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A REVIEW OF DOT COMPLIANCE WITH GASB 34 REQUIREMENTS SUMMARY BACKGROUND In June 1999, the Government Accounting Standards Board (GASB) adopted and released Statement 34 Basic Financial Statements--and Management's Discussion and Analysis--for State and Local Governments (herein after referred to as GASB 34), which GASB's Chair characterized as "the most significant change to occur in the history of government financial reporting." GASB 34 provides a comprehensive framework for financial reporting with the objective of making annual reports easier to understand and more useful to the people who rely on the financial information contained therein. The most significant aspect of GASB 34 was that, for the first time, general infrastructure assets were to be reported together with related depreciation or preservation costs. Although a traditional approach to financial reporting would entail depreciation of assets, AASHTO and the American Public Works Association (APWA) contended that, for several reasons, an optional method of compliance should be available. The reasons included the following: 1. Transportation and other public works network-based assets are not regarded as depreciable, as are equipment and other items; 2. State DOTs have good information and analytical tools to help identify the appro- priate level of investment needed to sustain in-service infrastructure assets, includ- ing pavement management systems, bridge management systems, and mainte- nance management systems; and 3. The minimal management contributions that would be obtained from computing depreciation lives and costs would not justify the effort required. GASB was sufficiently persuaded by these arguments to offer an optional method of compliance. Its June 1999 action authorized both the depreciation approach and a mod- ified approach that relied on asset management analysis and systems as acceptable methods of valuing infrastructure assets. That action also authorized a combination of the two if, in the judgment of the agency, depreciation was appropriate for some asset classes and the modified approach appropriate for others. With this development, many

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2 in the transportation community stopped viewing the requirement to report infrastruc- ture assets as a threat and began to see it as an opportunity to enhance asset manage- ment capability. GASB emphasized that its intent was to allow agencies flexibility in the details of how the methods are actually applied (e.g., in defining types of assets and networks and sub-networks). Moreover, GASB allowed approximations and reasonable estimates of costs. This latitude is embodied in GASB 34 itself and in the examples provided by GASB's Implementation Guides. GASB 34 includes the following provisions and requirements regarding the report- ing of general infrastructure assets: Capital assets should be reported at historical cost. The cost of a general capital asset should include ancillary charges necessary to place the asset into its intended location and condition for use. Infrastructure assets are long-lived capital assets that normally are stationary in nature and normally can be preserved for a signifi- cantly greater number of years than most capital assets. Depreciation Approach: Capital assets that are being or have been depreciated should be the reported net of the accumulated depreciation in the statement of net assets. Capital assets should be depreciated over their estimated useful lives unless they are either inexhaustible (e.g., land) or are infrastructure assets reported using the modified approach. Depreciation expense should be reported in the statement of activities. Depre- ciation expense should be measured by allocating the net cost of depreciable assets (historical cost less estimated salvage value) over their estimated useful lives in a systematic and rational manner. It may be calculated for (a) a class of assets, (b) a network of assets, (c) a subsystem of a network, or (d) individual assets. Modified Approach--infrastructure assets that are part of a network or subsystem of a network are not required to be depreciated as long as two requirements are met. First, the government manages the eligible infrastructure assets using an asset management system that has the characteristics set below: Provides an up-to-date inventory of eligible infrastructure assets; Performs condition assessments of the eligible infrastructure assets and sum- marizes the results using a measurable scale; and Estimates each year the annual amount to maintain and preserve the eligible infrastructure assets at the condition level established and disclosed by the government. Second, the government documents that the eligible infrastructure assets are being preserved approximately at (or above) a condition level established and disclosed by the government. Determining what constitutes adequate docu- mentary evidence to meet the second requirement involves professional judg- ment because of variations among government asset management systems and condition assessment methods. However, governments should document the following: Complete condition assessments of eligible infrastructure assets are per- formed in a consistent manner at least every 3 years. The results of the three most recent assessments provide reasonable assurance that the eligible infrastructure assets are being preserved approximately at (or above) the condition level established and disclosed by the government.

