Chapter 6
Capital projects funds are accounted for on the modified accrual basis. In government‐wide statements the funds are accounted for on a full accrual basis
(as discussed in previous chapters with respect to governmental funds in general) and consolidated with the government's other governmental funds.
In essence, they are of two types:
-Arbitrage restrictions. Primarily developed in 1969, these provisions establish a general rule prohibiting arbitrage. But they set forth several exceptions. Issuers are permitted to invest both construction funds and reserve funds for limited periods of time (e.g., 85 percent of the proceeds must be spent within three years). -Arbitrage rebates. Instituted as part of the Tax Reform Act of 1986, these regulations require that all arbitrage earnings, again with some exceptions (e.g., the proceeds are spent within six months or 75 percent of the proceeds are spent on construction within two years), be remitted to the federal government.
In most circumstances, however, the government is linked to the debt in some manner. These ties can be in a variety of arrangements:
-The government itself may issue the debt (as general obligation debt) with the expectation that the special assessments will be sufficient to cover the debt service. -To help make the debt more marketable and lower the interest rate, the government may either back the debt with its full faith and credit or guarantee it with some other type of commitment. -The government may have no legal commitment for the debt, but nevertheless may assume responsibility for it to protect its own credit standing. -The government may agree to share in the cost of the project and thereby to be responsible for a specified proportion of the debt.
Debt service funds may receive their resources from several sources:
-Transfers from the general fund -Special taxes restricted to the payment of debt (e.g., to construct a new high school, a school district may dedicate a portion of its property tax to the repayment of high school bonds) -Special assessments (charges to an identifiable group of residents who will receive a disproportionate share of the benefits of a project for which long‐term debt was issued) -As with capital projects funds, governments may be required to maintain several independent debt service funds or may be permitted to combine some or all into common funds.
Capital projects fund
A fund to account for financial resources set aside for the acquisition or construction of major capital facilities.
Debt service funds
A fund to account for financial resources set aside for the payment of interest and principal on long-term debt; a sinking fund.
Call prices
A predetermined price at which the issuer of bonds may redeem (call) the bonds irrespective of the current market price.
Bonds
A written promise to pay a specified sum of money (its face value) at one or more specified times in the future along with periodic interest. Bonds are a form of notes payable but are characterized by longer periods of maturity and more formal documentation.
In-substance defeasance
An advance refunding (retirement of bonds) in which the government places sufficient resources in a trust account to cover all required principal and interest payments on the defeased debt. Although the government is not legally released from being the primary obligor on the refunded bonds, the possibility of it having to make additional payments is considered remote.
Issue costs
Costs incurred to issue bonds, such as amounts paid to underwriters, attorneys, accountants, and printers.
When governments issue bonds, they seldom receive in cash an amount exactly equal to the bonds' face value. There are at least two sources of the difference between face value and cash received: 1
Issue costs. The bond underwriters (the brokers and dealers who will distribute the securities to other brokers and dealers or sell them directly to investors) charge for their services and will withhold a portion of the gross proceeds as their fees.
Generally accepted accounting principles direct that debt service funds be established when:
Legally required, or Financial resources are being accumulated for principal and interest payments maturing in future years
2
Premiums and discounts. The bond coupon rate (the stated interest rate) is rarely exactly equal to the market rate at the time of sale. Market rates fluctuate constantly, and the market rate that will prevail at the time of issue cannot be determined accurately in advance. The exact rate that the bonds will yield is established by issuing the bonds at a price greater or less than face value. A bond sold to yield an interest rate greater than the coupon rate will be sold at a discount. Because the prevailing rate is greater than the coupon rate, the bond is of less value to an investor than a bond with a comparable face value paying the prevailing rate; hence, the investor will pay less than the face value for it. Conversely, a bond sold to yield an interest rate less than the coupon rate will be sold at a premium. Because the prevailing rate is less than the coupon rate, the bond is of greater value than a bond with a comparable face value paying the prevailing rate. Historically, bonds were printed with a coupon rate days or weeks prior to the issue date, and hence there could be a significant difference between the coupon rate and the prevailing market rate at the date of sale. Today most bonds are issued in electronic rather than paper form. Moreover, U.S. tax laws discourage investors from acquiring bonds at a discount. Accordingly, premiums and discounts tend to be much smaller than in the past.
