Playing for keeps: local government distortion of depreciation accruals in response to high-stakes public policy-making

Use of discretionary accounting accruals has long been recognized as a vehicle for earnings management in the private sector. More recently, evidence has emerged suggesting that public officials may similarly manipulate discretionary accruals in order to achieve ‘balanced’ operating results. This paper extends the previous literature on the manipulation of depreciation accruals to the realm of high-stakes public policy-making.     

The Role of Resource Accounting in the UK Government's Quest for ‘Better Accounting’

The UK government intends to introduce resource accounting to central government departments under the banner of ‘Better Accounting for the Taxpayer's Money’. Under the proposed system of resource accounting, as outlined in a White Paper, an annual depreciation charge is to be incorporated in the cost statement and fixed assets included in a balance sheet at their depreciated replacement cost. This paper locates the proposed changes in accounting method for government departments in the general spread of accruals accounting through the public sector, and explores the relevance of accruals as a basis for measuring the results of activity undertaken by government departments. It goes on to examine the impact of the specific accounting change envisaged in the White Paper from both theoretical and practical aspects. The benefits envisaged in the White Paper are considered along with the extent to which they are likely to be realised, together with any consequences not explicitly foreseen. The conclusion is that, while the revised accounting techniques may be different, the proposition implicit in the White Paper's title that they re better is not proven by the evidence presented.     

Accounting Problems in Infrastructure Asset Valuation and Depreciation in New South Wales Local Government

The aim of this paper is twofold: (i) to investigate whether New South Wales (NSW) local government councils comply with Australian Accounting Standards in accounting for revaluation of their infrastructure assets and (ii) to assess any consequences for the reliability of financial reporting in NSW local government. Using road assets as an example, we analyse the results of revaluations of road assets undertaken by 89 NSW councils as reported in their financial statements during the period 2013 to 2016. In this analysis we focus on the effect of a change in accumulated depreciation and impairment loss component of fair value as a percentage of the gross replacement cost of the revalued assets. The analysis reveals that in most cases this effect is significant. However, the accounting and reporting of this effect is strikingly inconsistent between the councils. Based on a critical analysis of the accounting framework and disclosure of the revaluation effects, we conclude that the main reason for the change in the fair value of assets is altered estimates of remaining useful life. Furthermore, we argue that councils did not comply with the requirements of AASB 116 in determining the useful life of the assets.     

Hired Guns: Local Government Mergers in New South Wales and the KPMG Modelling Report

Across the developed world, including Australia, public policymaking now rests heavily on commissioned reports generated by for‐profit consultants, contrasting starkly with the earlier customary reliance on the civil service to provide informed policy advice to political decision makers. Dependence on commercial consultants is problematic, especially given the moral hazards involved in ‘hired guns’ providing support for policy ‘solutions’ desired by their political paymasters. This paper provides a vivid illustration of some of the dangers flowing from the use of consultants by examining the methodology employed by KPMG in its empirical analysis of the pecuniary consequences of proposed municipal mergers as part of the New South Wales’ (NSW) Government's Fit for the Future local government reform program. We show that the KPMG (2016) modelling methodology is awash with errors which render its conclusions on the financial viability of the NSW merger proposals fatally flawed.     

A Factor Analytic Assessment of Financial Sustainability: The Case of New South Wales Local Government

Financial sustainability in local government remains a pressing problem which has seen a host of public policy interventions, including compulsory consolidation and performance monitoring through financial sustainability ratios. In September 2014, the New South Wales (NSW) Government announced a reform program centred on increasing scale in local government to make councils ‘fit for the future’. We apply factor analysis to the financial ratios informing the NSW Government's reform initiative to identify the underlying factors for observed financial performance data. We find evidence indicating that three independent underlying factors account for the adopted measures of financial sustainability. The public policy implication arising from this study suggests that the reforms imposed by the NSW Government on NSW municipalities may only meet with limited successa.     

