Week # 5

Week # 5

Accounting

and

Financial Reporting

IntroductionAccounting and Financial Reporting

Chapter 4 introduced the concept of financial controlemployed by local government noting there are three interdependent systems of financial control: (1) Budget Implementation (2) Accounting (3) Financial Reporting

Budget Implementation was the focus of thepreceding session focused. During this session the focus will be the two other sources of financialcontrol --- Accounting and Financial Reporting.

It should be noted at the outset of

this session that the

budget document actually provides

both a foundation and framework

for an accounting system.

Accounting and Financial Reporting

Q5-1: Identify and briefly describe the

primary purpose of the accounting

system used by local government.

Q5-2: Identify at least two ways the

budget document provides the

foundation for accounting control.

An Accounting System provides the methods and means to compile data

for Financial Reports which …

summarize accounting information

allow monitoring of revenue collection and spending during the fiscal year

provide the means to control spending and make necessary corrections.

The Accounting System An Overview

Provides the record-keeping framework in whichtransactions authorized by the budget are logged.

Every transaction is recorded and aggregated intointerim financial reports and distributed to localgovernment managers to facilitate financial control.

At year-end, all transactions are compiled into astandardized format called the comprehensive annual financial report (CAFR).

Purpose of Financial Reports

Q5-3: Briefly describe the purpose served by interim financial reports and the

comprehensive annual financial report filed at the end of each fiscal year and identify one or more persons or groups

whowould be interested in receiving the information contained in these reports.

The Accounting SystemAn Overview

An accounting system provides….

Reliable information regarding the financial position of local government throughout the year (how muchmoney has been collected or spent).

Helps identify trouble spots (when spending is gettingout of control or collections are lagging behind).

Helps to identify when corrective measures must betaken (fund transfers, amendments, use of budget reserves).

Generally Accepted Accounting Principles (GAAP)

ACCURACY is the FIRST requisite of any accounting system!!!

For this reason, the accounting profession adopted a common set of standards several decades ago known as Generally Accepted Accounting Principles (GAAP Principles).

The GAAP Principles ensured transactions would be recorded thesame way by any organization – in any jurisdiction - at any time.

CONSISTENCY in recording/reporting of financial data is essential to the integrity of an accounting system --- and any financial records or reports that may be derived from any accounting system.

Standardized formats and reporting protocols make possible externalreview of financial records by auditors and other stakeholders.

GAAP Principles

The adoption of GAAP Principles provided the accounting profession with the meansto achieve the below listed six goals withrespect to the recording and reporting offinancial information.

Understandable Reliable

Relevant Comparable Consistent Timely

GAAP Principles

Q5-4: Review the list of six GAAP goals and

select the three goals that you think a

public sector manager would consider

to be the most important and support

your selection by briefly explaining the

importance of those particular goals.

The Government Accounting Standard Board

The six GAAP goals provided the conceptualbasis for the 13 GAAP Principles adopted by the Government Accounting Standards Board in 1984.

Turn to Page 108 and review the summary of the13 GAAP Principles adopted for governmental accounting.

Standardization of Accounting Systems

The text described and differentiated the basis for accounting systems used by the private sector and public sector and provided information on thefollowing three:

> Accrual Basis of accounting

> Modified Accrual Basis of Accounting

> Cash Basis of Accounting

Accrual Basis of AccountingThe accrual basis of accounting is used in the private sectorwhile the modified accrual basis of accounting is primarilyused in the public sector.

One easy way to understand the difference is to realize

the public sector does not EARN revenues by producing and selling goods or services (i.e., the public sector is not profit driven).

The public sector “collects revenues” to pay for the expenditures that must be made for public services or

public goods.

Therefore - no direct link exists between the cost of production and revenue.

Accrual vs. Modified Accrual

In accrual accounting … revenues from the sale ofproducts are recognized when they are both earned andmeasurable, and expenses for raw materials and laborare recognized when they are used in the productionprocess.

The focus of the accrual system is net income --- or said another way ( Income = Revenues – Expenses )

In the modified accrual basis of accounting … local government waits until revenue is available andmeasurable before recording it --- that is --- when theyknow how much and when revenue will be received.

Modified Accrual Basis of Accounting

In the public sector --- it is far more important to know if revenues received from taxes and other sources during a given fiscal period are sufficient to cover expenditures for that fiscal period.

