The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
FINANCIAL REPORTS: THEIR IMPORTANCE TO THE CREDIT STANDING OF MUNICIPALITIES March 18, 1958 FINANCIAL REPORTS: THEIR IMPORTANCE TO THE CREDIT STANDING OF MUNICIPALITIES By Raymond E, Hengren, Assistant Chief Division of Research and Statistics Federal Deposit Insurance Corporation Florida Municipal Finance Officers Association l6th Annual Short Course for Municipal Finance Officers and City Clerks At the University of Florida March 18, 195$ Financial Reports: Their Importance to the Credit Standing of Municipalities Emphasizing the obvious seems to be the major characteristic of any discussion covering municipal reports in particular and the re porting problem generally. This emphasis seems to be necessary even though the principles of municipal accounting have been fully developed and there is a wide area of agreement as regards good accounting prac tices. The literature on this subject certainly is adequate. While this literature is designed primarily to aid municipal officials, it also is helpful to other users of data. Almost without exception finance officers are acutely con scious of the advantages to their municipality of a good credit standing in the investment community. To these officials it is readily apparent that the quality of a credit is appraised in terms of the available pertinent facts. For the bulk of these facts, financial reports are the basic source. Moreover, these officials know that a municipality may not be accorded the standing that it actually deserves unless relevant information is brought to the attention of the investment community in a form that can be readily interpreted. So the need for good financial reports is urgent. In view of this background, it is appropriate to raise the question: Why, then, is it necessary to continue to talk about fi nancial reports and the part they play in municipal credit? Presumably municipalities would prepare and make available to the public very good reports on their finances. Nevertheless, there are municipalities with accounting systems even today that cannot be depended upon to produce the data required for good reports. Moreover, some financial reports are so inadequate that they fail to disclose and support a basically sound credit. Finally— and even harder to explain--some municipal credits suffer merely because it is very difficult to obtain accounting reports. Thus, the emphasis on the obvious may be justified because many communities fail to prepare and publicize adequate reports on their finances. By and large, their accounting practices cannot be classed as bad, but these communities are being penalized because of inadequate re porting. To be sure, it may require a special effort occasionally to spell out the characteristics of the particular community^ obliga tions. Expressed in words of the marketplace, however, this is the kind of "selling job" that a report can do very effectively. Like it or not, it is a fact that the investment community has prejudices and misconceptions about credits. Errors in the analysis of data can occur. Furthermore, there is always much inertia working against any change of mind, notwithstanding the tremendous changes in fact that have occurred over the past decade or two with respect to the 2 creditworthiness of various governmental subdivisions. Accordingly, it is of utmost importance for the analysts of municipal credits to be in formed of these changes and the financial report is a means of doing so. To understand the reporting problem with regard to munici palities it is necessary to consider the great variation in the nature of communities and of the people who manage them. Some of these com munities are large; some are small; some are well staffed with qualified personnel; some barely succeed in functioning from day to day. Moreover, like individuals, municipalities also vary greatly in terms of selfsufficiency. For the most part, the large communities are quite con scious of the general interest in their affairs and the need for supply ing answers to management questions that arise both within and outside the community. But surprisingly enough, there are many communities that consider themselves quite able to take care of themselves. In such instances, inquiry regarding credit quality is viewed as almost an intrusion. Whether any community can afford the luxury of this senti ment for long remains to be seen. A rarity indeed would be the municipality that as a matter of fact could not produce a report on its financial affairs which conforms with sound accounting practices. As a consequence, accounting matters will receive little attention here. Instead, the purpose of these re marks will be to stress the importance of good reporting practices by comments on the use of credit data in financial reports, and to make a few suggestions that may help to improve the existing situation. Purposes Served by Financial Reports In laying the groundwork for a good general discussion that I hope will grow out of these remarks, it would be appropriate to give some consideration to the question: What should financial reports be expected to do? Broadly speaking, these reports serve two important centers of interest. For lack of better terms, one of these may be described as local or internal, whereas the other centers completely outside the municipality. The use of audit reports covering the accounts of a municipailty to prove the integrity of operations over a period of time is commonplace. This is an important application of the document that serves interests both local and general in character^ As a matter of fact, it cannot be emphasized too strongly that nothing will take the place of a good audit at regularly recurring intervals. But in addition to proving the integrity of management and revealing the overall financial condition of a municipality, the fi nancial reports have applications general in character that also serve a local interest. For example, the reports furnish the basis for analyz- - 3 - ing and appraising managerial skill with respect to operational matters. By comparing data for different communities grouped by size, geographi cally, or in other significant categories it is possible to derive much useful information. Such studies could be expected to furnish bench marks with respect to the cost of various services, sources of revenue, and alternatives in debt management policy. Comparative studies of municipal activities are not uncommon, but I am inclined to believe that even more intensive analysis of such information would be quite rewarding. Demands for services are growing at a very rapid rate and the need for efficient administration is more urgent than it has been heretofore. Such studies can be very helpful in pointing out weak situations and possibly suggesting means for improve ment. Let us turn