Modified accrual basis
The accrual basis of accounting adapted to the governmental fund-type measurement focus. Revenues are recognized in the period in which they become available and measurable. Some expenditures are recognized on a accrual basis; others on a cash basis.
Arbitrage
The concurrent purchase and sale of the same or an equivalent security in order to profit from differences in interest rates. Generally, as it relates to state and local governments, the issuance of debt at relatively low, tax-exempt, rates of interest and the investment of the proceeds in taxable securities yielding a higher rate of return.
Deferred outflow of resources
The consumption of net position by the government that is applicable to a future reporting period.
Bond refundings
The issuance of new bonds to replace bonds already outstanding, usually with the intent of reducing debt service costs.
Coupon rate
The stated interest rate on the face of a bond; a bond's nominal interest rate.
Refinance
To replace existing debt with new debt, generally to take advantage of lower interest rates, or to shorten or lengthen the debt payout period.
Lacking explicit guidance from the GASB, governments take one of two approaches to accounting for the estimated rebates. Some report the rebates as
a deduction from interest revenue (a debit) offset by a payable to the U.S. government. Others treat the obligation as if it were a claim or judgment. In the debt service fund or capital projects fund in which the arbitrage is earned, they recognize (as both an expenditure and a liability) only the portion of the obligation to be liquidated with currently available resources. They account for the balance of the obligation as they would other long‐term obligations.
Until the late 1980s, special assessments were accounted for in a special type of fund called a special assessment fund. Today, however, special assessments are accounted for just as any other capital projects are. The construction phase is
accounted for in a capital projects fund. The debt service phase is accounted for in a debt service fund. When a government issues debt to finance a special assessment capital project, it should place the proceeds in a capital projects fund. It should account for issue costs, bond premiums and discounts, and construction costs no differently than those relating to other projects.
When the government levies the special assessments, it should recognize them in a debt service fund. Special assessments are imposed nonexchange transactions. They should be recorded as assets in the period in which the government has an enforceable legal claim to the resources that it will receive. In the debt service fund itself, which like other governmental funds is
accounted for on a modified accrual basis, they can be recorded as revenues only when available for expenditure. Therefore, when a government levies the special assessments, it should offset the assessments receivable with a deferred inflow of resources. Only as it collects the assessments (or as the assessments become available to meet current year expenditures) should it recognize them as revenues. It should report contributions from the general fund or other sources just as if they were for other types of projects.
Our focus is on each of the funds as independent fiscal and accounting entities. Both funds are governmental and accordingly are accounted for on a modified
accrual basis. However, like other governmental funds, when they are consolidated with other funds in government‐wide statements, their accounts are adjusted so that they are on a full accrual basis. First we discuss capital projects and debt service funds. Then we address the related issues of special assessments, arbitrage, and debt refunding.
Most often, special assessments are levied for infrastructure improvements—such as water and sewer lines, sidewalks, roads, and streetlights. They could
also be used for discrete projects such as parks, tennis courts, swimming pools, and recreation centers.
Governments ensure collectability of the assessments by attaching liens against the affected properties. Thus, they can foreclose on delinquent property owners
and can prevent the properties from being sold or transferred until the assessments are current. Like other financing mechanisms, special assessments may be subject to misuse and are not always advantageous, relative to conventional taxes, to property owners. The accompanying "In Practice: Use and Abuse of Special Assessments" suggests why.