Lawmakers and public sector managers must constantly monitor the financial condition of local government to ensure a fund’s current assets equal or exceed its current liabilities.

FUND

STRUCTURE

Fund Structure

The private sector combines the results of theoperations of all subsidiaries into one consolidatedreport.

The public sector disaggregates its operationsinto funds and creates a separate report for eachfund.

There are eleven (11) different types of fundcommonly used by local government. (See Page110 – Figure 5-3.)

Fund Structure

Fund (defined) ---

> A fund is an accounting entity with a self-balancing set of accounts.

> Governmental accounting information isorganized into funds, each with separaterevenues, expenditures (or expenses) andfund balances.

Fund Structure

Each fund…

– operates as though it were a self-contained business

– receives revenues from a different source

– spends money for different purposes

– maintains its own set of accounts and financialreports.

Governmental Funds- General funds- Special service funds- Debt Service Funds- Capital projects funds- Permanent funds

GovernmentalFunds• 3 categories• 11 types

Fiduciary Funds- Investment trust funds- Private-purpose trust funds- Pension trust funds- Agency funds

Proprietary funds- Enterprise funds- Internal service funds

General Fund

Usually the largest and most important.

Primary operating fund - and the most important in terms of operating budget.

As the name implies – any transaction that cannot be accounted for in another fund must be recorded in the General Fund.

Special Revenue Funds

Special Funds – as the name implies – are established to account for proceeds of revenue sources earmarked for a particular or “special” purpose.

Funds are restricted to a specific purpose and the “special” fund allows funding to be segregated and spending to be restricted to that special purpose.

While there is only one General Fund there may be several Special Funds (e.g., Hotel/Motel Tax Fund, City Parks Beautification Fund, etc.)

Debt Service Funds

This fund is used to account for resources used to pay theprincipal and interest on long-term debt, such as a generalobligation bond.

This fund segregates the funds that will be used to repaydebt AND to demonstrate sufficient funds have been setaside for this purpose.

Local government may have one or more debt servicefunds for specific sources of debt.

Also known as “sinking funds” because the funds are usedfor sinking (retiring) debt.

Capital Projects FundsThis fund is used to account for all resources used toconstruct and acquire capital facilities or infrastructure.

Revenues may come from a variety of sources, such astaxes, bonds, state or federal grants.

This fund allows all revenues and expenditures for theselarge capital projects to be segregated from other funds.

Segregating capital funds also allows the expenditure for a particular project to be monitored and better managed.

Once the project is complete, the fund is closed and any remaining balance is transferred elsewhere.

Permanent Funds constitute endowments madeto local government for a special purpose, suchas a fund to purchase library books.

The endowment principal must not be expended– only the income earned from the endowmentmay be spent (e.g., interest).

Provides a means to segregate these funds and ensure compliance with spending restrictions.

Permanent Funds

Proprietary Funds

There are two kinds of proprietary funds:> Enterprise funds> Internal service funds

Proprietary funds are used to account for the businesslikeactivities of local government such as city utilities (e.g.water service).

The accrual basis of accounting is used because bothtypes of proprietary fund receive revenues primarily fromcustomer charges which can be directly related to theproduction costs to provide the service - much like any business enterprise.

Enterprise Funds

Enterprise Funds account for services that are substantially supported by customer fees such as public utilities (e.g., city water service).

The use of Enterprise Fund(s) and the accrual

basis of accounting for these funds make it

possible to determine whether each enterprise

is bringing in enough revenue to pay all of costs

to provide the customer service.

Internal Service FundsUsed to account for goods and services produced by onedepartment and provided to another department of localgovernment on a cost-reimbursement basis.

For example, the Graphic Arts Department will chargeanother department for reproduction services.

It is not uncommon for departments who plan to use suchservices to include a line-item in the budget to pay for suchservices during the year.

Internal Service Funds make it possible to monitor costs and how much other department use certain services suchas use of motor pool vehicles.

Fiduciary Funds

Account for resources that governments hold in trust for individuals or other governments.

There are four types of fiduciary funds:

Investment Trust Funds

Private-purpose Trust Funds

Pension Trust Funds

Agency Funds

Investment Trust Funds

Funds from various governments that arecomingled such as County-Wide Pool Fund.

Allows an accounting of funds received fromvarious sources and also expenditures madefrom the fund.

