A depressed economy combined with less state aid has caused many local governments to operate at a deficit. Some entities try to hide from this problem by using budgeting and accounting gimmicks. Fiscal managers, accountants, and citizens must see that the problems are met without mortgaging the future and endangering financial viability.

Today, an increasing number of local governments find themselves fiscally stressed as they struggle through a severe and extended recession. Increasingly, local governments are raising taxes and user fees, making painful spending cuts, and using accounting gimmicks in a desperate attempt to keep their budgets balanced. With slow economic growth, the prospects are that local government revenues will not keep pace with spending demands. Thus local governments will face continuing fiscal pressures.

In October 1993, the U.S. General Accounting Office (GAO) issued a comprehensive report to the House of Representatives on state and local finances. This will enable Congress to better assess the ability of those governments to participate in welfare reform, healthcare reform, and other major policy initiatives. The study covered a seven-year period (1985 to 1991) and revealed, not surprisingly, that spending in local governments continued to grow faster than revenues, bringing year- end budget surpluses down. With the decline in the growth of the economy beginning in 1989, surplus balances as a percentage of operating expenditures declined significantly. Actions taken by governments were to raise fees and charges and cut expenses through salary and hiring freezes, furloughs, cutbacks in pension contributions, and reductions in capital expenditures. The GAO visited eight urban areas in five states to see in detail the plight of local governments. Memphis, Tennessee, one of the urban areas visited, presented a typical picture of a younger city experiencing fiscal stress. According to the GAO, service needs are increasing as the city grows and attracts unemployed from surrounding areas. The tax base has weakened as property values have declined with the weakening in the national economy. In each year during the period 1987 to 1992, general fund expenditures exceeded revenues eating into the general fund balance.

The picture painted by the GAO shows local governments, such as Memphis, struggling to be viable within the constraints of declining tax bases and increasing costs. There will be long-term consequences to deal with such as aging infrastructure and deteriorating educational facilities.

Databases Provide Additional Insight

The New York State Comptroller maintains a database of financial statistics for the wide range of local governments and school districts in New York State. This database shows some disturbing statewide fiscal trends.

The number of local governments reporting a fund deficit in their major operating fund (the general fund) has more than doubled from 35 in 1989 to 78 in 1991. The size of these deficits has also increased. While the highest reported deficit in 1989 was $6.8 million, in 1991 the highest deficit was $113 million, and five other local governments reported deficits that exceeded $6.8 million. Even those local governments fortunate to have weathered the storm have found their margin of safety has narrowed. The amount of unappropriated fund balance, which acts as a cushion against unexpected fiscal events, has declined as a percentage of expenditures in 1991, with every indication this trend continued in 1992. However, in New Jersey, where economic conditions mirror those in New York, local government fiscal conditions have generally been healthier than in New York. In recent separate analyses of New Jersey's 21 counties and New York's largest cities, Moodys reports most New Jersey counties enjoy favorable credit ratings, while the overall credit quality of New York's cities has declined. However, not all New Jersey counties are in good financial condition. In 1991, state legislation gave New Jersey counties the right to issue bonds to cure operating deficits, and Moodys reports three counties have taken advantage of this provision.

In New York, when deficits have grown too large to be handled internally through budgetary and program actions, local governments have had to resort to seeking authorization from the State Legislature to issue bonds to finance prior operating deficits. Historically, this step has been used only as a last resort when operating cash and local financing alternatives, such as budget notes and tax notes, have been exhausted. In 1992, however, eight general purpose local governments were granted authorization to issue deficit financing bonds--equal to the number of authorizations granted in the previous five years combined. The amount of deficit financing authorized in 1992 reached an all-time high of $130.7 million. Clearly, the trend in New York State has been that more local governments are experiencing greater levels of fiscal stress.

Economic Factors

The principal factors affecting local government fiscal condition are the economy, government spending and program requirements, and Federal and state financing. Unfortunately, all three factors have been working in tandem to put many local governments in a fiscal bind. The recession has had a severe impact on those revenues most relied on by local governments--real property taxes, sales taxes, and state aid. The share of total revenue provided by each of these sources varies from state to state and even between types of governments within a state.