The main accounting problems arise because the regulations permit issuers to calculate and remit their required rebates as infrequently as every five years. Moreover, the arbitrage earnings may be measured over multiyear, rather than
annual, periods. At the conclusion of any one year the government may be unable to determine its expenditure and related liability for that year. Thus, although the GASB has not issued a pronouncement pertaining to arbitrage, it is clear that governments must estimate their rebate obligations and recognize an appropriate expenditure and liability.
Our concern in this chapter is with the resources to acquire assets and to service debts, not with the assets or debts themselves. In governments, the resources to acquire capital assets, especially those that are financed with debt,
are generally accounted for in capital projects funds. However, the costs of capital assets may also be accounted for in the general fund or even special revenue funds, particularly if they are relatively low
Arbitrage subverts the federal government's rationale for exempting state and local debt from federal taxation—that of indirectly subsidizing state and local governments by enabling them to save on interest costs. At one time it was
argued that the federal government did not have the constitutional right either to regulate the issuance of state and local debt or to tax the interest on it. Today the federal government does regulate the issuance of state and local debt, and it is widely believed that a tax on municipal bond interest could withstand constitutional challenges.
Governments establish capital projects funds to account for and report financial resources that are restricted, committed, or assigned to expenditure for capital outlays. This includes the acquisition or construction of capital facilities (other than those to be financed by proprietary funds and trust funds for individuals, private organizations, or other governments) and other capital
assets. They may maintain a separate fund for each major project or combine two or more projects in a single fund. Capital facilities include buildings, infrastructure projects (such as roads, bridges, airports, and sewer systems), and plants and equipment. However, this fund is not used to account for capital assets that are purchased directly with current revenues of the general fund or a special revenue fund.
Capital improvement special assessments involve two distinct, albeit overlapping, phases: the construction and financing phase and the debt service phase. In the first phase—the construction and financing phase—a project is
authorized and the property owners are assessed. To finance the project, the government issues long‐term debt. It then undertakes construction. In the second phase, the property owners pay their assessments, and the debt is serviced. Whereas the first phase is usually fairly short—the time required to complete the construction—the second phase may extend over many years.
There are exceptions, however, to the general rule that there is no benefit to refunding. First, yield curves (the relationship between interest rates and time to maturity) may be such that by refunding the existing bonds with new bonds having a different maturity (and thus different prevailing interest rates and prices), the government can obtain true economic savings. Second,
bonds are often issued with specified call prices. These give the issuer the opportunity to redeem (call) the bonds at a preestablished price, irrespective of the current market price. The call price places a ceiling on the bond's market price. After all, why would an investor pay more for a bond than its call price, knowing that the government could, at its discretion, buy back the bond at the call price? If a government can redeem a bond at a call price less than the economic value of the existing bonds (i.e., what the market price of the bonds would be in the absence of a call provision), then, of course, it could realize an economic saving.
The more controversial question involves how refundings should be accounted for on a full accrual basis—
both in government‐wide and proprietary fund statements. The issue arises because on a full accrual basis long‐term liabilities are reported on the balance sheet. Hence, when a debt is refunded and must be removed from the balance sheet, a gain or loss may have to be recognized.
Cities and towns often levy special assessments when taxpayers in areas beyond their jurisdiction either want to be annexed into the city or town or want to benefit from certain of the city or town's facilities and services. In some
circumstances, the area to be assessed may be designated a special‐purpose government district (such as a local improvement district) and may be authorized to levy and collect the assessments. In others, the assessments are levied and administered by the city or town itself.
Governments must maintain capital projects funds for resources that are legally restricted and contractually required for the acquisition of capital assets. The primary purpose of this fund is to ensure and demonstrate the expenditure of the dedicated financial resource is both legally and contractually
compliant. Some governments also maintain capital projects funds for resources that they have assigned for capital purposes at their own discretion. Although this practice is permitted, it may mislead statement users into assuming that the resources are legally or contractually restricted when they are not.
