Chapter 1

For businesses, the annual report is the most significant financial document. A major company's announcement of annual earnings

(the preview of the annual report) makes front‐page news. By contrast, its annual budget is nothing more than an internal document, seldom made available to investors or the general public.

Each category of government will likely differ from others in the services it provides,

, the type of assets it controls, its taxing and borrowing authority, and the parties to which it is accountable.

The main users of the financial statements of governments and not‐for‐profits—like those of the financial statements of businesses—are the parties to whom the organizations are accountable. They include

-Governing boards -Investors and creditors -Taxpayers and citizens and organizational members -Donors and grantors -Regulatory and oversight agencies -Employees and other constituents

Budget

A plan of financial operations embodying an estimate of proposed expenditures for a given period and the proposed means of financing them.

American Institute of Certified Public Accountants (AICPA)

A professional organization for certified public accountants (CPAs) that is responsible for establishing auditing and related professional standards.

Fund accounting

An accounting system in which an entity's resources are divided among two or more accounting entities known as funds

Not-for-profit

An entity that conducts operations for the benefit of its users without a profit motive and has absence of ownership interests.

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Another government can unilaterally dissolve it and assume its assets without compensation. Under our legal system, a government can arbitrarily seize the assets only of other governments within its jurisdiction—not those of not‐for‐profits or businesses.

The purposes for which external financial statements—those included in an annual report—are employed vary from user to user and facilitate a combination of functions.4 For the most part, they should allow users to: 1

Assess financial condition. Users need to analyze past results and current financial conditions to determine the ability of the entity to meet its obligations and to continue to provide expected services. By establishing trends, users are better able to predict future fiscal developments and to foresee the need for changes in revenue sources, resource allocations, and capital requirements.

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Budgetary and fiscal compliance. "Financial reporting should demonstrate whether resources were obtained and used in accordance with the entity's legally adopted budget; it should also demonstrate compliance with other finance‐related legal or contractual requirements."

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Compare actual results with the budget. In light of the importance of the adopted budget, users want assurance that the entity adhered to it. Significant variations from the budget may signify either poor management or unforeseen circumstances that require an explanation.

Expenditures

Decreases in net financial resources under the modified accrual basis of accounting

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Determine compliance with appropriate laws, regulations, and restrictions on the use of the funds. Users want evidence that the organization has complied with legal and contractual requirements, such as bond covenants, donor and grantor restrictions, taxing and debt limitations, and applicable laws. Violations not only can have serious financial repercussions but can also jeopardize the entity's viability.

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Evaluate efficiency and effectiveness. Users want to know whether the entity is achieving its objectives and, if so, whether it is doing so efficiently and effectively. Hence, they need to compare accomplishments (outcomes) with service efforts and costs (resource inputs).

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Financial reporting should assist users in assessing the level of services that can be provided by the governmental entity and its ability to meet its obligations as they become due.

The GASB established two additional objectives, each also having three subobjectives. 1

Financial reporting should assist users in evaluating the operating results of the governmental entity for the year.

Municipality

In common usage, a municipality is a village, town, or city. Government specialists, however, use the term to refer also to any other nonfederal government, including school districts, public authorities, and even states.

Second, in business, the budget is an internal document, seldom made available to external parties.

In governments and not‐for‐profits, it stands as the key fiscal document that is as important to taxpayers, bondholders, and other constituencies as it is to managers.

Interperiod equity

In recent years, to emphasize that entities should not transfer the costs even to future years, to say nothing of future generations, the term interperiod equity has been accepted as more appropriate.

The GASB has divided the objective of accountability into three subobjectives: 1

Interperiod equity. "Financial reporting should provide information to determine whether current‐year revenues were sufficient to pay for current‐year services." It should show whether current‐year citizens shifted part of the cost of services they received to future‐year taxpayers.

The following characteristics, in addition to the power to tax, are indicative of a government: 1

It may issue tax‐exempt debt. Section 103(a) of the Internal Revenue Code exempts the interest on the debt of states, territories, and their political subdivisions from federal taxation. This privilege is a substantial economic benefit to governments because it reduces their borrowing costs. Virtually all local governments qualify as subdivisions of states and territories. Not‐for‐profits, such as colleges, universities, and hospitals, do not have this opportunity. However, they may be the beneficiaries of it, as governments may be permitted, on a limited basis, to issue tax‐exempt debt on their behalf.

