ALL RIGHTS RESERVED. FOR UIC CLASS USE ONLY. J. Chan V5.1 Feb. 2007 1 Chapter 11 GOVERNMENT-WIDE FINANCIAL STATEMENTS AND ACCRUAL ACCOUNTING Learning Objectives: • Identify the objectives of the government-wide financial statements. • Identify the general requirements for government-wide financial statements. • Describe the differences between primary governments and component units. • Demonstrate the relationship between the Statements of Net Assets and Activities. • Compare and apply the different degrees for recognizing revenue and cost of service. I. INTRODUCTION 2 II. GOVERNMENT-WIDE FINANCIAL STATEMENTS 2 A. Objectives of the Government-wide Financial Statements 2 B. General Requirements 5 C. Reporting Entity 5 D. Governmental and Business-type Activities 6 E. Statement of Net Assets 7 F. Statement of Activities 8 G. Summary 9 III. ACCOUNTING STANDARDS AND SYSTEM IN SUPPORT OF GOVERNMENT-WIDE FINANCIAL STATEMENTS 9 A. Need for Standards and System Support 9 B. Accounting with a Long-term Perspective 10 C. Accrual Accounting for Revenues and Receivables 13 IV. CONCLUSION 17 APPENDIX 19 Before GASB Statement No. 34 KEY CONCEPTS AND TERMS 25 REFERENCES 25 REVIEW QUESTIONS 25 DISCUSSION QUESTIONS 25 GLOSSARY 26
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ALL RIGHTS RESERVED. FOR UIC CLASS USE ONLY. J. Chan V5.1 Feb. 2007
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Chapter 11
GOVERNMENT-WIDE FINANCIAL STATEMENTS
AND ACCRUAL ACCOUNTING
Learning Objectives:
• Identify the objectives of the government-wide financial statements.
• Identify the general requirements for government-wide financial statements.
• Describe the differences between primary governments and component units.
• Demonstrate the relationship between the Statements of Net Assets and Activities.
• Compare and apply the different degrees for recognizing revenue and cost of service.
I. INTRODUCTION 2
II. GOVERNMENT-WIDE FINANCIAL STATEMENTS 2
A. Objectives of the Government-wide Financial Statements 2
B. General Requirements 5
C. Reporting Entity 5
D. Governmental and Business-type Activities 6
E. Statement of Net Assets 7
F. Statement of Activities 8
G. Summary 9
III. ACCOUNTING STANDARDS AND SYSTEM IN SUPPORT OF
GOVERNMENT-WIDE FINANCIAL STATEMENTS 9
A. Need for Standards and System Support 9
B. Accounting with a Long-term Perspective 10
C. Accrual Accounting for Revenues and Receivables 13
IV. CONCLUSION 17
APPENDIX 19
Before GASB Statement No. 34
KEY CONCEPTS AND TERMS 25
REFERENCES 25
REVIEW QUESTIONS 25
DISCUSSION QUESTIONS 25
GLOSSARY 26
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I. INTRODUCTION
In Statement No. 34, GASB requires state and local governments to produce a set
of basic financial statements that include both government-wide financial statements and
fund financial statements. This chapter discusses government-wide financial statements
and uses them to construct financial indicators and ratios to better understand a
government’s financial condition. Its content is based primarily on GASB Statement No.
34, “Basic Financial Statements… for State and Local Governments,” issued in June
1999. Chapter 12 will explain why governments use funds to organize their budgeting
and accounting systems and describe different ways of classifying funds. Then it will be
possible to understand the form and contents of the fund financial statements. We will
leave a detailed discussion of the accounting and financial statements of individual funds
to the next part. The last chapter, Chapter 13, of this part will place the financial
statements in the larger context of the Comprehensive Annual Financial Report (CAFR).
II. GOVERNMENT-WIDE FINANCIAL STATEMENTS
A. Objectives of the Government-wide Financial Statements
GASB requires state and local governments to produce two government-wide
financial statements: a statement of net assets and a statement of activities. The board
believes that these statements will help users:
• Assess the finances of the government in its entirety, including the year’s
operating results
• Determine whether the government’s overall financial position improved or
deteriorated
• Evaluate whether the government’s current-year revenues were sufficient to
pay for current-year services
• See the cost of providing services to its citizenry
• See how the government finances its programs – through use fees and other
program revenues versus general tax revenues
• Understand the extent to which the government has invested in capital assets,
including roads, bridges, and other infrastructure assets
• Make better comparisons between governments (GASB Statement No. 34,
“Preface”)
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Total primary government $ 117,112 $ 28,395 $ 5,176 $ 6,541 (80,015) 3,015 (77,000) -
Component units:
Landfill $ 3,382 $ 3,858 $ - $ 11 - - - 487 Public school system 31,186 706 3,937 - - - - (26,544)
Total component units $ 34,568 $ 4,564 $ 3,937 $ 11 - - - (26,056)
General revenues: Taxes: Property taxes, levied for general purposes 51,694 - 51,694 -
Property taxes, levied for debt service 4,726 - 4,726 - Franchise taxes 4,056 - 4,056 - Public service taxes 8,970 - 8,970 - Payment from Sample City - - - 21,893 Grants and contributions not restricted to specific programs 1,458 - 1,458 6,462 Investment earnings 1,958 601 2,559 882 Miscellaneous 885 105 990 22 Special item—Gain on sale of park land 2,653 - 2,653 -
Transfers 501 (501) - -
Total general revenues, special items, and transfers 76,901 205 77,106 29,259
Change in net assets (3,114) 3,220 106 3,203 Source: GASB No. 34, pp. 208-209, B-1 Net assets—beginning 126,673 82,349 209,022 16,026
Prepared by J. Arellano, 5/23/06 Net assets—ending $ 123,559 $ 85,569 $ 209,128 $ 19,229
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Exhibit 11.3. Balance Sheet with Broad Measurement Focus.
