Accounting Controls and Bureaucratic Strategies in

Municipal Government

We investigate the degree to which accounting and auditing characteristics in municipal governments lead to
effective control systems, i.e., systems which result in the production of services desired by the clcctorate at
minimum costs. Such control systems are subject to strategic manipulation by the bureaucracy.

The study examines the effects of accounting disclosure and auditing controls on the level of governmental
expenditurcs. We adopt the Gonzalez-Mchay model (GM 1985) from the public choice literature, which rclatcs
governmental expendi- tures to a number of structural and control variables. The GM model assumcs that
bureaucrats have a monopoly over information, disseminating little financial infor- mation outside the burcaucracy
fGM 1985, p. 90). In reality, bureaucrats are subjcct to auditing, budgcting, and public rcporting controls.

We found that budget control (as measured by surplus/dcficit variables) gener- ally supported a strategic
manipulation interpretation, as did total debt (for capital outlays). However, a public accountant’s audit opinion
appears to be an effective control device when an unqualified opinion is obtained. The city manager form of
government, especially when combined with a Certificate of Achievement, also supports a control interpretation. The
results suggest that, as with commercial organizations, appropriate monitoring methods can lead to superior
governmental performance, but that such monitoring methods are subject to capture by agents.

1. Introduction

Several accounting research studies in the last few years have focused on the efficacy of control
systems in principal-agent relationships (such as Smith and Warner 1979 and Healy 1985). Nearly all have
focused on such relationships within commercial firms. An equally interesting area is control of
government agencies. Lacking the discipline of the marketplace, government agencies are subject instead
to control by elected officials and, ultimately, the electorate. This difference in control relationships
implies a potentially unique set of monitoring issues which are of interest to accountants.

Our paper investigates the dcgree to which accounting and auditing arrangements in municipal
governments lead to effective control systems. We propose that an effective control system is one where the
degree of excess spending, as reflected in a larger discretionary budget, is close to zero. We acknowledge
that accounting and auditing controls are subject to capture by bureaucracies. This capture may lead to
strategic manipulation by agents, in which the agcnts subvert thc accounting and auditing controls to mask
their actual activities.
In order to address the issue of the efficacy of accounting and auditing controls in municipal
governments, we have adopted the Gonzalez-Mehay (GM) model (1985) from the public choice literature.
The GM model indicates that governments tend to overspend on public goods r'ir a t.'is the wishcs of the
general public (Gonzalez and Mehay 1985, pp, 90-93). This model has allowed us to proxy for the degree
of expenditurcs in a sample of large U.S. cities, and to test for the relationship between spending levels
and a number of accounting and auditing controls.
In the next section the governmental context is described and public- choice theory is presented. The GM
model is presented in Section 3. Scction 4 develops the specific hypotheses, including accounting-rclated
control devices. Section 5 discusses empirical results. The conclusions attempt to place this project in
perspective and focus on areas with the greatest potential for additional research.

2. Theoretical Development
Our study employs a model from the public-choice literature. The public- choice paradigm combines
economics and political science, in order to evaluate public output decisions based on the incentives of
the major actors involved in the process (Mueller 1975, p. 395). The actors consid- ercd in this analysis
are voters, electcd officials, and bureaucrats (see Figure 1). The public-choice literature specializes in
the complex public sector. The models are actor/incentives-based and thus closely linked to agency
theory.’
Bureaucrats are appointed by elected officials and have only the author- ity granted by the elected
officials. These bureaucrats may dominate public-choice processes with only moderate checks imposed by
legislators and voters, due to the relative incentives of thesc key actors and the

