Analyzing Government Financial Health by Using Financial Statements

There are several types of financial disclosure that will offer valuable financial information about government agencies. They include:

  • Budgets (sometimes including Capital Plans)
  • Comprehensive Annual Financial Reports
  • Pension system and OPEB plan reports
  • Interim updates
  • Open checkbooks
  • Employee payroll data

Two of the most useful documents are budgets and “CAFRs” (comprehensive annual financial reports). Here are the differences between the two:

Budgets:

  • Produced by almost all governments
  • Hard to compare with other governments
  • Often covers general fund only using cash basis of accounting
  • No independent review
  • Forward looking

CAFRs:

  • Produced by governments that issue municipal bonds and/or spend more than $750k in federal funds
  • Standardized presentation as specified by GASB
  • Includes government-wide financial statements using accrual basis
  • Reviewed by independent auditor
  • Backward looking – using actuals

Another way to evaluate the financial health of a government agency is to use credit ratings. While credit ratings are useful, there are drawbacks.

Why not just use credit ratings?

  • Many local governments are unrated because they don’t issue bonds or choose not to pay for a rating
  • Different rating agencies use different criteria, so it may not be appropriate to compare one city’s S&P rating with another city’s Moody’s rating
  • Rating agencies heavily weight local economic conditions, but governments in affluent areas can go bankrupt as Orange County showed in 1994

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COMPARING TWO CONSOLIDATED ANNUAL FINANCIAL REPORTS

In order to point out what to look for on CAFRs using two examples, what follows is a look at the CAFRs for two California cities, Fremont and Stockton.

Here is some general information about Fremont and Stockton. In general these selected indicators seem to suggest that Fremont is in better financial shape. But looking into the CAFRs will show a different story.

Moving on to have a look at the CAFRs for Fremont and Stockton, these can be found on any city or agency website in the financial or “finances” section. They can usually be found directly by Googling the name of the agency followed by “CAFR” or “consolidated annual financial statement. Here are the covers of the CAFRs for these two cities:

CAFRs often run 200 pages or more, but there are certain key portions to look at:

  • Government-wide Financial Statements
  • Governmental Fund Financial Statements
  • Pension, OPEB and Long Term Debt Footnotes
  • Audit opinions (in rare cases they are adverse)
  • Ten year financial trends

The “Statement of Net Position” offers an excellent snapshot of the agencies balance sheet, showing their assets and liabilities. As can be seen (below), Fremont’s statement of net position shows large liabilities for pension and OPEB (other post employment benefits, usually retiree health insurance). Their “unrestricted net position,” i.e., the difference between their total assets and their total liabilities, is negative, indicating the amount of their liabilities exceeds the amount of their assets.

The next example, the Statement of Net Position for Stockton (below), shows a very different financial picture. They have no OPEB obligations, and their unrestricted net position is positive.

Along with the balance sheet, or “Statement of Net Position,” the other fundamental financial statement is the income statement, or “Statement of Activities.” The next table compares Fremont and Stockton’s activities.

When examining a Statement of Activities, it is important to differentiate between the “general fund,” which includes all the traditional departments such as police, fire, code enforcement, etc., and the “business activities” such as water or sewer utilities, parking garage operations, etc. These business activities are typically tracked on separate statements.

The next two images show how important information can be found in the footnotes. In both cases below, the footnotes concern the pensions. The first, for Fremont, includes the disclosure that the required safety plan pension contribution was equivalent to 47 percent of payroll.

This next pension footnote, for Stockton, show that the city has embarked on a “PARS” program. PARS stands for “Public Agency Retirement Services,” a provider or “enhanced” pension plans. These potentially costly supplements to the traditional negotiated pension benefits should be looked into very closely in any diligent analysis of agency financials.

Another area where footnotes to agency financials can be very illuminating is with respect to “OPEB,” or Other Post Employment Benefits.” As can be seen below, the OPEB footnote for the City of Fremont indicates they are valuing their OPEB liability using a very high discount rate. The present value of future liabilities for retiree health care costs should not be discounted at a high rate unless the plan is well funded. But typically OPEB plans are not well funded, which is one of the reasons they use a lower, more conservative discount rate. This is a red flag.

Long-term liabilities, or “obligations” in government parlance, is another critical area, since these long-term obligations indicate how much debt the agency is carrying, and how much they have to pay to service the debt. The chart below shows the long-term obligation for the City of Fremont:

The next two charts show the long-term obligations for the City of Stockton. In Stockton’s case, an example of something evident on their statement of long-term obligations that should trigger further analysis are their parking bonds.

