When someone wants to evaluate a municipality’s financial condition, they usually turn to the organization’s financial statements and budget reports. While both documents contain useful information, seldom is such information sufficient to obtain the clear and complete picture a reader seeks. Often, consumers of such information are left with countless questions not addressed in the two documents. Worse, sometimes the relationship between the two documents is so murky, it is difficult for a reader to formulate relevant questions.
Much can and should be done to improve financial statements and budget reports as forms of communication to the public; however, there are several misconceptions about these documents that exacerbate a reader’s confusion and hamper those who seek to reform financial reporting and budgeting.
Myth #1: Financial statements play a key role in budget decision-making.
This assumption is credible because we cannot imagine organizational leaders in the private sector who would act without considering the effect of their decisions on the organization’s financial statements. In contrast, municipal budget decision-makers focus almost exclusively on short-term cash and fund balance impacts – and not on the projected effect of their decisions on financial reporting. Have you ever heard a city council member ask: “But how will this decision affect the city’s balance sheet (Statement of Net Position)?” Have you ever witnessed a budget presentation in which the budget manager explained: “This is how the proposed spending plan will impact the city’s Unrestricted Net Position”?
Even the use of financial statements in projecting cash and fund balance impacts is often superficial. Budgets for the upcoming year should start with the prior year’s ending (audited) balances, and the organization should have a reliable way to project ending balances for the current year. In practice, many municipalities fall short in one or both of these practices. Evidence of this is found whenever surprise surpluses or deficits are discovered later. Of those organizations proficient in budgeting, few leave a good trail of their rigor, as anyone who has attempted to compare a budget document with the financial statements used as the starting point can attest to.
And then there are those local governments that are delinquent in preparing their annual financial statements. Such municipalities have no opportunity to incorporate current financial information in their budget decision-making. The finance directors or budget managers then face preparing a budget for the upcoming year without the advantage of final figures from the previous year’s financial audit. Such managers are put in the position of not only projecting activity for the current year (a normal step in budgeting) but having to estimate key financial results for the previous year. Building budget projections from estimated rather than actual numbers compromises the reliability of the budget as a tool for allocating financial resources.
If financial statements do not contribute to decision-making, why do municipalities produce them? In many municipalities, financial statements are prepared and audited chiefly as a matter of compliance. Annual audits are required by bondholders, government codes, and municipal policies that incorporate best financial practices. Municipal officials’ focus on financial statements as compliance documents overshadows the use of these documents to communicate financial information and precludes such statements from playing more than an incidental role in budget decision-making.
Myth #2: The budget is a planning tool.
Some elements of municipal budgeting processes resemble planning, and financial planning is often cited as one of the purposes of creating a budget. However, it is a mistake to interpret budget results without regard for other overriding budgeting considerations.
For example, a city may end the year with a large budgetary surplus. Is such a result evidence of poor planning because the budget projections were significantly off target? Not necessarily. The budget also serves as legal authorization to spend. As such, it is not a prediction of what will happen. City management may not believe that they will fill all of their personnel vacancies during the year, but they need to retain the ability to spend those monies to the extent they do fill those open positions. Also, the fact that a city ended the year with no significant difference between budget projections and actual performance is not evidence of good planning. It may simply be that budget authorizations were changed throughout the year to match actual spending.
Myth #3: The budget reflects an organization’s priorities.
The development of the annual budget requires the finance director or budget manager to evaluate the municipality’s immediate financial commitments. Such commitments may or may not be closely connected to the organization’s priorities. Whenever I began to prepare a municipal budget, I quickly found that nearly all (if not all) of the organization’s revenues were already committed by (1) labor agreements; (2) other contractual obligations; and (3) programs that would take several months or years to curtail.
Even the claim that a budget reflects the organization’s priorities provides little assurance that the spending plan is appropriate. Municipalities describe their priorities in broad (and sometimes vague) terms such that almost any organizational expenditure can be justified. I witnessed this during a priority-driven budget process where city staff spent hundreds of hours analyzing the organization’s activities to ensure that the budget reflected the city council’s declared priorities. The owners and advocates for each program and service could always find a way to establish a link between their activities and at least one goal of the city council.
