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wiL79603_ch09_353-406.qxd 1/2/09 10:14 PM Page 353 ntt MC OS10:Desktop Folder:TEMPWORK:January 2009:MHBR093_02-01-09:ch09: Chapter Nine Financial Reporting of State and Local Governments Learning Objectives After studying this chapter, you should be able to: 1. Describe the concepts related to the financial reporting requirements of the GASB reporting model. 2. Explain the key concepts and terms used in describing the governmental reporting entity. 3. Apply the GASB criteria used to determine whether a potential component unit should be included in the reporting entity and, when included, the manner of reporting component units. 4. Identify and describe the contents of a comprehensive annual financial report (CAFR). 5. Understand how to reconcile governmental fund financial statements to governmental activity in the government-wide financial statements. 6. Identify and explain contemporary financial reporting issues. Chapters 2 through 8 present extended discussions of the principles of accounting for governmental, proprietary, and fiduciary funds and governmental and businesstype activities at the government-wide level. Chapters 1 and 2 provide overviews of Governmental Accounting Standards Board (GASB) financial reporting requirements, and financial reporting requirements for specific fund types are discussed in several chapters. This chapter presents the reporting requirements in more depth and discusses contemporary financial reporting issues. Prior to examining reporting requirements, a brief conceptual discussion of financial reporting is provided. CONCEPTS RELATED TO FINANCIAL REPORTING GASB Concepts Statement 11 identifies two objectives of government financial reports: to provide information that can be used to assess a government’s accountability and to assist users in making economic, social, and political decisions. The 1 GASB, Codification, Appendix B. 353 wiL79603_ch09_353-406.qxd 1/2/09 10:14 PM Page 354 ntt MC OS10:Desktop Folder:TEMPWORK:January 2009:MHBR093_02-01-09:ch09: 354 Part One State and Local Governments primary users of government financial reports are those external to government; principally, citizens, legislative and oversight bodies, and creditors. For the financial reports to be useful in meeting identified objectives, GASB indicates that the information provided in the reports should be understandable, reliable, relevant, timely, consistent, and comparable. An important part of providing useful information is communicating the information in a manner that is helpful to the user. GASB Concepts Statement 32 provides guidance regarding where and how items of information should appear in financial reports to be the most useful. The areas identified for communicating items of information are recognition in the financial statements, disclosures in the notes to the financial statements, presentation as required supplementary information, or presentation as supplementary information. GASB indicates that an item of information that meets the definition of an element and is measurable with sufficient reliability should be recognized in the financial statements. A note should be used if it can help support an item recognized in the financial statement or provide information that is essential to the user’s understanding of the item. An example of the relationship between recognized items and notes can be conveyed with the Investments account. Without a note disclosure relating information on fair values and risk exposure, the user is left without information that is relevant in assessing the quality and management of the government’s investments. Required supplementary information (RSI) and supplementary information are used to communicate information that is essential and useful, respectively. Without RSI the financial statements and related notes cannot be placed in the correct context. Examples of RSI include the budget to actual schedules (Chapter 3) and several pension disclosures (Chapter 8). Other supplementary information is useful but not essential in understanding the financial statements and related notes. Much of the supplementary information is found in the statistical section of the comprehensive annual financial report (CAFR). As indicated, before an item can be recognized in the financial statements it must meet the definition of an element. GASB Concept Statement 4,3 provides for seven financial statement elements. The elements are assets, liabilities, deferred outflows of resources, deferred inflows of resources, net position, outflows of resources, and inflows of resources. Since governments use two bases of accounting, GASB defines the elements in terms that will allow for recognition under both modified accrual and accrual accounting. For example, an outflow of resources can mean an expenditure or an expense. The GASB concept statements primarily serve the needs of standard-setters, providing them with guidance in writing standards that form the basis for the type and display of information found in the financial reports discussed in the remainder of the chapter. THE GOVERNMENTAL REPORTING ENTITY The average citizen—including accountants whose only experience has been with business organizations—has only a vague knowledge and little understanding of the overlapping layers of general purpose and special purpose governments that have 2 3 GASB, Codification, Appendix B. Ibid. wiL79603_ch09_353-406.qxd 