In some situations, the governmental entity is not responsible, in any manner, for special assessment debt issued to finance improvements that are accounted for in a proprietary fund. Instead, the debt is an obligation exclusively of
developers, property owners, or other outside parties. If so, then the government should report a "capital contribution" (in a section of its statement of revenues, expenses, and changes in fund net position that follows "nonoperating revenue") equal to the amount of the property that it capitalized
Major projects may take several years to complete. Moreover, governments may transfer a portion of the proceeds from a capital projects fund to a debt service fund, either because the proceeds include a premium or because the debt covenants stipulate that they must maintain a reserve fund to guard against default. Sound fiscal management
dictates that proceeds held for anticipated construction costs, for future debt service, or as bondholder‐required reserves be invested in interest‐earning securities, such as those issued by the U.S. government.
However, if the resources of a debt service fund are derived mainly from special taxes or assessments, then an appropriations budget, and suitable accounting
entries, may help enhance internal control and demonstrate legal compliance. In many circumstances, the decision of whether to adopt an appropriations budget is beyond the control of accountants; it is specified in the legislation authorizing the debt or establishing the fund.
As a general rule, if a government had to retire outstanding debt by repurchasing it in the open market and paying a price reflective of current interest rates, then there would be no benefit to refunding—
even in the face of prevailing interest rates that are substantially lower than those on the existing debt. There would be no economic gain because the premium to retire existing bonds would exactly offset the present value of the future interest savings. A simple example will demonstrate the point.
State and local governments can issue bonds for public purposes at lower interest rates than either the federal government or private corporations because, taking into account the required taxes on the taxable bonds, the tax‐
exempt bonds can provide the investor a return equivalent to that on the taxable bonds.
To accrue the debt service fund expenditure and liability in one period but record the transfer of financial resources for debt service purposes in a later period, it has been argued, would be confusing and would result in the overstatement of debt service fund
expenditures and liabilities and the understatement of the fund balance. The standards make clear, however, that when the general fund appropriates resources for debt service in one year for payment early (within one month) in the next, then the government may (but is not required to) accrue the expenditure and related liability in the debt service fund
As pointed out previously, budgetary entries give formal accounting recognition to the budget and enhance control. They help ensure that
expenditures do not exceed authorizations. Governments generally budget capital expenditures on the basis of projects rather than periods. Therefore, they may not find it necessary to prepare an annual budget, to make annual budgetary entries, or to include comparisons of budget‐to‐actual expenditures for the year in their financial statements.
If special assessment debt is related to, and expected to be paid from, a proprietary fund, then all transactions related to both the debt and the improvements financed by the debt should be accounted for in a proprietary
fund. The government should account for the special assessment revenues and receivables on a full accrual basis and should capitalize improvements financed with the assessments in the same manner as other capital improvements.
Government long‐term obligations can take many forms—the most common of which is bonds. Bonds are formal certificates of indebtedness, most frequently issued by governments for the long term. The discussion in this section can be
generalized to other forms of debt—such as long‐term leases and certificates of participation—which often differ from bonds more in legal form than in economic substance. Governmental funds, including capital projects funds, do not report long‐term obligations. Therefore, when the proceeds of bonds or other long‐term obligations are received by a capital projects fund, they must be accounted for as "other financing sources."
In not‐for‐profits, the resources in these funds are categorized as either without donor restrictions or with donor restrictions, depending on their source. For the most part,
he principles of revenue and expenditure recognition presented in earlier chapters are applicable to these funds. Nevertheless, because these funds are used to account for transactions having unique features and involving sizable amounts of resources, they warrant special consideration.
Inasmuch as the enhancements in either infrastructure or services may provide at least some benefits to the citizenry at large (e.g., improved roads are not for the exclusive use of the taxpayers who live along them), governments may share
in the cost of the improvements. Therefore, the projects may be financed in part by direct government contributions, by general obligation debt, or by revenue debt (debt to be repaid from user fees—such as water and sewer charges).
