Accounting Issues that contributed to the Detroit Bankruptcy - Essay Example

Accounting Issues that contributed to the Detroit Bankruptcy Introduction Detroit became the largest interms of size and population in the United States history to file for chapter 9 municipal bankruptcy in July, 18, 2013 with an estimated debt of $18-20 billion. The proceeding provides protection to financially distressed municipalities from creditors through the creation of a financial plan aimed at settling the debt. The purpose of the filing was to extend the loan terms while maintaining a lid on the interest rates. The announcement of bankruptcy by Detroit is a prophesied case. The liquidation of a municipal’s assets cannot happen as a result of the request of a creditor. A municipality is under the state’s jurisdiction as it is defined by the state. The 10th Amendment of the4 American constitution reserves any power not defined by the constitution for the state. Declaration of bankruptcy rulings ate made in U.S. Bankruptcy courts under federal jurisdiction Many factors have indicated reduced financial activity in the city. The population of the city dropped from a 1.5 million figure in the city’s peak in the fifties to a current size of around 700,000 leaving the city a shadow of itself with tens of thousands of abandoned buildings ("How Detroit went broke - Economics - AEI"). This coupled with the deindustrialization of the city have largely affected the collection of the revenues in the city. However, the major contributor of the state of the city is the accounting of the funds of the municipality. Legacy costs These are the bills of the municipality in the form of public employee pensions, healthcare, and other post employment benefits. The Government Accounting Standards Board (GASB) in 2006 required all local governments to report publicly OPEB liabilities but did not require the funding of the shortfalls of the OPEB liabilities (John Macomber). The city of Detroit uses 43% of the entire annual city revenue in making payments of this kind. This leaves only, 57% to run the city and cover the wage bill. In the last few decades, the percentage of the city’s revenue used in the settling of these bills has been on the rise with an estimation claiming the percentage will reach 65% in four years. These unfunded liabilities of the Detroit city funds have acted as a weight pulling down the city finances (How Detroit went broke). Half of the $18 billion debt is accounted in public employee retirement benefits, which are not funded. In 2012, the city spent $145 million on retiree health care benefits, which is greater by more than half of the $99 million used in 2000 ("How Detroit went broke - Economics - AEI"). The accounting methods relied in the evaluation of the finances of pensions of public employees allows rates of return that are overly optimistic on the supposed riskless pension to be assumed (How Detroit went broke). These also make it possible for the employer in the form of the city of Detroit, to contribute annual contributions that fall short of the required amount. These transform the guaranteed benefits such as pensions, into risky ones. The cause effect of these is a pension liability at a $3.5 billion level when appropriate accounting methods are used which is over 5 times the liability under the city’s accounting methods (John Macomber). This is not helped by the ratio of employees to retirees receiving pension, which stands at 2:1. Increased taxes After the post-war manufacturing and expansion, the city started losing revenue because of the high population decrease rates. In response, the city changed its accounting policies and imposed a 1% income tax on all corporations, residents, and non-residents. This aimed to cover the loss in revenues and maintain the city budget (How Detroit went broke). Over the years, the tax rate has been on the rise with the resident income tax doubling only six years after its establishment. A new utility tax came into being in 1971 aiming to maintain the services offered by the city as well as ensure continued payments of union benefits that were awarded by outside arbitrators. In 1999, the start of operation of casinos saw the imposing of a wagering tax with similar goals as the utility tax. The city’s accounting policies allowed for the raising of existing taxes and the institution of new ones to act as sources of revenue and cover the revenue loss yielded by population decrease. This produced a new source of revenue for the city to fund its projects and services in almost every decade after the fifties. Although this raised revenues, it resulted in making the city a more expensive place to live and invest (How Detroit went broke). This quality made the city an unattractive city for potential residents and investors and caused more deindustrialization and suburbanization as well as increased population decrease. The cause effect came in the form of further decrease of revenue collected by the city ("How Detroit went broke - Economics - AEI"). Even with the increased size and number of taxes, the city income collection has hit a 60-year low. The accounting policies of the city that aim to increase the city’s revenue collection through the institution of new taxes and the increase of current taxes has therefore contributed to the state of bankruptcy of the city through encouraging depopulation and generally reducing the revenue collection of the city. Borrowing spree Despite the effects of legacy costs and the changes to the tax policies of the city, the current state of bankruptcy was still