Chapter 2: Principles of Accounting and Financial Reporting for State and Local Governments

The seven elements as defined by Concepts Statement No. 4 are as follows:

1.) Assets, which are resources with present service capacity that the government presently controls. 2.) Deferred outflows of resources, which are the consumption of net assets by the government that apply to a future reporting period. 3.) Liabilities, which are present obligations to sacrifice resources that the government has little or no discretion to avoid. 4.) Deferred inflows of resources, which are the acquisition of net assets by the government that apply to a future reporting period. 5.) Net position, which is the residual when assets + deferred outflow's of resources - Liabilities - deferred inflows or resources is calculated (net position appears in a statement of financial position). 6.) Inflow of resources, which is the acquisition or net assets by the government in the current reporting period (e.g.. revenues and other resources). 7.) Outflow or resources, which is the consumption or net assets by the government in the current reporting period (e.g.. expenses, expenditures, and other uses of resources).

Fund

A fiscal and accounting entity with a self-balancing set of accounts recording cash and other financial resources, together with all related liabilities and residual equities or balances and changes therein, which are segregated for the purpose of carrying on specified activities or attaining certain objectives in accordance with special regulations, restrictions, or limitations. The concept of fund is fundamental to governmental accounting and reporting. As the definition states, a fund is a separate fiscal entity, which means it has its own resources, its own liabilities, and its own operating activity for the fiscal period. Furthermore, a fund conceptually has its own set of accounting records (e.g. journals and ledgers) allowing it to prepare separate financial statements. Thus, it is a separate accounting entity as well. The latter part or the definition of fund is also worth noting: specifically, a fund assists in carrying on specific activities on attaining certain objectives in accordance with special regulations, restrictions, or limitations. Funds may be established by grant or contract provisions imposed by external resource providers, by constitutional provisions or enabling legislation of state or local governments, or by the discretionary action of reporting governments.

Permanent Fund

A permanent fund is used to account for permanent endowments created when a donor stipulates that the principal amount of a contribution must be invested and preserved, but earnings on amounts so invested can be used for a purpose that supports the general public and the government's own programs. Examples of such public purposes include maintenance of a cemetery, a park, or aesthetic enhancements to public buildings. If the earnings from a permanent endowment can be used to benefit only private individuals, organizations, or other governments, rather than supporting a program of the government and its citizenry, a private-purpose trust fund-a fiduciary fund-is used instead of a permanent fund.

Fund Reporting

According to the GASB, a government accounting system should make it possible for financial statements to be presented fairly and in accordance with generally accepted accounting principles (GAAP) and allow users to determine compliance with finance-related legal and contractual provisions. In the government environment, legal and contractual provisions often conflict with the requirements of GAAP. As the first principle states, however, the accounting system must make it possible to present financial information that meets both requirements.

Deferred Inflows/Outflows

Although a deferred outflow of resources has the effect of increasing a governments net position, it does not meet the definition of an asset; thus, GASB has created a separate element. Similarly, a deferred inflow of resources has the effect of decreasing a government's net position: however, it does not meet the definition of a liability. Deferred inflows and deferred outflows of resources are only used when required by a GASB standard. An example of a deferred inflow of resources would be resources received in a period prior to when the resources are to be applied (a timing issue). Because such an advance payment does not meet the definition of a liability, GASB standards require that it be recognized as a deferred inflow of resources. An advance debt refunding (covered in Chapter 6) could result in a deferred outflow (or inflow) of resources. If the resources used to refund the old bonds is greater than the net carrying value of the old bonds, a deferred outflow of resources results, according to GASB standards. The difference does not properly meet the definition of an asset and it is not properly a "loss" because it relates to future periods over which the new debt has been substituted for the old debt.

Nonmajor Fund Reporting

Although the GASB requires nonmajor funds to be aggregated and reported in a single column, internal managers and perhaps a small number of external financial statement users may have an interest in the financial information for individual nonmajor funds. To meet these needs, many governments provide supplementary combining financial statements for nonmajor governmental and enterprise funds in their comprehensive annual financial report (CAFR). These statements provide a separate column for the financial information of each nonmajor fund as well as total column amounts that are the same as the totals reported in the Nonmajor Governmental Funds or Nonmajor Enterprise Funds columns of the basic financial statements.

