SAN FRANCISCO - The Government Accounting Standards Board last week issued an exposure draft on new accounting standards for bankrupt municipalities.

The draft - titled "Accounting and Financial Reporting for Chapter 9 Bankruptcies" - would establish standards for reporting liabilities that have been reduced by a bankruptcy court.

The proposed standard "would require governments to re-measure liabilities that are adjusted in bankruptcy when the bankruptcy court confirms (approves) a new payment plan," GASB said.

Bankruptcy leads to the modification of the terms of existing debt agreements. The draft would clarify whether governments should recognize reductions in future debt service payments as reductions in principal or reductions in interest. It also clarifies the timing of the accounting changes to coincide with the judge's approval of a final plan of adjustment for the debtor.

When a court reduces future payments on a debt, it doesn't necessarily specify whether it's reducing future principal payments or interest payments. The Financial Accounting Standards Board - which sets accounting standards for corporations - requires debtors to recognize such unspecified changes in debt service as reductions in interest expenses first, and as reductions in principal if the implied interest rate falls below zero.

But GASB's proposed standard would require governments to treat such unspecified reductions in debt service as a reduction in principal, and to use the pre-bankruptcy interest rate as the discount rate in determining the net present value of the reduced liability.

The result of the proposed GASB standard is that a bankrupt municipality would report a gain on its income statement and a reduction in the liabilities on its balance sheet for the period in which the plan of adjustment is approved. The FASB standard reflects the debt restructuring mainly via a corporation's income statement.

"The board did not adopt this [FASB] approach primarily because it fails to recognize a gain when the government is economically better off at the time the plan of adjustment is confirmed by the court," the GASB draft said.

If a court specifically changed the interest rate and the principal amounts of a debt in the plan of adjustment, the GASB standard would require that the government report the amounts of the debt and interest according to the new debt terms, not according to the FASB procedure described above.

The standard also clarifies that a government shouldn't report changes in its liabilities until a final plan of adjustment is agreed to by the court. The board said it chose that timing because a plan of adjustment may change considerably between the time that a creditor proposes a plan and a court accepts it.

Municipal bankruptcy is fairly uncommon. GASB said just 600 government bodies have declared bankruptcy in the seven decades since lawmakers created Chapter 9, but the current financial and economic crisis has increased financial stress on local governments, leading several cities and towns to consider bankruptcy. Last May, Vallejo, Calif., declared the biggest municipal bankruptcy since Orange County's 1994 filing.

GASB asked for public comments on its proposed standard by Aug. 28. GASB is a nonprofit organization that establishes generally accepted accounting principals for state and local governments in the United States.

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