Liabilities • Current liabilities • Long-term liabilities
o Debt related to capital assets o Bonds, notes o Operating debts, e.g. pension
payable
Assets • Financial resources
o Current financial resources ! Monetary assets ! Financial investments ! Receivables ! Inventories for sale
o Long-term financial resources ! Financial investments ! Receivables
• Non-financial resources o Inventories for use o Cultural and historical treasures o Capital assets
! Equipment and similar ! Buildings ! Infrastructure ! Land
Net Assets • Net assets invested in capital assets, net
of related debt • Net assets restricted for…
o Capital projects o Debt service o other purposes
• Unrestricted net assets o Designated o Undesignated
B. General Requirements
Government-wide financial statements are intended to provide information about the overall government.
Government-wide financial statements are required to distinguish between the primary government and its discretely presented component units. (See the “Reporting entity” subsection below for further discussion.)
The government-wide financial statements exclude information about fiduciary activities, including component units such as some public employee retirement systems. The reason is that when a government acts as a trustee or agent for others, it cannot use the principals’ resources to finance its programs.
Government-wide financial statements are required to distinguish between the governmental activities and business-type activities of the primary government.
The government-wide statement of net assets has a broad measurement focus. Assets encompass all financial and economic resources, including infrastructure fixed assets. Both short-term and long-term liabilities are presented on the statement of net assets (see Exhibit 11.3).
The government-wide statement of activities uses the accrual basis of accounting. It is designed to show whether current operations have made government better off or worse off in terms of having more or less net assets.
C. Reporting Entity
Government-wide financial statements are required to include the primary
government and its component units. The primary government is the focus of the government-wide financial statements. A total column is presented for the primary government. A total column for the entire reporting entity is optional.
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A primary government is a state government or a general-purpose (i.e. multiple service function) local government. A primary government usually has a high degree of autonomy and members of its legislature are always elected. A special district (i.e. single service function local government) can also be a primary government if it is legally independent, has a separately elected governing board, and has a high degree of fiscal autonomy. Even though component units (CU) are legally separate organizations, the primary government (PG) may be financially accountable for them. The financial accountability may derive from the power of the PG to appoint a majority of the governing board of the component unit, and either: (a) the PG can impose its will on the CU (e.g. to approve or disapprove its budget) or (b) the CU can benefit or burden the PG. If the relationship between a CU and the PG is so close that the CU is virtually a part of the PG, the CU’s financial statements should be blended (i.e. merged) with those of the PG. Otherwise, the CU’s financial statement are discretely (i.e. separately) presented alongside with the PG’s. See Exhibit 11.3.5 for examples.
Exhibit 11.3.5
Examples on Defining the Financial Reporting Entity
Blended CU
! “The City’s financial statements blend the following legally separate component units because they fare fiscally dependent on the City and perform services primarily for City employees: the Municipal Employees’ Annuity and Benefit Fund of Chicago… The Laborers’ and Retirement Board Employees’ Annuity and Benefit Fund of Chicago… The Policemen’s Annuity and Benefit Fund of Chicago… the Firemen’s Annuity and Benefit Fund of Chicago” (City of Chicago, FY 2005 CAFR, p. 47).
Determinants of Financial Accountability for Discrete Presentation of CU
Imposition of Will ! The Board of Supervisors of the City of … appoints all members of the …
Commission. The Board can remove appointed members at all.
Fiscal Dependency ! The Council of the City of … has the right to approve the fire protection districts’ tax
rates and charges.
Financial Benefit or Burden ! … The City of … operates the public education system in the City for grades
kindergarten through twelve. The City … provides a significant amount of funding for the school board.
Related Organizations – disclosure in Notes of PG’s Financial Statements
! “City [of Chicago] officials are responsible for appointing a voting majority of the members of boards of other organizations, but the City’s accountability for these organizations do not exceed beyond making appointments and no fiscal dependency exists between the City and these organizations. The Chicago Park Districts, Chicago Public Schools, Community College District No. 508, Chicago Housing Authority and the Chicago Transit Authority are deemed to be related organizations” (City of Chicago, FY 2005, CAFR, p. 47).
Joint Venture – disclosure in Notes in the PG’s Financial Statements
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! “The State [of Illinois] is a participant with the states of Michigan, Minnesota, New York, Ohio, Pennsylvania and Wisconsin in the Great Lakes Protection Fund…, an Illinois not-for-profit corporation” (State of Illinois, FY 2003 CAFR).