now to another center of interest with respect to financial reports. Consisting mostly of investors in municipal securi ties and centering primarily outside the community, this interest is concerned with the use of reports for determining the quality of public credit. Furthermore, there is a growing need on the part of investors for current information on the municipal credits in their portfolios. This is especially true for banks, but it would apply equally well to all other holders of municipal securities. Here again, a good financial report could be relied upon to satisfy the need for data. The larger governmental subdivisions have long recognized the need for keeping the investment community informed as to internal operations. Many smaller communities, particularly those that are growing and foresee the need for financing, now have set about to do likewise. In appraising the quality of a municipal credit it is neces sary to arrive at an evaluation of the ability of the community to manage its affairs successfully. Although the technique is far from scientific, a community*s ability to manage its affairs may be analyzed in a reasonably systematic manner. In this process, consideration is given to a community’s general ability and its financial strength as well as its long-range and short-term position. A review of financial reports reveals that some communities are far more efficient than others in managing their affairs. These efficiencies are reflected in the cost data on their operations. Also, they may be seen in the figures on reve nues. Even though statutes may impose very definite limitations on the revenue structure of municipalities, it is a fact that good management can take advantage of opportunities existing within almost any permitted framework. Evidence of skillfulness in obtaining revenues, controlling expenses, and managing debt is a vitally important ingredient in a sound municipal, credit. As regards the community’s financial ability to perform satis factorily on its obligations, the report of the municipal finance officer - k - is again the most important single source of information. This document shows the extent of the debt burden, and viewed historically, the suc cess with which the community has managed its financial affairs* The report answers questions about the extent of the local effort to service the debt as compared with reliance upon outside help. From analysis of the facts it is possible to determine the margin of protection for creditors* Moreover, the report, if it is properly prepared, furnishes some basis for projecting the extent of this margin into the future. A high quality municipal bond is one that is paid in full on the maturity date and each interest coupon is paid as it comes due. This is a schoolboy test of quality and unfortunately it points in the wrong direction. As a practical matter, future rather than past per formance is the vital consideration. How can future prospects be evaluated? For want of a better means, it is necessary to test the strength of a municipal credit by estimating the margin that exists or is likely to exist over and above debt service commitments. This mar gin takes many forms. Sometimes it is composed of cash or investments in a sinking fund; better yet is evidence of an ability to produce an excess of revenues over expenditures in poor times. Some municipalities have much general ability to handle their affairs while others may be lacking in this respect and yet enjoy at least temporary financial strength. Then there are the ones with basic long-term strength, but short-term weakness because of special difficul ties. These are all matters of relevance to credit position and fi nancial reports furnish the key information for the evaluation process. Enough has been said thus far to suggest the purposes a good report may serve. You can draw upon your own experience for detailed illustrations. So it is now my intention to shift the focus of this discussion to another question: Generally speaking, what information should be included in a good report on the finances of a municipality? Composition of Report Forms Uniformity in accounting practices and report forms is a de sirable objective. Many problems in analyzing municipal affairs would be greatly simplified if the bulk of governmental subdivisions standard ized their accounting. However, one must be realistic enough to face the fact that communities differ substantially one from another. Their historical origins vary greatly and they are subject to fundamental dif ferences in legal structure. As a consequence, it is not surprising that accounting standardization is more of an ideal than an actuality. Nevertheless, a reasonable degree of uniformity in accounting reports among municipalities is an achievable goal. - 5 - As a matter of fact, it seems to me that students of municipal government could settle at this time for financial reports that followed any reasonably acceptable accounting standards as long as there was a fair degree of consistency in the composition of reports from one year to another. The reports, however, should make a full disclosure as re gards the affairs of the municipality. Disclosure is far more important than the niceties of accounting theory. Furthermore, documents that are straightforward can always be used as a basis for the rearrangement of data that will present a significant picture. For emphasis, let me say again that reports on the finances of a municipality should cover all activities in sufficient detail to per mit an appraisal of the quality of management. This generalization can be satisfied only by a reasonable breakdown of the items of receipts and disbursements. Furthermore, there should be evidence that the community is securing revenues in adequate amount and on a broad enough base to insure continuance of the necessary activities without trouble. To the extent that support is obtained from other subdivisions of government, for example, a State or State agency, in carrying on the function normally performed by a local community, the facts should be clearly presented in the report. Evidence with respect to the credit standing of a municipality should certainly be reported clearly and in an unequivocal manner. Since the analyst of municipal credits is primarily concerned with the margin of debt service, it is essential that the report form include the information needed to support judgments regarding the average of present and future debt service requirements. Seldom does a community build up debt service protection by means of cash or trust fund accumulations. As a matter of fact, to do so might not be particularly sound policy. However, the margin of pro tection is usually found in a relatively rapid debt retirement program or an investment of necessary public facilities financed at least in part on a pay-as-you-go