Financial Performance Adjustment in English Local Governments

This paper analyses financial performance adjustment in English local governments and the specific accruals used to achieve it. Based on statistical approaches used in previous literature, our results indicate the use of abnormal accruals in English local governments in order to report surpluses/deficits close to zero as well as to avoid reporting big deficits. We find that depreciation and impairment expense of fixed assets is the item most significantly related to abnormal accruals. Consistent with the conservatism theory, local governments with higher leverage use more income‐decreasing accounting policies.     

The central banker as prudential supervisor: Does independence matter?

We study whether central bank independence (CBI) and monetary policy arrangements can jointly influence the likelihood of policymakers assigning banking supervision to central banks. Our empirical analysis shows that, assuming a benevolent government, a higher degree of central bank operational (economic) independence is associated with a lower probability of supervisory powers being entrusted to the monetary authority. We interpret this result as deriving from governments’ fear of the risk of excessively discretionary monetary policy. However, there is evidence that – conditional on operational independence – central banks are more involved in supervision when they pursue tighter monetary policy goals (a specific aspect of political independence). Our interpretation is that the latter may represent a commitment to mitigate central banks’ discretion in the monetization of financial distress. Our study suggests that CBI can be relevant, not only for its alleged effects on macroeconomic variables, but also in influencing policymakers’ decisions on the allocation of banking supervisory powers.     

Managers: Their Effects on Accruals and Firm Policies

This paper investigates whether top executives have significant individual‐specific effects on accruals that cannot be explained by firm characteristics. Exploiting individual executive and firm data from a period of 37 years, we find that individual executives play a significant role in determining firms’ accruals. We examine whether executives’ effects on accruals are related to their personal styles on firm policies, investment, financing and operating decisions. Our results show that individual executives’ effects on accruals are more correlated with their operating decisions than investment and financing decisions. We next investigate whether managers themselves also have a personal style for directly affecting accruals. We compare effects exerted by CEOs to CFOs. We find CEOs are more likely to affect accruals through firm policy decisions and CFOs are more likely to affect accruals through accounting decisions. CFOs tend to report more ‘solid’ earnings than CEOs, i.e., CFOs are more likely to push accruals to zero.     

ACCRUALS ACCOUNTING IN U.K. LOCAL GOVERNMENT: A HISTORICAL CONTEXT FOR CONTINUING CONTROVERSIES

Local authorities only adopt the accruals concept in a very narrow sense. Their financial accounting model can be called 'modified accruals', though it remains fundamentally different from best commercial practice. This paper explores the rationale for this unique model, using historical analysis. Because it has been used since before the First World War, and because the first decade of this century saw the only major public debate on local government accounting, the paper concentrates on this period. It was found that the essence of modified accruals is in the political nature of local government and control of it by central government.     

Complexities of Productivity Policies in the Finnish Public Sector: Knowing How to Do More with Less?

This paper examines public sector productivity policies as complexities between what is ‘known’ in policy principles and what is ‘done’ in everyday policy practice. Such complexities are explored in two productivity policy cases within Finnish local government: municipal amalgamations, and the low‐threshold concept of healthcare service. Utilising quantitative and qualitative data from Finnish local government the paper demonstrates the tensions between productivity policy principles, interpretations for productivity improvement (‘knowing’) and final outcomes for actually applying (‘doing’) productivity policy. The paper argues in favour of a new understanding for the research and practice of public policy and management.     

Asymmetric trading by insiders – comparing abnormal returns and earnings prediction in Spain and Australia

This paper examines whether the ‘external governance’ imposed by comparative financial accounting standards reduces the trading advantage of insiders. We do this by directly comparing insider trading returns and insider’s ability to predict future earnings from accruals in Spain and Australia. Results show higher excess returns and greater prediction of future earnings from conditioned insider trading in Australia that is then utilized by financial analysts to lower forecast errors – particularly in contrarian‐based accruals trading. Possible explanations include: (i) a high asymmetric quality for market‐based accruals, (ii) information transfer from informed insiders to uninformed insiders and financial analysts and (iii) a more timely dissemination of financial information in Spain through different ownership and governance structures.     

