During each year, usually monthly, city finance staff prepares financial statements for the city council. At the end of the fiscal year, the auditors spend one to three months preparing their report and audited financial statements, which they ultimately present to the city council. What do the numbers in these financial statements mean? Are they important? How can city councilmembers better understand them? This chapter answers these questions and addresses other city financial reporting issues.
Georgia cities are subject to specific accounting and financial reporting guidelines, standards, and rules. The Department of Community Affairs has developed a local government uniform chart of accounts
that municipal governments began using in 2000. In addition, the Governmental Accounting Standards Board
(GASB) issues financial reporting standards that municipal governments must implement. This chapter discusses these requirements and standards.
Financial reports are classified according to their content and the purposes for which they are issued. Different types of financial reports may be issued for different user groups according to how the reports will be used (internal or external) and when they are completed (interim or annual).
Interim financial reports are typically prepared monthly by management, normally for internal use, including that of the city council. Most cities issue some type of interim report to assist with their day-to-day management. Annual financial reports, which include data regarding operations in the previous year, are designed for external readers, such as citizens or bond rating services. Annual reports are less useful to city councilmembers because of the timing of their preparation. Because these reports are usually independently audited by a certified public accounting firm, it may take up to six months after the close of the fiscal year to complete this annual report. In addition to the regular annual report, some cities prepare a comprehensive annual financial report, which includes introductory, financial, and statistical information.
Types of Statements
Generally, governments prepare two types of financial statements: balance sheets (sometimes called statements of net position) and operating statements (sometimes called statements of activities or statements of revenues and expenditures/expenses). Balance sheets are financial statements that present what the city owns, what it owes, and what its worth is (i.e., fund balance or net position).
Operating statements are directed toward control over revenues and expenditures/expenses in the primary operating funds. The budgetary operating statement, which includes revenues and expenditures/expenses that are compared with the final revised budget and changes in fund balance, is most commonly used. A budgetary operating statement should be most useful to city councilmembers, particularly during the year, because it compares budgeted revenues with actual revenues and budgeted expenditures/expenses with actual expenditures/expenses. This kind of statement allows councilmembers to monitor overspending and to determine if revenues are being received as projected.
Municipal Versus Business Finances
Before one can understand city financial statements, it is important to note the differences between the financial operations of a municipality and those of the business world. Cities have objectives that are different from those of commercial enterprises; they operate in a different economic, legal, political, and social environment. Cities use capital assets to provide services, whereas businesses use capital assets to generate revenues. These differences often require accounting and financial reporting techniques unique to local governments.
Business enterprises exist to maximize economic profits. The “bottom line,” or profits and losses presented on an operating statement, is a reasonable indicator of the success of a business. For a city, however, the bottom line usually is not an accurate indicator of its success. If a city reports more revenues than expenditures in a fiscal year, is that good? If a city spends more than it receives in a fiscal year, is that bad? Whether a city reports more revenues than expenditures or spends more than it receives in a fiscal year is not all-important. The primary objective of a city is to provide services to its constituents within budgetary constraints. There is little regard for the bottom-line concept. The GASB financial reporting standard (discussed below) tends to move some city financial reporting toward private-sector accounting as statements are summarized and accounting entries are done like the business world.
In business, substantial discretion is allowed in obtaining and using resources. By contrast, Georgia municipal government financing and spending activities are subject to very specific legal and contractual provisions. To adequately review city financial reports, councilmembers should be familiar with municipal legal requirements.
Annual Operating Budget
Each year, Georgia cities adopt a budget showing where the money to operate the city comes from and how it will be spent. The annual operating budget plays a more expanded role in municipal government than it does in business. Budgets are an important internal planning tool for both business and government, but in municipal government they also play an important external role. Because a city is a public entity, parties inside (e.g., department directors) and outside (e.g., citizens) the city government may participate in the development of the annual operating budget. The law requires Georgia cities to conduct public budget hearings in which interested parties have an opportunity to ask questions and offer suggestions about the proposed budget. In most cities, very few people participate in budget hearings, but occasionally interested constituents attend budget hearings to express their opinions. For example, because the size of the budget usually affects property taxes, it is not uncommon for property owners to attend budget hearings. Once the city council adopts the budget, it establishes spending limits that cities normally cannot exceed unless the council legally changes (i.e., amends) the budget. These limits create spending constraints for city administrators that usually do not exist in the private sector.
