The Future of the Accounting Profession
Interview with David Jones
On May 31, 2005, the US Supreme Court overturned the
conviction of accounting firm Arthur Anderson on
charges related to its handling of the books of the now
defunct energy concern, Enron. It was only the latest
scene in a drama which unfolded at the height of the wave
of corporate malfeasance in the USA.
David C. Jones is a part-time research fellow at the Center
for Urban Development Studies of the Graduate School of
Design, Harvard University. He has been associated with
the University since 1987 when he retired from the World
Bank, where he served as financial adviser for water
supply and urban development.
He had joined the World Bank, as a senior financial
analyst, in 1970, after working as a technical assistance
advisor for the British Government in East Africa. He
began his career in British local government. He is a
Chartered Public Finance Accountant and a Chartered
Certified Accountant (UK). He is the author of
"Municipal Accounting for Developing Countries"
originally published by the World Bank and the Chartered
Institute of Public Finance and Accountancy (UK) in
1982.
Q: Accounting scandals seem to form the core of
corporate malfeasance in the USA. Is there something
wrong with the GAAP - or with American accountants?
A: Accounting is based on some fundamental principles.
As I say at the beginning of my textbook, the accountant
"records and interprets variations in financial position ...
during any period of time, at the end of which he can
balance net results (of past operations) against net
resources (available for future operations)".
Accountancy includes the designing of financial records,
the recording of financial information based on actual
financial transactions (i.e., bookkeeping), the production
of financial statements from the recorded information,
giving advice on financial matters, and interpreting and
using financial data to assist in making the best
management decisions.
Simple as these principles may sound, they are, in
practice, rather complicated to implement, to interpret and
to practice. About 80% of the transactions require only
about 20% of the effort because they are straightforward
and obvious to a book-keeper, once the rules are learned.
But - and it is a big but - the other 20% or so of
transactions require 80% of the intellectual effort. These
transactions are most likely to have major impacts on the
profit and loss account and the balance sheet.
My colleagues and I, all qualified accountants, have
heated discussion over something as simple as the
definition of a debit or a credit. Debits can be records of
either expenses or assets. The former counts against
income in the statement of profit and loss. The latter is
treated as a continuing resource in a balance sheet. It is
sometimes gradually allocated (expensed) against income
in subsequent years, sometimes not.
A fundamental problem with the financial reporting of
WorldCom, for example, was that huge quantities of
expenses were misallocated in the accounts as assets.
Thus, by reducing expenditures, profit appeared to be
increased. The effect of this on stock values and, thereby,
on executive rewards are secondary and tertiary outcomes
not caused directly by the accountancy.
Another example concerns interest on loans that may have
been raised to finance capital investment, while a large
asset is under construction, often for several years.
Some argue that the interest should be accounted for as
part of the capital cost until the asset is operational. Others
claim that because the interest is an expense, it should be
charged against that year's profits. Yet, the current year's
income includes none of the income generated by the new
asset, so profit is under-stated. And what if a hydro-
electric power station starts to operate three of its ten
turbines while still under construction? How does one
allocate what costs, as expenses or assets, in such cases?
Interestingly, the Generally Accepted Accounting
Principles (GAAP) require that "interest during
construction" be capitalized, that is included in the cost of
the asset. The International Accounting Standards (IAS)
prefer expensing but allow capitalization. From an
economic viewpoint, both are wrong - or only partially
right!
The accountancy profession should get together to
establish common practices for comparing companies,
limiting the scope for judgment. Accountants used to
make the rules in the USA and elsewhere until the
business community demanded input from other
professionals, to provide a more "balanced" view.
This led to the establishment of the Financial Accounting
Standards Board (FASB), with non-accountants as
members. The GAAP has been tempered by political and
business lobbying. Moreover, accounting rules for
taxation purposes and applied to companies quoted on
stock exchanges are not always consistent with the
GAAP.
Accountants who do not follow the rules are disciplined.
American accountants are among the best educated and
best-trained in the world. Those who wish to be
recognized as auditors of significant enterprises must be
CPAs. Thus, they must have obtained at least a finance-
related bachelor's degree and then have passed a five-part
examination that is commonly set, nation-wide, by the
American Institute of Certified Public Accountants
(AICPA). To practice publicly, they must be licensed by
the state in which they live or practice. To remain a CPA,
each must abide by the standards of conduct and ethics of
the AICPA, including a requirement for continuing
professional education.
Most other countries have comparable rules. Probably the
closest comparisons to the USA are found in the UK and
its former colonies.
