Local Governments Concerned by Liabilities – a primer

This article was sponsored by the AICPA’s Government Performance and Accountability Committee (GPAC).

If you are a resident or an elected official in a local government and have noticed the liabilities on the Statement of Net Position, this article may be helpful to you. It's common for liabilities to cause anxiety, especially if you are not well-versed in governmental accounting standards. Liabilities have a permanent place on the Statement of Net Position, but should you be worried? Not necessarily, as not all liabilities are created equal. Often categorized by some as either ‘good’ or ‘bad’ liabilities, when leveraged correctly, they can influence growth. These liabilities can be either beneficial or detrimental to the health of the entity's overall financial position. Monitoring liabilities is an ongoing process, and the details matter. So, let’s explore this further.

On the Statement of Net Position, you will find liabilities broken up into two categories: short-term and long-term.

Short-term liabilities are obligations due within one year, such as accounts payable, accrued expenses, and short-term debt. While repayment of these liabilities can place immediate pressure on a government’s cash flow, they are typically manageable and often reflect routine operations. For example, accounts payable often represent expenses like payroll or vendor invoices, which are expected and part of normal business activity.

One critical metric to watch is the current ratio, which compares short-term liabilities to short-term assets (such as cash or receivables). A low current ratio might signal potential liquidity problems, indicating that the organization could struggle to meet its short-term obligations. However, many short-term liabilities are not cause for concern, as they often pay off quickly without threatening the entity's financial stability.

Long-term liabilities, which extend beyond one year, often include bonds payable, pension liabilities, compensated absences, and long-term loans. These obligations are typically tied to the organization’s long-term financial commitments and can carry more weight compared to short-term liabilities.

When properly managed, long-term liabilities can be used to fund major projects, such as infrastructure development or capital improvements, that drive future growth. They allow governments to spread the cost of these projects over time while benefiting from them in the present. However, poorly managed long-term liabilities can become a significant burden, leading to future budget strain. It’s crucial to ensure that these liabilities are used for investments that generate tangible benefits for the community.

In government finance, some liabilities are not meant to be paid off in the traditional sense. For example, pension liabilities represent a long-term commitment to provide retirement benefits to employees. Unlike typical liabilities, pension obligations are not paid off all at once but are managed over time through contributions to pension funds, which are invested to generate returns. These investments help ensure the pension plan can meet its future obligations.

Pension liabilities are often carried indefinitely, as governments make ongoing contributions into the fund, which grows through investment returns. In many cases, governments may never fully "pay off" the pension liability but will instead maintain the fund to ensure it remains financially healthy. Ideally, a pension plan is considered healthy when it is at least 75% funded, meaning the fund has enough assets to cover 75% of its liabilities. Pension liabilities calculations depend heavily on actuarial assumptions such as discount rates, projected rates of return of investments, employment duration, and longevity, which can significantly impact the financial health of the pension plan. These factors cause major fluctuations in liabilities amount from year to year driven from stock market volatility. In addition to pension liabilities, OPEB liabilities, which include healthcare benefits for retirees, are also significant and require careful management.

Certain long-term environmental liabilities can also pose challenges for local governments. For example, if a government owns a landfill or a wastewater treatment plant, there may be significant liabilities related to the closure and post-closure care of these facilities, as mandated by environmental regulations. Some states require ongoing monitoring of landfill emissions and expensive chemical treatments for up to 30 years after the facility closes. While these liabilities can total millions of dollars, payments are made over time as the project reaches completion, and the government gradually works to meet these obligations.

Recent changes in accounting standards, particularly GASB 87 and GASB 96, require local governments to recognize leases and subscription-based IT agreements as liabilities on the Statement of Net Position. These agreements, whether for office space, equipment, or software, involve regular payments over time rather than large upfront costs, enabling governments to acquire resources without significant immediate capital outlays.

However, like other long-term liabilities, these agreements require careful management. They can support growth but impact future budgets and cash flow. Balancing these obligations with other financial commitments is essential to prevent them from becoming an unsustainable burden.

Additionally, GASB 87 and GASB 96 mandate that local governments account for expected lease renewals, even if not legally obligated. This helps forecast long-term financial obligations and assess whether leasing or purchasing is more cost effective. For instance, a government planning to lease office space for 15 years at $120,000 per year must account for a total cost of $1.8 million, compared to $360,000 for a three-year lease. This provides valuable insight into management’s future plans and supports informed decision-making.

Under GASB 96, subscription-based IT agreements, such as software or cloud storage, must also be accounted for as liabilities. Many local governments opt for subscriptions due to the constant updates and the high costs of internal software development. While renewals can increase liabilities, if managed within departmental budgets, they can be a better way to finance such expenses over time.

