City of San Angelo's CAFR: Huge Unfunded Liabilities Loom

Local accounting firm Armstrong Backus presented its Comprehensive Annual Financial Report (CAFR) for fiscal year 2011-2012 to San Angelo's City Council.  The report is noteworthy in many ways. 

Freddy Moore, Partner, Armstrong, Backus & Co., LLP and Gayla Thornton, Principal, Armstrong, Backus & Co., LLP

Here's how Freddy kicked off the presentation:

Our job is...we were engaged to render an opinion on the basic financial statements.  We do that, so an audit, just for a point of clarification, we don't look at all the transactions.  We have to go in there and use materialities and scopes and we test the various account balances and transactions for the purpose of giving, that we can obtain reasonable assurance that there are no material misstatements in there.  Some people think an audit is where we verify every detail and transaction down to the penny.  That's not the case.

The City received an unqualified opinion from Armstrong Backus.  Presenters gave a 30,000 foot view of the city's financial position at the end of FY 2012, i.e. a picture well over one year old. Highlights of their presentation included:

1.  Total assets as of 9-30-12 were $492 million, with $266 million total liabilities, which includes $241 million in long term debt.
2.  City's net assets/equity is $226 million up from $216 million for the prior year.
3.  Total revenue (taxes/fees) reached $121 million.   The city spent $110 million in expenses for the same period. 

The city's balance sheet carries a nearly 50% long term debt load.  Other cities are more highly leveraged, but San Angelo faces massive infrastructure demands for streets and future water supplies.

4.  There are $7 million in unrestricted net assets as of 9-30-2012.

One of the city's unrestricted funds is the employee/retiree health fund, with $1.1 million in net assets as of 9-30-12.  The health fund grew by over $550,000 during the fiscal year which spanned two major moves by the city.

Calendar year 2011 saw the city implement draconian premium hikes for dependents, causing 192 people to drop health insurance coverage.

In 2012 the city budgeted no new money for health insurance and signed an exclusive provider arrangement with San Angelo Community Medical Center.  The windfall produced by this arrangement is not in the CAFR presented.

However, the $1.1 million employee/retiree health fund comprised 16% of the city's $7 million in unrestricted net assets for FY 2012.

5.  San Angelo's Water and Sewer fund is significant, comprising $41 million of the city's $121 million in total revenue (taxes/fees).   Water/sewer fund assets were $134 million of the city's $$226 million in net assets, nearly 60% of  the total.

This revenue stream will be important when the city's balance sheet blows up in the future due to unfunded liabilities (see item 7).

Gayla spoke about the city's compliance with federal grant requirements and touched on future changes in the audit scope:

6.  The city expended $5 million in federal grants during FY 2012.  The handling of federal grants once again became an issue.  The city submitted reports to the federal government stating it spent money prior to actually doing so.  This was a significant deficiency for the second year in a row.  Upon hearing CFO/Assistant City Manager Michael Dane's solution to this deficiency, the auditor said "Hopefully."   

Last year Dane washed his hands of grant accounting, claiming a grants person needed to be hired.  This year he said an internal auditor would take on this responsibility.  Also, there was no mention of federal Early Retiree Reinsurance Program funds in the audit, either the amount used or the city's compliance with ERRP's maintenance of contribution requirement.

7.  Unfunded liabilities for retirement and health insurance are mostly absent from the 2011-2012 CAFR. The pension unfunded liability will be large, very material. 

Auditors reported that the unfunded liability for retiree/employee health insurance is being added incrementally.  It amounts to $4 million per year, but totals $80 million.  The auditor would not state the pension unfunded liability, but last year this was nearly $40 million.  These two items combined total $120 million.   

8.  COSADC will not be included next year.  

This will decrease the city's revenue by $8.5 million and fund balance by $10 million.  It's not clear if the Hickory Acquifer obligation will go with it:

2011-B Series Drinking Water SRF Promissory Note to Texas Water Development Board, original issue amount of $120,000,000, secured by utility revenues, interest rates of 0.00%-2.07%, final maturity September 15, 2031.

I doubt it will.  Items 7 and 8 stand to give the City's balance sheet a substantial haircut.  Ex-Mayor/Angel Investor Alvin New wanted the city's pension fund to go after return, which involves risk.  Will City Council concur and roll the dice?

Other strategies include selling off a revenue source for a pile of cash.  The City's water/sewer business is substantial and lucrative.  Private equity firms have targeted public infrastructure for investment.  It would not surprise me to see the city privatize its water/sewer business and for Alvin New and former Water Chief Will Wilde to somehow be involved in this evolution.  But then I speculate, which is like private equity.

The unfunded liability issue should arise in the next budget cycle, FY 2014-2015.  Armstrong Backus will be required to evaluate the City's financial statements and how they reflect the unfunded pension liability.    

Armstrong Backus' management letter identified four deficiencies as of September 30, 2012.  The first two they considered significant deficiencies from an internal control standpoint:

Inventory Security
During our physical observation of water/sewer inventory, we noted that a number of employees have access to the inventory yard and warehouse 24-hours a day and that there is no formal procedure to ensure items are secure. There are few security measures in place to prevent anyone from misappropriating inventory items. We recommend that gates to the property remain locked after business hours. We also recommend that employees have limited access to inventory after hours and that this access be monitored through security equipment or inventory logs (reconcile to periodic inventory counts).

Approvals and Authorizations of Cash Disbursements
During our review of cash disbursements, we noted three instances where purchases over $500 were made, and no purchase order was provided as supporting documentation for these items. We recommend that a purchase order be approved before any purchases are made. We also noted four invoices that showed no visible sign of authorization to pay. We recommend that all invoices be signed by a supervisor showing authorization. Without these consistent controls in place, purchases may be made without preauthorization or approval.

This is the period leading up to the Furniture Fiasco, where staff ordered and installed over $100,000 in Water Department furniture without a purchase order or required City Council approval.  Was that one of the three instances or will that show up in next year's audit?  On to the two weaknesses in internal controls:

Manual Journal Entries
We noted that controls surrounding journal entry preparation and entry have inherent internal control weaknesses. In order to strengthen the internal control over journal entries, we recommend ensuring that each manual journal entry be reviewed by someone other than the preparer prior to its entry into the accounting system.

Fair Market Value of Investments
Investments are not being adjusted to reflect fair market values. We recommend that unrealized gains/losses be recorded at least annually to properly report the value of the City’s investment portfolio.

The city's muted response to these deficiencies can be viewed in the City Council packet for 11-19-13.