Financial Accountability & Management, 24(2), May 2008, 0267-4424
CREATIVE ACCRUAL ACCOUNTING IN THE PUBLIC
SECTOR: ‘MILKING’ WATER UTILITIES TO BALANCE
MUNICIPAL BUDGETS AND ACCOUNTS
EIJA M. VINNARI AND SALME N
¨
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∗
INTRODUCTION
A balanced public sector economy requires that sufficient taxes and other
revenues are collected to cover public expenditures. Tax revenues are crucial
in financing a public economy, yet the various modes of levying taxes cannot
be multiplied indiscriminately and there are limits to how high taxation rates
can be raised. The demand for public services is invariably greater than the
resources available for their provision, in other words scarcity and the allocation
of resources have always caused problems in all public economies.
Recent attempts to solve the problems of public finance have included
adopting models from the private sector (see e.g., Hood, 1995; and Gruening,
2001). A case in point is New Public Management (NPM), which highlights
the role of financial management and accounting as a basis for reforms. The
conventional wisdom has been that public sector accounting, in particular the
fields of financial management and cost accounting, must be developed to
emulate business sector practices. The terms New Public Financial Management
(NPFM) and accountingization have been used in an attempt to stress the
economic and accounting orientation of public sector reforms (Olson et al.,
1998; and Power and Laughlin, 1992). In their article (1999, p. 210) Guthrie
et al. observe that:
an increasingly notable element of the NPM movement is the seemingly endless list of
accounting-based, ‘financial management’ techniques that are being drawn on in the
pursuit of reform
and that:

aforementioned types of NPM reforms: accountingization, i.e. the application of
business-sector accounting models in the municipal sector, and the formation
of profit-making municipal enterprises. More specifically, the paper aims to
determine whether these reforms have succeeded in attaining the oft-cited
goals of increased accountability, transparency and intergenerational equity, or
whether, on the other hand, any indications can be found of the contradictions,
ambiguities and paradoxes that have been suggested to underlie NPM reforms
(e.g., Olson et al., 1998). These questions are investigated through an in-depth
explanatory case study set in the context of Finnish local government, a city and
the city’s water utility.
The analysis in this paper is based on the financial statements, budgets and
other official documents of the case city and its water utility. Newspaper articles
and information obtained through discussions with city officials are also used
as empirical data. Even though the analysis is to a large degree founded on
accounting techniques, the study represents interpretative and to some extent
critical accounting research (Burrell and Morgan, 1979; Chua, 1986; Hopper
and Powell, 1985; Baker and Bettner, 1997; and Ryan et al., 2002). The authors’
view is that the heterogeneity of accrual accounting applications may lead
to creative accounting solutions especially in the public sector context, with
the consequence that accounting information is not sufficiently transparent,
users may be misled, and accounting does not properly fulfil its accountability
functions. The authors are critical (cf. Mouritsen et al., 2002) and wish to
facilitate ordered change towards more straightforward practices. This paper
therefore contributes to national and international efforts to develop and
improve public sector accounting principles and practices.
The paper proceeds as follows. The second section presents the concepts
of intergenerational and interperiod equity, accrual accounting, and creative
accounting, which provide the theoretical background for the research. The
third section describes the case, the sale of a public water utility (henceforth
referred to as Water Utility) to a public energy company (Energy Company) by

