Lending to Municipalities

Transcription

1 BANKERS INSIGHT GROUP, LLC Lending to Municipalities Understanding Their Unique Differences BIG BANKERS INSIGHT GROUP, LLC JEFFERY W. JOHNSON

2 LENDING TO MUNICIPALITIES AND OTHER GOVERNMENT UNITS INTRODUCTION American governmental units can be traced to 15 th century England and even further to the Roman Empire where local government was formalized. In Roman times, cities, were established and granted corporate status as subdivisions of the Roman Empire. These subdivisions had little independent rights and powers because they were established for Roman Administrative purposes instead of permitting self-rule. During the 15 th century, England governmental units, particularly cities, enjoyed some democratic powers, including the ability to tax locally. In exchange for these powers, the cities or towns were required to make payments to the Crown. The legal relationship between the city and the Crown was formalized through a written charter, a term used today in many states to describe the legal powers of certain municipalities. It is upon this foundation that American municipalities, including cities, towns, villages and boroughs were based. Counties are a separate and even older form of local government. It is believed that counties origin predates the 15 th English Kingdom. Counties have traditionally been designated as political subdivisions of some larger governmental body, and in earlier times, they were established for ease of governmental administration. Townships have their origins as administrative subdivisions of English counties. In the United States today there are many variations of local governments. Forms of local government are defined and legislated by state governments, which accounts for the many differences in terminology and in the meaning of similar terms for local government from state to state. Page 1

3 TYPES OF LOCAL GOVERNMENTS STATE A state is a compulsory political organization with a centralized government that maintains a monopoly of the legitimate use of force within a certain geographical territory. Some states are sovereign (the quality of having independent authority over a geographic area, such as a territory), while others are subject to external sovereignty or hegemony (where ultimate sovereignty lies in another state). The denomination state is also employed to federated states (a territorial and constitutional community forming part of a federal union) that are members of a federal union (a political entity characterized by a union of partially self-governing states or regions under a central federal government), which is the sovereign state. Not only does the state determine which local governments exist within its boundaries, but it also determines their powers, which can vary greatly from state to state. It is very important for a creditor to understand these powers, including: Ability to tax. Ability to issue debt. What types of activities the municipality can be involved in. Under what circumstances the voters (or the state) must approve any of the above. The ability of the municipality to increase tax rates or issue additional debt can be important secondary sources of repayment for debt. In addition to the state, the municipal charter may limit the taxation and debt powers. Under the federalist system in the United States, the U.S. Congress and the federal government should not interfere with a state's right to exercise its ability to control its municipalities. As we will see in later modules, the state is also a potential deep pocket for the municipality that runs into financial trouble. However, the states vary in their fiscal situation, and the financial condition of the state is one consideration in our credit evaluation process. Page 2

4 COUNTY The county is a political subdivision of a state and is generally defined by territorial limits. The county is viewed as an involuntary political division of the state, unlike cities, which are voluntary corporations organized by their own citizens for the purpose of obtaining rights of selfrule. Counties in most states are governed by state law and have no local lawmaking abilities. For example, Ohio law defines a county as a subdivision of the state, organized for judicial and political purposes. According to the state constitution, the county "is not a legal person or a separate political entity with any of the attributes of sovereignty...it is a mere agency of the state for certain specific purposes." In most states, counties (or parishes, as they are called in Louisiana) have state mandated forms of organization, including designation of county offices, whose holders are elected by county voters. As the largest and highest administrative political subdivisions of a state, counties may contain within their territorial borders other political subdivisions, including townships, cities, villages, and other forms of Municipality. These political subdivisions feature their own distinct political definitions and powers as designated by the state constitution and/or code of law. CITY The definition of a city varies from state to state, and states may make the important distinction between incorporated and unincorporated cities. Cities typically are created automatically from villages that grow to a certain size. For example, a village might automatically become a city when it grows to a population of 5,000 or more registered voters. BOROUGH A borough is a political subdivision used in a small number of states that resembles either a village or a city as we have defined them here. Depending on the state, a borough may be incorporated or unincorporated. TOWNSHIP Townships generally are subdivisions of counties, created by the state legislature and, in some cases, given limited powers of local government. The function of the township differs widely among the states, especially in the degree to which the township can exercise government powers. For example, in some New England states, the township (sometimes called town) is an unorganized subdivision of the county that has minimal political infrastructure. In many states, the township is an electoral and administrative district of the county, with stand-alone governance in areas such as zoning, road maintenance, parks, and fire protection. Page 3