1/2/09 10:14 PM Page 355 ntt MC OS10:Desktop Folder:TEMPWORK:January 2009:MHBR093_02-01-09:ch09: Chapter 9 Financial Reporting of State and Local Governments 355 some jurisdiction over us wherever we may live and work. Illustration 8–1, for example, shows that different levels of general purpose governments can levy taxes on property. The school funds in that illustration show that taxes are also levied by special purpose governments (an independent school district in that illustration). Omitted from the illustration, for the sake of brevity, are taxes levied by any special districts. Special districts are defined by the Bureau of the Census as “independent special-purpose governmental units (other than school districts) that exist as separate entities with substantial administrative and fiscal independence from generalpurpose local governments.”4 About 42 percent of the local governments in the United States are classified as special districts.5 Although the Census definition stresses the independence of special districts, in many instances they were created to provide a vehicle for financing services demanded by residents of a general purpose government that could not be financed by the general purpose government because of constitutional or statutory limits on the rates or amounts it could raise from taxes, other revenue sources, and debt. Building authorities are examples of special districts created as a financing vehicle. In addition to independent special districts, certain governmental activities are commonly carried out by commissions, boards, and other agencies that are not considered as independent of a general purpose government by the Bureau of the Census but that may have some degree of fiscal and administrative independence from the governing board of the general purpose government. In past years, some governments included in their annual reports the financial statements of such semi-independent boards and commissions and even certain of the special districts, whereas other governments excluded them. To improve uniformity in reporting and to promote the preparation of financial reports consistent with GASB Concepts Statement 1, GASB Codification, Section 2100 provides authoritative guidance on defining the reporting entity, and Section 2600 presents guidance on reporting entity and component unit presentations and disclosure. GASB Codification, Section 2100 also provides guidance for reporting certain affiliated organizations, such as fund-raising foundations. These sections provide the basis for the following discussion. Defining the Financial Reporting Entity Elected officials of state and local governments (primary governments) are accountable to their constituents. That accountability extends not only to the financial performance of the primary government, but also to any organizations that are financially dependent on the primary government or over which the primary government can impose its will. Thus, GASB takes the position that governmental financial reporting should report on all governments and organizations for which elected officials are accountable. Collectively, these governments and organizations are referred to as the financial reporting entity. Before proceeding further with the explanation of a financial reporting entity, it is important to more formally define the terms primary government and financial reporting entity. A primary government is a state government or general purpose local government. It can also be a special purpose government that has a separately elected governing 4 U.S. Department of Commerce, Bureau of the Census, 2002 Census of Governments, vol. 1, no. 1 (Washington, D.C.: U.S. Government Printing Office), p. vii. 5 http://www.census.gov/govs/cog/GovOrgTab03ss.html. wiL79603_ch09_353-406.qxd 1/2/09 10:14 PM Page 356 ntt MC OS10:Desktop Folder:TEMPWORK:January 2009:MHBR093_02-01-09:ch09: 356 Part One State and Local Governments body, is legally separate, and is fiscally independent of other state or local governments. A legally separate organization has an identity of its own as an “artificial person” with a personality and existence distinct from that of its creator and others. A fiscally independent organization has the authority to determine its budget, levy its own taxes, and set rates or charges; and issue bonded debt without approval of another government. GASB defines a financial reporting entity as a primary government, organizations for which the primary government is financially accountable, and 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 basic financial statements to be misleading. A primary government is generally the basis for the financial reporting entity. However, other types of governments can be the basis for a financial reporting entity if they issue separate financial statements. Examples of other types of governments that may serve as their own reporting entity are component units, government joint ventures, jointly governed organizations, or other stand-alone governments. A primary government is financially accountable for another organization if the primary government appoints a voting majority of the organization’s governing board and it is (a) able to impose its will on the organization or (b) there is a potential for the organization to provide specific financial benefits to, or impose specific financial burdens on, the primary government. The ability of the primary government to impose its will on