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 recog- 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.
Application to Governmental-Type Funds
Accounting within the governmental-type funds has evolved historically as an accommodation to budgetary needs. To manage the basic day-to-day activities accounted for in the governmental- type funds, departmental budget officers and the government’s central budget office need to know the amount of financial resources available for current spending. The central budget office also needs data to help monitor actual performance against the current year’s budget and to plan future years’ budgets.
Let’s look at the big picture first, taking the perspective of the central budget office. The governmental budget process is spending oriented, cash oriented, and short run in nature. The thinking used in preparing the annual budget runs something like this:
• If a government needs to acquire capital assets, its budget may provide for raising finan- cial resources by selling long-term bonds. When the financial resources are spent, the acquired capital assets are not available for future spending, unless they are sold and con- verted to cash.
• The government needs cash to pay principal and interest on the bonds, but depreciating assets does not produce cash. Instead, financial resources to pay the principal and interest must be raised primarily through taxation.
• Taxes will produce cash for the current budget period only to the extent the taxpayers pay in a timely manner. Taxpayers that don’t pay in time to pay the government’s bills don’t produce budgetary revenues.
• On the other hand, if liabilities are incurred during a year because employees earn, say, vacation pay, but the accrued vacation pay will be paid in the form of cash only on retire- ment, the current year’s budget need not raise taxes to finance it.
Now let’s look at budget management from the perspective of the city police depart- ment’s budget officer. Assume the police department is authorized to spend $60,000 to acquire supplies and $80,000 to acquire police sedans. If the department has spent $50,000 to acquire supplies, it has only $10,000 left to buy additional supplies. If it has spent $60,000 to buy two police sedans, it has only $20,000 left to buy another sedan. For budgetary management purposes, the relevant information is not the inventory of supplies or the depreciated value of the sedans; rather, what is relevant is the fact that the police department has $10,000 of finan- cial resources left to acquire more materials and $20,000 of financial resources left to buy another sedan.
To provide data on the amount of financial resources available for current spending , the cur- rent financial resources measurement focus is used in governmental-type funds. Using this mea- surement focus involves recording inflows and outflows of liquid assets and, as such, has a distinctly budgetary orientation. When the current financial resources measurement focus is used, resource inflows are classified broadly as “revenues” and “other financing sources.” Resource outflows are classified broadly as “expenditures” and “other financing uses.”
Governmental-type funds use a modified accrual basis of accounting, rather than the accrual basis of accounting, because the modified basis focuses on flows of current financial resources. The effect of the difference in measurement focus is that neither capital assets nor long-term lia- bilities are recorded in the governmental-type funds. Further, the combined effect of the differ- ences in measurement focus and basis of accounting is that accrual accounting is modified in the governmental-type funds to record only those accruals that affect near-term financial resource inflows and outflows.
We will discuss the accounting measurement implications of the current financial resources measurement focus and modified accrual basis of accounting in the governmental-type funds at length in Chapters 4 through 6 . For now, here are a few basic concepts:
• Revenue recognition. When accrual accounting is used, revenues are recognized when they are earned. When governments modify accrual accounting for purposes of recogniz- ing revenue in governmental-type funds, tax revenues such as property taxes must also be “measurable and available” to be recognized. Measurable refers to the ability to state the amount of revenue in terms of dollars. Available means collectible within the current period or soon enough thereafter so it can be used to pay the bills of the current period. For prop- erty tax revenues, “soon enough thereafter” is interpreted in the accounting standards to mean no more than 60 days after the accounting period ends. So, for example, property taxes levied for the year ended December 31, 2012, are recognized as revenue for 2012 if they are expected to be collected by the end of February 2013.
• Expenditure recognition. Expenditure recognition in governmental-type funds is influenced by the budgetary nature of those funds; that is, the funds are designed to have only current financial resources and to exclude long-term liabilities. As a result, three types of expenditures (decreases in financial resources) appear in operating statements prepared for governmental- type funds: current operating items; capital asset acquisitions; and debt service (interest and repayment of principal on long-term borrowing). Exclusion of long-term liabilities from gov- ernmental-type funds causes the amounts recognized for operating expenditures to be modi- fied from the amounts that would be recognized under full accrual accounting.
For many items (such as salaries, supplies, and utilities) operating expenditures are recognized in the period in which the related liabilities are incurred because the liabilities are payable from financial resources shortly after they are incurred. Some liabilities, how- ever, do not require liquidation with currently available financial resources and are gener- ally not provided for in the current budget. Such liabilities and the related operating expenditures are recognized when the liabilities mature . So, for example, if employees are allowed to accumulate vacation leave until they separate or retire from service, related expenditures and liabilities are not recognized until they come due for payment (mature) on employee separation. Expenditures and liabilities for pensions and retiree health care benefits earned by the employees during an accounting period are recognized for that period only to the extent the government finances them . These modifications (or exceptions) to the accrual basis of accounting, discussed in detail in Chapter 5 , can significantly affect the amounts reported as expenditures in a particular year compared with the amounts that are recognized under full accrual accounting. In short, excluding long-term liabilities also results in excluding the related expenditures.