5 TOWN The common usage of the word town has come to mean virtually any size and political configuration of a municipality. In many states, the term town has no legal meaning, although it is defined by some state constitutions as a municipal corporation with full home-rule rights. In this course, we will refer to incorporated municipalities as cities, but lenders should be sure to investigate and understand any legal distinction between a town and a city in their home states. VILLAGE In most states, a village is established by vote of residents in an area of a township. In some states, a village is considered an incorporated area, with the power to run its own affairs when its actions do not specifically conflict with state government. SPECIAL DISTRICTS State legislatures sometimes create additional political subdivisions called districts. These districts are created for special purposes and have limited powers, such as school districts, fire districts, water districts, etc. In most states, these districts are taxing districts and are considered quasi corporations with specific rules regarding tax levies and daily operations. MUNICIPAL CORPORATIONS Municipal corporations can include cities, villages, and, in some states, townships and boroughs, depending on state law. Incorporation is voluntary, by vote of the citizens of an unincorporated area. In most states, the effect of incorporation for a city, village, etc. is to establish a greater degree of self-governance. Non-incorporated areas of a state must abide by a generic set of state statutes and constitutional guidelines, whereas incorporated areas may, in a sense, customize the state provisions to meet their citizens' specific needs and preferences within limits. In this course, we will refer to any incorporated city, village, township, or other political subdivision as municipal corporations. In most states, counties (and, in some states, townships) are not generally regarded as municipal corporations because they are created involuntarily by the state instead of voluntarily by petition of the electorate. Unless a power or action directly contradicts state legislation, an incorporated municipality's rights are almost always superior to those of its surrounding county. Page 4

6 INTRODUCTION TO GOVERNMENTAL ACCOUNTING The objectives of governmental accounting are to follow the flow of funds to determine how government is using taxpayers money and being able to compare inflows and outflows to budgets. Fund accounting does a good job in meeting both of these objectives. As stated earlier, GASB issued Statement 34 in 1999, which changed the GAAP reporting method for governments and their financial reports issued after Now municipalities complying with GAAP must issue reports with some of the schedules using full accrual accounting and other schedules using fund accounting. FUND ACCOUNTING A fund is a fiscal and accounting entity with a set of accounts recording cash and other financial resources. They are segregated for the purpose of carrying on specific activities or attaining certain objectives. Consequently, governments establish different funds for specific functions. Funds are often funded from property taxes, income or sales of goods and services. They may also receive funds from grants from other government entities; from fines, licenses and user fees as well as charges for government-provided services Resources within Funds can only be expended in support of their defined function. For example, a fire department fund may not make expenditures to pay expanses of a city s parks and recreation department. Each fund has its own asset, liability, revenue and expense accounts. Full and separate financial statements must be prepared for each fund at the end of each fiscal period. Page 5

7 TYPES OF FUNDS Funds must fall into one of nine types Funds (called generic Fund types) and then grouped into three categories of Funds. In addition to the categories of Funds, governments maintain what are called account groups, which are not Funds actually, but special classifications used to account for fixed assets acquired and long-term debt incurred by government funds. A government can have many funds, some with very broad purposes (such as general city operations) and some with very narrow purposes (such as a city fund that exists to account for one state grant). Despite the potential number and variety of funds for even the smallest municipal government, all Funds must fall into one of the aforementioned nine types and grouped into one of three categories. The three fund categories are as follows: Governmental Fund: Used to account for a government's general operations, such as police, fire, and recreation. Proprietary Funds: Used to account for a government's activities that are similar to business entity activities, such as city-owned electric utilities, water services, or a transit system. Fiduciary Funds: Used to account for assets held by a government in its capacity as trustee or agent, such as estates willed to a city or a government pension plan. Each of the nine generic Fund types mentioned earlier falls into one of these three fund categories. The nine Fund types, organized by Fund category, are as follows: Governmental Funds General Fund: used to account for all resources not specifically accounted for in another fund. Most government financial transactions take place in this fund, and each government should maintain only one general fund. Page 6

