Financial Accountability & Management, 24(2), May 2008, 0267-4424 CREATIVE ACCRUAL ACCOUNTING IN THE PUBLIC SECTOR: ‘MILKING’ WATER UTILITIES TO BALANCE MUNICIPAL BUDGETS AND ACCOUNTS ă EIJA M VINNARI AND SALME NASI∗ 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 adoption of NPM ideology also involves attempts to streamline the public sector and reduce its costs Very often the core public sector has been reduced by separating the units producing utility-type services, such as energy ∗ 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 2008 The Authors Journal compilation C 2008 Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA C 97 98 ă VINNARI AND NASI and water services production, into public enterprises or public companies, which then operate as result-controlled responsibility or profit centres and accounting entities on commercial lines The formation of public enterprises can be considered an intermediate phase on the way towards the probable ultimate outcome of NPM: the privatization of most publicly owned utilities The purpose of this paper is to explore and analyse the effects of the two aforementioned types of NPM reforms: accountingization, i.e the application of business-sector accounting models in the municipal sector, and the formation of profit-making municipal enterprises More specifically, the paper aims to determine whether these reforms have succeeded in attaining the oft-cited goals of increased accountability, transparency and intergenerational equity, or whether, on the other hand, any indications can be found of the contradictions, ambiguities and paradoxes that have been suggested to underlie NPM reforms (e.g., Olson et al., 1998) These questions are investigated through an in-depth explanatory case study set in the context of Finnish local government, a city and the city’s water utility The analysis in this paper is based on the financial statements, budgets and other official documents of the case city and its water utility Newspaper articles and information obtained through discussions with city officials are also used as empirical data Even though the analysis is to a large degree founded on accounting techniques, the study represents interpretative and to some extent critical accounting research (Burrell and Morgan, 1979; Chua, 1986; Hopper and Powell, 1985; Baker and Bettner, 1997; and Ryan et al., 2002) The authors’ view is that the heterogeneity of accrual accounting applications may lead to creative accounting solutions especially in the public sector context, with the consequence that accounting information is not sufficiently transparent, users may be misled, and accounting does not properly fulfil its accountability functions The authors are critical (cf Mouritsen et al., 2002) and wish to facilitate ordered change towards more straightforward practices This paper therefore contributes to national and international efforts to develop and improve public sector accounting principles and practices The paper proceeds as follows The second section presents the concepts of intergenerational and interperiod equity, accrual accounting, and creative accounting, which provide the theoretical background for the research The third section describes the case, the sale of a public water utility (henceforth referred to as Water Utility) to a public energy company (Energy Company) by the parent or owner of the two aforementioned units, Owner1 City (or the City) The fourth section analyses the sale, its motivations and consequences in the light of the theoretical framework provided, and the final section sets out the authors’ conclusions THEORETICAL BACKGROUND The theoretical background of this paper consists of three elements: the concepts of intergenerational equity and interperiod equity in the public sector, accrual Journal compilation C C 2008 The Authors 2008 Blackwell Publishing Ltd 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 Năsi, 1999) This, in turn, requires balanced annual budgets a 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 Năsi, 1996) Guthrie et al (1999) have called for further research a on the claimed potentiality of accrual accounting reforms and their practical implications 2008 The Authors Journal compilation C C 2008 Blackwell Publishing Ltd 100 ă VINNARI AND NASI Following the spread of NPFM ideologies, governments in many countries have adopted business sector accounting thinking and models, not only in public enterprises but also in the core functions of the public sector (e.g., Guthrie et al., 1999; OECD, 2002; Christiaens, 2003; Schedler, 2003; Lăder and Jones, u 2003; Groot and Budding, 2004; Ridder et al., 2005; and Paulsson, 2006) In