Were governments permitted to engage in arbitrage, they could generate virtually unlimited amounts of earnings simply by issuing their own bonds and
investing the proceeds in higher‐yielding, risk‐free, federal government securities. Using the federal securities as collateral for their own bonds, they could also ensure that their own debt was risk‐free. To prevent municipalities from reaping the benefits of arbitrage, the federal government has added restrictions to the Internal Revenue Code and accompanying regulations.
Most call provisions do not become effective until a specified number of years after the bonds have been outstanding. By delaying the effective date, an issuer
is able to assure investors that they will receive their agreed‐upon return for the indicated period and thereby enhance the marketability of its bonds. Even if a call provision is not yet effective, the government can still lock in the savings that would result from a decline in prevailing interest rates.
Arbitrage, as it applies to states and other municipalities, refers to the issuance of debt at relatively low, tax‐exempt rates of interest and the investment of the proceeds in taxable securities yielding a higher return. Arbitrage is of
major concern to governments and can have important financial and accounting consequences for both capital projects and debt service funds.
Special assessments for services are often levied when a community wants greater services than the government would normally provide. For example, a community that would otherwise be protected by a volunteer fire department may request that it be serviced by a professional fire department. Or a
neighborhood may petition the city to maintain and provide electricity for its streetlights (perhaps after the neighborhood installs the lights itself), to provide trash collection service, or to snowplow its roads. Assessments for services present few, if any, unique accounting and reporting problems
udgetary entries are strictly an internal control mechanism; they do not affect year‐end financial statements. A unique feature
of capital projects funds is that the financial statements prepared at the end of the fiscal year may be considered interim financial statements because the capital projects funds exist only for the term (life) of the project under construction.
Legal mandates to maintain debt service funds are commonly incorporated into agreements associated with the issuance of the debt. Lenders want assurance that the funds will be available to make timely payments of interest and
principal. Therefore, they may require that the borrower maintain a specified amount, perhaps one year's interest, in a "reserve" fund—similar to the way a landlord requires a tenant to provide a deposit of one month's rent.
The key accounting issue pertaining to special assessments is if, and under what circumstances, a government should report the special assessment debt as its own debt. Special assessment debt is the primary responsibility of the
property owners on whom the assessments are levied. In economic substance, though not necessarily legal form, it is usually an obligation of the property owners, not the government. Arguably, therefore, the government need not report the debt on its own financial statements.
Nevertheless, budgetary accounts are as useful in maximizing control over project expenditures as they are over period expenditures. Therefore, the GASB
requires budgetary account integration in circumstances in which control cannot readily be established by means other than a budget. Integration is essential, for example, "where numerous construction projects are being financed through a capital projects fund or where such projects are being constructed by the government's labor force."1 On the other hand, when a government can establish control by entering into a fixed‐price contract with a single vendor or construction company, then budgetary entries are not necessary.
Governments, as well as not‐for‐profits,
retire debt prior to maturity for a variety of reasons.
Governments should report the underwriting and other issue costs as expenditures. If the issue costs are not set out
separately from premiums and discounts, then the government should estimate them.
Debt service funds are maintained to account for and report financial resources that are restricted, committed, or assigned to expenditure for principal and interest on all general long‐term debt. This does not include debt issued for and
serviced by enterprise or internal service funds and some trust funds. Debt service funds do not account for the long‐term debt itself. Indeed, the only circumstance in which the principal of debt is reported as an obligation is when it has matured but actual payment has been delayed.
They should be accounted for in the fund that best reflects the nature of the assessment and the
services to be provided—usually either the general fund, a special revenue fund, or an enterprise fund.
Governments sometimes assess property owners for projects that they would ordinarily account for in proprietary funds. These projects typically involve infrastructure associated with utilities—
such as water, sewer, and power lines and related facilities.
