Governmental and Nonprofit Accounting, [11 ed.] 2016046578, 9780133799569, 0133799565

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GOVERNMENTAL AND NONPROFIT ACCOUNTING

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GOVERNMENTAL AND NONPROFIT ACCOUNTING Theory and Practice

Robert J. Freeman Texas Tech University

Craig D. Shoulders University of North Carolina at Pembroke

Dwayne N. McSwain Sam Houston State University

Robert B. Scott City of Carrollton, Texas

ELEVENTH EDITION

New York, NY

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Copyright © 2018, 2013, 2011 by Pearson Education, Inc. or its affiliates. All Rights Reserved. Manufactured in the United States of America. This publication is protected by copyright, and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, ­mechanical, photocopying, recording, or otherwise. For information regarding permissions, request forms, and the ­appropriate contacts within the Pearson Education Global Rights and Permissions department, please visit www.pearsoned.com/permissions/. Acknowledgments of third-party content appear on the appropriate page within the text. PEARSON and ALWAYS LEARNING are exclusive trademarks owned by Pearson Education, Inc. or its affiliates in the U.S. and/or other countries. Unless otherwise indicated herein, any third-party trademarks, logos, or icons that may appear in this work are the property of their respective owners, and any references to third-party trademarks, logos, icons, or other trade dress are for demonstrative or descriptive purposes only. Such references are not intended to imply any sponsorship, endorsement, authorization, or promotion of Pearson’s products by the owners of such marks, or any relationship between the owner and Pearson Education, Inc., or its affiliates, authors, licensees, or distributors. Portions of various GASB and FASB documents, copyrighted by the Financial Accounting Foundation (FAF), 401 Merritt, PO Box 5116, Norwalk, CT 06856-5116, are reproduced with permission. Complete copies of those documents are available from the FAF.

Library of Congress Cataloging-in-Publication Data: Names: Freeman, Robert J., author. Title: Governmental and nonprofit accounting : theory and practice / Robert J. Freeman, Texas Tech University, Craig D. Shoulders, University of North Carolina at Pembroke, Dwayne N. McSwain, Sam Houston State University, Robert B. Scott, City of Carrollton, Texas. Description: Eleventh edition. | New York : Pearson Education, [2018] Identifiers: LCCN 2016046578 | ISBN 9780133799569 Subjects: LCSH: Municipal finance—United States—Accounting. | Local finance—United States—Accounting. | Finance, Public—United States—Accounting. | Fund accounting—United States. | Nonprofit organizations—United States—Accounting. Classification: LCC HJ9777.A3 L95 2018 | DDC 657/.83500973—dc23 LC record available at https://lccn.loc.gov/2016046578

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ISBN 10: 0-13-379956-5 ISBN 13: 978-0-13-3799569

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Dedicated to Our Beloved Families and Many Devoted Friends whose love, encouragement, support, and involvement in our lives make a significant difference in the richness, meaning, and fulfillment we are blessed to experience and cherish

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Brief Contents Preface  xiv CHAPTER 1 Governmental and Nonprofit Accounting

Environment and Characteristics  1

CHAPTER 2 State and Local Government Accounting and Financial Reporting Model The Foundation  31

CHAPTER 3 Budgeting, Budgetary Accounting, and Budgetary Reporting  69 CHAPTER 4 The General Fund and Special Revenue Funds  107 CHAPTER 5 Revenue Accounting — Governmental Funds  171 CHAPTER 6 Expenditure Accounting — Governmental Funds  220 CHAPTER 7 Capital Projects Funds  259 CHAPTER 8 Debt Service Funds  299 CHAPTER 9 General Capital Assets; General Long-Term Liabilities; Permanent Funds

Introduction to Interfund-GCA-GLTL Accounting  340

CHAPTER 10 Enterprise Funds  392 CHAPTER 11 Internal Service Funds  443 CHAPTER 12 Trust and Agency (Fiduciary) Funds

Summary of Interfund-GCA-GLTL Accounting  474

CHAPTER 13 Financial Reporting

The Basic Financial Statements and Required Supplementary Information  510

CHAPTER 14 Financial Reporting

Deriving Government-Wide Financial Statements and Required Reconciliations  551

CHAPTER 15 Financial Reporting

The Comprehensive Annual Financial Report and the Financial Reporting Entity  618

CHAPTER 16 Non-SLG Not-for-Profit Organizations  653 CHAPTER 17 Accounting for Colleges and Universities  692 CHAPTER 18 Accounting for Health Care Organizations  731 CHAPTER 19 Federal Government Accounting  762 CHAPTER 20 Auditing Governments and Not-for-Profit Organizations  799 Index  845

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Contents Preface xiv

CHAPTER 1 Governmental and Nonprofit Accounting: Environment and Characteristics  1 Characteristics and Types of G&NP Organizations  2 G&NP Sector Significance 2 The G&NP Environment 3 Objectives of G&NP Accounting and Financial Reporting  6 Authoritative Sources of G&NP Accounting Principles and Reporting Standards  6 The FAF 7 The FASB 7 FASB-GASB Jurisdictions 7 “Government” Defined 7 The GASB 8 GAAP Hierarchies 11 Concepts and Objectives of SLG Accounting and Financial Reporting  12 Governmental-Type Activities 12 Financial Report Users 17 Financial Report Uses 17 Business-Type Activities 17 Users and Uses of Financial Reports 18 Financial Reporting Objectives 19 Characteristics of SLG Accounting and Financial Reporting  20 Fund Accounting 20 Budgets and Appropriations 22 Other Distinguishing Characteristics 22 Commercial Accounting Comparison 23 Concluding Comments 23

Appendix 1-1

Questions 27 Exercises 27 Problems 29

Evolution of Accounting Principles and Standards — Prior to the GASB  24

CHAPTER 2 State and Local Government Accounting and Financial Reporting Model: The Foundation  31 Overview of the GASB Financial Reporting Model  32 The Fundamental Features of the SLG Accounting and Financial Reporting Model  33 GAAP and Legal Compliance 35 Fund Accounting 36 Fund Categories 37 Transaction Analysis 43 Types of Funds 44 Comparative Financial Statement Formats 51 Annual Financial Reporting 55 Concluding Comments 59 Questions 59 Exercises 60 Problems 64 Cases 67

CHAPTER 3 Budgeting, Budgetary Accounting, and Budgetary Reporting  69 The Government Budgetary Perspective  69 Budgetary Accounting Overview  71 Budgetary Accounting and Control 71 Budgetary Reporting Overview  77 The Budgetary Basis 77 Interim Budgetary Statements 78 Annual Budgetary Comparisons 79 Budgetary Comparison Statement Illustrated— ­Budgetary Basis Differs from GAAP 79

Budgetary Planning, Control, and Evaluation  82 Planning 82 Control 83 Evaluation 83 Basic Budgetary Terminology  83 Capital vs. Current Budgets 84 Tentative vs. Enacted Budgets 84 General vs. Special Budgets 84 Fixed vs. Flexible Budgets 85 Executive vs. Legislative Budgets 85 Budgetary Approaches and Emphases  86

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viii  Contents Budget Preparation  87 Overview 87 Preliminary Estimates 87 Preparing the Budget 88 Revenue Estimates and Requests 89 Expenditure Estimates and Requests 89 Expenditure Budgeting Approaches 89

Entries During 20X2  141 Classification of Expenditures  143 Combining Special Revenue Fund Statements  144 Concluding Comments 144

Appendix 4-1

Legislative Consideration and Action  92 Budget Execution  93 Concluding Comments 93

Appendix 4-2

Appendix 3-1

Appendix 4-3

Classification of Expenditures  93

Questions 98 Exercises 99 Problems 102 Cases 105

CHAPTER 4 The General Fund and Special Revenue Funds  107 General Fund and Special Revenue Funds: Use and Measurement Focus  107 Measurement Focus 108 Purposes and Assumptions of This Chapter 109 General Fund Accounting — Illustrative Example  109 Entries During 20X1 109 Budget Revisions 112 Year-End Adjustments 126 Preclosing Trial Balances 126 Illustrative Example Worksheets 127 20X1 Closing Entries 128 Level of Detail in Subsidiary Ledgers 130 Postclosing Trial Balance 131 Balance Sheets  131 Interim Balance Sheet 131 Year-End Balance Sheet 132 Fund Balance 132 Fund Balance Reporting Classifications 133 Interfund Receivables and Payables 136 Capital Assets and Long-Term Liabilities 137

Statement of Revenues, Expenditures, and Changes in Fund Balances  137 Restatements 138 Extraordinary Items and Special Items 139 Budget Comparison Statement or Schedule of Revenues, Expenditures, and Changes in Fund Balance — Budget and Actual  140 Budgetary Comparison Statement Illustrated — ­Budgetary Basis Same as GAAP  141

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General Ledger Worksheet and Subsidiary Ledgers  146 Alternative Account Structure and Entries  150 Budgetary Comparison Statement Illustrated —  Budgetary Basis Differs from GAAP  152

Questions 154 Exercises 155 Problems 159 Cases 165 Harvey City Comprehensive Case 167

CHAPTER 5 Revenue Accounting — Governmental Funds  171 Revenue Definition and Recognition  172 Nonexchange Transactions  174 Governmental Fund and Proprietary Fund Revenue Recognition Compared  176 Classification of Revenue Accounts  176 General Fund Revenues 177 Other Governmental Funds Revenues 179 Taxes  179 Taxpayer-Assessed Taxes 179 Property Taxes 180 Property Tax Statements/Schedules 188

Licenses and Permits  189 Intergovernmental Revenues  189 Intergovernmental Revenue Classifications 190 Intergovernmental Revenue Accounting 190

Charges for Services  193 Interfund Services vs. Reimbursements 194 Charges for Services 194

Fines and Forfeits  195 Investment Earnings  196 Valuation Approaches and Techniques 197 Disclosure of Inputs to Fair Value Measurements 197 Reporting Investments in the Financial Statements 198

Miscellaneous Revenues  201 Escheats 201 Private Contributions 201

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Contents  ix



Selected Nonrevenue Fund Balance Increases  201 Capital Asset Sales/Losses 201 Internal Payments in Lieu of Taxes (PILOTs) 202 Collateralized Borrowings 202

Revenue Reporting: GAAP vs. Budgetary  202 Balance Sheet Reporting Related to Unrecognized Revenues 205

Changes in Accounting Principles and Error Corrections  205 New GASB Standards 206 Error Corrections 206 Concluding Comments 207 Questions 207 Exercises 208 Problems 213 Cases 216 Harvey City Comprehensive Case 218

CHAPTER 6 Expenditure Accounting — Governmental Funds  220 Expenditure Definition and Recognition  221 Capital Outlay Expenditures 222 Debt Service Expenditures 223 Intergovernmental Expenditures 223 Current Operating Expenditures 223 Inventories and Prepayments 223 Expenditure Recognition Summary 224 Expenditure Accounting Controls and Procedures  225 Personal Services 226 Materials and Supplies 228 Other Services and Charges 230 Adjusting Entries  234 Encumbrances 235 Debt Service 236 Claims and Judgments 237 Compensated Absences 239 Pension/OPEB Plan Expenditures 241

Expenditure Reporting: GAAP vs. Budgetary  242 Changes in Accounting Principles  242 Alternative Principles 244 New GASB Standards 245 Error Corrections  245 Concluding Comments 246 Questions 246 Exercises 246 Problems 249 Cases 255 Harvey City Comprehensive Case 257

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CHAPTER 7 Capital Projects Funds  259 Capital Projects Fund Operations and Accounting Standards  261 CPF Financial Resources 261 Number of Funds 261 CPF Life Cycle 262 The Budget 263 Interim Financing 264 Project Costs 265 Intergovernmental Revenues 266 Recording Bond Issues 266 Capital Projects Fund — Case Illustration Begun, 20X1  266 Budgetary Entry 267 Transaction/Event Entries 268 General Ledger Worksheet(s) 270 Preclosing Trial Balance 270 Closing Entries 270 Financial Statements 273 Capital Projects Fund — Case Illustration Concluded, 20X2  274 20X1 Accounts Closed 275 Case Illustration Assumptions and Entries — 20X2 276 General Ledger Worksheet 278 20X2 Financial Statements 278

Other Capital Projects Fund Operations, Accounting, and Reporting Matters  281 Bond Anticipation Notes (BANs) 282 Investments and Arbitrage 283 Remaining Fund Balance 283 Reporting Multiple Projects 284 Combining CPF Statements 284 Concluding Comments 284 Questions 285 Exercises 285 Problems 289 Cases 295 Harvey City Comprehensive Case 297

CHAPTER 8 Debt Service Funds  299 Debt Service Fund Environment, Financing, and Expenditure Recognition  300 Long-Term Liabilities 300 Fixed vs. Variable Rates 301 Debt Service Payments 302 Bonds and Fiscal Agents 302

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x  Contents Required DSF Reserves 303 Bond Ratings 303 Bond Insurance 303 Sources of Financing 304 DSF Investments 304 DSF Expenditure Recognition 304

Debt Service Fund for a Serial Bond Issue: Case Illustration  305 Illustrative Entries 306 Financial Statements 308 Special Assessment Debt Service Funds  308 Illustrative Entries 310 Illustrative Financial Statements 312 Other Conventional Debt Service Fund Considerations  312 Nonaccrual of Interest 312 Combining Balance Sheet 313 Combining Operating Statement 313 Debt Service Fund for a Term Bond Issue  314 Debt Service Funds for Deep Discount Issues  317 Refundings 317 Reasons for Refundings 318 Refundings Defined 318 Defeasance of Debt 319

Debt Service Funds for Refundings  321 Current Refunding 321 Advance Refunding 323 Debt and Nondebt Financing 324 Reporting Refundings 325 Advance Refunding Disclosures 325 Concluding Comments 327 Questions 328 Exercises 329 Problems 332 Cases 336 Harvey City Comprehensive Case 338

CHAPTER 9 General Capital Assets; General Long-Term Liabilities; Permanent Funds: Introduction to Interfund-GCA-GLTL Accounting  340 Overview of General Capital Assets and General Long-Term Liabilities Accounting Procedures  341 General Capital Assets  342 General Capital Assets Defined 342 Initial Valuation 343 Classification 344 Capitalization Policy 344 Property Records 346

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Capital Assets Inventory 347 Additions, Betterments, and Renewals 347 Depreciation/Accumulated Depreciation 348 Updating GCA Accounts 349 Recording Depreciation 353 Sale, Replacement, or Retirement 353 Intragovernmental Transactions 354 Impairment 356 Insurance Recoveries 358 Damage or Destruction 359 Reporting and Disclosures 359

General Long-Term Liabilities  360 CPF-DSF-GLTL 363 Serial Debt 363 Special Assessment Debt 364 Other Government Liabilities 364 Pensions and OPEB  365 Interest-Related Adjustments 368 Defaulted Bonds 368 In-Substance Defeasance 369 GLTL Records 369 GLTL Reporting and Disclosures 370

Permanent Funds  370 Introduction to Interfund-GCA-GLTL Accounting  373 Concluding Comments 377 Questions 378 Exercises 378 Problems 384 Cases 388 Harvey City Comprehensive Case 389

CHAPTER 10 Enterprise Funds  392 Common Characteristics and Principles of Proprietary Funds  392 Accounting Equation 393 Accounting Principles 393 Financial Statements 393 Enterprise Funds Defined  394 Enterprise Fund Accounting Illustrated  396 Budgeting and Appropriations 396 Interfund Activity 396 Intergovernmental Grants 397 Interest Capitalization 397 Establishment of Fund and Acquisition of Plant 397 Accounting for Routine Operating Transactions 398 Preclosing Trial Balance and Financial ­Statements  — ­Basic Example 402

