CREATIVE ACCRUAL ACCOUNTING IN THE PUBLIC SECTOR: ‘MILKING’WATER UTILITIES TO BALANCE MUNICIPAL BUDGETS AND ACCOUNTS pot

Financial Accountability & Management, 24(2), May 2008, 0267-4424

CREATIVE ACCRUAL ACCOUNTING IN THE PUBLIC
SECTOR: ‘MILKING’ WATER UTILITIES TO BALANCE
MUNICIPAL BUDGETS AND ACCOUNTS
ă
EIJA M. VINNARI AND SALME NASI
INTRODUCTION

A balanced public sector economy requires that sufficient taxes and other
revenues are collected to cover public expenditures. Tax revenues are crucial
in financing a public economy, yet the various modes of levying taxes cannot
be multiplied indiscriminately and there are limits to how high taxation rates
can be raised. The demand for public services is invariably greater than the
resources available for their provision, in other words scarcity and the allocation
of resources have always caused problems in all public economies.
Recent attempts to solve the problems of public finance have included
adopting models from the private sector (see e.g., Hood, 1995; and Gruening,
2001). A case in point is New Public Management (NPM), which highlights
the role of financial management and accounting as a basis for reforms. The
conventional wisdom has been that public sector accounting, in particular the
fields of financial management and cost accounting, must be developed to
emulate business sector practices. The terms New Public Financial Management
(NPFM) and accountingization have been used in an attempt to stress the
economic and accounting orientation of public sector reforms (Olson et al.,
1998; and Power and Laughlin, 1992). In their article (1999, p. 210) Guthrie
et al. observe that:
an increasingly notable element of the NPM movement is the seemingly endless list of
accounting-based, ‘financial management’ techniques that are being drawn on in the
pursuit of reform

and that:
the field of NPFM is replete with jargon – terms such as ‘accrual accounts’,
‘performance indicators’, ‘delegated budgets’, ‘full costs’, . . .to name just a few.

The adoption of NPM ideology also involves attempts to streamline the
public sector and reduce its costs. Very often the core public sector has been
reduced by separating the units producing utility-type services, such as energy
∗ The authors are respectively Research Scientist, Tampere University of Technology, Institute
of Environmental Engineering and Biotechnology; and Professor, University of Tampere,
Department of Economics and Accounting.
Address for correspondence: Eija M. Vinnari, Tampere University of Technology, Institute
of Environmental Engineering and Biotechnology, PO Box 541, FIN-33101 Tampere, Finland.
e-mail:
2008 The Authors
Journal compilation C 2008 Blackwell Publishing Ltd, 9600 Garsington Road,
Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.
C

97


98

ă
VINNARI AND NASI

and water services production, into public enterprises or public companies,
which then operate as result-controlled responsibility or profit centres and
accounting entities on commercial lines. The formation of public enterprises can
be considered an intermediate phase on the way towards the probable ultimate

outcome of NPM: the privatization of most publicly owned utilities.
The purpose of this paper is to explore and analyse the effects of the two
aforementioned types of NPM reforms: accountingization, i.e. the application of
business-sector accounting models in the municipal sector, and the formation
of profit-making municipal enterprises. More specifically, the paper aims to
determine whether these reforms have succeeded in attaining the oft-cited
goals of increased accountability, transparency and intergenerational equity, or
whether, on the other hand, any indications can be found of the contradictions,
ambiguities and paradoxes that have been suggested to underlie NPM reforms
(e.g., Olson et al., 1998). These questions are investigated through an in-depth
explanatory case study set in the context of Finnish local government, a city and
the city’s water utility.
The analysis in this paper is based on the financial statements, budgets and
other official documents of the case city and its water utility. Newspaper articles
and information obtained through discussions with city officials are also used
as empirical data. Even though the analysis is to a large degree founded on
accounting techniques, the study represents interpretative and to some extent
critical accounting research (Burrell and Morgan, 1979; Chua, 1986; Hopper
and Powell, 1985; Baker and Bettner, 1997; and Ryan et al., 2002). The authors’
view is that the heterogeneity of accrual accounting applications may lead
to creative accounting solutions especially in the public sector context, with
the consequence that accounting information is not sufficiently transparent,
users may be misled, and accounting does not properly fulfil its accountability
functions. The authors are critical (cf. Mouritsen et al., 2002) and wish to
facilitate ordered change towards more straightforward practices. This paper
therefore contributes to national and international efforts to develop and
improve public sector accounting principles and practices.
The paper proceeds as follows. The second section presents the concepts
of intergenerational and interperiod equity, accrual accounting, and creative
accounting, which provide the theoretical background for the research. The

third section describes the case, the sale of a public water utility (henceforth
referred to as Water Utility) to a public energy company (Energy Company) by
the parent or owner of the two aforementioned units, Owner1 City (or the City).
The fourth section analyses the sale, its motivations and consequences in the
light of the theoretical framework provided, and the final section sets out the
authors’ conclusions.
THEORETICAL BACKGROUND

The theoretical background of this paper consists of three elements: the concepts
of intergenerational equity and interperiod equity in the public sector, accrual
Journal compilation

C

C 2008 The Authors
2008 Blackwell Publishing Ltd


CREATIVE ACCRUAL ACCOUNTING IN THE PUBLIC SECTOR

99

accounting and interperiod equity measures in the public sector context, and
creative accounting. These concepts are briefly discussed in the remainder of
this section.
The intergenerational equity requirement is often regarded as the key
criterion for the fiscal stance of a government. Intergenerational equity is based
upon the principle that the taxpayers of a certain generation should finance all
the current expenditure and contribute to financing inherited productive assets
in proportion to how much benefit they receive from those assets (Robinson,