the field of financial accounting, this can be seen in the application of accrualbased accounting and financial reporting, including an income statement, a comprehensive balance sheet and a statement of financial inflows and outflows The driving forces behind such reforms have been identified as the wish to instil greater financial awareness into public sector decision-making, to provide comprehensive financial information to facilitate efficient and effective decisions, and to provide information that allows citizens and other stakeholder groups to assess the extent to which revenues meet the full costs of public service provision (Guthrie et al., 1999; Stalebrink and Stacco, 2003; and Connolly and Hyndman, 2006) Politicians, financial institutions, management consultants, scholars, the media, and international organizations have all been influential in bringing about these reforms (Pina and Torres, 2004) However, accrual accounting is not just one specific accounting model There are many versions of it; starting with static and dynamic theories and models In Finland, until the obligatory adoption of IAS/IFRS by quoted companies in line with EU policy, prevailing accounting thinking in the business sector was strongly dynamic in nature.2 The Finnish municipalities adopted the dynamic accrual accounting model in their financial accounting reform in 1997, and they are still using it today The core of the Finnish dynamic accrual accounting model lies in the categorizing and recording of transactions, i.e the bookkeeping of revenues, expenditures and finance transactions, and in periodic income measurement Transactions are measured and recorded at their historical costs and at the exchange prices of the transaction date The matching principle is applied in the closing of accounts, i.e expenditures are matched against the corresponding revenues to calculate annual income (cf e.g., Skousen et al., 1991) The Profit and Loss (P/L) Statement is the primary financial statement in dynamic accounting thinking, and the Balance Sheet has more or less only the role of transferring the balances of different assets and liabilities accounts to the next accounting period The municipal accrual accounting model in Finland differs from the businesssector model in several ways, an important one of which is a terminology tailored for the local government sector only This concerns, for instance, the terms describing the intermediate results on the P/L Statement and the terms used on the Balance Sheet referring to equity/net assets This problem of self-invented terminology is discussed in more detail in the empirical part of this paper The third concept forming the theoretical background in this paper is creative accounting This is a term used in European accounting literature, while the preferred term in the United States, and consequently in most of the literature Journal compilation C C 2008 The Authors 2008 Blackwell Publishing Ltd CREATIVE ACCRUAL ACCOUNTING IN THE PUBLIC SECTOR 101 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! Artificial transactions, in turn, can be entered into both to manipulate balance sheet amounts and to transfer profits between accounting periods (Amat and Gowthorpe, 2004) Thomas et al (2004) tested for earnings management in the case of transactions between an owner company and its affiliates: For example, the [o]wner company can sell assets (e.g., inventory, land, etc.) to its subsidiary .The [o]wner company can report the sale and increased earnings in the current period For consolidated purposes, the affiliated transaction will be eliminated and not affect the financial statements (p 3) 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 2008 The Authors Journal compilation C C 2008 Blackwell Publishing Ltd 102 ă VINNARI AND NASI CASE STUDY – CREATIVE ACCRUAL ACCOUNTING SOLUTIONS IN THE MUNICIPAL SECTOR Accrual Accounting and Budgeting and Interperiod Equity Measures in Finnish Municipalities Local government reform in Finland took place with the implementation of the Local Government Act (365/1995), in which there was a reference to the application of the Accounting Act of 1973, reformed in 1997 (1336/1997) Taken together, these two Acts meant that the municipal sector adopted the accrual accounting method for both budgeting and financial accounts The Local Government Act also introduced the requirement that each municipality should draft a three-year financial plan which must be accepted by the municipal council concurrently with the municipality’s budget for the coming fiscal year If the municipality’s financial result for the current or the coming year is expected to be negative in accrual