If you’re a financial specialist who specializes in the municipal bond market, you were probably fixated on the news about Detroit, Michigan last Thursday. After all, the announcement of the largest municipal bankruptcy filing in American history reminded investors of Meredith Whitney’s 2010 prediction of the imminent fiscal collapse of dozens of cities.
Nevertheless, just one day later, an even more worrisome announcement was released for public consumption. The United States Securities and Exchange Commission (SEC) revealed that it is charging the city of Miami, Florida and its former budget director with securities fraud for making false and misleading statements about certain fund transfers. In other words, the city and its chief fiscal officer are accused of lying to the capital markets.
Because an advanced understanding of municipal accounting principles is often required to distinguish between true and untrue statements about fund transfers, the Miami story received far less news coverage than the Detroit story. Nevertheless, the Miami story may ultimately generate far more significant concerns for investors.
That’s because, even if Ms. Whitney proves to be correct, her predicted fiscal collapse would only involve a limited number of municipalities. The types of accounting practices that were charged by the SEC, though, represent much more pervasive problems.
In essence, the SEC has accused the City of Miami of inappropriately shifting monies in and out of certain high visibility funds in order to improve their cash positions. For instance, the regulator has charged that the city “orchestrated … transfers from (its) Capital Improvement Fund to its General Fund in order to mask increasing deficits in the General Fund, which is viewed by investors and bond rating agencies as a key indicator of financial health.”
Of course, shifting monies from one account to another is merely one approach that government officials take to hide financial shortfalls. Former Minnesota Governor Tim Pawlenty, for example, had been accused of shifting spending obligations from his state government to localities in order to improve his own fiscal budgets.
Connecticut Governor Dannell Malloy avoided such cost shifting activities, relying instead on tax increases and other tactics to balance his state’s budget. Interestingly, though, Malloy did opt to delay Connecticut’s adoption of Generally Accepting Accounting Principles (GAAP) by at least two years, a shift that allowed him to defer the recording of certain GAAP costs.
Such accounting shifts have long been employed in the private sector as well as the government sector. The accounting profession has adopted the phrase earnings management to describe such practices.
If the SEC is successful, though, some of these practices may come to be known by another phrase as well; namely: “criminally fraudulent activities.”