Speaker Biography. Chris Knopik CPA, CFE Clifton Larson Allen, LLP

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1 Speaker Biography Chris Knopik CPA, CFE Clifton Larson Allen, LLP Chris Knopik is a Principal with CliftonLarsonAllen s Minneapolis Office. He is a licensed certified public accountant and certified fraud examiner. He has been with CliftonLarsonAllen for 13 years working 100 percent of his time with state and local governments, throughout Minnesota, providing consulting and auditing services. He has extensive experience with the Uniform Guidance and audits of federal grant awards. Chris is currently a member of the American Institute of Certified Public Accountants, Association of Certified Fraud Examiners, Minnesota Government Finance Officers Association, Minnesota Society of Certified Public Accountants, National Association of College and University Business Officers and is a reviewer for the Certificate of Achievement for Excellence in Financial Reporting program for the GFOA. Chris has a Bachelor of Science in Accounting from Bemidji State University. He has attended numerous GFOA trainings and seminars and provided several trainings through CliftonLarsonAllen. 1

2 Speaker Biography Tom Kelly Finance Officer White Bear Township, MN Tom Kelly has served as the Finance Officer for Township from July 2012 to present and from August of 1994 through August He was the Finance Director at the City of Monticello from August 2007 July 2012, the Finance Director for the City of Falcon Heights for 5 years and served 8 years in various finance positions for the City of Plymouth. Tom is also a past member of the White Bear School District s Finance Committee. Tom currently serves on the National GFOA Committee on Economic Development and Capital Planning, he has previously served on the National GFOA Committee on Governmental budgeting and Fiscal Policy from 2001 to He has been an Independent Budget Reviewer for GFOA s Distinguished Budget Presentation Award program for the past twenty plus years. He s a 2007 graduate of GFOA s Advanced Government Finance Institute. Tom also is a trainer for the GFOA on various topics. Tom served on the Minnesota GFOA Executive Board including serving as the organization s President in 2003 and has been a member of various other Minnesota GFOA committees. He was the recipient of the Minnesota GFOA s Thomas J. Moran Award. Tom s budget documents have been the recipient of GFOA s Distinguished Budget Presentation Award and CAFRs have been recipient of GFOA s Certificate of Achievement in Finance Reporting Award. He has his BA in accounting from the University of St. Thomas and has attended in various GFOA National and State training seminars and classes. 2

3 SECTION 1 BASIC ACCOUNTING THEORY At the Fund Level OBJECTIVES This section provides the basics of accounting theory and it is essential that each participant understand the sections contents. After completing this section, you should be able to: Understand the relationship of the balance sheet to the operating statement or the income statement. Identify asset and liability accounts. Understand the basic accounting equation. Explain how revenues and expenditures affect fund equity. Understand how certain transactions affect the accounting equation. INTRODUCTION The Governmental Accounting Standards Board (GASB), an organization responsible for setting accounting standards for state and local governments, has decreed that governments should prepare financial statements that communicate the entity s financial position and economic condition. The difference in these two terms is significant. To satisfy the Board s requirement, different types of financial statements are required. Before we can explain the content of the statements it would be helpful to know what the terms mean. Financial position Conceptually, financial position represents a measure of a governments individual funds ability to meet their obligations as they become due. Financial statements demonstrate this by comparing expendable resources with short-term obligations. Economic condition This is a conceptual measure of an organization s overall wealth. Financial statements demonstrate this by comparing the organization s total resources and total obligations. In simpler terms financial position is an indicator of whether or not you ll be able to pay our bills, whereas economic condition is a measure of wealth. These terms are not necessarily analogous. An individual may accumulate tremendous wealth, however if their wealth is not in the form of cash or cash equivalents they may not have two dimes to rub together. In this course we will only address the accounting and financial reporting requirements that exist at the fund level. Discussion of entity-wide presentations will be deferred to Intermediate Governmental Accounting. 3

4 NATURE AND PURPOSE The ultimate goal of accounting is to demonstrate accountability. Accountability is communicated through the preparation of various types of financial statements. At the fund level of reporting the basic financial statements present information concerning: A fund s position or economic condition on a certain date, The results of operations (i.e., revenues and expenditures/expenses) for a fund during a period of time ending on that date, and Budgetary Information (comparison schedules) Two types of financial statements used to communicate this information are: A balance sheet or statement of net assets a financial statement that presents the fund s financial position or economic condition at a certain date. An operating statement a financial statement reflecting changes in a fund s equity and results of operations during a period ending on a certain date. BALANCE SHEET/STATEMENT OF NET ASSETS The financial information presented on the balance sheet/statement of net assets includes: BALANCE SHEET/STATEMENT OF NET ASSETS What a government owns. What a government owes. The difference between the two which is a measure of the net worth or equity. A FINANCIAL STATEMENT INCLUDES WHAT IS OWNED, WHAT IS OWED AND NET WORTH. IT IS SIMILAR TO A SNAPSHOT. IT DEMONSTRATES WHERE A GOVERNMENT STANDS FINANCIALLY AT A SINGLE POINT IN TIME. IT IS DATED ON A SINGLE POINT DAY, SUCH AS JUNE 30, 20XX. Balance sheets/statements of net assets are presented as of a particular date (e.g., the year ended, June 30). We can summarize these elements and their relationship to each other mathematically in the following basic accounting equation: OWNS OWES = NET WORTH In accounting terminology, assets are things that a government owns, liabilities are things that it owes, and equity is their net worth. By applying this terminology to the accounting equation, we can restate it as follows: OWNS OWES = NET WORTH or ASSETS LIABILITIES = EQUITY 4

5 The Accounting Equation To illustrate the accounting equation, assume a government has assets valued at $9,000 and liabilities of $6,000. What is its equity? Since assets (i.e., what is owned) minus liabilities (i.e., what is owed) equals equity, the equity in this example is $3,000: ASSETS LIABILITIES = EQUITY $9,000 - $6,000 = $3,000 To expand on the equation, assume that the same government has $240,000 in the bank (i.e., an asset) at June 30. However, it owes salaries to employees (i.e., a liability) of $165,000. What is its equity? Since equity equals assets minus liabilities, then: ASSETS LIABILITIES = EQUITY $240,000 - $165,000 = EQUITY $75,000 = EQUITY If we know the value of liabilities and equity, can we figure out the value of the assets? The preceding example states that assets minus liabilities equal equity. Using the amounts from the preceding example for equity and liabilities, we can determine the amount of the assets as follows: ASSETS LIABILITIES = EQUITY? - $165,000 = EQUITY Using simple algebra, we may change the accounting equation by moving the liabilities account from the left side of the equation to the right side of the equation and changing the sign. In algebra, when a number is moved from one side of the accounting equation to the other side of the equation, the sign (i.e., plus or minus sign) for the moved number changes. Therefore, the liabilities account changes from minus to plus: ASSETS = +LIABILITIES + EQUITY ASSETS = $165,000 + $75,000 ASSETS = $240,000 To summarize, when you know two of the three elements of the equation, you can always determine the third element by simple addition and subtraction. We have now stated the basic accounting equation two ways: 1. ASSETS LIABILITIES = EQUITY $240,000 - $165,000 = $75,000 $75,000 = $75,000 5

6 2. ASSETS = +LIABILITIES + EQUITY $240,000 = +165,000 + $75,000 $240,000 = $240,000 The accounting equation can change (i.e., added to or subtracted from) if additions and subtractions to both sides of the equation are in the same amount. Remembering that the equation must always be equal or balanced on both sides of the equals sign is important. There are instances when the total liabilities may be greater than the total assets. In these instances, a negative equity (not a good thing), known as a deficit, occurs. For example: CLASSIFICATION OF ASSETS AND LIABILITIES ASSETS LIABILITIES = EQUITY $240,000 - $255,000 = ($15,000) The further classification of assets and liabilities according to their degree of liquidity (i.e., how soon a government can convert them to cash, consume them or pay them) is important. Current assets are assets that a government is likely to use up, or convert to cash, within the next year. Examples of current assets include: Cash Investments Receivables Inventories Fixed assets or noncurrent assets are longer lived assets. Examples include: Land Buildings Equipment CLASSIFICATION OF ASSETS AND LIABILITIES CURRENT ASSETS - ASSETS THAT ARE CASH, CONVERTED TO CASH OR USED UP WITHIN ONE YEAR. FIXED ASSETS - LONGER LIVED ASSETS WHICH ARE INTENDED TO LAST LONGER THAN ONE YEAR. CURRENT LIABILITIES - LIABILITIES THAT WILL BE PAID WITHIN ONE YEAR. LONG-TERM LIABILITIES - LIABILITIES THAT WILL BE PAID OVER A PERIOD OF LONGER THAN ONE YEAR. Similarly, current liabilities are liabilities payable within one year from the balance sheet date and longterm liabilities are the balance of the liabilities. Examples of current liabilities include: Accounts payable Contracts payable Accrued salaries payable Payroll deductions payable 6

7 Examples of long-term liabilities include: Bonds payable Capital leases payable Compensated absences payable We classify the differences between current assets and current liabilities as net current assets. It is a measure of a government s liquidity. The following equation summarizes these elements of a government s liquid financial position and their relationships to each other: CURRENT ASSETS CURRENT LIABILITIES = NET CURRENT ASSETS Governments may classify portions of certain assets and certain liabilities as both current and long-term. For example, part of a liability (e.g., bonds payable) may be due within the current year (i.e., a current liability) and the balance due over the next ten years (i.e., a long-term liability). FUND ACCOUNTING Although we present a separate chapter in this book covering fund accounting, we need to introduce fund accounting here so we can better understand the balance of this chapter. Often different functions of a state s or local government s activities require different controls for management purposes. To satisfy this need, Generally Accepted Accounting Principles (GAAP) establish separate accounting entities that we call funds to account for resources affected by different types of spending restrictions. Fund accounting is this process. The state or local government organizes its accounting records along the lines of funds, each of which is considered a separate entity with a separate set of self-balancing accounts and financial statements. For example, capital construction may be accounted for in one fund, and tax-supported operational programs in another. GAAP classifies all individual funds broadly into one of three categories: governmental, proprietary, and fiduciary. However, for purposes of this chapter, we introduce the governmental and proprietary funds now. Section 5 includes a detailed discussion of fund accounting. The Governmental Category of Funds Governmental Funds are those through which most government functions are financed. An example of a governmental fund is the general fund. Generally, governmental funds report only current assets and current liabilities on their balance sheets and their primary operating statement is the statement of revenues and expenditures. Equity for governmental funds consists of fund balance accounts. Fund balance represents a measure of available spendable financial resources (i.e., net current assets or what is available to spend). 7 FUND CATEGORIES GOVERNMENTAL FUNDS - THOSE FUNDS THROUGH WHICH MOST GOVERNMENT FUNCTIONS ARE FINANCED. PROPRIETARY FUNDS - THOSE FUNDS THAT ARE ACCOUNTED FOR LIKE A BUSINESS.

