Accounting for State and Local Governments

In this article we will discuss about how the accounting for state and local governments is done.

Introduction to the Accounting for State and Local Governments:

In the United States, literally thousands of state and local government reporting entities touch the lives of the citizenry on a daily basis. In addition to the federal and 50 state governments, there are 87,849 local governments. Of these, 38,971 are general purpose local governments— 3,034 county governments and 35,937 sub-county governments, including 19,431 municipal governments and 16,506 township governments.

The remainder, which comprise more than one-half of the total, are special purpose local governments, including 13,522 school district governments and 35,356 special district governments. Income and sales taxes are collected, property taxes are assessed, schools are operated, fire departments are maintained, garbage is collected, and roads are paved. Actions of one or more governments affect every individual.

Accounting for such governments is not merely a matching of expenses with earned revenues so that net income can be determined. The changing of tax rates and allocating of limited resources among such worthy causes as education, police, welfare, and the environment create heated debates throughout the nation.

To keep the public informed so that proper decisions are more likely to be made, government reporting has historically focused on identifying the methods used to generate financial resources and the uses made of those resources, which activities are financed and which are not.

Indeed, this approach is appropriate for the short-term decisions necessitated by gathering and utilizing financial resources to carry out public policy. For the longer term, though, infor­mation to reflect the overall financial stability of the government is also needed.

Hence, in 1999, the Governmental Accounting Standards Board (GASB) adopted Statement 34, “Basic Financial Statements—and Management’s Discussion and Analysis—for State and Local Gov­ernments,” which mandated that state and local governments prepare not one but two complete and distinct sets of financial statements.

The perceived necessity of this dual reporting system demonstrates the difficulty that such governments have faced in satisfying a wide array of user needs. For the student of government accounting, nothing is more vital than recognizing that these governments now produce two sets of statements, each with its own unique principles and objectives.

This creation of a dual reporting system is probably the most significant single step that has transpired over the decades in the evolution of the generally accepted accounting principles used by state and local governments. The American Institute of Certified Public Accountants (AICPA) and the National Council on Governmental Accounting (NCGA) made significant strides during earlier decades in establishing sound accounting principles.

In June 1984, the Governmental Accounting Standards Board (GASB) became the public sector counterpart of the Financial Accounting Standards Board. The GASB holds the primary responsibility in the United States for setting authoritative accounting standards for state and local government units.

In the same manner as the Financial Accounting Standards Board, the GASB is an inde­pendent body functioning under the oversight of the Financial Accounting Foundation. Thus, a formal mechanism is in place to guide the development of governmental accounting.

Governmental Accounting—User Needs:

The unique aspects of any system of accounting should be a direct result of the perceived needs of financial statement users. Identification of these informational requirements is, therefore, a logical first step in the study of the accounting principles applied to state and local governments. Specific procedures utilized in the reporting process can be understood best as an outgrowth of these needs.

Often, though, user expectations are complex and even contradictory, especially for govern­mental entities. The taxpayer, the government employee, the bondholder, and the public official may each be seeking distinctly different types of financial information about a governmental unit.

In its Concepts Statement No. 1, “Objectives of Financial Reporting,” the GASB recog­nized this same problem by identifying three groups of primary users of external state and local governmental financial reports: the citizenry, legislative and oversight bodies, and cred­itors and investors. It then described the needs and interests of each of these groups.

Citizenry:

Want to evaluate the likelihood of tax or service fee increases, to determine the sources and uses of resources, to forecast revenues in order to influence spending decisions, to ensure that resources were used in accordance with appropriations, to assess financial condition, and to compare budgeted to actual results.

Legislative and Oversight Bodies:

Want to assess the overall financial condition when devel­oping budgets and program recommendations, to monitor operating results to assure compliance with mandates, to determine the reasonableness of fees and the need for tax changes, and to ascertain the ability to finance new programs and capital needs.

Investors and Creditors:

Want to know the amount of available and likely future financial resources, to measure the debt position and the ability to service that debt, and to review operat­ing results and cash flow data.

Thus, the quest for fair governmental reporting encounters a significant obstacle: User needs are so broad that no one set of financial statements or accounting principles can possi­bly satisfy all expectations. How can voters, bondholders, city officials, and the other users of the financial statements provided by state and local governments receive the information that they need for decision-making purposes?

Historically, and still today, many hold that public awareness should be the number one goal of such financial statements. “The most important users of financial reports are citizens act­ing through their elected representatives.” The question, though, has been constantly debated in connection with state and local government accounting: How can statements prepared for citizens also be sufficient for the needs of creditors and investors?

