Introduction to governmental and not for profit accounting 7th by pattion

Introduction to governmental and not for profit accounting 7th by pattion Introduction to governmental and not for profit accounting 7th by pattion Introduction to governmental and not for profit accounting 7th by pattion Introduction to governmental and not for profit accounting 7th by pattion Introduction to governmental and not for profit accounting 7th by pattion Introduction to governmental and not for profit accounting 7th by pattion

Introduction

to Governmental and

Not-for-Profit

Accounting

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S e v e n t h E d i t i o n

Introduction

to Governmental and

Not-for-Profit Accounting

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Library of Congress Cataloging-in-Publication Data

1 Fund accounting 2 Finance, Public—Accounting 3 Nonprofit organizations—Accounting

I Patton, Terry K II Patton, Suesan R III Introduction to governmental and not-for-profit

accounting IV Title

Chapter 1 Governmental and Not-for-Profit Accounting Environment

and Characteristics 1 Chapter 2 The Use of Funds in Governmental Accounting 15

Chapter 3 Budgetary Considerations in Governmental

Accounting 58 Chapter 4 The Governmental Fund Accounting Cycle: An Introduction

to General and Special Revenue Funds 100 Chapter 5 The Governmental Fund Accounting Cycle: General and

Special Revenue Funds (Continued) 127 Chapter 6 The Governmental Fund Accounting Cycle: Capital Projects

Funds, Debt Service Funds, and Permanent Funds 182 Chapter 7 The Governmental Fund Accounting Cycle: Proprietary-

Type Funds 228 Chapter 8 The Governmental Fund Accounting Cycle: Fiduciary

Funds 264 Chapter 9 Reporting Principles and Preparation of Fund Financial

Statements 308 Chapter 10 Government-Wide Financial Statements 355

Chapter 11 Federal Government Accounting and Reporting 398

Chapter 12 Accounting for Not-for-Profit Organizations 435

Chapter 13 Accounting for Health Care Organizations 487

Chapter 14 Analysis of Financial Statements and Financial

Condition 535 Chapter 15 Fundamentals of Accounting 574

Index 617

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Preface xiii

About the Authors xvii

Chapter 1 GOVERNMENTAL AND NOT-FOR-PROFIT ACCOUNTING

ENVIRONMENT AND CHARACTERISTICS 1

Governmental and Not-for-Profit Organizations 2 The Operating Environment 3

Users and Uses of Accounting Information 6 Objectives of Financial Reporting 7

Distinctive Accounting and Financial Reporting Characteristics 8 Accounting Principles and Standards 10

Organization of Textbook 12 Review Questions 13

Discussion Scenarios and Issues 13 Exercises 14

Chapter 2 THE USE OF FUNDS IN GOVERNMENTAL

ACCOUNTING 15

Fund Accounting 18 Measurement Focus and Basis of Accounting 21 Governmental-Type Funds 27

Proprietary-Type Funds 36 Fiduciary-Type Funds 43 Review Questions 46 Discussion Scenarios and Issues 46 Exercises 47

Problems 50

Chapter 3 BUDGETARY CONSIDERATIONS IN GOVERNMENTAL

ACCOUNTING 58

Budget Laws 60 Budgetary Types and Approaches 60 The Budget Process 63

Service Efforts and Accomplishments 70 Budgetary Review 70

The Budget Document 73 Legislative Consideration and Adoption of the Budget 73 Property Tax Levy 75

Using Budgetary Information 76

vii

Classifying Revenues and Expenditures 78 Budgetary Accounting 81

Other Aspects of Budgetary Accounting 88 Review Questions 91

Discussion Scenarios and Issues 91 Exercises 92

Problems 95

Chapter 4 THE GOVERNMENTAL FUND ACCOUNTING CYCLE:

AN INTRODUCTION TO GENERAL AND SPECIAL REVENUE FUNDS 100

Background 101 Basic Entries in General and Special Revenue Funds 104 Fund Financial Statements 111

Closing the Accounts 115 Control Accounts and Subsidiary Ledgers 116 Other Matters and Concluding Comments 117 Review Questions 118

Discussion Scenarios and Issues 118 Exercises 119

Problems 121

Chapter 5 THE GOVERNMENTAL FUND ACCOUNTING CYCLE:

GENERAL AND SPECIAL REVENUE FUNDS (CONTINUED) 127

Recognition and Measurement—General Principles 129 Property Tax Revenues and Receivables 131

Sales Tax and Income Tax Revenues and Receivables 136 Intergovernmental Grants and Other Revenues 138 Expenditures and Fund Liabilities 141

Interfund Transactions 145 Other Accounting Matters 149 Fund Balance Presentation 151 Review of Year-end Financial Statements 155 Review Problem on the General Fund 156 Review Questions 169

Discussion Scenarios and Issues 169 Exercises 170

Problems 174 Summary Problem—Complete Accounting Cycle of General Fund 179

Chapter 6 THE GOVERNMENTAL FUND ACCOUNTING CYCLE:

CAPITAL PROJECTS FUNDS, DEBT SERVICE FUNDS, AND PERMANENT FUNDS 182

Measurement Focus and Basis of Accounting 185 Capital Projects Funds 185

Debt Service Funds 198 Leased Assets 207 Permanent Funds 209 Concluding Comment 211 Review Questions 213 Discussion Scenarios and Issues 213 Exercises 214

Problems 217 Summary Problem 225

Chapter 7 THE GOVERNMENTAL FUND ACCOUNTING CYCLE:

PROPRIETARY-TYPE FUNDS 228

Overview 229 Specific Aspects of Internal Service Funds 231 Specific Aspects of Enterprise Funds 240 Review Questions 252

Discussion Scenarios and Issues 252 Exercises 253

Problems 255 Summary Problem 262

Chapter 8 THE GOVERNMENTAL FUND ACCOUNTING CYCLE:

Review Questions 297 Discussion Scenarios and Issues 298 Exercises 298

Problems 302 Summary Problems 305

Chapter 9 REPORTING PRINCIPLES AND PREPARATION OF FUND

Preparing Required Supplementary Information 333 Preparing the Statistical Section 337

Review Questions 339 Discussion Scenarios and Issues 340 Exercises 341

Problems 343 Continuing Problems 350

Chapter 10 GOVERNMENT-WIDE FINANCIAL STATEMENTS 355

Focus and Format of Government-Wide Statements 357 Preparing Government-Wide Financial Statements 368 Creating Government-Wide Financial Statements From Fund Financial Data: Comprehensive Illustration 374

Capital Assets, Including Infrastructure Assets 385 Review Questions 388

Discussion Scenarios and Issues 389 Exercises 389

Problems 393 Continuing Problems 396

Chapter 11 FEDERAL GOVERNMENT ACCOUNTING

AND REPORTING 398

Background 399 The Federal Accounting and Financial Reporting Model 408 Recording Transactions and Events 414

Federal Agency Financial Reporting 422 Review Questions 428

Discussion Scenarios and Issues 428 Exercises 428

Fund Accounting in NFPOs 461 Illustration Using Funds 462 Review Questions 470 Discussion Scenarios and Issues 470 Exercises 470

Problems 475 Appendix 12A Not-for-ProfIt Colleges and Universities 482 Financial Statements of Not-for-Profit Colleges

and Universities 482 Notes to the Financial Statements 485

Chapter 13 ACCOUNTING FOR HEALTH CARE

ORGANIZATIONS 487

Health Care Service Providers 489 Introduction to Hospital Accounting and Financial Reporting 489 Patient Service Revenues 492

Investment Income, Other Revenues, and Gains 497 Expenses 500

Other Transactions 502 Accounting for Transactions with Restrictions When Using Funds 504

Financial Statements 510 Review Questions 520 Discussion Scenarios and Issues 520 Exercises 521

Problems 525

Chapter 14 ANALYSIS OF FINANCIAL STATEMENTS AND FINANCIAL

Problems 569

Chapter 15 FUNDAMENTALS OF ACCOUNTING 574

The Accounting Equation: Transaction Analysis 575 The Accrual Basis of Accounting 582

Recording Transactions: Debits and Credits 586 Financial Statements 599

Closing the Books 602 Other Transactions and Other Matters 604 Review Questions 607