Inventory policy, accruals quality and information risk

This paper provides evidence consistent with firms with Last-in-first-out (LIFO) inventory policy being priced by the market as having lower information risk than First-in-first-out (FIFO) firms. Furthermore, the paper shows that this pricing differential is sustained after controlling for accruals quality, suggesting that the inventory policy signals some information risk characteristics that are not captured by accruals quality measure. We investigate the relation between inventory policy and accruals quality and find that accruals quality is systematically worse for FIFO firms than for LIFO firms after controlling for correlated omitted variables and known firm attributes. These findings complement the currently established relationship between the cost of capital, market pricing and accruals quality by focusing on the need for understanding the incremental effects of individual accounting policies.     

Accrual accounting and Australian fiscal policy

Australian governments have recently moved from cash accounting to accrual accounting. Accrual accounting has been accompanied at the national government level by the introduction of a new key fiscal policy measure: the ‘fiscal balance’. This paper explains and evaluates this new fiscal measure. It concludes that, given the present fiscal policy of the Australian government, fiscal balance is a superior fiscal policy measure to the ‘cash’ budget balance measure which it replaced. However, from the alternative ‘golden rule’ policy standpoint, fiscal balance is not a meaningful fiscal policy measure — although its stock counterpart, net financial liabilities, certainly is.     

Influences on the supply of accounting graduates in Australia: a focus on international students

This paper examines the influences on the potential supply of accounting graduates in Australia with reference to the personal and social influences on the decision to major in accounting using the Theory of Reasoned Action and focusing on differences between local and international students. Responses from 437 accounting majors’ found that personal attitudes linked to ‘intrinsic interest’ and ‘extrinsic interest’ was influential in choice of major. ‘Reference groups’ were an important social influence for international students. The findings have implications for government policy and the accounting profession in terms of attracting students and particularly international students, who are sufficiently interested in accounting as a career choice to address the skill shortage in Australia.     

Do accruals exacerbate information asymmetry in the market?

A considerable body of evidence, both archival and experimental, suggests that accounting accruals are heterogeneously interpreted by investors. We examine whether the information asymmetry among investors arising from this heterogeneous interpretation, implied in these empirical results, affects transactions costs in the form of the adverse selection component of the bid-ask spread. We examine this impact both, in a yearly setting and around the first release of quarterly accrual information. The results of the study provide empirical evidence of a positive association between the adverse selection component and accruals in the yearly analysis. Since wider bid-ask spreads are both theoretically and empirically linked to higher stock returns (Brennan & Subrahmanyam, 1996), our results provide a transaction cost basis for understanding one possible factor underlying the linkage between accruals and cost of equity capital, and accruals and information risk pricing as documented in Francis et al. (2005) and Ecker et al. (2006).     

Auditee Perceptions of External Evaluations of the Use of Resources by Local Authorities

The research reported in this paper takes up Michael Power's challenge that accounting researchers should pay more attention to the perceptions of auditees and how they respond to audit regimes. The setting of the study is the intense performance assessment regime imposed on local authorities in England from 2002 to 2009, one part of which – the Use of Resources (UoR) assessment – rated the financial management capability and performance of each English local authority. The perceptions of senior local authority finance officers within the Yorkshire and the Humber region are reported, using a written questionnaire and an interview to explore the reasoning behind the chosen responses. The results are more nuanced than suggested by either the official rhetoric justifying the UoR system or by those critics who view such systems as dysfunctional. Respondents portray themselves as intelligent actors, not as passive recipients. Most learned to use the UoR process to drive performance improvement, though there is some ambiguity as to whether the improvements were genuine or solely a product of the scoring system. Though adding to workload, UoR was regarded as one of the external pressures to be managed and its requirements largely represented professional views of best practice. Three of the types of control that characterise ‘regulation inside government’ (Hood et al., 1999) – oversight, competition and contrived randomness – are seen through the perceptions of the auditees. There is some evidence of the fourth style, mutuality – working through professional networks to help local authorities improve their actual and reported performance.     

