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INCOME STATEMENT INFORMATION AND REAL ECONOMIC BALANCE OF MUNICIPALITIES –EVIDENCE FROM THE MUNICIPALITIES OF FINLAND* Lotta-Maria Kärki, researcher Lasse Oulasvirta, professor Pentti Meklin, professor University of Tampere, Department of Economics and Accounting

*Published in Finnish Local Government Studies 4/2006 Abstract A balanced municipal economy is important both for the fulfilment of intergenerational justice and for a functioning, healthy economy. For an analysis of balanced municipal economy, we distinguish between the concepts of balance according to the income statement and real economic balance. Our hypothesis is that accrual surplus indicated by the income statement is insufficient to prove that local government economy is in a real state of economic balance that guarantees coverage for investments in the long run. Good municipal economic governance consists of both a balanced economy and services sufficient to meet the needs and demands of local residents.

1. Introduction Ever since 1997 Finnish municipalities have followed the budget and accounting array stipulated in the Local Government Act of 1995 (365/1995, §65). On an annual basis the municipal income statement may show a deficit, but according to the §65 of the Local Government Act (amendment 7.4.2000/353 and 29.6.2006/578), the municipality must draw up a budget that is in balance or shows a surplus during the next four-year planning period. The steps taken to cover a deficit must be adequate to finance the deficit that has been passed down from the earlier income statements and will be evident in a budget carried out during the ongoing budget year. According to the Government (Government proposals HE 157/1999 and HE 8/2006), the aim of the reform was to prohibit the accumulation of deficits in local governments. Before the amendments to the law, the municipalities could themselves estimate when the municipal economy was so unbalanced that balancing remedies were needed. According to §70 of the Local Government Act, the municipal board was responsible for preparing a stabilisation programme when the municipal board itself deemed that the municipal economy was unbalanced. The amendment of 7.4.2000/353 already stipulated, in a binding manner, how a deficit in a municipal economy must be covered during the next planning period (see the bulletin of Local and Regional Government Finland, Kuntataloustiedote 6/2000). The newest amendment, 29.6.2006/578, states that if the deficit has not been covered during the four-year planning period, the municipal council must approve a detailed action plan for balancing the economy. 1.2. Theoretical starting points and aim of the paper The achievement of a balance between municipal incomes and expenses is a natural principle in local government economy. The municipal economy is an economy commissioned by the electorate and taxpayers. It strives for a balanced economy (expenditures = incomes) instead of striving for profit in the way of business enterprises (Hosiaisluoma 1969, 249; Kilpiö 1956, 17).

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When municipalities use accrual-based bookkeeping, the deficit or surplus is calculated according to the same principles as an income statement in market-sector enterprises. The purpose of the income statement in the market sector is to calculate the distributable profit, taxable income and residual income to be kept within the enterprise for investments. Municipalities do not distribute profits or pay taxes, but they strive to balance their incomes and expenses in a way that enables them also to cover future investments in a financially durable way. The stimulus of this article has been a strong doubt that a result calculated according to accrual-based bookkeeping does not show the real economic balance of municipalities. In this article, we use the concepts of balance according to the income statement and real economic balance. In accrual-based bookkeeping, balance according to the income statement is shown on the income statement. By real economic balance, we mean a more many-sided balance that also requires non-financial information, such as information about the municipality’s service supply and demographic development.

Figure 1 illustrates the frame of our research. Bookkeeping as a measurement system of economy

Balance according to the income statement

Interpretation and operations provided by the law

Real economic balance

Operations provided by the real economy

Figure 1. The research frame

The objective of this article is to answer the following questions: 1) Does the income statement drawn up according to accrual-based bookkeeping give a “true and fair picture”of the real economic balance (deficit)? 2) Do balance and deficit differ in meaning in different municipalities? The interests are both scientific and practical. The interest from the scientific perspective is to examine the ability of accrual-based bookkeeping to produce a “true and fair view”of the balance of a local government. Answers to the above questions are important also in practice, especially if there is a local government act that requires steps to cover the deficit revealed by the income statement. If there is incongruence between a deficit shown by the income statement and real economic balance, steps to cover the deficit based solely on information from the income statement can be faulty and harmful. (See also Meklin & al. 2005, earlier version of this paper was presented in CIGAR conference 2005,)

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First we will explore balance theoretically, and then we will analyse the balance situation empirically on the basis of statistics on municipal income statements and two municipal cases.

