Chapter 3

Fixed budgets

A budget in which costs and revenues are fixed—that is, not subject to change as a result of increases or decreases in the volume of goods or services to be provided.

Flexible budgets

A budget in which dollar amounts vary according to the volume of goods or services to be provided.

Program budgets

A budget in which resources and results are identified with programs rather than traditional organizational units. See also performance budget

Object classification budget

A budget that details revenues and expenditures by object, rather than, for example, program or nature of activity

Performance budgets

A budget that focuses on measurable units of efforts and accomplishments and associates dollar expenditures directly with anticipated units of outputs or outcomes.

Budgetary control

The control or management of a government or enterprise in accordance with an approved budget to keep expenditures within the limitations of available appropriations and available revenues.

Appropriation budget

The legislatively approved budget that grants expenditure authority to departments and other governmental units in accordance with applicable laws.

In addition, many governments and not‐for‐profits prepare

performance budgets

The budget is executed (carried out) by an organization's executive branch. In some jurisdictions, expenditures are assigned in particular months or quarters by allotments or apportionments. Both allotments and apportionments are

periodic allocations of funds to departments or agencies, usually made by the chief executive's office, to ensure that an entire year's appropriation is not dissipated early in the period covered by the budget. They also prevent a department or agency from spending resources that may not be available in the event that actual revenues fall short of budgeted revenues.

The general approach to budgeting suggested in this chapter for governments is relevant, with some obvious modifications, to not‐for‐profits. The budget process is the same four‐phase process:

preparation, adoption (although by a board of directors or trustees rather than a legislature), execution, and reporting and auditing.

Performance budgets are closely related to program budgets, whereby resources and results are identified with programs rather than traditional organizational units, and expenditures are typically categorized by activity rather than by object. Program budgets often

report performance metrics by objective and may be couched in broader thematic budget areas

Governments may require that appropriation budgets also be developed and approved for special revenue, debt service, or capital project funds, in addition to

the general fund. However, such budgets may be unnecessary if a government has established adequate controls over spending by other means.

Governments, like businesses, should issue

interim financial statements to report on their progress in executing their budgets.

The GASB recommends that, in fund statements, revenues be classified first by fund

(i.e., the columns on a statement of revenues and expenditures) and then by source (i.e., the rows)

The basic books of account of both governments and not‐for‐profits correspond to those of businesses. They consist, either in manual or in electronic form, of:

-Journals, in which journal entries are recorded. Most transactions are entered initially in a special journal—such as a property tax cash receipts journal, a parking fines cash receipts journal, a purchases journal, or a cash disbursements journal. Both nonroutine transactions and account totals from special journals are recorded in a general journal. -Ledgers, in which all balance sheet and operating accounts are maintained. The general ledger consists of control accounts that summarize the balances of the detailed subsidiary accounts that are maintained in subsidiary ledgers.

However, irrespective of whether the budget is of object classification or performance type, in most organizations budgeting is a continuous, four‐phase process:

-Preparation -Legislative adoption and executive approval -Execution -Reporting and auditing

Suggested major revenue source classifications include:

-Taxes -Licenses and permits -Intergovernmental revenues -Charges for services -Fines and forfeits

Budgets

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

Capital budget

A plan of proposed capital outlays, such as for infrastructure, buildings, equipment and other longlived assets, and of the means of financing them.

Some expenditures are fixed by legislative action or can be determined

Accurately

Appropriation

An amount authorized by a legislative body for a department or to make expenditures and incur liabilities for a specified purpose.

These include: 1

Appropriation budgets, which are concerned mainly with current operating revenues and expenditures

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By activity (line of work contributing to a function or program)—such as highway patrol, burglary investigations, and vice patrol

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By character (the fiscal period they are presumed to benefit)—such as "current expenditures," which benefit the current period; "capital outlays," which benefit the current and future periods; and "debt service," which benefits prior, current, and future periods

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By function or program (a group of activities carried out with the same objective)—such as general government, public safety, sanitation, and recreation

Suggested classifications include: 1

By fund—such as the general fund, special revenue funds, and debt service funds

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By object classification (the types of items purchased or the services obtained)—such as salaries, fringe benefits, travel, and repairs

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By organizational unit—such as the police department, the fire department, the city council, and the finance office

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Capital budgets, which focus on the acquisition and construction of long‐term assets

Encumbrances

Commitments to purchase goods or services.

