Fund Accounting Part II Questions and Answers
In the Question and Answer segment of Webcast on Fund Accounting Part II on July 30th, we responded to the questions submitted. However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.
Q: Are the numbers on page 84 of the West Linn, Oregon, comprehensive financial report fiscal year-end numbers or amounts due at the end of 2008?
A: The amounts listed in the June 30, 2007 column were the amounts of uncollected property taxes as of June 30, 2007. The amounts listed in the June 30, 2008 column were the amounts of uncollected property taxes as of June 30, 2008. For example, at June 30, 2007, the amount of uncollected property taxes for the 2006/2007 fiscal year was $250,415. Yet over the following year – the time span from June 30, 2007, to June 30, 2008, that balance was worked down to $76,804. That is, the City of West Linn collected $173,611 of fiscal year 2007 property taxes due and payable in its 2008 fiscal year.
Q: What was the major change from 2006 to 2007 in primary government net assets on page 91? The amount increased from about $53MM to $280MM.
A: The City of West Linn added some fixed assets during the year, but the massive increase reflects an extensive revaluation of its fixed assets as a footnote to its 2008 comprehensive financial report indicates. Presumably, such revaluation is allowed under GASB.
Q: Would you please remind us of possible events that would cause negative unrestricted funds and the analytical implications of those situations?
A: Negative unrestricted funds means that the amount of net funds – the difference between assets and liabilities – is less than the amount of restrictions attached to revenues and contributions. In other words, the organization was unable to control expenses relative to revenue sources in such a manner that it net assets exceeded the amount of restriction placed on revenues and contributions. It was compelled, in effect, to use more revenue to satisfy expenses than it had pledged to use.
With respect to future operations, a negative unrestricted fund balance implies that the organization will be compelled to take some action – such as increasing taxes – to eliminate the negative unrestricted fund balance.
Q: For a municipality or for a not-for-profit, do you use a different debt service coverage ratio (DSCR) than for a commercial business? For example, if you used a DSCR of 1.20 for a commercial business, would you use a different DSCR for a municipality or not-for-profit organization?
A: With respect to a proper DSCR, I think there are two issues that should determine the risk factor, i.e., the spread over 1.00.
Setting an appropriate DSCR is a very inexact science. 1.20 seems a very reasonable base.
With respect to converting available profit to cash, it seems the conversion risk would be higher for a not-for-profit organization (NPO), since an NPO uses standard accrual accounting in reporting its results, than for a governmental entity reporting under fund accounting. The fund accounting operating statement is virtually identical to a cash flow statement. Therefore, there is little risk of conversion. However, keep in mind that the business enterprises within a governmental entity report on an accrual basis, which would argue for a larger DSCR.
With respect to achieving expectations, it seems that the most difficult to anticipate would be NPO revenues and available debt service in bad times, since so much of their revenue stream depends on contributions and grants. The latter tend to shrink dramatically when economic conditions turn.
The same is basically true for governmental entities. Tax collections fall and state and federal grants to municipalities, for example, are under great downward pressure. But since governmental entities are so dependent on outside financing, they are compelled to reduce all other expense streams to assure sufficient cash resources to meet interest-bearing debt service.
Because of the inherent uncertainty about future revenue streams and debt service resources for NPOs and governmental entities, it seems prudent to set a higher DSCR for both sets of borrowers.
Q: What do you feel is the greatest risk in lending to a municipality, and what is the best way to identify and assess that risk?
A: The most pressing risk is usually whether the municipality can control or reduce all non-debt service expenses, e.g., wages, salaries, and benefits, sufficiently to have the cash resources available to service interest-bearing debt. The following is one sequential approach to assessing risk:
Q: Are the numbers on page 84 of the West Linn, Oregon, comprehensive financial report fiscal year-end numbers or amounts due at the end of 2008?
A: The amounts listed in the June 30, 2007 column were the amounts of uncollected property taxes as of June 30, 2007. The amounts listed in the June 30, 2008 column were the amounts of uncollected property taxes as of June 30, 2008. For example, at June 30, 2007, the amount of uncollected property taxes for the 2006/2007 fiscal year was $250,415. Yet over the following year – the time span from June 30, 2007, to June 30, 2008, that balance was worked down to $76,804. That is, the City of West Linn collected $173,611 of fiscal year 2007 property taxes due and payable in its 2008 fiscal year.
Q: What was the major change from 2006 to 2007 in primary government net assets on page 91? The amount increased from about $53MM to $280MM.