asi, 1999). This, in turn, requires balanced annual budgets
and accounts. Controlling interperiod equity calls for appropriate budgeting and
accounting systems, and also equity measures, although the latter are in practice
ambiguous and controversial.
Public sector budgeting and budgetary accounting are traditionally based on
the concepts of expenditure and revenue, and the principle that annual revenues
should cover annual expenditures, i.e. the budgets and accounts should be in
balance. The balance principle belongs to traditional budgetary doctrine and is
part of the practice of most governments. In budgetary accounting, expenditures
and revenues are largely equated with cash expenditures and cash revenues, i.e.
accounting is cash-based, although not necessarily in a pure form. Furthermore,
the degree of interperiod equity of the economy or finances can be measured as a
balance between all cash revenues (including borrowing) and cash expenditures
(including long-term capital investments, repayment of loans and lending).
The superiority of accrual-based accounting compared to traditional public
sector (budgetary) accounting has been argued by many practitioners and
academics since the late 1980s and early 1990s. The debate on accrual vs.
budgetary accounting has inspired a plethora of articles, in which various
arguments for and against accrual accounting have been made. Most of the
arguments in favour of accrual accounting belong to one of the following themes:
(1) enhanced internal and external transparency; (2) better organizational
performance through improved resource allocation; and (3) more information
on the full costs of operations, leading to greater efficiency (for a review see
e.g., Carlin, 2005). Conversely, accrual accounting has been criticized for the
misallocation of resources and inadequate disclosure of assets and liabilities,
as well as for the ability of organizations to defer liabilities and thus burden
future taxpayers with these costs (e.g., Hoque and Moll, 2001). It has also been
claimed that the application of accrual accounting in the public sector leads to
measurements that are not reliable, fair, or neutral (McCrae and Aiken, 2000),
and that the microeconomic basis for its application is weak (Robinson, 1998; and

provision (Guthrie et al., 1999; Stalebrink and Stacco, 2003; and Connolly and
Hyndman, 2006). Politicians, financial institutions, management consultants,
scholars, the media, and international organizations have all been influential in
bringing about these reforms (Pina and Torres, 2004).
However, accrual accounting is not just one specific accounting model. There
are many versions of it; starting with static and dynamic theories and models.
In Finland, until the obligatory adoption of IAS/IFRS by quoted companies in
line with EU policy, prevailing accounting thinking in the business sector was
strongly dynamic in nature.
2
The Finnish municipalities adopted the dynamic
accrual accounting model in their financial accounting reform in 1997, and they
are still using it today.
The core of the Finnish dynamic accrual accounting model lies in the
categorizing and recording of transactions, i.e. the bookkeeping of revenues,
expenditures and finance transactions, and in periodic income measurement.
Transactions are measured and recorded at their historical costs and at the
exchange prices of the transaction date. The matching principle is applied in
the closing of accounts, i.e. expenditures are matched against the corresponding
revenues to calculate annual income (cf. e.g., Skousen et al., 1991). The Profit and
Loss (P/L) Statement is the primary financial statement in dynamic accounting
thinking, and the Balance Sheet has more or less only the role of transferring
the balances of different assets and liabilities accounts to the next accounting
period.
The municipal accrual accounting model in Finland differs from the business-
sector model in several ways, an important one of which is a terminology tailored
for the local government sector only. This concerns, for instance, the terms
describing the intermediate results on the P/L Statement and the terms used on
the Balance Sheet referring to equity/net assets. This problem of self-invented
terminology is discussed in more detail in the empirical part of this paper.

for depreciation will also be affected. Fixed assets are pliable, flexible and mobile.
Everything then except fixed!
Artificial transactions, in turn, can be entered into both to manipulate balance
sheet amounts and to transfer profits between accounting periods (Amat and
Gowthorpe, 2004). Thomas et al. (2004) tested for earnings management in the
case of transactions between an owner company and its affiliates:
For example, the [o]wner company can sell assets (e.g., inventory, land, etc.) to its
subsidiary The [o]wner company can report the sale and increased earnings in the
current period. For consolidated purposes, the affiliated transaction will be eliminated
and not affect the financial statements (p. 3).
The use of creative accounting has generally been associated with the private
sector, yet it can also be practised in public administration, where in fact
the context and regulations often offer ample opportunities to indulge in it.
This is especially the case when the accounting practices depend on the public
sector’sown regulations and not on any generally accepted accounting standards.
In Finland, for example, the adoption of the IPSAS standards has not been
considered in the municipal sector. The central government’s Accounting Board
did conduct a preliminary review of the standards but decided not to implement
them as long as they are incomplete. Furthermore, as the national legislation in
Finland only provides the general framework for municipal accounting, more
detailed principles and practices rely upon self-regulation, i.e. a municipal
accrual accounting model devised by the municipalities’ interest organizations.
This presents opportunities for the use of creative accounting as will be
demonstrated in the next sections.
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revenues and expenses. Another important measure is the bottom-line figure,
the Surplus/Deficit for the Financial Year, which is the official equity measure
that should at least break even in the three-year period. Achieving interperiod
equity using these measures is a problem in numerous Finnish municipalities,
3
and this difficulty was also the key factor in the application of creative accounting
solutions in the case municipality, Owner City.
Owner City and the Formation of the Public Enterprise, Water Utility
Owner City is located in central Finland and has a population of 83,000. During
the last few years, the City has suffered from financial problems that are
threefold: an uncovered deficit in the annual budgets and accounts, a small
Annual Margin that has to cover at least depreciation, and increasing long-
term debt. Because of the requirement to achieve balance, Owner City has been
compelled to try and improve its finances. In this effort, the City has taken
advantage of its formal position as the owner of municipal public enterprises
and companies, in particular its water utility.
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CREATIVE ACCRUAL ACCOUNTING IN THE PUBLIC SECTOR 103
Owner City’s Water Works was established in 1910, and it operated as part
of the city administration until the mid-1990s. In 1994, Water Works underwent
an organizational change to become a public enterprise, Water Utility, i.e., an
independent municipal profit centre and accounting entity with its own Balance
Sheet. As a hybrid of a municipal department and a public company, a public
enterprise in Finland is not required to pay Corporation Tax.