Governments sometimes construct capital projects or provide services that primarily benefit a particular group of property owners rather than the general citizenry. To assign the costs to the beneficiaries, they assess (i.e., charge) those
taxpayers the entire, or a substantial share, of the cost of the project or services. Generally, the majority of property owners within the area must vote their approval of the particular project or services and of the assessments. They can ordinarily pay the assessments in installments over several years, but they must pay interest on unpaid balances.
Governments attach call provisions to their bonds to give themselves the opportunity to take advantage of falling interest rates. In the event
that interest rates decline from what they were when the bonds were issued, the government can recall the outstanding high‐interest bonds and replace them with lower‐interest debt.
Because the general and special revenue funds, like the capital projects funds, are governmental funds,
the accounting entries and issues are similar. The resources to service debts are typically accounted for in debt service funds.
The interest paid on debt issued for public purposes by state and local governments is not subject to federal taxation. The federal government draws
the distinction between public and private purposes so as to prevent governments from providing assistance to private corporations by substituting their own low‐interest, tax‐exempt debt for that of the companies.
Both budgets and budgetary entries are less needed, and accordingly, less common in debt service funds than in other governmental funds. Insofar as debt service funds receive their resources from other funds, overall internal control is established by the budgets in those other funds. Moreover,
the expenditures of debt service funds are typically limited to payments of principal and interest, the amount and timing of which are established by the terms of the outstanding debt.
The tax provisions are complex because they must allow for legitimate temporary investment of funds, yet at the same time prevent arbitrage abuse. To achieve this objective,
the federal government has produced a set of regulations so complex that few governments can administer them without assistance from outside experts
It can do this through a process known as an in‐substance defeasance—a kind of advance refunding that does not entail a bond redemption and in which the borrower economically, although not legally, satisfies its existing obligations. Issuing new debt,
the government places in trust sufficient funds to make all required interest payments through the earliest call date and to redeem the debt on that date.
In contrast to the manner in which the expenditures for debt service are accounted for,
the interest revenue on bonds held as investments is, in effect, accrued as earned, because investments must be stated at fair value, and interest earned but not yet paid affects fair value.
Capital projects funds are similar to special revenue funds in that their revenues are restricted for special purposes. Accordingly,
the principles of revenue and expenditure spelled out in Chapters 4 and 5, which are applicable to all governmental funds, are also appropriate for capital projects funds.
Major capital projects are most commonly financed with general obligation bonds or other forms of long‐term debt, but they may also be funded by intergovernmental grants, special tax levies, or assessments. Restrictions on capital project resources usually stem from debt covenants or from legislation authorizing the taxes or assessments. Generally,
the restrictions are exceedingly specific about how the resources may be used.
In this section, however, we are concerned with bond refundings—the early retirement of existing debt so that it can be replaced with new debt. Governments refund—that is, refinance—
their debt to take advantage of more favorable (lower) interest rates, to shorten or lengthen the debt payout period, or to rid themselves of restrictive bond covenants (such as those that prevent them from incurring new debt).
Like capital projects funds, debt service funds are governmental funds, which are accounted for on the modified accrual basis. As discussed in Chapter 5, GASB standards stipulate that the major exception to the general rule of expenditure accrual relates to unmatured principal and interest on general long‐term debt. Until the period in which
they must be paid, interest and principal are not considered current liabilities of the debt service fund, as they do not require the expenditure of existing fund assets. Moreover, the resources required for payment are unlikely to be appropriated—and transferred to the debt service fund—until the period in which the interest and principal actually must be paid, not before.
The government should account for interest and principal payable on special assessment debt in a debt service fund no differently from that on debt relating
to other projects. Thus, it should recognize expenditures (and a corresponding liability) only when the payment is actually due. It should not accrue either interest or principal.
both governments and not‐for‐profits maintain separate funds (accounting and reporting entities) for resources to be
used to acquire long‐lived assets and to service debt. Governments classify these funds as governmental, as opposed to proprietary.