Q: Can you briefly compare the advantages and
disadvantages of the GAAP and the IAS?
A: It is asserted that the GAAP tend to be "rule-based"
and the IAS are "principle-based." GAAP, because they
are founded on the business environment of the USA are
closely aligned to its laws and regulations. The IAS seek
to prescribe how credible accounting practices can operate
within a country's existing legal structure and prevailing
business practices.
Alas, sometimes the IAS and the GAAP are in
disagreement. The two rule-making bodies - FASB and
IASB - are trying to cooperate to eliminate such
differences.
The Inter-American Development Bank, having reviewed
the situation in Latin America, concluded that most of the
countries in that region - as well as Canada and the EU
aspirants - are IAS-orientated. Still, the USA is by far the
largest economy in the world, with significant political
influence. It also has the world's most important financial
markets.
Q: Can accounting cope with derivatives, off-shore
entities, stock options - or is there a problem in the very
effort to capture dynamics and uncertainties in terms of a
static, numerical representation?
A: Most, if not all, of these matters can be handled by
proper application of accounting principles and practices.
Much has been made of expensing employee stock
options, for instance. But an FASB proposal in the early
nineties was watered down at the insistence of US
company lobbyists and legislators.
How to value stock options and when to recognize them is
not clear. A paper on the topic identified sixteen different
valuation parameters. But accountants are accustomed to
dealing with such practical matters.
Q: Can you describe the state of the art (i.e., recent
trends) of municipal finance in the USA, Europe, Latin
America (mainly Argentina and Brazil), and in emerging
economies (e.g., central and eastern Europe)?
A: There are no standard practices for governmental
accounting - whether national, federal, state, or local. The
International Federation of Accountants (IFAC) urged
accountants to follow various practices. It subsequently
settled mainly on accrual accounting standards.
Some countries - the UK, for local government, New
Zealand for both central and local government - use full
accrual at current value, which is beyond many private
sector practices. This is being reviewed in the UK. The
central government there is introducing "resource-based"
accounting, approximating full accrual at current value.
The US Governmental Accounting Standards Board has
recently recommended that US local governments
produce dual financial reports, combining "commercially-
based" practices with those emanating from the truly
unique US "fund accounting" system.
In my book I recognized that fixed assets are being funded
less and less entirely by debt, private sector accounting
practices increasingly intrude into the public sector, and
costs of services must be much more carefully assessed.
Q: Are we likely to witness municipal Enrons and
World.com's?
A: We already have! Remember the financial downfall
and restructuring of New York City in the seventies.
Other state and local governments have had serious
defaults in USA and elsewhere. Shortcomings of their
accounting, politicians choosing to ignore predictive
budgeting, borrowing used to cover operating
expenditures - similar to WorldCom. In the case of the
New York City debacle, operating expenditures were
treated as capital expenditures to balance the operating
budget.
More recently, I testified to the US Congress about
Washington DC, where the City Council ran up a huge
accumulated operating deficit, of c. $700 million. It then
sought Congressional approval to cover this deficit by
borrowing.
Even more recently, the State of Virginia decided to
abolish the property tax on domestic vehicles. This left a
huge gap in the following year's current budget. The
governor proposed to use a deceptive accounting device
and to set up a separate - and, thus not subject to a
referendum - "revenue" bond-issuing entity (shades of
Enron's "Special Purpose Entities"). The bonds were then
to be serviced by expected annual receipts from the
negotiated tobacco settlement, at that time not even
finalized. This crazy and illegal plan was abandoned.
The fact that both accounting and financial reporting for
local governments are very often in slightly modified
cash-based formats adds to the confusion. But these
formats could be built on. Indeed, in the very tight
budgetary situations facing virtually every local
government, it is essential that cash management on a day-
to-day basis be given high priority.
Still, the system can be misleading. It produces extremely
scant information on costs - the use of resources - compared
with expenditures (i.e., cash-flows). More seriously, cash
accounting allows indiscriminate allocation of funds
between capital and recurrent purposes, thus permitting no
useful assessment of annual or other periodic financial
performance.
A cash-based system cannot engender a credible balance
sheet. It produces meaningless and incoherent information
on assets and liabilities and the ownership, or trusteeship, of
separate (or separable) funds. It is not a sound system of
budgetary control. When year-end unpaid invoices are held
over, it creates a false impression of operating within
approved budgetary limits. Thus, local government units
can run serious budgetary deficits that are hidden from
public view merely by not paying their bills on time and
in full! A cash accounting system will not reveal this.
