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 or limitations. 1
In this definition, the term fiscal entity refers to the separate budgetary nature of funds that have only spendable financial resources, and the term accounting entity refers to a separate unit that is treated as an entity for accounting purposes. Some types of funds also have capital assets.
The accounting equation within the funds is similar to that used in commercial account- ing. In the absence of owners’ equity, however, the equity aspect of the governmental accounting equation becomes either fund balance or net position, depending on the type of fund involved. Why Governments Use Fund Accounting
Governmental entities must comply with legal requirements set forth in constitutions, city char- 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 on the use of governmental resources. Indeed, most funds are established based on specific legal requirements.
1 GASB Codification of Governmental Accounting and Financial Reporting Standards (GASB Cod.) Sec. 1300, “Statement of
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 gov- 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. 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 vari- 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 govern- 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 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 differ- ence between the accounting measurements made in the governmental fund category and those 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 conces- 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 par- 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 gov- 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 cate- 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 mea- 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.