How to Read Governmental Financial Statements, Part 1

Home , Balance sheet, Fund accounting, Governmental accounting, Retained earnings, Revenue

FOCUS: FINANCE AND BUDGETING

Gregory S. Allison

anagement and elected to-actual financial statements (that officials of governmen- is, statements comparing budgeted Mtal entities receive an of- amounts with actual results); brief ten overwhelming supply of finan- analyses of tax billings and collec- cial data. This information takes tions, as well as general revenue various forms—budgetary re- collections; and investment sum- ports, internally generated finan- maries—these are a few examples cial statements, schedules and of the internal information that summaries, and audited annual should be available to manage- financial statements. Usually, in- ment and elected officials on a ternally generated information continuing basis. In most cases the comes in a format that is com- format of these presentations is left prehensible to accountants and to the discretion of management, nonaccountants alike. Compre- elected officials, and staff respon- hending the audited financial sible for preparing the informa- statements, however, requires at tion. Some governing bodies may least a minimal understanding of desire a summary of revenues by the principles of governmental category (property taxes, utility financial reporting. This article, billings and collections, other the first of two parts, is designed taxes, and so forth). Others may to make the audited financial focus on key ratios on a monthly statements more user-friendly and basis (for example, tax collection to provide a key to unlocking the rates and expenditures to date basic information they contain. compared with budget projec- The article focuses on current tions). reporting requirements. Part 2, Governments typically operate scheduled for a future issue of purely from a cash perspective: rev- Popular Government, will intro- enue is recognized when cash duce readers to new governmental is collected, and expenditures are financial reporting requirements that paring financial statements for external recognized as cash is disbursed. This is will be implemented over the next use. Thus the GAAP financial state- consistent with how they budget their three to five years. ments of a government in California operations. The balanced budget re- Governmental accounting and fi- may be compared with those of a gov- quirement in North Carolina presumes nancial reporting standards, referred to ernment in North Carolina. The consis- that all expenditures, or uses of finan- as generally accepted accounting prin- tency is invaluable to those outside the cial resources, will be funded either by ciples, or GAAP, are established by the government who rely on this informa- revenue sources (taxes, grants, utility Governmental Accounting Standards tion, primarily investors, creditors, and fees, and so forth) or by uncommitted Board. GAAP provide consistency in fi- bond rating agents, as well as to federal cash on hand (for example, available nancial reporting. In other words, they and state agency personnel. fund balance). Internal financial state- offer rules and formats for all govern- Management must have timely ac- ments most often stay consistent with ments in the country to follow in pre- cess to financial information in order to this type of reporting. However, exter- make decisions, evaluate compliance is- nal financial statements, such as the The author is an Institute of Government sues, and obtain an overall “feel” for an “official” financial statements prepared faculty member who specializes in govern- entity’s fiscal status. Reports prepared in conjunction with the annual audit, mental accounting and financial reporting. for internal use serve this need. Budget- are prepared with the intention of