Contextualizing politicians’ uses of accounting information: reassurance and ammunition

This paper explores the use of accounting information by local government politicians. The authors examined three very typical council decisions in both their policy formulation and decision-making stages, which had different levels of political conflict. During policy formulation, accounting information was used mostly to provide answers—improving understanding. At the decision-making stage, the level of conflict influenced the quantity of information used, as well as the way it was used. Under low political conflict, accounting information primarily provided reassurance, whereas when there were conflicts between majority and opposition politicians, accounting information was used to (de)legitimize political positions and decisions. This paper is one of the first to contextualize politicians’ use of accounting information and has important implications for practice and future research.     

Accruals,Investment, and Future Performance

It is well documented that accounting measures of investment, such as working capital and capital expenditures, negatively predict future stock returns. The earnings fixation hypothesis suggests that investors overestimate and overvalue the persistence of the accrual component of earnings. Another stream of the literature argues that since accruals capture growth, the accruals anomaly can be explained by the investment anomaly, which finds that firms that grow their assets tend to have lower future returns. As empirical proxies for accruals and investment are either positively correlated or interchangeably used, it is difficult to distinguish between the competing hypotheses in empirical tests. This study contributes to the debate by identifying two special economic settings in which the two explanations offer diverging predictions. First, investment in research and development (R&D) represents an investment expenditure that reduces earnings but is not subject to accrual accounting. Thus, the earnings fixation hypothesis predicts a positive relation between increases in R&D investments and future returns, whereas the investment anomaly predicts a negative relation. Second, firms operating with negative working capital have working capital accruals that are negatively correlated with other forms of investment and growth. Therefore, while the earnings fixation hypothesis still predicts a negative relation between accruals and future returns in this setting, the investment explanation predicts a positive relation. For both sets of tests, the empirical evidence supports the earnings fixation hypothesis for the accruals anomaly and is inconsistent with the notion that the investment anomaly subsumes earnings fixation in explaining future stock returns.     

Disclosure Interactions and the Cost of Equity Capital: Evidence From the Spanish Continuous Market

Abstract:  The purpose of this paper is to provide some new evidence on the relationship between disclosure and the cost of equity capital. We propose a new specification for the empirical test based on the idea that in the previous models one crucial variable was missing: accounting policy choice. We test our theoretical hypothesis using a sample of Spanish firms quoted on the Spanish continuous market from 1999 to 2002. We adopt the ex-ante approach to measure the cost of equity capital, taking analysts predictions as a proxy for expected earnings. As an explanatory variable we use an index measuring annual report disclosure quality. This measure of disclosure is combined with a proxy for the accounting policy choice of the firm. We measure firms' conservatism using the modified Jones model of Dechow et al. (1995) to estimate discretionary accruals. Our results confirm that the relationship between disclosure and cost of capital is affected by the choice of accounting policy.     

Accounting for government grants: Standard-setting and accounting choice

This paper provides evidence on several matters relating to accounting for government grants under International Financial Reporting Standards (IFRS). Focusing on grants related to assets, we trace the development of International Accounting Standard (IAS) 20, outline some of the problems of current accounting practice, and suggest why these have not been addressed by the standard-setter. Then, by hand-collecting data relating to 559 firms from 15 countries, we empirically analyze several issues. We show that asset grants are economically important for some firms and that the frequency of grants is significantly different across the countries. For the non-financial firms in our sample, we identify the grant-related accounting policy choice: a firm can either show the grant as deferred income or net it against the asset. The options are roughly equally popular overall but the firm’s country of domicile is strongly associated with the choice. Further, as a key element of disclosure quality for this topic, we investigate whether or not the balance sheet-related numbers relating to grants are disclosed, finding that many firms do not disclose them. Disclosure quality is better for firms which use the ‘deferred income’ option, and it is also better in countries where a higher proportion of firms has received government grants. International differences and poor disclosure are detrimental to international comparisons, so we conclude that the policy choice should be removed from the accounting standard.