Exercises 607 Problems 613

Index 617

We have had extensive experience in teaching, in working at all three levels of government, in ting accounting standards, and in auditing financial statements We know that accounting stan-dards have become increasingly complex in an increasingly complex world Therefore, we wrote this basic-level text on governmental and not-for-profit financial accounting and reporting with one key objective: to make it easy to read and understand To accomplish this objective, we followed this general approach: discuss the accounting principle, show the journal entry, provide an illustration Given that the text is designated as an “introduction” to the subject, we tried to cover the basic accounting and financial reporting principles in as comprehensive a manner as possible To keep the text practical and of the “real world,” we enhanced the discussion of the principles with numer-ous illustrations drawn from financial reports prepared by actual governments and not-for-profit organizations We updated the material to cover the latest accounting standards issued by the stan-dards-setting bodies Finally, we designed the end-of-chapter questions, discussion scenarios, exer-cises, and problems specifically to help students better understand the material covered in the text This text is written for college students (both accounting and public administration majors) and for practitioners To permit use by different types of readers, its 15 chapters cover not only the specialized financial accounting and reporting standards applicable to the governmental and not-for-profit sectors, but also the basic processes of business-type accounting Those who have not had

set-a course in bset-asic set-accounting or who need set-a brief refresher cset-an stset-art with Chset-apter 15 (Fundset-amentset-als

of Accounting) and draw selectively on the governmental, not-for-profit, health care, and financial statement analysis chapters Because of its flexibility, this text can be used by all of the following:

1 Accounting majors who wish to learn the fundamentals of governmental and not-for-profit

accounting in either a full semester or less than a full semester

2 Public administration majors who have had no previous accounting training but who need

a basic understanding of general, governmental, not-for-profit, and health care accounting; financial reporting; and financial statement analysis

3 Persons employed by governments and not-for-profit organizations, including the federal

government, health care entities, colleges and universities, and voluntary health and fare organizations

4 Persons preparing for the Uniform Certified Public Accountant (CPA) examination,

Certi-fied Government Financial Manager (CGFM) examination, and civil service examinations

5 Persons who wish, on their own, to learn about the financial accounting and reporting

practices of governments and not-for-profit organizations

FEATURES OF THIS EDITION

Real Situations Illustrate the Application of Theory

To prepare for the practice of accounting, auditing, and financial management, students must be able to visualize the application of accounting theory to real-world situations In preparing this seventh edition, we made a particular effort to increase the use of illustrations based on financial statements issued by actual governments and not-for-profit organizations For example,

1 Throughout the text we used the financial statements of Mt Lebanon, Pennsylvania, a

rela-tively small governmental entity outside Pittsburgh, to illustrate governmental transactions,

xiii

events, use of funds, and financial reporting Mt Lebanon is small enough to allow dents to readily visualize the transactions leading to its financial statements To show how financial statements are used in the real world, we added our own analysis of Mt Lebanon’s financial position in Chapter 14

2 To supplement the data provided by Mt Lebanon’s statements, we used the financial

state-ments of many other entities, both governmental and not-for-profit For example, we used the notes to the financial statements of the American Museum of Natural History to illus-trate accounting for collections held by museums; the financial statements of New York’s Metropolitan Transportation Authority to illustrate how various types of subsidies are reported by governmental enterprises; and the notes to Fordham University’s financial statements to show how colleges and universities account for some of the more complex contributions they receive

3 To enliven the text, we significantly increased the special feature that we call

Governmen-tal (or Not-for-Profit) Accounting in Practice For example, our detailed discussion of the financial status of Social Security helps illustrate the extensive amount of detail provided

in the annual financial report prepared by the United States government; and our cussion of the procedures used by Charity Navigator to assess the financial performance

dis-of not-for-prdis-ofit entities helps illustrate the nature dis-of the data provided in not-for-prdis-ofit financial statements

Discussion of Modified Accrual Basis of Accounting Improved

Governmental accounting is taught after students have learned the theory of accrual ing and the journal entries needed to record accrual-related transactions and events Because

account-of this, some students have difficulty grasping both the concepts underlying the modified accrual basis/financial resources measurement focus used in governmental-type funds and the accounting and financial reporting implications Therefore, we completely rewrote Chapter 5 for this edition

Chapter 5 now contains extensive discussion of why modified accrual accounting is used, the basic principles of modified accrual accounting, and—in a Governmental Accounting in Practice illustration—a discussion of how financial statements prepared using modified accrual accounting can mislead the unwary reader because modified accrual does not always measure the economic substance of transactions and events We believe our frank coverage of the subject—and the classroom discussion it should engender—will help the student better understand it Chapter 5 also includes more detailed discussion of the accounting entries needed to record transactions and events under modified accrual accounting, a comprehensive end-of-chapter illustration that covers the entire accounting and financial reporting cycle, and many new discussion scenarios, exercises, and problems We also rewrote Chapter 4 to better set the stage for the material covered

in later chapters

Text Updated for New Accounting Standards

Keeping an accounting text up-to-date can be challenging because accounting standards-setters are invariably working on new standards while the text is being written This edition takes account of all standards issued by the Governmental Accounting Standards Board through GASB Statement No 63 and even refers to several statements and concepts statements in progress while the text was being written Chapter 5 of the text was updated to incorporate the requirements of

GASB Statement No 54, which has had a major effect on fund balance reporting All other chapters were also updated to incorporate relevant new standards (and GASB Implementation Guides) issued after the sixth edition of this text was prepared We will keep instructors informed of rele-vant new standards through the Pearson web site

Coverage of Other Types of Entities Expanded

Although most of this text ( Chapters 2 through 10 ) is devoted to state and local government accounting, we have continued to provide extensive coverage of the unique aspects of accounting and financial reporting for the federal government and not-for-profit entities, including not-for-profit hospitals We expanded Chapter 11 (federal government) to cite specific references to the government’s Standard General Ledger Exploring the citations included in this chapter will give students greater insight into federal government finances; our new Federal Financial Reporting

in Practice provides an accounting perspective on the growth of the federal deficit

We also added new illustrations to the material covered in the chapters on not-for-profit organizations All references to FASB standards and AICPA documents were changed to the FASB’s new Accounting Standards Codification (ASC) Recognizing some of the more complex financial instruments held by not-for-profit entities as a result of the contributions they receive,

we added a section on split-interest agreements

Actual Financial Statements Analyzed

Accounting and public administration students need to understand not only how accounting information is gathered and reported, but also how it is used Therefore, we continued the chapter

on financial statement analysis ( Chapter 14 ), which was included in previous editions Our sion of the principles of financial statement analysis is supplemented with our own analysis of a real government (Mt Lebanon) and a real hospital (unnamed) As a basis for analyzing the finan-cial position of the hospital, we used “indicators” and “norms” taken from data on actual hospi-tals, available at various web sites Our objective here was to provide the inquisitive student with sufficient data to “do it yourself.”

Continuing Problems

This text has three “continuing problems” for instructors who like to reinforce the discussion of accounting principles with problems that carry throughout the text One problem, called Leisure City, is designed to emphasize fund accounting It starts at the end of Chapter 5 and covers fund-level accounting and financial reporting in Chapters 5 through 8 The other two, called CoCo City and Croton Village, also cover fund-level accounting transactions but are designed primarily

to emphasize fund-level and government-wide financial reporting They are presented at the end

of Chapters 9 and 10 and are developed so that portions of each problem can be assigned, as appropriate, with Chapters 2 through 10

Ancillary Package

To assist instructors in the classroom, the solutions manual and test item file are available for download by registered faculty at the Instructor Resource Center www.pearsonhighered.com Updates on new standards, prepared by the authors of this text, are also available at that site

ACKNOWLEDGMENTS

We sincerely appreciate the help of the many members of the professional community, students, and faculty in preparing this edition and previous editions of this text In particular, we thank the following:

Joseph R Razek and Gordon A Hosch, who wrote the original text and who set the tone for the content and presentation of the material in the subsequent editions We have tried to con-tinue on the path they set

Those who assisted us in obtaining the financial statements and other material we used to make governmental and not-for-profit accounting and financial reporting come alive They are

Ms Marcia Taylor, Assistant Manager of the Municipality of Mt Lebanon, Pennsylvania, and a member of the Governmental Accounting Standards Board, and Mr John Lordan, Chief Finan-cial Officer and Treasurer of Fordham University, New York Marcia went beyond the call of duty

to answer the questions we raised to ensure that our many references to Mt Lebanon’s financial data were complete, accurate, and up-to-date

Those who answered the questions we raised during the writing of this edition regarding accounting standards and procedures They include Mr David Bean, Director of Research and Technical Activities, and Mr Kenneth Schermann, Senior Technical Advisor, of the Governmen-tal Accounting Standards Board; and Ms Wendy Comes, Executive Director, and Ms Eileen Parlow, Assistant Director, of the Federal Accounting Standards Advisory Board

The people at Pearson, Donna Battista, Editor-in-Chief; Christina Rumbaugh, Editorial Project Manager; Nancy Fenton, Senior Managing Editor; Clara Bartunek, Production Project Manager