spring 2000, popular government 23 “providing a single financial report tai- Table 1. Fund Types lored to meet the basic information needs of a broad range of potential us- General fund Accounts for general operations of government (e.g., legislative, ers.”1 These audited financial state- administrative, public safety, sanitation, and recreation) ments are in a format that is useful for Special revenue fund Accounts for legally restricted revenue sources, those that must be those with an understanding of govern- used for particular activities (e.g., E-911 taxes and community development block grants) mental accounting—for example, accountants, investors, lenders, and rating Debt service fund Accounts for resources that governments are required to accumu- late to pay debt service in future years agents—and they provide an excellent summary of the fiscal year’s financial Capital projects fund Accounts for major capital activities or construction that is being financed by governmental resources (e.g., taxes) or by bonds that events. Ironically the preparation of will be repaid by governmental resources these GAAP financial statements is the Enterprise fund Accounts for activities that are usually supported by user fees (e.g., specific responsibility of management, water, wastewater, electricity, and natural gas services) but they often are confusing and of little Internal service fund Accounts for internal activities that provide service to other depart- practical use to management and elected ments (e.g., government motor pools, in-house print shops, and officials on a day-to-day basis. Never- warehousing for utility activities) theless, management and elected offi- Trust and agency funds Account for various activities for which government acts as cials can easily obtain useful informa- fiduciary (e.g., pension plans, execution of trust and bequest tion from these statements. agreements, and taxes collected on behalf of other governments) ______Overview of GAAP Reporting of the financial statements themselves; The balance sheet is actually a “snap- Requirements see the sidebar, page 25). North Caro- shot” of the assets, the liabilities, and GAAP require that state and local gov- lina statutes require that all local gov- the equities—that is, the net worth—of ernmental entities use fund accounting, ernmental entities prepare these GAAP the fund types as of the end of the fiscal a concept unique to the government financial statements for the end of each year (June 30 for most North Carolina environment. Unlike agencies in the pri- fiscal year and have them audited by an governments, such as municipalities vate sector, governmental entities pro- independent certified public accoun- and counties). “Assets” is simply de- vide a tremendous variety of services. tant.2 These basic financial statements fined as items owned by the govern- Some services are “public purpose” in present aggregated information for ment (cash, investments, receivables, nature (for example, public safety, pub- each fund type. For example, a govern- fixed assets, and the like), and “liabili- lic works, and social services). Others ment may have three special revenue ties” is defined as obligations of the are “business-like” (for example, public funds, such as a community develop- government (for example, accounts utilities). The public-purpose services ment block grant fund, a capital reserve payable, salaries payable, and bonds are primarily financed by taxation fund, and an E-911 fund. For the basic payable). “Equity” is the net worth of (property taxes, sales taxes, income audited financial statements (often re- each of the fund types, which is simply taxes, and so forth), whereas most ferred to as the combined financial the fund’s assets minus its liabilities. business-like services are primarily fi- statements), that government combines This balance sheet is a visual represen- nanced by user fees (that is, payments these three special revenue funds into tation of the standard “accounting by those using the services). In most one column and identifies that column equation”: cases the various revenue sources for as the special revenue funds. Some ar- Assets = Liabilities + Equity the services each have restrictions on gue that this aggregation diminishes the how they may be used. Fund account- usefulness of the financial information. Each fund type is reported in a sepa- ing is an accounting and reporting ve- Most users of the information, how- rate column. Assets equal liabilities plus hicle that allows segregation of these ever, are assessing the government’s fi- equity for each column. services and their revenue sources. nancial situation as a whole. They do Unlike the operating statements, the Fund accounting uses three basic not necessarily need all the supporting balance sheet does not represent an ac- categories of funds: governmental, pro- detail. In contrast, internal reporting cumulation of transactions across the prietary, and fiduciary. Within each cat- almost always has a focus on the activi- year. Instead, it answers the following egory, several fund types are available ties of individual funds, which is neces- questions: to account for all the government’s ac- sary from an internal decision-making What does each fund type own as of tivities and services (see Table 1). perspective. • June 30? To present the minimum informa- • What does each fund type owe as of tion required by GAAP, governmental The Combined Balance Sheet— June 30? entities must prepare up to six basic fi- All Funds • What is each fund type’s net worth nancial statements and a comprehen- The combined balance sheet reports the as of June 30? sive set of related “note disclosures” assets, the liabilities, and the equity for (footnotes that communicate essential each of the government’s fund types Management and elected officials information not disclosed in the body (for a sample, see Exhibit 1, page 26). make decisions at the individual-fund

24 popular government, spring 2000 Note Disclosures

n addition to requiring the basic financial statements, funds are exposed. (Depositories and investment dealers I GAAP require a comprehensive set of note disclosures. usually insure government deposits and investments by Because of their obvious limitations, the basic financial “collateralizing” them—that is, by setting aside collateral statements cannot provide details about every number re- as insurance.) GAAP require disclosures about the types ported. The note disclosures provide critical details about of deposits and investments held by the government at the financial issues that are of importance to users of the fi- end of the fiscal year, as well as the collateral for those de- nancial statements. Some of the more significant types of posits and investments. disclosures are the following: Fixed-asset information. In most cases, the fixed assets reported on the combined balance sheet represent the • Significant accounting policies majority of the assets owned by the government. How- • Compliance issues ever, space limitations do not allow detail on the types of • Deposit and investment detail assets owned (land, buildings, equipment, and so forth), • Fixed-asset information their original cost value, and, if applicable, the accumu- • Information on outstanding long-term debt lated depreciation on the asset. The note disclosures pro- • Pension plan information vide this detail. GAAP also require a summary, by type of These categories of note disclosures are very broad, asset, of the additions to fixed assets that occurred during and a complete discussion of each one is beyond the the fiscal year and the retirements (the assets taken out scope of this article. However, together with the brief de- of use). scriptions that follow, they provide a basic overview of Information on outstanding long-term debt. This is the types of disclosures that are typically of most interest critical information to anyone assessing the government’s to management and elected officials. financial situation. Although all the government’s liabili- Significant accounting policies. This category encom- ties are reported on the combined balance sheet, it is im- passes various accounting and financial reporting policies possible to provide detail on the types of indebtedness of the government. Examples include a complete identi- and the specifics for each liability. GAAP require disclo- fication of the governmental entity and its fund structure, sure of the outstanding debt issuances, the interest rate budget practices, calendar, and investment and fixed- being paid, and the repayment terms. They also require asset policies. Although much of this information is stan- inclusion of a schedule that shows the amounts of princi- dard from government to government, the overall ac- pal and interest due each year for five years, and in five- counting and reporting policies are unique to each entity. year increments thereafter, until maturity. The require- Compliance issues. Governmental entities have exten- ments for repayment of principal and payment of interest sive concerns with legal compliance related to the budget, must be reported separately. bonds, investment policies, and more. GAAP require dis- Pension plan information. Pension plans are signifi- closure of any violations of these legal requirements. For cant operations and represent significant costs for most example, if a government exceeds its budget appropria- governments. Many governments participate in the tion in any department, it must disclose this violation of North Carolina Local Governmental Employees’ Retire- the budget ordinance. Likewise, if a government makes ment System; others sponsor their own plans. Also, some investments that violate its adopted investment policy, it governments supplement the state’s plan or their own must disclose that fact. plan with a deferred compensation plan. If the govern- Deposit and investment detail. This information is of ment participates in the state plan, then it must make dis- paramount importance to readers of the financial state- closures about the nature of the plan and the annual costs ments. North Carolina statutes require investment of all that it incurs to participate. If the government sponsors its idle public funds to maximize their earnings potential. own plan, then it must identify the assets and the liabili- State statutes also require insurance of all deposits and all ties of that plan, as well as the funding requirements, in investment securities, to limit the risk to which public the disclosures. level, not at the fund-type or total level. perspective represented in the total col- enue, capital projects, and debt service) For example, if a government is assess- umns of the balance sheet does not focus on financial assets and financial ing its ability to finance expansion of a serve this kind of purpose. liabilities, whereas proprietary funds water plant, either with cash on hand or GAAP have specific rules for the (that is, enterprise and internal service) through issuance of debt (such as types of assets and liabilities that may focus on all assets and all liabilities. A bonds), it does not look at its cash posi- be reported for certain funds. Exploring financial asset is an asset that either is in tion as a whole. Instead, it looks at the all the theoretical reasons for these re- cash form or will convert to cash in its water fund and that fund’s cash posi- quirements is beyond the scope of this natural course. Cash, investments, and tion, asking, Is cash available in the article. Suffice it to say that governmen- receivables are the most common ex- fund to finance the project? The broad tal funds (that is, general, special rev- amples. A financial liability is a very

