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Municipal Podcast recorded on November 29, 2016

Infrastructure Accounting: A Blind Spot Facing Investors?

Podcast Transcript

Hello this is Natalie Wright, product manager at Breckinridge and welcome to the Breckinridge podcast. Today I am joined by Andrew Teras, a member of our credit team and Andrew will be talking about one of the most closely followed issues for municipal credit, the challenges in infrastructure. Andrew will reference his recent white paper, Infrastructure Accounting: A Blind Spot Facing Investors, available on our website. So Andrew, let's start out with why you have written this piece.

Many stakeholders have become increasingly concerned about the state of America's infrastructure. So we have heard this a lot from policymakers, voters, civil engineers and a lot of different places. Even more attention is being paid to the issue of infrastructure condition, now that President-elect Trump has signaled he would like to increase spending on infrastructure to do something about this issue. So there is a great deal of market research detailing infrastructure needs and estimating infrastructure health in general, but we think investors should be aware of certain pitfalls in existing state and local government infrastructure accounting. These pitfalls make it difficult to assess the condition of infrastructure assets at the individual local government level. This is important because for some cities, counties and school districts, decaying infrastructure could be an even bigger problem than other things that also tend to get a lot of headlines like pension liabilities, for example. The problem is that in many cases, we just do not have a good sense of the magnitude of the problem when looking at one local government versus another.

All right, so the next question is, we often hear of the problems with infrastructure and municipal credits and the aging of infrastructure. This is something that’s covered all the time in the media and in market research. Are things really as bad as they say they are?

Well it is hard to say exactly. In general, there is widespread acknowledgment that infrastructure needs are a problem. You see it documented in many different places. So for example, the American Society of Civil Engineers, they assigned a grade of D+ to U.S. infrastructure health. They estimate that based on current trajectory, existing funding streams will fall $1.4 trillion short of required improvements over the next 10 years. Other places cite similar type claims, so the EPA has claims out, or estimates out, the Federal Highway Administration puts out estimates. These total infrastructure needs in the hundreds of billions of dollars. Looking at the Bureau of Economic Analysis spending data it is evident that public sector infrastructure investment is at its lowest level in decades. So I mean, clearly from many different sources, it is pretty clear that we have an issue. The other thing is that for local governments, legacy, pension and retiree healthcare costs are increasingly crowding out resources for infrastructure projects and you know, these types of concerns are also magnified by the need for new, more resilient, infrastructure to address things like climate change, sea level rise, things of that type.

Okay so with this focus on infrastructure, what are people currently doing to assess infrastructure needs?

At the individual government level, this actually can be a difficult task. So often the easiest way for investors or taxpayers or constituents to obtain information about infrastructure condition for a government is to use the reporting found in the audited financial statements. The problem is that there is a disconnect between how infrastructure assets are actually managed and the way they are reported in the financial statements.

Okay, could you give us some more information about that?

So managers of public infrastructure assets, we are talking about local public works departments, budget folks, they seek to assess infrastructure needs by estimating the cost of maintenance or upkeep needed to keep these infrastructure assets in a serviceable condition. By contrast, the infrastructure accounting in the financial statements, that is really tied to the valuation of these assets and then involves applying a depreciation schedule which as many people know, would be the assumed rate of decline in the value of that asset over time. So these concepts of valuation and depreciation, these are really more just theoretical concepts that are actually divorced from the efforts that government officials themselves are undertaking to assess their infrastructure needs.

So can you tick through some of the major issues that arise from some of the problems you are talking about with current accounting?

There are a bunch of issues. We talk about more of them in the actual white paper, but just to touch on a few, one of the main issues to start off with is that it is really unclear about how you even value infrastructure, like public infrastructure assets. So what is the value of a street or a water pipe or a series of water pipes that have been in service for many decades and they are never going to be sold. Accounting rules would require that these assets are valued at the historical cost of purchase or construction but is that really reflective of the actual value? So maybe it would be more accurate to record these assets at the equivalent market value if the streets were tolled, or if the water system was privatized. So the task of valuing these infrastructure assets is made even more complex when you are dealing with massive, very large local governments, like in New York City or City of Chicago, for example, which have thousands and thousands of these types of assets that would be required to be tracked and valued. Another problem is that there is really no standardized method for estimating how long an infrastructure asset might last. So how long it would remain in a serviceable condition and so in many ways these types of estimates in terms of how long these things will last is as much art as it is science, so accounting rules which are determined by the Governmental Accounting Standards Board, or GASB, they only provide guidance on lifecycles of infrastructure assets, but there is really no set standards that are provided and so there are many variables that come into play here. Like, for example, geography and construction materials. These are things that can influence the service life of an infrastructure asset and so what we have observed is that in many cases the assumptions of service life, these are revised often from community to community, as reported in the financial statements and in many cases this can produce significant changes or variations in reported infrastructure health. So one thing that we observed was for the City of Henderson, Nevada, in their 2015 financial statements, they changed the assumed lifecycle for their infrastructure from 50 years to as long as 100 years, so that is a pretty significant change. And what it did is when you look at the financial statements and compare them to previous years, you could get the impression that the city experienced some sort of dramatic change in the condition of its infrastructure when really all that happened is that the city just tinkered with its assumptions for infrastructure life.

