A Review of DOT Compliance with GASB 34 Requirements (2004)

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46 CHAPTER 6 INFORMATION GAPS AND RESEARCH NEEDS METHODS FOR CONDITION ASSESSMENTS AND PRESERVATION Summary While conducting the initial survey and follow-up case study interviews on GASB 34 implementation, the research team became aware of some issues and concerns of the state DOTs requiring additional information and research. As acknowledged by GASB Chair Tom L. Allen, “Statement 34 is the most significant change to occur in the history of gov- ernment financial accounting.” A change of this magnitude undoubtedly will require several years for affected agencies and their financial and management systems to fully absorb and make necessary adjustments. More specifically, there is a need for more detailed research on condition assessments and preservation methods that could (1) allow more integration of asset management data into the financial statement reporting process and (2) lead to better preservation results. Background GASB 34 required the implementation of a modified approach for the incorporation of condition assessment data into the financial statements. GASB reviewed a number of approaches generally based on methods of measuring whether or not infrastructure assets were being preserved. During the development of Statement 34, GASB heard from engineers and transportation finance officers and learned that, although these approaches are of great value in managing infrastructure assets, they have not developed to the point at which “consis- tent methods or measurement scales can be used to assess condition’s sufficient for recognition in financial statements.” The Board concluded that “additional research is needed” to determine if a workable, comprehensive “preservation method” can be developed (GASB 34 paragraph 340). More recently, the Board has identified a long-term goal to move toward finer gradations of review rather than the cur- rent “on-off switch” determination on whether preservation targets have been achieved. The Board plans to add a project to its agenda to address this issue. The research has shown that many transportation and finance officials think that depreciation of infrastructure is meaningless because it does not reflect how assets are man- aged or used. Nevertheless, the team’s research also demon- strates that many DOTs (in fact, a slight majority) selected the depreciation approach for FY2002 because of a lack of comfort with condition assessments and preservation model- ing and the uncertainty of having to shift from the modified approach to the depreciation model if targets are not met. It has been suggested that if a more consistent method for condition assessments and preservation could be developed, a long-term approach to reporting condition assessment data in the financial statements that would relate to funding of preservation (similar to how pension expense is now reported by employers—see NCHRP Web Document 63) would be more meaningful than the current modified approach. If GASB ultimately were to approve an infrastructure financial reporting approach similar to that used for pensions, then some improvements suggested below might be implemented. Parameters would be used that would bring consistency to the process, but allow divergence in practice, based on the characteristics of the state infrastructure. GASB staff have indicated an interest in tying condition assessment and preservation data to the financial statements (i.e., this would be desirable within the next 5 years). The methods so developed would NOT be intended to com- pare state DOTs—indeed, pension reporting does not com- pare pension plans of governments. Rather, the methods would be intended to bring consistency in approach of mea- suring how well the DOT is preserving infrastructure in com- parison with where the DOT wants to be with preservation. Unlike the current modified approach, the financial state- ments would directly report estimated preservation require- ments as a separate element of expenses, rather than identify that information reported as “required supplementary infor- mation.” This is exactly the type of measurement pension financial statements report—funding requirements based on one of several actuarial parameters. Consistent methods would lead to more comfort among DOT and finance personnel with using condition assessments. Most important, GASB 34 has already given momentum to better asset management. The development of consistent methods leading to a different financial statement approach will continue that momentum. To assist in this process, the research team suggests that the list of specific topics below warrant additional investiga- tion. Further, this investigation should be conducted with