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Controlling and administering. Budgets help ensure that resources are obtained and expended as planned. Managers use budgets to monitor resource flows and point to the need for operational adjustments. Legislative bodies—such as city councils or boards of trustees—use budgets to impose spending authority over executives (such as city managers or executive directors), who in turn use them to impose authority over their subordinates (such as department heads).

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Difference in the reporting entity. As you will learn in Chapter 11, GAAP requires that a government's reporting entity include organizations that are legally independent of the government, yet, in political or economic reality, an integral part of it. For example, a city may create a financing authority—a separate legal entity—to issue bonds on behalf of the city. If the city has political control over the authority (e.g., the mayor appoints the majority of the governing board) or is responsible for its financial affairs (e.g., approves its budget), then GAAP dictates that the authority be reported upon in the city's financial statements. Yet because the authority is a separate legal entity, the city may exclude it from its legally adopted budget.

The differences between legally adopted budgets and the GAAP‐based financial statements can be attributed to several factors. Among them are: 1

Differences in basis of accounting. As previously noted, governments often prepare their budgets on a cash or near‐cash basis, whereas their financial statements must be prepared on a modified accrual basis.

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Differences in perspective. Governments may structure their budgets differently from their financial reports. For example, a government may budget on the basis of programs. The programs, however, may be financed by resources accounted for in more than one fund. Thus, the amounts expended in each of the funds cannot be compared to any particular line item in the budget.

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Differences in timing. As shown in its budget, a government may appropriate resources for a particular project rather than for a particular period. For example, in approving resources for a construction project, the government will typically establish the total amount that can be spent. It will not allocate resources to specific years. By contrast, the annual report of the fund in which the project is accounted would have to present the expenditures year by year. Moreover, governments may permit departments to carry over to subsequent years resources not spent in the year for which they were budgeted. Thus, expenditures in a particular year may not have been budgeted in that year.

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Flexible budgets, which relate costs to outputs and are thereby intended to help control costs, especially those of business‐type activities

Allotments or apportionments

Periodic allocations of funds to departments or agencies to ensure that an entire year's appropriation is not expended early in the period covered by the budget or expended for certain programs or activities to the detriment of others

Budgets are intended to carry out at least three broad functions: 1

Planning.In a broad sense, planning comprises programming (determining the activities that the entity will undertake), resource acquisition, and resource allocation. Planning is concerned with specifying the type, quantity, and quality of services that will be provided to constituents, estimating service costs, and determining how to pay for the services.

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Reporting and evaluating. Budgets lay the foundation for end‐of‐period reports and evaluations. Budget‐to‐actual comparisons reveal whether revenue and spending mandates were carried out. More important, when tied to an organization's objectives, budgets can facilitate assessments of efficiency and effectiveness.

Whereas the GASB specifies the principles of accounting to which governments must adhere in reporting on their governmental funds, it is silent on those they can use in preparing their budgets. Unless a government reports its actual results using budgetary principles or its budget using GAAP

a comparison between the budget and actual results would not be meaningful. Therefore, per Statement No. 34, the GASB requires that governments present their budget‐to‐actual comparisons on a budgetary basis and include a schedule that reconciles the budgetary and the GAAP amounts.

Budgeting is an essential element of the financial planning, control, and evaluation processes of governments. Every governmental unit should prepare

a comprehensive budget covering all governmental, proprietary, and fiduciary funds for each annual (or, in some states, biennial) fiscal period

Budgeting exerts a major influence on

accounting and financial reporting principles and practices.

Unlike fixed budgets, flexible budgets capture the behavior of costs, distinguishing fixed and variable

amounts. A flexible budget is a form of "what‐if?" analysis. Fixed budgets may be appropriate for governmental funds in which the expenditures and level of activity are preestablished by legislative authorization. Flexible budgets are especially suited to enterprise funds in which the level of activity depends on customer demand.