Accounting and Financial Reporting
Generally accepted accounting principles (GAAP) are the accounting rules followed by most accountants in business and government alike. GAAP provide a set of uniform minimum standards and guidelines for financial accounting and reporting. Therefore, all financial statements prepared on a GAAP basis are comparable, regardless of the legal jurisdiction or geographic location of the government. Georgia law requires cities to prepare their audited financial statements in conformity with GAAP.
GAAP is used differently in business and government. The Governmental Accounting Standards Board (GASB) establishes GAAP for governments, and the Financial Accounting Standards Board sets standards for business. GASB, a nonprofit entity located in Norwalk, Connecticut, is made up of a full-time chairperson and six part-time board members and has a research and technical activities director and a permanent staff of accountants working under the direction of the chairperson. When applied to business financial statements, GAAP provide information (i.e., the profit or loss) that investors and creditors need to decide whether (and how much) to invest in stock or to loan money to a particular business. By contrast, individuals do not invest capital in government; therefore, governmental GAAP financial statements emphasize legal compliance (e.g., budget information).
Because city councilmembers have oversight responsibility for municipal financial operations, the rules that GAAP provide for preparing financial information to demonstrate accountability are very useful. Councilmembers are responsible for setting financial policies, which includes determining how much money the city may spend through the adoption of the annual operating budget and monitoring progress toward meeting those budgetary goals.
Most cities have independent audits conducted in conformity with GAAP and generally accepted governmental auditing standards
(GAGAS). GAGAS consist of the auditing rules that independent certified public accountants (CPAs) must follow when auditing municipal financial statements. In an independent audit, the CPA expresses an opinion as to the fairness of a city’s basic financial statements in conformity with GAAP. In other words, the auditor verifies that the financial statements present fairly the financial position and results of operations for the year ended.
Why Are Cities Audited?
The GASB and the Government Finance Officers Association
(GFOA) have long recommended that the financial statements of all local governments be audited independently in accordance with GAGAS. In addition, Georgia law requires cities that spend at least $300,000 annually or have a population in excess of 1,500 to be audited annually; most other cities are required to be audited at least every two years. Because cities operate largely on involuntary resources in the form of taxes, which are entrusted to elected and appointed officials for the provision of public services, an audit by an independent certified public accounting firm is essential to ensure that public funds have been expended as legally required. There is another significant reason for an independent audit: because some of the country’s larger cities have experienced financial difficulties, buyers of local government debt securities often rely on financial statements as a basis for investment.
City officials can realize many benefits from obtaining independent audits:
Types of Audits
- The results of financial and compliance audits can help elected and appointed officials in their decision-making roles.
- The additional assurances provided by audited financial statements and the audit testing of legal compliance allow officials to make more confident decisions concerning the future of municipal operations.
- Audit results also may point the way to constructive changes that benefit the city and its officials.
- Audits include a review of a city’s internal accounting controls, which helps curtail circumstances permitting inefficiencies or fraud.
Most independent audits conducted on behalf of cities are classified as both financial and compliance audits, whereas audits in the private sector are almost always financial audits. A financial and compliance audit expands the scope of the audit beyond validating financial records to include the city’s compliance with various finance-related legal and contractual provisions. This aspect of auditing is very important because, as mentioned earlier, municipalities must operate within a legally regulated environment.
Most cities in Georgia have an annual audit conducted by a CPA, in accordance with GAGAS. One type of financial audit is the single audit mandated by the provisions of the 1996 amendments to the U.S. Single Audit Act of 1984. The purpose of the single audit is to have one city-wide audit that will encompass not only local resources, but also all state and federal grants.
