Management Discussion & Analysis

I recently began my 20th year as a local government chief administrative officer (CAO).  One of my annual tasks is to write the "Management Discussion and Analysis" (MD&A) for the annual financial audit.  While many CAOs delegate this task to the Finance Director or Comptroller, I enjoy the challenge of unpacking the dense audit into readable prose.  My most recent MD&A is a first draft (which is why there are blanks for some numbers), but I think it captures my sense of what an MD&A should be:

Executive Summary

Management Discussion and Analysis

Caroline County Government, FY 18 Financial Audit

“This MD&A section of the financial report should be brief and objective and should be easily readable by an average reader, one not possessing a detailed knowledge of accounting.” Government Accounting Standards Board, Statement 34, June 1999

Very few Caroline County residents will ever read a County financial audit.  This is understandable.  Audits have a well-deserved reputation for being dry, boring, and full of numbers.  The Government Accounting Standards Board (GASB)—a rather dry organization itself—recognized this problem and adopted a requirement for every local government audit to have an introduction written in an understandable and conversational style.  This introduction—what you are reading now—is called the “Management Discussion and Analysis.”

The goal of the MD&A is to provide a plain language summary of the complex data in the audit.  It also serves other important purposes: It is a chance for the senior management team to speak candidly about the financial strengths and weaknesses of the organization, to discuss future challenges and opportunities, and to create a fiscal “trail of breadcrumbs” for future managers to follow.

 

The basic question the audit seeks to answer is: Is the County doing OK financially?  For fiscal year 18 (the period ending June 30, 2018), the answer is, “Yes.”  And “mostly.” 

The County ended the year “in the black,” accounting jargon for having higher operating revenues than operating expenses.  As a general rule, this is better than ending the year “in the red.”  The excess of revenues over expenses rolls into the County’s general unrestricted reserves.  This is accounting jargon for the County’s available cash account.

For each of the past seven years, the County has ended in the black.  During this time, the Commissioners occasionally have withdrawn money from reserves to fund capital expenses.  (Capital expenses meaning investment in vehicles, heavy equipment, buildings, and infrastructure.)  Despite these drawdowns, the unrestricted general reserves have grown to $____________.  This is a positive trend.

To evaluate a local government’s financial health, one of the measures frequently used is unrestricted general reserves as a percentage of operating expenses.  There are numerous “rules of thumb” ranging from one month’s expenses (8.3 percent), 10 percent, two month’s expenses (16.6) percent, 20 percent, or 25 percent.

The County’s adopted policy is not to allow reserves to dip below 5 percent.  As noted by auditors, bond rating agencies, and the senior management team, this is too low.  While the policy has not been amended, a goal of the senior management team has been to build the unrestricted reserves beyond the 5 percent threshold and to encourage the Commissioners to adopt a higher number.  This recommendation is 10 percent in the short term; 16.3 percent in the longer term.

Building reserves (and prudently managing the County’s finances) relies on projecting revenues conservatively and estimating expenses aggressively.  This is how the senior management team built the FY 18 budget.  As evidenced by this audit that process was successful.  At the close of the accounting period, the County had received $___________ more in revenues than expenses.

Before going further, it is important to note that the audit is primarily a one-year snapshot of the County’s finances.  In the MD&A, the senior management team will talk about the past and look into the future, but nearly all the numbers in the audit apply to fiscal year 2018.  As with all audits, it is important not to read too much into any single year.

Revenues

To begin explaining the audit, it helps to understand the County’s sources of revenues.  The two major revenue streams are property taxes and income taxes.  The State of Maryland assesses the value of all real estate.  The Commissioners set the County’s tax rate.  With the County, there are 10 incorporated municipalities (cities and towns) that impose property taxes as well. 

In the FY 18 budget, the Commissioners left the property tax rate unchanged at 98 cents per $100 of assessed value.  Caroline has the ________th highest property tax rate among Maryland’s 23 counties and Baltimore City, essentially “middle of the pack.”  The total amount of property taxes collected in FY 18 was $___________.

Income taxes are different.  While the State of Maryland collects income taxes, the process is a “black box” for local governments.  The State refuses to give local governments raw income tax data so the revenue can be difficult to predict.  During the budget process for FY 18, the County Commissioners left the income tax rate unchanged at 2.73%.  During the year, however, the Commissioners voted to increase the rate to 3.2%, the maximum allowed by state law.

Driving the decision was recognizing the need to replace Greensboro Elementary School and to build a new building for the Caroline County Sheriff’s Office.  Absent the increase in income taxes, the County lacks the revenues to support the debt for the two major projects.  In FY 18, the County received $____________ in income tax revenues.  Overall, other revenues like user fees remained stable.