and Loss Account
The Finnish Water Services Act (119/2001) defines ‘water services’ as the
conveyance, treatment and delivery of water to be used as household water,
as well as the disposal and treatment of wastewater, rainwater and drainage
water from foundations (
§ 1). The Act stipulates that water services charges
should cover the running costs and investments of the water undertaking in the
long run, and that the charges may, but do not have to, include a reasonable
rate of return on the owner’s capital investment (
§ 18). Since the Act provides
no further definition for the term ‘reasonable’ and the rates of return are not
regulated by any authority,
6
they vary widely in Finland and can amount to
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104 VINNARI AND N
¨
ASI
as much as 45.5 percent of a water utility’s annual turnover (Vinnari, 2006).
Owner City’s interpretation of this regulation can be seen in Water Utility’s
P/L Accounts (Table 1). In accordance with the Finnish municipal accounting
guidelines, the return on Owner City’s Basic Capital was entered in the P/L
Accounts as a financial expense item entitled ‘Compensation for Basic Capital’,
despite its dividend-like nature.

and hidden taxation, not only in the case city but also more generally in the
accounts of Finnish municipal enterprises.
Despite the steady income flow from the Water Utility, Owner City’sfinancial
predicament intensified at the beginning of 2000, and the City had to resort to
further measures to balance its budgets and accounts.
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CREATIVE ACCRUAL ACCOUNTING IN THE PUBLIC SECTOR 105
Table 1
Summary of the Profit and Loss Account Information of Water Utility, 1994–2004 (EUR million)
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Turnover 11.55 10.72 11.73 12.83 13.58 13.88 14.35 15.47 15.54 15.63 15.90
Operating Costs −4.75 −4.89 −5.60 −5.60 −5.80 −7.72 −6.6 −7.69 −7.34 −7.44 −7.54
Depreciation −2.85 −2.72 −2.77 −3.21 3.71 −4.08 −4.20 −4.51 −4
.56 −4.56 −4.56
Financial Income 0.05 0.057 0.028 0.011 0.007 0.004 0.005 0.011 0.011 0.018 0.016
Financial Costs
Interest Costs 0.00 −0.02 −0.03 −0.01 −0.06 −0.13 −0.26 −0.33 −0.39 −0.40 −0.34
Compensation for the Basic Capital −2.51 −2.63 −2.66 −3.53 −3.53 −3.36
−3.19 −3.19 −3.19 −3.19 −3.19
Extraordinary Income 0.00 0.00 0.00 0.00 0.00 0.00 −3.15 0.00 0.00 0.00 0.00
and Expenses (net)
Provisions
∗
−1.18 −0.51 −0.69 0.00 0.00 0.00 3.28 0.13 0.13 0.13 0.13