Mr Ives also thanks his wife, Eunice, whose encouragement in writing this text (and reminding him when it was time to eat) helped make the project a joy As new authors on the book, Mr and Mrs Patton thank their coauthor, Mr Ives, for his guidance and patience while working together on the seventh edition

Martin Ives, MBA, CPA (inactive), CGFM (retired), CIA , served for 16 years as Distinguished

Adjunct Professor of Public Administration at New York University’s Wagner Graduate School of Public Service Before entering the academic world, Mr Ives was Vice Chair and Director of Research of the Governmental Accounting Standards Board, First Deputy Comptroller of the City of New York, Deputy Comptroller of the State of New York, and a member of the Federal Accounting Standards Advisory Board

In addition to this text, Mr Ives is the author of the textbook Assessing Municipal Financial

Condition , coauthor of the textbook Government Performance Audit in Action , and coauthor of Program Control and Audit and Financial Condition Analysis and Management He has also written

chapters for books on auditing and municipal finance, has authored about 30 articles for the

Jour-nal of Government Financial Management, the JourJour-nal of Accountancy, the InterJour-nal Auditor , and

other professional journals, and has spoken to numerous professional and civic organizations

Mr Ives was founding president of the Albany chapter of the Institute of Internal Auditors, president of the Capitol District Chapter of the American Society for Public Administration, and

a member of the founding board of the Association of Government Accountants’ Certified ernment Financial Manager program He has received many honors and awards, including the Public Service Award (Fund for the City of New York); the Governor Charles Evans Hughes Award (Capitol District chapter of the American Society for Public Administration); and the S Kenneth Howard Award (Association for Budgeting and Financial Management) He has also been voted Adjunct of the Year by the students at NYU’s Wagner Graduate School

Terry K Patton, PhD, CPA, CGFM , is the Robert Madera Distinguished Professor of ing and Dean of the Dillard College of Business Administration at Midwestern State University in

Account-Wichita Falls, Texas He teaches governmental accounting, auditing, and accounting research and communications He received his Bachelor’s degree from Midwestern State University, a Master’s degree from the University of North Texas, and a PhD from Texas Tech University

Dr Patton began his career in public accounting, where he audited local governments Later, he served as a Project Manager and as the Research Manager for the Governmental Account-ing Standards Board He has coauthored a governmental accounting book for practitioners,

Guide to Governmental Financial Reporting Model: Implementing GASBS No 34 , and another

gov-ernmental accounting textbook published by Pearson Prentice Hall He has published articles in

the Accounting Review , Accounting Horizons , the Journal of Accounting and Public Policy , and the Journal of Public Budgeting, Accounting, and Financial Management , among others Dr Patton

regularly speaks to accounting professionals on state and local governmental accounting topics

Suesan R Patton is the National Director of Quality Initiatives for UHY LLP in Dallas, Texas, as well

as the principal author of two PPC Thomson practitioner guides on governmental accounting

and financial reporting— Preparing Governmental Financial Statements under GASBS No 34 and Governmental Financial Statement Illustrations and Trends Mrs Patton also currently serves as a

member of the Association of Government Accountants Financial Management Standards Board and as a reviewer for the Government Finance Officers Association’s Certificate of Excellence in Financial Reporting Program

Most of Mrs Patton’s career has been spent in standards-setting, beginning as a Manager with the American Institute of CPAs Accounting Standards Division and continuing with a 15-year stint with the Governmental Accounting Standards Board as a Senior Project Manager She received a Bachelor of Arts degree in English Literature with a Concentration in Accounting from the University of Cincinnati

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Chapter Outline

Learning Objectives

Governmental and Not-for-Profit Organizations

The Operating Environment

Organizational Purposes

Sources of Revenue and Relationship with Stakeholders

Potential for Longevity

Role of the Budget and Legal Requirements

Users and Uses of Accounting Information

Objectives of Financial Reporting

State and Local Government Financial Reporting

Federal Government Financial Reporting

Not-for-Profit Organization Financial Reporting

Distinctive Accounting and Financial Reporting Characteristics

Use of Fund Accounting

Incorporation of Budgets into Accounting Systems

Measurement Focus and Basis of Accounting

Entity-Wide and Fund-Level Reporting

Financial Reporting of Restricted Resources

Accounting Principles and Standards

Establishing Generally Accepted Accounting Principles

Governmental Accounting in Practice: Establishing Standards in a Political Environment

Hierarchy of Generally Accepted Accounting Principles

After completing this chapter, you should be able to do the following:

▪ The jurisdiction of their accounting standards-setting bodies

The entities covered in this textbook—state and local governments, the federal government,

and not-for-profit organizations—represent a significant portion of our total economic activity Government consumption expenditures account for more than 20 percent of gross domestic product, some $2.9 trillion of the $14.1 trillion of gross domestic product in 2009 But consumption data alone do not measure total government expenditures because they exclude sig-nificant payments to individuals for Social Security, Medicare, and Medicaid When payments to individuals are included, total state and local government current expenditures were more than $2.0 trillion, and total federal government outlays were nearly $3.0 trillion in 2008 To give you an idea of the financial scope of not-for-profit entities, the Internal Revenue Service reports that the total expenses of Internal Revenue Code 501(c)(3) organizations (religious, educational, charitable, sci-entific, and literary entities) were $1.3 trillion in 2007

Why is governmental and not-for-profit accounting covered separately from business prise accounting? In fact, many aspects of governmental accounting and most aspects of not-for-profit accounting are no different from those of business enterprise accounting Governments and not-for-profit entities do have some unique transactions—governments are financed primarily by taxes, and not-for-profit entities receive significant amounts of contributions But the answer to the question lies deeper than that Governmental and not-for-profit entities operate in an environment different from that of business enterprises, and the users of their accounting data have somewhat different information needs For example, the legally adopted budget plays a particularly significant role in governmental financial activities Legal restrictions and resource-provider restrictions on the use of resources play a greater role in governmental and not-for-profit entities than in business enterprises As a result, both internal accounting systems and external financial reporting for gov-ernmental and not-for-profit entity users are designed to provide certain types of data that differ from the data reported by business enterprises

This chapter discusses the characteristics of governmental and not-for-profit entities, the major differences between their environments and that of business enterprises, and the distinctive accounting and financial reporting resulting from those differences This chapter also describes the accounting and financial reporting standards-setting process for governmental and not-for-profit entities

GOVERNMENTAL AND NOT-FOR-PROFIT ORGANIZATIONS

It is not always easy to distinguish among governmental, not-for-profit, and for-profit organizations The distinction lies less in the functions these entities perform than in the details of how the entities are organized, governed, and financed For example, hospitals may be for-profit, not-for-profit, or

governmental organizations A hospital is not necessarily a governmental one just because it was financed partly with tax-exempt debt issued by a governmental agency An entity is not necessarily a not-for-profit one just because it was created under a state’s not-for-profit corporation law

Governmental entities include the following:

• Federal government

• General-purpose political subdivisions (such as states, counties, cities, and towns)

• Special-purpose political subdivisions (such as school districts)

• Public corporations and bodies corporate and politic (such as state-operated toll roads and toll bridges)

Other organizations created by governments by statute or under not-for-profit corporation laws are governmental if they possess one or more of the following characteristics: (1) their officers are popularly elected, or a controlling majority of their governing body is appointed or approved by governmental officials; (2) they possess the power to enact and enforce a tax levy; (3) they hold the power to directly issue debt whose interest is exempt from federal taxation; or (4) they face the potential that a government might dissolve them unilaterally and assume their assets and liabilities 1 Not-for-profit organizations exhibit certain basic characteristics that distinguish them from business enterprises Not-for-profit entities (1) receive contributions of significant amounts

of resources from resource providers who do not expect equivalent value in return; (2) operate for purposes other than to provide goods and services at a profit; and (3) lack ownership interests like those of a business enterprise 2 As a result, not-for-profit organizations may obtain contribu-tions and grants not normally received by business enterprises On the other hand, not-for-profit organizations do not engage in ownership-type transactions, such as issuing stock and paying dividends Four broad categories of not-for-profit organizations are discussed in this text: volun-tary health and welfare organizations, health care organizations, colleges and universities, and other not-for-profit organizations

THE OPERATING ENVIRONMENT

Governmental and not-for-profit organizations operate in a social, legal, and political ment different from the environment of for-profit business enterprises As a result, users of gov-ernmental and not-for-profit financial statements have somewhat different needs than do users of business enterprise financial statements These environmental differences have caused accounting standards-setters to develop accounting and financial reporting requirements for governmental and not-for-profit entities that sometimes differ from requirements for business enterprises

The Governmental Accounting Standards Board (GASB), the accounting standards-setting body for state and local governments, suggests that the major environmental differences between governments and business enterprises relate to organizational purpose, sources of revenue, potential for longevity, relationship with stakeholders, and role of the budget 3 Some of these

