The state as business partner

New public sector accounting standards will open new doors for the financial services industry, say Hans-Jürgen Dannheisig and Clemens Schuerhoff

Until now many financial service providers have seen little cause to get to grips with the ins and outs of doing business with the German state. It is a market with both enormous potential and hidden complications. These include arcane decision-making processes, unclear liquidity parameters, tight regulations, a need to compete in international tenders for larger deals and the difficulty of identifying target lists. Little wonder, then, that sales directors of asset management firms and banks tend to focus on other client segments.

The root of much of this complexity lies in the principle of single-entry accounting, which has been persistent in Germany until now.

Why is it time to view the German state as an attractive client base? The rationale lies in the switch from single-entry to double-entry accounting, which began in the late 1990s and is now central to the drive to modernise public sector finances. The many departments concerned are about to adopt the new regime. When they do, the consequences will be extensive, including attractive opportunities for institutional firms. 

Doppik is a comprehensive method for presenting the income, financial and asset positions of local councils. Justice for generations means the costs of any financial period should be balanced by current earnings rather than being borne by the following generation. Depreciation costs and reserving funds for future use are key features of Doppik.

The adoption of double-entry accounting amounts to a paradigm shift in Germany. It will particularly affect the way public sector decision-makers perceive their budgets. The cash-flow statement (inflows and outflows) and results statement (earnings and expenses) are the building blocks of the new accounting regime. The principle of balancing assets and liabilities is also introduced. Alongside ‘production' - all important state services are called products - the public asset position will be listed and valued, a completely new concept in this sphere.

The reporting method is based on the valuation requirements set out in article 252 of the German Commercial Code. For example, every public department will have to construct an opening balance sheet. Every asset must therefore be valued - at the local council level this will include streets, traffic lights, public buildings, libraries and other infrastructure.

The role played by finance officials - treasurers in the case of local authorities - will gradually change. The responsibilities and qualifications of treasury staff will start to resemble those of private businesses. The treasurer will become the council finance director and will significantly contribute to information management within the state apparatus. Control mechanisms will open to modernisation, making the consequences and risks associated with any given decision more transparent.

Substantial differences to commercial law will, of course, remain.

The advantages to the new financial regime include:

Greater transparency/comparability with the private sector (organisations which post balance sheets under commercial law); Greater political control; Better data for political decision-making; Focus on output will support a results-oriented approach; Control tools will primarily be the balance sheet and results statement; Performance and resource-based accounting; The supervision of targets and measures to address the failure to meet them will be future goals; Depreciation no longer means investment costs are borne solely by one financial year; for externally financed projects, depreciation in double-entry accounting corresponds to the old system of repayments; and Repayments and running pension costs no longer appear in the budget.

The disadvantages include:

Charges become visible: depreciation of capital assets, funding rate for spending provisions; Balancing the budget, for example for pensions; Use of the balancing contingency (in the transitional period excess liabilities can be airbrushed out of the double-entry system); Budget security system must be established; Difficulty of valuing municipal assets; Active project management and winning acceptance within the local authorities; and Higher cost (IT-systems, consulting costs, resources, etc).

North Rhine-Westphalia was the first state to pass an introductory act for budgetary reform (law for local council finance reform), setting a deadline of 2009 for the switch to double-entry accounting.

By the start of 2007, roughly a third of all local authorities in North Rhine-Westphalia had adopted the new regime. These were predominantly the ‘healthy' municipalities. The states of Hesse, Baden-Württemberg and Lower Saxony also started the transition some years ago. In addition, some towns and local councils have already adopted double-entry bookkeeping under pilot schemes and some states have granted their municipalities the right to vote on whether they want an extended version of the old rules or the double-entry system. But despite these voting rights, it is widely expected the latter will prevail.

As yet, there are no concrete signs of motions for change at a federal level. Given that the switch to double-entry accounting will have an enormous impact on all German public finances, it is extraordinary it has received no broad public attention. We are convinced that the new rules, with the benefits of transparency and an even balance-sheet they will bring to state finances, will lead to the kind of public discussions which at this stage can only remain a pipe dream. This is particularly the case at federal level.

The most important changes will occur in the management of state assets and finances.

These include:

Pension obligations; Balancing the budget; Need for high standards in transition/active project management; Difficulty of valuing council assets; Updating IT systems - opportunity for software providers; and Need for consultants - opportunity for consulting firms.

Managing the state's pension obligations is a key factor and one that provokes much speculation about potential forms of co-operation between the financial services industry and the public sector. The changes in financial management will cause many public bodies to discover they need to define and evaluate their pension costs and set aside reserves.

Our research did not find a single expert who dared give an estimate for the total pension obligations of all state departments and companies. But going by the costs of larger municipalities, which reach hundreds of millions or even billions, the amount is astonishingly high.

The function of pension reserves is to allocate funds fairly on the basis of the number of years employees have served. The reserves will then anticipate any indirect and direct pension obligations assumed by the public body. Pension reserves must be aligned with the cash value of pension credits accumulated by employees up to the financial closing date.

Payments made to external pension funds (the Federal and State Government Employees Retirement Fund VBL, land pension funds, municipal pension funds and so on) do not necessarily mean departments no longer need to set aside reserves.

When pension costs are taken out of the equation, the public sector will face different decision-making conditions. The new transparency will increase pressure to plan ahead. There will also be a strong trend towards financing pension costs. The city of Düsseldorf, for example, has just announced that it will fund more than €700m of pension obligations. It is also likely that the practice of putting pension costs off balance sheet in the form of contractual trust arrangements (CTAs) will also work its way into the public sector.

This will all present a vast opportunity set for financial services providers.

In conclusion, double-entry accounting will provide the public sector with an important support structure for managing state assets, but it is no sure guard against inefficiency or mistakes. It is no more than a disciplinary tool. Further caveats:

Balancing the budget (the regional authority retains its assets): double-entry accounting will only point to the most efficient possible path to a given goal; Like their predecessors, the new public accounting laws cannot take account of factors which are not subject to market forces or prices; The social consequences of actions taken by local authorities are not sufficiently clear; there is a risk of mistakes.

The change to double-entry accounting is a time bomb for German pension liabilities. It is a very sensible and long overdue step on the road to a funded public social security system. Asset management and pension companies now face an attractive but difficult new market.

Kommalpha has studied the possible consequences of introducing double-entry accounting into the public sector for many years. We urge all service providers to build expertise. Now is the time to make decisions and develop services. But we would advise against euphoria.

Hans-Jürgen Dannheisig and Clemens Schuerhoff are managing partners at Kommalpha Institutional Consulting GmbH, Hannover