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Commonwealth’s finances in dire shape

Official financial statements show accumulated deficit of almost $13 billion

BY CARLOS MARQUEZ of Caribbean Business

June 17, 2005
Copyright © 2005 CARIBBEAN BUSINESS. All Rights Reserved.

The commonwealth government is spending $1.75 for every dollar it receives, excluding federal grants

The finances of the government of Puerto Rico are badly in need of repair, and there will be no quick fix. For years, the commonwealth government has been spending more than it received, accumulating a deficit that reached nearly $13 billion by June 30, 2004–one year ago. While much has been said over the past six months regarding the Commonwealth’s structural fiscal deficit, no attention has been given to the government’s overall financial situation.

CARIBBEAN BUSINESS has obtained the Commonwealth of Puerto Rico’s Comprehensive Annual Financial Report (CAFR), and the numbers aren’t good. The CAFR reflects an accumulated deficit of $12.8 billion up to the fiscal year ended June 30, 2004. The annual report also shows deterioration in the Commonwealth’s financial position by nearly $3 billion from fiscal 2003. The Commonwealth’s financial statements for fiscal 2004 were prepared by the Puerto Rico Treasury Department (Hacienda) and audited by KPMG LLP, the independent auditors’ firm previously known as Peat Marwick. The audit report is dated April 8, 2005.

The CAFR’s bottom line: The Commonwealth’s finances are in terrible shape.

Financial statements are prepared to show companies’ or organizations’ economic performance. The balance sheet provides a snapshot of the assets, liabilities, and capital of the organization; and the income statement, or profit-and-loss account, shows the difference between total revenue received and total expenses. These statements are audited by independent auditors, who vouch the financial reports have been presented "fairly." Commonwealth statutes require an annual audit of government finances by independent certified public accountants to provide reasonable assurance the financial statements prepared by the government for the fiscal year are free of material misstatements.

The Commonwealth’s financial statements provide a broad view of the government’s operations in a manner similar to a private-sector business. The statements provide both short- and long-term information on the government’s financial position, which help assess the Commonwealth’s economic condition at the end of the fiscal year. The snapshot of Commonwealth finances for the fiscal year that ended June 30, 2004, reflects a dismal picture.

Deteriorating financial conditions

In fiscal 2004, the Commonwealth’s governmental activities reported total revenue of $12.2 billion and $15.2 billion in total expenses. In other words, the government spent about $3 billion more than it received.

The government is spending $1.25 per dollar of income, including grants received by the primary government (mostly from the federal government), or almost $1.75 if we exclude external grants.

Total government expenditures, including all fund types, went from $10.3 billion in the fiscal year ending June 30, 2001, to $15.2 billion in fiscal 2004, a 46.4% increase in four years. By comparison, from fiscal 1997 to fiscal 2001, total government expenditures grew from $9.3 billion to $10.3 billion, an increase of only 10.4% in four years.

These financial statements are prepared using methods similar to those applied by most businesses. They take into account all revenue and expenses connected with the fiscal year, even if the cash involved hasn’t been received or paid. The governmentwide financial report includes two statements: Statement of Net Assets and Statement of Activities.

The financial statements consist of separate sections for three types of Commonwealth activities: governmental activities, business-type activities, and component units. The primary government includes governmental activities and business-type activities.

Commonwealth government activities

Government activities are those mostly supported by taxes and federal grants. Most functions associated with the commonwealth government fall into this category, such as general government, public safety, health, public housing, welfare, education, and economic development.

Commonwealth’s business-type activities

Business-type activities include those government activities intended to recover all or a significant portion of their costs through user fees or charges to users for goods and services. Included in the business-type category are such major funds as the unemployment insurance trust fund and the lotteries.

Commonwealth component units

Component units are legally separate from the Commonwealth, but the government is either financially accountable for them or the nature and significance of the relationship with the Commonwealth is such that their exclusion would cause the government’s financial statements to be misleading or incomplete.