1998). As an abstract concept, it is operationalized through interperiod equity,
which in turn requires that enough taxes and charges are collected in each fiscal
period to cover the costs incurred in the provision of services during that period
(Robinson, 1998; and Năsi, 1999). This, in turn, requires balanced annual budgets
a
and accounts. Controlling interperiod equity calls for appropriate budgeting and
accounting systems, and also equity measures, although the latter are in practice
ambiguous and controversial.
Public sector budgeting and budgetary accounting are traditionally based on
the concepts of expenditure and revenue, and the principle that annual revenues
should cover annual expenditures, i.e. the budgets and accounts should be in
balance. The balance principle belongs to traditional budgetary doctrine and is
part of the practice of most governments. In budgetary accounting, expenditures
and revenues are largely equated with cash expenditures and cash revenues, i.e.
accounting is cash-based, although not necessarily in a pure form. Furthermore,
the degree of interperiod equity of the economy or finances can be measured as a
balance between all cash revenues (including borrowing) and cash expenditures
(including long-term capital investments, repayment of loans and lending).
The superiority of accrual-based accounting compared to traditional public
sector (budgetary) accounting has been argued by many practitioners and
academics since the late 1980s and early 1990s. The debate on accrual vs.
budgetary accounting has inspired a plethora of articles, in which various
arguments for and against accrual accounting have been made. Most of the
arguments in favour of accrual accounting belong to one of the following themes:
(1) enhanced internal and external transparency; (2) better organizational
performance through improved resource allocation; and (3) more information
on the full costs of operations, leading to greater efficiency (for a review see
e.g., Carlin, 2005). Conversely, accrual accounting has been criticized for the
misallocation of resources and inadequate disclosure of assets and liabilities,
as well as for the ability of organizations to defer liabilities and thus burden

future taxpayers with these costs (e.g., Hoque and Moll, 2001). It has also been
claimed that the application of accrual accounting in the public sector leads to
measurements that are not reliable, fair, or neutral (McCrae and Aiken, 2000),
and that the microeconomic basis for its application is weak (Robinson, 1998; and
Monsen and Năsi, 1996). Guthrie et al. (1999) have called for further research
a
on the claimed potentiality of accrual accounting reforms and their practical
implications.
2008 The Authors
Journal compilation

C

C

2008 Blackwell Publishing Ltd


100

ă
VINNARI AND NASI

Following the spread of NPFM ideologies, governments in many countries
have adopted business sector accounting thinking and models, not only in public
enterprises but also in the core functions of the public sector (e.g., Guthrie
et al., 1999; OECD, 2002; Christiaens, 2003; Schedler, 2003; Lăder and Jones,
u
2003; Groot and Budding, 2004; Ridder et al., 2005; and Paulsson, 2006). In
the field of financial accounting, this can be seen in the application of accrualbased accounting and financial reporting, including an income statement, a

comprehensive balance sheet and a statement of financial inflows and outflows.
The driving forces behind such reforms have been identified as the wish
to instil greater financial awareness into public sector decision-making, to
provide comprehensive financial information to facilitate efficient and effective
decisions, and to provide information that allows citizens and other stakeholder
groups to assess the extent to which revenues meet the full costs of public service
provision (Guthrie et al., 1999; Stalebrink and Stacco, 2003; and Connolly and
Hyndman, 2006). Politicians, financial institutions, management consultants,
scholars, the media, and international organizations have all been influential in
bringing about these reforms (Pina and Torres, 2004).
However, accrual accounting is not just one specific accounting model. There
are many versions of it; starting with static and dynamic theories and models.
In Finland, until the obligatory adoption of IAS/IFRS by quoted companies in
line with EU policy, prevailing accounting thinking in the business sector was
strongly dynamic in nature.2 The Finnish municipalities adopted the dynamic
accrual accounting model in their financial accounting reform in 1997, and they
are still using it today.
The core of the Finnish dynamic accrual accounting model lies in the
categorizing and recording of transactions, i.e. the bookkeeping of revenues,
expenditures and finance transactions, and in periodic income measurement.
Transactions are measured and recorded at their historical costs and at the
exchange prices of the transaction date. The matching principle is applied in
the closing of accounts, i.e. expenditures are matched against the corresponding
revenues to calculate annual income (cf. e.g., Skousen et al., 1991). The Profit and
Loss (P/L) Statement is the primary financial statement in dynamic accounting
thinking, and the Balance Sheet has more or less only the role of transferring
the balances of different assets and liabilities accounts to the next accounting
period.
The municipal accrual accounting model in Finland differs from the businesssector model in several ways, an important one of which is a terminology tailored
for the local government sector only. This concerns, for instance, the terms

describing the intermediate results on the P/L Statement and the terms used on
the Balance Sheet referring to equity/net assets. This problem of self-invented
terminology is discussed in more detail in the empirical part of this paper.
The third concept forming the theoretical background in this paper is creative
accounting. This is a term used in European accounting literature, while the
preferred term in the United States, and consequently in most of the literature

Journal compilation

C

C 2008 The Authors
2008 Blackwell Publishing Ltd


CREATIVE ACCRUAL ACCOUNTING IN THE PUBLIC SECTOR

101

on the subject, is ‘earnings management’, but such terms as ‘income smoothing’,
‘earnings smoothing’, ‘financial engineering’, and ‘cosmetic accounting’ are also
found in the literature (see Amat and Gowthorpe, 2004). Healy and Wahlen
(1999, p. 368) define earnings management as follows:
Earnings management occurs when managers use judgment in financial reporting
and in structuring transactions to alter financial reports to either mislead some
stakeholders about the underlying economic performance of the company or to
influence contractual outcomes that depend on reported accounting numbers.

Amat and Gowthorpe (2004) see creative accounting as the use of accounting
to mislead rather than help the intended user, deliberately taking advantage of

areas where there are ambiguities and discontinuities. Regulatory flexibility may
permit a choice of policy in, for example, fixed asset valuation, such as in the case
of IAS, which allow carrying non-current assets at either revalued amounts or
depreciated historical cost (ibid.). The problem related to fixed asset valuation
has also been noted by Griffiths (1986, p. 97):
Be it as part of bid defense or an attempt to beef up the balance sheet, or a
genuine effort to reflect true value to the business, fixed asset valuations will always
present opportunities for creative accounting. These opportunities are not restricted
to the balance sheet since the consequent charge to the profit and loss account
for depreciation will also be affected. Fixed assets are pliable, flexible and mobile.
Everything then except fixed!

Artificial transactions, in turn, can be entered into both to manipulate balance
sheet amounts and to transfer profits between accounting periods (Amat and
Gowthorpe, 2004). Thomas et al. (2004) tested for earnings management in the
case of transactions between an owner company and its affiliates:
For example, the [o]wner company can sell assets (e.g., inventory, land, etc.) to its
subsidiary. . .The [o]wner company can report the sale and increased earnings in the
current period. For consolidated purposes, the affiliated transaction will be eliminated
and not affect the financial statements (p. 3).