The Governmental Accounting Standards Board (GASB) advises that "multiple classification of governmental expenditure data is important from both internal

and external management control and accountability standpoints" as it "facilitates the aggregation and analysis of data in different ways for different purposes and in manners that cross fund and organizational lines."

Budgeting generally necessitates flows of policies and information to and from all parties involved in the budgetary process. Legislators, for example, will

apprise the executive branch as to what they think is politically feasible for revenue measures. Department heads will inform the legislative or executive budget committees as to what they see as their requirements.

Public attention focuses on the appropriation budget because it determines the amount of taxes, other revenues that must be generated to cover expenditures. Owing to the importance of

appropriation budgets and the influence, they have had upon the establishment of accounting principles and practices, this chapter directs attention mainly to this type of budget.

To complete the budget cycle, information on how the budget was executed must be provided to the analysts and governing officials, who must prepare and adopt the subsequent budget. At a minimum,

both governments and not‐for‐profits should include in their annual financial statements or supplementary reports budget‐to‐actual comparisons for each of the funds for which they have adopted budgets.

Not‐for‐profits differ from governments in at least one critical respect: they lack the authority to tax. Governments can first determine the level of services they wish to provide and then impose the taxes and fees sufficient to provide those services. Nonbusiness types of not‐for‐profits,

by contrast, are limited in their ability to generate revenues and hence must adjust the level of services they provide to the corresponding level of revenues raised.

On the revenue side, a comparable scheme works equally well: advancing the due date of taxes or fees from early in the following budget year to late in the current year, thereby picking up an extra tax or fee payment in the year of the

change. This tactic, like that of delaying the payday, can be employed only once for each revenue or expenditure. New devices must continually be developed.

Although the accounting cycle is traditionally one year, the budgeting process

commonly extends for a considerably longer period. The needs of an organization's constituents must be forecast and planned for years in advance.

Not‐for‐profits, of course, are not subject to the same types of penalties for violating budgetary mandates as governments are. Nevertheless, reliable estimates of revenues and expenditures are no less important. The consequences of underestimating costs or overestimating revenues are obvious. Not‐for‐profits, like businesses, are not guaranteed continued existence. The

consequences of overestimating costs or underestimating revenues, while not as potentially devastating as the reverse, can also be severe—especially to the organization's intended beneficiaries. A homeless shelter may unnecessarily reduce the number of people that it serves; a church or synagogue can cut back programs that it otherwise could have provided; a private college may defer maintenance only to have to incur greater costs to play catch‐up in the future.

To be sure, other sound managerial approaches can overcome the limitations of object classification budgeting. Performance budgets,

however, institutionalize effective decision processes and help ensure that they are carried out.

Upon agreeing to the budget, a legislature officially adopts it by enacting an appropriation measure authorizing expenditures. Legislatures differ in the degree of control that they exert over the details of appropriations. Some appropriate lump sums to

departments or programs, giving the executive branch the flexibility to allocate the resources among the various object classifications. Others go further, specifying not only the departments or programs but also the object classifications on which authorized funds can be expended. Then, any subsequent shifts from one classification to another require legislative approval.

How financial data are presented affects how they are used. Therefore, accountants, public administrators, political scientists, and economists have

directed considerable attention to the form and content of budgets. They are aware that the way the budget is prepared and presented can significantly affect the allocation of resources among organizations, programs, and activities.

The cash basis permits a government to balance its budget by taking any number of steps that artificially delay cash disbursements and advance cash receipts, which is very well illustrated in "In Practice: States Balance Their Budgets the Painless Way." Consider the quintessential budget‐balancing tactic

employed by a number of states and local governments: changing the date on which employees are paid from the last day of the month to the first of the next month. In the year of the change the government is able to pay its employees for one fewer payroll period than it would otherwise.