8 Individual balance sheets may be presented with financial data only for the latest fiscal period, or at the discretion of the preparer, comparative statements which display information for each of the latest two periods may be prepared. Exhibit 1-1 on the following page illustrates a comparative balance sheet for a governmental fund. GOVERNMENTAL FUNDS BALANCE SHEET GENERALLY REPORTS ONLY CURRENT ASSETS AND CURRENT LIABILITIES EQUITY CONSISTS OF FUND BALANCE WHICH IS CONSIDERED A MEASURE OF "AVAILABLE SPENDABLE RESOURCES." Exhibit 1-1 General Fund Comparative Balance Sheet December 31, 2015 December 31, 2015 December 31, 2014 Assets: Cash $ 102,371 $ 150,180 Investments 284, ,160 Interest receivable 1,592 4,732 Due from other funds 593 2,901 Total Assets $ 389,071 $ 350,973 Liabilities: Accounts payable $ 104 $ - Salaries payable 15,934 15,099 Contracts payable 18,239 21,085 Total Liabilities $ 34,277 $ 36,184 Fund Balance 354, ,789 Total Liabilities and Fund Balance $ 389,071 $ 350,973 8

9 The Proprietary Category of Funds Proprietary funds are used to account for activities that are financed and operated similarly to private business enterprises (e.g., the local grocery store or hotel) and/or where the intent of the legislature is that they finance the activities primarily from user charges (e.g., a port authority fund, water and sewer). PROPRIETARY FUNDS STATEMENT OF NET POSITION GENERALLY REPORTS TOTAL ASSETS AND TOTAL LIABILITIES EQUITY CONSISTS OF NET POSITION Therefore, proprietary funds report all assets and all liabilities, whether current or non-current, on their statement of net position. Exhibit 1-2 on the following page illustrates a statement of net position for a proprietary fund. 9

10 Exhibit

11 OPERATING STATEMENTS Operating statements are financial statements reflecting changes in the equity of funds. Operating statements can be measured and reported in several different ways. We call increases and decreases in cash receipts and disbursements. An operating statement that summarizes cash flow during a period, therefore, is called a statement of cash receipts and disbursements. OPERATING STATEMENT A FINANCIAL STATEMENT WHICH SHOWS HOW A A FUND'S EQUITY HAS CHANGED DURING THE YEAR. THIS STATEMENT IS SIMILAR TO A PROFIT AND LOSS STATEMENT PREPARED IN THE PRIVATE SECTOR. IT IS DATED FOR A PERIOD OF TIME SUCH AS "FOR THE FISCAL YEAR ENDED JUNE 30, 2000." Revenues and expenditures are increases and decreases in net current assets/fund balance (i.e., the difference between current assets and current liabilities). Therefore, a statement of revenues and expenditures summarizes a fund s sources and uses of its net current assets. Since net current assets are considered a measure of liquid or expendable resources, this operating statement presents a summary of the spending and financing activities of a fund during a fiscal period. OPERATING STATEMENTS CAN REPORT: RECEIPTS AND DISBURSEMENTS - INCREASES AND DECREASES IN "CASH." REVENUES AND EXPENDITURES - INCREASES AND DEACREASES IN "NET CURRENT ASSETS/FUND BALANCE." REVENUES AND EXPENSES - INCREASE AND DECREASES IN "TOTAL EQUITY/NET POSITION." statement of revenues and expenses summarizes the effect a fund s operations have had on its net assets during a fiscal period. The Governmental Category of Funds Revenues and expense are increases and decreases in net assets. The principle way in which expenses differ from expenditures is that expenses include the cost of using capital assets over time (i.e., a charge for depreciation) although the expenditures for those costs (i.e., when they purchase the capital assets) may occur in a different accounting period (we explain the difference between expenses and expenditures in detail in Section 6). Therefore, a Current year revenues always increase fund balance and current year expenditures always decrease fund balance at year-end as illustrated in the following equation: FUND FUND BALANCE + REVENUES - EXPENDITURES = BALANCE (At start of year) (During the year) (During the year) (At end of year) $45,000 + $185,000 - $190,000 = $40,000 11

12 In other words, the current year s revenues are added to the beginning fund balance that results in the amount of resources available for expenditures. Beginning fund balance $45,000 Current year s revenues 185,000 Total resources available For expenditures $230,000 Then we reduce this amount by the current year s expenditures which results in the fund balance at the end of the year. Beginning fund balance $45,000 Current year s revenues 185,000 Total resources available For expenditures $230,000 Current year s expenditures (190,000) Ending fund balance $ 40,000 We expand the above equation to explain the relationship between an operating statement (i.e., a statement of revenues and expenditures) and a balance sheet as indicated in the following accounting equation: FUND FUND CURRENT CURRENT BALANCE + REVENUES - EXPENDITURES = BALANCE = ASSETS - LIABILITIES (At start of year) (During the year) (During the Year) (At end of year) (At end of year) (At end of year) $45,000 + $185,000 - $190,000 = $40,000 = $160,000 - $120,000 The first four columns are included on the operating statement and the last three on the balance sheet. An example of a limited governmental fund operating statement is included on the following page in Exhibit

13 Exhibit

14 The Proprietary Category of Funds The statement of revenues and expenses reflects changes during the year in the equity of the proprietary funds as shown by the accounting equation: NET ASSETS + REVENUES - EXPENSES = NET POSITION (At start of year) (During the year) (During the year) (At end of year) $10,000 + $300,000 - $285,000 = $25,000 Similar to governmental funds, adding assets and liabilities will expand the equation: TOTAL TOTAL NET POSITION + REVENUES - EXPENSES = NET POSITION = ASSETS - LIABILITIES (At start of year) (During the year) (During the year) (At end of year) (At end of year) (At end of year) $10,000 + $300,000 - $285,000 = $25,000 = $210,000 - $185,000 Note that the equations for illustrating the relationships of the balance sheet/statement of net assets and operating statement for the proprietary fund types and the governmental fund types are similar. Balance Sheet December 31, 2015 Operating Statement Assets For the Fiscal Year Ended December 31, 2015 Liabilities Revenues Balance Sheet Fund Equity December 31, 2015 Expenditures/Expenses Assets Liabilities Fund Equity An example of an operating statement for the proprietary category of funds is included as Exhibit

15 EXHIBIT

16 EFFECT OF TRANSACTIONS ON THE ACCOUNTING EQUATION Displaying the effect of financial transactions on accounts by using the accounting equation is possible. Amounts may be added to or subtracted from the equation if equal amounts are applied to both sides of the equation. The accounting equation must always be in balance. Many transactions affect revenues and expenditures/expenses. However, certain types of transactions affect only asset and liability accounts and therefore only the balance sheet/statement of net assets. For example, 1. An asset may increase and another asset may decrease by an equal amount. For example, an investment (an asset) is purchased at a cost of $15,000 and cash (an asset) is disbursed. The asset account Investment increases, but the asset account Cash decreases by the same amount, $15,000. As illustrated in the following example, total assets remain the same, and neither liabilities nor fund balance is affected: ASSETS = LIABILITIES + FUND BALANCE Beginning Equation $60,000 = $22,000 + $38,000 Transaction ($60,000 + $15,000 - $15,000) = $22,000 + $38,000 Ending Equation $60,000 = $22,000 + $38, An asset may increase and a liability may increase by an equal amount. For example, a government borrows $18,000 by issuing revenue anticipation notes (resulting in a current liability) and receives cash (resulting in an asset). This increases both the asset account Cash and the liability account Notes payable by the same amount, $18,000, as follows: ASSETS = LIABILITIES + FUND BALANCE Beginning Equation $60,000 = $22,000 + $38,000 Transaction ($60,000 + $18,000 ) = ($22,000 + $18,000) + $38,000 Ending Equation $78,000 = $40,000 + $38, A liability may increase and another liability may decrease by an equal amount. For example, a government has a cash flow problem and cannot pay a vendor the amount owed of $24,000. The government signs a 90-day note to the vendor with interest of 7%, thereby swapping the accounts payable for a note payable. The liability account Accounts Payable decreases and another liability account Notes Payable increases by the same amount, $24,000, as follows: 16

17 ASSETS = LIABILITIES + FUND BALANCE Beginning Equation $60,000 = $22,000 + $38,000 Transaction $60,000 = ($22,000 + $24,000 - $24,000) + $38,000 Ending Equation $60,000 = $22,000 + $38, An asset may decrease and a liability may decrease by an equal amount. For example, a government issues checks (reducing an asset) totaling $14,000 to vendors to pay accounts payable (reducing a liability). This decreases both the liability account Accounts Payable and the asset account Cash by the same amount, $14,000, as follows: ASSETS = LIABILITIES + FUND BALANCE Beginning Equation $60,000 = $22,000 + $38,000 Transaction ($60,000 - $14,000 ) = ($22,000- $14,000) + $38,000 Ending Equation $46,000 = $8,000 + $38,000 There are two types of transactions that ultimately (i.e., at year-end) affect fund balance (or equity): revenue transactions and expenditure transactions. Revenues increase fund balance (equity) and expenditures decrease fund balance (equity). The accounting equation now expands to reflect these types of transactions. ASSETS = LIABILITIES + (FUND BALANCE + REVENUES EXPENDITURES) The following sample transaction illustrates the expanded equation. 1. The government receives payment of fines in the amount of $17,000. We can recognize revenue, so this transaction increases both the asset account Cash and the Revenue account by the same amount, as follows: ASSETS - LIABILITIES = (FUND BALANCE + REVENUES - EXPENDITURES) (At end of year) (At end of year) (At start of year) (During the year) (During the year) $60,000 - $22,000 = ($38,000) ($60,000 + $17,000) - $22,000 = ($38,000 + $17,000 - $0) $77,000 - $22,000 = ($38,000 + $17,000) The above transaction ultimately increases the fund balance by $17,000 (i.e., by increasing revenues that at year-end will be added to fund balance) while maintaining the balance in the accounting equation since the value of the assets increased by a similar amount. 17

18 2. Office supplies are received and invoices are approved totaling $14,000. This transaction increases Expenditures and it increases the liability account Accounts Payable, as follows: ASSETS - LIABILITIES = (FUND BALANCE + REVENUES - EXPENDITURES) (At end of year) (At end of year) (At start of year) (During the year) (During the year) $60,000 - $22,000 = ($38,000) $60,000 -($22,000 + $14,000) = ($38,000 + $0 - $14,000) $60,000 - $36,000 = ($38,000 + $0 - $14,000) The preceding transaction decreased the fund balance by $14,000 (by increasing expenditures that at year-end will be deducted from fund balance) while maintaining the balance in the accounting equation since liabilities increase by a similar amount. 18

19 SUMMARY 1. A balance sheet/statement of net position is a financial statement that presents either financial position or economic condition as of a given date. 2. An operating statement is a financial statement that presents changes in equity and results of operations during a fiscal period. 3. Assets are things a state or local government owns. 4. Current assets are cash or other assets that a state or local government could convert to cash or use up within one year. Receivables are converted to cash as collected and inventories are used up. 5. Liabilities are amounts a state or local government owes. 6. Current liabilities are liabilities due within one year. We classify all other liabilities as non-current. 7. Equity is the excess of assets over liabilities. Assets minus Liabilities = Equity. 8. Net current assets or fund balance is the difference between current assets and current liabilities. 9. Receipts are increases in cash; disbursements are decreases in cash. 10. Revenues are generally increases in assets that result in an increase in equity. 11. Expenditures are decreases in assets or increases in liabilities that result in a decrease in fund balance. 12. Revenues and expenses, respectively, are increases and decreases in net position. 13. Fund accounting is used to permit accounting separately for resources affected by different types of spending restrictions and/or accounting principles. 14. All governmental funds generally report only current assets, current liabilities, and net current assets, which is called fund balance. 15. All proprietary funds report total assets, total liabilities, and total fund equity, which are called net position. 19

20 SECTION 1 Exercise Circle the answer which seems most correct. 1. Net current assets are A. Total assets less total liabilities. B. Current assets less total liabilities. C. Current assets less current liabilities. D. Assets less current liabilities. 2. Increases and decreases in net current assets/fund balance are called A. Revenues and expenditures. B. Revenues and expenses. C. Receipts and disbursements. D. Revenues and disbursements. 3. Increases and decreases in total equity/net position are called A. Revenues and expenditures. B. Revenues and expenses. C. Receipts and disbursements. D. Revenues and disbursements. 4. Normally, governmental fund category balance sheets report A. Total assets and current liabilities. B. Current assets and total liabilities. C. Current assets, current liabilities, and fund balance. D. Total assets and total liabilities. 5. Indicate which accounts may be reported on a governmental fund s operating statement. A. Revenues, expenditures, and fund balance. B. Revenues, expenses, and net assets. C. Current liabilities, fund balance, and current assets. D. Liabilities, net assets, and assets. 20

21 6. Indicate which accounts may be reported on a proprietary fund s operating statement. A. Revenues, expenditures, and fund balance. B. Revenues, expenses, and net position. C. Liabilities, fund balance, and assets. D. Liabilities, retained earnings, and assets. 7. A proprietary fund s statement of net position reports only A. Total assets and current liabilities. B. Current assets and total liabilities. C. Total assets, total liabilities, and net assets. D. Current assets and current liabilities. 8. Expenditures ultimately decrease A. Account receivable. B. Revenues. C. Contributed capital. D. Fund balance. 9. Revenues ultimately increase A. Net assets. B. Expenditures. C. Contributed capital. D. Accounts payable. 10. What effect does the recognition of revenue ultimately have on equity? A. Increases equity. B. Decreases equity. C. No effect on equity. 11. What effect does the purchase of an investment with cash have on equity? A. Increases equity. B. Decreases equity. C. No effect on equity. 21