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3 The estimated annual amount calculated at the beginning of the fiscal year to maintain and preserve the level at (or above) the condition level established and disclosed by the government is compared with the amounts actually expensed for each of the past five reporting periods. If eligible infrastructure assets meet these requirements and are not depreci- ated, all expenditures made for those assets (except for additions or improve- ments) should be expensed in the period incurred. Additions or improvements to eligible infrastructure assets should be capitalized. GASB 34 called for the prospective reporting aspect of the new standards to become effective in fiscal years ending after June 15, 2002, for governments with total annual revenues of $100 million or more. The requirement for retroactive reporting of assets created prior to FY2002 is not effective until FY2005 for major governments, and the extent of retroactivity is limited to 1980. However, most state DOTs have found it more practical to include retroactive reporting in the initial year of implementation and to not make a distinction between pre- and post-1980 assets. Each of the 52 DOTs (DOTs for the 50 states plus the District of Columbia Department of Public Works and the Puerto Rico Department of Transportation and Public Works) is a member of a government in that category. Forty-eight departments have fiscal years ending June 30th; thus these requirements were first effective for the July 1, 2001, through June 30, 2002, fiscal year. Four departments have different fiscal years, and the effective date for these DOTs was deferred accordingly. NCHRP commissioned the conduct of this survey in order to "catalog and analyze the approaches taken by AASHTO member departments to comply with the requirements of GASB 34" during this first year of implementation. The intent is to share best prac- tice examples, identify alternative approaches to areas where the departments are encoun- tering difficulty, identify subjects that require further consideration by AASHTO com- mittees and other interested parties, and generally improve the state of the practice for reporting in future years. DOT SURVEY AND INTERIM REPORT The initial phase of the project was a survey of the state DOTs on their approach to GASB 34 during the first year of implementation. The survey was available as either a web-based instrument or a paper document. Fifty departments responded, and survey findings included the following: For this first year of implementation, a higher percentage of state DOTs have adopted the depreciation approach than initially indicated in surveys over the past several years. The various reasons for the greater preference for depreciation included the following: It is perceived as simpler to implement, It is preferred by (or more familiar to) state financial officials (and in some cases is the approach designated by state government), It avoids certain problems or requirements of the modified approach, and It is perceived by some that its results may present the state DOT in a more favorable light. Most states indicated that the modified approach was more helpful for decision making, although 10 states indicated that neither method was helpful. In view of the extended controversy leading to the adoption of GASB 34, it is remarkable that

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4 only 20% of the states now question the usefulness of the exercise. Most states indicated that the modified approach was more challenging to implement and report. There was considerable diversity of opinion as to which aspects of imple- mentation were the most challenging. In addition to the reasons provided for selecting one approach or the other, it appeared that an underlying consideration for some states was the potential effect on funding. For example, several states that selected the modified approach believed that the analysis underpinning this approach might help build the case for maintaining or increasing funding in their deliberations with legislative budget committees and other funding entities. Other states were concerned that this analy- sis would suggest to the legislature and to the general public that the department had not been discharging its responsibilities efficiently and thus might harm depart- ment credibility. A similar interplay of considerations was at work in the selection of targeted con- dition levels by the modified approach states. Some departments were inclined to establish relatively low condition targets that they were sure to achieve, thus gen- erating a positive report for their financial statements. Other departments were concerned that if the condition target was set too far below actual reported condi- tions, that target might suggest to a budget committee that excess funds had been allocated to maintaining conditions and that a funding cut might be in order. The approach to identifying condition targets by the modified approach states is summarized in Table 1. Some states were quite aggressive in their targeting; others provided for a considerable safety margin. These condition targets are found in the Required Supplementary Information (RSI) submitted by the modified approach states in their FY02 financial statements. Copies of the RSIs are provided in Appen- dix G to this report, which is available on line as NCHRP Web Document 63. There appeared to be more focus and certainty of purpose on subjects such as the calculation of historical asset cost than on disclosing target conditions and estimat- ing expenditures to achieve those conditions. This may suggest that many depart- ments have not yet fully come to grips with the policy aspects and programmatic implications of infrastructure asset management. States using the modified approach commented on the difficulty of estimating the annual costs of maintaining infrastructure at or above target condition levels. The application of existing management systems to this task (particularly Pavement Management System "PMS," Bridge Management System "BMS," and Mainte- nance Management System "MMS") was not widely mentioned. Several agencies continue to have concerns and questions about the details of implementation (e.g., categorization of costs). Other agencies, however, have suc- cessfully implemented GASB 34 without major issues. Current implementations of GASB 34 in some states may be more detailed than originally envisioned by GASB (e.g., in the number of asset classes). Resource requirements for implementing GASB 34 appear to be relatively nomi- nal. Costs were generally under $500,000 for those states reporting an estimate, hours were generally under 3,000, and only five states reported hiring additional staff (one staff member each). Modified states were much more likely to believe that the GASB 34 exercise improved communications among the engineering, finance, and maintenance depart- ments. However, of those states that believed communications had improved, depreciation states were more likely to indicate that this improved communication would lead to better resource allocation decisions.