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Its governing bodies are either popularly elected or appointed by another government. The governing body of a typical government is elected by the citizens within its jurisdiction. The governing boards of other governments, particularly public authorities, may be appointed by the legislature or by public officials of another government.

Fiscal compliance

One of the three subobjectives of government accountability; financial reporting should demonstrate compliance with other finance-related legal or contractual requirements.

SEA reporting provides decision‐useful information about an entity's efficiency and effectiveness in providing services to its citizens and other constituents that is not included in traditional financial statements. In 1994, the GASB stressed the importance of

SEA information by issuing Concepts Statement No. 2, Service Efforts and Accomplishments Reporting. Fourteen years later, after conducting research and constituent outreach, it reaffirmed the importance of SEA information by issuing Concepts Statement No. 5, Service Efforts and Accomplishments Reporting (An Amendment of GASB Concepts Statement No. 2).

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Service efforts costs and accomplishments. "Financial reporting should provide information to assist users in assessing the service efforts costs and accomplishments of the governmental entity." This information helps users assess the government's "economy, efficiency, and effectiveness" and "may help form a basis for voting or funding decisions.

Governmental Accounting Standards Board (GASB)

The authoritative accounting and financial reporting standard-setting body for government entities.

Intergenerational equity

The concept that constituents pay for the services that they receive and do not shift the burdens to their children has traditionally been labeled as this

Accountability

The cornerstone of financial reporting; requires governments to answer to its citizens and provide a "right to know" for public information.

Federal Accounting Standards Advisory Board (FASAB)

The federal board charged with establishing federal accounting standards

Revenues

The inflow of net resources owing to the production and delivery of goods or services or from transactions (e.g., taxes, contributions) involving an entity's primary activities.

Financial Accounting Standards Board (FASB)

The organization responsible for establishing external accounting and reporting standards for all nongovernmental entities, including not-for-profit organizations.

In the government and not‐for‐profit arenas, profit is no more an appropriate measure of performance for external parties than it is for internal departments.

The relevant performance measures must be drawn from the organizations' unique goals and objectives and are unlikely to be the same for all user groups.

Independent, or third, sector

The sector of the economy that is composed of not-for-profit organizations (as opposed to governmental and business entities).

Generally Accepted Accounting Principles (GAAP)

Uniform minimum standards and guidelines for financial accounting and reporting that govern the form and content of financial statements. They encompass the conventions, rules, and procedures necessary to define accepted accounting practice at a particular time.

Not‐for‐profit differentiates entities that don't intend to earn

a profit from those that simply fail to do so.

Currently, few governments and not‐for‐profits have established budgetary and accounting systems to measure and report adequately on the nonmonetary aspects of their performance. However,

accounting standard‐setting authorities have recognized the importance of performance measures and have taken steps to encourage the entities under their purview to provide them

. Governments, unlike not‐for‐profits, have the authority to command resources. They have the power to tax, collect license and other fees,

and impose charges. Should a government lack funds to satisfy its obligations or enhance services, it can obtain them by legislative action. From the perspective of accountants or financial analysts, this ability suggests that the actual assets reported on a government's balance sheet may not represent all the assets under its control

Governments and not‐for‐profits also borrow routinely from banks and other financial institutions. The loans may either finance new facilities or cover short‐term imbalances between cash receipts and cash disbursements. The lenders

and potential lenders use the financial statements of the governments and not‐for‐profits just as they would those of corporations—to help assess the creditworthiness of the borrowers.

Just as the auditors' reports on the financial statements of corporations are generally addressed to their boards of directors, those of governments and not‐for‐profits are directed to their governing boards. That the governing boards

are the prime recipients of the audit reports strongly implies that they are among the principal users of both the auditors' reports themselves and the accompanying financial statements.

Accounting principles can—and frequently do—have economic consequences. Important decisions and determinations are made on the basis of financial data

as presented and without adjustment.

Further, some not‐for‐profits, such as the United Way or organizations that fund medical research,

base their expenditures exclusively on their revenues. The more funds they raise, the more they spend.

Both governments and not‐for‐profits issue

bonds primarily to finance long‐term assets.