Enterprise Fund Accounting — Extended Illustration  411 Enterprise Fund Reporting — Extended Example   ­ 419

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Contents  xi



Combining Enterprise Fund Financial Statements  423 Concluding Comments 429 Questions 429 Exercises 430 Problems 433 Cases 438 Harvey City Comprehensive Case 441

Asset, and General Long-Term Liability Accounting Illustrations  495 Concluding Comments 500 Questions 501 Exercises 501 Problems 504 Cases 507 Harvey City Comprehensive Case 509

CHAPTER 11 Internal Service Funds  443

CHAPTER 13 Financial Reporting: The Basic F ­ inancial Statements and Required ­Supplementary Information  510

Overview of Accounting Principles  444 Initial Establishment 444 Pricing Policies and Methods  446 Pricing Methods 447 Relation to Budget 448 Financial Statements 448 Internal Service Fund Accounting Illustrated  448 Automotive Equipment Unit 449 Financial Statements–Basic Example  452 Central Stores Fund 452 Self-Insurance Fund  456 Disposition of Increase or Decrease in Net Position  461 Dissolution of an Internal Service Fund  461 Combining Internal Service Fund Financial Statements  462 Concluding Comments 462 Questions 466 Exercises 466 Problems 468 Cases 471 Harvey City Comprehensive Case 472

CHAPTER 12 Trust and Agency (Fiduciary) Funds: Summary of Interfund-GCA-GLTL Accounting  474 The Accountability Focus  475 Agency Funds  476 Simpler Agency Funds 477 Tax Agency Funds 477 Special Assessment Agency Funds 482

Trust Funds  483 Private-Purpose Trusts 483 Investment Trusts 485 Pension Trusts 486

Combining Trust and Agency Fund Financial Statements  494 Additional Interfund,  General Capital

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Basic Financial Statements Overview  512 Fund Financial Statements  513 Major Fund Reporting 513 Fund-Based Financial Statements 523 Government-Wide Financial Statements  526 Statement of Net Position 527 Statement of Activities 529 Measurement Focus 532 Reporting Expenses 532 Program vs. General Revenues 533 Internal Service Funds 536 Infrastructure Capital Assets 536 Note Disclosures  537 Required Supplementary Information  539 Management’s Discussion and Analysis 539 Other RSI 539 Special Purpose Governments 541 Concluding Comments 541 Questions 541 Exercises 542 Problems 545 Cases 547 Harvey City Comprehensive Case 550

CHAPTER 14 Financial Reporting: Deriving GovernmentWide Financial Statements and Required Reconciliations  551 Deriving Governmental Activities Data  553 Deriving Government-Wide Financial Statement Data for Governmental Activities — A Worksheet-Based Approach  554 The Conversion Worksheets 555 Balance Sheet Conversion Worksheet ­Adjustments 560 Farley County Balance Sheet Conversion 564 Operating Statement Conversion Worksheet ­Adjustments 566 Farley County Operating Statement Conversion 570

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xii  Contents Deriving Business-Type Activities Data  573 Preparing Government-Wide Financial Statements  575 Statement of Net Position 575 Statement of Activities 575 Reconciliations 579 Concluding Comments 581

Appendix 14-1

Appendix 14-2

A Two-Worksheet Approach to Deriving Governmental Activities Data: An Adjusting Entry Presentation  581 A One-Worksheet Approach to Deriving Governmental Activities Data  590

Questions 601 Exercises 602 Problems 605 Cases 612 Harvey City Comprehensive Case 616

CHAPTER 15 Financial Reporting: The Comprehensive Annual Financial Report and the Financial Reporting Entity  618 The Comprehensive Annual Financial Report  619 The Introductory Section 619 The Financial Section 621 The Statistical Section 625 Supplemental and Special Purpose Reporting  629 Financial Reporting — Complex Entity Structure  630 Reporting Entity Definition 631 Reporting Entity Disclosures 633 Integrating Component Units into the Reporting Entity  635 Blending 636 Discrete Presentation 637 Dual Reporting Entity Model 638 Other Issues 639 Separate Issuance of Primary Government Financial Statements  640 Related Organizations, Joint Ventures, and Jointly Governed Organizations  640 Concluding Comments 641 Questions 643 Exercises 644 Problems 647

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Cases 650 Harvey City Comprehensive Case 652

CHAPTER 16 Non-SLG Not-for-Profit Organizations  653 Classification of Organizations  654 Voluntary Health and Welfare Organizations ­(VHWOs) 655 Other Not-for-Profit Organizations (ONPOs) 655

Classes of Net Assets  656 Non-GAAP Accounting and Reporting Requirements  657 Basis of Accounting  657 Financial Statements  657 Statement of Financial Position (Balance Sheet) 658 Statement of Activities (Operating Statement) 659 Statement of Cash Flows 666 Statement of Functional Expenses  666

Nongovernment VHWO and ONPO Accounting and Reporting Illustration  666 Transactions and Entries 667 Illustrative Financial Statements 675 Concluding Comments 680 Questions 681 Exercises 681 Problems 685

CHAPTER 17 Accounting for Colleges and Universities  692 Classification as “Engaged Only in Business-Type Activities”  693 GAAP Reporting Requirements  694 Statement of Net Position 695 Statement of Revenues, Expenses, and Changes in Net Position 695 Statement of Cash Flows 701

Case Illustration — A Government University  702 Other Resources 707 Annuity and Life Income Gifts  714 Annuity Gifts 714 Life Income Gifts 717 Colleges and Universities Engaged in Both Governmental and Business-Type Activities  718 Nongovernment Not-for-Profit University Reporting  718 Concluding Comments 722 Questions 722 Exercises 722 Problems 724

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CHAPTER 18 Accounting for Health Care ­Organizations  731

CHAPTER 20 Auditing Governments and Not-for-Profit Organizations  799

Funds — Government Hospitals  732 Basic Principles 733

Overview  799

Unique Measurement and Display Features  733 Distinguishing Primary Activities 733 Classes of Revenues 733 Gains 736 Donations 736 Expense Classification 736 Restricted Assets 737 Property, Plant, and Equipment 738 Illustrative Case  738 Summary of Transactions and Events 739 Financial Statements 747 Statement of Net Position 747 Operating Statement 747 Statement of Cash Flows 749 Nongovernment Not-for-Profit Hospital Reporting  751 Concluding Comments 755 Questions 755 Exercises 756 Problems 759

CHAPTER 19 Federal Government Accounting  762 The Federal Financial Management Environment  763 Financial Accounting Responsibilities 763 Overview 765 The Budgetary Process  766 The Budget Cycle 766 Exceeding Budget Authority 769 Accounting Principles and Standards for Federal Agencies  769 The Federal Model 769 Standard General Ledger 773 Federal Fund Structure 775 Financial Reporting 776 Federal Agency Accounting and Reporting Illustrated  778 A Case Illustration 778 Maintaining Budgetary Control 779 Maintaining Proprietary Accounts 783 Other Transactions and Entries 783 Closing Entries 787 Reporting 789 Concluding Comments 793 Questions 794 Exercises 794 Problems 796

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What Is an Audit? 800 Classifications of Audits 800 Sources of Auditing Standards 801 External Auditor Classifications 803 The Financial Statement Audit  804 GAAS and GAGAS 804 Audit Materiality and Early Reporting of ­Deficiencies 806 Additional Reporting Requirements 806 Planning the Financial Statement Audit 807 Determining Materiality in Government 808 Performing the Audit 810 Audit Procedures 810 Reporting 811 Report on Internal Controls over Financial Reporting and on Compliance and Other Matters 811 Required Communications and the Management ­Letter 812

The Single Audit  812 Purposes and Recent Reforms 814 Applicability 815 Definitions 816 Objectives 816 Overview 816 Auditee Responsibilities 817 Auditor Responsibilities 819 Sources of Guidance for the Single Audit 821 Cognizant Agency Responsibilities 822 Major FFA Programs 822 Findings & Questioned Costs 826 Illegal Acts 826 Subrecipients 826 Auditor Reports — Single Audit 827 Auditee Reporting Responsibilities 828 Concluding Comments 831

Appendix 20-1 Appendix 20-2

Glossary  832 Data Collection Form for Reporting on Audits of States, Local Governments, and Nonprofit Organizations  833

Questions 837 Exercises 837 Problems 841 Cases 842

Index 845

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Preface The 11th edition of Governmental and Nonprofit Accounting continues a 75+ year tradition as a comprehensive, practice-relevant, up-to-date textbook covering state and local government, federal government, and not-for-profit organization accounting, financial reporting, and auditing. This new edition is in keeping with our philosophy that what students learn in the accounting classroom should correlate highly with what they must understand and apply on the CPA examination and as professional accountants. Governmental accounting, financial reporting, and auditing have experienced enormous changes recently, accelerating the trend of past years. In just the 10-month period from June of 2015 through March of 2016, the Governmental Accounting Standards Board (GASB) issued 10 Statements of Governmental Accounting Standards. Still other GASB standards became effective for the first time during that period, as did significant changes in Single Audit guidance. These changes have had significant impacts on government accounting, financial reporting, and auditing. Changes include a new hierarchy of generally accepted accounting principles (GAAP), up-to-date fair value guidance, and new standards for accounting for and reporting postemployment benefits—including both pensions and other postemployment benefits. Also, in August 2016, the Financial Accounting Standards Board (FASB) adopted Accounting Standards Update 2016-14, “Not-for-Profit Entities” (Topic 958), making major changes in not-for-profit organization financial statements. Governmental and Nonprofit Accounting: Theory and Practice, 11th edition, is updated for all of these and other relevant changes in accounting standards through the beginning of 2017.

EYES-OF-THE-LEARNER–MOTIVATED CHANGES Changes to this edition will allow students to master content more efficiently. By continuing to use the feedback from adopters and students, we have examined the text “through the eyes of the learner.” New features include: • The order of Chapter 3, “Budgeting, Budgetary Accounting, and Budgetary Reporting,” and Chapter 4, “General and Special Revenue Funds,” have been reworded so that budgeting is covered before General Fund accounting and reporting. This change allows budgetary accounting and reporting to be fully integrated with accounting for actual revenues and expenditures when initially discussed and illustrated. • An appendix has been added to Chapter 14, “Financial Reporting: Deriving GovernmentWide Financial Statements and Required Reconciliations.” It provides journal entries consistent with completing the two-worksheet-based conversion of governmental funds data to government-wide governmental activities data. The appendix was added because many students find that seeing the entries improves their understanding of the conversion. The oneworksheet conversion continues to be provided in a second appendix, as in recent editions. • Chapter 20, “Auditing Governments and Not-for-Profit Organizations,” has been reorganized and rewritten to facilitate understanding the audit requirements, processes, and responsibilities under recent revisions of Government Auditing Standards (GAS) and Single Audit requirements.

STANDARDS-DRIVEN CHANGES As should be expected, most of the modifications in the content of this 11th edition are necessary because of the numerous changes in government and nonprofit

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 Preface  xv

organization accounting standards and in auditing guidance. Changes required by this new guidance include the following: • Chapter 1, “Governmental and Nonprofit Accounting: Environment and Characteristics,” is updated for the new government GAAP hierarchy established by GASB Statement No. 76, “The Hierarchy of Generally Accepted Accounting Principles for State and Local Governments.” Both the authoritative levels of the hierarchy and the guidance for addressing transactions and events not covered in the authoritative literature are discussed. • Chapter 5, “Revenue Accounting–Governmental Funds,” is updated for the provisions of GASB Statement No. 72, “Fair Value Measurement and Application.” This coverage includes the new definitions of both fair value and investments, the applicability of fair value, fair value measurement guidance, and the requirement to disclose the levels of inputs (reliability) of the measurements. In addition, GASB Statement No. 77, “Tax Abatement Disclosures,” is addressed in this chapter. • Chapter 6, “Expenditure Accounting–Governmental Funds,” is updated for the provisions of (1) GASB Statement No. 68, “Accounting and Financial Reporting for Pensions—An Amendment of GASB Statement No. 27,” (2) GASB Statement No. 75, “Accounting and Financial Reporting for Postemployment Benefit Plans Other Than Pensions,” and (3) GASB Statement No. 82, “Pension Issues—An Amendment of GASB Statements No. 67, No. 68, and No. 73.” • Chapter 9, “General Capital Assets; General Long-Term Liabilities; Permanent Funds: Introduction to Interfund-GCA-GLTL Accounting,” discusses and illustrates accounting for net pension liabilities and related deferred outflows of resources and deferred inflows of resources. The computation of pension expense for governmental activities is demonstrated as well. Other postemployment benefits (OPEB) also are incorporated briefly. The chapter is updated for the GASB Statement No. 72 requirement to use acquisition costs for donated capital assets and certain other transactions. • Chapter 10, “Enterprise Funds,” includes the impact of the new pension and OPEB standards on Enterprise Funds. • Chapter 12, “Trust and Agency (Fiduciary) Funds: Summary of Interfund-GCA-GLTL Accounting,” is updated for the pertinent provisions of the new pension and OPEB standards—particularly pension plan and OPEB plan reporting. These standards include: • GASB Statement No. 67, “Financial Reporting for Pension Plans—An Amendment of GASB Statement No. 25” • GASB Statement No. 73, “Accounting and Financial Reporting for Pensions and Related Assets That Are Not within the Scope of GASB Statement 68, and Amendments to Certain Provisions of GASB Statements 67 and 68” (This standard supersedes GASB Statements No. 25 and No. 27.) • GASB Statement No. 74, “Financial Reporting for Postemployment Benefit Plans Other Than Pension Plans” (This standard supersedes GASB Statement No. 43.) • GASB Statement No. 82, “Pension Issues—An Amendment of GASB Statements No. 67, No. 68, and No. 73” • Chapter 13, “Financial Reporting: The Basic Financial Statements and Required Supplementary Information,” discusses and illustrates the government-wide statement of net position, including presentation of pension-related deferred outflows of resources and deferred inflows of resources as well as net pension liabilities. • Chapter 14, “Financial Reporting: Deriving Government-Wide Financial Statements and Required Reconciliations,” expands the coverage of the two-worksheet approach with a new appendix, including related journal entries, and incorporates new deferred items that must be included in the conversion. • Chapter 15, “Financial Reporting: The Comprehensive Annual Financial Report and the Financial Reporting Entity,” incorporates the new blending requirements adopted in Statement No. 80, “Blending Requirements for Certain Component Units—An Amendment of GASB Statement No. 14.” • Chapter 16, “Non-SLG Not-for-Profit Organizations,” has been revised to reflect the changes in not-for-profit financial statements required by the FASB’s Accounting Standards Update 2016-14, “Not-for-Profit Entities (Topic 958): Presentation of Financial Statement of Notfor-Profit Entities.” • Chapter 17, “Accounting for Colleges and Universities,” has been revised to incorporate both GASB Statement No. 81, “Irrevocable Split-Interest Agreements,” and FASB Accounting Standards Update 2016-14.

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xvi  Preface   

 • Chapter 18, “Accounting for Health Care Organizations,” has been updated for FASB Accounting Standards Update 2016-14. • Chapter 20, “Auditing Governments and Not-for-Profit Organizations,” incorporates recent changes in auditing guidance and audit reports. In particular, it is updated for the most recent state and local government audit guide and for the new “Uniform Guidance” that applies to Single Audits of governments and not-for-profit entities.

