4 Ways a City Can Hide Its Insolvency Using Accounting
This article was originally published, in slightly different form, on Strong Towns member Michel Durand-Wood’s blog, Dear Winnipeg. It is shared here with permission.
(Source: Pixabay.)
The fact that you saw the word “accounting” in the title and still clicked through to read this tells me you are a special human being. One that cares so deeply about their city that they’re willing to take time out of their busy day to deepen their knowledge of the issues in order to make a positive impact in their community. I humbly salute you.
On the other hand, if you only came here accidentally because you meant to click on that article listing “4 Ways To Be Just Ken,“ I promise to make it worth your while with several hilarious accounting memes. Not enough to keep you here? Fine, fine, I’ll throw in a shirtless Ryan Gosling, too!
If you don’t know the difference between the operating budget and the capital budget, you could read “Accounting 101 for Councillors, Mayors and Free Press Columnists” to brush up on some key concepts, and then follow it up with “Holy Leaping Dollars, Batman!”
But if you’re short on time, here’s a quick recap of the important stuff:
Very generally, infrastructure spending goes in the capital budget, while spending for services goes in the operating budget.
Money for the operating budget comes from taxes and fees collected in the same year it’s being spent.
Money for the capital budget comes from, well, basically anywhere.
It’s those last two points I want to focus on. In Manitoba, the province long ago made it a law that municipalities always balance their operating budget, meaning income must always exceed (or at least equal) expenses every year. Deficits are not allowed, by law. And by extension, that means going into debt to finance your city’s operations is also not allowed.
This is the case everywhere else in Canada, too, as well as many, if not most, places in the U.S.
And I think most people can pretty easily understand why this is good policy. Cities that routinely spend more than they take in would rapidly get into financial trouble, same as any person or business. After all, a City is basically just a corporation, and we are its shareholders.
But what about cases where debt could be used to smooth out cash flows? For example, infrastructure maintenance obligations usually aren’t equal from year to year because the infrastructure wasn’t all built in equal amounts over time. A careful use of debt could help a City meet its maintenance obligations without wild swings in spending (and taxation) from year to year.
Well, they thought of that. Because while municipalities aren’t allowed to take on debt in their operating budgets, they are allowed use debt for their capital budgets.
Now, it’s important to note that “operating” and “capital” are accounting distinctions, not real ones. Because money is fungible, a fancy term that means all dollars are identical and perfectly interchangeable. It doesn’t matter whether you have this dollar bill in your hand or that one, or which specific dollar was spent where.
So whether you borrow for your capital budget or your operating budget, the impact to your balance sheet is exactly the same.
Take for example two businesses: Prudent Corp. and Careless Inc. Both have $1 million in cash from past profits, a need for new equipment, and shareholders who demand a dividend.
Prudent Corp. decides to use their $1 million in cash to pay dividends to their shareholders, while borrowing $1 million to invest in new equipment to increase sales.
Careless Inc. instead decides to use their cash to invest in new equipment, and borrow the $1 million to pay the dividend to shareholders.
In the end, despite the difference in what they say they borrowed for, the balance sheets of both companies will be identical: $0 in cash, $1 million in debt, and $1 million in new equipment. It doesn’t matter which specific dollar went to what.
It’s the same for cities.
And since “operating” and “capital” are just constructs of accounting, and all dollars are fungible, it’s possible to turn one into the other, and back again, in order to borrow money for things we couldn’t borrow for before.
If we’re not paying attention, that makes it harder to tell whether a City is using debt to simply to smooth out cashflows, or if it’s just covering up insolvency.
Let’s look at a few of the ways to do it!
1. Outsource It
Ever wonder why the City doesn’t have its own staff to do road maintenance? Well, they used to. For a long time, that was how road construction and maintenance was done. Not only did the City have its own road maintenance workers, but they had a significant investment in equipment, machinery, and even their own concrete plants.
But around the 1960s, the City found itself short of money, so calls for the City to look at more cost-efficient ways of doing things started getting louder, including contracting out work that had traditionally been done by City staff.
Excerpt from the Winnipeg Tribune, January 12, 1961, page 82.
The debate raged on for decades, with both sides showing evidence that their way was cheaper. But 30 years later, the financial and political pressures finally took their toll, and the City made the full switch to contracting out all its roadwork to private contractors in the late 1990s.
Article headline from Winnipeg Free Press, January 19, 1996, page 22.
Now, I’m not here to judge which of in-house or outsourcing is actually the cheapest. What I want to show is the accounting impact of such a decision.
When the City was doing its own roadwork, the expense was a mix of operating and capital. The cost of buying machinery, the concrete itself, and other long-term expenses were capital expenses. And so the City could borrow money for these if it needed.
Meanwhile, the significant costs of worker wages, fuel for the machinery, and other short-term expenses were operating expenses.
But, by contracting out the roadwork, all of those expenses get lumped together into one product: a newly maintained road, which is a capital expense.
So, simply by outsourcing roadwork, the City had turned a sizable portion of its operating expenses into capital expenses. The end result was the same, a newly maintained road, but now you could fund the expenses that used to be operations, with debt.
This may not have been the intention, but it certainly was the result.
2. Transfer It
When a City has a year with more income than expenses in their operating budget, which you’ll remember is required by law, they put the surplus into reserve funds. Cities use reserve funds to, well, reserve funds for specific uses. Two types of those are capital reserve funds and rainy day funds.