D. Governmental and Business-Type Activities
Management’s discussion and analysis (MD&A) summarizes and explains the government’s financial position and activities as presented in the basic financial statements. Exhibit 11.4, excerpted from the sample MD&A in GASB Statement No. 34, introduces the Statement of Net Assets and the Statement of Activities in a narrative explanation.
Exhibit 11.4. MD&A: Reporting the City as a Whole.
The Statement of Net Assets and the Statement of Activities
Our analysis of the City as a whole begins on page 186. One of the most important questions asked about the City’s finances is, “Is the City as a whole better off or worse off as a result of the year’s activities?” The Statement of Net Assets and the Statement of Activities report information about the City as a whole and about its activities in a way that helps answer this question. These statements include all assets and liabilities using the accrual basis of accounting, which is similar to the accounting used by most private-sector companies. All of the current year’s revenues and expenses are taken into account regardless of when cash is received or paid. These two statements report the City’s net assets and changes in them. You can think of the City’s net assets—the difference between assets and liabilities—as one way to measure the City’s financial health, or financial position. Over time, increases or decreases in the City’s net assets are one indicator of whether its financial health is improving or deteriorating. You will need to consider other nonfinancial factors, however, such as changes in the City’s property tax base and the condition of the City’s roads, to assess the overall health of the City. In the Statement of Net Assets and the Statement of Activities, we divide the City into three kinds of activities:
• Governmental activities—Most of the City’s basic services are reported here, including the police, fire, public works, and parks departments, and general administration. Property taxes, franchise fees, and state and federal grants finance most of these activities.
• Business-type activities—The City charges a fee to customers to help it cover all or most of the cost of certain services it provides. The City’s water and sewer system and parking facilities are reported here.
• Component units—The City includes two separate legal entities in its report—the City School District and the City Landfill Authority. Although legally separate, these “component units” are important because the City is financially accountable for them.
Source: GASB Statement No. 34, p. 184 Governmental activities and business-type activities are distinguished in the government-wide financial statements. Taxes, intergovernmental grants and other non-
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exchange revenues finance governmental activities, which produce public goods to benefit the citizenry at large. User fees are the primary sources of revenue of business-
type activities, which produce individually consumed goods or services. Business-type activities are characterized by the exchange relationship between the government as a seller and the public as buyers of identifiable and divisible goods or services. Some business-type activities in government are expected to be self-sufficient like their private-sector counterparts, while others are subsidized by taxes like governmental activities. The GASB believes that the full cost of service (including the cost of using capital assets) is useful for public policy decisions on how much to subsidy them, if any. It is also important to recognize that, similar to governmental activities, government business-type activities are subject to the public accountability requirements. Due to the public goods nature of their services, governmental activities tend to be financed primary by taxes. Unlike business-type activities, the matching of cost of service and revenue is difficult or impossible at the individual level, and often unnecessary. The ability to pay is a secondary criterion for their allocation; indeed, the public is often a passive or even reluctant recipient of service (e.g. a traffic violation citation). Therefore, governmental-activities are characterized by non-exchange relationships on both the output side and input side. Their production is financed by budget allocations determined through the political process. Together governmental activities and business-type activities influence a government’s financial position and performance detailed in financial statements. In order to facilitate public understanding, the MD&A is required to provide financial highlights. Exhibit 11.5, excerpted from the sample MD&A in GASB Statement No. 34, points out notable comparisons between the current and previous year’s results (in dollar and percentage terms). These figures were deemed by management to be worthy of bringing to the user’s attention. Keep these points in mind as you scan the government-wide financial statements on the next two pages.
Exhibit 11.5. MD&A: Financial Highlights.
• The City’s net assets remained virtually unchanged as a result of this year’s operations. While net assets of our business-type activities increased by $3.2 million, or nearly 4 percent, net assets of our governmental activities decreased by $3.1 million, or nearly 2.5 percent.
• During the year, the City had expenses that were $6.3 million more than the $99.5 million generated in tax and other revenues for governmental programs (before special items). This compares to last year, however, when expenses exceeded revenues by $8.9 million.
• In the City’s business-type activities, revenues increased to $15 million (or 5.6 percent) while expenses decreased by 1.7 percent.
• Total cost of all of the City’s programs was virtually unchanged (increasing by $800,000, or less than 1 percent) with no new programs added this year.
• The General Fund reported a deficit this year of $1.3 million despite the one-time proceeds of $3.5 million from the sale of some of our park land.
• The resources available for appropriation were $1.1 million less than budgeted for the General Fund. However, we kept expenditures within spending limits primarily through a mid-year hiring and overtime freeze and our continuing staff
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restructuring efforts.