Walpaper

monopoly position of bureaucrats over information. Bureaucrats derive income and perquisites from
performance (Breton and Wintrobe 1975, p. 198), while elected officials’ incentives are associated with rc-
clection potential. The re-election incentives arc gcnerally associated with meeting constituent demands and
rarely relate directly to monitoring the bureau- cracy (Weingast 1984, p. 151).'
In the public-choice literature, the voter is depicted as relatively less informed about political decisions
than about comparable private market decisions. This concept is called rational ignorance (Browning and
Browning 1979, p. 258). According to the economic definition of rational ignorance, voters perceive that
the marginal costs of gathering information exceed the marginal benefits derived from the information
tWatts and Zimmerman 1986, p. 224).
Elected officials, who may be thought of as agents of the voters, are charged with overseeing the
bureaucracy. If elected officials have informa- tion available on the minimum costs needed to produce the
quantity of public goods desired by the voters, they would constrain the bureaucracy to supply this optimal
quantity at minimum cost through the budgeting process.
However, elected officials have little incentive to demand com- plete information due to the rational
ignorance of voters. Conversely, bureaucrats have incentives to maintain a monopoly position over
financial information to maximize their own perquisitcs and increase their discre- tion over public goods
provided. Thus, the bargaining power of the bureaucracy is relatcd to the ability to conceal relevant
information

£Gonzalez and Mehay 1985, pp. 90—91).

The difference between the budget allocated to a specific department and the amount desired by the
voters is a measure of control-loss, the discrepancy between the output provided by the bureaucrats and
the wishes of votcrs fBreton and Wintrobe 1975, p. 199)." There are two components of control-loss: 1)
excess supply of public goods, and 2) inefficient production (primarily associated with shirking). To
eliminate control-loss, both output control and shirking control devices are needed for these respective
problems. The use o1 control devices may allow an output levcl desired by votcrs at the least cost (Toma
and Toma 1960, p. 52; Brcton and Wintrobe 1975, p. 202).

The budget could be used as a control device in this context, i.e., to control costs and provide a
deterrent against the di.stortion of information. The effective use of budgeting has elements of both
output control and shirking control. First, the use of appropriations by department and by line item is a
means of output control.‘ Second, performancc measures can be used to measure efficiency, which is
negatively related to the level of shirking (Niskanen 1975, pp. 63S—639).

On the other hand, it is possible that bureaucrats may adopt a strategy of subverting both output and
shirking controls. As the bureaucracy controls access to information, they may limit control effectiveness.
For example, budget games are well known in the budgeting literature (Anthony and Herzlinger 1975,
Chapter 10). In addition, bureaucrats may limit audit effectiveness through scope limitations.

The GM model (1985) is typical of many recent models built on the Niskanen f1971, 19751 framework.
GM (p. 90) posits that bureaucrats behave as monopolists because governments have the authority to act
in a monopolistic fashion and bureaucrats have the incentives to maximize the discretionary budget of the
bureaucracy. This process is analogous to profit maximization by a monopoly firm. Bureaucrats have a
significant information advantage over other actors (indeed, virtually all relevant information is
generated by the bureaucracy), and face actors with few incentives to challenge the bureaucrats’ actions.
The GM model (1985, p. 90) assumes that no effective monitoring of any type takes place.

Realistically, it is unlikely that thcrc cxists a governmental entity which is not monitored. Federal law
requires state and local governments to have an annual financial and compliance audit. A local
government can obtain an unqualified opinion only if generally accepted accounting principles (GAAP)
are followed, if there are no restrictions on audit scope, and no factors arc known to cxist which would
adversely affect the financial position of the government. If an unqualified opinion is issued, voters and
other financial-statement users can expect full disclosure of relevant fi- nancial information according to
GAAP.

Bureaucrats must comply with federal requirements. Therefore, to limit the effectiveness of the audit,
bureaucrats would have to put up strategic roadblocks. Thcsc could includc the refusal to follow GAAP,
scope limita- tions on the auditors, or insisting on less than full disclosure in the annual report. The result
should be a qualified opinion, detailing the deficiencies noted. Unlike commercial firms, qualified opinions
are common for local governments. In fact, the majority of cities in our sample had indcpendent audit
qualificd opinions. One rcason for so many qualified opinions may be the use of strategic behavior by
bureaucrats.‘

The annual report provides no direct information on the necessary costs to produce the output derived
by the voters at minimum cost. The value of independent auditor’s unqualified audit opinion is that the
camouflaging of the true cost of‘ providing government services is morc difficult, i.e., “as a deterrent against
distortion of information” (Breton and Wintrobe 1975, p. 199a. The expectation is a moderating effect
associated with the indepen- dent auditor’s opinion on bureaucratic behavior fGiroux 19B9, p. 74).