Two Sets of Financial Statements:

Eventually, the desire to create statements that could satisfy such broad demands for information led the GASB to require the production of two distinct sets of statements:

1. Fund-Based Financial Statements:

Fund-based financial statements have been designed “to show restrictions on the planned use of resources or to measure, in the short term, the revenues and expenditures arising from certain activities.”

2. Government-Wide Financial Statements:

Government-wide financial statements will have a longer-term focus because they will report “all revenues and all costs of providing services each year, not just those received or paid in the current year or soon after year-end.”

Fund-based financial statements focus on specific activities and the amount of financial resources allocated to those activities as well as the use made of those resources. These fund-based statements help citizens assess the government’s fiscal accountability in raising and utilizing money. For example, fund-based financial statements should tell the amount spent each period on such services as public safety, education, health and sanitation, and the construction of new roads.

While the primary measurement focus in these statements, at least for the public service activities, is on the flow and amount of current financial resources, the timing of recognition in most cases is based on a system known as modified accrual accounting. Modified accrual accounting recog­nizes- (1) revenues when resulting current financial resources are measurable and available to be used and (2) expenditures when they cause a reduction in current financial resources.

In contrast, government-wide financial statements report a government’s activities and financial position as a whole. These statements provide a method of assessing operational accountability, the government’s ability to meet its operating objectives. This information helps users make long-term evaluations of the financial decisions and stability of the govern­ment by allowing them to-

i. Determine whether the government’s overall financial position improved or deteriorated.

ii. Evaluate whether the government’s current-year revenues were sufficient to pay for current- year services.

iii. Understand the cost of providing services to the citizenry.

iv. See how the government finances its programs—through user fees and other program rev­enues along with general tax revenues.

v. Understand the extent to which the government has invested in capital assets, including roads, bridges, and other infrastructure assets.

To achieve these reporting goals, the government-wide financial statements’ measurement focus is on all economic resources (not just current financial resources such as cash and receivables), and these statements utilize accrual accounting for timing purposes much like any for-profit entity. They report all assets and liabilities and recognize revenues and expenses in a way that is comparable to business-type accounting.

In announcing the change to a dual set of statements, the city manager of Sacramento, California, explained that the purpose of such government-wide financial statements is to provide readers a broad overview of the city in a manner similar to private sector business financial statements.

Financial Reporting and Accountability:

Despite the variety of users and the creation of a dual set of statements, one aspect of govern­mental reporting has remained constant over the years- the goal of making the government accountable to the public. Because of the essential role of democracy within U.S. society, applied accounting principles have attempted to provide a vehicle for evaluating governmental actions. Citizens should be aware of the means that officials use to raise money and allocate scarce resources.

Voters must evaluate the wisdom, as well as the honesty, of the members of government. Most voters are also taxpayers, thus they naturally exhibit special interest in the results obtained from their involuntary contributions, such as taxes. Because elected and appointed officials hold authority over the public’s money, governmental reporting has tradi­tionally stressed this stewardship responsibility.

Accounting emphasis has traditionally been directed toward measuring and identifying the resources generated and expended by each of a government’s diverse activities. The GASB has now expanded the notion of accountability to encompass both fiscal accountability (in the fund-based statements) and operational accountability (in the government-wide financial statements).

This is not an attempt to overturn the traditional reporting philosophy. Instead the GASB has sought to refine the reporting of individual government activities and then go beyond that to provide information about the government as a whole—hence the need for two sets of financial statements.

At least in connection with public service activities, such as the police department and pub­lic library, the fund-based financial statements answer three questions:

i. How did the government generate its current financial resources?

ii. Where did those financial resources go?

iii. What amount of those financial resources is presently held?

The term current financial resources normally encompasses monetary assets available for officials to spend to meet the government’s needs. Thus, when measuring current financial resources, a government is primarily monitoring its cash, investments, and receivables. To stress accountability, the traditional government accounting system has focused almost exclu­sively on these financial resources as well as any current claims against them.

For this reason, little reporting emphasis has been historically placed on accounts such as Buildings, Equip­ment, and Long-Term Debts that have no direct impact on current financial resources.

Obviously, stressing accountability by monitoring the flow of current financial resources is an approach that cannot meet all user needs; thus, many conventional reporting objectives have long been ignored. As a result, investors and creditors have frequently been sharp critics of governmental accounting. “When cities get into financial trouble, few citizens know about it until the day the interest can’t be met or the teachers paid. Had the books been kept like any decent corporation’s that could never have happened?”