Financial Reporting Model

As discussed in Chapter 1 (see illustration 1-3), every state and local government should provide, at a minimum, basic financial statements, a management's discussion and analysis (MD&A), and certain other required supplementary information. To understand the basic principles of accounting and financial reporting for state and local governments, it is important to first understand the GASB's integrated accounting and financial reporting model. This model is depicted in Illustration 2-2. Key to the integrated model is the requirement to provide two kinds of basic financial statements, government-wide and fund: each kind is intended to achieve different reporting objectives.

Government Wide Consolidation

Because the government-wide financial statements display information in multiple columns, they are not fully consolidated in the manner of corporate financial statements. Receivables and payables between two or more programs or functions that are reported in the Governmental Activities column or between business-type segments reported in the Business-type Actıvities column are eliminated in preparing the financial statements. Receivables/payables between governmental and busıness-type activities. however, are not eliminated because they are reported in different columns.

Fiduciary Fund Financial Statements

Because these resources may not be used to support the governments own programs, GASB Standards require that financial information about fiduciary activities be omitted from the government-wide financial statements; however, the information must be reported in two fund financial statements: • a statement of fiduciary net position-fiduciary funds, which is Similar to a balance sheet, • and a statement of changes in fiduciary net position-fiduciary funds. The statement of changes in fiduciary net position shows additions to and deductions from the funds net position during the reporting period. Both statements are prepared using accrual accounting with the economic resources measurement focus. Fund Financial Statement Focus: •Operational accountability •Flow of economic resources •Accrual basis Fund Financial Statements: •Statement of Fiduciary Net Position •Statement of Changes in Fiduciary Net Position

Determination of Major Funds

By its nature, the General Fund of a government is always considered a major fund. GASB standards require that any fund that meets the following size criteria also be designated as a major fund: (a.) Total assets, liabilities, revenues, or expenditures/expenses of that governmental or enterprise fund are at least 10 percent of the corresponding element total (assets, liabilities, and so forth) for all funds of that category or type (that is, total governmental or total enterprise funds), and (emphasis added) (b.) The same element that met the 10 percent criterion in (a) 1s at least percent of the corresponding element total for all governmental and enterprise funds combined In addition, any fund that a government considers of significant importance to financial statement users can be reported as major. It is important to note that the same element of a fund must meet both the a and b criteria for mandatory reporting as a major fund. On occasion, a fund may meet both criteria in the preceding fiscal year but only one or perhaps neither of the criteria in the current year. In such a case, the government may elect to continue to report the fund as a major fund in the current year pending a future year determination.

Enterprise Funds

Enterprise funds may be used to account for activities in which goods or services are provided to the public for a fee that is the principal source of revenue for the fund. Unless the activities are insignificant in amount, GASB standards require the use of an enterprise fund if: a.) The activity is financed with debt that is secured solely by a pledge of the net revenues from fees and charges of the activity. b.) Laws or regulations require that the activates costs or providing services, including capital costs (Such as depreciation or debt service), be recovered with fees and charges rather than with taxes or similar revenues. c.) The pricing policies of the activity establish fees and charges designed to recover its costs, including capital costs

Fiduciary Funds

Fiduciary activities of a government report on operational accountability of those activities by using the same princıples as proprietary fund and government-wide financial statements: the economic resources measurement focus and accrual basis of accounting.

GASB Concepts Statement No. 1

GASB Concepts Statement No. 1 identıfies two objectives of government financial reports: 1.) to provide information that can be used to assess a government's accountability 2.) and to assist users in making economic, social, and political decisions. Chapter 1 provided the definition of accountability and its importance in government reporting. The primary users of government financial reports are those external to government: • principally • citizens • legislative and oversight bodies • and creditors For the financial reports to be useful in meeting identified objectives, the GASB indicates that the information provided in the reports should have certain characteristics. The characteristics identified are: • Understandable • Reliable • Relevant • Timely • Consistent • Comparable. An astute reader will recognize that the GASB characteristics for useful financial information align closely with the qualitative characteristics of the FASB conceptual framework.

