Elsevier

Journal of Accounting and Public Policy

Volume 28, Issue 6, November–December 2009, Pages 525-540
Journal of Accounting and Public Policy

The quality and conservatism of the accounting earnings of local governments

https://doi.org/10.1016/j.jaccpubpol.2009.08.002Get rights and content

Abstract

Our aim is to provide insight into the usefulness of accounting earnings for measuring the economic performance of local governments across Australia. Specifically, we explore whether (i) accrual accounting provides useful information, and (ii) earnings of local governments are conservative. We find that accrual accounting by local governments provides useful information as measured by the ability to predict one-year-ahead operating cash-flows. We find no conservatism in the financial reports of the average local government. This, we posit, is due to a lower level of demand for high-quality accrual-based financial reports from these entities. Consistent with this argument, both the quality of accruals and the degree of conservatism increase for local governments for which we predict a demand for higher-quality financial reporting.

Introduction

We examine the quality of accounting earnings for a large sample of Australian local governments. More specifically, we examine whether (i) accrual accounting predicts cash-flows, and (ii) earnings of local governments are conservative. To address these objectives, we follow approaches similar to those used in prior studies of publicly-listed companies (Barth et al., 2001, Basu, 1997, Dechow, 1994, Dechow et al., 1998, Finger, 1994).

Our study is motivated by the interest of central rule-making agencies world-wide in encouraging or requiring government entities to prepare accrual-based financial reports under Generally Accepted Accounting Principles (GAAP). Traditionally, government entities reported on a cash or modified-cash basis. A number of countries now either require government entities to prepare accrual-based financial reports or are considering doing so. As examples, the US Government Accounting Standards Board (GASB) requires state and local governments, for the first time, to prepare financial reports on an accrual basis (GASB, 1999).2 Likewise, several other countries including Australia, the United Kingdom, New Zealand and Canada, either now require accrual-based financial reports for government entities or have the issue on the regulatory agenda (Luder and Jones, 2004).

This recent regulation presumes accrual-based financial reports better enable the assessment of the accountability and performance of government entities (Governmental Accounting Standards Board (GASB), 1999, International Federation of Accountants (IFAC), 2005, Potter, 2002). Even so, the economic benefits of applying existing GAAP to these entities continues to be debated (e.g. Barton, 1999, Barton, 2005, Walker et al., 1999, Walker et al., 2000). Resistance in the US to GASB-led initiatives to expand GAAP disclosure requirements for government entities is based on the costs of implementing and monitoring the expanded disclosures and questions about whether sufficient demand exists for this information (Barton, 1999, Copley et al., 1997, Jones and Puglisi, 1997, Rowles et al., 1998). If compliance with GAAP is costly and the benefits of accrual-based financial reports are not clearly established, imposing GAAP reporting on local governments potentially contradicts the public interest (Baber and Gore, 2008).

Whether accrual-based information for local governments is useful remains an open question. To consider this issue, we examine whether current-period earnings of local governments provide incremental information over current-period cash-flows for predicting future cash-flows (Dechow, 1994). In doing so, we examine whether a widely-asserted benefit often associated with accrual-based financial reporting holds in the local government setting – the assertion that accruals provide an improved measure of economic performance. If there is not sufficient demand for accrual accounting then, in equilibrium, this will result in low effort in preparation and poor-quality accrual estimates. If accruals are not estimated reliably due to low effort, the information content with respect to future cash-flows will be low. Thus, finding that accrual earnings provide a better measure of economic performance than cash-flows, suggests a demand for accrual accounting.

To provide further evidence, we examine whether the earnings of local governments are conservative. Consistent with Basu (1997), we define conservatism to be the more-timely recognition of losses rather than gains.3 Our examination of conservatism is motivated in two ways. First, it provides evidence about both the demand for information and the quality of the financial reporting by local government entities. Second, our examination also provides a unique test of arguments previously advanced for the existence of conservatism in the accounts of public companies. Specifically, according to Watts (2003a), the most likely reasons for conservatism in financial reports are contracting costs and shareholder litigation. These explanations for conservatism may not apply to local governments. Thus, we consider whether, in the absence of reasons for more-timely loss-recognition, earnings are conservative in the local government context.