terms, the municipal board (executive body) has to present the municipal council (decision-making body) with a plan of how it intends to cover the deficit during the planning period (§ 65) Thus, calculated over a period of three years, the municipality’s budget must at least break even The aim of this system is to guarantee interperiod, and, in the long run, intergenerational equity in Finnish municipal economies Yet, although the aim is clear, agreeing upon the most appropriate accounting system and the corresponding equity indicators is more problematic In the accrual budgeting and accounting system devised specifically for the Finnish municipalities, certain P/L Account figures clearly play a crucial role in measuring the balance of budgets and accounts One such figure is the Annual Margin (see the Appendix), the difference between a municipality’s running revenues and expenses Another important measure is the bottom-line figure, the Surplus/Deficit for the Financial Year, which is the official equity measure that should at least break even in the three-year period Achieving interperiod equity using these measures is a problem in numerous Finnish municipalities,3 and this difficulty was also the key factor in the application of creative accounting solutions in the case municipality, Owner City 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 longterm 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 Journal compilation C C 2008 The Authors 2008 Blackwell Publishing Ltd CREATIVE ACCRUAL ACCOUNTING IN THE PUBLIC SECTOR 103 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 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 2008 The Authors Journal compilation C C 2008 Blackwell Publishing Ltd 104 ă VINNARI AND NASI as much as 45.5 percent of a water utility’s annual turnover (Vinnari, 2006) Owner City’s interpretation of this regulation can be seen in Water Utility’s P/L Accounts (Table 1) In accordance with the Finnish municipal accounting guidelines, the return on Owner City’s Basic Capital was entered in the P/L Accounts as a financial expense item entitled ‘Compensation for Basic Capital’, despite its dividend-like nature In accordance with the full cost recovery principle set out in the Water Services Act, the Turnover from selling water should cover the operating costs, depreciation, and financial costs of Water Utility The bottom line figure (Surplus/Deficit for the Financial Year) in Water Utility’s P/L Accounts seems to indicate that it succeeded in breaking even but made very modest annual profits Interpreted in standard accrual accounting terms, this would mean that the Utility would have had few funds to distribute to the owner Yet, a more careful scrutiny of the accounts reveals that in fact Water Utility paid, and the City received, significant sums of money as Compensation for the Basic Capital This item was, however, presented as a financial expense, not an appropriation of profit In other words, Owner City used Water Utility to collect an income of EUR 2.51–3.53 million annually in the form of customer charges During 1994– 2004, the compensation rate paid by Water Utility ranged from 7.9 percent to 14.5 percent on the Basic Capital Expressed as a percentage of annual turnover, this equals 20–27.5 percent (Table 2) The income from Water Utility was not earmarked for any water services related purpose, so the City was able to use it to balance its budgets and finances This practice is not immediately detectable by looking at Water Utility’s P/L Accounts because, first of all, like most users of accounting information, the municipal council members very obviously monitor and understand first and foremost the bottom line figure, which in this case shows modest and acceptable profits Secondly, the heading ‘Compensation for the Basic Capital’ misleads rather than helps the reader to understand the financial information of Water Utility: she or he may assume that the item is equal to real external spending and expense, such as interest on a bank loan, rather than a return on Owner City’s ‘invested’ capital The arrangement conforms to Finnish public sector accounting regulations, but its adherence to the spirit of the Water Services Act, which calls for a ‘reasonable’ rate of return, can be questioned Therefore, the Compensation for the Basic Capital can be interpreted as creative accounting and hidden taxation, not only in the case city but also more generally in the accounts of Finnish municipal enterprises Despite the steady income flow from the Water Utility, Owner City’s financial predicament intensified at the beginning of 2000, and the City had to resort to further measures to balance its