22 12. What effect does the recording of invoices as expenditures and accounts payable ultimately have on equity? A. Increases equity. B. Decreases equity. C. No effect on equity. 13. What effect does the borrowing of money to pay outstanding accounts payable have on equity? A. Increases equity. B. Decreases equity. C. No effect on equity. 14. In the space below, arrange the following accounting equation in the correct sequence for a governmental fund type. Expenditures during the year ($4,500), Fund Balance at end of year ($14,500), Current Assets at end of year ($107,000), Revenues during the year ($9,000), Fund Balance at start of the year ($10,000), Current liabilities at end of year ($92,500). 15. The measurement of a fund s overall wealth is known as A. Fund Balance. B. Economic Condition. C. Financial Position. D. Net Current Assets. 16. The measurement of an individual fund s ability to pay its bills is known as A. Assets. B. Economic Condition. C. Financial Position. D. Liabilities. 22

23 17. The term expenditure represents a decrease in A. Economic Condition. B. Financial Position. C. Accounts Payable. D. Due to other funds. 18. The term expense represents a decrease in A. Economic Condition. B. Financial Position. C. Accounts Payable. D. Due to other funds. 23

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25 SECTION 2 ACCOUNTS AND CODING The Chart of Accounts OBJECTIVES This section explains how accounting information and data are organized through a chart of accounts. Upon completion of this chapter, the participant should be able to: Define chart of accounts. Explain how a chart of accounts is structured. Use a chart of accounts for processing transactions. INTRODUCTION The first step in setting up an accounting system is to decide what you need to keep track of. The chart of accounts is what fuels the accounting system. A chart of accounts is simply a listing of the accounts in an accounting system and is kept by every government to record and follow specific entries. The chart of accounts is the foundation of every accounting system and provides an organizing framework for budgeting, recording, and reporting on all financial transactions. This section describes the chart of accounts from a theoretical point of view and also how charts of accounts are maintained within governments. DEFINITION AND FUNCTION A chart of accounts is a listing of all accounts available for use in an individual accounting system. The basic function of an account is to serve as a classification that identifies the nature or characteristics of the financial information that the accountant records in the account. For example, as a state or local government issues purchase orders, the account to be charged should be included on the purchase order. An account number from the chart of accounts identifies this account. Accounts are assigned a number and arranged so that they may be identified with similar accounts (e.g., all asset accounts are together). Each account contains only a single kind of transaction, such as cash or the amount of receivables due to the government from taxes. The number of accounts used should be the minimum that will provide proper management information and meet external reporting needs. General ledger accounts are classified as: Balance sheet/statement of net assets accounts Revenue accounts Expenditure/expense accounts 25

26 DEVELOPING THE CHART OF ACCOUNTS The account numbers this section illustrates are those recommended by the Minnesota State Auditor s Office. The design of the State Auditors chart of accounts has been closely tailored to the Governmental Accounting, Auditing and financial Reporting Book (GAAFR or blue book ). The State Auditors recommended chart of accounts can be found on the OSA website. If a small government is maintaining a manual accounting system, the number of accounts included in the chart of accounts should be limited since the capability of presenting data in various formats is not feasible. Normally in a computerized accounting system there is far more flexibility in the size of the chart of accounts governments use. Often, computer systems use an account number scheme with a limited number of digits. However, governments usually can reorganize and report the financial data in various reporting formats. In a computerized accounting system, all account types normally use a common account structure (i.e., the same number of digits). A dimension is a segment of an account number. Each dimension provides different types of data that are (i.e., different dimensions) combined into a single overall account number. For example, since governments use fund accounting, they use a dimension for the fund classification (e.g., number 100 for the general fund). FUND IDENTIFIERS The following is a sample of fund account identifiers: 1XX General Fund 2XX Special Revenue Funds 3XX Debt Service Funds 4XX Construction Funds 6XX Proprietary Funds Generally, with balance sheet accounts, both a fund dimension and a dimension that simply describe the type of account are used. For example, we might code the general fund cash account as follows: 1XX- 1XXXX Type of Account: Cash in bank Fund: General 26

27 Usually, governments classify revenues by fund and by source (i.e., two dimensions). For example, a government might code property tax revenue for the general fund as follows: 1XX- 3XXXX Type of Account: Property Taxes Choosing which expenditure dimension to use is the most difficult decision. A smaller government might use a limited number of digits in its account number. For example, a small government might code the salary of the police chief in three dimensions and eleven digits as follow: 1XX- 1XXXX-XXX Fund: General Object of expenditure: Salaries Department/Program/Function: Finance Fund: General However, in most governments we have a greater fiduciary responsibility to the public to budget and report in a more detailed manner. States and large local governments need to be able to account and report in a variety of formats and detail to satisfy GAAP, regulators, other governments, legislators, taxpayers, and management. Therefore, information in the accounting database related to expenditures might include dimensions for: Fund, Agency/Organization/Department, Program/Function/Activity, Object, Sub-object, and in some cases Element/Other. When classifying accounts, a government should use the same account number for the same dimension (e.g., regular salaries) in all funds. For example, a government would use Cash in Bank, account in each applicable fund. The fund dimension distinguishes the fund Type of Account: Cash in bank Fund: General 27

28 AND In most cases individuals coding or inputting data will not have to define each of the dimensions because the system controls only allow you to assign object codes to the activity for which you account. Therefore, the other dimensions are preset with the other required data. ACCOUNT STRUCTURE Type of Account: Cash in bank Fund: Special Revenue Fund A In summary, the basic account structure has three dimensions: fund, account, and object code. Three digits are assigned to the fund, five to the account, and three to the object code. Where required, cities may expand the number of dimensions and/or the number of digits assigned to a dimension. The basic structure in the Uniform Chart of Accounts is as follows: Fund Account Object Assets XXX 1XXXX Liabilities XXX 2XXXX Revenues XXX 3XXXX Expenditures XXX 4XXXX XXX CONTROL ACCOUNTS Some large governments use control accounts on their general ledger for revenue and expenditure/expense accounts. A control account is a total of all revenue or expenditure accounts. These accounts are supported by subsidiary ledgers which show the details of individual revenue or individual expenditure accounts. 28

29 SUMMARY 1. A chart of accounts is a listing of all accounts used in an individual accounting system. 2. Dimensions are segments of an account number that we combine into a single account number that represents a single account. 3. The balance sheet accounts will normally be the easiest to input and code because they contain fewer dimensions. 4. We usually classify revenues by fund and source dimensions. 5. Expenditures usually require detailed coding and may be classified by fund, character, function and/or program, activity and object. 6. In many governments accounting systems, control accounts are used for revenues and expenditures/expenses, and these accounts are supported by detailed coding resident within the computer system s database. 29

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31 SECTION 3 DOUBLE ENTRY ACCOUNTING OBJECTIVES Some would say that with the common use of computers, accountants do not need to understand double entry accounting. For example, an accounts payable clerk usually just enters the expenditure/expense account number into the computer but makes no entry to the accounts payable account. In other words, the computer program records the transaction in the specific account. Although computers do most of the accounting works, the accountant still needs to understand what the computer is doing, particularly if an error occurs. When experienced accountants have an accounting problem, often they draw T accounts to follow the entries through the accounting system. As we illustrated Section 1, each financial transaction increases or decreases a government s accounts. The primary purpose of this section is to explain the relationship of increases or decreases and the accounting terms debits and credits. This section provides the basics of how accountants should record transactions. After completing this section, you should be able to: Record transactions using debits and credits. Understand how debits and credits affect accounts. DEBITS AND CREDITS Increases or decreases in a government s accounts are classified as debits or credits. Sometimes, the abbreviations for these terms in the accounting records are DR for debit and CR for credit. Before the use of computers for governmental accounting purposes, accountants pictured a general ledger account looking like a T. The left side of the T account was the debit side and the right side was the credit side. Debits on the left, credits on the right, as illustrated below. With the use of various levels of sophisticated computer equipment in governmental accounting, the T account no longer is visible in computer systems. However, an awareness of the notion of the T account is useful in understanding double entry accounting. ILLUSTRATION OF A "T" ACCOUNT ACCOUNT NAME AND NUMBER (DEBIT) DR (CREDIT) CR 31

32 CHANGES IN ACCOUNT BALANCES Transactions in accounting systems are simply changes in account balances. Changes in account balances, (i.e., a debit or credit) will result in an increase or decrease in an account balanced depending upon where that account appears in the accounting equation. Using the presentation below, we may analyze each transaction individually to decide which accounts we increase and decrease, resulting in ether debits or credits. DEBITS AND CREDITS NORMAL ACCOUNT ACCOUNT BALANCE DEBIT CREDIT Assets Debit Increase Decrease Liabilities Credit Decrease Increase Fund Equity Credit Decrease Increase Revenues Credit Decrease Increase Expenditures/Expenses Debit Increase Decrease Some accounting systems graphically represent debits and credits in their reports and input documents using (+) and (-) symbols. The theory behind this relates back to the basic accounting equation. ASSETS = LIABILITIES (+) EQUITY + - (+) - The sum of the numbers on one side of the equation must equal the sum of the numbers on the other side. The (+) represents something that goes on the left and a (-) represents something that goes on the right. We learned in Section 1 that revenues increase equity, and in this chapter we learned equity normally has a credit (-) balance. Therefore, logic dictates that the normal balance for a revenue account would be a credit (-) and expenditures/expenses a debit (+). 32

33 + EQUITY - EXPENDITURES REVENUES + - Debit Credit The following expanded accounting equation illustrates when debits and credits appear as increases or decreases (for purposes of illustration, we use the term expenditures, however, we could have substituted the term expenses): ASSETS = LIABILITIES + FUND BALANCE + REVENUES - EXPENDITURES Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit Increase Decrease Decrease Increase Decrease Increase Decrease Increase Increase Decrease Since the accounting equation must always be in balance, every transaction must always consist of the total debit amounts equal to the total credit amounts. Double entry accounting requires that for every entry (or entries) made to the debit side of an account(s), we make an entry (or entries) for the same total amount to the credit side of another account(s). The following examples illustrate the use of debits and credits. 1. A government begins the year with assets of $600, no liabilities and, therefore, a fund balance of $600. ASSETS = LIABILITIES + FUND BALANCE + REVENUES - EXPENDITURES Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit Increase Decrease Decrease Increase Decrease Increase Decrease Increase Increase Decrease $600 = + $ Note that the accounting equation balances and the debits equal the credits. 2. The government receives fines (a revenue) totaling $6,000. This transaction increases assets (i.e., a debit) and increases revenues (i.e., a credit) by the same amount. 33

34 ASSETS = LIABILITIES + FUND BALANCE + REVENUES - EXPENDITURES Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit Increase Decrease Decrease Increase Decrease Increase Decrease Increase Increase Decrease $600 = + $ $6,000 = + + $6,000 - $6,600 = + $600 + $6,000 - Note that the revenue increased so we credited the revenue account. The asset account increased, therefore, we debited. The total debits still equal the total credits (i.e., $6,600). 3. The government receives invoices for expenditures totaling $7,000. This transaction increases expenditures (i.e., a debit) and increases liabilities (i.e., a credit). ASSETS = LIABILITIES + FUND BALANCE + REVENUES - EXPENDITURES Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit Increase Decrease Decrease Increase Decrease Increase Decrease Increase Increase Decrease $600 = + $ $6,000 = + + $6,000 - = $7, $7,000 $6,600 = $7,000 + $600 + $6,000 - $7,000 Note that expenditures increased so we debited them. Liabilities increased so we credited them. 4. The government borrows $4,500 from the bank to cover future operating expenditures. This transaction increases assets (i.e., a debit) and increases liabilities (i.e., a credit). ASSETS = LIABILITIES + FUND BALANCE + REVENUES - EXPENDITURES Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit Increase Decrease Decrease Increase Decrease Increase Decrease Increase Increase Decrease $600 = + $ $6,000 = + + $6,000 - = $7, $7,000 $4,500 = $4, $11,100 = $11,500 + $600 + $6,000 - $7,000 The accounting equation still balances (i.e., $11,100 = $11,500 + $600 + $6,000 - $7,000). Also, note that the recording of each transaction results in debit amounts equal to credit amounts (i.e., $18,100). 34

35 The Golden Rules of Double Entry 1. The term debit simply means something goes on the left side of a T account. It is neither good or bad. 2. The term credit simply means something goes on the right side of a T account. It is neither good or bad. 3. A (+) symbol simply means something goes on the left side of a T account. It does not mean add. 4. A (-) symbol simply means something goes on the right side of a T account. It does not mean subtract. 35

