California State Auditor Ranks 471 Cities On Financial Health, Finds 18 at High-Risk
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Commentary

California State Auditor Ranks 471 Cities On Financial Health, Finds 18 at High-Risk

Overall, more than half of California's cities were listed as being at a moderate to high risk of experiencing fiscal distress.

Full disclosure: I had the privilege of advising on this project and am impressed with the tool that the auditor has delivered.

The California State Auditor launched a new dashboard that allows the public to compare the financial statistics of 471 cities and see which ones are at the highest risk of distress.

As the Associated Press reported:

State Auditor Elaine Howle ranked the financial condition of 471 California cities on Thursday, with Compton topping the list for local governments labeled “fiscally challenged.” More than half of the cities were listed as moderate to high risk for financial problems.

The cities’ struggles contrast with California’s overall economy, now in its 115th month of growth, breaking a record set in the 1960s. Unemployment is at historic lows and the state has so much tax revenue that the Legislature approved a budget earlier this year with a $21.5 billion surplus.

Howle said 337 out of 471 cities have not saved enough money to pay for future retiree health benefits. Nearly half of the cities are not saving enough money to pay pension benefits in five years.

She also said she was alarmed to see some cities borrowing money to pay for pension obligations. “Right now, we’re in strong economic times, but everybody is expecting that recession to hit,” Howle said. “So hopefully this information will trigger some discussions and decision-making that better prepare cities to be able to respond to that recession, without cutting services.”

Background

Four California cities filed for bankruptcy between 2008 and 2012, while others defaulted on municipal bonds. Also during this period, the city of Bell, while remaining solvent, was found to have engaged in a series of corrupt practices that resulted in the loss of millions of taxpayer dollars. Severe fiscal distress and corruption can result in the sudden loss of municipal services, sharp reductions in public employee benefits and layoffs.

The California state legislature responded to concerns over local government financial management by giving the state auditor the authority to operate a “Local Government High-Risk Program.” Since the inception of this program, the auditor has investigated numerous cities and special districts thought to have management issues or financial difficulties.

In a December 2018 report, for example, the auditor found that the city of Montebello (Los Angeles County) was siphoning money out of its general fund to offset losses at a city golf course, compromising its ability to maintain essential infrastructure and placing it at risk of a financial emergency.

But with over 400 cities and about 4,000 other California local governments, prioritizing entities for audit attention can be challenging. By using a standardized measure of financial wellbeing based on accounting ratios, the state auditor can more readily identify those governments requiring audit attention. The new dashboard, which features fiscal health scores on a 0-100 scale, fulfills this need for California cities.

The New Dashboard

After consulting with me and other advisors, the auditor’s staff selected 10 financial metrics to use for the scoring system. The metrics consider liquidity, revenue trends, debt burdens, pension and other post-employment benefits (OPEB) obligations. The highest weight is accorded to a general fund reserve ratio, a weighting supported by my own research on California bankruptcies. Low or negative general fund balances—relative to expenditures—are strongly associated with municipal bankruptcy filings.

As the dashboard explains:

We selected a set of 10 indicators that enabled us to assess each city’s ability to pay its bills in both the short and long term. Specifically, the indicators measure each city’s cash position or liquidity, debt burden, financial reserves, revenue trends, and ability to pay for employee retirement benefits…

We assigned points to cities based on the calculated result of each indicator, and then ranked cities based on their accumulated scores. Cities could score anywhere from zero points up to the maximum available points for each indicator. A perfect score across all indicators would equal 100 points with lower scores representing higher degrees of fiscal risk.

Several of the names on the auditor’s distress list—i.e., the cities with the lowest scores – have popped up in my own rankings. These include Compton, which received a zero because it is several years behind in filing its audited financial statements, as well as Maywood and Marysville. Another city on the distressed list, Richmond, was the topic of a recent Reason blog post.

But the data and analytics are far more elaborate than anything I have been able to produce. Staff collected three years of data for about 470 cities (a few cities are too small to issue audited financial statements) and set up the dashboard so that users can visualize this information in a variety of ways.

Opportunities for Improvement

We now have a state-of-the-art resource for monitoring municipal fiscal health. Going forward, I see two opportunities for improvement:  publish the scores faster and extend coverage from cities to other types of local governments. Right now, scores are based on data for the 2017 fiscal year for cities—counties and special districts are slated for a later stage.

Shorter lag time and greater coverage would be facilitated by introducing the use of XBRL for government financial statement reporting, as we have discussed elsewhere. The speed and scope of the auditor’s efforts are limited by the fact that financial data must be located and rekeyed from PDF financial statements. If these PDFs were replaced by machine-readable reports, the process of collecting data for the scoring system could be fully automated.

In theory, the auditor could use data supplied on the state controller’s ByTheNumbers website, but these sometimes diverge from the figures appearing in local government audited financial statements, which, because they are reviewed by an independent certified public accountant constitute the gold standard in financial reporting.

Earlier this year, State Sen, John Moorlach introduced SB 589, a bill that would have commissioned a study of XBRL technology for California local government reporting. Although supported by the treasurer and passed unanimously by both state houses, the bill was vetoed by Gov. Gavin Newsom. Perhaps legislators can alter the bill to meet the governor’s concerns, which focused on certain legislative details rather than the overall concept so that he’s open to signing a version in a future session.

Other policy reforms that would assist the auditor’s process would involve ensuring the timely availability of standardized audits from all-important local government entities. The state of Utah requires all governmental entities with more than $1 million of revenues and expenditures to file financial statements with that state’s auditor within six months of the end of the fiscal year. California should consider similar legislation. It should also consider requiring all entities to follow standards pronounced by the Government Accounting Standards Board (GASB). Two California cities filed cash-based audits and had to be excluded from the analysis for comparability reasons.

The Implications for Other States

With the release of the dashboard, California joins several states conducting systematic fiscal monitoring of local governments. Other states that have well-developed monitoring systems include New York, North Carolina, Ohio and Virginia.

Elsewhere, non-government organizations have conducted their own surveys of local finances. In 2018, the Yankee Institute published scores for Connecticut’s local governments. More recently, David Lucey, a Connecticut-based machine-learning consultant calculated scores using a similar approach over a 15-year period. Work on a Vermont municipal fiscal ranking will soon be published by the Ethan Allen Institute. Nationally, Truth in Accounting publishes fiscal grades for the country’s 75 largest cities, and in Puerto Rico, AbrePR has been scoring the commonwealth’s municipal governments for several years.

Conclusion

While there are always opportunities to do more, the bottom line is that the state auditor has taken an important step toward ensuring sound local government fiscal activity and preventing a future round of fiscal calamities. Hopefully, the early warnings provided by the dashboard will encourage fiscally responsible actions in the distressed cities and the auditor’s work will set an example for oversight agencies in other states.

Marc Joffe is a senior policy analyst at Reason Foundation.