2. The evaluation base for real economic balance and deficit of municipalities Balance of the economy and surplus/deficit are important concepts in both budgeting and bookkeeping. The budget of the municipality can be in balance, or the budget can show a surplus or a deficit. Deficit is usually defined as the amount of financial expenditure that exceeds revenues (Mitchell 2005, 502), and the municipality covers that amount by borrowing money from the capital market. There are two main points in the definition: on the one hand the budget shows a deficit, but on the other hand it can be balanced by taking a loan. The former means that expenditure and revenue are not in balance, the latter that the cash flows are in balance. The budget deficit or the budget surplus is used as an instrument of economic policy. It is commonly thought that economic policy falls in the sphere of the central government, not municipalities (Bailey 1999, 11-12). These two forms of balance have been enacted in the Municipal Act (§65). The cash flow segment of the budget (funds statement) has to present the additional sums in cash and loans that are needed, aside from income financing, for investment and loan installments (balance of cash flows). The income statement presents the deficit or surplus for the accounting period as the difference between expenditure and revenue (balance of expenditure and revenue). This short exposition indicates that there are many dimensions in balance of the economy. - Real economic balance or monetary balance? - In the monetary process of economy - Balance in monetary assets (the balance sheet) - Balance between expenditure and revenue on the whole or divided into periods, between expense and income or - Balance in cash flows? - Short-term or long-term balance? We will return to these questions after a theoretical review of balance in municipal economy. The theoretical reasons for balance of the municipal economy There are natural arguments for balance of the municipal economy stemming from the basic role of municipalities. The municipal economy is a commission economy (Hosiaisluoma 1969, 249; Kilpiö 1956, 17), whereas enterprises in the market are earnings economies. The basic function of municipalities is to provide inhabitants with services grounded in representative democratic decision-making. The economic purpose is to condition economically the provision of services; not to strive as such for a surplus (or a deficit), but rather, in the long run to maintain a balance between expenditures and revenues at reasonable taxation rates. Enterprises are profit seeking, that is to say, an enterprise starts up and keeps operating only if it can make a profit (Meklin 1998; Meklin 1999). Balance in the commissioned economy has been argued on the basis of equity between municipal inhabitants. This means that inhabitants who use the services also finance them. This principle appears, for instance, in the following ways:

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- Equity between generations or age groups. This means that no generation should cause deterioration in the property of the coming generations (Kilpiö 1956, 17; Rawls 1988, 166171; Robinson 1998a, 31-32; Robinson 1998b, 447; Musgrave & Musgrave 1973, 585-586 and Musgrave 1988, 133). - Equity between migrating people and the original population who finance the whole service structure. - Equity between municipal councils: no municipal council bequeaths an unreasonable debt that future councils have to deal with (Oulasvirta & Meklin 2002, 7). The arguments for the equity principle are much deeper than those for application of Bookkeeping Act. In the next chapters we consider the themes highlighted above. Real economic balance or monetary balance? When we evaluate balance of the municipal economy, a key question is: Should we analyse balance in the monetary process or in the real process? In the market sector where transactions are connected to immediate money flows between buyers and sellers, monetary economy is a mirror of real processes and the real economy. This is the reason why we can get a reasonable understanding of the state of the real economy by measuring the monetary flows and the monetary balance. In the real process, input and output flows have a monetary exchange value; the accrued assets have a monetary value as well. Although there may be discrepancies between the real and monetary economies, for instance, when the current value of the asset rises, such discrepancies aren’t realized in the same way in monetary flows. The Finnish municipal legislation has paid attention to preserving the central items of real assets. As early as in 1934 a statute added to the Municipal Act stipulated that municipal assets must be preserved without reduction (Kilpiö 1956, 80-81). The municipal budget was divided into a current budget and a capital budget. The principle of not diminishing permanent assets was expressed in the Municipal Act of 1934, §106, paragraph 2: “Capital incomes may not be used for current expenditures”. The aim was to prohibit municipalities from using their capital assets for current consumption, and to prevent municipalities from consuming their assets without acquisition of corresponding new assets or without amortizing long-term debts. Each generation is obliged to preserve the public assets inherited from previous generations, and perhaps even to increase them in order to guarantee the continuation of municipal activities meeting inhabitants’ needs. This preservation principle concerned the municipal fixed assets acquired for permanent use in serviceproduction. (Hosiaisluoma 1969, 222-223.) When the balance or deficit of the municipal economy is discussed, one typically doesn’t ponder the connections between real economy and monetary economy; instead, the discussion focuses only on the segment of the economy that falls in the sphere of monetary economy and is shown on the municipal income statement. The Local Government Act, too, concerns only the monetary balance expressed on the income statement. Our steadfast point of departure is that one must pay attention to the correspondence between real economy and monetary economy. The municipality may have a good-quality service-provision and a good supply compared against its needs, but at the same time the income statement may show a deficit –perhaps for just this reason. On the other hand, the surplus shown on the income statement may be achieved partly because of neglect in service-provision that may even be reflected in service levels below the statutory requirements. Balance in monetary assets?