CUSTOMIZATION FRIENDLY DESIGN As in the past, the text design allows professors to tailor their courses to their students’ needs and priorities. Therefore, the breadth of topics is wider than is covered in the typical government and not-for-profit accounting course. Chapters that tend to be among the ones omitted are constructed to permit their omission without harming the flow of a course.

LEARNING FRIENDLY The 11th edition also continues to incorporate the building block approach to the learning process consistent with the following philosophy: • Mastering governmental and not-for-profit accounting concepts, principles, and practices involves progressing through many different phases of knowledge and understanding. • Learning efficiency and effectiveness requires this progression to follow a logical sequence. • Logical sequencing keeps the next concept to be learned accessible from the base provided by the concepts learned already. (Students learn more in less time when taken through the right steps.) • Efficiently achieving more advanced levels of learning and knowledge requires attaining any prerequisite knowledge first. • Having this base of prior knowledge and understanding facilitates learning the new information and ideas.

This approach should guide both the ordering of chapters and the sequencing of material within a chapter. The learning process should take full advantage of the business accounting background the learner likely brings into the course.

OTHER POINTS OF DISTINCTION Other key features of the text, in addition to the learner orientation, flow from our teaching philosophies and goals, including: • Integrating the computerized Harvey City Comprehensive Case throughout Chapters 4 to 15 to simulate the experience of accounting and reporting for a small city • Correlation with professional practice, enhanced by: • Using a practice-relevant, conversion worksheet approach to develop government-wide financial statement data • Integrating practice examples for teaching purposes throughout the state and local government accounting, reporting, and auditing chapters • Incorporating case problems developed from actual state and local government financial reports in the end-of-chapter materials

INSTRUCTOR SUPPLEMENTS Supplements for this new edition of Governmental and Nonprofit Accounting are available for download by instructors only at www.pearsonhighered.com. Resources

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 Preface  xvii

include an Instructor’s Manual, Solutions Manual, Excel solution templates for the Harvey City Comprehensive Case and for selected problems, Test Item File, and a PowerPoint presentation.

ACKNOWLEDGMENTS We are grateful for the excellent input provided by numerous adopters and other individuals that led to improvements in the 11th edition of the text. A few individuals have provided particularly significant input to help us enhance the chapters. We offer special thanks to: Dr. Richard Brooks, West Virginia University Dr. Catherine A. Finger-Podosky, Saint Mary’s College of California

We appreciate the support and professional commitment of the development, marketing, production, and editorial staffs at Pearson. We particularly appreciate the efforts of Ashley Dodge, Director of Courseware Portfolio Management; Jeff Holcomb, Director of Production, Business; Ashley Santora and Alison Kalil, Managing Producers, Business; Neeraj Bhalla, Senior Sponsoring Editor; and Jona Centino, Project Manager, who kept us on track and made sure everything was complete.

AUTHORSHIP CHANGES As anyone familiar with this text will likely have noticed before even opening the book, we have the bittersweet misfortune of wishing two good friends and colleagues well as they end their time as co-authors of the text. Greg Allison continues to make monumental contributions to the governmental accounting profession and education in his roles at the University of North Carolina at Chapel Hill. The demands on his time continue to be immense. He recently contributed to the development of an online Masters of Accounting program at the university in addition to his work with the School of Government, the North Carolina Local Government Commission, and governments throughout the state and beyond. Greg has made valuable contributions to the text in the more than 10 years he has served as a co-author. G. Robert Smith, Jr., better known to us all as Smitty, has retired after a long and successful career during which he made valuable contributions not only to the universities and students he served but to the governmental accounting profession as well. Smitty held leadership roles in the Government and Not-for-Profit Section of the American Accounting Association, including serving as its president. He also served on the Governmental Accounting Standards Advisory Council, participated in multiple roles with the AICPA, and regularly provided continuing professional education for CPAs and government officials. Smitty accomplished all this even during the time that he was serving as the accounting department head at Middle Tennessee State University. One of the contributions to this text that has left its mark and that we value greatly is Smitty’s introduction of the two-worksheet approach to converting fund financial statement information into government-wide financial statement information. This is an effective approach for helping students (and practitioners) understand the conversion process. We wish Smitty the very best in his Tennessee mountain retirement. The other side of authorship changes is we get the benefit of the ideas, experience, and efforts of our new colleagues. Two outstanding professionals have joined us to carry the load left by the departures of Greg and Smitty. Dwayne McSwain, currently a member of the accounting faculty at Sam Houston State University, is a well-known and well-respected member of the governmental accounting and auditing specialists within academe. He has had extensive

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xviii  Preface   



experience in both governmental accounting roles and as a public school district finance director before entering the professorial ranks. Dwayne also co-authored a significant practitioner guide for several years. This extensive background and his publishing experience make Dwayne a valuable addition to our authorship team. Robert Scott, the chief financial officer and assistant city manager of the city of Carrollton, Texas, is among the most talented and respected CPAs in government today. He has been recognized as the outstanding CPA in government by the AICPA (2008) and serves on its State and Local Government Expert Panel. Bob has served the Government Finance Officers Association (GFOA) in many capacities, including as a member of its Executive Board, and is an outstanding continuing professional education instructor who has authored or co-authored well-regarded continuing education courses. Bob, like Dwayne, is a valuable addition to the author team. Both have made meaningful contributions to this edition.

MOST IMPORTANTLY Finally, we can never adequately express our love and appreciation to our families. They stand by us in all that we do, including the revision of this text. Clearly, their help and support multiply what we are able to accomplish. Most importantly, they enrich our lives in countless ways and are continuous sources of joy and blessings.

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Get Complete eBook Download Link below for instant download

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About the Authors ROBERT J. FREEMAN Robert J. Freeman, Ph.D., CPA, is the Distinguished Professor of Accounting Emeritus at Texas Tech University. He served on the Governmental Accounting Standards Board from 1990 to 2000 and on its predecessor, the National Council on Governmental Accounting, from 1974 to 1980. Dr. Freeman has received the Enduring Lifetime Contributions Award from the American Accounting Association Government and Nonprofit Section, the Louisiana Tech University Tower Medallion Award, and the AICPA Elijah Watt Sells Silver Medal Award. Prior to joining the Texas Tech faculty, Dr. Freeman was on the faculties of the University of Alabama and Louisiana Tech University, and served as national director of State and Local Government Activities at Arthur Young & Company. The extensive governmental accounting, financial reporting, and auditing seminars that he has offered each summer for the past 35 years have been attended by over 20,000 participants, including some of today’s leaders whose first introduction to governmental accounting and financial reporting was in his 3-day Governmental Accounting and Financial Reporting seminar. Dr. Freeman has contributed numerous articles to professional journals, including The Journal of Accountancy, Accounting Horizons, The Government Accountants Journal, Government Finance Review, The International Journal of Governmental Auditing, and The Journal of Public Budgeting, Accounting & Financial Management. He has served on the editorial boards of The Journal of Accountancy, Research in Governmental Accounting, The Journal of Accounting and Public Policy, and The Journal of Public Budgeting, Accounting & Financial Management. Also, Dr. Freeman and Dr. Shoulders were co-authors of multiple editions of Practitioners Publishing Company’s three-­ volume practice guide, Preparing Governmental Financial Statements.

CRAIG D. SHOULDERS Craig D. Shoulders, Ph.D., is a professor of accounting at the University of North Carolina at Pembroke. He served on the accounting faculty at Virginia Tech for the first 22 years of his career and also taught for 3 years at Western Carolina University. In addition to being the recipient of the Cornelius E. Tierney/Ernst & Young Research Award from the Association of Government Accountants, Dr. Shoulders has been recognized twice by the AICPA as an Outstanding Discussion Leader. He prepares and teaches continuing education courses and seminars on governmental accounting and auditing across the country and is a past president of the Roanoke Area Chapter of the Virginia Society of CPAs. Dr. Shoulders has conducted research for the GASB on the financial reporting entity and has served on GASB task forces on other projects. Dr. Shoulders coauthors several continuing education courses and for many years authored the government and not-for-profit sections of the ExamMatrix CPA Review. His articles have appeared in such journals as Issues in Accounting Education, The Journal of Accountancy, Government Finance Review, and The Journal of Government Financial Management. He received his bachelor’s degree from Campbellsville University, his master’s degree from the University of Missouri-Columbia, and his Ph.D. from Texas Tech University.

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xx  About the Authors   



DWAYNE N. MCSWAIN Dwayne McSwain, Ph.D., CPA, is an Associate Professor of accounting at Sam Houston State University. He previously served on the accounting faculties at Appalachian State University and Middle Tennessee State University. Dr. McSwain’s research has been published in Internal Auditing, Journal of Accounting Literature, Journal of Government Financial Management, and The CPA Journal, among others. He is a member of the American Accounting Association, American Institute of CPAs, Association of Government Accountants, Government Finance Officers Association, and the Texas Society of CPAs. Dr. McSwain has been teaching governmental and nonprofit accounting since 1999. He has more than 14 years of governmental accounting experience in practice, working as a staff auditor, payroll specialist, internal auditor, finance director, and accounting information systems specialist in Texas school districts. In addition to co-authoring several academic and practitioner articles related to governmental and nonprofit accounting, Dr. McSwain co-authored annual updates to Applying Government Accounting Principles for 8 years. He received his associate’s degree from Gaston College, his bachelor’s degree from the University of North Carolina at Charlotte, his master’s degree from Tarleton State University, and his Ph.D. from the University of Texas at Arlington.

ROBERT B. SCOTT Robert Scott is the chief financial officer/assistant city manager for the city of Carrollton, Texas. He earned a master’s degree in Accounting and a bachelor of science degree in Political Science from Texas Tech University. Today, he combines his extensive knowledge of governmental accounting with practical knowledge of what works in practice. Mr. Scott began his career in public accounting and has served both as a Practice Fellow at the Governmental Accounting Standards Board (GASB) and as a representative to the Governmental Accounting Standards Advisory Committee. He serves as a reviewer during revisions of Governmental Accounting, Auditing, and Financial Reporting (the “Blue Book”), is a past chair of GFOA’s Committee for Accounting, Auditing and Financial Reporting (CAAFR), and has served on the GFOA’s Executive Board. Mr. Scott serves on the AICPA State and Local Government Expert Panel, and in 2008 the AICPA named him the Outstanding CPA in Local Government.

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Governmental and Nonprofit Accounting Environment and Characteristics

CHAPTER

1

LEARNING OBJECTIVES After studying this chapter, you should be able to: 1.1 Describe the key unique characteristics and major types of government and nonprofit (G&NP) organizations. 1.2 Describe the objectives of G&NP accounting and financial reporting. 1.3 Identify the authoritative sources of financial reporting standards for various types of G&NP organizations and

the level of authority (hierarchy) of various pronouncements and guides. 1.4 Summarize the key distinguishing characteristics, concepts, and objectives of G&NP accounting and financial reporting. 1.5 Explain the key characteristics of state and local government financial reporting.

A

ccounting and financial reporting for governments and nonprofit (G&NP) organizations, as well as G&NP auditing, are based on distinctive concepts, standards, and procedures that accommodate their environments and the needs of their financial and audit report users. This book focuses on the most important of these concepts, standards, and procedures applicable to (1) state and local governments, including counties, cities, and school districts, as well as townships, villages, special districts, and public authorities; (2) the federal government; and (3) not-for-profit and governmental universities, hospitals, voluntary health and welfare organizations, and other not-for-profit (or nonprofit) organizations. Financial management and accountability considerations peculiar to G&NP organizations are emphasized throughout, and auditing G&NP organizations is discussed in the final chapter. This chapter introduces the characteristics and types of G&NP organizations and the objectives and nature of G&NP accounting and financial reporting. Additionally, it discusses and illustrates how to distinguish government and nongovernment organizations; identifies the various authoritative sources of G&NP accounting principles and reporting standards, including their relative authoritativeness; and introduces the state and local government (SLG) accounting and

1

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2  CHAPTER 1  Governmental and Nonprofit Accounting financial reporting environment, concepts, objectives, and distinctive features. The latter includes funds, legally enacted budgets and appropriations, and budgetary control.

CHARACTERISTICS AND TYPES OF G&NP ORGANIZATIONS Learning 1.1 Objective

Governments and other nonprofit organizations are unique in the following ways: • They do not attempt to earn a profit, and most are exempt from income taxes. Thus, typical business accounting, including income tax accounting, usually is not appropriate. • They are owned collectively by their constituents; because ownership is not evidenced by equity shares that can be sold or traded, residents who are dissatisfied with their government must await a change in its elected governing body or move elsewhere. • Those contributing financial resources to the organizations do not necessarily receive a direct or proportionate share of their services. For example, homeowners pay property taxes to finance public schools even if they do not have children in school. • Their major policy decisions, and perhaps some operating decisions, typically are made by majority vote of an elected or appointed governing body (e.g., a state legislature, a city council, or a hospital board of directors) whose members serve part time, receive modest or no compensation, and have diverse backgrounds, philosophies, capabilities, and interests. • Decisions usually must be made “in the sunshine”—that is, in meetings open to the public, including the news media—and most have “open records” laws that make their accounting and other records open to the public.

A G&NP organization exists because a community or society decides to provide certain goods or services to its group as a whole. Often, these goods or services are provided regardless of whether costs incurred will be recovered through charges for the goods or services or whether those paying for the goods or services are those benefiting from them. Indeed, many G&NP services could not be provided profitably through private enterprise. In addition, the community or society may consider these services so vital to the public well-being that they should be supervised by its elected or appointed representatives. The major types of government and nonprofit organizations may be classified as: 1. Governmental: federal, state, county, municipal, township, and village, as well as other local governmental authorities and special districts 2. Educational: kindergartens, elementary, and secondary schools; vocational and technical schools; and colleges and universities 3. Health and welfare: hospitals, nursing homes, child protection agencies, the American Red Cross, and United Service Organizations (USO) 4. Religious: Young Men’s Christian Association (YMCA), Young Women’s Christian Association (YWCA), Salvation Army, and other church-related organizations 5. Charitable: United Way, Community Chest, and similar fund-raising agencies; related charitable agencies; and other charitable organizations 6. Foundations: private trusts and corporations organized for educational, religious, or charitable purposes

This general classification scheme has much overlap among the classifications. Many charitable organizations are operated by churches, for example, and governments are deeply involved in education, health, and welfare activities.

