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Creative Accrual Accounting in The Public Sector: Milking' Water Utilities To Balance Municipal Budgets and Accounts
Creative Accrual Accounting in The Public Sector: Milking' Water Utilities To Balance Municipal Budgets and Accounts
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 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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98 VINNARI AND NÄSI
The theoretical background of this paper consists of three elements: the concepts
of intergenerational equity and interperiod equity in the public sector, accrual
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CREATIVE ACCRUAL ACCOUNTING IN THE PUBLIC SECTOR 99
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 Näsi, 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 Näsi, 1996). Guthrie et al. (1999) have called for further research
on the claimed potentiality of accrual accounting reforms and their practical
implications.
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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!
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.
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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.
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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.4 Another 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 1975–1993.5 This 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
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Table 1
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Summary of the Profit and Loss Account Information of Water Utility, 1994–2004 (EUR million)
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Turnover 11.55 10.72 11.73 12.83 13.58 13.88 14.35 15.47 15.54 15.63 15.90
Operating Costs −4.75 −4.89 −5.60 −5.60 −5.80 −7.72 −6.6 −7.69 −7.34 −7.44 −7.54
Depreciation −2.85 −2.72 −2.77 −3.21 3.71 −4.08 −4.20 −4.51 −4.56 −4.56 −4.56
Financial Income 0.05 0.057 0.028 0.011 0.007 0.004 0.005 0.011 0.011 0.018 0.016
Table 2
Owner City’s Basic Capital in Water Utility and the Compensation Paid for it, 1994—2004
1994 1995 1996 1997∗ 1998∗ 1999 2000 2001 2002 2003 2004
Basic Capital, EUR million 31.90 31.40 31.40 24.34 25.16 25.16 25.16 25.16 25.16 25.16 25.16
Compensation, EUR million 2.51 2.63 2.66 3.53 3.53 3.36 3.19 3.19 3.19 3.19 3.19
Compensation, % of basic capital 7.9 8.4 8.5 14.5 14.0 13.4 12.7 12.7 12.7 12.7 12.7
VINNARI AND NÄSI
Compensation,% of turnover 21.7 24.5 22.7 27.5 26.0 24.2 21.8 20.6 20.5 20.4 20.0
Note:
∗
Value of Basic Capital changed due to revaluation of fixed assets.
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Table 3
Value of Water Utility’s Infrastructure Assets According to Different
Valuation Methods and Valuators in 2005
Figure 1
Sale of Water Utility to Energy Company
Without this creative accounting procedure, Owner City’s budget for the year
2005 would have shown a deficit of EUR 19.69 million and a cumulative deficit
for the period 2004–2007 of EUR 42.63 million, contravening the Finnish Local
Government Act. When the ‘sale’ of Water Utility to Energy Company is included
in the figures, the City’s budgeted surplus for 2005 becomes positive (EUR 102.61
million) and the total balance for 2004–2007 is EUR 79.67 million7 (see Table 4
and Figure 2). The surplus for 2005 is sufficient to cover the deficit spending
and balance the budget and accounts for some years to come.
According to the City Mayor’s pronouncements, the aim of the sale was to
ensure the positive development of both Water Utility and Energy Company
under City ownership (Regional Newspaper, October 27, 2004). Other public
arguments for the sale were synergy and taxation benefits as well as emergency
relief for the City’s budget deficit and a stable income for the City for at least
fifteen years. The budget figures of Owner City for the period 2004–2007,
including Extraordinary Income from the sale of Water Utility in 2005, are
presented in the Appendix.
Energy Company had previously paid the City dividends, meaning that it had
had to show a profit on its P/L Account and pay the normal corporation tax of
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Table 4
Surplus/Deficit Figures of Owner City, 2004–2007
Figure 2
Financial Statement/Budget and Cumulative Surplus/Deficit Figures of
Owner City, 1997–2008
120
99.4
100 85.7
80 86.3
77.8 78.4
60
Million euros
40
20 7.3
6.4 3.7 7.3
0.4 -5.0 2.1 -13.2 0.6
0
-2.7 -2.4 2.1 1.6
-9.1 -7.3 -5.2 -8.4
-20
-16.9
-40
1997 1998 1999 2000 2001 2002 2003 2004 2005* 2006* 2007* 2008*
Note:
The figures for 2005—2008 are budgetary estimates.
26 percent. After the sale, the dividend requirement was abolished and replaced
with the interest payments on the loan that Energy Company had taken from
the City to finance its Water Utility purchase. This arrangement means that
Energy Company no longer has to show a profit in order to pay dividends, and
thus avoids corporation tax, while the City is guaranteed a stable interest income
during the loan period.