They’re just like they sound. Capital reserve funds are funds set aside to use for capital expenses that will come up in the future, like bridge replacements or sewage treatment plant upgrades. Rainy day funds are money set aside in order to smooth out unforeseen expenses in the operating budget.
They’re like savings accounts that we earmark for specific purposes. But just like real savings accounts, we can easily take money from one and put it in the other.
For example, in the 2023 budget, the City moved $15 million from the Water & Sewer capital reserve fund into the Financial Stabilization Reserve Fund (the “rainy day fund”). Meanwhile, the City currently projects it will need to draw $7.1 million from the rainy day fund to erase the operating deficit it is facing for 2023, as it must, by law.
This is the City taking cash that was set aside for capital expenses, and converting it into cash for operating expenses. Then it will need to use debt to fund the capital expenses since that cash is now gone. But the only reason that debt is needed in the first place is because of an operating shortfall. We are funding our operations with debt using nothing more than a journal entry.
Magic? No, accounting.
3. Syphon It
What if you could take money out of a capital reserve fund before it even gets there? Well, if your city operates its own water and sewer utility like Winnipeg does, you can!
In 1988, the city of Winnipeg started increasing its water and sewer rates in an effort to collect more revenue from user fees instead of property taxes. According to the mayor in this article of the December 10th, 1987 Winnipeg Free Press, this wasn’t only a policy aimed at “disguising the source of city revenues,” although it did do that. More importantly though, it would make it possible for money that could have normally gone into capital reserves to maintain water and sewer infrastructure, to be used to fund the City’s operations.
Just since 2011, nearly $392 million has been syphoned from the utility in order to fund the operating budget.
And with a planned increase to water and sewer rates of more than 20% over the next four years, that total will grow to nearly $750 million before the end of this decade.
That’s a lot of money. Almost enough to fund the entirety of the much-needed $1.035 billion work on the North End Sewage Treatment Plant. That money will now need to be borrowed.
Remember the example of the two businesses: whether we borrow to fund operations and use cash to upgrade our infrastructure, or we use cash to fund operations and borrow to upgrade the infrastructure, the end result on our balance sheet is the same. A dollar is a dollar.
In this case, spending utility rate income on operations is just an accounting way to allow us to borrow money to fill the hole in our operating budget.
4. Invent It
By this point, I think you’re starting to understand that the restriction on borrowing in the operating budget while allowing it in the capital budget is essentially meaningless, since there are many ways to, legally, change one type of dollar into the other and vice-versa. Like I’ve said before, capital dollars are just operating dollars from another year.
And because of this, there are countless other ways just waiting to be discovered that will effectively let a City borrow money to fund its operations, disguising its insolvency in debt purportedly being used for infrastructure.
Now, I want to make it clear that I’m not suggesting any of this is being done nefariously. Humans are just good at being creative in stressful situations, and the financial situation faced by our City, and most others in North America, is stressful. Well-meaning public servants and elected officials are simply doing their best to keep all the balls in the air for as long as possible. They wouldn’t be the first to pay their Visa bill with money advanced from their MasterCard to make ends meet.
But that doesn’t make it right.
And the first step to correcting it is identifying when it’s happening.
Now, it would be easy to take the fact that the City has been funding its operations through debt for decades as proof that its operating budget is out of control. That those fat cats at city hall just need to do a better job getting spending in line. The police budget, wages, red tape, inefficiencies!
But we’ve been looking for the problem in the operating budget since the 1960s, and things are worse than ever: even after more than six decades of service cuts, we’re now abandoning infrastructure because there’s no money, saved or borrowed, to fund its replacement.
So where’s the problem?
Well, we just spent nearly 2,000 words together showing how capital dollars and operating dollars are basically interchangeable. Here’s a thought: how about the capital budget?
The reality is that our City, like most others in North America, has built more infrastructure than it has means to maintain. More than we can pay for as taxpayers, in fact, to any level of government.
A recent report showed we have $12.8 billion of infrastructure work that needs doing over the next decade, but that we are short $8 billion to do so, a deficit which is $2 billion higher than five years ago. That works out to a shortfall of about $800 million per year, which is more than all the property taxes we budgeted to collect in 2023.
This didn’t happen overnight.
Because capital dollars are just operating dollars from another year, they don’t show up in our financial results right away. But every capital dollar we spend today impacts our operating budgets in the future. That delay is what makes it more difficult to spot those impacts.
Capital spending is often touted as an investment. And it is. But, just as with regular investments, there are good investments and there are bad investments.
And when you find yourself struggling to make your car payments because you lost your money on bad investments, the solution isn’t to ask your boss for a raise, borrow money from your parents, cut your grocery budget, and skip the oil changes. Those may be necessary, but they’re only interim measures to buy you time.
The solution is to stop making bad investments.
Thanks for sticking with me. And now, as promised, here’s a shirtless Ryan Gosling:
Michel Durand-Wood lives in the Winnipeg neighborhood of Elmwood with his wife and three children. He writes at DearWinnipeg.com, a really fun blog about infrastructure and municipal finance. He has no formal training or education in city planning, municipal finance, infrastructure maintenance, or anything else he talks about. He's just a guy, in love with a city, asking it to make better use of his tax dollars.