G&NP Sector Significance

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Governments and other nonprofit organizations have experienced dramatic growth in recent years and are major economic, political, and social forces in our society. Indeed, the G&NP sector now accounts for more than one-third of all expenditures in the U.S. economy. During the Great Recession, government spending temporarily

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Characteristics and Types of G&NP Organizations  3

grew to over 40 percent of the total gross domestic product. The total value of financial and human resources devoted to this sector is gigantic, both absolutely and relatively. Sound financial management—including thoughtful budgeting, proper ­accounting, meaningful financial reporting, and timely audits by qualified auditors—is at least as important in the G&NP sector as in the private business sector. Furthermore, because of the scope and diversity of its activities, proper management of the financial affairs of a city or town, for example, may be far more complex than that of a private business with comparable assets or annual expenditures. As the size and complexity of governments and nonprofit organizations have increased in recent years, so have the number of career employment opportunities in this sector for college graduates majoring in accounting and public administration (and other disciplines). Likewise, the number of governmental and nonprofit organization auditing and consulting engagements with independent public accounting firms has increased significantly. Accordingly, a significant portion of the Uniform Certified Public Accountant (CPA) Examination is on G&NP accounting, financial reporting, and auditing concepts, principles, and procedures. Government and nonprofit organizations are similar in many ways to profit-­seeking enterprises. For example:

The G&NP Environment

1. They are integral parts of the same economic system and use financial, capital, and human resources to accomplish their purposes. 2. Both must acquire and convert scarce resources into their respective goods or services. 3. Both must have viable information systems, including excellent accounting systems to assure that managers, governing bodies, and others receive relevant and timely information for planning, directing, controlling, and evaluating the sources, uses, and balances of their scarce resources. 4. Cost analysis and other control and evaluation techniques are essential to ensure that resources are utilized economically, effectively, and efficiently. 5. In some cases, both produce similar products. For example, both governments and private enterprises may own and operate transportation systems, sanitation services, and electric utilities.

On the other hand, significant differences distinguish profit-seeking organizations from G&NP organizations. Broad generalizations about such a diversified group as G&NP organizations are difficult, but the major differences include (1) organizational objectives, (2) sources of financial resources, and (3) methods of evaluating performance and operating results. Organizational Objectives Expectation of income or gain is the principal factor that motivates investors to provide resources to profit-seeking enterprises. To the contrary: • The objective of most governmental and nonprofit organizations is to provide as much service each year as their financial and other resources permit. • Typically, G&NP organizations operate on a year-to-year basis—that is, each year they raise as many financial resources as necessary and expend them in serving their constituencies. • Government and nonprofit organizations may seek to increase the amount of resources made available to them each year—and most do—but the purpose is to enable the organizations to provide more or better services, not to increase their wealth.

In sum, whereas private businesses seek to increase their wealth for the benefit of their owners, G&NP organizations seek to expend their available financial resources for the benefit of their constituencies. Financial management in the G&NP environment thus typically focuses on acquiring and using financial resources—on sources and uses of expendable financial resources, budget status, and

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4  CHAPTER 1  Governmental and Nonprofit Accounting cash flow—rather than on net income. Even G&NP entities whose external financial reports do not require primary emphasis on acquisition and use of financial resources emphasize this information for internal reporting and management decision-making purposes. Sources of Financial Resources The sources of financial resources differ between business and G&NP organizations, as well as among G&NP organizations. In the absence of a net income objective, no distinction generally is made between invested capital and revenue of G&NP organizations. A dollar is a financial resource whether acquired through donations, user charges, sales of assets, loans, or some other manner. The typical nondebt sources of financing for business enterprises are investments by owners and sales of goods or services to customers. These sources of financing are usually not the primary sources of G&NP organizations’ financial resources. Instead, G&NP organizations primarily rely on the following sources: • Governments have the unique power to force involuntary financial resource contributions through taxation of property, sales, and income. Indeed, all levels of government rely heavily on this power. Grants and shared revenues from other governments are also important state and local government revenue sources, as are charges for services provided. • Religious groups and charitable organizations usually rely heavily on donations, although they may have other revenue sources. • Some colleges and universities rely heavily on donations and income from trust funds; others depend primarily on state appropriations, federal and state grants, and/or tuition and fee charges for support. • Hospitals and other health care organizations generally charge their clientele, although many do not admit patients solely on the basis of ability to pay. Indeed, many G&NP hospitals serve numerous charity patients and/or have large amounts of uncollectible accounts, and some hospitals rely heavily on gifts, federal and state grants, and bequests.

Other, more subtle differences in sources of G&NP organizations’ financial resources as compared with profit-seeking businesses include these: • Many services or goods provided by these organizations, such as police and fire protection, are monopolistic. Thus, an open market for objectively appraising or evaluating their value does not exist. • User charges usually are based on the cost of the services provided rather than on supplyand-demand–related pricing policies. • Charges levied for goods or services often cover only part of the costs incurred to provide them; for example, tuition generally covers only a fraction of the cost of operating state colleges or universities, and token charges (or no charges) may be made to a hospital’s indigent patients. • Governments’ revenue-raising capacity is constrained by its geographic boundaries. A wellrun city cannot expand its service and taxing reach to other cities or jurisdictions as a result of its superior performance. At some point, all the usable property has been utilized by existing taxpayers and businesses. However, a government typically cannot expand its boundaries and increase its property tax base and revenue once its existing territory is fully developed to its capacity except through annexation.

Evaluating Performance and Operating Results Profit-seeking enterprises usually will modify or withdraw unprofitable goods or services offered to the consuming public. The direct relationship between the financial resources each consumer provides and the goods or services a consumer receives from each enterprise essentially dictates the type and quality of goods and services each profit-seeking enterprise will provide. Firms with inept or

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Characteristics and Types of G&NP Organizations  5

unresponsive management will be unprofitable and ultimately will be forced out of business. Therefore, the profit motive and profit measurement constitute an automatic allocation and regulating device in the free enterprise segment of our economy. This profit test/regulator device is not present in the usual G&NP situation. Because governments have the power to tax and lack market competition for most of the services they provide, governments generally continue to operate even if they are ineffective or inefficient. Because government services are unique or are provided without charge or at a token charge, consumers have no “dollar vote” to cast. Evaluating the performance and operating results of most G&NP organizations is extremely difficult because: 1. No open market supply-and-demand test occurs to evaluate the value of the services they provide. 2. The relationship, if any, between the resource contributors and the recipients of the services is remote and indirect. 3. G&NP organizations are not profit oriented in the usual sense and are not expected to operate profitably; thus, the profit test is neither a valid performance indicator nor an automatic regulating device. 4. Governments can force financial resource contributions through taxation.

Accordingly, G&NP organizations must employ measures and controls of operating results other than net income to ensure that their resources are used appropriately and to prevent inefficient or ineffective G&NP organizations from operating indefinitely. Governments and nonprofit organizations, particularly governments, are therefore subject to more stringent legal, regulatory, and other controls than are private businesses. All facets of a G&NP organization’s operations—especially of state and local governments—may be affected by legal or quasi-legal requirements (1) imposed externally, such as by federal or state statute, grant regulations, or judicial decrees, or (2) imposed internally or by mutual agreement, such as by charter, bylaw, ordinance, trust agreement, donor stipulation, or contract. Furthermore, the need to ensure compliance with such extensive legal and contractual requirements often necessitates more stringent operational and administrative controls than in private enterprise. Aspects of G&NP organizations’ operations that may be regulated or otherwise controlled include: 1. Organization structure: form; composition of governing board; number and duties of its personnel; lines of authority and responsibility; policies concerning which officials or employees are to be elected, appointed, or hired 2. Personnel policies and procedures: who will appoint or hire personnel; tenure of personnel; policies and procedures upon termination; compensation levels; promotion policies; types and amounts of compensation increments 3. Sources of financial resources: types and maximum amounts of taxes, licenses, fines, or fees a government may levy; procedure for setting user charges; tuition rates; debt limits; purposes for which debt may be incurred; allowable methods for soliciting charitable contributions 4. Uses of financial resources: purposes for which resources may be used, including the legal restriction of certain resources only for specific purposes; purchasing procedures to be followed; budgeting methods, forms, or procedures 5. Accounting: any or all phases of the accounting system—for example, chart of accounts, bases of accounting, forms, and procedures 6. Financial reporting: type and frequency of financial reports; report format and content; report recipients 7. Auditing: frequency of audit; who is to perform the audit; scope and type of audit; time and place for filing the audit report; who is to receive or have access to the audit report

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6  CHAPTER 1  Governmental and Nonprofit Accounting Finally, managers of G&NP organizations may have limited discretion compared with managers of businesses. The role and emphasis of G&NP financial accounting and reporting thus are correspondingly altered as compared with the profit-seeking business environment.

OBJECTIVES OF G&NP ACCOUNTING AND FINANCIAL REPORTING Learning 1.2 Objective

Financial Accounting Standards Board (FASB) Statement of Financial Accounting Concepts No. 4 (SFAC 4), “Objectives of Financial Reporting by Nonbusiness Organizations,” addresses the objectives of general purpose external financial reporting by nonbusiness (nonprofit) organizations. SFAC 4 notes that: • The objectives stem primarily from the needs of external users who generally cannot prescribe the information they want from an organization. • In addition to information provided by general purpose external financial reporting, managers and . . . governing bodies need a great deal of internal accounting information to carry out their responsibilities in planning and controlling activities.1

The financial reporting objectives set forth in SFAC 4 state that financial reporting by nonbusiness organizations should provide information that is useful to present and potential resource providers and other users in: • Making rational decisions about the allocation of resources to those organizations. • Assessing the services that a nonbusiness organization provides and its ability to continue to provide those services. • Assessing how managers of a nonbusiness organization have discharged their stewardship responsibilities and other aspects of their performance.

In addition, nonbusiness organization financial reporting should include explanations and interpretations to help users understand the financial information provided.2 Note that these broad objectives statements relate to all organizations and nonbusiness organizations, respectively. The objectives of state and local government accounting and financial reporting are discussed later in this chapter.

AUTHORITATIVE SOURCES OF G&NP ACCOUNTING PRINCIPLES AND REPORTING STANDARDS Learning 1.3 Objective

The G&NP accounting and reporting concepts, principles, and standards evolved separately from those for business enterprises. Beginning in the 1930s, unique principles and standards evolved separately for each of the several major types of G&NP organizations. • The National Council on Governmental Accounting (NCGA) and several similar predecessor committees led the development of accounting concepts, principles, and standards for state and local governments until the Governmental Accounting Standards Board (GASB) was created in 1984. • The American Hospital Association and the Healthcare Financial Management Association fostered the development of accounting principles and standards for hospitals and other health care institutions. • The American Council on Education and the National Association of College and University Business Officers led the development of those for colleges and universities. 1 Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 4, “Objectives of  Financial Reporting by Nonbusiness Organizations” (Stamford, CT: FASB, December 1980), p. xii. Emphasis added. 2

Ibid., pp. xiii–xiv.

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Authoritative Sources of G&NP Accounting Principles and Reporting Standards  7 • Committees of the American Institute of Certified Public Accountants (AICPA) set forth accounting principles and standards for nonprofit organizations in AICPA audit and accounting guides until the FASB began issuing guidance for nongovernmental, nonprofit organizations in 1993. • The Comptroller General of the United States led the federal government accounting standards effort until the Federal Accounting Standards Advisory Board (FASAB) was established in 1990.

In addition, each G&NP field has its own journals, newsletters, and professional societies. Both the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB) are overseen by the Financial Accounting Foundation (FAF). The FAF, which is comprised of prominent government and private-sector leaders, also appoints new members to the FASB and the GASB.

The FAF

The FASB has seven full-time members and over 60 staff members. Although not limited by its original charter or rules of procedure to setting business accounting standards, the FASB devoted its early efforts almost exclusively to business accounting concepts and standards, deferring the decision on what role, if any, it would play in the G&NP standards area. In 1979, the FASB (1) agreed to exercise responsibility for all specialized accounting and reporting principles and practices set forth in AICPA statements of position, accounting guides, and audit guides except those dealing with state and local governments (FASB Statement No. 32). Subsequently, the FASB rescinded FASB Statement No. 32 and issued standards for nongovernmental organizations, including nongovernmental not-for-profit organization accounting and financial reporting (discussed in Chapter 16). The FASB deferred action concerning state and local government standards during this period because discussions were underway among representatives of interested organizations, including the NCGA and the AICPA, about the appropriate structure for setting governmental accounting standards. At issue was whether state and local government accounting standards should continue to be established by the NCGA or should be set by the FASB or perhaps a new standards-setting body. These discussions led to formation of the Governmental Accounting Standards Board in 1984.

The FASB

The FAF created the Governmental Accounting Standards Board (GASB) in 1984 in a co-equal relationship with the Financial Accounting Standards Board (FASB). The jurisdiction agreement states that:

FASB-GASB Jurisdictions

• The GASB is responsible for establishing accounting and financial reporting standards for activities and transactions of state and local governments, including government nonprofit organizations. • The FASB is responsible for establishing accounting and financial reporting standards for all other organizations, including nongovernment nonprofit organizations.

Whether an organization is or is not a “government” is a critical determination that dictates whether it must follow GASB or FASB standards and guidance. Most state and local governments—including states, counties, municipalities, townships, and school districts—clearly are “governments” subject to the GASB’s jurisdiction. But it may be difficult to determine whether some not-for-profit and other organizations are governmental or nongovernmental. Accordingly, the GASB and FASB jointly developed a definition of government.

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“Government” Defined

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8  CHAPTER 1  Governmental and Nonprofit Accounting • This definition, summarized in Illustration 1–1, is published in AICPA audit and accounting guides to assist practitioners in determining whether organizations are governmental or nongovernmental and thus are under GASB jurisdiction or FASB jurisdiction. • Many nonprofit organizations are established by governments and are governments under this definition.

The practitioner must determine whether a specific organization is “government” or “nongovernment” using the FASB-GASB definition to apply the generally accepted accounting principles (GAAP) hierarchy guidance correctly.

The GASB

The GASB succeeded the NCGA in 1984 (see Appendix 1-1) as the body authorized to establish accounting standards for state and local governments (see Illustration 1–2). The GASB, FASB, and FAF offices are in the same building in Norwalk, Connecticut. Again, the GASB is responsible for establishing financial

ILLUSTRATION 1-1  Definition of State and Local Government Entities

Governmental organizations include (1) public corporations1 and bodies corporate and politic, and (2) other organizations if they have one or more of the following characteristics: • The popular election of officers or appointment (or approval) of a controlling majority of the members of the organization’s governing body by officials of one or more state or local governments • The potential for unilateral dissolution by a government with the net assets reverting to a government • The power to enact and enforce a tax levy • The ability to issue directly (rather than through a state or municipal authority) debt that pays interest exempt from federal taxation2 1

Black’s Law Dictionary defines a public corporation as “an instrumentality of the state, founded and owned in the public interest, supported by public funds and governed by those deriving their authority from the state.” 2 However, organizations possessing only that ability (to issue tax-exempt debt) and none of the other governmental characteristics may rebut the presumption that they are governmental if their determination is supported by compelling, relevant evidence. Source: Adapted from “FASB and GASB Define ‘Government,’ ” Journal of Accountancy, July 1996, pp. 16–17. This definition is cited in pertinent AICPA audit and accounting guides.

1-1 

IN PRACTICE

Not-for-Profit (Nonprofit) Organizations May Be Governments 1. Several states have established health care, drug abuse, professional licensing, economic development, and other agencies as 501(c)(3) not-for-profit (nonprofit) corporations. 2. Cities and counties also have established industrial development, economic development, civic center, convention center, sports complex, and other activities and facilities as 501(c)(3) corporations. 3. A professional (AAA) baseball team, the Columbus (Ohio) Clippers, is a less commonly encountered type of ­not-for-profit organization. 4. Finally, many public television stations are legally established as not-for-profit or nonprofit corporations by states, state colleges and universities, or other governments. Although all of these organizations are established as not-for-profit or nonprofit corporations legally, the GASB requires a “substance over form” approach to financial reporting. Thus, organizations such as these are “government not-for-profit or nonprofit organizations” and are under GASB jurisdiction for GAAP reporting.