Correspondingly, when a government is able to defer payments, it need not have the cash on hand until disbursements are required. Taxpayers are understandably reluctant to part with their dollars so that the government can retain the cash as "savings" until the year needed. Suppose that government

employees are permitted to defer until future years vacations that are earned in a current year. Although the services of the employees unquestionably benefit the period in which the vacations are earned, the government does not need—and the taxpayers might object to providing—the cash for the vacation payments until the employees actually take the vacations.

Comprehensive performance budgeting systems require managers to specify objectives, consider alternative means of achieving them,

establish workload indicators, and perform cost-benefit analyses.

The preparation of a budget requires both forecasts and estimates. Relatively few types of revenues can be determined accurately in advance of the budget period. These types are limited mainly to those that are contractually

established (e.g., from lease agreements), have been previously promised (e.g., grants from other governments), or are set by law and affect a known number of parties (e.g., property taxes and special assessments). Most, however, depend on factors that are largely outside the government's control. Most types of tax revenues, for example, are influenced by economic conditions; revenues from fines and fees are affected by the predilections of the citizenry.

These are budgets that focus on expected revenues, expenses, and net income under different assumptions of volume. Governments use flexible budgets for enterprise funds, which account for business‐type activities,

even though enterprise funds are generally not subject to the same statutory budget requirements as governmental funds.

The modified accrual basis does not allow for balance sheet recognition of long‐term assets and debts. However, it does permit a wide array of transactions and

events to be recognized when they have their substantive economic impact, not merely when they result in cash inflows and outflows. Many governments, however, reject the GASB's advice. They opt to prepare budgets on a cash basis or a slightly modified cash basis.

These assets can be expected to last for many years. Therefore, in the interest of interperiod equity, they generally are

financed with long‐term debt rather than taxes of a single year. The capital budget is, in essence, a plan setting forth when specific capital assets will be acquired and how they will be financed.

Despite the importance of budgets and the influence of budgeting on financial reporting, both the GASB and the Financial Accounting Standards Board (FASB) establish generally accepted principles only for financial reporting, not

for budgeting. Budgetary principles are established either by individual governments or organizations or by the governments or organizations that supervise them (e.g., states may establish the principles for their cities, towns, and districts; national associations may establish principles for their local chapters).

Thus, in the face of a balanced budget requirement, the cash basis of accounting ensures that the

government receives in taxes and other revenues only what it is required to disburse.

Governments and not‐for‐profits are disciplined mainly by their budgets, not by the competitive marketplace. With few exceptions,

governments reflect all significant decisions—whether political or managerial—in their budgets.

Nevertheless, budgets are as important to enterprise funds as they are to businesses and governmental funds. As a rule,

governments should prepare the same types of budgets for enterprise funds as would a private enterprise carrying out similar activities. For certain, they should prepare a series of flexible budgets, each of which contains alternative budget estimates based on varying levels of output.

Owing to the adverse consequences of violating budgetary mandates, both governments and not‐for‐profits can build safeguards into their accounting systems that help ensure budgetary compliance. These include preparing

journal entries both to record the budget and to give recognition to goods and services that have been ordered but not yet received.

Budgets are most commonly prepared by an organization's executive branch (e.g., the office of the mayor or executive director) and submitted to the

legislative branch (e.g., a city council or board of trustees) for approval. In some jurisdictions, particularly states, the legislature may either prepare its own budget or join with the executive branch in developing a common budget.

The benefits of the budgetary process cannot be fully achieved by a single budget or type of budget. A well‐managed government or not‐for‐profit—just

like a well‐managed business—should prepare budgets for varying periods of time from multiple perspectives.

Owing to these deficiencies, many governments and not‐for‐profits have adopted performance budgets in place of, or as a supplement to, object classification budgets. Performance budgets focus on

measurable units of efforts, services, and accomplishments. They are formulated so that dollar expenditures are directly associated with anticipated units of outputs or outcomes. They enable managers to define goals, plan their resource needs, and measure the achievement of their various objectives

Performance budgets, unlike traditional object classification budgets, create the basis for evaluating and auditing organizational efficiency and effectiveness. These budgets specify anticipated outputs or outcomes in a quantifiable,

measureable form. They thereby provide auditors (both internal and independent) with objective benchmarks by which to gauge organizational accomplishments and to compare them with budgetary expectations.