an organization exists if the primary government can significantly influence the programs, projects, or activities of, or the level of services performed or provided by, the organization. A financial benefit or burden relationship exists if the primary government (a) is entitled to the organization’s resources; (b) is legally obligated or has otherwise assumed the obligation to finance the deficits of, or provide financial support to, the organization; or (c) is obligated in some manner for the debt of the organization. Additionally, a primary government may be financially accountable for organizations with separately elected governing boards, governing boards appointed by other governments, or a jointly appointed board that is fiscally dependent on the primary government. Component Units Other organizations included as part of the financial reporting entity are called component units. Not-for-profit organizations, for-profit firms, or a nonprimary government can be component units of the financial reporting entity. A component unit is defined as a legally separate organization for which the elected officials of the primary government are financially accountable. A component unit can also be another organization for which the nature and significance of its relationship with the primary government is such that exclusion would cause the reporting entity’s financial statements to be misleading or incomplete. Because the reporting entity must include the component unit’s financial information in its financial statements, the GASB has provided that the information can be included by blending the information or discretely presenting the information. To assist in determining whether an organization should be included as a component unit of the reporting entity, the GASB has developed the flowchart in Illustration 9–1. In addition to assisting in determining whether a component unit should be included in the financial statements, the flowchart also assists in determining whether the component unit information should be blended or discretely presented. wiL79603_ch09_353-406.qxd 02/06/2009 12:01 am Page 357 ssen 1 HD 506:Desktop Folder: Chapter 9 Financial Reporting of State and Local Governments 357 ILLUSTRATION 9–1 Is the PCU legally separate? Decision Process for Inclusion or Exclusion of Potential Component Unit (PCU) NO Does the PG hold the PCU's corporate powers? YES NO Not part of this PG YES Part of this PG Does the PG appoint a voting majority of the PCU's board? Does the fiscal dependency criterion apply? NO YES Is the PG able to impose its will on the PCU? NO YES YES YES NO Does the organization’s relationship with the PG meet the criteria of Note A? A Would it be misleading The PCU is not a CU to exclude the PCU of this reporting entity because of its (see joint venture NO relationship with reporting requirements) the PG? YES Discrete presentation A NO Is there a financial benefit/burden relationship? See Note B below. YES Are the two boards substantively the same? Blend YES NO NO Related organization note disclosure A Does the CU provide services entirely or almost entirely to the PG? Blend YES NO Discrete presentation Notes: A. A legally separate, tax-exempt organization should be reported as a component unit of a reporting entity if all of the following criteria are met: (a) The economic resources received or held by the separate organization are entirely or almost entirely for the direct benefit of the primary government, its component units, or its constituents; (b) the primary government or its component units is entitled to or has the ability to otherwise access a majority of the economic resources received or held by the separate organization; (c) the economic resources received or held by an individual organization that the specific primary government, or its component unit, is entitled to or has the ability to otherwise access are significant to that primary government. B. A potential component unit (PCU) for which a primary government (PG) is financially accountable may be fiscally dependent on another government. An organization should be included as a component unit (CU) of only one reporting entity. Professional judgment should be used to determine the most appropriate reporting entity. A primary government that appoints a voting majority of the governing board of a component unit of another government should make the disclosures required for related organizations. Source: GASB, Codification, Sec. 2100.901. Blended presentation is when the component unit’s financial data for its funds and activities are reported with the same fund types and activities of the primary government. For example, if a component unit has special revenue funds the funds should be reported in the same manner as special revenue funds for the primary government. A separate column should be used in the governmental funds financial wiL79603_ch09_353-406.qxd 1/2/09 10:14 PM Page 358 ntt MC OS10:Desktop Folder:TEMPWORK:January 2009:MHBR093_02-01-09:ch09: 358 Part One State and Local Governments statements if the fund is considered major; if the fund is not major it should be aggregated with other nonmajor funds. At the government-wide level the component unit special revenue fund data should be reported in the Governmental Activities column. One exception is that the General Fund data of a component unit cannot be combined with the General Fund data of the primary government. Instead, the component unit