Major Fund Reporting

GASB standards recognize that most financial statement users are unlikely to have a significant interest in all of the funds that a government may use. Instead, it is likely that their interest will be focused on larger-dollar-amount funds. Consequently, GASB standards require that financial statements prepared for governmental funds and enterprise funds include a separate column for each major fund. An additional column is provided in each statement for the total amounts for all nonmajor funds of that type governmental or enterprise, as applicable.

Governmental Fund Financial Statements

Governmental fund financial statements (see Appendix A , Illustrations A2-3 and A2-5) assist financial statement users in assessing fiscal accountability by reporting on whether financial resources were raised and expended in compliance with budgetary and other legal provis1ons. As such, the governmental fund balance sheet reports on current financial resources including cash and near-term resources (principally receivables), and the claims against current financial resources such as current payables and other current period obligations. The difference between current financial resources and the claims against the current financial resources is reported as fund balances. Because noncurrent assets such as land, buildings, and equipment do not provide resources to pay current period obligations, they are not reported on the balance sheet. Similarly, because long-term obligations do not have to be paid in the current period, they are not reported on the balance sheet. Fund Financial Statement Focus: •Fiscal accountability •Flow of current financial resources •Modified accrual basis Fund Financial Statements: •Balance Sheet •Statement of Revenues, Expenditures, and Changes in Fund Balance

Fund Financial Statements

Governments also must present fund financial statements Or, more precisely, three sets of fund financial statements, one set for each of the three fund categories: governmental, proprietary, and fiduciary (see the lower half of Illustration 2-2 ). These categories correspond closely to the governmental, business-type, and fiduciary activities described earlier in this chapter. An observant reader will note, however, that although internal service funds are included in the proprietary funds category, their financial information usually is included as part of governmental activities in the government-wide financial statements.

Fiduciary Activities

Governments often act in a fiduciary capacity, either as a custodian or trustee, for parties outside the government. For example, a government may serve as a custodian for other governments in administering and collecting taxes. Governments also may serve as a trustee for investments of other governments in the government's investment pool, for escheat properties that revert to the government when there are no legal claimants or heirs to a deceased individual's estate, and for assets being held for employee pension plans, among other trustee roles. Under GASB standards, only custodial and trust relationships that benefit individuals, organizations, and other governments are reported as fiduciary activities. Activities with fiduciary characteristics that support the government's own programs, or provide residents or recipients with the government's goods and services, are treated as governmental activities for accounting and financial reporting purposes. .

Debt Service Fund

Governments that have bond oblıgations outstanding and certain other types of long-term general liabilities may be required by law or bond covenants to create a debt service fund. The purpose of a debt service fund is to account for financial resources segregated for making principal and interest payments on general long-term debt. Some governments account for all debt service on general long-term debt in their General Fund, but governments ordinarily create one or more debt service funds if they have general long-term debt.

Government Wide Statement of Activities

Illustration A2-2 shows Denver's statement of activities. The statement of activities is the city's operating (resource flows) statement reporting expenses and revenues. You will notice that rather than reporting expenses by natural classıfication or object of expense, as do business organizations, governments report by functions or programs. Revenues derived directly from programs or functions such as user charges, or resources received directly from external sources, such as grants and contributions, also are identified. In summary •Reports expenses and revenues classified by program or function •Uses separate columns for governmental activities, business-type activities, and component units

Concepts Statement No, 6

In Concepts Statement No. 6, the GASB indicates that those assets that are involved in the direct provision of services should be recorded and presented at the initial measurement amount. The initial amount 1s the transaction price or amount assigned when the asset is acquired (or a liability is reported). The GASB believes that the initial measurement amount is the amount most useful in providing information that can be used in determining the cost of services (e.g., capital assets). However, when assets are going to be converted to cash, Concepts Statement No. 6 indicates that a remeasurement amount should be used. A remeasured amount is the amount assigned when an asset (or liability) is remeasured at the financial statement date. Remeasurement amounts are useful when trying to determine the availability of resources to acquire services or meet oblıgations (e.g., investments). For liabilitıes, the GASB believes that a remeasured amount is more useful for those liabilities for which the timing and amount of payments may be uncertain (e.g., compensated absences). When determining initial amounts and remeasurement amounts, Concepts Statement No. 6 identifies four possible measurement attributes: historical cost, fair value, replacement cost, and settlement amount.