1 For further discussion, see American Institute of Certified Public Accountants, AICPA Audit and Accounting Guide,

Health Care Organizations (New York: AICPA, 2006), p 2 ; and Martin Ives, “What Is a Government?” The Government Accountants Journal (Spring 1994), pp 25 – 33

2 Statement of Financial Accounting Concepts No 4, “Objectives of Financial Reporting by Nonbusiness Organizations” (Stamford, CT: Financial Accounting Standards Board, 1980), par 6

3 “Why Governmental Accounting and Financial Reporting Is—and Should Be—Different,” Governmental Accounting Standards Board (2006)

factors apply as well to differences between the environments of not-for-profit entities and ness enterprises In the discussion that follows, we combine some of these factors and add another

busi-to show their potential consequences for accounting and financial reporting

In sharp contrast, governmental and not-for-profit entities exist to provide services to their constituents They generally try to accumulate a reasonable surplus of financial resources

to cushion against economic contraction and to provide for emergency needs But these ties do not operate to maximize inflows over outflows Indeed, if a local government were to accumulate large operating surpluses, many taxpayers would soon complain that they were being overtaxed

For governmental and not-for-profit organizations, reporting whether inflows exceeded outflows is only part of the picture The challenge to financial reporting lies also in demonstrat-

ing accountability for the resources entrusted to these organizations When used in the broad sense of the term, accountability embraces not only probity and legal compliance, but also effi-

ciency in delivering services and effectiveness in accomplishing program results The GASB encourages state and local governments to report on outputs (including cost per unit of service) and outcomes (program results) to supplement their annual financial reporting The federal gov-

ernment already requires federal agencies to prepare an annual Performance and Accountability

Report, which encompasses both financial and performance reporting

Sources of Revenue and Relationship with Stakeholders

Business enterprises derive virtually all their revenues from exchange transactions, generally involving specific products or services, between willing buyers and sellers Governments, on the other hand, obtain most of their revenues from taxation—wherein taxpayers involuntarily trans-fer resources for a basket of services that may or may not bear a direct relationship to what the taxpayer wants or needs Many not-for-profit entities obtain significant resources from voluntary donors who expect no product or service in exchange, but who are nevertheless concerned with whether their donations are achieving their intended purposes

Taxes and donations are unique to governmental and not-for-profit entities and hence require special accounting standards appropriate to those transactions Equally important, the nature of taxes and donations creates relationships with the providers of those resources that emphasize the accountability aspects of financial reporting, discussed in the preceding section Financial reporting for business enterprises means reporting to owners and lenders who can divest themselves quickly of their investments if they choose to do so Also, for business enterprises, accountability to their customers is direct and immediate: A consumer who doesn’t like the product or service simply will not buy it again In contrast, taxpayers are unlikely to be able to move from the jurisdictions where they reside as readily as investors can sell securities, and taxpayers may not benefit directly from the services provided by the taxes they pay Similarly, donors often cannot see for themselves the results of their contributions The need for and means

of demonstrating accountability take on added significance because of the nature of the ship between these entities and their stakeholders

Potential for Longevity

Business enterprises are at risk of going out of business for many reasons, such as global tion, emerging products, changing consumer tastes, inefficiencies, and recession Not-for-profit organizations face similar risks Business enterprises may also go out of business by being bought out by other enterprises However, because of the power to tax and the nature of their services, general-purpose governments rarely go out of business and are not bought and sold like business enterprises

As a result, governmental accounting standards-setters have tended to take a longer-term perspective than their business enterprise counterparts in developing accounting measurements for certain types of transactions One notable difference concerns the standards for pensions and other postemployment benefits

Role of the Budget and Legal Requirements

Business enterprises are free to provide only those goods and services they believe will enhance their profits They usually cannot be required to provide goods and services against their will, and if they cannot cope with the legal or social environment, they are free to leave the market Their spending decisions may or may not be subject to budgets, but if they are, the budgetary amendment process is relatively simple Commercial organizations also can borrow money when convenient, subject only to requirements of lenders and investors

Governmental entities, on the other hand, are required by law (constitution, charter, or statute) to provide certain services For example, most city charters provide for police and fire protection Managers cannot refuse to provide these services because of cost or because they believe their residents do not deserve them Indeed, local government managers often complain about “unfunded mandates” from higher-level governments—requirements to perform specific services without an equal amount of resources being provided

Most of the resources obtained by governmental entities come from taxes, higher-level ernment grants, and borrowing Some special-purpose governments, such as colleges and univer-sities, also receive significant resources in the form of donor contributions Spending decisions made by the federal government, states, and general-purpose local governments are based on budgets that have the force of law Budgetary appropriations typically cannot be exceeded with-out specific legislative approval Generally, resources provided by higher-level governments must

gov-be used only for the specific purposes designated by those governments Most governmental

bor-rowings are constrained by law as to purpose, quantity, and timing Amounts borrowed may be subject to specific limits, such as value of real property in the jurisdiction New bond issues may require approval by the electorate or by a higher-level government

Many not-for-profit organizations derive most of their resources from donor tions, which may be subject to restrictions as to what they can be used for, when they can be used,

contribu-or whether they must be maintained in perpetuity Recipient contribu-organizations are legally bound to adhere to these donor restrictions

Because of these factors, internal accounting for governmental and not-for-profit tions generally focuses on the controls needed to ensure compliance with laws and donor restric-tions Accounting records and internal reports for governmental entities are designed to ensure

organiza-adherence to spending limitations contained in legally adopted budgets and other legal ments Accounting records for not-for-profit entities are designed to ensure that purpose and time restrictions imposed by donors are heeded Further, external reports prepared by both gov-ernmental and not-for-profit entities are designed to inform users of the amount of available resources that may be used without restriction for the general purposes of the entity as well as the extent and nature of any restrictions

USERS AND USES OF ACCOUNTING INFORMATION

Persons both internal and external to entities use accounting information It is important to understand that internal users of information usually can specify the kinds of information they need to fulfill their duties Hence, accounting systems and most reports derived from those sys-tems are designed primarily to meet the needs of internal users For example, governmental man-agers need accounting information to keep day-to-day control over spending to ensure that amounts authorized by the budget are not exceeded and that sufficient resources will be available

to cover the full year’s operations Managers of not-for-profit entities need accounting data to help keep expenses in line with budgets and within limitations imposed by donors and grantors Managers of both governmental and not-for-profit entities need to monitor the day-to-day avail-ability of cash Boards of trustees require reports derived from accounting systems to help them perform their governance responsibilities

In establishing financial reporting standards, however, accounting standards-setters

emphasize the needs of external users—those not directly involved in the operations of the

reporting entity—because they do not have ready access to the entity’s information The major external users of governmental and not-for-profit entity financial reports are resource providers, oversight bodies, and service recipients Resource providers include taxpayers, donors and poten-tial donors, investors and potential investors, bond-rating agencies (which provide data to inves-tors), and grant-providing organizations, such as higher-level governments and foundations External oversight bodies include higher-level governments and regulatory agencies Service recipients include citizen advocate groups Because of the wide array of external users of financial reporting, the statements and related notes that comprise external reporting are often referred to

as “general purpose” reporting

Users of governmental and not-for-profit financial reporting might seek answers to the lowing types of questions:

• Does the entity have sufficient financial resources to provide a reasonable cushion against near-term revenue shortfalls caused by economic contraction?

• What is the likelihood of the entity’s ability to pay its short-term and long-term financial obligations?

• What is the entity’s ability to continue to provide a particular level of services?

• Does the entity use its resources consistent with budgetary limitations, donor restrictions, and legal and regulatory requirements?

• Do restrictions on use of resources appear to be reducing flexibility in meeting program goals?

• Do financial data show evidence of inefficiency, such as excessive administrative and raising costs or slow collection of taxes receivable?

• Is there evidence of excessive financial risk taking?