Standard‐setting authorities, the accountants and auditors of individual organizations, and statement users need to be aware that

budgets and financial statements can be intended to mislead. They must resist and adjust for any biases.

Even more critically, they need a system that either prevents them from overspending or sets off warning signals when they are about to do so. The budget is a control device, but it requires the support of a

complementary accounting and reporting system. Finally, auditors and other parties concerned with the organization's performance require a basis on which to evaluate accomplishments.

The revenues from donations of a not‐for‐profit entity may increase from one year to the next, but the change may be unaccompanied by a corresponding increase in the quantity, quality, or cost of services provided. Thus, the matching

concept—financial accounting's central notion that expenditures must be paired with corresponding revenues—may have a different meaning for governments and not‐for‐profits than for businesses.

Because it is so important, the budget, unlike the annual report, is a source of

constituent concern and controversy. Government budget hearings often draw standing‐room‐only crowds to the legislative chambers. The budget debates of religious organizations such as churches and synagogues are frequently marked by fervor more intense than that found in the congregants' worship services.

A government or not‐for‐profit's release of its annual report is customarily ignored by both organizational insiders and outsiders. Seldom does the report

contain surprises, for if revenues and expenditures were markedly different from what were initially budgeted, the entity probably was required to amend the budget during the year

the economic value of an asset is the present or discounted value of the cash inflows that it will generate or the cash outflows that it will enable the entity to avoid. Hence,

conventional capital budgeting models specify that in evaluating a potential asset acquisition, the business should compare the present value of the asset's expected cash outflows with its inflows.

annual reports are in fact better than budgets at capturing the

economic substance of the transactions and are far less subject to preparer efforts to artificially boost revenues or reduce expenditures.

Most governments are required by law, and most not‐for‐profits are expected by policy, to balance their operating budgets. Balanced operating budgets

ensure that, in any particular period, revenues cover expenditures and that, as a group, the entity's constituents pay for what they receive.

Approximately 90,000 local governments currently

exist in the US

In sum,

expenditures drive revenues

In elaborating on this objective, the FASB stresses that external financial statements can "best meet that need by disclosing failure to comply with spending mandates (which presumably are

expressed in budgets) that may impinge on an organization's financial performance or on its ability to provide a satisfactory level of services." By contrast, the GASB makes budgetary and fiscal compliance a central concern of financial reporting.

Local governments are normally obligated to file financial reports with state agencies; charitable organizations may have to file IRS Form 990 with the

federal government as well as similar financial forms with either state or local authorities, and religious and fraternal associations may have to file financial reports with their umbrella organizations

. However, a careful reading reveals significant differences in emphasis. These disparities have resulted in accounting and reporting standards that give decidedly different looks to the

financial reports of the two types of entities. For example, FASB objectives refer only obliquely to budgetary compliance. They provide that information should be useful in "assessing how managers of a nonbusiness organization have discharged their stewardship responsibilities."

Moreover, a government's release of its annual report is seldom newsworthy. The reports are ordinarily issued at least three months after the close of the government's

fiscal year, and current reporting practices are anything but user friendly.

e Governmental Accounting Standards Board (GASB), for state and local governments; the Federal Accounting Standards Advisory Board (FASAB),

for the federal government; and the Financial Accounting Standards Board (FASB), for the private sector, including private (nongovernmental) not‐for‐profits.

Financial Accounting Standards Board objectives for not‐for‐profit entities are

for the most part, seemingly similar to those of the GASB for governments.

Businesses attempt to match the costs of specific goods or services with the revenues that they

generate. Governments and not‐for‐profits, however, can sometimes do no more than associate overall revenues with the broad categories of expenditures they are intended to cover.

Governments and not‐for‐profits are governed mainly by their budgets, not by the marketplace. These organizations control or strongly influence both their revenues and expenditures through the budgetary process. The revenues of a

government may be determined by legislative action, and if they are, the government may not be subject to the forces of competition faced by businesses. Those of the not‐for‐profits, although they cannot be established by legal mandate, may be obtained from contributions, dues, tuition, or user charges—none of which are comparable to the sales revenue of a business.

