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Detroit-Style Financial Warnings to Update for City, State Risks

Jan. 20, 2022, 9:45 AM

When the city of Detroit declared bankruptcy in 2013, its auditor raised red flags about the city’s ability to continue as a going concern.

The warning—a financial statement call-out that there’s a strong chance an organization or government won’t survive the next 12 months—was rare in state and local government accounting. Unlike private enterprises, governments just don’t dissolve. Cities raise taxes, slash services, or float bonds before even thinking of turning out the lights at city hall.

Detroit survived, like the vast majority of state and local governments. This raises a question: Do going concern warnings matter for governments the same way that they do for private enterprises? Accounting rulemakers want to find out.

The Governmental Accounting Standards Board this year will undertake a deep-dive into existing going concern accounting rules for state and local governments to figure out what, if anything, needs to change.

Current rules, in GASB Statement No. 56, Codification of Accounting and Financial Reporting Guidance Contained in the AICPA Statements on Auditing Standards, are essentially copied and pasted from the private sector without modification for the unique challenges of government. The board plans to study whether the rules need tweaking and whether governments should divulge separate details about when they experience severe financial distress, said GASB Chair Joel Black.

The board will consider multiple paths, Black said.

“It could be that we define ‘going concern’ a little bit differently for a government,” Black said. “It could be ‘going concern’ is your ability to not make an established debt payment, versus ‘severe financial stress’ is maybe your ability to not provide services the way you have in the past. It could be any number of those kinds of things.”

GASB will be wading into tricky territory. Researchers at the board’s Norwalk, Conn. headquarters spent five years compiling data about the use of going concern warnings at state and local governments. Although current guidance tells state and local finance teams to evaluate their government’s ability to continue as a going concern, actually doing so is challenging. This leads to inconsistent conclusions in applying the guidance, GASB research showed.

Jodi Dobson, a partner at Baker Tilly U.S. LLP with more than 20 years as an auditor, said she has never had a government client that had to consider issuing such a warning. During the coronavirus pandemic, however, auditors started conversations to see if they needed to dust off the guidance as some clients dealt with financial stress.

“We at least asked the questions,” Dobson said.

Between 1996 and 2013, GASB researchers found just 318 going concern warnings for state and local governments. They also found that dissolution of a government was extremely rare: 132 governments dissolved during the same period, and of those, only 13 cases resulted from severe financial distress.

That gets to the next difficulty—a state operates differently from a town, which is different from a school district, state-run university, or public utility district—all of which follow the same government-specific accounting standards.

“It’s a wide variety of governments that have different structures and financial backing,” Dobson said. “Creating one set of indicators that can be combined correctly to trigger what is severe financial distress across that broad category is going to be a challenge.”

GASB also may encounter challenges about the relevance of the warnings. Governments typically compile financial statements once a year. Tallying the numbers and getting audited can take as long as six months. By then, a warning could be stale.

“Is that really in the right time frame for people to use that information?” said Amy Shreck, director at BKD CPAs & Advisors, who served as a researcher on GASB’s going concern project from 2015 to 2017. “Is that really even getting to what they’re trying to answer? Is something like a budget more helpful?”

This gets to the other part of the rulemaker’s work. Board research also shows that the users of state and local financial statements—taxpayers, bond holders, rating agencies, and creditors—need information about financial trouble and plans to fix things well in advance of the going concern warning. Existing GASB standards, however, contain no guidance for earlier warnings about severe financial distress.

Some governments will include details in the management’s discussion and analysis section of their financial statements prior to declaring bankruptcy or defaulting on bond payments. Others warn of big financial stressors. Long Beach, NY, for example, warned in its 2020 report that the beach town’s liabilities exceeded its assets, that the coronavirus pandemic had hobbled its revenues, and a major lawsuit would force the city to pay damages of up to $141 million. In December 2021, the city council approved a settlement that was worth almost $150 million after adding in interest costs, according to Bloomberg News. This detailed type of disclosure is “by no means universal,” GASB research shows.

“Those findings suggest that, in the absence of guidance on severe financial stress disclosures, it is not clear to preparers or auditors whether and when governments have a responsibility to evaluate and disclose their exposure to severe financial stress,” according to GASB.

GASB expects the project to take about five years to complete, which is standard for a major project.

“It’s a big job,” Shreck said. “I will be completely honest about that.”

To contact the reporter on this story: Nicola M. White in Washington at nwhite@bloombergtax.com

To contact the editors responsible for this story: Jeff Harrington at jharrington@bloombergindustry.com; David Jolly at djolly@bloombergindustry.com