17 INTRODUCTION TO FUND ACCOUNTING

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1 Jeter_int_Ch17_ hr.qxd :03 Page INTRODUCTION TO FUND ACCOUNTING LEARNING OBJECTIVES 1 Distinguish between a nonbusiness organization and a profit-oriented enterprise. 2 Explain the role of fund accounting. 3 Distinguish among the concepts of revenues, expenses, and expenditures as used in profit-oriented entities and as used for expendable fund entities. 4 Understand the classification of revenues and other resource inflows for fund accounting. 5 Understand the classification of expenditures and other resource outflows for fund accounting. 6 Describe the critical events in the use of financial resources of an expendable fund. 7 Explain how capital expenditures are recorded in an expendable fund. 8 Understand the role of a general fund. 9 Contrast the consumption and the purchases methods of accounting for inventories (and other prepaid items). IN THE NEWS The 2005 Financial Report of the United States Government provides the president, Congress, and the American public information about the federal government s financial results and position. This report is prepared in accordance with GAAP and is subject to audit by the Government Accountability Office (GAO). For fiscal years ended 2004 and 2005, the GAO was unable to express an opinion on the U.S. government s consolidated financial statements due to material deficiencies in financial reporting. Of the 24 agencies that are consolidated in this report, only 18 received unqualified audit opinions. Four agencies, including the Department of Defense and the Department of Homeland Security, received disclaimers of opinion because of material deficiencies in financial reporting or because they had limited the scope of the auditor s work. These agencies represented 58% of the government s total assets. 1 Accounting for nonbusiness organizations is referred to as fund accounting. Nonbusiness organizations are economic entities that are organized to provide a socially desirable service without regard to financial gain. In contrast, business enterprises are designed to earn a return on investment for equity investors, operate in a competitive market, and face liquidity concerns. 1 Financial Report of the United States (with a forward by Representative Jim Cooper), Nelson Current,

2 Jeter_int_Ch17_ hr.qxd :03 Page 803 Distinctions between Nonbusiness Organizations and Profit-Oriented Enterprises 803 The purpose of this chapter is to introduce the reader to fund accounting concepts and procedures. However, it is first necessary to present a brief introduction to the types and characteristics of organizations that use fund accounting concepts. CLASSIFICATIONS OF NONBUSINESS ORGANIZATIONS Nonbusiness organizations may be separated into five major classifications, as follows: 1. Governmental units. Governmental units include federal, state, and local governmental entities. Local governmental units include counties, townships, municipalities, school districts, and special districts. Special districts include organizational units such as port authorities, industrial development districts, sanitation districts, and soil and water conservation districts. 2. Hospitals and other health care providers. 3. Colleges and universities. 4. Voluntary health and welfare organizations. Voluntary health and welfare organizations are organizations that derive their revenue from voluntary contributions of the general public to be used for purposes connected with health, welfare, or community services. Examples of such organizations include heart associations, family planning councils, mental health associations, and foundations for the blind. 5. All other nonbusiness organizations. Other nonbusiness organizations take a variety of forms. They include such organizations as trade associations (Electrical Contractors Association), professional associations (State Society of Certified Public Accountants), performing arts organizations (the Tennessee Performing Arts Center), museums, religious organizations, and research and scientific organizations. IN THE NEWS With the United States officially in a recession, state and federal funding sources on which charitable organizations rely are drying up... Colleges and universities are seeing a marked increase in requests for financial aid, while hospitals are challenged by having to provide more charity care. These financial struggles have led many organizations to seek alternative revenue sources that are outside their charitable mission and, therefore, are taxable. 2 LO DISTINCTIONS BETWEEN NONBUSINESS ORGANIZATIONS AND PROFIT-ORIENTED ENTERPRISES 1 Nonbusiness organizations versus profitoriented enterprises. The most obvious characteristic that distinguishes a nonbusiness organization from a profit-oriented enterprise is the absence of a primary goal to earn a profit. The services performed by nonbusiness organizations are based on social need rather than on the profit motive. Thus, their financial statements are sometimes referred to as notfor-profit, or nonprofit, financial statements. Other characteristics of nonbusiness organizations also distinguish them from profit-oriented enterprises. For example, persons who contribute resources to a nonbusiness organization do not receive equity interests in the net assets of the organization. Nonbusiness organizations seldom finance their operations through charges to the individuals benefiting from the service. Thus, they must rely on political action (for example, tax levies) or fund-raising campaigns to sustain their activities and replenish their financial resources. 2 Reporting Unrelated Business Income, by Travis Patton and Jocelyn Bishop, Journal of Accountancy, February 2009, p. 52.