The use of creative accounting has generally been associated with the private
sector, yet it can also be practised in public administration, where in fact
the context and regulations often offer ample opportunities to indulge in it.
This is especially the case when the accounting practices depend on the public
sector’s own regulations and not on any generally accepted accounting standards.
In Finland, for example, the adoption of the IPSAS standards has not been
considered in the municipal sector. The central government’s Accounting Board
did conduct a preliminary review of the standards but decided not to implement
them as long as they are incomplete. Furthermore, as the national legislation in

Finland only provides the general framework for municipal accounting, more
detailed principles and practices rely upon self-regulation, i.e. a municipal
accrual accounting model devised by the municipalities’ interest organizations.
This presents opportunities for the use of creative accounting as will be
demonstrated in the next sections.
2008 The Authors
Journal compilation

C

C

2008 Blackwell Publishing Ltd


102

ă
VINNARI AND NASI
CASE STUDY CREATIVE ACCRUAL ACCOUNTING SOLUTIONS IN THE
MUNICIPAL SECTOR

Accrual Accounting and Budgeting and Interperiod Equity Measures in Finnish
Municipalities
Local government reform in Finland took place with the implementation of
the Local Government Act (365/1995), in which there was a reference to the
application of the Accounting Act of 1973, reformed in 1997 (1336/1997). Taken
together, these two Acts meant that the municipal sector adopted the accrual
accounting method for both budgeting and financial accounts.
The Local Government Act also introduced the requirement that each

municipality should draft a three-year financial plan which must be accepted
by the municipal council concurrently with the municipality’s budget for the
coming fiscal year. If the municipality’s financial result for the current or the
coming year is expected to be negative in accrual terms, the municipal board
(executive body) has to present the municipal council (decision-making body)
with a plan of how it intends to cover the deficit during the planning period
(§ 65). Thus, calculated over a period of three years, the municipality’s budget
must at least break even. The aim of this system is to guarantee interperiod,
and, in the long run, intergenerational equity in Finnish municipal economies.
Yet, although the aim is clear, agreeing upon the most appropriate accounting
system and the corresponding equity indicators is more problematic. In the
accrual budgeting and accounting system devised specifically for the Finnish
municipalities, certain P/L Account figures clearly play a crucial role in
measuring the balance of budgets and accounts. One such figure is the Annual
Margin (see the Appendix), the difference between a municipality’s running
revenues and expenses. Another important measure is the bottom-line figure,
the Surplus/Deficit for the Financial Year, which is the official equity measure
that should at least break even in the three-year period. Achieving interperiod
equity using these measures is a problem in numerous Finnish municipalities,3
and this difficulty was also the key factor in the application of creative accounting
solutions in the case municipality, Owner City.

Owner City and the Formation of the Public Enterprise, Water Utility
Owner City is located in central Finland and has a population of 83,000. During
the last few years, the City has suffered from financial problems that are
threefold: an uncovered deficit in the annual budgets and accounts, a small
Annual Margin that has to cover at least depreciation, and increasing longterm debt. Because of the requirement to achieve balance, Owner City has been
compelled to try and improve its finances. In this effort, the City has taken
advantage of its formal position as the owner of municipal public enterprises
and companies, in particular its water utility.

Journal compilation

C

C 2008 The Authors
2008 Blackwell Publishing Ltd


CREATIVE ACCRUAL ACCOUNTING IN THE PUBLIC SECTOR

103

Owner City’s Water Works was established in 1910, and it operated as part
of the city administration until the mid-1990s. In 1994, Water Works underwent
an organizational change to become a public enterprise, Water Utility, i.e., an
independent municipal profit centre and accounting entity with its own Balance
Sheet. As a hybrid of a municipal department and a public company, a public
enterprise in Finland is not required to pay Corporation Tax.4 Another notable
difference between a public enterprise and a private or public company in Finland
relates to a Balance Sheet item called ‘Basic Capital’ on the liabilities, which is
defined as the owner municipality’s permanent equity investment in its public
enterprise. When a public enterprise is formed, the opening balance sheet value
of the Basic Capital is calculated as the difference between the value of its assets
and debts (Accounting Board, Municipal Section, 1999). Thus, for the purpose of
constructing the first Balance Sheet for Water Utility, its infrastructure assets
needed to be recognized, valued and separated from the other assets of Owner
City. Because no official guidelines on public enterprise asset valuation existed
in 1994, Water Utility’s infrastructure assets were entered in the balance sheet
at acquisition cost, EUR 31.1 million, based on the investment made during
the period 1975–1993.5 This amount was also considered to reflect Owner City’s

capital investment in Water Utility, that is its Basic Capital. Thus, the sum (EUR
31.9 million after minor adjustments) was entered on Water Utility’s opening
Balance Sheet as the value of the infrastructure assets and, on the liabilities
side, as the Basic Capital.
Along with the general adoption of accrual accounting models by all the
Finnish municipalities in 1997, Water Utility’s infrastructure assets had to be
revalued to reflect the assets’ historical cost minus accumulated depreciation.
The value of the assets and, correspondingly, the value of the Basic Capital
were reduced to EUR 24.3 million. A year later, Water Utility acquired more
property, and the Basic Capital was raised to EUR 25.2 million, at which level
it remained until 2005. Since the publication of public enterprise accounting
guidelines (Accounting Board, Municipal Section, 1999), the revaluation of fixed
assets other than land or water areas has been forbidden.

Compensation for Owner City’s Basic Capital as an Expense Item on the Profit
and Loss Account
The Finnish Water Services Act (119/2001) defines ‘water services’ as the
conveyance, treatment and delivery of water to be used as household water,
as well as the disposal and treatment of wastewater, rainwater and drainage
water from foundations (§ 1). The Act stipulates that water services charges
should cover the running costs and investments of the water undertaking in the
long run, and that the charges may, but do not have to, include a reasonable
rate of return on the owner’s capital investment (§ 18). Since the Act provides
no further definition for the term ‘reasonable’ and the rates of return are not
regulated by any authority,6 they vary widely in Finland and can amount to
2008 The Authors
Journal compilation