budgets and accounts Journal compilation C C 2008 The Authors 2008 Blackwell Publishing Ltd C 2008 The Authors Journal compilation C 2008 Blackwell Publishing Ltd 0.00 −0.51 −1.18 0.21 −0.03 −2.66 0.00 −0.02 −2.63 0.00 0.00 −2.51 0.00 0.00 −0.69 11.73 −5.60 −2.77 0.028 10.72 −4.89 −2.72 0.057 1996 11.55 −4.75 −2.85 0.05 1995 Note: ∗ Voluntary provisions set aside for future investments Surplus/Deficit for the Financial Year Turnover Operating Costs Depreciation Financial Income Financial Costs Interest Costs Compensation for the Basic Capital Extraordinary Income and Expenses (net) Provisions∗ 1994 0.48 0.00 −0.01 −3.53 0.00 12.83 −5.60 −3.21 0.011 1997 0.49 0.00 −0.06 −3.53 0.00 13.58 −5.80 3.71 0.007 1998 0.13 0.00 −0.13 −3.36 0.00 13.88 −7.72 −4.08 0.004 1999 0.23 3.28 −0.26 −3.19 −3.15 14.35 −6.6 −4.20 0.005 2000 0.07 0.13 −0.33 −3.19 0.00 15.47 −7.69 −4.51 0.011 2001 0.23 0.13 −0.39 −3.19 0.00 15.54 −7.34 −4.56 0.011 2002 0.19 0.13 −0.40 −3.19 0.00 15.63 −7.44 −4.56 0.018 2003 Summary of the Profit and Loss Account Information of Water Utility, 1994–2004 (EUR million) Table 0.45 0.13 −0.34 −3.19 0.00 15.90 −7.54 −4.56 0.016 2004 CREATIVE ACCRUAL ACCOUNTING IN THE PUBLIC SECTOR 105 21.7 24.5 8.4 2.63 31.40 1995 22.7 8.5 2.66 31.40 1996 Note: ∗ Value of Basic Capital changed due to revaluation of fixed assets Compensation,% of turnover 7.9 2.51 Compensation, EUR million Compensation, % of basic capital 31.90 Basic Capital, EUR million 1994 27.5 14.5 3.53 24.34 1997∗ 26.0 14.0 3.53 25.16 1998∗ 24.2 13.4 3.36 25.16 1999 21.8 12.7 3.19 25.16 2000 20.6 12.7 3.19 25.16 2001 20.5 12.7 3.19 25.16 2002 Owner City’s Basic Capital in Water Utility and the Compensation Paid for it, 1994—2004 Table 20.4 12.7 3.19 25.16 2003 20.0 12.7 3.19 25.16 2004 106 ă VINNARI AND NASI Journal compilation C C 2008 The Authors 2008 Blackwell Publishing Ltd CREATIVE ACCRUAL ACCOUNTING IN THE PUBLIC SECTOR 107 The Sale and Fabricated Sales Profit of the Water Utility During the autumn of 2003 and 2004, when the financial plans and budgets of Owner City were being approved, the realization grew that deficit spending would continue and something radical would have to be done to meet the legal obligation to cover the deficit A solution was found in the sale of Water Utility, not outside Owner City Group, however, but as an intra-group rearrangement to Owner City’s own energy company that would permit a large additional sales profit to be recorded as income on Owner City’s P/L Account as a result of the fair value based revaluing and sale of Water Utility’s infrastructure assets As mentioned earlier, in the Finnish dynamic accounting theory based approach, the Balance Sheet was a secondary financial account, and assets and their valuation did not belong to the core elements of financial accounting With the advent of IAS/IFRS-based accrual accounting, more attention began to be paid to Balance Sheet information and assets valuation, but in the public sector, accounting regulations forbade revaluation of fixed assets other than land or water areas These developments also affected Owner City, which realized that its water utility assets were in a sense undervalued and that one way to improve the City’s financial results would be to revalue the assets at fair value The only way to this was via the sale of Water Utility In the autumn of 2003, the City had commissioned Consulting Firm X to analyse the feasibility of selling Water Utility to Energy Company and to calculate the fair value of Water Utility’s fixed assets, which consist mostly of infrastructure Although a recommendation report was written and was supposed to be presented to the City Council, the issue was shelved for a year and raised again in the autumn of 2004 in connection with the budget and the financial plan for 2005–08 After a second review and valuation of Water Utility’s assets by Consulting Firm Y, the proposal of the City Board to sell Water Utility to the City-owned Energy Company was accepted by the City Council, and the sale was to take place on the last day of 2005 The various outcomes of Water Utility’s asset valuations and the final sales price are presented in Table The wide variations in the values are of course due to different valuation methods and calculation parameters, and attest to the difficulty of reaching one single figure that could be considered the ‘correct’ fair value of Water Utility’s fixed assets The final sale arrangements are presented in Figure Owner City recorded the proceeds from the sale, the difference (EUR 113 million) between the current book value of Water Utility’s infrastructure assets (EUR 37 million) and the sale price (EUR 150 million), on