8 Special Revenue Funds: used to account for resources that are legally restricted for specified purposes, such as a public library whose revenues are derived from a special tax levy for its support. Capital Projects Funds: used to account for resources used in the acquisition or construction of major capital projects, such as a municipal building. This fund exists only during the acquisition or construction process and is closed once the project has been completed. Debt Service Funds: used to account for resources that repay principal and service interest expense on general purpose long-term debt, such as a building bond issue. Permanent Funds: resources that are legally restricted so that only the earnings generated from investing the money can be spent. An example would be a case in which a wealthy individual donates money to the municipality in his or her name, with the principal to be held in perpetuity and the earnings to be spent for the city's senior citizen centers. Proprietary Funds Internal Service Funds: used to account for the financing of goods or services provided by one department or agency of the government to another. These goods and services are provided at cost and only to the government's own departments or agencies, never to the general public. Central purchasing and printing services are two examples. Enterprise Fund: used to account for operations of the government that charge for services to the general public. Examples include cost-recovery enterprises, such as swimming pools whose operation is intended to be paid for through user fees, as well as enterprises the government intends to operate for profit, such as a sports arena or electric utility. Fiduciary Funds Trust Funds: used to account for assets held by the government as trustee. One example would be a trust created after a gift of land to a city. The trust fund would be considered an expendable trust fund if the donor stipulated that the land might be either sold or maintained by the city; it would be a non-expendable trust fund if the donor stipulated that the land must be held by the city forever, such as land donated to establish a city market. In the case of the market, the city would generally be permitted to use any revenues from operating the market, but it could not resell the property. Page 7

9 Agency Funds: used to account for assets held by the government as the agent for employees or another government. Examples include a county property tax account that holds collected property taxes for periodic distribution to municipalities, and city employee health care premium withholding funds. Page 8

10 FUND FINANCIAL STATEMENTS Financial statements must be prepared for each fund, including a balance sheet and a Statement of Revenues, Expenditures, and Changes in Fund Balances.' The following condensed financial statements show the presentation format for each statement. Balance Sheet Governmental Fund Balance Sheet Current Assets $XXX Current Liabilities $XXX Fund Balance: Reserved $XXX Unreserved $X XX Total Liabilities and Total Assets $XXX Fund Balance $XXX Notice that the balance sheet has a short-term focus on resources available to support the fund's purpose. There are no long-term assets or liabilities shown on the balance sheet, because these are not accounted for within the individual governmental funds. Instead, they are included in account groups, separate non-fund accounts used for the government's long-term capital assets and long-term debt. Short-term debt on the fund balance sheet includes such accounts as accounts payable, accrued payroll, or short-term notes such as tax anticipation notes Current assets might include cash and investments, receivables such as facility-use fees in the case of revenue funds, due from other governments, and inventory (supplies, for example) The fund balance account is parallel to a business's shareholders equity account, but there are some important differences between the two. Page 9

11 The fund balance is divided between unreserved, e.g., amounts available to the governing board for future use, and reserved. Reserved amounts of the fund balance have been set aside by the governing board for obligations or commitments for which monies will be needed in the future. Reserved amounts are generally encumbered funds that have been set aside for a specific future purpose. They are not expenditures but are treated in almost the same way as expenditures in governmental accounting. When a government obligates itself to pay for something, the amount needed to pay the obligation is set aside immediately. This method of recording "pre-spent" funds serves as a control function to prevent overspending. Page 10

12 STATEMENT OF REVENUES, EXPENDITURES, AND CHANGES IN FUND BALANCES Revenues Expenditures Excess of Revenues over Expenditures Other Financing Sources or Uses Excess of Revenues and Other Items over Expenditures and Other Items Fund Balance, Beginning of Fiscal Period Changes in Reserves of Fund Balance Fund Balance, End of Fiscal Period XXX XXX XX X XX X X XX Note that this statement is divided into three major sections: The top section is the operating section and includes revenues less expenditures for the period, showing the difference as the excess of revenues over expenditures or expenditures over revenue The middle section, other financing sources or uses, includes non-revenue items such as bond proceeds and some inter-fund transfers. The bottom section is the reconciliation of unreserved fund balance, and it reconciles the unreserved fund's ending balance for the result of operations. Any other financing sources or uses, changes in the reserved portion of the fund, and any equity transfers with other funds. BASIS OF ACCOUNTING (Accrual, Cash & Modified Accrual) Financial Statements and Tax Returns can be prepared on Cash or an Accrual Basis. The difference in the two accounting methods is vast. Both methods have their advantages and disadvantages. Unfortunately, bankers often do not have a say in type of accounting method the client will present unless while a problem loan situation in which the banker mandates the type of accounting method. Accrual Basis Financial statements prepared on an Accrual Basis will recognize all economic events regardless of the collection of cash at the point of sale or the payment of costs and expenses at the time the costs and expenses are incurred. Simply stated, the Accrual Method records all economic transactions that a normal entity will incur on a day-to-day basis. The advantage of the Accrual Method is that the user will see all the accounting transactions in a given period thus providing Page 11