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If we are considering balance from the monetary side of the economy, balance can be evaluated from the perspectives of asset and flow. On the balance sheet, balance in monetary assets (the balance sheet balance) can be estimated by comparing financial assets against financial liabilities, or debts. From the balance point of view, it is not irrelevant whether or not an indebted municipality has financial assets, or whether or not a municipality lacking liquid assets has debts. Balance in cash flows or balance between incomes and expenses? Balance can be also considered on the basis of the flows of expenditure and revenues on the income statement or from the balance in cash flows on the cash flow statement. From a pure flow perspective, a deficit is the result of cash payments that exceed cash incomes during the accounting period. In the balance, the cash incomes are sufficient for cash payments. The cash flow statement represents this balance thinking. From the flow perspective, the balance can also be assessed by the accounting income and expenditure, either periodized or not. According to the legislation on bookkeeping, the profit or loss of an enterprise shall be calculated on the income statement with incomes and expenses shown for an accounting period. In the same manner, a municipal surplus or deficit is calculated by subtracting the expenses from incomes for an accounting period.

Short-term or long-term balance? An essential question is the length of the time period during which balance should be measured (the question of short-term or long-term balance). Municipalities are assumed to function under the principle of going concern, but the income statement is drawn up for a one-year period. This is too short a period for measuring balance. This idea has been taken into consideration in the Finnish Local Government Act of 1995, which stipulates that the deficit must be calculated cumulatively; this means that a period longer than one year must be taken into consideration. Municipalities may draw up income statements that show a loss without taking steps to cover the deficit as long as the municipality has accrued sufficient surpluses from previous years to cover the deficits. The period of planning the balancing should coincide with the economic planning period of the municipality (SM 2005, 9). Municipal deficit on the income statement and in the real economic balance The accrual surplus is indicated by the formal income statement. Our argument is that this is an insufficient base to prove that local government economy is in a real state of economic balance that guarantees coverage for the investments needed in the long run. In the following section we consider the critical points of the income statement from the point of view of the real economic balance. The critical points include, for instance, the coverage of the income statement, the concepts of incomes and expenses, and the different sections of the income statement. Also critical is to know whether the deficit is caused by the items listed before the annual margin or by the items listed after the annual margin. This analysis thus affects the ways that can be considered appropriate for covering the deficit. 3. The coverage of the income statement A municipality can utilise its own organisation to accomplish its tasks, or it can make use of outside organisations, contractors, and so on. In practice, municipalities are groupings that encompass not only their own entities (gross or net budget entities) but also utilities and municipal companies. A

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municipality can also carry out its tasks by joining a federation of municipalities or through the use of external vendors. The income statement of the municipality still only covers the activities of the principal municipality, not the activities of the whole grouping. From the point of view of calculating the accounting deficit and surplus, the different ways in which local government activities are organised have different effects on the outcome of the income statement of the principal municipality. The financial performance of a municipal company is not included on the municipal income statement. On the other hand, the performance of a net budget entity taking care of the same activity would be included on the income statement. Large depreciations in a net budget entity may be an important cause of a deficit on the income statement of the municipality; but on the other hand, if the activity is organised as a company, the corresponding depreciations are not included on the income statement and the principal municipality may show a surplus. This illustrates the importance of the real coverage of the income statement vis-à-vis municipal activities and liabilities with regard to assessment of economic balance. 3.1 The concepts of incomes and expenses vs. real economic balance According to the legislation on bookkeeping, all revenues and expenditures must be periodized to the accounting period as incomes and expenses, which are then compared against each other to show the end result (deficit, balance or surplus). The realization of incomes and expenses is derived from the real economic transactions: incomes are ready for entering when the output is delivered and expenses when the input is received in the real process (the realization principle), not when the actual cash payments are made or received. In order to calculate the result on the income statement, the incomes from outputs delivered are compared against the expenses from inputs received during the accounting period (one calendar year); this is known as the matching principle. This principle is supplemented with the rule that incomes shown for an accounting period are also compared against expenditures that in the future will not generate incomes (for a deeper discussion, see Saario 1958/1968). This accounting principle doesn’t work as smoothly and consistently in the local government sector, which is financed mostly by taxes. The original intention wasn’t that municipalities would derive incomes from their core activities, but that they would provide services to the local inhabitants. The main income source, taxes, is not directly connected to the delivery of outputs, and core services are provided without cost or at costs below production costs (Meklin 2000, 201; Myllyntaus 2002, 1516). Incomes from taxes collected during a certain year are more than compensation for that year’s service supply; these incomes also represent compensation for the financing of earlier investments and perhaps savings for future investments. Thus far we have been discussing the public sector financed by taxes; “expenditure matched with the incomes, output or the benefits of the outputs”[Kallio 2000, 41; Näsi & Keurulainen 1999, 37, Suomen Kuntaliitto (Local and Regional Government Finland) 1996, 11]. In practice, it may be difficult to trace expenditure that will no longer generate benefits for the municipality (inhabitants). The periodized according to caused benefits brings about interesting ideas, because those who benefit from, for instance, municipal schools or hospitals may move from the municipality providing the service to another municipality, and may live in a place other than in the municipality which paid the costs that burden the income statement. It is easier to trace the expenditures arising from provision of the outputs (the principle of matching expenditures and output).

