June 2008

This month, we have a fabulously detailed article on how to compile government financial statements from an expert on the subject, Pete Rose, CGFM. In prior newsletters, I discussed the independence dilemma that auditors face in both compiling and auditing the financial statements. Under current Yellow Book standards, this practice is allowed, although in my opinion, it is not ideal—but I’m not heading down that trail today. Today, it is all about Pete and his expertise.

Pete is a Consultant to the Professional Certification Board for AGA. He is an instructor for AGA, presenting the CGFM study courses and other programs. He served as the Finance Director two municipalities in Central Ohio. He has also been employed by the State of Ohio in the Department of Administrative Services, Office of Budget and Management, and the Ohio Bureau of Workers’ Compensation. With the Office of Budget and Management, he was Deputy Director for State Accounting and managed the project to implement a GAAP accounting system in the State of Ohio.

He has received many awards for his work in government, including the Government Finance Officers Association’s Distinguished Budget Award and Certificate of Achievement for Financial Reporting; the Association of Government Accountant’s Frank L. Greathouse Distinguished Leadership Award, Distinguished Local Government Leadership Award and four President’s Awards. He has published numerous articles on various government financial management topics.

Mr. Rose has been very active in the financial management community. He served on GASB’s Financial Reporting Model Task Force. He has been very active in AGA and has chaired and served on a number of national boards and committees, including the National Executive Committee and Financial Management Standards Committee.

For those of you who are particularly interested in this topic, this article should be very helpful for you. You can reach Pete by email at PeteRoseCGFM@gmail.com.

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How to Compile Government Financial Statements

by Pete Rose

If you have never been involved with government, you might wonder, “What’s the big deal about compiling their financial statements? You start with the trial balance and make adjustments for accruals.”

Unfortunately, it is not that easy. You have to understand governments and government accounting. After all, governments are different. If you don’t believe it, consider some of the following points:

• Most government revenues come from taxes. There is no exchange. When do you recognize revenue?

• Many governments receive grants from states and the federal government. How do you recognize revenues?

• Governments have no stockholders. Who are they accountable to?

• Because there are no exchange revenues, governments have to have budgets. How does a government account for its budget?

As a result of these and other factors, compliers of government financial statements have to understand the requirements for preparing financial statements. This includes chief financial officers (CFO) of government entities, accounting personnel working for governments, as well as individuals and organizations with whom a government contracts for the preparation of financial statements.

It is not unusual for a government, particularly a small or medium sized local government, to contract with auditors to both compile and audit financial statements. Government auditing standards allow auditors to do this provided that they do not make management decisions when compiling the statements.

For example, preparing journal entries and asking the client to post them is making a management decision. The proper procedure is to present the entries to the client and ask them to review them. If they approve, then the entries can be posted.

Why do governments ask auditors or contractors to compile financial statements? The two primary reasons are lack of time and lack of expertise. A government CFO or finance director has a lot of responsibilities. There is not sufficient time to do everything. As a result, the decision is made to contract out the compilation of the statements and review and approve the statements. Also, government accounting is not easy to understand. As a result, the government prefers to ask someone with the expertise to prepare the statements.

For auditors and others involved in compiling government financial statements, the following are processes that need to be understood:

• The budget and budgetary accounting.

• Fund financial statements.

• Government-wide financial statements.

The Budget and Budgetary Accounting

In the private sector, the budget is an operating guide that is quite flexible. Unlike the private sector, the budget process in government results in the passage of a legal document, legally called the appropriation ordinance or appropriation act. Appropriations are not flexible. They can only be changed through legal means.

The U.S. Constitution, many state constitutions, and local charters generally prohibit any money being paid out of the treasury except against appropriations made by law. So, to pay employees, suppliers, contractors, and others, a valid appropriation must exist with a balance sufficient to make the payment.

As a result of this requirement, most government accounting systems are designed for budgetary control, first and foremost. Before an expenditure is approved, a check is made to see if there is a balance available. If the balance is not sufficient, then an adjustment needs to be made.

There are no standards for budgetary accounting. The most common basis is cash, followed by “near cash.” Under the cash basis, all transactions processed by the last day of the fiscal year are accounted for in that year. Transactions of the following day belong to the next fiscal year.

Some governments prefer to “clean out the pipeline.” These are transactions in process that have not reached the CFO or Controller’s Office. Even though they are processed in the following fiscal year, they are considered events of the fiscal year. The time allowed varies by government—anywhere from one or two days to a week. This is the “near cash” basis.

