The End Is Near for Outdated Government Financial Reporting

By way of a few paragraphs inserted into the recently enacted 4,000-page 2023 National Defense Authorization Act, Congress mandated that state and local governments prepare their annual financial statements in a standardized format that is electronically searchable. The provision effectively drags state and local governments kicking and screaming into the 20th century, if not the 21st.

As worthy an accomplishment as this appears to be, it was resisted mightily by the state and local government financial community. Most prominently, they argue, the measure can potentially result in a major transfer of accounting and reporting regulatory authority from states to the federal government, thereby undercutting what many consider a fundamental principle of federalism. Moreover, state and local officials see it as one more costly unfunded mandate imposed upon their governments.   

The opposition by state and local governments is understandable. But they have no one to blame but themselves. To this day they are wedded to a technological past. In a perverted way, they may be getting their just desserts. The act requires them to do little more than what they should have done years ago on their own for the benefit of their investors and other stakeholders.  

Implicit in the act is that governments will have to prepare their financial statements using XBRL (eXtensible Business Reporting Language) or some comparable reporting framework. This is the format that the Securities and Exchange Commission, which would be charged with implementing the new provision, currently demands corporations use in their financial filings. XBRL requires all entities to classify each of the elements of their financial statements (e.g., assets, liability, revenues and expenses) by identical rules and in machine readable form.    

Developing an XBRL or similar taxonomy inevitably involves establishing accounting standards beyond merely assigning accounts to specific boxes in a spreadsheet. Currently, accounting standards are developed by the Governmental Accounting Standards Board (GASB), a nongovernment entity. Although its pronouncements are recognized as “generally accepted accounting principles” by the accounting profession as well as state governments themselves, the states nevertheless retain ultimate authority over the form and content of financial statements.   

While nothing in the act explicitly transfers standard-setting authority from the GASB to the SEC, when a camel gets its nose in a tent, its tail cannot be far behind. In other words, the act may be a sign of greater SEC—and thus congressional—involvement in financial reporting matters previously left to GASB and individual states.   

Although XBRL reporting is a necessary step forward, it is nothing but a baby step. Embarrassingly, state and local governments are still committed to paper annual financial reports. Virtually all governments large enough to issue public debt post their annual financial reports as PDF files on their websites. But these files are, in essence, nothing more than photos of their paper reports, which for even just mid-sized governments can run in excess of 250 pages. They take virtually no advantage of computer capabilities that would make their annual reports more user-friendly and ultimately useful to governments various stakeholders.  

Genuine electronic reports, as opposed to PDF files, can provide detailed information for those who need it (e.g., incorporating electronic links to specific sections facilitating data “drill-downs”) without overwhelming other users with excessive amounts of information. This would improve the efficiency of the municipal securities market offering benefits to both governments that sell debt and the investors who buy it. This isn’t rocket science. In fact, it is not even computer science. It’s computer programming 101.   

While not addressed by the act, an even greater challenge for investors and other financial report users than the difficulty of navigating through paper-like reports is the tortoise-like speed at which state and local governments issue their financial statements. According to Merritt Research Services, the median time between the end of a government’s fiscal year and the date that its auditors sign off on the financial statements is 166 days. This contrasts with deadlines of 60 to 90 days that the SEC imposes upon businesses to file their annual reports. Since unfunded pension fund liabilities are often a government’s largest liability, and are directly dependent upon financial market valuations, this six-month delay effectively renders the financial statements useless for anyone charged with assessing the government’s fiscal sustainability.   

The costs of the improved technology required to issue financial statements that are both timelier and more informative cannot be minimized. Neither, however, can the analytical costs inherent in the status quo. These costs are currently borne by bond underwriters, rating services and individual investors. Ultimately, however, they are passed back to taxpayers in the form of higher borrowing costs paid by state and local governments as a result of unnecessary levels of financial information uncertainty.  

It is to be hoped that the measure just enacted will be a lesson learned by state and local governments. If they fail to do voluntarily what needs to be done for the investor community and their constituents, the federal government will be more than happy to do it for them.