The 2004 Parking Bonds were issued in the amount of $32,785,000 by the SPFA on June 25, 2004. As of June 30, 2018, the 2004 Parking Bonds totaling $28,600,000 are due in annual installments of principal ranging from $745,000 on September 1, 2018 to $2,950,000 on September 1, 2034, with interest rates ranging from 4.70% to 5.25%, and a final maturity date of September 1, 2034. The 2004 Parking Bonds were issued to finance the construction of the Stockton Events Center Parking Structure, the Edward S. Coy Parking Garage, and other parking facilities within the Parking Authority. The above bonds, held by investors, while still outstanding has been replaced by an alternate liability of the Parking Authority (“Authority”), which at June 30, 2018, has totaled $24,970,449, and was due in installments ranging from $301,540 to be paid in FY 2019 and $1,795,823 to be paid in FY 2047.

Another useful way to get information from a government agency CAFR is to view trends. The chart below, drawn from Fremont and Stockton’s CAFRs, shows their revenue trends over the past ten years, including at the bottom the average rate of annual revenue growth. Amounts are in thousands.

Here are some metrics that can be useful to determine if a government agency is headed for a fiscal crisis:

  • General Fund Balance / General Fund Expenditures
  • Interest or Debt Service Costs / Total Revenue
  • Long-term Obligations / Total Revenue
  • Unrestricted Net Position / Total Expenditures
  • Annual Change in Total Revenue

In the case of Fremont and Stockton, some of these metrics indicate there could be trouble. Fremont’s liabilities exceed their assets, giving them a negative Unrestricted Net Position / Total Expenditures. Both cities have long-term obligations that are more than twice their annual revenue.

When a city owes more than twice as much in debt as they collect in annual revenue, they are at risk of default. The U.S. map (below), shows how common municipal bond defaults were during the period between 1920 and 1939. If another severe economic downturn were to strike the U.S., the ratio of Long-term Obligations / Total Revenue will be a good indication of which cities will be able to service their debt, and which may default.

In all there were over 5,000 defaults between 1920 and 1939, heavily concentrated in specific states, esp. Florida, the Carolinas, Arkansas, Louisiana, Texas, New Jersey, Michigan, Ohio and California. No defaults were reported Maryland, Delaware, Connecticut, Vermont or Rhode Island.

U.S. Municipal Bond Defaults: 1920-1939 (yellow = special districts, red = school districts, green = cities, states and counties).

To find CAFRs and Related Information:

SENATE BILL 598 – Making Government Financial Statement Analysis Easier

The Vision:

  • The world would be a better place if we had a database of standardized government financial statistics based on audited financial reports available at low or no cost
  • This would reduce the cost of rating state and local governments, conducting state oversight and producing public policy research
  • By migrating documents from paper-like PDFs to a structured text format like XBRL, we greatly lower the cost of maintaining a public database

Florida’s XBRL Legislation serves as an example:

  • Florida HB 1073 (2018) empowers the state’s CFO to migrate local government filings to XBRL
  • CFO issued a Request for Proposals (RFP) to create an XBRL taxonomy or taxonomies for Florida local government financial reporting
  • This RFP was posted on April 1 at http://www.myflorida.com/apps/vbs/vbs_www.ad_r2.view_ad?advertisement_key_num=145915 and an addendum was added on April 17
  • Anticipated decision date is May 28 and contract start date is June 7

Overview of Proposed California Legislation (SB 598):

  • California SB 598 (2019), the Open Financial Statement Act, would transition the state and 1500+ local governments to Inline XBRL filing.
  • Introduced by Senator John Moorlach who now sits on the California Debt and Investment Advisory Commission.
  • As amended, the bill creates a commission that would investigate the feasibility of implementing an XBRL taxonomy and switching all CAFR filers over to Inline XBRL. It would report to the legislature at the end of 2020.
  • Commission would include representatives from the State Auditor, Controller and Treasurer, local governments and private sector.
  • Bill has passed three senate committees and should reach the senate floor by the end of May.

Financial Reporting: Producers and Consumers

Different information consumers have varying and overlapping data requirements.

Local governments often produce three types of annual financial reports: (1) CAFR, (2) State AFR, (3) Census Response. Some financial elements may be antiquated and only collected due to inertia.

FOR MORE INFORMATION

Reason Foundation Pension Integrity Project
Marc Joffe
Senior Policy Analyst, Pension Integrity Project
marc.joffe@reason.org
415-578-0558