spring 2000, popular government 25 Exhibit 1. This is an example of a combined balance sheet for a local school district, in this case the Craven County Board of Education. This governmental entity has a general fund, a capital projects fund, an enterprise fund, and several trust funds. Note the account group columns, which report the fixed assets and the long-term debt associated with the governmental funds. short-term liability, to be paid off soon, governmental fund columns them- over the long term, by reviewing the in- presumably with cash that is on hand or selves. Of course, governmental funds formation included in these columns. will be received in the near future. The purchase such assets and incur such This GAAP reporting approach, in fact, most common examples are vendor ac- long-term liabilities. However, these is consistent with how governmental counts payable and accrued payroll. items are included on the balance sheet funds are budgeted and managed. The Governmental funds report only fi- in the columns for the general fixed- budget for one year is designed to pro- nancial assets and liabilities. Nonfinan- asset account group and the general vide the resources to deliver services for cial assets, such as fixed assets (land, long-term debt account group, respec- that year. buildings, equipment, and so forth) and tively. Thus a user can determine the Proprietary funds, on the other long-term liabilities (for example, types of fixed assets a governmental hand, are managed with a long-term bonds payable that will be paid off over fund owns, or the types of liabilities a perspective. They operate more like a many years) are not recorded in the governmental fund will be repaying private-sector business, in which the