General Fund data should be reported as a special revenue fund (major or nonmajor).6 As shown in the flowchart, blending is required when the component unit is, in substance, a part of the primary government. An example of such an occurrence is a building authority that was specifically established to finance and construct capital assets for the primary government, with the debt service for the capital assets provided by lease payments from the primary government. Discrete presentation is when financial data of the component unit are reported in one or more columns, separate from the financial data of the primary government. An integral part of this method of presentation is that major component unit supporting information is required to be provided in the reporting entity’s basic financial statements by (a) presenting each major component unit in a separate column in the reporting entity’s statements of net assets and activities, (b) including combining statements of major component units in the reporting entity’s basic statements after the fund financial statements, or (c) presenting condensed financial statements in the notes to the reporting entity’s basic financial statements. Reporting by Other Government Organizations The financial reporting information in the remainder of the chapter is provided from the perspective that the financial reporting entity is composed of a primary government and its component units. However, the information would also apply to other government organizations that issue separate financial reports. Examples of such organizations would include governmental joint ventures, jointly governed organizations, and other stand-alone governments. Additionally, if a component unit chooses to provide financial statements separately from the financial reporting entity of which it is a part, it would also rely on the information provided in this chapter. A joint venture is a legal entity or other organization that results from a contractual arrangement and that is owned, operated, or governed by two or more participants as a separate and specific activity subject to joint control, in which the participants retain (a) an ongoing financial interest or (b) an ongoing financial responsibility. A jointly governed organization is a regional government or other multigovernmental arrangement that is governed by representatives from each of the governments that create the organization, but that is not a joint venture because the participants do not retain an ongoing financial interest or responsibility. An other stand-alone government is a legally separate governmental organization that (a) does not have a separately elected governing body and (b) does not meet the definition of a component unit. Other stand-alone governments include some special purpose governments, joint ventures, jointly governed organizations, and pools. 6 GASB, Codification, Sec. 2600.114. wiL79603_ch09_353-406.qxd 1/2/09 10:14 PM Page 359 ntt MC OS10:Desktop Folder:TEMPWORK:January 2009:MHBR093_02-01-09:ch09: Chapter 9 Financial Reporting of State and Local Governments 359 GOVERNMENTAL FINANCIAL REPORTS Once the reporting entity has been determined in accordance with the criteria discussed in the preceding section, persons responsible for preparing financial reports for the reporting entity should follow the guidance given in currently effective authoritative literature to determine the content of financial reports to be issued for external users. Chapter 2 contains a summary of the standards set forth for the content of the comprehensive annual financial report (CAFR) of a state or local governmental reporting entity. Chapters 3 through 8 elaborate on the application of those standards to accounting and financial reporting for each of the funds and governmentwide activities. Although much of the discussion in preceding chapters concerns general purpose external financial reporting, the needs of administrators, legislators, and other users not properly classifiable as “external” have been given some attention. In the following paragraphs, the discussion in preceding chapters is briefly summarized and placed in perspective. Need for Periodic Reports Individuals concerned with the day-to-day operations and activities of governmental funds should be familiar with much of the data processed by the accounting information system because it results from the events and transactions with which they are involved. However, it is easy for these individuals to become overconfident of their understanding of the data with which they are daily involved. Past events are not always as remembered, and the relative significance of events changes over time. Similarly, administrators at succeedingly higher levels in the organization may feel that participation in decision making and observation of the apparent results of past decisions obviate the necessity for periodic analysis of accounting and statistical reports prepared objectively and with neutrality. The memory and perceptions of administrators at higher levels are also subject to failure. Therefore, it is generally agreed that it is useful for financial reports to be prepared and distributed at intervals throughout a fiscal period as well as at period-end. Interim Financial Reports Government administrators have the greatest need for interim financial reports, although members of the legislative branch of the government (particularly those on its finance committee) may also find interim reports useful. Although the particular statements and schedules that should be prepared on an interim basis are a matter of local management preference, the authors believe the following interim schedules provide the minimum useful information for budgetary and cash management purposes. 