J. Account.

Public Policy 28 (2009) 525–540

Contents lists available at ScienceDirect

J. Account. Public Policy

journal homepage: www.elsevier.com/locate/jaccpubpol

The quality and conservatism of the accounting earnings

of local governments
Matt Pinnuck 1, Bradley N. Potter *
Department of Accounting and BIS, University of Melbourne, Australia

a r t i c l e i n f o a b s t r a c t

JEL Classification: Our aim is to provide insight into the usefulness of accounting
G28 earnings for measuring the economic performance of local govern-
H11 ments across Australia. Specifically, we explore whether (i) accrual
H79
accounting provides useful information, and (ii) earnings of local
M41
governments are conservative. We find that accrual accounting
Keywords: by local governments provides useful information as measured
Earnings by the ability to predict one-year-ahead operating cash-flows.
Accruals We find no conservatism in the financial reports of the average
Conservatism local government. This, we posit, is due to a lower level of demand
Usefulness for high-quality accrual-based financial reports from these entities.
Local governments
Consistent with this argument, both the quality of accruals and the
degree of conservatism increase for local governments for which
we predict a demand for higher-quality financial reporting.
Crown Copyright Ó 2009 Published by Elsevier Inc. All rights
reserved.

1. Introduction

We examine the quality of accounting earnings for a large sample of Australian local governments.
More specifically, we examine whether (i) accrual accounting predicts cash-flows, and (ii) earnings of
local governments are conservative. To address these objectives, we follow approaches similar to
those used in prior studies of publicly-listed companies (Barth et al., 2001; Basu, 1997; Dechow,
1994; Dechow et al., 1998; Finger, 1994).

* Corresponding author. Address: Department of Accounting and BIS, Faculty of Economics and Commerce, University of
Melbourne, Australia. Tel.: +61 3 8344 4989; fax: +61 3 9349 2397.
E-mail addresses: mpinnuck@unimelb.edu.au (M. Pinnuck), bnpotter@unimelb.edu.au (B.N. Potter).
1
Tel.: +61 3 8344 7539; fax: +61 3 9349 2397.

0278-4254/$ - see front matter Crown Copyright Ó 2009 Published by Elsevier Inc. All rights reserved.
doi:10.1016/j.jaccpubpol.2009.08.002
526 M. Pinnuck, B.N. Potter / J. Account. Public Policy 28 (2009) 525–540

Our study is motivated by the interest of central rule-making agencies world-wide in encouraging
or requiring government entities to prepare accrual-based financial reports under Generally Accepted
Accounting Principles (GAAP). Traditionally, government entities reported on a cash or modified-cash
basis. A number of countries now either require government entities to prepare accrual-based finan-
cial reports or are considering doing so. As examples, the US Government Accounting Standards Board
(GASB) requires state and local governments, for the first time, to prepare financial reports on an ac-
crual basis (GASB, 1999).2 Likewise, several other countries including Australia, the United Kingdom,
New Zealand and Canada, either now require accrual-based financial reports for government entities
or have the issue on the regulatory agenda (Luder and Jones, 2004).
This recent regulation presumes accrual-based financial reports better enable the assessment of the
accountability and performance of government entities (GASB, 1999; IFAC, 2005; Potter, 2002). Even so,
the economic benefits of applying existing GAAP to these entities continues to be debated (e.g. Barton,
1999, 2005; Walker et al., 1999, 2000). Resistance in the US to GASB-led initiatives to expand GAAP dis-
closure requirements for government entities is based on the costs of implementing and monitoring the
expanded disclosures and questions about whether sufficient demand exists for this information (Bar-
ton, 1999; Copley et al., 1997; Jones and Puglisi, 1997; Rowles et al., 1998). If compliance with GAAP is
costly and the benefits of accrual-based financial reports are not clearly established, imposing GAAP
reporting on local governments potentially contradicts the public interest (Baber and Gore, 2008).
Whether accrual-based information for local governments is useful remains an open question. To
consider this issue, we examine whether current-period earnings of local governments provide incre-
mental information over current-period cash-flows for predicting future cash-flows (Dechow, 1994).
In doing so, we examine whether a widely-asserted benefit often associated with accrual-based finan-
cial reporting holds in the local government setting – the assertion that accruals provide an improved
measure of economic performance. If there is not sufficient demand for accrual accounting then, in
equilibrium, this will result in low effort in preparation and poor-quality accrual estimates. If accruals
are not estimated reliably due to low effort, the information content with respect to future cash-flows
will be low. Thus, finding that accrual earnings provide a better measure of economic performance
than cash-flows, suggests a demand for accrual accounting.
To provide further evidence, we examine whether the earnings of local governments are conserva-
tive. Consistent with Basu (1997), we define conservatism to be the more-timely recognition of losses
rather than gains.3 Our examination of conservatism is motivated in two ways. First, it provides evidence
about both the demand for information and the quality of the financial reporting by local government
entities. Second, our examination also provides a unique test of arguments previously advanced for
the existence of conservatism in the accounts of public companies. Specifically, according to Watts
(2003a), the most likely reasons for conservatism in financial reports are contracting costs and share-
holder litigation. These explanations for conservatism may not apply to local governments. Thus, we con-
sider whether, in the absence of reasons for more-timely loss-recognition, earnings are conservative in
the local government context.
Accrual-based financial reporting has been mandatory for local governments in Australia since
1993. In contrast, the use of accrual accounting by US local governments is either mandated by states
or is at the discretion of the local governments. The population of financial reports of Australian local
governments therefore provides an opportunity to investigate accruals in a context not complicated
by discretionary or required deviations from the norm.
We find that accrual accounting provides useful information, although the economic magnitude of
the usefulness of accruals for forecasting cash-flows is less substantial for local governments than for
public companies. Such evidence provides qualified support for regulation that requires local govern-
ments to prepare financial accounts on an accrual basis. Providing further support for this argument,
we find stronger evidence of the ability of accruals to predict future cash-flows in the financial reports
of large local governments, where the demand for high-quality financial statements is likely to be