26 popular government, spring 2000 focus is on net income. Water rates, for that is to be repaid, and as an “advance Another common example of the example, are structured not only to pro- from other fund” (a liability account) in creation of deferred revenue is associ- vide resources for the current year’s op- the fund that is repaying the loan. ated with grants. This situation might erations but also to generate the neces- Intergovernmental receivables/pay- occur in either a governmental or a pro- sary capital to maintain the systems in ables. State monies paid to local gov- prietary fund. Assume that a local perpetuity. Therefore the GAAP bal- ernments in North Carolina are a com- government receives a federal grant. ance sheet presentation for the propri- mon example of an intergovernmental The grant is paid to the government in etary funds reflects all their assets and transaction, as are subsidies paid by advance, but the government does not liabilities—both financial and nonfi- municipalities to local housing authori- earn the right to keep it until certain cri- nancial assets, and both current and ties. If any of these receivables or teria have been met (for example, the long-term liabilities. payables are outstanding at the end of a grant must be actually spent for its par- Many of the account captions on fiscal year, they are captioned “inter- ticular purpose to become revenue; un- the balance sheet are relatively self- governmental” to reflect the underlying til that time it is technically refundable explanatory (for example, cash, invest- nature of the transaction. to the grantor). Until the government ments, taxes receivable, accounts pay- Compensated absences payable. As meets the grant requirements, it must able, and bonds payable). However, of the end of each fiscal year, the gov- report the amount as deferred revenue. other account captions that may be of ernment has incurred a liability to its As the grant provisions are met, the de- particular interest to management and employees for earned vacation and ferred revenue is reclassified as revenue elected officials merit additional de- similar types of compensation time. on the appropriate operating statement. scription. This kind of liability is reported in sev- Equity. As stated earlier, equity is the Due from/to other funds. Often, eral sections of the balance sheet. The net worth of a fund. Governmental fi- funds within a government provide ser- amount owed to general fund employ- nancial reporting uses different termi- vices for one another. For example, the ees is most commonly reported in the nology for equity in the different fund general fund pays for the water pro- general long-term debt account group. types. Following is a summary of the vided to city hall by the water depart- Likewise, the amount owed to employ- various equity accounts. ment, which is accounted for in the wa- ees in the proprietary operations is re- Fund balance. This term describes ter fund (a proprietary fund type). Sup- ported directly in those fund-type col- equity for the governmental fund types. pose the water fund has billed the gen- umns. These amounts do not represent Because the assets in a governmental eral fund for the most recent month’s liabilities that the government will pay fund are all financial ones and the li- water usage, but the fiscal year ends be- out in total at one time. GAAP require a abilities are all current ones, fund bal- fore the bill is settled. The water fund presentation of the full liability, but in ance actually represents the net finan- reports a “due from other fund,” which practice the government pays the cial resources potentially available in is a receivable, and the general fund re- amounts to employees incrementally as that fund. ports a “due to other fund,” which is a they use their vacation or similar com- However, North Carolina state stat- payable. This terminology is used in pensation time. utes include a formula that identifies lieu of the usual “accounts payable/ Deferred revenue. In governmental how much of fund balance is actually accounts receivable” to reflect that the funds, revenue is recognized as it is available for appropriation. Govern- underlying transaction is between funds available (that is, as it is received in cash ments may not appropriate more than within the government, not between the or becomes receivable in cash in a very “the sum of cash and investments mi- government and outside parties (for short period).4 In proprietary funds, nus the sum of liabilities, encum- example, customers and vendors). revenue is recognized as it is earned, re- brances, and deferred revenues arising Interfund receivables/payables and gardless of when it is actually collected from cash receipts.”5 (An “encum- advances to/from other funds. Occa- in cash. brance” is an outstanding commitment sionally one fund may lend money to In governmental funds, such as the of funds usually documented by a pur- another fund. For example, the general general fund, tax revenue is recognized chase order or a contract.) fund may borrow money from an elec- not as it is billed but as it is collected. In addition to that statutory limita- tric fund to purchase a computer sys- When property taxes have been billed tion, there are restrictions on portions tem. The transaction is reported as a but not paid as of the end of the fiscal of fund balance. “Reserved fund bal- loan between funds, using terminology year, and are not collected within sixty ance” reflects legal restrictions placed that reflects the repayment terms.3 The days after the end of the fiscal year, both by independent third parties. Manage- current portion of the loan (for ex- GAAP and North Carolina statutes re- ment or elected officials may not use re- ample, the amount to be repaid within quire that the amount of the tax receiv- served fund balance for any purpose the next year) is reported as an able on the balance sheet be reported other than that to which it is restricted. “interfund receivable” in the fund that not as revenue but as “deferred rev- In North Carolina some common is to be repaid, and as an “interfund enue,” which is reported similar to a li- examples of reservations are the fol- payable” in the fund that is repaying ability. Deferred revenue does not in- lowing: the loan. The long-term portion of the crease fund balance because it is not loan is reported as an “advance to other available for appropriation (that is, the Reserved by state statute. Fund fund” (a receivable account) in the fund cash it represents is not available). balance is a close approximation of