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Authoritative Sources of G&NP Accounting Principles and Reporting Standards  9 ILLUSTRATION 1-2  Financial Reporting Standards-Setting Structure

Financial Accounting Foundation (FAF)

(Financing and Oversight)

Financial Accounting Standards Advisory Council (FASAC)

Advises

Financial Accounting Standards Board (FASB)

Governmental Accounting Standards Board (GASB)

Advises

Governmental Accounting Standards Advisory Council (GASAC)

Source: Based on portions of various GASB documents. Complete copies of documents are available from the GASB.

reporting standards for activities and transactions of state and local governments; the FASB sets reporting standards for all other organizations, including nongovernmental, nonprofit organizations. The GASB has seven members. The chairperson serves full time, whereas the other six members serve part time. The board is assisted by a full-time professional staff of approximately 20 persons, led by the director of research, and meets in open session for two to three days about every six weeks, with one-day teleconference meetings in between. The GASB mission—including its mission statement, an overview of how its mission is accomplished, and its due process—is summarized in Illustration 1–3. The GASB’s activities focus on its agenda topics and projects. It may issue nonauthoritative invitations to comment, discussion memorandums, and preliminary views publications to obtain viewpoints of practitioners and others before issuing exposure drafts and, finally, an authoritative pronouncement. Its authoritative pronouncements are issued as Statements, Technical ­Bulletins, and Implementation Guides. (The GASB no longer issues Interpretations but some remain effective.) The GASB issues The GASB Report electronic newsletter to inform interested persons of its activities and also issues Concepts Statements, research studies, and other nonauthoritative publications from time to time. GASB Statement No. 1, “Authoritative Status of NCGA Pronouncements and AICPA Industry Audit Guide,” issued in 1984, provided a transition from the old standards-setting arrangements to the current one. Statement No. 1 recognized the then-effective NCGA pronouncements and certain accounting and reporting ­guidance in the then-effective AICPA state and local government audit guide as authoritative, stating that they are “continued in force until altered, amended, supplemented, revoked, or superseded by a subsequent GASB pronouncement.” 3 These NCGA and AICPA pronouncements—now recognized as GASB ­pronouncements—were integrated into its authoritative Codification of Governmental Accounting and Financial Reporting Standards in 1985.4 3 Governmental Accounting Standards Board, Statement No. 1, “Authoritative Status of NCGA Pronouncements and AICPA Industry Audit Guide” (Norwalk, CT: GASB, July 1984). 4

Governmental Accounting Standards Board and Governmental Accounting Research Foundation of the Government Finance Officers Association, Codification of Governmental Accounting and Financial Reporting Standards as of November 1, 1984 (Norwalk, CT: GASB, 1985).

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10  CHAPTER 1  Governmental and Nonprofit Accounting ILLUSTRATION 1-3  Facts about GASB

What Is the GASB? The Governmental Accounting Standards Board (GASB) is the independent organization that establishes and improves standards of accounting and financial reporting for U.S. state and local governments. Established in 1984 by agreement of the Financial Accounting Foundation (FAF) and 10 national associations of state and local government officials, the GASB is recognized by governments, the accounting industry, and the capital markets as the official source of generally accepted accounting principles (GAAP) for state and local governments. Accounting and financial reporting standards designed for the government environment are essential because governments are fundamentally different from for-profit businesses. Furthermore, the information needs of the users of government financial statements are different from the needs of the users of private company financial statements. The GASB members and staff understand the unique characteristics of governments and the environment in which they operate. The GASB is not a government entity; instead, it is an operating component of the FAF, which is a private sector not-for-profit entity. Funding for the GASB comes primarily from an accounting support fee established under the DoddFrank Wall Street Reform and Consumer Protection Act as well as the sale of certain publications. Its standards are not federal laws or regulations and the organization does not have enforcement authority. Compliance with GASB’s standards, however, is enforced through the laws of some individual states and through the audit process, when auditors render opinions on the fairness of financial statement presentations in conformity with GAAP. Why Is the GASB’s Work Important? The GASB, in keeping with its mission, issues standards and other communications that result in decision-useful information for users of government financial reports, including, for example, owners of municipal bonds, members of citizen groups, legislators and legislative staff, and oversight bodies. Those standards also help government officials demonstrate to their constituents their accountability and stewardship over public resources. Additionally, the GASB works to educate the public, including financial statement preparers, auditors, and users, about its standards and the information those standards require governments to present in their financial reports. To encourage broad public participation in the standards-setting process, GASB standards are issued only after

completion of extensive and rigorous due process activities, which are discussed here. How Does the GASB Set Standards? Before issuing its standards, the GASB follows the due process activities described in its published Rules of Procedure. The GASB’s stringent due process activities are designed to encourage broad public participation in the standards-setting process. These activities promote timely, thorough, and open study of financial accounting and reporting issues by the preparers, auditors, and users of financial reports. For many of the issues it addresses, the GASB • Appoints an advisory task force of outside experts. • Studies existing literature on the subject and conducts or commissions additional research if necessary. • Publishes a discussion document for public comment, setting forth the issues or concerns being addressed and possible solutions. • Broadly distributes an Exposure Draft of a proposed standard for public comment. • Conducts public hearings and forums on its due process documents. Significant steps in the process are announced publicly. The GASB’s meetings are open for public observation, and a public record is maintained. The GASB also is advised by the Governmental Accounting Standards Advisory Council, a 30-member group appointed by the FAF trustees that represents a wide range of the GASB’s constituents. Transcripts of public hearings, letters of comment and position papers, research reports, and other relevant materials on projects leading to issuance of pronouncements become part of the board’s public record and are available for inspection. In addition, letters of comment are available on the GASB website. To encourage public comment, discussion documents and Exposure Drafts are distributed by means of the Internet. Single printed copies are available without charge during the comment period to all who request them. Final pronouncements are distributed when published through GASB subscription plans and are posted to the GASB website. Printed copies of printed pronouncements may be purchased by placing an order on the GASB website, www.gasb.org, or by contacting the GASB’s Order Department at 800-748-0659.

Source: “Facts about GASB” from FACTS ABOUT GASB, 2015-2016. Copyright © 2015 by Financial Accounting Foundation. Reprinted with permission of the Financial Accounting Foundation, 401 Merritt 7, Norwalk, CT 06856, USA.

The GASB Codification is revised annually to incorporate subsequent GASB pronouncements (including implementation guides), as are its companion Original Pronouncements volumes, which contain the complete text of all GASB and NCGA pronouncements. Implementation guides address practice questions that arise regarding implementation of GASB standards. As a result of the new hierarchy established in GASB Statement No. 76, the GASB adopted Implementation Guide 2015-1 in June 2015, establishing a comprehensive implementation guide that had been subjected to due process. This guide superseded all previous implementation guides. Subsequent modifications made to this guide will be made

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Authoritative Sources of G&NP Accounting Principles and Reporting Standards  11

through separate implementation guides, including annual updates, in the future. The GASB will continue to provide a Comprehensive Implementation Guide containing all currently effective implementation guidance. All the GASB and predecessor literature is also available through its Governmental Accounting Research System (GARS), a readily accessible, online or personal computer disk search and retrieval system that is revised semiannually. (The GASB maintains an informative website at http://www.gasb.org.) Day-to-day accounting and interim reporting by G&NP organizations is often based on cash receipts, disbursements, and balances or assuring compliance with the organization’s budget. But their annual financial statements must meet the GASB’s uniform national standards if they are to comply with generally accepted accounting principles (GAAP) and thus be “presented fairly in conformity with generally accepted accounting principles.” The AICPA established parallel but distinct GAAP hierarchies to assist practitioners in determining (1) which authoritative financial reporting standards or other guidance should be considered in determining what constitutes GAAP and (2) their relative status or ranking. Both the GASB and the FASB recently adopted hierarchies that superseded the previous AICPA-established hierarchies. The FASB subsequently replaced its hierarchy with its Accounting Standards Codification. The current content of the Accounting Standards Codification is authoritative for all nongovernment entities, and all other literature is nonauthoritative. For governments, GASB Statement No. 76, The Hierarchy of Generally Accepted Accounting Principles for State and Local Governments, established two levels of authoritative pronouncements for state and local governments. All of the authoritative literature is incorporated in the Codification of Governmental Accounting and Financial Reporting Standards.

GAAP Hierarchies

a. Level a pronouncements include GASB Statements of Governmental Accounting Standards and Interpretations (and authoritative pronouncements of GASB’s predecessor body, the NCGA). b. Level b pronouncements include GASB Technical Bulletins and implementation guides (including the Comprehensive Implementation Guide) and if specifically made applicable to state and local governments by the AICPA and cleared by the GASB: AICPA Industry Audit and Accounting Guides and AICPA Statements of Position.

All other accounting literature is nonauthoritative. However, this nonauthoritative literature may be relevant guidance if no authoritative guidance is available. Indeed, GASB Statement No. 76 provides guidance regarding what to consider in choosing nonauthoritative literature to follow when authoritative guidance is not available. To determine the appropriate accounting and reporting treatment for a transaction or other event with no treatment specified in the authoritative literature, a SLG: • Should first consider accounting principles specified in Level a or Level b authoritative literature for similar transactions or other events to apply by analogy • Then may consider nonauthoritative accounting literature from other sources that does not conflict with or contradict authoritative GAAP.

Nonauthoritative literature includes, among others, GASB concepts statements, FASB pronouncements, AICPA literature not included in Level b, predominant practices in an industry, literature of other professional associations and regulatory agencies, and accounting textbooks, handbooks, and articles. Evaluating the appropriateness of nonauthoritative literature requires consideration of its consistency with the GASB Concepts Statements, relevance to the specific circumstances, its specificity, and the general recognition of the issuer or author as an authority.

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12  CHAPTER 1  Governmental and Nonprofit Accounting This text focuses initially on state and local governments and the “GASB Jurisdiction” hierarchy referred to as the “SLG GAAP hierarchy.” The GAAP hierarchies for nongovernmental, nonprofit organizations and the federal government are discussed in later chapters. Several points are particularly significant for the SLG GAAP hierarchy: 1. Its guidance applies only to state and local government organizations; non-SLGs follow the “FASB” GAAP hierarchy. 2. GASB Statements of Governmental Accounting Standards (and Interpretations that are still in force) are the highest-ranking authoritative pronouncements for SLGs, followed by GASB implementation guides and Technical Bulletins as well as certain AICPA guidance that has been cleared by the GASB. 3. FASB guidance that has not been incorporated in GASB pronouncements is not authoritative.

CONCEPTS AND OBJECTIVES OF SLG ACCOUNTING AND FINANCIAL REPORTING Learning 1.4 Objective

The earlier discussions of the G&NP organization environment, concepts and objectives of G&NP accounting and financial reporting, and characteristics of G&NP accounting deal with G&NP organizations generally. This section builds on those discussions and considers similar factors from the state and local government perspective, as set forth in GASB Concepts Statement No. 1, “Objectives of Financial Reporting.” The primary purposes of this section are to • Help the reader understand the principal features of SLGs that have influenced the development of SLG accounting and financial reporting objectives, concepts, principles, and standards—particularly features that differ from those of business enterprises. • Provide background necessary for the reader to understand and apply the GASB’s basic principles, which are discussed in the next chapter.

The environment of SLG accounting and reporting is considered first, followed by a discussion of the users and uses of SLG financial reports. A summary of the objectives of SLG external financial reporting in GASB Concepts Statement No. 1 concludes this section.5 One unique aspect of the SLG environment is that governments may be involved in both governmental-type and business-type activities. • Governmental-type (or governmental) activities include fire and police protection, the courts, street and traffic control, health and welfare, executive and legislative offices, and other “general governmental” activities. • Business-type activities include public utilities (e.g., electricity, water) and other activities for which user fees are charged and that are operated similarly to private businesses.

The environments of governmental-type and business-type activities may differ, even within one government, as may financial statement user information needs. Thus, the SLG environment, financial statement users, and user information needs are discussed first for governmental-type activities, and are then compared with those of business-type activities.

Governmental-Type Activities

The governmental-type activity environment is unique in several respects. These aspects include the distinctive SLG: • Purpose • Sources of financial resources 5

This section is drawn, with permission, primarily from GASB Concepts Statement No. 1, “Objectives of Financial Reporting,” which is reproduced in Governmental Accounting Standards Board, Codification of Governmental Accounting and Financial Reporting Standards as of June 30, 2011 (Norwalk, CT: GASB, 2011), Appendix B. Hereafter cited as GASB Codification.

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Concepts and Objectives of SLG Accounting and Financial Reporting  13 • Financial resource allocation mechanisms • Accountabilities • Reporting issues and problems

Purpose As noted earlier, a government’s primary reason for existence—particularly for its governmental-type activities—differs from that of business enterprises. Whereas the key objective of businesses is to earn a profit, the primary goal of governmental-type (also known as governmental or general government) activities is to provide goods or services, often without regard to the individual recipient’s ability to pay for them. Absence of the profit motive in governmental-type activities underlies several other differences between governments and businesses. As noted earlier, the basic performance evaluation measure in business—net income—does not apply to ­governmental-type activities. Moreover, most governments do not obtain significant financial resources for governmental-type activities from service charges to individual recipients in proportion to the services received. Because proportionate service charges are not a key source of general government financial resources: 1. Financial resources provided by one person or group may be used to finance services for another person or group, and 2. Government goods and services are not automatically allocated to individual users who are willing and able to pay.

Thus, the market supply-and-demand allocation mechanism does not function as it does for business. Sources of Financial Resources Because significant revenues from sales of services are not available to finance governmental-type activities, governments must raise financial resources from other sources. Two primary examples of these revenue sources are taxes and intergovernmental grants and subsidies. Taxation  The power to tax is unique to governments and most governmental-type SLG services—such as police and fire protection, elementary and secondary education, and streets and highways—are financed primarily by tax revenues. Indeed, even when SLGs charge fees for general government services, they often must be subsidized with tax revenues (e.g., many public health clinics). The power to tax causes taxpayers to be involuntary financial resource providers. Individual taxpayers cannot refuse to pay taxes if they think the government is using the resources improperly, or pay a lesser amount if they do not use as many of the government’s services as do others. Rather, the amount of taxes a taxpayer must pay is based on the value of the taxpayer’s real and/or personal property (property taxes), the amount of income earned (income taxes), retail purchases (sales taxes), and so forth—not on the amount or value of services received. Taxation, then, is a nonexchange transaction or event that eliminates any direct association between 1. The amount and quality of the services a constituent receives from the government, and 2. The amount the constituent pays to the government.

Many governments also have other powers similar to taxation, such as levying license and permit fees, fines, and other charges. This ability of governments to exact resources from individuals, businesses, and others by taxation and similar levies—without an arm’s-length exchange transaction—means that the types, levels, and quality of services a government provides are not automatically dictated or regulated by what its constituents are willing to pay for the services. This absence

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14  CHAPTER 1  Governmental and Nonprofit Accounting of the market resource allocation mechanism makes it difficult to measure the success of a governmental unit solely in financial terms. Intergovernmental Revenues  Grants and subsidies from higher-level governments are another significant source of SLG revenues. For many state and local governments, intergovernmental revenues approach or exceed the amount of the SLG’s own tax revenues in many fiscal years. The federal government provides several hundred billion dollars of revenues to SLGs every year, and states provide additional financial resources to local governments. Most intergovernmental revenues are not provided as a direct result of services received by the resource provider but are to help finance certain services for the recipient’s constituency. Financial Resource Allocation Mechanisms General government financial resource allocations are derived from processes clearly different from business enterprises. Indeed, absent a direct relationship between the financial resources provided by an individual taxpayer and the services provided to that individual taxpayer, it is impossible for resource allocations to be made in the same manner as for business enterprises. Rather, for the most part, the nature of the U.S. system of governance, including various restrictions on financial resource use and the budget process, determines how the allocations are made. Restrictions on Resource Use  One primary mechanism used for allocating general government resources to various uses is for restrictions to be placed on financial resource use by the resource providers or their representatives. One level of restriction requires that certain resources be used for a particular purpose or program. Such restrictions arise from • Intergovernmental grantors requiring that the resources provided be used for a particular purpose. • Taxes and similar resources being levied for a specific purpose, such as roads, education, or debt service. • Debt proceeds being restricted to a specific purpose.