Component units are divided into "blended units" and "discretely presented units." The Commonwealth’s three blended-component units include the Public Buildings Authority, Puerto Rico Maritime Shipping Authority, and the Children’s Trust. The discretely presented component units consist of 37 public corporations, including the Government Development Bank (GDB), University of Puerto Rico, Economic Development Bank of Puerto Rico, and the Puerto Rico Aqueduct & Sewer Authority (Prasa).

Primary government activities benefited from the government business-type activities since these reported total revenue of $1.2 billion, which exceeded the total expenses of $901 million, the difference helped reduce the primary government deficit by about $200 million.

According to the CAFR, the Commonwealth’s total deficit increased by $2.77 billion (a 26% increase) during fiscal 2004. Over time, increases or decreases in the Commonwealth’s net assets serve as a useful indicator of whether the Commonwealth’s financial position is improving or deteriorating.

An analysis conducted by CARIBBEAN BUSINESS of previous CAFRs demonstrates that over time the Commonwealth financial position has been deteriorating rapidly. For example, on June 30, 2001, according to the KPMG audited reports, primary government net assets reflected an accumulated deficit of $7.76 billion. By June 30, 2002, the Commonwealth’s accumulated deficit had increased to $9.40 billion and to $11.22 billion by June 30, 2003. As of June 30, 2004, the government’s accumulated deficit reached $12.8 billion, for an increase in the deficit of more than $5 billion or 65% in just three years.

Primary government activities show a deficit of approximately $13.7 billion as of June 30, 2004, mostly attributed to the long-term obligations that amounted, at the time, to approximately $23 billion, which is recognized in the statement of net assets. Compared to 2003, long-term obligations increased by $4 billion, or 21%; if this trend continues, the Commonwealth’s long-term obligation will double in less than five years.

On the other hand, the discretely presented component units (or public corporations) reported net assets of approximately $16 billion. This inverse relation between governmental activities and component units’ net assets reveals the operational structure of the Commonwealth, where the primary government issues debt, the proceeds of which are predominantly transferred to the component units and to other government municipalities, to finance capital improvement projects and other operational needs. Although the component units, or public corporations, have a $16 billion surplus, the net assets available for current operations (excluding capital assets and restricted funds) show a deficit of $660 million, a figure more indicative of the public corporations’ real financial condition.

The commonwealth government can impose its will on each of the public corporations through the appointment of the members to the governing boards.

For example, the GDB is governed by a seven-member board appointed by the governor; Prasa is governed by a nine-member board comprised of five members appointed by the governor; the Puerto Rico Electric Power Authority (Prepa) is governed by a nine-member board comprised of the secretary of the Department of Transportation & Public Works (DTOP by its Spanish acronym), six members appointed by the governor with the advice and consent of the Senate, and two members representing the consumer interest elected in a referendum as in Prasa; the Puerto Rico Highways & Transportation Authority is governed by the secretary of DTOP; and the Puerto Rico Infrastructure Financing Facility is governed by the board of directors of the GDB and the Treasury secretary.

The same situation applies to nonmajor component units. For example, the Agricultural Services & Development Administration is governed by the Agriculture secretary; the Puerto Rico Metropolitan Bus Authority is governed by the DTOP secretary; and the Puerto Rico Ports Authority is governed by the DTOP and Economic Development & Commerce secretaries and the executive directors of the Puerto Rico Industrial Development and Tourism companies.

The three blended-component units, while legally separate from the Commonwealth, meet the criteria to be reported as part of the primary government because they provide services entirely, or almost entirely, to the Commonwealth.

Commonwealth financial position

Net assets may serve over time as useful indicators of the government’s financial position. As of June 30, 2004, the total assets and liabilities of the Commonwealth’s primary government amounted to $12.9 billion and $25.7 billion, respectively, for a net deficit of $12.8 billion, a $2.7 billion increase in the deficit.

In just one year, the excess of expenditures over revenue increased by 59%, which resulted from an increase in primary government expenditures of nearly $1 billion, while the revenue decreased by more than $70 million.