Another important liability recognized under GASB 101 is compensated absences, which include paid time off (PTO) for vacation, sick leave, and other leave benefits. These obligations accumulate over time and represent a future liability for local governments. As employees earn leave, the government incurs a liability that must be accounted for in future periods. This can have a significant impact on the financial position of a government entity, especially as employees accumulate large balances of unused leave. Proper management and forecasting of compensated absences are critical to ensure that resources are allocated to meet these future obligations without straining cash flow.

Not all liabilities are formally recorded, but they should still be carefully considered as part of a comprehensive risk management strategy. Inadequate training or human errors in key areas can expose the city to substantial liabilities, including the costs of resolving issues or paying fines due to unforeseen lawsuits.

Furthermore, the Governmental Accounting Standards Board (GASB) has released Preliminary Views on critical issues concerning Infrastructure Assets. This is expected to result in a new standard that may require cities to begin recording deferred maintenance for essential assets, such as roads, bridges, water and sewer lines, and other critical infrastructure. Given this, it is essential to assess the age and condition of the city's infrastructure, systematically track asset deterioration, and accurately estimate the costs of necessary repairs. This will enable proper allocation of resources and better long-term planning.

Not all liabilities are inherently bad, and the key to understanding their impact lies in both how they are managed and how they originated. Liabilities can be "good" if they are used to finance growth-generating investments, such as infrastructure or capital improvements that support development of the community in the long run. However, liabilities incurred for short-sighted or poorly planned purposes may become "bad" liabilities, weighing down the financial health of an entity.

Proper liabilities management strategies, including maintaining a balance between liabilities and assets, ensuring timely repayment, and securing favorable interest rates, can turn liabilities into a useful tool for financial growth. On the other hand, excessive liabilities without careful planning or poor decision-making about its origin can strain future flexibility and financial health.

Government entities have unique tools like municipal bonds and access to taxes (e.g., property or income taxes), which allow them to raise capital for large-scale projects. However, they must balance these liabilities with their ability to repay them, ensuring they do not exceed thresholds that could hinder financial stability. Understanding both the origin of these liabilities and how they fit into the entity’s long-term goals is essential for decision-makers to ensure the health and sustainability of the organization’s finances.

To streamline the evaluation process, a two-step approach is recommended:

Determine whether the liabilities are related to recurring operational expenses or one-time capital projects. For example, if your budget is running a deficit (with expenses exceeding income), but you are still allocating $200,000 for a 4th of July fireworks display, borrowing to fund this activity may not be justified. If that's the case, consider options such as cost-cutting measures, improving efficiencies, seeking new grants, or raising taxes to ensure long-term sustainability.

On the other hand, some liabilities, such as investments in future growth or essential community improvements (e.g., replacing lead water pipes or fixing sewage leaks in drinking water), may be justifiable. These investments, while initially costly, can generate long-term benefits and enhance quality of life.

Next, evaluate whether you have the capacity to manage and repay these liabilities, or if they are becoming unmanageable and escalating beyond control.

To gain a comprehensive understanding of a local government's financial health, it is essential to monitor various financial ratios over time to gauge financial trends. Calculating the ratios below on a regular basis may help to identify the trends and measure improvements.

Debt Ratio - Total Liabilities / Total Assets: Measures the proportion of assets financed by debt. A higher ratio indicates greater leverage and potential financial risk, while a lower ratio suggests more stability.

Debt to Net Position Ratio - Total Liabilities / Net Position: Assesses the extent to which net position can cover liabilities, providing insight into financial leverage and long-term solvency.

Liquidity Ratio - Current Assets / Current Liabilities: Measures the ability to meet short-term obligations with the most liquid assets.

Revenue or Expenditures per Capita - Total Revenue or Total Expenditures / Population: Provides insight into revenue and expenditures per resident. Higher revenue per resident indicates higher income or spending, while stable or decreasing expenditures per resident suggest efficient operations.

Net Position Ratio - Net Position / Total Assets: Measures the proportion of total assets financed by net position, indicating financial stability and solvency.

Tax Collection Rate - Collected Taxes / Total Taxes Levied: Measures the efficiency of tax collection efforts. A higher rate indicates effective tax collection processes.

Liabilities on the Statement of Net Position may initially seem concerning, but not all liabilities are a cause for alarm. Short-term liabilities are often part of the normal flow of operations, while long-term liabilities can be used to fund growth and improve public services. The key is understanding the nature of each liability, how it originated, and how it fits into the long-term financial strategy of the entity.

Effective management of liabilities ensures that they serve as a tool for financial stability and growth, rather than becoming a financial burden. By monitoring liabilities carefully, making strategic decisions about their origin, and implementing sound financial practices, local governments can ensure they remain on solid financial ground.