36 SUMMARY 1. Debits are entries to the left side of any general ledger account in a manually maintained accounting system. 2. Credits are entries to the right side of any general ledger account in a manually maintained accounting system. 3. Assets, expenditures and expenses normally have debit balances. 4. Liabilities, revenues and equity normally have debit balances. 5. A government with a positive fund balance would have a credit balance in its fund equity account and a government with a fund balance deficit would have a debit balance in its fund equity account. 6. Debits increase asset balances and credits decrease assets balances. 7. Credits increase liability balances and debits decrease liability balances. 8. Credits increase fund equity balances and debits decrease fund equity balances. 9. Credits increase revenue balances and debits decrease revenue balances. 10. Debits increase expenditure or expense balances and credits decrease expenditure or expense balances. 11. Double entry accounting means that for every entry (or entries) made to the debit side of accounts, we must make equal entry (entries) to the credit side of the accounts. 36

37 Section 3 Exercise In the space provided after each transaction, record the nine transactions by indicating which accounts and the amounts we debit and which we credit. Unless otherwise indicated, assume we have not recorded the transaction previously. Use the following account numbers to record these transactions: Assets 100 Liabilities 200 Equity 300 Revenue 400 Expenditures 500 Transactions: Example: The government receives a $600 cash donation. Date Account Number Account Description Debit Credit 100 Assets $ Revenue $ The government receives an invoice for supplies for $1,500. Date Account Number Account Description Debit Credit 37

38 2. The government purchases $1,000 in investments. Date Account Number Account Description Debit Credit 3. The government pays $400 owed to XYZ Company. (This was previously recorded as both an expenditure and as accounts payable.) Date Account Number Account Description Debit Credit 4. The government borrows $5,000 from the bank and will repay in six months. Date Account Number Account Description Debit Credit 5. The government pays a $200 telephone bill. (This was not recorded as accounts payable.) Date Account Number Account Description Debit Credit 38

39 6. The government sells an investment costing $600 for $700. Date Account Number Account Description Debit Credit 7. The government pays $3,000 for salaries. (Note: This amount was not accrued.) Date Account Number Account Description Debit Credit 8. The government issues a 90-day note to the FGH Co. for $200 instead of paying the accounts payable owed. Date Account Number Account Description Debit Credit 9. The government receives $150 in miscellaneous revenues. Date Account Number Account Description Debit Credit 10. The government receives $10,000 in property taxes. Date Account Number Account Description Debit Credit 39

40 11. The government pays the $1,500 invoice for supplies from exercise #1. Date Account Number Account Description Debit Credit 12. The government pays the 90-day note to FGH Co. for $100. Date Account Number Account Description Debit Credit 13. The government pays legal fees for $1,000. Date Account Number Account Description Debit Credit 14. The government receives payment of an invoice for $500 from XYZ Developer for planning fees. Date Account Number Account Description Debit Credit 15. The governments receives a payment for a building permit in the amount of $500 of which $475 is for the permit and $25 is for state fees which will paid to the state in the future. Date Account Number Account Description Debit Credit 40

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42 SECTION 4 ACCOUNTING SYSTEMS AND RECORDS INTRODUCTION When computers were first integrated into the accounting process twenty-five to thirty years ago, tremendous gains in efficiency were experience while maintain the traditional structure and architecture of the accounting systems. Today the level of sophistication and complexity inherent in the technological design of information management systems is challenging many long held beliefs of what an accounting system is or how it s supposed to function. Some futurists have even speculated that the terms accounting and accountants will become obsolete within the next decade. A simplified description of leading edge systems is that they store all of an organization s information in large data bases (data warehousing), and that users (information technicians) can employ report writing software (data mining or extraction) to generate any reports they want. The obvious advantage of this approach is speed and flexibility in generating custom information. However, there is a tradeoff. The role of the accountant and accounting paraprofessional is becoming increasingly focused on input and output, while their knowledge of process decreases. Organized methods are necessary for a government to utilize the accounting process properly and accurately. These methods are reflected in part by the type of accounting records used. In order to heighten your understanding of the accounting process and the relevancy of certain types of accounting records and reports, we will describe within this chapter how a traditional (manual) system functions, and then discuss the facets of a computerized system. ACCOUNTING RECORDS JOURNALS LEDGERS Journals and ledgers are the two primary classifications of accounting records. With the sophistication of computer accounting systems, often specific journals and ledgers are not visible in the same way they are in an accounting system that a government maintains without a computer. This fact applies to most governments since the use of computers for accounting today is not an option. Though this section illustrates sample journals and ledgers that a government would use in a manually maintained accounting system, the section also includes a discussion on how computers may be used to generate similar accounting records. OBJECTIVES After completing this section, you should be able to: Understand the difference between journals and ledgers. Relate the journals and ledgers illustrated in this chapter to computer records. Understand how accounting systems take and process information into reports. Record transactions in journals and post to ledgers. Be aware of the value and purposes of a trial balance. 42

43 ACCOUNTING SYSTEMS (MANUAL) Governmental accountants record all financial transaction in the accounting records to maintain management control and provide the basis for financial reporting. The illustration below demonstrates the flow of data through an accounting system. Though the flow of data can be complicated, in this course we highlight the important accounting documents included in the chart. Source documents provide evidence of the original transaction. These documents should include sufficient details of the financial transaction to simplify recording the transaction in the accounting system. Internal documents might include a purchase order, a property tax bill, a cash receipt, or a check. Third parties prepare external documents as evidence of goods provided, services rendered or fees paid. These documents might include shipping slips, vendor invoices and taxpayer or customers checks. 43

44 JOURNALS A journal is a book of original entry. It is like a log book or a diary. Transactions are entered into a journal in the sequence in which they occur (i.e., chronological order). In an accounting system, the first step is to record transactions in a journal. We classify this recording as a journal entry and it could contain a summary of the transaction as follows: The date on which the transaction occurred. The accounts affected. How they are affected (i.e., whether debited or credited and by how much, and A brief description of the nature of the transaction. Journal A journal is a book of original entry TYPES OF JOURNALS Journals are classified as either a general journal or a special journal. Special journals are used to record transactions of a like nature. Journals General journal Special journals Special journals might include: A cash receipts and cash disbursements journal (i.e., a cash journal), A revenue and cash receipts journal, An expenditure and cash disbursement journal, A payroll journal, and A purchases journal, In this course, we will only use a general journal. States and local governments use the general journal to record transactions that do not fit in a special journal. Though not practical, governments could record all transactions in a general journal. A general journal might include columns for: A date Account Titles and explanation The account number A column to indicate we have posted the transaction to the ledger Columns for debit and credit amounts 44 General journal A general journal is used to record all transactions that do not fit in a special journal

45 The following illustrates a manually maintained general journal: GENERAL JOURNAL Page No. DATE ACCOUNT DEBITS CREDITS ACCOUNT TITLE AND EXPLANATION NUMBER As an example of a general journal entry in a non-computer system, assume that on July 28 th U.S. Treasury bills are purchased with a face value of $10,000 as an investment for cash at a cost of $9,542. GENERAL JOURNAL Page No. 1 DATE ACCOUNT DEBITS CREDITS ACCOUNT TITLE AND EXPLANATION NUMBER July 28 Investments Cash in Bank Note that the account debited is listed first and the account credited is listed second and indented this is the accepted format in a manual accounting system. A brief explanation of the transaction follows the recording of the account titles. 45

46 LEDGERS A ledger is an accounting record that accountants may use to summarize the financial activity in each account (e.g., accounts payable) of a governmental entity. We call ledgers books of final entry. Ledgers are the primary source of accounting data for the preparation of periodic management reports as well as annual financial statements. In a manual accounting system, we usually maintain a separate page of each ledger account. Ledgers are classified as either a general ledger or a subsidiary ledger. GENERAL LEDGERS The general ledger contains the basic accounts of a government and serves as the source of data for preparing financial statements (e.g., the balance sheet). A general ledger might include the traditional T account information (as illustrated Ledger in Section 3) but usually is modified to include columns to maintain a running A book of final entry total (i.e., current balance) for each The transactions of the state are summarized account. The balance in the account in a ledger will be a debit or a credit amount depending upon the totals of the entries in the debit and credit columns. The following is an example of the account Cash in bank in the general ledger for the general fund in a manual accounting system with a balance at the beginning of the fiscal period of $323,500. The posting reference column in the general ledger indicates the source of the posting (e.g. which journal and page number of a journal). The check mark indicates a balance carried forward from the prior year s general ledger. The balance columns in the general ledger allow the accountant to maintain a running balance (i.e., current balance) in the account. Usually, each time the general ledger is posted, the accounts are totaled and the balance is entered in the appropriate column as a debit or credit. 46

47 GENERAL LEDGER Account Description: CASH Account Number: 100 Page No. 35 Dr Cr Date Transaction PR Debit Credit Balance Balance 1-Jul N/A $323,500 5-Jul N/A CR4 $10,000 $333, Jul N/A CD3 $2,000 $331, Jul N/A CR5 $5,000 $336, Jul N/A CD4 $1,500 $335,000 In a computer system, posting references usually don t relate to separate journals. However, when a transaction is entered into the system, a transaction reference number might be affixed to each transaction. Accounts normally included in the general ledger are: Individual asset accounts (e.g., cash in bank) Individual liability accounts (e.g., accounts payable) Individual equity accounts (e.g., fund balance) Individual revenue accounts or revenue control account (e.g., revenues) Individual expenditure/expense accounts or an expenditure/expense control account (e.g., expenditures) SUBSIDIARY LEDGERS Subsidiary ledgers provide detailed subdivisions of selected general ledger accounts. The most common subsidiary ledgers are for the budgetary, the revenue and the expenditure accounts. For example, the general ledger might utilize a single account (e.g., the expenditure control account) to record the total year-to-date expenditures for a specific fund. Then the subsidiary ledger supporting the expenditure control account would include separate accounts for each individual expenditure (e.g., policemen s salaries). The total of the expenditure subsidiary ledger equals the control account in the general is included separately in the general ledger. States and large local governments generally use control accounts. With an automated system, subsidiary ledgers are generated from a data base using the computer s report writing capabilities. 47

48 POSTING TRANSACTIONS Posting is the process of taking information from journals and recording this data on the various ledgers. In other words, transactions are originally recorded in a journal and then recorded in a summarized form in ledgers. We call this process posting. In an automated system, the process of journalizing and posting may occur simultaneously. This is one primary advantage of using a computer accounting system. Since we record a single transaction in both the journal and ledger with a single entry into the computer, we reduce or eliminate the chance that we would post (i.e., record the amount) in error. General Journal.Posting General Ledger 48

49 THE TRIAL BALANCE If the accounts have been posted correctly, the total of all the debits should equal the total of all the credits. This is true because for every debit entry, there has been a credit entry of an equal or offsetting amount. At the end of the reporting period (e.g., a month), one of the accountant s tasks is to prepare a trial balance. The trial balance is simply a listing of all the accounts and account balances in the general ledger. The trial balance confirms that the general ledger is in balance. For example, we illustrate a trial balance for a manual accounting system as follows: ANY GOVERNMENT TRIAL BALANCE GENERAL FUND JULY 31, 20XX General Ledger Account Balance Account No. Account Title Debit Credit 100 Cash in Bank $ 71, $ Intergovernmental receivables 11, Inventory 3, Investments 9, Accounts payable - 8, Accured taxes payable - 1, Fund balance - 84, Revenue control - 17, Expenditure control 16, $ 111, $ 111, As indicated above, the total of the debits should equal the total of the credits in a trial balance. If they do not agree, either a posting error has occurred (i.e., the wrong amount was posted from a journal to an account in the ledger) or either the journal does not foot or cross foot or the general ledger does not foot or cross foot. The information in the trial balance is what will eventually be used to construct the financial statements balance sheet/statement of net assets and operating statements. 49

50 ACCOUNTING SYSTEMS (AUTOMATED) Accounting systems were first automated twenty-five to thirty years ago. Until the mid-1980s the automation manifested itself primarily in the recording of transactions to electronic journals that then posted to an electronic general ledger. The most time efficient applications were directed at subroutines that focused on subsidiary ledgers such as accounts payable, receivables, and payroll. Repetitive transactions of a volume nature were performed on the subsystems with cumulative batch totals recorded in the appropriate general ledger account. On a daily basis, larger systems would print out journals/logs of the day s transactions, and ledger cards (heavy paper almost like a thin cardboard) were run through an electronic posting machine which updated all of the general ledger accounts. Today s database systems are much more efficient. In today s accounting systems when a transaction occurs an input is made to the accounting system. Unlike manual accounting systems, the input bypasses the traditional journal, and is made directly to the database. To accomplish this insertion of data all that is required is for an individual sitting at a computer to pull down the appropriate screen and fill out the required fields. With computer accounting systems, accountants make most journal entries directly into a computer terminal either from a source document (e.g., a bank deposit) or from a computer input form 50