Real properly taxes. These taxes account for one-third of local government revenues in New York State, and are the largest single source of financing for most local governments. The real property tax base has been hit hard by the decline in existing real estate values and the recession. Local governments accustomed to growing real property tax bases in the boom decade of the 80's have found either the growth has slowed or, in the worst cases, has even declined. This is especially true in those communities hit hard by the slump in commercial real estate. Here local governments have seen a large increase in the number and dollar value of tax appeals filed seeking and receiving reductions in taxable assessed valuations. In addition, real property tax collection rates have dropped as unemployment and foreclosures have gone up. In California, local governments are reeling from the effects of a very severe recession compounded by the restrictions of Proposition 13, which rolled back and capped property taxes.

Sales taxes. In 1991, sales taxes accounted for about one-sixth of local government revenues and have become an increasingly important revenue source, especially for counties and cities. Because sales taxes are sensitive to economic conditions, budget forecasting is more difficult, and a stagnant economy has meant flat sales tax revenues for local governments. Sales tax revenue is often overestimated during budget preparation as officials have allowed their economic projections for retail sales to be influenced by their need for revenue to balance the budget.

State aid. The Federal government and many state governments, faced with the same dismal economic conditions, have cut back their support for local government. Unfortunately, there is no passing the buck at the local level. In New York State, aid payments to towns and villages dropped from $444 million in 1989 to $300 million in 1991. In contrast, in New Jersey, where state aid is the second largest revenue source for local government, payments from the state have increased and contributed to the stabilization of county financial operations. Operating expenditures. The recession has also affected local government operating expenditures, which have been increasing faster than revenues. The major impact has been felt in social service expenditures, health, and public safety. For example, in New York State, social service expenditures in counties have increased by 13 percent annually--from $2.56 billion in 1989 to $3.30 billion in 1991. The recession has resulted in higher spending with faster growth than expected, while revenues are lower than expected and growing more slowly than previously.

Budget Realities

Constitutional and statutory balanced budget requirements should work to force the fiscal discipline of balanced budgets on local government. However, squeezed by recessionary pressures on economically sensitive revenues and taxpayer discontent over increased real property taxes, local governments have had difficulty adopting truly balanced budgets. Rather than make difficult spending cuts, the tendency has been to make overly optimistic economic forecasts that are converted into unrealizable revenue estimates. This produces budgets balanced on paper that may turn out to be quickly unbalanced when faced with harsh economic reality. This is especially painful when there is no fund balance to cushion the revenue shortfall, which is now generally the case. One-shot or other non-recurring revenues used to finance recurring operating costs are another favorite budget-balancing technique. This may make the current year's budget whole without requiring tax increases or service cuts, but does not solve structural imbalances and puts pressure on the next year's budget that must be balanced with new revenues.

Revenue estimates based on overly optimistic assumptions permit a levy of real property taxes lower than needed to finance expenditures. When optimistic revenue assumptions fail to materialize, the resulting budget shortfall must be dealt with, and the sooner, the better. Inadequate budget monitoring during the year, especially of revenues, and a failure or a reluctance by the governing board to take prompt corrective action allows a small budget problem to grow larger, a manageable problem to become unmanageable.

Responsible Fiscal Management and Financial Reporting

In this difficult economic environment, it is the responsibility of the local governing board, other elected officials, fiscal managers, external accountants, and every citizen to see that the local government's budgeting, accounting, and financial reporting practices are sound, timely, and responsive. Budgeting. Conservative revenue estimates are key to a healthy budget. In New Jersey, local government budgets are approved by a state agency before they become final. In New York and other states, where this is not the case, some local governments look to their external auditors to provide an independent view. In some engagements, the independent auditor's work includes helping to develop revenue estimates that are objective and reasonable, or reporting on the reasonableness of management's estimates. Other times the auditor is asked to review the budget forecasting methodology in place or requested to analyze whether user charges and fees are set at a level related to the cost of providing the service.

Of importance is a system of budget reporting that provides timely and comprehensive financial information during the year. Many local governments maintain budgetary control over appropriations by preparing monthly expenditure reports or using a computerized real time system that compares budgeted appropriations with actual expenditures and encumbrances to date. When this system of budgetary control is designed to identify only overexpenditures of the annual amount of appropriations it may not provide sufficient and timely control. By the time this budget system reports an overexpenditure, it may be too late for management to take effective action. A percentage cut in expenditures made in the fourth quarter needs to be approximately twice as large as a cut made in the third quarter to have the same dollar impact. Budget appropriations should be allocated and monitored on a quarterly or other periodic basis. Alternatively, a system can be designed to monitor the rate of expenditure. Such a system can provide an early warning of budget overruns. Of course, any budget reporting system that also fails to closely monitor revenues is seriously deficient. In fact, revenue shortfalls rather than expenditure overruns have been the principal cause of recent fiscal stress affecting local governments.