External financial reporting by governmental and not-for-profit organizations provides tion to help answer these questions

OBJECTIVES OF FINANCIAL REPORTING

As previously mentioned, the GASB establishes accounting standards for state and local ernments The Federal Accounting Standards Advisory Board (FASAB) sets standards for the federal government, and the Financial Accounting Standards Board (FASB) sets them for not-

gov-for-profit entities All three have issued concepts statements on financial reporting objectives

for the entities in their jurisdictions Concepts statements are not standards; instead, they articulate the framework within which the standards are developed The individual concepts statements on objectives of financial reporting have both similarities and differences based on the differing environments within which the entities operate The governmental standards-setting bodies, in particular, emphasize the need for data to help financial report users assess accountability

State and Local Government Financial Reporting

The GASB statement of reporting objectives for state and local governments calls for financial reporting to assist in fulfilling government’s duty to be publicly accountable and to help users assess that accountability To meet those objectives, financial reporting needs to provide data to show whether current-year revenues were sufficient to pay for current-year services, to demon-strate whether resources were obtained and used in accordance with the legally adopted budget, and to help users assess the entity’s service efforts, costs, and accomplishments

In addition to helping users evaluate the entity’s operating results for the year and assess the level of services that can be provided by the entity, financial reporting that follows GASB objec-tives also discloses an entity’s ability to meet its obligations as they come due Financial reporting should accomplish the latter objective by providing information about financial position and condition and about physical and other nonfinancial resources with useful lives that extend beyond the current year, and by disclosing restrictions on resources and risk of potential loss of resources (The GASB’s financial reporting objectives are discussed in more detail in Chapter 9 .)

Federal Government Financial Reporting

FASAB objectives for federal financial reporting cover budgetary integrity, operating mance, stewardship, and systems and controls The objectives state that financial reporting should assist in fulfilling the government’s duty to be publicly accountable for money raised through taxes and other means and for their expenditure in accordance with the government’s budget Financial reporting also should assist report users in (1) evaluating the entity’s service efforts, costs, and accomplishments and its management of assets and liabilities; (2) assessing the impact on the nation of the government’s operations and investments and how, as a result, the nation’s financial condition has changed and may change in the future; and (3) understand-ing whether financial management systems and internal accounting and administrative controls are adequate

Not-for-Profit Organization Financial Reporting

The FASB’s financial reporting objectives for not-for-profit organizations focus on information useful to present and potential resource providers, as well as other users, in making rational decisions about allocating resources to those organizations Such information helps in assessing (1) the services provided by the entity and its ability to continue to provide them, (2) how the entity’s managers discharged their stewardship responsibilities, and (3) the entity’s performance,

including its service efforts and accomplishments Not-for-profit entities should provide mation about their economic resources, obligations, net resources, restrictions on the use of resources, and liquidity

DISTINCTIVE ACCOUNTING AND FINANCIAL

REPORTING CHARACTERISTICS

Several characteristics of governmental and not-for-profit organization accounting and financial reporting are unique or distinctive when compared with those of business enterprises These characteristics, which flow primarily from the environmental factors discussed earlier, are intro-duced here and described in greater detail in other chapters of this text

Use of Fund Accounting

Fund accounting is perhaps the most distinctive feature of governmental and not-for-profit organization accounting Fund accounting segregates an entity’s assets, liabilities, and net assets into separate accounting entities based on legal requirements, donor-imposed restrictions, or special regulations Fund accounting is a convenient control mechanism to help ensure that resources are spent for the intended purposes—like using separate cookie jars for food, rent, clothing, and so on

Because each fund is a separate accounting entity, each must have a set of self-balancing accounts;

that is, the total assets of a particular fund must equal the total of its liabilities and fund balance (or net assets or net position) Thus, the accounting records of a particular fund must identify the unique resources of that fund and the claims to those resources, as distinguished from all other funds Entities that use fund accounting generally maintain a General Fund or an Unrestricted Current Fund, whose resources can be used for any purpose designated by the governing body In addition, these entities use separate funds to account for the acquisition and disposition of resources whose use is restricted in some manner (generally by law, regulation, or donor require-ment) to specific purposes

For many years, fund accounting provided the foundation both for internal accounting control purposes and for external financial reporting by governmental and not-for-profit entities

In response to concerns expressed by external financial reporting users about the complexity of fund-based financial reporting, however, the reporting emphasis shifted away from funds and to the entity as a whole Nevertheless, general-purpose governments continue to use fund account-ing for internal purposes, and the GASB requires both government-wide and fund-based report-ing for external reporting purposes The FASB does not require not-for-profit entities to use fund-based reporting but does not preclude such reporting, provided the entity complies with the FASB’s financial reporting requirements

Incorporation of Budgets into Accounting Systems

A unique feature in governmental fund accounting is the use of budgetary accounts in the

accounting system for certain types of funds Budgetary accounting is particularly pervasive in the federal government, where budgetary and financial accounting tracks operate side by side State and local governments incorporate budgetary accounting to a somewhat lesser extent, but it

is nevertheless significant The requirement for incorporating budgetary accounting into mental fund accounting systems highlights the importance of ensuring that legally adopted bud-gets are not exceeded

Measurement Focus and Basis of Accounting

Business enterprises use the accrual basis of accounting, as distinguished from the cash basis of accounting, when they prepare financial statements Basis of accounting is a term that refers to when assets, liabilities, revenues, and expenses are recognized as such in an entity’s financial

statements Under the accrual basis of accounting, revenues are recognized when they are earned, not necessarily when cash is received; and expenses are recognized when they are incurred, not necessarily when cash is paid Not-for-profit organizations, including not-for-profit hospitals, and the federal government also use the accrual basis of accounting in finan-cial reporting

State and local governments also use the accrual basis of accounting when they report on their business-type activities For their basic governmental functions, however, state and local

governments use a unique, hybrid-type basis of accounting called the modified accrual basis of

accounting When using this basis of accounting, they measure only inflows and outflows of rent financial resources, rather than all economic resources The accounting implications of this

cur-measurement method and focus are discussed in Chapters 2 through 6 , and the financial ing implications are covered in Chapters 9 and 10

Entity-Wide and Fund-Level Reporting

Does the use of funds in governmental and not-for-profit internal accounting have a major effect

on external financial reporting? For many years, the answer to this question was yes Recently, however, the financial reporting focus has turned toward the entity as a whole The change in emphasis came about for practical reasons Entities having many types of funds and reporting on

a fund basis often issued financial statements that looked complex and were not readily hensible because of the extensive details State and local governments issued financial statements with 10 or more columns, and many not-for-profit organizations issued statements showing each group of funds layered one atop another in a “pancake” format

To make financial reporting more useful, accounting standards-setters now emphasize the need for financial reporting on the entity as a whole, specifically as follows:

• State and local governments report on two levels: a government-wide level that guishes only between governmental and business-type activities, and a fund level that reports on individual funds Although the fund-level financial statements are prepared on the same basis of accounting used within the funds, the government-wide financial state-ments are prepared using the full accrual basis of accounting

• Not-for-profit organization financial statements are required to focus on the organization

as a whole Within those statements, the organizations need to report on three classes of net assets: those that are unrestricted and those that are either temporarily restricted or perma-nently restricted by donors

Financial Reporting of Restricted Resources

Reporting on restricted resources is much more pervasive in governmental and not-for-profit entity financial reporting than it is in business enterprise reporting For state and local governments, report-ing by funds facilitates the reporting of restricted resources In addition, the fund balances within each fund must be reported in up to five classifications depicting the different levels of constraints on the use of resources And as previously noted, not-for-profit entities must show the extent to which resources are unrestricted, temporarily restricted, or permanently restricted as to use

ACCOUNTING PRINCIPLES AND STANDARDS

Rules guiding accounting and financial reporting are referred to as generally accepted

account-ing principles (GAAP) The American Institute of Certified Public Accountants (AICPA)

defines this term as follows:

[T]he consensus at a particular time as to which economic resources and obligations should

be recorded as assets and liabilities by financial accounting, which changes in assets and liabilities should be recorded, when these changes should be recorded, how the assets and liabilities and changes in them should be measured, what information should be disclosed and how it should be disclosed, and which financial statements should be prepared Generally accepted accounting principles encompass the conventions, rules, and procedures necessary to define accepted accounting practice at a particular time The stan-dard of “generally accepted accounting principles” includes not only broad guidelines of general application, but also detailed practices and procedures 4

Establishing Generally Accepted Accounting Principles

The origins of GAAP can be traced back to the period just after the 1929 stock market crash, when attempts were made to formulate accounting principles Many criticized the earliest statement of principles as being little more than a codification of the then-current accounting practices Contin-ued concerns with the way in which accounting principles were being established led to the formu-lation of the FASB in 1973 and then to the GASB in 1984 Seven members are appointed to each of these bodies by the Financial Accounting Foundation (FAF), an entity whose members are appointed by certain professional accounting and financial organizations Advisory councils to both the FASB and the GASB are composed of individuals representing organizations concerned with the activities of the standards-setting bodies The FASB–GASB structure is shown in Exhibit 1-1 The FASB and the GASB are charged with establishing and improving standards of account-ing and financial reporting within their respective areas of jurisdiction The GASB’s jurisdiction includes all state and local governmental entities, including government-sponsored colleges and universities, health care providers, and utilities The FASB establishes standards for all nongovern-mental entities, including not-for-profit colleges and universities and health care providers Under this arrangement, it is possible for the two boards to establish different accounting and reporting standards for similar transactions of similar entities, such as hospitals Although this situation occurs sometimes, the two boards cooperate with each other to keep differences to a minimum