Source: GASB Statement No. 34, p. 183 E. Statement of Net Assets
GASB Statement No. 34 requires that the statement of net assets to have a broad measurement focus. That is, it report all financial and capital resources, and all liabilities regardless of whether they are short-term or long-term. Capital assets are reported at historical cost. Capital assets include: land, improvements to land, easements, building, building improvements, vehicles, machinery, equipment, work of arts and historical treasures, infrastructure, and all other tangible and intangible assets with useful lives longer than one year. Infrastructure assets are normally stationery and, if maintained well, they can have very long useful lives. Examples include: roads, bridges, tunnels, drainage systems, water and sewer systems, dams, and lighting systems. Generally, capital assets are depreciated over their estimated useful lives. Exceptions are those assets that are inexhaustible (e.g. land and land improvements), or are infrastructure that are reported using the modified approach (described below). GASB does not prescribe any particular depreciation methods, other than requiring systematic and rational allocation of net cost. Infrastructure assets that are part of a network are not required to be depreciated if they are managed and preserved at or above the officially established (physical) condition level. GASB has detailed requirements of this “alternative approach.” The basic idea that capital expenditures made to keep infrastructure assets in good working conditions are treated as expense; however, expenditures that add or improve them should be capitalized. The capitalized requirements for works of art and historical treasures are similar to those of FASB Statement No. 117. GASB encourages governments to present a government’s financial position as: assets less liabilities equal net assets (not fund balance or equity). Assets and liabilities are presented in order of their relative liquidity: nearness to cash for assets, and maturity dates for liabilities. As Exhibit 11.1 shows, net assets are displayed in three components:
• Net assets invested in capital assets, net of related debt, • Restricted net assets, and • Unrestricted net assets.
In effect, restricted net assets and unrestricted net assets add up to the government’s net financial assets. Restrictions result from constraints imposed by creditors, grantors or high-level governments, as well as by law (e.g. constitutional provisions or legislations) directing specific purposes for certain resources. The restrictions in the net asset section come from the fund financial statements. This will be discussed in further detail in the next chapter. F. Statement of Activities
GASB Statement No. 34 requires that the full accrual basis be used in measuring expenses and revenues for reporting periodic financial performance in a statement of activities. Under the accrual basis, expenses include not only the use of financial and capital assets, but also increases in short-term and long-term liabilities incurred for
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rendering service. Also under the accrual basis, legally enforceable claim is the basis for recognizing revenues from non-exchange transaction, and service efforts and accomplishment is the basis for recognizing sales revenue. Because of this long-term orientation, the GASB believe that the accrual basis can promote interperiod equity. Interperiod equity reflects the value judgment that people who receive services should pay for them, rather than shifting them to another period for others to finance them. The implementation of this notion will be discussed in greater detail in the next section.
The expenses of providing services through governmental activities and business-type activities are detailed in the Statement of Activities. Exhibit 11.2 shows the net expense or revenue format of reporting a government’s financial performance during a period. That is, the expense of each service function is offset by a combination of fees, grants and contributions (collectively called program revenues) that are associated with that service function. Expenses include at least direct expenses, but may also include a service function’s share of indirect expenses. If the expense is greater than the program revenues, the difference is called net expense; if the expense is less than the program revenues, the difference is called net revenue.
This format is intended to highlight the relative financial burden each service function imposes on taxpayers. As would be expected, governmental activities usually have net expenses, while business-type activities can have net expenses, net revenue or breakeven. In the aggregate, net expenses are to be financed by general revenues from taxes and other sources that are not dedicated to specific service functions.
It is important to distinguish between program revenues and general revenues. GASB provides the following guidelines (Exhibit 11.6).
In the final analysis, if total expenses exceeded total revenues, net assets would decrease during the period; if total revenues exceeded total expenses, net assets would increase during the period. In this way, the statement of activities is articulated with the statement of net assets.
Exhibit 11.6. Program Revenue and General Revenue.
Financing Sources Revenue Classification
Those who purchase, use, or directly benefit from the goods or services of the program
Always a program revenue
Parties outside of the reporting government’s citizenry
Program revenue if restricted to a specific program or programs; if unrestricted, general revenue
The reporting government’s taxpayers regardless of benefits received
Always general revenue, even if restricted to a specific program
The reporting government itself (e.g. investment income)
Usually a general revenue
G. Summary
Government-wide statements are designed to evaluate the whole government’s financial condition. The comparative statements of net assets and the statement of activities can be used to determine whether the government’s overall financial position improved or deteriorated between two year-ends. The statement of activities shows
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whether the government’s current-year revenues were sufficient to cover the expenses of current-year services to the citizenry. By means of the net expense/revenue format, the statement of activities shows the extent to which government services are financed by fees, and restricted grants and contributions, or by general tax revenues. It is noteworthy that the statement of net assets reports investment in capital assets, including infrastructure assets. With some exception, depreciation expense is calculated and included in the expense of service, and capital assets are reported at their historical cost net of accumulated depreciation.
III. ACCOUNTING STANDARDS AND SYSTEM IN SUPPORT
OF GOVERNMENT-WIDE FINANCIAL STATEMENTS
A. Need for Standards and System Support
The government-wide financial statements discussed above were a major feature of a new reporting model required by GASB Statement No. 34. Statement No. 34, issued in June 1999, was the result of a decade-long deliberation and research of how to produce a meaningful overview of a government’s finances. The reformers argued that governments should produce financial statements that would be similar to those of corporations, with capital assets and long-term liabilities on the balance sheets. The traditionalists believed that government accounting systems should focus on the availability and use of current financial resources and observe the segregation of resources in funds; consequently fund financial statements should be included in external reporting. Statement No. 34 has attempted to accommodate both points of view by requiring both government-wide financial statements and fund financial statements, which will be discussed in later chapters. See the Appendix for the way governments used to present their financial overviews prior to GASB Statement No. 34.