Despite the use of an accrual accounting model since 1997 and the interperiod
balance in its financial accounts, the debt of Owner City has increased steadily
and is likely to grow or stay on the same high level in the future (Figure 3).
The creative sale arrangement did not solve the City’s fundamental economic
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Figure 3
Total and Per Capita Debt of Owner City in 1997–2008
250 2500
200 2000
150 1500
100 1000
50 500
0 0
1997 1998 1999 2000 2001 2002 2003 2004 2005* 2006* 2007* 2008*
problem: more money is being spent on the production and provision of services
than is being collected in revenues.
DISCUSSION
Natural monopolies such as water services utilities are often profitable milch
cows for their owners, usually municipalities or other public entities. Pricing
the services provided by the utilities offers owner municipalities a chance to
hide taxation and to collect revenues to balance deficit spending. In the case
study, the opacity of the financial accounts was caused by the inclusion in the
Finnish municipal accounting regulations of certain concepts that mislead rather
than help the users of financial accounting information. Adopting and applying
generally acceptable accounting principles would therefore be preferable to
nationally devised, tailor-made solutions for the municipal sector.
In the sale arrangement presented above, it seems that Owner City took
advantage of the difficulty of valuing infrastructure assets ‘correctly’ and the
room to manoeuvre provided by the IAS/IFRS and IPSAS norms. According to
the IPSAS definition, an infrastructure asset should be recognized as an asset
when (i) it is probable that the future economic benefits or service potential
associated with the asset will flow to the entity; and (ii) the cost or fair value
of the asset to the entity can be reliably measured (IPSAS 17, 13). The old
municipal water utility infrastructure assets meet the first precondition for the
IPSAS definition of property, plant and equipment, but hardly the second one.
Recognition of infrastructure elements as assets in the absence of generally
accepted and reliable valuation standards has been questioned (Cooper, 1993),
and the need for greater standardization is generally recognized (Lapsley, 1999).
It is claimed that the problems of determining the economic life and economic
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value of such assets are exacerbated in the public sector because the assets
are usually very large and their life may be extended indefinitely when they
are irreplaceable or provide essential services (Pallot, 1990). The difficulty of
valuing infrastructure assets arises from their inherent characteristics, which
include being immovable, part of a system or network, specialized in nature and
without alternative uses, and subject to constraints on disposal (IPSAS 17, 21).
Conversely, the valuation of assets within the neo-classical framework has been
defended on the basis that they conform to an economic definition of capital
goods because they are input set aside for producing output in future periods
(Stanton and Stanton, 1997). It has also been claimed that although market-
based valuation methods are not suitable for service-based public-good assets,
corporatization removes the public-good nature and enables the use of market
approaches to valuation (Bond and Dent, 1998).
Fair value can be defined as:
the amount for which an asset could be exchanged, or a liability settled, between
knowledgeable, willing parties in an arm’s-length transaction, as at the date relevant
for the valuation (IFAC, 2004; Parker, 1992).
The market for water utility assets is practically non-existent, and reliable
valuation based on an arm’s length transaction is a theoretical option only. Thus
the fair values of these assets present a paradox both in terms of their recognition
as assets and their reliable valuation, and so they are often carried on the Balance
Sheet, if one exists, at their initial cost less accumulated depreciation.
In Owner City, the sales price of Water Utility was determined on the basis
of two consulting companies’ assessments of the value of its operations. It is
difficult to assess the validity of the different values, but their wide variation
shows that by changing calculation methods and parameters the desired result
may be obtained. Despite the great difference in the economic and technical
values and the discounted free cash flow values, the former set of values were
chosen to represent the ‘fair’ value and the price of the water utility assets.
In addition to the official justification, another reason for the intra-municipal
sale of Water Utility could be that otherwise under Finnish accounting legislation
the revaluation of the water utility assets would not have been possible. By
matching the sale price to the highest estimated fair value, Owner City was able
to legally increase the value of its water utility assets on Energy Company’s
Balance Sheet. Thus, although the immediate cash flow effect of the sales
operation was zero, during the next fifteen years the cash flow to Owner City
will increase by the interest paid on the loan to Energy Company. While the sale
balanced Owner City’s budget and accounts in the three-year planning period,
as a solution to the financial problems of the City it was short-sighted, makeshift
and unfair. The interest and amortization funds can only be collected from future
water consumers, i.e. from future generations, in the form of higher customer
charges.