Total assets increased by $1 billion during fiscal 2004 when compared to the previous fiscal year. The CAFR noted the key element for this increase was a $1 billion increase in restricted cash in comparison to fiscal 2003. This increase primarily resulted from unused proceeds derived from the issuance of facilities revenue bonds by the Public Buildings Authority (PBA), which amounted to $490 million; unused proceeds from capital fund program bonds amounting to $734 million; and additions of capital assets and depreciation expenses of $491 million and $188 million, respectively.

Governmental activities decrease the Commonwealth’s net assets by $2.8 billion, compared with a decrease of $1.7 billion in the prior year. Key elements of this variance included a $400 million reduction in federal grants, a $189 million increase in expenses at the Department of Education in fiscal 2004, and a $168 million decrease in the transfer of land and recreational facilities to municipalities, according to the CAFR.

Total liabilities increased $2.7 billion during fiscal 2004 when compared to the prior year. The key elements for this increase are mostly due to a $4.5 billion net increase in debt issued or refunded, consisting of issuances during fiscal 2004 of the Commonwealth’s general obligation bonds, appropriation bonds, and notes payable to $3.6 billion, $888 million, and $5.5 billion, respectively, partially offset by repayments and defeasances of such debt in the amount of approximately $7 billion, according to the CAFR report.

However, even while the CAFR only highlights a $189 million increase in expenses related to the Department of Education, the actual increase in total expenses was $1.1 billion. Government activities were able to compensate for most of the reported $400 million decrease in federal grants by imposing an increase in general revenue in the form of local taxes.

Approximately 58% of the Commonwealth’s total revenue came from taxes, while 28% resulted from grants and contributions, primarily federal government financial assistance. Fees and charges for various goods and services provided 14% of the total revenue. Commonwealth expenses cover a range of services with education, public housing, welfare, and health, the largest expense. In 2004, governmental activity expenses exceeded program revenue, resulting in the use of $8 billion in general revenue (mostly taxes). On the other hand, program revenue from business-type activities in 2004 exceeded expenses by approximately $296 million, resulting in the use of $24 million in other general revenue.

General fund deficit

The general fund is the principal operating fund of the Commonwealth. For fiscal 2004, the excess of expenditures over revenue (the amount overspent) reported by the general fund reached $1.5 billion. The Commonwealth had to seek other financing resources, mostly issuance of long-term debt and net transfers from nongovernmental funds, of $1.2 billion to bring down the deficit for the year to a more manageable $300 million. If we add all governmental funds, the amount overspent in fiscal 2004 reached $3 billion, which was the deficit covered principally by the issuance of long-term debt.

Actual revenue exceeded final budgeted revenue by $62.8 million. The net increase was primarily attributed to revenue derived from a tax-incentive plan designed to attract tax debtors; contributions made by component units (public corporations) to the general fund in excess of anticipated amounts and a decrease in excise-tax revenue. Other revenue primarily comprised of fines, penalties, registration fees, and customs duties also reported an increase during 2004. The actual expenditures reflected an increase of $613 million when compared to the final budgeted amounts.

The variance in expenditures predominantly was caused by the Department of Education, with $302 million (a nontrivial 12.5% in budget overruns), the Department of Transportation & Public Works with $80 million, the Department of Health with $89 million, and the Social Economic Development Administration with $34 million. Most variances were financed through borrowing, which provided resources of $695 million. The proceeds from these borrowings are presented separately in the statement of revenue and expenditures: budget and actual, budget basis, and general fund. Transfers to other funds exceeded the final budget by $15 million, in addition to transfer shortfalls from other funds of $237 million. On a budgetary basis for fiscal 2004, there was an excess of expenditures and other uses over revenue and other sources of $108 million.

Capital assets

The Commonwealth’s investment in capital assets for its governmental and business-type activities as of June 30, 2004, amounts to $8.2 billion, an accumulated depreciation of $2.1 billion, leaving a book value of $6.1 billion. This investment in capital assets includes land, buildings, building improvements, equipment, and construction in progress. Actual expenditures to purchase or construct capital assets were approximately $1 billion for the year. Depreciation charges for the year totaled $189 million.