In order to produce the Statement of Net Assets with a broad measurement focus and the Statement of Activities using the strong accrual basis of accounting, a government’s accounting system requires the capacity to recognize and measure capital assets (along with their depreciation), long-term liabilities, as well as revenues and expenses. GASB has produced the necessary accounting standards to provide guidance to deal with related issues. Some of the requirements were also mentioned in the previous section. This section will provide a few examples to demonstrate the accounting process, which will be quite familiar to the reader as it is quite similar to business accounting. B. Accounting with a Long-term Perspective
GASB uses the terms “accrual basis” and “modified accrual” to refer to the basis of accounting applied to government-wide and governmental fund accounting, respectively. Basis of accounting refers to the timing of recognition of revenues, expenditures, expenses, and transfers -- and the related assets and liabilities -- in the accounts and reported in the financial statements. Unfortunately, GASB does not define “modified accrual” in precise terms, nor does it detail the intermediary degrees of accrual between the full accrual basis and the modified accrual basis. The author therefore proposes several degrees of accrual – strong, moderate and mild – to better define the grey area between full accrual basis and cash basis (see Exhibit 11.7).
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Exhibit 11.7. The Degrees of Accrual Concept.
Revenue Degrees of
Accrual
Expense/Expenditure
recognition on the basis of service efforts and accomplishment (SEA)
full (accrual basis)
recognition triggered by matching revenues with the economic resources used to generate them, incurrence of liabilities (regardless of maturity)
recognition on the basis of an enforceable claim
strong
use of economic resources (i.e. capital asset depreciation), incurrence of liabilities (regardless of maturity)
recognition on the basis of the availability of financial resources
moderate use of financial resources, incurrence of financial liabilities (regardless of maturity)
recognition on the basis of the availability of current financial resources
mild (modified accrual)
use of current financial resources, incurrence of current liabilities
Capital Assets and Long-term Debt. Suppose the Village of Oak Park at the beginning of last year issued $10 million of 5-year bonds to fund the replacement of its aging fleet of police cars and fire engines, and the entire amount was spent for this purpose. As Exhibit 11.8 shows, after the transactions were completed, the bond proceeds was exhausted and the government has $10 million of equipment, offset by $10 million of long-term bonds, resulting in no change in net position.
Exhibit 11.8. Accounting for Capital Assets and Long-Term Debt.
Account Classification and Title Debit Credit
A. Cash L. Bonds Payable
$10,000,000 $10,000,000
A. Equipment A. Cash
$10,000,000 $10,000,000
For accounting students, this way of accounting is common sense. For
government used to doing accounting focusing on current financial resources – cash in this simple case, incorporating capital assets and long-term liabilities into the accounts was a revolutionary act. Even if it is relatively easy to start capitalizing the spending for equipment, it is a very costly exercise to reconstruct historical records of fixed assets to present in the newly required Statement of Net Assets.
Expense. Suppose the Board of Trustees of the Village of Oak Park wanted to know the cost of providing police protection in the community last year. The “cost” can be interpreted in several ways (hypothetical numbers):
(1) It could mean the cash spent on employee salaries and wages ($2,000,000) and on equipment purchases ($300,000) for a total $2,300,000.
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(2) Suppose at the end of last year, the village government owed the police officers $100,000 in salary before the payday was a few days after year-end. One would argue that the cost should be $2,300,000 cash outlay plus the $100,000 current liability, for a total of $2,400,000.
(3) Suppose that the police officers were entitled to retirement benefits equal to 20% of their salaries. One would also argue the cost of police service should include another $400,000 (=20% x $2,000,000) for retirement benefits earned by the officers and attributable to last year.
(4) Some people might object to attributing the entire $300,000 in equipment purchase as the cost for last year. Suppose a police car has a useful life of five years, one might argue that only the annual depreciation expense of $50,000 should be included.
Each one of the methods is justifiable in some ways. Method 1, using the cash basis of accounting, is based on the argument that cash spent is the most objective and obvious way of measuring cost. Method 2 may be called a modified cash basis. By including the salaries payable, Method 2 is also learning toward the accrual basis, but it is only very mild accrual because only the soon to be paid amount owed is included. The $2,400,000 may be called an expenditure, to distinguish it from the cash outlay under Method 1.
Method 3 pushes accrual further by counting the value of retirement benefits attributable to last year as part of cost of police service received by the community last year. In doing so, Method 3 ignores when the benefits would be paid and focuses on capturing the total package of compensation for which the Village government (and therefore the local taxpayers) was responsible. The retirement benefits of $400,000 may be considered as part of the expense of providing police protection to the community. So expense differs from expenditure with respect to the treatment of increase in long-term liability related to services rendered. Sometimes the $400,000 of unpaid retirement benefits is called an operating debt because it arises from providing services; in contrast the bonds payable for equipment purchase is called a capital debt.
Method 4 makes the point that last year only used 1/5 of the service potential of a police car and, as such, should be attributed only 1/5 of the total cost, i.e. $60,000 of annual depreciation expense instead of the $300,000 of the capital outlay. The depreciation expense is at best an approximation, because it is a simple straight-line allocation of the historical cost. Be that as it may, it is much closer to the cost of “using up” a police car than the acquisition cost.