Still, moving to an accrual system should be done slowly
and cautiously. Private sector experience, in former Soviet
countries, of changing to accrual accounting was
administratively traumatic. Their public sector systems
may not easily survive any major tinkering, let alone an -
eventually inevitable - full overhaul. Skills, tools, and
access to proper professional knowledge are required
before this is attempted.
Q: Can you compare municipal and corporate accounting
and financing practices as far as governance and control
are concerned?
A: In corporate accounting practice, the notional owners
and managers are the shareholders. In practice, through
the use of proxies and other devices, the real control is
normally in the hands of a board of directors. Actual day
to day control reverts to the company chairmen, president,
chief executive or chief operating officer. The chief
financial officer is often - though not necessarily - an
accountant and he or she oversees qualified accountants.
The company's accountants must produce the annual and
other financial statements. It is not the responsibility of
the auditors whose obligation is to report to the
shareholders on the credibility and legality of the financial
statements. The shareholders may appoint an audit
committee to review the audit reports on their behalf. The
audit is carried out by Certified Public Accountants with
recognized accounting credentials. Both the qualified
accountants in the audit firm and those in the corporation
are subject to professional discipline of their accounting
institutions and of the law.
In local government accounting practice, the public
trustees and managers are normally a locally elected
council. Often, the detailed control over financial
management is in the hands of a finance committee or
finance commission, usually comprised only of elected
members.
Traditionally, only the elected council may take major
financial decisions, such as approving a budget, levying
taxes and borrowing. Actual day to day control of a local
government may be by an executive mayor, or by an
elected or appointed chief executive. There normally is a
chief financial officer, often - though not necessarily - an
accountant in charge of other qualified accountants.
It is the responsibility of the accountants of the local
government to produce the annual and other financial
statements. It is not the responsibility of the auditors
whose obligation is to report to the local elected council
on the credibility and legality of the financial statements.
The council may appoint an audit committee to review the
audit reports on their behalf, or they may ask the finance
committee to do this.
However, it is quite common, in many countries, for local
government financial statements to be audited by properly
authorized public officials. Auditors should be qualified,
independent, experienced, and competent. Audits should
be regular and comprehensive. It is unclear whether or not
public official auditors always fulfill these conditions.
In the United Kingdom, for example, there is a Local
Government Audit Commission which employs qualified
accountants either on its own staff or from hired
accountancy firms. Thus, it clearly follows high standards.
Q: How did the worldwide trend of devolution affect
municipal finance?
A: Outside of the former Soviet Union and Eastern
Europe, municipal finance was not significantly affected
by devolution, though there has been a tendency for
decentralization. Central governments hold the purse-
strings and almost all local governments operate under
legislation engendered by the national, or - in federal
systems - state, governments. Local governments rarely
have separate constitutional authority, although there are
varying degrees of local autonomy.
In the former Soviet Empire, changes of systems and of
attitudes were much more dramatic. Local government
units, unlike under the former Soviet system, are not
branches of the general government. They are separate
corporate bodies, or legal persons. But in Russia, and in
other former socialist countries, they have often been
granted "de jure" (legal) independence but not full "de
facto" (practical) autonomy.
There seems to be an unwillingness to accept that the two
systems are intended to operate quite differently. What is
good for a central government is not necessarily equally
good for a local government unit. For example, the main
purpose of local government is to provide public services,
with only enough authority to perform them effectively. It
is almost always the responsibility of a central or state
government to enact and enforce the criminal and civil
law. Local by-laws or ordinances are usually concerned
only with minor matters and are subject to an enabling
legislation. Moreover, they may prove to be "ultra vires"
(beyond their powers) and, therefore, unconstitutional, or
at least unenforceable.
It may be appropriate, under certain circumstances, for a
central government to run budgetary deficits, whether
caused by current or capital transactions. In local
government units, there is almost always a necessity to
distinguish between such transactions. Moreover, in most
countries, local government units are required by law to
have balanced budgets, without resort to borrowing to
cover current deficits.
A corporate body (legal person), whether a private or a
public sector entity, has a separate legal identity from the
central government and from the members, shareholders, or
electorate who own and manage it. It has its own corporate
name. Typically, its formal decisions are by resolution of its
managing body (board or council). Written documents are
authenticated by its common seal. It may contract, sue and
be sued in its own name. Indeed, unless specifically
prevented by law, it may even sue the central government!
It may also have legal relationships with its own individual
members or with its staff. It is often said to have perpetual
succession, meaning that it lives on, even though the
individual members may die, resign or otherwise cease their
membership.