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Still another interesting point arises in calculating expenses: expenditures are realized in the future but caused by present actions. As an example, Mitchell (2005, 503) takes the public decisions made in the present, which mean commitment to pensions and benefits in the future, thus burdening future tax-paying generations. Expenditures stemming from the present period may also include future expenditures; for instance, expenditures that are realized in the future when closing a dump. A strong accrual accounting and budgeting model may also take such future commitments into consideration when calculating the deficit and balance (see, for instance, EU 2000 and Vanne 2002). This consideration shows that the contents of the income concept and the matching principle in the municipal income statement are not completely clear. Despite this, incomes and expenses are compared against each other on the income statement of the municipality when the result and the deficit are calculated.

3.2. The reasons for a deficit vs. the real economy a) The reasons for a deficit before the annual margin The items before (above) the annual margin account for incomes and expenses arising from the ordinal annual service activity and administration. The annual margin is calculated from these items on the basis of accrual bookkeeping, which means that all items before the annual margin do not cause monetary flows (for instance, trade debts and receivables from sales and obligatory reserves). Items on the income statement before the annual margin reflect the balance between the incomes and expenses from activities, tax and grant incomes and financing costs and incomes (compound income and expenditure) associated with the ordinary yearly activities, entered according to accrual-based accounting. The minimum requirement is still that the annual margin should not be negative. A negative annual margin is interpreted to mean that the municipality in question is incapable of financing its ordinary yearly activities with its ordinary yearly incomes. In addition, a negative annual margin normally leads to a negative result and to a deficit. When the reason for a deficit comes before the annual margin, it means that the incomes are too low in proportion to the overly high expenses. Overly high expenses may stem from: -ineffective organization of activities -the need for service is greater than the income base -production of unnecessary services The lack of incomes may stem from: -a poor income tax base and/or overly low income tax rates -low pricing policy in fees and charges -State grants that are too small compared against the obligatory tasks. If it can be proved that a deficit is caused by items before the annual margin, it is natural to use items coming before the annual margin to cover the deficit as well. Steps of this kind to cover the deficit would be to cut back expenses, which would raise the profits. This would meet the principle of identity in costs and financing, meaning that the inhabitants using the services also finance the costs incurred by the current activities benefiting them. This will come about in practice especially when the population growth is stable.

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b) The reasons for a deficit after the annual margin The essential item after the annual margin is depreciation. The depreciation is made according to a calculation estimating the decrease in value of earlier investments that takes place during the accounting period. From the perspective of real economic balance, it is essential to analyse the relationship between investing and financing of the investments. In a situation of real economic balance, the municipality in the long run can finance all of its investments or loans taken for the investments. According to the model of a financial statement devised by the Association of Local Governments in Finland [Suomen kuntaliitto (Local and Regional Government Finland) 2001, 18], if the annual margin is adequate to cover depreciation, the income finance is enough to cover replacement investments. Following the fixed costs, balance on the income statement should show adequate funds to make replacement investments. This can be seen as the minimum situation from the perspective of real economic balance. In reality, municipalities are forced to make more investments than replacement investments, and to do so they need money. Municipalities must finance both their replacement investments and new investments. The self-financing share of the investment can be calculated by subtracting the shares of State grants and other external financing from the gross expenditure for acquisitions. Depreciation The depreciation expenses in income statement do not compare even with the replacement investments of following reasons (see Meklin & Oulasvirta 2001): 1. Depreciation is calculated from the self-financed share of the historical investment costs. For example, investment in 1970 may differ considerably from the replacement investment in 2000. 2. Grant funding reduces the self-financed share of the investment, and this self-financed part of the asset creates the basis for depreciation. If the State then cuts grants, the municipality encounters problems in keeping the self-financing share unaltered. 3. Often the replacement investment differs from the original investment; often it is also more expensive. 4. Depreciations are not made for all fixed assets that need replacement investments; for example, if the fixed assets have been donated. 5. When accrual-based bookkeeping was introduced, municipalities may have undervalued their assets. 6. When accrual-based bookkeeping was introduced, old assets meant small depreciations and new assets large depreciations, but old assets may require large replacement investments and new assets may require small replacement investments. 7. There may be a difference between the sum of depreciation calculated according to a plan and the real holding period of the investment. The amount of depreciations vs. the need to finance investments In interpreting the real economic balance and the balance according the income statement, the amount of depreciation expenses is an essential factor. It is assumed that municipalities which have accumulated their fixed assets decades ago have smaller depreciation expenses than municipalities which have invested in recent years. To achieve balance as indicated by the income statement, the former municipalities need smaller annual margin than the latter ones. To achieve a real economic balance, the situation is the opposite: a municipality whose investments are old may have a great need to make compensation investments and new investments, which means that it needs money.

