What if most of the public employee compensation enhancements of the past decade or more in California were based on inaccurately optimistic government financial statements? Or to be blunt, what if government decision makers thought they could afford these compensation enhancements, because the information they relied on used accounting gimmicks that would land a person in private industry in jail for fraud?
Back in February the California Public Policy Center (CPPC) published a study entitled “How Lower Earnings Will Impact California’s Unfunded Pension Liability,” where, using various rates of annual investment earnings, the number ranged between $128 billion and $576 billion. This study and others highlighted the fact that starting in 2014, not only will Moody’s Investors Services begin using a much lower investment projection in their credit analysis, but GASB – the Government Accounting Standards Board – will require government entities to recognize this liability on their balance sheets.
Earlier this week, the CPPC published a new study entitled “Unmasking Staggering Pension Debt and Hidden Expense,” that took a look at seven California counties, Alameda, Contra Costa, Marin, Mendocino, Orange, San Mateo, and Sonoma, and restated their balance sheets based on the new GASB financial reporting standards and the new Moody’s credit evaluation criteria. In his analysis of these seven California counties, researcher John Dickerson calculated that the new GASB rules will lower their combined net worth by a factor of ten, from a current reported $10.2 billion to less than $1.0 billion. And all of these losses, in any private enterprise, would have already been recognized.
Starting in 2014, GASB (Government Accounting Standards Board) will require state and local governments to report their unfunded pension obligation as a liability on their balance sheets, eliminating a loophole in their current regulations. It’s about time. The loopholes being plugged by GASB 68 have permitted California’s cities and counties to declare balanced budgets when in fact they were failing to report billions in pension expense.
The study not only calculates the impact of GASB 68, but goes on to estimate the impact of GASB’s new ruling combined with Moody’s new credit evaluation criteria on government financial statements. As Dickerson writes: “These seven counties all together would drop from $10.2 billion of Net Assets down to a negative $8.3 billion hole – $19 billion less. On average, they would have more unfunded pension debt than assets.”
One may argue heatedly as to whether or not Moody’s 5.5% discount rate is too low, but for the moment, let’s forget about the discount rate. Let’s go ahead and accept the long-term earnings projection of 7.5% per year as realistic. This still means that the seven counties analyzed had failed to report over $10.2 billion in liabilities. This still means that across all of California, the state and local governments had failed to report over $128 billion in liabilities. Because $128 billion is the State Controller’s officially acknowledged amount of unfunded pension liabilities.
When financial analysts warn us that the steps GASB and Moody’s are taking will make it harder for cities and counties to acquire credit by erasing most (or all) of their net worth, and will hasten awareness of the need for compensation reform, they’re right. But that’s only half the story: For the last decade or more, as cities and counties were negotiating enhancements to public employee pension plans, and other compensation enhancements – sometimes in council meetings packed with indignant public workers, other times in binding arbitration – they were basing their decisions on financial statements that were inaccurate. Would pension formulas have been enhanced from 2.5% at 55 to 3.0% at 50, for example, if everyone at the negotiating table had been examining city or county financial statements that were correctly recording these billions in losses?
No business can survive for long with bad financial information. Any auditor whose picked apart a few balance sheets, or any general ledger accountant whose closed a few fiscal years, understands how easy it is to commit fraud. If bankers and investors are wary of a company’s financial performance and need to see more profit, an unscrupulous entrepreneur might revalue their inventory to “market value,” and voila, a loss turns into a profit. What GASB 68 is going to prevent might only excite an accountant, but since its consequences affect us all, it’s still a story worth trying to tell.
When many of California’s cities and counties fell behind in their payments to the pension funds, they didn’t record a payable on their balance sheet – because GASB didn’t have a standard in place to force them to. Then when the time came to make the payment, they needed to borrow the money, but they didn’t want to ask voters to approve a pension obligation bond. So they essentially sued themselves, securing a court ruling that documented the fact that they owed the money. This allowed them to characterize the pension obligation bond’s issuance as a refinancing of existing debt, avoiding the need to submit the bond to voters for approval. Then (accounting wonks, pay attention here), when they put the pension obligation bond debt onto their balance sheet as a liability, because they had not recorded a preexisting payable to the pension fund, instead they put the debit onto the top of the balance sheet as an offsetting asset, which they are slowly amortizing. GASB 68 will wipe all of this out, creating billions in extraordinary losses that will mostly be declared in prior period adjustments of past financial statements.
This sort of behavior violates fundamental accounting concepts, most particularly, matching expenses to the time they are incurred. But during the 1990’s and since, it allowed cities and counties to avoid placing billions in losses on their income statements. And that allowed public employee unions, politicians, and arbitrators, to all make decisions based on flawed, overly optimistic financial information. And it enabled what is now a legacy of contracted compensation enhancements that are considered by their supporters to be beyond even the power of a bankruptcy court to amend.
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UnionWatch.org is edited by Ed Ring, who can be reached at email@example.com