As a consequence, government financial statements incorporate numerous mechanisms to demonstrate that the entity has acted in accord with budgetary mandates,

has adhered to the provisions of grants and contracts, and has complied with all applicable laws and regulations. These include reporting by fund, accounting for encumbrances (goods and services on order), and required actual‐to‐budget comparisons

As will be discussed in subsequent chapters, state‐of‐the‐art budgets establish that basis by indicating not only

how much will be spent on a particular activity but also what the activity will achieve.

Moreover, although the FASB statement of objectives, like that of the GASB, lists a wide range of potential users,

in practice the FASB standards aim at a far narrower group of users—mainly donors and other contributors of resources.

GASB and FASB objectives both endorsed the notion that financial reporting encompasses information on service efforts and accomplishments (SEA). This information cannot easily be expressed in monetary units and is still only rarely

included in the financial statements of either state and local government or not‐for‐profit organizations. Yet, the reporting of SEA performance information is important in assisting both governments and not‐for‐profits to demonstrate accountability to citizens and other resource providers.

not‐for‐profits are also many in number: over one million in the United States. These entities constitute what is sometimes referred to as the

independent, or third, sector. Their diversity limits the suitability of a common accounting model (i.e., set of accounting and reporting principles) for any single, or even for any particular type of, government or not‐for‐profit entity.

. Therefore, a conventional statement of revenues and expenditures cannot supply

information on demand for services. Supplementary information is required.

The concept that constituents pay for the services that they receive and do not shift the burdens to their children has traditionally been labeled as

intergenerational equity. In recent years, to emphasize that entities should not transfer the costs even to future years, to say nothing of future generations, the term interperiod equity has been accepted as more appropriate.

As noted earlier, neither governments nor not‐for‐profits have owners, and therefore they do not

issue shares of stock. Nevertheless, they look to the same financial markets as do corporations to satisfy their capital requirements.

As will be apparent throughout this text, the conflict between the two objectives of interperiod equity and budgetary compliance characterizes many of the

issues that government accountants, and the GASB in particular, have to face in ensuring that financial statements are informative and useful to the parties that rely on them.

In a government or not‐for‐profit, revenues may not be

linked to constituent demand or satisfaction.

The most obvious financial reporting implication of this distinction is that the

mathematical difference between assets and liabilities cannot sensibly be termed owners' equity. Some other term is required.

Therefore, as with budgets, the organization must design its accounting system so that management is prevented from inadvertently

misspending restricted resources. To this end, governments and not‐for‐profits employ a system of accounting known as fund accounting,

Investors commonly acquire the bonds of governments and

not‐for‐profits as part of an investment portfolio that also includes corporate securities.

The financial reports of governments and not‐for‐profits can provide information about an organization's inflows (revenues) and outflows (expenditures)

of cash and other resources. As a general rule, an excess of expenditures over revenues, particularly for an extended period of time, signals financial distress or poor managerial performance.

The concept of interperiod equity does not suggest that governments should never borrow. The prohibition against debt applies

only to operating, not capital, expenditures.

In addition, individual donors can, and should, obtain financial information about a charity prior to contributing to it. They can inquire as to the

organization's allocation of resources, the proportion of its resources directed to substantive programs as opposed to fundraising, and the salaries of the most highly paid executives

A postperiod assessment can then focus not only on whether the entity met its revenue and expenditure projections but also, equally important, on whether it attained what was expected of it. Evaluators can then assess

organizational efficiency by comparing inputs (such as dollar expenditures) with outcomes (results). The accounting system should be fashioned to facilitate this comparison, ensuring that the organization reports and categorizes both revenues and expenditures in a way that is consistent with the budget.

Third, the distinction between internal and external parties in governments and not‐for‐profits is more ambiguous than it is in business. Taxpayers and

organizational members, for example, cannot be categorized neatly as either insiders or outsiders. Although they are not paid employees (and thus, not traditional "insiders"), they may nevertheless have the ultimate say (through either direct vote or elected officers) on organizational policies.

U.S. managers of both corporations and public enterprises have been accused of sacrificing the long‐term welfare of their

organizations for short‐term benefits—sometimes for their organizations and other times only for themselves.

Moreover, governments and not‐for‐profits have relationships with the

parties providing their resources that are unlike those of businesses.