Governments following the cash basis can begin preparing their budgetary financial statements on the first day of the new fiscal year. What happens to services or goods received before the end of the fiscal year that are not invoiced until the following year? In what year are they posted? The answer depends on the government’s procedure regarding encumbrances.

An encumbrance is a budgetary control tool. It represents the unexecuted portion of contracts for goods or services. To ensure that authority is available to pay contractors when they perform, governments will “set aside” an amount through the establishment of an encumbrance.

For example, a government has an appropriation for supplies and materials for $100,000. The government intends to purchase tires for vehicles for $5,000 and establishes an encumbrance for this purpose. The available appropriation for other supplies and materials is now $95,000. As the supplier provides tires, the outstanding balance of the encumbrance is reduced and an expenditure is recorded. The balance of the appropriation is not affected.

Governments utilize one of two methods for encumbrances at year-end. If the encumbrance constitutes a continuing appropriation, the balance of the appropriation is accounted for as an expenditure—as if an invoice was received. In our example, if $1,000 remained at the end of the year in the encumbrance, the total expenditure reported would be $5,000—$4,000 already invoiced plus the balance of $1,000.

The second method is to cancel the balance of the encumbrance and carry forward the amount into the new year as an additional appropriation. In our example, if the new appropriation for supplies and materials was $102,000, an additional $5,000 would be added to make the total $107,000. (Internally, governments need controls to ensure that any balances of encumbrances are restricted so that a windfall does not occur. For example, if $200 remains that will not be spent, the balance should lapse and not be added to the $102,000.)

The cash or near-cash bases of accounting are not consistent with GAAP. Thus, to prepare the financial statements that are to be audited, adjusting entries are required.

Fund Financial Statements

Governments account for their activities in funds. Funds are fiscal and accounting entities, recording cash and other financial resources along with liabilities and residual equities. Funds are used to carry out governmental activities and are segregated.

There are three broad categories of funds—governmental, proprietary, and fiduciary. A complicating factor is that the accounting basis for governmental funds is different from the basis for proprietary and fiduciary funds. Governmental funds use the modified accrual basis of accounting, focusing on current financial resources. Proprietary and fiduciary funds use the accrual basis of accounting, focusing on economic resources.

Governmental funds are financed primarily with taxes, grants, user fees, and other sources. There is generally no ability or desire to match revenues with services provided. As a result, budgets (and appropriations) are required.

The governmental fund types are:

• General fund. Usually the largest fund of a government, which accounts for resources that are not required to be deposited in any other fund type. Unlike all other types, there can only be one general fund

• Special revenue funds, to account for resources that are restricted for specific purposes, such as grants.

• Capital projects funds, to account for resources to be used for the acquisition or construction of major capital facilities. The resources are often the proceeds from bond and other debt issues.

• Debt service funds, to account for the accumulation of resources for the payment of general long-term principal and interest.

• Permanent funds, to account for resources that are legally restricted so that only the interest earnings may be used to support government programs.

Proprietary funds types account for activities for which a fee is charged to users of services. However, the fee does not have to fully cover the cost. There are two types of proprietary funds—enterprise and internal service.

• Enterprise funds account for activities primarily charged to external users of goods or services.

• Internal service funds account for activities primarily charged to other funds, departments, or agencies of the government.

Fiduciary funds account for assets a government holds as a trustee or agent for others and cannot be used to support the government’s programs. The specific fund types are:

• Pension (and other employee benefit) trust funds, used to report resources required to be held in trust for members and beneficiaries of pension plans, post-employment benefit plans, or other employee benefit plans.

• Investment trust funds are used to report the external portion of investment pools.

• Private-purpose trust funds are used to report trust arrangements under which principal and income benefit individuals, private organizations and other governments.

• Agency funds report resources held by the government in a purely custodial capacity.

Modified accrual basis of accounting

The modified accrual basis of accounting is a hybrid system developed for state and local governments. It combines the measurement features of the cash basis of accounting, but recording events in the period in which the underlying transaction takes place.

The modified accrual basis of accounting measures financial resources—cash and resources that ordinarily can be converted to cash, such as investments and receivables. Thus, the focus is on the short-term. Transactions involving the receipt or use of financial resources are reported on the operating statement, including the issuance of long-term debt and the construction or acquisition of capital equipment and facilities.

