Secrecy Culture Continues

San Diego — A letter that has fallen into the Reader's hands reveals that the City of San Diego will have to confess many more accounting sins once it gets new audits from outside firms poring over its books. The city's assets have been inflated and liabilities deflated far more than citizens or bondholders have yet been told. The big question: is it felony stupid? Or felony, period?

Among many things, the letter reveals that for 2002, net assets of the wastewater department were overstated by $161 million, or 9 percent of net assets (total assets minus liabilities, mainly debt). During the same year, net assets of the water system were overstated by $52 million, or 5 percent. Background interviews reveal that an inexplicable and unacceptable accounting practice has led to the overstatement, and this incorrect method has been used in other city departments, too. Therefore, more big writedowns are coming.

In September of 2003, pension-board whistle-blower Diann Shipione challenged the veracity of a prospectus covering half a billion dollars of sewer bonds. The city canceled the offering. In January and March of 2004, the city confessed for the first time that it had been putting inaccurate information in bond prospectuses dating back to 1996.

But as the letter makes clear, you ain't seen nothin' yet.

The January 19, 2005, letter to city manager P. Lamont Ewell was written by John McNally of Hawkins Delafield & Wood, Washington, D.C., an outside bond counsel. In essence, he tells Ewell that the city doesn't have to confess its newly discovered accounting sins until it has a certified audit. It is not necessary to file another mea culpa using unaudited financial statements.

In the middle of the letter he points out the $161 million and $52 million net-asset overstatements. He notes that the Securities and Exchange Commission has in the past charged securities-law violations over much smaller numbers. For example, Syracuse was charged with disseminating false information in 1997 when it said its general fund was $400,000 in surplus when it was actually $9.4 million in deficit.

In addition, McNally states, "The 2002 financial statements contained numerous errors" (in addition to those reported in early 2004). He adds, "The initial drafts of the 2003 water and wastewater financials and related notes have undergone substantial revisions" because of comments by KPMG, the major accounting firm that refuses to release 2003 and 2004 audits until it is satisfied that it is getting straight information. The letter also states that KPMG has questions about accounting for so-called "employee offset," or the city's practice of paying a portion of employees' contribution to the pension fund.

The city will only say that the assets will have to be written down because KPMG prefers a different accounting methodology. Shipione has learned, and I have confirmed through background interviews, that the net-asset overstatements come mainly from the use of an accounting technique that has accounting pros scratching and shaking their heads. For some time, the wastewater and water departments -- and other city departments -- have begun depreciating assets after the final bill for the asset has been paid, rather than as soon as it goes into service. That's a little like not buying car insurance until you have paid off the car, rather than when you start driving it. Companies and governments take regular bookkeeping charges to write off the cost of an asset over its estimated useful life. It is not a cash outlay; funds are not set aside. But delaying depreciation charges inflates the asset's stated value.

"You begin depreciation when the asset is put in service," says Carl Johnson of the Governmental Accounting Standards Board in Norwalk, Connecticut. "I don't know any reason why the [installment] financing of the asset would delay the start of depreciation." Governments handle the accounting move the same way companies do, he says.

"It's a pretty fundamental accounting principle: you begin depreciating an asset when it is placed in service," says San Diego accountant April Boling, who is active in Republican politics. "The time of paying off that asset doesn't have anything to do with it."

"I can't believe their auditors would let them do that," says John Patrick Ford, retired partner from the firm now named PricewaterhouseCoopers.

This depreciation technique really defies the purpose of depreciation, say these accounting pros. So what explains the city's use of it? Stupidity? Something sinister? "Why would [city bureaucrats] knowingly want to overstate their assets?" asks Scott Barnett, former head of the San Diego County Taxpayers Association. "The sewer and water systems are self-sustaining. They can raise revenue with the vote of city council."

But, says Barnett, more than $100 million has been squirreled out of sewer and water to bulk up the general fund over the past decade. "You can easily say that $100 million is equivalent to 100 miles of sewer and water pipe."

Bond investors generally look to see if a municipality has the cash flow to service the debt. They are not so interested in assets.

However, there is a reason for a government to inflate assets. "Borrowing capacity goes up as assets go up," notes Shipione. "Higher assets give the appearance of a lot of debt capacity -- a false sense of liquidity."

This asset inflation is just one problem to which the city will have to 'fess up. "The city's financials will have to be severely restated," says Shipione. "You see it over and over again: artificial inflation of assets and diminishment of liabilities. This example of depreciation will be shown to be only one of many abuses that have infiltrated the city's financial reports."

"Numbers like this can't be a bureaucratic mistake," says former councilmember Bruce Henderson. "These are the sorts of numbers that suggest a massive cover-up."

"It's not in keeping with proper financial management. It's clear and convincing evidence of securities fraud. They have not only cooked the books on liabilities, but now they are significantly overstating assets," says Carl DeMaio, president of the Performance Institute, a private think tank promoting government efficiency. "The city should return those awards they got for financial management in the 1990s."

"It raises questions of auditor incompetence," says councilmember Donna Frye, who is the most knowledgeable councilperson on sewer and water issues. However, until I called her, she had only heard about the matter in a passing reference in one committee meeting. Like Henderson and DeMaio, she believes the local government should inform the citizens in some way of such problems, even though it is not making the specifics known to capital markets yet. "This culture of secrecy continues. It's so deeply rooted. We heard this constant mantra that we were the best-run city, but it was a story that included a lot of smoke and mirrors."