3 Jeter_int_Ch17_ hr.qxd :03 Page Chapter 17 Introduction to Fund Accounting GASB CONCEPTUAL FRAMEWORK The GASB has issued five statements on the conceptual framework: Concepts Statement No. 1: Objectives of Financial Reporting Concepts Statement No. 2: Service Efforts and Accomplishments Reporting Concepts Statement No. 3: Communication Methods in General Purpose External Financial Reports That Contain Basic Financial Statements Concepts Statement No. 4: Elements of Financial Statements Concepts Statement No. 5: Service Efforts and Accomplishments Reporting an amendment of GASB Concepts Statement No. 2 In the first concepts statement, the stated objectives of financial reporting are: a. To assist in meeting the government s duty to be publicly accountable by providing information for users to assess if current-year revenues are sufficient to pay for current-year services. b. To determine if the government s resources are obtained and used in accordance with legal or contractual requirements. Financial reporting should allow users to evaluate operating results by providing information about the sources and uses of resources and how the government s activities are financed. In addition, information needs to be provided about the impact of operations on the financial position of the government. Concepts Statement No. 2 develops the objective of clarifying the reporting of service efforts and accomplishments (SEA); it also identifies its elements and characteristics. The objective of SEA reporting is to provide more complete information about a governmental entity s performance than can be provided by the traditional financial statements. The elements of SEA reporting include categories of output and outcome indicators as well as efficiency and costoutcome indicators. SEA information should focus primarily on measures of service accomplishments and measures of the relationships between service efforts and service accomplishments. SEA information also should meet the characteristics of relevance, understandability, comparability, timeliness, consistency, and reliability. In Concepts Statement No. 3, a conceptual basis for determining the methods to present information within general-purpose external financial reports is provided. Communication methods might include recognition in basic financial statements, disclosure in the footnotes, and presentation of supplementary information (whether required or not). This Concepts Statement also addresses the necessary elements for the effective communication of relevant and reliable messages within financial reports. This includes a clarification of the roles and responsibilities of the preparer, the user, and the GASB for the effective communication of information. In Concepts Statement No. 4, seven elements of Statements of Financial Position are defined. These are: Assets resources with present service capacity that the entity presently controls Liabilities present obligations to sacrifice resources or future resources that the entity has little or no discretion to avoid A deferred outflow of resources a consumption of net resources by the entity that is applicable to a future reporting period A deferred inflow of resources an acquisition of net resources by the entity that is applicable to a future reporting period Net position the residual of all other elements presented in a statement of financial position Outflow of resources a consumption of net resources by the entity that is applicable to the reporting period Inflow of resources an acquisition of net resources by the entity that is applicable to the reporting period In Concepts Statement No. 5, four sections of Concept Statement No. 2 were modified and one section was deleted. Concept No. 2 deals with service efforts and accomplishment reporting.

4 Jeter_int_Ch17_ hr.qxd :03 Page 805 Financial Accounting and Reporting Standards for Nonbusiness Organizations 805 IN THE NEWS The government is like a baby s alimentary canal, with a healthy appetite at one end and no responsibility at the other. Ronald Reagan 3 In addition, tax levies and voluntary contributions cannot be justified based on the value of the nonbusiness organization s services to the individuals contributing the money. Those who contribute resources to nonbusiness organizations do not necessarily benefit proportionately or at all from the services provided by such organizations. Because of these characteristics, the net income concept cannot be used to measure the effectiveness of the management of resources dedicated to nonbusiness objectives. Therefore, the income determination model of accounting is generally not applicable to such organizations. In profit-oriented enterprises, net income functions as an implicit regulator in the sense that (1) in the long run, the organization must operate profitably to survive and (2) in the short run, failure to operate profitably will affect management s decisions and actions and perhaps whether management will be replaced. In the absence of this implicit regulator, stringent controls are often imposed to regulate the allocation and utilization of the financial resources of nonbusiness organizations. Such controls may be legally imposed (as in the case of governmental activities) or they may be imposed through formal action of the governing board. Restrictions or limitations on the use of resources may be directly imposed by the individuals or groups that contribute such resources. For example, most nonbusiness organizations receive gifts, grants, or endowments that are only used for specific purposes designated by the donor, such as construction of buildings, research activities, scholarships, operation of parks, recreation programs, or the acquisition of land. In addition, the donor may stipulate that the principal of the gift remain intact and that only the income on the invested principal can be used for the purposes designated by the donor. In order to account for these legally imposed, externally imposed, and self-imposed restrictions or limitations on the utilization of their resources, nonbusiness organizations have generally adopted the concepts of fund accounting. In essence, an organization that uses fund accounting separates the assets, liabilities, and residual equity (known as a fund balance) into distinct funds organized for specific activities or objectives. In fund accounting, each fund consists of a self-balancing set of accounts and constitutes a separate accounting entity created and maintained for a specific purpose. Accounting for the inflow and outflow of resources of each fund is designed so that they can be compared with the approved or stipulated resource flows for that fund. FINANCIAL ACCOUNTING AND REPORTING STANDARDS FOR NONBUSINESS ORGANIZATIONS The potential users of the financial reports of nonbusiness organizations include taxpayers, contributors, grantors, creditors, employees, managers, directors and trustees, service beneficiaries, financial analysts and advisers, brokers, underwriters, economists, taxing authorities, regulatory authorities, legislators, the financial press and reporting agencies, labor unions, trade associations, researchers, teachers, and students. 3 Quoted in New York Times Magazine. From The Merriam-Webster Dictionary of Quotations, Merriam-Webster, Inc.: Infopedia, SoftKey Multimedia Inc., 1996.