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CREATIVE ACCRUAL ACCOUNTING IN THE PUBLIC SECTOR 107
The Sale and Fabricated Sales Profit of the Water Utility
During the autumn of 2003 and 2004, when the financial plans and budgets
of Owner City were being approved, the realization grew that deficit spending
would continue and something radical would have to be done to meet the legal
obligation to cover the deficit. A solution was found in the sale of Water Utility,
not outside Owner City Group, however, but as an intra-group rearrangement
to Owner City’s own energy company that would permit a large additional
sales profit to be recorded as income on Owner City’s P/L Account as a result
of the fair value based revaluing and sale of Water Utility’s infrastructure
assets.
As mentioned earlier, in the Finnish dynamic accounting theory based
approach, the Balance Sheet was a secondary financial account, and assets and
their valuation did not belong to the core elements of financial accounting. With
the advent of IAS/IFRS-based accrual accounting, more attention began to be
paid to Balance Sheet information and assets valuation, but in the public sector,
accounting regulations forbade revaluation of fixed assets other than land or
water areas. These developments also affected Owner City, which realized that
its water utility assets were in a sense undervalued and that one way to improve
the City’s financial results would be to revalue the assets at fair value. The only
way to do this was via the sale of Water Utility.
In the autumn of 2003, the City had commissioned Consulting Firm X to
analyse the feasibility of selling Water Utility to Energy Company and to
calculate the fair value of Water Utility’s fixed assets, which consist mostly of

Table 3
Value of Water Utility’s Infrastructure Assets According to Different
Valuation Methods and Valuators in 2005
Asset Valuation Method Value, EUR Million
Book value 37
Technical and economic value (Firm X) 120–210
Technical and economic value (Firm Y) 130
Discounted Free Cash Flow value (Firm X) 50–80
Discounted Free Cash Flow value (Firm Y) 74
Final sales price, fair value + goodwill 130 + 20
Figure 1
Sale of Water Utility to Energy Company
OWNER CITY
budgeting and accounting
entity including public
enterprises, e.g. Water
Utility
ENERGY
COMPANY
Price, EUR 150 million, consisting of:
- fair value of Water Utility’s assets:
EUR 130 million
- goodwill: EUR 20 million
Bullet-type debenture loan, EUR 150 million
INTRA-GROUP SALE OF THE WATER UTILITY
Without this creative accounting procedure, Owner City’s budget for the year
2005 would have shown a deficit of EUR 19.69 million and a cumulative deficit
for the period 2004–2007 of EUR 42.63 million, contravening the Finnish Local
Government Act. When the ‘sale’of Water Utility to Energy Company is included
in the figures, the City’sbudgeted surplus for 2005 becomes positive (EUR 102.61

2007 +1.27 +1.27
Total −42.63 79.67
Figure 2
Financial Statement/Budget and Cumulative Surplus/Deficit Figures of
Owner City, 1997–2008
6.4
0.4
2.1
-8.4
0.6
7.3
1.6
99.4
-16.9
7.3
-9.1
-5.0
85.7
78.4
77.8
-13.2
3.7
2.1
-5.2
-7.3
-2.4
-2.7
-40
-20
0

¨
ASI
Figure 3
Total and Per Capita Debt of Owner City in 1997–2008
0
50
100
150
200
250
1997 1998 1999 2000 2001 2002 2003 2004 2005* 2006* 2007* 2008*
EUR million
0
500
1000
1500
2000
2500
EUR/capita
Total loan Loan/inhabitant
problem: more money is being spent on the production and provision of services
than is being collected in revenues.
DISCUSSION
Natural monopolies such as water services utilities are often profitable milch
cows for their owners, usually municipalities or other public entities. Pricing
the services provided by the utilities offers owner municipalities a chance to
hide taxation and to collect revenues to balance deficit spending. In the case
study, the opacity of the financial accounts was caused by the inclusion in the
Finnish municipal accounting regulations of certain concepts that mislead rather
than help the users of financial accounting information. Adopting and applying