2
Despite this requirement in GASB 34, the adoption of accrual accounting is at the discretion of the individual state or local
governments (Baber and Gore, 2008). States may require that municipal financial report disclosures follow GAAP, state-specific
regulations or the financial reporting disclosures may remain largely unregulated at the state level.
3
Ball et al. (2000), Watts (2003a), Ball and Shivakumar (2005) and Ball and Shivakumar (2006) use a similar approach.
 M. Pinnuck, B.N. Potter / J. Account. Public Policy 28 (2009) 525–540 527

high. In contrast, we find no evidence of conservatism in the earnings of the average local government,
although we find some conservatism in the financial reports of large local governments. Taken to-
gether, these results suggest that GAAP financial reports are cost-beneficial only for local governments
with certain attributes. Thus, we contribute to three streams of the literature. First, our findings sup-
port the conclusion that accrual-based information is relevant in the local government context (e.g.
Plummer et al., 2007). Second, our findings are relevant to the literature that seeks to understand
the role of conservatism as a property of accounting earnings. Third, we contribute to the emerging
literature that examines how the properties of earnings vary across different ownership structures
(e.g. Barragato and Basu, 2007).
The remainder of the paper is structured as follows. In the Section 2, we set out the motivation for
the study and develop the hypotheses. In Section 3, we describe the data, and in Section 4 we present
the empirical method and the results. In the Section 6 we conclude.

2. Motivation

Notions that accruals have the ability to predict future cash-flows (Dechow, 1994; Dechow et al.,
1998) and that there is demand for accrual-based earnings information (Dechow, 1994) are well-
established in the corporate context. To consider whether these properties hold for local governments,
we identify the fundamental differences and similarities between local governments and corporate
entities.
Unlike the corporate sector, governments do not have equity stakeholders but, instead, receive
funding from state or federal government grants plus revenues from taxes levied on citizens. Neither
party expects a direct financial return on their contribution. Consequently, the vested interest of these
stakeholders in following the economic performance of local governments may not be high, relative to
the interest of equity stakeholders in following the performance of a public company. We assume that
the typical local government entity does not have profit maximisation as a primary objective, although
we recognize that some local governments may aspire to expand the scale of their operations.4 The
absence of profit maximisation as an objective does not diminish the need for a high-quality perfor-
mance metric to assess economic performance against stated objectives. Alternatively expressed, regard-
less of the objective of local governments, there is a need to measure performance against objectives to
enhance public accountability (e.g. GASB, 1987).
While the financing environment and objectives of corporate and local government entities differ,
the operating environments of local governments and corporations are similar in that both business
and non-business organizations allocate scarce economic resources to the production and distribution
of goods and services. In this setting, we posit that, for local government entities, as with corporations,
the underlying economic events and the associated cash-flows may not always occur in the same per-
iod. Thus, accrual accounting for local governments potentially provides a more-timely measure of
current-period economic performance.

2.1. Hypotheses development

2.1.1. The usefulness of accruals

The properties and quality of earnings of publicly-listed companies are well documented. Recent
research examines how the properties and quality of earnings vary across ownership structures.
For example, research shows that family-controlled public firms report more-conservatively (Basu
et al., 2005; Wang, 2006). In a study of an ownership structure more-closely related to ours, Barragato
and Basu (2007) show that charities, which have no equity owners and which serve broadly similar
roles to local governments, report informative accruals but do not report conservatively.
The argument made by regulators for mandating accrual accounting for government entities is that
accrual accounting provides a more-timely recognition of economic transactions and, thus, provides a

4
A break-even assumption is frequently made in the literature on non-profit charity organizations, however, empirical evidence
shows that many such entities try to report surpluses (Chang and Tuckman, 1990).
528 M. Pinnuck, B.N. Potter / J. Account. Public Policy 28 (2009) 525–540

better measure of true economic performance. Whether stakeholders in governmental organisations

demand high-quality accruals is, however, not clear. Ball and Shivakumar (2005) hypothesized that
financial reporting quality is a function of the level of market demand. They tested this hypothesis
using the financial reports of private companies and found the quality to be lower than for public com-
pany financial reports. We argue that the rationale developed by Ball and Shivakumar (2005) in re-
spect of private companies potentially applies to local governments.
For private firms, information asymmetry between management and contracting parties creates a
demand for internally-generated accrual accounting measures of firm performance (Dechow, 1994).
Thus, the economic role of accrual accounting for these companies is to improve contracting efficiency.
However, because local governments lack the same level of access to public capital (Benson et al.,
1984; Ingram and Copeland, 1982; Plummer et al., 2007), external stakeholders may be less-inclined
to monitor local governments directly via financial reports. This, we posit, gives rise to a lower de-
mand for high-quality financial reports (Zimmerman, 1977).
Since working-capital accruals are costly to produce, if the demand for financial reporting informa-
tion from local governments is low, then in equilibrium, the effort devoted to accrual estimation will
be low. If accruals measure the future economic benefits of current-period events with error, their use-
fulness for forecasting future cash-flows decreases relative to accruals estimated in the presence of
higher demand for financial reporting information. In summary, the usefulness of accrual-based earn-
ings for measuring local government economic performance is unclear. Accordingly, we test the fol-
lowing hypothesis:

H1 Accrual-based earnings of local government entities provide useful information for predicting
future cash-flows.

2.1.2. The quality of accounting information

If poor-quality accrual estimates indicate lower demand for financial information from local gov-
ernments, other attributes of financial reporting quality can also be lower. Following Basu (1997),
and Ball and Shivakumar (2005), the second attribute of financial reporting quality we examine is
timeliness in financial statement recognition of economic losses (i.e. conditional conservatism).
Timely loss-recognition increases financial statement usefulness generally, particularly in debt
agreements.
Ball and Shivakumar (2005) argue that the demand for high-quality public company financial state-
ments induces managers and auditors to recognize economic losses in a more-timely fashion due to
the litigation costs of failing to do so. Watts (2003a,b) argued that accounting conservatism ‘‘evolved
from accounting’s contracting role”, whereby timely loss-recognition mitigates agency problems asso-
ciated with manager’s investment decisions. Watts (2003a) singled out ‘‘avoidance of inappropriate
distributions to claim holders to protect more senior claims (i.e. debt)” as an important contracting
reason for conservatism in public companies as well as to contain management’s optimism when
reporting accounting measures used in managerial compensation contracts.
In local government, there is no direct distribution of reported profits as dividends to residents nor
is there any evidence of income-based managerial compensation.5 Moreover, stakeholder litigation is
less likely than in the private sector. Thus, the financial reports of local governments are unlikely to play
a central role in contractual relations and we predict the contracting-based incentives for conservatism
are unlikely to apply. Formally, our hypothesis is:

H2: Local governments do not report losses in a more-timely manner than gains.