4 Statement No 4, “Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises” (New York: AICPA, 1970), pars 137 and 138

Financial Accounting Standards Advisory Council

FASB

Governmental Accounting Standards Advisory Council GASB

FAF

EXHIBIT 1-1 Relationship Between the FASB, the GASB, and the FAF

The FASAB was established in 1990 to develop accounting standards and principles for the federal government Its nine members include six public (nonfederal) members and representa-tives of the offices of the three officials who have prime responsibility for federal accounting and financial management—the U.S comptroller general, the director of the Office of Management and Budget (OMB), and the secretary of the Treasury FASAB proposals become GAAP for fed-eral agencies if neither the comptroller general nor the director of OMB objects

Standards promulgated by the three boards are GAAP by virtue of the due process used by the boards in developing them and the authority accorded them by the Code of Professional Conduct of the AICPA The due process used in developing the standards includes using task forces, holding public hearings, issuing “exposure drafts” of proposals for comment by interested parties, and carefully considering those comments before issuing the standards Auditors may not express unqualified opinions on financial statements that violate standards issued by the applicable board

Standards are identified by Statement Number and in Codifications issued by the Boards Individual Statements also contain the basis for the conclusions reached by the Boards “Basis for Conclusions” sections tend to be detailed and are helpful to the student desiring more detailed understanding of issues underlying a particular standard as well as the matters considered by the Board in reaching conclusions Throughout this text, we identify applicable standards either by Statement Number or by Codification section

Governmental Accounting in Practice

Establishing Standards in a Political Environment

The GASB establishes accounting standards, but it has no enforcement powers Several institutions, however, play a major role in enforcing GASB standards, including the governments themselves, the accounting profession, and the credit-rating agencies Recent experience in Connecticut and Texas illus-

trates this point

The state of Connecticut passed a law in the early 1990s requiring that its budget be balanced in

accordance with generally accepted accounting principles (This is unusual because GASB standards apply to financial reporting, not budgeting.) Each year, however, the state legislature delayed implement-

ing the law because it chose not to raise the taxes or to cut the expenditures needed to achieve GAAP balance As a result, the state ran up annual deficits when measured in accordance with GAAP Then, in

2007, the legislature passed a bill giving the state comptroller the authority to establish GAAP for

finan-cial reporting Someone had the bright idea that, if the standards don’t fit the situation, all you need to do

is change the standards!

Governor M Jodi Rell, deeply concerned that the bill would jeopardize Connecticut’s credit

rat-ing, promptly vetoed it The governor felt that credit analysts and municipal bond buyers wanted to see

financial statements that followed uniform accounting standards set by an independent standards-setting

body Right on, Madam Governor!

But not everyone thinks the way Governor Rell thinks Some officials in Texas were bothered by the implications of a new GASB standard that requires financial statement recognition of expenses and

liabilities for employee postemployment health care benefits (We discuss this standard in Chapter 8 .) So

Texas enacted a law in 2007 giving the state and its local governments the option to ignore the standard

Because governments feared that auditors and creditors would take a dim view of those who chose to ignore the standard, the state and most Texas local governments decided to follow the standard anyway

Source: New York Times, articles by Mary Williams Walsh, May 18, June 2, and July 8, 2007

Hierarchy of Generally Accepted Accounting Principles

As business practices and new financial instruments continue to evolve, financial statement parers may encounter transactions not specifically addressed by their standards-setting body To deal with these situations, practitioners may be helped by documents issued by the staff of the standards-setting body or by other organizations that issue relevant professional guidance They, therefore, need to know the relationships various sources of professional guidance have with each other For this reason, a hierarchy of GAAP has been established to guide financial statement preparers and auditors for each type of entity For example, GASB standards recognize the follow-ing hierarchy of pronouncements for state and local governments, ranked from most authorita-tive to least authoritative:

a Officially established accounting principles; that is, GASB Statements and Interpretations These Statements and Interpretations are periodically incorporated into the GASB’s Codi-

fication of Governmental Accounting and Financial Reporting Standards

b GASB Technical Bulletins Also, AICPA Industry Audit and Accounting Guides and AICPA Statements of Position, provided they are specifically made applicable to state and local government entities by the AICPA and cleared by the GASB

c AICPA Practice Bulletins, provided they are specifically made applicable to state and local government entities and cleared by the GASB Also, consensus positions of a group of accountants organized by the GASB that attempts to reach consensus positions on account-ing issues applicable to state and local government

d Implementation guides published by the GASB staff Also, practices that are widely nized and prevalent in state and local government

If the accounting treatment for a transaction or event is not specified in any of the foregoing sources, a financial statement preparer may consider other accounting literature, such as GASB Concepts Statements; pronouncements within the GAAP hierarchy for nongovernmental entities

if not specifically made applicable by the GASB to state and local government entities; FASB cepts Statements; FASAB Statements, Interpretations, Technical Bulletins, and Concepts State-ments; AICPA Issues Papers; International Public Sector Accounting Standards of the International Public Sector Accounting Standards Board; and certain other enumerated sources

ORGANIZATION OF TEXTBOOK

Chapters 2 through 10 of the textbook cover state and local government accounting and financial reporting The chapters move from the recording of budgetary and financial accounting informa-tion to the preparation of financial statements Chapters 2 and 3 introduce you to some of the unique aspects of governmental accounting—the use of fund accounting, the accounting mea-surements used in each fund, and the way budgetary accounting is integrated into the accounting system Chapters 4 through 8 discuss the nature of the transactions generally encountered in each fund and describe the applicable accounting procedures and measurements Accounting within the funds provides the basis for preparing fund-level financial statements, discussed in Chapter 9 Adjustments are then made to the fund financial statements to prepare the government-wide financial statements, discussed in Chapter 10

Separate chapters are presented on federal government accounting ( Chapter 11 ), profit accounting ( Chapter 12 ), and hospital accounting ( Chapter 13 ) Chapter 14 shows how an analyst would review an entity’s financial statements to help draw conclusions about some of the

not-for-factors that affect the financial health of governments and hospitals Chapter 15 provides an introduction to general accounting; it can be used as a refresher for the accounting student or as

a basic introduction to accounting for the public administration student

Review Questions

Q1-1 Describe the characteristics that distinguish not-for-profit organizations from business enterprises Q1-2 Identify the various types of entities that constitute governmental organizations, and describe the characteristics of other organizations that, when created by governments, are also considered to be governmental entities

Q1-3 Identify and briefly explain three major environmental characteristics of governmental and profit organizations

Q1-4 Illustrate the kinds of restrictions placed by laws on the ability of governments to use resources, and

by donors on the ability of not-for-profit entities to use resources

Q1-5 Who are the users of governmental and not-for-profit entity accounting information, and for what purposes might they use that information?

Q1-6 List the three ways identified by the GASB in which financial reporting can help users assess ernmental accountability

Q1-7 List three unique characteristics of state and local governmental accounting as contrasted with ness enterprise accounting

Q1-8 What are the jurisdictions of the accounting standards-setting bodies: GASB, FASAB, and FASB?

Q1-9 Why is a hierarchy of generally accepted accounting principles needed?

Discussion Scenarios and Issues

D1-1 Croton Hospital was a not-for-profit entity Because it experienced financial difficulties, the county

in which the hospital was located assumed control of Croton’s assets and liabilities The county executive appointed all five members of the hospital’s new board of trustees The hospital’s chief accountant, who was not replaced, continued to use the same accounting principles and financial reporting used before the county takeover Explain the position the county comptroller should take regarding Croton’s accounting and financial reporting

D1-2 State law provides that all cash not immediately needed by school districts to finance current tions be forwarded to the counties in which the school districts are located The law also requires that county treasurers place these resources in a separate fund and invest them on behalf of the school districts Because Contra County is experiencing financial problems and to provide resources

opera-to the county, the county treasurer tells the county administraopera-tor that he plans opera-to invest the school district funds in “junk bonds” yielding 9 percent interest He will credit the “normal” rate of return (5 percent) to the school districts and the remaining 4 percent to the county itself Explain the posi- tion the county administrator should take on the treasurer’s proposal

D1-3 A city ordinance provides that “no money shall be spent for any purpose without the prior approval

of the city council.” In approving the budget for the year, the council had authorized spending

$1,300,000 for road maintenance Late in the year, after the city had spent virtually the entire