basis. The latter policy has the advantage of limiting somewhat the growth of debt. In any event, the financial report should be so designed as to permit the analyst to see readily what policy, if any, is being followed. The composition of a good municipal report form is deserving of far more attention than we can hope to give it at this time. In the foregoing remarks a few important points have been mentioned. There are many others entitled to some consideration which will occur to you as you think about the subject. Now, however, it seems to me that we should turn to another facet of this subject, namely, the question: What can be done to make reports on the finances of municipalities available to users? - 6 - Availability of Information This brings us, then, to a question of central concern in this portion of your program: How can financial reports be publicized ef fectively? For the most part, the needs of officials and the local com munity are well cared for by existing procedures. It is a fact that audit reports do find their way into the files of officers charged with management responsibilities in the community, where they are available for study. Furthermore, newspapers and others concerned with local affairs make information generally available to interested citizens. But the finance officer in any municipality is properly con cerned with the task of bringing his reports to the attention of out siders, that amorphous entity known for want of a better term as the financial community. Not only is there need for general information about the subdivisions of government, but there is a growing need for very specific data about the affairs of each one of the many communities. Actual and potential investors require information on municipal finance in order to manage their own affairs intelligently. They may be expect ed to consider investment in areas where information is most readily available. So one of the simple devices for bringing the credit of an individual community within the field of investment consideration is widespread publication of the financial report. Inertia is a powerful force and finance officers should recog nize that the members of the investment community will be disposed to concentrate their activities on municipal credits already known to them. Furthermore, profit margins in the securities business tend to be small and neither dealers in securities nor investors can afford to spend much time or money searching for information about the finances of individual municipalities. Accordingly, a well designed program for bringing re ports to the attention of the investing public can substantially broaden the market for a municipality*s securities. Suggestions for Reporting Usually suggestions with respect to municipal reporting per tain to the accounting systems, the content of the audit reports, or the form of presentation. The question of availability of financial infor mation, however, receives much less attention than it deserves. As regards comparative data, States and the Federal Government from time to time compile data on a census basis for various categories of municipali ties. This approach to the information problem in terms of a census is good as far as it goes. As a practical matter, however, it is subject to quite severe limitations. In the first place, this approach is ex ceedingly costly and time consuming. Secondly, in the nature of the case much detailed information about the individual municipalities is lost in the aggregates. Hitherto, there have been efforts on occasion to bring informa tion on the finances of individual municipalities to the attention of certain classes of individuals, namely, investors by means of standard report forms covering specific items of information. Some of you un doubtedly are familiar with these so-called uniform credit files or forms that have been devised to implement these plans for reporting. Up to now, these systems for reporting have not gained wide acceptance. Some of the larger cities publicize information regarding their affairs by an active program for distributing the audit report. This practice certainly accomplishes the objective of making information available to people who need it. However, it probably is a practical solution only for communities of substantial size. Dissemination of in formation in this way is costly and to be effective necessitates the distribution of reports to many individuals who actually may throw them in the waste basket. For moderate-sized communities or small govern mental subdivisions it just does not seem practical to publish and distribute reports widely. One simple solution to the problem of making financial infor mation available readily, it seems to me, would be for some organization such as yours to enlist the cooperation required to maintain a central file of reports where the documents could be assembled and studied by individuals who need information. Machinery for carrying out such a project would not be expensive. Essentially, I envisage nothing more than a file case in the custody of someone who has an interest in main taining the contents up to date. The communities whose audits are placed in the file would be encouraged to supply new documents as they are prepared. Admittedly, coverage would never be perfect, but it might be quite broad enough for most purposes. Possibly the sanction of law to require the filing of finan cial reports with some governmental authority would help to make a report system work effectively. Some States have such legal arrangements and they do play an important part in publicizing municipal data. But it is not absolutely necessary to do the job that way. A community effort on a State-wide basis is likely to be just as effective as legal machinery. As a matter of fact, reporting statutes sometimes are ignored. The important ingredient in developing a program for publicizing information is a determination on the part of interested public officials to see that the job is done. The nub of the reporting problem then is to bring about an awareness of the advantage of good reports to each individual community; to teach the lesson that information, irrespective of how complete and adequate it may be, serves no useful purpose unless it is brought to the attention of those who need it. Finance officers in municipalities, even those that are relatively small, would be well advised to give some thought to the types of individuals who have a real need for information about the affairs of their communities. It is only by bringing informa tion to the attention particularly of the financial community that it will be possible to open up new sources of financing. Over the years to come ell communities are going to need access to the markets for funds. Now is a good time for them to take the steps that would make this access possible.
@FedFRASER