Much of the financial information available to constituents is not subject to GAAP. There is no budget
GAAP, and the information presented in the annual budget is based on political or bureaucratic
decisions. The statistical section of the annual report generally is not based on GAAP. The content of this
section seems to focus on the needs of creditors rather than voters and related constituents. Additional
disclosure on many finan- cial facets potentially goes beyond GAAP requirements, such as pension and
employee-related disclosures. Thus, much of the information pre- sented is based on political needs,
creditor requirements, or other induce- ments rather than GAAP.

3. Accounting Control Devices Using the Gonzalez and Mehay Model

Gonzalez and Mehay f1985, pp. 90—91) assumc that bureaucrats behave as discretionary budget-
maximizing monopolists, based on their monopoly position over information.’ Bureaucrats will maintain
this monopoly posi- tion over information as long as there are no constraints on their ability to exploit this
situation. As pointed out by Toma and Toma: “the difference between the budget that the bureau
succeeds in obtaining and that desired by politicians is the amount of consumers’ surplus appropriated by
the bureau and is therefore a measure of control-loss” (1974, p. 199). The municipality can move toward a
more cost-effective position (i.e., providing scrviccs according to voter preferences at minimum cost) with
improved financial information and effective monitoring. The budget and other accounting information,
as well as the financial and compliance audit, may be viewed as a means of exerting control over the
spending behavior of bureaucrats.

GM 11985, p. 91) assumes that bureaucrats maximize the discretionary budget (DB), where DB —— T —
C[Q]. T represents total taxes and C[@] is minimum appropriation levels to meet voter needs. DB is a
measure of control-loss associated with burcaucratic monopoly ovcr information. Con- sider how a
reduction in the information monopoly held by bureaucrats might be expected to lead to a reduction in
DR. To the extent that elected officials are better able to impose accounting controls (such as budget
controls and auditor opinions) over bureaucrats, elected officials are able to determine the level of
appropriations ncccssary to provide the dcsircd level of services. Thus, the opportunity for excess
spending should decline (Giroux 1989, p. 77).

Our papcr cxpands the GM model to incorporate not only the structural determinants of municipal spending,
but also the accounting and auditing controls which may limit the level of overall spending. In other words,
we test whether the various accounting and auditing controls are effective in limiting DB. The relationship of
these controls to the public-choice model is summarized in Fifi•^e 2.

If the controls are significantly related tin the expected directions to increased efficiency’, this
provides evidence that the controls can moderate control-loss.

However, the bureaucratic information monopoly makes it possible for bureaucrats to engage in
strategic behavior designed to limit the effectiveness of these controls. In the case of an independent
audit opinion and the use of a Big Eight (now Big Six) audit firm, the relative effects of the control and the
strategic behavior cannot be differentiated as the predicted effects are the same for both. In all other
cases the expected effect of controls runs in the opposite direction to that of the bureaucratic strategic
behavior. Table 1 summarizes the expected relationships of the accounting and auditing variables, given
the dominance of the control or the strategic manipulation function.

Section 3.1 discusses the expected effects associated with external audit- ing. Section 3.2 describes the
use of budgetary controls and several strategies which might be adopted by bureaucrats in order to avoid
the discipline of budgetary controls. Next, the expected effects associated with mayor versus city-
manager form of government and the interaction effect of the chief executive with the use of the
Certificate of Achievement are examined. A political competition variable is introduced as a control
factor, followed by a discussion of the relationship between total debt and DB.