5 Jeter_int_Ch17_ hr.qxd :03 Page Chapter 17 Introduction to Fund Accounting IN THE NEWS It was once said that the moral test of government is how that government treats those who are in the dawn of life, the children; those who are in the twilight of life, the elderly; and those who are in the shadows of life the sick, the needy and the handicapped. Hubert H. Humphrey 4 Unlike for-profit organizations and depending on the type of nonbusiness organization, the accounting standards are not established by one unique standardsetting body. Until 1980, the Financial Accounting Standards Board (FASB) and its predecessor bodies gave little, if any, attention to standards of reporting for nonbusiness organizations. In 1980, however, the FASB issued Statement of Financial Accounting Concepts No. 4, Objectives of Financial Reporting by Nonbusiness Organizations. In that statement, the Board identified providers such as members, taxpayers, contributors, and creditors as the most important users for purposes of establishing external financial reporting objectives for nonbusiness organizations. In 1984, the Governmental Accounting Standards Board (GASB) was created. Like those of the FASB, the operations and financing of the GASB are overseen by the Financial Accounting Foundation. The GASB is responsible for establishing financial accounting standards for all state and local governmental bodies, and the FASB is responsible for establishing financial accounting standards for all other nonbusiness organizations. Accounting and reporting standards for governmental units are described and illustrated in this chapter and in Chapter 18. Accounting and reporting standards for nongovernment nonbusiness organizations are described and illustrated in Chapter 19. Illustration 17-1 indicates the standard-setting body (the GASB or the FASB) primarily responsible for determining the accounting standards for various types of nonbusiness organizations. Having two separate bodies establishing accounting standards can be confusing for users of the financial statements. For instance, the financial statements of a state university, such as the University of Tennessee, are prepared using ILLUSTRATION 17-1 Financial Accounting Standards for Nonbusiness Organizations GASB FASB Primary body establishing accounting standards f Governmental Units 1. Federal units Veterans hospitals 2. State units State hospitals State universities 3. Local governments Country government School districts Municipalities Port authorities Nongovernmental Units 1. Private colleges, universities, and community colleges 2. Private hospitals and voluntary health and welfare organizations 3. Other nongovernmental units Private elementary schools Professional organizations Labor unions Civic organizations Trade associations Nonbusiness organizations 4 Excerpt from a 1977 speech. From The Merriam-Webster Dictionary of Quotations, Merriam-Webster, Inc.: Infopedia, SoftKey Multimedia Inc., 1996.

6 Jeter_int_Ch17_ hr.qxd :03 Page 807 Fund Accounting 807 GASB rules, while a private university, such as Vanderbilt University, prepares its financial statements under the guidance of the FASB. Currently, there are significant accounting differences in rules between the FASB and the GASB. It is important for users of not-for-profit financial statements to have an understanding of the standards provided by both the GASB and the FASB. In this chapter and Chapter 18, the GASB rules are illustrated for governmental units; in Chapter 18, the hierarchy of generally accepted reporting standards for governmental entities is described; and in Chapter 19, the FASB s standards for other nonbusiness organizations are presented. FUND ACCOUNTING LO 2 The role of fund accounting. Fund accounting is designed primarily to meet internal reporting and control objectives; thus fund accounting may not be sufficient in itself to meet the objectives of financial reporting by nonbusiness organizations. Nevertheless, it does provide a basis for determining the fiscal responsibility and status of the organization and the compliance of administrators with the approved or stipulated receipt and utilization of financial resources. Therefore, fund accounting is an important means of meeting several of the accounting, control, and reporting objectives of most nonbusiness organizations. Fund entities may be classified in a number of different ways. For example, they may be classified as expendable fund entities, fiduciary fund entities, and proprietary fund entities. Expendable fund entities are the funds most closely associated with basic fund accounting concepts, while proprietary fund entities are the nonbusiness funds that are most similar to business entities. Fiduciary funds entities are used to follow the activities in which the government acts as an agent or trustee for resources that belong to others, such as employee pension plans. Expendable Fund Entities LO3 Differences in applications of revenues, expenses, and expenditures. Expendable fund entities consist of net financial resources that are dedicated to a specified use. Thus, separate expendable fund entities are established based on the purpose for which financial resources may or must be used. Examples of funds set up for specific purposes include a capital projects fund created to account for new highway construction or a debt service fund created to account for interest and principal payments on long-term debt. Thus within a government, many funds are established. Financial resources consist of cash and claims to cash such as receivables and investments in marketable securities. The difference between the financial resources of an expendable fund entity and claims against those resources is referred to as the fund balance. Thus, the statement of financial position, or balance sheet, for an expendable fund entity reflects the financial resources of the fund, the claims against those resources, and the fund balance. Typically, assets and liabilities are not subdivided into current and noncurrent assets and liabilities. At a particular time the fund balance represents the net financial resources that are available for expenditure for the specified purposes or objectives for which the fund was created. The financial resources of an expendable fund entity are not intended to be maintained intact. Ordinarily it is intended that they will be expended annually or over some other specified time period in order to carry out the objectives for which the fund was created. The measurement focus is on the flow of current financial resources in contrast to proprietary fund accounting, where the measurement focus is on the flow of economic resources.