Using Method 4, the total amount of expenses of providing police protection for the Village of Oak Park would be $2,560,000 (see Exhibit 11.9). Method 4 is used in arriving at the amounts of expenses for the various government services in the government-wide Statement of Activities.
Exhibit 11.9. Accounting for Expenses.
Account Classification and Title Debit Credit
NA. Expenses A. Cash Short-term L. Salaries Payable Long-term L. Retirement Benefits Payable A. Equipment – Accumulated Depreciation
$2,560,000 $2,000,000
100,000 400,000 60,000
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Exhibit 11.10. Comparing Measures of Cost of Service.
Basis of Accounting Measure of Cost of Service Amount
cash basis Cash outlay $2,300,000
mild accrual Expenditure $2,400,000
moderate accrual Expense, not including purchase cost of equipment or depreciation
$2,500,000
strong accrual Expense, including depreciation expense $2,560,000
Exhibit 11.10 summarizes the above discussion of various measures of cost of
service, and the associated basis of accounting. Is this exercise just a play of words? In a way, it is: most people probably would not tell the difference between expenditure and expense. But it is an important kind of play of words. Words have meanings, and the different meanings carry different financial consequences. Specifically, expenditures are “decreases in net financial resources” and arise only under the mild accrual basis. Decreases in cash and increases in short-term liabilities are examples of decreases in current financial resources. In contrast, expenses include increases in long-term liabilities (moderate accrual basis) and outflows of non-financial resources (strong accrual basis).
Suppose that police protection is funded by property tax, and the property owners in the Village of Oak Park believe strongly that they should only pay for the cost of police services they receive in a year. If the village’s board of trustees asked you as the finance director how much the cost of police service was last year, what would you tell them?
You could give them the four numbers in Exhibit 11.10 and provide them with an exposition of their differences. But the board has to select one number to base the amount of property tax. Which one of the four numbers is the best?
From the point of view of the least amount, Method 1 (the cash basis) is the “best” as it would result in the smallest tax bill for the property owners last year. But Method 1 is mixed blessing: last year absorbed the $300,000 cash payment for equipment, but avoided the $100,000 wages payable to be paid in the following year, and the $400,000 retirement benefits to be paid many years later.
Method 4 is the “worst” method for the property owners as it would produce the largest amount for their property tax bills. It includes one-year depreciation expense (rather than the entire purchase cost of equipment), but it is burdened with the $400,000 retirement benefits, an increase to long-term liability.
On the other hand, Method 4 is most consistent with inter-period equity. Inter-
period equity means that the taxpayers in a year should pay for all of the cost of service provided in that year regardless of when the cost will be paid in cash. By including both personnel and capital expenses, as well as increases to short-term and long-term liabilities attributable to last year, Method 4 seeks to prevent the shifting of financial burden for current services to future taxpayers. Since GASB apparently believes in inter-period equity, it has chosen “expense” as the preferable method for measuring cost of service. Method 4 is the underlying strong accrual basis used to calculate the expenses of various services in the Statement of Activities.
C. Accrual Accounting for Revenues and Receivables
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The accounting for the commercial activities is the same regardless if they take place in the private sector or public sector. From the seller’s point of view, cash received in advance of service delivery gives rise to a liability. Service delivered in advance of customer’s payment entitled the seller to record a receivable. In other words, sales revenue is recognized to the extent of services delivered.
Like expenses, the amount of revenue recognized depends upon the basis of accounting being applied. Thus, a framework with progressive degrees of accrual also exists for revenue recognition. Under the cash basis, the receipt of cash triggers revenue recognition. The mild accrual basis recognizes revenues when a corresponding short-term receivable is recognized. In the case of short-term taxes receivable, only the soon to be collected amount is included. The next degree, the moderate accrual basis, counts long-term receivables as revenues, in addition to cash and short-term receivables.
The strong accrual basis includes so-called in-kind payments as revenues. In-kind payments are made in lieu of cash to satisfy tax obligations. For example, a famous painter died with no money to pay off his taxes. However, his estate satisfied the tax obligation by giving paintings to the government. From the government’s standpoint, the paintings are economic resources representing revenue under the strong accrual basis. In an example with hypothetical numbers (Exhibit 11.11), the strong accrual basis yields the largest amount of revenues recognized ($2,560,000). Exhibit 11.12 compares the components of revenue recognized under each basis of accounting.
Exhibit 11.11. Accounting for Revenues.
Account Classification and Title Debit Credit
A. Cash Short-term A. Taxes Receivable Long-term A. Taxes Receivable A. In-kind Payments NA. Revenues
$2,000,000 100,000 400,000 60,000
$2,560,000
Exhibit 11.12. Comparing Components of Revenue.
Basis of Accounting Components of Revenue Amount
cash basis Cash receipts $2,000,000
mild accrual Above, plus short-term receivables $2,100,000
moderate accrual All of the above, plus long-term receivables $2,500,000
strong accrual All of the above, plus in-kind payments $2,560,000
Governmental activities are financed primarily by taxes and grants, and
secondarily by contributions and user fees. With the exception of user fees, these other revenue sources come from what GASB calls non-exchange transactions. The GASB has defined a non-exchange transaction as an exchange in which “a government (including the federal government, as a provider) either gives value (benefit) to another party without directly receiving equal value in exchange or receives value (benefit) from another party without directly giving equal value in exchange.”