spring 2000, popular government 27 resources that will eventually be ated, is not legally binding, and may be tions are self-explanatory. Examples of available in a governmental fund. modified as the elected officials desire. common revenue resources are prop- North Carolina statutes prohibit Obviously, undesignated fund balance erty taxes, licenses and permits, charges a government from considering re- reflects the portion of fund balance that for services (that is, user fees), interest, ceivables as resources that it may is not legally reserved or designated by and receipts from other governmental appropriate in its calculation of the governing board for future use. entities (that is, intergovernmental rev- available fund balance. “Reserved Retained earnings. Equity in the pro- enues, such as sales taxes, grants, and by state statute” generally reflects prietary funds is referred to as “retained other types of state-shared monies). Ex- the amount of fund balance that is earnings.” Unlike equity in the govern- penditures are typically categorized by attributable to receivables that the mental funds, equity in the proprietary “character” and “function.” “Charac- applicable governmental fund has funds reflects the total assets minus the ter” identifies the nature of an expendi- recognized as revenue under GAAP total liabilities of the fund. Therefore, ture: current, intergovernmental, debt but may not yet appropriate under retained earnings reflect not only finan- service, and capital outlay. “Current North Carolina law. cial assets (minus financial liabilities) of character” expenditures are typically Reserved for encumbrances. Of- the fund but all other assets, such as identified by function. The most com- ten there will be outstanding encum- fixed assets (minus long-term liabilities). mon types of functions are general gov- brances (that is, outstanding pur- Total retained earnings do not represent ernment, public safety, public works, chase orders or contracts) at the end spendable resources. As in the private sanitation, and recreation. of the fiscal year. A reservation for sector, they reflect total net worth of the Governmental funds use the term encumbrances indicates that a por- fund, which includes assets that are not “expenditure” as opposed to “ex- tion of fund balance is dedicated to convertible to cash for spending. pense.” An expenditure is an actual pay for the encumbered items once Contributed capital. Sometimes a outflow of cash resources. Because the the goods or the services have been proprietary fund receives capital contri- governmental funds’ operating state- received, presumably early in the butions from outside third parties. For ment focuses on the cash perspective, next fiscal year. Technically the ven- example, a developer may pay for the this term is more appropriate for it. In dor with whom the purchase was installation of water lines in a new sub- contrast, the term expense is used for made is the independent third party division. When the water lines are con- the proprietary funds’ operating state- who has a claim on these resources. nected to the local government’s water ment because it focuses on all transac- Reserved for Powell Bill. Munici- system, they become the property of the tions of the operation, regardless of palities in North Carolina receive government. The water fund has re- their effect on cash. An expense is an annual allotments of Powell Bill ceived an asset at no cost. Contributed outflow of cash resources or the recog- money from the state. Powell Bill capital simply represents the equity that nition of noncash transactions such as money may be used only for specific a proprietary fund has built with out- depreciation of capital assets and write- street construction and maintenance side contributions. The total net worth off of bad debts. Broadly stated, an ex- projects. Usually, municipalities have of a proprietary fund is retained earn- pense is an allocation of all the costs of unspent portions of the distribution ings plus contributed capital. an operation. in their fund balance at the end of Other financing sources/uses. Fol- each fiscal year. Although they may The Combined Operating Statement: lowing revenues and expenditures, there use it in future fiscal years, the state Governmental Funds usually is another category of transac- legally restricts how they may use it. There are two main types of operating tions, referred to as “other financing Thus portions of unspent Powell Bill statements for governments, one for the sources (uses).” These are resources or money as of the end of the fiscal year governmental funds6 and another for uses that do not meet the basic criteria must be reported as reserved fund the proprietary funds. (As discussed of a revenue or an expenditure. This cat- balance. later, some governments may have a egory is not for miscellaneous revenues third type of operating statement, for and expenditures. In fact, only a few Portions of fund balance that are not their pension trust funds.) Because gov- kinds of transactions may be reported reserved are considered to be unre- ernmental funds focus on current finan- in this category, as follows: served. This classification may be fur- cial resources, the operating statement ther categorized as “designated” or of a governmental fund is similar to a Operating transfers in/out. Funds “undesignated.” The primary differ- checkbook register (for a sample, see often transfer money to other funds. ence between a reservation and a desig- Exhibit 2). The revenues and the other For example, a proprietary fund may nation is the role that the governing financing sources are like deposits; the routinely transfer money to the general body plays in the latter’s determination. expenditures and the other financing fund. The receiving fund reports the Elected officials may designate portions uses are like withdrawals. The net result transaction as an “operating transfer of available fund balance for any num- of these “deposits” and “withdrawals” in,” the contributing fund as an “oper- ber of purposes—future capital needs, is an increase or a decrease in the check- ating transfer out.” In contrast, rev- operating-budget resources for the fol- book balance (that is, the fund balance). enues and expenditures reflect transac- lowing year, special projects, or pur- Revenues and expenditures. Most of tions with third parties. Given that chases. A designation is internally cre- the account categories under these cap- operating transfers are internal in na-

28 popular government, spring 2000 ture, it is more appropriate to consider them other financing transactions. Proceeds of debt issuances. Obvi- ously a common resource for governmental entities is the issuance of bonds or similar financing instruments. When such debt is issued by a governmental fund, receipt of the debt proceeds increases the financial resources of the fund. Given that the operating statement of the governmental funds is similar to a checkbook, the proceeds of the debt issuance must be reflected. Catego- rizing them as a revenue source is inap- propriate; they are simply a resource that was borrowed. Thus they are reported as an other financing source. Payments to bond escrow agents. Governments often refinance existing debt to take advantage of better interest rates or more favorable debt-service requirements. This type of transaction is referred to as a “refunding.” The actual transaction is rather simple. The government issues refunding bonds, and it uses the proceeds to pay off the existing debt. However, just as homeowners often may not prepay mortgages without penalties, governments may not prema- turely liquidate many bonds until the maturity date or a predetermined “call- able” date. Yet there are legal ways to effectively eliminate the government’s liability and satisfy the terms of the outstanding bonds at the same time. When the proceeds of the refunding bonds are received, they are paid to an independent escrow agent. That agent pays off the old indebtedness. Once these funds are placed with the escrow agent, they are no longer accessible to the government, and the government’s liability for the old bonds has effectively been satisfied. In the year this transaction takes place, the proceeds of the refunding bonds are reported as an other financing source, and the subsequent payment to the escrow agent is reported as an other financing use. Sale of fixed assets. Occasionally, governments dispose of fixed assets purchased by the governmental funds. Any proceeds of the sale obviously add to the cash balance of the fund making the sale. These proceeds are reported as an other financing source. Exhibit 2. This excerpt from Forsyth County's combined governmental fund operating statement shows information about the county's general fund. The net effect of revenues and other financing sources minus expenditures