Under the modified accrual basis of accounting, revenues are recognized in the accounting period when they are susceptible to accrual—that is, when they are measurable and available. Measurable means the amount is know or can be estimated. Available means they are collectible in the current period or soon enough after to pay the liabilities of the current period. This is commonly called the availability period and determines financial resources that are “current.” Revenues received after the period are deferred until the period when they become available.

How long is “soon enough after?” GAAP has only one standard involving property taxes—no more than 60 days. For all other revenue sources, the period is determined by the government. Although GAAP recommends the use of a single period, such as 60 or 90 days, some governments choose different periods for different sources (i.e., taxes may use 60 days while intergovernmental grants use a 120 day period).

Although proceeds from long-term obligations involve an inflow of current financial resources, they are not reported as revenues. Instead, they are reported as other financing sources in order to avoid distorting revenues. The same is true regarding the proceeds from the sale or disposal of capital assets.

Under the modified accrual basis of accounting, expenditures are reported in the period fund when a fund liability is incurred. This is essentially the same as accrual accounting, with important modifications.

An expenditure involves the use of current financial resources. Thus, a liability is not recognized until payment is due. This is different from the recognition of an expense, which is recognized when it occurs. The following example, involving interest on long-term debt, highlights the difference.

A government has a Jan. 1–Dec. 31 fiscal year. An interest payment on a bond is due on June 1, for the period Dec. 1 of the prior year to May 31 of the current year. That is the expenditure reported on June 1, when payment is due. Under accrual accounting, the expense is recognized for the period Jan. 1–May 31. The expense for the prior Dec. 1–Dec. 31 was reported in the previous fiscal year. That is when the liability was incurred.

If a principal payment on the bond was due on Dec. 1, the expenditure would be recognized under modified accrual accounting. Under accrual accounting, there is no expense. Instead, an asset (cash) has been exchanged for a reduction in a long-term liability (bonds payable).

Long-term liabilities, such as compensated absences and claims and judgments, are not recognized as expenditures under modified accrual until payment is due. For example, a workers’ compensation claim for medical services would be reported in the period the hospital or doctor submitted an invoice for services rendered. Under accrual accounting, as estimated expense is reported when the claim occurred, even if no requests for payment had been rendered.

Compiling Modified Accrual Statements from Cash Basis Records

As previously mentioned, government accounting systems are basically designed to control appropriations (the budget), and most budgets are on a cash or near-cash basis. Thus, it is necessary to examine transactions to determine how they should be reported under modified accrual. The majority of the transactions occur at the start and end of the fiscal year. The following discussion assumes the government has a Jan. 1-Dec. 31 fiscal year.

Revenue Transactions

Revenue transactions received after the end of the fiscal year need to be examined to determine if they should be reported in the prior fiscal year. For example, a government sends residents bills for refuse collection in January for services rendered in the fourth quarter of the previous year. All payments made prior to the end of the availability period should be reported as revenues of the prior fiscal year. (Under the cash basis of accounting, they would be current period revenues.) Receivable outstanding after the end of the availability period should be reported as deferred revenue.

Property taxes are susceptible to accrual since the government knows the liability of all property owners. Property taxes outstanding after 60 days should be reported as deferred revenue. It is also necessary to establish an allowance for uncollectible property taxes.

Fines are susceptible to accrual. The government determines when the offender has a liability and can recognize a receivable and revenue at that time. However, many fines are not paid. Thus, a government needs to establish an allowance for uncollectibles for fines.

Governments that have expenditure-driven grants need to recognize receivables and revenues. For example, a government is required to submit reimbursement requests after the end of each quarter. The expenditure for Oct.-Dec. is reported as a receivable and revenue for the fiscal year.

Revenues are reported net of allowances and discounts.

Expenditure Transactions

There are a number of expenditure transactions that take place in the new fiscal year that need to be reported in the prior fiscal year, including payroll, goods and services.

On a cash basis, payroll expenditures are recognized in the period when pay checks are issued. Under modified accrual, the payroll expenditure is recognized based on the date services were rendered. For example, the paychecks for the Dec. 14-27 pay period are issued on Jan. 4. On the cash basis, the payroll expenditure is recognized on Jan. 4.

Under the modified accrual basis, the payroll expenditure is reported in the prior fiscal year and offset as an accrued payroll liability. Similarly, the payroll expenditure for Dec. 28-Dec. 31, issued on Jan. 18, is reported in the same manner.