C

C

2008 Blackwell Publishing Ltd


104

ă
VINNARI AND NASI

as much as 45.5 percent of a water utility’s annual turnover (Vinnari, 2006).
Owner City’s interpretation of this regulation can be seen in Water Utility’s
P/L Accounts (Table 1). In accordance with the Finnish municipal accounting
guidelines, the return on Owner City’s Basic Capital was entered in the P/L
Accounts as a financial expense item entitled ‘Compensation for Basic Capital’,
despite its dividend-like nature.
In accordance with the full cost recovery principle set out in the Water
Services Act, the Turnover from selling water should cover the operating costs,
depreciation, and financial costs of Water Utility. The bottom line figure
(Surplus/Deficit for the Financial Year) in Water Utility’s P/L Accounts seems
to indicate that it succeeded in breaking even but made very modest annual
profits. Interpreted in standard accrual accounting terms, this would mean that
the Utility would have had few funds to distribute to the owner. Yet, a more
careful scrutiny of the accounts reveals that in fact Water Utility paid, and the
City received, significant sums of money as Compensation for the Basic Capital.
This item was, however, presented as a financial expense, not an appropriation
of profit.
In other words, Owner City used Water Utility to collect an income of EUR
2.51–3.53 million annually in the form of customer charges. During 1994–
2004, the compensation rate paid by Water Utility ranged from 7.9 percent to

14.5 percent on the Basic Capital. Expressed as a percentage of annual turnover,
this equals 20–27.5 percent (Table 2).
The income from Water Utility was not earmarked for any water services
related purpose, so the City was able to use it to balance its budgets and finances.
This practice is not immediately detectable by looking at Water Utility’s P/L
Accounts because, first of all, like most users of accounting information, the
municipal council members very obviously monitor and understand first and
foremost the bottom line figure, which in this case shows modest and acceptable
profits. Secondly, the heading ‘Compensation for the Basic Capital’ misleads
rather than helps the reader to understand the financial information of Water
Utility: she or he may assume that the item is equal to real external spending
and expense, such as interest on a bank loan, rather than a return on Owner
City’s ‘invested’ capital. The arrangement conforms to Finnish public sector
accounting regulations, but its adherence to the spirit of the Water Services Act,
which calls for a ‘reasonable’ rate of return, can be questioned. Therefore, the
Compensation for the Basic Capital can be interpreted as creative accounting
and hidden taxation, not only in the case city but also more generally in the
accounts of Finnish municipal enterprises.
Despite the steady income flow from the Water Utility, Owner City’s financial
predicament intensified at the beginning of 2000, and the City had to resort to
further measures to balance its budgets and accounts.

Journal compilation

C

C 2008 The Authors
2008 Blackwell Publishing Ltd

C

2008 The Authors
Journal compilation

C

2008 Blackwell Publishing Ltd

0.00

−0.51

−1.18

0.21

−0.03
−2.66
0.00

−0.02
−2.63
0.00

0.00
−2.51
0.00

0.00

−0.69

11.73
−5.60
−2.77
0.028

10.72
−4.89
−2.72
0.057

1996

11.55
−4.75
−2.85
0.05

1995

Note:
∗
Voluntary provisions set aside for future investments.

Surplus/Deficit for
the Financial Year

Turnover

Operating Costs
Depreciation
Financial Income
Financial Costs
Interest Costs
Compensation for the Basic Capital
Extraordinary Income
and Expenses (net)
Provisions∗

1994

0.48

0.00

−0.01
−3.53
0.00

12.83
−5.60
−3.21
0.011

1997

0.49

0.00

−0.06
−3.53
0.00

13.58
−5.80
3.71
0.007

1998

0.13

0.00

−0.13
−3.36
0.00

13.88
−7.72
−4.08
0.004

1999

0.23

3.28

−0.26
−3.19
−3.15

14.35
−6.6
−4.20
0.005

2000

0.07

0.13

−0.33
−3.19
0.00

15.47
−7.69
−4.51
0.011

2001

0.23

0.13

−0.39
−3.19
0.00

15.54
−7.34
−4.56
0.011

2002

0.19

0.13

−0.40
−3.19
0.00

15.63
−7.44
−4.56
0.018

2003

Summary of the Profit and Loss Account Information of Water Utility, 1994–2004 (EUR million)

Table 1

0.45

0.13

−0.34
−3.19
0.00

15.90
−7.54
−4.56
0.016

2004

CREATIVE ACCRUAL ACCOUNTING IN THE PUBLIC SECTOR

105


21.7

24.5

8.4

2.63

31.40

1995

22.7

8.5

2.66

31.40

1996

Note:
∗
Value of Basic Capital changed due to revaluation of fixed assets.

Compensation,% of turnover

7.9

2.51

Compensation, EUR million

Compensation, % of basic capital

31.90

Basic Capital, EUR million

1994

27.5

14.5

3.53

24.34

1997∗

26.0

14.0

3.53

25.16

1998∗

24.2

13.4

3.36

25.16

1999

21.8

12.7

3.19

25.16

2000

20.6

12.7

3.19

25.16

2001

20.5

12.7

3.19

25.16

2002

Owner City’s Basic Capital in Water Utility and the Compensation Paid for it, 19942004

Table 2

20.4

12.7

3.19

25.16

2003

20.0

12.7

3.19

25.16

2004

106
ă
VINNARI AND NASI

Journal compilation

C

C 2008 The Authors
2008 Blackwell Publishing Ltd


CREATIVE ACCRUAL ACCOUNTING IN THE PUBLIC SECTOR

107

The Sale and Fabricated Sales Profit of the Water Utility
During the autumn of 2003 and 2004, when the financial plans and budgets
of Owner City were being approved, the realization grew that deficit spending
would continue and something radical would have to be done to meet the legal
obligation to cover the deficit. A solution was found in the sale of Water Utility,
not outside Owner City Group, however, but as an intra-group rearrangement
to Owner City’s own energy company that would permit a large additional
sales profit to be recorded as income on Owner City’s P/L Account as a result
of the fair value based revaluing and sale of Water Utility’s infrastructure
assets.
As mentioned earlier, in the Finnish dynamic accounting theory based
approach, the Balance Sheet was a secondary financial account, and assets and
their valuation did not belong to the core elements of financial accounting. With
the advent of IAS/IFRS-based accrual accounting, more attention began to be
paid to Balance Sheet information and assets valuation, but in the public sector,
accounting regulations forbade revaluation of fixed assets other than land or
water areas. These developments also affected Owner City, which realized that