spring 2000, popular government 29 Exhibit 3. This is a portion of Wake County's budget-to-actual presentation, which shows the budgeted and actual revenues and expenditures of the general fund. and other financing uses of any govern- events would be reported as a direct ad- fund types that legally adopt an annual mental fund is an increase or a decrease justment to fund balance and identified budget (for a sample, see Exhibit 3). in fund balance. Occasionally, other as a “prior period adjustment.” Such The primary purpose of this statement transactions may be reported on the adjustments do not necessarily reflect a is to demonstrate compliance with the governmental fund operating statement problem. budget. The statement has little practi- as direct adjustments to fund balance: cal use, for the fund-type columns still The ending fund balances for each of are aggregated. For example, if a gov- Residual equity transfer in/out. Un- the governmental fund types should ernment has more than one special rev- like an operating transfer, a residual agree with the fund balances reported enue fund, the budget-to-actual pre- equity transfer is an unusual and infre- on the combined balance sheet. In sum- sentation includes all of them in one quent transfer of resources between mary, the balance sheet is a snapshot of column. funds. For example, the general fund the assets, the liabilities, and the equity For North Carolina governments, may make a one-time contribution to a (fund balance or retained earnings, as the formats of the combined govern- proprietary fund to help finance a capi- appropriate) at the end of the fiscal year mental fund operating statement and tal project. The funds are not to be re- (June 30 for North Carolina govern- the budget-to-actual statement are paid, and the contribution is a one-time ments). The governmental fund’s oper- practically identical. The same account event. These transfers are reported as a ating statement reports the transactions captions—revenues, expenditures, and “residual equity transfer in” to the re- throughout the year that either increase other financing sources and uses— ceiving fund and as a “residual equity or decrease the applicable fund’s fund are used. GAAP simply limit this transfer out” of the contributing fund. balance. combined budget-to-actual statement Prior period adjustments. Occasion- to governmental funds that legally ally, errors made in previous years need The Combined Budget-to-Actual adopt an annual budget. Therefore, if to be corrected. Also, adjustments may Statement: Governmental Funds multiyear (or project-length) budgets be necessary to reflect the implementa- GAAP require that the combined finan- are adopted for special revenue or capi- tion of a new accounting and financial cial statements include a budget-total projects funds, they would not be reporting standard. Either of these actual statement7 for governmental included on the statement.

30 popular government, spring 2000 The Combined Operating Statement: Proprietary Funds A governmental entity’s financial statements may include two types of operating statements if the entity has both governmental and proprietary funds. The operating statement for the proprietary funds8 is formatted differently from the operating statement for the governmental funds. The primary rea- son is that the statements are designed for different purposes. The governmental funds’ operating statement can be used like a checkbook register. Propri- etary funds are reported from a perspective of total economic resources: all revenues earned, not just those that are available (as is the case with the governmental funds). Accordingly the expenses reflect all events that affect the equity of the fund—cash outflows for operations, purchase of capital assets, payment of debt service, and noncash transactions such as depreciation and write-off of bad debts. Operating revenues. This category on the proprietary funds’ operating statement identifies the revenues gener- Exhibit 4. This is the first half of a proprietary fund operating statement— ated by the operation itself—for ex- the revenues, the expenses, and the net income of Garner's enterprise fund (a type of proprietary fund). ample, in the case of a water fund, fees earned for providing water. Also, revenues are recorded as they are earned, consistent with the focus of the govern- are subsidized by resources that are not regardless of their availability (unlike mental funds’ operating statement on generated by the operation itself. Com- the governmental funds’ operating transactions that affect cash. However, mon examples are taxes, grants, interest statement). Otherwise, the account cap- with the proprietary funds’ focus being revenue, and intergovernmental rev- tions themselves are relatively self- much broader, the cost of a capital asset enue. In many cases these are substan- explanatory. is allocated over its useful life, not sim- tial amounts. They are classified as Operating expenses. This category ply expensed when it is purchased. De- “nonoperating” activities simply to in- identifies the expenses generated by pro- preciation expense does not result in a dicate that they are not generated by the viding particular operations. In the pre- cash outflow but systematically reduces operation itself but are the result of ex- ceding example of the water fund, all the fund’s equity in an asset as it is be- ternal events (for example, taxation). the direct costs of providing water ser- ing used. Likewise, expenses are incurred that are vice are considered operating expenses. Bad debt expense occurs when ser- not a direct result of the operation. The Some common types of operating ex- vice billings are not collected. Often, most common example is interest expenses are salaries and wages, employee such accounts receivable are “written pense associated with a fund’s long- benefits, materials, and supplies. off” as a loss when it is determined that term debt. Expenses incurred as part of the op- they will not be collected. Such losses Transfers to/from other funds. Pro- eration but not resulting in a cash out- are considered operating expenses. prietary funds often receive operating lay are included in the operating ex- Operating income. The net of oper- transfers from other funds or provide pense category. Two common examples ating revenues and operating expenses transfers to other funds. For example, are depreciation and bad debt expense. is known as “operating income.” This the electric fund may routinely transfer “Depreciation” is the allocation of the amount simply identifies the income (or money to the general fund to keep cost of an asset over its useful life. In the loss) generated by the operation itself. property tax rates down (property governmental funds, the full cost of ac- (For an excerpt of a statement show- taxes being the primary source of rev- quiring a capital asset is recognized ing operating revenues, operating ex- enue for the general fund). When this when the transaction occurs (for expenses, and operating income, see Ex- occurs, the transactions are reported as ample, capital outlay expenditure). hibit 4.) gross amounts (that is, transfers in and Therefore the financial reporting theory Nonoperating revenues and ex- transfers out are not combined into one of depreciation does not apply. This is penses. Many proprietary operations sum) on the operating statement in a