Each stakeholder can then examine revenueand expenditures.

Private-purpose Trust Funds

Have a similar fiduciary relationship in that the government holds resources in trust on behalf of individuals, a private organization or even other governments.

For example, a scholarship fund provided by a private organization for the education of children of fallen police officers.

Pension Trust Funds

Funds contributed by employees and also government for the retirement of their employees.

Accounts for all contributions, investments and pay outs.

Agency Funds

This fund accounts for the collection of taxes and fees for other governments, such as the state collecting sales tax and remitting a portion to local government.

Allows collection and distribution of funds during a fiscal period.

ACCOUNTS

ACCOUNTSFunds are the basic building blocks of governmentalaccounting --- and --- funds are made up of accounts

An account is defined as a “separate financial reportingunit for budgeting, management and/or accountingpurposes”.

Every transaction, starting with the adoption of the budget,is recorded in an account. Budgetary accounts -- the estimated revenues andappropriations -- link the budget and accounting systemsand form the cornerstone of the accounting records.

ACCOUNTS

Each account is given a unique number that

identifies the fund in which the account is found

and the type of account it is – such as cash,

supplies, taxes receivable, accounts payable, etc.

Example of Account Numbering system:

100-201-3010-2100

(See Figure 5-6 on Page 116)

Kinds of accounts

In the budget --- there are two kinds

of accounts:

(1) Estimated revenues

(2) Appropriations

Each source of revenue and each type of appropriation is given a separate account number.

Three Additional Account Types

While there are two types of budgetary accounts (i.e., estimated revenues and appropriations), the accounting system has three additional types of accounts

that form the basic accounting equation:

Assets = Liabilities + Fund Balance

Asset Accounts

A type of account that records information onthings of value to the fund.

Asset accounts are of two general types:

– Current assets – such as cash or things that can beconverted fairly quickly (e.g., investments, receivablesand inventory)

– Fixed assets – such as things of value with a lifeexpectancy of more than one year (e.g., land,buildings and equipment)

Liability AccountsA type of account that contains information onclaims to the fund’s assets, either by other fundsof the local government or by external entities.

Liabilities represent legal obligations that requiretransfer of assets to satisfy the obligation.

Said another way --- as liabilities come due (e.g., accounts payable, bonds payable), thencash and other assets are transferred to theclaimant to satisfy the claim.

Liability Accounts

The delivery of a piece of equipment creates

a liability and eventually requires the transfer

of cash to the vendor.

Each day an employee works, a liability is incurred that requires the transfer of cash in the form of salary top satisfy the obligation.


It should be noted ---

> the delivery of a piece of equipment creates a fixed asset on the left-hand side of the accounting equation

AND

> a corresponding liability on the right-hand side of the accounting equation.

Fund BalanceIn the private sector, net assets represent the wealthaccumulated by a business as a result of its operationswhich is determined by calculating the differencebetween assets and liabilities.

In the public sector, the purpose is not to accumulate wealth but to deliver services and the difference betweena fund’s assets and its liabilities is the fund balance.

Said another way --- the fund balance is located on theright-hand side of the accounting equation and whenadded to liabilities it equals the assets of a fund.


Three Components of the Fund Balance

(1) Reserved Portion

(2) Designated Portion

(3) Undesignated Portion

Three Components of the Fund Balance

The reserved portion of the fund balance represents netfinancial assets not available for appropriation becausethey have been legally committed to some future use. Theunreserved portion of the fund balance represents moneythat is available for appropriation in the next period.

The unreserved portion is divided into the designated andundesignated portions of the fund balance. The designatedportion of the fund balance includes resources earmarkedfor some purpose such as a rainy day account or pendinglitigation. The undesignated portion of the fund balancehas no reservations or management designations and is available for re-appropriation.

Chart of AccountsAs you will recall, three GAAP requisites for an accountingsystem is to render information that is: understandable,

comparable, and consistent.

The Chart of Accounts provides a common framework toidentify each Fund – Department – Account - Object ofExpenditure used in both the budgeting and accountingsystem for a local government.

By requiring all units of a local government to use acommon terminology and common numeric coding system,account information can easily be moved from the budget to the accounting system and back again.