Expenditures

FY 18 was a relatively routine year for expenses.  As noted in previous audits, a majority of County expenditures are mandatory—either an obligation of state law like funding the K-12 education system or paying obligations like debt service.  Expenditures like the County’s ambulance system are not legally mandated, but most residents would consider the service essential for public health and safety.

By category, Caroline County expenditures largely parallel other Maryland’s counties.  The single largest expense is labor in the form of wages and benefits.  The County has about 160 full-time employees in its nine departments.  The County also provides payroll and human resources support for some “local” state agencies like the Circuit Court and State’s Attorney’s Office.

In the FY 18 budget, the Commissioners approved a 3 percent pay increase to employees and adopted a new grade/range pay scale.  The Board added two new positions for road deputies in the Sheriff’s Office, making another step towards the goal of adding five new officers before the end of the Board’s term.  The Board also converted four part-time EMS positions to full-time positions.  This reduced the EMS system’s reliance on part-time EMTs and Paramedics to fill shifts.  In FY 18, the County completed its transition to a “living wage.”  Under this policy, the minimum annual wage for a full-time County employee is $30,900.

The Commissioners also made some structural changes to local government services.  The Board dissolved the longstanding Memorandum of Understanding (MOU) with the Caroline Economic Development Corporation (CEDC), choosing to bring economic development “in house.”  This move allowed the CEDC Board to focus on tourism and for the Commissioners to have more direct control over economic development activities.

The Commissioners made a similar decision regarding animal control.  Traditionally, the Caroline County Humane Society has fielded the County’s Animal Control Officers (ACOs).  The Board believes that ACOs are public safety employees deserving of a pay structure and benefits on par with other similarly-situated County employees.  The three ACOs hired by the Humane Society were transitioned to County employment in FY 18.  The economic development decision was budget neutral.  The change to animal control represented an increase in costs.

The only budget reduction in FY 18 was a decrease to Delmarva Community Transit.  In FY 17, the Commissioners approved an increase of $15,000 to provide additional services.  Since these services never materialized, the Board returned the funding to the FY 17 level.

Debt

In FY 18, the County’s bond rating remained AA-.  This is essentially the County’s credit rating.  This is a lower rating than more affluent Maryland counties, but the bond rating agencies have commented favorably on Caroline County’s strong management, improving financial position, and relatively low debt.  The agencies also correctly noted that the County has a relatively small economy heavily dependent on agriculture.  Much like a credit rating for a consumer depends on income, our bond rating is limited by our modest tax base.

The County did not issue any new debt in FY 18.

Capital

In government accounting, capital expenses are commonly defined as purchase of an asset greater than $5,000 in value and with an expected useful life of five years or longer.  Common examples are buildings, equipment, and vehicles.  Setting aside K-12 schools, public libraries, and property owned by allied agencies, the County owns 399 miles of treated roads, 78 miles of dirt roads, 39 bridges and structures, over 250,000 square feet of buildings, and over $10 million in vehicles and heavy equipment.

FY 18 marked the second consecutive year the County funded a normal capital budget.  The FY 18 capital improvement plan (CIP) totaled $6.69 million but that number may be misleading.  About $594,000 represented unspent capital projects rolled over from the prior fiscal year.  Some of the CIP reallocated $562,000 of unspent bond funds recovered from the Preston Elementary Renovations.  About $1.8 million are expenditures related to sources like grant funds or dedicated revenues.

What is important to note is that FY 18 capital investment was funded by a $2 million drawdown of the County’s unrestricted general reserves.  The Commissioners made a similar decision to fund capital in the FY 19 budget.  These were necessary measures to continue capital investment and address the “deferred maintenance” challenge, however, it is not sustainable in the longer term.  Given the County’s total infrastructure—vehicles, equipment, buildings, roads, and bridges—the capital budget should be between $3 million and $4 million per year, and that money should come largely from operating revenues.

Unfunded Liabilities

“Unfunded liability” is an accounting term.  It is essentially a promise to pay something in the future where the necessary funds have not been set aside yet.  This term is most commonly used when referring to pension plan and retiree health care plans.

Unfunded liabilities are a big deal, particularly for local governments—so much so that the Government Accounting Standards Board (GASB) adopted Statements 67 and 68.  These statements updated the standards for local governments reporting pension liabilities.  This occurred because some local governments were not reporting liabilities accurately.