Consequently, the GASB mandated the inclusion of government-wide financial statements to provide an additional dimension for government reporting. These statements do not focus solely on current financial resources but seek to report all assets at the disposal of government officials as well as all liabilities that must eventually be paid. Likewise, revenues and expenses are recognized according to accrual accounting providing a completely different level of finan­cial information.

With two sets of financial statements, each user (whether citizen or investor) can select the information considered to be the most relevant. Of course, not everyone believes that addi­tional data are always helpful. “One of the tougher challenges of the current information age is sorting out the information most relevant for decision making from the vast amounts of data generated by today’s state-of-the-art information systems. Financial reports cannot sim­ply keep growing in size indefinitely to encompass every new type of information that becomes available.”

Reporting Diverse Governmental Activities—Fund Accounting:

In gathering financial information for most state and local governments, the accountant faces the challenge of reporting a diverse array of activities. Accountability and control become special con­cerns for governments that operate through a multitude of relatively independent departments and functions. Consequently, for internal monitoring purposes, the accounting for each government activity is maintained in separate quasi-independent bookkeeping systems referred to as funds.

Hence, the accounting process accumulates data to describe the financial results of every activity (library, school system, fire department, road construction, and the like). The internal information gathered in this manner has traditionally served as the foundation for fund-based financial state­ments. An underlying assumption of government reporting has long been that most statement users prefer to see information segregated by function in order to assess each activity individually.

Because no common profit motive exists to tie all of these various functions and services together, consolidated balances have historically been omitted. Combining operating results from the city zoo, fire department, water system, print shop, and the like would provide figures of questionable utility if accountability and control over the usage of current financial resources are the primary goals. The purpose of this approach to reporting was to provide information about the individual activities, not the government as a whole.

The requirement for inclusion of government-wide statements does not affect the use of fund accounting for control purposes. Consequently, the separate funds monitored by a state or local government still serve as the basic foundation for internal reporting.

Although a sin­gle list of identifiable functions is not possible, the following frequently are included:

Public safety – Judicial system

Highway maintenance – Debt repayment

Sanitation – Bridge construction

Health – Water and sewer system

Welfare – Municipal swimming pool

Culture and recreation – Data processing center

Education – Endowment funds

Parks – Employee pensions

The actual number of funds in use depends on the extent of services that the government offers and the grouping of related activities. For example, separate funds may be set up to account for a high school and its athletic programs, or these activities may be combined into a single fund.

The general rule is to establish the minimum number of separate funds consistent with legal specifications and operational requirements. Using too many funds causes inflexibility and undue complexity and is best avoided in the interest of efficient and economical financial administration.

Fund Accounting Classifications:

For internal record keeping, all funds (whether for the police department, the municipal golf course, or some other activity) can be categorized into one of three distinct groups. This clas­sification system allows for a clearer reporting of the government’s various activities. Fur­thermore, having three separate groups allows for unique accounting principles to be applied to different types of activities.

The three are as follows:

i. Governmental Funds:

Include all funds that account for activities that a government carries out primarily to provide services to citizens and that are financed primarily through taxes. A police or fire department should be reported within the governmental funds.

ii. Proprietary Funds:

Account for a government’s ongoing organizations and activities that are similar to those conducted by for-profit organizations. This fund type normally encom­passes operations that assess a user charge so that determining profitability or cost recov­ery is important. For example, both a municipal golf course and a toll road are reported within the proprietary funds.

iii. Fiduciary funds:

Account for monies held by the government in a trustee or agency capac­ity. Such assets must be held for others and cannot be used by the government for its own programs. Assets held for a pension plan for government employees are monitored within the fiduciary funds.

Governmental Funds:

In most state or municipal accounting systems, the governmental funds tend to dominate because a service orientation usually prevails. The internal accounting system can maintain individual funds for every distinct service function- public safety, libraries, construction of a town hall, and so on. Each of these governmental funds accumulates and expends current financial resources to achieve one or more desired public goals.

To provide better reported information and control, the governmental funds are subdivided into five categories- the General Fund, Special Revenue Funds, Capital Projects Funds, Debt Service Funds, and Permanent Funds. This classification system allows specific accounting guidelines to be directed toward each fund type while providing an overall structure for finan­cial reporting purposes.

1. The General Fund:

The GASB’s definition of the General Fund appears to be somewhat understated- “to account for all financial resources except those required to be accounted for in another fund.” This description seems to imply that the General Fund records only miscella­neous revenues and expenditures when, in actuality, it accounts for many of a government’s most important services.