its water utility assets were in a sense undervalued and that one way to improve
the City’s financial results would be to revalue the assets at fair value. The only
way to do this was via the sale of Water Utility.
In the autumn of 2003, the City had commissioned Consulting Firm X to
analyse the feasibility of selling Water Utility to Energy Company and to
calculate the fair value of Water Utility’s fixed assets, which consist mostly of
infrastructure. Although a recommendation report was written and was supposed
to be presented to the City Council, the issue was shelved for a year and raised
again in the autumn of 2004 in connection with the budget and the financial
plan for 2005–08. After a second review and valuation of Water Utility’s assets
by Consulting Firm Y, the proposal of the City Board to sell Water Utility to the
City-owned Energy Company was accepted by the City Council, and the sale was
to take place on the last day of 2005.
The various outcomes of Water Utility’s asset valuations and the final sales
price are presented in Table 3. The wide variations in the values are of course
due to different valuation methods and calculation parameters, and attest to the
difficulty of reaching one single figure that could be considered the ‘correct’ fair
value of Water Utility’s fixed assets.
The final sale arrangements are presented in Figure 1. Owner City recorded
the proceeds from the sale, the difference (EUR 113 million) between the current
book value of Water Utility’s infrastructure assets (EUR 37 million) and the sale
price (EUR 150 million), on its P/L Account (as an Extraordinary Income item).
The sale of Water Utility had no positive effect, however, on Owner City’s cash
flows at the time of sale as the sale proceeds were balanced by a loan for the
same amount to the buyer, Energy Company, for a period of fifteen years at an
annual interest rate of 5.91 percent.
2008 The Authors
Journal compilation

C

C

2008 Blackwell Publishing Ltd


¨
VINNARI AND NASI

108

Table 3
Value of Water Utility’s Infrastructure Assets According to Different
Valuation Methods and Valuators in 2005
Asset Valuation Method

Value, EUR Million

Book value
Technical and economic value (Firm X)
Technical and economic value (Firm Y)
Discounted Free Cash Flow value (Firm X)
Discounted Free Cash Flow value (Firm Y)
Final sales price, fair value + goodwill

37
120–210
130
50–80
74

130 + 20

Figure 1
Sale of Water Utility to Energy Company

OWNER CITY
budgeting and accounting
entity including public
enterprises, e.g. Water
Utility

Price, EUR 150 million, consisting of:
- fair value of Water Utility’s assets:
EUR 130 million
- goodwill: EUR 20 million

ENERGY
COMPANY

Bullet-type debenture loan, EUR 150 million

INTRA-GROUP SALE OF THE WATER UTILITY

Without this creative accounting procedure, Owner City’s budget for the year
2005 would have shown a deficit of EUR 19.69 million and a cumulative deficit
for the period 2004–2007 of EUR 42.63 million, contravening the Finnish Local
Government Act. When the ‘sale’ of Water Utility to Energy Company is included
in the figures, the City’s budgeted surplus for 2005 becomes positive (EUR 102.61
million) and the total balance for 2004–2007 is EUR 79.67 million7 (see Table 4
and Figure 2). The surplus for 2005 is sufficient to cover the deficit spending

and balance the budget and accounts for some years to come.
According to the City Mayor’s pronouncements, the aim of the sale was to
ensure the positive development of both Water Utility and Energy Company
under City ownership (Regional Newspaper, October 27, 2004). Other public
arguments for the sale were synergy and taxation benefits as well as emergency
relief for the City’s budget deficit and a stable income for the City for at least
fifteen years. The budget figures of Owner City for the period 2004–2007,
including Extraordinary Income from the sale of Water Utility in 2005, are
presented in the Appendix.
Energy Company had previously paid the City dividends, meaning that it had
had to show a profit on its P/L Account and pay the normal corporation tax of
Journal compilation

C

C 2008 The Authors
2008 Blackwell Publishing Ltd


109

CREATIVE ACCRUAL ACCOUNTING IN THE PUBLIC SECTOR

Table 4
Surplus/Deficit Figures of Owner City, 2004–2007
Surplus/Deficit of the City Without
the Sale of Water Utility, EUR Million

Surplus/Deficit Including
the Sale of Water Utility, EUR Million

−16.9 (realized)
−19.69
−7.31
+1.27
−42.63

−16.9 (realized)
+102.61
−7.31
+1.27
79.67

2004
2005
2006
2007
Total

Figure 2
Financial Statement/Budget and Cumulative Surplus/Deficit Figures of
Owner City, 1997–2008
120
99.4

100

85.7

Million euros

80

86.3
77.8

60

78.4

40
20

6.4

7.3
0.4

-5.0

2.1

-7.3

-5.2

3.7

7.3

-13.2

0.6

0
-20

-2.7

-9.1

-2.4

2.1

1.6

-8.4
-16.9

-40
1997

1998

1999

2000

2001

2002

Financial (roman figures) Statement/Budget

2003

2004

2005*

2006*

2007*

2008*

Cumulative (italic figures) Surplus/Deficit

Note:
The figures for 2005—2008 are budgetary estimates.

26 percent. After the sale, the dividend requirement was abolished and replaced
with the interest payments on the loan that Energy Company had taken from
the City to finance its Water Utility purchase. This arrangement means that
Energy Company no longer has to show a profit in order to pay dividends, and
thus avoids corporation tax, while the City is guaranteed a stable interest income
during the loan period.
Despite the use of an accrual accounting model since 1997 and the interperiod
balance in its financial accounts, the debt of Owner City has increased steadily

and is likely to grow or stay on the same high level in the future (Figure 3).
The creative sale arrangement did not solve the City’s fundamental economic
2008 The Authors
Journal compilation

C

C

2008 Blackwell Publishing Ltd


¨
VINNARI AND NASI

110

Figure 3
Total and Per Capita Debt of Owner City in 1997–2008
EUR million

EUR/capita

250

2500

200

2000

150

1500

100

1000

50

500

0

0
1997

1998

1999

2000

2001

2002

Total loan

2003

2004

2005* 2006* 2007* 2008*

Loan/inhabitant

problem: more money is being spent on the production and provision of services
than is being collected in revenues.
DISCUSSION

Natural monopolies such as water services utilities are often profitable milch
cows for their owners, usually municipalities or other public entities. Pricing
the services provided by the utilities offers owner municipalities a chance to
hide taxation and to collect revenues to balance deficit spending. In the case
study, the opacity of the financial accounts was caused by the inclusion in the
Finnish municipal accounting regulations of certain concepts that mislead rather
than help the users of financial accounting information. Adopting and applying
generally acceptable accounting principles would therefore be preferable to
nationally devised, tailor-made solutions for the municipal sector.
In the sale arrangement presented above, it seems that Owner City took
advantage of the difficulty of valuing infrastructure assets ‘correctly’ and the
room to manoeuvre provided by the IAS/IFRS and IPSAS norms. According to
the IPSAS definition, an infrastructure asset should be recognized as an asset
when (i) it is probable that the future economic benefits or service potential
associated with the asset will flow to the entity; and (ii) the cost or fair value
of the asset to the entity can be reliably measured (IPSAS 17, 13). The old
municipal water utility infrastructure assets meet the first precondition for the
IPSAS definition of property, plant and equipment, but hardly the second one.