Caroline County has its own pension plan and retiree health care benefit plan.  This is somewhat unusual in Maryland where many counties participate in the State of Maryland’s plans.  The pension plan is supported by the County’s pension fund.  Retiree healthcare is funded through the Other Post-Employment Benefits (OPEB) fund.  As noted in previous audits, the County has made steady progress improving the pension fund by: 1) reforming the pension system; 2) phasing in employee contributions; 3) paying more into the pension fund than the required annual contribution.

As you may read later in the audit, the County’s total pension liability was $____________ at the end of the fiscal year.  The pension fund had $____________ in assets.  This means the County has an unfunded liability of $____________ and that the plan is ________% funded.  The goal of the County’s Pension Board is to reach 100 percent funding with a lower expected rate of return on investments.

It’s important to note that the pension liability is an estimate based on some best guesses.  These guesses are made by an independent professional actuarial firm, not the senior management team.   

The most important guess is the rate of return the pension fund will earn on its investments.  The current estimate is 7.15 percent although the Pension Board has voted to slow reduce the number to 7 percent.  This slow reduction in the expected rate of return makes the County’s pension fund seem less well funded, however, making the estimate more conservative means the pension fund is better funded.

Caroline County is the only jurisdiction in Maryland whose OPEB plan is over 100 percent funded.  This is due to two reasons.  First, the County offers only a modest Medicare supplement plan and does not subsidize health insurance for employees under age 65.  Second, the County set aside money for the OPEB fund before the Great Recession.  Careful management of those funds has resulted in a plan that is ________% funded.

Over the past seven years, the County has addressed other unfunded liabilities like the past policy of cash payouts for accrued sick leave on retirement.  The previous Board of Commissioners paid employees for some accrued sick leave and changed to pension plan to allow conversion of all unused sick leave into pension service credit at retirement.

Along with the improvement in unrestricted cash reserves, progress on unfunded liabilities has been a major financial accomplishment for the County.  It bears mentioning, however, that both the pension and OPEB funds are comprised of a mix of investments including equities.  The U.S. stock market is in the midst of the longest “bull market” in history.  Sooner or later, the economy will cool and the stocks will tumble in a “bear market.”  The senior management team strongly believes the County should continue decreasing unfunded liabilities to allow the pension and OPEB funds to endure a market correction.

Municipal Property Tax Differential

Property owners in Caroline’s five largest towns receive a break on their County taxes.  While not required by law, the Commissioners have continued to provide this benefit, foregoing about $_________ million cumulatively in property tax revenues over the past six years.  The five smallest towns receive support in the form of direct payments.  For the FY 18 budget, the Commissioners followed the differential formula established in 2012.

Summary

The goal of this executive summary is to explain the annual audit—the snapshot of the County’s FY 18 fiscal year—in plain language.  If you have read to this point, congratulations!

Buried amid the mountain of data is a simple message.  FY 18 was a good year.  The County continues to improve financially.  Services have been expanded and, in some instances, restructured.  The Commissioners have continued a focus on public safety.  The collaborative budget process—the Caroline Way—has minimized conflict and competition.  The relationships between the County and allied agencies is as strong as in any county in Maryland.  After the pain of the Great Recession, the collapse in housing prices, cost shifting by the State of Maryland, and draconian cuts in funding, the County has largely recovered.

The Commissioners made a critical decision to increase the income tax rate during the year, a financially prudent measure necessary to build a new building for the Sheriff’s Office and to replace Greensboro Elementary School.  Of all Board decisions made in the past decade, that likely will prove the most significant.

Like every Eastern Shore county, Caroline faces some significant challenges.  The regional labor market has tightened.  Some departments have struggled to recruit and retain entry level employees.  There are signs of inflation—the general increase in prices.  Interest rates are increasing and some expenses are increasing at a higher rate than the County’s tax base is growing.  Perhaps the biggest challenge for the County is truly balancing the budget, i.e., funding a sustainable capital improvement plan without drawing down reserves.  The senior management team is hopeful that the income tax increase will allow this to occur.

Despite the challenges, Caroline County has proven exceptionally resilient.  A fiscally conservative governing body is supported by a capable management team.  While not readily evident in the audit, the strength of Caroline is its team of leaders committed to collaboration, cooperation, and community.  As long as this unique culture exists, the senior management team believes the County financial progress will continue.

The predictable fate of the newspaper

While not one often to admit it in mixed company, one of my degrees is in journalism.  When I arrived at university, I told my Jesuit advisor I wanted to write and was thinking about majoring in English.  He tartly observed that English majors study what other people have written; journalism majors write.