1. Schedule of actual and budgeted revenue (for the General Fund and special revenue funds and other funds for which budgets have been legally adopted). 2. Schedule of actual and budgeted expenditures (for the General Fund and special revenue funds and other funds for which budgets have been legally adopted). 3. Comparative schedule of revenue and expense (for each enterprise and internal service fund). 4. Combined schedule of cash receipts, disbursements, and balances—all funds. 5. Forecast of cash positions—all funds. Other statements and schedules, in addition to those just listed, may be needed, depending on the complexity and scope of a government’s activities. A statement of wiL79603_ch09_353-406.qxd 1/2/09 10:14 PM Page 360 ntt MC OS10:Desktop Folder:TEMPWORK:January 2009:MHBR093_02-01-09:ch09: 360 Part One State and Local Governments investments held and their cost and fair values is an example of an additional statement that may be useful. Schedules of past-due receivables from taxes, special assessments, and utility customers may also be needed at intervals. Interim reports of government-wide activities can be done only if the information system can capture the information. Complete interim reports should be prepared and distributed at regular intervals throughout a fiscal period, generally monthly, although small governments that have little financial activity may find a bimonthly or quarterly period satisfactory. Partial interim reports dealing with those items of considerable current importance should be prepared and distributed as frequently as their information would be of value. For example, reports of the fair values of investments and of purchases and sales may be needed by a relatively small number of users on a daily basis during certain critical periods. Annual Financial Reports Governmental annual financial reports are needed by the same individuals and groups receiving interim reports. They are also often required to be distributed to agencies of higher governmental jurisdictions and to major creditors. Other users include citizens and citizen groups; news media; financial underwriters; debt insurers; debt rating agencies; debt analysts; libraries; other governments; associations of governmental administrators, accountants, and finance officers; and college professors and students. Most larger governments prepare a comprehensive annual financial report (CAFR). The CAFR is the government’s official annual report prepared and published as a matter of public record. A CAFR provides information beyond the minimum requirements of general purpose external financial reporting, which includes management’s discussion and analysis (MD&A), basic financial statements and related notes (government-wide and fund), and required supplementary information (RSI). In addition, it includes individual fund and combining financial statements, schedules, narrative explanations, a statistical section, and other material management deems relevant. For CAFRs containing audited financial statements, the auditor’s report should also be included. Introductory Section As discussed in Chapter 1, the introductory section of a CAFR generally includes the table of contents, a letter of transmittal, and other material deemed appropriate by management. The letter of transmittal should cite legal and policy requirements for the report. The introductory section may also include a summary discussion of factors relating to the government’s service programs and financial matters. Matters discussed in the introductory section should not duplicate those discussed in the MD&A. Because the MD&A is part of the information reviewed (but not audited) by the auditor, it presents information based only on facts known to exist as of the reporting date. Since the introductory section is generally not covered by the auditor’s report, it may present information of a more subjective nature, including prospective information such as forecasts or expectations. Financial Section The financial section should contain sufficient information to disclose fully and present fairly the financial position and results of financial operations during the fiscal wiL79603_ch09_353-406.qxd 1/2/09 10:14 PM Page 361 ntt MC OS10:Desktop Folder:TEMPWORK:January 2009:MHBR093_02-01-09:ch09: Chapter 9 Financial Reporting of State and Local Governments 361 year. GASB Codification, Section 2200 identifies the minimum content for the financial section of a CAFR as consisting of the: 1. Auditor’s report (discussed in Chapter 12) 2. MD&A 3. Basic financial statements a. Government-wide financial statements (1) Statement of net assets (see Illustration A1–1) (2) Statement of activities (see Illustration A1–2) b. Fund financial statements (1) Governmental funds (a) Balance sheet (see Illustration A1–3) (b) Statement of revenues, expenditures, and changes in fund balances (see Illustration A1–5) (2) Proprietary funds (a) Statement of net assets (see Illustration A1–7) (b) Statement of revenues, expenses, and changes in fund net assets (see Illustration A1–8) (c) Statement of cash flows (see Illustration A1–9) (3) Fiduciary funds (including component units