Internal Service Funds

Internal service funds are created to improve the management of resources and generally provide goods or services to departments or agencies of the same government and sometimes to other governments on a cost-reimbursement basis. Examples of services typically recorded by internal service funds include central purchasing and warehousing of supplies, motor pools, centralized data processing, and self-insurance pooIs.

Current Financial Resources

It is hardly surprising that accounting for governmental funds focuses on the inflows and outflows of current financial resources. Current financial resources are cash or items such as receivables that will be converted into cash during the current fiscal period or that will be available soon enough after the end of the period to pay current-period liabilities. With the lone exception of property tax revenues, which GASB standards require to be collectible within 60 days of the end of the current fiscal year to be considered available, governments are free to establish their own definition of available and, therefore, which items to recognize in their financial statements as current financial resources and revenues. Most governments have adopted a 60-day policy for all governmental fund revenues, although some governments have other policies that can range from 30 days to one year Because governmental funds account for the inflows and outflows of current financial resources, the balance sheet for governmental funds generally reports only current assets and deferred outflows of resources, current liabilities and deferred inflows of resources, and fund balances

Governmental Activities

One key difference between governments and for-profit business organizations is that governments are not profit seeking but exist to meet citizens' demand for services with the resources available to provide those services. As shown in Illustration 2-14, most general purpose governments engage in three broad categories of service activities: governmental, business-type, and fiduciary. Although the types and levels of services vary from government to government, general purpose governments provide certain core services: those related to protection of life and property (e.g.. police and fire protection), public works (e.g.. streets and highways. bridges, and public buildings), culture and recreation facilities and programs, and educational and social services. Governments also must incur costs for general administrative support such as data processing, finance, and personnel. Core governmental services, together with general administratıve support, comprise the major part of what GASB Concepts Statement No. 1 refers to as governmental-type activities. In its more recent pronouncements, the GASB refers to these activities as simply governmental activities Chapters 3 through 6 of the text focus on various aspects of accounting for governmental activities.

Proprietary Fund Financial Statements

Proprietary fund financial statements present financial information for enterprise funds and internal service funds. Both types of funds operate essentially as self-supporting entities and, therefore, follow accounting and reporting practices similar to those of business organizations; that is, the accrual basis of accounting and a focus on the flow of economic resources. Enterprise funds an internal service funds are distinguished primarıly by the kinds of customers they serve. Enterprise funds provide goods or services to the public, whereas internal service funds mainly serve departments of the same government. As required by GASB standards. the City and County of Denver reports proprietary funds financial information in three financial statements: • a statement of net position-proprietary funds (illustration A2-7): • a statement of revenues, expenses, and changes in fund net position proprietary funds (Illustration A2-8); • and a statement of cash flows-proprietary funds (Illustration A2-9). Fund Financial Statement Focus: •Operational accountability •Flow of economic resources •Accrual basis Fund Financial Statements: •Statement of Net Position •Statement of Revenues, Expenses, and Changes in Fund Net Position •Statement of Cash Flows

Proprietary Funds

Proprietary funds of a government follow accounting and financial reporting principles that are similar to those for Commercial business entities. As in business, if a government intends to charge users for the goods or services provided, its officials need to know the full cost of those goods and services so they can determine appropriate prices or fees. Determining the full cost is also essential in deciding whether the government should continue to produce or provide particular goods or services or contract for them with an outside vendor. Accrual accountıng, including depreciation of capital assets, is essential for governments to determine the full cost of providing business-type services and to report on the extent to which each service is covering its full cost of operation As Illustration 2-2 shows, there are two types of proprietary funds: internal service funds and enterprise funds. Legislative approval is ordinarily required to establish proprietary funds, although they may be required by law or contractual provisions such as debt covenants. The two funds differ primarily in terms of their objectives and the way the financial information of each type of fund is reported in the fund and government-wide financial statements.