These numerous restrictions are the primary reason for the use of funds and nonfund accounts—to account for financial resources segregated according to the purpose(s) for which they may or must be used and any related capital assets and long-term liabilities, respectively. The GASB recognizes the importance of the governmental fund structure and the fund accounting control mechanism in the SLG environment, observing that funds and fund accounting controls • Complement the budgetary process and annual budget in ensuring that a government uses its financial resources in compliance with both external restrictions and the annual budget. • Facilitate fulfilling the SLG’s accountability to its constituency, grantors, and others.

The Budget  Taxes and other revenues are allocated to various uses by placing even more detailed budgetary restrictions on their use. Theoretically, taxpayers could meet and decide as a group how to allocate the resources to various uses. However, in our representative form of government, citizens have delegated that power to public officials through the election process. In addition, a system of checks and balances over the potential abuse of power is provided by the separation of powers among the executive, legislative, and judicial branches of government. These more detailed restrictions are thus placed on the use of financial resources by elected officials through the budget process, which is a key element of the decision-making processes in government. The budget is adopted into law and essentially becomes a contract between the executive branch, the legislative branch, and the citizenry. In most jurisdictions, significant changes in this budget contract should be

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Concepts and Objectives of SLG Accounting and Financial Reporting  15

made only through a process similar to the budget process itself. In the budget process, • The executive branch typically prepares a proposed budget and submits appropriation requests to the legislative branch. • The legislative branch has the power to approve those requests, thus authorizing the executive branch to make expenditures within the limits of the appropriations and any laws that may affect programs covered by those appropriations. • The executive branch is accountable to the legislative branch for operating within those appropriations and laws, and both branches are accountable to the citizenry.

The annual budgetary process and budget are extremely important in the SLG governmental-type activities environment. The budget is an expression of public policy and intent. It is also a financial plan that indicates the proposed expenditures for the year and the means of financing them. Moreover, an adopted budget has the force of law. It both 1. Authorizes amounts to be expended for various specified purposes, and 2. Limits the amount that may be expended for each of those purposes.

Budgetary limitations generally cannot be exceeded without due process. Thus, the budget is both a form of control and a basis for evaluating performance in a budgetary context. Accordingly, a government must demonstrate its budgetary accountability, which entails reporting whether revenues were obtained and expended as anticipated and whether authorized expenditure limitations (appropriations) were exceeded. Establishing the budget—determining the types and amounts of taxes and other revenues to be exacted from the citizenry and how those resources will be used—is one of the most important functions that elected representatives perform. Indeed, the citizenry’s perception of a representative’s budgetary performance is a significant factor in voting decisions. Hence, the budget process is a vital part of the political process. Accountabilities The numerous environmental features discussed earlier result in distinct SLG accountabilities, which are unique both in terms of (1) to whom SLGs and their officials are accountable and (2) the focuses of their accountability. To Whom Accountable  The need for accountability exists between (1) SLGs and their constituencies, (2) SLGs and other governments, and (3) the SLG’s own legislative and executive bodies. 1. State and local governments are accountable to their constituencies for various reasons. Elected officials are empowered by citizens to act on their behalf and are evaluated by voters in part on their fiscal and budgetary performance, as well as on the perceived efficiency and effectiveness with which the SLG is operated. Thus, SLG officials must demonstrate to citizens that revenues or bond proceeds approved for specific purposes were in fact used for those purposes. 2. The SLG’s accountability to other governments arises in part because senior levels of government often have some oversight authority over lower levels of government; it also arises when other governments provide grants or other intergovernmental subsidies to the SLG. 3. Accountability between each SLG’s legislative and executive bodies focuses on demonstrating that the fund restrictions and budget contract have been complied with and that resources have been used efficiently and effectively.

Accountability Focuses  The financial reports for governmental-type activities focus on two types of accountability: fiscal accountability and operational accountability.

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16  CHAPTER 1  Governmental and Nonprofit Accounting 1. Fiscal accountability is a government’s responsibility to demonstrate its compliance with public decisions about the raising and spending of public monies in the short term.6 This accountability encompasses: • The use of financial resources from various revenue sources or bond issues in accordance with any restrictions on their use. • Compliance with fund and budget restrictions. 2. Operational accountability is a government’s responsibility to demonstrate the extent to which it has met its operating objectives and whether it can continue to meet its objectives in the foreseeable future.7 This accountability results in a government providing: • A measure of the economic costs of providing services (operating costs). • An assessment of whether a government is raising sufficient revenues each period to cover the cost of providing services (operating results). • An assessment of whether services are being provided economically and efficiently.

Reporting Issues and Problems The characteristics of the SLG general government environment also create issues and problems that must be dealt with in SLG financial reporting and/or auditing, including 1. The need to demonstrate compliance with restrictions on the use of financial resources. 2. The need for appropriate budgetary reporting. 3. The impact of restrictions on the use of financial resources (such as from intergovernmental grants) on revenue recognition. 4. The difficulty of measuring and reporting the efficiency and effectiveness of SLGs in providing services. 5. The opportunity to hide or disguise the use or availability of financial resources for various purposes by (a) improperly reporting transactions between the various SLG funds and (b) developing an inappropriate fund structure. 6. The lack of comparability that can result between financial reports of two similarly designated governments that perform different functions (which is common in SLGs). 7. The existence of taxation and debt limits. 8. The impact on materiality and reporting judgments caused by (a) overexpenditure of appropriations being a violation of law and (b) failure to follow compliance requirements related to intergovernmental revenues, possibly requiring forfeiture of such revenues or loss of future revenues.

Furthermore, financial reporting for governments must be responsive to the temptations that result because the budget process is a vital part of the political process. Elected representatives serve for relatively short terms, and officials may be tempted to employ practices that permit a budget to be technically in balance even without true budgetary equilibrium. Accordingly, to appropriately reflect the degree of budgetary equilibrium, the GASB notes that financial reporting should indicate the extent to which • Current operations were financed by nonrecurring revenues or by incurring long-term liabilities. • Certain essential costs, such as normal maintenance of government capital assets, have been deferred to future periods.

The GASB provides a more thorough discussion of the reasons for the unique characteristics of state and local governmental financial reporting in a white paper that is posted at its website (http://www.gasb.org). The white paper is titled, “Why Governmental Accounting and Financial Reporting Is—And Should Be—Different.” 6

Governmental Accounting Standards Board, Statement No. 34, “Basic Financial Statements–and Management’s Discussion and Analysis–for State and Local Governments” (Norwalk, CT: GASB, June 1999), par. 203.

7

Ibid.

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Concepts and Objectives of SLG Accounting and Financial Reporting  17

The GASB has identified the primary groups of users of external financial reports of SLGs.8 The user groups are:

Financial Report Users

1. The citizenry: those to whom the government is primarily accountable, including citizens (taxpayers, voters, service recipients), the media, advocate groups, and public finance researchers 2. Legislative and oversight bodies: those who directly represent the citizens, including members of state legislatures, county commissions, city councils, boards of trustees and school boards, and executive branch officials with oversight responsibility over other levels of government 3. Investors and creditors: those who lend or participate in the lending process, including individual and institutional investors and creditors, municipal security underwriters, bond rating agencies, bond insurers, and financial institutions

The needs of intergovernmental grantors and other users are considered by the GASB to be encompassed within those of these three primary user groups. Internal executive branch managers usually have ready access to the SLG’s financial information through internal reports and are not considered primary users of external financial reports. However, if they are without adequate access, a fourth primary user group is: 4. Government administrators: internal executive branch managers who do not have ready access to the government’s internal information

The GASB notes that financial reporting should provide information useful in making economic and political decisions and in assessing accountability by9

Financial Report Uses

1. Comparing actual financial results with the legally adopted budget. 2. Assessing financial condition and results of operations. 3. Assisting in determining compliance with finance-related laws, rules, and regulations. 4. Assisting in evaluating efficiency and effectiveness.

In contrast to SLG governmental-type activities, a government’s business-type activities

Business-Type Activities

• Provide the same types of services as private sector businesses. • Involve exchange relationships—that is, the consumer is charged a fee for services received, and there is a direct relationship between the services provided and the fee charged the consumer. • Are often separate, legally constituted, self-sufficient organizations, although some resemble governmental-type activities because they are regularly subsidized by the SLG or are operated as departments of the SLG.

The GASB contrasts the general government environmental factors discussed earlier with those for SLG business-type activities.10 The GASB discusses the differences in terms of the relationship between services received and resources provided by the consumer, revenue-producing assets, similarly designated activities and their potential for comparison, the nature of the political process, and budgets and fund accounting. The Relationship between Services Received and Resources Provided by the Consumer Business-type activities often involve a direct relationship between the charge and the service. In that relationship, termed an exchange relationship, a user fee is charged for a specific service provided, such as a toll for use of a road, a charge for water, or a fare to ride the bus. 8

GASB Codification, Appendix B, pars. 30–31.

9

Ibid., Appendix B, par. 32.

10

Ibid., Appendix B, pars. 43–50.

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18  CHAPTER 1  Governmental and Nonprofit Accounting This exchange relationship in a business-type setting causes users of financial reports to focus on measuring the costs (or financial resource outflows, or both) of providing the service, the revenues obtained from the service, and the difference between the two. The difference is particularly important because it may affect future user charges. Measurement of both the cost of services and financial resource outflows is useful. Whether one is more important than the other depends on various factors, including the way in which user charges are calculated and whether subsidies are provided by the general government. Revenue-Producing Capital Assets Most capital assets of business-type activities are revenue producing. Therefore, the incentive for business-type activities to defer needed maintenance may not be as great as for governmental-type activities. Similarly Designated Activities and Potential for Comparison The business-type activities of a government often perform only a single function. If the function is supplying water, for example, the problems, procedures, and cost elements of obtaining, treating, and delivering it are similar, regardless of whether the function is performed by a private-sector business, a public authority, an Enterprise Fund, or an activity financed by the government’s General Fund. As a result, there is normally a greater potential for comparability among business-type activities that are performing similar functions than among governmental-type activities, which vary from government to government. The Nature of the Political Process Some government business-type activities are designed to be insulated from the political process. They are not part of the general government budgetary process, they have a direct relationship between fees and services rendered, and they are separate, legally constituted agencies. In some instances, however, this insulation from the political process has less substance than appearances suggest. Indeed, especially in subsidized activities, rate setting (even by independent boards) is political in nature. For example, charging mass transit users sufficient fares to pay all costs of the system may be politically or economically undesirable, so subsidies are provided from general tax revenues or grants from other jurisdictions. If operating or capital subsidies are provided, the influences of the political process are often as significant as in governmental-type activities. Budgets and Fund Accounting Business-type organizations often perform a single function, so multiple-fund accounting is not as common as it is in governmental-type activities. The typical business-type activity is operated as a government department during the year, and budgets and budgetary controls are internal management processes and tools. Some lack the force of law, but most business-type activity budgets are legally enacted and have the force of law.

Users and Uses of Financial Reports

Several similarities and differences between the users and uses of financial reports on the SLG’s business-type activities, compared with reports covering its governmental-type activities, are noted in GASB Concepts Statement No. 1:11 • The users and uses of governmental financial reports typically are essentially the same regardless of whether the activity is business-type or governmental-type. However, the users and uses of financial reports for business-type activities may differ, depending on whether the activity reports separately or as part of a broader general government. 11

Ibid., Appendix B, pars. 51–55, adapted.

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Concepts and Objectives of SLG Accounting and Financial Reporting  19 • The uses of financial reports of business-type activities generally differ only in emphasis from the uses of financial reports of governmental-type activities. Users of separate financial reports of business-type activities are concerned primarily with the financial condition and results of operations for that activity; they are often not concerned with comparing actual results with budgeted amounts. • Investors and creditors are concerned primarily with whether the business-type activity is generating, and will continue to generate, sufficient cash to meet debt service requirements. In addition, many investors and creditors are as concerned with compliance with bond provisions by business-type activities as they are about compliance by governmental-type activities. • Citizen groups and consumers may use information on results of operations primarily to assess the reasonableness of user charges. • Legislative and oversight officials and executive branch officials review financial reports of business-type activities from the perspectives of the reasonableness of both the cash flow and the user charge. • Legislative and oversight officials also use financial reports to assess the potential need to subsidize a business-type activity with general governmental revenues or the potential to subsidize the general government with business-type activity resources. • Both citizen groups and legislative and oversight officials need information about effectiveness, economy, and efficiency, particularly because that information has an effect on user charges. • All user groups may be concerned with the relationship between the financial position and operating results of the business-type activity and that of the government as a whole— particularly­if the business-type activity is subsidized by, or subsidizes, the general government.

Financial reporting objectives set forth what SLG financial statements should accomplish. GASB Concepts Statement No. 1, “Objectives of Financial Reporting,” does not establish GAAP standards. Rather, it describes concepts that the GASB uses as a framework for evaluating present standards and practices and for establishing financial reporting standards in the future. The GASB notes that its financial reporting objectives are intended to describe broadly the nature of information needed to meet the needs of users of SLG external financial reports, giving consideration to the SLG environment. Briefly stated, the GASB concluded that accountability is the “cornerstone”—the paramount objective—of government financial reporting and that interperiod equity is a significant part of accountability. Moreover, the GASB concluded that governmental financial reporting should provide information to assist users in (1) assessing accountability and (2) making economic, social, and political decisions. Accordingly, SLG financial reporting should provide:

Financial Reporting Objectives

1. A means of demonstrating the SLG’s accountability that enables users to assess that accountability. Specifically, the information provided should a. Permit users to determine whether current-year revenues were sufficient to pay for the current year’s services and/or whether future-years’ citizens must assume burdens for services previously provided. b. Demonstrate the SLG’s budgetary accountability and compliance with other financerelated legal and contractual requirements. c. Assist users in assessing the SLG’s service efforts, costs, and accomplishments. 2. Information necessary to evaluate the SLG’s operating results for the period, including information a. About the sources and uses of financial resources. b. On how the SLG financed its activities and met its cash requirements. c. Necessary to determine whether the SLG’s financial condition improved or deteriorated during the year. 3. Information necessary to assess the level of SLG services and its ability to continue to finance its activities and meet its obligations, including

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20  CHAPTER 1  Governmental and Nonprofit Accounting a. Information about the SLG’s financial position and condition. b. Information about the SLG’s physical and other nonfinancial resources having useful lives that extend beyond the current year, including information that can be used to assess their service potential. c. Disclosure of (1) legal and contractual restrictions on the use of resources and (2) risks of potential loss of resources.12

CHARACTERISTICS OF SLG ACCOUNTING AND FINANCIAL REPORTING Learning 1.5 Objective

Fund Accounting

Some state and local government activities, such as utilities and public transportation, are similar to those of some profit-seeking enterprises. In such cases, the accounting roughly parallels that of their privately owned counterparts. In most of their operations, however, governments and nonprofit organizations are not concerned with profit measurement. (Even those SLG entities that account for revenues, expenses, and income may not seek to maximize profits, but only to ensure continuity and/or improvement of service.) Operations established primarily to generate profits, such as lotteries, are the exception in government. Accounting is a service function that must continually evolve to meet the information demands in a given environment. In the SLG environment, decisions concerning financial resource acquisition and allocation, managerial direction and control of financial resource utilization, and custodianship of financial and other resources have traditionally been framed in terms of social and political objectives and constraints rather than profitability. Legal and administrative constraints have served as society’s methods of directing its SLG institutions in achieving those objectives. Thus, SLG accounting and reporting have a strong emphasis on control of and accountability for expendable financial resources. The two most important types of legal and administrative control provisions affecting accounting in this environment are (1) the use of funds and (2) the distinctive role of the budget. Using financial resources in accordance with stipulations inherent in their receipt and reporting on this compliance to others are essential custodianship obligations. Recall that: • Many financial resources provided to SLG organizations are restricted; that is, their use is limited to specified purposes or activities. For example, a county may receive donations for a building addition; a city may borrow money to construct a sewage treatment plant; a school district may receive a federal grant for research. Such external restrictions create significant accountability. • Governing bodies and management may also constrain certain financial resources to use for specific purposes. For example, the governing body or management may wish to accumulate resources for equipment replacement or facility enlargement. Because such constraints are internal plans and may be changed by the governing body or management, some require only internal accountability.