Recognition of infrastructure elements as assets in the absence of generally
accepted and reliable valuation standards has been questioned (Cooper, 1993),
and the need for greater standardization is generally recognized (Lapsley, 1999).
It is claimed that the problems of determining the economic life and economic
Journal compilation

C

C 2008 The Authors
2008 Blackwell Publishing Ltd


CREATIVE ACCRUAL ACCOUNTING IN THE PUBLIC SECTOR

111

value of such assets are exacerbated in the public sector because the assets
are usually very large and their life may be extended indefinitely when they
are irreplaceable or provide essential services (Pallot, 1990). The difficulty of
valuing infrastructure assets arises from their inherent characteristics, which
include being immovable, part of a system or network, specialized in nature and
without alternative uses, and subject to constraints on disposal (IPSAS 17, 21).
Conversely, the valuation of assets within the neo-classical framework has been
defended on the basis that they conform to an economic definition of capital
goods because they are input set aside for producing output in future periods
(Stanton and Stanton, 1997). It has also been claimed that although marketbased valuation methods are not suitable for service-based public-good assets,
corporatization removes the public-good nature and enables the use of market
approaches to valuation (Bond and Dent, 1998).
Fair value can be defined as:
the amount for which an asset could be exchanged, or a liability settled, between

knowledgeable, willing parties in an arm’s-length transaction, as at the date relevant
for the valuation (IFAC, 2004; Parker, 1992).

The market for water utility assets is practically non-existent, and reliable
valuation based on an arm’s length transaction is a theoretical option only. Thus
the fair values of these assets present a paradox both in terms of their recognition
as assets and their reliable valuation, and so they are often carried on the Balance
Sheet, if one exists, at their initial cost less accumulated depreciation.
In Owner City, the sales price of Water Utility was determined on the basis
of two consulting companies’ assessments of the value of its operations. It is
difficult to assess the validity of the different values, but their wide variation
shows that by changing calculation methods and parameters the desired result
may be obtained. Despite the great difference in the economic and technical
values and the discounted free cash flow values, the former set of values were
chosen to represent the ‘fair’ value and the price of the water utility assets.
In addition to the official justification, another reason for the intra-municipal
sale of Water Utility could be that otherwise under Finnish accounting legislation
the revaluation of the water utility assets would not have been possible. By
matching the sale price to the highest estimated fair value, Owner City was able
to legally increase the value of its water utility assets on Energy Company’s
Balance Sheet. Thus, although the immediate cash flow effect of the sales
operation was zero, during the next fifteen years the cash flow to Owner City
will increase by the interest paid on the loan to Energy Company. While the sale
balanced Owner City’s budget and accounts in the three-year planning period,
as a solution to the financial problems of the City it was short-sighted, makeshift
and unfair. The interest and amortization funds can only be collected from future
water consumers, i.e. from future generations, in the form of higher customer
charges.
Indeed, a plan to raise the customer charges of Water Utility was announced
immediately after the sale plan had been confirmed. According to the then

2008 The Authors
Journal compilation

C

C

2008 Blackwell Publishing Ltd


112

ă
VINNARI AND NASI

Managing Director of Water Utility, the price rise that was to take effect from
the beginning of 2005 was not part of the sale preparations but was instead
an inflation adjustment due to the increased prices of electricity and chemicals
(Regional Newspaper, October 30, 2004). But then, after the finalizing of the sale
in November 2005, Energy Company announced that because of the high cost of
acquiring Water Utility, customer charges for water and wastewater would be
raised each year for the following ten years, with the exact figures to be disclosed
at a later date (Regional Newspaper, November 4, 2005). The sales operation
thus brought about interperiod equity but at the same time, from the standpoint
of future generations, it violated the principle of intergenerational equity.
The sale of Water Utility and the earlier practice of using it to produce income
for the City can be strongly criticized from the perspective of transparency and
accountability, key motives behind the accounting reforms. Both arrangements
conflict with the requirements of the Water Services Act, which states that
the grounds for customer charges should be transparent and correspond to the

actual cost of producing the services. As there is very little economic regulation
of municipal water services in Finland, the responsibility for overseeing their
finances rests on elected municipal council members. Yet understanding the consequences of the accounting transactions involved in the arrangements demands
advanced accounting knowledge, which most municipal council members, not to
mention the residents, cannot be expected to possess. This non-transparency
prevents accounting from fulfilling its key function of accountability (cf. Ijiri,
1975).
Dubious accounting practices cannot be blamed on a specific accounting model
but rather on how it is used. Nevertheless, traditional public sector cash-focused
budgetary accounting did not provide such opportunities for creative accounting
solutions. The misuse of accrual accounting in the case of natural monopoly
industries such as water services could be prevented by a proper institutional
framework of legislation and independent economic regulation.
All in all, it is possible to question the ownership policy and implementation
adopted as part of NPFM by the public sector. In the case presented, Water
Utility’s assets were regarded as the municipality’s, not the residents’, investments, and the Utility collected a considerable return on the capital invested by
Owner City through customer charges. This approach suggests that the City sees
itself as an investor rather than a provider of essential services, which conflicts
with the notion of a municipality existing first and foremost to look after the
interest of its residents. Furthermore, the restructuring of Water Utility will
inevitably increase water prices and transfer more money from the residents
to the owner municipality. Thus, in effect, the savings of past generations, i.e.,
the investments in Water Utility, are used to cover past and current deficit
spending. Bearing in mind the hundred-year history of Water Utility in Owner
City, it should be remembered that Water Utility was financed and ‘owned’ by
residents and consumers of water, past and present, rather than Owner City.