A: The City of West Linn added some fixed assets during the year, but the massive increase reflects an extensive revaluation of its fixed assets as a footnote to its 2008 comprehensive financial report indicates. Presumably, such revaluation is allowed under GASB.
Q: Would you please remind us of possible events that would cause negative unrestricted funds and the analytical implications of those situations?
A: Negative unrestricted funds means that the amount of net funds – the difference between assets and liabilities – is less than the amount of restrictions attached to revenues and contributions. In other words, the organization was unable to control expenses relative to revenue sources in such a manner that it net assets exceeded the amount of restriction placed on revenues and contributions. It was compelled, in effect, to use more revenue to satisfy expenses than it had pledged to use.
With respect to future operations, a negative unrestricted fund balance implies that the organization will be compelled to take some action – such as increasing taxes – to eliminate the negative unrestricted fund balance.
Q: For a municipality or for a not-for-profit, do you use a different debt service coverage ratio (DSCR) than for a commercial business? For example, if you used a DSCR of 1.20 for a commercial business, would you use a different DSCR for a municipality or not-for-profit organization?
A: With respect to a proper DSCR, I think there are two issues that should determine the risk factor, i.e., the spread over 1.00.
- The first is the risk that not all reported profit, adjusted for the sum of distributions and loans to owners, would be fully converted to cash. For example, if the lender were 100% certain that all reported profit, after adjustments, will be converted to cash, then a DSCR of 1.00 will suffice, i.e., so long as the borrower meets the 1.00 DSCR, it will have sufficient cash flow from business operations to properly service its interest –bearing debt. But the greater the risk of fully converting adjusted profit to cash, then the higher the appropriate DSCR, e.g., 1.20, or 1.35, or 1.50, etc.
- The second is the risk that profit available for debt service will fall below expectations. Consequently, the risk then determines the maximum amount of interest-bearing debt – and, therefore, the maximum amount of interest-bearing debt service – the lender is willing to provide.
Setting an appropriate DSCR is a very inexact science. 1.20 seems a very reasonable base.
With respect to converting available profit to cash, it seems the conversion risk would be higher for a not-for-profit organization (NPO), since an NPO uses standard accrual accounting in reporting its results, than for a governmental entity reporting under fund accounting. The fund accounting operating statement is virtually identical to a cash flow statement. Therefore, there is little risk of conversion. However, keep in mind that the business enterprises within a governmental entity report on an accrual basis, which would argue for a larger DSCR.
With respect to achieving expectations, it seems that the most difficult to anticipate would be NPO revenues and available debt service in bad times, since so much of their revenue stream depends on contributions and grants. The latter tend to shrink dramatically when economic conditions turn.
The same is basically true for governmental entities. Tax collections fall and state and federal grants to municipalities, for example, are under great downward pressure. But since governmental entities are so dependent on outside financing, they are compelled to reduce all other expense streams to assure sufficient cash resources to meet interest-bearing debt service.
Because of the inherent uncertainty about future revenue streams and debt service resources for NPOs and governmental entities, it seems prudent to set a higher DSCR for both sets of borrowers.
Q: What do you feel is the greatest risk in lending to a municipality, and what is the best way to identify and assess that risk?
A: The most pressing risk is usually whether the municipality can control or reduce all non-debt service expenses, e.g., wages, salaries, and benefits, sufficiently to have the cash resources available to service interest-bearing debt. The following is one sequential approach to assessing risk:
- Check total and partial change in net assets, i.e., enterprise-wide vs. governmental activities and business activities. If you lend only to general fund, in effect, focus primarily on developments in the general fund and governmental activities.
- Identify why change occurred, i.e., increase or decrease in tax collections, increase or decrease in grants and contributions, increase or decrease in transfers, increase or decrease in expenses. Follow usual income statement assessment.
- Check liquidity position via unrestricted or undesignated funds measured against non-capital asset expenses. We would like to see around 20%. Repeat for business activities if you buy revenue bonds but focus on debt coverage. May be hard to dig out.
- Identify pending debt service obligations. Can get the current maturities from the enterprise-wide balance sheet. Can project interest expense, given the level of outstanding debt.
- Dig into background information via the statistical section, e.g., movements in tax collections, changes in tax base, employment trends, indebtedness per capita, changes in municipal employees, and so on. Search for any local information about inflexible operating expenses, e.g., strong union opposition to changes in salaries and benefits. Check unfunded liabilities for pensions and benefits.