Walpaper

3. Auditin8
There is substantial anecdotal evidence of strategic behavior discovered by the auditing process. The
Annual Report of New York City in 1975 claimed that a surplus had been achieved. However, the
independent audit opinion was qualified and a related reconciliation schedule indicated a
$712 million deficit according to GAAP (Giroux and Flory l9fi0, p. 25). The difference represented the
conflict between GAAP and accounting procedures allowed by state law (Giroux and Flory 1980, p. 25).
Federal law forced Boston to undergo its first audit in 1978. The opinion was qualified because accounting
procedures were used which were allowed by state law but not GAAP (Giroux and Flory 1980, pp. 25—
26). The indepen- dent audit report for Chicago in 1982 was qualified. The independent audit opinion stated
that property tax was recognized on a non-GAAP basis and pension costs were underfunded according to
GAAP, although these procedures did not violate state law (Giroux and Flory 1950, p. 26).
New York City’s (NYC) subsequent history demonstrates the moderat- ing effects of the audit as a
control device. NYC is now a leader in financial reporting in accordance with GAAP hand even prepares
budgets on a GAAP basis). The major reason seems to be the adverse political effects associated with
noncompliance with GAAP throughout the 1970s (Goldin 1955, p. 276).
The audit may be identified as both a shirking control (to maintain efficiency) and an output control
method (Toma and Toma 1980, p. 46). In our sample, only 214 of the cities received unqualified
independent audit opinions. Over half the independent audit opinion qualifications were
scope limitations associated with fixed assets, such as the lack of records or ths inability to audit fixed
assets. The overproduction of fixed assets is characteristic of control-loss. Examples of potential shirking
behavior identified by the independent auditor report include the detection of the use of pay-as-you-go
pension plans and other underfunding of pension liabilities, cash basis accounting for employee benefits
(e.g., nonreporting of accrued sick leave or vacation pay), funds which were previously unaudited, and
other non-GAAP procedures. Once these problems come to the attention of the mayor and city council,
voters, and superior government oversight agencies, corrective action becomes more likely. The public
exposure of these problem areas suggests that, over time, the monopoly position which bureaucrats have
over information will erode, unless they can strategically undermine the monitoring function.
OPIN is measured as a dummy variable, where one equals an unquali- fied independent audit opinion.
Furthermore, OPIN is expected to have a negative coefficient under either the effective control or
bureaucratic strategy interpretation. The independent audit is a more effective control device if an
unqualified audit opinion is received, with concomitant lower expenditure levels. If bureaucrats limit audit
effectiveness, a qualified independent audit opinion is expected, associated with highcr spending. If the
independent audit opinion does not measure control effectiveness, the OPIN should be insignificant.
BIG8 is a dummy variable where one equals the use of a Big Eight firm.
Big Eight firms have been associated with a “brand name” effect of a differentiated (higher quality) product
(Francis and Wilson 1988, p. 670; Palmrose 1986, p. 98). Poor audit quality increases the likelihood of
audit failure. Palmrose (1988, p. 61) found significantly lower litigation rates for Big Eight firms and
concluded that the Big Eight firms produced a higher quality audit. A negative coefficient is expected,
assuming that the Big Eight firms indeed provide higher quality audits and, therefore, greater monitoring
potential.
The formal relationship of the financial audit is stated in null form as:

Hi : The II) audit opinian tqualified its. unqualified) and (2) auditor tyf›e

(Big 8 us. non-Big 81 are unrelated to municfpal expendfture leuels..