that are fiduciary in nature) (a) Statement of fiduciary net assets (see Illustration A1–10) (b) Statement of changes in fiduciary net assets (see Illustration A1–11) c. Notes to the financial statements 4. Required supplementary information other than MD&A, including, but not limited to, the budgetary comparison schedule (see Illustration 3–5) 5. Combining statements and individual fund statements and schedules State and local governments may provide in the financial section of the CAFR combining financial statements for nonmajor funds of each fund type and individual fund statements for the General Fund or for a nonmajor fund that is the only fund of a given type (for example, a debt service fund that is the only fund of that type). The GASB requires that all “lower” level statements, such as combining statements, be prepared and displayed in the same manner as “higher” level statements, such as the governmental funds financial statements. Examples of all required basic financial statements were provided in Chapter 1; however, no example is provided in Chapter 1 for an MD&A. An example of an MD&A from the City and County of Denver is presented as Appendix B of this chapter. As shown in Appendix B, the MD&A should provide an overview of the government’s financial activities and financial highlights for the year. The MD&A should provide a narrative explanation of the contents of the CAFR, including the nature of the government-wide and fund financial statements, and the distinctions between those statements. The remainder of the MD&A should describe the government’s financial condition, financial trends of the government as a whole and of its major funds, budgetary highlights, and activities affecting capital assets and related debt. Finally, the MD&A should discuss economic factors, budget, and tax rates for the next year. Statistical Section In addition to the output of the accounting information system presented in the financial section of the governmental annual report, statistical information reflecting wiL79603_ch09_353-406.qxd 1/2/09 10:14 PM Page 362 ntt MC OS10:Desktop Folder:TEMPWORK:January 2009:MHBR093_02-01-09:ch09: 362 Part One State and Local Governments social and economic data, financial trends, and the fiscal capacity of the government are needed by users interested in better understanding the activity and condition of the government. GASB indicates that generally the statistical section should present information in five categories to assist the user in understanding and assessing a government’s economic condition.7 To be most useful, the 10 most recent years of data should generally be included (unless otherwise indicated) in the schedules used to meet the requirements of the five categories defined by the GASB. Following are descriptions of the five categories. 1. Financial trends information provides the user with information that is helpful in understanding and assessing how a government’s financial position has changed over time. Schedules in this category are prepared at both the fund level and government-wide level. The focus is on showing the trend in fund balances and net asset categories, including changes in net asset and fund balances. 2. Revenue capacity information assists the user with understanding and assessing the government’s ability to generate its own revenues (own-source revenues), such as property taxes and user charges. The schedules presented should focus on the government’s most significant own-source revenues. Suggested schedules provide information on the revenue base (sources of revenue), revenue rates (including overlapping tax rate information), the principal revenue payors, and property tax levy and collection information. 3. Debt capacity information is useful in understanding and assessing the government’s existing debt burden and its ability to issue additional debt. Four types of debt schedules are recommended—ratios of outstanding debt to total personal income of residents, information about direct and overlapping debt, legal debt limitations and margins, and information about pledged revenues. 4. Demographic and economic information assists the user in understanding the socioeconomic environment in which the government operates and provides information that can be compared over time and across governments. Governments should present demographic and economic information that will be most relevant to users, such as information on personal income, unemployment rates, and employers. 5. Operating information is intended to provide a context in which the government’s operations and resources can be better understood. This information is also intended to assist users of financial statements in understanding and assessing the government’s financial condition. At a minimum, three schedules of operating information should be presented—number of government employees, indicators of demand or level of service (operating indicators), and capital asset information. Some of the information in the statistical section has been discussed previously. For example, reporting the ratio of debt per capita, as well as the computation of legal debt limit, legal debt margin, and direct and overlapping debt and future debt service requirements, are all illustrated and discussed in Chapter 6. Other information listed by the GASB as recommended for presentation in the statistical section of the CAFR is generally self-explanatory. 7 GASB, Codification, Sec. 2800.