Significant errors in budget estimates, irrespective of direction or cause, thwart the political process and may lead to a distribution of resources that

misrepresent what was expressed by voters through their elected representatives. At the very least, as suggested by "In Practice: Budgeting and Legislative Constraints," they can make for colorful political contretemps. Insofar as budgets are used by investors or creditors, they may contribute to misguided fiscal decisions and misallocation of resources.

the not‐for‐profit sector covers organizations that range from those that depend entirely, or almost entirely, on donor contributions (e.g., certain social service organizations) to those that are run

much like business (e.g., a university "co‐op" bookstore). Accordingly, the budgeting process must be custom designed to suit each particular type of entity.

Similarly, by issuing bonds, it may authorize spending for specified capital projects. Still, principles of sound management dictate that a

nonappropriation budget—a financial plan not subject to appropriation—be prepared each year for such funds and organizational units. Budgets of some type are almost always necessary if activities are to be effectively planned, controlled, and evaluated.

The traditional, and most commonly prepared, budget is referred to as an object classification budget because it is characterized by the expenditure classification that categorizes objects—such as the type of goods or services to be acquired. The primary virtue of an

object classification budget is that it facilitates control. The managers who prepare the budget, and the legislators who pass it, establish rigid spending mandates and thereby direct, in detail, how every dollar should be spent.

Cash basis budgeting complicates financial accounting and reporting. Governments must maintain their accounts to facilitate preparation of two sets

of reports—one that demonstrates compliance with the budgetary provisions and one in accordance with GAAP.

A capital budget, in contrast to an appropriation budget, typically covers multiple years,

often as many as five. It concentrates on the construction and acquisition of long‐lived assets such as land, buildings, roads, bridges, and major items of equipment.

Moreover, the committees authorizing new programs may be different from those determining the amount to be spent

on them. The committees typically make recommendations to the legislature as a whole; the legislature may revise their proposals as it deems appropriate.

A government's current or operating budget covers its general fund. The operating budget is almost always an appropriation budget—

one incorporating the legislatively granted expenditure authority, along with the related estimates of revenue. In most state and local jurisdictions, the operating budget must, by law, be balanced.

Capital budgets are closely tied to operating budgets. Each year a government must include current‐year capital spending in its

operating budget. If the capital projects are financed with debt, however, the capital expenditures will be offset with bond proceeds and will not affect the operating budget's surplus or deficit.

By assessing performance, instead of mere compliance with budgetary spending mandates, auditors can transform the audit from what administrators may

perceive as an annoyance into an essential element of the management process.

The deleterious consequences of cash basis budgeting are exacerbated by the use of fund accounting. Because each fund is a separate accounting entity, governments can readily transfer resources from a fund that has a budget surplus or that does not require a balanced budget to one that needs extra

resources. Some governments budget interfund "loans" for the last day of one fiscal year and repayments for the first day of the next. Others delay, for one day, required payments from the general fund to other funds or sell assets, sometimes to entities that they themselves created and control, and lease them back. Still others reduce expenditures in ways that may balance the budget in the short term but will unquestionably have deleterious consequences in the long term

Governments integrate their budgets into their accounting systems. In that way, they are able to monitor continually how

revenues and expenditures to date compare with the amounts that have been estimated or authorized. Moreover, to enhance control and facilitate end‐of‐period, budget‐to‐actual comparisons, they use the same account structure for their budgets as for their actual revenues and expenditures.

Governments have valid reasons for budgeting on a cash basis. After all, bills must be paid with cash, not receivables or other assets; therefore, the required cash must be on hand in the year the payments have to be made. And goods or

services must be paid for in the year of acquisition (or in the periods set forth in a borrowing agreement), not necessarily in the year or years in which the benefits will be received.

the budgets of governments have the force of law, and officials may be subject to

severe penalties for violating them. To prevent overspending, governments are required to institute certain accounting controls—such as integrating both the budget and purchase orders into their accounting systems—that are optional for not‐for‐profits.