defended on the basis that they conform to an economic definition of capital
goods because they are input set aside for producing output in future periods
(Stanton and Stanton, 1997). It has also been claimed that although market-
based valuation methods are not suitable for service-based public-good assets,
corporatization removes the public-good nature and enables the use of market
approaches to valuation (Bond and Dent, 1998).
Fair value can be defined as:
the amount for which an asset could be exchanged, or a liability settled, between
knowledgeable, willing parties in an arm’s-length transaction, as at the date relevant
for the valuation (IFAC, 2004; Parker, 1992).
The market for water utility assets is practically non-existent, and reliable
valuation based on an arm’slength transaction is a theoretical option only. Thus
the fair values of these assets present a paradox both in terms of their recognition
as assets and their reliable valuation, and so they are often carried on the Balance
Sheet, if one exists, at their initial cost less accumulated depreciation.
In Owner City, the sales price of Water Utility was determined on the basis
of two consulting companies’ assessments of the value of its operations. It is
difficult to assess the validity of the different values, but their wide variation
shows that by changing calculation methods and parameters the desired result
may be obtained. Despite the great difference in the economic and technical
values and the discounted free cash flow values, the former set of values were
chosen to represent the ‘fair’ value and the price of the water utility assets.
In addition to the official justification, another reason for the intra-municipal
sale of Water Utility could be that otherwise under Finnish accounting legislation
the revaluation of the water utility assets would not have been possible. By
matching the sale price to the highest estimated fair value, Owner City was able
to legally increase the value of its water utility assets on Energy Company’s
Balance Sheet. Thus, although the immediate cash flow effect of the sales
operation was zero, during the next fifteen years the cash flow to Owner City
will increase by the interest paid on the loan to Energy Company. While the sale

conflict with the requirements of the Water Services Act, which states that
the grounds for customer charges should be transparent and correspond to the
actual cost of producing the services. As there is very little economic regulation
of municipal water services in Finland, the responsibility for overseeing their
finances rests on elected municipal council members. Yet understanding the con-
sequences of the accounting transactions involved in the arrangements demands
advanced accounting knowledge, which most municipal council members, not to
mention the residents, cannot be expected to possess. This non-transparency
prevents accounting from fulfilling its key function of accountability (cf. Ijiri,
1975).
Dubious accounting practices cannot be blamed on a specific accounting model
but rather on how it is used. Nevertheless, traditional public sector cash-focused
budgetary accounting did not provide such opportunities for creative accounting
solutions. The misuse of accrual accounting in the case of natural monopoly
industries such as water services could be prevented by a proper institutional
framework of legislation and independent economic regulation.
All in all, it is possible to question the ownership policy and implementation
adopted as part of NPFM by the public sector. In the case presented, Water
Utility’s assets were regarded as the municipality’s, not the residents’, invest-
ments, and the Utility collected a considerable return on the capital invested by
Owner City through customer charges. This approach suggests that the City sees
itself as an investor rather than a provider of essential services, which conflicts
with the notion of a municipality existing first and foremost to look after the
interest of its residents. Furthermore, the restructuring of Water Utility will
inevitably increase water prices and transfer more money from the residents
to the owner municipality. Thus, in effect, the savings of past generations, i.e.,
the investments in Water Utility, are used to cover past and current deficit
spending. Bearing in mind the hundred-year history of Water Utility in Owner
City, it should be remembered that Water Utility was financed and ‘owned’ by
residents and consumers of water, past and present, rather than Owner City.

Revenues from operations 96.48 100.55 171.69 172.95
Production for own use 14.46 14.24 0.00 0.00
Operating expenses −374.37 −378.16 −460.77 −462.80
Operating margin −263.43 −263.37 −289.08 −289.85
Tax revenues 220.29 227.09 238.10 246.89
State grants 43.05 47.04 53.66 55.54
Financial revenues and costs (net) 5.19 4.52 8.36 7.95
Annual margin 5.10 15.28 11.04 20.53
Depreciation −22.72 −31.74 −20.02 −20.48
Extraordinary income 0.14 116.92 0.00 0.00
Net result for financial year −17.48 100.46 −8.98 0.05
Provisions 0.60 2.23 0.54 0.
55
Surplus/deficit for financial year −16.88 102.69 −8.44 0.60
(without the sale of Water Utility) (−19.69)
Note:
∗
The figures for 2006 and 2007 are estimates.
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NOTES
1 The City is referred to as the ‘owner’ of Water Utility with the recognition that it is a faceless

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