While a corporation owes its existence to legislation, a
local government unit is established, typically, under
something like a "Local Government Organic Law".
Corporate status differs fundamentally from that of (say)
government departments in a system of de-concentration.
Permanent closure or abolition of a municipal council, or
indeed any change in its powers and duties, would almost
always require formal legal action, typically national
parliamentary legislation.
A local government unit makes its own policy decisions,
some of which, especially the financial ones, often require
approval by a central government authority. Still, the central
government rarely runs, or manages, a local government
unit on a daily basis. The relationship is at arms length and
not hands on. A local government unit usually is
empowered to own land and real estate. Sometimes, public
assets - such as with roads or drainage systems - are deemed
to be "vested in" the local authority because they cannot be
owned in the same way as buildings are.
Q: Local authorities issue bonds, partake in joint ventures,
lend to SME's - in short, encroach on turf previously
exclusively occupied by banks, the capital markets, and
business. Is this a good or a bad thing?
A: Local governments are established to provide services
and perform activities required or allowed by law!
Normally, they won't seek or be permitted to engage in
commercial activities, best left to the private sector.
However, there have always been natural monopolies
(such as water supply), coping with negative economic
externalities (such as sewerage and solid waste
management), the provision of whole or partial public
goods (such as street lighting, or roads) and merit goods
(such as education, health, and welfare), and services that
the community, for economic or social reasons, seeks to
subsidize (such as urban transport). Left to the private
marketplace, these services would be absent, or under-
supplied, or over-charged for.
Such services are wholly or partially financed by local
taxation, either imposed by local governments, or by
central (or state) taxation, through a grant or revenue-
sharing system. What has changed in recent years is that
local governments have been encouraged and empowered
to outsource these services to the private sector, or to
"public-private" partnerships.
Charges for services, and revenues from taxation cover
current operating expenditures with a small operating
surplus used to partly fund capital expenditure or to
service long, or medium term debt, such as bond issues
secured against future revenues. Commercial banks,
because of their tendency to lend only for relatively short
periods of time, usually have a relatively minor role in
such funding, except perhaps as fiscal agents or bond
issue managers.
Other funding is obtained via direct - and dependence-
forming - capital grants from the central or state
government. Alternatively, the central government can
establish a quasi-autonomous local government loans
authority, which it may wholly or partially fund. The
authority may also seek to raise additional funds from
commercial sources and make loans on reasonable terms
to the local governments.
Third, the central government may lend directly to local
governments, or guarantee their borrowing. Finally, local
governments are left to their own devices to raise loans as
and when they can, on whatever terms are available. This
usually leaves them in a precarious position, because the
market for this kind of long and medium term credit is
thin and costly.
Commercial banks make short term loans to local
governments to cover temporary shortages of working
capital. If not properly controlled, such short-term loans
are rolled over and accumulate unsustainably. That is
what happed in New York City, in the seventies.
Q: In the age of the Internet and the car, isn't the added
layer of municipal bureaucracy superfluous or even
counterproductive? Can't the center - at least in smallish
countries - administer things at least as well?
A: I am quite sure that they can. There are many glaring
examples of mismatches of sizes, shapes and
responsibilities of local government units. For example,
New York, Moscow and Bombay are each single local
government units. Yet, they each have much bigger
populations than many countries, such as New Zealand,
the republics of former Yugoslavia, and the Baltic states.
On the other hand, the Greater Washington Metropolitan
Area comprises a federal district, four counties and
several small cities. The local government systems are
under the jurisdictions of two states and the federal
government. Each of the two states has a completely
different traditions and systems of local governance,
emanating from pre-independence times. Accordingly, the
local government systems north and east of the Potomac
River (which flows through the Washington area) are
substantially different from those to the south and west.
Finally, the Boston area, a cradle of U.S. democracy, is
governed by a conglomerate of over 40 local government
jurisdictions. Even its most famous college, Harvard, is in
Cambridge and not in Boston itself. Many of the
jurisdictions are so small (Boston is not very big by U.S.
standards) that common services are run by agencies of
the State of Massachusetts.
The problem of centralizing financial records would,
indeed, be relatively simple to solve. If credit card
companies can maintain linkages world-wide, there is no
practical reason why local government accounts for (say)
a city in Macedonia could not be kept in China. The issue
here is quite different. It revolves around democracy,
tradition, living in community, service delivery at a local
level, civil society, and the common wealth. It really has
very little to do with accountancy, which is just one tool
of management, albeit an important one.