Choosing the Right Annual Financial Report for Your Entity

This blog post was cowritten by Mike Bailey and Toni Nelson. 

Over the past few months we have been reviewing the options available to local governments for satisfying their financial reporting obligations in Washington State. In our first article, we described the basis and rationale for annual financial reporting options. The second article described the Generally Accepted Accounting Principles option known as GAAP, and we followed that up with the third article describing the alternate method of accounting and reporting on a Cash Basis (also known as the “Other Comprehensive Basis of Accounting” or OCBOA).

In this last article of this four-part series, we will provide some of our thinking on policy issues that you might consider in selecting the best option for your local government. It is our hope that you can use these articles as part of a thoughtful approach to selecting the best method of financial reporting for your entity.

A Recap

First, a brief recap of the two choices. GAAP is determined by the Governmental Accounting Standards Board (GASB) and focuses on both the current and longer-term implications of financial activity. It adheres to such principles as inter-period equity (putting activity in the time-period where the underlying activity occurred) and long-term financial condition (long-term assets and liabilities).

Cash-basis reporting requirements are determined by the Washington State Auditor’s Office (SAO) and focuses on the current fiscal period. If the activity impacts cash, it is recorded. The use of cash basis revolves around bank account activity and the receipt and disbursement of cash. Long-term, non-cash financial transactions are not recorded (such as depreciation, earning future revenues, or incurring future liabilities). As a result, the focus of cash basis is the short-term financial impacts to cash flow.

Arguments for GAAP

The fundamental theory of GAAP reporting aligns with an evolving notion of long-term fiscal solvency. Many local governments have recently pursued a longer-term view of financial planning in order to provide more stability for their operations over time. GAAP financial statements include long-term assets and liabilities. They record future outlays of cash being earned by employees as expenses — in the current fiscal period. GAAP statements recognize the slow consumption of long-term assets as they are utilized rather than only when they need to be replaced (depreciation and amortization). In short, GAAP statements reflect the impacts on our financial condition of current services and facilities regardless of when this impact actually hits “cash.” While this effort to identify all potential impacts has led to some rather esoteric examples (e.g., impairment of assets, irrevocable split-interest arrangements, etc.), few can argue that it isn’t a more accurate reflection of our operations than strictly relying on cash-basis accounting.

Arguments for Cash

The primary argument for reporting on a cash basis has always been based on cost savings and efficiency. The simplicity of both the daily accounting of financial transactions in addition to the simplified method of reporting financial activities are strong arguments for cash-basis accounting and reporting. Cash-basis reporting represents a cost savings both in the area of finance staff expertise with governmental accounting requirements as well as the time efficiencies realized in performing the day-to-day duties of finance staff. These increased efficiencies are most apparent when preparing the annual financial report. For smaller jurisdictions with limited staff who have multiple demands upon their time, this is a significant factor for the use of cash basis.

Financial statements and the notes to financials can be easily generated using the SAOs tools and templates as long as care has been taken to reconcile the cash activity throughout the year. While the SAO continues to impose additional GAAP requirements on cash-basis entities, the increased time required to prepare the report is substantially below that of GAAP-reporting entities.

Cash-basis reporting does not require the extensive analysis required by GAAP entities. Instead, it focuses its attention on the cash available for current budgetary needs. Additionally, cash basis provides greater transparency of the flow of cash through the organization, provides an accurate picture of how much cash is on hand, and easily allows for a comparative analysis of budget-to-cash availability to assure budgetary compliance.

Arguments against GAAP

Attempting to identify all fiscal implications of current activity, including those that won’t be realized until some future date, can be complicated. In fact, GAAP reporting is very complicated and getting more so all the time. This highly technical work requires a great deal of expertise in a very obscure field — government accounting. Finding (and retaining) staff with this level of expertise is challenging. Additionally, maintaining sufficient staff skills and knowledge as the standards continue to evolve can be an expensive proposition. Attempting to adhere to GAAP standards when staff is in transition or does not have access to current training can lead to misstatements and audit problems.

Comparison of GAAP-style financial reports to budgetary reports and plans can be challenging. As we’ve stated previously, the cash format more closely resembles the budget approach for most organizations. In fact, for those organizations that split the difference — using GAAP for annual financial reports and something more like cash for budgeting — it can become confusing. This isn’t helpful for the agency, as the whole purpose of the financial report is to provide clarity and transparency. Notes to the financial statements in a GAAP annual financial report can be dozens of pages long! Often, we find that policymakers are more comfortable with the budget-basis perspective rather than the more esoteric GAAP financial data.

Arguments against Cash

The most significant argument against the cash-basis method is the fact that it’s focus is short-term in nature. Cash-basis reports do not reflect the true financial condition of the entity because the financial statements do not provide information about assets held by the agency and liabilities are presented as a separate supplemental schedule.

The lack of a long-term fiscal perspective requires additional consideration, especially in the areas of debt management and planning for future capital needs. More sophisticated studies of financial viability and impacts of proposed changes to levels of service may require outside assistance from consultants that specialize in these areas of analysis.

Conclusion

Local governments have a unique opportunity here in Washington State as SAO, in establishing its guidelines for annual financial report, created two alternatives; GAAP or cash, giving agencies a choice in how to approach the required annual financial reporting.

Which approach an agency will take should be a thoughtful policy decision, made after weighing the benefits and negative aspects of either choice. Typically, smaller organizations have used the cash approach while larger organizations, with larger, technically trained staff have utilized GAAP. However, we’ve heard from some mid-sized governments asking for advice on which might be best for them. The answer, of course, is “It depends.”

Hopefully these articles have helped you evaluate your options and make the best choice for your organization.