The Uniform Chart of Accounts
In 1997 the Georgia General Assembly passed legislation with significant implications for municipal financial reporting. As required by the legislation, the Georgia Department of Community Affairs (DCA) developed a local government uniform chart of accounts and a set of community indicators that allows state and local policymakers to monitor the social and economic conditions of Georgia communities. The primary purpose of a state chart is to provide a uniform format for local government financial reporting and accounting, allowing state agencies to collect more reliable and meaningful financial data and information from local governments. It is currently in its third edition
All Georgia cities are required to comply with this uniform chart of accounts in reports to state agencies. Cities must also classify their transactions in conformity with the fund, balance sheet, revenue, and expenditure classification descriptions in the chart, and their accounting records should reflect these account classifications. Although local governments are not required to use the chart’s numbering system in their own accounting systems, they may find that using the uniform chart of accounts for accounting purposes facilitates their financial reporting to DCA and other state agencies.
The DCA requires local governments to submit reports on their services and operations
as a condition of receiving state-appropriated funds from the department. These reports are produced using data from the local government finance and operations surveys administered by the department. The community indicators report is developed using data from these surveys and other sources for all local governments in the state with annual expenditures of $250,000 or more. A community’s report focuses on demographic patterns, economy, finance, education, health, social environment, civic participation, and selected municipal government services. Any city that receives state funds from the governor’s emergency fund or from a special project appropriation must submit a grant certification form to the state auditor in conjunction with its annual audit. This form requires the city council and the auditor of the city to certify that the grant funds were used solely for the purpose for which the grant was made. Failure to submit this certification results in forfeiture of the grant and the return of any grant funds already received by the local government. If cities do not receive a specific amount of grant funds, a single audit is not required.
Fund accounting requires cities to keep separate records for each individual fund, which includes having a separate balance sheet and operating statement. GAAP define a fund as an entity with separate accounting records for a specific activity. For example, a city might account for a state grant in one fund and record the proceeds from a building bond sale in another fund. GAAP encourages cities to keep the minimum number of funds to be in legal compliance. Fund accounting can complicate manual bookkeeping. The use of a computer and computerized government accounting systems for fund accounting greatly simplify the process.
Generic Fund Types
For city councilmembers to be able to read and understand city financial statements, they need to know the nature and purpose of 11 fund types (defined by GAAP as generic fund types), which are grouped into three categories. These categories are important because the accounting rules that cities must follow may be applied differently to each of the fund categories.
Figure 1 presents a fund organizational chart illustrating the three categories and the relationship of categories A, B, and C to the 11 generic fund types. The categories are briefly described here:
- Governmental fund types. Used to account for general municipal functions (e.g., police department, public works, parks and recreation).
- Proprietary fund types. Used to account for city activities that are similar to private-sector businesses (e.g., water and sewer, other utilities).
- Fiduciary fund types. Used to account for assets held by a city in a trustee or agent capacity (e.g., the city is the administrator of a trust for nongovernment purposes).
Five generic fund types are categorized within governmental funds:
- General fund. Used as the chief operating fund for the city. All financial resources not required to be reported in another fund are accounted for in the general fund. Departments like streets, parks and recreation, clerk, and general government are normally here.
- Special revenue funds. Used to account for resources that are legally or administratively restricted for specific purposes. A federal grant fund might be classified here.
- Capital projects funds. Used to account for resources restricted for major capital outlays. The proceeds from building bond issues to build new libraries that will be repaid from property taxes would be accounted for here.
- Debt service funds. Used to account for the payment of principal and interest on general long-term debt, such as a building bond issue.
- Permanent funds. 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 city’s programs (that is, for the benefit of the city or its citizenry). For example, the perpetual care of a cemetery that the city operates could be classified as a permanent fund.
The two following generic fund types are classified as proprietary fund types:
- Enterprise funds. Used to account for operations that are financed and operated in a manner similar to business enterprises. Public utilities are the most common city activity reported in this way.
- Internal service funds. Used to account for operations that provide goods or services primarily to other departments within the same city on a cost-reimbursement basis. Cities often report as internal service funds activities such as data processing, motor pools, and print shops. Normally the larger cities use internal service funds.
Included in the fiduciary fund are:
- Agency funds. Used as holding accounts for assets belonging to some entity other than the city. For example, a trust for nongovernment purposes is classified as an agency fund.
- Pension trust funds. Used by cities to account for their own (single employer) pension plans. In other words, the retirement assets held for the city’s employees who have retired or will retire are reported here. Only a few Georgia municipalities maintain their own single employer pension plans.