Journal compilation

C

C 2008 The Authors
2008 Blackwell Publishing Ltd


113

CREATIVE ACCRUAL ACCOUNTING IN THE PUBLIC SECTOR
CONCLUSIONS

Based on the case study and discussion above, the following general conclusions
can be drawn. (1) Accounting systems, such as public-sector cash-based budgetary
accounting or commercial accrual accounting, are not good or bad per se. The
authors do, however, argue that the application of accrual-based accounting
in the public sector does not guarantee intergenerational equity, transparency
or accountability, but instead opens up new kinds of possibilities for creative
accounting. This contradicts the basic idea of accounting as a means of
providing a reliable, true and fair view of the overall financial situation of the
accounting entity. Thus, public sector accounting practices should be reviewed
and developed further. (2) Uniform standards based on generally accepted
accounting principles are needed to regulate accrual accounting in the public
sector. This concerns specifically the fair value based valuation of fixed assets,
such as the infrastructure assets of a water utility. These present an opportunity
for creative accounting, especially if regulation is based on loose or purposefully
tailored national norms.

APPENDIX
Budget and Financial Plan Figures for Owner City, 2004–2007
2004
Revenues from operations

Production for own use
Operating expenses
Operating margin
Tax revenues
State grants
Financial revenues and costs (net)
Annual margin
Depreciation
Extraordinary income
Net result for financial year
Provisions
Surplus/deficit for financial year
(without the sale of Water Utility)

96.48
14.46
−374.37
−263.43
220.29
43.05
5.19
5.10
−22.72
0.14
−17.48
0.60
−16.88

Note:
∗

The figures for 2006 and 2007 are estimates.

2008 The Authors
Journal compilation

C

C

2008 Blackwell Publishing Ltd

2005
100.55
14.24
−378.16
−263.37
227.09
47.04
4.52
15.28
−31.74
116.92
100.46
2.23
102.69
(−19.69)

2006∗
171.69
0.00

−460.77
−289.08
238.10
53.66
8.36
11.04
−20.02
0.00
−8.98
0.54
−8.44

2007∗
172.95
0.00
−462.80
−289.85
246.89
55.54
7.95
20.53
−20.48
0.00
0.05
0.55
0.60


114

ă
VINNARI AND NASI
NOTES

1 The City is referred to as the ‘owner’ of Water Utility with the recognition that it is a faceless
administrative entity representing the real owners, i.e., its residents.
2 This was due to the Finnish Expenditure-Revenue theory of accounting, developed by Martti
Saario in the 1940s.
3 Out of a total of 416 municipalities in mainland Finland, 135 had a negative annual margin and
184 had an uncovered deficit in 2005 (Statistics Finland, 2005).
4 To be more exact, a municipal enterprise does not pay Corporation Tax on the business activities
conducted within its owner municipality’s territory. On business activity conducted in other
municipal territories, a municipal enterprise has to pay the municipal and church taxes, which
in 2007 amounted to 6.1828% of taxable income. The normal tax rate for businesses in Finland
is 26%, consisting of the state tax in addition to the aforementioned municipal and church taxes.
5 The residual value of assets that were acquired before 1975 was estimated to be almost zero,
and only the historical cost of those assets acquired in the last 20 years could still be traced in
the bookkeeping.
6 The Finnish Competition Authority, a government agency for promoting economic competition
and efficiency in the public and private sectors, is allowed to investigate the overall level of water
and wastewater charges but its mandate does not extend to specific cost categories such as the
rate of return.
7 These figures have been calculated on the assumption that the sales price was EUR 160 million.

REFERENCES
Accounting Act 1336/1997, State of Finland (Helsinki).
Accounting Board, Municipal Section (1999), Yleisohje kunnan ja kuntayhtymăn liikelaitoksen ja
a
taseyksikkănă kăsiteltăvăn rahaston kirjanpidollisesta kăsittelystă [General guidelines concerning the
o a a

a a
a
a
accounting of municipal public enterprises and other separate accounting units][in Finnish], Association
of Local and Regional Governments (Helsinki).
Amat, O. and C. Gowthorpe (2004), ‘Creative Accounting: Nature, Incidence and Ethical Issues’,
Universitat Pompeu Fabra Economics Working Paper No. 749.
Baker, C.R. and M.S. Bettner (1997), ‘Interpretive and Critical Research in Accounting: A
Commentary on Its Absence from Mainstream Accounting Research’, Critical Perspectives on
Accounting, Vol. 8, No. 4, pp. 293–310.
Bond, S. and P. Dent (1998), ‘Efficient Management of Public Sector Assets. The Call for Correct
Evaluation Criteria and Techniques’, Journal of Property Valuation & Investment, Vol. 16, No. 4,
pp. 369–85.
Burrell, G. and G. Morgan (1979), Sociological Paradigms and Organizational Analysis (Heinemann,
London)
Carlin, T. (2005), ‘Debating the Impact of Accrual Accounting and Reporting in the Public Sector’
Financial Accountability & Management, Vol. 21, No. 3, pp. 309–36.
Christiaens, J. (2003), ‘Accrual Accounting Reforms in Belgian Local Governments: A Comparative
Examination’, Journal of Public Budgeting, Accounting & Financial Management, Vol. 15, No. 1, pp.
92–109.
Chua, W.F. (1986), ‘Radical Developments in Accounting Thought’, The Accounting Review, Vol. LXI,
No. 4, pp. 601–32.
Connolly, C. and N. Hyndman (2006), ‘The Actual Implementation of Accruals Accounting. Caveats
from a Case within the UK Public Sector’, Accounting, Auditing & Accountability Journal, Vol. 19,
No. 2, pp. 272–90.
Cooper, K. J. (1993), ‘Public Sector Valuations’, New Zealand Valuers’ Journal (December), pp. 11–18.
Griffiths, I. (1986), Creative Accounting. How to Make Your Profits What You Want Them to be (Unwin
Hyman Limited, London).
Groot, T. and T. Budding (2004), ‘The Influence of New Public Management Practices on Product
Costing and Service Pricing Decisions in Dutch Municipalities’, Financial Accountability &

Management, Vol. 20, No. 4, pp. 421–43.
Gruening, G. (2001), ‘Origin and Theoretical Basis of New Public Management’, International Public
Management Journal, Vol. 4, No. 1, pp. 1–25.