13 the opportunity to perform a thorough analysis on the entity. The disadvantage is that the Accrual Method does not indicate the amount of cash generate or used by the entity. Cash Basis Financial statements prepared on the Cash Basis will recognize economic events only when cash is collected from sales and paid out for costs and expenses. It is meant to present a more conservative look at the performance on an entity by ignoring transactions that do not generate cash or use cash. Companies that use this method do not want to Count Their Chickens Before They Hatch, so to speak. Since the Cash Basis only reflects cash transactions, there is no need to perform a Cash Flow Analysis because the financial statements are on a Cash Basis already. The disadvantage is that the user of the financial statements will not see all of the economic events an entity incurred and as such, a thorough analysis of the entity cannot be performed. Cash Basis of accounting is often used by law, accounting, engineering, architectural firms and many other similar service related businesses because collections of amounts due from clients may take longer than other entities that provide a vital product that is critical to the production of goods and services. In Fund accounting, the cash basis is not generally acceptable, and government entities that adhere to GAAP must use both accrual accounting and a third basis, the modified accrual basis, in recording their transactions. Governments are required to use both methods, applying the modified accrual basis to most funds and the accrual basis to a few funds. MODIFIED ACCRUAL BASIS The modified accrual basis is a hybrid system that includes some aspects of accrual accounting and some aspects of cash basis accounting. Highlights of the modified accrual basis follow: Revenues are recognized in the accounting period in which they become available and measurable. Available means the revenues are collected in the current year or soon enough thereafter to pay liabilities from the current year. Under the modified accrual basis, some types of revenue are actually recognized nonetheless on the accrual basis, including property taxes, firm intergovernmental grants and revenues, interest on investments, income and sales taxes, and regularly billed charges for services, so long as they will be received in a relatively short time after fiscal year-end. Property taxes can be accrued if they will be received within 60 days after fiscal year-end. Page 12

14 Expenditures are recognized in the accounting period in which the fund liability is incurred, if measurable, which is similar to the accrual method. However, if the liability will not be liquidated with current resources, it is not reported as an expenditure at the time incurred. There are exceptions to the application of these rules, such as recognition of un-matured interest on general long-term debt and on special-assessment debt secured by interest-bearing special assessment levies, which are always recognized when due. Fixed assets and long-term debt are not recorded on the balance sheets of funds that report on a modified accrual basis. Fixed assets are considered an operating expenditure of the fund where the purchase is made and also as an asset in the non-fund fixed assets account group. Similarly, long-term debt is considered a financing source on the fund's operating statement, as well as a liability in the non-fund long-term debt account group. When debt is repaid, it is considered an operating expenditure (usually in the debt service fund) as well as a reduction of liability in the general long-term debt account group. Under the modified accrual basis, depreciation may be reported (optionally) in the fixed assets account group, but it is not recognized as an expenditure of the fund owning the asset, because the full amount of the purchase was originally recognized as an expenditure when the asset was acquired. Page 13