avoidable until around the start of the 21st century. Under the administrations of mayors Kilpatrick and Bing, the city accounting policies adopted policies of aggressive borrowing to run the city’s operation costs. In 2005, Detroit adjusted its legal entities that allowed the borrowing of $1.44 Billion with $740 million going to the general city employee pension and $687 million going to fire and police services pensions ("How Detroit went broke - Economics - AEI"). Kilpatrick’s administration adopted policies concerning the city’s accounts that allowed the issuing of $61.07 million fiscal stabilization bonds soon after he took office (How Detroit went broke). Several bond issues under the Kilpatrick administration that aimed to keep the budget of the city afloat followed this. Bing followed suit with $250 million fiscal stabilization bond in 2009. Even after continued downgrade of the city credit rating by Wall Street, the accounting department allowed it to continue borrowing money for operational costs with investors scooping each city bond. This borrowing spree happened without the creation of plans on how to get back the money in order to pay the loans. The money was used to cover the operations bill of the city without the investment in new revenue earning schemes in place (How Detroit went broke). This meant that future administrations would have to account for the loans, as the municipal administration at the time could not repay them. If the city’s account policies restricted the borrowing of loans without prior development of a payment scheme, the debt incurred from the loans and their interest rates would not have reached the current level, which would reduce the chances of the city being bankrupt. The Wall Street credit rating of the city of Detroit has declined over the years. A low credit rating requires the payment of higher interest rates on loans (How Detroit went broke). This means the city would have to pay more when repaying loans acquired during periods of low credit ratings. With this in mind, the administrations continued to take loans because the monetary policies of the city allowed them to do so. This resulted in the city getting loans at high interest rates which increased the debt that the city ("How Detroit went broke - Economics - AEI"). If the policies restricted borrowing when the city credit rating reaches a certain low point, the high interest rates that are the cause of a significant portion of the city’s debt, would have been avoided which would contribute to the chances of avoiding the current financial state of the city. Financial disaster of the Kilpatrick deal Kilpatrick engineered a $1.44 billion complex pension deal with a design aimed at elimination of unfunded pension liabilities in the city. The award winning deal was hailed for the legal framework and creativity that constituted it. Seeking to save $277 million annually in the city’s obligation in pension contribution, the deal allowed Detroit to sell obligation certificates of pensions and put the money into pension funds providing funding for the liabilities (How Detroit went broke). The deal also changed the city policies to allow it to purchase complex financial deals of Wall Street called swaps that would bring steady interest rates within a 6% range. Although the deal was a creative proposal, in reality it turned out to be a disaster with the schemes constituting close to a fifth of the current Detroit city debts. Three years after the deal was passed the stock market collapsed with the interest rates tanked. This saw the credit rating of the city reduced with the city having to pay $400 million to creditors, which would have resulted in the city filing for bankruptcy (How Detroit went broke). The city pledged the revenue from the casino tax as collateral to creditors in order to avoid the payment. Five years down the line, a $2.8 billion debt is owed by the city in the form of interest, principal, and payments for insurance for the next 22 years. The paying of interest for only five years is the reason for the soaring of the debt. The Kilpatrick deal therefore resulted in the opposite of its goals contributing to a fifth of the current city debt ("How Detroit went broke - Economics - AEI"). On June 14, this year the city failed to make $40 million payment and triggered defaulting to POC debt holders. The blocking of the deal would have avoided a significant portion of the current debt that would have contributed to avoiding the bankruptcy of the city. Conclusion The current distress in the financial sector of the city of Detroit echoes the financial crisis of the city in the Great Depression of the 1930s. This means it is possible for the city to recover and regain prosperity through the implementation of policies of stubborn stands against deficit allowance. This would mean putting a lid on and cutting the city’s budget to a minimal size. Workers and unions should agree to reasonable reforms that would allow chances of a successful financial recovery. A federal bailout of the city’s financial woes will only serve to encourage an untenable moral hazard. Other cities should learn from the Detroit case to implement changes to avoid the situation. Work cited "How Detroit went broke - Economics - AEI." Aei.org, 2013. Web. 19 Nov 2013. . "How Detroit went broke: The answers may surprise you ? and don't blame Coleman Young." Detroit Free Press, 2013. Web. 18 Nov 2013. . John Macomber, And Benjamin Kennedy. "Detroit Files for Bankruptcy: HBS Faculty Weigh In — HBS Working Knowledge." Hbswk.hbs.edu, 2013. Web. 19 Nov 2013. Read More