Chalk or Cheese?

Commentary, Larry Mitchell, Local Government

Chalk and cheese: As your stomach would tell you if you accidentally mixed them up the difference between two substances really matters.

Unlike the obvious difference between those two items, Canadian municipalities often mix up two very different accounting categories—operating and capital expenditures. The result is that an educated reader is left to guess about municipal financial statements.

This problem was revealed recently in a study on municipal finances I co-authored and which looked at 79 cities across Canada. In it, 18 cities (about 22 per cent) made no distinction between operating and capital expenditures. Some cities provided vague or opaque data and in one serious case involving a major city, operating expenditures were reclassified to capital expenditures (it overstated the year’s results to make it look better).

Such defaults involve a failure to consistently apply proper accounting and audit practices, practices that are fundamental to a correct interpretation of financial results. The result is non-compliance with a mandated reportable change of accounting policy.

So does this matter and if so why?

Certainly. The proper use of accounting standards and accounting policies are essential to the integrity of financial reporting as any Accounting 101 student can attest.

Some of the most basic accounting principles essential for financial reporting integrity relate to an adherence to the accounting period standard (termed a “convention”) that is, the accurate and consistent measurement of a year’s financial result.

Let’s look first at the principles involved and then move to what happens if proper practices are not followed and finally, what can be done to fix it?

Operating expenditures, in the manner in which the proverbial “bean counters” define them, are expenditures that deliver an immediate benefit and are comprised of payments for goods and services that are realised within the current accounting period, usually a (financial) year.

Capital expenditures confer future benefits and are treated quite differently in terms of the measurement of results (profits or losses in the private sector). While operational expenditures as a category are matched (expensed) against a year’s revenues to determine a result, a capital expense is deferred (capitalised) to later years and is matched against the revenues of the future periods to which it relates.

Consider the effect upon reported results of misallocating the two classifications, or the effects of switching from an operating to a capital expenditure. In sporting terms, this would be comparable to moving the goalposts and sloping the playing field at the same time. The score at the end of the game will have been affected by these events. Similarly, an accounting result that arises from incorrect operating-capital distinctions will be biased toward an under- or over-statement of the financial result.

Accountants, both as practitioners and as auditors, have a professional responsibility to ensure the correct distinction between operating and capital expenditures is rigorously adhered to. They need to ensure the practice is consistently applied year on year. In fact, accurate measurement of period results is one of their most important duties because it is fundamental to judgements of performance and results. This duty is essentially no different in accounting standards and practice terms whether the reporting entity is a municipality or a private sector firm.

However, many Canadian municipalities seem to follow widely varying standards. As a result, readers of municipal financial statements – most critically the taxpaying public – are often left in the dark when they try to assess how well (or not) their municipality has performed.

Regrettably, municipal auditors also appear to turn a blind eye to these abuses. My study found no audit opinion that noted a city had misreported operating and capital expenditures, even though it was clear some cities had done just that.

If the performance of municipalities is to be improved, an important first step is to ensure that the operating-capital distinction is meticulously observed. Municipal management should set financial and other performance targets measured in accounting terms that are correct and appropriate. Taxpayers and other readers of their municipal public financial statements can then confidently rely on this reporting. They may then exercise better accountability over both management and their elected members with respect to the actual results compared to projected financial results.

Presently, given the wide variance in how municipalities measure their results, city taxpayers cannot tell if these performance objectives are reached every year, or not. The chalk is being dished up to the public as if it were cheese. It’s about time this changed and the professionals involved acted to correct these anomalies. Readers of municipal financial statements need to be sure about what it is that they are asked to swallow.

This is the first of a series of articles relating to local government. All comments, feedback or direct contact on the subject of this contribution and other local government topics are warmly welcomed.