The net book value of the Commonwealth’s capital assets as of June 30, 2004, was distributed by function/general activity, including 17% for government; public safety 14%; health 4%; public housing and welfare 35%; education 29%; and economic development 1%. The infrastructure asset, representing items that normally are immovable and of value only to the government, such as roads, highways, bridges, toll facilities, water, and systems, lighting production, transmission, and distribution systems, and similar items, principally are owned by the component units of the Commonwealth and not included in governmental and business-type activities.

Credit-rating statements in previous reports

Concern over the Commonwealth’s financial situation has led the credit-ratings agencies Moody’s Investors Service and Standard & Poor’s (S&P) to downgrade the government’s bonds. Although the Commonwealth’s financial situation was deteriorating over the past several years, it wasn’t reflected in the previous statements issued by the Treasury secretary in past years’ audited statements (CAFRs).

On Feb. 28, 2002, then-Treasury Secretary Juan Flores Galarza wrote in the CAFR that as of June 30, 2001, the Commonwealth had a number of debt issues outstanding, including approximately $5.6 billion in general obligation bonds (GOs) and approximately $1.7 billion in revenue bonds, including $1.6 billion of the Public Buildings Authority.

The Commonwealth has maintained an A credit rating from S&P and a Baa1 from Moody’s Investor Service on GO issues, and "we expect these classifications will be maintained or improved in future years," Flores Galarza stated.

By October 2001, S&P had downgraded its outlook on Puerto Rico from stable to negative. Three months after Flores Galarza’s letter, in May 2002, S&P downgraded the Commonwealth’s GOs rating from A to A-.

In his transmittal letter included in the 2002 CAFR and dated May 30, 2003, the former Treasury secretary wrote that the Commonwealth has maintained an A- credit rating from S&P, a Baa1 from Moody’s, and again repeated expectations that these classifications will be maintained or improved in future years. Only a month earlier, in April 2003, S&P had lowered the outlook on its A- classification on Puerto Rico’s GOs from stable to negative.

Flores Galarza’s 2003 statement accompanied the 2002 financial report, which stated the Commonwealth’s total long-term obligations had increased by $1.47 billion (8.8%) during the fiscal year and mentioned as a key factor in the increase the issuance of $2.7 billion in GOs and the GDB securing approximately $2.443 billion in loans and advances made to the Commonwealth agencies and corporations. During the fiscal year, the net-assets deficit had increased by $1.63 billion, a 21% increase.

In his transmittal letter accompanying the fiscal 2004 annual report, Treasury Secretary Juan Carlos Méndez is more cautious as he states they are "focusing" their efforts to maintain or improve the ratings.

While the Commonwealth already had the lowest bond ratings of any state in the U.S., before this latest downgrade, Moody’s downgraded the Commonwealth’s long-term GOs from Baa1 to Baa2 and S&P followed with a downgrade from A- to BBB.

No Certificate of Achievement for fiscal 2004

Since fiscal 1996, the financial statements prepared by the Treasury secretary have carried a copy of the Certificate of Achievement for Excellence in Financial Reporting, presented by the Government Finance Officers Association of the U.S. and Canada. The Certificate of Achievement is a prestigious national award that recognizes conformance with the highest standards for preparation of state and local government financial reports. This practice was introduced in Puerto Rico under the administration of former Gov. Pedro J. Rosselló. No certificate was presented for fiscal 2003. The certificate included in the 2004 CAFR was issued for the financial statement for the fiscal year ended June 30, 2002.

To be awarded the Certificate of Achievement, a government unit must publish an easily readable and efficiently organized Comprehensive Annual Financial Report (CAFR), whose contents conform to the program standards. The CAFR must satisfy generally accepted accounting principles and applicable legal requirements. A Certificate of Achievement is valid for only one year.

This Caribbean Business article appears courtesy of Casiano Communications.
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