Creative Accounting and the Quality of Audit Institutions : The Achilles ’ heel of the Fiscal Responsibility

Creative accounting has been documented in OECD countries (Milesi-Ferreti 2003, Bernoth and Wolff 2008, Von Hagen and Wolff 2006). In this paper we investigate the extension of the use of creative accounting at the subnational level in Brazil. Despite the hard budget constraints imposed by the Fiscal Responsibility Law in 2000, the Brazilian state governors retain some strategically ability to undertake fiscal window-dressing as a response to fiscal stress. The Fiscal Responsibility Law mandated that state audit institutions (Tribunais de Contas) must audit the enforcement of the law by imposing procedural rules (reporting transparency, etc) that the Tribunal checks. On the basis of empirical exercises we reach two major conclusions. First, there is ample evidence of creative accounting in the states, which in itself represents indication that the influence of the audit institutions (Tribunais de Contas) is binding and that there are costs for breaching the law. Second, because the Tribunais de Contas are not immune to the influence legislature and state governor, there is evidence that the institutional quality of those institutions is associated with more creative accounting. More independent and active institutions constrain the use of creative accounting at the state level. In addition, political competition also matters for creative accounting. Specifically, we find evidence of the correlation between alternation of the elite in power (government turnover) and restos a pagar (unpaid commitments which are delayed to the subsequent fiscal year, whereby postponing their impact on the primary balance) as well as unpaid commitments and the quality of the Tribunais de Contas. The Achilles’ heel of the Fiscal Responsibility Law in Brazil is therefore the quality of subnational audit institutions. * This preliminary version was prepared to be presented at the 13 Annual Conference of the International Society for New Institutional Economics, University of California at Berkeley, Walter A. Haas School of Business, USA, June 18-20, 2009.