The sovereign debt crisis could see the public sector go bust. More consistent and transparent government accounting can help lower the risk carried by future generations

Incentives have consequences, good and bad. The latter are often unintended.

That, to me, is the key lesson of the economic episodes that have punctuated the bumpy path from dot com boom and bust to the banking crisis to the sovereign debt crisis we face today.

In the United States, where I grew up, at least three industry sectors have gone bankrupt during my lifetime: the steel industry in the 1970s; the airline industry in the 1980s/1990s; and the car industry just a few years ago. To these three sectors, I think we are perilously close to adding a fourth – not just in the US, but also in Europe – and that’s the public sector.

Many put the blame for these sector failures squarely on the labor unions, for demanding too much. But in my view, the unions were just doing their job. When they asked for better pay, the management chose to reward workers through pensions and welfare provisions – because these didn’t hit the current profit & loss. The accounting rules of the time incentivized management to essentially sweep these costs under the carpet. That bulge under the carpet continued to grow, until eventually entire industries tripped over it.

What this illustrates, in my view, is that rules create incentives that directly influence behavior. And that accounting rules and budgetary policies create definite incentives.

So, how is this relevant to the sovereign debt crisis? Fast-forward and switch the scene to government, and I think we face a similar situation – whereby rules are incentivizing the wrong kind of behavior.

Today’s governments are incentivized to mortgage their long-term future for short-term benefit. Election and budgetary cycles encourage governments to concentrate on short-term reporting cycles. Consequently, many are still accounting for pensions, post-retirement health benefits and other entitlements on a cash basis. They don’t have the processes or systems in place to take stock of the assets and liabilities they hold. And this is at a time when the need for governments to be accountable for their decisions around resource allocation is more important than ever before.

The sovereign debt crisis exposed the seriousness of poor financial management and sub-standard reporting by the public sector. It exposed the problems of archaic accounting and the need for modernizing control systems and financial infrastructure. Yet today, governments are still taking far-reaching decisions, which will affect their countries for years to come, with limited discussion and almost no disclosure of the long-term consequences.

In the aftermath of the financial crisis, governments, the IMF, bond markets and investors need to be making the right decisions more than ever. But they need much better information to do so, and the public has a right to see such information. So it’s inevitable that questions are being asked today about the appropriateness of government accounting.

Poor government accounting alone did not get us where we are today. Fundamental issues need to be addressed around market reform; government spending and taxation; and social provision and dependency cultures. But accounting can help lower the risk of decisions being made that burden future generations, and I think that this can be done in three ways.

1. Improve transparency in government accounting

Over a generation or so, the private sector has had to incorporate measures that address the transparency and usability of financial statements. In my view, the public sector urgently needs to do the same.

We have to go into this with our eyes open – with improved transparency, the financial situation of many governments might well look worse before it looks better. But I firmly believe that better quality financial information is a must for governments to perform efficiently and effectively.

More widespread adoption of accrual accounting is an important step. While many countries have moved to accrual-based accounting, there are exceptions such as Germany, Italy, The Netherlands and Japan. And, while not affected by sovereign debt in the same way, major economies like India, Brazil and China are still using cash-based accounting.

Of course, there are hurdles to change. The link between financial accounting and budgetary accounting and appropriations is one. A lack of resources to fund these reforms and to develop internal expertise is another. But these are not insurmountable challenges. And organizations like the World Bank and IMF are very active in funding capacity building, conversion and implementation.

In addition, governments need to provide more comprehensive reporting. It’s no longer enough to judge governmental performance limited to the financial perspective, based on a single balance sheet date. Governments need to move beyond the four-year election window and take a longer-term view – say over 40, 50 or even 75 years – and consider General Purpose Financial Reports such as ‘Reporting on the long-term sustainability of Public Finances’ or ‘Service Performance Reporting’.

2. Improve consistency and comparability by adopting international accounting principles

My profession has long argued that today’s complex and interconnected world demands a single set of high-quality accounting standards to provide the comparability that cross-border companies, cross-border investors and global capital markets need. The same holds true for the public sector.

Yet, unlike Government Financial Statistics, governmental accounting and financial reporting standards are still largely inconsistent. As governments increasingly work together on co-ordinated rescue efforts – and as such share a common liability – it becomes more unacceptable for differences between accounting standards and levels of transparency to be continued.

In fact, global financial regulatory convergence is something that the G20 and many other countries have called for to create stability for capital markets and investors. We think International Public Sector Accounting Standards (IPSAS) are a large part of the answer, but few countries are applying them in their entirety.

There have been some encouraging signs, however. While the rejection of the European Parliament monetary and economic affairs committee’s proposal to mandate IPSAS for its member states was disappointing, although not surprising, the proposal itself is positive. And we’re pleased that a study is being conducted on the average gap between current Governmental Accounting and IPSAS, which Ernst & Young is helping Eurostat with. Based on these results, Eurostat will assess the feasibility of an EU-wide conversion before the end of the year.

3. Improving clarity of communications and therefore accountability

Our Toward Transparency study found that few governments see essential stakeholders as key users of governmental financial statements. When asked who their key users were, around two-thirds of governmental financial officials across 33 countries did not mention international financial institutions and ratings agencies. And only half mentioned their own citizens – who presumably have a great, and growing, interest in how their taxes are being spent.

As governments come under increasing scrutiny from stakeholders questioning their response to the current economic situation – governments will be forced to change their approach. Presenting information to a broader range of stakeholders, in a clear and digestible form, helps to improve stakeholder understanding. Just as importantly – it helps to foster a culture of accountability, which aids better decision making.

There are some examples of leading practice. France’s Les Comptes de l’État gives an easily digestible overview of the important financial facts, for example, and the United States’ Citizens Guide to the fiscal year 2011 is another.

But in demanding clearer communications and accountability, there are fundamental cultural issues that need to be addressed. Politicians need a framework that incentivizes them to take decisions that better align to the long-term public interest – not the electoral or annual budgeting cycle.

As a profession, and indeed as citizens, we must call for institutional arrangements that change politicians’ incentives and effectively constrain their behavior. The work that IFAC and the UK’s Chartered Institute of Public Finance and Accountancy are jointly pursuing to establish a governance framework for public sector organizations is a positive and encouraging step.

Building skills

Achieving these three improvements will require a commitment from governments to build their financial management skills and capabilities. Just recently in Australia, the Auditor General’s report to the New South Wales’ parliament highlighted the need for more senior accountants after finding 1,256 mistakes in the state’s financial records submitted last year. Of those, 540 needed to be corrected before an audit opinion could be issued. Australia is by no means alone, just transparent.

Our profession can, and should, advise on a wide range of related issues from bridging skills gaps or dealing with high staff turnover. We can help with better education, training and development. Ernst & Young, for example, has just agreed to work with CIPFA to help countries adopting IPSAS.

Facing the facts

Finally, governments have to face up to the fact that change is not optional. The current situation can’t continue indefinitely – the costs are too high in terms of fiscal instability, investor confidence and economic growth.

Accounting alone can’t guarantee that governments will always make the right decisions – but it can help them make better ones.

This is an edited version of a speech given by James S Turley, chairman and CEO of Ernst & Young, to the International Federation of Accountants (IFAC) on March 20, 2012 at its seminar in Vienna, ‘The Sovereign Debt Crisis, a Matter of Urgency – from Lessons to Reform’