)f current policies are kept in place indefinitely, the [publicly held debt-to-GDP] ratio is projected to exceed 350% in 2085 and to rise continuously thereafter.” The sobering reality is that, depending on how all of the federal government’s liabilities and other financial obligations are grouped, the United States has already reached the 350%-of-GDP mark.
Exhibit 2 is an analysis based on data extracted from the 2010 Financial Report. It illustrates what happens when you lump together all of the federal government’s liabilities as they appear on its balance sheet, including intragovernmental borrowing from the Social Security and Medicare “trust funds,” and combine them with the present value of all future benefit payments to those current and future participants in Social Security and Medicare. As shown, these liabilities and other financial obligations total $51.8 trillion, which is 351% of 2010 GDP. In the end, or until these other promises are altered by law, intragovernmental debt and social services obligations will have to be addressed by the same productive capacity of the nation, as will the repayment of publicly held debt—which makes a case for why these other debts and obligations also should be measured against the GDP yardstick.
Prior to the mid-1960s, the three levels of government—federal, state and local—generally tended their own gardens. The expansion of intergovernmental funding since that time has, however, dramatically altered that model. Using the published reports of state and local governments, the data resources of the U.S. Census Bureau and Bureau of Economic Analysis, and statistical reports of the U.S. Defense Department, the General Services Administration and the U.S. Treasury Department, it is possible to determine key measures of intergovernmental financial dependency as shown in Exhibit 3.
Based on a compilation from the 2009 audited financial reports of 47 states, the percentage of total state revenue that comes directly from the federal government averages 39%. As illustrated in Exhibit 3, federal funds account for between 27% and 49% of the total revenues of Virginia, Colorado, Pennsylvania and Illinois. The economies of these four states also are affected by federal funds flowing directly to their local governments, billions of dollars in federal purchases from businesses located in the states, and payments made by the federal government directly to their residents for salaries and wages, pension benefits, Social Security and Medicare coverage. Exhibit 3 illustrates how these total direct and indirect federal flows range from 19% of real GDP for Colorado to 34% of real GDP for Virginia. Exhibit 4 also illustrates the indirect economic impact of the federal government associated with its ownership or lease of millions of square feet of buildings as well as the presence of military facilities.
Similar measures of intergovernmental financial dependency can be obtained for local governments. For example, in Virginia, direct federal and state assistance as a percentage of total locality revenues was 25% for the cities of Virginia Beach and Richmond in 2008–09 and 32% for Henrico County (see Exhibit 5). Indirect federal flows relating to the purchases of goods and services and payments to individual residents amount to hundreds of millions of additional dollars in revenues for those localities.
Besides the impact of federal funding and payments on state and local governments, the businesses and residents of each state and a variety of nonprofit organizations also are affected by these federal flows. Clearly, we are all in the same boat, including the members of the CPA profession who provide vital services to businesses, governments, organizations and individuals throughout each state.
ADDRESSING THE RISKS
Perhaps the biggest risk from intergovernmental financial dependency is ignoring its existence. Ignoring the federal government’s fiscal problems has allowed the matter to get much worse, and to make the options for resolution all the more painful. From the CPA’s perspective, our challenge is that the clients we serve, most often, do not recognize the buildup of risks within their financial planning and reporting. Very few state and local governments disclose and discuss the concentration of intergovernmental revenues for their entire entity within their annual reports or seek to alert their readers to the risks of such dependency. A continued absence of dependency information will limit the ability of state and local government leaders to take into account the ramifications of such dependency when they seek to institute proactive measures prior to reductions in intergovernmental flows and a possible worsening of the federal debt crisis.
One government that has taken a first step to boost its reporting on intergovernmental dependency is the city of Durham, N.C. The transmittal letter to its annual financial report contains this warning about the risks associated with intergovernmental financial dependency: “The City depends on financial resources flowing from, or associated with, both the Federal Government and the State of North Carolina. Because of this dependency, the City is subject to changes in specific flows of intergovernmental revenues based on modifications to Federal and State laws and Federal and State appropriations. It is also subject to changes in investment earnings and asset values associated with U.S. Treasury Securities because of actions by foreign government and other holders of publicly held U.S. Treasury Securities.”
This disclosure, while generally worded supplemental information, acknowledges the significant nature of intergovernmental financial dependency and alerts the reader to the potential for changes caused by outside forces.
An additional example of how states might approach this issue can be seen in the following illustrative note disclosure based on AICPA SOP 94-6: “During fiscal year ending June 30, 2009, the State received $25.8 billion from the federal government, which is 39.0% of total State revenues reported by the primary government and component units for charges for services, capital grants and contributions, operating grants and contributions, and general revenues. Funds flowing from the federal government to the State are subject to changes to federal laws and appropriations. Based on the reported financial position of the federal government, including disclosures concerning fiscal sustainability, it is at least reasonably possible that events will occur in the near term that will significantly affect the flows of federal funds to the State.”
If one ties this illustrative disclosure back to the reported disclosures within the 2010 Financial Report, it becomes inescapable that states, local governments and virtually all elements of their respective economies are being, and will be, affected by the unsustainable fiscal condition of the federal government.
THE CPA PROFESSION’S INVOLVEMENT
GASB has a project on its agenda called Economic Condition Reporting: Financial Projections (tinyurl.com/3fbjedq). The project’s long-term objectives are to identify the information that users require to assess a government’s fiscal sustainability, to compare these needs with the information users receive under current standards, and to consider whether guidance should be considered for the remaining information. The project includes consideration of the information necessary for users to assess the risks associated with a government’s intergovernmental service interdependencies.