2.1.3. Cross-sectional variation in quality

We also test for cross-sectional variations in the quality of the information reported by local govern-
ments. Because of a lack of prior theoretical work, we consider our examination in this section to be
exploratory. Thus, since the key stakeholders in local governments are the citizenry, legislative and over-

5
We recognize that managers of large local governments are likely to receive greater compensation and acknowledge there may
be some form of incentive-based compensation in some circumstances.
 M. Pinnuck, B.N. Potter / J. Account. Public Policy 28 (2009) 525–540 529

sight bodies, and creditors (GASB, 1987), we posit several characteristics of local governments that may
induce differential levels of demand for quality financial information. Our intuition is that the quality
and conservatism of local government financial reports will vary with the demand for the information.
We predict greater demand for quality information for larger local governments where there are a
greater number of external stakeholders. Such entities are also likely to have longer operating cycles,
be subject to greater political competition and have higher agency costs (Baber, 1983; Baber and Sen,
1984; Evans and Patton, 1983; Ingram, 1984).6 Larger local governments may also have greater exper-
tise in the preparation of financial statements as, due to economies of scale, they may have higher-qual-
ity accounting information systems.7
We also predict a higher demand for quality financial information in circumstances where con-
tracting incentives mean that external stakeholders are more likely to use financial reports for mon-
itoring purposes. Thus, consistent with prior studies, we test for increases in the quality and
conservatism of reported financial information for those local governments with higher levels of debt
(Ball and Shivakumar, 2005) and government grants (e.g. Giroux and McLelland, 2003; Gore, 2004; In-
gram, 1984; Robbins and Austin, 1986). We also test for increases in the quality and conservatism of
reported information where greater political competition exists. Such competition can also give rise to
a contracting incentive for political agents to supply high-quality financial reports to reduce costs
resulting from contracting with supporting interests (Baber, 1990; Baber and Sen, 1984). Political
competition also creates a regulatory incentive to provide high-quality financial reports by rendering
incumbents more vulnerable to claims of irresponsible management. This increases incentives to
demonstrate a commitment to efficient management by using high-quality financial reporting (Baber
and Sen, 1984),8 leading to the following hypotheses:

H3a The usefulness of the accruals of local governments is independent of the characteristics of local
governments.
H3b The timeliness with which local governments report losses is independent of the characteristics
of local governments

3. Data

3.1. The financial reporting setting for local governments in Australia

The general-purpose financial reports of Australian local governments are prepared using accrual
accounting principles in accordance with Australian Accounting Standards. As a consequence of the
‘‘sector-neutral” perspective on accounting standard setting adopted in Australia, there is little differ-
ence between the accounting regulations applying to governments and corporations. Two key vari-
ables used in this study are net profit or loss and cash-flow from operations. These variables are
obtained from the income statements and statements of cash-flows. Since these statements are pre-
pared according to GAAP, there is no conceptual or practical difference in the calculation of net profit
or loss and cash-flow from operations between corporate and local government entities.
Operating cash-flow for Australian local government entities is defined in accordance with the
accounting standard, AASB 107Cash-Flow Statements. The standard defines cash-flows from operations

6
Large local governments may have longer operating cycles because the size of their constituency may give rise to both a
demand and a capacity to supply different types of goods and services than provided by smaller local governments. On average, as
the size or scale of an investment increases, so does the length of the time between the original cash outlay and the final cash
inflow (i.e. the operating cycle).
7
Higher quality auditors may also be involved in the audit of larger local governments. However we are unable to determine
this from the financial statements in our sample. In Australia, the local government audit opinion is the responsibility of the State
Government Auditor General, although the Auditor General may, on occasion, outsource part of the operational responsibility for
the audit to private sector audit firms. However any outsourcing is not disclosed in the financial reports.
8
We acknowledge that the predicted direction of the impact of political competition on the conservatism is ambiguous. For
example, political competition could create an incentive to demonstrate a commitment to efficient management. One dimension of
efficiency is that the local government is not making losses. This implies local governments, in the presence of a highly competitive
political environment may be less inclined to recognize losses in a timely manner.
530 M. Pinnuck, B.N. Potter / J. Account. Public Policy 28 (2009) 525–540

as cash-flows attributable to ‘‘the principal revenue-producing activities of the entity and other activ-
ities that are not investing or financing activities” (AASB 107, para. 6).9 These cash-flows are reported
using the direct method, therefore differences between the net profit variable and the cash-flow from
operations variable are due to accrual adjustments. The definition of cash-flow from operations ap-
plied in Australia is conceptually consistent with that applied in the US via SFAS 95 Statement of
Cash-Flows.

3.2. Obtaining the financial reports

The annual financial reports of Australian local governments are located at the Office of Local Gov-
ernment in each State. These offices are state bodies responsible for the administration and regulation
of local governments. Reports are also available from the local governments themselves. To obtain an-
nual financial reports, we approached the office of local government in five states across Australia.
With the exception of Queensland, we were granted access to the financial reports of local govern-
ments for the years 1996–2003. The financial reports for Queensland were obtained by directly con-
tacting a random sample of councils.10 The final sample of local government reporting years used is
2058 which represents 67% of local government reporting years across the sample period.11

3.3. Descriptive statistics

Univariate descriptive statistics for key variables are reported in Table 1. There is a large variation
in the magnitude of each of the variables examined, most likely due to the dispersion in the size of
local governments. The large variation in the size of the entities is evident from their populations,
which range from a minimum of 1009 to a maximum of 270,109. The mean, but not the median, local
government is profitable, reporting a return on assets of 0.9% and has positive net operating cash-
flows. The positive rate of return is consistent with local governments not necessarily having break-
even as their primary objective. A possible explanation is that self-interested managers have incentive
to grow the size of local governments if part of their compensation is linked to the size of the entity.
Growth in the size of an organization can be achieved by generating surpluses. Consistent with this
proposition, the descriptive statistics show the average council had a 15.4% growth in total assets over
the sample period, although such growth might also be explained partly by increases in asset fair val-
ues (Lott, 1999).