spring 2000, popular government 31 tions on utility billings. Examples of cash outflows are payments to vendors and employees. GAAP also require that miscellaneous cash inflows or outflows that do not fit the criteria of the other cash-flow categories be reported as operating activities. Cash flows from non-capital- financing activities. Often a proprietary fund will receive cash inflows or incur cash outflows that are indirectly related to the operation itself but not related to capital acquisitions. (This category is similar to nonoperating revenues and expenses, discussed earlier.) Common examples are tax revenues, grant revenues, and operating transfers from other funds. Examples of non-capital- financing cash outflows are operating transfers to other funds or grants made to other governmental entities. Cash flows from capital financing activities. Especially in proprietary funds, Exhibit 5. This is the second half of Garner's proprietary fund operating cash flows related to capital acquisi- statement. This portion of the statement's column follows the revenue, tions can be very significant. Examples expense, and net income portion shown in Exhibit 4. of cash inflows related to capital financing are debt proceeds associated with capital financing, grants restricted to separate category immediately follow- tively to identify cash flows. GAAP re- acquisition of capital items, and trans- ing the nonoperating category. quire that governments with propri- fers from other funds restricted for Net income. Operating income mi- etary and nonexpendable trust funds capital purposes. Also, cash generated nus nonoperating revenue and ex- include a statement of cash flows in by the sale of any fixed assets is reported penses, as well as transfers in and out of their external financial statements (for as a cash flow from capital financing the fund, is captioned “net income.” an excerpt, see Exhibit 6).9 activity. Examples of cash outflows are This amount either increases the fund’s The statement of cash flows focuses purchase of capital items and debt- equity (that is, retained earnings), re- on transactions that directly affect the service payments when the debt is capi- sulting in a net income, or decreases it, fund’s cash balance. Governments have tal related. resulting in a net loss. the option of focusing on cash alone Cash flows from investing activities. (For an excerpt of a statement show- or including cash equivalents. A “cash The statement of cash flows segregates ing nonoperating revenues and ex- equivalent” is defined as a highly liquid, all activity associated with the fund’s penses, and net income, see Exhibit 5.) short-term investment that has an origi- investing activities. Sales or maturi- The ending retained earnings should nal maturity (maturity at the time of ties of investments, as well as interest agree with the retained earnings re- purchase) of no more than ninety days. earned and collected on those invest- ported on the combined balance sheet. Each of the cash flows is reported at ments, are reported as cash inflows in Events such as residual equity transfers gross amounts. Simply put, cash in- this category. Purchase of investments is or prior period adjustments are re- flows are reported separately from cash the most common cash outflow associ- ported as direct adjustments to the re- outflows. For example, operating trans- ated with investing. tained earnings balance. fers in are reported separately from operating transfers out. The net result of all the identified The Combined Statement of Cash This statement focuses on four cat- cash inflows and outflows per propri- Flows: Proprietary Funds egories of cash flows, as follows. The etary fund type represents how cash10 As explained earlier, the governmental transactions identified within each cat- changed from the beginning of the year funds’ operating statement basically egory are relatively self-explanatory. to the end. The ending cash amount gauges the cash inflows and outflows of should agree with the cash amounts re- the governmental funds. In contrast, the Cash flows from operating activities. ported by fund type on the combined proprietary funds’ operating statement Any proprietary fund has cash inflows balance sheet. includes cash and noncash transactions. and outflows associated with the opera- GAAP recognize that some transac- Therefore the proprietary funds’ oper- tion of the activity itself. The most com- tions do not result in actual cash in- ating statement cannot be used effec- mon example of a cash inflow is collec- flows or outflows but are not obvious