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Conversely, a municipality that has made recent investment may not need to make additional investments. Financing investments: before or afterwards Comparing net investments against the annual margin is not a simple task because municipalities are a commissioned economy. Investments can be financed in three ways, all of which have a different influence on the income statement and on the balance sheet. First of all, investments can be financed with the municipality’s own cash (financing beforehand). This requires that the municipality must save cash beforehand, and this may mean surpluses on the financial statements. Secondly, investments can be financed with loans (financing afterwards). Then a municipality repays the loans afterwards, and it needs cash to pay the loan’s interest and amortizations. The third way is to finance investments partly beforehand and partly after their acquisition. This is the most commonly used, for instance, in Finnish municipalities. In a commissioned economy, the most equitable method for financing investments is the financing afterwards strategy, because then the people who use the investments also finance them. If a municipality uses the method of financing beforehand, the present citizens are financing investments that will be used by future citizens. A similar situation is created by migration. When financing is collected beforehand, the original citizens finance investments and the immigrants use them. When financing is done afterwards, both the original citizens and the newcomers take part in financing. c) Other items on the income statement In interpreting deficit, a few other items can also cause problems. Many municipalities that have amassed funds by selling their energy utilities or their shares in municipally owned energy corporation have invested the money obtained in securities. According to the Accountancy Board, losses of value in securities that are included in the financial assets must be entered on the income statement as expenses. Losses in the value of securities must be entered when the likely sale price at the closing of the accounts is below the acquisition price. Securities included in the long-term assets may also encounter losses in value. When share prices fall, some municipalities may suffer a negative result, and thereby face a need to cover the resulting deficit. The recommendation states that one should follow conservatism and not speculate that the value of the shares which depreciated will rise later in the planning period [Kuntataloustiedote (the bulletin of Local and Regional Government Finland) 1/2001]. If the municipality has invested the funds amassed by selling its fixed assets, it is more reasonable to use balance sheet equity capital to cover the deficit from than it is to use the positive result shown on the income statement. Public utilities create a further problem in interpreting accounting and budget statements. The gross incomes and expenditures of public utilities are not included in the municipal budget and three-year economy plan; only the net effects are shown in the budget statement. This means, for instance, that only the public utility surplus transferred to the owner municipality is entered in the budget as income, not the gross sales revenue from that public utility. Yet in the financial statement, the incomes earned and expenditures caused by the public utility are all included in the municipal

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income statement. This financial statement calculation gives a better view of the gross result of the municipality than the budget statement. The contingent items in the income statement should also be separated as a cause of deficit, because they are extraordinary items. These accounting differences and accounting items must be noted when estimating the amount of deficit (or surplus). If the reasons for deficit are caused by items below the annual margin, and there is no structural imbalance in the income and expenditure flows emanating from the regular yearly activities. Thus the use of balance sheet funds and equity to cover the deficit is a viable alternative. It may often be reasonable to use balance sheet funds to cover a deficit caused in the profit and loss account by depreciation costs. In general, it may be reasonable to use balance sheet items to cover deficit costs when the reasons for the deficit do not emanate from the regular yearly activities but from the extraordinary items, and from the balance sheet based depreciations and downscaling of asset values. [For more about ways to cover a deficit, see Kuntataloustiedote (the bulletin of Local and Regional Government Finland) 6/2000, Meklin & Oulasvirta 2001 and SM 2005.] Some municipalities may need a surplus; others can manage with a deficit The above discussion argues that economic balance is an ambiguous measurement problem that must be approached with care. Even if the long-term objective is balance, from the perspective of real economic balance, some municipalities may need surpluses; others can manage for a while with deficits. 4. Interpreting the real economic balance in all municipalities and in two cases In the following we will explore the view of the real economic balance income statements give for all municipalities and for two case municipalities. We will also use Finnish municipal data to examine the economic situation underpinning an income statement showing a surplus or a deficit. The situation in all municipalities is shown in Figure two.

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ALL MUNICIPALITIES 4500 Annual margin

€ per inhabitant

3500

Surplus/deficit Depreciations

2500

Investments

1500

Loans Financial assets

500

-500

1997 1998 1999 2000 2001 2002 2003 2004 2005 Year

Figure 2.

1. The accumulative surplus of the municipalities increased eighteen-fold (1,893%) from 1997 (when it was €30 per inhabitant) to 2005 (€568 per inhabitant). These data lead to the conclusion that on the municipal level, the economy is well in balance. However, a closer look changes that conclusion. 2. Regardless of the surplus, municipalities are running into debt; alarmingly so in the past few years. The amount of debt increased from 1997 (€745 per inhabitant) to 2005 (€1351 per inhabitant) by 81 per cent. 3. The economic balance required by the Local Government Act and established by the income statement does not guarantee that the economy is really in balance. 4. The reason is that the net investments financed by the municipalities themselves are much greater than the share of revenues remaining once running expenses (operating costs and finance costs) for investing have been deducted. Next we will explore two cases, one of which has a surplus and the other a deficit. Pirkkala is the example of a municipality whose income statement shows a surplus. Pirkkala has approximately 15,000 inhabitants, but the population is growing rapidly, the annual increase being over three per cent. Migration to Pirkkala is very fast and no change is foreseen for the near future.