Goods and services received by Dec. 31 but not billed until January or later are reported as expenditures and accrued liabilities. This would include most utility suppliers. It would also include services provided by contractors and others.

Compiling Accrual Statements from Cash Basis Records

Proprietary and fiduciary funds use the accrual basis of accounting. Many of the adjustments discussed for modified accrual statements would also apply for accrual statements. There would be additional adjustments as well, however.

Revenue Transactions

Under modified accrual, revenue transactions not received by the end of the availability period are deferred. There is no deferral on the accrual basis for lack of availability. Revenues are only deferred if they are not earned.

Transactions involving the issuance of long-term obligations are not reported as other financing sources. For proprietary and fiduciary funds, such transactions only have an impact on the balance sheet.

Expense Transactions

There are a number of adjustments that need to be made for expense, including capital outlay, reporting of depreciation, claims and judgments, and others.

On the cash and modified accrual bases, capital outlay is reported as an expenditure. On the accrual basis, capital outlay only impacts the balance sheet—the exchange of a capital asset for a reduction in another asset, cash. Only the expense for depreciation is reported on the operating statement.

Compilers need to review capital asset records to determine the cost of a capital asset. The government needs to establish the useful life of the asset. Thus, the expense for depreciation can be calculated and would be reported on the operating statement. Infrastructure assets, such as roads, water, sewer, sanitary sewer, bridges, culverts, etc. are reported as capital assets and are depreciated.

If capital assets are sold or disposed of, only the gain or loss from the sale would be reported on the operating statement.

The expense and liability for compensated absences needs to be determined. If an employee earns 120 hours of vacation during the fiscal year, the expense for the year is based on the value of the 120 hours. (An expense for $1,200.00 would be recognized for an employee earning $10.00 per hour.) If the employee only used 100 hours during the year, a liability for compensated absences of $200.00 would be reported.

The expense for claims and judgments would be reported based on the estimated cost.

If a government issues debt and there is a premium or discount on the issue, the premium/discount is amortized over the life of the debt issue and recognized on the operating statement. The same is true for the cost associated with the bond issue. It is reported as a prepaid expense (asset) and amortized over the life of the issue.

Compiling Government-wide Statements from Fund Statements

The government-wide level of reporting focuses on activities, not funds. The basis of accounting at the government-wide level is accrual. The statements reflect governmental activities and business-type activities. There is a relationship between the activities and the funds.

Governmental activities include all governmental funds plus internal service funds. Thus, the same adjustments discussed for preparing accrual statements from cash basis statements would now apply to modified accrual statements as well.

Business-type activities include only enterprise funds. Since enterprise funds are reported on the accrual basis, there would be no adjustments needed with the exception of interfund payables and receivables, transfers, and possibly the gain or loss for internal service funds.

Fiduciary funds are not reported at the government-wide level.

Adjustments Required

There are two government-wide statements—the statement of net assets and the statement of activities. The statement of net assets uses this formula:

Assets – Liabilities = Net Assets

In reporting interfund payables and receivables, only the net amount between governmental activities and business-type activities is reported. Thus, transactions between governmental funds or between enterprise funds are eliminated.

Net assets are reported in three components—invested in capital assets, net of related debt; restricted; and unrestricted. Essentially, invested in capital assets net of related debt is the difference between the net value of capital assets and the total debt outstanding that was issued to purchase or construct the assets.

For example, a government issued $10 million to purchase a building. The building has a useful life of 25 years. The debt is to be retired over ten years. By end of the first year, the building has a book value of $9,600,000 ($10 million less $400,000 depreciation) and the outstanding debt is $9 million ($10 million less $1 million retired). The investment in capital assets, net of related debt, is $600,000.

Restricted assets are those that have external restrictions imposed, such as grantor requirements or bond covenants. Unrestricted net assets is the residual amount remaining.
The statement of activities uses a net cost format:

Expense – Program revenues = net cost
Net cost – general revenues = change in net assets

Program revenues are reported in three columns—charges for service, operating grants and contribution, and capital grants and contributions. Charges for services includes user fees, licenses and permits, as well as fines and forfeitures. Operating grants that have a capital component (some funds can be used for acquiring equipment, etc.) are reported as operating grants.

General revenues include all taxes even if the tax is earmarked for a specific purpose.