Journal compilation

C

C 2008 The Authors
2008 Blackwell Publishing Ltd


CREATIVE ACCRUAL ACCOUNTING IN THE PUBLIC SECTOR

115

Guthrie, J., O. Olson and C. Humphrey (1999), ‘Debating Developments in New Public Financial
Management: The Limits of Global Theorising and Some New Ways Forward’, Financial
Accountability & Management, Vol. 15, No. 3&4, pp. 209–28.
Healy, P.M. and J.M. Wahlen (1999), ‘A Review of the Earnings Management Literature and Its
Implications for Standard Setting’, Accounting Horizons, Vol. 13, No. 4, pp. 365–83.
Hood, C. (1995), ‘Emerging Issues in Public Administration’, Public Administration, Vol. 73, No. 1,
pp. 165–83.
Hopper, T. and A. Powell (1985), ‘Making Sense of Research into Organizational and Social Aspects
of Management Accounting: A Review of Its Underlying Assumptions’, Journal of Management
Studies, Vol. 22, No. 5, pp. 429–65.
Hoque, Z. and J. Moll (2001), ‘Public Sector Reform. Implications for Accounting, Accountability
and Performance of State-Owned Entities – An Australian Perspective’, The International
Journal of Public Sector Management, Vol. 14, No. 4, pp. 304–26.
IFAC (2004), IPSAS 19 and IPSAS 20 Glossary of Defined Terms, International Federation of

Accountants (New York).
Ijiri, Y. (1975), ‘Theory of Accounting Measurements’,Studies in Accounting Research, No. 10 (American
Accounting Association, Sarasota, FL).
IPSAS Handbook of International Public Sector Accounting Pronouncements (International Federation of
Accountants, (New York).
Lapsley, I. (1999), ‘Accounting and the New Public Management: Instruments of Substantive
Efficiency or a Rationalising Modernity?’, Financial Accountability & Management, Vol. 15, No.
3 & 4, pp. 201–7.
Local Government Act 365/1995, State of Finland (Helsinki).
Lăder, K. and R. Jones (eds.) (2003), Reforming Governmental Accounting and Budgeting in Europe
u
(Fachverlag Moderne Wirtschaft, Frankfurt am Main).
McCrae, M and M. Aiken (2000), ‘Accounting for Infrastructure Service Delivery by Government:
Generational Issues’, Financial Accountability & Management, Vol. 16, No. 3, pp. 265–87.
Monsen, N. and S. Năsi (1996), Local Government Accounting in Finland and Norway: A Historical
a
Note on Cameralism’, Research in Governmental and Nonprofit Accounting, Vol. 9, pp. 259–
74.
Mouritsen, J., H.T. Larsen and A. Hansen (2002), ‘Be Critical! Critique and Naivete – Californian
and French Connections in Critical Scandinavian Accounting Research’, Critical Perspectives on
Accounting Vol. 13, No. 4, pp. 497513.
Năsi, S. (1999), Kunnallinen kirjanpitouudistus [Municipal Accounting Reform] [in Finnish] Kunnallisalan
a
kehittămissăătiă (Helsinki).
a
aa o
OECD (2002), Accrual Accounting and Budgeting – Key Issues and Recent Developments (OECD, Paris).
Olson, O., J. Guthrie and C. Humphrey (eds.) (1998), Global Warning: Debating International
Developments in New Public Financial Management (Cappelen Akademisk Fărlag, Oslo).
o

Pallot, J. (1990), ‘The Nature of Public Assets: A Response to Mautz’, Accounting Horizons (June),
pp. 79–85.
Parker, R. (1992), Macmillan Dictionary of Accounting, (2nd ed. Macmillan, London).
Paulsson, G. (2006), ‘Accrual Accounting in the Public Sector. Experiences from the Central
Government in Sweden’, Financial Accountability & Management, Vol. 22, No. 1, pp. 47–62.
Pina, V. and L. Torres (2003), ‘Reshaping Public Sector Accounting: An International Comparative
View’, Canadian Journal of Administrative Sciences, Vol. 20, No. 4, pp. 234–50.
Power, M. and R. Laughlin (1992), ‘Critical Theory and Accounting’, in M. Alvesson, and H. Wilmott
(eds.), Critical Management Studies (Sage, London).
Ridder, H-G., H-J. Bruns and F. Spier (2005), ‘Analysis of Public Management Change Processes:
The Case of Local Government Accounting Reforms in Germany’, Public Administration,
Vol. 83, No. 2, pp. 443–71.
Robinson, M. (1998), ‘Accrual Accounting and the Efficiency of the Core Public Sector’, Financial
Accountability & Management, Vol. 14, No. 1, pp. 21–37.
Ryan, B., R. Scapens and M. Theobald (2002), Research Method & Methodology in Finance & Accounting,
(2nd ed., Thomson, London).
Schedler, K. (2003), ‘Local and Regional Public Management Reforms in Switzerland’, Public
Administration, Vol. 81, No. 2, pp. 325–44.
Skousen, K.F., H.Q. Langenderfer and W.S. Albrecht (1991), Financial Accounting, (4th rev. ed.,
Southwestern Publishing Co., Cincinnati).

2008 The Authors
Journal compilation

C

C

2008 Blackwell Publishing Ltd

116

ă
VINNARI AND NASI

Stalebrink, O.J. and J.F. Stacco (2003), An Austrian Perspective on Commercial Accounting
Practices in the Public Sector, Accounting Forum, Vol. 27, No. 3, pp. 339–58.
Stanton, P. and J. Stanton (1997), ‘The Questionable Economics of Governmental Accounting’,
Accounting, Auditing & Accountability Journal, Vol. 11, No. 2, pp. 191–203.
Statistics Finland (2005), ‘Kuntien ja kuntayhtymien talous ja toiminta –tilaston ennakkotiedot’
[Preliminary information on the finances and activities of municipalities and joint municipal
boards] [in Finnish]. Press release (June 8, 2005).
Thomas, W.B., D.R. Herrman and T. Inoue (2004), ‘Earnings Management through Affiliated
Transactions’, Journal of International Accounting Research, Vol. 3, No. 2, pp. 1–25.
Vinnari, E.M. (2006), ‘The Economic Regulation of Publicly Owned Water Utilities: The Case of
Finland’, Utilities Policy, Vol. 14, No. 3, pp. 158–65.
Water Services Act 119/2001, State of Finland (Helsinki).

Journal compilation

C

C 2008 The Authors
2008 Blackwell Publishing Ltd