GASB in late 1998 issued Statement No. 33 “Accounting and Financial Reporting for Non-exchange Transactions” in advance of Statement No. 34 so that government
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would know how to account for their taxes, grants and contributions on the strong accrual basis. In general, “claim” replaces “service delivery” as the basis for recognizing receivable and revenue in non-exchange transactions. A claim is an assertion of a right to someone else’s property. Such an assertion inevitably would invite the question: on what is the claim based? Several situations are described below, so that a small number of recognition criteria can be developed to justify the assertion of claims. (The term “taxing authority” will be used frequently below instead of “government” in order to focus on this important power of government.)
Tax Derived from Taxable Transactions or Activities. If it is permitted by the applicable law (e.g. constitution or statutes), a government may identify certain transactions or activities as taxable, and specify the tax rates as well as other parameters (e.g., exemptions) to arrive at the amount of tax. Examples include: sales taxes, personal and corporate income taxes, motor fuel taxes, or consumption. Since these taxes originate from an underlying transaction or activity, they are called derived taxes. Let us use sales tax for illustration.
Ideally, the tax authority recognizes a sales tax receivable as soon as the underlying taxable transaction has completed, because at that time an enforceable legal claim arises (Scenario A in Exhibit 11.13, xxx symbolizes dollar amounts). Practically, the taxing authority recognizes the receivable as soon as it has information that the taxable transaction has taken place. Such information becomes available typically when the merchants periodically (e.g. monthly) remit the taxes in cash to the tax authorities (Scenario B). In the unlikely event that taxes are paid in cash in advance of the taxable transaction, the taxing authority should defer revenue recognition until the taxable transaction has occurred (Scenario C).
Exhibit 11.13. Accounting for a Derived Tax.
Account Classification and Title Debit Credit
Scenario A A. Sales Taxes Receivable NA. Sales Revenue A. Cash A. Sales Tax Receivable
xxx
xxx
xxx
xxx
Scenario B A. Cash NA. Sales Revenue
xxx
xxx
Scenario C A. Cash L. Deferred Revenue L. Deferred Revenue NA. Sales Revenue
xxx
xxx
xxx
xxx
Imposed Taxes. Property tax is a common example of imposed taxes. According to the GASB, “The principal characteristic of these transactions is that the required
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transmittal of resources to the assessing government is imposed by that government on an act committed or omitted by the provider (such as property ownership or the contravention of a law or regulation) that is not an exchange transaction.” Property tax is a major revenue source of American local governments, including school districts. The amount of property tax is calculated by multiplying a property tax rate by the estimated value of the taxable property (e.g., a house or commercial property such as shopping mall), adjusted by exemptions and other provisions. Property tax is usually levied on an annual basis to fund the operations of a government for a particular fiscal year. Therefore timing is an important consideration. Consider the three scenarios in Exhibit 11.14. In Scenario A, the tax authority receives property tax payments in Year 1 for use in Year 2. It should therefore defer recognition of Year 2 property tax revenue. In Scenario B, tax receipts arrive in the year for which property tax is levied; Year 2 tax revenue is recognized for the Year 2 tax payments received. In Scenario C, property taxpayers in Year 3 pay for Year 2 expenditures to be financed by Year 2 property tax levy. Since the taxing authority has an enforceable legal claim in Year 2, in Year 2 it can record property tax receivable and property tax revenue. Cash received in Year 3 reduces the amount of previously recorded property tax receivable.
Exhibit 11.14. Accounting for an Imposed Tax – Property Tax.
Account Classification and Title Debit Credit
Scenario A: Advance tax receipt occurs in Year 1 for use in Year 2. Journal entry in Year 1
A. Cash L. Deferred Property Tax Revenue Journal entry in Year 2
Scenario B: Tax receipt occurs in Year 2 for use in Year 2 and journal entry is made in Year 2 A. Cash NA. Property Tax Revenue (for Year 2)
xxx
xxx
Scenario C: Tax receipt occurs in Year 3 for Year 2 property tax levy Journal entry made in Year 2
A. Property Tax Receivable NA. Property Tax Revenue (Year 2) Journal entry made in Year 3
A. Cash A. Property Tax Receivable
xxx
xxx
xxx
xxx
Grants. Local governments receive grants from their state government and the
federal governments; state governments also receive grants from the federal governments. Some grants are awarded virtually automatically to recipients who meet certain pre-specified eligibility requirements. Other grants have to be individually applied and are awarded to those who meet the criteria set by the grantor. The GASB defines
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grants are “transactions in which one governmental entity transfers cash or other items of value to (or incurs a liability for) another governmental entity, an individual, or an organization as a means of sharing program costs, subsidizing other governments or entities, or otherwise reallocating resources to the recipients.” In general, grant revenue is recognized on the basis of the existence of an enforceable claim, which is asserted by virtue of having met all eligibility requirements, which could include defeating competing grant applicants. Again, timing is important consideration in illustration in the three scenarios in Exhibit 11.15.
In Scenario A, the potential grant recipient receives cash advance in Year 1 before meeting all eligible requirements, it therefore has to defer recognition of revenue until the requirements are met in Year 2.
In Scenario B, the grant recipient receives cash and meets all eligible requirements in Year 2, and therefore recognizes revenue in Year 2.
