The Effect of Voluntary GAAP Compliance and Financial Disclosure on Governmental Borrowing Costs

Abstract

State and local governments are not subject to Securities and Exchange Commission (SEC) regulations requiring compliance with generally accepted accounting principles (GAAP). It was only in 1980 that Standard & Poor's issued a policy statement indicating a failure to conform with GAAP would be considered a negative factor in establishing municipal bond ratings. Until May 1986, governmental GAAP was not even enforceable under Rule 203 of the AICPA code of ethics. While some state governments regulate the accounting practices of their local governments, the states themselves are exempt from all accounting regulations. In this unregulated environment, differential levels of financial disclosure by the states are observed. Differential disclosure is presumably the outcome of an economic decision based on the conventional equalization of the marginal costs and benefits of GAAP compliance. In this paper, we try to estimate the magnitude of one potential benefit accruing from differential GAAP compliance—the interest cost savings on general obligation bonds. Our study suggests the bond markets are “informationally efficient” in the sense that bond prices incorporate the effects of differential GAAP compliance.