GASB intends to publish a Preliminary Views document this fall that sets forth the board’s thinking on how fiscal sustainability and intergovernmental service dependency issues can be disclosed by state and local governments, possibly as required supplemental information.
While future guidance bearing on long-term fiscal sustainability evolves through GASB’s due process efforts, CPAs preparing the financial statements of state or local governments and CPAs performing attest functions can respond today to the more present and immediate risks associated with intergovernmental financial dependency. Such a response can be developed by applying established GAAP and professional judgment while considering information such as the reported fiscal condition of governments providing intergovernmental revenues and the degree to which the reporting government is dependent on revenues, procurements or other flows received from these intergovernmental sources.
In this regard, state and local governments have several options for reporting intergovernmental financial dependency, which, it is important to note, do not contradict or conflict with GASB pronouncements. In addition to the two disclosures mentioned above, they could include the following information within their comprehensive annual financial reports:
In MD&A, a “description of currently known facts, decisions or conditions that are expected to have a significant effect on financial position or results of operations,” based on guidance within GASB Statement no. 34, Basic Financial Statements—and Management’s Discussion and Analysis—for State and Local Governments (par. 11h), and GASB Statement no. 37, Basic Financial Statements—and Management’s Discussion and Analysis—for State and Local Governments: Omnibus (par. 4).
A note to the financial statements providing “information about the concentration of credit risk … by disclosing … investments in any one issuer that represent 5% or more of total investments,” including securities issued by the U.S. Treasury Department, based on guidance within GASB Statement no. 40, Deposit and Investment Risk Disclosures.
A note to the financial statements citing “probable” future losses in federal and/or state revenues based on enacted legislation and/or “reasonably possible” future losses in revenues based on the reported financial condition of a government providing funding and known activities that are “more than remote” in creating a reduction in intergovernmental revenues, based on guidance within GASB Statement no. 62, Codification of Accounting and Financial Reporting Guidance Contained in Pre-November 30, 1989 FASB and AICPA Pronouncements.
Beyond these specific measures, CPAs who prepare or audit governmental financial reports should seek to understand the conditions reported in the 2010 Financial Report of the United States Government and the comprehensive annual financial reports of the state or local governments in which they practice.
A SHARED CHALLENGE
The CPA community is not alone in helping to bear the task of addressing the federal government’s sustainability issues. Beyond ensuring that their state and local government clients are aware of and are properly acknowledging financial dependency on intergovernmental flows, CPAs have an opportunity to develop an understanding of recent recommendations for reforming federal fiscal practices and the possible implications of recent changes to federal law associated with raising the nation’s debt ceiling and curbing deficit spending.
In November and December 2010, three well-regarded, nonpartisan reports were published that sought to identify reasonable ways in which the federal government’s fiscal sustainability could be restored. Notable among these reports were proposals from the National Commission on Fiscal Responsibility and Reform, which issued its formal report, The Moment of Truth (tinyurl.com/36o9okt), in early December. The commission’s report tackles all of the major areas of government policy that have the most significant impact on future deficits, including discretionary spending cuts, tax reform, health care, Social Security and process reform.
A key point in the report is that all spending and revenue matters must be taken into consideration together. Without doing so, the political and other forces beholden to the status quo will inhibit proceeding with the substantive changes necessary to alter the fiscal trajectory of current policies. Although written in December 2010, well before this summer’s congressional debate, this point still holds substantial merit.
In the words of the report: “We must stabilize and then reduce the national debt, or we could spend $1 trillion a year in interest alone by 2020. There is no easy way out of our debt problem, so everything must be on the table. A sensible, realistic plan requires shared sacrifice—and Washington must lead the way and tighten its belt.”
With major cutbacks in federal spending looming, more attention needs to be paid to the financial interdependency of federal, state and local governments and the impact of potential federal cuts at the state and local levels.
The percentage of total state revenue sourced directly from the federal government averages 39%, based on a compilation of the 2009 audited financial reports of 47 states. Local governments also are highly dependent on federal and state assistance.
Very few state and local governments currently disclose and discuss the concentration of intergovernmental revenues for their entire entity within their annual reports.
The challenge of CPAs is to help government clients better recognize the buildup of risk associated with intergovernmental financial dependency within their financial planning and reporting.
AICPA Statement of Position (SOP) 94-6, Disclosure of Certain Significant Risks and Uncertainties, can be a particularly valuable tool for assessing and disclosing intergovernmental financial risks.
GASB intends to publish a Preliminary Views document in the fall of this year that sets forth the board’s thinking on the disclosure of long-term fiscal sustainability and intergovernmental service interdependency issues by state and local governments.
Elements of guidance within established GAAP can be applied in developing potential disclosures relating to current and historical intergovernmental financial dependency and related risks.
Edward Mazur (firstname.lastname@example.org) is a senior adviser for public-sector services with Clifton Gunderson LLP; and John Montoro (email@example.com) is a partner in the Richmond, Va., office of Cherry, Bekaert & Holland LLP. Taylor Powell (firstname.lastname@example.org), an associate in the Federal Government Assurance practice of Clifton Gunderson LLP, provided research assistance in the preparation of this article. A version of this article originally appeared in the March-April edition of Disclosures magazine, published by the Virginia Society of CPAs.
To comment on this article or to suggest an idea for another article, contact Kim Nilsen, executive editor, at email@example.com or 919-402-4048.