In Scenario C, the grant recipient meets all eligibility requirements in Year 2 (e.g. by making qualifying expenditures), and can therefore assert an enforceable claim against the grantor, providing the basis for recognizing revenue in Year 2.
Exhibit 11.15. Accounting for Grants.
Account Classification and Title Debit Credit
Scenario A: Cash received in Year 1 in advance of meeting all eligibility requirements in Year 2. Journal entry in Year 1
A. Cash L. Deferred Grant Revenue Journal entry in Year 2
L. Deferred Grant Revenue NA. Grant Revenue (Year 2)
xxx
xxx
xxx
xxx
Scenario B: Cash received in Year 2, when all eligibility requirements are met A. Cash NA. Grant Revenue (Year 2)
xxx
xxx
Scenario B: All eligibility requirements are met in Year 2 and cash is received in Year 3. Journal entry made in Year 2
A. Grant Receivable NA. Grant Revenue (Year 2) Journal entry made in Year 3
A. Cash A. Grant Receivable
xxx
xxx
xxx
xxx
In summary, revenues from non-exchange transactions are recognized on the
basis of the ability to assert an enforceable claim. Enforceable means that there exists a basis in the applicable laws or agreements for the claim to have a reasonable chance of winning a favorable verdict in a court of law. A court battle may not be necessary or advisable, but that option is available. The claim is justified on the basis of:
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• the occurrence of taxable transactions or activities in the case of derived tax revenues, • being able to or required to use the resources in the case of property tax, and • meeting all eligibility requirements in the case of grants.
IV. CONCLUSION GASB requires state and local governments to produce a statement of net assets and a statement of activities. Both are government-wide in scope and, as such, are characterized by a broad measurement focus. This focus, when applied to the statement of net assets, encompasses financial and economic resources, as well as current and long-term liabilities. However, fiduciary assets and liabilities are excluded from government-wide financial statements, as these resources cannot be used to finance the government’s programs and operations. Government-wide financial statements are also accounted for under the strong accrual basis of accounting. Revenues are recognized on the basis of establishing an enforceable claim. Expense recognition is triggered by the use of economic resources or the incurrence of short- and long-term economic liabilities. The degrees of accrual concept presented in Exhibit 11.7 compares the strong accrual basis with the moderate and mild bases. The latter is used in governmental fund accounting and will be discussed in subsequent chapters. Governmental and business-type activities are distinguished in the government-wide financial statements. Governmental activities produce public goods which benefit citizens as a whole and are financed by taxes, intergovernmental grants, and other non-exchange revenues. In contrast, business-type activities produce goods and services for individual consumers and are financed by user fees. The statement of net assets presents assets less liabilities equal net assets, but not fund balance or equity. The three components of net assets are net assets invested in
capital assets, net of related debt, restricted net assets, and unrestricted net assets. Restricted and unrestricted net assets form the government’s net financial assets. Restrictions are imposed by creditors, grantors, higher-level governments, and law. The statement of activities follows the net revenue or expense format. If direct expenses and the program’s share of indirect expenses are greater than program revenues, the difference is called net expense. If the reverse is true, if expenses are less than program revenues, the difference is called net revenue. In keeping with the nature of such activities, governmental activities usually have net expenses, while business-type activities can have net expense, net revenue, or breakeven. The accounting system supporting the government-wide financial statements rests upon the concepts of accounting bases and accrual. Under the cash basis, revenues and expenses are recognized with the receipt or disbursement of cash, respectively. The mild accrual basis, used in governmental fund statements, counts increases in current receivables as revenue and increases in current liabilities as expenditure. The scope broadens with the moderate accrual basis, which also recognizes long-term receivables and liabilities as revenue and expense, respectively. Lastly, the strong accrual basis used in government-wide financial statements includes economic (non-financial) measures of expense and components of revenue. Using the Village of Oak Park example (Exhibit
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11.10), each basis produces a different measure of cost of service, with the cash basis yielding the lowest cost of service and the strong accrual basis producing the highest. The government-wide financial statements are essentially an aggregation of data found in the fund financial statements. For example, restrictions of net assets for debt service or capital projects come from the debt service and capital project fund financial statements. The next chapter discusses funds and fund accounting.
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APPENDIX
Before GASB Statement 34
Prior to the issuance of GASB Statement No. 34 in June 1999, the National Council on Governmental Accounting (NCGA, GASB’s predecessor) required American state and local governments to report a Combined Balance Sheet and a Combined Statement of Revenues, Expenditures, and Changes in Fund Balance. Described in NCGA Statement No. 1, these statements are reproduced for comparison purposes in Exhibit 11.A-2 and Exhibit 11.A-3, respectively.
Exhibit 11.A-1. A Comparison of Current and New Requirements.
Amount available in Debt Service Funds - - - - - - - - - 210 210 285 Amt to be provided for retirement of general long-term debt - - - - - - - - - 1,890 1,890 1,075
Total Other Financing Sources (Uses) (74) - - 964 10 3 903 2
Excess of Revenues and Other Sources over (under) Expenditures and Other Uses 77 18 27 593 (62) 1 653 4 Fund Balances—January 1 202 151 183 357 293 26 1,213 1,209