With a certain prescient pessimism, the Governmental Accounting Standards Board has issued an exposure draft of a proposed standard that provides guidance for governments that file for bankruptcy protection under Chapter 9 of the U.S. Bankruptcy Code.

The proposal applies to municipalities, counties and other government entities smaller than states. These rarely find themselves filing for bankruptcy, but in truth, it has happened almost 600 times since 1934, and given current financial woes across the country, it can certainly happen again - in fact, it's already happening in Vallejo, Calif., and Jefferson County, Ala.

GASB project manager Wesley A. Galloway said that the project has been on an expedited schedule since deliberations began in December of 2008. "The board was a little concerned that, with the current economic environment, guidance would be needed in this particular area," he said. "Folks are looking over the horizon and seeing some storm clouds out there."

Municipal bankruptcies are especially thorny because of their widespread ramifications, and because a city cannot simply go out of business and disappear.

There is no accounting guidance written specifically for governments under Chapter 9 protection. The closest guidance is the American Institute of CPAs' Statement of Position 90-7, which applies only to organizations under Chapter 11, and it expressly does not apply to governmental organizations. Statement 15 of the Financial Accounting Standards Board, Accounting by Debtors and Creditors for Troubled Debt Restructurings, also applies only to Chapter 11.

Dr. Keren H. Deal, an associate professor at Auburn University - Montgomery, has done extensive research on municipal bankruptcies, and her findings are somewhat disturbing. "I found that not many accountants or auditors were aware of how to handle a municipal bankruptcy, because there's very little information from a financial accounting perspective," she said.

Deal said that she expected a rise in municipal bankruptcies not only because of the economy, but because there has been a rise in services offered by municipalities and a concurrent drop in tax revenues. Though municipal bankruptcies may not become endemic, Deal said, the ill effects can spread as one town's bankruptcy drives down the bond ratings of neighboring towns.

The chief difference between Chapter 11 and Chapter 9 protection is that under the latter, only some of a government's debts are subject to adjustment. Restructuring is generally effected by extending debt maturities, reducing the amount of principal or interest, or refinancing debt with additional borrowings. Governments also have the power to reject and renegotiate unexpired leases and executory contracts, including collective bargaining agreements and retiree benefit obligations. Revenue-backed debt is generally not affected.

GASB's Galloway said that governmental bankruptcies are significantly different from bankruptcies in the private sector. Courts determine much of what happens as private companies go through the process, but governments are expected to formulate a plan and then follow it as they see fit.

The board had expected the project to be relatively simple, but it hit up against complications in how best to recognize the adjustments that are made in bankruptcy. The Statement 15 principle primarily recognizes the interest rates on adjusted debt as the mechanism behind reducing interest rate payments, with principle reduced only when the interest rate goes below zero. The board rejected that approach and decided that when a court approves a debt adjustment plan, the accounting should honor the plan as it is, reporting reductions in principle or interest rate or both, as specified in the plan.

The exposure draft requests opinions on that approach, as opposed to a suggested alternative in which reductions in future cash outflows for debt, whether they relate to principle or interest, should be reflected as a gain because the net present value of the debt has been reduced.

The proposed statement applies to any "political subdivision or public agency or instrumentality of a state" that has been granted relief under Chapter 9, including those that are not expected to emerge as going concerns.

If approved, the statement will be effective for periods beginning after June 15, 2009, with retroactive application for all prior periods presented during which a government was in bankruptcy.

(c) 2009 Accounting Today and SourceMedia, Inc. All Rights Reserved.

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