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PIRKKALA 4500 Annual margin

€ per inhabitant

3500

Surplus/deficit Depreciations

2500 Investments

1500

Loans Financial assets

500

-500

1997 1998 1999 2000 2001 2002 2003 2004 2005 Year

Figure 3. [Pirkkalan kunnan talousarviot ja -suunnitelmat vuosilta 1997-2005 and Pirkkalan kunnan toimintakertomukset vuosilta 1997-2005 (Annual budgets of Pirkkala from 1997 to 2005 and Annual reports and financial statements of Pirkkala from 1997 to 2005)]

The income statement shows that: 1. The cumulative surplus is good compared to that of other municipalities, and it has increased from 1997 (€29 per inhabitant) to 2005 (€760 per inhabitant). 2. Despite the surplus, Pirkkala has run into debt. The amount of debt has more than quadrupled from 1997 (€329 per inhabitant) to 2005 (€1547 per inhabitant). 3. Financial assets have simultaneously decreased markedly from €160 per inhabitant in 1997 to and €-171 per inhabitant in 2005. 4. Cumulative net investments (which were €3,028 per inhabitant in 2005) are much greater than cumulative depreciation (€1,284 per inhabitant in 2005). The income statement shows that the economy of Pirkkala is balanced. The annual margin is big enough to cover depreciation and the income statement shows a surplus. Yet the municipality has run seriously into debt and it has consumed its cumulative financial assets. The situation does not yet show on the income statement, but in the future depreciation will increase, investment income will decrease, and interest costs will rise and the municipality may also face the risk of a general increase in interest rates. Regardless of its real economic situation, Pirkkala does not have to make any plans on how to balance the economy. Kuhmo is an example of a municipality with a deficit. Kuhmo has falling population, the annual loss being over 2.5 per cent. The unemployment rate is high in Kuhmo; this is the most important factor underlying the rapid migration from the periphery to the growing centres. The population is approximately 10,000 inhabitants.

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KUHMO 4500 Annual margin

3500 € per inhabitant

Surplus/deficit Depreciations

2500

Investments

1500 Loans

500

-500

Financial assets 1997 1998 1999 2000 2001 2002 2003 2004 2005

Year

Figure 4. [Kuhmon kaupungin talousarviot ja -suunnitelmat vuosilta 1997-2005 and Kuhmon kaupungin toimintakertomukset 1997-2005 (Annual budgets of Kuhmo from 1997 to 2005 and Annual reports and financial statements of Kuhmo from 1997 to 2005)]

The income statement of Kuhmo shows that: 1. A small deficit has accumulated since 1999, being €-166 per inhabitant in 2005. 2. The city has run up a slight debt, the amount of debt being only 16 per cent greater in 2005 (€718 per inhabitant) than it was in 1997 (€586 per inhabitant). 3. Financial asset loans have increased appreciably, from €66 per inhabitant in 1997 to €831 per inhabitant in 2005. 4. The cumulative net investments of Kuhmo were only €443 per inhabitant in 2005, being remarkably smaller than the cumulative depreciation of €1,644 per inhabitant in the same year. The income statement of Kuhmo gives a pretty poor view of the municipal economy: a deficit has accumulated on the balance sheet. The reason for deficit is above the annual margin. Migration has cut the amount of State grants and taxation income, thereby weakening the operating margin and therefore also the annual margin. In reality, the economy of Kuhmo seems balanced. The amount of debt does not give cause for concern, the financial assets have increased, and the cumulative depreciation exceeds the cumulative net investments. The need to invest is small, so the income finance is adequate. Regardless of the good situation in Kuhmo, the city must plan how it will cover the deficit and balance the economy. 5. Conclusions and discussion The aim of the article is to answer the following questions: 1) Does the income statement drawn up according to accrual-based bookkeeping give a “true and fair view”of the real economic balance (deficit), and 2) Do balance and deficit differ in meaning in different municipalities?