When fund financial resources are spent to acquire capital assets, financial resources are consumed and cannot be spent for anything else. Accordingly, capital outlay expendi- tures equal to the amount spent are reported in the governmental fund operating statement because available financial resources have decreased. (Records are kept of the acquired cap- ital asset, but those records are not part of the fund financial accounting system; they are used only for the government-wide statements.) Similarly, debt service expenditures are reported when debt principal is repaid because financial resources have decreased. Interest on long-term debt is also a debt service expenditure, but is recognized as an expenditure in the period the interest is due for payment , similar to the way interest is treated in the bud- get. This is yet another modification to the accrual basis of accounting.
• Bond Proceeds. A further distinguishing characteristic of the current financial resources measurement focus is the accounting treatment of general obligation bond proceeds. When a business enterprise obtains resources from the sale of bonds, it credits the long-term lia- bility account “bonds payable” to offset the debit to cash. But bond proceeds provide cur- rent financial resources available for spending and governmental-type funds do not report long-term liabilities; therefore, the recipient fund recognizes an inflow of financial resources in its operating statement , reporting the inflow as an “other financing source.” (As with capital assets, records are kept of the long-term bond liabilities, but those records are not part of the fund financial accounting system.)
As the foregoing concepts indicate, the current financial resources measurement focus/ modified accrual accounting basis is generally consistent with the way governments budget. (Budgets are not prepared in a uniform manner among state and local governments; some are prepared on a cash basis, and some are modified just slightly from the cash basis.) However, accounting and financial reporting to accommodate budgetary needs does not mean that capital assets and longer-term obligations are ignored. If they were ignored, there would be a potential for misrepresentation. Therefore, as previously noted, governmental financial reporting stan- dards require two sets of financial statements. The fund-level statements are based on the stan- dards for accounting within the funds, so statements prepared for governmental-type funds use the current financial resources measurement focus and modified accrual basis of accounting. For government-wide financial reporting, the data reported for governmental-type funds are aggre- gated and adjusted to the economic resources measurement focus and accrual basis of account- ing. Capital assets and bonds payable are reported in the government-wide statements.
Governmental Accounting in Practice
Form versus Substance in Budgeting
In exchange for providing services, governmental and private-sector employees generally receive com- pensation in the form of salaries and benefits. Benefits may include pensions and retiree health care. Employees receive the salary portion of their compensation shortly after they perform the work. The employees earn the right to the benefits during the periods they work but don’t receive the cash (or what- ever form the benefit may take) until after they retire. The employer, however, receives the full value of the employment exchange during the periods the employees work; therefore, the employer’s obligation for paying both salaries and benefits arises during those working periods.
But what if the government budgets for those benefits on a purely cash basis; that is, by not budgeting for the benefits until the years the actual payments are due, after the employees retire? Is the budget “balanced” if the government fails to set aside money for the benefits in the years the benefits are earned? We suggest such budgets are balanced in form—on a cash flow basis—but not in economic substance.
In fact, some governments consistently do not budget in the current year for the full amount of pension benefits earned by employees in the current year, and virtually every government budgets for retiree health care benefits in the year they are paid, not when the employees earn the benefit. In a 2011 report, the Pew Center for the States pegged the cumulative unfunded obligation for employee benefits at more than $1.2 trillion, just for states and localities that participate in state plans. Part of the unfunded obligation resulted from declines in equity security values, but most of it was caused by not budgeting for the benefits when earned by the employees.
Tables 2-1 and 2-2 summarize the measurement focus, basis of accounting, and broad cat- egory of activities embraced within the three fund categories. Table 2-3 lists the specific fund types within each category and shows the measurement focus and basis of accounting applicable to each fund type. An overview of these funds and examples of individual fund financial state- ments are presented in the remainder of this chapter.
TABLE 2-1 Fund Categories
Governmental-Type Funds Proprietary-Type Funds Fiduciary-Type Funds Focus Current financial resources Economic resources Economic resources Activity General government activities Activities financed by user
fees
Resources held for others
Legally dedicated resources
TABLE 2-2 Cash, Accrual, and Modified Accrual Bases of Accounting
Cash Basis Accrual Basis Modified Accrual Basis
Record revenue When cash is received When revenue is earned When measurable and available
Record expenses (expenditures)
When cash is paid When asset is consumed or expense is incurred
Generally when liability is incurred (with specific exceptions) Applicable fund
category
Proprietary, Fiduciary Governmental
TABLE 2-3 Summary of Accounting Procedures within Funds
Fund Type Category Measurement Focus
Basis of Accounting General Governmental Current financial resources Modified accrual Special Revenue Governmental Current financial resources Modified accrual Debt Service Governmental Current financial resources Modified accrual Capital Projects Governmental Current financial resources Modified accrual Permanent Governmental Current financial resources Modified accrual Enterprise Proprietary Economic resources Accrual
Internal Service Proprietary Economic resources Accrual Pension Trust Fiduciary Economic resources Accrual Investment Trust Fiduciary Economic resources Accrual Private-Purpose Trust Fiduciary Economic resources Accrual
Agency Fiduciary Economic resources Accrual
Source: Adapted from GASB Statement No. 34, “Basic Financial Statements—and Management’s Discussion and Analysis—for State and Local Governments” (Norwalk, CT: GASB, 1999), Table B-2, p. 151 .