$1,300,000, a major storm washed out portions of several roads leading to the elementary school The school was inaccessible, and the mayor wanted to enter into an emergency contract to repair the roads City engineers estimated that the cost of the repairs would be about $350,000 If the city entered into such a contract, the total amount spent on road maintenance for the year would be greater than the amount authorized Recognizing the need for prompt action, the mayor immedi- ately entered into the contract without seeking prior city council approval Comment on the legal, financial, and accounting systems implications of this scenario

Exercises

E1-1 (Characteristics of not-for-profit and governmental entities)

The mayor of a large city approaches a group of citizens and suggests that they form an organization

to provide social, educational, and recreational programs for local youth The group agrees and forms an entity called the Community Youth Organization (CYO) The group also chooses a board

of directors, and the board hires an executive director and several staff members CYO’s activities are financed entirely by grants from the city, and many of CYO’s programs are held after school hours in the high school Is the CYO a not-for-profit or a government organization? Why? What changes in characteristics would be needed to change it from one type of entity to the other? E1-2 (Accounting standards-setting bodies)

Three accountants started talking about hospitals One said he was treated at a not-for-profit tal, another said she was treated at a county hospital, and the third said he had just returned from the hospital run by the U.S Veterans Administration They wondered why three different bodies established accounting standards for hospitals Give reasons for and against the existence of three accounting standards-setting bodies

E1-3 (Accounting standards-setting procedures)

Several not-for-profit organizations use television campaigns to obtain pledges to contribute cash Some people think that not-for-profit entities should recognize pledges as revenues when the cash

is actually received Others would recognize revenues when the pledges are made, subject to a vision for amounts not likely to be collected Based on that scenario, discuss (a) the need for an accounting standards-setting body, (b) the qualifications that members of that body should possess, and (c) the procedures that body should adopt in establishing accounting standards

E1-4 (Objectives of financial reporting)

An objective of business enterprise financial reporting is to provide “information about an prise’s performance provided by measures of earnings and its components.” City governments, how- ever, are not concerned with “earnings.” One of the financial reporting objectives cited by the GASB regarding governments is that reporting should show whether current-year revenues were sufficient

enter-to pay for current-year services Based on these objectives, comment on the following assertions:

a Accrual accounting is not necessary in governmental financial reporting

b Financial reporting alone is insufficient for measuring governmental performance; there is also

a need for reporting on program efficiency and effectiveness

E1-5 (Use of funds in governmental accounting)

On Election Day, the citizens of a small village voted affirmatively on the following proposition: “To authorize the sale of $3,000,000 in bonds for the purpose of constructing a new firehouse.” The vil- lage manager then told the finance commissioner: “Put the entire proceeds from the bond sale into the General Fund That way, we can hire more firefighters with any proceeds from the bond sale that were not used to build the firehouse.” Comment on the village manager’s instructions to the finance commissioner

Funds as Subdivisions of an Entity

Why Governments Use Fund Accounting

Fund Categories

Financial Reporting with the Use of Funds

Measurement Focus and Basis of Accounting

Application to Proprietary-Type and Fiduciary-Type Funds

Application to Governmental-Type Funds

Governmental Accounting in Practice: Form versus Substance in Budgeting

Governmental Accounting in Practice: Current Financial Resources versus Economic Resources

Governmental-Type Funds

The General Fund

Comparison with Business Enterprise Reporting—Operating Statement

Comparison with Business Enterprise Reporting—Balance Sheet

Special Revenue Funds

Capital Projects Funds

Debt Service Funds

Permanent Funds

Proprietary-Type Funds

Enterprise Funds

Internal Service Funds

Reporting on Proprietary-Type Funds

Fiduciary-Type Funds

Pension (and Other Employee Benefit) Trust Funds

Investment Trust Funds

Private-Purpose Trust Funds

Agency Funds

Governmental Accounting

Reporting on Fiduciary-Type Funds

Governmental Accounting in Practice: How Many Funds Are Enough?

of the material that will be discussed in detail in Chapters 3 through 10 We discuss the nature of fund accounting, describe the purposes of the various funds used in state and local governmental accounting, and introduce the concept of the current financial resources measurement focus and modified accrual basis of accounting

To better understand the unique aspects of state and local governmental accounting, it is necessary to consider the types of activities performed by governments, how the activities are financed, and how governments are organized to perform them It is also necessary to grasp the important role played by laws and budgets State constitutions and statutes and local laws deter-mine what governments do, how their activities are financed, and how they are organized Most day-to-day governmental activities are driven by budgets that, once enacted, have the force of law Accounting systems must be designed not only to help provide accountability for resources entrusted to the government, but also to help ensure compliance with budgetary requirements and limitations

There are several ways to characterize governmental activities One is to distinguish them

as either governmental, business, or fiduciary in nature The distinction among the three lies primarily in their purposes and in how the activities are financed

• Governmental-type: General-purpose governments (such as states, counties, and cities) provide a range of basic, day-to-day services, including police and fire protection, sanita-tion, parks and recreation, and transportation The operating costs of these services are financed mostly by tax revenues, intergovernmental grants, and general fees Capital assets (such as buildings and roads) used in providing these services are financed primarily by long-term borrowing, which is ultimately paid off primarily from tax revenues

• Business-type: General-purpose and, often, special-purpose governments provide other specific services—such as mass transit and water and electric utility services—financed not

by taxes, but instead by user fees or charges that cover both operating and capital costs Because of how they are financed and administered, these activities are often referred to as business-type or proprietary-type activities

• Fiduciary-type: Many governmental entities also perform certain fiduciary-type services, holding segregated resources on behalf of others For example, a government may perform investing or tax collection services on behalf of other governments Also, governments may hold and invest resources on behalf of their employees and those of other governments to pay pensions when the employees retire

Not all governments are organized similarly, nor are their activities financed the same way For example, one municipality may finance its trash and garbage collection from general tax revenues, another may create a legally separate governmental corporation to provide these services through user charges, and a third may leave trash collection to private-sector carters Similarly, electricity may be provided to the citizenry through the legally constituted govern-mental entity, a separate specially created governmental corporation, or private enterprise One municipality may finance all aspects of highway maintenance through general tax revenues, while another may impose a special gasoline tax just to finance a particular aspect of highway maintenance Therefore, care needs to be taken when comparing the finances of one govern-ment with those of another

Governmental-type activities are controlled by a legally adopted budget—perhaps the gle most important financial document prepared by governments The revenue side of the budget shows estimates of how much will be raised from each revenue source On the spending side, the budget both authorizes and limits how much may be spent for each activity or purpose Internal accounting systems are designed to, among other things, meet the needs of the central govern-ment budget manager (to help monitor actual results in relation to the budget), the departmental budget manager (to show resources available for spending), and the cash manager (to help in preparing day-to-day cash forecasts)

State constitutions and statutes and local ordinances generally require “balanced budgets;” even where not specifically required, the balanced budget is the norm for prudent fiscal behavior But what is a balanced budget? Does it mean balanced on the accrual basis, the cash basis, or some other basis of accounting? In fact, governmental budgets tend to be balanced more on the

cash basis than the accrual basis of accounting Terms like expenditures are not defined in the

laws, and major obligations resulting from current-year activities may not be financed fully in the budget Some balanced budget laws permit current-year operations to be financed with long-term borrowing As a result, governmental budgets may be balanced in form, but not in eco-nomic substance (See the box “Form versus Substance in Budgeting” later in this chapter.) If the accounting system needs to be responsive to budgetary needs, what are the accounting measure-ment and financial reporting implications of budgetary practices? This is one of the issues dis-cussed here and in later chapters

FUND ACCOUNTING

Funds as Subdivisions of an Entity

You are already familiar with the entity concept As you know, the reporting entity defines the boundaries of a particular financial reporting unit by describing whose assets, liabilities, reve-

nues, expenses, and equities are included in its financial report If a parent corporate business enterprise exercises control over its legally separate subsidiaries, the financial activities of all those units are consolidated for financial reporting purposes

Although it is defined in a somewhat different manner, this notion of reporting entity applies as well to state and local governments New York City’s 2010 financial report, for example, covered not only the activities of the legally constituted government of New York City, but also the activities of about 20 separate legal organizations (such as the Health and Hospitals Corpora-tion) for which New York City is financially accountable In this context, New York City is called

the primary government; its constituent legally separate entities, which are public authorities or public benefit corporations, are called component units We will return to this aspect of the report- ing entity in Chapter 9

In state and local governmental accounting, however, there is an additional dimension to the reporting entity For internal accounting purposes, the primary government itself is disag-gregated—subdivided—into separate fiscal and accounting entities, called funds Each fund accounts for particular assets, liabilities, net assets, and inflows and outflows of resources Funds are the basic building blocks of governmental accounting and financial reporting