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5 TABLE 1 Performance measures used by state DOTs in GASB 34 financial reporting for FY 2002 State Asset Class Measure Description Latest Value 2002 Target Alabama Pavements Distress Rating 0-100 scale assigned to 50m segments 79.7 75 based on roughness, cracking, rutting, patching, raveling Bridges GASB 34 Bridge Rating 0-10 scale assigned to each 6.69 5 componenet-rating category Arizona Pavements Present Serviceability 0-5 scale based on subjective rating by 3.6 3.23 Rating (PSR) road users Bridges Condition Rating Index 1-9 scale based on condition of bridge 93.6% >92.5% (CRI) joints, deck, superstructure and substructure Colorado Pavements Remaining Service Life Poor (0-5 years), Fair (6-10 years) or 54% good or 54% good or (RSL) Good(11+ years) based on surface fair fair distress Bridges National Bridge Index 0-9 scale based on deck, 6.6% struct. 25% struct. superstructure and substructure rating deficient deficient Delaware Pavements Overall Pavement 0-5 scale based on pavement distress 9.8% in poor 15% in poor Condition (OPC) condition condition Bridges Bridge Condition Rating 0-9 scale based on structural and deck 5.2% in poor 10% in poor (BCR) rating condition condition Florida Pavements Pavement Condition 0-10 scale for pavement segments 79% >6 for all 3 80% >6 for all 3 Survey based on ride smoothness, pavement criteria criteria cracking and rutting Bridges NBI Standards 0-9 scale based on deck, 93% 5 90% 5 superstructure and substructure rating Idaho Pavements Roughness Index (RI) and RI - 0.0 to 5.0 based on public 18% <2.5 18% <2.5 Cracking Index (CI) perception; CI - 0.0 to 5.0 for each pavement section Indiana Pavements Pavement Quality Index 0-100 scale based on 3 surface Int - 87 Int - 75 (PQI) distress factors NHS - 83 NHS - 75 Other - 80 Other - 65 Bridges Sufficiency Rating 0-100 scale based on 4 factors Int - 91% Int - 87% reflecting ability to remain in service NHS - 91% NHS - 85% Other - 88% Other - 83% Kansas Pavements Performance Levels (PL) PL1: Good condition; PL2: requires Int 97% PL1 Int 80% PL1 maintenance; PL3: Poor condition Other 91% PL1 Other 75% PL1 Bridges Health Index 0-100 scale based on condition of Overall - 91 Overall 80 several elements Kentucky Pavements Pavement Condition Index Good, Fair and Poor based on 20.6% Poor 30% Poor pavement smoothness Bridges NBI Standards 0-9 scale based on deck, 5.3% Struc. 7% Struc. superstructure and substructure rating Deficient Deficient Maine Pavements Highway Adequacy 0-100 scale based on Pavement Overall - 76.6 Overall - 60 Condition Rating, safety, backlog, ADT, posted speed and shoulder Bridges Sufficiency Rating 0-100 scale based on structure, Overall - 77.0 Overall - 60 functionality, essentiality and special features Michigan Pavements Sufficiency Rating Excellent, Good, Fair, Poor, Very Poor 22% Poor or 30% Poor or based on surface distresses Very Poor Very Poor Bridges NBI Standards 0-9 scale based on deck, 20.9% Struct. 35% Struc. superstructure and substructure rating Deficient Deficient (continued on next page)

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TABLE 1 (Continued) State Asset Class Measure Description Latest Value 2002 Target Minnesota Pavements Pavement Quality Index 0.0-4.5 scale based on smoothness Princ. - 3.39 Princ. 3.0 (PQI) and distress (cracking) Other - 3.30 Other 2.8 Bridges Structural Condition Rating Good, Fair or Poor based on 3 0-9 NBI Princ. - 96% Princ. - 92% condition codes plus 2 NBI appraisal Fair to Good Fair to Good ratings Other - 91% Other - 80% Fair to Good Fair to Good Nebraska Pavements Nebraska Serviceability 0-100 scale based on surface Overall - 84% Overall 72% Index (NSI) distresses - cracking, patching, roughness, rutting, faulting Nevada Pavements International Roughness Profile index based on vehicle response I - 83% <80 I - 70% <80 Index (IRI) by road to roughness (lower=smoother) II - 77% <80 II - 65% <80 classification (I-V) III - 86% <80 III - 60% <80 IV - 65% <80 IV - 40% <80 V - 19% <80 V - 10% <80 Bridges Condition Level 6% substandard 10% substandard Ohio Pavements Pavement Condition 1-100 scale based on cracking, Priority - 78% Priority 75% Rating (PCR) potholes, deterioration, other with 65 PCR with 65 PCR Other - 97% Other 75% with 55 PCR with 55 PCR Bridges Appraisal Condition Rating 0-9 scale based on major structural 97% of deck 85% of deck items area 5 rating area with 5 rating Tennessee Pavements Maitnenance Rating Index 1-100 scale based on pavement, Overall - 87.75 Overall 75 (MRI) shoulders, roadside elements, drainage, and traffic services Bridges NBI Standards 0-9 scale based on deck, 80% of deck >75% of deck superstructure and substructure rating area neither area neither Struct. Deficient Struct. Deficient nor Funct Obs nor Funct Obs Texas Pavements Maintenance Assessment 1-5 scale based on pavement, traffic Interstate 82% Interstate 80% Program operations and roadside with 1=20%, Other 79% Other 75% 2=40%, 3=60%, 4=80% and 5=100% Utah Pavements Ride Index 1-5 scale based on vehicle response to 70% with 2.75 50% with 2.75 roughness with adjustment for rating; 8% with rating; 15% pavement type 1.84 rating with 1.84 rating Bridges Structures Inventory 1-100 scale based on condition of 70% with 80 50% with 80 System major elements rating; 3% with rating; 15% 49 rating with 49 rating Washington Pavements Pavement Condition Index Pavement section assigned lowest 91% with 40 90% with 40 value among Pavement Structural rating rating Condition, IRI and rutting Bridges Bridge Inventory System Good, Fair or Poor based on NBI 97% with Good 95% with Good structural appraisal or Fair rating or Fair rating Wisconsin Pavements International Roughness 0-5 index based on vehicle response to 5% with Poor 15% with Poor Index (IRI) roughness (lower=smoother) rating rating Bridges NBI Standards 0-9 scale based on deck, 7.6% Struc. 15% Struc. superstructure and substructure rating Deficient Deficient Wyoming Pavements Pavement Serviceability 0-5 scale based on ride, rutting and NHS - 3.56 NHS - 3.5 Rating (PSR) cracking Other - 3.24 Other - 3.0 Bridges Sufficiency Rating 0-100 scale based on structure and NHS - 85% NHS - 83% functionality to determine whether Other - 84% Other - 80% acceptable Sources: FY2002 Comprehensive Annual Financial Reports

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7 The states reported considerable diversity of approach in their costing method- ologies. For example, there was little unanimity regarding the following: The approach to calculating historical cost; The distribution of costs among maintenance, preservation, and capital cate- gories; and The appropriate point in the project development process to capitalize costs. In some cases, the differences may be a matter of nomenclature rather than of sub- stantive practice. These subjects may warrant further consideration by the AASHTO Finance Committee. Many states expressed interest in seeing the survey results and learning about how other states plan to use the information produced for the GASB 34 reports. CASE STUDY INTERVIEWS The panel selected six state DOTs--Michigan, South Carolina, Tennessee, Texas, Vermont, and Washington--to be the subjects of follow-up case study interviews. To facilitate comparison of the interview results, a structured question-and-answer format, tied to survey topics, was developed by the research team. Although the interviews benefited from the structure of prepared questions, the research team did not rigidly follow this format. If a topic was of particular interest to a state, or a state had employed an especially noteworthy approach, the research team tried to follow that discussion wherever it might lead. The research team thought that the information thus obtained was more important than ensuring that each particular question was specifically addressed by each state. All interviews were conducted by at least two, and sometimes three, members of the research team. On the DOT side, par- ticipants ranged in number from 2 to 10. Three of the interviewees (i.e., Michigan, Tennessee, and Washington) were modi- fied approach states, two (i.e., South Carolina and Vermont) selected the depreciation approach, and one (i.e., Texas) used both approaches for different major asset classes. The selection of approach was influenced by many factors, but the most important appears to be the maturity of the DOT's asset management information system. Those DOTs with systems in place that generated the information necessary to support the modified approach tended to select that approach; absent such systems, the deprecia- tion approach was preferred. Seven areas of discussion were judged to be of particular interest: Implementation procedure/organization--each of the interviewed DOTs had some degree of involvement with central state finance entities (e.g., comptroller's office, division of finance and administration, or state auditor), but in all cases the DOT's infrastructure assets represented the overwhelming majority of state total assets. The DOTs primarily relied on internal committees