51 Often, we generate a transaction report from the data added to the computer systems, which is the equivalent of a general journal. As with input forms, the output and format on the transaction report will vary. Most of the information included in the example of the manual general journal (Page42) would appear in the transaction report except for the posting reference and an explanation of the transaction. However, there might be a reference to a purchase order or a check that serves as the explanation. Ina computer accounting system, a report writer is often used to compile a general ledger for each account. The report would include whatever information the person writing the query specified, however, it would be desirous to include a beginning balance, month-to-date totals for all transactions or a presentation of all individual transactions for the fiscal period and all transactions incurred during the fiscal period reported (e.g., a month) and an ending balance at the end of the fiscal period. Computer systems allow direct access to review any account balance via a monitor and can view the current month s data and year-to-date data. Reviewing accounts through monitors is just like opening a manual general ledger and looking at the details of a specific account. In most computer systems, the journal entries entered must balance or be rejected. Therefore, when the general ledger and any trial balances are generated they usually are in balance. When on transaction is recorded in the transaction report (i.e., the journal) and in the general and subsidiary ledgers simultaneously, the chance of the trial balance not balancing is minute. However, if a posting is made in the correct amount, but to the wrong account, the general ledger will balance but certain accounts will be misrepresented. This type of error, if immaterial, often is difficult to locate. 51

52 SUMMARY 1. In an accounting system, a journal entry is generated when a financial transaction occurs. This entry flows from a journal to a ledger. 2. A journal is an accounting record where transactions entered are recorded originally. 3. A journal is known as the book of original entry. 4. A ledger is an accounting record that summarizes financial transactions by type of account. 5. A ledger is known as the book of final entry. 6. The process of taking financial information from a journal and recording it in a ledger is called a posting. 7. A general ledger contains the basic accounts of a government. 8. A subsidiary ledger contains details of a specific general ledger account. 9. A computer system contains the same data that is included in journals and ledgers even though it might not be readily accessible. 10. A trial balance is a listing of all the accounts used by the government and account balances. 11. The purposes of preparing a trial balance are to determine whether the debits and the credits in the general ledger balance and to prepare financial statements. 52

53 Section 4 Exercise The purpose of this exercise is to test whether you have grasped most of the concepts discussed in this chapter. While it s true that in real life most of you are only concerned with data input, we are going to have you complete the exercise using a manual process. This exercise should help you understand the process of how a transaction ends up being reported at the conclusion of the fiscal period. Complete this exercise in the following order: 1. Start your exercise by recording the journal entries for each of the seven following transactions using the account numbers provided on the beginning trial balance. The input document on which you record the journal entries will serve as your general journal. 2. Then post the entries in the general ledger for the month of July 20XX using the account numbers in the trial balance. 3. Once you have completed the posting, create a trial balance. 53

54 ANY GOVERNMENT TRIAL BALANCE GENERAL FUND JULY 1, 20XX General Ledger Account Balance Account No. Account Title Debit Credit 100 Cash in Bank $ 50, $ Petty Cash Investments 100, Accounts payable - 20, Accrued salaries Notes payable - 50, Fund balance - 80, Revenue control Expenditure control - - Total $ 150, $ 150,

55 TRANSACTIONS: 1. On July 7, revenue is received in the amount of $18,000. Date Account Number Account Description Debit Credit 2. On July 8, an investment of $10,000 is purchased for cash. Date Account Number Account Description Debit Credit 3. On July 12, accounts payable are paid in the amount of $480. Date Account Number Account Description Debit Credit 4. On July 13, an invoice for utilities is received in the amount of $392. Date Account Number Account Description Debit Credit 5. On July 15, a new petty cash fund is established in the amount of $100. Date Account Number Account Description Debit Credit 55

56 6. On July 15, salaries totaling $3,000 are paid. (Note: disregard payroll deductions withheld.) Date Account Number Account Description Debit Credit 7. On July 21, $15,000 is borrowed from the bank and will be repaid in 3 months. Date Account Number Account Description Debit Credit 8. On July 22, an investment costing $4,000 is sold for $4,500. Date Account Number Account Description Debit Credit 9. On July 23, a $2,000 bill was paid of which $500 was already set up as an accounts payable and $1,500 has not be recorded. Date Account Number Account Description Debit Credit 10. On July 31 interest on the governments bank accounts is received in the amount of $100. Date Account Number Account Description Debit Credit 56

57 GENERAL LEDGER Page No. Account Description: CASH Account Number: Dr Cr Date Transaction PR Debit Credit Balance Balance 1-Jul $50,000 GENERAL LEDGER Account Description: PETTY CASH Account Number: Page No. Dr Cr Date Transaction PR Debit Credit Balance Balance 1-Jul $0 57

58 GENERAL LEDGER Account Description: INVESTMENTS Account Number: Page No. Dr Cr Date Transaction PR Debit Credit Balance Balance 1-Jul $100,000 GENERAL LEDGER Account Description: ACCOUNTS PAYABLE Account Number: Page No. Dr Cr Date Transaction PR Debit Credit Balance Balance 1-Jul $20,000 58

59 GENERAL LEDGER Account Description: ACCRUED SALARIES Account Number: Page No. Dr Cr Date Transaction PR Debit Credit Balance Balance 1-Jul $ - GENERAL LEDGER Account Description: NOTES PAYABLE Account Number: Page No. Dr Cr Date Transaction PR Debit Credit Balance Balance 1-Jul $ 50,000 59

60 GENERAL LEDGER Account Description: FUND BALANCE Account Number: Page No. Dr Cr Date Transaction PR Debit Credit Balance Balance 1-Jul $ 80,000 GENERAL LEDGER Account Description: REVENUE CONTROL Account Number: Page No. Dr Cr Date Transaction PR Debit Credit Balance Balance 1-Jul $ - 60

61 GENERAL LEDGER Account Description: EXPENDITURE CONTROL Account Number: Page No. Dr Cr Date Transaction PR Debit Credit Balance Balance 1-Jul $0 61

62 General Ledger Account Balance Account No. Account Title Debit Credit 100 Cash in Bank 104 Petty Cash 107 Investments 200 Accounts payable 214 Accrued salaries 251 Notes payable 380 Fund balance 400 Revenue control 500 Expenditure control Total ANY GOVERNMENT TRIAL BALANCE GENERAL FUND JULY 31, 20XX 62

63 Section 5 FUND ACCOUNTING Reporting Entity Governmental Proprietary Fiduciary Category Category Category General Private Purpose Fund Enterprise Trust Funds Funds Special Revenue Investment Trust Funds Internal Funds Service Funds Capital Projects Fund Pension Funds Debt Service Funds Agency Funds Permanent Funds 63

64 OBJECTIVES Governments account for and allocate resources in separate sub-entities, identified as funds, based upon the purposes for which they are to be expended and the means by which spending activities are legally controlled. A fund is an accounting entity with a separate set of accounting records for resources, in which related liabilities and equities are segregated for conducting a specific activity. For example, a government might account for a federal grant in one fund. It could record the proceeds from a bond sale (e.g., a building bond) in a different fund. The more individual funds maintained, the more tedious the record keeping can become. However, many accounting systems are designed specifically for fund accounting that reduce potential record keeping problems. After completing this chapter, you should be able to: Define each of the fund categories and generic funds within each category. Determine when to use each of the generic funds. Identify the basis of accounting used by each category and generic fund. NUMBER OF FUNDS Generally accepted accounting principles (GAAP) require that governments establish and maintain the minimum number of funds consistent with legal requirements and sound financial administration. In other words, the government should maintain as few funds as possible consistent with the above criteria. Usually the sophistication of the government s accounting system determines the latter requirement. If the accounting system can segregate revenues, expenditures and fund equity for particular activities within a single fund, a government should use a single fund (e.g., the general fund). However, there may also be political considerations that could impact the number of funds a government chooses to create and maintain. For example, if the government were to impose a new tax of a controversial nature where there is a high level of expectation for separate accountability, the creation of a separate fund for that one tax and its program expenditures could be warranted. FUND CATEGORIES For reporting purposes, governments must classify their individual funds within three categories. These categories are important since the accounting rules differ for each of the fund categories. A brief explanation of these three categories follows: 64

65 A. Governmental Funds account for general operations such as government administration, education, social services, natural resources, and transportation programs. The primary income source for these programs is taxes. B. Proprietary Funds account for activities that are similar to the commercial sector (e.g., the water and sewer operations). In essence these are business-type activities A. that are owned and operated by the government. They are generally seen as being selfsupporting and derive most, if not all, of their revenues from consumer fees. C. Fiduciary Funds account for assets held by the government in a trustee or agent capacity such as taxes collected and held on behalf of local governments, pension plans, and trusts which receive external donations for the benefit of parties external to the government. GENERIC FUNDS The Governmental Accounting Standards Board (GASB) subdivides the fund categories into generic funds. The exhibit above presents a fund organizational chart illustrating the three categories and the discussions below depict their relationship with the generic funds. Knowledge of the generic fund classifications is important for a thorough understanding of financial statements produced by a governmental entity. The Governmental Category includes the following generic funds: 1. The General Fund accounts for all resources that are not required to be accounted for in another fund. Most financial transactions are reported in this fund. Only one general fund is permitted for reporting purposes. 2. Special Revenue Funds account for proceeds of specific revenue sources that are restricted or committed to expenditures for specific purposes other than debt service or capital projects. 3. Capital Project Funds account for resources that are restricted, committed, or assigned to expenditures for capital outlays, including the acquisition or construction of capital facilities and other capital assets. The proceeds from a bond issue used to construct a new street that will be repaid from general property taxes or special assessments would be accounted for here. 4. Debt Service Funds account for resources that are restricted, committed, or assigned to expenditures for principal and interest. 5. Permanent Funds should be used to report resources that are legally restricted to the extent that only earnings, and not principal, may be used for purposes that support the reporting government s programs that is, for the benefit of the government or its citizenry. 65

66 The following generic funds are included in the Proprietary Category: 1. Enterprise Funds account for activities financed and operated like those of business enterprises. The government s water or sewer operations are examples of this fund type. Intent is that services will be funded primarily through fees to users. 2. Internal Service Funds account for operations similar to those accounted for in enterprise funds, but provide goods or services to other departments within the same government. Activities such as centralized data processing, a motor pool or a print shop could be accounted for as internal service funds. However, if the fees an activity collects are not sufficient for the activity to break even over time, the activity may be accounted for elsewhere, preferably the general fund. The final category of funds is called the Fiduciary Category and includes the trust and agency funds. GAAP subdivides the fiduciary category into four generic funds. 1. Agency Funds are holding accounts for assets belonging to someone other than the government. For example, a government could collect cable franchise fees that are then allocated to various cities. 2. Pension Trust Funds account for those assets maintained for single and/or multiple employer pension plans. In other words, the state or local government would report the assets that it holds for retirement payments to its employees (i.e., those who have or will retire) here. An expenditure for active employees is not recorded here, but in the fund in which the applicable employee works. 3. Investment Trust Fund is a fund that a government uses to account for the external portion of a government sponsored investment pool. 4. Private-purpose Trust Funds should be used to report resources held and administered by the reporting government when it is acting in a fiduciary capacity for individuals, private organizations, or other governments. One example for local governments would be a cemetery fund. Each individual fund maintained in a government is classified into one of the three fund categories and within the eleven generic funds. 66

67 BASIS OF ACCOUNTING Although we will discuss the term basis of accounting more fully in a later section, it is important to note that all generic funds within the governmental category, at the fund level, are accounted for on the modified accrual basis of accounting. At the entity-wide level of reporting, the governmental fund information will be aggregated and reported on the accrual basis of accounting. The proprietary and fiduciary funds are reported using the accrual basis of accounting at the fund level. At the entity-wide level of reporting, the proprietary funds are reported using the accrual basis of accounting, and fiduciary funds are not reported. The following exhibit summarizes the basis of accounting for each generic fund at the fund level. Fund Type Governmental Funds: General Special Revenue Capital Projects Debt Service Permanent Proprietary Funds: Enterprise Internal Service Fiduciary Funds: Private-Purpuse Trust Investement Trust Pension Trust Agency Basis of Accounting Modified Accrual Accrual X X X X X X X X X X X 67