- Private purpose trust funds. Used to report trust arrangements under which principal and income benefit individuals, private organizations, or other governments. These funds do not benefit the reporting city.
- Investment trust funds. Used to report external investment pools.
The GASB establishes financial reporting requirements for state and local governments throughout the United States. Its goal is to provide a framework for governmental financial reporting that is easily understood and comparable to others, both in the public and private sector. GASB requires two levels of reporting in the annual financial report: fund-level reporting and government-wide reporting.
Fund-level Financial Reporting
GASB requires municipalities to provide information about funds in annual reports. To sharpen the focus of financial statements, cities are required to report information about their most important (or “major”) funds, including the city’s general fund, separately and their less important (or “nonmajor”) funds in the aggregate.
Fund statements assess the “operating results” of many funds by reporting the amount of cash on hand and other assets that can easily be converted to cash. These statements show the performance (in the short term) of individual funds using the same indicators that many cities use when financing their current operations.
Fund-level reporting basically requires municipalities to present balance sheets and operating statements for each fund category (i.e., governmental, proprietary, and fiduciary). In addition, cities are required to provide budgetary comparison information in their annual reports, both original and final with explanations regarding the changes. Many cities revise their original budgets over the course of the year for a variety of reasons.
Requiring cities to report their original budget in addition to their revised budget increases the usefulness of the budgetary comparison.
Government-wide Financial Reporting
Municipal financial managers are asked to share their insights in a required management’s discussion and analysis (MD&A) by giving readers an objective and easily readable analysis of the government’s financial performance for the year. Municipalities include government-wide financial statements in their annual financial report, prepared using accrual accounting for all of the government’s activities. Most governmental utilities and private-sector companies use accrual accounting, which measures not only current assets and liabilities, but also long-term assets and liabilities, such as capital assets (including infrastructure) and general obligation debt. It also reports all revenues and all costs of providing services each year, not just those received or paid in the current year or soon after year-end (like the modified accrual basis). Cities are to prepare both a government-wide balance sheet (known as the statement of net position) and a government-wide operating statement (known as the statement of activities), with aggregate governmental activities and aggregate business-type activities.
These government-wide financial statements help users
- assess the finances of the city in total, including the current year’s operating results
- determine whether the city’s overall financial position improved or deteriorated
- evaluate whether the city’s current-year revenues were sufficient to pay for current-year services
- understand the cost of providing services to its citizenry
- see how the city finances its programs through user fees and other program revenues versus general tax revenues, and
- understand the extent to which the city has invested in capital assets, including roads, bridges, and other infrastructure assets.
Basis of Accounting
When does a city record the sale of water? When the customer uses the water, when the city reads the meter, or when the customer pays the bill? The basis of accounting answers this type of question. Basis of accounting refers to when revenues, expenses (on the accrual basis of accounting) or expenditures (on the modified accrual basis of accounting), and related assets and liabilities are formally recognized in the accounting process and reported in the financial statements.
Like basis of accounting, the “measurement focus” (an interrelated concept) is reflected in a municipality’s financial statements. Measurement focus indicates what the financial statements are trying to communicate; that is, what is being measured by the statements. Most cities use two types of measurement focus:
- Current financial resources measurement focus. Financial statements using this focus, commonly known as “flow of funds,” report only current assets (i.e., those that the city can convert to cash quickly) and current liabilities (i.e., those due in the short term) on their balance sheets. The difference between these assets and liabilities, or the fund balance, is considered to be the amount available for spending. On these statements, the emphasis is on accountability. The financial data and information assist city councilmembers in their oversight function.
- Economic resources measurement focus. Financial statements using this focus report all assets and liabilities on their balance sheets. The difference between all assets and all liabilities is the capital, or equity, of the fund. On these statements, the emphasis is on “profit” or “loss.” City councilmembers can thereby monitor financial projections.
Measurement focus determines what is measured in the financial statements; the basis of accounting determines when transactions are formally recognized in the financial statements. When measurement focus is determined, the basis of accounting to be used is determined as well. Basis of accounting is a difficult concept. However, in order to understand municipal financial statements, city councilmembers need to understand the different bases of accounting and which funds in their city use which basis at which financial reporting level.