Okay, so it sounds like many of the pitfalls revolve around actually valuing the assets as well as the lack of standardization and estimating the lifecycles of some of these assets. Are there any other issues you can point to briefly for us with regard to current infrastructure accounting methods?

Yes, so another issue is that the true pace of asset deterioration, it may not be reflected in the financial statements. This is because depreciation methods rarely capture the actual rate of decline of an infrastructure asset. So the vast majority of governments are depreciating their assets in their financial statements using what is called the straight-line method. This is the most simple way to record depreciation because it recognizes the rate of decline of the asset evenly over its life. But of course, in reality as most people would imagine infrastructure assets do not really decline in such a clean uniform fashion. The other issue which sort of builds upon this is that accounting rules as they are currently set up, make it very difficult to track or tell when a local government is deferring or putting off routine maintenance costs for infrastructure. So when this maintenance is put off, you know, the asset may be declining much, much faster than what is assumed in the depreciation schedule as reported in the financial statements.

All right, well given that this is all such a hot button issue, what can be done to improve disclosure of local government infrastructure condition?

Yeah, so it is pretty clear that a revamp of current accounting rules for infrastructure would probably be helpful. One option would be to promote greater use of the modified approach for infrastructure reporting. So the modified approach, which is actually currently permitted under the current accounting rules, allows a government to forego recording depreciation of infrastructure as long as it can demonstrate that it is maintaining its assets in reasonably good condition. So the requirements for this approach would include maintaining a detailed inventory of infrastructure assets and generating regular condition assessment reports with disclosure of annual maintenance spending necessary to keep the assets in what is called a state of good repair. So unlike depreciation accounting, the modified approach provides insight into how governments actually manage their infrastructure assets. So if you think back to what we mentioned before, this, what I just described here, is much more in line with what is actually going on and what is actually being conducted by state and local officials when they are trying to determine what infrastructure needs they might have. This approach also provides for more transparent disclosure of deferred maintenance. So when these annual maintenance costs are clearly disclosed that is helpful for investors and taxpayers and other constituents to see which state and local governments are actually keeping up with this type of maintenance spending. All that being said, there are a few flaws to this modified approach just like there are with regular depreciation accounting. The first is that the depreciation approach is rarely used by full-service local governments, and the reason is because it is often very time-intensive and costly. And the other issue... there are a couple of other issues... but one of the other big issues is that again like we talked about before in terms of standardization, this approach also allows a local government to set itself to determine the asset condition level that constitutes a state of good repair. So this, again, introduces a level of subjectivity to the analysis and makes comparability across issuers difficult. So to sum up, clearly improved disclosure is needed but despite its flaws, we think drawing from the concepts of the modified approach might be a good place to start.

All right. Thanks so much Andrew. For more information please see Andrew's white paper on our website, Infrastructure Accounting: A Blind Spot Facing Investors. We look forward to you joining us on our next podcast. Thank you.;


DISCLAIMER: The material in this transcript is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Portions of this transcript may have been edited from the original podcast recording to improve clarity of message.Nothing in this transcript should be construed or relied upon as legal or financial advice. Any specific securities or portfolio characteristics listed above are for illustrative purposes and example only. They may not reflect actual investments in a client portfolio. All investments involve risk including loss of principal. An investor should consult with an investment professional before making any investment decisions. This document may contain material directly taken from unaffiliated third party sources, including but not limited to federal and various state and local government documents, official financial reports, academic articles, and other public materials. If third party material is included, it is believed to be accurate, and reliable. However, none of the third party information should be relied upon without independent verification. All information contained in this document is current as of the date(s) indicated, and is subject to change without notice. No assurance can be given that any forward looking statements or estimates will prove accurate or profitable.