Required Supplementary Information (RSI)

Required supplementary information (RSI) and Supplementary information are used to communicate information that is essential and useful, respectively. Without RSI, the financial statements and related notes cannot be placed in the correct context. For example, many users of financial reports highly value the management discussion and analysis (MD&A) when trying to put into context numbers presented in the financial reports. Other examples of RSI include the budget to actual schedules (discussed in Chapter 3 ) and several pension disclosures (Chapter 8 ), Other supplementary information is useful but not essential in understanding the financial statements and related notes. Much of the supplementary information is found in the statistical section of the comprehensive annual financial report (CAFR) Before an item can be recognized in the financial statements, it must meet the definition of an element. GASB Concepts Statement No. 4 identifies the seven financial statement elements.

Business Type Activities

Some readers may be surprised to learn that governments also engage in a variety of business-like activities. These activities include, among others, public utilities (e.g.. electric, water, gas, and sewer utilities), transportation systems, toll roads, toll bridges. hospitals. parking garages and lots., golf courses, and swimming pools. Many of these activities are intended to be self-supporting by charging users for the services they receive. Operatıng subsidies from general tax revenues are not uncommon, however, particularly for transportation systems. Accounting for business-type activities is covered in Chapter 7 of the text.

Government Wide Statement of Net Position

The City and County of Denver's government-wide statement of net position (see illustration A2-1) is essentially a balance sheet, which reports the government's fiscal year-end assets, deferred outflows of resources, liabilities, deferred inflows of resources, and net position. Net position is the difference between total assets plus deferred outflows of resources and total labilities plus deferred inflows of resources. It should be noted that Denver reports its net position in the three categories required by GASB standards: • net investment in capital assets, • restricted (for the purposes shown), • unrestricted. Although the net position section of the statement is different from a business entity's balance sheet, you will notice some similarities to the business entity balance sheet in that assets are listed in the order of liquidity and liabilities are separated into current and noncurrent In summary •Reports year end financial position •Most comparable to a business' balance sheet

Classification of Governmental Fund Balances

The GASB requires that fund balances reported on the governmental fund balance sheet be classified according to the constraints on the use of the fund balances. In classifying fund balances, a government must first determine if any amount of the fund balance is nonspendable. Once it is determined how much of the fund balance is not spendable, the remaining fund balance amount is identified according to any constraints on how the funds may be used.

General Fund

The General Fund is the main operating fund of local governments. Most departmental operating activities, such as those of police and fire, public works, culture and recreation, education, and social services, as well as general government support services, such as the city manager's office, finance. personnel, and data processing, are typically recorded in the General Fund. Unless a financial resource is required to be recorded in a different fund type, it is usually recorded in the General Fund

Custodial Funds

The fiduciary fund category consists of custodial funds and three types of trust funds: • investment trust funds, • pension (and other post-employment benefit) trust funds, • private-purpose trust funds. Custodial funds are used when the government oversees cash or other assets for external parties such as individuals, organizations, or other governments. An example of a custodial fund is taxes collected by one government on behalf of other governments.

Government Wide Statements

The government-wide financial statements report on the government reporting entity as a whole but focus on the primary government. As illustrated by the City and County of Denver, Colorado's government-Wide financial statements (see Illustrations A2-1 and A2-2 in Appendix A at the end of this chapter), as well as Illustration 2-2, the government- wide statements present the financial information for the governmental activities and business-type activities of the primary government in separate columns, although there is a total column for the primary government. The City and County of Denver also The government-Wide statements present all financial information using the economic resources measurement focus and the accrual basis of accounting-similar to the measurement focus and basis of accounting used in the financial statements of for-profit business organizations. Economic Resource Measurement Focus: Attention on measuring the total economic resources that flow in and Out of the government rather than on measuring current financial resources only.

Governmental Funds

The governmental funds category includes five types of funds: • General Fund, • Special revenue funds, • Debt service funds capital projects funds, • Permanent funds, Every state and local government has one and only one General Fund, although occasionally it may be called by a different name such as General Revenue Fund or General Operating Fund. Other governmental funds will be created as needed.