its P/L Account (as an Extraordinary Income item) The sale of Water Utility had no positive effect, however, on Owner City’s cash flows at the time of sale as the sale proceeds were balanced by a loan for the same amount to the buyer, Energy Company, for a period of fifteen years at an annual interest rate of 5.91 percent 2008 The Authors Journal compilation C C 2008 Blackwell Publishing Ltd ă VINNARI AND NASI 108 Table Value of Water Utility’s Infrastructure Assets According to Different Valuation Methods and Valuators in 2005 Asset Valuation Method Value, EUR Million Book value Technical and economic value (Firm X) Technical and economic value (Firm Y) Discounted Free Cash Flow value (Firm X) Discounted Free Cash Flow value (Firm Y) Final sales price, fair value + goodwill 37 120–210 130 50–80 74 130 + 20 Figure Sale of Water Utility to Energy Company OWNER CITY budgeting and accounting entity including public enterprises, e.g Water Utility Price, EUR 150 million, consisting of: - fair value of Water Utility’s assets: EUR 130 million - goodwill: EUR 20 million ENERGY COMPANY Bullet-type debenture loan, EUR 150 million INTRA-GROUP SALE OF THE WATER UTILITY 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 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 Journal compilation C C 2008 The Authors 2008 Blackwell Publishing Ltd 109 CREATIVE ACCRUAL ACCOUNTING IN THE PUBLIC SECTOR Table Surplus/Deficit Figures of Owner City, 2004–2007 Surplus/Deficit of the City Without the Sale of Water Utility, EUR Million Surplus/Deficit Including the Sale of Water Utility, EUR Million −16.9 (realized) −19.69 −7.31 +1.27 −42.63 −16.9 (realized) +102.61 −7.31 +1.27 79.67 2004 2005 2006 2007 Total Figure Financial Statement/Budget and Cumulative Surplus/Deficit Figures of Owner City, 1997–2008 120 99.4 100 85.7 Million euros 80 86.3 77.8 60 78.4 40 20 6.4 7.3 0.4 -5.0 2.1 -7.3 -5.2 3.7 7.3 -13.2 0.6 -20 -2.7 -9.1 -2.4 2.1 1.6 -8.4 -16.9 -40 1997 1998 1999 2000 2001 2002 Financial (roman figures) Statement/Budget 2003 2004 2005* 2006* 2007* 2008* Cumulative (italic figures) Surplus/Deficit 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 2008 The Authors Journal compilation C C 2008 Blackwell Publishing Ltd ă VINNARI AND NASI 110 Figure Total and Per Capita Debt of Owner City in 1997–2008 EUR million EUR/capita 250 2500 200 2000 150 1500 100 1000 50 500 0 1997 1998 1999 2000 2001 2002 Total loan 2003 2004 2005* 2006* 2007* 2008* Loan/inhabitant 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 Journal compilation C C 2008 The Authors 2008 Blackwell Publishing Ltd CREATIVE ACCRUAL ACCOUNTING IN THE PUBLIC SECTOR 111 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 marketbased 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 2008 The Authors Journal compilation C C 2008 Blackwell Publishing Ltd 112 ă VINNARI AND NASI 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 consequences 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’, investments, 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 Journal compilation C C 2008 The Authors 2008 Blackwell Publishing Ltd 113 CREATIVE ACCRUAL ACCOUNTING IN THE PUBLIC SECTOR 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 2004 Revenues from operations Production for own use Operating expenses Operating margin Tax revenues State grants Financial revenues and costs (net) Annual margin Depreciation Extraordinary income Net result for financial year Provisions Surplus/deficit for financial year (without the sale of Water Utility) 96.48 14.46 −374.37 −263.43 220.29 43.05 5.19 5.10 −22.72 0.14 −17.48 0.60 −16.88 Note: ∗ The figures for 2006 and 2007 are estimates 2008 The Authors Journal compilation C C 2008 Blackwell Publishing Ltd 2005 100.55 14.24 −378.16 −263.37 227.09 47.04 4.52 15.28 −31.74 116.92 100.46 2.23 102.69 (−19.69) 2006∗ 171.69 0.00 −460.77 −289.08 238.10 53.66 8.36 11.04 −20.02 0.00 −8.98 0.54 −8.44 2007∗ 172.95 0.00 −462.80 −289.85 246.89 55.54 7.95 20.53 −20.48 0.00 0.05 0.55 0.60 114 ă VINNARI AND NASI NOTES 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 This was due to the Finnish Expenditure-Revenue theory of accounting, developed by Martti Saario in the 1940s 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) 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 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 The Finnish 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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... their financial accounting reform in 1997, and they are still using it today The core of the Finnish dynamic accrual accounting model lies in the categorizing and recording of transactions, i.e the