4. Empirical methodology and results

4.1. Usefulness

To test H1 we examine whether past earnings contain information about one-year-ahead cash-
flows (Dechow, 1994; Dechow et al., 1998; Finger, 1994). The appropriate regression is stated below:
CFOitþ1 ¼ a þ b1 Profit it þ b2 CFOit þ b3 Popi þ eitþ1 ; ð1Þ
where CFOit+1 is the cash-flow from operations of local government i in year t + 1 scaled by total assets
as at the end of year t; Profitit is the reported profit for local government i in year t scaled by total as-
sets as at the end of year t  1; CFOit is the cash-flow from operations of local government i in year t

9
In the financial statements comprising our sample, the items disclosed as part of cash flows from operations were significantly
similar and related to the day-to-day provision of council goods and services. Examples of items commonly disclosed as cash
inflows from operations included rates and charges while cash outflows from operations included items such as wages and
materials purchased.
10
A random sample was used because of the time and cost involved in corresponding with each individual local governments in
Queensland.
11
There are two reasons for missing observations. First, for many local governments, financial report data for the year ending
1996 were not available, due to space-related constraints of the repositories of the reports. Second, most of the data were collected
at the beginning of 2004. For some local governments the financial reports had not been released for the year ending December
2003.
 M. Pinnuck, B.N. Potter / J. Account. Public Policy 28 (2009) 525–540 531

Table 1
Descriptive statistics.

Total profit Operating cash- ROA CFO/total Total assets Population Growth in
$000s flow $000s assets $000s assets
Mean 2201 5789 0.009 0.032 267,000 40,497 0.154
Median 0 2615 0.000 0.024 115,000 17,587 0.006
Maximum 57,584 47,799 0.316 0.348 2,000,000 270,109 19.187
Minimum 12,396 1332 0.149 0.033 0 1009 1.000
Standard deviation 9740 8556 0.051 0.047 374,000 49,158 1.575

The table presents the descriptive statistics for the key variables for the final sample of 2058 local government-years. ROA is
calculated as net income/total assets.

Table 2
The usefulness of accruals.

Coefficient t-Statistic Probability

Intercept 0.01 **6.11 0.00
Profitit 0.08 *1.73 0.08
CFOit 0.58 **6.94 0.00
Popi 0.04 0.14 0.89
Adjusted R-squared 0.45
Number of observations 1114

The table reports the results from estimation of model (1) in the text: CFOit+1 = a + b1Profitit + b2CFOit + b3Popi + eit+1. The t-
statistics are calculated using Newey–West corrected standard errors. Significance levels for t-statistics are ** and * indicate
significance at the 1% level (two tail) and 5% level (two tail), respectively.

scaled by total assets as at the end of year t  1; Popi is the number of registered constituents for each
local government as of 31 December 2002 scaled by total assets at the end of the year 30 June 2002.
In this model, Profitit provides a test of H1 as it examines the news about future cash-flows con-
tained in current-period profit. The coefficient on profit, b1, is positive if accounting profit contains
economic information about future cash-flows incremental to that contained in current-period
cash-flows. The variable CFOit controls for expected CFOit+1 conditional on information at the beginning
of year t. A positive coefficient b2 is expected. Popi is included in the model to control for cross-sec-
tional differences in the size of the entities comprising the sample. For local governments, population
size is likely to be an exogenous factor that pre-determines both the level and properties of reported
financial reporting accounting numbers. To address scale effects further and to be comparable to prior
research, variables are deflated by total assets lagged one period. Finally, to alleviate concerns that
uncontrolled scale differences give rise to heteroskedastic error variances, we calculate t-statistics
using Newey–West corrected standard errors.
The results from the estimation of model (1) are in Table 2. The results show that the coefficient b1
on Profitit is positive and significantly different from zero. The result is consistent with the proposition
that accrual-based earnings have incremental ability beyond current-period cash-flows to predict fu-
ture operating cash-flows.

4.2. Supporting evidence for the ability of accruals to predict cash-flows

As a robustness measure we provide some supporting evidence for the usefulness of accruals for
predicting future cash-flows. A key role of accruals is the mitigation of operating cash-flow noise that
arises from exogenous variations in working-capital levels (Dechow et al., 1998). A testable implica-
tion of this is that accruals and cash-flows from operations are contemporaneously negatively-corre-
lated because accruals offset transitory cash-flow effects.12 To illustrate the economic intuition

12
See Dechow et al. (1998, pp.138–140) and Dechow and Dichev (2002, pp. 37–39) for the formal derivation of this property of
accruals.
532 M. Pinnuck, B.N. Potter / J. Account. Public Policy 28 (2009) 525–540

Table 3
The relationship between accruals and cash-flows.

Coefficient t-Statistic Probability

Intercept 0.01 0.95 0.34
CFOit 0.47 *1.94 0.05
CFOit-1 0.42 **2.67 0.00
CFOit+1 0.05 *1.65 0.10
Popi 0.91 0.72 0.47
Adjusted R-squared 0.48
Number of observations 816

The table reports the results from estimation of model (2) ACCit = a + b1CFOit + b2CFOit1 + b3CFOit+1 + b4Popi + eit. The t-statistics
are calculated using Newey–West corrected standard errors. Significance levels for t-statistics are ** and * indicate significance
at the 1% level (two tail) and 5% level (two tail), respectively.