Governmental Fund Financial Statements (cont)

The operating statement prepared by governmental funds is the statement of revenues, expenditures, and changes in fund balances. Under the modified accrual basis of accounting used by governmental funds, revenues are recorded only if they are measurable and available for paying current period obligations. Expenditures are the amount of resources used to acquire an asset or service and are generally recognized when an obligation that will be paid from current financial resources has been incurred. As shown in Illustration A2-5, the governmental fund statement of revenues, expenditures, and changes in fund balances reports expenditures because outlays to acquire goods or services are more relevant than expenses in measuring the outflow of current financial resources. Expenses, on the other hand, are costs expired or used up in providing services and are more relevant at the government-Wide level, as they provide a long-term measure of the cost of providing services. To ensure integration of these statements, total fund balances reported on the balance sheet-governmental funds (Illustration A2-3) must be reconciled to the total governmental activities net position reported in the statement of net position Illustration A2-1).

Nonspendable Fund Balance

These amounts are not in a form that can be spent, or according to law or contract cannot be spent. Examples of items that are in a nonspendable form include inventories, prepaid amounts, and long-term notes receivable. An example of an item that is legally or contractually required to remain intact is a permanent endowment.

Assigned Fund Balance

These are amounts intended to be used by the government for specific purposes that are neither restricted nor committed. Intent can be expressed in one of two ways: (a) the governing body can state its intent to use resources for a specific purpose or (b) the governing body can delegate authority to others (e.g. a budget or finance committee or a city manager) to express intent to use amounts for specific purposes. Additionally, it is implied that the amounts reported in special revenue, capital project, debt service, or permanent funds that have not been designated as restricted or committed are assigned.

Restricted Fund Balance

These are amounts that can be spent only for the specific purposes designated by external providers, constitutionally, or through enabling legislation. Restrictions are changed or lifted only with the consent of resource providers. Examples of external resource providers include creditors, grantors, and donors.

Committed Fund Balance

These are amounts that can only be used for the specific purposes determined by a formal action (e.g.. legislation or ordinance) of a government's highest level of decision-making authority (e.g.. legislature, county commission, or city council). Changing or removing a commitment requires taking the same formal action that originally imposed the constraint. It should be noted that enabling legislation differs from actions taken to commit funds. Enabling legislation provides authorization to raise revenue for a restricted purpose. The revenue component of enabling legislation prevents the use of the resources for anything other than the restricted purpose, whereas committed funds can be used for another purpose by reversing the formal action that committed the resources.

Unassigned Fund Balance

This is the amount remaining in the General Fund fund balance after classifying amounts as nonspendable, restricted, committed, or assigned. Unassigned amounts are technically available for any purpose.

Capital Projects Fund

To account for tax or grant revenues or bond proceeds earmarked for a capital project, as well as payments to architects, engineers, construction contractors, and suppliers, a capital projects fund is typically created. Multiple capital projects funds may be created if a government has multiple capital projects.

Pension, Investment, and Private Purpose Trust Funds

To be categorized as a trust fund, there must be a trust agreement or equivalent arrangement in place, or the activity must be a pension or other post-employment benefit arrangement. Pension trust funds (and other postemployment benefit trust funds) hold assets in trust to provide retirement benefits for employees. Investment trust funds are used to report the equity of external participants (typically other governments) in a sponsoring government's investment pool. Private-purpose trust funds can be created to benefit private individuals, organizations, or other governments. An example of such a fund would be one that is established to provide scholarships for the children of firefighters and police officers killed in the line of duty Accounting for trust funds is typically much more complex than just accounting for investments.

Special Revenue Fund

When tax or grant revenues or private gifts are restricted by external resource providers or committed by enabling legislation for particular operating purposes, such as the operation of a library or maintenance of roads and bridges, a special revenue fund is created. The number of special revenue funds used by state and local governments varies greatly, rangıng from a few to many. Nevertheless, GASB standards recommend that governments establish only the minimum number of funds needed to comply with legal requirements and to provide sound management. Using too many funds creates undue complexity and contributes to inefficient financial administration.

National Council on Governmental Accounting (NCGA)

When the GASB was first fornmed in 1984, it adopted the accountıng and financial reporting principles established by its predecessor standard-setting body, the National Council on Governmental Accounting (NCGA).