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In order to answer the first question, we separated the concepts of balance according to the income statement and the real economic balance. The balance of a municipal economy is a many-sided phenomenon that the municipal income statement treats in a one-sided manner. Besides the information from accounting and from the financial statements, Evaluation of the real economic balance also requires information on the real production processes and on the quality and level of service supply. All of these data must be connected in a way that gives a realistic view of the structural and demographic development of the municipality in question. With our case studies, we gave concrete examples of how the municipal income statement gives an inadequate picture of the real economic balance of a local government. Analysis of the municipal data showed that despite a surplus, some municipalities had run into debt and their cash resources had decreased. On the other, some municipalities had a quite good real economic balance although they showed a deficit on the income statement. One important problem arising on the income statement involves the historical costs and depreciation from an acquisition net value (gross value minus investment grants): The depreciation costs become too small compared against the real financial needs, e.g. to repair and replace old production factors (schools, hospitals, roads, sewage pipes, etc.). It is essential to use comprehensive information on both the monetary process and the real process, and to consider both assets and flows when making an assessment of the real economic balance. The elementary features of a balanced real economy are: 1. The current income of a municipality is adequate to cover current expenditure that facilitates a sufficient service supply for local inhabitants. 2. The municipality is able to take care of replacement investments and new, needed investments for its service structure and facilities. 3. The municipality has a sufficient amount of fixed assets for service-production, and this service infrastructure is mainly financed with the municipality’s own capital. Another important question in our study was whether a deficit or surplus in different municipalities has a different meaning. A real and durable balance of municipal economy requires that the service supply is competitive and corresponds adequately with the demand in the municipality. A municipality may have a good financial statement but at the same time it is not competitive in its service supply, which doesn’t correspond adequately to the needs of local inhabitants and taxpayers (enterprises included). It may be that despite a good accounting result, the municipality lacks enough resources to make all the necessary investments in the future. At the same time, one must evaluate both the economy and the activities of the municipality (Brorström, Haglund and Solli 1998, 104). Our analysis proves how municipalities differ from each other in the need to cover the deficit. Although several factors cause differences – for instance, the ways of organising service-provision, among other – we concentrated on two decisive factors: the status of productive assets and their financing needs, and further on the demographic variable –whether the municipality has a growing population, a stable population, or a declining population. For the assessment of the real economic balance, it is important to note the point in time of the acquisition of the assets, and it’s the method by which the acquisition was financing. Old assets often mean small current depreciation costs and new ones mean high depreciation costs during the current accounting period. Another influencing factor is the need for financing: whether the asset in

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question has been financed in advance with the municipality’s own funds (saving strategy) or with debt money (the strategy of financing afterwards). In the first strategy, the municipality may manage for a quite long time with annual deficits if the investments have been paid with earlier savings and if there are no needs for new investments in the near future. In the latter strategy, the municipality needs income financing to amortize the loans. If the municipality annually amortizes the loans in a manner corresponding with the depreciation costs on the income statement, the real economic balance and the balance according to the income statement approximately correspond with each other. The balance according the income statement should so be compared against the municipality’s investment plans and investment financing. In a real economic balance, the municipality ought to be able to implement its investments with a realistic financing plan without running into great debt. One should also note that if the municipality changes its financing strategy, problems in evaluating the income statement may occur during the transition period – for instance, if the municipality changes its strategy from debt financing afterwards to financing through advance savings, it should show a considerable surplus in order to be able both to finance amortization of the old loan and to begin new savings for future investments. Our approach to the analysis emphasises the importance of information other than that from the accrual income statement in assessing the real economic balance. Non-financial information about demographic development and service needs is needed to supplement the information applied in the assessment of real economic balance and the risks affecting it (compare Brorström & al. 1995, 4547). Especially the demographic situation and development are important factors for explaining investment needs and investment financing needs. A municipality that has a growing number of inhabitants also has a growing need for municipal services; when the capacity of old facilities becomes insufficient, the municipality has to invest in new facilities and thus the need for net investment financing out of the municipality’s own revenues also increases. In such a situation, the real economic balance may require considerable surpluses in the financial statements if the municipality wishes to avoid getting into debt. A municipality that has a falling number of inhabitants also has also a decreasing need for net investments and investment financing out of its own revenues. If inhabitants move away, the service needs diminish and the investment needs concentrate on maintenance of old infrastructures; there may be even a need to dismantle capacity. In such a situation, the municipality may be in real economic balance although for some time it shows deficits in the financial statements. The rules for covering deficits mean that municipalities must seriously analyse their financial statements. But, if the central government stipulates rigid rules for covering deficit, rules that do not take into consideration the factors we have analysed in this article, the outcome can be impropriate and short-sighted savings measures in municipalities that try to comply with formal balance according to the income statement requirements. This may also mean unnecessary tax rises from the point of view of real economic balance. The purpose of bookkeeping is to enter transactions in a systematic view and to give warning signals of possible problems in the economic balance. The ability to read financial statements and to interpret their meaning in a reasonable manner is important – this ability should be taught to municipal politicians and others using the financial statements. It would be a good starting point if the different local suppliers and users of financial statement information would use basic accounting concepts and could interpret figures with the same basic understanding. This consideration also

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applies to the central government decision-makers and officials who shape the central government policy towards municipalities. It is problematic if they interpret the same financial statement figures differently and see the signals given by accounting information differently. Both local governments and the central government are responsible for the public-sector economy and the balance of local government economy. The municipal economy is not independent of the central State economy and economic policy, and municipalities have limited possibilities to direct the local private-sector economy that creates the tax base. The State cannot use rules on covering deficits or rules on budgetary discipline like a magic wand that will make lasting structural economic problems caused by a falling population and diminishing job possibilities in the local community disappear. From the point of view of municipalities, the central government should also understand that imbalance of the local government economy may be a serious signal that central government policy towards municipalities is out of balance and that obligatory municipal tasks stipulated by legislation do not correspond adequately with municipalities’own income sources and State grants. Municipalities’own income sources are too limited, and central government grants are perhaps directed to different municipalities in a way that treats certain municipalities unfairly. All these factors create a far more complex picture of the elements of real economic balance in municipalities. Bibliography: Bailey, Stephen J. London:MacMillan