32 popular government, spring 2000 on the proprietary funds’ operating statements. “Noncash” transactions that affect the assets and the liabilities of a fund, and would have been reported in the operating, non-capital- financing, or capital financing categories if cash had actually exchanged hands, must be disclosed in a separate noncash activities section of the statement of cash flows. Two of the most prevalent examples of this type of transaction are acquisition of a capital asset through a capital lease agreement (that is, acquisition of an asset and in- currence of a liability without any ini- tial cash flow) and receipt of a capital asset by donation, such as water and sewer lines from a developer.

The Statement of Changes in Net Assets: Pension Trust Funds Most local governmental entities participate in pension plans for their employees that are under the fiduciary care of another entity. The most common example of this in North Carolina is the Local Governmental Employees’ Retirement System. The state is the fiduciary of a pension plan that benefits participating local governmental employers and employees in North Carolina. However, some local governments either sponsor an additional plan for their employees only or provide a plan in lieu of participation in the state- sponsored plan. The most common example is the Law Enforcement Officers’ Special Separation Allowance. In these cases the local government acts as the fiduciary of a pension plan, and GAAP require the inclusion of a separate operating statement for that plan (for a sample, see Exhibit 7) because the required format of the statement is so different from that of a proprietary fund. (The assets, the liabilities, and the equity of such a plan are included on the combined balance sheet.) The resources of a pension plan are categorized as “additions to net assets,” and the uses of those resources are categorized as “deductions from net assets.” Additions include contributions from employers, contributions from Exhibit 6. This is an excerpt from fictional Carolina County's more exten- participating employees, and net invest- sive statement of cash flows. There is a column for each fund type; the ment income.11 Deductions include ben- information shown here is for the enterprise fund. efits (and refunds) paid to participants in the plan, as well as administrative

spring 2000, popular government 33 mental accounting, management and elected officials can better fulfill their fiduciary duties.

Notes 1. STEPHEN J. GAUTHIER, AN ELECTED OFFICIAL’S GUIDE TO FINANCIAL REPORTING at 8 (Chicago: Government Finance Offic- ers Association, 1995). 2. N.C. GEN. STAT. § 159-34. Hereinaf- ter the General Statutes will be cited as G.S. 3. Governmental financial statements sometimes report these interfund loan ar- rangements with the “due to/due from” terminology discussed earlier. Although this is technically not prohibited, the use of the different language is designed to identify clearly the underlying nature of the transaction. 4. GAAP define “availability” as revenue collected in cash as of the end of the fiscal year, or within a short period following the end of the fiscal year. The North Carolina Local Government Commission recommends that the availability period be no more than sixty days. In practice the short period is usually sixty to ninety days following the balance sheet date. 5. G.S. 159-13(b)(16). 6. If a government also has expendable trust funds, they will be included in a separate column on this statement. The technical title of a governmental fund operating statement is Combined Statement of Revenues, Expenditures and Changes in Fund Bal- ances. 7. The technical title of this statement is Combined Statement of Revenues, Ex- penditures and Changes in Fund Balances— Budget and Actual. Most governments pre- Exhibit 7. This sample operating statement for Carolina County's pension pare additional statements and schedules trust fund is typical for a government required to report such information. that exhibit budgetary compliance for individual funds. For example, if a government prepares a comprehensive annual financial report, such information is included therein. 8. The technical title of the proprietary expenses incurred in the operation of edge in interpreting the information, fund operating statement is Combined the plan. but any interested party certainly can Statement of Revenues, Expenses and As with the operating statements of glean useful information from these Changes in Retained Earnings. If a govern- both the governmental and the propri- statements. External financial reporting ment also has a nonexpendable trust fund, it etary funds, the net of these additions is the specific responsibility of manage- will be included in a separate column on this and deductions is the increase or the ment. Management and elected officials statement. decrease in the pension plan’s equity for must make every effort to understand 9. The technical title of the statement the year. the landscape of these financial state- of cash flows is Combined Statement of ments. This article is designed not to Cash Flows. teach the principles of governmental 10. Governments also may include cash Conclusion equivalents. GAAP but to highlight for management 11. Investment income is reported mi- Financial statements for local govern- and elected officials the fundamental in- nus appreciation or depreciation of the fair mental entities can be very complex. formation included in the combined fi- value of investments, as well as administra- Those with at least limited knowledge nancial statements. By understanding tive costs and costs associated with invest- of governmental accounting and finan- the basic logic of financial presentation, ment management (for example, an invest- cial reporting principles may have the and the terminology unique to government adviser’s fees).

34 popular government, spring 2000