3.2 Surplus / Deficit Ratios

In an earlier section, we argued that bureaucrats seek to maximize the discretionary budget, in part, to
provide financial slack. Financial slack (a form of shirking behavior) is important to bureaucrats
because 1) it permits rapid response to the demands of constituents, because of the private goods
nature of operating spending, and 2) it provides flexibility when facing the rigid control structure of
budgetary accounting (e.g., laws requiring a balanced budget and appropriations/spending by line
item) (Moe 1984, p. 740). Moe (1984, p. 740) posits that such a resource cushion can be used to maintain
policy coalitions and facilitate a smooth transition as organizations and environments change.
Although Gonzalez and Mehay (1985, p. 93) assume a balanced budget, revenues normally do not equal
expenditures in practice. This provides bureaucrats with a back-door method of expanding DB through
strategic manipulation of budgeted vs. actual surpluses or deficits.
Two surplus/deficit measures are employed in our study. The budget surplus/deficit (BSD), defined as
general fund (GF) estimated revenues/appropriations from the annual operating budget, is used to examine
general fund expenditures. Effective budget control would bring about a negative relationship between
expenditures and budgeted surplus/deficit (i.e., budgeted surpluses should accompany spending which is
lower than would be predicted by the GM model (GM 1985, pp. 93-95)). However, bureaucratic strategic
manipulation can be expected to result in a positive relationship between expenditures and BSD (e.g.,
bureaucrats may treat a budget surplus as a resource cushion, using the cushion to expand DB through
gamesmanship fMoc 1984, pp. 740—742)).
The actual surplus/deficit (ASD) is used to test budgetary control for total current expenditures
(budgeted amounts are not consistently avail- able beyond the general fund), and is defined as total
government rev- enues/total operating expenditures. Here, effective budgetary control is expected to bring
about a negative relationship between expenditures and ASD because limiting expenditures to
appropriations (and, assuming bal- anced budget requirements, to revenues) can be expected to reduce
spending from what it might be without such limitations. Conversely, if there is a positive relationship
between ASD and expenditures, this implies that the bureaucracy has effectively expanded DB, and has
funded it with actual revenues. This expansion comes through bureaucratic gamesman- ship, and indicates
that the preferences of the bureaucrats prevail over those of voters and elected officials.
The null hypothesis is:

H0 . Surplus / de/cu ratios and expendfture leuels are unrelated.

3.3 City Manager and Cenificate of Achievement

The chief executive officer of a city can be either the mayor or a city manager. The mayor is an elected
official and is subject to political competition, the need to serve special interests, and other political factors
associated with re-election. The mayor’s incentives parallel those of the city council and suggest that the
mayor would not control the bureaucracy unless political competition was high (Mayper et a1. 1991, pp. 38
—39). A city manager ECM) is a professional administrator. The interpretation of the incentives of a CM
is mixed. A CM can be considered the chief

bureaucrat, with the bureaucratic incentives of maintaining a monopoly over information. On the other
hand, the CM may be a liaison between the bureaucracy and the city council whose incentives are
associated with administrative efficiency. The CM, under the latter interpretation, would want to
demonstrate and signal competence to elected officials, con- stituents and investors.
A Certificate of Achievement (CA), previously called a Certificate of Conformance, is awarded by the
Government Finance Officers’ Associa- tion (GFOA) for financial reports which conform to GAAP and
disclosure recommendations of the GFOA (Evans and Patton 1983, pp. 156—158). A CA is one measure of
reasonably complete financial reporting and can be considered an accounting monitoring technique. The
CA is voluntary, has been obtained by less than one-percent of all local governments, and has been
associated with the need to issue municipal bonds (Evans and Patton 1953, pp. 156—158). As the
disclosures required to obtain the CA would reduce the information monopoly of the bureaucracy, it is
expected that the CA is associated with lower expenditures levels.
Evans and Patton (1983, p. 160) posit the CA to be a personal accom- plishment of the CM, to
demonstrate and signal the competence of the CM. This is consistent with the liaison position which
would align the CM with voters and elected officials. We explicitly test for the interaction between CM and
the CA. We do so by designating three independent dummy variables: one (MCA) for a city with a mayor
as chief executive and a CA; one (CMNCA) for a city with a city manager and no CA; and one (CMCA)
with a city manager and a CA. The fourth possibility, mayor and no CA, is picked up in the intercept term
as a baseline case. Thus, the significance of the above three interaction variables is by comparison to the
baseline case. For each of the three interaction terms tested, a negative coefficient would be associated
with effective control (that is, the CA or the city manager would be associated with reduced spending).
Alternatively, positive coefficients would indicate bureaucratic strategic manipulation (that is, either the
CA or the city manager would be associated with additional spending).
The null hypothesis is:

H 3: No combfnation of city manager or Certificate of Achfeuement is

related to municipal expenditure levels in excess oJ' the mayor and no Certf9- cate of Achieuemeni
combiHO£fOH.