to conduct the work with little or no contribution from new hires or consultants. An early start was generally deemed critical to success, with 18 months prior to the close of FY02 the typical beginning date. Determination of condition targets--for modified approach states, the calculation of meaningful condition targets was a key step in the process and various methods were employed. Different condition targets were adopted for the two principal asset classes, roads and bridges. Fiscal constraint was an important aspect in deter- mining these targets in order to ensure that they were realistic. Estimated cost to achieve targets--linking targeted conditions to required expen- ditures is problematic for the modified approach states. The principal difficulties

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8 are that (a) the management information systems, as deployed at the time, were not mature enough to generate reliable expenditure estimates; and (b) the cost def- initions contained in GASB 34 were not compatible with the DOTs' budget prac- tices and management systems (see next bullet). For several reasons, the DOTs are working to improve their performance on the first issue; there is less interest in addressing the second. Several DOTs made the point that they view the compari- son between planned and actual expenditures as much less significant than the comparison between targeted and actual conditions. Categorization of costs--a related source of difficulty is the categorization of costs among capital, preservation, and maintenance. The GASB 34 guidelines use a functional approach to these categories--maintenance costs achieve the original design life; preservation costs extend that design life, but do not increase capacity or service; and capital costs increase capacity or service. However, the traditional DOT definitions relate more to type of construction--a full reconstruction project is viewed as capital, whether or not lanes are added; a resurfacing project is viewed as preservation, whether or not there are ancillary safety benefits. A potential solu- tion is to allocate costs within a project to the three categories, but this is strongly resisted as impractical by the DOTs, which typically must account for hundreds, if not thousands, of projects each year. The conflict between traditional and GASB 34 categories is particularly pronounced for the division of capital and preserva- tion. Accordingly, this discrepancy is less significant for depreciation approach states because those states capitalize both categories. Some DOTs have questioned the degree to which the difference between the structures is material in the over- all financial statements. Estimated historical costs--to reduce the burden associated with estimating his- torical costs, GASB 34 deferred the effective date of this requirement for 4 years and further provided that it was necessary to report costs incurred only since July 1, 1980. However, each of the interviewed states elected to report his- torical costs in the initial year of GASB 34 implementation, and four of the six went back to well before 1980. Estimates were prepared using a combination of costs identified in AASHO: The First 50 Years, financial statements, project records, and written down replacement costs. Additions and retirements--the reporting of additions to and retirements of infra- structure assets for the first time in the financial statements was troublesome for many DOTs. Although DOTs typically track such changes in physical assets through management programs and other inventory records, a link to costs recorded in the accounting system typically did not exist. Many states found it necessary to initially accomplish this linkage manually and with other ad hoc methods. Most have now developed automated links. Usefulness of and interest in information--there was general agreement among the interviewed DOTs that the information generated in the GASB 34 exercise was potentially useful in budgeting and resource allocation, particularly the informa- tion included in Required Supplemental Information for the modified approach states. However, all reported in FY02 that the benefit remained a potential and was not realized--the new information generated virtually no interest or inquiries out- side the agencies. One DOT observed that this is just the first year of implemen- tation. General interest probably will increase as the accuracy of the information improves and as a time series of validated data becomes available and trends can be observed.