15 FUND CATEGORIES AND TYPE OF ACCOUNTING METHODS Government Fund Government Funds are accounted for on the Modified Accrual Basis. Their fundamental focus is flow-of-funds and the availability of resources for short-term expenditures. The difference between assets and liabilities, or fund equity, is considered available for spending instead of viewed as long-term capital. This perspective is compatible with the short-term focus of the modified accrual basis; recall, for example, that a fixed asset is fully accounted for as an expenditure instead of being capitalized and depreciated as under the accrual basis. Proprietary Fund Proprietary Funds are accounted for on the accrual basis. They include the internal service fund and the enterprise fund. Both of these funds are in common with business enterprises: Each is established for government operations that have management objectives for both income and capital maintenance. An example of a Proprietary Fund is a sports arena which is operated for a profit. As a feature of the accrual accounting basis, these funds record their own long-term assets, and they recognize depreciation on those assets. They also record long-term debt and accrue interest expense. Fiduciary Funds Fiduciary Funds are accounted for on either the accrual or the modified accrual basis, depending on fund purpose. For example, agency funds usually have a focus on the flow of current resources that are held in agency by the governing unit, a temporary custodian of those resources. The short-term perspective of these funds means they should be accounted for on the modified accrual basis. On the other hand, other fiduciary funds have a capital maintenance objective, such as the non-expendable trust funds. For example, the fund that supports bequeathed land for a city market clearly has a longer-term focus and would be accounted for on the accrual basis. It is important to understand the basis of accounting used by a local government borrower, and this information should always be disclosed in the footnotes to the government's financial statements. Page 14

16 FINANCIAL REPORTING ENTITY A financial reporting entity should include: 1. The primary government. 2. Organizations for which the primary government is financially accountable. 3. Other organizations for which the nature and significance of their relationship with the primary government are such that exclusion would cause the reporting entity's financial statements to be misleading or incomplete. A primary government is defined as a state, a general-purpose local government (city, county, etc.), or a special-purpose government (school district, special district, etc.) A special-purpose government qualifies as a primary government only if the following conditions are met: 1. It has a separately elected governing body. 2. It is legally separate (can sue and be sued and buy property in its own name). 3. It is fiscally independent of other governments (establishes its own budget, levies its own taxes or sets its own charges, and issues its own long-term debt or bonds). If a special-purpose government is not legally separate, it is reported with the primary government that holds its corporate powers. The financial reporting entity must include all component units. Component units are any other legally separate organizations that the primary government is financially accountable for or that should be included to prevent the financial statements from being misleading or incomplete. Financial accountability exists if: I. The primary government appoints a majority of the governing body. Page 15

17 2. The primary government can impose its will on the organization (such as remove appointed members of the governing board at will, modify or approve the budget, or overrule decisions of the board). Most component units are presented in separate columns on the financial statement. However, if the activities are intertwined with those of the primary government (such as both boards are the same or the component unit provides services chiefly to the primary government), the activities of the component unit will be blended into those of the primary government. FINANCIAL REPORTING UNDER GASB 34 GASB 34 requires the following at a minimum for GAAP-prepared external financial statements for governments: 1. Management discussion and analysis (MD&A). 2. Basic financial statements that include a combination of fund financial statements, government-wide financial statements, and notes. 3. Required supplementary information. The MD&A section is a narrative in which the management highlights the operating results of the municipality for the year and the reasons for changes, such as the opening or closing of a major employer's facility. The basic financial statements currently have the following format: 1. Government-wide Statements a. Statement of Net Assets b. Statement of Activities 2. Fund Financial Statements a. Governmental Funds I. Balance Sheet II. Statement of Revenues, Expenditures, and Changes in Fund Balances Page 16

18 Ill. Reconciliations to the Government-wide Statements b. Proprietary Funds I. Statements of Net Assets or Balance Sheet II. Statement of Revenues, Expenses, and Changes in Fund Net Assets III. Statement of Cash Flows c. Fiduciary Funds I. Statement of Fiduciary Net Assets II. Statement of Changes in Fiduciary Net Assets 3. Notes to the Financial Statements Page 17

19 COMPREHENSIVE ANNUAL FINANCIAL REPORT (CAFR) The CAFR is a voluntary report format that many state and local governments choose to use for financial reporting. The CAFR is a very detailed report that goes beyond the requirements of GAAP. It covers all funds and account groups and all financial transactions that took place during the year. The CAFR is more than a financial report, in that it contains supplementary information that is useful to a variety of audiences. The CAFR includes three sections: Introductory section, including the government's organizational structure, nature and scope of its services, agencies included in the reporting entity, a summary of the government's financial activities, and the details of its legal operating environment. Financial section, including the independent auditor's report, financial statements, footnotes, and schedules. Statistical section, including statistical tables designed to give a more detailed and comprehensive picture of the government's financial tables than is provided by the financial section. Accompanying this course is a portion of a CAFR for Bloomington, Illinois, a small to mid-size city. Excerpts of this CAFR is a part of your materials. Page 18