Whereas the other governmental funds report specific activities or projects, the General Fund records a broad range of ongoing functions. For example, the 2006 fund-based financial statements for the City of Baltimore, Maryland, disclose 11 major areas of current expenditures within its General Fund- general government, public safety and regula­tions, conservation of health, social services, education, public library, recreation and culture, highways and streets, sanitation and waste removal, public service, and economic development. Expenditures reported for these categories of the General Fund were in excess of $1 billion and made up more than 49 percent of the total for all of the city’s governmental funds for the year ended June 30, 2006.

2. Special Revenue Funds:

Special Revenue Funds account for assets that have been legally restricted as to expenditure. Because of donor restrictions or legislative mandates, these financial resources must be spent in a specified fashion. Saint Paul, Minnesota, for example, reported approximately $100 million of revenues within over 30 individual Special Revenue Funds during the 2006 fiscal year.

Sources as diverse as cable television franchising fees, rent received from the use of Municipal Stadium, administration fees for charitable gambling, money received from solid waste and recycling programs, and parking meter fees generated this money.

The Special Revenue Funds category accounts for these monies because legal or donor restrictions had been attached to the revenue to require that expenditure be limited to specific operating purposes. As an exam­ple, according to the annual financial report, receipts from charitable gambling have to be admin­istered “in conformance with City Council action for the support of youth athletics or otherwise as legally determined.” Thus, the accounting system monitors any financial resources received from this source by including them in the Special Revenue Funds.

3. Capital Projects Funds:

As the title implies, this fund type accounts for costs incurred in acquiring or constructing major government facilities such as bridges, high schools, roads, or municipal office complexes. Funding for these projects normally comes from grants, sale of bonds, or transfers from general revenue.

The actual asset being obtained is not reported here; only the money to finance the purchase or construction is recorded. For example, the Lexing­ton-Fayette Urban County Government in Kentucky reported as of June 30, 2006, that it was holding more than $25 million in financial resources in its Capital Projects Funds to be used in projects such as acquisition or construction in connection with a cultural center, road projects, a golf course, and equipment leasing.

4. Debt Service Funds:

These funds record financial resources accumulated to pay long-term liabilities and interest as they come due. However, this fund type does not account for a government’s long-term debt. Rather, Debt Service Funds monitor the monetary balances currently available to make the eventual payment to satisfy long-term liabilities.

Thus, on June 30, 2005, the city of Birmingham, Alabama, reported more than $200,000 of cash and investments in its debt service funds, money being held to pay long-term debt and interest. For the year then ended, this fund had made more than $19 million in principal payments and $17 million in interest payments.

5. Permanent Funds:

The Permanent Funds category accounts for assets contributed to the gov­ernment by an external donor with the stipulation that the principal cannot be spent but any income can be used by the government, often for a designated purpose. As an example, the City of Dallas, Texas, reported holding nearly $9 million as of September 30, 2005, that had come almost entirely from private donations whose income was designated to maintain four different parks. Such gifts are frequently referred to as endowments.

Proprietary Funds:

The Proprietary Funds category accounts for government activities, such as a bus system or subway line, that assess a user charge. Such services resemble those found in the business world.

To facilitate financial reporting, the proprietary funds are broken down into two major divisions:

1. Enterprise Funds:

Any government operation that is open to the public and financed, at least in part, by user charges may be classified as an Enterprise Fund. A municipality, for example, might generate revenues from the use of a public swimming pool, golf course, airport, water and sewage service, and the like. As an illustration, the City of Charlotte, North Carolina, reports the operation of its airport, public transit, and water and sewer services as Enterprise Funds.

The number of Enterprise Funds has increased rather dramatically over recent years as gov­ernments have attempted to expand services without raising taxes. This situation requires those citizens utilizing a particular service to shoulder a higher percentage of its costs. “Enterprise funds have become an attractive alternative revenue source for local governments to recover all or part of the cost of goods or services from those directly benefiting from them.”

Enterprise Fund activities that assess direct fees from customers resemble business activi­ties. Not surprisingly, even in the fund-based financial statements, the accounting process for these operations very much parallels that found in for-profit reporting. These funds use accrual basis accounting with a focus on all economic, not just current financial, resources.

A question arises, though, as to how much revenue an activity must generate before it is viewed as an Enterprise Fund. For example, if a city wants to promote mass transit and charges only a nickel to ride on its bus line, should that activity be viewed as part of an Enterprise Fund (a business-type activity) or within the General Fund (a governmental activity)?