General‐purpose financial statements are targeted mainly at parties external to the organization. As is the case in corporate accounting, reports intended for external groups are inappropriate for many types of managerial decisions. Executives, agency heads, and other managers can, and should,

rely on their organization's internal reporting system for the financial information they require. Nevertheless, the information needs of internal and external parties may overlap. Therefore, internal parties, though not intended to be principal users of general‐purpose financial statements, may in fact rely on them for a considerable amount of necessary data.

June 1999. Statement No. 34 required the most significant changes to the

reporting model in 60 years and, in fact, does require that governments prepare the two sets of financial statements cited in the previous paragraph.

major donors and grantors—such as the United Way; the Ford Foundation; and federal, state, and local governments—are more discriminating in how they part with their resources. They not only will

request financial reports and other relevant fiscal information from supplicant associations but will also examine and analyze them with the same care as a banker making a loan.

. For the most part, governments and not‐for‐profits provide services targeted at groups of constituents either advocating a political or social cause or carrying out

research or other activities for the betterment of society. The objectives of governments and not‐for‐profits cannot generally be expressed in dollars and cents, are often ambiguous, and are not easily quantifiable.

for example, a sizable share of one government's revenues may be from other governments and, more than likely,

restricted for specific purposes. The federal government may give a state or local government a grant for construction of low‐income housing, in which case the award can be used only for low‐income housing and not for any other purposes, irrespective of how worthy they might be.

Both governments and not‐for‐profits need to assure the parties providing the restricted funds that the money is used properly. At the same time, they must

show in their financial reports that the restricted resources are unavailable for purposes other than those specified. Therefore, the financial statements must either segregate the restricted from the unrestricted resources or disclose by some other means that some resources can be used only for specific purposes.

More substantively, however, the distinction suggests that the financial

statements of governments and not‐for‐profits must be prepared from the perspective of parties other than stockholders.

A government's governing body is typically an elected or appointed legislature,

such as a city council or a board of commissioners. A not‐for‐profit's governing body is usually a board of trustees or a board of directors.

Governments and not‐for‐profit organizations have much in common with businesses. However, the differences between the two environments are

sufficiently pronounced that business schools have established a separate course in governmental and not‐for‐profit accounting apart from the usual accounting courses—financial accounting, managerial accounting, auditing, and information systems.

This statement reflected developments in SEA accounting and reporting that occurred in the years since Concept Statement No. 2 was issued. Then, in July 2010, the GASB further promoted SEA reporting by issuing Suggested Guidelines for Voluntary Reporting, SEA Performance Information. Nevertheless,

the GASB has so far been unable to convince key constituents (mainly preparer groups) that SEA information should be an integral part of external financial reports. Consequently, it continues to encourage, but does not mandate, SEA reporting.

Taking into account the unique characteristics of governments and their environment,

the Governmental Accounting Standards Board has established accountability as the cornerstone of financial reporting.

Many—probably most—bondholders do not themselves evaluate the bonds they acquire. Instead, they rely on

the assessments of bond‐rating services and are thereby only indirect users of financial reports

both governments and not‐for‐profits make significant investments in assets that neither produce revenues nor reduce expenditures. Therefore,

the conventional business practices used to value assets may not be applicable.

Neither governments nor not‐for‐profits have defined ownership interests like those of businesses. Typically,

these entities cannot be sold or transferred. Should they be dissolved, they involve no stockholders or bondholders who are entitled to receive residual resources.

Governing boards cannot neatly be categorized as either internal or external users. Customarily,

they are composed of members from outside the management team.

A government's budget may be backed by the force of law. State and local government officials are ordinarily prohibited from spending more than what

was budgeted. Indeed, they can go to jail for severe violations of budgetary mandates.

Constituents of an organization want information on the extent of adherence to the budget. They want assurance that the organization has not spent more than

what was authorized. They want to know whether revenue and expenditure estimates were reliable. The accounting system and the resultant financial reports must be designed to provide that information.

Governments and many not‐for‐profits establish the level of services that they

will provide, calculate their cost, and then set tax rates and other fees to generate the revenues required to pay for them

it is ironic that the standard‐setting agencies focus exclusively on the annual report. Except insofar as governments—such as states—establish rules for cities or other governments

within their jurisdiction, or parent not‐for‐profits—such as national fraternities—set guidelines for local affiliates, budgetary practices are within the discretion of the individual entity.