underlying this property of accruals, consider an entity which has a positive economic shock to its oper-
ations. For such activities, there is a net positive increase in accruals as revenue is accrued. However
there is also a net decrease in cash-flows as cash is used to purchase more raw materials and supplies.
This relationship induces a negative association between current-period accruals and cash-flows. Consis-
tent with prior studies (e.g. Ball and Shivakumar, 2006), we test this prediction using the Dechow and
Dichev (2002) model of accruals as follows:
ACC it ¼ a þ b1 CFOit þ b2 CFOit1 þ b3 CFOitþ1 þ b4 Popi þ eit ; ð2Þ
where ACCit represents accruals for local government i in year t scaled by total assets at end of the year
t  1. The accruals are calculated as net profit in year t less cash-flow from operations in year t.13 All
other variables are as previously defined. We predict a negative coefficient b1 on contemporaneous per-
iod cash-flows as in Dechow et al. (1998). If accruals provide useful information about future cash-flows
and deferrals reflect past cash-flows, the predicted sign of the coefficients b2 and b3 is positive.
The results from the estimation of model (2) are reported in Table 3. The results show that the coef-
ficient b1 on the current-year cash-flow is negative and statistically significant and the coefficients b2
and b3 on the prior and following year cash-flows are positive. These results are consistent with those
reported by Dechow and Dichev (2002) for publicly-listed companies. Dechow et al. (1998) argue that
the role of accruals is to mitigate operating cash-flow noise that arises from exogenous variation in
working-capital levels. Our result that accruals and cash-flows from operations of local governments
are contemporaneously negatively-correlated is consistent with this, implying that accruals of local
governments are useful as they reduce the noise in operating cash-flows.

4.3. Economic importance

We also explore whether the additional information provided by the accruals in reported account-
ing profit is economically significant in terms of the extent that accruals alleviate timing problems and
bring forward future cash-flows into the measurement of current-period income. In particular, we
compare our results to those from prior research that examined similar questions for public compa-
nies. We argue that governmental financial accounting is less useful than company financial reporting
because there is less demand for high-quality accrual-based financial reports. Comparing the magni-
tudes of the estimated coefficients from our setting to research in public-company settings supports
this notion. Specifically, compared to the findings for public companies, the earnings of local govern-
ments exhibit only modest incremental usefulness relative to current cash-flows for forecasting future
cash-flows.

13
When using the balance sheet method to calculate accruals, unusual business events and circumstances (e.g. mergers and
acquisitions, divestures and foreign currency translations) may confound inferences about the behaviour of typical or normal
accruals (Hribar and Collins, 2002). However, we neither use the balance sheet method to calculate accruals, nor are local
governments subject to these types of events. Nevertheless our results could still be confounded by unusual accruals. To address
this, we removed from our sample 17 government years that reported an extraordinary item. The results from our tests after
removing these government-years are consistent with those reported.
 M. Pinnuck, B.N. Potter / J. Account. Public Policy 28 (2009) 525–540 533

Dechow et al. (1998) estimated the following firm-specific regression for firm i in year t, Operat-
ing Cash-Flowsit+1 = a + c1 Operating Cash-Flowsit + c2 Earningsit where all variables are scaled by num-
ber of shares. The reported magnitudes for the coefficients are 0.07 (c1) and 0.45 (c2). This indicates
that for public companies, earnings are incrementally more useful than current-period cash-flows
for forecasting future cash-flows. In contrast, in our results for local governments, the coefficient
on our earnings variable (0.08) suggests only modest incremental forecasting power relative to
the coefficient on current-period cash-flows (0.58). In summary, earnings are incrementally more
relevant than current cash-flows in forecasting future cash-flows for public companies than for local
governments.
Similar conclusions are made from comparing our results for the magnitudes of the coefficients re-
ported for the Dechow and Dichev model (our regression 2) to those reported for this model for public
companies. Dechow and Dichev (2002, p. 44) scaled variables by total assets, as we do, and reported
coefficient estimates of: 0.19 (CFOt1); 0.51 (CFOt) and 0.18 (CFOt+1). In our study, the comparable
coefficients are 0.42 (CFOt1); 0.47 (CFOt) and 0.05 (CFOt+1). The variable that measures the ability
of accruals to forecast future cash-flows is CFOt+1. The coefficient on this variable for local govern-
ments is below that for public companies, although the magnitudes of the coefficient on CFOt are com-
parable between public companies and local governments.14

4.4. Conservatism

Following Ball and Shivakumar (2005), we employ two models to test for the existence of conser-
vatism: a time-series model of timeliness in loss-recognition and an accruals-based test of loss-recog-
nition. Finally, as a robustness measure, we also use skewness of earnings as a test of conservatism.

4.4.1. Time-series model of timeliness in loss-recognition

We test for conservatism by examining whether there is asymmetry in the recognition of transitory
gain and loss components in accounting income. Specifically, we estimate the following specification
of Basu’s (1997) linear regression:
DProfitit ¼ a þ b1 DProfitit1 þ b2 DNEG þ b3 DNEG  DProfitit1 þ b4 Profitit1 þ b5 Popi þ eit ; ð3Þ
where DNEG is a dummy variable taking the value 1 if DProfitt1 is negative; DProfitit is calculated as
Profitit  Profitit1. All other variables are as previously defined and all variables are scaled by total as-
sets lagged one period.
The coefficient on the variable DProfitit1 provides a measure of the permanence of good earnings
news recorded in local government financial reports. Deferring gains until the relevant increases in
cash-flows are realized, causes gains to be recognized as persistent positive components that do not
reverse (Ball and Shivakumar, 2005; Basu, 1997). The implication is that good earnings news is perma-
nent, and therefore does not reverse in subsequent periods (i.e. implying b1 = 0). The coefficient on the
variable DNEG  DProfitit-1 provides a measure of the difference in the permanence of accounting losses
versus accounting gains. If local governments are conservative, accounting losses should be more-
transitory than accounting gains. Therefore, the hypothesis that economic losses are recognized in a
more-timely fashion, and hence are more-transitory than gains, implies b3 < 0. A negative coefficient
is expected because accounting losses are more likely than profits to reverse in the following period.
We offer no prediction in respect of other variables specified in model (3) which are as defined
previously.