47 formal involvement of the GASB staff in order to enhance the effectiveness of the investigation. Also, near the conclusion of this research project, the research team began hearing anecdotal reports of local gov- ernments receiving improved bond ratings after preparing FY02 financial statements in accordance with GASB 34’s modified approach. The bond rating agencies did not officially disclose the reasons for rating adjustments, but the govern- ments involved appear convinced that the modified approach was responsible. They used the Management Discussion & Analysis to disclose that they were effectively preserving their infrastructure and thereby were not accumulating unfunded liabilities for future generations to address. These governments believe that the rating agencies were favorably impressed by this analysis and adjusted ratings accordingly. RESEARCH TOPICS 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 best practices for the DOTs to select from based on specific cir- cumstances. This approach is consistent with current GASB philosophy, which relies on principle-based standards, rather than a more prescriptive detail-oriented approach. Methods for Condition Assessments As noted above, GASB developed a “modified” rather than a “comprehensive” approach for condition assessment report- ing because consistent condition assessment methodology has not yet been developed. Further, there is a lack of com- fort of some DOT and finance officials with the use of con- dition assessments. The objective of this research topic would be to develop more detailed, but still voluntary, methods for consistent condition assessments and disclosures that could (1) prove sufficient for future comprehensive GASB recognition and (2) result in more comfort and acceptance by DOT officials. Linking Condition Targets to Required Expenditures Virtually all modified approach states experienced diffi- culty in estimating the expenditure level necessary to achieve targeted conditions. In theory, such estimates should be avail- able from asset management systems (e.g., the PONTIS bridge management system). However, the DOTs report that the cur- rent stage of deployment of such systems is not sufficiently mature to generate reliable estimates, with availability of data a particular problem. This finding is confirmed by earlier research that indicated that DOTs typically are not taking full advantage of the capabilities inherent in these systems. A second problem is that the GASB 34 definitions of expenditure categories are not consistent with the definitions traditionally used in the management systems (and in DOT budgeting). Because of these two factors, the DOTs’ esti- mates of required expenditures are based more on historical funding and budgetary patterns, rather than an analytically based estimate as GASB had anticipated. As the deployed capabilities of the management systems improve over time, this issue probably will become less troublesome. In the near term, however, there is a discrepancy between GASB expec- tations and DOT realities. The objective of this research topic would be to identify practical near-term methods of arriving at an expenditure tar- get and comparing that target with actual expenditures in a manner that meets GASB’s objectives while still being as consistent as possible with the capabilities of DOTs’ manage- ment systems as currently deployed. Cost Categories—Capitalized Versus Expensed As noted above, 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 cat- egories—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 ser- vice. 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 proj- ect is viewed as preservation, whether or not there are ancil- lary safety benefits. These definitions are significant because they determine whether costs are to be capitalized or expensed in the financial statements. In particular, preservation costs are to be expensed in modified approach states, but research indicates that this is often not the case. GASB has suggested that a potential solution 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. Some DOTs have suggested that the difference between the two approaches is not material for the purposes of financial statements. The objective of this research topic would be to first assess the materiality of the difference between the two approaches by analyzing the annual construction program of a represen- tative (but small) state. If the difference is material, the next step would be to develop a more sophisticated approach to cost categorization that would be meaningful to DOTs while still satisfying GASB objectives. Application of FHWA def- initions would be investigated. Additions and Retirements Most DOTs had difficulty in accounting for additions to and retirements of infrastructure assets in their financial state- ments. They have, of course, traditionally tracked such changes in their physical inventory systems, but before GASB 34,

there was no reason to create a link to costs reported in the accounting system, disaggregated by asset class. Some DOTs (e.g., Michigan) were able to address this requirement through the use of work type codes. The objective of this research topic would be to further develop the approaches employed by Michigan and others into a tool for additions and retirements that could be applied by many states. Required Shift to Depreciation Several DOTs questioned the wisdom of requiring a state to shift from the modified approach to depreciation if the con- dition targets were not achieved. They noted that a recurring failure to achieve targets indicated a problem, one that war- rants public scrutiny. Requiring a shift to depreciation seems to suggest that, in effect, the solution to the problem is to stop disclosing it. (However, GASB notes that the logic behind requiring governments to begin depreciating if the infrastruc- ture is not at or about the established condition level is that because the condition of the asset has dropped below a sus- tainable level, it can no longer be preserved indefinitely. Its useful life has gone from indefinite to definite.) The DOTs suggest that states be permitted to continue using the modi- fied approach and that the shortfall continue to be reported, much as a shortfall in a pension program is reported. The objective of this research topic would be to devise a method by which a state not meeting its condition targets could continue to use the modified approach, if it so chose. This method, which ultimately would have to be approved by GASB, would involve directly reporting preservation infor- mation in the financial statements, as discussed above. Potential Effect on Bond Ratings As noted above, several local governments have reported improved bond ratings as a result of preparing financial state- ments in accordance with the modified approach. Although a comprehensive review of local governments’ compliance with GASB 34 is outside the scope of current or proposed NCHRP research, these reports are clearly of great interest to the state DOTs. If confirmed, there could be a substantial effect on how state DOTs comply with GASB 34. Of equally great interest would be to gain insight into the bond rating agen- cies’ thinking as they determine whether a particular presen- 48 tation in Management Discussion & Analysis is sufficiently persuasive to warrant an improved rating. The objective of this research topic would be to confirm whether improved bond ratings have indeed occurred because of adherence to the modified approach and, if so, to better understand what factors are important in the bond rating agencies’ review. RESEARCH METHODOLOGY Research would be performed through the following activities: 1. Enhance initial data collection on infrastructure report- ing techniques with a follow-up questionnaire, for all states and selected local governments, that focuses on the research topics noted above. 2. Review and analyze data with follow-up telephone and site visits to selected states. 3. Determine best as well as most common practices, high- lighting differences where appropriate for various state characteristics. 4. Outline multiple approaches as parameters for use in conducting condition assessments. 5. Review results with bond rating agencies to gain insight into their assessment of the effectiveness of various approaches. 6. Identify a list of recommended solutions for each of the items identified in the Research Topics section above. Review these recommendations with GASB and pre- sent them in cooperation with the GASB staff at the conference described in Step 7. 7. Conduct a second conference on GASB 34 implemen- tation by state DOTs. (During the original survey and follow-up case study interviews, it was remarkable how many states noted the 2001 AASHTO conference con- ducted in Tennessee as a key step in their planning process. The research team believes that many DOTs would welcome the opportunity to compare notes again after the initial 2 years of implementation. The confer- ence could also be used to present and receive feedback on the research topics described above.) 8. Throughout, consult with the NCHRP panel and GASB staff for direction that will result in a high probability of achieving complete integration of asset management techniques in the financial reporting process.