7 Jeter_int_Ch17_ hr.qxd :03 Page Chapter 17 Introduction to Fund Accounting The relevant measures of the operations of expendable fund entities are not, therefore, revenue, expense, and net income, but rather increases in fund resources, decreases in fund resources, and the change in the fund balance. The accounting model for the operating statement of an expendable fund entity is: Financial resources inflows (by source) - Financial resources outflows (by function) = Change in fund balance Thus, increases in fund resources include not only revenues, but also items such as proceeds from debt issuances and transfers from other funds. Decreases in fund resources include expenses, other expenditures, and transfers to other funds. However, the term expense as defined under GAAP is typically not used with fund accounting. Instead the term expenditure includes expenses as well as other items giving rise to cash (or other resource) outlays, without regard to timing or the matching with revenue that is an integral part of income determination under GAAP. Conversely, expenses may include items that are not current expenditures because of the timing of the outlay. The operating results of expendable fund entities are thus measured in terms of inflow, outflow, and balances of net current financial resources assigned to the fund. The appropriate operating statement for such entities is essentially a statement of changes in net financial resources. To provide a basis for comparison, both budgeted and actual resource flows may be presented in the operating statement or in related schedules. Later in this chapter, we describe the modified accrual basis commonly used in fund accounting, and the need for accrual-based reporting under GASB Statement No. 34. In summary, in accounting for expendable funds, the emphasis is changed from matching revenues and expenses to a comparison of the actual inflows and outflows of financial resources with stipulated or approved resource flows. The objective in accounting for expendable fund entities is to measure the extent to which management has complied with the regulations or restrictions that govern the use of expendable fund resources. A secondary objective is to assist management with such compliance. Restricted and Unrestricted Fund Entities Expendable fund entities may be further classified as restricted or unrestricted. This classification is usually applicable to nonbusiness organizations other than governmental units. The unrestricted expendable fund entity includes the net current financial resources of the nonbusiness organization that are available to carry out the primary or general activities of the organization at the discretion of the governing board. Current financial resources that are restricted by donors or other outside agencies for specific current operating purposes are included in restricted expendable fund entities. The term restricted refers to resources that bear a legal restriction as to use imposed by parties outside the organization. The primary purpose of this distinction is to assist in the determination of the current financial resources that are available for use at the discretion of the governing board and those over which the governing board has little, if any, discretion as to use because of externally imposed restrictions. As illustrated in Chapter 19, most nonbusiness organizations other than governmental units have one unrestricted fund and one or more restricted funds.

8 Jeter_int_Ch17_ hr.qxd :03 Page 809 Fund Accounting 809 Proprietary Fund Entities Proprietary fund entities are used to account for the activities of nonbusiness organizations that are similar to those of business enterprises. Many nonbusiness organizations engage in quasi-commercial activities. The operation of an electric or water utility by a municipality and the rental of real estate by a religious organization are examples of such activities. Accordingly, even though these activities are accounted for in separate fund entities, relevant accounting measurements and reports are similar to those applicable to profit-oriented enterprises and focus on the determination of net income, financial position, and cash flows. The accounting model for the statement of financial position of a proprietary fund entity is similar to a for-profit firm and is represented as follows: Assets Current and Noncurrent = Liabilities Current and Noncurrent + Equity Net Assets The accounting model for the statement of revenues, expenses, and changes in fund net assets of a proprietary fund entity is presented as follows using the allinclusive format: Operating revenues Less: operating expenses = Operating income Plus (minus): nonoperating revenues and expenses = Income before other revenue, expenses, gains and losses, and transfers Other revenue, expenses, etc.: capital contributions, additions to permanent and term endowments, special and extraordinary items = Increases (decreases) in net assets Plus: net assets beginning of period = Net assets end of period Fiduciary Fund Entities Fiduciary funds include both trust and agency funds. Trust funds are funds where the government acts as trustee for an individual or organization. An example of a trust fund might be a pension trust fund in which the fund accounts for the accumulation of resources for pension benefit payments to employees, police, and firefighters of the city. An agency fund accounts for resources of various taxes, bonds, and other receipts held for individuals, outside organizations, and/or other funds. Budgetary Fund Entities (Governmental Funds) In the traditional compliance model of reporting on the operations of governmental units, actual and approved (or stipulated) inflows and outflows of resources are compared. Approved resource flows are incorporated into annual budgets. In some instances the budget for an expendable fund entity is so important (often because of legal requirements) to management control of fund resources that entries for budgeted revenues and expenditures are recorded in the books. Fund entities in which the budget is formally incorporated into the accounting records are sometimes referred to as budgetary funds. (This is illustrated later in the chapter.)