The formal definition of a fund is:

a fiscal and accounting entity with a self-balancing set of accounts recording cash and other financial resources, together with all related liabilities and residual equities or bal-ances, and changes therein, which are segregated for the purpose of carrying on specific activities or attaining certain objectives in accordance with special regulations, restrictions

Why Governments Use Fund Accounting

Governmental entities must comply with legal requirements set forth in constitutions, city ters, statutes, local ordinances, and so forth Because their day-to-day activities are guided by budgets proposed by the executive branch and enacted into law by the legislative branch, internal accounting systems are needed to ensure compliance with budgetary spending limits Funds have traditionally provided a basic control mechanism for ensuring compliance with legal restrictions

char-on the use of governmental resources Indeed, most funds are established based char-on specific legal requirements

1 GASB Codification of Governmental Accounting and Financial Reporting Standards (GASB Cod.) Sec 1300, “Statement of

Principle—Fund Accounting Systems” (Norwalk, CT: GASB, 2010)

To illustrate, if the legislature wants to segregate gasoline taxes from other revenues to ensure a steady flow of resources that can be used only to repair roads, it may establish a dedi-cated fund to record receipt of the taxes and their subsequent expenditure If the citizens vote to approve a bond issue for a new firehouse, segregating the bond proceeds in a dedicated fund helps ensure that the proceeds are used for no other purpose If the legislature wishes to demon-strate its intent to dedicate resources to the repayment of the debt, it may create a fund for that purpose A dedicated pension trust fund that accumulates employer and employee contributions and the related earnings helps ensure that the resources will be used to pay pension benefits when employees retire

Is fund accounting absolutely necessary? Not to the extent it is used in practice Many ernments can readily accomplish the purposes of fund accounting by establishing separate accounts for restricted resources within a single accounting and fiscal entity In fact, there is no consistency among governments in the extent to which they create funds Some governments use many more funds than others, even though they perform the same functions Further, excessive use of funds—for example, earmarking a particular type of tax to finance one purpose, a particu-lar fee for another purpose, and so on—is considered a poor financial management practice because it reduces a government’s flexibility in providing for citizen needs as priorities change

gov-Finally, fund accounting provides no absolute assurance that dedicated resources will be used

only for authorized purposes—a simple coding error can result in a charge to the wrong fund; hence, we used the phrase “helps ensure” in the preceding paragraph

On the other hand, some governments are quite complex because they are engaged in ous business-type activities Creating separate funds (and legally separate component units) helps provide the control mechanisms, the financing tools, and the administrative structures needed to manage those activities

Fund Categories

As noted earlier, the activities performed by governments can be categorized as either mental, business (or proprietary), or fiduciary, depending on their purpose and/or how they are financed The funds used by state and local governments can be similarly categorized Within

govern-each category are several specific fund types The categories are described next, and the fund types

within each category are described later As we will see in the next section, there is a major ence between the accounting measurements made in the governmental fund category and those

differ-in the other two fund categories

Governmental-type funds are used to account for most of the day-to-day public services

provided by state and local governments Depending on the type of government, these services may include public safety (policing and fire suppression), elementary and secondary education, health and mental health, sanitation, environmental protection, parks and recreation, transpor-tation, and so forth Governments finance these services primarily by levying taxes on various revenue bases, such as real property values, general sales and specific types of sales (such as cigarettes and motor fuel), and personal incomes They may also receive grants from other levels

of government in addition to other revenues such as fines, fees, investment income, and sion income

Capital assets used to provide these services (such as police stations and office buildings) are often financed through the proceeds of debt, which are accounted for in a separate govern-mental-type fund To repay the debt sold to finance capital assets, funds are accumulated, primar-ily from tax revenues, in yet another governmental-type fund

One of the characteristics of governmental-type funds is that their expenditures are likely

to be controlled by budgets proposed by the executive branch of government and legally adopted

by the legislative branch in the form of appropriations —authorizations to spend The way

govern-ments prepare budgets and the legal status afforded them profoundly affect accounting within the

governmental-type funds, as we shall see in the next section of this chapter and in later chapters

Although well-run governments do long-range planning, their annual budgets for day-to-day operations are short run in nature They generally cover activities for only one year

Proprietary-type (or business-type) funds are used to account for governmental activities

that operate in a manner similar to that of private-sector businesses in the sense that they charge fees for services and measure whether their revenues will cover their expenses Examples of such activities are municipal hospitals, electric and water utilities, mass transit facilities, lotteries, and central motor pools Many of these activities are self-supporting because their fees are sufficient

to cover their costs Others (such as mass transit facilities) may receive subsidies from their ent government, while some (such as lotteries) provide net revenues for the parent When these business-type activities are performed by agencies within the legally constituted government, a separate proprietary fund is established When the activities are performed by legally separate component units, these entities use what is called “proprietary fund accounting.”

Fiduciary-type funds are used to account for resources that governments hold in a trust

or agency capacity for others “Others” might be individuals, other governments, or private organizations Because they are held for others, the resources in these funds cannot be used to support the government’s own programs Examples of situations in which a government might

be acting in a trust or agency capacity include investment pools operated by a sponsoring ernment on behalf of other governments and sales taxes collected by a state on behalf of county and city governments

Financial Reporting with the Use of Funds

External financial reporting is guided by the requirements of GASB Statement No 34, “Basic Financial Statements—and Management’s Discussion and Analysis—for State and Local Gov-ernments” (1999), as amended GASB Statement No 34 requires two sets of financial state-

ments, fund statements and government-wide statements Two sets of statements are prepared

for several reasons:

• The measurement focus and basis of accounting used in the governmental-type fund gory is different from that in the other two categories, as discussed in the next section

• The information provided by the fund statements for the governmental-type fund category

is incomplete (and may be misleading because it is incomplete)

• While reporting on each fund serves a purpose, there is also a need for an overview of the finances of the government as a whole

The fund set of financial statements consists of three groupings—by fund category—of individual sets of statements prepared for each fund For the governmental-type fund category, the statements report resource inflows and outflows (which we will sometimes refer to as “operat-ing statements”) and financial position (balance sheets) Financial statements for proprietary-type funds are operating statements, statements of net position, and statements of cash flows Statements of net position and changes in net position are prepared for fiduciary-type funds The government-wide set of financial statements consolidates the individual funds into two groups of activities, governmental- and business-type In preparing the government-wide

statements, adjustments are made to the fund statements so that all activities use the same surement focus and basis of accounting In addition, the fiduciary-type funds are excluded from the consolidation because they do not support the government’s own programs (As you read Chapters 4 , 5 , and 6 , keep in mind that certain adjustments will be needed to prepare the gov-ernment-wide financial statements.) Chapters 9 and 10 describe how the financial statements are prepared

MEASUREMENT FOCUS AND BASIS OF ACCOUNTING

In addition to the use of funds, another distinctive feature of state and local governmental accounting lies in the way inflows and outflows are measured in one of the fund categories—governmental-type funds To grasp the implications of this notion, we first need to discuss the

terms measurement focus and basis of accounting

• Measurement focus refers to what is being expressed and which resources are being

mea-sured in reporting an organization’s financial performance and position For example, when a business enterprise focuses on measuring its net profit for the year, it takes account

of transactions and events affecting both its financial and capital resources If it wants to know how its activities affected its cash balance, it considers only the transactions that increase or decrease cash

• Basis of accounting is a timing concept It relates to when the assets, liabilities, revenues, and

expenses (or expenditures) are recognized (recorded) in financial statements

Measurement focus and basis of accounting are considered together because timing of nition helps achieve what one is trying to measure For example, using the accrual basis of accounting provides the most accurate measure of the change in an organization’s net assets and liabilities

Application to Proprietary-Type and Fiduciary-Type Funds

Proprietary-type funds are used to account for governmental activities that operate in a manner similar to that of commercial business enterprises Although not motivated to make a profit, managers of governmental business activities are concerned with whether the revenues derived from user charges are sufficient to cover all costs of doing business Therefore, just like that for commercial business entities, the accounting system for governmental business activities must

take account of transactions and events that affect all the economic resources available to the activity—financial and capital GASB literature refers to this measurement focus as the economic

resources measurement focus

To determine whether revenues are sufficient to cover costs, accounting measurements in

proprietary-type funds are made using the accrual basis of accounting This means that, in the

proprietary-type funds, revenues are recognized in the period they are earned, even if the cash has not been received Expenses are recognized when assets are consumed (or costs have expired)

or when liabilities are incurred, even if the cash has not been paid Capital outlays, for example, are initially recorded as assets and then depreciated to allocate their costs over their estimated useful lives Also, because of the passage of time, unpaid interest on borrowed capital is accrued when financial statements are prepared even if it is not yet due to be paid

The economic resources measurement focus and accrual basis of accounting are also used for accounting and reporting on fiduciary-type funds