68 SUMMARY 1. A fund represents that portion of a government recognized as a separate fiscal and accounting sub-unit, with a separate set of accounting records segregated for carrying on a specific activity(s). 2. The GASB has classified all individual funds into three categories: governmental, proprietary of fiduciary. 3. Governmental funds include general, special revenue, capital projects, debt service, and permanent generic funds. 4. Proprietary funds include the enterprise and internal service generic funds. 5. Fiduciary funds include the pension trust, private purpose trust, investment trust, and agency funds. 6. Governmental funds use the modified accrual basis of accounting at the fund level. 7. Proprietary funds and fiduciary funds use the accrual basis of accounting at the fund level. 68

69 Section 5 Exercise Circle the answer that seems most correct. 1. The Fiduciary Fund type encompasses A. General Trust Funds, Non-expendable Trust Funds and Agency Funds. B. Special Revenue Trust Funds, Pension Trust Funds and Agency Funds. C. Proprietary Trust Funds, Pension Trust Funds, and Agency Funds. D. Investment Trust Funds, Private Purpose Trust Funds, Pension Trust Funds and Agency Funds. 2. Normally, the proceeds from general obligation bonds sold for the construction of a new street would be reported in the A. General Fund. B. Special Revenue Fund. C. Capital Project Fund. D. Internal Service Fund. 3. Donations that may be spent by the government, for programs of the government, are accounted for in A. Governmental Funds. B. Proprietary Funds. C. Pension Trust Funds. D. Agency Funds. 4. Donations that may only be spent for private individuals or organizations are accounted for in A. Governmental Funds. B. Proprietary Funds. C. Fiduciary Funds. D. An indecent manner. 5. Agency funds are accounted for in A. Governmental Funds. B. Proprietary Funds. C. Fiduciary Funds. D. None of the above. 69

70 6. A government should maintain A. The minimum number of funds consistent with legal requirements. B. The minimum number of funds consistent with sound administration. C. The minimum number of funds consistent with legal requirements and sound financial administration. D. A separate individual fund for each individual fund activity. 7. The expenditure for payments made for the government s share of retirement paid to their retirement system should be recorded in A. The fund in which the applicable employees work. B. The General Fund. C. A Pension Trust Fund. D. An Agency Fund. 8. The activities of data processing, which include charges to other departments or funds, may be accounted for A. In the Internal Service Fund. B. In the General Fund. C. In either A or B. D. In an Investment Trust Fund. 9. One of the more significant differences between the accounting treatments applied to governmental funds and proprietary funds involves the accounting conventions of A. Period versus project measurement. B. Relevancy, reliability and materiality. C. Historical cost versus fair market valuations. D. The basis of accounting. 10. The classification proprietary is considered A. A category classification. B. A generic fund type classification. C. An account group classification. D. An expendable trust fund. 70

71 11. The classification special revenue fund is considered A. A category classification. B. A generic fund classification. C. An account group classification. D. An expendable trust fund. 12. How many general funds may a government report? A. 1. B. 2. C. It depends. D Explain the difference between an enterprise fund and an internal service fund. 14. The classification fiduciary is considered A. A category classification. B. A generic fund classification. C. An asset classification. D. A liability classification. 71

72 Matching Funds. Choose the letter of the sample transaction in the left-hand column that best matches the purpose of the fund listed in the right-hand column. Each fund is used only once. Example Fund 15. Construction of highway, bridges, or parks. A. Agency 16. Administrative expenses of the government B. Capital projects 17. Gifts in which the principal and interest may C. Debt Service be used to provide scholarships to children of police officers who died in the line of duty. 18. Costs of a central purchasing and warehouse D. Enterprise function. 19. Assets held for external government E. General participants in the government s investment pool for the purpose of earning investment income. 20. Gifts in which the principal must be invested F. Internal Service and preserved but the investment earnings can be used for public purposes. 21. Costs of operating a governmental swimming G. Investment Trust pool. 22. Grant revenues restricted for particular H. Pension Trust operating purposes. 23. Assets held in trust to provide retirement I. Permanent benefits for municipal workers. 24. Principal and interest payments on general J. Private-Purpose Trust long-term debt. 25. Taxes collected on behalf of another K. Special Revenue governmental unit. 72

73 Section 6 The Basis of Accounting INTRODUCTION An important principal that the Governmental Accounting Standards Board (GASB) Codification of Governmental Accounting and Financial Reporting Standards includes within the code is the basis of accounting. The basis of accounting: Refers to when revenues, expenditures, expenses and transfers, and the related assets and liabilities, are recognized in the accounts and reported in the financial statements. In other words, the basis of accounting governs the time at which the accounting system recognizes transactions. For example, the basis of accounting determines when a government should recognize a transaction as a revenue, an expenditure or an expense. Should you recognize the revenue when it is earned, when it is received, or at some other point in time? OBJECTIVES: After completing this chapter, you should be able to: Define the phrase basis of accounting. Contrast the three common bases of accounting. Understand when to recognize revenues and expenditures under the modified accrual basis of accounting. Understand when to recognize revenues and expenses under the accrual basis of accounting. BASES OF ACCOUNTING The three common bases of accounting that a state or local government may use include: Cash basis; Accrual basis; and Modified accrual basis. THE CASH BASIS OF ACCOUNTING Cash basis accounting recognizes transactions only when cash is received or disbursed. Even though used in some governments, the cash basis of accounting and reporting is not a desirable practice. THE CASH BASIS OF ACCOUNTING recognizes transactions only when cash changes hands Cash basis financial statements do not include assets and liabilities not arising from cash transactions (i.e., they ignore the effects of accounts receivable, accounts payable and other accruable items). Since these items are commonly 73

74 of significant dollar amounts, cash basis financial statements generally do not present financial position or results of operations in conformity with generally accepted accounting principles (GAAP). The only instance in which cash basis financial statement representations are in RECOGNIZING TRANSACTIONS ON THE CASH BASIS conformity with GAAP is in the unlikely situation where all accounts receivable, accounts payable, and other accrued items are nonexistent or insignificant. Cash basis accounting permits distortions in financial statement representations due to shifts in the timing of cash receipts and THE POINT IN TIME THAT A TRANSACTION IS RECOGNIZED disbursements reflecting underlying economic events near the end of a fiscal period. For example, a government may speed up or slow down cash collections and payments near the end of the period. These cash flow changes would affect the government s financial position and results of operations. Summary of the Cash Basis of Accounting Under the cash basis of accounting, revenues are recorded when cash is received and costs are reported when a check is written and cash is disbursed. THE ACCRUAL BASIS OF ACCOUNTING The accrual basis of accounting recognizes transactions when they occur regardless of the timing of related cash flows. The use of accrual accounting techniques prevents distortions in financial statement representations, due to shifts in the timing of cash flow and related underlying economic events near the end of a fiscal period. In other words, the receipt or disbursement of cash has no effect on the reporting of revenues and expenses. Accrual accounting techniques enhance the comparability of financial statements from period to period and from one governmental entity to another. All proprietary and fiduciary funds use the accrual basis of accounting in their fund financial statements under GAAP. (CASH) CASH RECEIVED OR DISBURSED THE ACCRUAL BASIS OF ACCOUNTING recognizes transactions when they occur, regardless of the timing of the related cash flows 74

75 COMPARISION OF ACCRUAL AND CASH BASIS ACCOUNTING (Accrual) Transaction Occurs (Cash) Cash Received or Disbursed THE POINT IN TIME THAT A TRANSACTION IS RECOGNIZED Revenue Recognition Under the accrual basis of accounting, revenue recognition occurs in the accounting period in which the revenue becomes objectively measurable and earned. Objectively measurable means the amount can be determined accurately. Obviously, a transaction cannot be Revenue recognition - accrual basis accounting reported unless the amount of the transaction can be determined. The recognizes Revenues in the accounting accounting staff must either know period in which they are: the actual amount of a transaction - EARNED or be able to estimate the amount. - MEASURABLE This criterion is applicable to the recording of all financial transactions. For a government to earn revenue, it must have provided the goods or services. For example, the city rents a meeting room to a private group at $25 per participant: The revenue is earned when the group uses the room. The revenue is measurable when the city knows how many participants attended. After the above criteria are met, the government would record the transaction as revenue regardless of when the group pays the bill. Expense Recognition When using the accrual basis of accounting, expenses are recognized in the period incurred, if measurable. To incur an expense, the item purchased must be received and consumed or the vendor must have performed the service. For example, the government must receive and use the purchased consumable (e.g., chemicals for the water plant) before it can report an expense for the cost of these supplies. 75

76 As another example, the exterminator must have completed all work at the water plant before the expense is uncured and the cost reported. For an expense to be measurable, we must be able to determine the amount. Normally we know the Expense recognition - accrual basis accounting recognizes Expenses in the accounting period in which they are: - MEASURABLE - INCURRED amount when the invoice for the Purchase of the service is received. However, if the amount is known as a result of a contract or the amount could be estimated, we can consider the amount as meeting the measurable criteria. THE MODIFIED ACCRUAL BASIS OF ACCOUNTING All governmental funds use the modified accrual basis of accounting. Revenue Recognition Under the modified accrual basis of accounting, revenues are recognized when a transaction meets two criteria: Measurable, and Available. Revenue recognition MODIFIED accrual basis of accounting As previously stated, a government recognizes transactions (e.g., revenues) using either the modified accrual or accrual basis of accounting when they are measurable. Revenues are objectively considered measurable if the amount can be determined accurately. Generally, some revenues such as licenses, fees and similar revenues, are not considered measurable until they are received in cash. They become measurable when received (i.e., meeting one of the two revenue recognition criteria under the modified accrual basis of accounting). The requirement that revenues must be available before recognizing them distinguishes the modified accrual basis revenue recognition from that of accrual basis. Available means that the revenue was collected during the year or will be collected soon enough after the end of the year to pay liabilities of the current period. In practice, governments interpret the term available in different ways. Alternative interpretations include the following: They collect the revenue within a period of time after year-end equal to the government s normal bill paying cycle. 76 recognize srevenues in the accounting period in which they are: - MEASURABLE -AVAILABLE

77 They collect the revenue within a specified, standardized time period after year-end, such as 30, 60 or 90 days. They collect the revenue within 12 months after year-end (i.e., the transaction results in a current asset at year-end). As noted, GAAP allows flexibility when applying this criterion; however, a similar available period should be used consistently from year to year. Expenditure Recognition Expenditures are normally recognized under the modified accrual basis: When measureable, Generally, when the liability is incurred, and When the liability will be liquidated with current resources. Governments normally consider expenditures measureable when an invoice is received for the goods or services. If the expenditure results from a bid (i.e., the cost is known), the amount could be estimated and the transaction could be considered measureable before the invoice is received. To incur a liability, the goods must be received in satisfactory condition and/or the service must be performed. For example, the expenditure is recorded when goods or services are received (note that it is not necessary that the goods be used) or when repairs are completed (i.e., the liability is incurred) and the invoice is received (i.e., the transaction are measurable). GASB 6 defines the third expenditure criterion to man that in the absence of an applicable accrual modification, governmental fund liabilities and expenditures should be accrued. Liabilities that governments normally pay in a timely manner and in full from expendable available financial resources (for example, salaries and utilities) should be recognized when incurred, without regard to the extent to which resources are currently available to liquidate the liability. What this means is that if there are bills/liabilities that exist at year end, and these bills would normally be expected to be paid within the normal bill paying cycle, this criterion usually is considered met. Usually, if a liability exists at year-end, this amount should be reported as an expenditure. There are some exceptions or alternatives to this expenditure recognition criteria: 1. Governments recognize principal and interest on general long-term debt generally when the payments for these purposes are due. 2. Inventory items such as supplies may be considered as expenditures either when purchased or when used. 3. Expenditures that the government prepays for insurance and similar services extending over more than one accounting period (e.g., the fiscal year) may be allocated between accounting periods (i.e., one-third of a three-year insurance premium could be charged as an expenditure each year) or may be recognized in the period of acquisition. The latter alternative is most common. 77