4.4.2. Accruals-based test of loss-recognition

Model (3) outlined above uses the total change in profits to test for conservatism. We also employ
an accruals-based test of conservatism using techniques advanced in Ball and Shivakumar (2005,

14
The coefficient on lagged cash-flows is greater for local governments than public companies possibly due to differences in the
nature of operations. A positive correlation between current-period accruals and past cash-flow arises when the recognition of
some past cash-flow is deferred into current earnings (i.e. revenue received in advance). A possible explanation for this is that some
local governments offer discounts to encourage tax-payers to pre-pay their annual taxes.
534 M. Pinnuck, B.N. Potter / J. Account. Public Policy 28 (2009) 525–540

2006). This approach predicts asymmetry in the relation between accruals and current-period cash-
flows in the accruals model of Dechow et al. (1998) because of income conservatism. Economic losses
are more likely to be recognized on a timely basis as accrued charges against income. To test the
hypothesized relation between cash-flows and accruals we apply the Ball and Shivakumar (2006)
model:
ACC it ¼ a þ b1 CFOit þ b2 CFOit1 þ b3 CFOitþ1 þ b4 DBAD þ b5 DBAD  CFOit þ b6 Popi þ eit ; ð4Þ
where all variables are as previously defined and DBAD is a dummy variable that distinguishes govern-
ment-years with decreases in cash-flows. That is, the dummy variable DBAD takes the value of 1 if
DCFOit = CFOit  CFOit1 is negative, and zero otherwise.
This model facilitates examining two distinct roles of accruals (Ball and Shivakumar, 2006). First,
the noise-reducing role of accruals, in the timing of the recognition of operational transactions, which
induces a negative correlation between current-period operating cash-flows and current-period accru-
als. The noise-reducing role of accruals, predicts a negative coefficient b1 on the cash-flow variable
CFOit (Dechow et al., 1998). The second role of accruals is asymmetric timely loss-recognition of unre-
alized losses in the fundamental value of assets and liabilities.15 The asymmetric loss-recognition role
of accruals predicts a positive relation between current-period accruals and current-period cash-flows.16
Following Ball and Shivakumar (2006), we expect that accrued unrealized losses, due to conservative
accounting, are more likely than accrued unrealized gains. Thus, we predict b5 > 0 on the variable
DBAD  CFOit. To clarify, we predict a positive coefficient because when there is a negative cash-flow
shock, if the accountant is conservative then the associated unrealized losses are recorded. In contrast,
when there is a positive cash-flow shock, the associated unrealized gains are not recorded.
The results from estimation of model (3), our time series-based test of conservatism, are in Table 4.
The coefficient on our proxy for ‘‘bad news”, DNEG  DProfitit1, is not significantly different from zero,
which suggests no conservatism in the financial statements of local governments. The absence of con-
servatism is consistent with Ball et al. (2003), who found that, for Four East Asian countries (Hong
Kong, Malaysia, Singapore and Thailand), where likely demand for high-quality financial statements
is low, conservatism in financial reporting will also be low.
The results from estimation of model (4), our accrual-based test of the timeliness of loss-recogni-
tion, are reported in Table 5. The coefficient b5 on DBAD  CFOit, the dummy variable that distinguishes
negative cash-flow years, is not significantly different from zero. This implies the properties of accru-
als in years when the change in cash is negative are not significantly different to those of the accruals
in years where such negative changes do not occur.17

4.4.3. Skewness of earnings

As a third and final approach to testing for conservatism we examine the skewness of earnings. A
basic feature of a conservative reporting system is that the earnings distribution should be negatively-
skewed (Basu, 1997). Consistent with prior papers showing that the accounting income of publicly-
listed companies is negatively-skewed whereas operating cash-flows are positively-skewed, we also
use skewness of earnings as a measure of conservatism (Ball et al., 2000; Basu, 1997; Givoly and Hayn,
2000; Krishnan, 2005, 2007; Lang et al., 2003).
As can be observed from the descriptive statistics reported in Table 1, both accounting income and
cash-flows are positively-skewed (the means exceed the medians). The skewness coefficient is 4.32 for
accounting income and 3.24 for cash-flows. Therefore, there is no evidence from the skewness of the
earnings distribution of more-timely loss-recognition or conservatism by local governments. In

15
Examples of timely recognition of losses, but not gains, include inventory write-downs due to spoilage or obsolescence and
provisions for operating costs arising from adverse current-period events.
16
This occurs because revisions in the current-period cash flows from a durable asset are likely to be positively correlated with
revisions in its expected future cash flows (Ball and Shivakumar, 2006, p. 213). If current-period cash flow changes, expected future
cash flows, on average, are likely to change also. Timely recognition of revisions in expected future cash flows requires accruals,
which are positively correlated with the shock to current cash flows.
17
As a robustness/sensitivity measure, we also define DBAD using either government/years when the change in cash flows are
below the median or government/years when CFOit < 0. For both alternative definitions there is no statistical evidence of a stronger
positive association between accruals and cash flows in years when there is bad economic news.
 M. Pinnuck, B.N. Potter / J. Account. Public Policy 28 (2009) 525–540 535

Table 4
Profitability-based test of conservatism.

Coefficient t-Statistic Probability

Intercept 0.01 2.07 0.04
DProfitit1 0.20 *1.77 0.08
DNEG 0.00 0.23 0.81
DNEG  DProfitit1 0.09 0.66 0.51
Profitit1 0.63 **8.28 0.00
Popi 0.65 1.17 0.24
Adjusted R-squared 0.44
Number of observations 816

The table reports the results from estimation of model (3): DProfitit = a + b1DProfitit1 + b2DNEG + b3DNEG  DProfitit1 +
b4Profitit1 + b5Popi + eit. Significance levels for t-statistics are ** and * indicate significance at the 1% level (two tail) and 5% level
(two tail), respectively. The t-statistics are calculated using Newey–West corrected standard errors.

Table 5
Accruals based test of conservatism.

Coefficient t-Statistic Probability

Intercept 0.02 0.92 0.36
CFOit 0.59 *1.78 0.08
CFOit1 0.65 **2.60 0.01
CFOit+1 0.05 *1.77 0.09
DBAD 0.02 0.83 0.41
DBAD  CFOit 0.35 0.52 0.60
Popi 1.29 0.84 0.40
Adjusted R-squared 0.49
Number of observations 816

The table reports the results from estimation of model (4) ACCit = a + b1CFOit + b2CFOit1 + b3CFOit+1 + b4DBAD + b5DBAD  CFOit +
b6Popi + eit. The t-statistics are calculated using Newey–West corrected standard errors. Significance levels for t-statistics are **
and * indicate significance at the 1% level (two tail) and 5% level (two tail), respectively.

summary, three approaches to testing for the existence of conservatism found no evidence of more-
timely loss-recognition in the earnings of local governments.