9 Jeter_int_Ch17_ hr.qxd :03 Page Chapter 17 Introduction to Fund Accounting The preparation, use, and importance of budgets for governmental units cannot be overemphasized. The annual budget for a governmental unit is usually prepared by the executive branch of the governmental unit. It is then presented to the legislative branch for consideration and enactment. In the case of annually levied taxes such as property taxes, adoption of budgeted revenue amounts may require the enactment of enabling legislation. In the case of continually levied taxes such as sales taxes and income taxes, no new legislation authorizing the tax is ordinarily required for the adoption of the budgeted amounts of revenue. When budgeted expenditures are enacted into law, they are referred to as appropriations. Appropriations represent the maximum expenditures that are authorized by the legislature. As such, they represent (by budget category) amounts that cannot be legally exceeded unless subsequently amended by the legislative body. Accordingly, the accounting system must provide administrators of governmental units with timely information as to actual expenditures and allowable expenditures (appropriations) by budget category. In addition, financial reports must be prepared in such a way that the legislature or its representatives can determine that the spending limits authorized by it have not been exceeded. The approved budget may, therefore, be formally recorded in the accounting records of the appropriate fund(s). Such formal budgetary account integration is useful in assisting in the control and administration of fund resources. Basis of Accounting The basic financial statements of a government include two sections; governmentwide financial statements and fund financial statements. Government-wide financial statements report on all the nonfiduciary activities of the government and provide both short- and long-run information about the financial status of the government. In addition to reporting the government funds statements on a modified accrual basis, a government-wide Statement of Activities and a government-wide Statement of Net Assets are required. 5 The government-wide financial statements are prepared using the economic resources measurement concept and the accrual basis of accounting (this is also appropriate for proprietary and fiduciary fund entities.). Governmental fund (expendable funds) financial statements are reported using the current financial resources concept and the modified accrual basis of accounting. Financial resources of an expendable fund entity include cash, receivables, and securities that can be converted into cash. Revenues are recognized when they are measurable and available. Revenues are available when they are collectible within the current period or soon enough to pay liabilities of the current period. Governments are required to disclose the length of time used to define available for use for purposes of defining revenues. The cash basis of accounting is not appropriate. Under the modified accrual approach, it is not sufficient for an economic event to occur to affect the operating statement. Instead, the related cash flow must occur within a period short enough to have an effect on current spendable resources. In other words, revenues must be both measurable and available to liquidate liabilities of the current period. 5 Governmental Accounting Standards Board (GASB), GASB Statement No. 34, Basic Financial Statements and Management s Discussion and Analysis for State and Local Governments (Norwalk, CT: June 1999).

10 Jeter_int_Ch17_ hr.qxd :03 Page 811 Fund Accounting 811 RELATED CONCEPTS Government-wide financial statements are now presented on an accrual basis. One reason for the change is that accrual accounting better assists users in assessing whether the costs of services were shifted to future periods. Also, this information will assist users in determining whether a government s financial position has improved or deteriorated. The term expenditure rather than expense is used for governmental funds. Expenditures are recorded when a liability is incurred, similar to accrual accounting. However, because governments generally do not attempt to allocate costs to periods benefited and because some expenditures of the expendable fund entities are not recognized in the period in which they are incurred, the term modified accrual accounting is also used. Therefore, expenditures are recognizable when an event is expected to use current spendable resources (rather than future resources). Before proceeding further, it is useful to contrast the concepts of revenue, expense, and expenditure as they are used in relation to profit-oriented entities and to expendable fund entities. Profit-Oriented Entities (Income Determination) Revenues increases in net assets resulting from the sale of goods or services. Expenses costs of resources used to produce current period revenues. Unusual, Infrequent, and Extraordinary Items Extraordinary items are items that are both unusual in nature and infrequent of occurrence; they are reported net of taxes. Items that are either unusual or infrequent, but not both, are shown on a separate line, if material, but are not shown net of taxes. Expendable Fund Entities Revenues any increase in (source of) net current financial resources other than increases from other financing sources (as defined below). Expenditures any decrease in (use of) net current financial resources other than decreases from other financing uses (as defined below); or the amount of financial resources expended during the period to carry out the operations and activities of the fund entity. Other Financing Sources and Uses (and Transfers) proceeds from debt issuances and transfers of financial resources to and from other funds. Special and Extraordinary Items Extraordinary items are both unusual in nature and infrequent of occurrence. Special items are significant transactions within the control of management that are either unusual or infrequent. In the remainder of this chapter, fund accounting concepts are developed within the framework of state and local governmental units. IN THE NEWS When President Barack Obama signed the American Recovery and Reinvestment Act of 2009 into law, the largest deficit in American history is almost guaranteed (doubling the deficit of 2008). In January, the Congressional Budget Office projected that the deficit this year would be $1.2 trillion before the stimulus package. That's more than the entire GDP of all but a handful of countries, and more, in nominal dollars, than the entire United States national debt in Classification of Revenues LO 4 Revenues are classified by fund and by major revenue source. Major sources of revenue for state and local governmental units are summarized in Illustration Classification of revenues. As shown, the number of sources of revenue available to governmental units is impressive when compared with those available to business enterprises. 6 WSJ, February 17, 2009, A Short History of the National Debt by John Gordon.