Accounting and Financial Reporting. Deteriorating balance sheets have increased the tendency to prematurely recognize revenue and delay expenditure recognition. Until GASB Statement 11 becomes effective, and that day seems further away than ever, revenues in governmental funds must be measurable and available to be accrued. Recently, a favorite budget balancing revenue has been the proposed sale of land or other "unneeded" municipal real property. An alternative is a sale and lease- back arrangement if the property is still needed. As times get tough, even once sacred assets are eyed as a possible source of funds. What better way to soften the impact of budget cuts than by selling assets-- even city hall, or at least that has sometimes been the plan. But the more likely outcome, in a weak real estate market, is "no sale." Projecting revenue from an asset sale is an easy way to balance a budget, and failing to sell the asset is a sure way to run into fiscal difficulty. Unrealized asset sales are phantom revenues and should not be accrued on the financial statements; nor should revenue from any other source be accrued that does not meet the criteria of measurable and available.

Another fiscal gimmick is to use next year's property taxes to pay this year's bills. This technique is possible in those municipalities where the real property tax collection period begins in the prior fiscal year. Property taxes collected in advance of the fiscal year for which they are levied should be recognized as deferred revenue at year end.

Deferred revenue is also the appropriate recognition where real property tax collections are delayed and not realized in time to meet GAAP criteria. Current GAAP requires property taxes to be collected within 60 days after the period in which the property tax revenue was recognized. The failure to properly classify a revenue as deferred results in an overstated financial position. Similarly, there is now more pressure to delay recognition of liabilities that have been incurred and to delay payment of the related bills. The latter may help cash flow and the balance sheet, but the failure to recognize liabilities in the fiscal year incurred violates GAAP. A more complex issue is the recognition of liabilities as current or non-current. Under current GAAP, governments may account for certain liabilities, such as judgments and claims and compensated absences, as current (recognized as a fund liability) or non-current (recognized as a liability in the General Long-Term Debt Account Group) depending on whether the liability is normally to be liquidated by using expendable available financial resources. This distinction can be abused. At times these liabilities have been financed, but operating needs have caused the funds to be used for other purposes. The liability has been shifted improperly from the operating fund to the long-term debt account group. Response by State Governments

Recently the National Conference of State Legislatures released survey results that showed a number of states were forecasting slow growth of general fund revenues in 1994. The recession is expected to continue unabated in California and Maine. Some other states, like New York and Texas, are expected to struggle to keep expenses and revenues in balance. This will likely result in increased fiscal pressures on local governments in those states.

As the number of local governments in New York facing fiscal stress has increased, the State Comptroller has stepped up his role of fiscal monitoring and supervision. Besides monitoring fiscal conditions through the local government database, the Comptroller's Office conducts a program of periodic field examinations of individual local governments. In those cases where local finances have gone from bad to worse and insufficient corrective action has been taken, audit reports will make specific recommendations to the local governing board on actions that should be taken to restore fiscal health. Under current state law, however, these recommendations are not binding on local elected officials, and too often these recommendations are not implemented. In addition, a special program of oversight has been implemented to identify and monitor those local governments where available financial information may indicate fiscal stress. Municipalities under review include those authorized to issue deficit financing and those that have reported significant fund deficits. Also included are those units that have exceeded 90% of their tax or debt limits or have received speculative credit ratings by credit rating firms. However this early warning role is not defined in state statute and local governments are not under any express obligation to respond to requests for information or to provide any formal plan for resolving their deficits.

In contrast, New Jersey has had legislation on the books for some time that provides for strong state supervision of local government fiscal practices, including the review and approval of municipal budgets. In addition, if a local government is unable to meet its debt service, or is otherwise grossly negligent, statutes provide for the state to apply for a court order to take control of the local government's fiscal affairs.

Clearly an ounce of prevention is worth a pound of cure. To implement an effective preventive program, there should be mechanisms in place to ensure local governments are required to evaluate, in a critical way, comments and suggestions from the Comptroller's Office for dealing with conditions of fiscal stress. Consequently, the Comptroller is proposing a change in state oversight that would establish a reasonable sequence of oversight, technical assistance and controls for local governments in fiscal distress.