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Kuhmon kaupungin talousarviot ja -suunnitelmat vuosille 1997-2005 (Annual budgets of Kuhmo from 1997 to 2005). Kuhmon kaupungin toimintakertomukset vuosilta 1997-2005 (Annual reports and financial statements of Kuhmo from 1997 to 2005). Kuntataloustiedote 6/2000. (The Bulletin of Local and Regional Government Finland, Municipal economy 6/2000) Helsinki:Suomen Kuntaliitto. Kuntataloustiedote 1/2001. (The Bulletin of Local and Regional Government Finland, Municipal economy 6/2000) Helsinki:Suomen Kuntaliitto Meklin, Pentti (1998). Tilinpäätöksen tunnuslukuja pitäisi tulkita huolellisesti. (Municipal financial statements must be analysed carefully.) Kuntalehti, nro 13/1998, s. 62-63. Helsinki:Suomen Kuntaliitto. Meklin, Pentti (1999). Kunnan taloudellinen tulos ja sen mittarit. (The economic result of municipality and its indicators.) Kunnallistieteellinen aikakauskirja, nro 1/1999, s. 9-21. Kunnallistieteen yhdistys ry. Meklin, Pentti (2000). True and fair view -vaatimus ja liikekirjanpito kunnan taloudellisen tuloksen kuvaajana. Artikkeli teoksessa Hoikka (ed.), Kunnat 2000-luvun kynnyksellä, s. 199-223. Tampere:Tampere University Press. Meklin, Pentti & Oulasvirta, Lasse (2001). Kuntatalous tasapainoon - pakolla? (Municipal economy in balance –with force?)Kuntalehti nro 15/2001, s. 73-74. Helsinki:Suomen Kuntaliitto. Meklin, Pentti; Oulasvirta, Lasse & Kärki, Lotta-Maria (2005). Accounting Information and Economic balance of Municipalities –Evidence from the Finnish Municipalities. Paper presented in CIGAR Conference May 26-27, 2005. Mitchell, Daniel J. (2005). The economics of budget deficits. Public Choice 122, s. 501-512. Blacksburg:VA. Musgrave, Richard A. & Musgrave, Peggy B. (1973). Public Finance in Theory and Practice. New York: McGraw Hill. Musgrave, Richard A. (1988). Public Debt and Intergenerational Equity. Artikkeli teoksessa Arrow, Kenneth J. & Boskin, Michael J. (eds.) (1988). The Economics of Public Debt. Lontoo:MacMillan. Myllyntaus, Oiva (2002). Kuntatalouden ohjaus. Budjetoinnin ja kirjanpidon teoriaperusteita ja kehityssuuntia. Helsinki:Suomen Kuntaliitto. Näsi, Salme & Keurulainen, Juha (1999). Kunnan kirjanpitouudistus. (The accounting reform of municipality.) Vammala:Kunnallisalan kehittämissäätiö. Oulasvirta, Lasse & Meklin, Pentti (2002). Finska kommuners skyldighet att tackä underskott. Kommunal ekonomi och politik nro 4/2002, s. 7-23. (The obligation of Finnish municipalities to cover deficit.) Göteborg:Kommunforskning i Västsverige.

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Pirkkalan kunnan talousarviot ja -suunnitelmat vuosille 1997-2005 (Annual budgets of Pirkkala from 1997 to 2005). Pirkkalan kunnan toimintakertomukset vuosilta 1997-2003 (Annual reports and financial statement of Pirkkala from 1997 to 2005). Rawls, John (1988). Oikeudenmukaisuusteoria. Helsinki:WSOY. Robinson, Marc (1998). Accrual Accounting and the Efficiency of the Core Public Sector. Financial Accountability and Management nro 14/1 Helmikuu. Blackwell. Robinson 1998a. Robinson, Marc (1998). Measuring Compliance with the Golden Rule. Fiscal Studies nro 19/4, s. 447-462. London:Institute for Fiscal Studies. Robinson 1998b. Saario, Martti (1958/1968). Meno-tulo-kirjanpito. Helsinki:Otava. SM (Sisäasiainministeriö) (2005). Kuntien alijäämän kattamisvelvoitteen arviointi ja kehittämisehdotukset. Sisäasiainministeriön julkaisusarja 13/2005, Helsinki:Sisäsiainministeriö. Suomen Kuntaliitto (Local and Regional Government Finland) (1996). Kunnan ja kuntayhtymän kirjanpito-ohjeet, osa I. Saarijärvi:Gummerus Kirjapaino Oy. Suomen Kuntaliitto (Local and Regional Government Finland) (2001). Kunnan ja kuntayhtymän tilinpäätösmalli. Helsinki:Suomen Kuntaliitto. Vanne, Reijo (2002). The Finnish Generational Accounting Revisited. Central Pension Security Institute Working Papers 1. Helsinki: Central Pension Security.