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9 5TH ANNUAL ASSET MANAGEMENT CONFERENCE The research team was invited to present summary findings of the project's survey and interviews at the 5th Annual Asset Management Conference, sponsored by TRB, AASHTO, and FHWA, which was conducted in September and October of 2003. The presentations were generally well received with lively question-and-answer discus- sions. Of particular interest, however, were several anecdotal reports from local gov- ernments that they had received improved bond ratings after preparing FY02 financial statements in accordance with GASB 34's modified approach. The bond rating agen- cies did not officially disclose the reasons for rating adjustments, but the governments involved seemed convinced that the modified approach was responsible. The state DOTs used the Management Discussion & Analysis materials to disclose that they were effectively preserving their infrastructure and thereby were not accumulating unfunded liabilities for future generations to address. The state DOTs also reported that the rating agencies were favorably impressed by this analysis and adjusted ratings accordingly. The research team has not had the opportunity to confirm that the modified approach was the reason for the improved ratings, but, if true, confirmation would have major implications for the state DOTs as they continue to assess their approach to complying with GASB 34. INFORMATION GAPS AND RESEARCH NEEDS While conducting the initial survey and follow-up case study interviews on GASB 34 implementation, the research team became aware of several issues and concerns of the state DOTs requiring additional information and research. More specifically, there is a need for more detailed research on condition assessments and preservation meth- ods that will (a) allow more integration of asset management data into the financial statement reporting process and (b) lead to better preservation results. The specific topics proposed for additional research are listed below. For all of these topics, the intention is not to identify the single "right" answer, but to develop a list of recommended best practices from which the DOTs can select an alternative that reflects their specific circumstances. This approach is consistent with current GASB thinking, which is moving toward principle-based standards rather than a more prescriptive detail- oriented approach. The following topics are recommended for additional research: Methods for Condition Assessments--a consistent condition assessment method- ology has not yet been developed. Linking Condition Targets to Required Expenditures--virtually all modified approach states experienced difficulty in estimating the expenditure level neces- sary to achieve targeted conditions. Cost Categories (Capitalized versus Expensed)--there is a discrepancy between GASB 34 cost categories and what is traditionally used by DOTs. The GASB 34 guidelines use a functional approach to these categories, while the traditional DOT definitions relate more to the type of construction. These definitions are significant because they determine whether costs are to be capitalized or expensed in the finan- cial statements. Additions and Retirements--most DOTs had difficulty in accounting for additions to and retirements of infrastructure assets in their financial statements.

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10 Required Shift to Depreciation--several DOTs questioned the wisdom of requir- ing a state to shift from the modified approach to depreciation if the condition tar- gets were not achieved. Potential Effect on Bond Ratings--additional research is needed to confirm whether or not improved bond ratings for local governments have occurred as a result of adherence to the modified approach and, if so, to better understand what factors are important in the bond rating agencies' review. Each of these research topics is discussed in greater detail in Appendix G which is available as part of NCHRP Web Document 63. The research team suggests that rec- ommendations be developed for each of the topics, to be presented at a second state DOT conference on GASB 34 implementation.