78 4. The government reports expenditures for vested compensated absences (e.g., vacation, sick pay) in a governmental fund when they will liquidate them with expendable available financial resources. Unfortunately, as with the revenue recognition available criteria, the term expendable available financial resources is not defined clearly or applied consistently from government to government. Examples - General Fund 1. Repair and maintenance expenditure Accounts Payable City receives order for vehicle repair part 2. Accounts payable Cash Debit $ 1,000 $ 1,000 Credit $ 1,000 $ 1,000 Difference from accrual basis: Generally do not have inventory of repair parts so expensed when receive part rather than when used As stated above, GAAP has a special rule when to record an expenditure for consumable inventories (e.g., office supplies). Governmental funds, using the modified accrual basis of accounting, may use either of the two methods: Purchases method (when you buy it) or Consumption method (when you use it). When using the purchases method, the expenditure is recorded when the inventory is purchased. When using the consumption method, the government must record the expenditure when it uses (i.e., consumes) the inventory. Note that Proprietary funds must use the consumption method. Summary of the Modified Accrual Basis of Accounting The modified accrual basis of accounting falls somewhere between the cash basis of accounting and the accrual basis of accounting. Revenue recognition under the modified accrual basis is similar to revenue recognition under the accrual basis, as long as the cash is received soon enough after the year-end to pay current year liabilities (i.e., it is considered available). Generally, an expenditure is recognized and 78

79 recorded as it would be under the accrual basis, as long as the liability resulting from the expenditure is liquidated from current resources. The timing of cash receipts for revenue transactions, and of liquidation of the liabilities resulting from expenditures, affect when a transaction is recorded under the modified accrual basis of accounting. When cash is received from the transaction determines when it considers revenue available. When the liability resulting from the expenditure is liquidated determines whether the liability was liquidated from current resources. COMPARISION OF ACCRUAL MODIFIED ACCRUAL AND CASH BASIS ACCOUNTING (Accrual) Transaction Occurs (Modified accrual measurable available/liquidated (Cash) Cash Received or Disbursed THE POINT IN TIME THAT A TRANSACTION IS RECOGNIZED Summary Comparison of the Bases of Accounting As indicated, there are major differences between the non-gaap cash basis of accounting and the two GAAP methods of accrual accounting. The three bases we discussed above can be compared as they relate to cash received and disbursed as follows: 1. Cash basis States or local governments report revenues and costs only when they receive or disburse cash. The cash basis of accounting is not an acceptable report basis (unless you are a government under 2,500 in Minnesota). 2. Modified accrual basis States or local governments normally recognize revenues if anticipated receipt of the revenue will occur during the year, or soon enough thereafter to pay the current year s bills. Expenditures are recognized when drawn on current available expendable resources. However, in the absence of an applicable accrual modification, governmental fund liabilities and expenditures should be accrued. Liabilities that governments normally pay in a timely manner and in full from expendable available financial resources (for example, salaries and utilities) should be recognized when incurred, without regard to the extent to which resources are currently available to liquidate the liability. 3. Accrual basis State or local governments recognize revenues and expenses when the event occurs without regard to when they receive or disburse cash. 79

80 The following exhibit summarizes the two acceptable bases of accounting explained below. COMPARISON OF THE BASES OF ACCOUNTING (1) (2) Accrual Basis Modified Accrual Basis A. Revenues are recorded Measurable (the amount can be Measurable (the amount when: determined) and can be determined) and Earned (the service has been provided) Available (the revenue was collected in the current fiscal year or will be collected soon enough after the close of the fiscal year to pay liabilities of the current year) B. Expenses/expenditures (Expenses) (Expenditures) are recorded when: Measurable (the amount can be Measurable (the amount determined) and can be determined) and Incurred and consumed (goods received and used or services performed) Incurred (the liability has been created and will normally be paid from current resources) 80

81 RELATIONSHIP TO FUND ACCOUNTING All generic funds must use either the accrual or the modified accrual basis of accounting as illustrated on this page. Governmental funds use the modified accrual basis of accounting and the proprietary and fiduciary funds use the accrual basis of accounting. Fund Type Governmental Funds: General Special Revenue Capital Projects Debt Service Permanent Proprietary Funds: Enterprise Internal Service Fiduciary Funds: Private-Purpuse Trust Investement Trust Pension Trust Agency Basis of Accounting Modified Accrual Accrual X X X X X X X X X X X 81

82 SUMMARY 1. The basis of accounting determines when a state or local government records transactions in its financial statements. 2. Cash basis accounting is not considered a desirable practice. 3. Under the accrual basis of accounting, states or local governments recognize revenues in the accounting period in which they become measurable and are earned. 4. Under the accrual basis of accounting, states and local governments recognize expenses in the accounting period incurred, if measurable. Incurred simply means the goods have been received and used or the services have been performed. 5. Proprietary and fiduciary funds use the accrual basis of accounting. 6. Under the modified accrual basis of accounting, revenues are recognized in the accounting period when they become susceptible to accrual, that is, when they become measurable and available (i.e., collected during the year or soon enough after year-end to pay liabilities of the current period). 7. Under the modified accrual basis of accounting, expenditures are recognized in the accounting period when measurable and generally when the liability is incurred and would normally be expected to be liquidated with current resources. 8. Governmental funds use the modified accrual basis of accounting at the fund level. 82

83 Section 6 Exercise Circle the answer that seems most correct. 1. The basis of accounting determines. A. Whether expenses or expenditures are measured. B. Whether capital assets are reported on the balance sheet. C. When transactions are recognized. D. Whether budgetary comparisons must be presented. 2. Which funds are accounted for using the modified accrual basis of accounting? A. All governmental funds. B. All proprietary funds and fiduciary funds. C. Only budgetary funds. D. All except Special Revenue Funds. 3. Which funds are accounted for using the accrual basis of accounting? A. All governmental funds and private purpose trust funds. B. All proprietary and fiduciary funds. C. Only budgetary funds. D. All except Special Revenue Funds. 4. Under the modified accrual basis of accounting, revenues are recognized A. When the related asset(s) is recognized. B. In the same manner as under the accrual basis. C. When they become measurable and available. D. When they are received in cash. 5. The major difference between the accrual and modified accrual basis of accounting for revenues is A. When liabilities are recognized. B. There are no differences. C. The revenue recognition criterion is measurable. D. The revenue recognition criterion is available. 83

84 6. Objectively measurable means A. An item purchased must be used before expenditure recognition. B. An amount can be determined accurately. C. An amount can be collected. D. All of the above. 7. Inventories of materials and supplies may be considered expenditures A. When purchased. B. When consumed. C. Either of the above. D. None of the above. 8. Many governments interpret the revenue criterion available and soon enough thereafter to be used to pay liabilities of the current period as A. Within a period of time after year-end equal to the government s normal bill paying cycle. B. Within a specified standardized period of time after year-end (e.g., 30, 60, or 90 days). C. Within 12 months after year-end (the item is a current asset at year-end). D. Any of the above. 9. During the year, a government contracted for $30,000 worth of services, $26,000 of which was provided and invoiced. The government paid $23,000 on the invoices. Using the accrual basis of accounting, what amount of expenses would be recorded? A. $30,000 B. $26,000 C. $23,000 D. $7, During the year, a government earned $15,000, $12,000 of which was in cash. At year-end $3,000 is still owed to the government. Of the $3,000, $1,000 is expected to be collected shortly after the close of the year and could be used to pay current year s bills. Under the modified accrual basis of accounting, how much would be reported as revenue? A. $15,000 B. $13,000 C. $12,000 D. $11,000 84

85 11. During the year, a government earned $15,000, $12,000 of which was in cash. At year-end $3,000 is still owed to the government. Of the $3,000, $1,000 is expected to be collected shortly after the close of the year and could be used to pay current year s bills. Under the accrual basis of accounting, how much would be reported as revenue? A. $15,000 B. $13,000 C. $12,000 D. $11,000 85

86 Section 7 Basic Budgeting What is a Budget? A Budget is a quantified planned course of action over a definitive time period. Budgets reflect the government s plans, policies and goals regarding services and sound resource management. A budget: Considers the organization s goals Forces an organization to consider the demand for services/resources required Translates priorities into resources Highlights potential problems in sufficient time to take corrective actions Is a communication tool revealing an organization s plan for the coming year 86

87 Creates a baseline against which actual results can be compared The budget process is a crucial government activity. Governments are under great pressure to streamline operations and meet strict financial standards at the same time. Just adopting the prior year s budget is not acting in the best interests of the government. Some of the differences in government and private sector are seen in the table to the right. Characteristics of the budget process determine: Quality of decisions made Level of acceptance of budget decisions The budget process promotes linkages and should be well-integrated with: Comprehensive Plan Capital Programming (CIP) Long-range financial plan Policy Development Service/performance targets This is a weakness for many governments. Why? The following page will help to explain this statement. Mission of the Budget Process Governments Provide services and programs for the entire community Budgets focus on public safety and wellbeing of the community as a whole Must fund a wide variety of activities from safe roads and clean water to economic development Subject to a significant number of state and federal mandates or laws that legally require cities to provide certain service but do not provide funding for them Private Sector Provide service to a discreet set of customers Private companies allocate money to meet shareholders or owners expectations for profit Focus spending on narrowly defind programs or services Not subject to such extensive and numerous legally binding mandates that require both provision and levels of service Must not borrow money from a bank but issue debt in the form of bonds to Obtain funds by borrowing money to build build public infrastructure such as roads or improve their business or buildings and brides Use taxing authority to raise funds to provide services and programs often at or below cost Charge for service or programs at a cost that includes a profit Prepare budgets in public and include Prepare budgets in private with no public the public in the process and in the final participation product Information on budget decisions, Detailed budget decision and information revenue and expenditures is public data, on private companies is not public and done done in public in private Governing board must make bugeting decision by consensus Competing interests are a given when governments prepare budgets Must budget for services in good and bad markets based on community needs, goals and objectives Subject to stringent and comprehensive financial controls and public reporting to prevent mismanagement and misuse of public funds Non-governmental organizations often vest decision-making authority in one person Fewer competing interests - making a profit and/or being competitive is typically the focus Make budget decisions based on competition with other businesses and on market conditions Not subject to public accounting and financial controls or public scrutiny of funds and spending activities Data table adapted from information in the League of Minnesota Cities Handbook, Chapter 21 Municipal Budgeting The mission is to help decision makers make informed choices about the provision of services and capital assets, and promote stakeholder participation in the process. To do this you must have a Budget Process that also uses Strategic Budgeting. Budget Process is defined as: Activities that encompass the development, implementation and evaluation of a plan for the provision of services and capital assets For most, time horizon focuses on a 1-year period. Strategic Budgeting is defined as: 87

88 Process that protects a community s long-range goals from being obliterated by the major and minor decisions that are part of annualized budgeting Time horizon greater than 1 or 2 years. 88

89 The essential Features of a good budget process include: Long-term perspective Linkages to organizational goals Focuses decisions on results and outcomes Provide incentives to management and employees Promotes effective communications with stakeholders A stakeholder is defined as: Anyone that has a stake in government Citizens, customers, elected officials, management, employees and their representatives, businesses, other governments, and the media Twelve Elements of the Budget Process Establish Broad Goals to Guide Government Decision Making o Assess community needs priorities, challenges and opportunities o Identify opportunities and challenges for government services, capital assets, & management o Develop and disseminate broad goals Develop Approaches to Achieve Goals o Adopt financial policies o Develop programmatic, operating and capital policies and plans o Develop programs/services that are consistent with policies and plans o Develop management strategies to deliver the strategic plan Develop a Budget Consistent with Approaches to Achieve Goals o Develop a process for preparing and adopting a budget o Develop and evaluate financial options o Make choices necessary to adopt a budget Evaluate Performance and make Adjustments o Monitor, measure, and evaluate performance o Make adjustments as needed Development of Financial/Budgetary Policies Financial Policies are guidelines for operational and strategic decision-making related to financial matters. They Identify acceptable/unacceptable courses of action, establish parameters in which to operate, and provide standard against which fiscal performance can be judged. The essential characteristics should be consistent with broad goals, mutually consistent and integrated into various planning processes, such as: program planning; capital planning; and budget preparation 89