11 Jeter_int_Ch17_ hr.qxd :03 Page Chapter 17 Introduction to Fund Accounting ILLUSTRATION 17-2 Major Sources of Revenue for State and Local Governmental Units Property taxes Grants from federal, state, or local government units Income taxes Shared revenues from federal, state, Sales and excise taxes or local government units Gift and inheritance taxes Payments in lieu of taxes from federal, state, Fines and penalties or local government units Gifts and donations Interest earned on loans and investments Forfeits Licenses and permits Sales of property Charges for services Other Financing Sources Debt Issue Proceeds Governmental units may finance their operations through the issuance of bonds or other debt instruments. Although debt issue proceeds are sometimes classified as revenue of a particular fund entity, they are not revenue from the point of view of the issuing governmental unit because of the offsetting debt. Accordingly, debt issue proceeds should be classified separately from revenue for purposes of financial reporting. Debt issue proceeds are accounted for as other financing sources. Transfers of Resources from Other Funds Transfers of resources from other fund entities within an organization do not represent an increase in the expendable financial resources of the organization as a whole. Accordingly, even though they represent an increase in the financial resources of the recipient fund entity, they should ordinarily be classified separately from revenue for financial reporting purposes. Interfund operating transfers are accounted for as other financing sources, or uses. Recognition of Revenue In accounting for profit-oriented enterprises, revenue is ordinarily not recognized until (1) a transaction has taken place (that is, the amount of revenue can be objectively measured) and (2) the earnings process is complete or substantially complete. Criterion 2 is not applicable to expendable fund entities. The revenue-recognition criteria for expendable fund entities can be stated as follows: In accounting for expendable fund entities, revenue is ordinarily not recognized until (1) it can be objectively measured and (2) it is available to finance expenditures of the current period. Many sources of fund revenue do not meet the criteria of measurability and availability until they are received in cash. On the other hand, significant amounts of revenue (for example, property taxes, pledges, regularly billed charges for routine services, and some types of grants) meet both criteria and are recognized as revenue prior to the receipt of cash. The application of these criteria to several significant sources of revenue of governmental units may be illustrated as follows. Property Taxes Property taxes usually meet both criteria when levied. The amount of property tax is precisely determinable when levied and the amount of uncollectible taxes ordinarily can be reasonably estimated on the basis of previous

12 Jeter_int_Ch17_ hr.qxd :03 Page 813 Fund Accounting 813 experience. Thus, the amount of property tax revenue is objectively determinable at the time the taxes are levied. Ordinarily, taxes are also considered to be available in the period levied, even though they are collectible in a period subsequent to the levy, because (1) they provide a basis for obtaining cash resources through the issuance of tax anticipation notes 7 and (2) they are usually collectible early in the subsequent period and thus are available to finance current period operations. Income Tax and Sales Tax Self-assessed taxes such as the income tax and the sales tax usually are not objectively measurable or available until the tax returns are filed with payment. Where the tax returns have been filed but payment is delayed, revenue should be recognized when the returns are filed, assuming that a reasonable estimate can be made of noncollectible amounts, if any. In addition, sales taxes held by merchants may be recognized as revenue before they are received by the fund entity if the measurability and availability criteria are met. Fines and Forfeits The amounts of fines, forfeits, inspection charges, parking meter receipts, and so on, are not objectively determinable or available until assessed or collected and are, therefore, not normally recognized as revenue until collected. Sales of Property The entire amount of proceeds from the sale of property is treated as revenue at the time of sale because expendable assets are increased and are available to finance current expenditures in the same manner as any other revenues. Pledges and Grants A pledge to contribute resources is considered revenue at the time it is made, so long as a reasonable estimate of uncollectible pledges can be made and there is no restriction on the time period in which the pledged resources can be expended. Grants may or may not be recognized as revenue at the time the grant is authorized. If the grant is dependent on the performance of services, or if the expenditure of funds is the prime factor for determining the eligibility for the grant funds, revenue should not be recognized until the time the services are performed or the expenditures are made. Grants that are not dependent on performance or expenditure of funds should be recognized in the period in which they are authorized. IN THE NEWS Did the U.S. deficit increase or decrease in 2005? The answer to this question depends on how you measure the deficit. The commonly used definition (and the one used by President Bush) is based on cash accounting and is often quoted as being $318.5 billion. Under this measure the deficit decreased for However, using the accrual basis (which is required of private-sector firms), the deficit was $760 billion, which was significantly worse than the $600 billion deficit in the prior year. 8 7 Tax anticipation notes are notes or warrants issued in anticipation of the collection of taxes and are usually retirable only from the proceeds of the tax levy whose collection they anticipate. 8 Financial Report of the United States (with a foreword by Representative Jim Cooper), Nelson Current, 2006.