Indeed, a plan to raise the customer charges of Water Utility was announced
immediately after the sale plan had been confirmed. According to the then
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Managing Director of Water Utility, the price rise that was to take effect from
the beginning of 2005 was not part of the sale preparations but was instead
an inflation adjustment due to the increased prices of electricity and chemicals
(Regional Newspaper, October 30, 2004). But then, after the finalizing of the sale
in November 2005, Energy Company announced that because of the high cost of
acquiring Water Utility, customer charges for water and wastewater would be
raised each year for the following ten years, with the exact figures to be disclosed
at a later date (Regional Newspaper, November 4, 2005). The sales operation
thus brought about interperiod equity but at the same time, from the standpoint
of future generations, it violated the principle of intergenerational equity.
The sale of Water Utility and the earlier practice of using it to produce income
for the City can be strongly criticized from the perspective of transparency and
accountability, key motives behind the accounting reforms. Both arrangements
conflict with the requirements of the Water Services Act, which states that
the grounds for customer charges should be transparent and correspond to the
actual cost of producing the services. As there is very little economic regulation
of municipal water services in Finland, the responsibility for overseeing their
finances rests on elected municipal council members. Yet understanding the con-
sequences of the accounting transactions involved in the arrangements demands
advanced accounting knowledge, which most municipal council members, not to
mention the residents, cannot be expected to possess. This non-transparency
prevents accounting from fulfilling its key function of accountability (cf. Ijiri,
1975).
Dubious accounting practices cannot be blamed on a specific accounting model
but rather on how it is used. Nevertheless, traditional public sector cash-focused
budgetary accounting did not provide such opportunities for creative accounting
solutions. The misuse of accrual accounting in the case of natural monopoly
industries such as water services could be prevented by a proper institutional
framework of legislation and independent economic regulation.
All in all, it is possible to question the ownership policy and implementation
adopted as part of NPFM by the public sector. In the case presented, Water
Utility’s assets were regarded as the municipality’s, not the residents’, invest-
ments, and the Utility collected a considerable return on the capital invested by
Owner City through customer charges. This approach suggests that the City sees
itself as an investor rather than a provider of essential services, which conflicts
with the notion of a municipality existing first and foremost to look after the
interest of its residents. Furthermore, the restructuring of Water Utility will
inevitably increase water prices and transfer more money from the residents
to the owner municipality. Thus, in effect, the savings of past generations, i.e.,
the investments in Water Utility, are used to cover past and current deficit
spending. Bearing in mind the hundred-year history of Water Utility in Owner
City, it should be remembered that Water Utility was financed and ‘owned’ by
residents and consumers of water, past and present, rather than Owner City.
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CONCLUSIONS
Based on the case study and discussion above, the following general conclusions
can be drawn. (1) Accounting systems, such as public-sector cash-based budgetary
accounting or commercial accrual accounting, are not good or bad per se. The
authors do, however, argue that the application of accrual-based accounting
in the public sector does not guarantee intergenerational equity, transparency
or accountability, but instead opens up new kinds of possibilities for creative
accounting. This contradicts the basic idea of accounting as a means of
providing a reliable, true and fair view of the overall financial situation of the
accounting entity. Thus, public sector accounting practices should be reviewed
and developed further. (2) Uniform standards based on generally accepted
accounting principles are needed to regulate accrual accounting in the public
sector. This concerns specifically the fair value based valuation of fixed assets,
such as the infrastructure assets of a water utility. These present an opportunity
for creative accounting, especially if regulation is based on loose or purposefully
tailored national norms.
APPENDIX
Budget and Financial Plan Figures for Owner City, 2004–2007
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NOTES
1 The City is referred to as the ‘owner’ of Water Utility with the recognition that it is a faceless
administrative entity representing the real owners, i.e., its residents.
2 This was due to the Finnish Expenditure-Revenue theory of accounting, developed by Martti
Saario in the 1940s.
3 Out of a total of 416 municipalities in mainland Finland, 135 had a negative annual margin and
184 had an uncovered deficit in 2005 (Statistics Finland, 2005).
4 To be more exact, a municipal enterprise does not pay Corporation Tax on the business activities
conducted within its owner municipality’s territory. On business activity conducted in other
municipal territories, a municipal enterprise has to pay the municipal and church taxes, which
in 2007 amounted to 6.1828% of taxable income. The normal tax rate for businesses in Finland
is 26%, consisting of the state tax in addition to the aforementioned municipal and church taxes.
5 The residual value of assets that were acquired before 1975 was estimated to be almost zero,
and only the historical cost of those assets acquired in the last 20 years could still be traced in
the bookkeeping.
6 The Finnish Competition Authority, a government agency for promoting economic competition
and efficiency in the public and private sectors, is allowed to investigate the overall level of water
and wastewater charges but its mandate does not extend to specific cost categories such as the
rate of return.
7 These figures have been calculated on the assumption that the sales price was EUR 160 million.
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