The proposal is a five step plan that would link the oversight powers to the degree of fiscal stress a municipality is experiencing. The oversight would begin when a government's deficit exceeded five percent of its operating budget or $30,000, whichever is greater.

The first step would allow local officials to solve their own problems with a minimum of state intrusion. A series of progressive measures could culminate in the State Legislature determining to take over a municipality's financial affairs during periods of chronic fiscal stress. Monitoring would include review of proposed budgets and quarterly and annual financial reports. A major factor in the legislation would be a requirement for written responses from the local government to all findings and concerns raised by the Comptroller's staff. The worst case scenario, creation of a state financial control board, would be similar to the one established for New York City during the fiscal crisis of the mid-1970's and the Emergency Financial Control Board now operating in the City of Yonkers. The control board would have the power to review and approve annual budgets and multi-year financial plans and to monitor performance against the plan. This is not a step the state would take lightly. State oversight for New York City and Yonkers was initiated only when the credit markets denied access. One of the goals of the Comptroller's legislative proposal is to gain corrective action before the market denies access. The prospect of losing local control may be so distasteful local officials would take whatever action is necessary to prevent fiscal conditions from deteriorating to the point where such a control board would be required.

Destiny Is In Their Own Hands

Governing boards, elected officials, and fiscal managers have the prime responsibility to maintain financial viability and integrity. Consultants and external auditors can help. But the tough decision of raising revenue and planning expenditures can not be abrogated. In New York State, there are mechanisms to help protect the public. But these types of mechanisms need to be strengthened and should be a last resort, because at best they are a short-term solution.

The Bridgeport Experience

Bridgeport, Connecticut's largest city, is a singular example of a local government experiencing fiscal stress. Bridgeport has faced the same fiscal problems other local governments face -- cuts in Federal and state aid, a recession impacting economically sensitive revenues and eroding the property tax base, and increasing costs of public services. What has been unique has been the city's response to its fiscal difficulties.

Even before the recession had affected other parts of the Northeast, Bridgeport's manufacturing base had been hit hard, putting pressure on property taxes. In addition, the city's hospital was running large deficits. By 1988, the city had rung up cumulative operating deficits totaling $35 million and was willing to accept a state financial review board to oversee its finances in return for help in selling bonds to cover the deficit.

The Bridgeport Financial Review Board has the power to approve the city's three-year financial plan and current year operating budget. The board carefully reviews budget projections to determine that city estimates are achievable. Under the fiscal discipline imposed by the review board, Bridgeport's reported financial position improved and by the end of the 1991 fiscal year was actually healthier than many other cities; certainly healthier than Philadelphia, the only city whose bonds were rated as junk bonds at the time. However, to keep budgets balanced, Bridgeport had levied the highest property tax rates in Connecticut and had made substantial cuts in services. City management felt the options available to balance the 1992 fiscal year budget--increase property taxes to an even higher level or cut essential services further--were unacceptable. In June 1991, the city adopted a budget for the 1992 fiscal year that was out of balance by approximately $16 million or 5% of its $320 million budget.

In defiance of the review board and hoping to avoid an 18% property tax increase needed to balance the 1992 fiscal year budget, Bridgeport, on June 6, 1991, became the largest municipality to seek the protection of Chapter 9 of the U.S. Bankruptcy Code. The city intended to use bankruptcy court to reorganize and to break "economically burdensome contracts." However, the bankruptcy court judge ruled the city had not demonstrated an inability to pay its bills as they mature and thus, was not insolvent and did not qualify for the protection afforded by Chapter 9.

Subsequently, a new city administration implemented cost cutting measures and was able to finish the 1992 fiscal year with a $6.6 million deficit (figured on an accounting basis required by state legislation). Further belt tightening and an increase in property taxes took place in the 1993 fiscal year's budget. The Bridgeport situation did not involve accounting gimmicks or inadequate financial reporting. The problems were structural, caused by fundamental economic problems. The city continues to work its way back to fiscal health and hopes to regain access to credit markets and the financing it needs to rebuild its infrastructure.

Gregory D'Alessandro, CPA, is Chief Examiner of Municipal Affairs in the Office of the State Comptroller of the State of New York. He is a member of the NYSSCPA Committee on Government Accounting and Auditing.