13 Jeter_int_Ch17_ hr.qxd :03 Page Chapter 17 Introduction to Fund Accounting Classification of Expenditures and Other Resource Outflows LO5 Classification of expenditures. As mentioned earlier, an expenditure is any decrease in net current financial resources other than transfers to other funds. Thus expenditures are not matched to the production of current revenues as are expenses for profit-seeking enterprises. Expenditures may be classified by fund, by function and/or activity, by organizational unit, by character (nature of the expenditure), or by object class. Since different classifications serve different purposes, multiple classification of expenditures is usually recommended. For example, the various classifications might be illustrated as follows: Function Public Safety Organizational Unit Fire Department or Police Department Activity Drug Control Character Current Operating Object Class Supplies or Salaries Classification by Function and Activity Typical functional classifications of expenditures for state and local governmental units are presented in Illustration Classification by function refers to the broad purposes for which expenditures are made. Classification by activity refers to the specific types of work performed to accomplish such purposes. For example, public safety is a major function of a municipality. The function of public safety may be divided into subfunctions such as police protection, fire protection, and protective inspection. The subfunction of police protection can be classified into activities such as criminal investigation, vice control, patrol, custody of prisoners, and crime laboratory. Functional and activity classifications are particularly important and are the classifications ordinarily recommended for published financial reports. In addition, as noted by the National Council on Governmental Accounting: Activity classification is particularly significant because it facilitates evaluation of the economy and efficiency of operations by providing data for calculating expenditures per unit of activity. That is, the expenditure requirements of performing a given unit of work can be determined by classifying expenditures by activities and providing for performance ILLUSTRATION 17-3 Functional Classification of Expenditures for State and Local Governmental Units General Government Health and Welfare Legislative Judicial Recreation Cultural Executive Playgrounds Elections Swimming pools Financial administration Golf courses Parks Libraries Public Safety Police Fire Urban Redevelopment and Housing Inspection Public Works Highways and streets Sanitation Economic Development and Assistance

14 Jeter_int_Ch17_ hr.qxd :03 Page 815 Fund Accounting 815 measurement where such techniques are practicable. These expenditure data, in turn, can be used in preparing future budgets and in setting standards against which future expenditure levels can be evaluated. Further, activity expenditure data provide a convenient starting point for calculating total and/or unit expenses of activities where desired, e.g., for make or buy and do or contract out decisions. Current operating expenditures (total expenditures less those for capital outlay and debt service) may be adjusted by depreciation and amortization data... to determine activity expense. 9 Classification by Organizational Unit and by Object Class Classification of expenditures by organizational unit is important for management, control, and internal reporting purposes including responsibility accounting. Classification of expenditures by organizational unit is based on the departments, divisions, bureaus, or other administrative units that make expenditures to carry out their designated functions. Examples include police department, attorney general s office, corporation commission, city planning, and the like. Each organizational unit may have responsibility for several functions or activities. In some instances a function or activity may cross organizational unit lines. Classification of expenditures by object class identifies what is acquired in return for the expenditure (i.e., the types of items purchased or services obtained). Typical object classifications are presented in Illustration Classification by object is useful primarily for internal management and may be omitted from published financial reports. ILLUSTRATION 17-4 Classification of Expenditures by Object Class Personal Services Salaries Employee health and retirement benefits Payroll taxes, etc. Supplies Office supplies Operating supplies Small tools Other Professional services Telephone and telegraph Travel Rental (equipment, buildings, machinery) Postage and shipping Printing and publications Repairs and maintenance Insurance Miscellaneous Capital Expenditures Land Buildings Improvements Machinery and equipment Motor vehicles Furniture and furnishings Office machines 9 National Council on Government Accounting, Statement 1: Governmental Accounting and Financial Reporting Principles (Chicago: Municipal Finance Officers Association of the United States and Canada, 1979), pp