4.4.4. Assessment of test power

Although the preceding analysis suggests that our findings are robust, the regressions may lack suf-
ficient statistical power to detect significant differences. Specifically, large standard errors could ren-
der the coefficient b3, in our regression (3) statistically insignificant, even if losses are more-transitory
than gains. To consider this, we examine the standard error of the coefficients in our regression (3) to
gauge statistical power (e.g. Leuz, 2003, p. 462). We find that that we can reject the null hypothesis at
the 5% level if the coefficient on ß3 is 0.27 (1.96  0.1363). This coefficient implies that for a shock to
accounting earnings, recognized accounting losses have to reverse by an amount that is 26% greater
than for an accounting gain to be statistically more-transitory and thus conservative. The economic
magnitude of this effect is plausible. For example, Ball and Shivakumar (2005, p. 10), who used a sim-
ilar regression and the same variables for public companies, reported income-reversals in the range of
60–70%. This implies that large standard errors and low power are not an immediate explanation for
our tests for conservatism in local government earnings being statistically insignificant.

4.5. Exploratory examination of cross-sectional variation in quality

We also examine how the usefulness of accruals and the presence of conservatism vary across
local governments. To test for cross-sectional differences in the usefulness of accruals we modify
model (1) by including a dummy variable to allow for differences in the usefulness of accruals
536 M. Pinnuck, B.N. Potter / J. Account. Public Policy 28 (2009) 525–540

Table 6
Cross-sectional differences in usefulness of accrual across characteristics of local governments.

Variable Characteristics of local government

Size Leverage Grant Political competition
Intercept 0.01 0.01 0.01 0.00
(5.30)** (4.67)** (5.67)** (0.70)
CFOt 0.58 0.59 0.58 0.21
(6.74)** (6.98)** (6.80)** (3.54)**
Profitt 0.06 0.11 0.08 0.01
(2.13)* (2.12)* (1.34) (0.13)
Pop 0.07 0.20 0.01 0.06
(0.23) (0.77) (0.04) (0.09)
LARGE 0.00
(0.91)
LARGE  Profitt 0.05
(1.61)
LEVERAGE 0.01
(3.46)**
LEVERAGE  Profitt 0.06
(0.79)
GRANT 0.00
(0.99)
GRANT  Profitt 0.01
(0.15)
POLITICAL COMPETITION 0.01
(2.64)**
POLITICAL COMPETITION  Profitt 0.00
(0.05)
Adjusted R-squared 0.45 0.46 0.45 0.16
Observations 1114 1114 1114 234

The table reports the results from estimation of model (5) to examine the differential usefulness of accruals across charac-
teristics of local governments. Column size reports the results from the following regression CFOit+1 = a + b1Profi-
it+1 = a + b1Profitit + b2CFOit + b3Popi + b5LARGEi + b6LARGEi  Profit + eit+1. The other columns reports results from the same
regression adapted to each characteristic. LARGE = 1 if the population of the local government is greater than the median and
zero otherwise. LEVERAGE = 1 if the leverage of the local government is above the median and zero otherwise. GRANT = 1 if the
ratio of grants to total assets is greater than the median and zero otherwise. POLITICAL COMPETITION = 1 if the turnover of local
government councillors is above the median and zero otherwise. The t-statistics are calculated using Newey–West corrected
standard errors. Significance levels for t-statistics are ** and * indicate significance at the 1% level (two tail) and 5% level (two
tail), respectively.

across each of the local government characteristics for which we have developed predictions as
follows:

CFOitþ1 ¼ a þ b1 Profit it þ b2 CFOit þ b3 Popi þ b4 CHARACTERISTIC

þ b5 CHARACTERISTIC  Profit it þ eitþ1 ; ð5Þ

where each characteristic is defined as follows: LARGE = 1 if the population of the local government is
greater than the median, and zero otherwise; LEVERAGE = 1 if the leverage (non-current borrowingst/
total assetst1) for the local government at the end of period t  1 is greater than the median, and zero
otherwise; GRANT = 1 if the level of grant funding (government grantst/total assetst1) for the local
government is greater than the median, and zero otherwise; POLITICAL COMPETITION = 1 if the local
government is subject to high political competition at election, and zero otherwise.18 Data limitations

18
Similar to prior research (Baber, 1983; Baber and Sen, 1984; Ingram, 1984), we measure political competition based on
turnover of the councillors at elections. High political competition for local governments is taken to exist where the turnover of
councillors at elections is greater than the median turnover. We could only obtain measures of councillor turnover for a single
election over the time-period we examined. We therefore assume that political competition remains constant across time.
 M. Pinnuck, B.N. Potter / J. Account. Public Policy 28 (2009) 525–540 537

Table 7
Cross-sectional differences in conservatism across characteristics of local governments.

Variable Characteristics of local governments

Size Leverage Grant Political competition
Intercept 0.00 0.01 0.00 0.02
(1.26) (1.45) (1.21) (0.94)
DProfitt1 0.17 0.23 0.16 0.12
(1.28) (2.04)* (1.17) (1.85)
DNEG 0.00 0.00 0.00 0.00
(0.22) (0.16) (0.42) (0.27)
DNEG  DProfit 0.12 0.21 0.14 0.06
0.76 (1.10) (0.71) (0.50)
Profitt1 0.62 0.60 0.63 1.02
(8.31)** (7.73)** (8.16)** (16.32)**
Pop 0.61 0.61 0.72 0.69
(1.09) (1.27) (1.28) (0.74)
LARGE 0.01
(1.79)
LARGE  DNEG 0.01
(1.83)
LARGE  DProfit 0.21
(2.56)**
LARGE  DProfit  DNEG 0.22
(1.79)
LEVERAGE 0.00
(0.23)
Leverage  DNEG 0.00
(0.12)
Leverage  DProfit 0.24
(1.14)
Leverage  DProfit  DNEG 0.29
(1.11)
GRANT 0.00
(0.98)
GRANT  DNEG 0.00
(0.06)
GRANT  DProfit 0.08
(0.49)
GRANT  DProfit  DNEG 0.33
(1.22)
POLITICAL COMPETITION 0.01
(0.89)
POLITICAL COMPETITION  DNEG 0.00
(0.02)
POLITICAL COMPETITION  DProfit 0.02
(0.26)
POLITICAL COMPETITION  DProfit  DNEG 0.05
(0.34)
Adjusted R2 0.46 0.46 0.45 0.66
Number of observations 816 816 816 234