Chart of Accounts

Example: Accounting for Salary Payments

The following code number (100-210-3010-2100) illustrates how a salary expenditure would be coded to record a salary payment by theBudget Office, a unit within the City Manager’s Finance Office, usingmoney drawn from the general fund:

Fund Department Sub-agency Expenditure/Revenue Code Code Code Code

100 201 3010 2100 General Fund Finance Budget Office Salaries

Chart of Accounts

The system for numbering accounts is essentially similaracross local governments.

However, each local government has some peculiaritiesand therefore each will vary somewhat from jurisdictionto jurisdiction.

Most importantly, the commonality of the Chart of Accountsallows information contained in the budget and accountingsystems to be linked and also for the information to be understandable, comparable and consistent within one local government and from jurisdiction to jurisdiction.

Reconciling the Budget with Accounting Data

The heart of the accounting system is the recording and reconciling of transactions!

Each transaction generates some type of documentation.

The data from each financial document leads to an entryin a journal to maintain a general record of all transactions.

The journal data is later compiled and used as the basisfor other accounting reports to summarize on-going financial activity.

Journal Entries

Journal entries always are entered chronologically and always involve at least two entries.

By convention, the first line of the journal entry is the debit (or left-hand side), and the second line is the credit (or right-hand side) which is indented.

A brief written explanation is usually entered to briefly describe the transaction.

The sum of debits must always equal the sum of the credits.

General Ledger

Information from journal entries is later transferred to a general ledger (and subsidiary ledgers) to organize the information according to accounts.

General and subsidiary ledgers allow information to be tracked and monitored within various accounts.

Interim and financial accounting reports can be compiled using the account information contained in general and subsidiary ledgers.


The “accounting cycle” is described on Page 117 and briefly summarized in Figure 5-7.

It is important to note that adoption of the budget constitutes a transaction that is first journalized and then posted to ledgers.

This point is important because it demonstrates the link between the budget and the accounting system.


Interim financial reports are prepared to allow acomparison of the budget amount for each account – both estimated revenues and appropriations – with the

actual amount – revenues and expenditures to date.

This accounting record is a vital part of financial management as it ensures both…

– actual receipts for each revenue source are keeping pace with revenue estimates

– expenditures and encumbrances for each account do not exceedthe amounts authorized in the budget

Monitoring the Balance

Assuming a balanced budget is adopted, and that Assets = liabilities + fund balance, then…

– If revenues exceed estimated revenues the fund balance will increase

– If revenues fall below estimated revenues the fund balance willdecrease

– If expenditures and encumbrances fall below the appropriationthe fund balance will increase

– If expenditures and encumbrances exceed the appropriation thefund balance will decrease

Turn to Page 118

Here is another equation that reflects the information listed at the bottom of the previous slide._____________________________________________________________________

Assets =

liabilities + fund + estimated - revenues + expenditures – appropriations balance revenues & encumbrances

_____________________________________________________________________

It is important to note the four accounts to the right of the fund balance are closed at year’s end, and by doing so, financial reports reflecting important information is created for each fund. Most importantly, the operating statement is created which compares the budget with actual revenues and expenditures .

_____________________________________________________________________

Financial Reporting

The culmination of financial reporting

is the preparation of interim and annual

financial reports.

Interim Financial Reporting

Interim reports reproduce expenditure and revenue ledgers for each fund and show the proportion of the total budget that has been expended to date.

These reports enable the Budget Office

(an other managers) to monitor the budget

status and each line-item appropriation.

Comprehensive Annual Financial Report

The CAFR summarizes financial data for the previous fiscal year in a standardized format (i.e., usually prescribed by GAAP).

The CAFR is organized by fund types and containsthe following information:

1. An Auditor’s Report2. Management’s Discussion and Analysis (MD &A)3. A Statement of Net Assets (balance sheet for governmental funds)4. A Statement of Activities for all funds 5. An Operating Statement for Governmental funds (or a statement

of revenues, expenditures and changes in fund balance for allgovernmental funds).

Auditing

Approximately 3 – 4 months after the close of the fiscal year, the Comptroller prepares the CAFR.

It is common for the council to retain an auditing firm to undertake afinancial and compliance audit of that report.

Te accuracy of the recording and reporting of account data isexamined and also the internal controls for the budgeting andaccounting systems.

An unqualified opinion is the goal – meaning the CAFR presentsfairly the financial position of the government. A qualified opinionmeans the CAFR presents fairly – but then cites any inconsistencieswith accounting data or internal controls.

Documents

Week # 5