Accrual-based financial reporting has been mandatory for local governments in Australia since 1993. In contrast, the use of accrual accounting by US local governments is either mandated by states or is at the discretion of the local governments. The population of financial reports of Australian local governments therefore provides an opportunity to investigate accruals in a context not complicated by discretionary or required deviations from the norm.

We find that accrual accounting provides useful information, although the economic magnitude of the usefulness of accruals for forecasting cash-flows is less substantial for local governments than for public companies. Such evidence provides qualified support for regulation that requires local governments to prepare financial accounts on an accrual basis. Providing further support for this argument, we find stronger evidence of the ability of accruals to predict future cash-flows in the financial reports of large local governments, where the demand for high-quality financial statements is likely to be high. In contrast, we find no evidence of conservatism in the earnings of the average local government, although we find some conservatism in the financial reports of large local governments. Taken together, these results suggest that GAAP financial reports are cost-beneficial only for local governments with certain attributes. Thus, we contribute to three streams of the literature. First, our findings support the conclusion that accrual-based information is relevant in the local government context (e.g. Plummer et al., 2007). Second, our findings are relevant to the literature that seeks to understand the role of conservatism as a property of accounting earnings. Third, we contribute to the emerging literature that examines how the properties of earnings vary across different ownership structures (e.g. Barragato and Basu, 2007).

The remainder of the paper is structured as follows. In the Section 2, we set out the motivation for the study and develop the hypotheses. In Section 3, we describe the data, and in Section 4 we present the empirical method and the results. In the Section 6 we conclude.

Section snippets

Motivation

Notions that accruals have the ability to predict future cash-flows (Dechow, 1994, Dechow et al., 1998) and that there is demand for accrual-based earnings information (Dechow, 1994) are well-established in the corporate context. To consider whether these properties hold for local governments, we identify the fundamental differences and similarities between local governments and corporate entities.

Unlike the corporate sector, governments do not have equity stakeholders but, instead, receive

The financial reporting setting for local governments in Australia

The general-purpose financial reports of Australian local governments are prepared using accrual accounting principles in accordance with Australian Accounting Standards. As a consequence of the “sector-neutral” perspective on accounting standard setting adopted in Australia, there is little difference between the accounting regulations applying to governments and corporations. Two key variables used in this study are net profit or loss and cash-flow from operations. These variables are

Usefulness

To test H1 we examine whether past earnings contain information about one-year-ahead cash-flows (Dechow, 1994, Dechow et al., 1998, Finger, 1994). The appropriate regression is stated below:CFOit+1=α+β1Profitit+β2CFOit+β3Popi+εit+1,where CFOit+1 is the cash-flow from operations of local government i in year t + 1 scaled by total assets as at the end of year t; Profitit is the reported profit for local government i in year t scaled by total assets as at the end of year t  1; CFOit is the cash-flow

Conclusion

Despite claims by accounting regulators and other advocates that accrual accounting provides an improved measure of performance, little is known about either the usefulness or the properties of the financial reporting by local governments. In this study we use a unique dataset of accrual-based financial reports of Australian local governments to address this limitation in the existing literature. We examine both the usefulness of accruals in a local government setting and the conservatism of

Acknowledgements

We are grateful to the editors, two anonymous referees, participants at the American Accounting Association annual meeting (2005) and at the Accounting and Financial Association of Australia and New Zealand annual conference (2005) for their helpful comments. We also acknowledge the helpful feedback from Jere Francis and Mike Bradbury and colleagues at research seminars held at the Deakin Business School, the University of Tasmania and the University of Melbourne on earlier versions of this

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