90 which includes a periodic review of policies, including the impact of policies on the budget, and adjustments if necessary. The benefits of financial policies include: Good government practice Streamline decision-making process which provides direction to decision makers Improved control Avoid hazards of short-term horizon for decision making Provide political cover for difficult decisions If state statutes or law are sufficient, financial policies would be redundant for certain items. Try to use the minimum number of controls needed, to help you achieve maximum control and managerial discretion. For a small sized government, you need to consider the level of service standards and programmatic policies. NACSLB has a number of recommendations: Stabilization funds Fees and charges Debt issuance and management Debt level and capacity Use of one-time revenues Use of unpredictable revenues Balancing the operating budget Contingency planning Accounting, auditing, & financial reporting Accounts payable/disbursements Capital Improvement Liability and risk management Purchasing Cash management policies Investment policies Human resource policies 90

91 Outsourcing policies When drafting policies, outline major categories, identify the nature and orientation, consider legal requirements and existing policies, use clear and concise language, and seek input from interested parties. Organizing the Budget Function Remember the budget role is not accounting. While budgeting uses accounting reports, budgeting is more about forecasting and projections. There are legal foundations to the function in a government setting. State or Federal law, municipal charters, and local ordinances all play a part. They all determine the basic framework within which budgeting must be carried out. This includes: o Responsibilities of local officials o Legal actions required to establish an official budget o How detailed must budget enactments be o General schedule for budget enactments o Budget Amendments Budget Preparation manuals are very valuable as they list: o Legal foundations o Budget Calendar o Procedures for preparing and implementing o Policies regarding treatment of various expenditures categories o Standard forms for all budget actions: Submitting requests, requesting new positions, planned capital, etc. When looking at the budget participants, we must realize that this encompasses two broad categories of responsibilities o Executive (Administrative) o Legislative (Policy making) This means that the preparation, adoption, and implementation will require a cooperative effort between the parties. 91

92 Legislative Roles Budgetary and programmatic policies are a legislative role. They are effective in establishing the scope and direction of services and make sure that the needs of residents are met with available resources. These policies are developed long before the preparation of specific budget requests. The legislative role should not concern itself with administrative and financial details which includes organizational structures for how the budget is formulated. A Budget or Finance Committee should be constructive involvement to enhance the process. The role of this committee should: [Note not every entity has a committee] o Review recommended budgetary policies prior to formulation of budget o Important that committee include at least one elected official o Committee monitors budget implementation and various alternatives for long-term service level provision and funding Administrative Roles The administrative role is normally delegated to the Budget Office or the Chief Executive in charge of preparing the budget or his/her designee. This role is responsible for preparing budget proposals; seeing that organizational goals and objectives are met with the budget; explaining current fiscal conditions, fiscal prospect, etc.; and implementing the budget enacted by the legislative body (this includes the organizational structure for formulating the budget). The role of budget function is the focal point for issuing guidelines, reviewing materials, and responding to questions. It is responsible for coordinating and supervising the budget process as well as policy guidance. Coordination Budget calendar Designing budget forms Assisting departments in formalizing budget submissions Preparing revenue estimates Reviewing worksheets for accuracy and completeness Assisting chief executive in preparing a recommended budget 92

93 Policy Guidance Issuing guidelines to departments Evaluating requests and adjusting to policy guidelines Developing budget objectives Balancing expenditure requests with available revenues Making recommendations for budget action to the legislative body Supervision Enduring do not exceed budget limits; approve budget transfers Consultation with departments in meeting operational objectives Reporting on budgetary performance Closely monitoring departmental performance to determine adverse trends Preparing/Adopting the Operating Budget Functions of the Operating Budget The budget is a means not an end. It Turns policy and intentions into services. The budget is a policy document, it determines who gets what and establishes organizational priority. Budgets enable organizations to prioritize resources to attain objectives and they define the scope of specific operational activities. The goal of the budget function is to manage the balancing act between providing funding for vital services, protecting the fiscal health of the whole agency and ensuring the budget meets the goals of elected officials. The budget is a tool for proving services. Budget Function (The Balancing Act) Revenues and expenditures must balance Agency requests consistent with overall priorities and financial policies Budget reflects the sometime contradictory policies and intent of elected officials Long term fiscal health not sacrificed to short term solutions Boards/Councils make informed decisions Common Functions in Budgeting Establish the budget calendar and guidelines Financial policy development Operating budget facilitation and control 93

94 Capital budget facilitation and control Revenue analysis and forecasting Program evaluation, performance measurement, and management analysis Position control Grant Management Long-term financial planning Debt analysis and issuance Other Key Activities Related to the Operating Budget Review individual agency budget requests Analyze estimated expenditures and revenues for the entire organization Review/evaluate proposals for new or expanded programs Align agency requests with organizational goals and priorities Non-departmental specific expenditures (debt service, health care, capital) Departmental Expenditure Analysis Analyze department s historical expenditure data: o Major spending categories and line items historically? o Major variances from year to year? o What factors account for the major variances? o What will be different going forward (legislation, community priorities, and other service cuts)? o How has spending changed over time? Are the changes attributable to known events? o Are activities represented that were never authorized? o Have significant shortfalls occurred in certain areas? o Are the assumptions used to create past funding levels still valid? Examining Personnel Services Costs Look for staffing increases/decreases o Changes in Overtime and Part-Time Personnel savings (surplus) o Are positions reconciled with compensation plan? o Turnover savings Are positions left vacant too long Are positions really necessary for department What are causes of high turnover Impact of Capital Projects on Operating Budget Operating and maintenance costs 94

95 Personnel o Based on total square footage/other facilities, etc. Non-personnel services o Utilities, supplies, equipment New vs. innovations o Potential costs savings of improvements vs. new structures Cost of debt service Reviewing New Proposals/Initiatives Criteria to consider o Does it provide a valuable /needed service? o Legal considerations? o Consistent with the mission and goals of the department? Does it represent a new Goal? o Priority for elected officials? Types of justification o Performance measurement data o Methodology used to determine new spending needs o Explanation as to why the cost can t be absorbed Analyzing Program and Service Delivery Alternatives Mandated program? Appropriate agency to engage in this activity? Is this function available from other governmental or non-governmental entities? Are there policies established which govern how this program is to be delivered? What resources are required, and do they already exist in the agency? Benchmarking other jurisdictions? Tactics Used to Justify/Fund New Proposals Disguise new programs as extensions of existing programs Obtain funding for a pilot/demonstration program Demonstrate that the proposal will produce more revenue than its cost Argue that the expenditure would lead to a reduction elsewhere in the budget Compare the jurisdiction to others match the competition Find/use a political advocate for a program expansion/protection Assess the Implications of Budget Actions Awareness of political issues and personalities o Understand the political environment surrounding your area(s) of responsibility Communicate regularly with departmental and administrative/legislative staff 95

96 Develop relationship with line staff (departments), as they are closest to the clientele. Benchmarking Other Jurisdictions Unique jurisdictional mandates, organizational structures, and other factors affect the data you collect and its relevance to the analysis Have justification for determining the other jurisdictions selected for comparison Departments Main Goal for Departments: Obtain resources sufficient to cover program needs to deliver services Role in the Process: Responsible front-line numbers Provide information about factors that may impact budget Formulate budget request that balances internal and external demands Provide information about services provided Sections within Departments Main Goal: Focus on individual programs Advocates for specific services Key Components: Departmental Budgeting Mission Goals and Objectives Performance Measures Key Issues and Highlights Expenditure Planning Revenue Planning (If applicable) Making the Business Case Making the Business Case The business case should: Define the service(s) addressed by the request Demonstrate how proposal is aligned with organization s strategic plan/goals State measurable outcomes for the service Detail the costs and revenues for the request Address both short-term and long-term costs Address both short-term and long-term impacts If program expansion is necessary, must be able to demonstrate why additional expenditures are needed 96

97 o Statement indicating the impact of not approving the request should be presented Best Practices for Developing Departmental Budgets Should recognize their department is only one of several competing for limited resources Budgets that are presented with solid justification have a better chance of being approved Preparing budgets solely on the basis of an incremental change from the current year s budget are not utilizing the budget as a planning or management instrument Prioritize and make reasonable requests Revenue Forecasting: A Survival Guide Revenue Forecasting Viewed as a technical and arcane exercise that is the domain of budget analysts. PROCESS ; not just a technical exercise Important political and policy implications Process involves many stakeholders internal and external Legislators scrutinize to fund new programs Management base tax policy and expenditure requirements Rating Agencies evaluate financial condition Unions question to improve bargaining position Media looking for headline Forecasting: range of techniques producing estimates of future revenues and expenditures by modeling causal relationships Not an exact science! Projections. not prophecy! Producing Revenue Forecasts Planning the forecasting process typically includes: Identifying the end users of the forecast Identifying specific variables to be used in projections, as well as the time horizon Construction of a model; includes selection of the forecasting techniques 97

98 Identifying external factors that will drive the forecasting model Identify process by which these external factors are projected Step One - Establish base year Step Two - Assess Revenue growth trend What are the characteristics of the revenue? o Is revenue increasing or decreasing o At a stable or exponential rate o Is revenue source deterministic (predictable) or characterized by high degree of uncertainty Step Three - Specify Underlying Assumptions Research consensus about economic conditions, political environment, changes in policies, etc. Assumptions help choose appropriate projection method 98

99 Step Four Select a forecasting method (discussed in another section) Step Five - Assess Reliability and Validity Re-evaluate assumptions o Are assumptions reasonable, given current environment o Are assumptions obsolete because of changes in the environment (if so, Step 3 revisited) Step Six Monitor revenue collections Step Seven Update revenue forecast Major Challenges of Revenue Forecasting What makes survival difficult? Administrative, economic, and political environment always in flux All factors that affect a revenue can never be fully identified Complex forecasting methods are difficult to understand Intrinsically political - fewer resources means politicians can promise and do less Considerations for using forecasting tools (methods) A variety of techniques Forecast will entail a certain level of uncertainty; key assumptions must be communicated to decision-makers Forecasting; art and a science still need for subjective judgment Qualitative Forecasting; producing estimates of future revenue yield with the aid of non-statistical techniques Judgmental Forecasting: Based on a single forecaster s best and reasonable estimate Relies on experience, intuition, and knowledge about the revenue source Expert Revenue Forecasting 99

100 Based on informed opinion of experts (economists, demographers, market researchers, etc.) In general, used to forecast revenues affected by national or regional economic patterns Consensus Forecasting A group collectively reaches agreement: give and take discussion o Similar to judgmental forecasting; projection of revenue based on previous patterns, experience, and historical events The Wisdom of Crowds Revenue sources that have inadequate or unreliable data; can provide a reasonable projection Qualitative Forecasting Major Strengths Accuracy in the absence of sufficient data Consensus o Individuals can reach agreement of the factors used to make projections; less conflict Dependability o Reliable for revenue sources that have a high degree of predictability Relevance o Historical events and relevant factors are included in the forecasting process Simplicity Timeliness o Can be obtained quickly and without manipulating multi-year data Qualitative Forecasting Major Weaknesses Anchoring events o Forecasters focus on certain events they were close to Availability of information o Using data easily available; give more weight to the recent past Illusory correlation o Using independent variables not directly related to revenue being forecasted Selective perception o Ignoring information that is inconsistent with their view of reality Wishful thinking 100

101 o Putting more stock in outcomes that coincide with their outlook on the future Political pressure o Simply raise or lower estimates to satisfy or meet organizational imperatives for balanced budgets Quantitative Forecasting: producing estimates of future revenue yield with the aid of statistical techniques. Trend Analysis: A simple statistical technique used to estimate the growth pattern for a revenue based on historical trends Average historical growth rate Moving averages: A time series statistical technique that uses the average level of revenue in a designated number of periods. Removes both seasonal and random fluctuations Exponential smoothing: A time series technique that applies a weight to data to stabilize data. More weight is given to recent periods; assumed to be better predictors of what will happen in the future Linear regression: Advanced statistical technique; determines the statistical, linear relationship between one independent variable and one dependent variable Demand for pool passes is an independent variable that impact pool pass sales, which is a dependent variable Econometric Forecasting: An advanced regression technique incorporating various economic data as the drivers (independent variables) in the model. The more independent variables included in the model, the more complex the model. Quantitative Forecasting Major Strengths Consistency in methodology use the same technique for projecting future revenue based on historical trends Reliability can assess the extent to which the forecasting model produces accurate results 101

102 Validity can verify whether the most appropriate technique was used given the historical trend of the data. Quantitative Forecasting Major Weaknesses Complexity requires extensive knowledge of statistical techniques and results are not easily communicated to decision makers. Data Intensive requires an extensive amount of historical data (at least 40 data points) for dependable projections Dealing with uncertainty usually underestimates uncertainty by assuming the administrative, economic, and political environment will remain the same 102