GAAP find two bases of accounting acceptable for cities: accrual and modified accrual. Other existing bases are unacceptable. The most common unacceptable basis of accounting is the cash basis. On the cash basis, the city records the revenue when the money comes in; when the city writes the check, it reports the cost. While using this type of basis may be simple, ultimately it is not truly informative. The cash basis of accounting fails to recognize receivables and payables (i.e., amounts still due to or owed by the city). Therefore, under the cash basis of accounting, the financial statements do not accurately represent the financial position or results of city operations.
The Accrual Basis of Accounting
Cities use the accrual basis, which is used by most major corporations, in all government-wide statements and for their proprietary and fiduciary fund types. When cities use the accrual basis, they report revenues in the financial statements when they earn revenue: a city earns the revenue when it provides the service. For example, when a resident waters his or her yard, the city has provided for the use of water and earned that revenue, even though the city does not record the revenue until the water meter is read and the number of gallons the customer used is calculated. A city reports expenses when they are incurred; that is, when the city owes a supplier for an item purchased or owes an employee for a service performed. For example, once an employee works one day, an expense is incurred because the city owes the employee a day’s pay. GAAP has special rules regarding when cities must formally recognize taxes and grants.
Using the accrual basis of accounting, a city can purchase capital assets (equipment, vehicles) and report them on the balance sheet as assets and not as costs in the operating statement. However, each year the city must include in the operating statement a charge for the use of each capital asset, based on its estimated useful life. This charge is called depreciation.
On the accrual basis of accounting, all liabilities (both short term and long term) are included on the balance sheet. For example, when a city issues long-term bonds for an enterprise fund (e.g., the water fund), the bonds payable are reported as a liability on the balance sheet of the enterprise fund, but this transaction is not reported on the operating statement. When a portion of the principal is paid, the liability is reduced, but the operating statement is not affected. However, any interest costs are reported as an expense.
The Modified Accrual Basis of Accounting
The other acceptable basis of accounting, the modified accrual, is used by cities to report their governmental fund types at the fund reporting level. Under modified accrual accounting, revenues are reported when they are considered to be available—not when they are earned, as in the accrual basis of accounting. Availability of revenue (i.e., when it is formally recognized as revenue) primarily differentiates these two bases of accounting.
“Available” means the city will collect the revenue in the current year or shortly after the end of the year to pay liabilities from the current year. For example, if the fiscal year ends on June 30 and the city will receive revenue for that fiscal year in July, it will probably be reported as revenue as of June 30, as long as it relates to the year just ended. However, if the available revenue is not received until December, it will probably not be reported as revenue for the year ending June 30 because it cannot be used to pay outstanding liabilities on June 30.
On both the accrual and modified accrual bases of accounting, an expense or expenditure, respectively, is recognized when the liability is incurred, but the due date for payment of a liability affects how it is reported. If payment for the liability is not due at year-end, on the modified accrual basis, the liability is not reported as an expenditure at the time incurred. On the accrual basis, the due date of the payment, or when the city pays the liability, does not affect when the city reports the expense.
On the modified accrual basis, cities report capital assets, such as equipment and vehicles, as expenditures on the operating statement; they are reported as assets on the balance sheet on the accrual basis. However, because the city has acquired assets, these purchases also are reported separately in the city’s capital asset system but not on its governmental fund type balance sheet. When the modified accrual basis of accounting is used, depreciation is not reported in the operating statement because the city already has reported the total cost of the capital asset as an expenditure when purchased.
Long-term debt generally cannot be reported on the balance sheet of a fund that uses the modified accrual basis of accounting. When a city sells bonds and cash is received, the proceeds from the sale of bonds are reported on the operating statement in a special section called “other financing sources/uses.” Although the city must pay back the principal on the bonds, the liability is not reported in the governmental fund type. Therefore, a balance sheet at the fund level for governmental funds will not include any long-term liabilities. However, cities do report both their capital assets and their long-term debt at the government-wide reporting level, as the basis of accounting there is the accrual basis.
To summarize, when it comes to fund accounting it is about what you measure when you look at financial statements. The accrual basis measures total resources (capital assets and non-current debt), while the modified accrual basis measures the current resources (cash, receivables, payables, etc.).