15 Jeter_int_Ch17_ hr.qxd :03 Page Chapter 17 Introduction to Fund Accounting Transfers to Other Funds Transfers of resources to other fund entities within an organization do not represent decreases in the expendable financial resources of the organization as a whole. Accordingly, even though they represent a decrease in the financial resources of a particular fund, they ordinarily should be classified separately from expenditures for financial reporting purposes. Recognition of Expenditures LO 6 Critical events in the use of financial resources. An expenditure is one of four critical events in the use of the financial resources of an expendable fund entity. The sequence of events is as follows: Appropriation or authorization Encumbrances Expenditure Disbursement Appropriation Appropriations represent the maximum amount of expenditures that entities are authorized to spend. Administrators are responsible for expending fund resources only in the amounts and for the purposes prescribed in the appropriations act. In the case of governmental units, administrators are held strictly accountable for the provisions of the appropriation act, and stiff penalties are provided by law for those who fail to follow them. Thus, an important function of financial statements is to let administrators know how they stand relative to their appropriation authority. Furthermore, accounting safeguards must be in place to prevent the misuse of fund resources. Encumbrance Since the amount of an appropriation cannot be legally exceeded, the placing of purchase orders and the signing of contracts are critical events in controlling the expenditures of expendable fund entities. The financial resources of a fund are said to be encumbered when a transaction is entered into that requires performance by another party before the governmental unit becomes liable to perform its part of the transaction by spending financial resources. An encumbrance reduces the remaining portion of appropriations encumbered and is formally recorded in the accounting records. Thus, at any particular time the accounting records will reflect management s remaining available appropriation authority as follows: Appropriations - (Encumbrances + Expenditures) = Unencumbered balance The unencumbered balance is the amount of resources that can still be obligated or expended without exceeding the legal or authorized limit. Encumbrances are recorded as follows: Purchase Order (Encumbrance) (1) Encumbrance (appropriately classified) 10,000 Reserve for Encumbrance 10,000 To record an order for goods in the amount of $10,000. Expenditures An expenditure is a decrease in fund resources or an increase in fund liabilities that occurs when the vendor or supplier performs on a contract or purchase order and goods or services are received. Expenditures are recognized in the accounting period in which the fund liability is incurred, except for unmatured interest on long-term debt, which is recognized when due, and certain compensated absences and claims and judgments, which are recognized when obligations are

16 Jeter_int_Ch17_ hr.qxd :03 Page 817 Fund Accounting 817 expected to be liquidated with expendable available resources. Thus, an expenditure and a corresponding liability or cash disbursement is recorded at the time goods or services are received or at the time funds are granted to an authorized recipient. When the goods ordered in (1) above are received, the following entries are made: Receipt of Goods (Expenditure) (2) Expenditures (appropriately classified) 12,000 Vouchers Payable 12,000 To record the receipt of goods invoiced at $12,000. (3) Reserve for Encumbrance 10,000 Encumbrance 10,000 To remove the encumbrance recorded in (1) for goods received and recorded as an expenditure in (2). In this case, the goods cost $2,000 more than was estimated when the order was placed. Disbursements Disbursements represent the payment of cash for expenditures. Such payments may precede the expenditure (an advance), coincide with the expenditure (a direct payment), or follow the expenditure (the payment of a liability). The payment for the goods purchased in (2) above is recorded as follows: Payment of Goods (4) Vouchers Payable 12,000 Cash 12,000 To record payment of vouchers payable. Encumbrances and expenditures are classified on the same basis (by fund, function, organizational unit, activity, character, or object class) as appropriations. The effect on appropriation control of incorporating appropriations, encumbrances, and expenditures into the accounting records is demonstrated in Illustration 17-5 for an imaginary budget line item number 103. In Illustration 17-5, it is assumed that the appropriation for budget category 103 is $50,000 and that the amount of expenditures in this category prior to the entries illustrated above was $15,000. The effects of entries (1), (2), (3), and (4) on the subsidiary ledger card for budget category 103 are to reduce the unencumbered balance by $12,000 (the amount of the actual expenditure). The most important thing to note is that at any particular time, information is available to administrators concerning their unexpended and uncommitted appropriation authority. ILLUSTRATION 17-5 Subsidiary Ledger Control Card for One Budget Category Function: Sanitation; Activity: Sanitary Sewer Cleaning; Object: Operating Supplies (E) (D) Unencumbered (A) (B) (C) Total Balance Budget Line 103 Appropriation Encumbrance Expenditure (B) (C) (A) (D) Prior Balance $50,000 $ $15,000 $15,000 $35,000 Purchase Order [entry (1)] 10,000 10,000 (10,000) Balance 50,000 10,000 15,000 25,000 25,000 Expenditure [entries (2) & (3)] (10,000) 12,000 2,000 (2,000) Balance $50,000 $ $27,000 $27,000 $23,000