Cash versus Accrual Accounting

In the municipal market, there are debt issuers that follow cash-basis accounting and those that practice accrual-basis accounting.  Cash-basis accounting recognizes expenditures only when the cash is actually disbursed, while accrual-basis accounting matches revenues with expenses.  The difference in accounting methodologies is material to determining the credit worthiness of an issuer because cash-basis accounting is susceptible to manipulation and could potentially present a false financial picture.  Most municipal issuers, with the exception of local governments in New Jersey, practice US GAAP accrual-basis accounting for fiscal year-end financial reporting.  However, almost all municipalities and states use cash-basis practices for budgeting.  This is problematic because it is easy for a municipality to use budget gimmicks to show a balanced budget, when in fact its financial position may be deteriorating.  Recently we heard of California’s $2 billion+ budget surplus, credit rating upgrade, and credit spread compression.  At the same time, California pension liabilities grew by $10 billion+, which could lead to diminishing balance sheet strength.  It is important to remember that a cash-basis budget is the road map for a municipality to follow during the year.  A budget estimates tax revenues and sets spending priorities based on the agenda of an elected leadership.  In no way does a balanced budget mean a high level of credit worthiness.   A balanced cash-basis budget does provide insight into management’s character and its ability to adjust spending to match economic condition.  This is the reason we spend so much time analyzing year-end financial reports and give them more weight than annual budget plans.