Not long ago the Baltimore Sun's editorial board responded to a request from the Boston Globe to opine on the dangers of an assault on free press.  A snippet from that editorial:

"So that’s the goal: to assess, analyze and uncover truth. That’s obviously easier said than done, and our profession’s “truths” do not always reflect the entire public’s — particularly those on the right. While we try to keep our personal feelings out of our work, they can still unintentionally influence the things we cover and the way we cover them. And to many, that’s a failure on our part — one we’ve largely been given a pass on in the past. But not in today’s partisan climate."

Newspaper circulation has dropped below what it was in 1940.  Newspapers had it good for decades, but when technology changed the nature of mass communication, they were slow to adopt as an industry.  One of the reasons is arrogance.  Newspapers largely survived the advent of television news albeit with no small measure of diffidence towards the purportedly less serious medium.  What happened along the way, however, was the vast diminishment of "two paper towns."  As newspapers settled into comfortable local monopolies, they did what monopolists do.  They stopped caring about innovation, customers, and costs.  They lobbied Congress to block electronic classified ads and other competition.  Newspapers attempts to transition to the digital medium was inevitably ham-handed.  When the lower transactional cost of the Internet and low/no cost sites like Craigslist, newspapers simply lumbered along like dinosaurs looking for a tar pit.

Another factor is that newspapers began drifting away from the role of informing into the role of opining.  Pick-and-shovel journalism is hard work, and often tedious.  During my nearly 20 years leading local governments, I've often apologized to reporters covering public meetings with a version of, "I'm sorry you had to sit through that."  And I've been quick to praise lucid, well-written news stories about rambling, difficult-to-follow public discussions.  Great local reporters are rare and incredibly valuable.  On that note, a tip of my hat to Abby Andrews, local government beat reporter for the Times Record who has proven one of the best.

Tip O'Neill is most often given credit for the phrase, "All politics is local."  I think there's an argument to made be that all journalism is local.  Great reporting will always be great reporting.  And there will always be a market for accurate, timely, local information.  What the editors at the Baltimore Sun dismiss is any recent assault on the free press pales in comparison to the damage newspapers have done to themselves.

Dude, Where's My Car?

The City of Albuquerque has it!

Some of New Mexico's cities have a penchant for seizing vehicles, so much so that the State Legislature changed the law to prevent its municipalities from financially benefiting from civil forfeitures.  Albuquerque did not "get the memo," but they received a new one from U.S. District Court Judge James Browning on Monday.

Judge Browning found the City's vehicle forfeiture program unconstitutional.  Specifically:

"The Court concludes that the City of Albuquerque has an unconstitutional institutional incentive to prosecute forfeiture cases, because, in practice, the forfeiture program sets its own budget and can spend, without meaningful oversight, all of the excess funds it raises from previous years. Thus, there is a 'realistic possibility' that forfeiture officials’ judgment 'will be distorted by the prospect of institutional gain.'”

The case that precipitated the legal decision involved a woman who lent her car to her adult son.  The son was arrested for DUI and the City seized the car.  In a Kafka-esque twist the City apparently offered to sell the mother her car for $4,000 if she agreed to have it booted for a year-and-a-half.  So, an innocent woman lends her car to a family member.  The family member (allegedly) breaks the law and, in turn, a municipal government tries to extort $4,000 and an agreement to immobilize a car she is still making payments on?

Albuquerque has a Chief Administrative Officer: Sarita Nair, JD, MCRP.  Ms. Nair not only is an attorney, she is reportedly "AV-rated by Martindale Hubbell, and has been recognized by Best Lawyers, Southwest Super Lawyers, and Chambers & Partners USA."  So, how exactly does a municipal government with an annual budget of nearly $1 billion managed by a "super lawyer" end up running a program that flouts state law AND the Constitution?

I'll let economist Steven Landsburg provide the answer:

“Most of economics can be summarized in four words: “People respond to incentives.” The rest is commentary.”

Local governments are--contrary to the suspicions of some citizens--organizations comprised almost entirely of people.  Individually and collectively, those people respond to incentives.  And there is something more going on.  The average citizen is likely to recoil in horror hearing the story of an innocent woman having her car seized by the government.  The average third-grader would find it patently unfair.  But something happened in the City of Albuquerque, a change in the culture that allowed the unacceptable to become acceptable, commonplace, routine.

One of the jobs of the local government CAO is to remain ever watchful and vigilant of an organization's culture, to ask the difficult moral questions, to challenge complacency and the "this is the way we've always done it" trap.  And the wise CAO understand the power of Landsburg's observation.  We all respond to incentives, so it is critical that the structure of our organizations reward us for doing the right things.