3.4 Puliticul Competition

Baber (1983, pp. 215—216) argues that elected officials have greater incen- tives to monitor the
bureaucracy when political competition is high. The rational ignorance of voters stems, in part, from the
personal costs of investigating burcaucratic behavior exceeding the personal benefits of doing so. Under
conditions of high political competition, political rivals can be expected to incur the costs necessary to
gather information regard- ing bureaucratic behavior which reflects badly upon the incumbent elected
officials. Thus, elected officials can be expected to more closely monitor the spending behavior of
bureaucrats when competition is high.
 In our study, political competition is measured as the mayor’s percent- age margin of victory in the most
recent election (WIN%), where the higher the percentage, the lower the competition (Mayper et a1. 1991,
pp. 34—37). Because there is a negative relationship between WIN9c and competition, and a negative
relationship between competition and expen- ditures, it is predicted that WINWo is positively related.
The null hypothesis is:

Hz 4 . The lei el of political competition is unrelated to expenditure leuels.

3.5 Total Debt

Long-term dcbt rcprcscnts an alternativc rcsourcc inflow in addition to revenues. It has been presented in
the public-choice literature as a fiscal illusion device which allows bureaucrats to increase spending with
voters being unaware that future taxes will be necessary to service the debt (i.e., interpreted as a form of
spending without taxation) lWagner 1975, p. 46). Log of total dcbt (TD) will be analyzed for capital
outlays. A positive sign is expected if bureaucratic strategy dominates. However, the disclosure of total
debt should moderate further capital outlays, particularly if con- stituents understand the relationship of
new debt to increased taxes. Thercforc, control of capital outlays may be associated with both con- stituent
and investor incentives (Wagner 1975, pp. 51—53).
The null hypothesis is:

H 5 : The let’el of long-term debt fs unrelated tO total capftal outlays.

In summary, five hypotheses and eight accounting-rclatcd and control variables have been tested using the
GM model. The variables have been used to evaluate the effectiveness of controls versus the relative
effective- ness of bureaucratic strategic behavior.

4. The Empirical Model

Based on the analysis presented in the Appendix, the following log-linear model is used to estimate the
base model:

In E, —— In A Btln P, + B, ln PD, + B3ln , + B In iG,

B,PC, + B, In f/, ( l)

where E —— the definition of expenditures; P —— population; PD —— population density; NW —— percent of

nonwhite population; /G — intergovernmental grants to total rcvcnue; PC —— population change, and PI
—— personal income. The model is identical to Fawson and Giroux (1988, pp. 80—81), an extension of GM
(1985).
Three measures of expenditures are used for empirical testing to proxy for public output.’ Total current
expenditures (TCE) includes all operating spending associated with government funds. General Fund
expenditures (GFE) is a more narrow definition of operating spending and excludes all restricted spending,
such as debt service and special revenue expenditures. Capital outlays (CO) represents spending on the
construction and acquisi- tion of fixed assets associated with government funds. As capital spending
represents primarily one-time, long-term infra-structure and related fixed-asset projects, it is likely that the
behavior of this spending category differs from current spending categorics. Capital outlays also may be
associated with the issuance of long-term debt, which may have unique characteristics relative to other
resource inflows.
Five control variables are included in the model. Population density (PD) controls for economies of
density, as spending may relate to land area and changes in land area rather than changing population size
fGonzalez and Mehay 1985, pp. 96-97). Average personal income (PI) is a wealth measure. The demand for
government services should be positively related to the income of the community. Intergovernmental grants
(IG) represents additional revenues obtained from external sources (Gonzalez and Mehay 1955, pp. 96-97).
Previous studies indicate that grants increase local spending rather than provide tax relief‘ (Fisher 1982, p.
329). Percent of non-white population (NW) is a dependency measure to capture differ- ential municipal
services which may be provided (Fawson and Giroux 1988,
p. 82). Population change (PC) measures the percentage change from
1970—1980 and may indicate cities in a disequilibrium position due to lag effects in spending adjustmcnts
to population change. A significant nega-