In contrast to expenditures, revenues present less significant issues of classification. Most revenues are not designated for

specific purposes (or, if they are, they are reported in separate funds); therefore, their classification is relatively straightforward.

Property taxes are commonly levied (authorized by the legislature) annually. Most other revenues—

such as income and sales taxes—are not authorized each year unless there is to be a change in rates or other provisions.

Legislators often spend more extravagantly on capital assets than on operating resources. Capital projects, they reason, can be financed with debt rather than taxes and thus will not affect the surplus or deficit of the general fund, the budget of which must be balanced. Their error is in failing to

take into account the additional operating costs associated with new long‐term assets. Roads must be repaired, buildings maintained, and equipment tuned up. Further, in future years the debt must be serviced with interest and principal payments made from operating resources. As of 2017, the American Society of Civil Engineers assigned America's infrastructure an overall grade of D+ for "poor" condition, one grade above "failing."

The public budgeting literature is replete with descriptions of forecasting models and techniques. However, these models or techniques are no better

than the underlying assumptions and the legislative constraints faced by the officials, who have tried to balance their current budgets through various means (see "In Practice: Budgeting and Legislative Constraints"). In addition, as might be expected, the differences between actual results and budgetary estimates can be substantial.

When the budget is presented to a legislature for consideration, it is typically turned over to one or more committees for review. In some legislatures—such as the U.S. Congress—

the committees that act on revenues are separate from those that recommend expenditures.

Governments that budget on a cash basis assign revenues and expenditures to the period in which the government is expected to receive or disburse cash. Some governments modify the cash basis by requiring that encumbrances (commitments to purchase goods or services) be accounted for as if they were

the equivalent of actual purchases. Others permit certain taxes or other revenues to be recognized in the year in which they are due rather than expected to be collected, as long as they are expected to be collected within a reasonable period of time.

The "one‐shot" budget balancing techniques would generally not affect revenues and expenditures as reported in the annual financial statements. Governments must prepare the external financial reports of their governmental funds on a modified accrual basis. As defined by the GASB,

the modified accrual basis requires that short‐term loan proceeds, whether from another fund or from an outside source, be accounted for as liabilities rather than revenues. Similarly, most required outlays are reported as expenditures in the period to which they apply, irrespective of when they are actually paid

Although it lacks the authority to establish standards for budgeting, the GASB nevertheless recommends that governments prepare their annual budgets for governmental funds on the modified accrual basis—

the same basis they are required to use for reporting on the governmental funds in their external financial statements.

The GASB encourages, but does not require, governments to present in a separate column the variances (i.e., differences) between actual results and the budget. It recommends that, if presented,

the variances be based on the final rather than the original budget. However, inasmuch as governments must include columns that show both the original budget and the final budget, statement users can readily calculate the differences between actual results and the original budget as well as the changes in the budget that were authorized during the year.

Accordingly, generally accepted accounting principles (GAAP) dictate that governments include in

their annual reports, as required supplementary information, a comparison of actual results with the budget for each governmental fund for which an annual budget has been adopted

Budget‐to‐actual comparisons may demonstrate either legal compliance or managerial effectiveness in adhering to budget estimates. The current GASB model requires governments to report their actual results and both their original and final appropriated budgets. For some governments,

their final budget incorporates changes they authorized only after they were aware of the actual revenues and expenditures of the year.

Budgeting practices in governments and not‐for‐profits are not standardized;

they differ from entity to entity.

The adverse consequences of the cash basis should not be overlooked. The cash basis may distort the economic impact of a government's planned fiscal activities. A budget that is balanced on a cash basis may be decidedly

unbalanced as to economic costs and revenues. It may give the appearance of a budget that has achieved interperiod equity when it really has not.

Budgets are to governments and not‐for‐profits what the sun is to the solar system. Trying to understand government and not‐for‐profit accounting

without recognizing the centricity of the budget would be like trying to comprehend the earth's seasons while ignoring the sun.

Most governments divide these classifications into numerous subclassifications

—such as property taxes, sales taxes, and hotel taxes.