Myth #4: Together, a municipality’s financial statements and budget documents provide a complete financial picture.
When I needed to assess an unfamiliar municipality, I pored over its financial reports. Upon completing my financial review, I realized that I had learned many financial facts about the organization, but I did not know how to assess these facts. Something important was missing. Financial statements are often consistent with governmental accounting standards but neglect to provide the reader with a rich and full context description of the organization’s financial activity. For example, it is typical for financial narratives to note that a given financial metric increased or decreased without explaining why it increased or decreased or, most importantly, why it matters that it increased or decreased.
In the government budgeting world, there are no formal rules or standards. Many municipal budgets are homegrown products that reflect the organization’s legacy approach to resource allocation. In some organizations, budget schedules are presented in great detail, while in others, the public presentation is limited to a summary form. There is no requirement that the budget format be consistent from year to year, thus making analysis of budgets across a period of years very difficult.
As a result of the limitations of municipal financial reports, I was dependent upon extensive interviews with several people across the organization to gain a genuine understanding of the municipality’s financial condition. If it was challenging for me – an insider with access to key municipal personnel – to grasp the full financial picture, one can imagine the obstacles those outside the organization faced.
So, in light of these misconceptions, what should we and our municipalities do to address the deficiencies in budgeting and financial reporting? And what other problems might municipal officials have created by using inadequate decision-making tools?
First, municipal officials should integrate their budgets with their financial statements and, once completed, demonstrate that they have done so. Finance directors and budget managers should explain the links that exist between the budget and financial reporting. They should also explain how annual budgets will impact the organization’s financial statements. Such actions require the organization to produce timely financial statements, employ consistent naming conventions (e.g., fund balance, reserve balance, etc.), and maintain a stable and comprehensive format for budget presentations.
We all should recognize that there are legitimate financial management challenges for government organizations. The Governmental Accounting Standards Board has issued over one hundred statements guiding financial reporting. Budgeting has become increasingly complex as municipalities have taken on new, diverse activities. (More activities mean more accounting funds to track, report, and budget for such activities.)
On the financial statement side, there is no easy way to reconcile the complex regulatory requirements with the demand for current, useful information. The statements must satisfy prevailing auditing standards before the independent auditors approve their release to the public. Municipal officials are generally satisfied to complete their financial statements on time and have little capacity to delve into ambitious initiatives to improve the usefulness of the financial narratives.
On the budget side, some municipalities look to a two-year budget to reduce the workload on staff and the governing board. But a two-year budget only works for organizations that have mastered one-year budgets. Further, a two-year budget creates additional challenges to ensuring that the budget is tied to actual financial reporting as it becomes available.
Are budgeting needs and accounting requirements intractably overwhelming, or have municipalities taken on more than they can effectively manage, budget, and account for?
Municipalities have undertaken commercial services (sometimes including business-type investments) as well as many activities that were previously relegated to nonprofit organizations. Yet, they have resisted the financial accountability for their assets (early 2000s) and their pension obligations (mid-2010s) that at the time was, well-established in the private sector. Local governments struggle to manage these activities in part due to their having to endure the bureaucratic burdens that are appropriate for a legislative body with enforcement powers (e.g., public meetings and public records requirements), but that leaves them ill-equipped to deliver a diverse array of complex services. And, since we are focusing on the effective use of financial information, municipalities close their books annually – a frequency of 1/12 of that of equally complex private sector organizations. (Note – the presentation of monthly or quarterly budget vs. actual reports should not be confused with a full accounting close from which financial statements can be produced.)
Budgeting and financial statement reform cannot be complete without municipal officials’ commitment to examining the decisions that they have made without regard to their full impact on the organization’s financial statements, impacts which affect taxpayers and ratepayers. Thus, the much-needed reform in governmental financial reporting and budgeting should be accompanied by a similar reform of the scope of activities that our municipalities have taken on.
Mark Moses has thirty years of experience in local government administration and finance. His recent book, The Municipal Financial Crisis – A Framework for Understanding and Fixing Government Budgeting, was published by Palgrave Macmillan in 2022 and is available from online booksellers. Website: http://munifinanceguy.com/ Twitter: @MuniFinanceGuy