State and local government organizations establish funds to control restricted and designated resources and to both ensure and demonstrate compliance with legal and administrative requirements. Funds are separate fiscal and accounting entities and include both cash and noncash resources—segregated according to the purposes or activities for which they are to be used—as well as related liabilities. Two basic categories of fund accounting entities are used by SLGs: 1. Governmental (expendable) funds: To account for the financial assets, related liabilities, changes in net assets, and balances that may be expended in its nonbusiness-type activities (e.g., for fire and police protection) 12

Ibid., Appendix B, pars. 77–79.

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Characteristics of SLG Accounting and Financial Reporting  21 2. Proprietary (nonexpendable) funds: To account for the revenues, expenses, assets, liabilities, and net position of its business-type activities (e.g., utilities, cafeterias, or transportation systems)13

The fund concept involves an accounting segregation—not necessarily the physical separation—of assets and liabilities; however, fund assets are often physically segregated as well, for example, through separate checking accounts for the cash of different funds. Use of the term fund in G&NP situations should be sharply distinguished from its use in private enterprise. • A fund of a commercial enterprise, such as a bond sinking fund, is simply a portion of its assets that has been restricted to specific uses, not a separate and distinct accounting entity. Revenues and expenses related to such funds are part of enterprise operations; that is, fund revenue and expense accounts appear side by side in the general ledger with other enterprise revenue and expense accounts. • A fund in the G&NP accounting sense is a self-contained accounting entity with its own asset, liability, revenue, expenditure or expense, and fund balance or net position accounts— and with its own ledger(s). (See Illustration 1–4.) • A complete set of financial statements may be prepared for each fund of an SLG organization, as well as for the organization as a whole.

ILLUSTRATION 1-4  Single Accounting Entity vs. Multiple Accounting Entities SINGLE ACCOUNTING ENTITY (Profit-Seeking Enterprise)

A = L + OE or A – L = OE

MULTIPLE ACCOUNTING ENTITIES (Government Organization)

FUND 1 A – L = FB (Expendable)

FUND 2 A – L = FB (Expendable)

FUND 3 A – L = NP (Nonexpendable)

FUND 4 A – L = FB (Expendable)

FUND 5 A – L = FB (Expendable)

FUND 6 A – L = NP (Nonexpendable)

GENERAL CAPITAL (FIXED) ASSETS

GENERAL LONG-TERM LIABILITIES (DEBT)

Legend: A = Assets—only expendable available financial assets in most expendable (governmental) funds; both current and noncurrent in nonexpendable (proprietary) funds L = Liabilities—only current (related) liabilities in most expendable (governmental) funds; both current and noncurrent in nonexpendable (proprietary) funds OE = Owners’ Equity (of the enterprise) FB = Fund Balance (expendable or governmental funds) NP = Net Position (nonexpendable or proprietary funds) = The government as a whole

13

In addition to assets and liabilities, governments report deferred outflows and deferred inflows of resources (discussed in later chapters). Net position is the title the GASB requires to refer to the residual balance of proprietary funds assets and deferred outflows less liabilities and deferred inflows. Net position also is used to refer to the corresponding amounts in the government-wide statement of net position.

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22  CHAPTER 1  Governmental and Nonprofit Accounting Budgets and Appropriations

The creation of a governmental (expendable) fund ordinarily does not carry with it the authority to expend its resources. SLG expenditures may be made only within the authority of appropriations—which are authorizations to make expenditures for specified purposes—or similar authorizations by the governing body. A fixed-dollar budget is commonly prepared for each governmental (expendable) fund. That is, the organization’s chief executive (or perhaps each department head) asks the governing body for permission to incur a specified (“fixed”) amount of expenditures (e.g., for salaries, equipment, supplies, etc.) during the budget period to carry out the department’s mission. This budget is the vehicle normally used to make and communicate financial resource allocation decisions establishing the types and quantities of goods and services to be provided during the budget period. When approved by the governing body, the budgetary expenditure estimates become binding appropriations, which both authorize expenditures for specified purposes and limit the amounts that can be expended for each specified purpose. Appropriations must indicate the fund from which the expenditure may be made and specify the purposes, the maximum amount, and the period of time for which the expenditure authority is granted. A department or activity may be financed from several funds. In such cases at least one appropriation must be made from each supporting fund to provide the requisite expenditure authority. To ensure control and demonstrate budgetary compliance, most governments establish budgetary accounts within governmental fund ledgers. This technique permits managers to determine their remaining expenditure authority at any time during the period. Fixed-dollar budgeting of governmental and/or proprietary funds often gives rise to a unique dual basis of accounting and reporting for G&NP organizations. This is because (1) GAAP prescribe specific standards for the measurement of revenues, expenditures, expenses, and other amounts reported in financial statements that “present fairly in conformity with GAAP,” but (2) for budgetary purposes, SLG governing boards may estimate revenues and authorize expenditures on a variety of non-GAAP bases, such as the cash basis. Where the budgetary basis differs from the GAAP basis: 1. The accounts are maintained on the budgetary basis during the year to effect budgetary control through the accounts, so that interim and annual budgetary statements may be prepared on the budgetary basis. 2. Adjustments are made at year end to convert the budgetary basis data in the accounts to the GAAP basis; the GAAP basis annual statements may then be prepared. 3. The differences between the budgetary basis and the GAAP basis statements are explained and reconciled in the annual financial report of the governmental organization.

Budgetary accounting and reporting are distinctive characteristics of SLG organizations, and are discussed and illustrated at numerous points throughout this text.

Other Distinguishing Characteristics

A key focus of most SLG accounting and reporting is expendable financial resources, accounted for in governmental fund entities and allocated by the budget and appropriation process. The cost measurement focus of proprietary (nonexpendable) fund accounting and of entity-wide financial reports of G&NP organizations, like that of business accounting, is expenses—the cost of assets and services consumed during the period. In contrast, the cost measurement focus of governmental (expendable) fund accounting is expenditures—the amount of net financial resources expended during the period for: • Current operations (e.g., salaries, utilities) • Capital outlay (acquiring capital assets) • Long-term debt principal retirement and interest

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Concluding Comments  23

Expenditures thus decrease net expendable available financial assets. More specifically, the term expenditures refers to “the cost of goods delivered or services rendered, whether paid or unpaid, including current operating costs, provision for retirement of debt not reported as a liability of the fund from which retired, and capital outlays.”14 Thus, expenditures—the term that is significant in expendable fund accounting—should not be confused with expenses, as defined for accounting for profit-seeking enterprises. Capital assets that are not proprietary or trust fund assets are not appropriable financial resources. Thus, they are listed and accounted for separately from the governmental fund accounting entities in a nonfund accounting entity. Similarly, unmatured long-term liabilities that are not liabilities of a particular proprietary or fiduciary fund (but of the government as a whole) are listed in a separate nonfund accounting entity. Accordingly, the cost of acquiring a capital asset is considered an expenditure (use of expendable net financial resources) in the period in which it occurs, as is the retirement of a maturing long-term liability, because both reduce the net financial assets of a governmental fund. Although commercial-type accounting and financial reporting are employed where SLG organizations are engaged in commercial-type activities (e.g., electric utilities), accounting and reporting for other SLG endeavors have evolved largely in view of these key differences from profit-seeking enterprises:

Commercial Accounting Comparison

1. Objectives: acquiring resources and expending them in a legal and appropriate manner, as opposed to seeking to increase, or even maintain, capital 2. Control: substitution of statutory, fund, and budgetary controls in the absence of the supply and demand and profit regulator/control devices inherent in profit-seeking endeavors

These factors—objectives and control—underlie the major differences between commercial and SLG accounting. The primary consideration in the SLG environment is on compliance and accountability, and SLG accounting, reporting, and auditing have developed principally as tools of compliance control and accountability demonstration.

Concluding Comments There continue to be several sources of authoritative pronouncements concerning G&NP accounting and financial reporting and several distinct subsets of GAAP applicable to the various types of G&NP organizations. This text is based on the most authoritative pronouncements relevant to each of the organizations discussed. Sources of authoritative support are cited throughout the text. Accounting is often referred to as the language of business. It is also the language of government and nonprofit organizations. Whereas most terms and their meanings are the same in both, each has some of its own terms and occasionally uses a term with a different connotation than the other. Accordingly, new terms and the occasional use of a familiar term in an unfamiliar way should be noted carefully in reviewing this and later chapters. State and local government budgeting, accounting, and financial reporting concepts, principles, standards, and procedures are discussed and illustrated in the next several chapters. Federal government accounting and reporting—and that for public sector and nonprofit hospitals, colleges and universities, and other nonprofit organizations—are discussed in later chapters, as is auditing in the G&NP organization environment. 14

Based on Committee on Governmental Accounting, Governmental Accounting, Auditing, and Financial Reporting (Chicago: Municipal Finance Officers Association of the United States and Canada, 1968), p. 160.

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24  CHAPTER 1  Governmental and Nonprofit Accounting This first chapter is designed to help you begin the transition from business to nonbusiness accounting and financial reporting. As you study and restudy this chapter, note particularly the different environmental factors, concepts, objectives, and terms (e.g., expenditures, fund balance, and net position) as well as the abbreviations and acronyms peculiar to G&NP accounting and financial reporting. The next several chapters focus on SLG accounting principles, budgeting, accounting, and financial reporting. You may find it useful to refer to this chapter as you study these and later chapters.

APPENDIX 1-1 Evolution of Accounting Principles and Standards—Prior to the GASB Although the origin of the profession of accountancy is sometimes traced to ancient governments, modern municipal accounting developed in the twentieth century, its beginning inseparably woven within the municipal reform movement near the turn of the century. About that time, attention was focused on the scandalous practices in the financial administration of many cities; the National Municipal League suggested uniform municipal reporting formats, and the U.S. Census Bureau encouraged more uniformity in city accounts and reports.

INITIAL EVOLUTION (1900 – 1933) A flurry of change in municipal accounting and reporting practices occurred during the first decade of the twentieth century. In 1901, the firm of Haskins and Sells, Certified Public Accountants, investigated the affairs of the city of Chicago at the request of the Merchants’ Club. Subsequently, the firm installed a completely new system of accounting for that city. The cities of Newton, Massachusetts, and Baltimore, Maryland, published annual reports during 1901 and 1902 along the lines suggested by the National Municipal League, and the states of New York and Massachusetts passed legislation in the areas of uniform accounting and reporting in 1904 and 1906, respectively. Many other examples of progress took place during this period as other cities and states followed suit. During this era Herman A. Metz was elected Comptroller of New York City on a “business man for the head of the city’s business office” slogan.15 At that time an estimated one-fourth of New York’s $80 million personal services budget was being lost through collusion, idleness, or inefficiency, and city departments commonly issued bonds to finance current operating expenditures. Although Metz was said to have been an outstanding comptroller, his most important contribution was the formation of the Bureau of Municipal Research. One of its purposes was “to promote the adoption of scientific methods of accounting [for] and of reporting the details of municipal business.”16 The Handbook of Municipal Accounting, commonly referred to as “The Metz Fund Handbook,” was called “the most significant contribution of the 1910 decade [because] it brought together for the first time many of the basic characteristics and requirements of municipal accounting and outlined methods of appropriate treatment.”17 Similarly, the bureau’s publications were the “first organized materials that could be called a treatise in Municipal Accounting.”18 Pamphlets, articles, and a few textbooks appeared as others became more interested in the subject. 15 Slogan from election 1905, New York City Comptroller Herman A. Metz (1867–1934) in office 1906–1909. 16

Bureau of Municipal Research, Making a Municipal Budget: Functional Accounts and Operative Statistics for the Department of Health of Greater New York (New York: BMR, 1907), 5. 17

Lloyd Morey, “Trends in Governmental Accounting,” Accounting Review, 23 (July 1948), 224.

18

W. K. Newton, “New Developments and Simplified Approaches to Municipal Accounting,” Accounting Review, 29 (October 1954), 656.

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Appendix 1-1  25

Municipal leagues were formed in various states and, as Newton expressed it, “We soon began a very serious development of the specialized field of Municipal Accounting.”19 Interest waned during the 1920s and early 1930s. In a study of Illinois cities during 1931 and 1932, W. E. Karrenbrock found that few had accounting systems adequate to segregate transactions of different activities. None had budgetary accounts coordinated within the regular accounting system.20 Writing in 1933, R. P. Hackett observed: The first fact that we are confronted with when searching for recent developments, or any developments, in governmental accounting, particularly that of municipal governments, is the marked absence of any general improvement. . . . It must be admitted that there is very little development in the actual practice of governmental and institutional accounting.21

NATIONAL COMMITTEES ON MUNICIPAL AND GOVERNMENTAL ACCOUNTING (1934 – 1974) The National Committee on Municipal Accounting was organized in 1934, under the auspices of the Municipal Finance Officers Association, to bring together representatives of various groups concerned with municipal accounting and to put into effect sound principles of accounting, budgeting, and reporting. Its membership included representatives of the American Association of University Instructors in Accounting; the American Institute of Accountants; the American Municipal Association; the American Society of Certified Public Accountants; the International City Managers’ Association; the Municipal Finance Officers Association; the National Association of Cost Accountants; the National Association of State Auditors, Controllers, and Treasurers; the National Municipal League; and the Bureau of the Census.22 Each group represented also had a subcommittee on municipal accounting within its own ranks. At its organizational meeting, the Committee tentatively adopted certain “principles” of municipal accounting and reporting and began an extensive municipal accounting research program. The Committee’s formation was hailed as “the first effort on a national scale to establish principles and standards for municipal accounting and actively promote their use.”23 It was the major event in municipal accounting until that time. Indeed, the Committee’s principles were officially recognized by the American Institute of Accountants, predecessor of the American Institute of Certified Public Accountants (AICPA).24 Numerous publications defining proper or improved municipal accounting and financial administration practices were issued by the Committee and the Municipal Finance Officers Association (MFOA) in the 1930s and 1940s. In 1948, Morey stated, There is no longer any doubt as to what constitutes good accounting, reporting, and auditing for public bodies. The work of the National Committee on Municipal Accounting in particular, in establishing standards and models in these subjects, provides an authority to which officials, accountants, and public may turn with confidence.25 19

Ibid.