Any activity that charges the public a user fee may be classified as an Enterprise Fund. However, this designation is required if the activity meets any one of the following criteria so that the amount of revenue is viewed as significant:

i. The activity generates net revenues that provide the sole security for the debts of the activity.

ii. Laws or regulations require recovering the activity’s costs (including depreciation and debt service) through fees or charges.

iii. Fees and charges are set at prices intended to recover costs including depreciation and debt service.

2. Internal Service Funds:

This second proprietary fund type accounts for any operation that provides services to another department or agency within the government on a cost-reim­bursement basis. As with Enterprise Funds, Internal Service Funds charge fees but perform the service for the primary benefit of the government rather than for outside users. In the same manner as Enterprise Funds, Internal Service Funds are accounted for much like a for-profit operation in the private sector.

The City of Lincoln, Nebraska, lists seven operations in its 2006 financial statements that are accounted for as separate internal service funds:

Information Services Fund- To account for the cost of operating a central data processing facility.

Engineering Revolving Fund- To account for the cost of operating a central engineering pool.

Insurance Revolving Fund- To account for the cost of providing several types of self-insurance programs.

Fleet Services Fund- To account for the operations of a centralized maintenance facility for city equipment.

Police Garage Fund- To account for the operation of a maintenance facility for police and other government vehicles.

Communication Services Fund- To account for the costs of providing graphic arts and telecommunications services.

Copy Services Fund- To account for the cost of providing copy services.

Fiduciary Funds:

The final classification, fiduciary funds, accounts for assets held in a trustee or agency capacity for external parties so that the money cannot be used to support the government’s own programs. Like proprietary funds, fiduciary funds use the economic resources measurement focus and accrual accounting for the timing of revenues and expenses. Because these assets cannot be used for the benefit of the government, fiduciary funds are not included in government-wide finan­cial statements but do have separate statements within the fund-based financial statements.

Four distinct types of fiduciary funds can exist:

1. Investment Trust Funds:

The first fund type accounts for the outside portion of investment pools when the reporting government has accepted financial resources from other governments in order to have more money to invest and hopefully to be able to earn a higher return for both parties.

2. Private-Purpose Trust Funds:

The second fund type accounts for monies held in a trustee capacity when both principal and interest are for the benefit of external parties such as indi­viduals, private organizations, or other governments. Unclaimed property is usually recorded here, for example.

3. Pension Trust Funds:

The third type accounts for an employee retirement system. Because of the need to provide adequate benefits for government workers, this fund type can become quite large. The City of Baltimore, for example, reported assets of more than $3.4 billion in its pension trust fund at the end of 2006.

4. Agency Funds:

The fourth type records any resources a government holds as an agent for indi­viduals, private organizations, or other government units. For example, one government could collect taxes and tolls on behalf of another. To ensure safety and control, the Agency Fund sep­arately maintains this money until it is transferred to the proper authority.

Coverage of Fund Accounting Procedures:

As can be seen in Exhibit 16.1, knowledge of the formal classification system just described is extremely useful in understanding the financial reporting of a state or local government.

i. What is being Measured?

When the current financial resources measurement focus is used, statements measure resources that can be spent in the near future and any claims on them. The typical assets reported are cash, receivables, and investments. The liabilities reported are debts now owed that will be paid quickly enough to require the use of the current finan­cial resources reported as assets.

Conversely with an economic resources measurement focus, statements report all assets and all liabilities regardless of whether they are current or long-term.

ii. Timing of Recognition:

Modified accrual accounting recognizes revenues when the resulting resources are measurable and available. Available typically means that current financial resources will be received quickly enough to be used to pay for current period expenditures. The determination of what is meant by “quickly enough” is up to the reporting government.

The 2006 financial statements for the City of Norfolk, Virginia, disclose “the City generally considers revenues, except for grant revenues, to be available if they are collected within 60 days of the end of the fiscal year.” For that reason, a 2006 revenue that was collected within the first 60 days of 2007 is still recognized in 2006.

However, the financial statements for Raleigh, North Carolina, show a slightly different accounting policy. The city considers all rev­enues to be available if they are collected within 90 days after year-end, except for property taxes. Obviously, the number of days used for revenue recognition can vary by government.

In contrast, accrual accounting recognizes revenues when the earning process is sub­stantially completed and the amount to be received is subject to a reasonable estimation. Accrual accounting recognizes expenses by matching them, in most cases, to the revenues they helped to generate.

Because of the variety of funds and the alternatives for measurement and timing, the appro­priate reporting can best be visualized by setting up the matrix found in Exhibit 16.1.