The table reports the results from estimation of model (6) to examine the differential conservatism of accruals across char-
acteristics of local governments. Column size reports the results from the following regression DProfitt = a + b1DProfitit1 +
b2DNEG + b3D NEG  DProfitit1 + b4Profitit1 + b5Popi + b6LARGE + b7LARGE  DNEG + b8DProfitt1  LARGE + b9DNEG  DProfitt1 
LARGE + eit. The other columns report results from the same regression adapted to each characteristic. LARGE = 1 if the popu-
lation of the local government is greater than the median and zero otherwise. LEVERAGE = 1 if the leverage of the local
government is above the median and zero otherwise. GRANT = 1 if the ratio of grants to total assets is greater than the median
and zero otherwise. POLITICAL COMPEITION = 1 if the turnover of local government members is above the median and zero
otherwise. The t-statistics are calculated using Newey–West corrected standard errors. Significance levels for t-statistics are **
and * indicate significance at the 1% level (two tail) and 5% level (two tail), respectively.

reduced the number of observations available to test the political competition hypothesis. We estimate
model (5) separately for each of the four characteristics. Our exploratory prediction is that the coefficient
on the interactive variable between each CHARACTERISTIC and Profitit is positive.
538 M. Pinnuck, B.N. Potter / J. Account. Public Policy 28 (2009) 525–540

The results from individual estimation of model (5) for each characteristic are in Table 6. We first
examine the impact of local government size on the quality of accounting accruals. We find weak evi-
dence that the coefficient b5 on the interaction variable LARGE  Profitit is positive and significantly dif-
ferent from zero (10% level, one-tail test). This is consistent with the accruals of large local
governments being more informative about future cash-flows than the accruals of small local
governments.
The coefficient b5 on the variables used to examine the impact of leverage, government grants and
political competition on accrual quality, LEVERAGE  Profitit; GRANT  Profitit and POLITICAL COMPETI-
TION  Profitit are not significantly different from zero. Thus, we find no evidence that large levels of
either debt or grants create an implicit demand for financial information that results in higher-quality
accruals. In summary, we find large local governments have higher-quality accruals than small local
governments, but that there is no incremental increase in the usefulness of accruals where high levels
of debt, government grants or political competition exist.
Finally, to test for cross-sectional differences in conservatism we modify model (3) by including a
dummy variable to allow for differences in this quality measure across the local government charac-
teristics as follows:

DProfitit ¼ a þ b1 DProfit it1 þ b2 DNEG þ b3 DNEG  DProfitit1 þ b4 Profitit1 þ b5 Popi

þ b6 CHARACTERISTIC i þ b7 CHARACTERISTIC i  DNEG þ b8 DProfit it1
 CHARACTERISTIC i þ b9 DNEG  DProfitit1  CHARACTERISTIC i þ eit ; ð6Þ

where each of the four characteristics (LARGE; LEVERAGE; GRANT; and POLITICAL COMPETITION) exam-
ined in model (5) are also examined in model (6). We estimate model (6) separately for each of the
four characteristics. The coefficient of interest in each estimated equation is b9 on the interaction var-
iable DNEG  DProfitt1  CHARACTERISTIC. In the presence of more-conservative reporting, we predict a
negative coefficient on the interaction variable for each characteristic in bad-news years.
The results in Table 7 from estimation of model (6) for each characteristic show that it is only the
coefficient on the interaction between LARGE and DProfitit1 in ‘‘bad news” years that is negative and
significantly different from zero (<10%, two-tailed). This provides some evidence consistent with large
local governments being more-conservative in their financial reporting than small local governments.
We find no evidence that having high levels of debt, government grants or a greater level of political
competition correspond to more-conservative financial reporting.

6. Conclusion

Despite claims by accounting regulators and other advocates that accrual accounting provides an
improved measure of performance, little is known about either the usefulness or the properties of
the financial reporting by local governments. In this study we use a unique dataset of accrual-based
financial reports of Australian local governments to address this limitation in the existing literature.
We examine both the usefulness of accruals in a local government setting and the conservatism of
the information reported. We find that accrual accounting provides information useful for predicting
cash-flows. We find no evidence of conservatism in the earnings of the average local government. We
argue this is due to lack of demand for conservatism as a basis for accounting in this context. Consis-
tent with this argument, we find some evidence of conservatism in the financial reports of large local
governments, where the use of accounting for contracting purposes is more likely. These results sup-
port the arguments in Ball et al. (2000) and Ball et al. (2003) that financial reports are economic goods
whose quality is determined by market demand.
These findings have at least two general implications. First, the results potentially inform account-
ing regulators in many countries as to the properties of the accrual-based information reported by lo-
cal government entities and how they vary in the cross-section. Our findings provide qualified support
for recent efforts by accounting regulators to implement accrual-based reporting for local government
entities. This support is qualified by the observation that the economic magnitude of the usefulness of
the accruals for predicting future cash-flows does not appear to be as substantial as that reported for
 M. Pinnuck, B.N. Potter / J. Account. Public Policy 28 (2009) 525–540 539

public companies. Second, our findings also support the theoretical arguments that financial reports
are economic goods whose quality is determined by market demand. Moreover, the results accord
with the arguments that, while accrual-based earnings for local government entities has potential
information content it cannot be assumed that this information is necessarily informative in the same
ways as occurs for public companies (Barton, 1999). The finding that the properties of local govern-
ments earnings, such as conservatism, differ from those documented for public companies, is consis-
tent with this reasoning.

Acknowledgements

We are grateful to the editors, two anonymous referees, participants at the American Accounting
Association annual meeting (2005) and at the Accounting and Financial Association of Australia and
New Zealand annual conference (2005) for their helpful comments. We also acknowledge the helpful
feedback from Jere Francis and Mike Bradbury and colleagues at research seminars held at the Deakin
Business School, the University of Tasmania and the University of Melbourne on earlier versions of this
paper.
Financial support from the Faculty of Economics and Commerce, University of Melbourne, is also
acknowledged.

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