20

R. P. Hackett, “Recent Developments in Governmental and Institutional Accounting,” Accounting Review, 8 (June 1933), 122. 21

Ibid., 122, 127.

22

Carl H. Chatters, “Municipal Accounting Progresses,” Certified Public Accountant, 14 (February 1934), 101.

23

Ibid.

24

American Institute of Accountants, Audits of Governmental Bodies and Accounts of Governmental Bodies (New York: AIA, 1934 and 1935). 25

Morey, “Trends in Governmental Accounting,” 231.

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26  CHAPTER 1  Governmental and Nonprofit Accounting In 1951, the Committee, by then known as the National Committee on Governmental Accounting, issued Municipal Accounting and Auditing.26 This book combined and revised the major publications of the Committee and became the basis for the major textbooks in the area, as well as for many state laws and guides relating to municipal accounting, auditing, and reporting. This “bible of municipal accounting,” as it came to be called, was succeeded in 1968 by Governmental Accounting, Auditing, and Financial Reporting (GAAFR 68), often referred to as the “blue book.”27 In 1974, the AICPA issued an audit guide, Audits of State and Local Governmental Units (ASLGU), to assist its members in the conduct of governmental audits.28 The ASLGU recognized GAAFR as authoritative and stated that, except as modified in ASLGU, the principles in GAAFR constituted generally accepted accounting principles. The National Committee on Governmental Accounting was not a staff-­ supported, permanent body that met regularly. Rather, a new committee was formed of appointees of various government agencies, public administration groups, and accounting organizations whenever deemed necessary (historically about every 10 years) and served in an advisory and review capacity for revisions proposed by its members and consultants.

NATIONAL COUNCIL ON GOVERNMENTAL ACCOUNTING (1974 – 1984) The National Council on Governmental Accounting (NCGA) succeeded the National Committee on Governmental Accounting in 1974. The MFOA—now the Government Finance Officers Association (GFOA)—established the NCGA as an ongoing body to reconcile the differences between GAAFR and ASLGU and continually evaluate and develop state and local government accounting principles. The Council consisted of 21 members who served four-year terms on a parttime, voluntary basis and met for about two days, two to four times each year. The NCGA maintained close liaison with the Financial Accounting Standards Board (FASB), the AICPA, and other organizations concerned with state and local government accounting and financial reporting standards. The NCGA’s major agenda project, called the GAAFR Restatement Project, was to develop a statement described as “a modest revision to update, clarify, amplify, and reorder GAAFR.” An important related objective was to incorporate pertinent aspects of ASLGU and reconcile any significant differences between GAAFR and ASLGU. NCGA Statement 1, “Governmental Accounting and Financial Reporting Principles,” commonly known as the GAAFR Restatement Principles, was issued in 1979. The GAAFR–ASLGU differences had been reconciled during the principles restatement. Accordingly, the AICPA issued a statement of position in 1980 (SOP 80–2),29 amending ASLGU to incorporate NCGA Statement 1 by reference and provide additional guidance to auditors of state and local government financial statements. The NCGA issued seven Statements, eleven Interpretations, and one Concepts Statement during its 1974–1984 tenure. Its early years coincided with a turbulent period marked by the fiscal emergency of New York City and by similar financial problems, including debt defaults, in several other major cities and school districts. These crises led to demands that the NCGA issue additional accounting standards. 26

Published by the Municipal Finance Officers Association (Chicago, 1951).

27

Published by the Municipal Finance Officers Association (Chicago, 1968), hereafter cited as GAAFR (68).

28

Committee on Governmental Accounting and Auditing, American Institute of Certified Public Accountants, Audits of State and Local Governmental Units (New York: AICPA, 1974). 29

Audit Standards Division, American Institute of Certified Public Accountants, Inc., Statement of Position 80–2, “Accounting and Financial Reporting by Governmental Units” (New York: AICPA, June 30, 1980).

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Exercises  27

But the NCGA’s efforts to provide timely guidance were hampered by the fact that its members served part time, at no pay, and had limited staff support. Thus, leaders of the accounting profession, including members of the NCGA, sought to devise an improved approach to setting accounting standards applicable to state and local governments. Their efforts led to the creation of the Governmental Accounting Standards Board (GASB) in 1984 to succeed the NCGA, as discussed earlier in this chapter.

Questions Q1-1 Discuss (a) the similarities in accounting for profit-seeking and G&NP organizations, and (b) the unique aspects of accounting for G&NP organizations designed to help ensure compliance with budgeted spending limits. Q1-2 (a) Define fund as used in government organizations. (b) Contrast that definition with the same term as used in a profit-seeking organization. (c) Does the creation of a fund constitute authority to spend or obligate its resources? Explain. Q1-3 Distinguish between governmental (expendable) funds and proprietary (nonexpendable) funds. Q1-4 Contrast the terms expense and expenditure. Q1-5 It was noted in this chapter that most of the differences between commercial accounting and accounting for G&NP organizations result from differences in (a) organizational objectives, (b) sources of financial resources, and (c) methods of evaluating performance and operating results. Explain. Q1-6 Discuss the roles of the GASB and the FASB in standards setting for G&NP organizations. Q1-7 The revenues of profit-seeking organizations are based on user charges. Users may be charged for various services provided by G&NP organizations as well. However, the nature and purpose of user charges of G&NP organizations and those of profit-seeking organizations often differ. Explain. Q1-8 Different sets of accounting and reporting concepts, principles, and standards have evolved for state and local governments, nonprofit organizations, and business enterprises. Given the differences between and among them, how can they all be considered “generally accepted accounting principles”? Q1-9 (a) What is the purpose of the GASB’s GAAP hierarchy guidelines? (b) How would an accountant or auditor use the hierarchy if the guidance given in a GASB statement and an AICPA audit and accounting guide regarding the proper accounting treatment of a state government transaction or event conflict? Q1-10 How can one determine whether a specific not-for-profit organization should follow GASB guidance? FASB guidance?

Exercises E1-1 (Multiple Choice) Identify the best answer for each of the following:

1. The body with primary accounting standards-setting authority for state and local governments is the a. American Institute of Certified Public Accountants. b. Financial Accounting Standards Board. c. Government Finance Officers Association. d. Governmental Accounting Standards Board. 2. The body with primary accounting standards-setting authority for colleges and universities is the a. National Association of College and University Business Officers. b. Financial Accounting Standards Board. c. Governmental Accounting Standards Board. d. Governmental Accounting Standards Board for governmental colleges and universities and the Financial Accounting Standards Board for all other colleges and universities. 3. A governmental (expendable) fund accounting entity a. is often useful in accounting for general government activities but is optional (expendable). b. includes only financial assets and related liabilities and depreciable (expendable) capital assets. Nondepreciable capital assets are not reported in governmental funds.

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28  CHAPTER 1  Governmental and Nonprofit Accounting c. includes financial assets and related liabilities. d. has its operating activities measured and reported in terms of revenues and expenses, but the timing of expense recognition differs from that in similar business organizations. 4. In which of the following situations would the amounts of expense and expenditure for the period differ? a. An entity uses and is billed for utilities but has paid only half of the amount billed at year end. b. An entity purchases equipment for cash. The purchase occurred on the last day of the fiscal year. c. Salaries and wages incurred and paid during the period were $100,000. Additional salaries and wages accrued at year end were $4,000. d. The amount of expense and expenditure to be recognized differs in more than one of these situations. 5. Legally adopted budgets of governmental funds are a. fixed-dollar budgets, which establish expenditure limits that are not to be exceeded. b. fixed budgets that cannot be modified during the budget year. c. flexible budgets in which the expenditure limits are automatically modified to reflect larger than budgeted levels of various services. d. always adopted using the same basis of accounting required by GAAP. 6. Which of the following statements is false? A fund a. is an entity for which financial statements can be prepared. b. has a self-encompassing, self-balancing accounting equation. c. is used to account for a subset of an organization’s resources that is to be used for a specific purpose or to achieve a particular objective. d. is an accounting entity that is used for one year only. Each year a new set of funds must be established. 7. Which of the following pronouncements provides the most authoritative guidance applicable to financial reporting for state and local governments? a. FASB Accounting Standards Codification b. GASB Technical Bulletins c. The AICPA government audit guide d. GASB Statements of Governmental Accounting Standards. 8. One unique characteristic of most government and nonprofit organizations is that a. a primary source of financing is sales of services and goods to customers. b. their constituency automatically dictates what the government’s or nonprofit organization’s resources are (to be) used to accomplish. c. there is no direct relationship between the amount of goods or services that most resource providers receive and the amount of resources provided by each individual. d. these entities sometimes have restrictions placed on what their resources may be used for, whereas such restrictions cannot be placed on business resources. 9. Organizations that are considered to be nonprofit typically include all of the following except: a. Churches b. The Boy Scouts and Girl Scouts c. Semi-professional baseball teams d. State CPA societies 10. Which of the following statements is true? a. Governmental and nonprofit organizations never operate with a profit motive. b. Businesses have scarce resources that must be allocated to different uses; governments and nonprofits are able to command sufficient resources to avoid the need for such allocations. c. Typically, governmental and nonprofit organizations have more restricted resources than do business entities. d. Nonprofit organizations never use fund accounting. E1-2 (Expenditures vs. Expenses) Family Services, a small social service nonprofit agency, began operations on January 1, 20X1, with $40,000 cash and $150,000 worth of equipment, on which $60,000 was owed on a note to City Bank. The equipment was expected to have a remaining useful life of 15 years with no salvage value. During its first year of operations, ending December 31, 20X1, Family Services paid or accrued the following: 1. Salaries and other personnel costs, $100,000. 2. Rent and utilities, $24,000. 3. Debt service: interest, $5,500, and payment on long-term note principal, $10,000. 4. Capital outlay: additional equipment purchased January 3, $30,000, expected to last 6 years and have a $6,000 salvage value. 5. Other current operating items paid with cash, $4,500. There were no prepayals or unrecorded accruals at December 31, 20X1, and no additional debt was incurred during the year.

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Problems  29 Compute for the Family Services agency, for the year ended December 31, 20X1, its total (a) expenses and (b) expenditures.

Required

Problems P1-1 (Statement of Revenues and Expenditures—Worksheet) Hatcher Township prepares its

annual General Fund budget on the cash basis and maintains its accounting records on the cash basis during the year. At the end of Hatcher Township’s 20X9 calendar year, you determine the following: Budget (Cash) Basis General Fund

Accruals

Budget

Actual

1/1/X9

12/31/X9

 Taxes.......................................

$600,000

$595,000

$   –

$ 6,000

 Licenses..................................

200,000

206,000

–

–

 Intergovernmental................

100,000

110,000

9,000

1,000

Revenues:

50,000

45,000

5,000

  –

950,000

956,000

14,000

7,000

 Salaries...................................

700,000

704,000

17,000

11,000

 Utilities...................................

80,000

85,000

–

–

 Other...................................... Expenditures:

 Supplies..................................

70,000

64,000

–

7,000

 Equipment.............................

60,000

58,000

2,000

12,000

 Other......................................

30,000

31,000

  –

  –

940,000

942,000

$19,000

$30,000

$ 10,000

$ 14,000

Excess of Revenues Over   (Under) Expenditures..........

1. Prepare a worksheet to derive a GAAP basis (including accruals) statement of revenues and expenditures for the Hatcher Township General Fund for the 20X9 fiscal year. 2. Could the readers of the budgetary basis and GAAP basis statements get different ­impressions of the 20X9 operating results of the Hatcher Township General Fund? Explain. P1-2 (SLG GAAP Hierarchy) Mark O. Sleuth, a recent accounting graduate, has been assigned to research several local governmental accounting and financial reporting issues. For each issue, rank the sources of guidance according to the governmental GAAP hierarchy. 1. Issue 1: The AICPA state and local government (SLG) Audit and Accounting Guide, a GASB Technical Bulletin, a leading governmental accounting textbook, a GASB Interpretation, and a section of the FASB Accounting Standards Codification 2. Issue 2: A leading governmental accounting textbook, a GASB Implementation Guide, an article in a leading auditing journal, and a speech by a leading governmental accounting professor 3. Issue 3: The AICPA SLG Audit and Accounting Guide, a GASB Statement, a journal article that summarizes current practice on the issue in the United States, notes from a telephone conversation on the issue with the GASB director of research, and a FASB Accounting Standards Update 4. Issue 4: An AICPA Statement of Position (cleared by the GASB), an article by the managing partner of an international public accounting firm, a GASB Technical Bulletin, and the FASB Accounting Standards Codification 5. Issue 5: GASB Implementation Guide 2015-1, the AICPA SLG Audit and Accounting Guide, four articles from the Journal of Accountancy, and a leading governmental accounting textbook 6. Issue 6: A predominant practice, Statement of Governmental Accounting Concepts, an AICPA Statement of Position not included in Level b

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30  CHAPTER 1  Governmental and Nonprofit Accounting P1-3 (Internet Research Problem) Locate the homepages for the following organizations and

prepare a brief critique (one to three pages, perhaps with attachments) of the contents of each site: 1. Governmental Accounting Standards Board 2. Financial Accounting Standards Board 3. American Institute of Certified Public Accountants 4. Government Finance Officers Association 5. Association of Government Accountants 6. National Association of State Auditors, Comptrollers, and Treasurers 7. National Association of College and University Business Officers 8. Association of School Business Officials International P1-4 (Internet Research Problem) Locate the GASB white paper, “Why Governmental Accounting and Financial Reporting Is—And Should Be—Different,” on the Governmental Accounting Standards Board website. Prepare a brief summary and critical analysis of the white paper.

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State and Local Government Accounting and Financial Reporting Model

CHAPTER

2

The Foundation

LEARNING OBJECTIVES After studying this chapter, you should be able to: 2.1 Visualize, summarize, and discuss the major overall aspects of the GASB state and local government financial reporting model, including the dual perspective of government-wide and fund financial statements. 2.2 Explain the fundamental features of the state and local government accounting and financial reporting model, including: • Distinguishing the three broad categories of funds—governmental, proprietary, and fiduciary— and the specific types of funds in each fund category.

• Identifying and explaining the measurement focus and basis of accounting used for each category of funds and the financial statements required for funds of each category. • Analyzing the effects of transactions on the proprietary fund and governmental fund categories and on the General Capital Assets and General Long-Term Liabilities accounts. • Identifying typical budgetary accounting and reporting requirements. • Explaining the financial reporting requirements for a government’s basic financial statements and its comprehensive annual financial report.

S

tate and local government is truly “big business.” The 50 states and 90,000 local governments within the United States employ nearly 20 million p ­ ersons— more than seven times the federal government civilian e­ mployment—and spend more than $3.3 trillion annually. Although the federal government accounts for over half of all government expenditures, state and local governments spend more for nondefense purposes than does the federal government. Furthermore, state and local government revenues, expenditures, debt, and employment—both total and per capita—have been increasing in recent years. Today the state government often is the largest industry within a state, and city hall often houses the ­biggest business in a town. The types and numbers of local governments are shown in Illustration 2-1. However, the extent of local government jurisdictional overlap is not obvious from that listing. It is common for a given geographic area to be served by a municipality, a school district, a county, and one or more special districts. In fact, many metropolitan areas have 100 or more separate and distinct local government units.

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